SEC and FINRA To Hold 2014 Regional Outreach to Broker-Dealers

Broker-dealers are reminded, beginning this  spring, the SEC’s Office of Compliance Inspections and Examinations (OCIE), and the SEC’s Division of Trading and Markets, is partnering with FINRA to sponsor regional compliance outreach programs for broker-dealers. The programs will take place in Denver, Los Angeles, Chicago, Miami, Philadelphia, and New York.  Registration is open to all broker-dealer risk, audit, legal, and compliance professionals. Continue reading “SEC and FINRA To Hold 2014 Regional Outreach to Broker-Dealers”

Cyber-Security: FINRA’s Targeted Examination Letter

The IPR Blog: FINRA's Targeted Examination LetterAs we posted earlier in outlining  FINRA’s  2014 Regulatory and Examination Priorities Letter, one focus included FINRA’s concern for the integrity of member firms’ policies, procedures and controls that are supposed to protect sensitive customer data.  In the letter, FINRA states that it will examine and conduct targeted investigations and followed up by issuing  a separate notice concerning  Targeted Examination Letters that some firms may get seeking information about how the firm addresses the issue of cyber-security threats, vulnerabilities, and management of related risks.  The cyber-security topics FINRA will examine or assess include a firm’s

Continue reading “Cyber-Security: FINRA’s Targeted Examination Letter”

An Outline of The SEC’s 2014 Examination Priorities

Last week I wrote about FINRA’s 2014 exam priorities. This week, the SEC announced its 2014 examination priorities covering a number of topics important to investment advisers, investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.

While the SEC makes clear the list is not exhaustive, areas that firms will see heightened scrutiny include fraud detection and prevention, corporate governance and enterprise risk management, technology controls. Included also are issues concerning the growing relationship between broker-dealers and investment advisers, new rules and regulations, and retirement investments and rollovers. Continue reading “An Outline of The SEC’s 2014 Examination Priorities”

FINRA’s 2014 Broker-Dealer Exam Focus

As it does every year since 2006, the FINRA has just released its 2014 Regulatory and Examination Priorities letter  highlighting significant risks and regulatory issues for member firms and how FINRA plans to address such matters in its examination of broker-dealers.  The hope is that broker-dealers will use the letter to identify risk exposures to enhance their supervisory, compliance and risk management programs to protect investors, the integrity of the markets and themselves.  Unfortunately, for some the letter goes unheeded until later the firm is ”shocked” to learn during a FINRA cycle exam that the examination staff is spending so much time reviewing the firm’s records on an issue raised in the letter. Continue reading “FINRA’s 2014 Broker-Dealer Exam Focus”

Reminder: SEC National Compliance Outreach Program

Advisers are reminded the SEC’s annual compliance outreach program National Seminar will be held on January 30, 2014, at its headquarters in Washington, D.C. Investment adviser and investment company senior officers, including chief compliance officers (CCOs) are invited to register and attend.

This year’s agenda will likely include panel discussions with SEC staff from the Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement’s Asset Management Unit and investment adviser personnel. The agenda’s topics will include SEC exam priorities in 2014, private fund advisers, registered investment companies, valuation, and the role of the CCO. Continue reading “Reminder: SEC National Compliance Outreach Program”

Compliance Risks With Leveraged and Inverse ETF Sales

FINRA has ordered Atlanta-based broker-dealer, J.P. Turner & Company, L.L.C. to pay $707,559 in restitution to 84 customers for sales of unsuitable leveraged and inverse exchange-traded funds (ETFs) and for excessive mutual fund switches.

FINRA’s action against J.P. Turner is another reminder of the need for broker-dealers to carefully scrutinize the suitability of such non-conventional investments products like inverse exchange-traded funds.

While FINRA mutual fund switch violation cases (a practice FINRA has addressed repeatedly) are more common, inverse ETFs sales practice violations case have not been as prominent, but should come as no less a surprise. Continue reading “Compliance Risks With Leveraged and Inverse ETF Sales”

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.

SEC ANNOUNCES REGIONAL COMPLIANCE OUTREACH SEMINARS

The SEC has announced its schedule for the  upcoming Compliance Outreach Program regional seminars to be held in Chicago, New York, Atlanta and San Francisco.   Investment adviser and investment company senior officers, including chief compliance officers (CCOs) are invited to register and attend.  The first meeting will occur in Chicago on August 28. 

 This years’ Compliance Outreach Program, which started off  in Boston in May, will likely include panel discussions with SEC staff from the Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement’s Asset Management Unit.  Topics will vary depending on location. For example, the Chicago seminar will address traded and non-traded real estate investment trusts, investment companies with special emphasis on alternative investment funds and money market funds, and current enforcement actions in the investment management industry.  The New York seminar will focus more on newly registered investment advisers, dual registrants and to investment advisers affiliated broker-dealers, and will topics like the SEC’s examination process, priorities, risk surveillance, and examination selection process.   

 As we’ve alerted our audience in previous blogs, investment advisers should attend these meetings because “[t]he seminars highlight areas of focus for compliance professionals.  They provide an opportunity for the SEC staff to identify common issues found in related examinations or investigations and discuss industry practices, including how compliance professionals have addressed such matters.”

Registration information about the regional seminars is available at:

http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539720572#.Uef5kdK1Eec