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Global Firm Gutted Valuation Control Function


The SEC fined a large broker-dealer $5.75 Million for failing to allocate sufficient resources to its valuation control function, thereby allowing rogue traders to inflate securities valuations and positions.  The firm eliminated 15 valuation control positions as part of a global efficiency initiative, which, according to the SEC, left the control function understaffed and under-trained to adequately implement the firm’s valuation supervision policies.  One manager complained internally that four staff members were tasked with verifying prices for more than 20 trading desks that held over $200 Billion in Level 2 and 3 securities.  The SEC alleges violations of the books and records and supervision rules.

OUR TAKE: Having a valuation control function is not the same as having an effective valuation control function.  Global firms must consider metrics before gutting compliance and supervisory functions that could ultimately allow bad actors to put the firm at risk.  Firm leaders should think of compliance and supervision as the defense to protect assets and the firm’s reputation.  And, defense wins championships.


Over-Reliance on Automated Surveillance Tools Costs IA/BD $4.5 Million

The SEC fined a large BD/IA $4.5 Million for overly relying on flawed compliance technologies that failed to prevent 5 registered representatives from stealing over $1 Million from clients over a 4-year period.  One of the systems, which was designed to compare disbursement addresses against controlled addresses, contained a technical error that resulted in a failure to generate the necessary red flags for further investigation.  The other system, a transaction-monitoring tool, had a design limitation that required an exact word-for-word address match, thereby failing to identify suspicious addresses.  Complementary manual supervision and monitoring also failed to uncover the conduct.  The SEC charges the firm with failures to supervise and to implement reasonable policies and procedures.

OUR TAKE: We love compliance regtech as a tool to leverage compli-pros’ efforts to uncover wrongdoing.  However, over-reliance on technology without professional judgment and intervention will lead to a false sense of compliance security.  An automatic hammer will not build a house without the architects and the builders.


Wrap Sponsor Did Not Evaluate Trading Away by Portfolio Managers

The SEC fined a wrap sponsor and ordered it to enhance its policies and procedures in connection with failures to evaluate and disclose trading away practices by third party portfolio managers.  The SEC, which reviewed the firm’s practices back to 2008, asserts that 40% of the portfolio managers stepped-out trades to non-participating brokers, resulting in additional costs to the wrap client.  The SEC faults the sponsor for neglecting to (i) provide historical trading away information about the portfolio managers to participating advisers so that they could conduct adequate suitability reviews and (ii) disclose the costs of trading away practices.  The SEC charges violations of the compliance rule (206(4)-7) for failing to adopt reasonable policies and procedures.

OUR TAKE: We have warned that the SEC does not like wrap programs.  If your firm insists on operating a wrap program, we would recommend a strict policy against trading away with a non-participating broker-dealer, unless the portfolio manager can document the execution benefits on a trade-by-trade basis.  Of course, the wrap sponsor must disclose the trading away information as soon as possible to participating RIAs and wrap clients.


Adviser Cross-Traded at Bid Price to Benefit Certain Clients

The SEC censured and fined an investment adviser $900,000 for effecting client cross-trades at the bid price, rather than the bid-ask midpoint, thereby favoring its buying clients over its selling clients.  According to the SEC, the adviser had an interest in maintaining higher prices for the subject thinly-traded municipal bonds because the adviser often had a controlling, institutional position.  By using the bid price, the adviser generally favored his current clients over terminating clients.   The SEC also accuses the adviser of challenging bids upward to inflate the bonds’ valuation.   Although the adviser did not benefit directly, the SEC faults the firm for favoring certain clients over others and for failing to adopt policies and procedures that obtained independent broker quotes, supervised the portfolio manager, subjected prices to review by a valuation committee, and retained records.

OUR TAKE: It is very difficult to implement sufficient procedures or provide enough disclosure to sanitize the significant conflicts of interest that arise when cross-trading securities between client accounts.  Our compliance advice is to avoid cross-trades and liquidate securities through an independent third party.

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The Friday List: 10 Examples of Brokers Behaving Badly

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.

The debate about the now-vacated DoL fiduciary rule and the recently proposed Regulation Best Interest continues.  We have argued that a uniform fiduciary standard should apply to both retail brokers and advisers.  Why?  We accept the position that retail consumers should not have to hire a lawyer to determine the advice standards to which his/her financial professional adheres.   More significant, however, is that brokers behave badly and need a higher standard.  An academic study that was first published in 2016 reported that 7% of broker-advisers have misconduct records, prior offenders are 5 times more likely to engage in misconduct, and 44% of brokers fired for misconduct are re-employed within a year.  The authors concluded: “We find that financial adviser misconduct is broader than a few heavily publicized scandals.”   They also argued that a more stringent standard would help the industry by improving the low reputation of financial professionals.  Our reporting of cases also shows endemic broker misconduct.  In today’s list, we highlight examples of brokers behaving badly, which should inform the debate on a uniform fiduciary standard.


