OCIE has now issued examination observations related to cybersecurity and operational resiliency practices taken by investment advisers and other market participants. With examples, the observations included governance and risk management, access rights and controls, data loss prevention, mobile security, incident response and resiliency, vendor management, and training and awareness. Members are encouraged to incorporate these observations in their cybersecurity assessments. A copy of the examination guidance can be found here.
OCIE has announced its 2020 exam priorities as part of its risk-based approach to protecting investors. As in the past, key risk areas that are prioritized impacting SROs, clearing firms, investment advisers and other market participants include:
- Retail Investors, Including Seniors and Those Saving for Retirement
- Market Infrastructure related to capital markets, including clearing agencies, national securities exchanges, alternative trading systems and transfer agents
- Cyber and information security risks
- Examining RIAs, including investment companies, ETFs, private funds that have never been examined, including new RIAs and RIAs never examined and oversight practices of their boards of directors
- AML requirements
Fintech and innovation, including digital assets and electronic advice
- Oversight of FINRA and MSRB operations, programs and their examinations of broker-dealers and municipal advisors
OCIE makes clear that the above risk areas is not exhaustive and will be dependent on risk-based approaches employed by OCIE and its staff. A copy of the 2020 exam priorities can be found here.
Following its concept release in June 2019 soliciting public response on ways to improve upon the Securities Act exemptions related to private offerings, the SEC has voted to propose amendments to the definition of “accredited investor,” a test applied in determining eligibility of persons seeking participation in private offerings through private capital markets. According to the SEC, the goal is to improve the definition to better “identify institutional and individual investors that have the knowledge and expertise to participate…”
Adding new categories of natural persons to the definition is a featured aspect of the amendments which, among other things, will:
“- add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution;
– with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund;
– add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify as accredited investors;
– add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
– add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
– add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.”
The proposed amendments will now be subject to a 60-day public comment period. The rule is not without controversy — with some questioning its goals and effectiveness. A copy of the proposed rule can be found here.
The SEC recently announced the filing of an emergency action and the obtaining of an asset freeze against operators of a South Florida-based investment scheme that defrauded over 100 retail investors, many of them seniors. The announcement noted that two of the defendants charged were previously barred by the SEC from acting as brokers and offering penny stocks to investors. SEC v. NIT Enterprises, Inc. et al. The complaint is here.
Unfortunately, while these kinds of actions are not new, these cases should serve as a reminder to financial institutions (including investment advisers and broker-dealers) that their senior clients may be the targets of such fraud. The pattern is a familiar one — that of older clients with diminishing mental or physical capacity becoming a frequent and easy target for financial abuse. Before it happens, investment advisers and broker-dealers may find themselves serving as a kind of first “line of defense” in identifying signs of potential elder financial fraud.
For reasons that are obvious, they may be first to notice whether someone appears to be seeking to exploit an elderly client based on their position of trust or influence over an elderly client: thus, making it easier to gain access to the client’s assets. Whether it’s through the Senior Safe Act of 2018 (enacted May 2018) or other regulatory policy, federal and state regulators have provided meaningful guidance aimed at educating and training advisers to identify red flags when it comes to elder financial abuse. Signs include:
- Sudden reluctance to discuss financial matters
- Investing in private offerings of securities promising inflated investment returns
- Unusual or unexplained account withdrawals, wire transfers, or other financial changes
- Cash or other items missing from the home
- Drastic shifts in investments
- Abrupt changes in wills, trusts, power of attorney or beneficiaries
- Concern or confusion about missing funds
“BUT WHY BOTHER? WE’RE NOT LIKE THESE ALLEGED FRAUDSTERS”
Believing (i) that these actions have little to do with their legitimate financial service offerings, (ii) perhaps fearing, among other things, a violation of the client’s privacy (an excuse that is less persuasive given the Senior Safe Act’s immunity availability) or (iii) the time-consuming nature of investigating, reporting and taking steps to protect an uncooperative client’s assets, an adviser may be reluctant to get involved. So what is the cost of doing nothing or simply dropping the elder client because they won’t accept your advice?
