Advisory Fees – What Does the Law Say?

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There has been a lot of debate this year about the fairness of advisory fees. Who am I kidding? This is a debate that has been going on for years now. In this post, I address what the law says about advisory fees (but not performance-based fees). In my next post I plan to share some ideas that I have on the fairness and value of advisory fees.

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Federal Data Breach Law is Long Overdue

I recently assisted a client with a response to a data breach incident. This isn’t an uncommon occurrence. Our law firm is notified almost weekly of a data breach incident involving one of our investment adviser clients. Most commonly, an unauthorized person gains access to an employee’s email and the inbox contains non-public information.

The first thing we ask our clients is: “Do you have data breach or cybersecurity insurance?”

The second thing we try and determine is how expansive is the breach so that we can try and determine how big of a financial and time commitment it will it be for our client to comply with the law. As a general rule of thumb, breaches become more time consuming and expensive as the number of clients and the states of residency increase.

This is because there is no federal law that dictates what businesses must do in the event of a data breach. The status quo requires a business to analyze every state law where a client was potentially impacted to determine (i) what is the state’s definition of a “breach”, (ii) was the client in question subject to a “breach”, (ii) what are the business’s notification requirements, (iii) does the business have any other reporting obligations? To get a sense of how ridiculous this task is, a current list of those requirements by state is available here.

It is long past time for Congress to make this process for uniform and manageable for businesses. The array of state data breach laws is inefficient, burdensome, and might even incentivize businesses to circumvent reporting obligations in various states.

The federal law should, at a minimum, settle on a uniform definition of a “breach”. The law should also create a federal website that allows for easy reporting by businesses to the federal government. That website would then automatically notify state governments in any state where an impacted client resides. This would alleviate the burden on businesses reporting to various state Attorney Generals while still providing states with the broad police powers they are entitled to in trying to protect their citizens and resolve and prevent data breaches.

I can think of no reason why Congress shouldn’t act on this important measure, except many law firms and consulting firms profit from the current patchwork framework.

The Interconnectedness of Markets and Reserving Judgment in Light of Recent Trading Events

Acting Chair Allison Herren Lee and Commissioners Peirce, Roisman, and Crenshaw recently released a statement on the recent market volatility. Their statement highlighted the Commission’s essential mission to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.”

Recent events serve as a reminder that these functions are interconnected and there are very different and diverse investors that the Commission is tasked with protecting. The Commission should always place retail investors in a priority position when carrying out its mission of protecting investors. However, this approach becomes incredibly difficult when considering the various exposure that retail investors have to the markets.

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Managing Cryptocurency and Digital Assets in Separate Accounts. Comply With The Custody Rule!

In late 2020, MicroStrategy, led by CEO Michael Saylor, purchased $650 million worth of Bitcoin as a reserve asset. Morgan Stanley and its subsidiaries and affiliates also purchased a considerable part of MicroStrategy. In early 2021, the value of Bitcoin crossed $30,000. Then $40,000. Institutional investors started flocking to the asset. Even an old stodgy insurance company–Massachusetts Mutual Life Insurance (MassMutual), dipped its toes in the water to the tune of $100 million.

If you own or operate an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”) or if you are a financial professional, you have probably been asked questions about Bitcoin and other digital assets. This article is intended to help address the custody issue associated with rendering investment advice on Bitcoin and other digital assets. Additional posts will address other legal and operational issues stemming from managing these digital assets.

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A Running List of Practical Pointers Under the New Marketing Rule

The new marketing rule provides an opportunity for investment advisers to compliantly test out new marketing methods. This post will provide a running list of pointers that I think investment advisers and investment professionals may find helpful or interesting. All of these practice pointers assume the rule is effective. None of these pointers should be relied upon as legal advice and I encourage you to seek out local counsel before engaging in any marketing practices under the new rule.

Also, please feel free to contact me if there are any issues that you would like me to address.

Practical Pointer #1: Centers of influence, such as lawyers and accountants, that refer clients to an investment adviser might be inadvertently providing testimonials or endorsements.

