SEC Update

Publication December 2019

2019 Report on FINRA Examination Findings and Observations

In October 2019, the Financial Industry Regulatory Authority (FINRA) released its 2019 Report on Examination Findings and Observations (2019 Report). The 2019 Report contains effective practices that may help firms improve compliance and risk management programs. Noteworthy findings include:

  • Digital communications
    • Firms are required to create and preserve originals of all correspondence related to “business as such,” pursuant to Exchange Rule 17a-3, Exchange Rule 17a-4, FINRA Rule 3110(b) (4) and FINRA Rule Series 4510.
    • The 2019 Report noted that some firms encountered challenges complying with supervision and recordkeeping requirements for various digital communication tools, technologies and services.
    • The 2019 Report also identified a number of practices implemented by firms that were effective in managing registered representatives’ use of digital channels. These practices included: (1) establishing comprehensive governance; (2) defining and controlling permissible digital channels; (3) managing video content; (4) training; and (5) disciplining misuse of digital communications.
  • Anti-money laundering
    • The Bank Secrecy Act (BSA) requires that firms monitor, detect and report suspicious activity to the US Treasury’s Financial Crimes Enforcement Network (FinCEN). FINRA Rule 3310 (Anti-Money Laundering (AML) Compliance Program) requires that members develop and implement a written AML program reasonably designed to comply with the requirements of the BSA and regulations promulgated thereunder. FINRA also notes that FinCEN’s Customer Due Diligence rule requires that firms identify beneficial owners of legal entity customers, understand the nature and purpose of customer accounts, conduct ongoing monitoring of customer accounts to identify and report suspicious transactions, and — on a risk basis — update customer information.
    • The 2019 Report identified a number of issues relating to firms’ AML programs. These included:
    • The failure to tailor transaction monitoring to the risks of the firm’s business or to adjust programs to take into account new sources of revenue/higherrisk customers with increased activity levels.
    • The failure to adequately monitor trading for suspicious activity reporting purposes, including inadequate delegation of such monitoring, e.g. to the securities trading desk.
    • The failure to adequately identify and investigate red flags associated with third-party wire transfers that were either out of the ordinary for the customer or appeared designed to deter verification of the transfer instruction.
    • Overreliance by introducing firms on their clearing firms for transaction monitoring and suspicious activity reporting with the result that the introducing broker failed to meet its obligation to monitor for suspicious activity attempted or conducted through the firm.
  • Observations on cybersecurity
    • The 2019 Report stated that cybersecurity attacks continued to increase in both number and level of sophistication.
    • While recognizing that there is no one-size-fits-all approach for all members, the 2019 Report highlighted a number of effective practices that firms have implemented to strengthen their cybersecurity risk-management programs, including: (1) branch controls; (2) documented policies on vendor and third-party management; (3) incident response planning; (4) data protection controls; (5) system patching; (6) access controls; (7) management of asset inventory; (8) data loss prevention controls; (9) training and awareness; and (10) change management processes.

SEC Proposes amendments to enhance retail investor protections

On September 26, 2019, the US Securities and Exchange Commission (SEC) voted to propose amendments to Exchange Act Rule 15c2-11 (the Rule), which sets out requirements with which a broker-dealer must comply before it can publish quotations for securities in the over-the-counter (OTC) market. The SEC characterizes the proposed amendments as designed to modernize the Rule and enhance investor protection by requiring that current and publicly available issuer information be accessible to investors before a broker-dealer can begin quoting that security.

Currently, the Rule requires that a broker-dealer review basic information about an issuer before quoting securities to investors in the OTC market. Once quoting begins, the Rule’s exceptions permit broker-dealers to continue to publish quotations notwithstanding that current information about the issuer is no longer available to the public or the broker-dealer. The SEC is concerned that today’s market participants can take advantage of these exceptions to disadvantage retail investors.

The proposed amendments would limit use of these exceptions where required issuer information is no longer current or available to the public. At the same time, the proposed amendments would add new quotation exceptions with respect to certain OTC securities where there is less concern regarding fraud and manipulation.

Highlights of proposed amendments

The proposed amendments would facilitate the availability of current issuer information by:

  • Mandating that documents and information that broker-dealers are required to obtain and review be current and publicly available.
  • Conditioning use of the piggyback exception, which allows brokerdealers to publish quotations for a security in reliance on the quotations of a broker-dealer who initially performed the required information review, on required issuer information being both current and publicly available.
  • Similarly, conditioning the unsolicited quotation exception, where used on behalf of company insiders, on required issuer information being both current and publicly available.

