FINRA has proposed a new outside business activities supervision rule that would exclude independent investment advisers. Under the proposal, third party investment advisers would need to receive informed consent for their activities, but the BD would not have supervisory obligations. The BD could impose certain requirements based on a required risk assessment of conflicts of interest and customer confusion. The proposal also limits BD obligations to supervise non-investment related activities.
OUR TAKE: That sound you heard yesterday was the Greek chorus of cheers from investment advisers who have had to pay their broker-dealers a percentage of their advisory fees for required supervision. We expect the larger independent broker-dealers will lobby heavily against this proposal as it cuts off a lucrative revenue source. The proposal would help smaller regional firms that want to recruit reps but don’t have the currently-required supervisory resources. We expect much debate.
The SEC barred a private fund manager and ordered him to pay nearly $3 Million in disgorgement for creating fake identities and performance track record. The SEC alleges that the respondent created on-line doppelgangers and hired an internet-based search engine manipulator to fabricate search results to make it appear that his firm was managed by several legitimate investment management professionals. Instead, the respondent, who had a criminal background, was the sole owner/operator. The SEC also accused the fund manager of supplying Morningstar with false performance data and history so that the fund could secure a 5-star rating. In addition to the SEC penalties, the fund manager is serving a 60-month prison sentence.
OUR TAKE: If you are an investor or an adviser that recommends third party managers, you need to conduct significant due diligence, which necessarily goes beyond a web search and a Morningstar rating. As this case shows, a fraudster can manipulate internet results and fool databases.
The SEC has voted to delay the classification requirement of the open-end fund liquidity risk management rule until June 1, 2019 for large funds (over $1 Billion) and December 1, 2019 for smaller funds. The other requirements of the rule – implementing a risk management program, limiting illiquid investments to 15% of the portfolio – will still go into effect on December 1, 2018 for large funds and June 1, 2019 for smaller funds. The SEC also released a series of FAQs that provide additional guidance about how to effect the classification requirements.
OUR TAKE: The bad news is that the Clayton SEC will not rescind the liquidity risk management rule. The good news is that the SEC will provide more time and flexibility to implement its more complicated requirements.
The SEC has issued cybersecurity guidance that directs public companies to adopt effective disclosure controls and procedures and overhaul their disclosure about incidents and threats. The SEC believes that public companies should adopt and implement cybersecurity risk management policies and procedures that ensure timely disclosure, internal reporting, processing of risks and incidents, and prevention of insider trading. The SEC also admonishes public companies to review all public disclosures including the materiality of incidents and security, risk factors, MD&A disclosure, business description, legal proceedings, financial statements, and board risk oversight. Firms should also consider disclosing past incidents “in order to place discussions of these risks in the appropriate context.” The SEC believes that “the importance of data management and technology to business is analogous to the importance of electricity and other forms of power in the past century.” The SEC said that it will be reviewing cybersecurity disclosures.
OUR TAKE: We expect institutional investors will add similar cybersecurity inquiries into their Operational Due Diligence processes before choosing an investment firm. So, even if you do not work for a public company, you should consider implementing the SEC’s recommendations.
The United States Supreme Court has ruled that Dodd-Frank’s anti-retaliation provisions apply only to whistleblowers who report the misconduct to the SEC. In the case, the employee brought a claim under Dodd-Frank’s whistleblower anti-retaliation provisions, even though he had not reported to the SEC, because he claimed that he was fired as a result of reporting to management suspected securities law violations. The Supreme Court reversed the decision of the Ninth Circuit based on the plain reading of the statute which defines “whistleblower” as any individual who provides information relating to a violation of the securities laws to the SEC. The Court rejected the SEC rule that expanded anti-retaliation protection to those who only report internally. Looking at legislative history, the Court reasoned that “Dodd-Frank’s award program and anti-retaliation provision thus work synchronously to motivate individuals with knowledge of illegal activity” to report to the SEC.
