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Regulatory Update June 2017

  • DOL Fiduciary Rule Effective June 9, 2017: The June 9, 2017 deadline imposed by the Department of Labor’s (DOL) Fiduciary Rule is coming up fast. Just to recap, back in April, the DOL issued a regulation delaying the applicability date of the Fiduciary Rule until June 9, 2017.  The applicability date of all of the new and amended prohibited transaction exemptions, including the Best Interest Contract Exemption (“BICE”) was also extended until June 9, 2017.  But the DOL also has significantly reduced the compliance burdens during the transition period (from June 9, 2017 to January 1, 2018).  Financial institutions that want to rely on the prohibited transaction exemptions cited in the Fiduciary Rule now no longer will have to provide transition disclosures, appoint a BICE officer, or create transition agreements, but they will have to comply with the Impartial Conduct Standards.  See our blog post for more details and our Rollover IRA Checklist and disclosures.  In a move that provides some comfort to financial institutions, the DOL released a non-enforcement policy during the phased implementation period ending on January 1, 2018.  This policy provides that the DOL will not go after fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions.  The DOL also issued a new set of FAQs for the transition period. 
  • National Outreach for Broker-Dealers: On July 27, 2017, SEC’s Office of Compliance Inspections and Examinations (OCIE), in coordination with the SEC’s Division of Trading and Markets and FINRA, will host the 2017 National Compliance Outreach Program for Broker-Dealers.  The program will be held at the SEC’s Washington D.C. headquarters from 10:30 a.m. to 4:45 p.m.  Topics of discussion will be cybersecurity and investing by seniors, as well as other regulatory topics, with a focus on current compliance practices.  The event is free, but limited to the first 500 individuals who register, with a limit of 10 attendees per firm.  The event will also be broadcast live on the SEC’s website.  Registration information can be found here.  Registration is apparently closed as of June 2, 2017, but interested parties can apply for the waitlist, or watch the webcast.
  • WannaCry Alert: The SEC Office of Compliance Inspections and Examinations (OCIE) has taken advantage of the recent world-wide ransomware attack known as WannaCry to remind investment advisers and broker-dealers to beef up their cybersecurity preparedness.  OCIE issued a National Exam Program Risk Alert on May 17, 2017, Cybersecurity:  Ransomware Alert as a not-so-subtle reminder of the importance of conducting penetration tests and vulnerability scans on critical systems and implementing system upgrades.
  • FINRA Provides Further Guidance on Social Media and Business Communications: FINRA issued Regulatory Notice 17-18, which compliments previously issued Regulatory Notices 10-06 and 11-39, by providing additional guidance on the application of FINRA Rule 2210 Communications with the Public) to social media and digital communications.  In its Notice, FINRA reiterated past guidance related to recordkeeping, third-party posts, and hyperlinks to third-party sites and provided new insight in the way of 12 Q&As addressing: text messaging, personal communications, hyperlinks, sharing, testimonials, and endorsements.  For more details, please see our blog post.
  •  Form ADV Updates: Get Ready!  Advisers will have additional reporting requirements in light of the amendments to the Form ADV Part 1A that were recently adopted by the SEC. Amendments include: additional reporting requirements for separately managed accounts; changes to the umbrella registration option; and additional disclosures and clarifications. Initial and amended ADVs have a compliance date of October 1, 2017, while all advisers’ March 2018 annual filings are expected to comply with the new rules. Please see our latest blog post for more details.

 Lessons Learned From Recent SEC Cases:

BD to Pay $28 Million despite FINRA Safe Harbor- Say What?  Barclays Capital Inc. (a broker-dealer subsidiary of Barclays PLC) agreed to settle with the SEC on charges that it failed to reasonably supervise its traders to prevent violations of antifraud provisions of the federal securities laws. Two traders who bought and sold non-agency residential mortgage backed securities were charging customers undisclosed excessive mark-ups on intra-day trades. The traders’ were misrepresenting the bid and offer prices to widen the spreads on the trades, inflating the mark-ups.  In one instance, the mark-up was more than 20%.