First, advisers and broker-dealers may be required under their state’s law to report suspected cases of financial abuse of an elderly client to an adult protective service or similar agency whose role is to investigate and intervene if needed. Twenty-one states have adopted laws covering both guidance and mandates on the topic. In some instances, failure to report may subject the financial institution to statutory fines and penalties, and expose them to the civil claims of third parties, including an elder client’s later-appointed guardian or family member claiming losses of the client’s assets.
Second, the SEC may end up reviewing what the adviser has chosen to ignore. As with the above case, for some time now, the SEC has taken a multifaceted approach to senior investor abuse that includes (in addition to education, regulatory policy) examinations and enforcement actions. As for examinations, OCIE has sought to protect seniors through risk-based exams (i.e. its Senior-Focused Initiative examing 200 advisers doing significant work with seniors). OCIE has examined broker-dealers to review how they identify how seniors might be financially exploited. Similarly, the FINRA examines broker-dealers to review (including suitability, training, use of designations, marketing, supervision, etc.) their compliance with FINRA Rules 4512 (Customer Account Information) and 2165 (Financial Exploitation of Specified Adults).
In May 2019, the SEC published a white paper entitled How the SEC Works to Protect Senior Investors describing what the SEC is doing to protect senior investors. The paper noted, in addition to the above concerns, that both FINRA and SEC exams will continue to examine practices that ask question about (i) whether advisers obtained trusted contact information from senior clients; (ii) how advisers and broker-dealers handle concerns about a senior client’s diminished capacity, (iii) what policies and practices are used to handle client beneficiary change requests, and what training the investment advisers were providing their staff on elder financial exploitation and protecting senior clients.
Investment Advisers and broker-dealers would do well to read the paper. The Ponzi schemes targeting seniors will continue; as will the number of SEC enforcement actions. What will not change is federal and state regulators’ determination to ensure that advisers and broker-dealers do their part to protect their senior clients from financial exploitation. If you didn’t read it, the white paper can be found here.
Last week, the Securities and Exchange Commission’s Division of Enforcement issued its annual report for 2019. Based on, and in keeping with its stated five core principles that include: (1) focus on the Main Street investor, (2) focus on individual accountability, (3) keep pace with technological change, (4) impose remedies that most effectively further enforcement goals, and (5) constantly assess the allocation of resources, the SEC brought a mixture of 862 enforcement actions, including 526 standalone actions. In total, the SEC obtained judgments and orders totaling more than $4.3 billion in disgorgement and penalties.
The majority of the SEC’s 526 standalone cases in 2019 concerned investment advisory and investment company issues (36%). Securities offerings (21%), and issuer reporting/accounting and auditing (17%) matters, actions against broker-dealers (7%), insider trading (6%), and market manipulation (6%), as well as other areas such as FCPA (3%) and Public Finance (3%) made up the rest.
A copy of the 2019 Annual Report is available here.
The Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert providing investment companies, investors, among others, information on the most cited deficiencies found in 300 fund exams of registered investment companies. The Risk Alert also includes observations from national examination initiatives focused on money market and target date funds. While many of the funds weren’t cited for all the deficiencies referenced, the most noted weaknesses concerned:
The Fund Compliance Rule. Staff observed funds’ failures to adopt and implement policies and procedures reasonably designed to prevent violations of the federal securities laws, including policies and procedures “that provide for the oversight of compliance for each investment adviser, principal underwriter, administrator, and transfer agent of the fund (collectively, “service providers”).” Observations included:
● Compliance programs that did not take into account the nature of funds’ business activities; didn’t consider specific risks, method of pricing of securities; advertisements and sales literature problems;
● Policies and procedures not followed or enforced i.e. funds’ policies and procedures related to the fair valuations determined by the valuation committee where certain funds failed to follow or enforce policies and procedures;
● Inadequate service provider oversight i.e. failure to provide ongoing monitoring or due diligence of providers’ services relating to pricing of portfolio securities and fund shares;
● Annual reviews either not performed or did not addressed the adequacy of the funds’ policies and procedures; Certain funds conducted annual reviews of their policies and procedures that failed to address the adequacy of the funds’ policies and procedures;
Disclosure to Investors. Staff observed funds that provided incomplete or potentially materially misleading information in their prospectuses, statements of information, or shareholder reports when compared to the funds’ actual activities that the staff observed during examinations (i.e. service provider fees, change in investment strategy).