The adopting release states, “Depending on the facts and circumstances,
a lawyer or other service provider that refers an investor to an adviser, even infrequently, may also meet the rule’s definition of testimonial or endorsement.”

Under the new rule, “[a]n advertisement may not include any testimonial or endorsement, and an adviser may not provide compensation, directly or indirectly, for a testimonial or endorsement, unless the investment adviser complies” generally with three conditions. Under the new rule, a “testimonial” is defined as “any statement by a current client or investor in a private fund advised by the investment adviser:

  1. About the client or investor’s experience with the investment adviser or its supervised persons;
  2. That directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or
  3. That refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser.”
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SEC Amends Advertising and Solicitation Rules

On December 22, 2020, the U.S. Securities and Exchange Commission adopted amendments to the rules under the Investment Advisers Act of 1940 relating to advertisements. A copy of the adopting release is available here. When news first broke, I provided my initial thoughts via Twitter (which I have included below), but the purpose of this post is to provide a little cleaner overview of the amendments and the new rule.

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VOYA Financial Advisors Enforcement Action

Who should be worried? What should we be doing? What went wrong? Should we care?

The U.S. Securities and Exchange Commission (“SEC”) settled an enforcement matter with Voya Financial Advisors, Inc. on December 21, 2020. This is yet another case that does a disservice for the investment advisory legal and compliance industry by providing unclear guidance in a settled enforcement action with a party that neither admits nor denies wrongdoing.

The Illiquid Alternatives Allegation

Among the allegations raised by the SEC were that “Voya’s policy [] requir[ed] advisory clients to pay an upfront brokerage commission when purchasing illiquid alternative investment products (“Illiquid Alts”) when the same investment was available to advisory clients with the brokerage commissions waived.”

What Types of Investment Advisers Should be Worried?

For investment advisers i) that are dually registered as broker-dealers, ii) that have an affiliate that is a broker-dealer, or iii) have associated persons that are registered representatives of a broker-dealer (i.e., hybrid advisers), this case is really important. These firms should be thoughtful in the structures, policies, and disclosures in place for recommending commission-based securities products to investment advisory clients.

What Should These Firms be Doing?

Compliance departments should i) understand what securities are being recommended, ii) when they are being recommended, iii) how they are being recommended, iv) are there identical or substantially similar securities available, and if so are they less expensive, and v) are there other conflicts of interest in the recommendation process (both at the representative and firm level).

Once a compliance department understands these issues, then they should make sure that their disclosures align with any conflicted practice or that the conflicted practice is eliminated altogether. 

What Went Wrong and What Could it Have Done Differently?

In this matter, it appears that Voya had a formal policy that required advisory clients to purchase these illiquid alternative investment products (“Illiquid Alts”) on a commission basis, when they might have been able to purchase them on an advisory basis without regard to whether this was expected to be the most appropriate way for the client to acquire the security (i.e., the most affordable).

Had Voya disclosed the existence of this policy and its financial impact to clients, then I don’t believe these claims would have had merit. This much is clear from Paragraph 30 of the Order. Because the claims are also raised in the section on “best execution”, it does give me pause, but we have seen these types of claims incorrectly raised in this context in many other settled enforcement actions.  

Also, if Voya’s policy had been that representatives were required to make the most appropriate selection using their best judgment at the time of the recommendation, and the representatives actually made a justifiable recommendation, these charges would not have likely had merit.

How Much Weight Should this Case be Afforded?

I would pay serious attention to this matter and its findings, but also try and keep it in context. Voya was clearly going to take a beating on the share class selection and money market sweep issues, so they probably didn’t have much incentive to defend these claims on the Illiquid Alts as vigorously.

Department of Labor’s Final Fiduciary Rule Exemption – What’s Different Between the Proposal and the Final Exemption?

The Department of Labor announced its long-awaited final class exemption from certain prohibited transaction under the Employee Retirement Income Security Act of 1974, as
amended (the Act
).

Putting aside whether the Biden administration will freeze and repeal this exemption, this post is designed to address the differences between the proposal and the final exemption. The final exemption appears to be nearly identical to the proposal, with the following three major differences.

