Articles Posted in Compliance

Last month the Securities and Exchange Commission (SEC) instituted and simultaneously settled an administrative enforcement case in which a civil penalty of $225,000.00 was assessed against Cambridge Investment Research Advisors, Inc. (Cambridge).  The action illustrates the importance of designing and implementing effective heightened supervision programs for investment adviser representatives who have a history of allegations of rules violations or other misconduct or disclosure items on the Form U-4.

The case stemmed from an incident that was the subject of a separate SEC proceeding filed in 2013 against Richard P. Sandru, who was an investment adviser representative operating from Cambridge’s Perrysburg, Ohio branch office.  In that proceeding, Sandru was found to have forged clients’ signatures on financial planning agreements or, in some cases, adding client charges to the agreements without the clients’ knowledge and without obtaining additional signatures from the clients authorizing the additional charges.  Sandru’s conduct, which the SEC characterized as a fraudulent scheme to misappropriate client funds, took place between 2009 and 2011 and potentially affected 47 advisory clients, from whom Sandru allegedly misappropriated “at least $308,850.00.”  Sandru was, at this time, an OSJ of Cambridge and supervised two other Cambridge representatives and other administrative assistants.

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The Financial Industry Regulatory Authority (“FINRA”) recently released guidance on effective practices for financial services firms that provide digital investment advice services. While the report analyzed rules of the securities industry that relate to such services, it discusses effective practices that “may be valuable to financial professionals generally,” including registered investment advisers.  With the increasing use of digital investment advice tools in the financial services industry, FINRA undertook to review a broad range of these tools to ensure broker dealers as well as investment advisers are complying with their legal obligations.

The digital investment advice tools FINRA is referring to include both financial professional-facing tools and client-facing tools. These tools typically perform the necessary functions involved in managing an investor’s portfolio, including customer profile development, asset allocation, portfolio selection, trade execution, portfolio rebalancing, and tax-loss harvesting. Client-facing tools which perform these functions are commonly known as “robo advisors.” Financial professional-facing tools usually include portfolio analysis capabilities in addition to those listed functions.

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A compliance advisor working for City Securities Corporation (“City Securities”) has agreed to a Letter of Acceptance, Waiver and Consent (AWC) in a FINRA enforcement case alleging deficiencies in the way the advisor performed his compliance duties at the broker-dealer.  John Walter Ruggles, who first became registered in 1993 and became associated with City Securities in May 2014, was charged with failing to generate monthly Municipal Continuing Disclosure Reports (MCDs), which are required in order to comply with the Municipal Securities Rule Making Board’s (MSRB) disclosure requirements.  More specifically, among Ruggles’ tasks were to populate the MCDs with transaction data on behalf of City Securities’ customers and to email the data to the private client group, who would then routinely use the information contained in Ruggles’ emails to prepare customer satisfaction letters to City Securities’ clients regarding recent municipal bond trading activity.

The AWC alleges that Ruggles’ supervisor confronted Ruggles with the fact that he had not received the MCDs due for February 2015, and asked Ruggles to produce documentation showing that Ruggles had performed the tasks going back to June 2014.  Ruggles provided six printed emails to his supervisor in response to the supervisor’s request.  Those emails contain the trade details that were supposed to have been included in the MCDs.  The supervisor, however, attempted to verify the data contained in Ruggles’ printed emails, but in investigating the situation found (1) that City Securities’ email backup files did not contain any of the emails that Ruggles provided, (2) that several of the execution dates referenced on the bond trades in the emails were different from the actual execution dates as reflected in the transaction data, (3) that for a period of approximately five months, the firm’s compliance system showed that Ruggles had not opened and viewed the MCDs from which he was supposed to have taken the data, and (4) that the falsified emails contained erroneous dates in the subject lines.

