A large BD/IA agreed to pay a $1 Million fine and retain an independent compliance consultant as a result of a third-party intrusion into its customer system. Outside hackers impersonated independent consultant registered representatives and tricked internal IT personnel to change passwords over the phone. Although there was no unauthorized transfer of funds, the impersonators were able to access personally identifiable information of over 5000 customers. The SEC charges the firm with violating the Safeguards Rule and with failing to implement an effective Identity Theft Prevention Program. The SEC faults the firm for allowing outside contractors to use their own equipment, which often had security and encryption problems, and with failures to follow remote session termination procedures.
OUR TAKE: This is the nightmare scenario for retail BD/IAs. The desire to make life easier for the producing reps creates IT vulnerabilities exploited by bad actors. Our recommendation is to retain an outside firm that can conduct an honest vulnerability assessment.
A private fund manager agreed to pay a $500,000 fine for failing to disclose, and obtain consent for, transactions for which it acted as a broker and principal. The SEC maintains that the fund manager received compensation for two transactions whereby one advisory client purchased assets from another client. The SEC also asserts that the fund manager engaged in a principal transaction when it caused a subsidiary to purchase assets from one client and then subsequently sell them to another client. The SEC charges the firm with violating Section 206(3) of the Advisers Act for failing to provide written disclosure and obtain consent for the transactions.
OUR TAKE: Moving assets around among client funds may have been common practice before Dodd-Frank required private fund managers to register. However, Section 206(3) specifically limits such transactions by requiring notice and consent.
The SEC fined a large broker/custodian $500,000 for failing to file Suspicious Activity Reports for terminated advisers suspected of engaging in risky activity. The firm would only file SARs when an individual employee referred the adviser to the Anti-Money Laundering Department. According to the SEC, the firm failed to supervise employees making such referrals, which resulted in inconsistent referrals based on a misunderstanding of regulatory requirements. The firm failed to file SARs despite knowledge of potentially unlawful activity such as improperly shifting trade error losses to clients, charging questionable fees, and making false statements. The SEC charges the broker/custodian with failing to file SARs with respect to activity that had “no business or apparent lawful purpose.”
OUR TAKE: The SEC is again using a broad reading of the Bank Secrecy Act and the SAR filing requirement to force broker/custodians to police all potential wrongdoing by advisers using their platforms. The SEC does not contend that the misbehaving advisers were engaging in money laundering or that the broker/custodian in any way assisted such activity. Nevertheless, the broker/custodian must file a SAR anytime it has reason to believe that any regulatory violation has occurred. It is also noteworthy that the broker/custodian did not get much credit for ceasing business activities with the questionable advisers.
The SEC censured and fined an investment adviser and its principal for allowing a radio station to air testimonials. The adviser purchased radio spots that aired over a two-year period, during which one of the radio hosts became a client. During both live and pre-recorded segments, the radio host noted his relationship with the firm, expressed his satisfaction, and praised his wealth manager by name. The SEC faults the adviser for failing to take any action to monitor the spots (including by declining to accept transcripts offered by the radio station). Separately, the SEC also accuses the adviser’s principal with failing to report personal securities accounts to the firm’s Chief Compliance Officer.
OUR TAKE: This failure to monitor media also applies to social media where firms have an obligation to squelch potential client testimonials on sites that the firm makes available (e.g. Web page, LinkedIn, Facebook).
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.
The SEC hates wrap programs. Nobody at the SEC has actually said that, but the regulator’s actions support that conclusion. Nearly every year, OCIE targets wrap programs as an exam priority. Over the last couple of years, the Enforcement Division has brought case after case alleging that wrap programs violated applicable provisions of the Advisers Act. In response, we have advised compli-pros at firms that offer wrap programs to conduct serious reviews and testing to make sure their programs don’t become Enforcement examples. Today, we offer 10 reasons why the SEC hates wrap programs.