The proposed amendments would further limit the piggyback exception by:

  • Limiting the exception only to bid and ask quotations that are published at specified prices.
  • Eliminating the exception during the first 60 calendar days after the termination of an SEC trading suspension under Section 12(k) of the Securities Exchange Act of 1934.
  • Eliminating the exception for securities of “shell companies”.

At the same time, the proposed amendments would add new quotation exceptions for situations that raise less concern regarding fraud and manipulation. These new exceptions would apply:

  • To securities of well-capitalized issuers whose securities are actively traded.
  • Where the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular.
  • Where a regulated third party complies with the Rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception.
  • In reliance on publicly available determinations by regulated third parties that the requirements of certain exceptions have been met.

SEC fines rise to 30-year high

The SEC brought 526 enforcement actions in the past fiscal year, which ended September 30, 2019. According to SEC data, the tally was lifted by 95 cases against investment advisers for inadequately disclosing their practice of selling more expensive funds to retail clients.

The SEC’s civil caseload produced monetary sanctions totaling US$4.3 billion, the highest tally in nominal dollars since at least 1987, according to data from Georgetown University law professor Urska Velikonja. A higher share of the SEC’s largest cases in 2019 were against private companies or individual defendants, according to Ms. Velikonja, whose research focuses on SEC enforcement. The total shows the SEC’s focus on protecting less sophisticated traders, as opposed Global asset management quarterly to scouring for bigger cases where institutional or wealthy investors were defrauded, can still yield big fines.

It isn’t known how much of that money will be collected. Among the 10 largest fines this year, 55 percent of the total sanctions came from cases in which individuals and “shell companies” are responsible for paying the judgments. According to agency data, the SEC collects about 57 percent of its enforcement sanctions, but has created a dedicated unit to go after scofflaws skipping out on fines. The SEC levied fines totaling US$12.1 billion during the past three years under the Trump administration, compared with US$12.4 billion from 2014 through 2016.

The largest fine obtained last year, US$892 million, stemmed from the SEC’s lawsuit against the defunct Woodbridge Group of Companies LLC, which authorities say fleeced 8,400 people through sham realestate investments. The SEC also obtained a US$100 million fine against Woodbridge owner Robert Shapiro, who was sentenced to 25 years in prison in a parallel criminal case.

The number of new SEC investigations has been falling. The SEC opened 869 enforcement investigations in 2018, compared with 965 in 2017 and 1,063 during 2016, according to agency budget reports. “That is a reflection of trying to be judicious in what we are opening, and that is a reflection that we are operating with reduced resources and we are trying to be smarter,” said Steven Peikin, co-director of the SEC’s enforcement division.

The SEC in 2019 returned to using industry-wide enforcement campaigns to target entrenched misconduct. More than 90 investment advisers who steered clients into higher-fee mutual funds without adequately disclosing their practice were required to repay US$135 million to customers. The companies included Wells Fargo & Co. and Raymond James Financial Services Advisors Inc. In some cases, the misconduct occurred more than four years ago. The SEC says last year’s investment-adviser cases were different because the regulator’s work earned money back for investors and saved them from paying extra fees in the future.

Separately, the Commodity Futures Trading Commission (CFTC), the regulator of US derivatives markets, claimed enforcement sanctions last year of US$1.3 billion, the highest level since 2015. The agency’s total heavily depended on a single lawsuit that obtained US$978 million in restitution for investors. The CFTC filed the suit in 2009 against brokerage firm WG Trading Co., and its executives, for stealing hundreds of millions of dollars in client assets. The executives, Paul Greenwood and Stephen Walsh, went to prison after pleading guilty. The agency filed 69 new cases, consistent with its annual average over the past five years. The CFTC’s enforcement output this year included 12 cases against futures traders at banks, such as JPMorgan Chase & Co., accused of spoofing, a type of market manipulation.

CFTC commissioners raise concerns over agency’s interpretation of SEC rules in record spoofing settlement

On November 7, 2019, the US CFTC settled charges against proprietary trading firm Tower Research Capital (Tower) regarding nearly two years of spoofing in equity index futures. The settlement included penalties of US$67.4 million, the largest total monetary relief levied in a spoofing case. Tower also entered into a simultaneous resolution with the Justice Department to settle criminal charges. Spoofing is a form of market manipulation in the commodity markets in which the trader bids or places orders with no intent of executing them. Later they are cancelled. The practice can distort the pricing in the markets and cause injury to other traders who are deceived. The Dodd-Frank Act, in view of this, gave the CFTC additional enforcement authority in this area.

In a dissent, Commissioner Dan Berkovitz agreed with the basic findings of the case but questioned the CFTC’s decision to grant Tower a waiver from “bad actor” disqualification under rules of the US SEC. “The CFTC has neither the legal authority nor the expertise” to make such a determination regarding the securities markets,” Berkovitz said. “These matters are the core responsibility of the SEC, not the CFTC.” Commissioner Rostin Behnam concurred with the judgment against Tower, but he offered similar criticism and “extreme reservations” about the disqualification in a statement of his own.

