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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. 

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.


SEC Takes Action against Head of Regulatory Reporting

The SEC issued a cease and desist order against the Head of Regulatory Reporting of a large investment bank for causing violations of the firm’s customer protection rule.  As previously reported, the firm agreed to pay $415 Million to settle the charges.  The SEC faults the respondent, who also served as the Financial and Operational Principal, with misleading regulators about the true purpose of certain synthetic transactions intended to reduce the amount held in the firm’s reserve account.  The SEC cites FINRA’s handbook which prohibits any window dressing designed to reduce the reserve formula.

OUR TAKE: It is noteworthy that the Head of Regulatory Reporting was the only individual specifically charged by the SEC in this action even though the firm paid a staggering settlement.  Regulatory officers, including CCOs and FINOPs, continue to be targeted by the regulators.


Broker-Dealer Responsible for Trading Desk’s Unlawful Trading Practices

An interdealer broker agreed to pay $2.5 Million in disgorgement for failing to disclose markups and markdowns on securities traded for clients.  According to the SEC, the broker-dealer’s Cash Equity Desk marketed its services as agency only, charging commissions between 1 and 3 cents per share.  However, the SEC alleges that during periods of market volatility, the Cash Equity Desk charged additional markups and markdowns on trades without telling clients and then misleading them about actual purchase/sale prices.  The conduct also violated its compliance policies.  The SEC faults the entire firm for the unlawful misconduct because the employees were “acting within the scope of their authority.”

OUR TAKE: Firms encountering bad conduct by a small number of employees will have a hard time making the “rogue employee” defense.  The SEC has increasingly taken a more strict liability approach whereby the firm is liable for all actions of all employees.


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.


Large BD Failed to Remedy Mini-Flash Crashes

Failed to Remedy Flash Crash

A large broker-dealer agreed to pay $12.5 Million to settle charges that it violated the market access rule (15c3-5).  The SEC charges that senior executives had discretion to set pre-trade controls at levels that allowed significant erroneous orders to reach the exchanges.  In several cases over a 3-year period, erroneous orders caused mini-flash crashes in the affected security.  Despite these events, which should have been red flags, the SEC faults the respondent for taking no action to address the market access until contacted by SEC staff.

OUR TAKE: This is the type of breakdown that can easily occur at large firms where compliance is left to individual business units, and no designated person has overall responsibility to monitor trading practices.