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SEC and FINRA Struggle with Digital Assets; Reg BI Disclosure Duties Explained; RIA’s Fail when Hiring Advisors with Black Marks; and Firms Pay the Price for Employees’ Greed: Regulatory Update for August 2019

For Broker-Dealers and Investment Advisers:

Yes, Digital Assets are Securities, but no, We’re Not Ready to Let You Deal in Them Yet. The SEC and FINRA issued a Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities on July 8.  On the plus side, the regulators demonstrated that they are tackling issues raised by new types of securities by seeking industry input.  On the minus side, the regulators failed to give any indication when broker-dealers will be approved to deal in digital assets. The central message from the joint statement is that digital assets are securities and are subject to the federal securities laws.  Consequently, anyone dealing in digital asset securities may need to be registered as a broker-dealer with the SEC and comply with FINRA rules.  The biggest hurdles identified by the regulators are compliance with (i) the Customer Protection Rule and (ii) the record-keeping and record retention rules under the Securities Exchange Act of 1934.  In typical regulatory fashion, FINRA and the SEC provided no guidance on how these hurdles might be cleared. 

The SEC and FINRA discussed three digital asset business models that would cause them less agita since they do not involve custody of digital asset securities.  All three examples involve situations where the broker-dealer acts as agent to facilitate transactions between buyers and sellers by providing matching services, providing instructions and where the buyers and sellers complete the transaction directly.  This may be an indication that the regulators are more inclined to approve applications involving these types of activities first before they can move onto the more complicated business models involving custody.  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

Regulation BI – Dissecting the Disclosure Obligation. Securities and Exchange Act Rule 17 CFR 240.15l-1 (“Regulation Best Interest” or “Reg BI”) establishes a new standard of conduct for broker-dealer firms and their representatives (“Broker-Dealers”) when they recommend a securities transaction or an investment strategy involving securities to a retail customer.  Reg BI will require Broker-Dealers to “act in the best interest of the retail investor at the time a recommendation is made, without placing the financial or other interests of the Broker-Dealer ahead of the interests of the retail customer.”  This is known as the General Best Interest Obligation (“General Obligation”).

To satisfy the General Obligation, a Broker-Dealer must comply with four component obligations: (1) Disclosure; (2) Care; (3) Conflict of Interest; and (4) Compliance.  In this edition of Compliance Informer®, we are analyzing the Disclosure Obligation (see pages 130-245 of the Final Rule).

In our July Regulatory Update, we highlighted the need to identify and document conflicts of interest associated with compensation programs as well as each product, service, and strategy offered to retail customers.  For each conflict identified, firms should determine what material facts should be disclosed to retail customers and the best method(s) of disclosure.

While Form CRS (to be covered in a future edition of Compliance Informer®) will be instrumental in communicating conflicts and certain aspects of Broker-Dealer client relationships, it will only be the initial layer of disclosure and will NOT satisfy all of the firm’s disclosure obligations.  Firms will still need to provide detailed disclosures applicable to a specific client or transaction (e.g., a written contract for the periodic or ongoing review of customer accounts for recommending changes in investments) using other existing or stand-alone documents (e.g., account application, customer relationship agreement, trade confirmation, and verbal disclosures).

Before, or at the time of, the recommendation, a Broker-Dealer is required to provide retail customers with full and fair written disclosure of all material facts related to the scope and terms of the relationship with the customer and conflicts of interest associated with the recommendation.  At a minimum, a Broker-Dealer must specifically disclose:

  • Firm capacity – State that the firm or natural person is acting as a Broker-Dealer or an associated person of a broker-dealer with respect to the recommendation. Disclose whether the Broker-Dealer is acting as agent or principal.  In cases where the firm or associated person is dually registered as a broker-dealer and investment adviser or when an associated person is only registered as a broker-dealer at a dually registered firm, additional clarifying disclosures will be required.
  • Material fees and costs that apply to the transactions, holdings, and accounts – Firms must disclose why the fee is being charged and when it will be assessed.
  • Type and scope of services – At a minimum, the Broker-Dealer must disclose whether account monitoring services will be provided (and if so, the scope and frequency of those services), minimum account balance requirements, and any material limitations on recommendations (e.g., proprietary products only or limited representative registration).
  • Investment philosophy/strategy.
  • General risks associated with the Broker-Dealer’s recommendations.