OUR TAKE: We re-state our opinion that the Court is correct on the law even though Congress probably did want to protect those who only reported internally. Regardless, companies should still avoid retaliating against internal whistleblowers because (i) good companies should want to ferret out wrongdoing by encouraging employees to come forward and (ii) other laws and rules (e.g. state employment laws, Sarbanes-Oxley) could serve as the basis for a lawsuit.
The President of a broker-dealer was fined and barred for failing to supervise an inexperienced and ineffective Chief Compliance Officer. The CCO failed to properly monitor and halt excessive mutual fund trading by a registered rep. The CCO had difficulty analyzing the firm’s trade blotter and mutual fund reports even after a compliance consulting firm was hired to assist. FINRA faults the President for failing to recognize the CCO’s failures and take the necessary action to implement an adequate supervisory system. FINRA blames the President because he “was ultimately responsible for supervision.”
OUR TAKE: Do you know if your CCO is competent? Firm leaders do not satisfy their obligations to implement a compliance and supervisory system by merely calling somebody the Chief Compliance Officer. A CCO must be competent, have the necessary resources, effectively implement policies and procedures and test them. Then, firm management must monitor the CCO to ensure that the CCO adequately performs the role.
The Massachusetts Securities Division has commenced administrative proceedings against a large broker-dealer because it ran sales contests that violated its own policies adopted to comply with the Department of Labor’s fiduciary rule. The DoL rule, which became effective in June 2017, requires firms to follow an “impartial conduct standard” including acting in the best interest of customers, charging reasonable compensation, and ensuring full disclosure. In response to the rule, the BD adopted compliance policies prohibiting conflicts of interest when dealing with retirement accounts. Following adoption of the new policies, the firm launched sales contests, which the MSD alleges involved misrepresentations and conflicts of interest. The MSD alleges that the firm violated Massachusetts ethical conduct standards by failing to abide by its own policies and the DoL rule.
OUR TAKE: Even though he DoL won’t enforce the fiduciary rule, the impartial conduct standard applies to firms that recommend products to retirement accounts. Nevada has already passed its own fiduciary legislation. Now, Massachusetts uses its enforcement powers to compel fiduciary compliance. Expect other states to follow.
A large broker-dealer agreed to pay over $5.3 Million in remediation, disgorgement, fines, and interest to settle charges that it failed to properly supervise the traders and salespeople working on its non-agency CMBS desk. Additionally, the head of the CMBS desk was fired, fined, and suspended from the industry for failing to supervise. The SEC alleges that the CMBS desk regularly misrepresented terms and parties on the other side of secondary market CMBS transactions. Although the firm had policies and procedures and conducted training, the SEC faults the firm for not conducting “specialized training regarding the opaque CMBS secondary market” and for weak surveillance that “used generic price deviation thresholds in its trade surveillance to flag potentially suspicious trades instead of ones tailored to specific types of securities.”
OUR TAKE: This case is an example of what we call “compliance voodoo” i.e. the appearance of a compliance program that does not actually discover or stop wrongdoing. Sure, the firm had policies and procedure prohibiting making misrepresentations. Sure, the firm provided compliance training. Yet, the compliance and surveillance team completely missed the ongoing scheme of misrepresentations on the CMBS desk.
The SEC’s Enforcement Division is offering amnesty from civil penalties for firms that self-report failures to fully disclose conflicts of interest when recommending mutual fund share classes that pay 12b-1 fees. Under this new “Share Class Selection Disclosure Initiative,” self-reporting firms would disgorge the 12b-1 fees and reimburse clients as well as implement other compliance procedures to prevent future wrongdoing. The Share Class Initiative would apply to a registered adviser that failed to fully disclose the conflict of interest where it recommended mutual fund share classes that paid back 12b-1 fees to the firm or affiliates when lower fee share classes were available. The amnesty program would not apply to firms already involved in enforcement actions related to share classes but would be available if a firm is undergoing a pending OCIE examination. This amnesty program will not protect individuals associated with self-reported firms as the Enforcement Division will do a “case-by-case assessment of specific facts and circumstances, including evidence regarding the level of intent and other factors such as cooperation by the individual.”
OUR TAKE: Advisers should consult counsel to conduct a cost/benefit analysis of self-reporting, including the potential impact on senior executives.