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BD Pays $26.4 Million for Failing to Conduct Targeted Email Reviews

 

A large broker-dealer agreed to pay $26.4 Million in client reimbursements and fines for failing to supervise traders that lied to customers about CMBS and RMBS transactions over a multi-year period.  The SEC asserts that the traders misled customers about bond prices, bids/offers, compensation, and ownership in very opaque secondary trading markets.  The SEC alleges that targeted reviews of electronic correspondence would have uncovered the illegal activity, thereby constituting a failure to supervise in violation of Section 15(b)(4)(E) of the Exchange Act.  As part of the remediation, the firm has implemented additional procedures for targeted reviews of communications relating to transactions that fall within certain risk-based parameters.

The most interesting legal point is that the SEC argues that the failure to implement compliance policies and procedures that would have uncovered wrongdoing can serve as a predicate for a failure to supervise charge.  In the past, the regulators generally separated the compliance program from the supervisory obligations.  Does this mean that a compli-pro can be charged with aiding and abetting his/her firm’s failure to supervise if the compliance monitoring program fails to detect wrongdoing?

CCS Releases Summaries of Regulation Best Interest, Form CRS, and Companion Interpretations

 Last month, the SEC adopted Regulation Best Interest for broker-dealers making recommendations to retail clients and adopted the new Form CRS requiring advisers and broker-dealers to provide standardized disclosure to retail customers.  Companion releases included an interpretation of an adviser’s fiduciary responsibilities as well as the contours of the “solely incidental” exception to adviser registration for broker-dealers.  The CCS team has spent the last few weeks reviewing the new regulatory information and offer the following summaries.  Please feel free to contact Jay Haas, Mark DeAngelis, Suzette Hagan or Larry Clay directly if you want to ask any deeper questions.

 

Regulation Best Interest: The CCS Summary by Jay Haas

Form CRS: The CCS Summary by Mark DeAngelis

Fiduciary Interpretation: The CCS Summary by Suzette Hagan

“Solely Incidental”: The CCS Summary by Larry Clay

Unregistered Adviser Barred From Industry for Marketing Misrepresentations

 

The SEC fined an unregistered investment adviser and barred its principal from the industry for making false representations in marketing materials primarily to professional athletes.  The SEC asserts that the adviser, which terminated its SEC registration in 2008 but continued to market its investment advisory services through 2018, baldly lied about its assets under management, clients, management, and employees.  The firm emailed its misleading brochure to over 80 prospects over a 12-month period and included a cover email that also included significant misrepresentations.  The SEC alleges violations of the Advisers Act’s antifraud rules.

Just because you do not register with the SEC does not mean that you are exempt from its antifraud rules.  Section 206 applies to any statement made by an investment adviser, whether registered or unregistered, that could defraud any client or prospective client.

SEC and FINRA Raise Crypto Custody Concerns

 In a joint statement, staffs of the SEC’s Division of Trading and Markets and FINRA’s Office of General Counsel, raised significant regulatory concerns for broker-dealer firms deemed to have custody of digital assets.  The joint statement questions how a broker-dealer could comply with the customer protection rule (15c3-3), especially the obligation to safeguard customer assets.  The regulators, noting that $1.7 Billion worth of digital assets were stolen in 2018, express concern about how to adequately guard against fraud and theft.  They also ask how to reverse transactions made in error and how to properly control digital assets.  The SEC and FINRA staffs are also concerned about SIPA protection for the firm and its clients.  The next step is continued dialog with the industry: “The Staffs encourage and support innovation and look forward to continuing our dialogue as market participants work toward developing methodologies for establishing possession or control over customers’ digital asset securities.”

Now, what?  Will the SEC, in conjunction with the industry, offer some solutions to these difficult questions?  Or, will the regulator continue to push the crypto-industry to the Wild West corners of the securities markets including offshore jurisdictions and private networks?

