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Month: March 2018

SEC Prosecutes Current and Former Compliance Officers for AML Failures

The SEC fined and barred from the industry an anti-money laundering compliance officer for failing to file Suspicious Activity Reports.  The SEC asserts that the AML CO ignored red flags about heavy trading in low-priced securities including specific alerts provided by the clearing firm and warnings from the SEC OCIE staff.  The SEC also commenced proceedings against the previous AML CO for similar failures. The Bank Secrecy Act and the firm’s Written Supervisory Procedures specifically required filing of SARs for several transactions that the respondents ignored over a 2-year period.    The SEC also fined the firm and its CEO.

OUR TAKE: This firm did not have the requisite compliance “tone at the top” when 2 compliance officers and the CEO all ignored AML red flags, yet the SEC seeks to hold the compliance officers specifically accountable.  Also, compliance officers should take note that they don’t escape liability for past actions when they quit a job.  The SEC can still bring charges against former employees for misconduct that occurred while they acted in a compliance function.



Broker-Dealer Unlawfully Commingled and Pledged Client Assets

The SEC fined and censured a broker-dealer for violations of the customer protection rule arising from transactions with its clearing broker.  The SEC alleges the firm failed to properly segregate customer funds and securities held at its omnibus account at the clearing firm, which held unlawful liens against the assets.  The respondent failed to obtain the proper consent from clients to move assets.  The result of the violative transactions allowed the broker-dealer to borrow money from the clearing firm using client assets as collateral.  The transactions violated the customer protection rules.

OUR TAKE:  Hire a competent Financial Operations Principal.  Without expert help, a broker-dealer can easily and unwittingly violate the complicated and esoteric customer protection rules.


SEC Official Questions Registration Exemption for ETF Index Providers

The SEC’s Director of the Division of Investment Management, Dalia Blass, questioned whether ETF index providers should continue to claim a blanket exemption from investment adviser registration.  Ms. Blass, acknowledging an exemption for publishers of broad-based indexes, asked whether providers of more narrow indexes should register as investment advisers especially where such providers create indexes for a single fund or take significant input from the fund sponsor.  Ms. Blass cautioned “against assuming that the status of a provider can be determined based simply on its characterization as an index provider” and encouraged fund sponsors and index providers to “refresh your analysis if you are looking at a bespoke or narrowly focused index.”  Ms. Blass also advised funds to consider disclosure implications of narrow indexes.

OUR TAKE: As a result of Ms. Blass’s speech, index providers should expect some hard questions from fund counsel and independent directors’ counsel as the lines blur between index creation and investment recommendations.


Fifth Circuit Vacates Fiduciary Rule

The Fifth Circuit Court of Appeals, in a 2-1 decision, vacated the Department of Labor’s fiduciary rule primarily on the grounds that the DoL unlawfully expanded the definition of the term “fiduciary” to include commissioned brokers.  The Court opined that the DoL departed from the common law and contextual definition of “fiduciary” and dispensed with the criteria used for the past several decades.  The Court agreed with business groups that argued that the Rule would cause many financial service providers to exit the market for retirement advice, thereby hurting the people that the DoL intends to protect.

OUR TAKE: We assume that the DoL will consider appealing this decision to the Supreme Court, which could take months/years.  In the meantime, our recommendation is to comply with the best interest standard that went into effect last June and see what happens in the courts, in Congress, and at the DoL.


The Friday List: 2018 Examination Priorities

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Both FINRA and the SEC OCIE staff recently released their 2018 examination priorities.  Today’s list synthesizes their missives into the 10 most significant regulatory priorities for investment management firms.   Several of these priorities are new this year including cryptocurrency, wrap fee programs, and thinly-traded securities.  Others such as AML, suitability and best execution are regulatory greatest hits that appear nearly every year.   Compli-pros should use these letters to prepare their compliance programs and exam readiness.


10 Most Significant 2018 Examination Priorities


  1. Disclosure of fees and expenses: Both OCIE and FINRA champion full transparency of fees and expenses so that clients can make informed decisions and understand possible conflicts of interest.
  2. Cryptocurrency:  Expect a lot of attention paid to initial coin and cryptocurrency offerings including recommendations, disclosure, volatility, and security.
  3. Cybersecurity:  The regulators want to ensure that firms implement adequate cyber policies and procedures to protect client information and data systems.
  4. AML and KYC:  This is an area that both regulators have identified for many years, although the focus has moved to customer due diligence and firms’ gatekeeper role to keep securities markets safe.
  5. Protecting senior investors: Both regulators want to protect senior investors.  The SEC focuses on recommendations to retirement accounts.  FINRA will review compliance with rules to prevent exploitation.
  6. Wrap fee programs: The SEC continues its persecution and prosecution of wrap fee programs, including due diligence, best execution, and conflicts.
  7. Thinly-traded ETFs and microcaps:  The regulators have raised the red flag about recommending thinly-traded securities that are subject to market manipulation and pay exorbitant commissions.
  8. High risk brokers:  FINRA wants firms to enhance hiring and supervision practices to keep bad actors out of the industry.
  9. Suitability: Firms must implement procedures to vet products and train reps.
  10. Best execution:  FINRA is particularly concerned about order-routing practices and resulting conflicts of interest.

