Header graphic for print

The BD/IA Regulator

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

SEC Launches Exam Initiative for Newly Registered Municipal Advisors

Posted in Investment Adviser Regulation, Municipal Advisors

The SEC is not wasting any time making sure that newly registered municipal advisors are introduced to their regulator.  On August 19, 2014, the SEC announced a two-year examination initiative for municipal advisors that registered with the SEC in accordance with final municipal advisor rules that became effective on July 1, 2014.  OCIE’s National Examination Program (NEP) stated that the initiative will include “focused, risk-based” examinations of municipal advisors registered with the SEC but not with FINRA.

The examinations will address municipal advisors’ compliance with both the final SEC municipal advisor rules and Municipal Securities Rulemaking Board rules as they become final.

The examination initiative will proceed in three phases: (1) an “engagement” phase, during which the NEP will reach out to newly registered municipal advisors to inform them of their obligations under the Dodd-Frank Act and related rules, (2) an “examination” phase, during which the NEP staff will review selected municipal advisors’ compliance programs in one or more identified risk areas, and (3) an “informing policy” phase during which the NEP will report its observations to the SEC.  OCIE said that the particular risk areas that may be included in its examinations will include registration, fiduciary duty, disclosure, fair dealing, supervision, books and records, and training/qualifications.

The NEP noted that the results of OCIE’s examinations are typically used by the SEC “to inform rule-making initiatives, to identify and monitor risks, to improve industry practices and to pursue misconduct.”  In other words, municipal advisors should expect that these examinations will result in additional SEC guidance to municipal advisors regarding how they conduct their businesses.

At this time, there is no indication of how examination participants will be selected, but OCIE has announced that it plans to examine a “significant percentage” of new municipal advisors.  Newly registered municipal advisors should plan to participate in OCIE’s compliance outreach program, which will take place later this year, to learn about compliance issues and practices, and to understand what to expect from an OCIE examination.

Lying to Examiners Can Lead Quickly to Criminal Charges

Posted in Broker-Dealer Regulation, SEC Enforcement

Hell hath no fury like a regulator (allegedly) lied to.  This week, the SEC brought civil charges, and the U.S. Attorney for the Southern District of New York brought criminal charges, against a broker-dealer and its founder for falsifying books and records to hide capital deficiencies from SEC examiners, as well as for violating net capital requirements. The cases are in litigation, so the following account is based on the government’s allegations.

The SEC’s enforcement action, brought as an administrative proceeding, alleges that the firm and its head attempted to disguise the firm’s extensive and repeated net capital insufficiencies.  The respondents improperly off-loaded liabilities onto the books of an affiliated firm, and improperly treated non-marketable stock as an allowable asset.  According to the SEC, the affiliated firm did not have sufficient resources to pay for the liabilities, which related to services actually performed for the firm.  The SEC discounted an expense-sharing agreement between the firm and the affiliate as a sham.

More seriously, however, the principal tried to hide the broker-dealer’s true financial condition by providing the SEC examiners with “falsified documents” that sought to mask the extent of the firm’s liabilities.  The CEO of the broker-dealer was thus charged criminally for his alleged obstruction of the SEC examination and for making false statements and false filings.  The charges carry maximum prison sentences of 20 years and 5 years, respectively.

When announcing the SEC’s case, senior SEC officials pointed to “the SEC’s critical work in overseeing broker-dealers and other regulated entities” (Enforcement Director Andrew Ceresney), and the importance of the net capital rule in monitoring the financial health of brokerage firms (NY Regional Office Associate Director Amelia Cottrell).  The U.S. Attorney and other criminal justice representatives likewise highlighted the defendants’ attempts to “blow smoke in the eyes of the SEC” by maintaining false books and records, and creating falsified documents in response to SEC requests.

Everybody knows that a regulated entity must maintain accurate books and records, and accurately report its financial condition.  Everybody knows that a firm should not aggravate a situation by lying to examiners and falsifying documents.  The lesson of these cases is that once a firm steps over the line and decides to attempt to deceive the regulators, it opens itself up to criminal prosecution.  The Department of Justice is willing and able to support its civil partner and seek criminal sanctions for such conduct.  Moreover, perhaps slightly less obvious but equally crucial, this case highlights the need for all firms and their personnel to be meticulous and vigilant about the accuracy of information provided to the SEC—lest an examination blossom into an enforcement action and explode into criminal charges.