The Disclosure Obligation applies to both the broker-dealer firm and its associated persons.  When an associated person knows, or should have known, that a firm disclosure does not include all material facts, the associated person is responsible for supplementing that disclosure (e.g., limitations on the scope of products/services due to licensing restrictions or deficiencies).  The initial disclosure should also include information on how amendments or updates to the disclosure will be communicated (when and how).  Whether a Broker-Dealer has acted in the retail customer’s best interest will be determined based on the facts and circumstances of a particular recommendation at the time it is made.

Use of the title “Advisor” or “Adviser” by a broker-dealer or associated person of a Broker-Dealer that is not registered as an investment adviser is a violation of the Disclosure Obligation of Reg BI.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant.

Commonwealth of Massachusetts Proposes Fiduciary Standard. It should be no surprise that the states have started to impose their own definition of the fiduciary standard of conduct.  The latest proposal comes from the Massachusetts Securities Division (the “Division”) of the Office of the Secretary of the Commonwealth.  On June 14th, the Division requested preliminary comments on a regulation that will impose a fiduciary conduct standard on investment advisers and their representatives as well as broker-dealers and their agents when dealing with their clients.

The proposed conduct standard is based on the common law fiduciary duties of care and loyalty and allows for the payment of transaction-based remuneration if the remuneration is reasonable, is the best of the reasonably available remuneration options, and the care obligation is satisfied.  The Division feels this regulation is necessary as the SEC’s Regulation Best Interest, “fails to establish a strong and uniform fiduciary standard.”  The Division rejected the SEC’s approach under Regulation Best Interest, stating that “[w]hile relationship and conflict disclosure is important for all investors, it cannot replace a clear fiduciary standard of conduct, which is the basis for the Division’s proposal.”  The comment period ended on July 26thContributed by Rochelle A. Truzzi, Senior Compliance Consultant.

For Broker-Dealers:  SEC Actions

FINRA Increases Margin Requirements for ETNs Effective August 16, 2019For anyone who missed our Regulatory Update on July 16, FINRA issued Regulatory Notice 19-21, announcing that Exchange-Traded Notes (“ETNs”) will be excluded from the reduced margin requirements set forth under Rule 4210(e)(2)(C) and available to positions in ordinary investment-grade debt securities, non-equity securities, and “other margin eligible non-equity securities,” as defined by FINRA Rule 4210.   FINRA has also established higher initial and maintenance margin requirements for ETNs, listed options on ETNs, and leveraged ETNs and their associated uncovered options, given the complex nature and increased risk exposure of these products.

Additionally, FINRA clarified that ETNs and options on ETNs are not eligible for Portfolio Margin Treatment provided under Rule 4210(g)(6).  The Options Clearing Corporation will be removing all ETNs (approximately 40) and related options from the Customer Portfolio Margin (“CPM”) theoretical Output File.  See OCC Information Memo #45304.

While the changes are not effective until August 16, 2019, member written requests for “hardship extensions” were due to FINRA by July 26, 2019.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant.

FINRA’s Mutual Fund Waiver Initiative Generated $89 Million in Restitution: FINRA recently provided 56 examples of what happens when broker-dealers fail to meet their obligations under FINRA Rule 2111, the suitability rule.  The regulator announced the final results of its Mutual Fund Waiver Initiative, and found that the sanctioned firms failed to waive upfront sales charges on Class A mutual fund shares offered to eligible retirement accounts and charities, as stated in the mutual funds’ prospectuses.  FINRA recognized the extraordinary cooperation of 43 of the sanctioned firms by not imposing fines.  The remaining 13 firms were fined a total of $1.32 million).  These cases highlight the obligations imposed on broker-dealers under Rule 2111, specifically that firms and their associated persons should have a reasonable basis to believe, based on reasonable diligence, that a recommendation is suitable for at least some investors and is suitable for a specific investor based on that customer’s investment profile.  Registered representatives must first know and understand the products being offered, including, at a minimum, the risks and rewards, fees, available discounts or waivers, or other benefits offered by the issuer.  Broker-dealers are responsible for the training and supervision of their representatives to ensure they understand the attributes of products being offered. Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