The Tower case is the latest in a string of enforcement actions regarding spoofing. It is also evidence of recently appointed CFTC Chairman Heath Tarbert’s commitment to “be tough on those who break the rules,” as he said in a statement announcing the settlement.

Seventeen additional advisers charged with recommending higher cost fund share classes

The SEC ordered the payment of over US$125 million in disgorgement and interest against 79 investment advisers who self-reported that they recommended share classes that paid back 12b-1 fees when lower-cost share classes were available. Combined with the group of settlements back in March, the SEC has brought 95 total cases and Global asset management quarterly ordered over US$135 million returned to investors pursuant to its Share Class Selection Disclosure Initiative. The largest restitution order of the most recent 16 cases exceeded US$2.9 million. The SEC also settled an action against a firm that did not self-report, resulting in a US$300,000 fine, in addition to ordering over US$900,000 in restitution. The cases allege that the firms did not sufficiently disclose the conflict of interest arising by recommending a share class that paid back revenue sharing to the adviser, its affiliates, or their personnel.

SEC proposes expedited exemptive reviews for registered funds

The SEC has proposed a new rule for the expedited review of exemptive applications under the Investment Company Act of 1940. Under the proposal, an applicant could request expedited review if the application is substantially identical to two other applications granted within the prior two years. If the staff agrees that expedited review is permitted, the staff will issue the notice within 45 days of filing. Additionally, the SEC has proposed a rule requiring that the staff take some action (e.g. providing comments) within 90 days of filing any exemptive application. The SEC acknowledges that lengthy reviews delay transactions, prevent firms from rapidly adapting to changing market conditions and slow product development. The 30-day comment period for this proposed rule ends November 17, 2019.

New York State expands Securities Enforcement Statute

New York Governor Andrew Cuomo signed a law that reinstates the 6-year statute of limitations for the Martin Act, a statute that prohibits deceptive practices in securities transactions. A recent court case, seemingly counter to prior precedent, had limited the statute to three years. The New York State Attorney General Letitia James stressed the importance of the Martin Act because “the federal government continues to abdicate its role of protecting investors and consumers.” Governor Cuomo explained that New York State is “enhancing one of the state’s most powerful tools to prosecute financial fraud so we can hold more bad actors accountable, protect investors and achieve a fairer New York for all.”

Depending upon circumstances, choice of law decisions may be affected by the advantages and disadvantages of a longer or shorter statute of limitations. The New York statute of limitations is 6 years, whereas the state of limitations for the Securities Act of 1933 is 3 years, and the statute of limitations for the Securities Exchange Act of 1934 is 2 years after the fraud has been discovered, and not more than 5 years after the fraud has occurred.

Clayton scolds foreign securities regulators

Jay Clayton, Chairman of the US SEC, criticized foreign securities regulators around the world for inconsistent and ineffective enforcement of anti-bribery laws. Clayton fears that a two-tier system is in place that adversely affects the US’s diligent adherence to antibribery laws and improperly rewards countries that do not enforce antibribery laws. Only 23 of 44 countries that agreed to make corruption of public officials a crime have concluded an enforcement action.

Clayton also said market regulators are examining the growth of corporate debt and how investors are managing the associated risk. More than a decade of low interest rates have encouraged companies to issue more debt, while investors looking for better returns have pushed into riskier bank loans and lower-rated bonds that pay higher returns. Clayton surmised that regulators would have to examine the effects of this leverage as bond prices continue to rise, fueled by concerns of an economic slowdown.

Chief compliance officer, a former SEC staffer, indicted for stealing confidential investigation information

The US Attorney for the Eastern District of New York has indicted the former Chief Compliance Officer of a private equity firm for obstructing justice and illegally accessing confidential government information. According to the indictment and press accounts, the defendant misused his position and access as an SEC employee to obtain information about a pending investigation of the private equity firm while negotiating his new position. The firm itself is being investigated for sales practice violations. The defendant faces more than 20 years in prison.

