There’s clearly no summer lull at the SEC Division of Enforcement’s Asset Management Unit—over the past two weeks, we’ve seen a deluge of more cases impacting investment advisers than we’ve seen afternoon thunderstorms (and here in DC, that’s saying something). In this post I’m going to briefly summarize some of the take-aways for these cases impacting the pay-to-play rule, the “testimonial rule,” and the custody rule.
The Pay-to-Play Rule
The SEC settled three enforcement actions stemming from violations of Advisers Act Rule 206(4)-5, the pay-to-play rule. As a reminder, the pay-to-play rule generally prohibits investment advisers and certain of their “covered associates” from making (or coordinating or soliciting) political contributions to certain candidates for and holders of U.S. state and local elected office, if the officeholder is directly or indirectly responsible for, or would have the power to influence the outcome of, the hiring of an investment adviser by a “government entity” or the investment in a private fund by such “government entity.” (A government entity would include, among other things, a U.S. state or local pension plan or general fund.) The rule provides certain de minimis exceptions for political contributions, but carries a hefty penalty: an investment adviser in violation of the rule would be prohibited for two years from receiving any compensation from a government entity related to the candidate or officeholder to whom the political contribution was given–even if there is no indication that the contribution ultimately played any role in the selection or retention of the investment adviser (or private fund).
These most recent settlements all largely mirror the same types of violations identified by the SEC in its last set of pay-to-play settlements against 10 investment advisers in January 2017 (check out Mayer Brown’s legal update on those 2017 actions): the contributions were in some cases relatively small (sometimes barely over the de minimis contributions permitted by the rule), and in some cases the individuals that made the contributions promptly requested that they be returned. Notably, while in the first set of enforcement actions no fine was greater than $100,000, this latest set of enforcement actions saw fines ranging from $100,000 to $500,000, which may indicate that the SEC is ratcheting up the fines in comparison to advisers who settled early. Notably, the SEC did not seek disgorgement of fees received by investment advisers from “government entity” clients/investors related to the impermissible contributions at issue in either the first set of actions or the more recent set.
As always, we caution investment advisers to train their personnel about these requirements and have good procedures to pre-clear potentially problematic political contributions and catch any impermissible contributions after the fact, which can at least open the door for the investment adviser to seek exemptive relief and potentially avert enforcement actions like those noted above.
The “Testimonial Rule”
The SEC settled five enforcement actions stemming from violations of the so-called “testimonial rule” —i.e., the prohibition on the use of testimonials—found in Advisers Act Rule 206(4)-1(a)(1). Four of these cases were interrelated, stemming from “reputation services” wherein a company would post positive reviews on YouTube, Google, Facebook, Twitter, Yelp, and other websites. The company providing the service claimed that the program was “100% compliant for investment advisers,” though that was clearly not the case. One recipient of the service eventually identified the potential issue, flagged it for the service provider, and requested that the testimonials be taken down, but the service provider ignored the request for over six months, and continued to take on other investment adviser clients. That first (unnamed) investment adviser was not the subject of the enforcement actions, but the service provider and three of its other investment adviser clients (and/or their principals) were. One important note here is that the service provider was found to have “caused” the violations of the other investment advisers, though the service provider was not itself subject to the Advisers Act, of course. This also seems like a good time to remind our readers of the SEC staff’s prior statements regarding the interplay between the testimonial rule and social media: Division of Investment Management; OCIE.
The fifth enforcement action related to a 31-minute video created by a dual-registrant BD/IA in celebration of the firm’s 50th anniversary. The video, originally created for use at the firm’s anniversary party, contained statements from 27 advisory clients regarding their experiences with the firm. The firm later posted the video on its public website and on YouTube (where it garnered 291 views over a nearly 5 year period). They also later created a shorter, eight minute version of the video (containing many of the same statements from the first video), and similarly posted it on the firm’s website and on YouTube (yielding a more modest 117 views over a 3 year period).
The Custody Rule
The SEC settled an enforcement action against a private equity fund adviser arising out of repeated violations of Advisers Act Rule 206(4)-2, the custody rule, related to late delivery of audited financial statements to fund investors. As many of our readers may be aware, the custody rule provides advisers to private funds with two different methods for compliance if the adviser is deemed to have “custody” of private fund assets (which will almost always be the case in traditional fund structures, because having an affiliate serve as general partner of a fund organized as a limited partnership is sufficient to cause the adviser to have “custody”): (1) the default option, which requires (A) the adviser to undergo a “surprise examination” by an independent public accountant and (B) the fund’s custodian to deliver account statements to each fund investor on a quarterly basis, or (2) the “audit exception,” under which the adviser generally must deliver annual financial statements prepared in accordance with US GAAP and audited by an independent public accountant in conformance with US GAAS to fund investors within 120 days of the fund’s fiscal year end (subject to a few exceptions not relevant for our purposes here).
The settlement order noted that this adviser failed to deliver the audited financial statements on a timely basis, providing the table below:
| Fiscal Year | Number of Days Late |
| 2012 | 42 |
| 2013 | 22 |
| 2014 | 18 |
| 2015 | 37 |
| 2016 | 245 |
| 2017 | 6 |
The settlement order further noted that the SEC staff has provided guidance in FAQs to excuse late delivery of audited financial statements in limited circumstances:
“[t]he Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances.”
The SEC pointed out that despite the repeated late deliveries over the years, the adviser made no material changes to its processes related to the preparation and delivery of the financial statements, making the circumstances of their late delivery no longer “unforeseen,” and making reliance on the staff FAQ “unreasonable.”
While this shouldn’t impact fund advisers that experience one-off late deliveries of fund financial statements, it drives home the point that repeated deficiencies—particularly where no action has been taken to try to prevent future violations—is ripe for SEC action.