For Investment Advisers:  SEC Actions

Risk Alert: Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest. In 2017, the SEC conducted an exam initiative (“Supervision Initiative”) of more than 50 RIAs, collectively representing over 220,000 clients (the vast majority retail clients), to review the supervisory practices of firms that have employed, or currently employ, individuals with disciplinary histories.  The Supervision Initiative focused on the adequacy of (a) compliance programs and supervisory oversight procedures, especially those addressing “previously-disciplined individuals”, (b) public disclosures, such as Form ADV and marketing materials, and (c) conflict identification procedures and related disclosures of such conflicts, calling specific attention to those related to compensation arrangements and account management.  In summarizing its findings, the Staff underscored the importance for firms to fully consider the risks associated with hiring individuals with disciplinary histories, as well as the value of written policies and procedures in heading off and detecting potential compliance violations related to these decisions.  Commonly cited deficiencies include:

  • Lack of policies and procedures to oversee supervised persons with disciplinary histories. Approximately half of the Supervisory Initiative’s disclosure-related deficiencies were the result of inadequate disclosure of disciplinary events, including omitted, incomplete, or confusing disclosures (largely due to firms’ overreliance on self-reporting without sufficient verification) and late delivery of updated disciplinary disclosures following amendments to Form ADV or CRD. Many examined firms lacked processes to properly consider the risks associated with hiring individuals with disciplinary histories, including processes to help firms identify incomplete or inaccurate self-attestations.
  • Weak supervisory policies and procedures. Issues uncovered during the Supervisory Initiative as a result of weak or insufficient policies and procedures included: incorrect client billing for services not actually performed by the adviser, noncompliant marketing and advertising materials (including websites), and geographically remote supervised persons operating in a manner contradictory to the firm’s policies and procedures.
  • Weak compliance supervisory practices. The Staff noted that many firms had written compliance policies and procedures that assigned responsibility to certain individuals or teams, but lacked supervision to ensure the procedures were occurring as expected.  Weaknesses were uncovered in the procedures used by compliance teams to monitor the client-type selection process (i.e., wrap vs. separate account) including verifying whether such an assessment was performed and documenting the factors considered, as well as books and records procedures, including maintaining a list of discretionary accounts, and identifying individuals with access to sensitive information.
  • Other weaknesses identified included perennial issues such as compliance policies that were inconsistent with business practices, especially those addressing the calculation of commissions, fees and expenses (with specific mention given to solicitation fees, management fees and compensation-related practices); annual compliance program reviews that didn’t sufficiently identify the risks associated with supervised persons with a disciplinary history; and insufficient or missing conflict disclosures, especially those relating to undisclosed compensation that could result in conflicted advice.

The Alert recommends that advisers consider the following if they hire individuals with disciplinary histories:

  • Establish written policies and procedures that address the process to review an individual with a prior disciplinary history. The Staff noted that “almost all of the firms’ written policies and procedures required investigations of the disciplinary events and several also required ascertaining whether barred individuals were eligible to reapply for their licenses”.
  • Implement enhanced due diligence processes. The Staff acknowledged that a wide variety of practices are used and noted that written procedures commonly include: background checks of employment and educational histories, disciplinary records, financial and credit information (many times using third parties to perform this research), internet and social media searches, fingerprinting, and personal reference checks.  Where applicable, the SEC also described common procedures that leverage the Form U-5, including: requesting a copy of the Form U-5 from the new hire, and using CRD/IARD to review the U5 initially and after a longer, specified period of time, such as after one to three months (intended, in part, to help identify undisclosed termination notices that could have been filed after the hiring decision was made).
  • Adopt “heightened supervision” policies and procedures. While many firms lacked written policies and procedures to address the supervision of individuals with disciplinary histories, the Staff noted that firms that did implement them were more likely to detect errors in the self-attestation and self-reporting procedures.  Firms should especially consider heightened supervisory procedures for certain disciplinary events, such as those related to “misappropriation, unauthorized trading, forgery, bribery, and making unsuitable recommendations”.
  • Refresh complaint policies and procedures to include protocols for how complaints related to supervised persons will be handled.
  • Supervision of remote employees should be addressed in compliance policies and procedures, especially if any such supervised persons have disciplinary histories.  Contributed by Cari A. Hopfensperger, Senior Compliance Consultant

