Category Archives: code of ethics

Senate Bill Would Increase SEC Penalties To $1 Million And Up

Under a Senate bill, the SEC would be able to administratively impose a maximum $1 million per violation penalty on individuals and a maximum $10 million per violation penalty on financial firms for the most serious (e.g., fraud, deceit) violations.  The current levels are substantially lower — at $181,071 for individuals and $905,353 for firms — though the SEC is empowered to go to federal court to get the equivalent of the ill-gotten gains in a given case.

Under the proposed measure, the SEC would not have to go to federal court to get large remedies, though the total remedy per violation would be capped – the maximum penalty for an individual could not exceed, for each violation, the greater of (i) $1 million, (ii) three times the gross pecuniary gain, or (iii) the losses incurred by victims as a result of the violation.  The maximum amount that could be obtained from entities could not exceed, for each violation, the greater of (i) $10 million, (ii) three times the gross pecuniary gain, or (iii) the losses incurred by victims as a result of the violation.

In addition, individuals and firms that were found civilly or criminally liable for securities law violations in the 5 years leading up to a new violation could face up to three times the new caps, e.g., penalties of $3 million/$30 million.

It is important to note that SEC administrative or “in-house” courts have faced substantial constitutional challenges recently and are often considered subject to agency bias.  At a minimum, it is clear that the SEC courts lack some of the procedural safeguards provided in federal court.  If the Senate bill becomes law, the SEC will have significantly increased leverage in negotiations with respondents not only because of the amounts involved but because the Enforcement staff would not need to go to federal court to get such amounts.

 

 

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Trump Administration May Suspend DOL Fiduciary Rule

The DOL Fiduciary Rule, effective April 2017, is among the items that the new administration may put on hold upon taking office in January 2017. Once effective, the Rule makes all financial advisers providing rollover and other advice to retirement investors “fiduciaries” required to put retail customers’ interests before the advisers’ interests in getting compensated. Broker-dealers, investment advisers, and mutual fund complexes have already sunk millions of dollars into upgrading and changing their compliance and business models in anticipation of the Rule.

At the center of the Rule is the so-called “Best Interest Contract” Exemption or BIC. It permits fiduciaries to enter into prohibited transactions (e.g., accepting commissions in connection with providing rollover and other investment advice) if the financial firm and professional enter into a BIC with the customer, provide certain disclosures, adhere to Impartial Standards of Conduct, charge only “reasonable” compensation, and acknowledge fiduciary status.

Due to its complexity and related compliance costs, some firms have announced that they will not be opening new commissions-based retirement accounts. Others have said that they will continue to open such accounts but will make continuous efforts to review accounts for the appropriateness of commission-based versus fee-based compensation based on a number of factors (e.g., the amount of trading in the account).

The new administration may ask the SEC to step in and issue a unifying rule covering investment advice to retirement accounts. Currently, the SEC’s regime for registered investment advisers under the 1940 Investment Advisers Act provides that investment advisers (who typically charge a percentage of assets under management) are fiduciaries. Such advisers may enter into conflicted transactions if adequate disclosures are made to the customers and if not otherwise prohibited by law.

By contrast, SEC Rules do not impose a fiduciary duty on brokers who provide rollover and other advice to retirement accounts in return for a commission. Brokers charging a commission for transactions are not considered fiduciaries and are instead held to the lesser “suitability” standard.

Regardless of whether the DOL Rule survives, the kinds of changes and industry introspection that have occurred are probably not a complete waste of time and money. FINRA and the SEC are already monitoring investment advisers and broker-dealers for conflicted transactions and policies with respect to compensation. For example, FINRA tends to take a very broad view of whether an investment recommendation, including a rollover recommendation, is “suitable”. Further, the plaintiffs’ litigation bar has long been asserting claims for breach of fiduciary duty in FINRA arbitrations even in the technical absence of such a duty.

Bottom line: regardless of the durability of the DOL Rule, advisers and their firms should continue evaluating their business practices to conform to a “best interests” standard.

For further discussion, here is a recent article from The Hill:

http://thehill.com/policy/finance/305287-financial-adviser-rule-could-be-in-trumps-crosshairs

 

 

 

 

 

 

“Nothing Succeeds Like Success” Unless “Success” Is Based On Inflated AUM

Having substantial assets under management (AUM) can really boost an investment adviser’s ability to attract new money. Accordingly, there is tremendous pressure to report strong numbers to the investing public, including through news sources (e.g., Barron’s top advisors list). As one adviser has found out, the price of inflating such AUM numbers can be millions in dollar in fines and a permanent bar from the industry.

Specifically, an SEC Administrative Law Judge (ALJ) has found that Dawn Bennett and her firm falsely claimed between $1 – $2 billion in AUM when the most she ever had was $400 million. Ms. Bennett made such claims on a radio show she hosts and to Barron’s magazine in order to secure “top Barron’s advisor” recognitions for three years. In addition, Ms. Bennett provided performance information based upon “model portfolios” while representing that such returns were actual customer returns. Ms. Bennett and her firm also face FINRA customer arbitrations relating to the above issues as well as alleged account churning.

In its decision, the ALJ fined Ms. Bennett $600,000 and her firm $2.9 million. The ALJ also ordered $556,000 in disgorgement and imposed a permanent industry bar finding that Ms. Bennett “is not fit to remain in the industry in any capacity.”

Bottom line — while the temptation to inflate performance is very strong, especially in this competitive market, advisors who make false statements do so at their own peril.

