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CCO Fined and Barred for Failing to Conduct Rule 144 Due Diligence

 

A broker-dealer Chief Compliance Officer was fined $50,000 and barred from the industry for failing to implement procedures to prevent the unlawful liquidation of microcap securities.  FINRA asserts that the firm and its principals liquidated 74 million shares of microcap securities without satisfying Rule 144, thereby distributing securities in violation of the Securities Act.   The firm’s Written Supervisory Procedures designated the CCO as the person responsible for Rule 144 compliance.  FINRA rejected the CCO’s defense that the WSPs did not reflect how the firm actually operated.  FINRA also faulted the CCO for adopting inadequate WSPs, which failed to outline procedures to conduct adequate due diligence.

The CCO should review the compliance manual or WSPs and ensure s/he understands and undertakes all designated responsibilities.  If the CCO can’t or won’t follow the procedures, then s/he must revise the procedures to satisfy regulatory requirements while reflecting the firm’s accurate allocation of authority.

SEC Warns Firms to Take Action Against Cyber-Frauds

 

The SEC has issued and investigative report that advises public companies to enhance internal accounting controls to prevent losses from cyber-related frauds.  The SEC report describes frauds at 9 issuers that involved spoofing emails and false vendor invoices that resulted in significant losses when internal employees transferred funds to the wrongdoers.  One of the companies made 14 wire payments, resulting in a loss of over $45 Million.  Another paid 8 invoices totaling $1.5 Million.  Although the SEC did not bring enforcement actions against these registrants, the SEC alleges that the companies violated their obligations to implement internal accounting controls sufficient to ensure transactions are only permitted with management’s authorization.  In particular, the SEC advises companies to review and enhance their payment authorization and verification procedures and employee training.  SEC Chairman Jay Clayton warned: “Cyber frauds are a pervasive, significant, and growing threat to all companies, including our public companies.”

OUR TAKE: You’ve been warned.  The SEC gave these 9 companies a pass, but we don’t expect the same treatment for future violators who should now take action to prevent spoofing and email cyber-frauds. 

Top 5 Regulatory Alerts – August-September 2018

Here are our Top 5 Regulatory Alerts for August-September 2018, ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – August-September 2018

  1. LARGE ASSET MANAGER PAYS $97 MILLION FOR OVER-RELYING ON FAULTY QUANT MODELS (8/28/18)
  2. HACKERS IMPERSONATED REPS TO GAIN ACCESS TO CLIENT INFO (9/27/18)
  3. BROKER/CUSTODIAN FAILED TO FILE SARS FOR TERMINATED ADVISERS (9/25/18)
  4. PRIVATE EQUITY MANAGER LOWBALLED PURCHASE OFFER TO LPS (9/10/18)
  5. GLOBAL FIRM GUTTED VALUATION CONTROL FUNCTION (8/17/18)

 

Most Read – August-September 2018

  1. SEC WITHDRAWS LETTERS THAT ALLOWED ADVISERS TO RELY ON PROXY VOTING FIRMS (9/18/18)
  2. ASSET MANAGER FINED $1.9 MILLION OVER HYPOTHETICAL BACK-TESTED PERFORMANCE (9/5/18)
  3. CCO BLAMED FOR SIGNING CERTIFICATIONS THAT FACILITATED UNLAWFUL SECURITIES LENDING (8/2/18)
  4. COMPLIANCE FAILURES LEAD TO FIRM’S DEMISE (8/27/18)
  5. ADVISER FAILED TO STOP RADIO HOST FROM GIVING TESTIMONIALS (9/24/18)

SEC Allows Fund Boards to Rely on CCO for Exemptive Rule Compliance

 The staff of the SEC’s Division of Investment Management has issued no-action relief allowing fund boards to rely on the representations of the Chief Compliance Officer for Rule 10f-3, 17a-7 and 17e-1 transactions.  Rather than duplicate the due diligence performed by the CCO, the no-action letter allows fund boards to rely on quarterly CCO representations that transactions effected under exemptive Rules 10f-3 (affiliated underwriting), 17a-7 (cross-trades) and 17e-1 (affiliated brokerage) complied with the applicable fund procedures.  The SEC opines that this reliance will allow fund boards to more efficiently exercise its oversight role with respect to conflicts of interest.  The no action letter reverses a 2010 staff position.

OUR TAKE: The no-action position reflects the reality of how most funds operate.  The Board has very little ability to perform due diligence independent of the work performed by the Chief Compliance Officer, so it makes sense to rely on the representations.  The big open question is whether this position increases CCO liability, thereby creating additional due diligence requirements.

