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Month: January 2020

The Friday List: 10 Interesting Things We Learned at Inside ETFs

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.

We made it down to Hollywood, Florida this week for Inside ETFs, the annual self-congratulatory industry confab of everything ETFs.  We saw issuers big and small, service providers, advisers, and technologists.  There were also some pretty cool special guests like Barney Frank and Derek Jeter.  We took in a lot of information over three days of sessions and networking.  For those that couldn’t make it (or for those that may have, ahem, missed a few of the sessions), we offer the ten most interesting things we learned at the conference.

10 Interesting Things We Learned at Inside ETFs

  1. Zero fees: Competition helps firms with scale but investors should consider hidden costs.
  2. Service matters: Many investors/RIAs are willing to pay more for service.
  3. Quality: Low expenses get you in the game, but performance may ultimately keep you there.
  4. Active and non-transparent: Active ETFs are not new, but non-transparent ETFs are changing the industry.
  5. ESG. ESG is a screen applied to almost any equity strategy rather than a strategy unto itself.
  6. Model portfolios. Model portfolios are better tools that RIAs can use; they don’t replace the RIA.
  7. Niche marketing. Smaller firms have to define a niche to attract clients.  A niche is a small enough cohort to differentiate but large enough to sustain growth.
  8. Fixed income. With uncertain economic conditions, fixed income ETFs are likely to become a more significant part of the industry.
  9. Mission investing. Interest group-focused products such as the LGBTQ fund will target investors looking to use their money for more than just yield.
  10. Our daughters will rule the world. Julian Guthrie’s Alpha Girls provides a “see it so you can be it” template for high-performing women in male-dominated industries.

SEC’s OCIE Issues Cybersecurity Best Practices Report

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has published a report of cybersecurity best practices.  The report advises registrants to assess their cybersecurity practices in seven key areas: governance and risk management, access rights and controls, data loss prevention, mobile security, incident response, vendor management, and training.  Citing industry best practices, OCIE advises firms to conduct risk assessments; adopt, implement and test policies and procedures; restrict access; inventory the location of data; conduct vulnerability scanning; implement patches; encrypt networks; create an incident response plan; and supervising vendors.  OCIE recommends following statements from the Cyber Infrastructure Security Agency as well as the National Institute of Standards and Technology.  OCIE identifies cybersecurity as “a key risk for security market participants” and a “key priority” for exams.

Cybersecurity transcends merely hiring a random IT firm to conduct a penetration test.  OCIE requires an entire firm governance and compliance infrastructure.  Our firm, in conjunction with Align Cybersecurity, includes a cybersecurity assessment and remediation plan in our compliance outsourcing service.

Series Trust Fund Manager Pays $10 Million for Ignoring Risk Limits


A mutual fund manager agreed to pay over $10 Million to settle charges that it did not observe its own risk management practices, which ultimately resulted in the fund losing 20% of its value.  The fund, part of a larger series trust and converted from a private fund in 2013, invested in S&P 500 index futures contracts.  The fund’s marketing materials described significant risk management procedures that would limit downside through hedged positions and stop-loss triggers.  The SEC alleges that the portfolio manager ignored the risk mitigation limits and that the CEO failed to supervise him.  The SEC charges several violations of the Advisers Act including the antifraud provisions.  A federal lawsuit continues against the portfolio manager, and the CFTC also settled charges with the respondents.

Don’t allow your portfolio managers to play regulatory Jenga.  Very often, former private fund managers have a hard time abiding by the strictures imposed by the Advisers Act and the Investment Company Act.  Firms should impose heightened supervision and training to ensure that hedge fund PMs understand the limitations. 

Broker Should Have Disclosed Investment Product Red Flags


An unregistered broker agreed to pay $600,000 to settle charges that he sold third party investments without disclosing numerous red flags and negative facts to potential investors.  According to the SEC, the respondent painted an overly rosy picture of the investments (ultimately Ponzi schemes) and the sponsor by highlighting consistent rates of return and a personal business relationship.  However, the respondent did not disclose that the sponsor had previous issues with the SEC, multiple failed investments schemes, and financial problems.  The SEC argues that once the respondent described the investments in a positive way, he “was under a duty to make materially fair and complete disclosure rather than presenting only a one-sided and unbalanced view of the investment.”  The SEC charges the unregistered broker with violating the antifraud provisions of the Securities Act.

When selling investment products, you cannot merely disclose the good facts.  In this case, the respondent may not (or may) have known the investments were Ponzi schemes, but he did have enough facts to suspect and should have warned potential investors. 

The Friday List: 2020 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 2020 examination priorities.  Today’s list summarizes their 10 most significant concerns for investment managers and broker-dealers.   New areas this year include Regulation Best Interest, digital assets and cash sweep programs. Some longtime favorites include anti-money laundering, best execution, and retail sales practices.  Compli-pros should use these letters to prepare their compliance programs and exam readiness.

