TIMELY SECURITIES COMMENTS
The following are a collection of informative, timely, and valuable articles on securities with insightfull and personal commentary from Mr. Schulz.
Raymond James Agrees to Pay $15 Million for Improperly Charging Retail Investors
Commentary by Douglas Schulz
The SEC press release below discusses how various Raymond James retail stockbrokers took advantage of and misled their clients and investors as it relates to the purchase and sale of unit investment trusts, aka UITs. In the last couple years, I have had some very large cases on exclusively UITs. UITs have been a problematic, conflict-ridden, complicated investment for decades. The biggest problem is that they pay stockbrokers and advisors a much higher commission than they can earn over other investments. Plus, the stockbroker/firm will earn fees and commissions that a client will pay not only on the purchase of the UIT but also on the sale and any redemption/switches. This creates a massive conflict interest. An unscrupulous broker, like the ones mentioned in the SEC press release, can easily take advantage of his clients – conduct that is violative of the SEC regulations, FINRA regulations, and various state securities regulations.
FOR IMMEDIATE RELEASE
Washington D.C., Sept. 17, 2019 —
The Securities and Exchange Commission today instituted a settled order against three Raymond James entities for improperly charging advisory fees on inactive retail client accounts and charging excess commissions for brokerage customer investments in certain unit investment trusts (UITs).
The SEC order finds that Raymond James & Associates, Inc., and Raymond James Financial Services Advisors, Inc., failed to consistently perform promised ongoing reviews of advisory accounts that had no trading activity for at least one year. According to the order, because they did not conduct the reviews properly, they failed to determine whether the client’s fee-based advisory account was suitable. The order further finds that the entities also misapplied the wrong pricing data to certain UIT positions held by advisory clients, causing them to overpay fees.
In addition, the order finds that Raymond James & Associates, Inc., and Raymond James Financial Services, Inc., recommended that their brokerage customers sell UITs before their maturity and buy new UITs without adequately determining whether these recommendations were suitable. According to the order, the recommendations for early sales and purchases resulted in customers incurring (and the Raymond James entities receiving) greater sales commissions than would have been charged had the customers held the UITs to maturity and then purchased new UITs. The order further finds that Raymond James also failed to apply available sales discounts for brokerage customers that rolled over their proceeds after selling a maturing UIT to purchase another one.
“Investment advisers and broker-dealers have on-going obligations to their clients and customers,” said C. Dabney O’Riordan, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “Raymond James’ failures cost their advisory clients and brokerage customers millions that will be repaid as part of this settlement."
The order charges Raymond James & Associates, Inc. and Raymond James Financial Services Advisors, Inc., with violating Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7, and charges Raymond James & Associates, Inc., and Raymond James Financial Services, Inc., with violating Sections 17(a)(2) and (3) of the Securities Act of 1933. To settle the charges, the three Raymond James entities agreed to be censured and to disgorge approximately $12 million representing inappropriate client advisory fees and unit investment trust commissions, together with prejudgment interest, and to pay a $3 million civil penalty. The three Raymond James entities have agreed to make distributions to harmed investors.
The SEC’s investigation was conducted by Salvatore Massa in the Asset Management Unit and New York Regional Office. The case is being supervised by Jessica Weissman. The staff received assistance from Mark Fowler of the Office of Compliance, Inspections and Examination from the Philadelphia Regional Office and Andrew Shelton, J. Matthew Jenkins, Deuce Tu, Michael Watson, Lundy Ben, Dmitry Malinskiy, and John LaVoie of OCIE’s Risk Analysis Examination Team.
Commentary by Douglas Schulz
February 6, 2018
When you play with fire, you can get burned: our mothers
taught us this. Yet once again Wall Street dishes up another perfect example of
how investors buying into one of their newly created products/investments, you
can lose your shirt. Another classic example of how Wall Street, stock brokers,
investment advisors, money managers and portfolio managers forget lessons that
were supposedly learned from earlier bear markets and failed investments. We’ve
been in a very bull market for roughly 8 years, and so once again Wall Street
is pushing riskier and riskier investments. The speculative ETFs mentioned in
the article below are just a few of the wild crazy ETFs and other products Wall
Street has created in the last decade. ProShares, Ultra, and Direxion 2X and
Direxion 3X R example of these leveraged and inverse ETFs. Guess right, and you
can make a lot of money, guess wrong and you will be washing dishes. Did the
brokerage firms, brokers and advisers who push and recommend these products,
really fully explain the incredible risk to their clients and investors?
