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SEC Proposes Broker Best Interest Standard

The SEC has voted to propose a best interest standard for broker-dealers giving advice to retail customers.  The proposed “Regulation Best Interest” requires a broker to act in the best interest of the retail customer at the time the recommendation is made, notwithstanding its own financial interests.  The broker must disclose its conflicts of interest and have a reasonable basis to believe the recommendation and the series of transactions are in the client’s best interest.  The proposal also requires that brokers and advisers deliver a new disclosure form describing the relationship and conflicts of interest.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.  The Rule defers to existing broker-dealer regulation to define the term “recommendation.” The SEC also proposed a companion rule seeking to clarify an investment adviser’s fiduciary duty including the obligation to provide advice in the best interest of the client, a duty of best execution, a commitment to provide ongoing monitoring, and a duty of loyalty.  The SEC has provided a 90-day comment period.

OUR TAKE: Don’t change anything yet based on this proposal.  Expect much debate during the comment period and thereafter, as even one of the SEC Commissioners dissented.  Our view is that brokers should be subject to the same fiduciary standard as investment advisers.  We don’t understand why the SEC would take this half-measure and enhance the broker standard without making it the same as the adviser standard.  This confusion is bad for customers and for brokers.

https://www.sec.gov/news/press-release/2018-68

Adviser Marketed Misleading Hypothetical Backtested Performance

 

The SEC censured and fined an investment adviser and its principal for misleading advertisements that utilized hypothetical backtested performance.  According to the SEC, the adviser continually updated its models but failed to fully disclose that the models’ out-performance resulted from these post hoc revisions.  The SEC alleges that the respondents revised the models to specifically account for unforeseen events such as market movements.  The SEC charges the firm and the principal, who also acted as the Chief Compliance Officer, with engaging in manipulative practices and for failing to implement a reasonable compliance program.  As part of the settlement, the firm agreed to retain a dedicated Chief Compliance Officer and an outside compliance consultant.

OUR TAKE:  As we have advised many times in the past: (i) do not advertise hypothetical backtested performance and (ii) retain a dedicated Chief Compliance Officer that has regulatory credentials.  Also, rather than continue to bring these cases whereby a dual-hatted principal continues to fail as Chief Compliance Officer, the SEC should solve this pandemic by requiring all advisers to undergo periodic third party compliance reviews.

https://www.sec.gov/litigation/admin/2018/ia-4885.pdf

CCS’s Scavetti Reports on IAA Compliance Conference  

Joe Scavetti of Cipperman Compliance Services recently attended the Investment Adviser Association Compliance Conference in Washington.  The conference brings together senior regulatory officials and compliance professionals to address cutting-edge regulatory issues.  Linked below is a more detailed summary of the meeting prepared by Joe, who would be happy to discuss with you in more detail.  SEC Commissioner Hester Peirce, the conference headliner, spoke at length about the SEC’s regulatory agenda including the prospect of an SEC conduct rule.  SEC officials Peter Driscoll, Director of OCIE, and Stephanie Avakian, Co-Director of Division of Enforcement, also participated, offering their views on examination and enforcement priorities.  Over the course of 2 days, several panels addressed issues such as mutual funds, cybersecurity, vendor management, advertising, Form ADV, custody, and SEC exams.

IAA Compliance Conference Report 2018

SEC Warns Advisers about Fee and Expense Practices

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert detailing investment adviser failures to properly calculate and disclose fees and expenses.  OCIE cites failures to properly value assets, thereby leading to overbilling, using the incorrect fee rate, and billing based on the wrong time period.  OCIE also details faulty disclosure practices including Form ADVs that do not reflect actual billing practices and failures to fully disclose compensation arrangements.  OCIE also highlights fund sponsors that misallocate expenses.  The OCIE findings result from issues identified in deficiency letters issued in recent SEC exams.  The Risk Alert advises that firms take action by reimbursing clients and enhancing policies and procedures.

OUR TAKE: These Risk Alerts often precede enforcement actions.  Compli-pros should review their fee billing and disclosure practices in anticipation of an OCIE sweep.

https://www.sec.gov/ocie/announcement/risk-alert-advisory-fee-expense-compliance

NYS Attorney General Reports 1500 Data Breaches in 2017

The New York State Attorney General has issued a report indicating that a record 1583 data breaches affecting 9.2 Million New Yorkers were reported to the NYAG in 2017.   The information exposed included social security numbers (40%) and financial account information (33%).  Hacking was the leading cause of the data security breaches.  NYAG Eric Schneiderman warned “My office will continue to hold companies accountable for protecting the personal information they manage.”  The NYAG has urged the New York State legislature to pass the SHIELD Act, which would require companies to adopt reasonable safeguards to protect sensitive data, including relevant policies and procedures.