Additional Fees on Securities Transactions – FINRA Sees No Justification

Posted in Broker-Dealer Regulation, FINRA Enforcement

In an area of broker-dealer practices with relatively little guidance—the appropriate level of commissions or mark ups on securities trades—FINRA recently brought another in a series of cases that provides insight into the regulator’s view on additional transaction-based fees.  In this particular case, FINRA found that a broker-dealer characterized a $60.50 charge on its customer trade confirmations, which was in addition to or instead of a commission, as “miscellaneous” and/or as an “additional fee.”  However, much of this fee, FINRA found, was not attributable to any specific cost or expense the firm incurred in executing the transaction.  FINRA found, in effect, that the fee was a commission by another name, and the firm thus understated the amount of the total commissions that it charged on its securities transactions.

According to FINRA’s settlement order, a substantial portion of the charge was not reasonably related to any specific cost or expense the firm incurred in executing each transaction, or determined by any formula applicable to all customers.  Instead, a substantial portion of the charge represented a source of additional transaction-based remuneration or revenue to the firm, and was effectively a minimum commission charge.  By claiming that the charge was in addition to or in place of a designated commission charge, the firm mischaracterized and understated the amount of the total commissions the firm charged.

FINRA found that the firm violated NASD Conduct Rule 2430, which requires charges for services performed—including miscellaneous services such as collection of moneys due for principal, dividends—or interest; exchange or transfer of securities; appraisals, safe-keeping, or custody of securities; and other services to be reasonable and not unfairly discriminatory between customers.  FINRA also found that the firm violated Securities Exchange Act Rule 10b-10, which requires broker-dealers to disclose specified information in writing to customers at or before the completion of a transaction.

The firm consented, without admitting or denying the findings, to a fine of $50,000 (which was imposed for these and several other violations), and to comply with the undertakings and revise its written supervisory procedures.  The undertakings are significant, since they reflect FINRA’s view as to the proper way to disclose commissions.  In brief, FINRA required the firm, going forward, to identify any transaction-based charge that constitutes remuneration to the firm as a commission or markup/markdown, and not as any charge or fee for postage, handling, or any miscellaneous, additional fee; and to the extent that any transaction-based charge does represent a service performed or a cost incurred by the firm that is not included as part of the reported commission or markup/markdown, required the firm to properly disclose it.  FINRA also required the firm to revise its written supervisory procedures to address the requirements of this undertaking and provide relevant training to all associated persons.

FINRA previously announced, in a September 7, 2011 press release, five similar actions against firms that FINRA fined as much as $300,000.  The cases resulted from a targeted review of improper fees charged by broker-dealers in which FINRA found that the firms were routinely charging customers – as much as $100 per trade in addition to the disclosed commissions – for handling fees that far exceeded the actual cost of the direct handling-related services the firms incurred in processing securities transactions.  There is little doubt that a review of firms’ fees and markups/markdowns remains an important part of FINRA exams, and its exam procedures likely will continue to include a review of “additional” or “miscellaneous” fees.

SEC Requires Floating NAV for Institutional Money Market Funds; IRS Eases Tax Reporting Burden for Fund Investors

Posted in Fund Regulation

A divided Securities and Exchange Commission today adopted rules that will require floating net asset values (NAVs) for institutional money market funds and give most money market funds the discretion to impose liquidity fees and gates.  The 3-2 vote, which closes the latest tumultuous chapter of money market fund regulatory reform, will fundamentally change the way that most money market funds operate.

The floating NAV requirement will not apply to retail money market funds, including retail funds and all government money market funds (whether or not they are institutional funds).

The new rules increase responsibility on money market fund boards.  Fund boards will be authorized to temporarily “gate” redemptions and impose redemption fees of up to two percent when a fund’s weekly liquidity falls below 30 percent of its total assets; but when weekly liquidity drops to 10 percent, the fund must impose a one percent redemption fee.  The original proposal would have required a mandatory two percent redemption fee at the 15 percent level, although the fund’s board could waive that fee or impose gates.

The rules will impose additional disclosure, reporting and stress testing requirements.

Chairman Mary Jo White said that while the new rules “could diminish the attractiveness” of some money market funds for investors, the rules strike a balance to address two principal risks that grew out of the 2008 global financial crisis.

These two risks are:

  • The “first mover advantage” that encourages investors to be the first to redeem so they can receive the fixed one dollar NAV price even if the market value of the money market fund’s holdings is less than one dollar per share; and
  • The fear of widespread investor runs and the “potential for contagion from one fund” that can result in heavy redemptions.

Commissioners Kara M. Stein and Michael S. Piwowar voted against the proposals.

Commissioner Piwowar said that a combination of both a floating rate NAV and liquidity fees and redemption rates “impedes” the SEC’s goals of preserving the benefits of money market funds.  The floating NAV option, he said, would not reduce the “first mover advantage” because money market funds will exhaust cash on hand to pay early redeemers, and thus the market‑based NAV may not capture the likely increasing illiquidity of a fund’s portfolio.  Other less onerous alternatives exist, he said.

