“Punishing Every Small Violation . . . Means Casting Discretion Aside in Favor of Making the SEC Look Tough.”

May 21, 2018

The weekly news source for investment management legal and compliance professionals

“Punishing every small violation . . . means casting discretion aside in favor of making the SEC look tough.”

SEC Should Not Prioritize Enforcement Over Other Parts of its Mission: Peirce SEC enforcement is important and must continue, but has gone too far. While enforcement is necessary, agency staff should use it as a last resort and rein in the kind of Inside Insights enforcement-by-numbers philosophy that the SEC has been using over the past few 8 Note to Readers years.

Those are the views of commissioner Hester Peirce, who spoke8 May 11 in Denver on why she sometimes votes “no” on approving enforcement actions brought by the Division of Enforcement. She cited an article in Bloomberg Law which she said noted continued on page 2

Hedge Fund Adviser Execs May Face Personal Fines if They Ignore Red Flags A chief financial officer at a hedge fund advisory firm on May 8 settled8 SEC charges that he failed to act on red flags involving asset mismarking and insider trading. The firm ended up paying more than $10 million, and the CFO agreed to separately pay a $100,000 fine. The lesson: Advisory firm executives need to be on the lookout for signs of fraud, and act on them when they find them.

What happened, according to the SEC, was that two portfolio managers of New York City-based Visium Asset Management, a SEC-registered hedge fund adviser with continued on page 4

Technology: IAA Urges Treasury to Recommend a Principles-Based Approach As new technologies and networks proliferate among advisory firms and other non-bank financial institutions, many will require regulation, but will that regulation encourage innovation, or stifle it? The Investment Adviser Association, in a recent letter8 to the Department of the Treasury, urged the Department to support innovation by recommending and encouraging regulators to adopt regulations that are principles-based.

Principles-based regulations generally avoid the prescriptive instructions that many continued on page 6 SEC Should Not “When I believe that we ought not [emphasis Peirce] to continued from page 1 have spent our Enforcement Division’s time and effort on a matter, I am likely to vote against it,” she said. that she casts a “no” vote 15 percent of time, a higher rate than any other commissioner. Cleary Gottlieb partner and former SEC chief litigation counsel Matthew Solomon said that Peirce’s comments “The SEC is not an enforcement agency, but enforce- about a more calibrated approach to enforcement in ment is an important tool for the SEC,” she said, noting view of resource constraints “is no surprise – they mir- that the Enforcement Division is currently the largest of ror statements made by Enforcement Division leader- the divisions and offices within the agency, with more ship which presumably reflect the chairman’s views. than 1,100 personnel. Enforcement, however, should be But she also noted that the vast majority of enforcement viewed as part of the SEC, and “properly calibrated” actions win unanimous Commission approval, and that into “part of the regulatory framework within which our the Enforcement Division plays a critical role in the capital markets operate. . . . To appropriately calibrate Commission’s overall mission.” our enforcement program, we must spend our limited enforcement resources wisely.” No more broken windows Peirce also used her comments to urge the Commission In terms of more recent history, Peirce advocated a to tread carefully when considering whether to impose rollback of former SEC chair Mary Jo White’s “broken liability on chief compliance officers. “CCOs advocate windows” approach to enforcement, although she did for compliance at registered entities,” she said. “They not mention her name. Under “broken windows,” the implement and update compliance programs. They agency investigated and prosecuted small violations, monitor for violations. We need to empower them, not as well as large. dissuade them from taking the jobs in the first place.” “In the past, we sometimes have taken a less What Peirce’s speech, as well as SEC chairman Jay resource-conscious approach – a more-is-always- Clayton’s stated goal of prioritizing capital formation, better approach,” Peirce said. “From 2013 to 2016, for represents is a “swing of the pendulum back to how example, the SEC embraced a ‘broken windows’ phi- the SEC operated prior to the Bernie Madoff problem,” losophy of enforcement. . . . Punishing every small said Buckley Sandler partner and former SEC Office of violation, however, means casting discretion aside in Market Intelligence chief Thomas Sporkin. “She comes favor of making the SEC look tough. Violations are not from the same school as former agency commission- all equally serious.” She noted Piwowar’s past state- ers Paul Atkins and Daniel Gallagher, as well as current ment that “if every rule is a priority, then no rule is a commissioner Michael Piwowar, which is to pull back priority.” from the overly aggressive enforcement approach em- Peirce suggested that, during this time, “perhaps the ployed by the SEC since Madoff and the 2008 financial SEC should have changed its name to the ‘Sanctions’ crisis and turn the SEC back into a regulatory and capital and Exchange Commission, because it acted like a formation agency.” branch of the U.S. Attorney’s Office for the Southern “As I consider enforcement matters before the District of New York.” That U.S. Attorney’s Office, Commission, one of the things I think about is wheth- coincidentally – or perhaps not-so-coincidentally – was er we are using our enforcement resources wisely,” the Office White headed as U.S. attorney. “Maybe this Peirce said. “Was there a meaningful violation? Is this approach is natural for a prosecutor, although in the a matter that could have been handled by OCIE or that criminal context, discretion is important too,” Peirce another foreign or domestic authority is already han- continued. dling? Would a rulemaking, an interpretive release, or She then listed five “major problems” that she said an investor alert be a more appropriate response to an occur with “an enforcement philosophy that pursues issue?”

