A large ETF adviser agreed to pay a $1.5 Million fine for operating a fund without obtaining the required exemptive relief. According to the SEC, from 2010 to 2015, the adviser relied on exemptive relief for a separate ETF trust even though the SEC staff had opined that the relief did not apply to the fund at issue. The SEC asserts that both internal and outside counsel advised (incorrectly, according to the SEC) that the firm could rely on the pre-existing exemptive relief. The SEC did acknowledge that the fund complied with exemptive order requirements even though it did not obtain its own, specific relief. The offending fund was merged out of existence in 2015. An exemptive order is required to operate an ETF because it would otherwise violate various pricing provisions of the Investment Company Act.
OUR TAKE: Why would the SEC take action against a fund that no longer exists and an adviser that complied with conditions that would have been applicable to a fund where no investor harm was alleged? The answer is that the SEC is very serious about compliance with exemptive orders and ensuring that ETF sponsors strictly follow the conditions (see e.g. SEC 2016 Exam Priorities Letter). Just because you are driving safely doesn’t mean you can drive without a license.
The SEC filed insider trading charges against an investment bank VP who worked in the risk management department and received material nonpublic information as part of his duties to provide technical information to support internal committees. According to the SEC, the defendant learned inside information about a pending going-private transaction when he was copied on an email intended for the firm’s Debt Loan Committee and those that supported its functioning. The SEC alleges that the risk management VP used undisclosed personal brokerage accounts in his name and his wife’s name to trade call options and stock in the target, thereby collecting over $40,000 in ill-gotten gains. In addition to the SEC’s civil charges, the U.S. Attorney has filed a parallel criminal action.
OUR TAKE: It hurts all compli-pros when a risk management professional misuses his position and access to engage in unlawful activity. Who can you trust? Presumably nobody, which is why nobody should be exempt from oversight and testing.
The SEC has commenced enforcement proceedings against the portfolio manager of a registered fund for engaging in a matched trade scheme that allowed him to generate $1.95 Million in profits at the fund’s expense. The SEC alleges that the portfolio manager matched call options bought/sold from his personal brokerage account against matching options bought/sold by the fund in less liquid securities with relatively wide NBBO spreads. These trades benefitted his brokerage account when he immediately sold the call options to third parties at more favorable prices. The SEC maintains that the portfolio manager failed to disclose his personal brokerage account to his employer (for review under the Code of Ethics) and failed to disclose his employer to his broker-dealer. The SEC charges violations of Investment Company Act Section 17(j) and Rule 17j-1 (Code of Ethics) as well as securities fraud. The U.S. Attorney has filed a parallel criminal action.
OUR TAKE: The SEC will hold individuals liable for securities law violations they cause especially where they intentionally seek to evade compliance efforts by lying to their employers. It is unclear at this point whether his employer will also suffer an action for failing to detect his unlawful trading.
An SEC Administrative Law Judge has ruled that once a respondent waives attorney-client privilege by raising reliance-on-counsel as an affirmative defense, the client also waives privilege with respect to successor counsel. The respondent claimed as an affirmative defense that it relied on outside counsel’s advice on the interpretation of state law, the main issue in the SEC case, and subsequently filed a malpractice action. The respondent then tried to assert privilege with respect to communications with successor counsel. The ALJ rejected the assertion of privilege because the affirmative defense constituted an implied privilege waiver that extended to “all communications with counsel relating to the same subject matter, even communications with other counsel.” To hold otherwise would allow the respondent to abuse the privilege by using it as a shield and a sword, depending on the circumstances. The ALJ also ordered the respondents to show cause why the successor counsel should not be disqualified because of its inherent conflict of interest as a potential defendant in another malpractice case.
OUR TAKE: The SEC does not particularly like the attorney-client privilege (See e.g. “SEC’s Enforcement Director Warns Defense Lawyers about Tactics.”) Respondents should know that the Enforcement Division and the ALJs will seek to pierce the privilege when possible, making the reliance-on-counsel defense very difficult.
An interdealer broker agreed to pay $2.5 Million in disgorgement for failing to disclose markups and markdowns on securities traded for clients. According to the SEC, the broker-dealer’s Cash Equity Desk marketed its services as agency only, charging commissions between 1 and 3 cents per share. However, the SEC alleges that during periods of market volatility, the Cash Equity Desk charged additional markups and markdowns on trades without telling clients and then misleading them about actual purchase/sale prices. The conduct also violated its compliance policies. The SEC faults the entire firm for the unlawful misconduct because the employees were “acting within the scope of their authority.”
OUR TAKE: Firms encountering bad conduct by a small number of employees will have a hard time making the “rogue employee” defense. The SEC has increasingly taken a more strict liability approach whereby the firm is liable for all actions of all employees.
A financial adviser was sentenced to 10 years in prison and ordered to make $2.9 Million in restitution because his emails that furthered his activities were transmitted over state lines, thereby constituting federal wire fraud. The SEC alleged that the defendant used cross-border emails and a web-based portal to provide false account statements and Ponzi-like payments. The SEC asserts that he misappropriated client funds by stealing their checks and depositing them into his bank account. The U.S. Attorney brought a criminal indictment against him for wire fraud based on the emails.
OUR TAKE: Federal wire fraud crime carries big prison and financial penalties. In this case, the U.S. Attorney leveraged the SEC charges into a federal conviction based on his cross-state emails.
The Massachusetts Securities Division fined a large broker-dealer $1 Million for compensating financial advisers to encourage clients to open securities-based lending accounts at an affiliated private bank. The MSD asserts that the firm violated its own policies against sales contests and failed to quickly stop the program after Compliance raised objections. The MSD cites statistics showing significant growth in securities-based lending associated with the program. The MSD charges supervisory violations and failure to ensure “commercial honor and just and equitable principles of trade.”
OUR TAKE: The MSD could not assert a suitability violation because the securities-based lending accounts are not securities. Instead, the regulator employed the “equitable principles” catch-all doctrine, which looks very much like a fiduciary standard. Even if the DoL rule dies and the SEC refuses to move on a fiduciary standard, watch out for the state regulators.
The SEC censured and fined a proprietary trading firm for failing to register as a broker-dealer. The firm offered $5000 memberships to individual traders who could use a limited amount of firm capital and also had access to firm research, training, software, and execution services. The SEC maintains that the firm’s principals benefitted through access to better execution resulting from higher trading volumes. The SEC charges violations of Section 15(a) of the Exchange Act for effecting transactions in securities without registering as a broker-dealer.
OUR TAKE: It is unclear why the firm could not rely on Rule 15b9-1, the exemption generally utilized by proprietary trading firms. In fact, two years ago, the SEC proposed to close the exemption but never followed through with a final rule. Maybe, the SEC intends to take a narrow reading of the rule in enforcement cases rather than change the rule.
The SEC fined and barred an attorney from practicing before the Commission for failing to conduct proper due diligence as underwriter’s counsel for misleading municipal bond offerings. According to the SEC, the lawyer prepared disclosure documents that contained erroneous statements that the issuer would comply, and had complied, with certain continuing disclosure obligations. The SEC faults the lawyer for failing to conduct proper due diligence and relying solely on statements from the issuer. The SEC also alleges that the lawyer ignored red flags that the disclosure was inaccurate. The SEC separately prosecuted the issuer and the underwriter.
OUR TAKE: We have previously predicted that the SEC would target lawyers as a class of gatekeepers responsible for policing securities markets. Counsel cannot ignore wrongdoing by claiming to have relied solely on client representations.