Probably not, even though they are required to do so under the securities
We had an interesting correction in the markets the last two days, it’s inevitable: corrections are inevitable, and this market was due because of the historical run-up in values recently. Most of the time investors’ portfolios can live through these corrections if they are short in duration. But who gets hurt in these corrections, is those investors who are in leveraged funds, inverse funds, and margin accounts. I distinctly remember what is still considered one of the greatest market corrections of all time, 1987. Even though the market had a huge correction in the fall of 1987, all in all the markets were positive for the year of 1987. So, for those investors who were properly diversified and did not have margin or leveraged investments in their portfolios, they weathered the 1987 crash with very little loss. But the opposite happened for those portfolios there were using options, margin, in other riskier investments. Their portfolios were quickly wiped out, and they couldn’t stay for the long run. After the article by the Wall Street Journal, below I have listed some of the wilder riskier crazy ETFs, tread lightly, very likely.
Investors Suffer Heavy Losses on Bets Against Volatility
Its return is claiming casualties
On Tuesday morning in Tokyo, Japanese securities firm Nomura Holdings said it would redeem an investment product whose performance was linked to the Cboe Volatility Index, or VIX. It lost much of its value hours after the VIX spiked when stocks in the U.S. fell sharply on Monday. And trading in the VelocityShares Daily Inverse VIX Short Term ETN XIV known by its ticker symbol XIV, was halted Tuesday morning in Europe. Credit Suisse Group CS , which created the instrument in 2010, is expected to provide an update about redeeming it before U.S. markets open, a person familiar with the matter said. It recently had a market capitalization of $1.6 billion.
outside its Tokyo headquarters, Japan,
PHOTO: RODRIGO REYES MARIN/ZUMA PRESS
Products like XIV and
Nomura’s Next Notes S&P 500 VIX Inverse ETN are notes whose value goes down
when the VIX goes up. Their issuers are allowed to redeem them early if the
value plunges sufficiently. XIV, for instance, can be redeemed if the value drops
more than 80% in a day. The value of XIV moves inversely to the S&P 500 VIX
Short-Term Futures Index, which jumped 96% Monday.
In the years since the financial crisis, shorting volatility has become a popular and profitable strategy for investors while yields have plunged around the world and stocks have moved placidly upwards.
“We apologize from the bottom of our hearts for causing great inconvenience for the holders,” a unit of Nomura that issued the notes said in a statement. Investors in the product were told they would receive just 4% of its market value a day earlier.
The Nomura investment product was a complex bet that volatility in stocks, as measured by movements implied by options prices, would fall.
The Next Notes product’s total market capitalization was about around $297 million as of Feb. 5. Before Monday’s crash, it had more than doubled from a year earlier.
But when U.S. stocks lurched downward on Monday, the volatility index surged, causing losses for the Tokyo-listed exchange-traded notes—which were issued by a European unit of the Japanese brokerage.
The S&P 500 index dropped 4.1%, while the VIX jumped 117% in its largest-ever percentage gain for a single day. The underlying index tracked by the Next Notes product fell more than 80%, triggering a condition requiring early redemption.
Nomura said Tuesday that the notes would be redeemed at steep discount to their closing price on Monday in Asia, crystallizing large losses for investors. Shareholders will receive Y1,144 ($10.5) per share before fees, according to a regulatory filing by Nomura. That was just under 4% of Monday’s closing price of Y29,400 ($266) a share.
It was the first instance of an early redemption for exchange-traded funds or notes on the Tokyo Stock Exchange, according to an exchange spokeswoman.
There are roughly a dozen inverse VIX exchange-traded products with more than $3.4 billion in total assets under management, according to Morningstar data. Most are traded on U.S. or European exchanges.
A ProShares fund with the ticker SVXY that previously had $1.4 billion in assets also collapsed in value and was also halted in early trading on Tuesday.
A Credit Suisse spokeswoman said late Monday that there was “no material impact” to the bank from the activity in the fund.
Credit Suisse doesn’t itself own shares in the exchange-traded product, VelocityShares Daily Inverse VIX Short Term ETN, according to a person familiar with the matter. Credit Suisse holds roughly 4.8 million shares of the note, according to FactSet, but does so on behalf of clients such as hedge funds.
