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.
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.
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.
T he 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.
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.
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.
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
Stealing from clients. A broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
Churning. A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
Misrepresenting disciplinary record: A 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.
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.
Revenue sharing. A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
Undisclosed markups/markdowns. An interdealer failed to disclose markups and markdowns on securities traded for clients.
Commission kickbacks. A trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
Pump-and dump. A broker engaged in an ongoing penny stock pump-and-dump scheme.
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.
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.
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
The SEC has voted to propose a best interest standard for broker-dealers giving advice to retail customers. The proposed “Regulation Best Interest” requires a broker to act in the best interest of the retail customer at the time the recommendation is made, notwithstanding its own financial interests. The broker must disclose its conflicts of interest and have a reasonable basis to believe the recommendation and the series of transactions are in the client’s best interest. The proposal also requires that brokers and advisers deliver a new disclosure form describing the relationship and conflicts of interest. A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes. The Rule defers to existing broker-dealer regulation to define the term “recommendation.” The SEC also proposed a companion rule seeking to clarify an investment adviser’s fiduciary duty including the obligation to provide advice in the best interest of the client, a duty of best execution, a commitment to provide ongoing monitoring, and a duty of loyalty. The SEC has provided a 90-day comment period.
OUR TAKE: Don’t change anything yet based on this proposal. Expect much debate during the comment period and thereafter, as even one of the SEC Commissioners dissented. Our view is that brokers should be subject to the same fiduciary standard as investment advisers. We don’t understand why the SEC would take this half-measure and enhance the broker standard without making it the same as the adviser standard. This confusion is bad for customers and for brokers.
A large clearing broker-dealer agreed to pay over $1.3 Million in disgorgement, interest, and fines to settle charges that it underfunded its reserve account. Due to a coding error, the firm miscalculated its reserve formula pursuant to the customer protection rule (15c3-3) resulting from repos with its parent company. After discovery by a FINRA examination team, the broker-dealer deposited $133 Million into its reserve account, thereby triggering a liquidity crisis for the firm as it worked to raise the necessary capital. The SEC criticized the BD, which has had other compliance issues, for a “lack of personnel for a regulated entity of its size and import.”
OUR TAKE: Under-resourcing compliance is a red flag for regulators and often leads to enforcement actions. Firms should spend no less than 5% of revenue on compliance infrastructure and should spend more where their activities involve several complex processes.
A broker-dealer and its principal were censured and fined for failing to observe information barriers intended to safeguard material nonpublic information contained in research reports. According to the SEC, notwithstanding the BD’s written supervisory procedures, (i) the principal and other employees engaged in active personal trading without pre-approval, (ii) the firm failed to observe information barriers between research and sales, (iii) employees disseminated material information such as price targets to existing and prospective customers, and (iv) the firm failed to prevent trading ahead of research reports or decisions to commence coverage. FINRA had previously cited the firm about similar issues. The SEC alleges violations of Section 15(g) of the Exchange Act, which requires broker-dealers to establish and enforce policies and procedures to prevent the misuse of material nonpublic information.
OUR TAKE: The SEC will bring an enforcement action based on issues raised by other regulators (e.g. FINRA) but not adequately remediated. The regulators will throw the book at recidivists. (see e.g.
). In re Morgan Stanley