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Broker Should Have Disclosed Investment Product Red Flags

 

An unregistered broker agreed to pay $600,000 to settle charges that he sold third party investments without disclosing numerous red flags and negative facts to potential investors.  According to the SEC, the respondent painted an overly rosy picture of the investments (ultimately Ponzi schemes) and the sponsor by highlighting consistent rates of return and a personal business relationship.  However, the respondent did not disclose that the sponsor had previous issues with the SEC, multiple failed investments schemes, and financial problems.  The SEC argues that once the respondent described the investments in a positive way, he “was under a duty to make materially fair and complete disclosure rather than presenting only a one-sided and unbalanced view of the investment.”  The SEC charges the unregistered broker with violating the antifraud provisions of the Securities Act.

When selling investment products, you cannot merely disclose the good facts.  In this case, the respondent may not (or may) have known the investments were Ponzi schemes, but he did have enough facts to suspect and should have warned potential investors. 

Barred Adviser Lied to Investors about Track Record, Credentials and Performance

 

The SEC has commenced proceedings against a barred investment adviser for fraudulent statements made during a note offering.  The SEC alleges that the respondents concealed a barred adviser’s disciplinary history and industry bars by entering into a bogus operating agreement showing a 5% ownership interest when he had a 50% stake.  The other partner to the venture had little to no securities experience.  The SEC accuses the respondents of lying to investors to induce them to purchase promissory notes with their self-directed IRA accounts.  The respondents allegedly lied about performance, safety, track record, and credentials.

This is exactly why the industry needs an active regulator.  Only by ridding the industry of (alleged) liars and thieves like this can the investment industry instill confidence in the regulators, the clients, and the lawmakers.  Ultimately, strong regulation facilitates growth as evidenced by the $20 Trillion in assets in registered funds and ETFs, the most regulated investment products on the planet. 

FINRA Wants Reps to Obtain Approval Before Acting as Beneficiary/Executor/Trustee

FINRA has proposed a new rule requiring registered representatives to obtain approval from their firms any time a firm customer designates the rep as a beneficiary, executor, or trustee or grants a power of attorney.  Upon receiving written notice, the firm must implement review procedures to assess whether the designation or grant presents undue risk for the client.  FINRA believes such a rule is necessary because of the inherent conflicts of interest coupled with evidence that reps have attempted to circumvent firm prohibitions by using a friendly colleague or naming a family member.

Regardless of where FINRA lands on this rule, we recommend that compli-pros prohibit such designations in the WSPs.  FINRA correctly cites the conflicts of interest, especially with senior investors.  If reps already circumvent firm rules, how can FINRA ensure that reps will notify their firms? 

SEC Alleges that Lawyer/Adviser Swindled Concussed NFL Players

 

The SEC has filed a lawsuit against a lawyer that operated an investment adviser that allegedly defrauded former NFL players and misled them about the credentials of one of the principals.  The lawyer represented the players in class action concussion litigation against the NFL and then solicited them to invest in private funds that purportedly invested primarily in securities.  However, the SEC asserts that the fund primarily served to advance settlement payments to other clients in the litigation.  Also, the SEC charges that the respondents failed to disclose that the lawyer’s investment partner had a long regulatory and criminal history that included an industry bar and jail time.  Disclosure documents described the partner as an adviser and consultant when in fact he managed the funds and shared profits with the lawyer.  Item 9 of Form ADV requires disclosure of disciplinary information for any current employee, officer, partner, or “any person performing similar functions.”

The SEC views Item 9 disciplinary disclosures as critical to Form ADV because it provides potential clients with a window on an adviser’s reputation.  A person with a regulatory history can’t avoid disclosure simply by becoming a “consultant” when the actual duties and financials show otherwise. 

Withdrawing BD Registration Doesn’t Stop the SEC from Prosecuting for Failure to Supervise

 

The SEC fined a broker-dealer and its CEO for failure to supervise even though the firm withdrew its registration.  A broker at the firm pleaded guilty to providing inflated quotes to an investment manager as a quid pro quo for receiving future trading business.  The SEC alleges that the CEO knew that the trader provided quotes but failed to adopt and implement reasonable procedures to supervise the trader and his provision of price quotes to third parties.  The BD withdrew from registration, but an SEC Enforcement official warned, “Deregistering with the Commission in the midst of an enforcement investigation will not enable such firms to evade liability.”

Just because you abandon your car before the police can stop you doesn’t mean that you can’t get arrested.  It appears that the respondent’s efforts to avoid prosecution by withdrawing may have exacerbated their SEC problems by making them look more guilty. 

Large BD Mistakenly Relied on Bank Affiliate to Conduct Background Checks

 

FINRA fined a large broker-dealer $1.25 Million for failing to conduct adequate background checks on over 10,000 non-registered associated persons over a 7-year period.  For these non-registered persons, the BD relied on less comprehensive background checks conducted by its bank affiliate, which was required by the banking laws.  The required Exchange Act background checks include a review of regulatory actions in addition to criminal activity.  A FINRA official warned that “member firms must live up to their responsibility as a gatekeeper protecting investors from bad actors.”

This case is similar to an action against another bank-affiliated broker-dealer back in 2017.  Large firms with multiple regulated affiliates must ensure compliance with each regulatory regime.  Compliance with one financial services statute does not necessarily mean compliance with another.  Firms should hire compliance specialists with substantive backgrounds in the applicable laws and regulations.

SEC Inspections Staff Chides Advisers for Weak Supervision and Compliance

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies.  Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories.  The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies.  OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation.  The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.

 

How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program?  An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation. 

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?

FINRA Proposes More Segregated Capital for Firms that Hire Bad Brokers

FINRA has proposed a new rule that would require broker-dealers with a large number of disciplinary events to set aside segregated funds to pay future penalties or arbitration awards. Proposed Rule 4111 (Restricted Firm Obligations) would score each firm against its peers based on registered person and member firm adjudicated events and expulsions. Based on FINRA’s grid, the firm would be required to deposit funds in a segregated account until the firm takes action to remedy the situation, thereby allowing a reduction in the amount deposited. FINRA seeks to address the small number of firms that attract brokers with significant disciplinary records but have not appropriately responded to FINRA’s previous efforts to require heightened supervision or enhance sanctions.

On the positive side, requiring what amounts to a net capital penalty should get the attention of senior leaders at these problem firms. On the other hand, FINRA needs to be careful that such a firm doesn’t make a cold calculation to hire a bad broker if the broker’s production offsets the additional financial obligation.

Firm’s Procedures Did Not Guide Management on How to Respond to Red Flags

A large broker-dealer was fined and censured for failing to act against a longtime broker charged with participating in pump-and-dump transactions.  The SEC faults the firm for ignoring red flags including emails outlining the illegal activity, FINRA arbitrations, and customer complaints.  One supervisor explained that he did not act more aggressively because the broker worked at the firm for 30 years and her business partner was a partial owner of the firm. The SEC asserts that the firm’s supervisory system “lacked any reasonable coherent structure to provide guidance to supervisors and other staff for investigating possible facilitation of market manipulation.”  The SEC also maintains that the firm “lacked reasonable procedures regarding the investigation and handling of red flags.”

Reasonable policies and procedures must do more than simply restate the law and the firm’s commitment to comply with the law.  The compliance manual or WSPs must specifically describe HOW a firm will prevent and address regulatory misconduct.