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The BD/IA Regulator

Providing securities regulatory, enforcement and litigation trends for broker-dealers, investment advisers and investment funds

FINRA Sanctions Member Firm for Failure to Deliver ETF Prospectuses

Posted in Enforcement, FINRA Enforcement

FINRA recently sanctioned a broker-dealer (the “Firm”) for failure to deliver prospectuses in connection with its sale of ETFs.  FINRA also found that the Firm failed to implement a supervisory system reasonably designed to achieve compliance with securities laws and regulations governing ETF prospectus delivery.  The Firm was censured and agreed to a fine of $3 million. This fine is a significant increase in the amounts imposed by FINRA since 2011 in its disciplinary proceedings against  member firms for their failures to meet their prospectus delivery obligations (see our related blog post).

FINRA found that the Firm failed to deliver prospectuses for approximately 255,000 purchases of 160 ETFs during the period from September 2010 to November 2010.  The Firm self-reported the delivery failures to FINRA. 

According to FINRA, the Firm used manual reviews of three stock exchange websites to identify newly-listed ETFs.  If a new ETF was identified, the reviewer manually entered a code in the Firm’s automated system to trigger prospectus delivery when it sold an ETF.  FINRA found that the procedures did not require quality checks and that supervisors in fact did not perform such checks.  FINRA said that it was “reasonably foreseeable that the manual process could result in human errors, [but] the Firm’s supervisory system did not provide a sufficient process through which the Firm could detect and prevent these errors.”

FINRA also found that the Firm’s decentralized supervisory system was not reasonably designed to ensure compliance with ETF prospectus delivery obligations.  As a result of a previous FINRA matter, the Firm was required to certify that its policies and procedures regarding delivery of ETF prospectuses were reasonably designed to ensure compliance with the federal securities laws and NYSE rules.  However, when the individual who signed the 2007 certification departed the Firm, there was no longer clear ownership of ETF prospectus delivery.  FINRA said that the decentralized supervisory system contributed to the Firm’s failure to identify deficiencies in its ETF prospectus delivery process and to timely remedy the inadequacies in its manual process.  Moreover, FINRA said that the Firm did not timely respond to red flags indicating that it had experienced failures to deliver.

According to FINRA, the firm’s testing of ETF prospectus delivery that was conducted by internal audit, compliance, and operations control was conducted on a limited sample of trades.  FINRA said that the small sample size was inadequate to ensure verification of the Firm’s procedures, and internal audit did not assign an appropriate risk level to testing the ETF delivery procedures.

Our Take

Prospectus delivery continues to be an important issue for FINRA, and against the backdrop of FINRA’s generally increasing monetary penalties, the regulator could impose substantial fines for prospectus delivery failures if it finds a systemic pattern of delivery failures.  To put it another way, delivery failures resulting from gaps in procedures can add up in a hurry, and fines are often proportional to the number of failures.

Firms that sell ETFs, mutual funds, and other such products should consider reviewing their policies and procedures for prospectus delivery, with a view to addressing the deficiencies found by FINRA in this and other actions.

  • Responsibility for these procedures should be clearly assigned, with the line of governance clearly traceable to the top of the compliance structure.
  • Testing procedures should be evaluated for the scope and frequency of the tests and a clear understanding of prospectus delivery obligations.
  • Seemingly isolated instances of delivery failures should be examined, with the root cause analyzed to ensure that it is not emblematic of a larger problem.

That said, FINRA’s findings related to the failure of the Firm to ensure that the lessons of past regulatory deficiencies were not lost over time, and FINRA stressed that changes of personnel are at least as significant as the failure to meet prospectus delivery requirements.  Broker-dealers should ensure that compliance policies are not only reasonably designed to comply with the federal securities laws but that procedures are implemented to review and consider past regulatory deficiencies on a regular basis, and ensure that compliance policies and related testing protocols, adequately address such matters.


CFTC Staff Grants Family Offices No-Action Relief from Registration as Commodity Trading Advisors

Posted in Investment Adviser Regulation

The Commodity Futures Trading Commission’s (CFTC) Division of Swap Dealer and Intermediary Oversight (DSIO) recently issued no-action relief for failure to register with the CFTC as a commodity trading advisor (CTA) to any “Family Office” that provides advisory services to a “Family Client” (“CTA Letter”).  The relief supplements prior relief (“Letter No. 12-37”) for Family Offices from registration as a commodity pool operator (CPO). 

A Family Office is generally a professional organization that is wholly owned by clients in a family and is exclusively controlled (directly or indirectly) by one or more members of a family and/or entities controlled by a family. 

