AdvisorCounsel Law Blog

The Broker Protocol simplified employment transitions by financial professionals over the last decade and a half. (I use the term “employer” and “employment” loosely, and it is intended to capture independent contractor situations too.) The Broker Protocol made it relatively simple to transition from one broker-dealer or financial institution to another without fear of litigation where both institutions were members of the protocol. Over the years, some large firms have withdrawn from the protocol. It is pretty easy to speculate that the reason for departure was based on the net departure of financial professionals and the assets that they manage. Regardless, the new normal for transitioning financial professionals is less efficient, more litigious, and more anxiety-producing. So how do you navigate a non-Broker Protocol transition? The truth is–carefully. Below is a high level list of items that you will want to consider as you plan a non-protocol transition.

1. Check for Broker Protocol Membership. The first step is to review the list of Broker Protocol members to determine whether both firms are members. The purpose of this article is to examine non-protocol transitions, so let’s assume they are not.
2. Review Legal Agreements. You must carefully review the employment agreement and any other agreements entered into between the parties for relevant terms and conditions that would impede a smooth transition. You should also include policies and procedures and other similar employment handbooks as they may contain relatively important contractual or quasi-contractual terms. The agreements may include restrictive covenants, such as non-compete or non-solicit provisions. The financial professional may have also agreed to repay loans, pay for departing clients, return property, return intellectual property, and so forth. The review of these agreements is typically a job that should be performed by knowledgeable legal counsel, because some of these provisions might not be enforceable and some may be more expansive than you think. For example, the return of property may include your company-issued laptop, but it might also include the list of clients that you service.
3. Review of the Law. While there might not be any specific, contractual provisions that govern the employment relationship, there are a number of state and federal laws that could protect the employer’s “property” upon transition. That property might include customer lists and information that is otherwise non-public. So be careful in assuming that the absence of any restrictive covenants in an employment agreement gives you free range on your departure.
4. Review Privacy Policies. The next step is to review the current employer’s privacy policy and notices to clients and customers to determine what information can be used in the transition process and to more generally create a strategy for the transition. There are a handful of cases where the SEC and FINRA alleged violations of privacy laws against the receiving employer. For example, see Next Financial Group, Kestra Investment Services, and Woodbury Financial Services.
5. Develop Your Strategy. I am not being overly dramatic when I say that your career in the financial services industry might be over if you have a temporary restraining order imposed on you after you resign. If it is, you will be prohibited from contacting your former clients in violation of the restraining order. As long as you are restrained, your former employer will be working over your former book and solidifying its relationships. Don’t let this happen to you.

• Understand exactly what information you can take with you and what information you are prohibited from taking.
• Understand what information you may share with your new employer.
• Understand what information you new employer may mail to your clients, whether consent is require, and how will consent be obtained.
• Understand when you are permitted to contact your clients.
• Understand how you can solicit or whether you can solicit your former clients at all.
• Understand how you can potentially use social media (i.e., Linkedin) or local advertisements to your benefit.
• Understand what you might owe your employer in terms of forgivable loans or transition assistance that was previously paid to you.
• Understand your employer’s appetite for litigation.
• Make an informed decision on how much risk you are willing to take in the transition process.
• Have litigation counsel on stand-by in the event you are served with a temporary restraining order.

Once you have made up your mind that your current employer is no longer a good fit, you should do everything you can to prepare for a smooth transition.

This is a gentle reminder that while FINRA only regulates its broker-dealer members, it hosts the Investment Adviser Registration Depository (“IARD”) and Central Registration Depository (“CRD”). The IARD and CRD are two systems used by investment advisers registered with states and the SEC and exempt-reporting advisers.

FINRA has adopted a new multi-factor authentication system (“MFA”) for all persons who have access to the IARD and CRD system. FINRA started rolling it out in May and expects it to be fully operational for all firms by December 2020.

This new system is a burden on compliance consultants and law firms. Each time a compliance consultant or lawyer is given access rights to the system, they must create a separate username and password. They must then link a phone, tablet, or email to their account. They receive a code and must enter the code in the system. Then they must sit by and wait for a phone call to confirm their account. They have to go through this process for every single client that they assist on the IARD and CRD system.

I recently wrote to Marcia E. Asquith, EVP, Board and External Relations with FINRA to request that FINRA consider a revision to their system for compliance consultants and law firms that would provide a single access point for multiple registrants.