ACA Insight 2 minor violations with the same vigor as it does major number of enforcement actions is likely to be high. A violations:” key metric to gauge success becomes the number of enforcement actions. By holding up raw numbers as 1. Diverts resources from high priority issues. “The the measure of success, the broken-window era SEC unsurprising result of the broken windows approach felt pressure to excel its previous year’s enforcement – one that aligned perfectly with our metrics of choice actions. It was an arms race as our lawyers rushed to – was that the SEC brought a lot of enforcement settle a case or sprint to the courthouse – or the admin- actions with lots of penalties,” Peirce said. “But the istrative law judge – to file the next action, especially end goal is better functioning markets and investor as the SEC’s fiscal year end neared: our own version of protection.” earnings management.” 2. Discourages contact with the SEC. “An enforce- She noted that in 2013, the agency brought 686 enforcement-first approach sends the message to regulated ment actions with monetary sanctions of $3.4 billion. entities and others that picking up the telephone to Of these, however, 132 involved what she described ask the SEC a question about how to comply is risky,” as “simple filing matters, in which a company was she said. “Why draw attention to yourself by asking deregistered for being delinquent in their Commission a compliance question of an agency that thinks every filings.” foot fault is enforcement-worthy?” “Deregistering delinquent filers is important, but giving 3. Provides bad incentives for Commission staff. “It these types of matters the same weight as a complex rewards enforcement staff for the number, rather accounting fraud in a count of enforcement actions is than the quality of cases,” Peirce said. “It nudges misleading,” Peirce said. staff to recommend charging some violation [emphasis Peirce] – even a minor one – rather than clos- In 2016, the final year of “broken windows,” the SEC ing an investigation without bringing an enforcement brought 868 enforcement actions with monetary sanc- action.” tions of $4 billion, she said.

4. Contributes to an unhealthy capital formation en- “Again, though, we have to delve deeper into the vironment. “Companies considering an initial public numbers to understand what happened. Of these 868 offering (IPO) have one more reason not [emphasis enforcement actions, 404 actions – 47 percent – Peirce] to conduct an IPO,” she said. “Why should resulted from the following: first, ‘follow-on’ adminis- companies expose themselves to a potential enforce- trative proceedings seeking bars based on the outcome ment action based on a slight misstep in complying of Commission actions or actions by criminal authori- with the extensive public company ruleset?” ties; second, proceedings to deregister public companies that were delinquent in their Commission filings; 5. Imposes unwarranted costs on companies and indi- and third, actions brought as part of the Commission’s viduals. “The effects of an investigation or proceed- voluntary, self-reporting program that targeted mis- ing on a private party can be devastating,” Peirce statements and omissions in municipal bond offering said. She quoted from the SEC’s canon of ethics: documents.” “’The power to investigate carries with it the power to defame and destroy.’ This price is too high for vio- Today is different, Peirce said, with the SEC “no longer lations that are minor.” measuring its success by tallying up enforcement statis- tics.” The agency instead is “making a more concerted The numbers game effort to bring only meaningful enforcement “An enforcement program that pursues every minor actions . . . focusing its resources on key areas of con- violation might appear, at first glance, to be a success- cern, such as the protection of retail investors and ful one,” Peirce said. “Under such an approach, the raw cybersecurity.” d

