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Month: November 2018

Federal Court Rules that the SEC Must Prove that Digital Tokens are Securities

A federal judge has ruled that an initial coin offering may not constitute an offering of securities.  In rejecting the SEC’s request for a preliminary injunction against an ICO, Judge Gonzalo Curiel of the Southern District of California, opined that the SEC failed to present sufficient facts to satisfy the Howey test requiring an investment of money in a common enterprise with an expectation of profit produced by the efforts of others.  Faced with conflicting interpretations of how the ICO operated, the Court denied the preliminary injunction because of genuine disputes about material facts.

The significance of this decision is that a court is requiring the SEC to factually prove the three prongs of the Howey test rather than simply accept the SEC’s position that digital tokens are securities.  If the SEC fails to prove its case and digital tokens are not securities, the SEC will not have the legal authority to regulate ICOs. 

BD Fined $2.75 Million for Omitting Customer Complaints from Forms U4 and U5

 

FINRA fined a large broker-dealer $2.75 Million for failing to include customer complaints on Forms U4 and U5 and for neglecting to file Suspicious Activity Reports for cyber-related events.  FINRA examined a small sample of customer complaints and found that the firm should have reported more than 22% of its customer complaints on Forms U4 and U5.  Extrapolating the small sample that FINRA reviewed, the firm should have reported nearly 300 customer complaints over the 2013-2016 period.    The firm erroneously construed the filing requirement by declining to report customer complaints unless the customer expressly requested more than $5000 in compensation.  FINRA also faults the firm for providing inaccurate guidance to supervisory personnel and thereby failing to file more than 400 SARs to report cyber intrusions or attempts.

 FINRA requires firms to heighten supervision over bad brokers.  To ensure compliance, FINRA needs to make sure that Forms U4 and U5 include all customer complaints and other reportable activity.  Compli-pros should err on the side of reporting notwithstanding the objections of producers and their supervisors.   

SEC Fines Two Initial Coin Offerings

The SEC ordered two initial coin offerings to offer investors rescission and pay a $250,000 fine for failing to register the offerings under the securities laws. These cases represent the first time that the SEC has imposed civil penalties solely for ICO securities offering registration violations.  One of the respondents raised $15 million by selling digital tokens intended to create a new digital coin ecosystem related to advertising and mobile phones.  The other respondent raised $12 Million to create a blockchain technology for the emerging cannabis industry.    The SEC maintains that the digital tokens are “securities” under the Howey test and, therefore, the offerings violated the registration requirements of the 1933 and 1934 Acts.  Both respondents undertook to register the offerings.

Given the SEC’s concerns about disclosure and compliance for ICOs, it will be interesting to see the extent of disclosure required in the promised registration statements. 

Top 5 Regulatory Alerts – October 2018

Here are our Top 5 Regulatory Alerts for October 2018, ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – October 2018

  1. SEC WARNS FIRMS TO TAKE ACTION AGAINST CYBER-FRAUDS (10/18/18)
  2. SEC ALLOWS FUND BOARDS TO RELY ON CCO FOR EXEMPTIVE RULE COMPLIANCE (10/15/18)
  3. PRIVATE FUND FIRM FAILED TO TIMELY DELIVER FINANCIALS TO LPS (10/4/18)
  4. SERVICE PROVIDERS ACCOUNTABLE FOR DESTRUCTION OF BROKER-DEALER RECORDS (10/30/18)
  5. STATE SECURITIES REGULATORS REPORT SIGNIFICANT INCREASES IN CRIMINAL PENALTIES (10/11/18)

 

Most Read – October 2018

  1. SEC WARNS FIRMS TO TAKE ACTION AGAINST CYBER-FRAUDS (10/18/18)
  2. PRIVATE FUND FIRM FAILED TO TIMELY DELIVER FINANCIALS TO LPS (10/4/18)
  3. LARGE FUND COMPANY PAYS OVER $2 MILLION FOR ALLOWING CROSS-TRADES (10/1/18)
  4. SEC ALLOWS FUND BOARDS TO RELY ON CCO FOR EXEMPTIVE RULE COMPLIANCE (10/15/18)
  5. ACCOUNTING FIRM FOLLOWED THE WRONG INDEPENDENCE STANDARDS (10/9/18)

Advisory Clients Did Not Receive Promised Fee Breaks

 

A registered investment adviser agreed to pay $354,000 in client reimbursements and penalties for failing to give clients the benefit of promised fee breakpoints over an 8-year period.  The adviser marketed a fee schedule that offered lower fees as assets increased and offered clients lower fees for aggregated household accounts.  According to the SEC, the respondent failed to apply the lower fees as clients reached the breakpoints or to aggregate household accounts for certain clients.  The SEC maintains that the firm overcharged 293 clients an aggregate of $304,000, which the firm voluntarily refunded following the commencement of the enforcement investigation.  In addition to alleging violations of the Advisers Act’s antifraud provisions, the SEC also faults the firm for failing to implement reasonable compliance policies and procedures.

