The SEC’s investor advocate, Rick Fleming, has told Congress that one of the SEC’s focuses in the coming budgetary year (starting October 2016) will be the quality of advisor and broker dealer fee disclosures. The SEC is concerned that such disclosures (referencing things like advisory, trailer, administrative, “regulatory,” and custodial fees) are confusing to retail investors who don’t know industry parlance. Broker dealers are likely to be paying extra attention to the quality of their disclosures, not only because of this initiative but because the “best interests” standard under the DOL’s fiduciary rule will take effect in April 2017. For further discussion, please see the link below.
The SEC recently announced it would pursue fraud charges and freeze the assets of the Jay Peak, Inc. Vermont ski resort. The SEC alleges that Ariel Quiros, of Miami, and William Stenger, of Vermont, conducted an illegal Ponzi-like scheme in connection with the funds raised for the resort. The total amount of money in question with these activities is $350 million, a large portion of which was raised through the EB-5 Immigrant Investor Program, a program designed to incentivize foreign investment by promising a fast track to a green card.
According to the SEC, Quiros and Stenger diverted money from the ski resort project to other projects in an attempt to finance them. In addition, an alleged $50 million was spent on Quiros’s personal expenses, such as his personal income taxes and a luxury condominium. There appears to be little money left to fund the ski resort renovations.
Further, the actions of Quiros and Stenger could put many investors’ funds and immigration petitions in jeopardy. In order to get their green card the investors need to fund at least 10 new jobs, which may not happen here.
Given these charges, it is unclear whether investors who were considering committing capital to U.S. projects under EB-5 will still do so. It is also unclear as to whether this is a continuing problem or isolated incident.
Here’s the link to the SEC news release. https://www.sec.gov/news/pressrelease/2016-69.html
The long awaited and much contested DOL Rule imposing a fiduciary duty on brokers providing advice to retirement accounts is now final. Though it provides a significant runway for implementation (at least a year), the Rule is already changing business models from small brokerages right up to the biggest wirehouses.
The Big Change
Under current rules, brokers, for the most part, operate under a standard that only requires advice to clients to be suitable, but not necessarily in the client’s bests interests. Investment advisers, by contrast, are always operating under a best interests fiduciary duty standard.
The DOL, with strong support from the White House, has moved to plug this gap by using its powers to issue a best interests standard for ALL advisers providing advice over retirement plans. (Such plans are defined as 401(k)s and other employer-sponsored plans, IRAs and other tax-deferred accounts, such as health savings accounts.) The Rule is supposed to provide increased protection for retail investors, who the DOL says are more likely to use brokers on commission than their more expensive counterpart – investment advisers paid as a percentage of assets under management.
While it was already the case that brokers providing repeated investment advice (e.g., asset allocation and rebalancing advice) for a fee had a fiduciary duty, the new DOL Rule broadens the definition to include even one-time investment consultations or recommendations. Rollover recommendations also would be considered fiduciary advice.
The potential impact on brokerage houses and their representatives is immense. For one thing, investors who bring suit or arbitrations against their representatives will have a broader claim basis – representatives could be personally liable for losses caused by a breach of the best interests duty.
Fiduciaries also are subject to potentially large excise taxes for engaging in prohibited transactions, unless they qualify for an exemption. ERISA currently prohibits fiduciaries from completing transactions that involve conflicts of interest unless they disclose the conflicts and operate under the oversight of an independent fiduciary.
Commissions/Annuities Still Ok
The Rule permits brokers to charge commissions provided they comply with the Best Interest Contract Exemption (BICE) and other requirements. BICE permits a firm to charge commissions if the adviser and the client enter into a contract that specifies that all advice be in the best interests of the client, clearly discloses all conflicts, directs the customer to a webpage disclosing the compensation arrangements entered into by the adviser and firm, and makes customers aware of their right to complete information on the fees charged. In addition, broker-dealers will need to have procedures in place to encourage advisers to make recommendations in the client’s best interests.
Finally, there was industry concern that the sale of certain financial products considered to be riskier or more expensive than others (i.e., annuities, insurance, and mutual funds) on commission would have been barred under the Rule. However, the Rule permits such sales under the BICE.
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:
- 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).
- 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.
- Performance Advertising: Pay particular attention to the distinctions between true actual performance, model performance, and back-tested performance.
- Third-Party Affiliations: Disclose any business relationships with 3d parties (e.g., solicitor and sub-advisory relationships) and the potential conflicts they pose.
- 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).
- 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).
- Code of Ethics/Insider Trading: Make sure the Code is up to date and has adequate personal trading and disclosure restrictions.
- Best Execution: If firm has authority to pick BDs, make sure to disclose how firm selects BDs and any “soft dollar” arrangements.
- Principal Trading: Disclose it; make sure Rule 3T being followed.
- 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).
The SEC has sued the Rhode Island Economic Development Corporation (RIEDC) and bond underwriter Wells Fargo alleging that RIEDC and Wells Fargo misled bond investors in connection with their investments in Curt Schilling’s failed video game company, 38 Studios. RIEDC had lured 38 Studios to Rhode Island with significant incentives, including the bond deal, only for 38 Studios to fail.
According to the SEC, investors, who poured $75 million into 38 Studios, were not told that it needed substantially more money to produce a video game. In addition, Wells Fargo allegedly failed to disclose that it had a side deal with 38 Studios, which presented a potential conflict of interest. When the company went belly up, the investors were left with the bag. Although neither Schilling nor his company is accused of any wrongdoing in the SEC action, they have been sued civilly.