ACA Insight 3 Hedge Fund Adviser Execs ing scheme (see below), according to the settlement continued from page 1 order. more than $7.8 billion in assets under management, A question of supervision inflated the value of securities held by its funds. This Where was Visium management while these activities caused the funds to falsely inflate their returns, over- were going on? According to the agency, the advisory state their aggregate net asset value, and pay approxi- firm’s CFO, Steven Ku, “failed reasonably to super- mately $3.15 million in excess fees to Visium, the agen- vise two portfolio managers, Christopher Plaford and cy said. Stefan Lumiere, by failing to respond appropriately to As for the insider trading allegations, the SEC charged red flags that should have alerted Ku to their miscon- that certain Visium portfolio managers traded in the duct.” The red flags cited by the SEC included the fre- securities of pharmaceutical companies in advance quency with which the portfolio managers used price of two generic drug approvals by the Food and Drug overrides and the fact that the overrides almost always Administration. “The trades were based on confidential resulted in higher valuations for the Credit Fund. information received from a former FDA official work- Despite these and other red flags named in Ku’s settle- ing as a paid consultant to Visium,” the agency said. ment order, “Ku failed to take appropriate action to In addition, according to the SEC’s separate settlement determine whether an employee under his supervision order8 with Visium, “trades were also made in the was engaged in unlawful conduct and failed to take rea- securities of home healthcare providers in advance of a sonable steps to prevent violations of the federal securi- proposed cut to certain Medicare reimbursement rates ties laws,” the agency said. “On several occasions, Ku by the Centers for Medicare and Medicaid Services asked Plaford about the valuations, but each time Ku (CMS),” this time based on confidential information simply accepted as true Plaford’s false representations obtained from a former CMS employee now working as that the override quotations were reliable because they a Visium paid consultant. were obtained from broker-dealers who made markets in the particular distressed securities. Ku failed to take “The SEC will always be interested in fraudulent mis- appropriate steps to verify the reliability or indepen- marking by entities and their employees, particularly in a dence of the brokers or quotes Plaford and Lumiere manner that allows for millions of dollars in ‘fraudulent’ used to support Visium’s price overrides for the securi- fees,” said Mayer Brown partner Richard Rosenfeld. ties at issue.” Two Visium funds were involved in these settlements. “Advisory firms must create a culture of zero tolerance One was the Visium Credit Master Fund, which the when it comes to unlawful conduct, and supervisors at adviser launched in May 2009 for investing primarily those firms must take reasonable measures necessary in high risk and at times thinly traded corporate debt to detect and prevent securities law-related violations instruments issued by health care companies. by their personnel,” said SEC New York Regional Office According to the settlement order, the Credit Fund, over director Marc Berger. its life, raised approximately $600 million in investor capital. “From May 2009 to June 2013, the fund report- Behind supervisory liability ed positive returns in 44 of 50 months,” the SEC said, noting that at its peak, in March 2012, it had more than “This is yet another example of the SEC pursuing super- $471 million in net assets. However, in 2013, following a visory liability claims based on the alleged misconduct string of redemption requests, Visium closed the fund of certain rogue employees,” said Paul Hastings partner and began liquidating its assets. John Nowak. “With the apparent benefit of 20/20 hind- sight, the agency examined the policies and practices of The other fund, the Visium Balanced Master Fund, was the adviser in the context of the perceived misconduct involved, along with the Credit Fund, in the insider trad- by the rogue employees and identified alleged incon-

ACA Insight 4 sistencies between the adviser’s internal practices and Visium did not respond to a voice message or an email its own policies.” seeking comment.

