SEC Risk Alert: Business Continuity and Disaster Recovery Planning

The SEC has issued a new Risk Alert stemming from its observations of  the  business continuity and disaster recovery planning practices of  a number of  investment advisers.  The alert follows an National Examination Program (“NEP”) review of the plans of approximately 40 investment advisers following  Hurricane Sandy.  The SEC says the goal is to encourage investment advisers to review their business continuity and disaster recorvery plans (“BCPs”) to improve responses and recovery times for threats that might disrupt market operations.

Certain weakenesses observed, and that advisers would do well to heed,  include the following areas:

  • Preparation for widespread disruption. Some advisers whose BCPs did not adequately address and anticipate widespread events experienced more interruptions in their key business operations and inconsistent communications with clients and employees.
  • Planning for alternative locations.  Some advisers who switched to back-up sites or systems reported that the buildings where they usually conduct their business were closed for days.  At least, one adviser reported its building was closed for several weeks.  Other problems included extended outages of power, phone systems, and internet service and lack of geographically diverse office operations.
  • Preparedness of key vendors.  Some advisers failed to even evaluate the BCPs of their service providers or keep a list of vendor’s contact information.  Some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports. 
  • Telecommunications services and technology.  Some advisers failed to hire service providers to make sure back-up servers functioned properly, relying solely on self-maintenance, which led to more interruptions in their operations.
  • Communication plans.  Poor planning, inconsistencies and weak deployment in how to contact employees during a crisis.  Some plans did not identify which employees would execute and implement  various parts of the BCP.
  • Reviewing and testing.  Inadequate testing of operations and systems relative to size and nature of  advisory businesses.  Some problems here were based on adviser failures to conduct certain critical tests based on costs and other disincentives.  

The risk alert also encourages advisers to consider those best practices and lessons learned that were described in the Joint Review of Business Continuity and Disaster Recovery of Firms by the Commission’s National Examination Program, the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority on August 16, 2013.  They are  available at http://www.sec.gov/about/offices/ocie/jointobservations-bcps08072013.pdf

While the alert serves as a friendly reminder, to avoid a potential enforcement action, the advice covered should be reviewed, and where appropriate, implemented.  The days of  preparing a boilerplate disaster recovery handbook to be left to collect dust on an adviser’s bookshelf have long passed.

SEC Risk Alert: Options Trading That Evades Short-Sale Rule Requirements

risk managementShort sale activity continues to be a significant focus of the SEC, particularly when it involves short sales without delivery, or “failures to deliver.”

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has now  issued a new Risk Alert raised by its examination staff’s observation that some options trading strategies are being used to evade the short-sale rule, Rule 10b-21.  The alert addresses the need for customers, broker-dealers and clearing firms to be aware of options trading activity that could be used to avoid complying with the close-out requirements of Reg SHO.

Under the rule,  it is fraudulent to sell an equity security if it deceives a person participating in the transaction about the seller’s  intention or ability to deliver the security by settlement date.  Rule 10b-21 covers such situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, and the seller then fails to deliver securities by settlement date.  The violative activity would include broker-dealers (including market makers) acting for their own accounts.  Broker-dealers could also be held liable for aiding and abetting a customer’s fraud under Rule 10b-21.

In addition to addressing, with examples, trading strategies that could be used to circumvent Reg SHO requirements, and other helpful ways that OCIE has observed that some firms have used to effectively detect and prevent violation of the rule, the alert provides summary guidance covering (a) Reg SHO Close-out Requirement; (b) Reg SHO Locate Requirement; (c) Rule 10b-21; (d) Key Trading Terms and Concepts; and (d) Option Activity Related to Hard to Borrow and/or Threshold Securities.

ACHIEVING “BEST EXECUTION” AND RECENT SEC ENFORCEMENT

Two SEC enforcement cases last week demonstrate (i) how using affiliated brokerage on an agency or principal basis raises potential conflicts of interest  when dealing with ” best execution” concerns , and (ii) the importance of having robust best execution policies and procedures and then following them.  In both cases, the SEC sanctioned investment advisers for not heeding these concerns in failing to seek best execution on client trades placed through in-house brokerage divisions.

While the duty of an adviser or fund to seek best execution may not expressly be stated in the federal securities laws, to the extent they are typical, these cases tend to follow a pattern:  An SEC best execution enforcement action might involve the SEC’s examination staff first finding that a firm failed to disclose compensation on client brokerage, failed to adequately its brokerage practices or failed to properly disclose to clients the adviser’s best execution policies and procedures.  The two recent cases are no exception.

In the first case against A.R. Schmeidler & Co. (ARS), a dually registered investment adviser and a broker-dealer, the SEC found that ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm.  This resulted in ARS retaining a greater share of the commissions it received from clients, a best execution violation.  The SEC found that the firm also failed to implement policies and procedures reasonably designed to prevent the best execution violations.  To settle the SEC charges, ARS agreed to pay disgorgement of $757,876.88, prejudgment interest of $78,688.57, and a penalty of $175,000.  The firm also must engage an independent compliance consultant, and had to consent to a censure and cease-and-desist order.

The second case involved a CEO who also served as Chief Compliance Officer officer, Goelzer, and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM).  The SEC found that GIM made misrepresentations in its Form ADV about the process of selecting itself as broker for advisory clients.  The SEC found that GIM failed to seek best execution for its clients by neglecting to conduct the comparative analysis of brokerage options described in its Form ADV, and recommended itself as broker for its advisory clients without evaluating other introducing-broker options as the firm represented it would.  Goelzer and GIM agreed to pay nearly $500,000 to settle the charges that included GIM paying disgorgement of $309,994, prejudgment interest of $53,799, and a penalty of $100,000.  The firm was also required to comply with certain undertakings, including the continued use of a compliance consultant and the separation of its chief compliance officer position from the firm’s business function.  Goelzer agreed to pay a $35,000 penalty, and Goelzer and GIM consented to censures and cease-and-desist orders.

