12b-1 Fees | Conflicts of Interest | Cross Trading | Custody | Mutual Fund Regulation | Mutual Funds | NFA

Time to Pay Your Dues, Increase Cross Trade Testing and Disclose Your Conflicts: Regulatory Update November 2018

Photo by Matt Seymour on Unsplash

For Investment Advisers: SEC Actions

Annual Renewal Program for IARD System: Get out your checkbooks!  It is time for the annual renewal of investment adviser (IA) firms and their IA representatives’ (IARs) registrations with jurisdictions/states. Preliminary renewal statements for the IARD system will be available November 12, 2018, and the deadline for the receipt of preliminary statement payment is December 17, 2018.   Contributed by Jaqueline M. Hummel, Partner and Managing Director

For Broker-Dealers:  FINRA Actions 

Let the 2019 CRD Renewal Program Begin:  Preliminary Statements will be available through E-Bill beginning November 12, 2018.   FINRA’s Deadline for receipt of Preliminary Statement payments is December 17, 2018.  Click here for more information regarding the Web CRD Renewal Program, including the 2019 Calendar and payment options.   Before November 9th, Hardin recommends reviewing your firm and branch rosters to verify registrations are complete and accurate.  Be sure to monitor the balance of your Flex-Funding Account to ensure that the amount will cover your assessment.  Firms may now submit post-dated Forms U5 and BR Closing/Withdrawals dated December 31, 2018.  Web CRD will shut down for the remainder of the year on Thursday, December 27, 2018 at 6:00 pm, Eastern Time.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

FINRA Regulatory Notice 18-32 – OTC Equity Quotations:  FINRA reminds firms that Securities Exchange Act of 1934 Rule 15c2-11 prohibits firms from publishing a quotation in OTC securities unless they have obtained and reviewed current information about the issuer and believe that such information is accurate and from a reliable source. FINRA Rule 6432 requires firms to file Form 211 to demonstrate compliance with SEA Rule 15c2-11. Firms may not initiate or resume quotations (after a trading suspension) in OTC securities until FINRA reviews and approves Form 211.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

For Mutual Funds: SEC Actions 

SEC Allows Mutual Fund Boards to Rely on CCOs for Compliance with Affiliate Transaction Rules.  The SEC published a no-action letter stating that mutual fund boards may now rely on quarterly Chief Compliance Officer Certifications that transactions effected in reliance on Rules 10f-3, 17a-7 or 17e-1 under the Investment Company Act complied with the fund’s procedures.  Previously, the board was responsible for determining compliance and usually did so by relying on representations from the CCO anyway.  The SEC appears to have acknowledged that this process avoids duplication of the CCO’s work.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

Adoption of Updated EDGAR Filer Manual  The EDGAR system is scheduled to be upgraded on October 1, 2018, and the revised manual reflects updates to the technical specifications to the Forms N-CEN and N-PORT.  Contributed by Cari A. Hopfensperger, Compliance Consultant

For Hedge Fund Managers:  NFA Actions

NFA Issues Interpretive Notice on Rule 2-46 on Avoiding Errors.  The NFA issued this notice to NFA Member Commodity Pool Operators and Commodity Trading Advisers (required to report under CFTC Regulation 4.27), highlighting that some firms are incorrectly reporting their Current Asset/Current Liability ratio, and Total Revenue/Total Expenses ratio.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

Failure to pay Annual Dues Can Lead to Automatic Withdrawal from NFA.  The CFTC recently approved amendments to NFA Bylaw 1303, effective on October 31, 2018, stating that a member’s failure to pay its annual dues, late fees, and assessments or audit fees within 30 days of the due date will be deemed a request to withdraw.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

Lessons Learned from Recent SEC and FINRA Cases:

SEC Sees through Scheme to Circumvent Cross Trading Rules:  A team is only as strong as its weakest player.  In yet another cross-trading enforcement case this year, the SEC exposed the practice of hiding cross-trading activity by prearranging deals with broker-dealers.

Zachary Harrison (“Harrison”) worked as a portfolio manager (“PM”) in Putnam Investment Management LLC’s (“Putnam”) Structured Credit Group, where he placed cross-trades between mutual fund accounts and affiliated accounts. Harrison would prearrange, using code words, with one of three broker-dealers to “temporarily” sell bonds at the highest, or only, bid received. He would then buy back the bonds the next day at the same price with a small markup. This resulted in undisclosed favorable treatment of the buyers over the sellers.