“This case should act as a reminder to compliance Plaford and Lumiere were not charged in the May 8 counsel and fund personnel to periodically review writ- complaint, having been charged, along with a former ten procedures and disclosures to ensure that the prac- FDA official, by the SEC in a June 2016 enforcement tices of the adviser are in conformity with written poli- action (ACA Insight, 6/20/168). Lumiere was barred cies and procedures, and to update and amend written from the securities industry by the agency earlier this policies and procedures as the business activities of the year, based on a final judgment in the SEC’s case, as adviser change,” he said. well as his conviction in a parallel criminal case, the agency said. The SEC’s case against Plaford, mean- “Defending an SEC investigation is trickier if a firm fails while, has been stayed pending the completion of a par- to comply with its own procedures,” said Bell Nunnally allel criminal case against him, according to the agency. partner Robert Long. “Accordingly, a firm’s procedures need to be tailored, but realistic so they can be Mismarking allegations followed.” “From at least July 2011 to December 2012, Plaford “Advisers should also be aware that the SEC will be an and Lumiere repeatedly obtained sham broker quotes armchair quarterback when it finds ‘red flags,’” he said. to inflate falsely the value of certain securities held by “That’s a luxury that firm officers and compliance per- the Credit Fund, the fund’s reported NAV, and its personnel don’t have. They need to be vigilant.” formance,” the SEC said. “The sham quotes were used to override available prices from established pricing “The facts cited by the agency staff include informa- sources that the Credit Fund’s independent administration designed to show that Ku should have known about tor otherwise should have used when striking the fund’s the fraudulent conduct, including Ku receiving reports month-end NAV, to price securities held by the fund.” that showed Visium’s valuations to be significantly They were also used to price securities at month-end higher than the same valuation in a separately managed at times when the independent administrator did not account,” said Rosenfeld. “The action taken against provide Visium with available prices from established the individual supervisor here shows how serious the pricing sources, the agency said. SEC regards supervision and its place in the regulatory framework. On the heels of the settlement8 with The quotes were allegedly procured from one or more Wedbush Securities earlier this year, the Commission of three friendly outside brokers at three different reg- is sending a strong reminder to the industry that super- istered brokerage firms. “To make the sham quotes visors must take their responsibilities seriously, or risk appear to be legitimate quotes from independent out- significant SEC action.” side brokers, Plaford and Lumiere asked the friendly brokers for the specific prices they wanted with the Penalties direction to email or instant message the prices back to Visium, as part of the settlement, had to pay disgorge- them as the brokers’ own quotes,” a practice known as ment of more than $4.7 million, plus interest of more “U-turning” the quotes. than $720,000, the agency said. It also had to pay a On at least 308 occasions, Visium relied on the sham civil money penalty of more than $4.7 million, meaning quotes and provided them to the fund’s independent the total settlement costs to the adviser are more than administrator to strike the fund’s month-end NAV, $10 million. Ku, as part of his individual settlement, was according to the Visium settlement order. “Of the 308 ordered to pay a $100,000 civil money penalty and was price overrides, 282, or 91.56 percent, resulted in higher suspended from the securities industry for one year. An valuations for long positions or lower valuations for attorney representing Ku said that his client was happy short positions held by the Credit Fund.” to have resolved the matter. An attorney representing

ACA Insight 5 “The mismarking scheme caused the Credit Fund procedures designed to prevent the misuse of mate- to overstate its month-end NAV routinely, during rial nonpublic information by the firm and the persons the relevant period, by approximately 2.4 percent to associated with it.” d 7.2 percent, and the fund’s audited and reported NAV for year-end 2011 and 2012, by approximately Technology 5.1 percent and 7.0 percent, respectively,” the SEC said. continued from page 1 “As a result, some investors bought into the fund at advisers and other financial entities find problematic. an inflated NAV. Some investors redeemed out of the The use of principles-based standards typically allow fund at an inflated NAV, thereby diluting remaining those regulated to determine the methodology of com- investors’ interests.” pliance in achieving required goals. The bottom line here was that for 2011 and 2012, Visium “To allow for the industry to keep up with and har- received from the Credit Fund more than $2.6 million in ness changing technology, regulation must [emphasis ill-gotten performance fees, the agency said. Incentive IAA] be principles-based,” the IAA said in its 11-page compensation was paid to the Credit Fund investment April 25 letter, which it posted on its website last week. team from that money. The fund also allegedly received “Prescriptive rules become quickly obsolete and, $533,700 in management fees that it was not entitled to. because they often fail to anticipate novel uses of tech- The total take of ill-gotten fees from the Credit Fund was nology, they invariably act as a roadblock to innovation. more than $3.1 million, the SEC said. In the area of quickly developing financial innovation Insider trading and technology, broad uniform standards are likely to be more effective than rules.” Visium involved both the Credit Fund and the Balanced Fund in its insider trading, according to the administra- Ropes & Gray counsel David Tittsworth said that the tive order. IAA’s call for a prescriptive-based approach when it comes to regulation of technology “resonates strong- One of the adviser’s portfolio managers for the Balanced ly with me, in part because of the general principles- Fund caused the fund to trade in the securities of phar- based approach of the Advisers Act. I also agree that maceutical companies in advance of generic drug prescriptive rules can become outmoded as technology approvals by the FDA’s Office of Generic Drugs (OGD), advances and changes quickly and may actually impede “based on material, nonpublic information he received meaningful and effective regulation in the long run.” from a former OGD official,” the SEC said. “The theme that runs throughout the IAA letter in Another portfolio manager caused both the Credit regard to the needs of the investment adviser commu- and Balanced Funds to trade in the securities of home nity is, ‘We need to innovate, so please don’t give us healthcare providers in advance of a proposed cut to over-prescriptive regulations,’” said Mayer Brown part- certain Medicare reimbursement rates by CMS, based ner Adam Kanter. “‘We need room to grow. Don’t box on material, nonpublic information he received from a us in.’” former CMS employee, the agency alleged. “The insider trading generated more than $7 million in illicit profits Treasury Department reports for the Credit and Balanced Funds combined, and nearly The IAA sent its letter following two meetings with $1.6 million in ill-gotten performance and management Treasury Department officials, the first in January in fees for Visium,” the agency said. regard to providing investment advice through the use It’s not that Visium didn’t have policies and procedures of digital platforms, and the second in April in regard to that addressed insider trading, but that the adviser, how advisers are exploring technology to enhance the according to the SEC, “failed to enforce policies and client experience and relationship, streamline back office functions, and provide business efficiencies.

