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SEC Hits Pause Button for ALJs; Updates on Custody Rule; SEC Director Discusses What Makes Cryptocurrency a Security; Mutual Funds Allowed to Save Trees: Regulatory Update for July 2018

For Investment Advisers:  SEC Actions

SEC Stops All In-House Cases after Defeat in Supreme Court:   The SEC enforcement division suffered a blow when the U.S. Supreme Court held that the process for hiring SEC’s administrative law judges (“ALJs”) was unconstitutional.    The Court held that the ALJs must be appointed under the Constitution’s Appointments Clause since they are “officers” within the meaning of that clause.  The Court issued its 7-2 decision on June 21, 2018, in Raymond J. Lucia vs. Securities and Exchange Commission.   For defendant Raymond Lucia, this ruling means that he will be getting a new hearing in front of an ALJ appointed by the Securities and Exchange Commissioners.

 The SEC anticipated this outcome, and, on November 30, 2017, the Commission ratified the prior appointments of its five incumbent ALJs.  Does this solve the problem?  Who knows.  In a footnote, the Supreme Court said “[w]e see no reason to address that issue.” Seriously?  This case has left many unanswered questions, prompting the SEC’s halt to current ALJ proceedings for the next 30 days.

By way of background, the facts of the original case involved radio personality and investment adviser Raymond Lucia, Sr. At least on the surface, Mr. Lucia seemed intent on grabbing the SEC’s attention by touting an investment strategy called “Buckets of Money,” and supporting his results with back-testing.  Lucia was fined $300,000 and barred from working as an investment adviser after an SEC ALJ found he misled prospective clients.  The ALJ found that Mr. Lucia misrepresented the accuracy of the backtested investment portfolios to prospective investors and failed to maintain sufficient documentation supporting the backtested returns.  Contributed by Jaqueline M. Hummel, Partner and Managing Director


 SEC Updates FAQs on Custody and Ignorance is Bliss — Sometimes: In its response to Question II.11, the SEC finally recognized that investment advisers are not parties to their clients’ custody agreements, and, sometimes, do not even know what the custody agreements say.  The answer states that “[a]n adviser that does not have a copy of a client’s custodial agreement, and does not know, or have reason to know whether the agreement would give the adviser Inadvertent Custody, need not comply with the custody rule if Inadvertent Custody would be the sole basis for custody. The Division of Investment Management would not recommend enforcement action to the Commission under the custody rule or under Section 207 of the Advisers Act against any such investment adviser if that adviser neither complied with the requirements of the custody rule nor indicated it has custody in its Form ADV filing.   There is a large BUT attached to this response since the SEC states that this relief will not apply where the adviser recommends, requests or requires that clients use a particular custodian.    Contributed by Jaqueline M. Hummel, Partner and Managing Director


 Schwab Provides Expanded Definition for “First Party” Transfers under Custody Rule  – In a recent communication to advisers, Charles Schwab says it has been working with Investment Adviser Association to provide a more consistent definition of “first party” money movement, which should, hopefully, match the SEC’s definition.  According to the SEC, an adviser that has the authority to move money among a client’s own accounts (first party) via journal, check or ACH is generally not considered to have custody under the Custody Rule.   Most custodian’s interpret “first party” transfer to mean movement between accounts with identical registration (same tax identification or social security number).  Going forward, Schwab says it will expand its definition of “first party,” and provided these examples of first-person transfers:

  • A transfer between an individual’s account and his/her IRA account,
  •  A transfer between an individual’s account and his/her revocable living trust (total identity trust),
  • A transfer between a husband/wife’s joint account and the same husband/wife’s community property account.