Municipal finance deals face increased SEC scrutiny. This applies to issuers and underwriters. As SEC Director of Enforcement Andrew Ceresney has stated, “[m]unicipal issuers and underwriters must provide investors with a clear-eyed view of the risks involved in an economic development project being financed through bond offerings.”
In two recent cases, the SEC ordered JP Morgan Chase to pay over $270 million for what it deemed inadequate disclosures about certain conflicts of interest. When closely examined, these two cases illustrate just how detailed and granular the Commission can be when evaluating and prosecuting conflicts non-disclosure issues.
The Proprietary Funds Case
On December 18, 2015, the SEC announced that two J.P. Morgan wealth management subsidiaries had admitted wrongdoing (though no intentional violations) relating to the firm’s investment advisory business and agreed to pay $267 million. Specifically, J.P. Morgan Securities LLC (JPMS) and JPMorgan Chase Bank, N.A. (JPMCB), preferred to invest clients in the firm’s proprietary mutual funds without properly disclosing this preference to clients. In addition, JPMS breached its fiduciary duty to certain wealthy clients when it did not inform them that they were being invested in a more expensive class of J.P. Morgan mutual funds shares than other available classes, or that JPMS preferred third-party-managed hedge funds that made certain “retrocession” payments to a J.P. Morgan affiliate.
The level of scrutiny applied in this case is striking. The SEC was initially focused on a possible charge that JPMS was improperly steering clients to house products so that it and its affiliates could make additional fees. JPMS’s Form ADVs, however, disclosed that JPMS “may have a conflict of interest in including affiliated [Mutual] Funds…because [JPMS] and/or its affiliates will receive additional compensation.” Further, in advance of opening an account, JPMS clients were specifically informed how much of their assets were to be allocated between proprietary mutual funds and third-party funds. Because of such disclosures, the SEC pivoted to the theory that there should have been an additional disclosure that JPMS “preferred” to invest client assets in proprietary products.
Holding the bank to this level of scrutiny seems severe; as noted, JPMS disclosed its incentive to put client money into house funds and these were discretionary accounts. Its “preference” for house funds seems axiomatic. All things considered, however, the penalty could have been far worse. Perhaps because of its cooperation and proactive remedial measures, J.P. Morgan was permitted to continue to provide these kinds of investment advisory services and was able to avoid the so-called automatic “bad actor” disqualification, which would have blocked it from the lucrative business of raising money for private companies, including hedge funds and startups. In addition, while the penalties and disgorgement are certainly significant, they amount to roughly one month of JPMS’s operating profits.
The Broker Compensation Case
In the second settlement, JPMS agreed to pay $4 million to resolve charges that it falsely stated on its private banking website and in marketing materials that individual advisors were compensated based on the performance of client investments, not on commission. As it turned out, advisor compensation was not tied to investment performance; it consisted of a salary plus a bonus determined by a number of factors, none of which were performance based. Although it appears that no investor was harmed, the SEC believed that sanctions were warranted: “JPMS misled customers into believing their brokers had skin in the game and were being compensated based upon the success of customer portfolios.”
Based upon recent developments, it is clear that the SEC intends to look under every rock to see if all conflicts of interest, regardless of their severity, have been disclosed. Accordingly, firms should take a close look at their business practices and make sure their Form ADVs, websites, marketing materials and other disclosure documents accurately reflect those business practices.
 http://www.sec.gov/litigation/admin/2015/33-9992.pdf. The $267 million consisted of penalties, disgorgement and interest.
 https://www.sec.gov/litigation/admin/2016/33-10001.pdf. JPMS neither admitted nor denied any wrongdoing.
The SEC has doled out over $50 million in awards to 15 individuals since it inaugurated the Dodd-Frank mandated whistleblower program 3 years ago. That program permits whistleblower awards of 10% to 30% of the total money recovered from a securities law violator provided the sanctions exceed $1 million. Whistleblower awards are usually restricted to individuals who provide original information derived from their independent knowledge or analyses. Failure to be deemed an “original” source of information is ordinarily the end of a whistleblower claim.
On March 2, 2015, however, the SEC approved an award of $475,000 to $575,000 to an unnamed executive who merely passed along original information. That award stemmed from a special carve-out designed to incentivize officers and directors to report out where the company fails to take corrective action. Specifically, an executive may be entitled to a whistleblower award if he or she reports information to the SEC 120 days after alerting upper management of the problem. Similarly, if upper management is already aware of the problem at the time the executive learns of it, the executive-whistleblower must wait 120 days before reporting to the SEC.
The rationale for the 120-day rule is two-fold. On the one hand, the SEC wants to protect companies that have robust compliance programs in place and a strong compliance tone from the top. After all, companies who invest in compliance programs and take potential violations seriously should be afforded a safe harbor whereby they are protected from individuals hoping to make a quick buck by passing information along before the 120-day period expires.
On the other hand, the SEC realizes that executives and directors are uniquely placed to take action when upper management will not remedy the problem. Executives regularly receive management and compliance reports and are often the first persons to whom an employee will turn to report an issue. The SEC wants to incentivize such executives to step forward when upper management refuses to take corrective action.
However, an executive considering becoming a whistleblower risks significant reputational and financial harm. Although the whistleblower process is anonymous, upper management at the company may be able to figure out who reported out and may take retaliatory action against that individual. Or, the individual may have already resigned due to irreconcilable differences with the company. In either case, there is no guarantee of a whistleblower award. Accordingly, executives and directors thinking about “reporting out” should carefully consider the quality of the information they possess and the potential financial and reputational risks.