10 2017 PCAOB inspection reports summary

2017 global network firms inspections overview

The Public Company Accounting Oversight Board (PCAOB) recently released the public portion of the 2017 inspection reports with respect to the US affiliate of all six global network accounting firms. The table below summarizes the results of the 2017 inspections of these firms. For comparison, a similar table showing results of the 2016 inspections follows

2017 Inspections of US Affiliates of global networks (Reports publicly available in 2019)
Firm Report Date Engagements Inspected Deficiencies Percentage
Deloitte & Touche December 20, 2018 55 55 20%
Ernst & Young September 12, 2019 55 17 31%
KPMG January 24, 2019 52 26 50%
PwC February 28, 2019 55 13 24%
2017 Big Four Subtotals 217 67
2017 Big Four Average 54 17 31%
BDO June 20, 2019 23 9 39%
Grant Thorton March 21, 2019 34 6 18%
2017 Global Firm Totals 274 82
2017 Global Network Firm Average 46 14 30%

2016 Inspections of US Affiliates of global networks (Reports publicly available in 2017/18)
Firm Report Date Engagements Inspected Deficiencies Percentage
Deloitte & Touche November 28, 2017 55 13 24%
Ernst & Young December 19, 2017 55 15 27%
KPMG January 15, 2019 51 22 43%
PwC December 17, 2019 56 11 20%
2017 Big Four Subtotals 217 61
2017 Big Four Average 54 15 28%
BDO July 12, 2018 24 16 75%
Grant Thorton December 19, 2017 34 8 24%
2017 Global Firm Totals 275 85
2017 Global Network Firm Average 46 14 30%

The PCAOB found an increase in deficiencies from the 2016 to 2017 inspections, from 61 to 67, among the Big Four. In several cases, the PCAOB found that firms had not obtained sufficient appropriate audit evidence to support its opinion.

SEC allows testing of distributed ledger system for securities settlement

The SEC’s Division of Trading and Markets has provided limited period no-action relief to beta test a service that will allow securities clearance using a distributed ledger system. The 24-month relief would allow the applicant to operate a securities settlement service whereby securities and cash would be represented by digitized securities entitlements that would be exchanged in accordance with the underlying securities transactions. Without no-action relief, the applicant would have to register as a clearing agency. The SEC is allowing limited testing of the system without registration, so long as the applicant follows strict guidelines that limit use of the system and volume.

SEC proposes new investment adviser advertising rule

The SEC has proposed a new investment adviser advertising rule that broadens the definition of “advertising,” more specifically regulating performance information, and allowing certain testimonials and endorsements. Revised Rule 206(4)-1 would broadly include any communication, distributed by any means, that promotes advisory services or a pooled fund and prohibits any misleading or unsubstantiated statements. The new rule would require all retail-directed advertisements to include one, five and ten-year periods when presenting investment performance information. Advisers would be able to use testimonials so long as the adviser fully discloses whether the person is a client and whether compensation has been provided to that person. The new rule would require approval, in writing, by a designated employee, before dissemination. The SEC said it may rescind current no-action letters. The SEC proposed a new solicitation rule that would require additional disclosure about the solicitor, but eliminate the current rule’s requirement to collect client acknowledgements. Both rules require at least a 60-day comment period ending on December 3, 2019.

ILPA publishes Model Limited Partnership Agreement for the first time for private equity funds

On October 30, 2019, the Institutional Limited Partners Association (ILPA) released the first publicly available Model Limited Partnership Agreement (LPA) for the private equity industry. The legal template, which is available for complimentary, industry-wide use, conforms to ILPA Principles 3.0 and sets a new standard for alignment of interests between general (GP) and limited partners (LP). The Model LPA also addresses a persistent and shared need of GPs and LPs to reduce the complexity, cost and resources required to negotiate the terms of investment in private equity funds. “The industry has to date lacked freely accessible model documents that can serve as a baseline for reasonable legal terms and conditions associated with private equity funds,” said Steve Nelson, CEO, ILPA. “Consequently, the hundreds of LPAs developed each year are the product of bespoke efforts and one-off negotiations that come with excessive cost to both GPs and LPs. We encourage all industry stakeholders to review the ILPA Model LPA and use it as a basis for a more effective process, with the confidence that the provisions therein are supported by the LP community.” The model LPA is available on the ILPA website at no cost.

SEC finds pervasive regulatory failures by registered funds and boards

The SEC’s Office of Compliance Inspections and Examinations (OCIE) warned the registered fund industry about rampant regulatory violations involving compliance programs, disclosure, advisory contract approvals, and Codes of Ethics. In a recent Risk Alert detailing common deficiencies and weaknesses, based on 300 examinations over the last two years, OCIE chided the industry for weak compliance programs, including:

  • Policies and procedures that failed to prevent violations of investment guidelines or to ensure fulsome disclosure in fund marketing materials.
  • Breakdowns in providing the Board with adequate fair valuation information and broker quotes.
  • Weak service provider and subadviser oversight.
  • Inadequate annual reviews.

OCIE also criticized the information used to approve advisory contracts and shareholder disclosure in offering documents. OCIE warned that funds need to enhance their Codes of Ethics including reporting and how to define “access persons.”

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