Family Offices previously relied upon the exemption from CPO registration for pools offered only to qualified eligible persons that was contained in CFTC Reg. 4.13(a)(4).  CTAs that advised such exempt pools were likewise exempt from CTA registration.  CFTC Reg. 4.13(a)(4) was repealed in 2012, but Letter No. 12-37 addressed only CPO registration requirements and was silent with respect to relief from registration as a CTA.

In the CTA Letter, DSIO expressed the view that the no-action relief from registration as a CPO should also apply to a Family Office in the context of CTA registration.  Accordingly, the CTA Letter grants no-action relief from CTA registration for Family Offices that are eligible for relief under Letter No. 12-37 in connection with their advisory services to Family Clients and that (i) submit a claim electing the relief and (ii) otherwise remain in compliance with Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940.

The relief is not self-executing.  An eligible Family Office must file with DSIO a claim for relief from registration as a CTA, which is effective upon filing so long as the claim is accurate and complete.  The claim must:

  • State the name, main business address, and main business telephone number of the Family Office claiming the relief;
  • State the capacity (i.e., CTA) and, where applicable, the name of the pool(s), for which the claim is being filed;
  • Be electronically signed by the Family Office; and
  • Be filed with DSIO using the email address dsionoaction@cftc.gov with the subject line “Family Office CTA Relief.”


SEC and PCAOB Combine Their Focusses on Broker-Dealer Audits and Independence in Settlements with Fifteen Audit Firms

Posted in Broker-Dealer Regulation, SEC Enforcement

On December 8, 2014, the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) announced settlements with fifteen audit firms for violating independence rules applicable to auditors of broker-dealers.  The PCAOB sanctioned seven firms for violating independence rules when those firms prepared the financial statements of brokerage firms that were also their audit clients.  The SEC sanctioned eight auditors for similar independence violations and for causing those clients to violate SEC rules by submitting financial statements that did not comply with Generally Accepted Accounting Standards.

The Independence Requirement 

Violating independence rules means, in short, that the auditors were auditing their own work.  Section 17(e)(1)(A) of the Exchange Act (passed as part of the Sarbanes-Oxley Act) requires every registered broker or dealer to file an annual financial statement report with the Commission that must be audited by an independent public accounting firm registered with the PCAOB.

Those broker-dealer audits must be performed by a public accountant that is independent from the audit client, under Exchange Act Rule 17a-5.  Rule 2-01(b) and (c) of Regulation S-X specify various independence requirements.   Among the most important of the applicable independence requirements is that the auditor is prohibited from preparing an audit client’s financial statements that are filed with the Commission.  In this context, “preparing” includes actions such as aggregating, revising, classifying, or supplementing financial information obtained from the audit client.  Note that most, but not all, independence rules apply to audits of broker dealers; for example, partner rotation requirements do not apply.

The SEC and PCAOB Settlements 

The fifteen cases covered a three-year period, and involved audit firms that lacked independence in audits of as many as seventy firms.  In each of the fifteen settled cases, the broker-dealer provided the audit firm with the basic financial materials such as the trial balance worksheet, a FOCUS Report that contained a Statement of Financial Condition, a Statement of Income, and a Statement of Changes in Ownership Equity, among other accounting documents.  The auditors then took steps that modified, expanded, or otherwise changed the data received from the client to complete management’s financial statements.  Those financial statements were among the materials reviewed as part of the independent audits.  The settlement orders did not find that the auditors violated independence rules in each year audited, but in many of the cases the violations affected a number of audits during the client relationship.

Each settlement included a censure against the firm and a cease-and-desist order, and required various undertakings aimed at improving independence on broker-dealer audits.  The SEC settlements included penalties that varied from no penalty for two of the auditors (who were found to have violated independence rules in only one audit each) to $55,000.  The eight settlements consented to by the firms without admitting or denying the findings, collectively total $140,000 in penalties.  In each of its seven settlements, the PCAOB imposed a fine of $2,500.

Our Take 

Broker-dealers should make sure that their auditors do not become involved in the preparation of management’s financial statements in the course of conducting the audit.  Discussions with the auditor regarding its audit procedures should focus on what bookkeeping services are prohibited by the independence rules.  Furthermore, broker-dealer employees should be educated on what services the auditor can and cannot provide under the independence rules in order to avoid requests to the audit firm that could compromise the auditor’s independence and may result in a violation of SEC rules by the broker-dealer in connection with filing its financial statements with the Commission.  The concern is not limited to the immediate audit; if an auditor is violating independence rules with respect to another of its broker-dealer clients, it can compromise its reputation or its ability to complete necessary audits, which can adversely impact all of the firm’s broker-dealer clients.