I don’t believe that this would compromise any registrants or their information materially if the consultant or law firm’s account was also subject to MFA. If needed, FINRA could impose some level of due diligence before approving any consultant or law firm.

I would request that law firms and compliance consultants that use the IARD and CRD system make similar requests.

On Tuesday, June 23, 2020, the Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert aimed at registered investment advisers that manage private equity funds and hedge funds. The Risk Alert can be found here.

The Risk Alert identified three primary areas for deficiencies issued by OCIE to these advisers as a result of examinations. Each of the three areas is discussed in more detail below.

Conflicts of Interest

OCIE observed various conflicts of interest that it believed to be undisclosed or inadequately disclosed. The conflicts cited by OCIE involve:

1. Conflicts related to allocations of investments.
2. Conflicts related to clients investing in the same issuer, but through different investments (i.e., preferred stock vs. debt).
3. Conflicts related to economic relationships between the adviser and select investors or clients.
4. Conflicts related to preferential liquidity rights.
5. Conflicts related to an adviser’s or its affiliates’ interest in recommended investments.
6. Conflicts related to co-investments.
7. Conflicts related to service providers.
8. Conflicts related to fund restructurings.
9. Conflicts related to cross-transactions.

Fees and Expenses

OCIE also identified issues surrounding fees and expenses associated with private funds and their advisers. The issues identified by OCIE include:

1. Issues involving the allocation of fees and expenses.
2. Inadequate disclosure surrounding the role and compensation of individuals rendering services to a fund, but are not the adviser’s employees.
3. Issues involving valuation of a fund’s assets.
4. For private equity funds, issues with respect to the receipt of fees from portfolio companies, such as monitoring fees, board fees, or deal fees.

Policies and Procedures Relating to Material Non-public Information (“MNPI”)

In what has become a recurring theme for the SEC, OCIE identified advisers that failed to establish, maintain, and enforce (1) written policies and procedures reasonably designed to prevent the misuse of MNPI, and (2) provisions in their code of ethics designed to prevent the misuse of MNPI.

Conclusion

If your firm is an adviser to any sort of private investment fund, it would be a wise investment to review the Risk Alert and your practices relating to the funds to ensure that none of these issues will subject your firm to an enforcement action.

Background

The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law on March 27, 2020, and introduced the Paycheck Protection Program (the “PPP”) with the goal of preventing job loss and small businesses failure due to losses caused by the COVID-19 pandemic. To accomplish the policy behind the program, qualifying businesses are provided with a forgivable loan to cover payroll and other costs.

PPP Loan Qualifications

The CARES Act made loans available for any business with “not more than 500 employees” and for other “small business concerns”. Allowable uses of program loans include payroll support, employee salaries, mortgage payments, rent, utilities; and other debt obligations that were incurred before the March 1, 2020. In addition, the CARES Act specifically removed the standard Small Business Administration requirement that the business certify that they were unable to obtain credit elsewhere. The only requirement for a small business to receive a loan is that they be able to certify, in good faith, that “the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient.”

The certification contains three key terms that are extremely flexible and can be interpreted either at a point-in-time or forward looking. Each of those is discussed further below:

Uncertainty of Current Economic Conditions

There was and remains without a doubt great economic uncertainty due to COVID-19. Most investment adviser’s revenues are directly dependent on their assets under management, which track the United States and world economies. Any business owner or investment adviser suggesting that they knew the financial markets would be relatively stable by April, May, or June would be lying. This supports their decision to apply for a PPP loan.

The United States and the world have not witnessed a scarier medical-economic event since arguably polio in the mid-to-late 1950’s.  The U.S. deficit in comparison to gross domestic product is at levels that have not been reached since World War II.  When the pandemic first reached the United States, forecasts for growth plummeted, and while some experts believed that growth would pick back up in the third and fourth quarters of 2020, no one could truly predict how long the pandemic would impact our country.  Notably, PIMCO put it quite eloquently when it stated: “there is a risk if not a likelihood of an uneven recovery, with significant setbacks along the way.”

Necessary

Notably, the CARES Act does not require a showing of absolute necessity. The certification was not intended to be a binary test for whether a business would or would not survive without the loan. The decision by the SBA to remove the requirement to seek out credit elsewhere supports this view.

Too many commentators are viewing the necessary standard too narrowly. If Congress intended it to be an absolute necessity standard, then they would have written it into the law—which it is not.  If that were the intent of the Small Business Administrator Carranza, then she would have ensured that the certification be drafted accordingly.  The program was designed primarily to retain employees, so the certification needs to be viewed through that lens. If a business applied for a loan to retain employees, to keep payroll at levels that employees (including owner-employees) were accustomed to receiving, or avoid furloughing employees, then the applicant likely made the certification in good faith.