Schwab noted that it will take time fto modify its systems to incorporate this more expansive definition.  The big takeaway from this is that while the SEC may consider a transfer from an individual account to a joint account and vice versa to be a first-party money movement, some custodians may disagree.  Just because a custodian requires the adviser to provide a third-party standing letter of authorization (SLOA) to move funds between an individual’s brokerage account and his/her IRA account does not mean that an adviser has custody for the purposes of the Custody Rule.  A custodian’s internal policies do not trump SEC regulation.  Contributed by Jaqueline M. Hummel, Partner and Managing Director


Digital Assets Like Bitcoin are not Securities:  In a recent speech, Dean Hinman, the SEC’s Division of Corporate Finance Director clarified the SEC’s stance on whether cryptocurrencies and initial coin offerings are securities.  For example, digital assets like Bitcoin and Etherium are not securities since they are sold only to purchase goods or services on a decentralized network.  Hinman said that the key to determining whether the digital asset is a security is how the promoters marketed the asset and the expectations of its purchasers.  Cryptocurrency tokens can be considered a security when they are sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others.   However, the nature of a digital asset transaction can change over time. If the network on which the token or coin is to function becomes decentralized, and the efforts of a third party are no longer key in determining the enterprise’s success, the token would no longer be considered a security.  Contributed by Doug MacKinnon, Senior Compliance Consultant


CFTC and State Regulators Agreement to Cooperate and SEC and CFTC to Cooperate: The Commodity and Futures Trading Commission (“CFTC”) and the North American Securities Administrators Association (“NASAA”) signed an agreement to enhance the exchange of information between the regulators to allow cooperation in enforcement operations.  The impetus to the Memorandum of Understanding (“MOU”) lies in the explosion of cryptocurrencies and modern commodities.  Each jurisdiction will be required to sign an MOU to receive leads, tips, complaints and referrals from the CFTC.  The SEC also jumped on the bandwagon with the CFTC and approved an update to an MOU signed by the two agencies back in 2008 to ensure continued coordination and information sharing between the two agencies. The updated MOU addresses the “regulatory regime for swaps and security-based swaps.”  Contributed by Heather D. Augustine, Senior Compliance Consultant


The Cayman Islands Adopts Beneficial Ownership Registry Requirement: As of July 1, 2018, companies and limited liability companies incorporated or registered in the Cayman Islands are required to maintain a beneficial ownership register at their Cayman Islands-registered offices (or appointed service provider), unless an exemption applies.  Hedge funds and private investment companies registered as companies or limited liability companies in the Cayman Islands should check with their Cayman service providers to confirm whether they comply.  Hedge funds regulated or licensed with the Cayman Islands Monetary Authority (“CIMA”), and hedge funds and private equity funds managed by a person (or a subsidiary of a person) who is regulated or listed in Cayman or an approved jurisdiction, are exempt from this requirement.  Approved jurisdictions include Canada, Hong Kong, Ireland, the United Kingdom and the United States.  For more details, check out our blog postContributed by Denise Alfieri, Managing Director

For Mutual Funds:  SEC Actions

  •  SEC Grants No-Action Relief For Delays in Redemptions of Mutual Fund Accounts where Financial Exploitation is Suspected: The SEC issued a No-Action Letter to the Investment Company Institute (“ICI”), stating that it would not bring an enforcement action against a mutual fund or its transfer agent for delaying payment of redemption proceeds due to suspected senior financial exploitation. This relief affords transfer agents similar protections provided to broker-dealers under FINRA Rule 2165, which became effective earlier this year.  The No-Action letter allows mutual funds and their transfer agents to place a temporary hold on the disbursement of funds from an account (but not on securities transactions) when there is a reasonable belief of financial exploitation, provided that they satisfy certain operational and compliance conditions. Mutual funds whose transfer agents take advantage of this relief must add disclosure to the fund’s prospectus and Statement of Additional Information disclosing the authority of the transfer agent to institute the hold and related activities.  Contributed by Cari A. Hopfensperger, Compliance Consultant  


