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Marketplace Lender Fined $3 Million for Overstating Returns Due to Coding Errors


A marketplace lender agreed to pay a $3 Million fine for overstating returns because of coding errors.  The SEC asserts that the firm’s legacy coding omitted charged-off loans from historical performance calculations once the charged-off loans were sold to a third party.  According to the SEC, the firm knew as far back as 2014 that its legacy code had significant issues but failed to fix the code affecting the return calculations.  The firm used the inflated returns in client reporting and marketing. 

As firms implement FinTech and RegTech, they cannot simply set it and forget it.  Compliance, operations, and IT personnel must work together in real time to ensure that systems reflect current regulatory requirements.  Technology is a great tool, but it is not the complete answer to regulatory compliance. 

SEC Alleges that RIA and Principal Ignored Compliance Obligations

The SEC has commenced enforcement proceedings against an adviser and its principal for disregarding its compliance obligations for over 10 years.  The SEC alleges that the firm did not even draft or adopt compliance procedures until an SEC examination commenced in 2015, 11 years after it initially registered.  The SEC also asserts that the principal named two individuals on Form ADV as Chief Compliance Officers even though neither person had responsibility for compliance, and one of the individuals did not even know that he was named as CCO.  The SEC also charges the firm with failing to conduct annual compliance reviews, comply with the custody rule, and maintain required books and records. 

The SEC will offer no quarter to RIAs who ignore their basic compliance responsibilities.  At a bare minimum, firms must appoint a dedicated and qualified CCO, adopt tailored policies and procedures, annually test the program, and generally attempt to comply with the Advisers Act.  The initiation of proceedings, rather than a settled order, suggests that the SEC intends to pursue aggressive penalties. 

Best of the Law Firms – February 2019 edition

Welcome to the February 2019 edition of the Best of the Law Firms.  In this feature, we recommend some of the best recent articles and analyses authored by top investment management lawyers.  These articles offer a more comprehensive review of the issues that we address in our daily “Our Take” alerts. 

The best law firms cranked out some great articles during the last several weeks, perhaps feeling a post-holiday burst of energy.  Paul Hastings offers a great overview of the esoteric world of Section 13 and Section 16 filings.  Morgan Lewis addresses best execution issues when recommending mutual fund share classes.  Dechert tries to discern the future of Brexit.  There were also some great pieces on co-investments from Pepper Hamilton, political and lobbying activities from K&L Gates, and a CFTC survey from WilmerHale.

SEC Reporting Obligations Under Section 13 and Section 16 of the Exchange Act (Paul Hastings)

When Best Execution Isn’t Best: Mutual Fund Share Class Selection (Morgan Lewis)

Brexit Manoeuvres: Potential Implications of a “Hard Brexit” for Fund Managers: A UK Perspective (Dechert)

Common Considerations and Complications of Co-Investments (webinar) (Pepper Hamilton)

Involuntary Termination of Investment Adviser: The Nuclear Option (Perkins Coie)

Fund Boards Are Not Immune to Activists (Skadden)

A Guide to Political and Lobbying Activities (K&L Gates)

A Year to Remember for Business Development Companies (Mayer Brown)

2018 CFTC Year-In-Review (WilmerHale)

Artificial Intelligence in Financial Services: Tips for Risk Management (Kramer Levin)

Preparing for the Next Generation of Actively Managed ETFs (Thompson Hine)

Securities Cases That Will Matter Most In 2019 (Willkie Farr & Gallagher)

Top 5 Regulatory Alerts – November 2018

  1. SEC FILED 32% MORE ENFORCEMENT CASES AGAINST ADVISERS AND FUNDS IN FISCAL 2018 (11/5/18)
  2. CCOS LIABLE FOR FAILING TO “MEANINGFULLY” IMPLEMENT COMPLIANCE PROGRAMS (11/12/18)
  3. SEC IS EXAMINING REGISTERED FUNDS AND ETFS FOR OVERSIGHT, POLICIES, AND CONFLICTS (11/9/18)
  4. FEDERAL COURT RULES THAT THE SEC MUST PROVE THAT DIGITAL TOKENS ARE SECURITIES (11/28/18)
  5. SEC WARNS ADVISERS ABOUT SOLICITATION RULE VIOLATIONS (11/1/18)