Lessons Learned from Recent SEC and FINRA Cases

State Street Settles with the SEC after Nearly 20 Years of Undisclosed Markups on Custody Fees. State Street was recently found to have overcharged its mutual fund and other investment company clients certain out-of-pocket custody fees over a nearly 20-year period beginning in 1998 and ending in 2015. More specifically, while the custody fee schedule with its clients included asset-based and transaction fee components, as well as out-of-pocket expenses (which were understood to be expenses that would be paid by State Street and reimbursed by the client), State Street was marking up and overbilling its clients for certain out-of-pocket expense changes, with the majority of the undisclosed markups inflating per-transaction SWIFT messaging fees.

While the mechanics of the case are fairly straightforward, it offers some important take-aways:

First, fund advisors (and any advisor) should be knowledgeable about its service provider fee schedules and how those fees are calculated.  Advisors should then periodically review fees being charged to ensure they match the schedule.   This is especially critical for mutual fund expenses given the disclosure requirements surrounding fund expenses and the common practice of a mutual fund establishing a cap on total fund expenses, whereby the fund’s advisor agrees to reimburse the fund for expenses over a certain rate.  When fees are overbilled, the fund (i.e., ultimately its shareholders) pays more than it should, and if any expense cap is breached as a result, the fund’s advisor would then over-reimburse the fund for such expenses, creating accounting complexities to unwind – to say the least.

Second, the practice of marking up the SWIFT transaction out-of-pocket costs was identified and discussed internally at State Street on multiple occasions, as far back as ten years ago. The decision made during each of those reviews was essentially to implement an appropriate rate for new clients and contract re-negotiations, while markups continued for its other existing clients.  In certain instances, the fee was then lowered with no explanation of why or any disclosure explaining that they had been overcharged for years.  Generally, when an issue is discovered, its resolution should be evaluated to consider the impact on all affected clients and firms should err on the side of over disclosure to clients about the resolution.

Finally, this case offers insight into the remediation steps taken by State Street, which the SEC considered important when negotiating the settlement.  The order contains additional details, but in summary, they included bringing in a consultant with forensic expertise to calculate the amounts overbilled and identify the clients affected, as well as the development of several operational, technical and compliance mechanisms designed to ensure this type of issue would not reoccur.  Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

Bad Boys, Bad Boys, What you Gonna Do When They Come for You…Bob Marley couldn’t have said it better. In yet another case regarding manipulation of valuation processes, the SEC barred Swapnil Rege from working in the securities industry for three years for willfully aiding and abetting and causing a Fund Adviser’s violation of Section 206(1), 206 (2) and 206(4) of the Advisers Act and Rule 206(4)-8 and pay almost $750,000 in fines and penalties.  The Fund Adviser, who is not itself named in the filing, discovered the fraudulent activities and turned in Rege.  Rege, a trader who had previously been fired from two prior firms (red flag number one), joined the Fund Adviser as a trader in interest rate swaps and swaptions and soon after was able to convince management that they should change their valuation process.  Instead of using counterparty quotes they “began using a model to determine fair value pricing for interest rate swaps and swaptions in the Fund. The model had various inputs, which the Fund Adviser could alter” (red flag number two). “However, the Fund Adviser instructed Rege and other portfolio managers and traders to use the model’s default inputs and settings.”  Rege’s compensation was tied to performance (red flag number three) and “[i]n 2016, Rege was to receive a bonus of 8% of his profits”.  What’s a man to do when faced with this dilemma?  Rege decided it was in his best interest to manipulate the valuation model, ignore the default inputs and settings and, therefore, artificially inflate the gains in the fund.  To make matters worse, when Management questioned his practices, Rege began a cover-up campaign to support the artificial prices.

