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Month: June 2018

SEC Proposes ETF Rule

The SEC proposed a new rule that would allow exchange-traded funds to launch without obtaining an individualized exemptive order, a discretionary process that can take several months.  Proposed rule 6c-11 would allow ETFs structured as open-end funds to operate so long as they provide daily portfolio transparency on their websites, disclose historical premium, discount and bid-ask spread information, and adopt policies and procedures about the use of custom baskets.  Other conditions may be included in the full proposal once it is released.  The proposed rule would rescind current exemptive relief granted to ETFs that could rely on the new rule.  Since 1992, the SEC has issued more than 300 ETF exemptive orders, creating a $3.4 trillion market that includes over 1,900 ETFs representing nearly 15% of total investment company assets.

OUR TAKE:  The SEC already went down this road back in 2008.  Let’s hope that the Commission adopts a rule and ends the costs and delay associated with requiring formulaic exemptive orders.


CCS’s Garcia Reports on Futures Industry Association Conference 

Bridget Garcia of Cipperman Compliance Services recently attended the Futures Industry Association Law and Compliance Conference in Washington.  The well-attended event addressed cryptocurrencies and related regulation, a major issue of interest to the industry.  Panels discussed the evolution and purpose of cryptocurrencies and how the CFTC, SEC and FINRA will carve up regulatory responsibilities.  Moving onto more tactical matters, one panel discussed regulatory hot topics, including AML and GDPR, and another panel tackled CCO responsibilities.  Day 3 focused heavily on swaps and derivatives.  Feel free to contact Bridget if you want more information.

Link to conference summary

BD/RIA Knew about Flipping Transactions but Failed to Stop Them

A large bank-affiliated broker-dealer/adviser agreed to pay over $5.1 Million in disgorgement, interest and penalties for failing to stop its brokers from churning/flipping high-commission market-linked investment products.  The SEC alleges that the respondent knew that its brokers engaged in flipping transactions as far back as 2005 but took inadequate measures to stop the misconduct.  For several years, the firm relied on supervisor pre-approval but failed to provide supervisors adequate guidance or training, resulting in routine approvals.  The firm finally stopped the unlawful activity by implementing a centralized electronic supervisory pre-approval process.

OUR TAKE: The regulators will not give credit for “voodoo compliance” whereby a firm superficially creates a compliance infrastructure, but the designated policies and procedures fail to stop unlawful conduct.  Ad hoc supervisory reviews rarely serve as adequate tools to check brokers with a significant financial incentive.


Unknowing Adviser May Have Custody if it Recommended Custodian


An adviser that recommends a third party custodian will be deemed to have custody of client assets where the custodial agreement allows the adviser to instruct the custodian to disburse or transfer funds or securities, even if the adviser does not know the contents of the custody agreement.  However, if the adviser did not recommend, request or require the third party custodian, the adviser will not have inadvertent custody that will require meeting the several elements of the custody rule (206(4)-2), including the surprise examination, notwithstanding the terms of the custody agreement.  The staff of the Division of Investment Management seeks to clarify last year’s guidance concerning inadvertent custody (see FAQ II.11).

OUR TAKE: There are now well over 50 FAQs about the custody rule.  Perhaps, the SEC will acknowledge that it needs to re-write the rule rather than continue to issue FAQs.


Supreme Court Ruling Challenges Decisions by ALJs Not Properly Appointed

The U.S. Supreme Court has ruled that the SEC must approve the appointment of Administrative Law Judges, thereby invalidating the appointment of ALJs appointed by SEC staff members.  The Constitution’s Appointments Clause requires officers of the United States to be appointed by the President, a court of law, or a head of department.  The Supreme Court opined that ALJs are “officers” and not mere employees because ALJs occupy a continuing office and exercise powers similar to a trial judge (e.g. discovery, subpoenas, admissibility, sanctions).  The Court ordered a new hearing before an ALJ appointed by the SEC.

OUR TAKE: This decision opens the door to a re-hearing in every case decided by an ALJ not appointed by the SEC.  Many industry observers and respondents have questioned the fairness of the ALJ process given that the SEC hardly ever loses a case.


