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The BD/IA Regulator

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

SEC Staff Allows Fund Boards to Rely on CCO Reports

Posted in Enforcement, SEC Enforcement

On October 12, 2018, the staff of the SEC’s Division of Investment Management issued a no-action letter to the Independent Directors Council (“IDC”) agreeing that the staff will not recommend enforcement if, in lieu of making certain determinations under Rule 10f-3, 17a-7 and 17e-1 (the “Exemptive Rules”) under the Investment Company Act of 1940 (the “1940 Act”), a fund’s board instead receives from its Chief Compliance Officer (“CCO”) a written representation that transactions entered into reliance on any of the Exemptive Rules were affected in compliance with the related procedures adopted by the board.

Read our client alert.

SEC Sanctions Adviser and Portfolio Manager for Improper Cross Trades and Failure to Seek Best Execution

Posted in Enforcement, SEC Enforcement

In a recently settled enforcement matter, the SEC imposed a $1 million penalty on an investment adviser based on findings that the adviser violated the Investment Advisers Act of 1940 (the “Advisers Act”) and caused violations of the Investment Company Act of 1940 (the “Investment Company Act”). The charges stemmed from inappropriate cross trading and the adviser’s failure to: (i) disclose the resulting favorable treatment of certain advisory clients; (ii) seek to obtain the best price and execution for certain of its clients; and (iii) have in place an adequate compliance program.

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Broker-Dealer Settles Record Keeping Charges for $1.25 Million

Posted in Broker-Dealer Regulation, SEC Enforcement

On July 17, 2018, the SEC announced that it had entered into a settlement with a broker-dealer charged with failure to preserve certain records and inaccurately recording travel, entertainment, and other expenses. The broker-dealer agreed to pay a $1.25 million penalty to settle the charges.

The SEC found that after receiving document requests from the SEC’s Division of Enforcement, the broker-dealer deleted audio files for certain recorded telephone lines that were responsive to the document requests. According to the SEC, the files were deleted in accordance with the firm’s records policy after an unrelated litigation hold was lifted. Although the broker-dealer had issued a separate litigation hold notice after receiving the SEC staff’s document request, it did not ensure that this litigation hold notice was distributed to the technicians in the department responsible for maintaining voice recordings.

The SEC also found that the broker-dealer failed to maintain books and records that accurately recorded compensation, travel, entertainment, and gifts. For example, the SEC found that the broker-dealer provided a high-performing broker with season tickets worth more than $600,000 per year and did not record the cost of the tickets as compensation in its general ledger. The SEC also found that the broker-dealer reimbursed certain brokers for expenses associated with travel and other personal expenses without a sufficiently documented business purpose, and that the broker-dealer recorded certain gifts to customers as entertainment rather than gifts.

According to the SEC staff, the “failure to preserve and produce responsive documents undermines the Commission’s ability to provide effective oversight of registrants and to carry out its mission to protect investors.” The broker-dealer settled the charges without admitting or denying the SEC’s findings.

Our Take

Broker-dealers and other registrants need to ensure that their policies and procedures include policies designed to ensure compliance with applicable record keeping obligations. Although record keeping violations will often appear as secondary deficiencies or violations, they are grounds for separate SEC enforcement action, as this broker-dealer found out the hard way.

OCIE Risk Alert Identifies Common Best Execution Deficiencies

Posted in Investment Adviser Regulation

On July 11, 2018, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert identifying the most common deficiencies that its staff observed in recent examinations of registered investment advisers’ best execution practices. As with prior OCIE Risk Alerts, investment advisers should carefully examine their compliance policies and procedures in light of the issues identified by OCIE and make improvements where necessary.

Read our client alert.

FINRA Asks Members: What Are You Doing with Digital Assets?

Posted in FINRA Enforcement

In a July 2018 regulatory notice (Regulatory Notice 18-20, available here: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-20.pdf), FINRA has requested that members notify it if they engage, or intend to engage, in any activities related to digital assets, such as cryptocurrencies. In addition, until July 31, 2019, FINRA requests that firms notify their point of contact with FINRA, their regulatory coordinators, if they begin to engage in new activities of this type. Relevant activities include, among other things:

  • transactions in or advice regarding digital assets;
  • transactions in or advice regarding pooled assets investing in digital assets;
  • transactions in derivatives, such as futures and options, and perhaps structured products that are linked to digital assets;
  • offerings of digital assets, such as initial coin offerings;
  • accepting payment from customers in the form of cryptocurrencies; and
  • mining cryptocurrencies.

The above non-exclusive list does not include activities relating to companies that are engaged in the digital asset sector, such as participating in equity offerings of companies that are engaged in digital asset technology. Although absent from this list, broker-dealers have to be mindful of their investor suitability, due diligence, and other obligations in participating in offerings relating to new and potentially volatile industries.

It is premature to determine whether any new rules or regulations or guidance will emerge. First, FINRA needs to understand the asset class better, learn about broker-dealer activities in the area, and whether there are potential risks for investors as a result of these activities.