OUR TAKE: The state regulators have taken a primary role in enforcing data protection safeguards.  Make sure your compliance procedures have the necessary policies and procedures that include governance, incident response, vulnerability assessment, and vendor management.

https://ag.ny.gov/press-release/ag-schneiderman-announces-record-number-data-breach-notices-2017

Top 5 Regulatory Alerts – February-March 2018

 

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

 

Top 5 Regulatory Alerts – February-March 2018

  1. FIFTH CIRCUIT VACATES FIDUCIARY RULE (3/19/18)
  2. OCIE RELEASES 2018 EXAM PRIORITIES (2/8/18)
  3.  SUPREME COURT RULES THAT WHISTLEBLOWER MUST REPORT TO SEC (2/22/18)
  4. SEC ISSUES CYBERSECURITY COMPLIANCE AND DISCLOSURE GUIDANCE (2/23/18)
  5. COMPLIANCE OFFICER CHARGED WITH SECURITIES FRAUD (3/15/18)

 

Most Read – February-March 2018

  1. SEC ISSUES CYBERSECURITY COMPLIANCE AND DISCLOSURE GUIDANCE (2/23/18)
  2. COMPLIANCE OFFICER CHARGED WITH SECURITIES FRAUD (3/15/18)
  3. BD PRESIDENT SANCTIONED FOR FAILING TO SUPERVISE INEXPERIENCED CCO (2/21/18)
  4. SEC PROSECUTES CURRENT AND FORMER COMPLIANCE OFFICERS FOR AML FAILURES (3/29/18)
  5. SEC OFFICIAL QUESTIONS REGISTRATION EXEMPTION FOR ETF INDEX PROVIDERS (3/21/18)

Three Advisers Tagged for Recommending Higher-Cost Fund Share Classes

Three investment advisory firms will pay nearly $15 Million in fines and disgorgement for recommending more expensive mutual fund share classes that paid revenue sharing.  The SEC faults the firms for failing to fully disclose that recommending higher-fee fund share classes in exchange for revenue sharing presented a conflict of interest.  The SEC also alleges that recommending the higher-fee classes violated the firms’ best execution obligations.  An SEC official “strongly encourage[s]” eligible firms to participate in the recently announced Share Class Disclosure Initiative amnesty program.

OUR TAKE: Given the number of cases in this area, it may be that, as a practical matter, an adviser can never include enough disclosure that would justify recommending anything other than the cheapest share class available.  We recommend that compli-pros conduct an internal sweep of their firms’ mutual fund recommendation practices.

http://www.sec.gov/litigation/admin/2018/34-83004.pdf

http://www.sec.gov/litigation/admin/2018/ia-4876.pdf

http://www.sec.gov/litigation/admin/2018/34-83003.pdf

Adviser Lacked Required AUM to Register with the SEC

The SEC fined and suspended the principal of a defunct investment adviser for falsely claiming SEC registration eligibility.  The firm claimed that it had at least $25 Million in assets under management through 2011 and then suddenly claimed it had at least $100 Million assets under management following passage of the Dodd-Frank in 2012.  The SEC asserts the firm had no basis for claiming SEC registration eligibility because it did not have the purported assets under management.  The SEC also alleges violations of the custody rule arising from the firm’s role as a private fund manager.

OUR TAKE: Lying to the SEC about registration eligibility is more than mere marketing puffery.  It can prompt a public enforcement action.  Make sure you have records to support the claimed assets under management.

https://www.sec.gov/litigation/admin/2018/ia-4875.pdf

The Friday List: The Risks of the Dual-Hat Model for CCO and/or FINOP

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.

We hate the practice of dual-hatting i.e. appointing a senior executive with non-regulatory responsibilities as a Financial and Operations Principal or Chief Compliance Officer.  The SEC, through several enforcement actions, also appears to dislike the practice, which it alleges to have caused a wide variety of regulatory breakdowns.  The dual-hat model also exposes senior executives to direct personal liability.  In today’s list, we offer 10 significant risks of the dual-hat model identified in a series of SEC enforcement actions.  For reference, we have included links to our blog posts where you can read more.

 

10 Risks of the Dual-Hat CCO or FINOP Model

  1. Failure to supervise executive conduct.
  2. Taking undisclosed fees and/or overbilling.
  3. Under-resourcing the compliance function.
  4. Ignoring cited exam deficiencies.
  5. Engaging in conflicts of interest.
  6. Inadequate disclosure.
  7. Not conducting required annual compliance reviews.
  8. Using a stock “off-the-shelf” compliance manual.
  9. Failure to implement compliance policies and procedures.
  10. Not properly calculating net capital.

SEC Fines Dual-Hat CEO/FINOP for Incorrect Net Capital Calculations

The SEC censured and fined a broker-dealer and its dual-hatted CEO/FINOP for failing to properly calculate and report its required net capital.  The firm executed transactions with foreign banks which would have required a $250,000 minimum net capital rather than the reported $5000 minimum net capital.  The firm also failed to properly accrue for legal liabilities.  The CEO, a certified public accountant, also served as the firm’s financial and operations principal.  As part of the settlement, the firm agreed to hire a FINOP acceptable to the Commission.

OUR TAKE: Firms should not “dual-hat” C-suite executives to serve in regulatory roles such as FINOP or Chief Compliance Officer.  The dual-hat model exposes senior executives to significant regulatory risk and shortchanges the required functions.  If you can’t afford a full-time person, engage a third party firm that offers these services.

https://www.sec.gov/litigation/admin/2018/34-82951.pdf