SEC to Require Living Wills and Stress-Testing for Investment Advisers

Posted in Investment Adviser Regulation

In a speech on December 11, 2014, SEC Chair Mary Jo White announced three broad “proactive initiatives” to address the risks of “increasingly complex portfolio composition and operations” in the asset management industry. 

White amplified items on the SEC’s agenda, announced in November, and said that the SEC will consider new regulations to require stress testing and living wills for asset managers.

Acknowledging that long-term changes in the asset management business have created “new risks and challenges,” White said that new regulations should build on the “lessons of the financial crisis.” 

White announced the initiatives for the $63 trillion asset management business in the context of rapid growth, noting that assets under management have doubled since 2004 alone, pointing to the increased complexity of products created in response to investor demands.

The SEC, she said, has focused in the past on controlling conflicts of interest, as well as enhancing reporting and disclosure regimes; it has also focused on issues related to private fund advisers.  Now, she said, the SEC will begin initiatives focusing on portfolio composition and operational risks. 

Enhanced data reporting.  The SEC is considering new rules that would require standardized reporting for derivatives used by funds and securities lending.  The data-collection efforts may extend to private funds.

  • Our take: We can expect the SEC to require registered funds and private funds to report specific data more regularly, concerning derivatives holdings and securities lending activities. This data might be used for the SEC’s surveillance and enforcement efforts, in a manner similar to how the SEC plans to use data derived from public company financial reporting and audit trail information.

Controls on risks related to portfolio composition.  White identified liquidity risks and the use of derivatives as key staff priorities.  Registered funds must establish controls that identify and manage those risks. 

Consistent with January 2014 guidance published by the Division of Investment Management, White said that the staff is concerned that mutual funds may have difficulty meeting redemptions if portfolios come under stress and are forced to sell securities at fire-sale prices, which in turn could drive down asset prices for other funds and other investors.   The staff also is concerned that funds’ use of derivatives frequently results in “leveraged investment exposures and potential future obligations that can create risks.”

White called for a “comprehensive approach” to address risks related to liquidity and derivatives.  While White was short on specifics, she said that the SEC’s staff is reviewing options such as updated liquidity standards, disclosures of liquidity risks, or limits on leverage created by use of derivatives. 

  • Our take:  It is not clear what the actual rule proposals would look like.  An educated guess is that the SEC will refine the definition of “liquidity” — that is, when a fund should consider an investment to be illiquid.  The current definition is buried in instructions to Form N-1A and, most recently, the 2014 amendments to the money market fund rules.  A new definition may be more market-oriented, taking into account the perceived tightening of the fixed income market and shrinking bond inventories.  The SEC may also attempt to pull in the reins on leverage, or tighten asset segregation requirements.  In any event, these proposals are likely to generate substantial controversy and public comment.

Transition planning and stress testing.  Borrowing from the Dodd-Frank Act playbook, the SEC may require large asset managers to adopt the functional equivalent of “living wills” to ensure that clients’ needs are protected when an asset manager loses key personnel or plans to shut its doors.  The SEC likely will require advisers to adopt “transition plans” to prepare advisers and their clients to deal with an “actual severe disruption in the adviser’s operations.”

The SEC will also implement a Dodd-Frank Act requirement by requiring annual stress testing by large broker-dealers, investment advisers and registered investment companies.  The requirement would be based upon stress testing requirement for banks, and more recently, money market mutual funds.

  • Our take: It appears that the SEC may attempting to control the debate over whether asset managers should be designated as “systemically important financial institutions,” or SIFIs, possibly in reaction to the controversial report on this topic published by the Office of Financial Research, at the direction of the Financial Stability Oversight Council.  The SEC may be sending a message that it, rather than the federal banking regulators, is better positioned to address the systemic risks of asset managers.  The requirements for living wills and stress testing should come as no surprise to observers of how regulations evolve, and indeed many funds and advisers have been moving in this direction.  But these requirements undoubtedly will increase compliance costs, and take up real estate on crowded fund board agendas.

* * * 

We expect that over time, more and more information will trickle out of the SEC about these initiatives.  Meanwhile, it is too early to tell how the new proposals will affect funds and advisers.

Investment Management Director Offers Top 10 Lessons Learned in 2014

Posted in Fund Regulation, Investment Adviser Regulation

In a December 10, 2014 speech, Norm Champ, the Director of the SEC’s Division of Investment Management, offered a glimpse at the top 10 industry lessons learned in 2014.  While admitting that his Top Ten list “may not be as entertaining as one you would see on Letterman,” Champ said the list provides a view into both how the Division operates and its future goals.