10 Reasons Why the SEC Hates Wrap Programs
- Weak due diligence: Wrap Sponsor Pays $97 Million for Inadequate Due Diligence
- Favoring affiliates: Adviser Didn’t Fully Disclose Financial Incentive to Recommend Affiliated Wrap Program
- Reverse churning: Wrap Sponsors to Pay over $9.5 Million to Settle Share Class and Reverse Churning Charges
- Overbilling: Large Wrap Sponsor Pays $18.3 Million for Compliance Problems in Business Sold 8 Years Ago
- (Not) best execution: Wrap Sponsors Fined for Failing to Disclose Trading Away Commissions
- Step-out trading: Wrap Sponsor Did Not Evaluate Trading Away by Portfolio Managers
- Trading away: Wrap Sponsor Fined for Failing to Monitor Trading Away Practices
- Double-charging: Failure to Heed Compliance Consultant’s Recommendations Results in Enforcement Action
- Lower share classes available: Wrap Sponsor Failed to Update Compliance Policies for Lower Share Classes
- Inadequate Form ADV disclosure: SEC Imposes $300,000 Fine for Wrap Program ADV Missteps
A large broker-dealer agreed to pay nearly $13 Million to settle charges that it misled institutional customers about the operation of its dark pool and failed to register as an exchange or an ATS. The SEC alleges that the broker-dealer, contrary to marketing and other representations, allowed high frequency traders into its dark pool. According to the SEC, the HFTs represented more than 17% of all execution during the relevant 3-year period. The SEC also faults the firm for routing orders to external venues that charged less for execution without passing the lower cost to clients. The SEC also charges that the dark pool should have registered as a national securities exchange.
OUR TAKE: Apparently, the prosecutions of dark pools and high frequency traders have not ended. The SEC has focused on the trading venues as a backdoor way to regulate HFTs.
The SEC has withdrawn two no-action letters that allowed an investment adviser to rely on third-party proxy voting services so long as the adviser had policies in place to ensure independence. The SEC withdrew the letters because it wants to open debate about the regulation of proxy voting services at its upcoming Roundtable on the Proxy Process in November. The SEC wants to consider whether investment advisers are “relying on proxy advisory firms for information aggregation and voting recommendations to a greater extent than they should, and whether the extent of reliance on these firms is in the best interests of investment advisers and their clients, including funds and fund shareholders.” The SEC withdrew the Egan-Jones Proxy Services (5/27/04) and Institutional Shareholder Services (9/15/04) no-action letters.
OUR TAKE: The Egan-Jones and ISS letters provided a de facto safe harbor for advisers to rely on third party voting services. Their withdrawal and upcoming roundtable open the door to additional requirements on advisers to supervise proxy voting.
The SEC has commenced enforcement proceedings against a hedge fund manager for taking short positions in a public company and then engaging in a negative and public relations campaign to drive down the company’s stock price. The hedge fund manager used interviews, social media and published research reports to make false claims about the company’s product and financial situation. According to the SEC, the false negative information had the intended effect of lowering the company’s stock price, which fell 34% during his negative campaign. The SEC charges violations of the anti-fraud rules.
OUR TAKE: We suspect that many public companies are cheering this action because the SEC seeks to chill a short seller from disseminating negative information for financial gain. In this case, the SEC maintains that the hedge fund made false factual statements. This type of case will not help prevent negative opinions based on accurate facts.
The manager of a crypto hedge fund offered its investors rescission and agreed to pay a $200,000 fine for failing to comply with the securities. The SEC argues that the fund, which invested in digital assets, was “engaged in the business of investing, holding, and trading certain digital assets that were investment securities.” Consequently, the offering, which did not comply with Regulation D’s private offering safe harbors, should have been registered under the Investment Company Act. The SEC charges violations of the registration provisions of the Securities Act and the Investment Company Act as well as the antifraud rules. This case is the SEC’s first enforcement action against a crypto hedge fund manager for failing to register under the Investment Company Act.
OUR TAKE: Most significant is the SEC Enforcement Division taking the position that a fund that invests in digital assets is subject to the securities laws. It remains to be seen whether others will challenge that position in the courts.
A bank-affiliated adviser agreed to reimburse clients over $600,000 and pay an additional $100,000 fine for failing to disclose that it had an incentive to recommend an affiliated wrap program. The affiliated wrap program paid a 2% up-front incentive to the adviser if its investment counselor recommended the program. If the client withdrew from the program within two years, the client would pay a termination fee. Approximately 78% of client assets were directed to the affiliate program even though two other third-party wrap programs were available. The SEC faults the firm’s disclosures for failing to fully describe the financial incentive to recommend the affiliate program and that the investment counsellor would retain the up-front incentive fee even if the client terminated. Although the adviser was state (not SEC) registered, the SEC maintains that the respondent violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction that operates as a fraud on any client or potential client.
OUR TAKE: Recommending proprietary products over third party products requires enhanced due diligence and disclosure because of the inherent conflicts of interest. When the adviser recommends proprietary products that benefit the adviser to the direct detriment of the client, the arrangement will draw heightened scrutiny and will often result in an enforcement action.