To use the Investment Company Act’s Rule 17a-7 cross-trade exemption, the fund adviser must use an independent current market price defined as the “average of the highest current bid and lowest independent offer,” and no compensation or remuneration can be paid to the broker-dealer. Also, Putnam’s policies and procedures required the PM to obtain two bids and two offers and cross at the mid-point of the highest bid and lowest offer within an hour, without paying any brokerage commissions or other compensation.

The SEC stated that Harrison’s practice avoided market exposure because he was selling and buying the securities at the same price. Also, the SEC cited Putnam for its lack of training regarding Rule 17a-7 procedures and insufficient monitoring of the trading. Although the Compliance Department examined overnight repurchases, it ignored Harrison’s transactions since the trades included a small markup or spread. Compliance assumed this meant that the broker-dealer was taking market risk.  Furthermore, Compliance did not review the communications with the broker-dealers on the trading desk or raise any red flags that traders gave virtually the same responses when asked by Compliance about potential cross-trades. Ultimately, Harrison confessed.  He was fired and suspended by the SEC for nine months and had to pay a $50,000 fine.  Putnam self-reported to the SEC and retained outside counsel to conduct an internal audit.  Putman paid the $1 million fine but received some leniency for self-reporting. The firm and Harrison were cited for just about everything under the Investment Advisers Act:  Section 206 violations for engaging in fraud, Section 207 violations for making untrue statements in the Form ADV and to the Commission, Section 206(4) and Rule 206(4)-7 violations for having inadequate policies and procedures, and a Section 203 (c)(6) violation failure to supervise.  Putnam also did not meet the requirements for the Rule 17a-1 and 17a-2 exemption under the Investment Company Act.

This case illustrates how important it is to take the time to set-up testing against regulatory requirements and internal policies and procedures.  It also reveals the importance of effective supervision of PMs to risk management and investing in a highly-trained and experienced compliance staff for a strong and effective organization.

This case is incredibly similar to the SEC’s proceeding against Western Asset Management Company Western Asset Management Company back in 2014, which also involved fixed income securities, pre-arranged trades, and buying the securities back at the sale price with a small markup (see our prior blog post).  Here are some basic pointers:

  • Involving a broker-dealer does not eliminate a cross-trade. The transaction has to be arm’s length, meaning that the broker has to take some market risk.
  • Just because a broker-dealer holds a security for a period of time does not mean that the broker-dealer is taking market risk.
  • Repurchasing securities from a broker-dealer with a small markup to cover the broker’s expenses does not make it a fair deal for clients. In this case, Harrison agreed to sell the securities at the highest bid price, and then purchase them back at the same price with a small markup to compensate the broker-dealer for his expenses. The buying clients then got a better deal at the expense of the sellers.  This is a violation of a firm’s fiduciary duty.
  • Testing for cross-trading activity should include a review of sales and purchases of the same security over a period of time (such as overnight), looking both at the price of the buy and the sell and the amount of commission or markup.

Contributed by Heather Augustine, Senior Compliance Consultant

SEC Forces Adviser to Reimburse Clients for 12b-1 Payments and Disclosure Failures.  In another twist on the growing list of disclosure and share-class selection enforcement actions, Harbour Investments, Inc. (“Harbour”) was charged for failing to disclose compensation that it received under a marketing services agreement with a third-party custodian (Custodian A).  One of four custodians recommended by the firm to its clients, Custodian A paid Harbour two basis points of the value of assets maintained by the adviser with the custodian.  The SEC charged that this agreement created an incentive for Harbour to recommend Custodian A over the others, and therefore, Harbour had an obligation to disclose this conflict in its Form ADV.  Custodians frequently offer incentives to win an adviser’s (and its underlying clients’) business. This case highlights that firms should review their custodial arrangements and pricing schedules carefully for negotiated rebates, additional products and services to assist in managing and administering client accounts, and other concessions that benefit the adviser to ensure that additional compensation and benefits are disclosed on Form ADV.  Firms should also consider conflicts of interest when selecting vendors and include appropriate disclosure in the Form ADV Part 2A.  Finally, firms should have a due diligence process that includes documenting the reasons for recommending any custodian to its clients.