Ongoing Operations

While the period for determining forgiveness under PPP is currently based on the eight-week period after receiving a loan, neither Congress nor the SBA suggested that the period for considering whether a business is able to “support [its] ongoing operations” be viewed over that same period.  Most businesses considering applying for a PPP loan were thinking longer term.

If there was any realistic chance that a business would need the money to support its ongoing operations, regardless of whether that need would occur in two weeks or two years, an adviser would be in a position to make a good faith certification.

If an investment adviser’s worst nightmares and financial projections came to fruition and they did not apply for the PPP loan, they would have been thoroughly upset.  The PPP loan program would not have been available in a year or two if the economy didn’t recover.  It would only seem prudent to apply for a loan to avoid this scenario.

Implications on Morality

I acknowledge that my conclusion that most investment advisers acted in good faith and likely qualified for PPP loans may not sit well with some people.  However, I don’t believe that makes an investment adviser immoral, unethical, or any less of a fiduciary because they received a PPP loan and have not returned it.  Given where current financial markets stand, many people are considering it a windfall. Perhaps it is, but only time will tell.

Either way, I would ask these same people questioning the morality of investment advisers who have not returned loan proceeds how they feel about deferring payroll taxes under the CARES Act. There is no need to take advantage of this provision, but you would be imprudent if you didn’t.

In hindsight, perhaps Congress and the SBA should have created stricter requirements for PPP surrounding qualifications and forgiveness.  Perhaps businesses with year-over-year revenues that only decrease a certain percentage should have been eligible for forgiveness. These are policy issues that should have been determined during the legislative process.  It is unfair—and probably even unconstitutional—to apply them with the benefit of hindsight.

Disclosure Unnecessary?

The Securities and Exchange Commission’s Division of Investment Management released guidance on April 27, 2020, addressing disclosure surrounding an investment adviser’s participation in PPP.As the guidance correctly references, whether the application for or receipt of a PPP loan is material, and therefore requires disclosure to clients, is a question of fact. “A matter is material if there is a substantial likelihood that a reasonable person would consider it important…The omission or misstatement of an item…is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the disclosure would have been changed or influenced by the inclusion or correction of the item.” Put another way, would a typical client or prospective client consider this information important to their investment advisory relationship with their firm.

While the Division of Investment Management staff has stated its belief that disclosure would be necessary if a loan was “require[d] to pay the salaries of your employees who are primarily responsible for performing advisory functions…,” I do not believe that this is a helpful standard in determining materiality, and ultimately, whether disclosure is necessary.

I would recommend that investment advisers analyze all of the facts and circumstances associated with their current financial position and their decision to participate in the PPP.  After performing this analysis, if they believe that a client could consider their current financial position material, I would recommend disclosure.

I also do not believe that investment advisers have any obligation to try and reconcile their PPP certification and the whether their receipt of a PPP loan is a material fact requiring disclosure.  The PPP certification for most advisers was a forward-looking activity that was heavily predicated on future economic uncertainty.  If those uncertain events never come to fruition, then clients do not have any need to know about the investment adviser’s financial position assuming that they remain able to perform their contractual obligations. Materiality under the Investment Advisers Act of 1940 relating to a business’s financial position has never before required a future financial forecast, and in my opinion, that obligation should not start now.

On May 13, 2020, the SBA released new guidance in consultation with the Department of the Treasury. The guidance is set forth below:

46. Question: How will SBA review borrowers’ required good-faith certification concerning the necessity of their loan request?

