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FINRA Proposes Excluding RIAs from OBA Supervision

FINRA has proposed a new outside business activities supervision rule that would exclude independent investment advisers.  Under the proposal, third party investment advisers would need to receive informed consent for their activities, but the BD would not have supervisory obligations.  The BD could impose certain requirements based on a required risk assessment of conflicts of interest and customer confusion.  The proposal also limits BD obligations to supervise non-investment related activities.

OUR TAKE: That sound you heard yesterday was the Greek chorus of cheers from investment advisers who have had to pay their broker-dealers a percentage of their advisory fees for required supervision.  We expect the larger independent broker-dealers will lobby heavily against this proposal as it cuts off a lucrative revenue source.  The proposal would help smaller regional firms that want to recruit reps but don’t have the currently-required supervisory resources.  We expect much debate.


BD President Sanctioned for Failing to Supervise Inexperienced CCO

The President of a broker-dealer was fined and barred for failing to supervise an inexperienced and ineffective Chief Compliance Officer.  The CCO failed to properly monitor and halt excessive mutual fund trading by a registered rep.  The CCO had difficulty analyzing the firm’s trade blotter and mutual fund reports even after a compliance consulting firm was hired to assist.  FINRA faults the President for failing to recognize the CCO’s failures and take the necessary action to implement an adequate supervisory system.  FINRA blames the President because he “was ultimately responsible for supervision.”

OUR TAKE: Do you know if your CCO is competent?  Firm leaders do not satisfy their obligations to implement a compliance and supervisory system by merely calling somebody the Chief Compliance Officer.  A CCO must be competent, have the necessary resources, effectively implement policies and procedures and test them.  Then, firm management must monitor the CCO to ensure that the CCO adequately performs the role.


SEC Fines and Bars Two Advisers for Selling Away Private Equity Fund

The SEC fined and barred two advisers for selling interests in a private equity fund to their clients away from their broker-dealer and other securities law violations.  The defendants operated a branch office of a registered IA/BD and held licenses.  However, the SEC asserts that they formed the private equity fund and sold interests therein without the knowledge or consent of the BD.  The SEC maintains that the selling activity constituted unregistered broker-dealer activity because they acted outside the scope of their employment and their mere association with the broker-dealer did not cover their activities.  The SEC also charges the pair with other securities laws violations including misrepresentations and conflicts of interest.

OUR TAKE: Individuals that sell private fund securities must obtain appropriate securities law licenses and submit to broker-dealer supervision.  Just having a Series 7 does not give you carte blanche to engage in any securities activity unless your broker-dealer approves and supervises.


Adviser Failed to Stop Principals from Looting Client Accounts

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.


IA/BD Failed to Supervise Its CEO/CCO

 The SEC fined and censured an IA/BD for failing to supervise its CEO/CCO who was ultimately criminally convicted of stealing from clients.  The CEO/CCO used the firm’s consolidated reporting system, which allowed manual inputs of outside investments, as a way to mislead clients about false investments that he siphoned off into his own account.  The SEC faults the firm for failing to implement reasonable policies and procedures to review the consolidated reports, which, according to the SEC, would have quickly uncovered the obvious scheme.  The SEC charges violations of the antifraud rules and the compliance rule (206(4)-7), which requires firms to adopt and implement reasonable compliance policies procedures to prevent violations of the securities laws.

OUR TAKE: It’s never good when the CEO (or any other revenue-producing individual) also serves as the CCO.  Such a structure virtually ensures a lack of proper supervision.  Firms must ensure that the CCO, whether inside or outsourced, has significant independence from management and the revenue-producing function.  The SEC has brought several enforcement actions against dual-hatted CCOs, who also serve in a management capacity.


Weak Compliance Costs Firm who Failed to Stop Employee’s Cherry-Picking

The SEC fined and censured a large investment adviser for failing to implement adequate compliance polices that could have prevented a managing director from cherry-picking trades for his own benefit.  The MD had exclusive access to an omnibus account at the firm’s prime broker through which he allocated trades after the close of the trading day.  According to the SEC, the MD allocated 99% of profitable trades to his own account.  The SEC faults the firm for failing to adopt or implement adequate policies and procedures or supervisory controls.  Ultimately, the prime broker discovered the cherry-picking scheme and terminated the block trading account.  As part of the remedy, the SEC has required the adviser to pay client remediation based on first-day returns of less than .25%, the blended return earned on all of the accounts including the personal allocations.

OUR TAKE: Although the firm did not benefit from its employee’s misconduct, it suffers the regulatory consequences for failing to implement an adequate compliance and supervisory program to stop a bad actor.  Firms without a compliance infrastructure have no defense against regulatory accusations involving rogue employees.  Separately, it is worth noting that the SEC, for the first time (we think) has used a specific formula (based on total returns) to calculate client remediation in a cherry-picking case.


Hedge Fund Firm and Senior Manager Failed to Supervise Analyst Convicted of Insider Trading


A hedge fund firm agreed to pay nearly $9 Million in disgorgement, interest and penalties and a senior research analyst was fined and barred from the industry for failing to reasonably supervise an analyst convicted of insider trading.  The SEC alleges that the firm and the supervisor ignored red flags including receiving confidential information that preceded public announcements, allowing the analyst to work out of his home, and the absence of any documentary support for recommendations.  Moreover, the supervisor violated the firm’s policies by failing to report the red flags to the firm’s Chief Compliance Officer for further investigation and testing.  The SEC asserts that the firm should have implemented heightened supervision including requiring reporting conversations with employees of public companies, requiring heightened information, and tracking recommendations.

OUR TAKE: The SEC properly placed responsibility on the firm and its line management (and not the CCO) for failing to supervise and report concerns to the CCO for further investigation.  Management should have accountability for regulatory compliance, while the compliance department owns the drafting and testing of procedures and advising management on regulatory issues.


Large BD to Pay $15 Million for Failing to Properly Train Reps


A large broker-dealer agreed to pay over $15 Million in disgorgement and fines for failing to adequately train its reps about the risks of structured notes sold to retail investors.  The SEC maintains that its rep training did not include sufficient information about volatility and breach risk such that the reps could satisfy their reasonable basis suitability obligations.  Over a 3-year period, the firm sold over $500 Million (notional amount) in the subject structured notes to more than 8,000 retail customers.  The SEC charges the firm with failure to supervise.

OUR TAKE: What is interesting about this case is that the SEC holds the firm accountable for failure to properly train the reps, rather than pointing the finger at the compliance department or the reps themselves.  This continues the trend of holding organizations and senior executives accountable for compliance failures.  Also, firms have a high regulatory burden when selling complex financial products to retail investors.