Harbour also offered a variety of mutual funds to its advisory clients in fee-based programs, and its IARs commonly invested client accounts in Class A shares, which generated 12b-1 fees received by Harbour and its registered representatives in its role as broker-dealer.  During the SEC’s examination period, the firm invested certain accounts in Class A shares when another share class, without 12b-1 fees, was available.  Consistent with the prevalent fact pattern in similar cases, Harbour’s Form ADV disclosed that it “may” receive 12b-1 fees from mutual fund investments by advisory clients and that such fees created a conflict of interest.  However, the adviser did not disclose the conflict associated with share class selection specifically or that Harbour in some cases selected classes with 12b-1 fees for clients even when a different class without a 12b-1 fee was available to a client.  As a result of Harbour’s share class selections, the SEC also found that Harbour failed to achieve best execution.  As we’ve noted in prior Compliance Informer Regulatory Updates, firms are advised to ensure they have robust policies and procedures related to best execution and mutual fund share class selection and that they disclose the conflicts associated with any 12b-1 fees or other additional compensation received by the adviser as the result of the share class selected.  Contributed by Cari A. Hopfensperger, Compliance Consultant

 All Men Make Mistakes, but Only Wise Men Learn From Them.  In its case against Hudson Housing Capital LLC (“Hudson”), the SEC fined Hudson for violating the Custody Rule (Advisers Act Rule 206(4)-2), because the firm failed to deliver audited financial statements to private fund investors within 120-days of the fund’s fiscal year-end.  This is not new; the SEC has been bringing cases for similar violations for years now.  What distinguishes this case from the rest is Hudson’s systemic failure of delivery.  From 2012 through 2017, the firm consistently missed the deadline for distribution of audited financial statements to fund investors, and, in some cases, failed to distribute the statements at all.  So, in addition to the violation of the Custody Rule, the SEC found that Hudson also failed to meet its obligations under Advisers Act Rule 206(4)-7, the Compliance Program Rule, for failing to update its policies and procedures to fix the issue.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

 Worth Reading: 

Five Ways to Really Aggravate Your Compliance Officer:  Sara Grillo at Advisor Perspectives tells us how advisors can be their own worst enemies when dealing with compliance.

With Midterm Elections Looming, Fund Managers Must Review the Pay to Play Rule:  Robin L. Barton of the Hedge Fund Law Report reviews the Pay to Play Rule through the lens of recent SEC enforcement actions with Hardin consultant, Cari Hopfensperger.  (Subscription Required)

Cyberattacks, Fraud and Getting to the Root of it All:  Jason Cropper dives into these complex topics and asserts that despite all the emphasis on systems and technology, the key to effective risk management is communication and training of employees.

SEC’s New Strategic Plan Puts Investors, Innovation, and Performance at Top:  The SEC announced its new four-year strategic plan.  Mercifully shorter than the prior plan at 12 pages (the prior plan ran 56 pages), this new plan’s goals reflect the Commission’s struggle to understand and protect investors, to adapt to a continuously evolving market environment, and to use its resources wisely.

SEC Investigative Report: Public Companies Should Consider Cyber Threats When Implementing Internal Accounting Controls:  The SEC decided not to pursue enforcement against these public companies for control weaknesses that ultimately resulted in successful cybersecurity attacks, but has published this report of its findings for the benefit all firms.  It describes the types of attacks and the high-level actions that the companies took after the attacks were discovered.

What Happens When a CFO Fails to Listen to the CCO?: Michael Volkov discusses the benefits of a firm’s CFO and CCO having an open and productive relationship, and the risks that can be exposed when they do not.

Filing Deadlines and To Do List for November 2018


  • Form 13F: Form 13F quarterly filing for Q3 2018 is due for advisers within 45 days after the end of the calendar quarter. Due date is November 14, 2018. https://www.sec.gov/divisions/investment/13f/13flist2018q3.pdf
  • Annual Renewal Program for IARD System: The IARD Renewal Program facilitates the annual renewal of investment adviser (IA) firms and their IA representatives’ (IARs) registrations with jurisdictions/states. Preliminary renewal statements for the IARD system will be available November 12, 2018, and will be accessible only through the E-Bill System.  Renewal statements reflect the registration renewal fees and annual system processing fees for all IARs and state-registered IA firms.  Deadline for the receipt of preliminary statement payment is December 17, 2018.  Questions? Check out the FAQs.



  • FINRA 2019 Renewal Program Preparations: Consult the FINRA website to access important dates and information regarding the 2019 Renewal Program.  Be sure to update your calendars and ensure your Renewal Account is sufficiently funded. Due date is November 1, 2018.
  • Rule 17a-5 Monthly and Fifth FOCUS Part II/IIA Filings:  For the period ending October 31, 2018. 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 is November 27, 2018. 
  • Annual Audit Reports for Fiscal Year-End September 30, 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 November 29, 2018. 
  • Supplemental Inventory Schedule (“SIS”): For the month ending October 31, 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 November 30, 2018. 
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of October 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 November 30, 2018. 
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of April 30, 2018.  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 November 30, 2018.
  • SIPC-7 Assessment: For firms with a Fiscal Year-End of September 30, 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 November 30, 2018.


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