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REIT Sponsor Tried to Circumvent Hiring a Broker-Dealer for Distribution

 

The SEC fined and censured a non-traded REIT sponsor for acting as an unregistered broker-dealer and using unlawful marketing tactics.  The fund sponsor, bypassing the use of a registered broker-dealer, marketed the REITS on its website, through social media, and on the radio and collected 3% of the offering proceeds.  The sponsor also used radio endorsement adds to market the REITs and subsidized an investor relations team to follow up with interested investors. The SEC asserts that the sponsor violated Section 15(a) of the Exchange Act by operating as a broker-dealer without registration.  The SEC also charges the firm with using marketing materials that did not comply with the Securities Act’s prospectus requirements.

Rule 3a4-1 provides a very limited safe harbor that allows issuers to offer their own products without the involvement of a broker-dealer.  To rely on the safe harbor, the issuer cannot receive commissions in connection with the sale of the investment product.  This issuer probably could have used some timely legal and compliance advice before it launched a broad-based marketing campaign.

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?

SEC Adopts Regulation Best Interest, Raising Broker Standard of Care

The SEC adopted Regulation Best Interest for broker-dealers that make recommendations to retail clients. Regulation Best Interest, intended to enhance a broker’s standard of care beyond suitability, requires a broker-dealer to act in the retail customer’s best interest and to refrain from transactions that favor the interests of the broker over the customer. The new rule requires disclosure as well as policies and procedures to ensure that brokers identify and mitigate conflicts of interest. The SEC also adopted new Form CRS that requires both advisers and brokers to provide retail customers with standardized information about their relationship, including services, fees, conflicts, standard of conduct, and disciplinary history. The SEC also issued an interpretation that addresses an adviser’s fiduciary responsibilities. Part of this regulatory package includes a refining of the “solely incidental” exception to adviser registration for brokers. Firms have until June 30, 2020 to comply with Regulation Best Interest, although the new interpretations apply immediately upon publication.

Let’s rename this “The Compliance Officer Full Employment Act.” Compli-pros at broker-dealers will have to rework all of their Written Supervisory Procedures, revise client agreements, create disclosures, and eliminate all prohibited conflicts. Compliance offices at investment advisers must address the new Form CRS requirement and implement new client onboarding procedures while figuring out the changes required by the investment adviser fiduciary interpretation. And, we only have 12 months to get this all done.

Fund Manager Failed to Register as Broker-Dealer

A former fund manager was barred from the industry and faces possible fines and disgorgement for misrepresenting fees and commissions and for selling the fund without registering.  His partner previously settled with the SEC by agreeing to pay over $1.2 Million.  According to the SEC, the defendant hid the nature of the compensation received for selling the fund, which constituted transaction-based compensation requiring broker-dealer registration.  The SEC also charged the adviser with failing to register his firm as an investment adviser and with securities fraud. 

Fund managers that engage in selling efforts must register as broker-dealers unless they can take advantage of the issuer exemption (Rule 3a4-1), which prohibits the receipt of specific transaction-based compensation. 

SEC Allows Broker-Dealer Fund Research Reports

 The SEC has adopted a new rule allowing third party broker-dealers to publish mutual fund research reports, so long as the reports include standardized performance information.  The new rule (139b) provides that a research report prepared by a broker-dealer unaffiliated with the mutual fund manager or sponsor will not result in an unregistered offering, and the research report will not constitute a prospectus.  The rule requires several conditions including: (i) the subject fund must have met all reporting requirements during the prior 12 months, (ii) the fund must have a net asset value of at least $75 Million, and (iii) any performance information must comply with Rule 482, which requires performance information to be presented in a standardized format.  The SEC initially proposed the rule in May.

The only controversy here is whether performance information should need to comply with Rule 482.  To keep performance information consistent probably makes life simpler for investors, broker-dealers, and the staff at the SEC and FINRA.  Regardless, we still believe that the SEC should take a fresh look at Rule 482 given the proliferation of investment products beyond open end funds investing in publicly-traded securities. 

SEC Adopts Disclosure Rules for Trade Routing

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. 

Service Providers Accountable for Destruction of Broker-Dealer Records

 The SEC recently warned service providers to broker-dealers that they could not delete or discard required records in response to non-payment of fees.  The SEC explained that it has experienced difficulty in accessing required records in situations where a broker-dealer had financial problems.  The staff opined that contractual provisions that permitted the service providers to delete or discard records because of the non-payment of fees would violate Rule 17a-4.  Moreover, the loss of records could subject the service provider to secondary liability for causing or aiding and abetting the broker-dealer’s primary violation.

 Firms such as banks and consultants should take notice that the SEC and/or FINRA will take action for failure to preserve required records.  Consult your compli-pro to ascertain the records required by Rules 17a-3 and 17a-4

CCO Fined and Barred for Failing to Conduct Rule 144 Due Diligence

 

A broker-dealer Chief Compliance Officer was fined $50,000 and barred from the industry for failing to implement procedures to prevent the unlawful liquidation of microcap securities.  FINRA asserts that the firm and its principals liquidated 74 million shares of microcap securities without satisfying Rule 144, thereby distributing securities in violation of the Securities Act.   The firm’s Written Supervisory Procedures designated the CCO as the person responsible for Rule 144 compliance.  FINRA rejected the CCO’s defense that the WSPs did not reflect how the firm actually operated.  FINRA also faulted the CCO for adopting inadequate WSPs, which failed to outline procedures to conduct adequate due diligence.

The CCO should review the compliance manual or WSPs and ensure s/he understands and undertakes all designated responsibilities.  If the CCO can’t or won’t follow the procedures, then s/he must revise the procedures to satisfy regulatory requirements while reflecting the firm’s accurate allocation of authority.

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.

Broker/Custodian Should Have Filed SARs to Report Advisers Act Violations

A large custodian/clearing firm agreed to pay $2.8 Million to settle charges that it failed to file Suspicious Activity Reports about the conduct of dozens of terminated advisors that the SEC claims violated the Advisers Act.  The SEC asserts that the Bank Secrecy Act required the custodian/clearing firm to file SARs when it suspected that advisers using its platform engaged in questionable fund transfers, charged excessive management fees, operated a cherry-picking scheme, or logged in as the client.  According to the SEC, such unlawful activities fall within the SAR rules because they had no lawful business purpose or facilitated criminal activity.

OUR TAKE: The SEC is leveraging the Bank Secrecy Act, adopted to combat money laundering, to require broker/custodians to police advisers on their platforms for violations of the Advisers Act.  It’s a novel legal theory to further the regulator’s enforcement goal of requiring large securities markets participants to serve in a gatekeeping role for the industry