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The Department of Labor (“DOL”) released the final version of its new fiduciary rule on Wednesday April 6, ending months of widespread speculation and apprehension in the financial services industry. The DOL appears to have heard the thousands of public comments asking for more clarification and simplification, particularly as related to the Best Interests Contract (“BIC”) exemption. The final rule contains some notable deviations from the proposed rule.

As we discussed in an earlier blog post, the former definition of fiduciary for providing investment advice to a covered employee benefit plan under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986 (“Code”) stated that financial advisers were generally only fiduciaries if such investment advice was given on a regular basis and pursuant to a mutual understanding that the advice would serve as the primary basis for investment decisions and would be individualized to the particular needs of the plan. This definition typically encompassed only financial advisers in established and ongoing relationships with their clients, such as investment advisers who provided investment advice to covered plans. Meanwhile, broker-dealers and insurance agents were generally excluded, and broker-dealers were only held to the same suitability standard for retirement plans that applies to their recommendations made to non-retirement plans.

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The Consumer Financial Protection Bureau (“CFPB”) recently instituted a cybersecurity enforcement action against an online payment platform, Dwolla, Inc., in the form of a consent order. This consent order is significant because it is the first time the CFPB has sought to institute an enforcement action in the cybersecurity arena after it was given the authority to do so under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), highlighting the increasing emphasis being placed by financial regulators on cybersecurity practices. The Securities and Exchange Commission (“SEC”), Financial Industry Regulatory Authority (“FINRA”), and the Federal Trade Commission (“FTC”), among others, have all been quite active in policing data security practices of financial institutions in recent years. The SEC even listed cybersecurity control procedures of registered broker-dealers and investment advisers as one of its examination priorities for 2016.

The Dodd-Frank Act gives CFPB supervisory authority over providers of consumer financial products or services. It also authorizes CFPB to take enforcement action to prevent unfair, deceptive or abusive acts or practices from these providers. In this case, Dwolla allegedly made several exaggerated claims regarding the strength of its data security practices that the CFPB found to be deceptive within the meaning of the Dodd-Frank Act.

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The Securities and Exchange Commission (“SEC”) recently brought an administrative proceeding against unregistered fund manager Steven Zoernack and his firm, EquityStar Capital Management, LLC (“EquityStar”), for engaging in allegedly fraudulent conduct in violation of federal securities and investment adviser laws. Mr. Zoernack and EquityStar allegedly concealed Mr. Zoernack’s criminal history, used false identities, and distributed false and misleading marketing materials, among other things, in their bid to lure investors.

As alleged, Mr. Zoernack created EquityStar in May of 2010 to serve as the investment adviser for two private investment funds, Global Partners and Momentum. Between 2011 and 2014 Mr. Zoernack actively sought investors for the two funds, managing to sell approximately $5.6 million of interests in Global Partners and Momentum. As EquityStar’s managing member and sole employee, he handled all activities of the firm and drafted all marketing and offering materials. In the furtherance of these activities, Mr. Zoernack allegedly made many material misrepresentations to investors and prospective investors regarding himself and EquityStar.

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As the Department of Labor’s (“DOL’s”) proposed fiduciary rule awaits final adoption, market participants are starting to predict how it will affect retirement investment advice given that financial advisers such as broker-dealers, investment advisers, insurance companies, and other financial institutions, as well as their representatives, may soon be subjected to heightened fiduciary standards. Specifically, the sale of annuity products is predicted to face a large amount of change given its commission-based nature.

Currently, under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986 (“Code”), financial advisers are generally only fiduciaries if they provide investment advice or recommendations for compensation to employee benefit plans or participants and such advice is given on a regular basis and pursuant to a mutual understanding that the advice will serve as the primary basis for investment decisions and will be individualized to the particular needs of the plan. While investment advisers already have fiduciary duties under the Investment Advisers Act of 1940, the current narrow definition of fiduciary under ERISA and the Code generally does not encompass broker-dealers.

