Thinking of conditioning the settlement of a customer arbitration claim on the customer agreeing to expunge her complaint against you? Think again. The FINRA is now awaiting the SEC’s approval of a FINRA rule proposal that would prohibit associated persons from conditioning settlements of customer disputes on, or otherwise compensating customers for, an agreement not to oppose a request to expunge information from an associated person’s Central Registration Depository (CRD) record. Continue reading “The End of Not Opposing Expungements in Return For Settlement?”
As 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
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”
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”
As they were required to do under the Dodd-Frank Act, the SEC announced that it has now voted to adopt permanent rules requiring municipal advisors to register. Previously, and immediately after Dodd-Frank, municipal advisors were placed under a temporary registration requirement, and following it, more than 1,100 municipal advisors registered with the SEC.
The permanent rule, the SEC says, will address the long concern about the fallout from losses suffered, in part, by municipalities purchasing complex derivatives products and relying on the advice from unregulated advisors — advisors, who municipalities may not have been aware, may have had conflicts of interest. In addition to defining the term “municipal advisor,” and who is exempted from that definition, the rule identifies when a person is considered to be providing “advice.” For example, the SEC says, other than general giving information, a person recommending to a municipal entity advice based on a particular need related to municipal financial products or related to the muncipalities’ issuance of municipal securities would be considered providing muncipal advice.
The SEC’s Press Release states that the new rules will be effective 60 days after publication in the Federal Register.
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.
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.
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.
Broker-dealers and other financial service firms using third-party service vendors, whether to reduce costs, enhance performance, and obtain access to specific expertise, and perform vital functions, sounds good in most instances. But doing so is not without risks.
FINRA’s recent disciplinary action against Ameriprise, tagging it with a censure and fine of $525,000, is a reminder of inherent risks when firms fail to monitor outsourced service work to third parties. In settling with Ameriprise (through an Acceptance Waiver and Consent, FINRA Case # 2011029100301) FINRA found that Ameriprise, in approximately 580,000 transactions, failed to timely deliver mutual fund prospectuses to its customers within three business days of their purchases. FINRA also found Ameriprise to have failed to establish and maintain adequate supervisory systems and written supervisory procedures that should have reasonably monitored and ensured the timely delivery of mutual fund prospectuses — a requirement of Section 5(b)(2) of the Securities Act of 1933.
As FINRA noted, Rule 10b-10, promulgated under Section 10(b) of the Securities Exchange Act of 1934, requires a broker-dealer to provide to the customer, in writing, certain information “at or before completion of such transaction” and that transactions are complete when they settle. Rule 15c6-l(a) provides that securities transactions settle in three business days, unless otherwise specified. Consequently, a broker-dealer must deliver a prospectus to a customer who has purchased a mutual fund no later than three business days after the transaction.
What are the compliance takeaways from the Ameriprise action? How does a firm avoid or mitigate legal, reputational and operational risks to its business when dealing with outside vendors?
First, firms should make sure they hire qualified vendors and that such relationship are structured to avoid operational problems. Expectations on both sides need to be clearly articulated. Second, monitor frequently and document that the outsourced activity is being properly managed.* Appropriate oversight ensures that the third-party program is meeting its regulatory purpose. Third, document and make sure that the third-party has adequate internal controls. Finally, make sure that the vendor has a contingency plan in the event of a disruption, and make sure that you do the same.
In the end, while day-to-day management of a service like sending the prospectus can, in some instances, be transferred to a third party, ultimate responsibility for any compliance requirement cannot be delegated and remains with the financial service firm.
*Outsourcing Financial Services Activities: Industry Practices to Mitigate Risks, Federal Reserve Bank of New York, October 1999, p. 5, available online.; Outsourcing By Financial Services Firms, Broker-Dealer Regulation (Second Edition) Practicing Law Institute, C.E. Kirsch.
Reporting on Mary Jo White’s speech at a Wall Street CFO Network function, the Washington Post notes her comments about the long-simmering topic of failure of securities law violators to admit guilt when they settle with the SEC. As a matter of practice, the SEC has routinely allowed defendants to settle cases “without admitting or denying wrongdoing.” In light of public criticism and some pointed criticisms by judges handling these type settlements(See my December 15, 2011 blog post ), White wants to draw a sharper distinction between those cases where clear-cut misconduct is shown and those cases where wrongdoing or guilt is less clear.
The Washington Post article notes that “[i] an e-mail sent to the SEC staff earlier this week, the co-directors of the enforcement division said that cases in which the defendant engaged in “egregious intentional misconduct” may justify requiring an admission, as would the obstruction of an SEC investigation or “misconduct that harmed large numbers of investors.”
Despite public protestations, and some courts’ misgivings about allowing defendants to pay large fines to settle cases without admitting wrongdoing, wholesale changes in the settlement policy are unlikely. Further, district courts have limited authority to change an executive branch agency’s decision to settle a claim, including the SEC’s “neither admit nor deny” policy.
Whether a sharper line is drawn or not, such settlements still serve an important public policy. Similar to the rationale for plea bargaining in criminal cases, without being able to settle without admitting guilt, many defendants would not settle. Some defendants would rather risk going to trial than admit guilt that might leave them open to other lawsuits, denial of insurance coverage, or higher insurance premiums. Still other defendants, lacking resources, might simply consider walking away from these cases. The result — long investigations and trials with even harsher fines and sanctions that may go uncollected and waste limited resources.