What are some of the lessons for advisers and funds engaged in managing potential conflicts related to best execution?

While the SEC provides no specific definition of “best execution,” it has said that managers should seek to execute securities transactions for clients in such a manner that the client’s total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account.  So what  should advisers learn from these cases?    

  • Recognize the importance of having strong written policies and procedures that provide guidance concerning the quality of trade execution while, at the same time, attending client investment objectives and constraints.
  • Make sure that disclosures in Form ADV and elsewhere include information about trading and actual and potential trading conflicts of interest.
  • Document compliance with best execution policies and procedures and disclosures to clients.
  • Consider setting up a brokerage or trade management committee to review trade placement and best execution. The committee should address such topics as broker trading cost and execution, brokerage expertise and infrastructure and the broker’s willingness to explore alternative trading options.
  • Test for best execution, including possibly hiring a third party service provider to periodically assess the broker’s capacity to evaluate which competing markets, market makers, or electronic communication networks (ECNs) offer the most favorable terms of execution, the speed of execution, and the likelihood that the trade will be executed.   

There are numerous sources to consult when thinking about and developing best execution policies.  A few advisers might want to consider include:  Trade Management Guidelines (Nov. 2002), available at www.dfainstitute.org/standards/ethics/tmg; See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (“1986 Soft Dollar Release”); Lori Richards, Valuation, Trading, and Disclosure: The Compliance Imperative, Remarks at the 2001 Mutual Fund Compliance Conference of the Investment Company Institute (June 14, 2001), available at www.sec.gov/news/speech/spch499.htm.   

In statements following these cases, the SEC warned all investment advisers with affiliated broker-dealers that it would hold them accountable to ensure clients are obtaining the most beneficial terms reasonably available for their orders.

THE UPWARD TREND IN MUNCIPAL SECURITIES CASE ENFORCEMENT

upwards-trendThe past two weeks has seen the SEC’s continued ratchet upward the number of enforcement actions against municipal securities participants for disclosure violations.

These enforcement actions also continue to ensnare an array of players in municipal securities transactions, that include underlying obligors, their chief executive officers, national and regional investment banks, the heads of public finance departments at several investment banks, as well as individual investment bankers at various levels of seniority, issuers, issuer officials, financial advisers, attorneys and accountants.

The cases have involved everything from  tax or arbitration-driven fraud, pay-to-play and public corruption violations, public pension accounting and disclosure fraud, valuation/pricing issues, and most recently, more offering offering and disclosure fraud, involving misleading statements or omissions in offerings.

Two recent enforcement actions illustrate this trend.  The first, SEC v. City of Miami, Florida and Michael Boudreaux, an SEC complaint filed in federal court in Miami alleged that the City of Miami, through its then Budget Director, charged that beginning in 2008, the City and the budget director made materially false and misleading statements and omissions concerning certain interfund transfers in three 2009 bond offerings totaling $153.5 million, as well as in the City’s fiscal year 2007 and 2008 Comprehensive Annual Financial Reports.  The City puportedly transferred a total of approximately $37.5 million from its Capital Improvement Fund and a Special Revenue Fund to the General Fund in 2007 and 2008 in order to mask increasing deficits in the General Fund.

The complaint alleged that the City and the budget director failed to disclose to bondholders that the transferred funds included legally restricted dollars which, under Miami’s city code, was not permitted to be commingled with any other funds or revenues of the City.  The defendants  also failed to disclose that the funds transferred were allocated to specific capital projects which still needed those funds as of the fiscal year end or, in some instances, already spent that money.  The transfers enabled the City of Miami to meet or come close to meeting its own requirements relating to General Fund reserve levels.  According to the SEC, the results of the transfers, meant that the City’s bond offerings were all rated favorably by credit rating agencies.

The second and most recent case, In The Matter of  West Clark Community Schools, a settled administrative cease-and desist proceeding, involved the West Clark Community Schools, an Indiana school district.  In 2005, the West Clark Community Schools contractually, in accordance with SEC rules, undertook to annually disclose certain financial information, operating data and event notices in connection with a $52 million municipal bond offering.  In 2007, the school district, in connection with a $31 million municipal bond offering, stated in public bond offering documents that it had not failed, in the previous five years, to comply in all material respects with any prior disclosure undertakings. That statement, the SEC alleged, as well as a Certificate and Affidavit signed by the School District attesting that the offering documents did not contain any untrue statement of material fact, was materially false.  To the contrary, the SEC found that between at least 2005 and 2010 the School District never submitted any of its contractually required disclosures.

As a result, the SEC claimed that the school district violated Section 17(a)(2) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5(b) thereunder.  In a separate, but related, settled cease-and-desist proceeding, In the Matter of City Securities Corporation and Randy G. Ruhl, the SEC found that City Securities, the underwiter, and an vice president of City Securities’ municipal bond department conducted inadequate due diligence and, as a result, failed to form a reasonable basis for believing the truthfulness of material statements in an the school district’s  official statement, resulting in City Securities offering and selling municipal securities on the basis of a materially misleading disclosure document.

In addition to being censured, City Securities was ordered to pay disgorgement and civil penalties.  The vice president was barred from the securities industry with a right to reapply after one year and ordered to pay disgorgement and civil penalties.

In July 2012, the SEC  issued a comprehensive report with recommendations aimed at helping improve the structure and enhance disclosure provided to investors for a municipal securities market that has grown to $3.7 trillion in municipal debt outstanding from a level of $361 Billion in 1981.  To that, add potential enforcement actions from the MSRB, states, and other SROs, and there’s little doubt that the enforcement action trend will escalate.