Massachusetts Takes on Risky Broker-Dealers That Offer Private Placements

Posted in Broker-Dealer Regulation

On July 2, 2018, the State of Massachusetts announced that it was investigating 10 broker-dealers that have 15% or more of their agents with current disciplinary incidents and that offer private placements to individual investors.

According to the announcement, the investigation arises in large measure due to a recent Wall Street Journal investigation into these types of firms, which targeted senior investors in particular. The Wall Street Journal’s article on the subject can be found at the following link: https://www.wsj.com/articles/firms-with-troubled-brokers-are-often-behind-sales-of-private-stakes-1529838000. In addition, it should be noted that the State of Massachusetts has a reputation for aggressively pursuing brokers that it believes may have engaged in improper sales practices.

Private placements encompass a broad range of financing transactions, including venture capital investments made by “angels,” bespoke complex securities offered to hedge funds and equity offerings made by private companies and small public companies targeting higher net worth individual investors. The Massachusetts initiative appears to be focused on the last category of private placements, where brokers may be incentivized to offer these securities with commissions as high as 10% of the offering price. Due to the higher potential fees and the lack of liquidity generally associated with securities offered through private placements, and because they tend to be less transparent than public offerings, it is not a surprise that such transactions are a focus for regulators.

The fact that a broker-dealer employs agents with a disciplinary history does not necessarily mean that private placements are being sold through improper sales practices or to accounts for which such investments may not be suitable. However, these types of employees, combined with the higher commissions and greater risks often associated with these securities, together could perhaps be viewed by some as “circumstantial evidence” of improper practices. The Wall Street Journal review provides empirical support for this proposition.

New Exemptive Rule Could Lower Barriers to Entry for New ETFs

Posted in Uncategorized

At an open meeting held June 28, 2018, the SEC voted unanimously to propose a new rule codifying exemptions to certain rules under the Investment Company Act.  These exemptions have enabled the exchange-traded fund (ETF) industry to grow to more than $3.4 trillion in 24 years.  In order to even the playing field for existing ETFs and new entrants to the market, the proposed rule would rescind the existing exemptive orders upon which most ETFs currently operate.

Like mutual funds, ETFs continuously offer their shares for sale.  Unlike mutual funds, however, investors in ETFs cannot purchase or redeem individual shares directly with the fund.  Instead, “authorized participants” enter into contractual arrangements with an ETF’s distributor to purchase and redeem ETF shares in “creation units.”  That is, the authorized participant deposits with the ETF a “basket” of securities and other assets, and the ETF issues a creation unit of ETF shares in return for those assets.  The basket is representative of the ETF’s portfolio and is identified by the ETF daily.  After purchasing a creation unit, the authorized participant may hold individual ETF shares or sell individual shares to individual investors in secondary market transactions.  ETF shares may trade at a premium or at a discount to net asset value, which provides authorized participants with arbitrage opportunities that can help keep the market price of ETF shares close to the fund’s net asset value.

In order to operate in this fashion, ETFs need exemptions from certain rules and sections under the Investment Company Act.  Proposed Rule 6c-11 would eliminate the need for most ETFs to obtain individual exemptive relief.

As proposed, Rule 6c-11 would only be available to ETFs organized as open-end funds.  ETFs that are organized as unit investment trusts or structured as a share class of a multi-class fund would not be able to rely on the proposed rule.  Leveraged or inverse ETFs would also be precluded from relying on the proposed rule.  The excluded ETFs would continue to rely on existing exemptive relief.

Under proposed Rule 6c-11, an ETF would be required to provide daily portfolio transparency on its website. ETFs would also be required to disclose information regarding historical premiums and discounts to net asset value and bid-ask spread information.  The SEC said that these disclosures are intended to inform investors about the efficiency of an ETF’s arbitrage process.

Under the proposed rule, ETFs would also need to post on their websites information regarding a published basket at the beginning of each business day.  ETFs would be permitted to use baskets that do not reflect a pro-rata representation of a fund’s portfolio or that differ from other baskets used in transactions on the same business day (“custom baskets”), provided that such ETFs would be required to adopt written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets.  The board of an ETF using custom baskets would be required to find such use to be in the best interests of the ETF and its shareholders.

This is not the first time that the SEC has proposed a rule aimed at codifying the existing exemptive regime for so-called “plain vanilla” ETFs.  Rule 6c-11 was first proposed in 2008, but the intervening global financial crisis required the SEC and its staff to refocus attention on rule-making under the Dodd-Frank Act.  In the interim, new entrants to the ETF market have had to obtain individual exemptive orders, a process that is both lengthy and costly.  Adopting proposed Rule 6c-11 should meaningfully lower the barriers to entry for new entrants to the ETF space.

Comments on proposed Rule 6c-11 will be due 60 days from publication of the proposed rule in the Federal Register.