The Fund Adviser ultimately fired Rege, but had to liquidate the investments and re-calculate the Fund’s valuation for the time period during which Rege was providing the valuations.  The Fund Adviser returned $577,000 in management fees to the Fund, and “reimbursed the Fund $123,000 in excess payments to redeeming investors”.  Luckily for the Fund Adviser, the SEC was merciful.  As this case shows, compensation drives behavior.  This is a great case to provide to human resources and executive management to encourage having penalties in place for violating securities laws or ethical lapses to help mitigate self-serving bad decision-making.  Also, having solid hiring standards is also helpful in vetting new people in high-risk positions at a firm.  And finally, always trust but verify when processes allow for manual intervention.  Contributed by Heather D. Augustine, Senior Compliance Consultant.

Bond Traders Give into Temptation and Nomura repays $25 million to customers. In two separate cases (SEC Order for CMBS; SEC Order for RMBS), the SEC brought Nomura to task for its failure to supervise bond traders who lied to customers to make more profit on trades in commercial backed mortgage securities (“CMBS”) and non-agency backed residential mortgage-backed securities (“RMBS”).

The facts underlying the two cases are simple.  According to the SEC’s orders, the traders involved misled customers about the prices at which Nomura had bought securities, the amount of profit Nomura would receive on the trades, and who currently owned the securities.  The traders would tell customers that they were still negotiating with another seller when Nomura had already purchased the security in order to get the customer to pay more.  Some traders would persuade customers to sell bonds at lower prices by lying about the offers received from potential buyers.

It’s easy to understand why these traders would mislead their customers.  The traders were paid bonuses based on the profitability of the trading desk; the more money they made for Nomura, the bigger their bonuses. (Check out the complaints against two of the traders.)  Customers relied on dealers like Nomura to locate other buyers and sellers of the bonds since they had the access to the market and the inventory.  And the possibility of the traders being caught lying by a customer was nil since there was no public information available on the trading prices of these bonds.

Ultimately, the SEC found that although it had procedures in place to review communications to detect violations of the firm’s policies, they were weak.  A lot of the negotiations were conducted via email and instant messages and “Nomura failed reasonably to implement procedures for monitoring communications that reasonably would be expected to detect false or misleading statements to Nomura customers”.  The SEC orders do not specify exactly where Nomura went wrong.  Apparently, Nomura was reviewing customer communications but “it did not do so with a view to determining whether the [traders] were making the types of false or misleading statements to Nomura customers described in [the order].”

The lesson learned from this case is, first and foremost, that it pays to cooperate with the SEC.  Although Nomura was forced to repay customers $25 million, the fine imposed for its misbehavior was a mere $1.5 million, a relatively small amount when compared to the revenue Nomura earned from its bond trading business.  The SEC emphasized that it was being merciful because of Nomura’s “extensive cooperation during the SEC’s investigation, including remedial efforts to improve its surveillance procedures and other internal controls.”  Second, in an industry where greater sales mean greater rewards, firms should be wary of individuals or groups that bring in the most revenue. Greed is a powerful incentive.  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

Worth Reading

Staff Statement on LIBOR Transition and related press release.  Firms planning for the anticipated replacement of LIBOR and reviewing their exposure may find this July 12, 2019 statement from the Division of Corporation Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant, to be helpful.

New York’s Department of Financial Services Investigates First Post Cybersecurity Regulation’s Breach.  Cynthia J. Borelli with Bressler Amery Ross summarizes the NYDFS’ response to news of First American’s recent cybersecurity incident, which “demonstrates how quickly legal and financial liability can develop following the discovery and announcement of a security incident”.

EU Adopts New Rules for Marketing Investment Funds. Advisers with funds distributed to professional investors in the UK should take note of these new supplementary rules, as efficiently summarized by Ropes & Gray.

The Great Convergence and The Death Of Fiduciary Differentiation (For RIAs). Michael Kitces offers his perspective on the impetus for Reg BI and where the “great convergence” of services provided by broker-dealers and RIAs may take us in the future.