State Securities Regulators Report Significant Increases in Criminal Penalties

 The North American Securities Administrators Association (NASAA) reports that in 2017 the 51 state securities regulators brought cases resulting in 1,985 years of prison time and probation, a 47% increase over the prior year.  The state regulators also commenced 4,790 investigations in 2017, a 10% increase over the prior year, and initiated 2,105 enforcement actions, a nearly 6% increase.  State securities regulators continued their increased focus on registered investment advisers, taking 377 enforcement actions against RIAs as compared to 270 against BDs.  NASAA reports that cases against unregistered firms and individuals exceeded those against registered firms and individuals.   “Securities fraud is a constant, ongoing, ever-evolving threat to investors. But as this year’s enforcement survey demonstrates, NASAA members are well-prepared, well-organized, and uniquely qualified to continue to aggressively protect investors,” said NASAA’s Enforcement Chair.

OUR TAKE: Unlike the SEC, the state securities regulators have the power to pursue criminal penalties including prison time.  Regardless of what happens at the federal level, the states appear ready to flex their enforcement muscles.

FBI Takes Down Unregulated Non-U.S. Swaps Dealer

 

An FBI sting operation ensnared an unlawful non-U.S. based securities dealer that offered securities-based swaps without registering.  The Austrian-based defendant operated an internet-based platform that offered contracts for difference, which operated as securities-based swaps based on publicly-traded U.S. equity and indexes.   An undercover FBI agent opened an account with nothing more than a username and a password and traded CFDs with bitcoin.  The platform served as the counterparty and collected the bid-ask spreads.  The SEC charges the platform with failing to register the securities offering and the platform as a broker dealer.  The SEC also asserts that the CFDs were required to be traded on a registered securities exchange.

OUR TAKE:  We love innovation and technology.  However, when you apply new technologies to a highly regulated industry, you must follow the same rules as everybody else.  Trading in securities with U.S. persons implicates the whole panoply of U.S. securities regulation including the regulation of the offering, the parties, and the venue.  Also, never assume that law enforcement or the regulators won’t find you.  Your competitors and clients have an interest in helping the investigators find those who are cutting regulatory corners.

Accounting Firm Followed the Wrong Independence Standards

 An accounting firm was fined and barred from any engagement arising from an SEC rule because it violated independence rules by auditing funds and firms for which it also prepared financial statements.  The SEC charges that the accounting firm prepared financials including preparing draft statements for management review, converting from cash to GAAP accounting, proposing accounting adjustments, and drafting notes.  Regulation S-X prohibits a firm that provides bookkeeping or other accounting services from auditing the same financial statements.  According to the SEC, the firm wrongly applied AICPA independence rules rather than Regulation S-X, which applies to private fund and broker-dealer audits.  The SEC charges the firm with causing its clients violations of the securities laws.

OUR TAKE: Performing audits of registered advisers, broker-dealer, or public companies involves a thorough understanding of the applicable securities laws and accounting standards.  Accounting firms should not undertake engagements without retaining a compli-pro that can help navigate the regulatory waters.  Advisers and broker-dealers should not retain a firm that lacks a track record of practicing in this area.

Private Fund Firm Failed to Timely Deliver Financials to LPs

 

The SEC censured and fined a private fund manager for failing to timely deliver audited financial statements to limited partners.  Since the firm registered in 2012, it did not meet the 120-day deadline required by the custody rule (206(4)-2) with respect to 178 audits of 440 funds, a 40% failure rate.  In some cases, no financial statements were ever delivered.  The SEC faults the firm for failing to implement required policies and procedures to ensure delivery of the financial statements in accordance with the custody rule even though the firm, for most of the funds, had engaged a PCAOB audit firm to conduct the audits.  The SEC also cites violations of the compliance rule (206(4)-7) for failing to conduct annual reviews of the adequacy and effectiveness of the compliance program.

OUR TAKE: Hire a compliance officer – either in-house or through a compliance services firm.  These types of regulatory missteps can be easily avoided if you retain a professional that knows the rules and has the responsibility and authority to implement them.  If you don’t, you subject your firm to a debilitating and humiliating public enforcement action.

RIA Platform Failed to Disclose Mutual Fund Revenue Sharing

 

An investment adviser platform was fined and censured for receiving fund revenue sharing from a custodian and clearing firms it recommended without proper disclosure.  The platform had more than 150 independent investment adviser representatives and 200 registered representatives working out of more than 100 offices.   The SEC criticizes weak disclosure that failed to fully describe the conflict of interest when the firm recommended a custodian that kicked back 2 basis points on assets.  The SEC also maintains that the firm violated disclosure, fiduciary and best execution obligations when it recommended mutual fund share classes that paid back 12b-1 fees to the firm and its reps when lower fee share classes were available.  The firm did not meet its obligations with vague website disclosure that described how the firm “may” receive compensation but failed to fully inform all clients about how fees were paid or calculated.

OUR TAKE: The RIA platform business is extremely competitive, with many firms competing to recruit successful RIA teams.  The real cost of an enforcement action like this is the reputational and competitive threat during the recruiting process.  Also, as platforms compete for business and margins shrink, the incentives to accept (questionable) revenue sharing increases.