Credit Suisse said Tuesday that it suffered no trading losses from XIV.
Credit Suisse shares were down 4.5% midmorning in London on Tuesday. Even if Credit Suisse doesn’t incur losses from the instrument’s collapse, it does face reputation damage if its clients incur heavy losses.
—Mike Bird contributed to this article.
Wall Street Journal Article - Wall Street versus Vanguard
Commentary by Douglas Schulz
(WSJ article follows)
January 29, 2018
Whose Best Interest?
You watch and read all those ads by Wall Street with a claim to only have your best interest at heart, but don’t be fooled. Wall Street hasn’t had your best interest at heart since the days of paper tickertape. The attached article is once again more proof that Wall Street keeps its heart in its wallet. The reason that consistently some of the highest-paid professionals in the country are in the stock brokerage business is because Wall Street knows how to squeeze as many commissions, management fees, margin interest in trading spreads from each of its investors/clients. Vanguard mutual fund management has been a thorn in Wall Street for decades. While the rest of the mutual fund industry was always seeking new ways to make more money from their investors, Vanguard has been the industry leader on how to reduce costs to its investors. And now the brokerage industry, including those broker-dealers who specialize in Internet and online brokerage services, are fighting back. Fidelity, Ameritrade, Morgan Stanley and a few others are now going to penalize investors who invest in the Vanguard mutual funds with no front-end fees and exceptionally low annual fees. And some firms like Ameritrade - it just decided not to let you buy Vanguard funds at all. Whose best interest? Not yours!
Wall Street to Vanguard: We’re Not Your Doormat
Fidelity makes it more expensive for some clients to invest in Vanguard funds, while others cut off access altogether
Updated Jan. 28, 2018 4:20 p.m. ET
Wall Street is fighting back against Vanguard Group.
In the past year, large financial firms including Fidelity Investments, TD Ameritrade andMorgan Stanley have all made changes to their fees or product lineups that make it more expensive for some customers to invest in Vanguard’s funds. In some cases, these firms have even made it impossible to invest in Vanguard mutual funds at all.
The changes made so far are small and have occurred in several different corners of the investing market, but they represent a stark shift for an industry that has struggled to manage being both Vanguard’s partner and competitor.
Vanguard has pulled in record levels of new cash in recent years as investors plowed money into lower-cost index-tracking funds. It now manages nearly $5 trillion in assets, up from $1.4 trillion 10 years ago.
That growth was aided for years by Wall Street as many wealth managers and brokerage firms sold inexpensive Vanguard products to their customers. More recently, rival money managers have tried to better compete on price, slashing their fees.
Now, rival asset managers, brokerage firms and retirement-plan administrators are fighting back more aggressively.
Fidelity, the largest 401(k) plan administrator in the country, will now charge some new corporate customers that hire the firm to run their 401(k) plans a fee of 0.05% on assets invested in Vanguard funds. That new fee covers administrative services that Fidelity provides as a 401(k) record-keeper, a spokeswoman for the Boston firm said.
“A small number of fund families have not compensated Fidelity for certain services, and this pricing change is designed to address that disparity with the intention of providing fairness across all of our business relationships,” she added. “This is about leveling the playing field.”
Fidelity explicitly requires employers to pay the fee, rather than passing it off to plan participants, a person familiar with the matter said. Companies and plan participants typically share 401(k) plan administration costs, however, which means savers could bear some or all of the new cost if an employer sought to recoup the new expense in a less explicit way, retirement industry executives say.
The fee is small but could add up over time.
For example, an investor who put $10,000 into a mutual fund that charges 0.1% and achieves a 5% annual return would have $41,942 after 30 years, according to Bankrate.com. An additional 0.05% fee on those assets would mean the investor earns $626 less over that period.
Executives from the two firms have been in talks for years over Vanguard’s refusal to pay the servicing costs. In December, leaders from both firms met at Vanguard’s Pennsylvania headquarters, and Fidelity executives pressed the firm to reconsider its stance, according to people familiar with the matter. Fidelity ultimately put the fee change in place without notifying Vanguard, the people said.
“It’s definitely unusual; we haven’t seen any other charge like this,” said Emily Wrightson, director at Cammack Retirement Group, Inc., adding that it could deter companies considering whether or not to hire Fidelity if their employees prefer Vanguard funds. “I don’t think it’s going to help” Fidelity win new business, she said.