Proskauer Launches Private Equity SEC Enforcement Tracker.  Proskauer’s new tracker includes “all SEC enforcement actions involving private equity advisers… providing [readers] with quick access to comparable cases and allowing [readers] to identify important enforcement trends impacting private equity advisers as they develop”.

Industry Regulators Get Tough on the Cannabis Industry. Eversheds Sullivan discusses the recently announced Commonwealth of Massachusetts’ “wide scale sweep into businesses raising money through investments in the state’s cannabis industry”.

Filing Deadlines and To Do List for August 2019


  • Form 13F: Form 13F Quarterly Filing for Q2 2019 is due for advisers within 45 days after the end of the calendar quarter.  Due date is August 14, 2019.
  • Form PF for Large Hedge Fund Advisers: Large hedge fund advisers must file Form PF within 60 days of each quarter end on the IARD system.  Due date is August 29, 2019.


  • Form CTA-PR (June 30 Quarter End).  Commodity Trading Advisors are required to file Form CTA-PR quarterly with the NFA. Due date is August 14, 2019.
  • Blue Sky Filings (Form D): Advisers to private funds should review fund blue sky filings and determine whether any amended or new filings are necessary.  Generally, most states require a notice filing (“blue sky filing”) within 15 days of the first sale of interests in a fund, but state laws vary.  Did you know that Hardin Compliance Consulting offers a convenient and economical blue sky filing service to help firms manage this complicated monthly task?  Learn more here and give us a call to discuss your needs further.  Due August 15, 2019.
  • NFA Form CPO-PQR (June 30 Quarter End): Small, Mid-Sized and Large Commodity Pool Operators are required to file Form CPO-PQR quarterly with the NFA. Due date is August 29, 2018.


  • Rule 17a-5 Monthly and Fifth FOCUS Part II/IIA Filings:  For the period ending July 31, 2019. For firms required to submit monthly FOCUS filings and those firms whose fiscal year-end is a date other than a calendar quarter.  Due date August 23, 2019. 
  • Supplemental Inventory Schedule (“SIS”): For the month ending July 31, 2019. The SIS must be filed by a firm that is required to file FOCUS Report Part II, FOCUS Report Part IIA or FOGS Report Part I, with inventory positions as of the end of the FOCUS or FOGS reporting period, unless the firm has (1) a minimum dollar net capital or liquid capital requirement of less than $100,000; or (2) inventory positions consisting only of money market mutual funds.  A firm with inventory positions consisting only of money market mutual funds must affirmatively indicate through the eFOCUS system that no SIS filing is required for the reporting period. Due date August 28, 2019. 
  • Annual Audit Reports for Fiscal Year-End June 30, 2019FINRA requires that member firms submit their annual audit reports in electronic form.  Firms must also file the report at the regional office of the SEC in which the firm has its principal place of business and the SEC’s principal office in Washington, DC. Firms registered in Arizona, Hawaii, Louisiana, or New Hampshire may have additional filing requirements.  Due date August 29, 2019. 
  • SIPC-7 Assessment: For firms with a Fiscal Year-End of June 30, 2019.  SIPC members are required to file the SIPC-7 General Assessment Reconciliation Form together with the assessment owed (less any assessment paid with the SIPC-6) within 60 days after the Fiscal Year-End. Due date August 29, 2019. 
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of July 31, 2019, AND claiming an exclusion from SIPC Membership under Section 78ccc(a)(2)(A) of the Securities Investor Protection Act of 1970.  This annual filing is due within 30 days of the beginning of each fiscal year. Due date August 30, 2019. 
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of January 31, 2019.  SIPC members are required to file for the first half of the fiscal year a SIPC-6 General Assessment Payment Form together with the assessment owed within 30 days after the period covered. Due date August 30, 2019. 

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Hardin Compliance Consulting provides links to other publicly-available legal and compliance websites for your convenience. These links have been selected because we believe they provide valuable information and guidance.  The information in this e-newsletter is for general guidance only.  It does not constitute the provision of legal advice, tax advice, accounting services, or professional consulting of any kind.