A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another. The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids. Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities. The private fund ultimately sold the securities at a significant profit. The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.
Firms should avoid client cross-trades. One side will always benefit, which gives rise to conflict of interest and favoritism allegations. A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure.
OUR TAKE: Compli-pros face an enormous challenges in large, global institutions to ferret out multi-lateral business relationships and ensure that the firm adequately observes its fiduciary obligations.
OUR TAKE: Without proper disclosure and consent, a transaction that benefits the fund sponsor or its principals will violate the Advisers Act’s fiduciary duty whether or not the investors suffered any harm. This case also highlights the perils of the CCO dual-hat model whereby a senior executive with a pecuniary interest also serves as the Chief Compliance Officer, thereby avoiding independent scrutiny.
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.
10 Things You Need to Know About Regulation Best Interest
Reasonable basis. A broker must have a reasonable basis that the recommendation is in the best interest of the client.
Applies to retail customers. A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
“Recommendation” remains the same. The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
No definition of “best interest”. In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
More than suitability, less than fiduciary. Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
Fails to harmonize RIA and BD standards. Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers. This proposal fails to ensure a “uniform” standard.
Disclosure of conflicts of interest. The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
Must consider series of transactions. Expanding traditional suitability, a broker must also consider the series of recommended transactions.
Product neutrality not required. Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
Regulation Best Interest is not law. Comments are due on this controversial proposal by August 7, 2018. Thereafter, we expect much debate and re-drafting before any final rule is adopted.
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.
OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled. Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.
The SEC censured an investment adviser and ordered it to pay $1.7 Million in fines, disgorgement, and interest for failing to implement a compliance program that would detect and prevent the looting of client accounts. Two firm principals ultimate went to prison for using their positions as fiduciaries over trust accounts to steal funds. The SEC faults the firm for (i) failing to adopt legitimate policies and procedures, (ii) neglecting to obtain the required surprise examinations, and (iii) preparing misleading Form ADVs. In addition to charging violations of the Advisers Act fiduciary, custody and compliance rules, the SEC also cites violations of Section 10(b) and Rule 10b-5, which prohibit fraudulent conduct in the offer or sale of securities, presumably for misleading statements made in Form ADV.
OUR TAKE: Just because the principal wrongdoers went to jail doesn’t mean the firm is off the hook. The SEC holds the adviser accountable for allowing the conduct to continue. It is also significant that the SEC uses 10b-5 as a charge, which opens the door to more significant civil and criminal penalties.
The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees. The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm. According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings. The client’s representatives ultimately contacted Schwab, who then informed his employer. The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.
OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated. Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions. Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.
OUR TAKE: The SEC appears to be most disturbed that the fund sponsor did not return client assets and double-dipped advisory fees by moving assets into the reserve fund. Private fund firms that registered after 2012 as a result of Dodd-Frank, should audit their operations to determine whether longstanding business practices run afoul of their fiduciary duties.