Reminder: Broker-Dealer and Investment Adviser 2014 Renewals

In Regulatory Notice 13-76, FINRA reminds broker-dealers and investment advisers that the 2014 Renewal Program began on November 11, 2013, when FINRA made the online Preliminary Renewal Statements available to all firms on Web CRD/IARD.

Beginning  November 1, 2013, firms could begin submitting post-dated Form U5, BR Closing/Withdrawal, BDW and ADV-W filings via Web CRD/IARD.  FINRA’s 2014 Renewal Program Calendar reminds of  critical renewal dates. First, Preliminary Renewal States were available beginning November 11, 2013 on Web CRD/IARD. Second, by December 13, 2013, full payment of Preliminary Renewal Statements is due. Third, on January 2, 2014, Final Renewal Statements are available on Web CRD/IARD. Fourth, full payment of Final Renewal Statements is due by January 10, 2014.

FINRA also warns firms that failure to remit full payment of their Preliminary Renewal Statements to FINRA by December 13, 2013, may cause the firm to become ineligible to do business in the jurisdictions where it is registered, effective January 1, 2014 and be subject to late fees.

NEW REGISTRATION RULES FOR MUNICIPAL ADVISORS

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.

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.

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.

FORM 13F: FILINGS DUE AUGUST 15

 

The August 15 deadline for investment advisers to make Form 13F filings to report equity security securities holdings of their managed accounts is approaching.  Form 13F must be filed within 45 days of the end of a calendar quarter.

As required by Section 13(f) of the Securities Exchange Act of 1934, and rule 13f-1, Institutional investment managers ( which includes investment advisers)  must file Form 13F with the SEC if they exercise investment discretion for accounts holding Section 13(f) securities.  Section 13(f) securities are defined in the rules as securities having an aggregate fair market vaule of at least $100 million on the last trading day of any month of any calendar year. 

What types of securities are Section 13F securities? The SEC has said that “[s]ection 13(f) securities generally include equity securities that trade on an exchange (including the Nasdaq National Market System), certain equity options and warrants, shares of closed-end investment companies, and certain convertible debt securities.  The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.”  Advisers can find Section 13(f) securities on the Official List of Section 13(f) Securities.  An updated list of 13(f) securities is published on a quarterly basis.

Advisers can also find valuable information about the filing’s requirements in the Frequently Asked Questions About Form 13F.   

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

 

Time For Quarterly Transaction Reports

FE_DA_Deadline_050613425x283A reminder to advisers,  the code of ethics you adopted probably requires quarterly reports to be prepared for all personal securities transactions made by access persons.  If it doesn’t there are two possible reasons (1) chances are you haven’t read it, or (2) you don’t have one — in which case you need to first read Rule 204A-1 of the Investment Advisers Act of 1940.

The Timing of Transaction Reports

Under Rule 204A-1(b)(2), these reports are due no later than 30 days after the close of the calendar quarter.   Access persons who would be submitting duplicate information contained in trade confirmations or account statements that an  adviser holds in its records (provided the adviser has received those confirmations or statements not later than 30 days after the close of the calendar quarter in which the transaction takes place) may be excused by their investment advisers from submitting transaction reports.

Who is an access person?

Rule 204A-1(e)(1) defines an access person as a supervised person who has access to nonpublic information regarding clients’ purchase or sale of securities, is involved in making securities recommendations to clients or who has access to such recommendations that are nonpublic.  Further, a supervised person who has access to nonpublic information regarding the portfolio holdings of affiliated mutual funds is also an access person, but only to the extent they make, participate in, or obtain information regarding, the purchase and sale of the fund’s securities, or if their functions relate to the making of any recommendations for such transactions.

This definition is broad enough to include, for example,

(i) portfolio management personnel and, in some organizations, client service representatives who communicate investment advice to clients;

(ii)  administrative, technical, and clerical personnel if their functions or duties give them access to nonpublic information;

(iii) organizations where  employees may have broad responsibilities, and fewer information barriers are in place  to prevent access to nonpublic information.  On the other hand, as the SEC has noted, organizations that keep strict controls on sensitive information may have fewer access persons; and

(iv) presumably if the firm’s primary business is providing investment advice, then all of its directors, officers and partners would be access persons.

When must access persons report personal securities transactions?

Under Rule 204A-1(b), each of an adviser’s access persons must report his securities holdings at the time that the person becomes an access person and at least once annually thereafter. Further, they must make to the adviser’s Chief Compliance Officer or other designated person a report at least once quarterly of all personal securities transactions in reportable securities.

What are “reportable securities”?

Rule 204A-1 treats all securities as reportable securities, but list five exceptions designed to exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover. These include transactions and holdings in:

  • direct obligations of the Government of the United States.
  • money market instruments — bankers’ acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments.
  • shares of money market funds.
  • shares of other types of mutual funds, unless the adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund.
  • units of a unit investment trust if the unit investment trust is invested exclusively in unaffiliated mutual funds.

There are other exceptions. For example, under Rule 204A-1, no reports are required for transactions effected under an automatic investment plan; No reports are required for securities held in accounts over which the access person has no direct or indirect influence or control; and finally, under Rule 204A-1(d), no report is required in the case of an advisory firm that has only one access person, so long as the firm maintains records of the holdings and transactions that rule 204A-1 would otherwise require be reported.

