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.
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.
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.
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.
A large clearing broker-dealer agreed to pay over $1.3 Million in disgorgement, interest, and fines to settle charges that it underfunded its reserve account. Due to a coding error, the firm miscalculated its reserve formula pursuant to the customer protection rule (15c3-3) resulting from repos with its parent company. After discovery by a FINRA examination team, the broker-dealer deposited $133 Million into its reserve account, thereby triggering a liquidity crisis for the firm as it worked to raise the necessary capital. The SEC criticized the BD, which has had other compliance issues, for a “lack of personnel for a regulated entity of its size and import.”
OUR TAKE: Under-resourcing compliance is a red flag for regulators and often leads to enforcement actions. Firms should spend no less than 5% of revenue on compliance infrastructure and should spend more where their activities involve several complex processes.
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.
Every year, we offer our predictions on what will happen in the investment management regulatory world. Last year, we went 4-6 (not great on a test, but pretty good in baseball). We were right about the fiduciary rule, whistleblowers, state enforcement, and individual liability. We missed on our predictions of regulatory changes and how the industry would respond to the increased demand for bonds.
The current uncertain regulatory environment has changed our hubris to humility. Thus, it is with humble intent that we look forward to offer our 2018 predictions:
Predictions for the 2018 Regulatory Year
- More states will adopt fiduciary rules. Nevada has already adopted a uniform fiduciary standard in the wake of the DoL’s delay. We expect other states (e.g. California, New York, Connecticut) to follow.
- The SEC will propose a uniform fiduciary rule for retail advisers and broker-dealers. Chairman Clayton has spoken publicly about the need for the SEC to wade into the fiduciary waters. Expect a proposed rule this year.
- The SEC will commence significant cybersecurity enforcement actions. The staff has done a sweep and issued guidance. We have not yet seen significant enforcement actions. We expect several this year.
- There will be cases alleging C-suite wrongdoing in private equity. The SEC Enforcement Division has focused on the private equity industry for the last couple of years. Given their interest in prosecuting senior executives to deter unlawful conduct, expect a couple of big cases against private equity execs.
- FINRA will bring actions against firms for hiring bad brokers. Rather than simply prosecute the brokers, FINRA will dedicate some enforcement resources to firms that fail to screen out the bad brokers, thereby making it a firm responsibility.
- SEC and/or FINRA will bring cases alleging inadequate branch office supervision. Both regulators have expressed concerns about remote office supervision. Enforcement cases will ensure the industry’s attention.
- The SEC will commence significant marketing/advertising cases. Seemingly out-of-the-blue, the SEC warned advisers about misleading marketing and advertising claims. We are assuming that OCIE is uncovering a lot of problems.
- The SEC will propose a re-write of the custody rule. The custody rule has the right intent, but the rule itself is too open to interpretation and questions (see multiple FAQs). We think the Division of Investment Management will undertake a re-write (although maybe this is just wishful thinking.)
- The SEC will propose cryptocurrency regulations. Bitcoin futures are flying high. The SEC has expressed its opinion that it should regulate cryptocurrency offerings. We expect some rules.
- The SEC will re-propose the ETF rule. Plain vanilla ETFs should have a rule that allows them to proceed without an exemptive order. The SEC proposed and abandoned a rule several years ago. We anticipate that the SEC will resuscitate the effort.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) reports widespread compliance failures among municipal advisers reviewed as part of its 2014-15 examination sweep. OCIE staff “frequently observed” supervision failures including the failure to adopt and implement written supervisory procedures and appoint a responsible principal. OCIE also faulted frequent failures to file and amend registration documents and to maintain required books and client and financial books and records. By publishing the results, OCIE “hopes to encourage MAs to reflect upon their practices, policies, and procedures in these areas and to make any necessary improvements.” Municipal advisers became subject to SEC registration and jurisdiction pursuant to the Dodd-Frank Act.
OUR TAKE: This Risk Alert is the warning shot across the bow for municipal advisers. OCIE often publishes these types of examination findings and recommendations as a foreshadowing of impending enforcement actions.
A privately-held benefits consulting firm agreed to pay a $450,000 fine, and its former CEO agreed to pay over $500,000, for failing to disclose compliance failures during fundraising. The SEC maintains that the firm evaded state insurance licensing laws by rigging online examination courses and allowing employees to sell insurance without required licenses. The SEC charges that the firm violated the securities laws by failing to disclose the compliance failures when raising money from institutional investors during at least 3 financing rounds that raised over $500 Million. The related stock purchase agreements included false representations that the company complied with applicable laws including licensing requirements. The respondent has also faced regulatory actions by at least 40 states who have imposed more than $11 Million in sanctions. As part of the SEC settlement, the company created a Chief Compliance Officer position.
OUR TAKE: Be very careful when claiming compliance with applicable laws in disclosure or fundraising documents. You might want to ask your Chief Compliance Officer if any issues require more disclosure. The SEC can use holes in your regulatory compliance as a predicate to an enforcement action for securities fraud.