Fidelity is by far the largest 401(k) record-keeper in the U.S., according to consulting firm Cerulli Associates, with a nearly 30% market share and about $1.4 trillion in assets in the plans it administers. Of those assets, 13% are in Vanguard products, according to research firm BrightScope Inc.
Ahead of the PackTop 401(k) record keepers by plan assetsMarket shareSource: Cerulli AssociatesNote: As of the third quarter of 2016; assets used inFidelity's market-share calculations are estimates
The recent move by Fidelity’s retirement business, which was first reported by InvestmentNews, is unconventional because it appears to only affect Vanguard and because of the scale of the fee, industry executives say. The 0.05% charge on assets in Vanguard funds amounts to more than 40% of the average expense ratio across Vanguard’s mutual funds.
Fidelity’s additional fee makes comparably priced funds with similar investment mandates it offers even more competitive with Vanguard’s funds.
In 2016, Fidelity slashed prices on more than two dozen index-tracking funds, putting them on par with or below those of comparable products offered by Vanguard. Across the industry, there are now 571 mutual funds that charge investors 0.1% or less, compared with 425 at the end of 2012, according to Morningstar At Vanguard, the average expense ratio of its funds is 0.12%.
One reason Vanguard has been able to offer such low fees for so long is the structure of its business: It is owned by its fund shareholders. The Malvern, Pa., money-management giant also allows investors to buy mutual funds directly from it unlike many of its rivals and trade its exchange-traded funds commission-free.
The new 401(k) fee at Fidelity won’t apply to existing clients with assets in Vanguard funds. Large companies that currently offer Vanguard funds in 401(k) plans run by Fidelity include International Business Machines , according to the most recent regulatory filings available from the Labor Department.
Fidelity isn’t alone in targeting Vanguard. Other brokerage platforms have also taken steps that make the index giant’s products less appealing than comparably priced funds sold by rivals.
TD Ameritrade late last year overhauled its commission-free ETF trading lineup, dropping all 32 Vanguard products it had previously included. That overhaul increased the total number of ETFs that could be traded commission-free.
Morgan Stanley last year decided to ban its financial advisers from selling clients new positions in Vanguard mutual funds, the Journal reported. Merrill Lynch has long had such a policy for its advisers.
Moves to deter the use of Vanguard funds have at times stalled.
Morgan Stanley, for example, considered changing the compensation calculation for its financial advisers to discourage them from keeping clients in Vanguard funds, but ultimately decided against it, according to people familiar with the matter. The change mooted would have excluded client assets in mutual funds that don’t pay for distribution when calculating financial-adviser compensation.
While some moves have made rival funds relatively less expensive, they have so far done little to halt the tidal wave of new cash flowing into Vanguard’s products and in some cases risk driving investors loyal to Vanguard to the firm’s own retirement administration and brokerage businesses.
Sarah Krouse at firstname.lastname@example.org
WALL STREET JOURNAL ARTICLE - MARGIN LENDING
Commentary by Douglas Schulz
(WSJ article follows) July 27, 2017
An excellent article in today’s Wall Street Journal pointed out that some of the largest broker dealers (brokerage firms) have increased their margin lending to investors since the 2008/2009 crash. As a securities expert witness who has testified in numerous FINRA arbitrations relating to margin, I feel this is alarming. Historically speaking, when individual investor's margin debt/balance increases significantly, it is often a precursor to a bear market. When investors take on ever increasing margin debt (leveraging their accounts), it is a strong sign that there is excessive enthusiasm among investors. Of course, the nation’s broker dealers are happy to see this increasing margin debt. Charging margin interest on the margin/debit balances is a huge profit center for Wall Street. Margin has an additional conflict of interest because it allows doubling of the size of money to invest. So, by pushing investors to borrow on margin, brokers can double their commissions by selling more investments to their customers. As a securities expert, I have been in hundreds of margin based FINRA arbitration cases going back as far as 1989. When I’m acting as a securities expert witness in a margin related case these are often some of the points I make:
1. Was the risk of margin/leverage fully explained to the investor?
2. Was the risk fully explained to the investor that when you have a leveraged stock or bond portfolio, when there is a decline in value of the holdings, that decline in percentages is magnified due to the leverage?