10 Most Significant 2020 Examination Priorities

  1. Compliance programs. OCIE’s overriding concern is assessing whether compliance is actively engaged in firm operations and whether the CCO is knowledgeable and empowered.  FINRA wants firms to evaluate the “state of their compliance, supervisory and risk management programs.”
  2. Regulation Best Interest. Both OCIE and FINRA warn firms to implement new procedures and processes to comply with Regulation Best Interest, including Form CRS, and related interpretations.
  3. Retail Sales Practices. OCIE wants firms to re-consider disclosure, sales practices and conflicts of interest when advising retail clients.  FINRA adds supervision and focuses on certain products such as private placements and variable annuities.
  4. Revenue Sharing. The regulators have serious reservations about advisers who have a financial interest in the products they recommend.
  5. Information Security. Firms need to assess systems, technology governance, and testing to ensure the protection of clients’ personal information.
  6. Trading Practices. FINRA will target market manipulation practices, mark-ups/mark-downs, short sales, short tenders, and TRACE reporting.
  7. Digital Assets. OCIE worries that firms may not understand the differences between digital assets and more traditional products.  The examination staff will review suitability, trading, custody, valuation, and supervision.
  8. Anti-Money Laundering. Both regulators expressed concerns about how broker-dealers comply with their anti-money laundering obligations.
  9. Cash Sweep. FINRA wants firms to consider how they communicate features and options and how the programs operate.
  10. Best Execution. Always a perennial favorite, FINRA will focus on routing decisions, odd-lots, and options.

Broker-Dealers Busted for Tendering More than their Net Long Positions

Two broker-dealers were fined and censured for tendering more than their net long positions in a partial tender offer.  Both of the firms had sold call options, thereby reducing their net long positions, but the firms tendered the full amount of their long positions, thereby receiving more than their fair shares of the partial tender.  The broker-dealers violated Rule 14e-4 (aka the short tender rule), which prohibits a person from tendering more than its net long position in a partial tender offer.

Closed-end funds with limited liquidity should surveil for these types of trading shenanigans so that brokers don’t game the tender offer system. 

FINRA Allows More Family Offices to Participate in IPO Allocations

FINRA has broadened the definition of “family investment vehicle” so that more family offices can receive IPO allocations.  The amended definition now cross-references the family office definition from the Advisers Act to include all lineal descendants and their spouses as well as family clients including family trusts.  The changes to Rule 5130 (IPOs) and 5130 (new issue allocations) also address foreign investment companies, retirement plans, SPACs, and charitable organizations.

This change fixes an anomaly where family offices were treated differently for different regulatory purposes.  For broker-dealer compli-pros at firms that deal in IPOs and new issues, it may be worth taking a refresher on the arcane rules. 

Form CRS Not Enough to Satisfy Regulation BI’s Disclosure Obligations

The SEC’s Division of Trading and Markets, in recently released FAQs, clarified that Form CRS (the newly required Customer Relationship Summary) will not satisfy a broker’s Regulation Best Interest disclosure obligations.  The staff opines that Regulation BI and Form CRS have “distinct disclosure delivery obligations” that cannot be satisfied through a hyperlink or other cross-reference.  Regulation BI requires disclosure of “all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation,” information that likely exceeds Form CRS’s specific requirements.  The staff also notes that, in most cases, brokers may not make oral disclosures, then make a recommendation, and then follow up with the written disclosures.  The FAQs also address the definition of “recommendation” and how to mitigate conflicts of interest.

Expect several more FAQs this year as firms grapple with implementing Regulation Best Interest and Form CRS.  One practice point on conflict of interest disclosure: If it takes more than two sentences of disclosure, you probably shouldn’t do it. 

FINRA Plans Review of Regulation BI Compliance Among Other Examination Priorities

 FINRA plans to examine firm compliance with new Regulation Best Interest, Form CRS and related SEC guidance and interpretations during the upcoming year, according to its 2020 Risk Monitoring and Examination Priorities Letter.  FINRA will review whether firms have implemented procedures and training, whether their reps observe the best interest standard of care, how the firm guards against excessive trading, and the extent to which firms identify and address conflicts of interest.  Other significant priorities include sales practices and supervision (especially complex products, variable annuities, private placements, mark-ups/downs, and senior investors), trading authorization, best execution, TRACE reporting, and cybersecurity.

It is notable that FINRA intends to prioritize Regulation BI in the first year.  Usually, the regulators give some time for firms to put operations in place before conducting regulatory sweeps for compliance with new laws and regulations.      

Barred Adviser Lied to Investors about Track Record, Credentials and Performance


The SEC has commenced proceedings against a barred investment adviser for fraudulent statements made during a note offering.  The SEC alleges that the respondents concealed a barred adviser’s disciplinary history and industry bars by entering into a bogus operating agreement showing a 5% ownership interest when he had a 50% stake.  The other partner to the venture had little to no securities experience.  The SEC accuses the respondents of lying to investors to induce them to purchase promissory notes with their self-directed IRA accounts.  The respondents allegedly lied about performance, safety, track record, and credentials.

This is exactly why the industry needs an active regulator.  Only by ridding the industry of (alleged) liars and thieves like this can the investment industry instill confidence in the regulators, the clients, and the lawmakers.  Ultimately, strong regulation facilitates growth as evidenced by the $20 Trillion in assets in registered funds and ETFs, the most regulated investment products on the planet.