Answer: When submitting a PPP application, all borrowers must certify in good faith that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” SBA, in consultation with the Department of the Treasury, has determined that the following safe harbor will apply to SBA’s review of PPP loans with respect to this issue: Any borrower that, together with its affiliates,20 received PPP loans with an original principal amount of less than $2 million will be deemed to have made the required certification concerning the necessity of the loan request in good faith. SBA has determined that this safe harbor is appropriate because borrowers with loans below this threshold are generally less likely to have had access to adequate sources of liquidity in the current economic environment than borrowers that obtained larger loans. This safe harbor will also promote economic certainty as PPP borrowers with more limited resources endeavor to retain and rehire employees. In addition, given the large volume of PPP loans, this approach will enable SBA to conserve its finite audit resources and focus its reviews on larger loans, where the compliance effort may yield higher returns. Importantly, borrowers with loans greater than $2 million that do not satisfy this safe harbor may still have an adequate basis for making the required good-faith certification, based on their individual circumstances in light of the language of the certification and SBA guidance. SBA has previously stated that all PPP loans in excess of $2 million, and other PPP loans as appropriate, will be subject to review by SBA for compliance with program requirements set forth in the PPP Interim Final Rules and in the Borrower Application Form. If SBA determines in the course of its review that a borrower lacked an adequate basis for the required certification concerning the necessity of the loan request, SBA will seek repayment of the outstanding PPP loan balance and will inform the lender that the borrower is not eligible for loan forgiveness. If the borrower repays the loan after receiving notification from SBA, SBA will not pursue administrative enforcement or referrals to other agencies based on its determination with respect to the certification concerning necessity of the loan request. SBA’s determination concerning the certification regarding the necessity of the loan request will not affect SBA’s loan guarantee.2

What this means is that any borrower who received loans of less than $2 million will be presumed to have made their certification in good faith. The SBA will not likely second guess a borrower’s determination as to the certification and their interpretation of the terms “economic uncertainty”, “necessary” or “ongoing operations”. This is good news for borrowers, because the vague standard was creating a great level of discomfort. Now there exists some level of certainty for smaller borrowers.

Also helpful in the new guidance is that upon review by the SBA, regardless of the loan size, if the SBA disagrees with your certification at a later date, they will not pursue an enforcement action or refer your application to the Department of Justice or another agency as long as you repay the loan. I can only assume that the SBA would still make referrals for outright fraud.

This guidance should help smaller borrowers sleep a little better. The only risk that I see remaining are public relations risk and repayment risk for borrowers that have received less than $2 million.

On April 28, 2020, the U.S. Small Business Administration published an interim final rule. This interim final rule applies to applications submitted under the Paycheck Protection Program (“PPP”) through June 30, 2020, or until funds made available for this purpose are exhausted.

As noted in the interim final rule, the SBA provided a limited safe harbor for businesses who may no longer believe that they have made their certification on their Borrower Application Form (SBA Form 2483) in good faith in light of more recent guidance that the SBA has released in recent days. The interim final rule provided borrowers who applied for a PPP loan prior to April 24, 2020, until May 7, 2020 to repay their loan in full without the SBA questioning whether the borrower made their certification in good faith.

On May 5, 2020, the SBA, in consultation with the Department of the Treasury, updated its Frequently Asked Questions on the Paycheck Protection Program Loans.  Question and Answer 43 extended the safe harbor from May 7, 2020 until May 14, 2020 and noted that the SBA intends on providing additional guidance on how it will review (and presumably interpret) the certification prior to May 14, 2020.

Investment advisers who applied for a PPP loan prior to April 24, 2020 (and perhaps those who have applied after that period) should reconsider their timeline for making a decision and keep informed on updated guidance. 

Do not hesitate contacting me if you would like to discuss the interim final rule, the extension of the safe harbor, any SBA guidance, or disclosure issues.

The Securities and Exchange Commission’s Division of Investment Management released new guidance on April 27, 2020, addressing disclosure surrounding an investment adviser’s participation in the Paycheck Protection Program. That guidance is set forth below:

Q.  I am a small advisory firm that meets the requirements of the Paycheck Protection Program (PPP) established by the U.S. Small Business Administration in connection with COVID-19. If I receive or have received a PPP loan, what are my regulatory reporting obligations under the Investment Advisers Act of 1940 to my firm’s clients?

A.  As a fiduciary under federal law, you must make full and fair disclosure to your clients of all material facts relating to the advisory relationship. If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance. If, for instance, you require such assistance to pay the salaries of your employees who are primarily responsible for performing advisory functions for your clients, it is the staff’s view that you would need to disclose this fact. In addition, if your firm is experiencing conditions that are reasonably likely to impair its ability to meet contractual commitments to its clients, you may be required to disclose this financial condition in response to Item 18 (Financial Information) of Part 2A of Form ADV (brochure), or as part of Part 2A, Appendix 1 of Form ADV (wrap fee program brochure).  (emphasis added).