  

Most Read – November 2018

  1. CCOS LIABLE FOR FAILING TO “MEANINGFULLY” IMPLEMENT COMPLIANCE PROGRAMS (11/12/18)
  2. INSUFFICIENT COMPLIANCE RESOURCES COST FIRM AND CEO (11/8/18)
  3. SEC WARNS ADVISERS ABOUT SOLICITATION RULE VIOLATIONS (11/1/18)
  4. SEC IS EXAMINING REGISTERED FUNDS AND ETFS FOR OVERSIGHT, POLICIES, AND CONFLICTS (11/9/18)
  5. ADVISORY CLIENTS DID NOT RECEIVE PROMISED FEE BREAKS (11/20/18)

Deficient Compliance Will Cost RIA/BD $600,000; CCO Must Undergo Training

 A dually registered RIA/BD agreed to pay approximately $600,000 in disgorgement, penalties and interest because a deficient compliance infrastructure failed to ensure full disclosure of revenue sharing.  According to the SEC, the respondent engaged in a scheme since 1999 whereby its clearing broker would kick back a $20 markup fee on trades.  The clearing broker also paid trailer fees on NTF mutual funds.  The SEC alleges that the firm failed to properly disclose the revenue sharing and, in many cases, reps who didn’t know better told clients that the firm did not receive compensation from the clearing broker.  The SEC charges that the firm did not have adequate compliance policies and procedures and ordered the Chief Compliance Officer, the firm’s former receptionist, to complete 30 hours of compliance training.  The firm also agreed to hire an independent compliance consultant.

“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements.  The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest.  Perhaps, the firm never considered that its longstanding practice violated the securities laws.  This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm. 

Compliance Failures Cost BDC Manager $4 Million in Penalties and $2.6 Billion in Assets

 A BDC manager’s compliance failures led to nearly $4 Million in fines, disgorgement and penalties and the loss of its advisory business.   The SEC charges the firm with misallocating overhead expenses to the registered Business Development Companies it managed and with overvaluing portfolio companies.  The SEC maintains that the registrant used material nonpublic information about BDC portfolio companies to benefit affiliated hedge funds that it managed.  In 2014, the firm had over $2.6 Billion in assets under management but withdrew its adviser registration in 2017 following the SEC enforcement action.  The SEC asserts violations of the compliance rule (206(4)-7) in addition to a laundry list of other securities laws violations.

Failure to implement an effective compliance program has consequences beyond penalties and fines.  The negative impact to a firm’s and its principals’ reputations could ultimately bring down the entire franchise. 

Top 5 Regulatory Alerts – July 2018

Here are our Top 5 Regulatory Alerts for July 2018, ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – July 2018

  1. ADVISERS FAILING BEST EXECUTION COMPLIANCE OBLIGATIONS (7/16/18)
  2. FUND MANAGERS FINED FOR DISQUALIFYING POLITICAL CONTRIBUTIONS (7/11/18)
  3. BROKER/CUSTODIAN SHOULD HAVE FILED SARS TO REPORT ADVISERS ACT VIOLATIONS (7/10/18)
  4. SEC CHARGES VIOLATIONS OF TESTIMONIAL RULE (7/12/18)
  5. SEC SEEKS EXPANSION OF WHISTLEBLOWER PROGRAM (7/2/18)

 