Here is a link to the ALJ opinion — https://www.sec.gov/alj/aljdec/2016/id1033jeg.pdf

Auditing the Auditor: SEC Charges Firm With Inadequate Surprise Exams

On April 29, 2016, the SEC brought and settled charges that an accounting firm, Santos, Postal & Co. (“Santos”) and one of its principals, Joseph Scolaro (“Scolaro”), performed inadequate surprise exams of one of their investment advisor clients, SFX Financial (“SFX”), the president of which stole over $670k from SPX clients. Santos and Scolaro neither admitted nor denied the allegations in the SEC Order but consented to its entry and to disgorgement and penalties totaling over $55,000. Santos and SColaro agreed to be suspended from practicing before the SEC, which includes preparing financial reports and audits of public companies. Santos and Scolaro are permitted to apply for reinstatement after one and five years, respectively.

Because SFX was deemed to have custody of client assets under SEC Rule 206(4)-2 (the “Custody Rule”), SFX was required to hire an independent accountant (Santos) to perform surprise audits. The Custody Rule seeks to protect clients from asset misappropriation by investment advisors (e.g., Ponzi schemes). Accordingly, among other things, Santos was supposed to contact SFX’s clients to verify that they were aware of the contributions and withdrawals into and out of their accounts as reflected in SPX’s records. According to the SEC Order, Santos failed to actually contact clients about such transactions.

The SEC previously announced charges against SFX’s president Brian Ourand, who was later found by an administrative judge to have misappropriated funds from client accounts in violation of the Investment Advisers Act of 1940. Ourand was ordered to pay disgorgement of $671,367 plus prejudgment interest and a $300,000 penalty, and was barred from the industry. SFX and its CCO separately agreed to settlements.

The SEC’s Order relating to Santos and Scolaro can be found here:

https://www.sec.gov/litigation/admin/2016/34-77745.pdf

Investment Advisors Beware: Ten Things OCIE Is Looking At

The SEC is increasing the number RIA inspections by the Office of Compliance Inspections and Examinations (OCIE) and has signaled an aggressive agenda for such exams. Here is a non-exhaustive list of items a Chief Compliance Officer and his or her staff may want to consider well in advance of getting a call from OCIE:

  1. Cybersecurity Policies and Procedures: Make sure the firm’s policies are periodically reviewed and cover key issues (e.g., electronic security (passwords, encryption, “need to know” segmentation), physical security, employee training, incident response planning, and vendor due diligence).
  2. Product Selection: For both RIAs and BDs, the SEC is taking a close look at certain products (e.g., variable annuities) sold to retail investors. Ensure proper monitoring of client recommendations and allocations.
  3. Performance Advertising: Pay particular attention to the distinctions between true actual performance, model performance, and back-tested performance.
  4. Third-Party Affiliations: Disclose any business relationships with 3d parties (e.g., solicitor and sub-advisory relationships) and the potential conflicts they pose.
  5. Fee Structure/Reverse Churning: OCIE is looking at disclosures re: fee structure and the appropriateness of fee-based compensation (e.g., is a firm actively managing an account or just collecting fees).
  6. Custody: “Custody” is broadly defined in Rule 206(4)-2. Firms that have custody need to comply with the Rule’s requirements (e.g., hire an independent CPA to conduct an annual surprise audit).
  7. Code of Ethics/Insider Trading: Make sure the Code is up to date and has adequate personal trading and disclosure restrictions.
  8. Best Execution: If firm has authority to pick BDs, make sure to disclose how firm selects BDs and any “soft dollar” arrangements.
  9. Principal Trading: Disclose it; make sure Rule 3T being followed.
  10. Anti-Money Laundering Policies: For firms that are also BDs, make sure to have AML policies and procedures designed to pick up on suspicious activity (e.g., lots of relatively small transactions).

SEC Sanctions $1B AUM Investment Adviser for Weak Compliance Culture

On June 23, 2015, the SEC censured an investment advisor and its two principals for rickety compliance policies and procedures.[1] Among other things, the SEC found that, due to systemic compliance failures, the advisor overcharged its high net worth clients for their investments in a mutual fund called the Appleseed Fund. The firm, Pekin Singer, offered shares in the Appleseed Fund under a sliding fee structure where clients who met a higher minimum investment paid a lower fee. Pekin Singer failed to timely advise its clients, most of whom met the higher minimum investment threshold, that they could convert to the lower costs shares, thereby improperly increasing the firm’s bottom line at the expense of customers.

Pekin Singer’s internal compliance issues ran deep. In 2009 and 2010, it failed to conduct required annual compliance program reviews and it chronically underfunded and underemphasized its compliance function. For example, the firm’s former CCO had limited compliance experience and was required to simultaneously serve as the CFO of the firm. Because of the multiple hats the he wore, the CCO was only able to devote 10% to 20% of his time to compliance issues.

Further, the CCO, aware of his limitations in the compliance area, sought to hire outside compliance help. After two years of lobbying, the firm hired an outside compliance consultant. The consultant’s review coincided with an OCIE examination by the SEC’s Chicago office. The examination and consultant’s review uncovered a number of compliance failures, including improper trading by an employee, which could have been prevented if the firm had enforced its code of ethics.

To its credit, Pekin Singer fully cooperated with the SEC and returned the excessive fees to its clients. It also hired a new CCO whose only job is compliance and hired an outside attorney to advise on securities law issues relating to mutual funds. Finally, the firm has continued and expanded its relationship with an outside compliance consultant who is charged with monitoring and advising on the firm’s annual compliance program reviews.

Bottom line: Advisory firms and their principals should not skimp on or de-prioritize compliance issues. While having robust compliance policies and controls in place can seem costly up front, the costs to the firm, both in terms of reputation and money, can be much more if OCIE finds deficiencies.

[1] http://www.sec.gov/litigation/admin/2015/ia-4126.pdf