Number 10:  An Organization Is Only as Strong as Its Staff.  Champ praised the staff of the Division for its commitment to the Division’s mission to “protect investors, promote informed investment decision, and facilitate appropriate innovation in investment management products and services.”  He reminded attendees that, over the last several years, the Division has added staff with significant expertise in specialized financial service and complex products.

Number 9:  The Division Is Not a “Regulatory Island.” Champ said that the Division “seek[s] to encourage an inclusive, collaborative working environment within the Division, across the Commission, and with outside stakeholders.”  He cited recently adopted amendments to the money market funds rule as an example of collaboration with the Department of the Treasury and the IRS.  Other observers may take a different view of the level of “collaboration” involved in getting the money market rule across the finish line (see our related blog post).

Number 8:  Risk Monitoring Is an Area of Focus.  Champ said that the Division is gathering and analyzing data and monitoring risk through

  • routine review of disclosure filings;
  • its senior level engagement program (i.e., meetings with fund boards and management);
  • industry monitoring;
  • increasing the Division’s expert staff; and
  • coordinating with other offices at the Commission.

Champ noted that the Division’s Risk and Examinations Office (REO), established in 2012, provides ongoing qualitative and quantitative financial analysis of the industry.  “Although REO may conduct its own exams,” Champ said, “where practical, REO will work together with OCIE to obtain information about OCIE’s examinations.” We think that means that there are multiple examination staffs to which the industry may be accountable, but there is limited transparency into what REO is doing.

Number 7:  Data Helps to Develop Policy and Regulation.  We have heard this before, but Champ again emphasized that the staff gathers and crunches data from industry participants in an effort to help the Commission make “better and more informed policy recommendations.” Champ cited the amendments to Rule 2a-7 as an example of such data usage in the regulatory process.  Data are also useful in helping the enforcement efforts, as demonstrated by a recent enforcement matter related to violations of Rule 2a-7 that stemmed, in part, from a review of funds’ gross yields as a risk indicator.  Champ said that the staff analyzes data from Form ADV and Form PF; industry participants would be well served to keep in mind that upgrades to the Division’s staff (see Number 1 above) means that the Ph.D.s on the Commission staff are looking for trends and risks indicated by such data.  Industry participants may want to implement front-end analysis of that data before that data go to the Commission in an effort to identify and proactively address any such trends and risks.

Number 6:  Regulatory Transparency Benefits the Public and the Regulators.  Champ acknowledged that “interpretive ambiguity is costly” and said that the Division’s increased use of Guidance Updates is a “meaningful way to decrease ambiguity and improve the public’s understanding of the staff’s view on critical issues.”  He identified a January 2014 Guidance Update related to risk management in the fixed-income markets as an example of such transparency (see our related blog post).  While the Guidance Updates are “meaningful communications representing the staff’s thinking on discrete issues,” Champ said, they are not substitutes for rulemaking, the exemptive application process, or the no-action process.  He cited the recently published notice of the staff’s intent to deny exemptive relief for non-transparent, actively managed ETFs as an example of the Division’s attempt to increase transparency into the exemptive application process.

Number 5:  Appropriate Innovation Is Necessary to Meet the Needs of Investors.  Champ acknowledged the need for new and innovative investment products to meet the needs of investors, and said that the Division is “working to become smarter, more strategic and more targeted in anticipating, identifying the monitoring the risks of the current landscape.”  He characterized the no-action and exemptive relief process as a “laboratory” enabling the Division to conduct this work.  Clearly, sometimes those experiments fail (as in the case of non-transparent, actively managed ETFs) but sometimes the experiments lead to new products (as in the case of exchange-traded mutual funds).

Number 4:  Promoting a Culture of Compliance – Happy Birthday to Rule 38a-1. The compliance rule is 10 years old, and Champ took the opportunity to reflect on the changes to the compliance landscape since the rule was adopted.  He noted that fund CCOs and compliance policies and procedures are now a “defining characteristic of the fund industry.”  He also identified new and developing issues that should be addressed in fund compliance policies, including cyber-security and the proliferation of social media.  Champ also pointed to a recent enforcement action against a portfolio manager that misled and obstructed a CCO.  While we applaud the Commission for so strongly supporting a CCO on the front lines, we have also seen increased use of Rule 38a-1 in enforcement actions more generally.  Could the staff be hinting that it intends to broaden the rule without the transparency of the rulemaking process?  We hope that Division’s intention to engage in a transparent and collaborative regulatory process extends to the use of this and other rules in the enforcement arena. 

