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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. 

SEC Examinations to Focus on Compliance, Reg BI, and Retail


The SEC’s Office of Compliance Inspections and Examinations (OCIE) will focus on compliance programs, retail investors, and Regulation Best Interest according to its 2020 Examination Priorities Letter.  OCIE will investigate whether the CCOs are knowledgeable and empowered and whether they are actively engaged in firm operations.  OCIE will prioritize reviewing dually registered firms, advisers that use sub-advisers, and ESG advisers.  OCIE will also spend significant resources ensuring that firms follow Regulation Best Interest, deliver the new Form CRS, and observe the new Advisers Act fiduciary interpretations.  OCIE will scrutinize disclosures, fees, conflicts, and suitability related to recommendations of funds, ETFs, and other products to retail investors.  Other topics in the Letter include information security, robo-advisers, digital assets, and series trusts operated by third-party administrators.  OCIE warns that the priorities listed “are not exhaustive and will not be the only issued OCIE addresses in its examinations.”

The year is only a week old, but don’t blame compli-pros if they’re already exhausted.  Even before the year started, compliance professionals faced a mountain of new work because of Regulation BI and Form CRS.  Next comes a massive 28-page priorities letter with dozens of new “ToDos.”  We recommend that senior management seriously consider a budget increase for the compliance team.   

Auditor Independence Proposal Should Foster More Competition for Fund Audits


The SEC has proposed amendments to the auditor independence rules that would not preclude fund audits by firms that also provide services to portfolio companies.  Amendments to Rule 2-01 would modernize the definition of affiliate relationships so that minor engagements with portfolio companies would not violate the auditor independence rules for the fund engagement.  The proposal would also allow audit partners to carry student loans and de minimis consumer loans without impairing independence.  The proposal also adds a governance framework to address inadvertent independence violations resulting from merger and acquisition transactions.

Modernizing the auditor independence rules will facilitate more competition and hopefully drive down audit costs.  Also, rigid auditor independence rules oftentimes exclude an audit firm that may be best positioned through knowledge or experience to conduct an audit. 

The Friday List: My 2020 Predictions

Today, I offer the “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  The Friday Lists are an expanded “Our Take” on a particular subject, offering my unique (and sometimes controversial) perspective on an industry topic.

As reported last week, I went 4-4-2 on my 2019 regulatory predictions (26-19-5 over the last 5 years).  Below I offer my 2020 predictions, addressing Regulation Best Interest, closed-end funds, private equity, and compliance.  My one caveat is that my crystal ball is always cloudier during a presidential election year.  For example, if Jay Clayton or Dalia Blass decide to resign (not predictions although possible based on history), all bets are off as the SEC would grind to a regulatory halt.   Regardless, it should be an interesting regulatory year after all of the SEC’s 2019 new rules and proposals.  If you want more, please pick up a copy of my book: The Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm (available on Amazon).


Prediction for the 2020 Regulatory Year


Lawsuits will delay implementation of Regulation Best Interest.   Multiple states as well as a coalition of financial planners have filed lawsuits challenging Regulation BI.  The lawsuits claim that the SEC exceeded its authority or did not follow Dodd-Frank’s requirements.  The financial planners argue that Regulation BI competitively discriminates.  We expect the SEC will have to delay implementation and perhaps re-write the rule in response.

Congress will propose/adopt legislation increasing SEC penalties.  Both Republicans and Democrats agree that corporate wrongdoers should face more severe punishments.  Increasing SEC penalties died when Rep. Hensarling stepped down and his efforts to overturn Dodd-Frank ended.  We expect Congress will resuscitate this initiative as it relates to SEC penalties.

New SEC rules will expand the closed-end fund market.  The SEC will adopt changes to the accredited investor definition and facilitate the registered closed-end fund offering process with modernized disclosure and tender offer rules.  The closed-end fund market will blossom, allowing retail investing into otherwise privately-offered securities.

The SEC will attack zombie funds.  As far back as 2014, the SEC raised concerns about “zombie” funds i.e. private funds that lock up investor redemptions but do not attract new assets or make new investments.  Late last year, the SEC brought a significant case alleging that the fund manager took illicit management fees even though it claimed the fund was illiquid.  We expect a number of significant enforcement actions against zombie funds this year.

The SEC will bring significant valuation cases against private equity firms.  As the retail market opens for private equity (see above), expect the SEC to scrutinize how PE firms value assets to calculate fees and performance.  The SEC has already shown its willingness to attack PE valuations.

OCIE will conduct an adviser advertising sweep.  It’s great news that the SEC recently proposed a modernized marketing and advertising rule.  We expect that the SEC will adopt the rule (in current or modified form) and then direct OCIE to conduct an industry sweep to ensure compliance.

Dual registrants will face a series of reverse churning cases.  The SEC has expressed concerns about dual registrants that put clients in fee-based programs when those clients would pay less in traditional brokerage accounts.  The SEC has brought a few cases charging reverse churning.  Expect a slew of these cases as sequels to the revenue sharing cases of the prior few years.

The SEC will allow the use of distributed ledger technology for securities settlement  and shareholder transactions.  The SEC has already allowed the beta test of a distributed ledger technology for securities settlement.  Although the SEC has raised significant regulatory concerns especially around custody, we expect that the use of these technologies will become more widely permitted and utilized this year.

The Enforcement Division will commence several cases against registered funds alleging inadequate fund compliance programs.  A recent OCIE sweep uncovered widespread regulatory failures by registered funds.  The industry has received its warning shot.  Expect litigation this year.

There will be a dramatic increase in the launch of niche ETFs.  Although ETF launches were down last year, we expect that the adoption of the new ETF rule will facilitate the launch of smaller, niche ETFs who will no longer have to obtain an exemptive order.