Some very elementary supervision, operations and compliance infrastructure could have avoided the overcharging and the resulting enforcement action.  Emerging firms looking to squeeze out some profits should not skimp on the basic must-haves of running a proper firm. 

CFTC Penalties Nearly Triple in Fiscal 2018

 The Commodity Futures Trading Commission, the primary commodities and derivatives regulator, imposed nearly $1 Billion in civil monetary penalties, restitution and disgorgement during the fiscal year that ended on September 30.  The CFTC Division of Enforcement imposed $947 Million in penalties, disgorgement and restitution, including $897 Million in civil penalties, a nearly threefold increase over last year’s total.  The CFTC filed 83 enforcement actions, the most since 2012, and imposed $10 Million judgments in 10 cases, a CFTC high water mark.  More than 2/3 of cases charged an individual executive, reflecting the CFTC’s priority to hold individuals accountable in part because it deters others who become “fearful of facing individual punishment.”  The CFTC has also prioritized parallel criminal proceedings, setting enforcement records for the number of cases filed in parallel with criminal prosecutors.

The CFTC’s regulatory sphere has greatly expanded with the emergence of swaps, derivatives, cryptocurrencies, and alternative hedge funds.  The CFTC, like the SEC, has ramped up its enforcement activities to historic levels.

Dark Pool Fined $12 Million for Sending Trade Data to HFTs

The SEC fined a large dark pool $12 Million for sending confidential trading data to third party high frequency traders over an eight-year period.  The information included daily aggregated order and execution information and suggested that the recipient HFTs use the reports to identify unsatisfied liquidity needs.  The SEC also faults the firm for allowing unfettered access to trading data by sales and trading personnel.  While engaging in the alleged activity, the respondent consistently advertised the confidentiality of the trading information through the dark pool.

The whole point of trading through the dark pool was to avoid signaling to HFTs.  Yet, this firm allegedly exploited its trusted position by using the dark pool to court large, presumably profitable, third party market players. 

SEC Says that Digital Tokens are Securities; Requires Trading Platform to Register as Exchange

The SEC fined and censured the founder of a digital token trading platform that failed to register as a national securities exchange.  The SEC argued that, under SEC v. Howey, the tokens traded included securities because the purchasers of tokens “invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others.”  The token exchange allowed buyers and sellers to view pairs available for trading and a display of the top 500 bids and allowed users to enter buy and sell orders.

We expect a well-funded party will ultimately challenge the SEC in the courts about whether digital tokens are securities subject to SEC supervision.  However, until a court decides otherwise, those that trade in digital tokens and those that facilitate trading must register as broker-dealers or as exchanges. 

CCOs Liable for Failing to “Meaningfully” Implement Compliance Programs

 

A unanimous SEC, in a decision upholding sanctions against a Chief Compliance Officer, stated that it will not exempt a CCO from liability if the CCO “fails meaningfully” to implement the compliance program.  Although the Commission will defer to “good faith judgments of CCOs made after reasonable inquiry and analysis,” the SEC will hold the CCO liable where the CCO engages in wrongdoing (or attempts to cover it up), “crosses a clearly established line,” or fails to implement policies and procedures for which he or she has direct responsibility.  In the case itself, the SEC upheld FINRA’s findings of CCO liability because the CCO abdicated his obligation to review emails and failed to follow up on red flags relating to payments to a disqualified individual.

We think the standard should be much higher i.e. that a CCO should only be liable if s/he participated in the wrongdoing, actively covered it up, or directly and personally benefited.  We in no way condone the lack of diligence alleged in this case.  Perhaps, the CCO should have been terminated (or never hired in the first place).  However, so long as the SEC continues to hold CCOs liable based on retrospective and subjective determinations of how well the CCO implemented the program, good compliance people will continue to either leave the industry or demand hazard pay.

SEC Is Examining Registered Funds and ETFs for Oversight, Policies, and Conflicts

 

The SEC’s Office of Compliance Inspections and Examinations has announced a sweep of certain mutual funds and ETFs. The OCIE staff will target smaller ETFs and funds/ETFs that use custom indexes, allocate to securitized assets, exhibit aberrational underperformance, or employ inexperienced managers or private fund sponsors that manage a similar mutual fund.  The SEC will assess compliance policies and procedures and fund oversight of risks and conflicts, disclosures to shareholders and the Board, and oversight processes.  Among some of the issues of concern to the OCIE staff include bid/ask spreads for secondary market trading of smaller ETFs, portfolio management for underperforming funds, the effect of unexpected market stresses on securitized assets, and side-by-side allocations for private and public funds.  OCIE is encouraging fund sponsors and boards “to consider improvements in their supervisory, oversight, and compliance programs.”

Compli-pros and fund lawyers should mobilize to review policies and procedures for affected advisers and boards, consult about changes, and implement enhanced oversight and processes.  We recommend taking action before the OCIE staff arrives for its examination.