Top 5 Regulatory Alerts – Q2 2019

Here are our Top 5 Regulatory Alerts for Q2 2019 (April-June), ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – Q2 2019

  1. SEC ADOPTS REGULATION BEST INTEREST, RAISING BROKER STANDARD OF CARE (6/6/19)
  2. SEC ALERTS RIAS/BDS TO CLOUD PROVIDER MONITORING OBLIGATIONS (5/24/19)
  3. SEC SAYS THAT ICO IS NOT A SECURITIES OFFERING (4/4/19)
  4. LARGE CUSTODY BANK TO PAY $89 MILLION FOR MARKING UP OUT-OF-POCKET EXPENSES (6/28/19)
  5. HEDGE FUND FINED $5 MILLION FOR WEAK VALUATION PROCEDURES (6/5/19)

 Most Read – Q2 2019

  1. ADVISER FACES INDUSTRY DEATH PENALTY AND CRIMINAL PROSECUTION FOR IGNORING CUSTODY RULE (4/1/19)
  2. BIG 4 FIRM FINED $50 MILLION FOR STEALING EXAM ANSWERS (6/18/19)
  3. CHIEF COMPLIANCE OFFICER STOLE EMPLOYEE INFORMATION TO BID AT AUCTIONS (6/4/19)
  4. DUAL-HAT PRINCIPAL/CCO CAUSED MULTIPLE COMPLIANCE VIOLATIONS (5/29/19)
  5. FRAT BRO RAN PONZI SCHEME (6/11/19)

Adviser Benefited When Clients Invested in Its Lender

An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.

Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.

FINRA’s Financials $110 Million Worse than Last Year

FINRA reported a net loss of $68.7 Million for fiscal 2018, as compared to $41.6 Million in net income for fiscal 2017, a swing of more than $110 Million in one year. Most of the change arose from losses in FINRA’s investment portfolio. Total fines imposed were down slightly – $61 Million vs $64.9 Million – although both 2017 and 2018 reflect much lower fines than the prior several years. Other regulatory revenues were up slightly.

We don’t relish the idea of a regulator that has to fill a large financial deficit, especially since it could use fines to fill some of this hole. We expect the lower fine numbers during the last 2 years to be more of an aberration.

Large Custody Bank to Pay $89 Million for Marking Up Out-of-Pocket Expenses

A large custody bank agreed to pay almost $89 Million in fines, disgorgement, and interest to settle charges that it overcharged investment company clients by marking up purported out-of-pocket expenses for nearly two decades. The most significant markups occurred on SWIFT messages as the bank failed to adjust the charges as its internal costs decreased over time. The SEC also maintains the bank overcharged investment company clients on 12 other classes of expenses, collecting $170 Million in profit during the period. The SEC charges the custody bank with causing its fund clients to maintain inaccurate books and records.

This case should prompt fund financial officers to review the charges imposed by the custody bank. That nickel and diming on everything from wire fees to foreign custody reports may be unlawful. Service providers should also take note that the SEC will initiate enforcement for overcharging registrants even where the service provider itself is not an SEC registered or regulated entity.

Massachusetts Proposes Its Own Fiduciary Rule

The Massachusetts Securities Division has proposed a fiduciary rule for all brokers and advisers for the provision of recommendations, advice and selection of account type. The proposed rule would require that all recommendations and advice be made in the best interest of customers and clients without regard to the broker/adviser’s interests. The MSD asserts that the suitability standard has not sufficiently protected customers against sales contests, churning, risky products and bad brokers. The MSD also criticizes the SEC’s recently adopted Regulation Best Interest because it (i) does not fully protect investors; (ii) relies too much on disclosure; and (iii) does not resolve customer confusion about the applicable standard of care. The MSD is accepting comments until July 26.

The expansive MSD proposal includes any type of financial adviser, any type of customer, and any type of advice. If adopted, the MSD’s rule would set up a court case about whether Regulation Best Interest preempts state fiduciary rules.

No-Action Relief for Diversified Index Funds and ETFs

The SEC staff has granted no-action relief to allow index funds to become non-diversified as a result of market changes to the underlying index components. Without the relief, an index fund that tracks a third-party index would have to obtain shareholder approval to change its status from diversified to non-diversified when certain underlying component securities increased in value such that they would make up more than 5% of the portfolio. The relief would require prospectus disclosure that the fund could become non-diversified during these periods. The fund would still be constrained by the diversification requirements of the tax code and the applicable exchange on which it is traded.

This issue has dogged large index funds and ETFs for the last couple of years as the FAANG securities have increased in market value as compared to other index components. This letter offers welcome relief.