A large custody bank agreed to pay almost $89 Million in fines, disgorgement, and interest to settle charges that it overcharged investment company clients by marking up purported out-of-pocket expenses for nearly two decades. The most significant markups occurred on SWIFT messages as the bank failed to adjust the charges as its internal costs decreased over time. The SEC also maintains the bank overcharged investment company clients on 12 other classes of expenses, collecting $170 Million in profit during the period. The SEC charges the custody bank with causing its fund clients to maintain inaccurate books and records.
This case should prompt fund financial officers to review the charges imposed by the custody bank. That nickel and diming on everything from wire fees to foreign custody reports may be unlawful. Service providers should also take note that the SEC will initiate enforcement for overcharging registrants even where the service provider itself is not an SEC registered or regulated entity.
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.
The SEC fined and censured a fund administrator for causing a money market fund’s violations of the Investment Company Act. The SEC asserts that the administrator used a flawed valuation methodology that resulted in violations of Rule 2a-7. The fund was used as a vehicle to invest securities lending collateral for the benefit of affiliated mutual funds. Because the fund failed Rule 2a-7, the investments by the registered funds violated the affiliated transaction rules.
OUR TAKE: As was the case with another recent case against a fund administrator, the SEC will broadly interpret the securities laws to hold non-registrant service providers accountable as gatekeepers of the securities markets.
The full SEC dismissed an enforcement case against a self-directed IRA custodian because it had no fiduciary or other obligation to investigate the merits of underlying investments. The custodian held assets that ultimately turned out to be Ponzi schemes, but the SEC opined that the custodian, which was not registered as an investment adviser or broker-dealer, had no implied duty to conduct due diligence in the absence of actual knowledge of red flags suggesting misconduct. The SEC cited the custodian’s low per account fees and its client agreements which specifically disclaimed any fiduciary obligation. The SEC determined that the firm acted as a reasonably prudent passive self-directed IRA custodian, as determined by governing state law. The SEC dismissed the appeal of the Enforcement Division from a similar finding by the Administrative Law Judge.
OUR TAKE: The full SEC came to the right decision on the law given the Enforcement Division’s dubious legal theory that could encompass almost any third party actor in any way connected to a fraudulent transaction. (See https://cipperman.com/2015/06/17/sec-takes-action-against-ira-custodian/.) Unfortunately, it took the respondent more than 2 years to clear its name. Third party service providers would be better off conducting due diligence and avoiding any SEC entanglements altogether.
A valuation firm was censured and fined and its principal was fined and barred for misleading its investment firm client about how it valued European options. The valuation firm represented that it valued the options using independent data and Black-Scholes modeling. The SEC charges that the firm merely used the estimated valuations provided by the client and then applied formulaic ranges. The SEC asserts that the valuation firm acted as an unregistered investment adviser because it “provided advice…about the value of securities…in exchange for compensation.” Following therefrom, the SEC charged violations of Section 206(2) of the Advisers Act, which prohibits investment advisers form engaging in any fraudulent activity.
OUR TAKE: The SEC uses a tortured reading of the definition of “investment adviser” to hold accountable a third party valuation agent responsible for mis-pricing a fund. All service providers should beware that the SEC will seek to assert its authority through broad use of the securities laws.