On the other hand, Commissioner Stein did not object to the floating rate concept but believes that “gates are the wrong tool to address” the first mover risk, because, among other reasons, investors would have an economic incentive to redeem ahead of others to avoid the uncertainty of losing access to their capital.

In tandem with the Commission’s new rules, the Department of the Treasury and the Internal Revenue Service are expected to provide tax relief that will “eliminate significant costs” of the floating NAV requirements.  As a result, the IRS rules will let money market fund investors determine gains and losses on a net basis over a year, rather than requiring investors to track individual transactions.  Also, the IRS will ease the “wash sale” rules for losses on shares of floating NAV money market funds.

The Commission also proposed amendments to Rule 2a-7 that would remove references to credit ratings, as required by the Dodd-Frank Act.  If adopted, money market fund boards must determine that portfolio securities have “minimal credit risk” instead of relying in part on objective standards, such as credit ratings.  The Commission also proposed a rule that would exempt money market funds from the confirmation requirements of Rule 10b-10 of the Securities Exchange Act of 1934.

The long-term effects of the new rules, including whether they will discourage or encourage first redeemer syndrome remain to be seen.  But, at least for the short term, the rules are likely to reduce to intense pressure that the Commission has faced to adopt money market fund reform.


VA Switches: FINRA Disciplinary Action Reminds Firms About the Need for Adequate Supervisory Procedures

Posted in Broker-Dealer Regulation, FINRA Enforcement

In a case involving unsuitable variable annuity (VA) transactions, FINRA found that having good procedures and discovering improper conduct are not enough.  A member firm must also ensure that it has adequate supervisory systems in place to ensure that its procedures are properly implemented.  In this case, two of the firm’s registered representatives—who were independent contractors—recommended and effected unsuitable VA transactions for their customers, causing their customers to pay unnecessary surrender fees on VAs that had only been held for two to three years, and incurring longer surrender periods on new VAs.

FINRA’s facts and figures give a good sense of the seriousness of the conduct.  One of the brokers switched 140 customers who held 214 fixed or variable annuities to a VA issued by an unaffiliated third-party insurance company, costing the customers approximately $208,000 in unnecessary surrender penalties and earning the broker $380,235 in commissions.  The other broker switched 66 customers who held 87 fixed or variable annuities to the same unaffiliated VA, costing the customers approximately $155,173 in unnecessary surrender penalties and earning the broker $196,684 in commissions.  As a result of each replacement transaction, the customer incurred a new surrender period.

It gets worse.  FINRA found that the brokers employed a “one size fits all” investment strategy, notwithstanding the diversity of their customer base.  Although the customers were between the ages of 27 and 73, some were working and some were retired, and they had varied net worths and income, the brokers classified all of their customers as having the same risk tolerance and primary investment objectives.  In addition, the brokers switched substantially all of their customers into the same VA, the same rider, and the same asset allocation investment fund option.

FINRA fined the firm $100,000 and found that while the firm’s written procedures generally addressed suitability considerations related to VA sales, its systems had the following deficiencies:

  • The firm failed to ensure that sales of VAs by these representatives adhered to its written procedures;
  • The supervisors approved VA replacements based on limited firm systems and with inadequate written guidance, computer systems, and surveillance tools;
  • The firm failed to verify the amount of surrender fees reported by its broker on replacement transactions, which were underreported; and
  • The firm also did not have a system or web-based access to a database that allowed it to adequately compare the annuity to be replaced with the other VAs.

FINRA also found that, as a result of the firm’s limited systems, it was unable to identify the substantial volume of VA replacement activity for the brokers.  The firm also did not identify trading trends in customer accounts, including when customers surrendered one VA and switched into the same VA; when customers purchased replacement VAs with substantially the same investment objectives and risk tolerance, asset allocation investment fund options, and riders; when VA replacement paperwork had substantially the same rationale for the replacement of the prior VA; and the existence of other red flags.  FINRA noted that the two brokers were supervised remotely by firm managers.

The firm consented to the sanctions without admitting or denying the findings.

This was a relatively extreme case of sales practice abuses involving sales of VAs, but presents a good opportunity to remind member firms that FINRA continues to scrutinize procedures and practices with respect to the sales of VAs.  FINRA has issued useful guidance over the years on supervision of VA sales, including Notice to Members 99-35, Notice to Members 96-86, and this compilation of guidance about compliance with suitability standards with respect to VAs and a broad range of complex products.  Broker-dealers should continue to review their level of VA switching activity, look for red flags, and make sure that their systems and procedures are adequate to pick up outlier conduct on a routine basis.

