Home » Compliance Blog

FINRA Releases 2018 Examination Results

FINRA has released its 2018 Examinations Findings as a “resource for firms to strengthen their compliance programs and supervisory controls.” FINRA says the report selected certain observations because of “their potential significance, frequency, and impact on investors and the markets.” The report highlights widespread deficiencies in suitability policies and procedures including “quantitative suitability” (i.e. series of transactions), overconcentrations, excessive trading, and variable annuities. FINRA also cites widespread failures to ensure fulsome disclosure of fixed income mark-ups, reasonable private placement due diligence, and abuse of discretionary authority. The broker-dealer regulator summarizes other concerns including anti-money laundering, net capital and customer protection calculations, best execution and outside business activities.

This extensive list (15 pages) covers many of FINRA’s greatest regulatory hits. It’s a great document for new compliance officers because it covers a wide range of broker-dealer compliance requirements. Rather than helping compli-pros focus resources, it works better as a checklist to verify that the firm has addressed the most serious regulatory requirements.

Three Firms Fined $6 Million for IT Breakdowns that Caused Inaccurate Reporting

 

The SEC fined three broker-dealers more than $6 Million for providing inaccurate securities trading information to the regulator over several years.  The SEC asserts that coding errors caused the firms to provide inaccurate blue sheets for millions of trades.  The SEC faults the BDs for failing to implement a supervisory and control structure to ensure that they provided accurate information.  Two of the firms hired regulatory professionals to oversee the re-vamping of the underlying reporting systems.

Most larger firms rely on fintech for a variety of heavy-lifting tasks including collecting data for the regulators.   Management must integrate the compliance and regulatory professionals with the IT folks to ensure that the systems match the legal requirements.   Compli-pros must learn to “speak tech” to properly advise their employers and clients. 

BDC Censured for Mischaracterizing Distributions as Income Rather than Return of Capital

 The SEC censured a business development company for overstating its income as a payment of dividends rather than a return of capital and thereby violating several reporting rules.   The BDC included all payments received from underlying asset management subsidiaries as dividends even though a significant portion of the distributions should have been deemed returns of capital.  According to the SEC, the firm failed to offset taxable and accumulated net operating losses.  The SEC asserts that the mischaracterization was material because tax-basis distributable income is a significant metric used by analysts and investors to evaluate BDCs.  The BDC restated its financial statements and reported a material weakness in its financial control infrastructure.

The BDC should be thankful it didn’t get fined.  Although the SEC alleged facts suggesting that the firm should have known about the mischaracterization, an allegation that the firm intentionally juiced reported returns would have resulted in much more significant penalties. 

SEC Re-Considering Adviser Marketing and Advertising Rules

The SEC’s 2019 regulatory agenda includes amendments to adviser marketing rules.  The SEC will consider Rule 206(4)-1, the general advertising rule that prohibits fraudulent statements and specifically limits testimonials, past specific recommendations, and “black box” claims.  The SEC will also re-visit Rule 206(4)-3, which regulates the payment of cash solicitation fees to third parties.  Last year, the SEC took action on 23 of the 26 rules on its regulatory agenda.

Presumably, this rulemaking review has arisen from last year’s sweep whereby OCIE reported widespread marketing violations including misleading performance claims, cherry-picking results, the use of past specific recommendations, and improper claims of GIPS compliance.  The rules haven’t really changed much in several decades, so a re-boot makes some sense.  We recommend that the SEC consider specific standards rather than relying on a general anti-fraud rule. 

Compliance Failures Cost BDC Manager $4 Million in Penalties and $2.6 Billion in Assets

 A BDC manager’s compliance failures led to nearly $4 Million in fines, disgorgement and penalties and the loss of its advisory business.   The SEC charges the firm with misallocating overhead expenses to the registered Business Development Companies it managed and with overvaluing portfolio companies.  The SEC maintains that the registrant used material nonpublic information about BDC portfolio companies to benefit affiliated hedge funds that it managed.  In 2014, the firm had over $2.6 Billion in assets under management but withdrew its adviser registration in 2017 following the SEC enforcement action.  The SEC asserts violations of the compliance rule (206(4)-7) in addition to a laundry list of other securities laws violations.

Failure to implement an effective compliance program has consequences beyond penalties and fines.  The negative impact to a firm’s and its principals’ reputations could ultimately bring down the entire franchise. 

SEC Allows Broker-Dealer Fund Research Reports

 The SEC has adopted a new rule allowing third party broker-dealers to publish mutual fund research reports, so long as the reports include standardized performance information.  The new rule (139b) provides that a research report prepared by a broker-dealer unaffiliated with the mutual fund manager or sponsor will not result in an unregistered offering, and the research report will not constitute a prospectus.  The rule requires several conditions including: (i) the subject fund must have met all reporting requirements during the prior 12 months, (ii) the fund must have a net asset value of at least $75 Million, and (iii) any performance information must comply with Rule 482, which requires performance information to be presented in a standardized format.  The SEC initially proposed the rule in May.

The only controversy here is whether performance information should need to comply with Rule 482.  To keep performance information consistent probably makes life simpler for investors, broker-dealers, and the staff at the SEC and FINRA.  Regardless, we still believe that the SEC should take a fresh look at Rule 482 given the proliferation of investment products beyond open end funds investing in publicly-traded securities. 

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)