Most Read – July 2018

  1. PRIVATE EQUITY FIRM FAILED TO DELIVER FINANCIALS WITHIN 120 DAYS (7/19/18)
  2. ADVISERS FAILING BEST EXECUTION COMPLIANCE OBLIGATIONS (7/16/18)
  3. PORTFOLIO MANAGER MADE PERSONAL LOAN TO CEO TO GET ON BOARD (7/17/18)
  4. PRIVATE EQUITY EXEC BARRED FROM INDUSTRY FOR PERSONAL TRANSACTION WITH PORTFOLIO COMPANY (7/27/18)
  5. BROKER-DEALER FINED $1.25 MILLION FOR DELETING PHONE CALLS AND INADEQUATE RECORDS RETENTION (7/18/18)

Over-Reliance on Automated Surveillance Tools Costs IA/BD $4.5 Million

The SEC fined a large BD/IA $4.5 Million for overly relying on flawed compliance technologies that failed to prevent 5 registered representatives from stealing over $1 Million from clients over a 4-year period.  One of the systems, which was designed to compare disbursement addresses against controlled addresses, contained a technical error that resulted in a failure to generate the necessary red flags for further investigation.  The other system, a transaction-monitoring tool, had a design limitation that required an exact word-for-word address match, thereby failing to identify suspicious addresses.  Complementary manual supervision and monitoring also failed to uncover the conduct.  The SEC charges the firm with failures to supervise and to implement reasonable policies and procedures.

OUR TAKE: We love compliance regtech as a tool to leverage compli-pros’ efforts to uncover wrongdoing.  However, over-reliance on technology without professional judgment and intervention will lead to a false sense of compliance security.  An automatic hammer will not build a house without the architects and the builders.

 

Broker-Dealer Failed to Discipline Commission-Sharing Traders

 The SEC fined a broker-dealer $1.25 Million for failing to take sufficient disciplinary action against brokers that shared commissions in violation of firm policy.  The SEC asserts that the one broker, who ultimately became a supervisor, assigned accounts to junior traders in exchange for off-the-book kickbacks paid by personal checks.  The transactions violated the firm’s policies and procedures and books and records requirements.  Upon discovering the arrangement 13 years after it began as a result of a FINRA investigation, the firm responded by issuing a memo condemning the activity and offering the participants the opportunity to resign.  The SEC faults the firm for failing to discipline the wrongdoers.

OUR TAKE: Having policies and procedures, but taking no significant action against those who violate them, eviscerates their purpose.  This compliance voodoo – the mere appearance of a compliance program – will draw the ire of the regulators.

 

Top 5 Regulatory Alerts – February-March 2018

 

Here are our Top 5 Regulatory Alerts for February-March 2018, ranked by significance.  We have also included the Top 5 most read Alerts.

 

Top 5 Regulatory Alerts – February-March 2018

  1. FIFTH CIRCUIT VACATES FIDUCIARY RULE (3/19/18)
  2. OCIE RELEASES 2018 EXAM PRIORITIES (2/8/18)
  3.  SUPREME COURT RULES THAT WHISTLEBLOWER MUST REPORT TO SEC (2/22/18)
  4. SEC ISSUES CYBERSECURITY COMPLIANCE AND DISCLOSURE GUIDANCE (2/23/18)
  5. COMPLIANCE OFFICER CHARGED WITH SECURITIES FRAUD (3/15/18)

 

Most Read – February-March 2018

  1. SEC ISSUES CYBERSECURITY COMPLIANCE AND DISCLOSURE GUIDANCE (2/23/18)
  2. COMPLIANCE OFFICER CHARGED WITH SECURITIES FRAUD (3/15/18)
  3. BD PRESIDENT SANCTIONED FOR FAILING TO SUPERVISE INEXPERIENCED CCO (2/21/18)
  4. SEC PROSECUTES CURRENT AND FORMER COMPLIANCE OFFICERS FOR AML FAILURES (3/29/18)
  5. SEC OFFICIAL QUESTIONS REGISTRATION EXEMPTION FOR ETF INDEX PROVIDERS (3/21/18)