BD Fined $42 Million for Masking Trade Execution

The SEC fined a large broker-dealer $42 Million for masking trade execution venues over a 5-year period. The SEC asserts that the respondent routed orders to various undisclosed third party execution venues in an effort to increase order flow to those venues, avoid trading access fees, and give the impression that the firm was a more active trading center.  The firm acknowledges that it masked trading venues by reconfiguring FIX messages, modifying TCA reports, and misleading clients.  The SEC argues that the firm withheld material information because many large buy-side clients consider trading venue material to their execution strategies.

OUR TAKE: Although this case was brought as a failure to disclose material information, it is really a fiduciary duty case.  The SEC does not allege that the customers suffered any harm i.e. that they paid higher commissions or received worse execution.  Instead, the SEC faults the respondent for using its unique position to benefit itself (and its trading partners).


CCS’S Calvano Reports on FINRA Annual Conference 

Ray Calvano of Cipperman Compliance Services recently attended the FINRA Annual Conference in Washington.  Major speakers included FINRA President and CEO Robert Cook and SEC Chairman Jay Clayton.  Mr. Clayton cited the SEC’s continuing concerns about cryptocurrencies and ICO offerings.  He also tried to offer some insight into the new Regulation Best Interest and what it means for broker-dealers.  The Conference also addressed how FINRA could tailor its regulations to the needs of smaller firms.  Feel free to contact Ray if you want more information.

Link to forum summary

New York’s Highest Court Limits Martin Act’s Statute of Limitations to 3 Years

The New York State Court of Appeals has ruled that the NYS Attorney General must institute cases under the Martin Act within a three-year statute of limitations period.  The court reasoned that the Martin Act, a broad securities fraud statute, expands liability beyond common law fraud and does not permit private rights of action.  Consequently, the shorter 3-year statute of limitations applies, rather than the default 6-year period requested by the Attorney General.  The case involved Martin Act fraud allegations against the sponsor of residential mortgage-backed securities.

OUR TAKE: This decision follows recent Supreme Court cases limiting statutes of limitations in government enforcement proceedings.  The case also materially constrains the use of the (over) broad Martin Act.


SEC Official Says that a Cryptocurrency is Not a Security, Absent a Sponsored Offering


The SEC’s Director of Corporation Finance, William Hinman, recently opined that cryptocurrencies themselves are not securities subject to SEC oversight, although undertakings operated by a central control group and targeted to passive third parties would constitute a securities offering.  Absent a “central enterprise” such that the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, Mr. Hinman would not apply the securities laws. Factors that transform an enterprise into an offering of securities include (i) a central group that promotes the offering and benefits and expends assets/effort to increase the value; (ii) the raising of funds in excess of what is necessary to establish a functional network; (iii) purchasers that seek a return in excess of the current market value; and (iv) a sales effort directed to the general public rather than users.  Mr. Hinman announced that the Division would be willing to offer promoters more formal interpretive or no-action guidance to ensure legal comfort.

OUR TAKE: Mr. Hinman offers practical guidance and some clarity on how to apply decades-old precedent to modern cryptocurrency networks and offerings.  We expect more guidance in the coming months from the other SEC divisions.


CFTC and States Sign Information Sharing Agreement for Enforcement

The Commodity Futures Trading Commission (CFTC) and the North American Securities Administrators Association (NASAA), the organization of state securities regulators, have signed an information sharing agreement intended to facilitate state regulators to investigate and enforce the Commodity Exchange Act.  The Agreement also allows the CFTC to share information about state securities laws violations.  The NASAA President described the unique role of state securities regulators because “they can bring enforcement actions for both securities law and commodities law violations” which is “particularly relevant given the recent epidemic of schemes involving cryptocurrencies and other modern types of commodities.

OUR TAKE:  The MOU deputizes the state regulators to enforce the commodities laws, which helps the budget-strapped CFTC.  It also continues the trend of more active state securities authorities.