Section 15(c) Process. Staff observed some funds’ failure to request and evaluate information reasonably necessary for the board to evaluate the terms of the adviser’s contract, including shareholder reports that failed to discuss adequately the material factors that informed the board’s approval of an advisory contract; failure to implement, follow or enforce code of ethics, or failed to comply with their own approval and reporting obligations.
Certain National Examination Initiatives – Money Market Funds (MMFs) and Target Date Funds (TDFs)
As for observations from the national examination initiatives focused on money market funds and target date funds, the staff observed instances of deficiencies or weaknesses related to MMFs’ portfolio management practices, compliance programs, and disclosures.
In examining over 30 TDFs, including both “to” and “through” funds, the staff observed instances of deficiencies or weaknesses related to TDFs’ disclosures and compliance programs, including:(i) incomplete and potentially misleading disclosures in prospectuses and advertisements; and (ii) incomplete or missing policies and procedures related to monitoring asset allocations, advertising and sales literature, and glide path deviations.
A copy of the Risk Alert can be found here.
At the request of member firms (according to FINRA), FINRA has now released its 2019 Reports on Examination Findings summarizing key findings from member exams. Different from earlier reports (2017 and 2018), this time around, FINRA says it wanted to make clearer the distinction between exam findings (violations of SEC, FINRA rules) and observations (suggestions for improving control environment).
FINRA’s stated goals are to identify issues and advise members of effective practices that can address deficient compliance programs in areas covering sales practice and supervision, firm operations, market integrity, and financial management. While the list contains many of the usual deficiencies, it also includes specific and noteworthy observations about how to strengthen compliance in these areas, including
supervision and document requirements
Suitability Rule violations
Digital Communication Use
Anti-Money Laundering (AML)
Uniform Transfers and Grants to Minors Accounts
Business Continuity Plans
Fixed Income Mark-up Disclosure
Direct Market Access Controls
Liquidity and Credit Risk Management
Segregation of Client Assets
Net Capital Calculations
A link to the report can be found here.
“For these examinations, OCIE will select firms with practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges. With respect to mutual fund share classes, OCIE will continue to evaluate financial incentives for financial professionals that may influence their selection of particular share classes….” *
*From SEC’s 2019 Examination Priorities (Office of Compliance and Examinations)
By the time many firms read the SEC’s missive, they were likely already at the stage of settling enforcement actions, self-reported or been apprised by examiners of their failure to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.
BMO Harris Financial Advisors and BMO Asset Management are two of the latest casualties in the SEC’s crack down on mutual fund share-class disclosure failures. The affiliated advisers agreed to settlement of charges that they failed to disclose a practice of maintaining approximately 50% of their client funds in proprietary mutual funds and selecting higher-cost share classes of these funds and certain other funds when lower-cost share classes were available for the same funds. The practice benefited the BMO advisers allowing them to receive additional management fees and avoid paying transaction costs to its clearing broker. The SEC found these actions (i) to be a conflict of interest (ii) involved revenue sharing not disclosed to clients (iii) violated the firms’ duty of best execution and (iv) failed to implement written policies and procedures to prevent violations of the Investment Advisers Act of 1940 and the rules thereunder.
Both firms agreed to a censure, disgorgement, prejudgment interest and a civil penalty totaling about $38 million.
