A broker-dealer was censured and fined for delegating certain regulatory obligations to an inexperienced compliance associate. The firm filed forms with FINRA that certified due diligence about OTC issuers whose quotations it published. The firm’s policies and procedures required the trader to conduct the necessary due diligence and a firm principal to certify the information. In practice, an inexperienced compliance associate was tasked with obtaining the information and filing the Form 211s with FINRA by inserting the electronic signature of a principal.
This is an example of what we call compliance alchemy i.e. the appearance of compliance without actually complying. The firm had the correct procedures and filed the right forms. However, there was no substance behind the due diligence or the certifications. The regulators have become wise to firms that simply check the box without actually doing the underlying compliance work.
The SEC has proposed significant changes to the disclosure requirements for public companies, including how a registrant describes its business, its legal proceedings and risk factors. When describing the business (Item 101), the proposal would move to a more principles-based disclosure regime focused on material information a registrant should disclose rather than a list of topics. The new disclosures should also include a discussion of how the management of human resources affects the business. The proposal also would require a narrative about the effect of government regulations on a company’s capital expenditures, earnings and competitive position. There will be a 60-day comment period following publication.
It’s always good to focus disclosure on the material issues. However, every SEC administration trumpets a goal of “improving disclosure.” This effort may be like putting a coat of paint on a structurally defective house to prepare it for sale. The issue for public companies is not how the lawyers should interpret Item 101, but the onerous compliance and regulatory obligations that may discourage private and non-U.S. companies from accessing the public markets.
An SEC Administrative Law Judge determined to infer adverse conclusions to questions that a respondent refused to answer by invoking his Fifth Amendment privilege against self-incrimination. The respondent refused to answer every question in the proceeding including background and foundational questions. He also did not invoke the Fifth Amendment during the SEC’s investigation. The ALJ explained that an administrative proceeding as well as a district court could draw such adverse inferences in order to prevent a witness from gaining an unfair litigation advantage.
The Fifth Amendment to the U.S. Constitution states that no person “shall be compelled in any criminal case to be a witness against himself” (emphasis added). A court or an ALJ cannot make you testify if it would compromise your case in a parallel criminal action, but the judge can draw negative conclusions from invoking the Fifth. In other words, don’t invoke the Fifth Amendment just to be petulant in front of an ALJ. Consult your counsel to determine whether invoking the Fifth makes litigation sense given your civil and criminal predicament.
The SEC has sued a large RIA platform for failing to fully disclose that it had a material conflict of interest because it received revenue sharing from certain funds. The SEC alleges that the defendant received ongoing revenue sharing through its clearing firm on certain funds and share classes. Although the firm disclosed that it received revenue sharing and might have a conflict, it did not fully disclose that it actually received millions of dollars in revenue sharing and that lower cost funds and share classes were often available. The SEC asserts that the firm should have described the incentive it received to select funds and classes that benefited the firm to the detriment of its clients.
The SEC breaks new ground in this complaint by suggesting that the firm should have invested client assets in other funds (including funds sponsored by an affiliate of the clearing broker) that did not offer revenue sharing. Most prior revenue sharing cases have focused on the use of higher fee share classes of the same fund. This line of argument raises a concern that the SEC is implicitly advocating for the lowest cost fund regardless of investment mandate or performance. For example, would an adviser violate its fiduciary duty, absent revenue sharing, if it recommended a higher cost fund for reasons other than total expense ratio?
FINRA fined a large broker-dealer $1.25 Million for failing to conduct adequate background checks on over 10,000 non-registered associated persons over a 7-year period. For these non-registered persons, the BD relied on less comprehensive background checks conducted by its bank affiliate, which was required by the banking laws. The required Exchange Act background checks include a review of regulatory actions in addition to criminal activity. A FINRA official warned that “member firms must live up to their responsibility as a gatekeeper protecting investors from bad actors.”
This case is similar to an action against another bank-affiliated broker-dealer back in 2017. Large firms with multiple regulated affiliates must ensure compliance with each regulatory regime. Compliance with one financial services statute does not necessarily mean compliance with another. Firms should hire compliance specialists with substantive backgrounds in the applicable laws and regulations.
The SEC fined an investment adviser and its two principals for failing to disclose compensation received for recommending a third-party investment fund and for not registering as a broker-dealer. The adviser received a 1.25% up-front payment and trailing fee from the manager of a private fund that the respondents recommended. The adviser did disclose that it would receive compensation but did not disclose the conflict of interest resulting because the fees received exceeded its customary 1.00% asset management fee, thereby creating a financial incentive to recommend the fund. Because the compensation was transaction-based, the respondent was required to register as a broker-dealer, and the principals needed to obtain their relevant securities licenses.
The interesting twist here is that the SEC doesn’t really describe why the compensation should be characterized as transaction-based, triggering broker-dealer registration, rather than permissible asset-based compensation. Instead, the SEC relies more on the source of the compensation (e.g. the product sponsor) rather than a direct fee charged to the client. Could the firm have avoided the broker-dealer registration charges if it assessed the 1.25% fee on the client rather than collect it as revenue sharing from the product sponsor? This may be an economic distinction without a difference, but the SEC will view it through a different regulatory lens.
The SEC fined a large technology company $100 Million for misleading shareholders in public filings about breaches of its policies protecting user information. The firm was also fined $5 Billion by the FTC. According to the SEC, the firm knew in 2015 that a researcher had violated its policies by obtaining and transferring confidential user data to a third party research firm. Regardless, the defendant’s public filings for the next two years presented the risk of misappropriated data as hypothetical even though the researcher had already transferred the data and admitted the scheme to the defendant. The SEC charged the company with violating the securities laws by issuing several misleading public filings.
Last February the SEC issued cybersecurity guidance to public companies about their obligations to fully disclose cybersecurity risks and incidents. If public companies didn’t take the SEC seriously then, we expect that the combined $5.1 Billion in fines will garner attention. For asset managers and broker-dealers, in addition to implementing required customer data protections, they must also consider their disclosures in Form ADV and Form BD as well as any relevant offering documents.
The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies. Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories. The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies. OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation. The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.
How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program? An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation.
A private fund portfolio manager was barred from the industry and ordered to pay $749,000 in disgorgement and fines for intentionally inflating swap valuations and concealing his activities. According to the SEC, the PM, whose compensation was directly tied to fund performance, convinced management to use a discretionary valuation model for certain swaps and swaptions. Without telling management, he then began using discretionary inputs rather than default values for pricing. The SEC asserts that he used different discount curves to maximize valuations, fund performance, and his own compensation. The SEC further alleges that he hid his activities by lying to the fund administrator and third party brokers. Within 16 months after discovery of the mispricing, the firm reimbursed clients, shut down what had been a $375 Million fund, and ceased operations.
Firms should seriously re-consider tying portfolio management compensation directly to fund performance, especially where the PM is responsible for Level 3 (non-exchange traded) fair-valued securities. For both the C-suite and compli-pros, this case shows how a failure to properly supervise one bad employee can blow up your firm. As for the PM (and any other potential wrongdoer), the industry bar will make it difficult to find a job to get out of the six-figure hole resulting from the wrongdoing.
A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses. The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty. The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions. The SEC accused the defendants of securities fraud and falsifying books and records.
Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients. When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.