  •  SEC Saves Forests by Allowing Mutual Funds to Deliver Shareholder Reports via Website:  Almost two years after its proposal, and despite opposition by lobbyists, the SEC adopted Rule 30e-3 under the Investment Company Act of 1940, which creates a new web-based option for shareholder report delivery.  Using a “notice and access” method, funds may deliver shareholder reports through their websites provided they also send investors a paper notice of the reports’ online availability.  Funds must also post quarterly holdings for the last fiscal year on their websites.  Importantly, investors will retain the ability to request paper reports on an ongoing or ad hoc basis free of charge.  The rule applies on January 1, 2021, and becomes effective on January 1, 2022.  Funds intending to adopt the notice and access method before January 1, 2022 will need to prominently disclose their intent on existing shareholder documents beginning January 2019.  Given the long runway on the rule’s effectiveness, interested mutual fund advisers should consider their options and upcoming disclosures.  Trees win!  Contributed by Cari A. Hopfensperger, Compliance Consultant

For Investment Advisers and Broker-Dealers: DOL Actions

  •  Fiduciary Rule is Really and Truly Dead.  On June 21, 2018, the U.S. Court of Appeals for the Fifth Circuit issued the final mandate vacating the DOL’s Fiduciary Rule.  So does that mean we can all go back to business as it was in the pre-Fiduciary Rule era?  No.  Check out our blog post to find out why.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

For Broker-Dealers:  FINRA Actions

FINRA to Transform CRD and Other Registration Systems: FINRA’s multi-phased transformation of its registration and disclosure programs began on June 30th, with a roll-out of WebCRD’s new user interface.  The new and improved WebCRD will alert participants to important information and critical issues that require prompt attention.  FINRA’s overhaul of its registration and disclosure programs is expected to, “increase utility and efficiency of the registration and disclosure process for firms, investors and regulators, as well as to reduce compliance costs for firms.”   The Investment Adviser Registration Depository (IARD), Investment Advisor Public Disclosure system (IAPD), Private Fund Reporting Depository (PFRD), and BrokerCheck will all be enhanced for the benefit of their users.  FINRA expects the project to be completed in 2021.  Click here for more details on the transformation, including the New CRD Reference Guide, and important information regarding new CRD entitlements.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

Firms Can Rely on FINRA’s New Disclosure Review Process — Most of the Time: FINRA has improved its disclosure review process, and will now allow firms to rely on its verification process to comply with the requirement to conduct public searches related to bankruptcies, judgments, and liens under Rule 3110(e).   FINRA will also allow firms to rely on the fingerprint results obtained through FINRA’s CRD system to satisfy meet their obligations to search public records to identify criminal matters required to be reported on Form U4.

FINRA is instituting this new process on July 9, 2018, and will conduct a search of public records within fifteen calendar days of a broker-dealer registered representative submitting an initial or transfer Form U4.  If the information submitted on U4 is different from FINRA’s search results, FINRA will notify the member firm, after which the firm will have thirty calendar days to amend Form U4 to avoid a late disclosure fee.

We caution firms to investigate any discrepancies before amending Form U4.  Prior FINRA disclosure reviews have resulted in many false hits.  FINRA is working on a report to show when identified none of the information relating to public financial records that was not already disclosed on the applicant’s Form U4.  However, until that report becomes available, no news is good news.

Relying on FINRA’s disclosure review and fingerprint screening will not satisfy all requirements outlined in Rule 3110(e).  Firms will still need to do the following:

  • investigate the character, business reputation, qualifications and experience of an applicant before submitting an initial or transfer Form U4 on behalf of the applicant;
  • review a copy of the applicant’s most recent Form U5 within 60 days of filing an initial or transfer Form U4;
  • review the applicant’s employment experience to determine the need to review CFTC Form 8-T, based on whether the applicant has been employed by a Futures Commission Merchant or an Introducing Broker that is notice-registered with the SEC; and
  • verify the accuracy and completeness of the remaining information on an applicant’s initial or transfer Form U4 within 30 days of filing.

The remaining information includes, but is not limited to, name, date of birth, social security number, current residential address, employment history, and other business activities.