As this guidance correctly references, whether the application for or receipt of a PPP loan is material, and therefore requires disclosure to clients, is a question of fact.  “A matter is material if there is a substantial likelihood that a reasonable person would consider it important…The omission or misstatement of an item…is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the disclosure would have been changed or influenced by the inclusion or correction of the item.”  Put another way, would a typical client or prospective client consider this information important to their investment advisory relationship with their firm.[1]

While the Division of Investment Management staff has stated its belief that disclosure would be necessary if a loan was “require[d] to pay the salaries of your employees who are primarily responsible for performing advisory functions…,” we do not believe that this is a helpful standard in determining materiality, and ultimately, whether disclosure is necessary. 

I would recommend that investment advisers analyze all of the facts and circumstances associated with their current financial position and their decision to participate in the PPP.  After performing this analysis, if they believe that a portion of clients could consider their current financial position or their decision to participate in the PPP material, I would recommend disclosure. In performing the analysis, an investment adviser may want to consider the following non-exhaustive factors:

• What was the total amount of PPP loan received?
• What are the investment adviser’s assets and liabilities? Revenues and expenses?
• How much cash on hand or other lines of credit[2] does the investment adviser have?
• What will be the distinct use of the loan proceeds? Which employees will receive the loan proceeds? Are the proceeds intended to cover commissions, salaries, or bonuses? Can the investment adviser support all of these items through documentation (e.g., tracking of funds or corporate resolution)?
• Without the receipt of the loan, what steps will the adviser need to take?
  • Will it simply reduce a profits interest for a principal owner or owners?
  • Will it require all investment professionals to agree to a reduction in salary?
  • Will employees be furloughed?
  • Will all employees be impacted?
• What level of revenues does the adviser expect in the near future?

Keep in mind that this disclosure need not take the form of a Form ADV Part 2A, Item 18 disclosure.  Investment advisers may determine to notify clients in another manner—such as a client newsletter, market update, or client alert.

In the event that an investment adviser receives a PPP loan and determines that disclosure is unnecessary after performing its analysis, we believe that adviser should document its rationale in reaching their conclusion.  This will be important in the event of a future examination.   If an investment adviser needs any assistance analyzing their specific situation or with documenting their rationale, we remain available to assist.

My previous guidance regarding disclosure obligations under Item 18 of Form ADV Part 2A remain unaffected by the recent guidance.

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[1] However, this analysis should not focus on morality or the role of government in our society.  Materiality ought to turn on whether the investment adviser and its personnel remain in an appropriate financial position so that they are able to continue their operations and render investment advice.

[2] Advisers should also be familiar with the recent “Frequently Asked Questions” issued by the Small Business Administration in consultation with the Department of Treasury, available at https://home.treasury.gov/system/files/136/Paycheck-Protection-Program-Frequently-Asked-Questions.pdf. While the guidance appears to apply to large and publicly traded companies, advisers should analyze the “necessity” of the loan in connection with potential other sources of capital.

31. Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?

Answer: In addition to reviewing applicable affiliation rules to determine eligibility, all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application. Although the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere (as defined in section 3(h) of the Small Business Act), borrowers still must certify in good faith that their PPP loan request is necessary. Specifically, before submitting a PPP application, all borrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. For example, it is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification. Lenders may rely on a borrower’s certification regarding the necessity of the loan request. Any borrower that applied for a PPP loan prior to the issuance of this guidance and repays the loan in full by May 7, 2020 will be deemed by SBA to have made the required certification in good faith.

The question remains whether a Zoom hearing or teleconference is appropriate for your situation. The all-too-comical lawyer answer of “it depends” is a fit response here. Some of the items that I would personally consider before agreeing to a Zoom or telephonic hearing are:

• Who are the parties involved?
• Where is the hearing expected to be when the proceeding is resumed from adjournment?
• What is the matter at issue? Is it employment-related, customer claim, or expungement?
• What are the damages alleged? A claim for $10,000 in investment losses could be ripe for a Zoom hearing where a $5mm loss probably warrants an in-person hearing. Also, an expungement proceeding could probably proceed through Zoom.
• What are the ages of the primary and secondary witnesses?
• Are the primary and secondary witnesses healthy? Do you expect them to remain healthy through September?
• How complex is the case?
• Can you hold the attention of the panel remotely?
• Do you expect there to be a lot of documentary evidence? Powerpoint presentations? In my opinion, physical evidence tends to present better in-person.
• Do all of the parties have technology that would permit a Zoom or teleconference?

I would imagine that the volume of cases heard through remote means don’t skyrocket based simply on FINRA’s invitation. It takes both sides to agree to a remote hearing, and that is always a difficult task in adversarial proceedings.