There are other requirements in Rule 204A-1, the Code of Ethics Rule, covering access persons transactions and holdings that advisers should review.  These includes such issues as pre-approval of certain investments, review of personal holdings and transaction reports, procedures to address personal trading and reporting of violations.

 

 

A Lesson From Ameriprise: Risk Mitigation With Third-Party Prospectus Delivery

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.

FINRA’s Targeted Examination Letter on Social Media Use

wallpapers-red-bull-s-eye-target-psdgraphics-x-1June 2013,  has seen FINRA publish another targeted examination letter — this time aimed at members and associated persons use of social media.  FINRA uses these letters, primarily, to educate member firms about how it uses targeted exams, known as sweeps, to gather insights on member regulatory responses on emerging issues, and carry out investigations.

Relying on FINRA Rule 2210(c)(6) which subjects member firms’  communications (including electronic)  to periodic spot-check procedures, FINRA’s Advertising Regulation Department is asking firms and their associated persons for information about how they use social media (e.g., Facebook, Twitter, LinkedIn, blogs).  Questions and information requests include:

  • how a firm’s social media (e.g., Facebook, Twitter, LinkedIn, blogs) platform is being used as part of its business purpose; 
  • URL information for all social media sites the firm uses; date of first use, and the identity of those who post or update content;
  • how a firm’s associated persons are using social media;
  • a firm’s written supervisory procedures covering the production, approval and distribution of social media communications;
  • what measures firms adopt to monitor compliance with social media policies (e.g., training meetings, annual certification, technology);
  • a list of a firm’s top 20 producing registered representatives (based on commissioned sales) who used social media for business purposes to interact with retail investors, including the type media they use, their name, CRD number, and dollar amount of sales made and commissions earned during a specific period.

FINRA says its  selection of firms for the targeted exam is based on a number of factors, including the “level and nature of business activity in a particular area, customer complaints and regulatory history, and prior examination findings.”

The letter demonstrates the attention broker-dealer’s should pay to both adopting policies and procedures and supervising interactive electronic communications to ensure that content requirements of FINRA’s communications rules are not violated.  In doing so, members should review FINRA’s Regulatory Notices 07-59, 10-06,  11-39 and FINRA Conduct Rules 2210 and 3010.

 

Is It Okay for Sub-Advisers to Rely on Investment Advisers for Form ADV Delivery?

Can a sub-adviser or unaffiliated adviser, selected by an investment adviser to help manage client assets, deliver its Form ADV Part 2 to the adviser, instead of the client? Yes, they can, according to a recently issued SEC no-action letter  to Goldman, Sachs & Co.

Generally, under Rule 204-3 of the Advisers Act, the “Brochure Rule,” an investment adviser must deliver a copy of its Form ADV (Part 2A) brochure  and any required supplements (Part 2B) to each of its advisory clients or prospective clients before or at the time of entering into an advisory contract with them.  This includes sub-advisers who are required to deliver their own brochure to the advisory client.

Goldman operates discretionary wrap-fee or managed account programs that employ the services of over 40 unaffiliated sub-advisers.  The programs hire and allocate Goldman’s client assets across multiple sub-advisers.  The fact that these sub-advisers managed client assets, establishes a fiduciary relationship with the client, and makes them also responsible for complying with the Brochure Rule.

Goldman sought assurances that permitting clients to elect not to receive the brochure documents but, instead, rely on Goldman to receive them on the client’s behalf would not result in the SEC bringing an enforcement action.In support, Goldman pointed to several examples of so-called “constructive delivery” where the SEC has permitted delivery of documents to a properly authorized agent — thus, constituting delivery to the agent’s principal  in accordance with well-established common-law agency principles.

Examples of  this in other contexts, Goldman noted, included, the SEC permitting investment advisers to receive offering prospectuses on behalf of their clients; the SEC approving various SROs rules allowing broker-dealers to satisfy their proxy delivery obligations, annual and semi-annual reports, and other shareholder communications obligations to customers by sending the materials to the customers’ investment advisers instead of the customers;  under Regulation S-P, the SEC permitting advisers to satisfy their obligations to deliver initial and opt-out notices to consumers by sending the notices to the consumers’ legal representatives; and under rule 206(4)-2, the Custody Rule, the SEC permitting advisers to satisfy their obligations to send notices of custodial arrangements and any required account statements to a client by sending them to an “independent representative” designated by the client.

Investment advisers relying on the Goldman no-action letter should consider implementing, among others, the following  steps:

1.  Offer the client, in writing, the choice of appointing you,  the adviser,  to receive the brochure document from sub-advisers and briefly explain, in plain English, the information in the sub-adviser’s brochure document. This can be done in the investment management agreement or a separate agreement;

2. Inform the client of the identity of any sub-advisers you engage to manage the client’s assets, and inform the client  that allowing you to receive the brochure does not waive or diminish their right to receive the brochure if they so choose;

3. Preserve the brochure documents that you receive and make them available to clients upon request.  Clients should be free to change their minds at any time and request, at no additional cost, that the  sub-advisers’ brochure documents be delivered to them directly;

4. Maintain policies and procedures designed to ensure that the sub-adviser’s brochure documents are appropriately reviewed by the adviser, and ensure that such policies address and manage any conflicts related to any business relationship the adviser has with a sub-adviser; and

5. Finally, when evaluating a particular sub-adviser’s disclosure for material conflicts, consider whether to (a) not retain the sub-adviser or (b) inform affected clients of a specific conflict and seek the client’s consent, even though the client may have elected not to receive brochure documents.