Firms are not required to use FINRA’s enhanced disclosure review process to comply with their verification obligations.  Firms may continue to use third-party service providers to conduct these searches.  FINRA notes that the ability of a firm to rely on credit reports from major national credit reporting agencies for purposes of compliance with FINRA Rule 3110(e) is not affected by the fact that these reports exclude judgments and liens that do not include consumers’ names and addresses, and Social Security numbers and or dates of birth.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

For Municipal Advisors and Brokers

  • Frequently Asked Questions Regarding MSRB Rule G-42 (Non-solicitor Municipal Advisors and Making Recommendations): The MSRB published FAQs on Rule G-42, providing clarity on making recommendations, and the obligations for municipal advisors that result from those recommendations.  Contributed by Doug MacKinnon, Senior Compliance Consultant

Lessons Learned from Recent SEC and FINRA Cases:

SEC charges 13 Private Fund Advisers for Failing to File Form PF:  Ever wonder what happens when an adviser fails to make a required filing?  They get fined, as some investment advisers recently discovered.  On June 1, the SEC announced settlements with 13 registered investment advisers, both private equity and hedge fund managers, that were delinquent in filing annual reports on Form PF over multi-year periods. Since 2012, Form PF is a required filing for advisers to report about the private funds that they advise, including the amount of assets under management, fund strategy, performance, and use of leverage and derivatives. To remedy the situation, the 13 advisers agreed to pay a $75,000 civil penalty – as well as making the necessary filings. Still have questions? Read the latest responses on the Form PF FAQ page on the SEC’s website.  Contributed by Maria Bernabo, Compliance Associate

SEC Slams Firm For Failing to Disclose Payments From Outside Managers:  Lyxor Asset Management, Inc. (“Lyxor”) agreed to be censured and pay a $500,000 fine after the SEC charged the firm with failing to disclose conflicts of interest, failing to implement policies and procedures to identify and mitigate conflicts, and failing to maintain books and records.   The conflicts of interest violation stemmed from a side letter Lyxor signed with two affiliated third-party investment advisers. The side letter required the third-party advisers to make payments to Lyxor for Lyxor client assets placed in funds managed by the third-party advisers.  Lyxor received about $648,000 in fees over a two-year period.  Lyxor did not disclose the arrangement to its clients.  The side letter contradicted the terms of two different client agreements.  To complicate matters, the third-party advisers signed an additional side letter with Lyxor’s corporate parent, Lyxor S.A.S., which directed that payments from the Lyxor side letter be paid to Lyxor S.A.S.  The arrangement was uncovered during an SEC examination (hence the books and records violation for not booking the payments on Lyxor’s financials).

This sounds like a classic case of someone forgetting to invite legal and compliance to the meetings.  It’s so important in bigger corporate entities, where silos form, that the right people are involved in negotiating deals and that proper review of agreements take place. The SEC noted that Lyxor tried to negotiate in good faith on behalf of their clients initially, but the third-party advisers would not agree which probably led to the bright idea of diverting the payments to the corporate entity.  Apparently, someone in this equation also forgot that emails are retained and archived which is how this creative maneuvering was discovered.  Contributed by Heather Augustine, Senior Compliance Consultant

SEC fines RIA $8 million for Failure to Disclose Kickbacks:  deVere USA, Inc. (DVU) had a unique industry niche.  A registered investment adviser, DVU advised clients that had pensions from past employment in the U.K., similar to defined benefit and 401(k) plans in the U.S.  DVU recommended and assisted clients in rolling over their U.K. pension assets to retirement plans that would receive favorable tax treatment under U.K. tax laws. DVU would then provide investment advice for the transferred assets.  DVU’s dirty little secret was that the firm’s investment adviser representatives (IARs) received payments from various service providers the firm recommended, such as custodians, trustees, and foreign exchange providers, and received front-end sales loads from European investments.  None of these payments were disclosed on the Firm’s Form ADV Part 2A.  The SEC issued a deficiency letter to DVU in March 2015 specifically citing these disclosure failures.

