FINRA has released its 2019 Report on Examination Findings and Observations, offering insight on enforcement cases and risk management concerns. FINRA provides a long list of examination and enforcement findings including negligent practices related to (i) supervision (failure to amend WSPs for new or amended rules, weak branch office inspections); (ii) suitability (product exchanges, churning); (iii) digital communications (failure to stop individual texting, electronic sales seminars); (iv) anti-money laundering (inadequate transaction monitoring, overreliance on clearing firms); (v) UTMA/UGMA (know your customer); (vi) cybersecurity; (vii) business continuity plans; (viii) fixed income mark-ups; (ix) best execution; (x) market access; (xi) short sales; (xii) liquidity risk management; (xiii) segregation of client assets; and (xiv) net capital. A senior FINRA official explained the purpose of the Report: “We hope firms find the Exam Findings and Observations Report useful in strengthening their own control environments and addressing potential deficiencies before their next exam.”
The Exam Report is more useful than the annual Exam Priorities letter because it reflects actual cases and findings rather than a regulatory wish list. We recommend that all compli-pros establish an internal working group to address the issues raised in the Report.
We don’t relish the idea of a regulator that has to fill a large financial deficit, especially since it could use fines to fill some of this hole. We expect the lower fine numbers during the last 2 years to be more of an aberration.
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.
As reported last week, I went 8-2 on my 2018 regulatory
predictions, bringing my mark to 22-15-3 over the last four years. For the upcoming year, I want to take a few
more chances and swing for the fences on a couple of predictions. While this
may lower my percentage, I hope my readers and our clients will reward the
boldness (perhaps by reading my new book: The
Compliance Advantage: Ten Must-Know Trends to Protect Your Investment Firm
(available on Amazon).
Predictions for the 2019 Regulatory Year
The SEC will propose a comprehensive adviser marketing/advertising rule. Last year, we accurately predicted that the Enforcement Division would focus on marketing and advertising cases. We predict that the Division of Investment Management will use these cases as the justification to propose a new rule addressing adviser marketing practices.
The SEC will re-propose the broker best interest standard. Responding to industry comments, the SEC will re-propose the rule and make it closer to an adviser fiduciary standard but stopping just short of reconciling the two standards.
The Enforcement Division will bring several significant cases alleging violations of the solicitor rule. OCIE has already cited widespread noncompliance with the solicitation rule (206(4)-3), which limits how advisers can pay solicitors for recommending their services. We expect that the Enforcement Division will follow up with significant litigation.
The SEC will liberalize the private offering rules. Look for the SEC to raise the accredited investor definition, change offering exemptions, or seek new private offering categories.
OCIE will examine at least 20% of advisers. Chairman Clayton committed to increasing adviser reviews to respond to media and Congressional criticism that the SEC needs to enhance industry supervision. The SEC reviewed 15% of advisers last year. This will be the year that the SEC hits the 20% mark.
The SEC will bring significant cases against independent fund directors. Both OCIE and the Enforcement Division have increased scrutiny of registered funds and their management. I foresee that the Enforcement Division will go beyond the fund sponsors and look to hold independent directors accountable for regulatory failures.
The SEC will allege securities fraud in secondary market private equity transactions. Both private equity sponsors and third parties have expanded the secondary market for private equity investments. Because of the information imbalance between buyers and sellers, we expect that the SEC will seek to even the playing field by bringing securities fraud cases.
The SEC will approve a registered crypto fund. I won’t try to predict which fund, or the conditions imposed, but I believe the SEC will green-light at least one crypto-based registered fund. I suspect it will be sponsored by a (very) large firm.
The Supreme Court will decide that digital tokens are not securities and that an ICO is not a securities offering. This issue is roiling the lower courts and the industry. Eventually, the Supremes will have to end the uncertainty. Although I think there are good arguments on both sides, I think this Supreme Court will rule against SEC regulation.
The SEC will expand the whistleblower program. The SEC will expand the program to include criminal actions prosecuted by the Department of Justice as well as state enforcement actions.
The CFTC’s regulatory sphere has greatly expanded with the emergence of swaps, derivatives, cryptocurrencies, and alternative hedge funds. The CFTC, like the SEC, has ramped up its enforcement activities to historic levels.
The SEC Enforcement Division filed 32% more standalone enforcement cases against investment advisers and investment companies in fiscal 2018 (through September 30), as compared to 2017. Cases against investment advisers and investment companies (the second largest category) and broker-dealers (fourth largest) represented 35% of all standalone actions filed. Overall, the SEC Enforcement Division brought 490 standalone cases in fiscal 2018, a 10% increase over 2017. Excluding the municipal disclosure initiative, the Enforcement Division filed more cases than it did in 2016 and 2015, the last two years under the prior administration. The Enforcement Division obtained $3.9 Billion in penalties and disgorgement, which is consistent with amounts obtained during the prior several years. The Enforcement Division outlined five core principles, including a focus on individual accountability because “holding culpable individuals responsible for wrongdoing is essential to achieving our goals of general and specific deterrence and protecting investors by removing bad actors from our markets.”
The Enforcement Division continues to pursue its active litigation agenda, especially against the investment industry. Apparently, the Jay Clayton SEC is not much different from the Mary Jo White SEC when it comes to enforcement cases against adviser, funds, and broker-dealers.
OUR TAKE: Unlike the SEC, the state securities regulators have the power to pursue criminal penalties including prison time. Regardless of what happens at the federal level, the states appear ready to flex their enforcement muscles.
The SEC has upheld a FINRA bar of a registered rep for failing to timely respond to FINRA’s requests for information. Following the filing of a U5 indicating the rep was terminated for failure to comply with firm policies and disclosure obligations, FINRA initiated an investigation. The respondent repeatedly failed to respond to requests sent to his CRD address. Eleven months after the initial request and 9 months after the bar became effective, the respondent sought relief from the bar on the grounds that health issues prevented his timely response. The SEC rejected his argument because he continued to work and remain active and failed to timely respond as reasonably practical.
OUR TAKE: The regulators will proceed with penalties if you ignore their requests for information. Once penalties, such as an industry bar, are imposed, it becomes very difficult to demonstrate good faith.
In its 2017 fiscal report, the SEC’s Enforcement Division cites individual accountability as one of its core enforcement principles. The report expresses the Enforcement Division’s view that “individual accountability more effectively deters wrongdoing.” Since Chairman Clayton took office, the SEC has charged an individual in more than 80% of standalone enforcement actions. The report notes that it can be more expensive to pursue individuals, but “that price is worth paying.” The report notes a modest decrease in filed enforcement actions and recoveries since 2016: 754 vs. 784 cases (excluding municipal cases) and $3.8 Billion vs. $4 Billion in total money ordered.
OUR TAKE: “Just because you’re paranoid doesn’t mean they aren’t after you.” (Joseph Heller) The data and the explanation imply that the SEC will prioritize prosecuting individuals, even if the money ordered is smaller than in institutional actions, because of the fear and deterrent effect. If financial executives need another reason to engage a best-in-class compliance program, how about protecting yourselves from a career-ending enforcement action?
OUR TAKE: Over the last several years, the state securities regulators have expanded examinations and enforcement along with the SEC and FINRA, making it much more difficult for any adviser or broker-dealer to avoid regulatory scrutiny. It’s worth noting that many state securities regulators have criminal enforcement authority.