Number 3:  Open Communications with the Industry and the Public Is Imperative. Champ focused on the Division’s ongoing initiative to engage fund boards and senior management personnel as an example of its communications outreach.  Champ said, however, that this initiative has thus far focused on meetings with some of the country’s “large asset managers.”  We are concerned that this may skew the Division’s view of the industry and its level of sophistication, particularly with respect to systems and infrastructure.  This could put smaller asset managers at a disadvantage as the Division develops guidance and new regulation.

Number 2:  Investor Protection Is Critically Important.  Protection of investors is one of the Commission’s three key missions.  Champ referred to the Division’s initiatives, including risk monitoring, data analysis, publishing guidance updates, and its various rulemaking initiatives as examples of its focus on protecting investors.  He also informed attendees that the Disclosure Review and Accounting Office is refocusing on the consistency and effectiveness of staff comments on disclosure documents, and reminded mutual funds of the need to provide clear, concise disclosure in fund prospectuses.

Drumroll, please . . .

Number 1:  Happy 75th Birthday to the 1940 Act and the Advisers Act. Champ anticipated the large celebration that will break out across the country in 2015 in recognition of the 75th anniversary of the two key statutes that shape the asset management industry.  Indeed, Champ indicated that the Division will be hosting a birthday bash in the New Year to include a day of roundtables and dialogue with industry pioneers, former regulators, and prominent academics.  But will there be a cake?

SEC Chair’s Agenda Provides Glimpse of New Rules to Come

Posted in Investment Adviser Regulation

The SEC offered a peek into what new rule proposals we can expect in the coming months.  The sneak preview includes some eye openers, like proposed rules to require funds to adopt liquidity management programs and stress-testing for large asset managers.

Insights were contained in the SEC Chair’s agenda of rulemaking actions, published on October 21, 2014, on a website of the Office of Information and Regulatory Affairs of the President’s Office of Management and Budget.  Here are some of the items of interest:

Investment company use of derivatives.  The Division of Investment Management is considering recommending that the SEC propose new rules under the Investment Company Act addressing the use of derivatives by funds and related matters, including disclosure of fund use of derivatives.  It is not clear whether the proposal will address some of the more knotty issues, such as segregation of assets, or how to define concentration or diversification when a fund uses derivatives. 

Liquidity management programs for funds.  The Division of Investment Management is considering recommending that the SEC propose a new rule requiring open-end funds to adopt and implement liquidity management programs and that the SEC provide enhanced guidance related to required liquid assets in open-end funds.

Transition plans for investment advisers.  The Division of Investment Management is considering recommending that the SEC propose a new rule that would require registered investment advisers to create and maintain “transition plans.  It is not clear what kind of “transitions” the Division is referring to.

Stress-testing for large asset managers and large investment companies.  The Division of Investment Management is considering recommending that the SEC propose new requirements for stress-testing by large asset managers and large investment companies, to implement Section 165(i) of the Dodd-Frank Act.

Exchange-traded funds.  The Division of Investment Management is considering recommending that the SEC re-propose new rules and rule amendments to provide exemptive relief for index-based and actively managed exchange-traded funds (ETFs).  The SEC proposed rules in 2008, but never acted on them.  Currently, ETFs must apply for an exemptive order to operate.

Exchange-traded products.  The Division of Trading and Markets is considering recommending that the SEC seek public input to evaluate the listing and trading of exchange-traded products (ETPs) in the marketplace, assess the risks posed by ETPs with certain characteristics, and explore areas of focus in reviewing exchange proposals to list and trade new ETPs for consistency with the Securities Exchange Act of 1934.


New Valuation Guidance: A Reminder of Directors’ Responsibilities

Posted in Fund Regulation

In the December 2014 issue of Fund Directions, Investment Management partner Jay Baris discusses in the “Learning Curve” column challenges faced by mutual fund directors as they struggle to comply with new valuation guidance from the Securities and Exchange Commission. The long-awaited guidance appeared without fanfare—buried in the 869- page release adopting money market fund rule amendments published in July—but it may transform the way directors approach fair value of portfolio securities held by all funds, not just money market funds.

In the release, the SEC reminded fund directors that they have a non-delegable statutory duty to determine the fair value of portfolio securities when market prices are not available. The Commission was clear: While directors may “appoint others” to “assist them in determining fair value,” the responsibility to actually determine fair value lays at their feet.

To read the full article, click here.