ACA Insight 6 The meetings are part of Treasury’s preparations for institutions taking a reasonable, risk-based approach its fourth and final report addressing the U.S. financial when assessing, implementing and applying tech- system. Each report focuses on an aspect of the sys- nology to their businesses; and tem. The first three addressed, respectively, depository institutions (banks, savings associations, credits unions Use of technology and more), capital markets (debt, equity, commodities The IAA’s recommendations to Treasury in regard to and derivatives, among others), and the asset manage- existing technologies included the following: ment and insurance industries (ACA Insight, 11/6/178). The fourth report will address non-bank financial insti- • Digital advice. “It is important to underscore that the tutions (i.e., investment advisers), financial technology use of technology by digital advisers to offer invest- and financial innovations. ment services does not change the regulatory envi- ronment in which they operate, nor does it change General principles the types of investments (e.g., asset classes and investment strategies) that they offer their clients,” Among the general principles that the IAA recommend- the IAA said. The association said that any recom- ed to the Treasury, in addition to regulations being prin- mendations that Treasury makes in this area should ciples-based, were the following: support the approach set out in past SEC guidance • Regulations and standards should be “technology- and that they should be principles-based and apply neutral and not based on the presence, absence or to all advisers. type of technology; • Distributed ledger technology. Treasury should • Regulatory focus should continue to be on investor adopt “a measured approach” by focusing on the protection and market integrity and efficiency, while promise of this technology, “which, we believe, supporting and facilitating exploration of financial could revolutionize financial services,” the IAA said. innovation; “We believe that DLT has enormous potential to create operational efficiencies in a number of different • Regulators should expressly support financial

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ACA Insight 7 areas, including, for example, in areas of recordkeep- that in regard to Rule 204-2, the Books and Records ing and in the trading and settlement of investments. Rule, the SEC should make it clear that digital ledger Treasury should encourage these developments and technology and cloud services may be used to store work with the financial industry to map out a regu- records. For Rule 206(4)-2, the Custody Rule, the IAA latory approach that will facilitate exploration and advised Treasury that regulators need to under- innovation.” stand new and evolving structures for custody and cryptoassets. • Cloud services. The IAA urged the Department to encourage regulators to issue updated guidance that The IAA also raised concerns regarding the need would make it clear that “no law or regulations pro- for modernization in regard to data breach and hibits the use of the public cloud. They also should cybersecurity regulations and personally identifiable make it clear that regulated entities may employ information. cloud services – directly or through their service pro- In regard to modernizing existing rules, Tittsworth said viders – provided they develop effective oversight that the rules in question “have developed cobwebs mechanisms designed to ensure that customer data over time and would benefit from a fresh look that rec- and critical operations are protected.” ognizes and acknowledges developments in financial Modernization of existing regulations technology.” d The IAA has already called for modernizing a number of existing rules, but used the opportunity provided by the Note to Readers Treasury’s need for input to note technological reasons The next issue of ACA Insight will be dated June 4, 2018. for certain rules to be updated. For instance, it noted Have a happy and safe Memorial Day weekend. d

The weekly news source for investment management legal and compliance professionals The weekly news source for investment management legal and compliance professionals

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