In the administrative order, the SEC also noted that DVU misled clients about the benefits of transferring their assets.  The $8-million penalty will be used to establish a Fair Fund to be distributed to affected clients.  The SEC also ordered DVU to notify clients of the proceeding, provide four hours of training each year for the next two years to all employees on fiduciaries duties, and to retain an independent compliance consultant to review the firm’s compliance program.  Separate charges have been filed against former DVU CEO, Benjamin Alderson, and Bradley Hamilton, both of whom were IARs of the firm.

The lessons from this case are nothing new.  Investment advisers should understand by now that payments received from service providers are conflicts of interest and must be disclosed.  Second, advisers should address issues cited in a deficiency letter promptly.  Third, all firm employees should understand what it means to be a fiduciary.  The firm’s annual training presentation should include a section on “Fiduciary Obligations.”

Worth Reading:

 Humans Have an Uncanny Ability to Sniff out Hypocrisy:  Great post by Matt Kelly on why you can’t delegate ethical responsibility.

Is It Back to the Future for the DOL’s Fiduciary Rule?  Great summary of current status of the fiduciary rule by

Lots of Financial Regulation is Illegal:  Matt Levine provides comic relief in his discussion of the Supreme Court’s findings that the SEC’s Administrative Law Judges are unconstitutional.

AARP’s Campaign to Close the Loophole on Regulation Best Interest:  As of June 29, 2018, there are about 2,820 comments letters on the SEC’s Proposed Rule: Regulation Best Interest, with a common theme:  the SEC should “close the loophole” that “makes it easy for many advisers to take advantage of hard-working Americans and line their own pockets with our retirement savings.” AARP has made it easy for individuals to provide comments to the SEC, providing talking points and an easy-to-use form to send the comments to the SEC.

Paul Weiss provides this excellent analysis of the Lucia v. SEC case.

Filing Deadlines and To Do List for July


  • Form 13H: Following an initial filing of Form 13H, all large traders must make an amended filing to correct inaccurate information promptly (within ten days) following the quarter-end in which the information became stale.   Recommended due date:  July 10, 2018.  (Note:  Neither the SEC nor its staff has provided guidance on the definition of “promptly” for Form 13H.)



  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of May 31, 2018, 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 is July 2, 2018.
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of November 30, 2017.  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 is July 2, 2018.
  • Customer Complaint Quarterly Statistical Summary: For complaints received during the 2ndQuarter, 2018.  FINRA Rule 4530 requires Firms to submit statistical and summary information regarding complaints received during the quarter by the 15th day of the month following the calendar quarter.  Due date is July 16, 2018. 
  • Rule 17a-5 Quarterly FOCUS Part II/IIA Filings:  For Quarter ending June 30, 2018. FINRA requires that member firms file a FOCUS, (Financial and Operational Combined Uniform Single) Report Part II or IIA on a quarterly basis. Clearing firms and firms that carry customer accounts file Part II and introducing firms file Part IIA.  Due date is July 25, 2018.
  • Quarterly Form Custody:  SEC requires that member firms file Form Custody under SEA Rule 17a-5(a)(5) for the quarter ending June 30, 2018.  Due date is July 25, 2018.
  • Annual Audit Reports for Fiscal Year-End May 31, 2018:  FINRA 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 is July 30, 2018.
  • Supplemental Statement of Income (“SSOI”): For the quarter ending June 30, 2018.  FINRA requires firms to submit additional, detailed information regarding the categories of revenues and expenses reported on the Statement of Income (Loss) page of the FOCUS Report Part II/IIA.  Due date is July 30, 2018.
  • Supplemental Inventory Schedule (“SIS”): For the month ending June 30, 2018. 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 is July 30, 2018.
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of June 30, 2018 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 is July 30, 2018.
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of December 31, 2017.  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 is July 30, 2018.
  • SIPC-7 Assessment: For firms with a Fiscal Year-End of May 31, 2018.  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 is July 30, 2018.



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