So how did these excessive mark-ups get overlooked?  First, there was no supervision of communications with clients to pick up on the false and misleading statements.  Second, the electronic monitoring system used to detect excessive mark-ups failed, resulting in inadequate review of trading activity.   Barclays Capital argued that FINRA policy provides that mark-ups or mark-downs of no more than 5% are generally fair, but this policy did not apply to “Qualified Institutional Buyers” (QIBs) buying and selling non-investment grade debt.  Since the clients were QIBS, Barclays argued, the firm was free to charge mark-ups of greater than the 5% guidance.  The SEC pointed out, however, that just because the firm was dealing with QIBs did not mean that Barclays Capital had free reign to charge them excessive mark-ups.  No matter what the FINRA guidance said, the anti-fraud provisions of securities law still applies, prohibiting unreasonable mark-ups.

Another red flag should have gone up when reviewing the trading desk’s profit and loss statements.  Given the outsized profits being earned, sales, supervision and/or finance should have brought in compliance to question how the traders were achieving such success.  In addition to Barclay’s penalties, the two traders received a 12-month suspension and personal fines of $125,000 and $200,000 respectively, not to mention an ugly U5 disclosure history.

Don’t Make Promises You Can’t Keep:  As the saying goes, you are what you do; not what you say you’ll do.  The SEC appears to agree and Barclays Capital Inc., is paying the price – to the tune of $97 million – for what they said they’d do – and didn’t.  The SEC charged Barclays Capital with overcharging clients by close to $50 million in advisory fees and mutual fund sales charges. The heftiest of the fines stemmed from misrepresentation by Barclays Capital that the firm was performing due diligence and monitoring of certain third-party managers and strategies associated with two of their investment advisory wrap fee programs.

Barclays Capital’s registered investment advisory division promised in its Form ADV Part 2A and client contracts that the firm would perform initial and ongoing due diligence on third-party managers.  At the end of the day, however, the Barclays Capital group responsible for this ongoing due diligence and monitoring simply didn’t do it, claiming they were underfunded and understaffed.

The SEC also found that Barclay’s Capital incorrectly calculated fees for advisory clients over a four year period, due to a combination of human error and a change in the calculation method.  Additional charges against Barclays Capital included purchasing more expensive mutual fund share classes for client accounts when lower-fee classes were available. The $97 million fine is made up of roughly $50 million in disgorgement fees, $14 million in prejudgment interest, $30 million in penalties, and $3 million in underperformance and excessive sales charges and 12b-1 fees.

The bottom line: if a firm claims to be doing something – especially in return for a fee – there should be policies and procedures in place to ensure it’s getting done AND getting done accurately.

Two Mutual Fund Firms Fined for “Distribution-In-Guise”:  In enforcement cases arising from the SEC’s four-year old distribution sweep exam program, two mutual fund advisers were found to have improperly used mutual fund assets.  What does “distribution in guise” mean?  Mutual funds can pay other financial intermediaries to help distribute their funds, but they must follow certain rules, including following a Rule 12b-1 plan, that requires oversight by the mutual fund board.   The intermediaries that distribute the mutual funds may also provide a range of recordkeeping and other services for individual customer accounts, i.e., non-distribution services.  As a result of its sweep, the Staff has been scrutinizing whether fees paid out of fund assets that were earmarked for non-distribution services were actually used for distribution-related activity, a practice the staff termed “distribution in guise.”  See IM Guidance Update on this issue.

In these two cases, Calvert Investment Distributors, Inc. and Calvert Investment Management, Inc. (Calvert), and William Blair & Company, the findings were similar.  In making payments for various services to financial intermediaries, there were inaccurate characterizations of payments (using fund assets to pay for distribution instead of sub-TA costs), resulting in a violation of Rule 12b-1 of the Investment Company Act, failures by the advisers to reimburse the mutual funds when expense caps were exceeded, and miscalculations of certain fees.  Because of these errors, shareholders of the mutual funds ended up paying for, or paying more for, certain services.

In both cases, the SEC apparently gave some credit to the investment advisers for their self-reporting, cooperation and prompt remediation.   Nonetheless, the SEC required Calvert to pay more than $22.6 million in disgorgement, prejudgment interest and civil penalties.   William Blair & Company paid about $4.5 million in penalties.

Worth Reading:

Filing Deadlines and To Do List for June

No filings deadlines for June.


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