First, the final exemption includes a new disclosure requirement, which was not contemplated by the proposal. The exemption requires the following of a Financial Institution:

Prior to engaging in a rollover recommended pursuant to the exemption, the Financial Institution provides the documentation of specific reasons for the rollover recommendation, required by [the exemption], to the Retirement Investor.

Second, the policies and procedures requirement appears to have been softened.  The final exemption will require a Financial Institution relying on the exemption to maintain “policies and procedures [to] mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests ahead of the interest of the Retirement Investor.” This creates a “reasonable person” standard for reviewing policies and procedures, whereas the proposed exemption would have required policies and procedures that were “prudently designed to avoid misalignment of the interests” between the Financial Institution and Investment Professional.

Lastly, the final exemption contains a self-correction process for any inadvertent non-compliance. The final exemption states:

A non-exempt prohibited transaction will not occur due to a violation of the exemption’s conditions with respect to a transaction, provided:


(1) Either the violation did not result in investment losses to the Retirement Investor or the Financial Institution made the Retirement Investor whole for any resulting losses;

(2) The Financial Institution corrects the violation and notifies the Department of Labor of the violation and the correction via email to IIAWR@dol.gov within 30 days of correction;

(3) The correction occurs no later than 90 days after the Financial Institution learned of the violation or reasonably should have learned of the violation; and

(4) The Financial Institution notifies the person(s) responsible for conducting the retrospective review during the applicable review cycle and the violation and correction is specifically set forth in the written report of the retrospective review required under subsection II(d)(2).

SEC Likely to Adopt New Advertising Rules for Investment Advisers

On Wednesday, December 16, 2020 at 10:00 am, it is looking highly like that the U.S. Securities and Exchange Commission will adopt amendments to the advertising rules under the Investment Advisers Act of 1940.

If you are interested, here is a link to the notice announcing the meeting (and the likely vote). The hearing will be available by webcast on the Commission’s website at www.sec.gov. I will be tuning in and live tweeting @advisercounsel.

My predictions:

1. We will see a new principles-based rule governing advertisements.
2. We will see the approval of testimonials and endorsements.
3. All communications, not just written communications, will be treated as advertisements. The rule will apply equally to podcasts, videos, TikTok, and more.

Assuming the rule is approved, I will be blogging about what it means for investment advisers, investment adviser representatives, registered fund managers, marketers, web developers, and public relation firms shortly thereafter. If there are any specific angles you are interested in hearing about, feel free to reach out in the meantime.

New York Investment Adviser Representatives to Become Subject to Licensing (Finally)

On December 1, 2020, New York Attorney General James announced rules that will require the licensing of investment adviser representatives (“IARs”) in New York. IARs will be required to register through the Central Registration Depository/Investment Adviser Registration Depository. If you render investment advice from a place of business in New York, now is the time to begin reviewing the rule and your licensing obligations. This new law applies even if you previously filed a NY-IAQ on behalf of a state-registered investment adviser.

Beginning on February 1, 2021, IARs of both state-registered and federally registered investment advisers will be required to meet examination requirements and register with the state. The licensing fee is $200 and will be the second most expensive in the country behind Georgia.

The rule contains an implementation period, which will allow those currently engaged in business to continue their business without an approved registration until December 2, 2021.

The rule also provides for an examination waiver for people who have been serving as IARs for at least two years prior to February 1, 2021 so long as they are not disqualified. Disqualifying events include being subject to any regulatory or civil action, proceeding or arbitration, either pending or in the preceding ten (10) years from the date of application, that would require disclosure on Form U4, or that person has been notified or has reason to believe that they currently are or remain the subject of a regulatory or law enforcement investigation related to investment-related activities.

The Office of the Attorney General provided helpful information for financial professionals and compliance departments that summarize what should be done to apply and request an examination waiver.

If you need any help (i) in determining whether you qualify for an examination waiver, (ii) how to file a Form U4, (iii) whether you must amend your firm’s notice filings, (iv) when you must file your application, or (v) in preparing and submitting your Form U4, do not hesitate reaching out.