Also, yesterday, the SEC announced settled orders against 10 other investment advisers finding that they failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available. These SEC’s orders have found that the settling investment advisers placed their clients in mutual fund share classes that charged 12b-1 fees – which are recurring fees deducted from the fund’s assets – when lower-cost share classes of the same fund were available without adequately disclosing that they were selecting the higher cost share class.
Presumably, and sooner than later, the SEC will announce more settlements, and the SEC’s examination program will continue to make share class selection-related violations a priority.
The SEC National Exam Program has issued a new Risk Alert addressing some of the most common deficiencies associated with advisers’ best execution obligations identified by OCIE staff. In addressing the deficiencies, the alert reminds advisers of existing requirement that in determining best execution an adviser must seek to obtain the execution of transactions for clients in such a manner that the client’s total cost in each transaction is the most favorable under the circumstances. “[T]he determinative factor [in an adviser’s best execution analysis] is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” The SEC has brought enforcement actions against advisers who fail to meet this standard.
Common adviser best execution deficiencies that were observed by the staff include:
• failure to demonstrate periodic and systematic evaluation of the execution performance of broker-dealers used to execute client transactions.
•failure to consider the full range and quality of a broker-dealer’s services in directing brokerage.
•failure to seek or consider the quality and costs of services available from other broker-dealers.
•advisers who failed to provide full disclosure of best execution practices.
•failure to provide full and fair disclosure in Form ADV of their soft dollar arrangements.
•advisers who did not “appear to make a reasonable allocation of the cost of a mixed use product or service according to its use or did not produce support, through documentation or otherwise, of the rationale for mixed use allocations.”
•advisers that appeared to fail to have adequate compliance policies and procedures or internal controls for best execution.
•advisers who failed to follow their policies and procedures regarding best execution, including failing to seek comparisons from competing broker-dealers to test for pricing and execution, not allocating soft dollar expenses in accordance with their policies, and not conducting ongoing monitoring of execution price, research, and responsiveness of their broker-dealers.
Advisers should remember that as fiduciaries, they have a duty to obtain best execution in client transactions. The alert list several actions advisers may want to consider when cleaning up such deficiencies. Actions that might be taken by advisers include, amending their best execution or soft dollar arrangements disclosures, revising compliance policies and procedures, and changing their practices regarding best execution or soft dollar arrangements.
Variable Annuity Exchanges: $Six Million is the Costs for Failing to Consider and Accurately Describe their Costs and Benefits
For the second time, the FINRA has sanctioned Fifth Third related to its sale of variable annuities. This time, Fifth Third failed to ensure that its reps obtained and assessed accurate information when recommending VA exchanges. FINRA also found that the firm’s reps and principals were not adequately trained in how to conduct a comparative analysis of the material features of its VAs, causing the firm to misstate the costs and benefits of exchanges, thus making the exchange appear more beneficial to its customers. To make matters worse, the firm’s principals approved approximately 92 percent of the exchange applications submitted for review. FINRA reviewed a sample of VA exchanges Fifth Third approved from 2013 through 2015, and found that Fifth Third misstated or omitted at least one material fact relating to the costs or benefits of the VA exchange in approximately 77 percent of the sample.
FINRA fined Fifth Third Securities, Inc. $4 million and required restitution to customers of approximately $2 million. So what went wrong? FINRA found Fifth Third’s practices included
- overstating the total fees for existing VA or misstating fees associated with various additional optional benefits, known as riders;
- failing to disclose that existing VAs had an accrued living benefit value, or understating that a customer would forfeit a living benefit value, upon executing an exchange; and
- representing that a proposed VA had a living benefit rider when it did not.
Compared to FINRA’s fine against MetLife Securities, Inc., ($20 million and order to pay $5 million to eligible customers, for similar behavior, around the same time two years ago) Fifth Third fared better. Do these firms believe that such fines (which could have easily been avoided) are simply a cost of doing business? Or maybe Fifth Third believes for namesake that, next time, a “third” time violation may be just the charm.