Commissioner Piwowar Slams “Dodd-Frank Politburo” for Overstepping Authority

Posted in Fund Regulation

In a speech on July 15, 2014, SEC Commissioner Michael S. Piwowar expressed his views about the Financial Stability Oversight Council (FSOC) operating in secrecy as it tries to expand its regulation of financial institutions and the capital markets.

Commissioner Piwowar opened his speech with a number of phrases about FSOC, calling it, among other things:

  • The Firing Squad on Capitalism
  • The Vast Left Wing Conspiracy to Hinder Capital Formation
  • The Bully Pulpit of Failed Prudential Regulators
  • The Dodd-Frank Politburo
  • The Modern-Day Star Chamber
  • The Unaccountable Capital Markets Death Panel

But how does Commissioner Piwowar really feel about FSOC?

FSOC members include the chairs of various commissions and boards (including the SEC), but not the individual commissioners or board members.  Commissioner Piwowar complained that FSOC rebuffed his attempt to attend its meetings as a non-participating guest, which, he said, was disappointing but not surprising.  But, he said, FSOC also shut out Congressman Scott Garrett, the Chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises, from FSOC meetings.  He called this action “shocking, appalling and downright insubordinate.”

Commissioner Piwowar accused FSOC, led by the “alpha dog” Board of Governors of the Federal Reserve Board, of starting a turf war by asserting broad regulatory authority over matters that are exclusively in the SEC’s jurisdiction, thus compromising the SEC’s mission to protect investors, maintain fair, orderly and efficient markets, and promote capital formation.

As an example of the Federal Reserve Board’s “attempt to gain authority over capital markets actors,” the Commissioner cited FSOC’s “much-discussed hubris” in recommending money market fund regulatory reforms.  “It would be comedic,” he said, “if not in such a serious context, that it did so while publicly acknowledging” that the SEC is best positioned to implement money market fund reforms.

To sum up, the Commissioner called for more transparency at FSOC, and said he supported efforts by Representative Garrett to make FSOC “accountable and transparent.”

The Commissioner, however, stopped short of accusing FSOC of trying to regulate the SEC as a Systemically Important Financial Institution.


PCAOB Issues Guidance to Auditors of Broker-Dealers

Posted in Broker-Dealer Regulation, PCAOB

On June 24, 2014, the Public Company Accounting Oversight Board (PCAOB) released staff guidance to help auditors of brokers and dealers registered with the Securities and Exchange Commission (SEC) plan and perform audits in accordance with PCAOB standards as mandated by the Dodd-Frank Act and SEC rules.

In July 2013, the SEC adopted amendments to Rule 17a-5 under the Securities Exchange Act of 1934 annual reporting rules for brokers and dealers.  The amendments, among other things, require audits of brokers and dealers to be performed in accordance with the standards of the PCAOB for fiscal years ending on or after June 1, 2014.  Prior to the effective date of the amendments, those audits were performed under generally accepted auditing standards.

This staff guidance was developed primarily to assist auditors of smaller brokers and dealers that have less complex operations in adhering to PCAOB standards. Because some auditors of smaller, less complex brokers and dealers will be applying PCAOB standards for the first time, the publication includes a “Getting Started” chapter, which introduces these auditors to certain PCAOB standards and rules. “To enhance investor protection, broker-dealer auditors must now meet PCAOB requirements,” said PCAOB Chairman James R. Doty. “This guidance is tailored to help auditors of smaller broker-dealers develop a cost-effective, scaled approach to their audits.

Under SEC rules, broker-dealers are required to maintain minimum levels of net capital and take steps to safeguard customer securities and cash.  These financial responsibility rules help serve the SEC’s overriding function of protecting investors.  The roles of the auditors, under the PCAOB standards, will enhance the quality of information provided to the SEC and in turn improve regulatory oversight of broker-dealers who serve the investing public.

The staff guidance highlights relevant requirements for SEC-required broker and dealer audits and attestation engagements and provides staff guidance on the application of PCAOB standards to these engagements. The publication is intended to help auditors plan and perform audits of brokers and dealers in accordance with PCAOB standards. Additionally, this publication highlights some of the significant provisions of SEC Rule 17a-5 and PCAOB standards and rules applicable to audits of brokers and dealers.

There were 783 registered auditors that issued audit reports on 2012 year-end financial statements of broker-dealers that were filed with the SEC, as of May 2013.  Given the number of auditors with broker-dealer clients, the guidance will affect a substantial number of auditing firms.