10 Examples of Broker Behaving Badly

  1. Stealing from clientsA broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
  2. Churning.   A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
  3. Misrepresenting disciplinary recordA broker’s website claimed he never had a complaint, even though several customers filed and settled complaints over the course of an 8-year period.
  4. Misusing client information. A broker shared nonpublic personal information (including holdings and cash balances) about clients with a person no longer affiliated with his firm.
  5. Revenue sharing.   A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
  6. Undisclosed markups/markdownsAn interdealer failed to disclose markups and markdowns on securities traded for clients.
  7. Commission kickbacksA trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
  8. Pump-and dumpA broker engaged in an ongoing penny stock pump-and-dump scheme.
  9. Bribing public officials.    A broker spent nearly $20,000 on hotels, meals and concert tickets to bribe a public plan official to secure brokerage business from a public plan.
  10. IPO kickbacks.   A broker and his client conspired in a kickback scheme whereby the customer would pay back 24% of his profits in exchange for preferred IPO and secondary offering allocations.

Target Performance Statements Cost Firm, CFO and Sales Chief

 A public company, its CFO, and its SVP of Sales were censured and fined nearly $2 Million for providing misleading revenue guidance in a press release, during analyst calls, and on Form 8-Ks.  The SEC accuses the respondents of providing inflated forward-looking revenue targets when they knew, or should have known, that such targets would not be achieved.  According to the SEC, the respondents knew that the sales pipeline was weaker than expected and that the company pulled revenue into a prior year period.  When the company revised the revenue target down later in the quarter, the stock price fell more than 33%.

OUR TAKE: The lesson here for fund managers is to avoid forward-looking or target performance projections.  If the rosy predictions ultimately fall short, the SEC will retrospectively review all internal communications and activities for any information that might have suggested lower numbers.  We recommend discussing performance through the lens of the rear-view mirror rather than the windshield.

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BD Sued for Broker’s Inaccurate Website

 The Massachusetts Securities Division has filed a complaint against a broker and his firm for allowing the continued website publication of misleading disciplinary information.   The broker’s website claimed that he “NEVER” (sic) had a complaint made against him.  Although this statement may have been accurate when the website went live in 2008, several customers filed and settled complaints between 2011 and 2018.  The MSD faults the firm for failing to flag the misleading website language even though it conducted 4 branch audits during the period and had actual knowledge of the complaints.  The MSD criticized policies and procedures that failed to require the firm to “regularly review content after publication.”

OUR TAKE: Earlier this year, FINRA admonished member firms to heighten supervision of brokers with a disciplinary history.  The states – including Massachusetts – can jump into the enforcement fray to ensure that the home office properly monitors the branch offices.

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Broker-Dealer Failed to Discipline Commission-Sharing Traders

 The SEC fined a broker-dealer $1.25 Million for failing to take sufficient disciplinary action against brokers that shared commissions in violation of firm policy.  The SEC asserts that the one broker, who ultimately became a supervisor, assigned accounts to junior traders in exchange for off-the-book kickbacks paid by personal checks.  The transactions violated the firm’s policies and procedures and books and records requirements.  Upon discovering the arrangement 13 years after it began as a result of a FINRA investigation, the firm responded by issuing a memo condemning the activity and offering the participants the opportunity to resign.  The SEC faults the firm for failing to discipline the wrongdoers.

OUR TAKE: Having policies and procedures, but taking no significant action against those who violate them, eviscerates their purpose.  This compliance voodoo – the mere appearance of a compliance program – will draw the ire of the regulators.

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CCO Blamed for Signing Certifications that Facilitated Unlawful Securities Lending


The SEC censured and fined the Chief Compliance Officer of a broker-dealer for signing certifications that she knew, or should have known, were inaccurate, thereby enabling her firm to engage in unlawful securities lending transactions.  The CCO signed certifications to third party depositaries that confirmed her firm complied with certain ADR pre-release agreements that required that her firm hold ordinary shares that evidenced ADRs.  The SEC maintains, however, that the CCO knew the firm did not comply with those agreements because she participated in drafting the firm’s procedures for acquiring pre-release ADRs and knew that the firm did not comply with the pre-release agreements.  The SEC charges the CCO with causing her firm’s violations of the Exchange Act’s antifraud provisions.

OUR TAKE: Compliance officers should avoid signing certifications that facilitate securities transactions.  If the situation requires a certification, a CCO must conduct adequate due diligence to ensure the accuracy of all statements made.  Also, we would recommend that a CCO obtains back-up certifications from others in the organization.

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General Partner Fined for Violating Tender Offer Rules


The SEC censured and fined the General Partner of a private partnership for failing to file the required notice and response to third party tender offers.  The SEC faults the GP for failing to file a Schedule 14D-9 following the receipt of information of tender offers for more than 5% of the partnership’s interests.  The Schedule 14D-9 is the method by which investors receive information about a tender offer and management’s response.  Because no public market existed for the partnership’s interests, the failure to notify investors could have resulted in fewer investors selling their interests to the third party.

OUR TAKE: Closed-end funds that rely on tender offers for investor liquidity must ensure strict compliance with the arcane and voluminous tender offer rules.  As the market for more esoteric products grows, the SEC will use the tender offer rules to ensure full and fair disclosure.

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