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The Financial Industry Regulatory Authority (“FINRA”) recently filed its revised pay-to-play rules proposal with the Securities Exchange Commission (“SEC”). Investment advisers have been awaiting FINRA’s pay-to-play rules ever since the SEC announced last year that it would not recommend enforcement action against an investment adviser or its associated persons for the payment to a third party for the solicitation of a government entity for investment advisory services until either FINRA or the Municipal Securities Rulemaking Board (“MSRB”) had adopted its own pay-to-pay rules for broker-dealers.

Pay-to-play activities involve the practice of making cash or in kind contributions, or soliciting others to make those contributions, to state or local officials or other government entities as an incentive for the receipt of government contracts. Pursuant to Rule 206(4)-5, investment advisers are prohibited from providing a government entity with investment advisory services for compensation within two years of contributing monetarily to that government entity. In addition, and of particular interest here, under Rule 206(4)-5 investment advisers may not provide payment to any third party to solicit a government entity for investment advisory services on behalf of the investment adviser unless that third party is a registered investment adviser, a registered broker-dealer, or a registered municipal adviser.

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The Office of Compliance Inspections and Examinations (“OCIE”) of the Securities Exchange Commission (“SEC”) recently released its Examination Priorities for 2016. These examination priorities provide valuable insight into what OCIE perceives to be the greatest risk to investors and what it will be focusing its efforts on throughout the year. This year its overall goals stayed approximately the same as last year: 1) protecting investors saving for retirement; 2) assessing market-wide risks; and 3) using data analytics to identify and examine illegal activity.

In regards to its goal of protecting investors saving for retirement, OCIE intends to continue its Retirement-Targeted Industry Reviews and Examinations (“ReTIRE”) initiative which focuses on the suitability of investment recommendations made to investors, supervision and compliance procedures, conflicts of interest, and marketing practices. It will also continue to review the supervision procedures of branch offices of SEC-registered entities and fee selections which can lead to reverse churning. New areas of focus include exchange-traded funds (“ETFs”) which OCIE intends to examine for compliance with various regulatory requirements. It will focus on sales strategies, trading practices, disclosures, excessive portfolio concentration, and suitability, and will pay particularly close attention to niche or leveraged/inverse ETFs. In addition, variable annuities have become a large part of many investors’ retirement plans and OCIE intends to assess the suitability of these sales as well as the adequacy of disclosures. Lastly, OCIE will examine public pension advisers to ensure these advisers are not engaging in any pay-to-play activities or giving undisclosed gifts in return for appointments or other favors.

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The Securities and Exchange Commission (“SEC”) recently published guidance on the characterization of mutual fund fees, specifically 12b-1 distribution fees and sub-accounting fees, as part of their ongoing Distribution-in-Guise Initiative. Pursuant to Rule 12b-1 under the Investment Company Act of 1940, payments made by mutual funds (“funds”), to financial intermediaries from fund assets for the distribution of fund shares must be paid pursuant to a Rule 12b-1 plan that has been approved and adopted by the fund’s shareholders and Board of Directors (“Board”). In recent years the SEC has noticed that there are various fees being paid to intermediaries, in addition to distribution fees, that are being characterized as non-distribution-related fees and are not being paid pursuant to a Rule 12b-1 plan. Those fees include sub-transfer agent fees, administrative sub-accounting fees, and other shareholder servicing fees (collectively “sub-accounting fees”).

While these sub-accounting fees may in some cases be valid non-distribution-related fees, if they directly or indirectly compensate at all for any distribution-related activities, they are improperly labeled. Because of the importance of this issue given that fund fees directly impact investor returns and inherently involve conflicts of interest, the SEC has published guidance to assist funds in ensuring that distribution-related fees are being properly labeled and disclosed in a Rule 12b-1 plan as required. This potential problem was brought to the SEC’s attention after a recent sweep examination of various market participants including mutual funds, investment advisers, transfer agents, and broker-dealers.

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