Compliance Officer Charged with Securities Fraud

The SEC charged a compliance officer with securities fraud and aiding and abetting his employer’s violations by “adding an aura of legitimacy” to an oil and gas offering fraud.  The SEC accuses the compliance officer with ignoring misstatements in offering documents and client communications and with failing to conduct required investor eligibility due diligence. The SEC also charges the compliance officer with filing false Form Ds with the Commission.

OUR TAKE: This is what we call “voodoo compliance” i.e. using purported compliance as a tool to further securities law violations.  The SEC has become wise to firms that implement sham compliance programs.


Broker Guilty of Bribing Public Plan Official

A broker charged with bribing a public plan official to secure brokerage business pled guilty to criminal securities fraud charges and was barred from the industry.  The SEC charges that the broker spent nearly $20,000 on hotels, meals and concert tickets and then concealed the name of the public plan official on expense reports.  The SEC argues that the bribes resulted in over $1 Billion in fixed income trading for her firm and significant commissions paid to the broker.  The SEC also asserts that she knew the public plan official violated his disclosure obligations.

OUR TAKE: The payor of illegal solicitation payments will incur as much legal wrath as the recipient.  It is unlikely that the commissions received will compensate her for the fines, criminal penalties and industry bar.


State-Registered Adviser Barred and Fined for Cherry-Picking

The SEC fined and barred the principal of a state registered adviser for cherry-picking trades to favor his personal accounts over client accounts.  The adviser used an omnibus account at two different brokerage firms over a 3-year period to engage in day trading.  The SEC asserts that the adviser allocated trades after the relevant security’s intraday price changed.  The SEC maintains that the trading outcomes indicate a statistically significant allocation to personal accounts.  Over the period, the respondent’s first day allocations resulted in 81.9% profitable trades to his personal account but only 16% to client accounts.  The brokerage firms closed his omnibus accounts because they suspected cherry-picking, although they did not inform the respondent why they terminated.  A third brokerage firm did not allow omnibus accounts.

OUR TAKE: State-registered advisers are not subject to SEC exam or the compliance rule (206(4)-7), which requires a compliance program that includes annual testing and reporting.  As a consequence, an adviser that is not SEC registered can go several years engaging in clearly illegal conduct without detection.



Fund Manager to Pay $3.6 Million for Failing to Fully Disclose Securities Lending Benefits


A large mutual fund manager agreed to pay $3.6 Million in disgorgement, interest, and penalties for failing to disclose that affiliates would receive tax deductions that would deprive fund investors of securities lending income.  The fund manager told investors and the Board that it would engage in discretionary securities lending and told the Board that affiliates could benefit from certain tax deductions.  The SEC faults the respondent for failing to tell either investors or the Board that it might recall securities before the dividend record date, which allowed affiliates to take a dividend received deduction and deprived the fund and its shareholders of additional securities lending revenue.  The SEC cites violations of the Advisers Act’s antifraud rules, acknowledging that proof of intent is not required and that such charges “may rest on a finding of simple negligence.”

OUR TAKE: This type of fraud charge based on simple negligence looks a lot like the type of “broken windows” enforcement cases that former SEC Chairman Mary Jo White championed.  The SEC does not allege that fund investors would have made a different investment decision if it included the SEC’s enhanced disclosure.  The conflict of interest makes the disclosure insufficient notwithstanding any effect on investors.


Stock Exchanges Pay $14 Million Fine for Weak Backup Procedures

The SEC fined the three affiliated exchanges $14 Million for failing to implement required business continuity and disaster recovery procedures and other compliance violations uncovered during significant market disruption events.  The SEC charges that the exchanges violated Regulation SCI, adopted in 2014, because it relied on backup affiliate systems rather than ensure reasonably designed backup and recovery capabilities.  The SEC also charged the exchanges with making misrepresentations during market disruptions and wrongly implementing trading halts.

OUR TAKE: Advisers and Broker-Dealers also must implement reasonable business continuity and disaster recovery procedures.  If the SEC will bring charges against national exchanges, expect scrutiny during exams.