The SEC ordered two initial coin offerings to offer investors rescission and pay a $250,000 fine for failing to register the offerings under the securities laws. These cases represent the first time that the SEC has imposed civil penalties solely for ICO securities offering registration violations. One of the respondents raised $15 million by selling digital tokens intended to create a new digital coin ecosystem related to advertising and mobile phones. The other respondent raised $12 Million to create a blockchain technology for the emerging cannabis industry. The SEC maintains that the digital tokens are “securities” under the Howey test and, therefore, the offerings violated the registration requirements of the 1933 and 1934 Acts. Both respondents undertook to register the offerings.
Given the SEC’s concerns about disclosure and compliance for ICOs, it will be interesting to see the extent of disclosure required in the promised registration statements.
A registered investment adviser agreed to pay $354,000 in client reimbursements and penalties for failing to give clients the benefit of promised fee breakpoints over an 8-year period. The adviser marketed a fee schedule that offered lower fees as assets increased and offered clients lower fees for aggregated household accounts. According to the SEC, the respondent failed to apply the lower fees as clients reached the breakpoints or to aggregate household accounts for certain clients. The SEC maintains that the firm overcharged 293 clients an aggregate of $304,000, which the firm voluntarily refunded following the commencement of the enforcement investigation. In addition to alleging violations of the Advisers Act’s antifraud provisions, the SEC also faults the firm for failing to implement reasonable compliance policies and procedures.
Some very elementary supervision, operations and compliance infrastructure could have avoided the overcharging and the resulting enforcement action. Emerging firms looking to squeeze out some profits should not skimp on the basic must-haves of running a proper firm.
The Commodity Futures Trading Commission, the primary commodities and derivatives regulator, imposed nearly $1 Billion in civil monetary penalties, restitution and disgorgement during the fiscal year that ended on September 30. The CFTC Division of Enforcement imposed $947 Million in penalties, disgorgement and restitution, including $897 Million in civil penalties, a nearly threefold increase over last year’s total. The CFTC filed 83 enforcement actions, the most since 2012, and imposed $10 Million judgments in 10 cases, a CFTC high water mark. More than 2/3 of cases charged an individual executive, reflecting the CFTC’s priority to hold individuals accountable in part because it deters others who become “fearful of facing individual punishment.” The CFTC has also prioritized parallel criminal proceedings, setting enforcement records for the number of cases filed in parallel with criminal prosecutors.
The CFTC’s regulatory sphere has greatly expanded with the emergence of swaps, derivatives, cryptocurrencies, and alternative hedge funds. The CFTC, like the SEC, has ramped up its enforcement activities to historic levels.
The SEC fined a large dark pool $12 Million for sending confidential trading data to third party high frequency traders over an eight-year period. The information included daily aggregated order and execution information and suggested that the recipient HFTs use the reports to identify unsatisfied liquidity needs. The SEC also faults the firm for allowing unfettered access to trading data by sales and trading personnel. While engaging in the alleged activity, the respondent consistently advertised the confidentiality of the trading information through the dark pool.
The whole point of trading through the dark pool was to avoid signaling to HFTs. Yet, this firm allegedly exploited its trusted position by using the dark pool to court large, presumably profitable, third party market players.
The SEC fined and censured the founder of a digital token trading platform that failed to register as a national securities exchange. The SEC argued that, under SEC v. Howey, the tokens traded included securities because the purchasers of tokens “invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others.” The token exchange allowed buyers and sellers to view pairs available for trading and a display of the top 500 bids and allowed users to enter buy and sell orders.
We expect a well-funded party will ultimately challenge the SEC in the courts about whether digital tokens are securities subject to SEC supervision. However, until a court decides otherwise, those that trade in digital tokens and those that facilitate trading must register as broker-dealers or as exchanges.
A unanimous SEC, in a decision upholding sanctions against a Chief Compliance Officer, stated that it will not exempt a CCO from liability if the CCO “fails meaningfully” to implement the compliance program. Although the Commission will defer to “good faith judgments of CCOs made after reasonable inquiry and analysis,” the SEC will hold the CCO liable where the CCO engages in wrongdoing (or attempts to cover it up), “crosses a clearly established line,” or fails to implement policies and procedures for which he or she has direct responsibility. In the case itself, the SEC upheld FINRA’s findings of CCO liability because the CCO abdicated his obligation to review emails and failed to follow up on red flags relating to payments to a disqualified individual.
We think the standard should be much higher i.e. that a CCO should only be liable if s/he participated in the wrongdoing, actively covered it up, or directly and personally benefited. We in no way condone the lack of diligence alleged in this case. Perhaps, the CCO should have been terminated (or never hired in the first place). However, so long as the SEC continues to hold CCOs liable based on retrospective and subjective determinations of how well the CCO implemented the program, good compliance people will continue to either leave the industry or demand hazard pay.
The SEC’s Office of Compliance Inspections and Examinations has announced a sweep of certain mutual funds and ETFs. The OCIE staff will target smaller ETFs and funds/ETFs that use custom indexes, allocate to securitized assets, exhibit aberrational underperformance, or employ inexperienced managers or private fund sponsors that manage a similar mutual fund. The SEC will assess compliance policies and procedures and fund oversight of risks and conflicts, disclosures to shareholders and the Board, and oversight processes. Among some of the issues of concern to the OCIE staff include bid/ask spreads for secondary market trading of smaller ETFs, portfolio management for underperforming funds, the effect of unexpected market stresses on securitized assets, and side-by-side allocations for private and public funds. OCIE is encouraging fund sponsors and boards “to consider improvements in their supervisory, oversight, and compliance programs.”
Compli-pros and fund lawyers should mobilize to review policies and procedures for affected advisers and boards, consult about changes, and implement enhanced oversight and processes. We recommend taking action before the OCIE staff arrives for its examination.
The SEC fined an investment adviser $400,000 and fined and censured its CEO for failing to devote sufficient resources to compliance, thereby contributing to the firm’s failure to uncover an offering fraud. The firm appointed a portfolio manager, who did not have regulatory experience, to assume the Chief Compliance Officer role in addition to his other duties. The PM/CCO highlighted several compliance deficiencies and pleaded for more resources, but the CEO did not address his concerns, and, in fact, cut the compliance budget. The SEC maintains that the under-resourced compliance program contributed to the firm’s failure to conduct promised due diligence, which may have uncovered the offering fraud that harmed clients.
Based on our experience and several industry studies, registered investment advisers should spend at least 5% of revenue on compliance infrastructure. Also, firms should appoint a fully engaged and experienced regulatory professional to serve as Chief Compliance Officer and avoid the cheaper dual-hat model that puts both the firm and the CCO at risk. Compli-pros should take solace that the SEC did not name the CCO, presumably because he highlighted the compliance deficiencies and advised the firm on how to remediate.
The SEC has adopted new rules that will require broker-dealers to deliver a standardized set of individualized disclosures about how the BD routed “not held” orders. The SEC intends the disclosures to inform a customer about how its broker-dealer routed and handled orders to assess the impact of routing decision on execution quality. Under the new rules, upon customer request, a BD would deliver a report covering the prior 6 months that would include information about shares executed, orders exposed to IOIs, fill rates, fees, rebates, pricing, and liquidity. The new rules, amendments to Rule 606 under Regulation NMS, provide for 2 de minimis exceptions. The new disclosure rules go live 6 months after publication.
The new disclosure rules will add transparency to how broker-dealers assess and choose alternative trading venues and ensure institutional customers have information about fees, rebates, and payments for order flow.