3. Using margin in a fixed income/bond portfolio almost never makes sense, especially in these low-interest rate environments.
4. Margin interest charges are a conflict of interest because the margin interest being charged is a profit center for the broker-dealers.
5. Was the investor fully aware that when there is a decline in the portfolio, the broker-dealer, based on the agreement the investor signed, can sell the client out without any notice at all?
6. Was the investor fully aware that when a broker-dealer decides to sell a client out (liquidate securities to meet the margin call), the broker-dealer can sell any of the securities they choose?
7. Margin interest is a capital impairment. I explain to FINRA arbitration panels that it is hard enough to make money in the markets, but when the investor is paying margin interest, it is a drag on potential profits.
WALL STREET NEEDS YOU TO BORROW AGAINST YOUR STOCK
A boom in securities-backed lending is bolstering bank profits, but critics say it doesn’t always benefit clients, and regulators have been keeping a close eye on the practice. Securities-backed lending is growing in importance at brokerages such as Merrill Lynch.
PHOTO: KEITH BEDFORD/REUTERS By Michael Wursthorn
Updated July 27, 2017 7:46 p.m. ET
Wall Street brokerages have been selling billions of dollars in loans backed by stocks and bonds, a trend that yields lucrative fees for the firms but poses risks for borrowers. While banks don’t always report these loans in the same way, these securities-backed loans total at least $100 billion for the biggest brokerages—up exponentially since the financial crisis—with several billions of dollars of additional debt held at smaller brokerages, banking analysts estimate. Executives at Morgan Stanley MS 0.25% earlier this month highlighted these loans to individuals as a big growth area and revenue driver, saying the loans helped expand the bank’s overall wealth lending by about $3.5 billion, or 6%, in the second quarter. On Thursday, Goldman Sachs Group Inc. took a step toward expanding its securities-based lending business through a new partnership with Fidelity Investments. The loans work a lot like margin loans. Brokerages lend against the value of an investor’s portfolio. But unlike margin lending, customers don’t use the debt to buy more securities. Brokerage executives say the loans can help clients avoid selling assets. The client can get cash without shifting their investments; they also avoid potentially locking in losses or incurring taxable gains, or missing out on future stock market gains. Clients are also able to borrow money at relatively low interest rates because the loans are secured. “Securities based loans can be a valuable financial planning tool for appropriate clients,” a Morgan Stanley spokesman said. Critics worry that the surging stock market has made investors numb to the risks of borrowing against their investments—a scenario that has played out before. In the runup to the Great Depression, the dot.com bubble of 2000 and the financial crisis, investors binged on margin debt that proved perilous when stocks tumbled. Investors using these loans now could face a similar fate if markets tank and the value of their collateral shrinks, prompting the bank to demand repayment. If the margin call isn’t met, the securities backing the loans are sold and the borrower is responsible for any remaining balance. For brokerages, these loans have become a reliable source of revenue in the years since the financial crisis, as firms have begun moving from a business model of charging commissions for trading to a system of fees based on assets under management. The loans themselves help brokers retain these assets because customers don’t have to sell stocks and other securities when they need cash. These loans have also become a big factor in brokers’ compensation. Several Merrill Lynch brokers said they have asked longstanding clients to open a securities-backed line of credit to help them hit bonus hurdles, assuring that clients wouldn’t need to use it or pay any fees for opening it. Merrill brokers receive continuing payments for getting clients to tap credit lines, and those loan balances contribute to year-end bonus calculations, people familiar with the matter said. Brokerage executives have said the longer a client has one of these loans tied to their account, the more likely they are to use it. “We were dramatically pushed to put these on all of our client accounts,” said Steven Dudash, a former Merrill Lynch broker who has been managing his own investment-advisory firm since 2014. “Whenever you’re product-pushing, it’s not in the client’s best interest.” Merrill representatives say its brokers offer these loans to clients in a responsible manner, including disclosing the risks and fees. “If people need the money, they should sell securities,” said Terrance Odean, a professor of finance at the Haas School of Business at the University of California, Berkeley. “It’s very risky to take a leveraged position in the market, and I don’t think people are thinking about it that way.” Wells Fargo & Co. recently changed practices around how brokers pitch lending products. Starting this year, Wells Fargo stopped offering brokers bonuses tied to how many loans, including securities-backed debt, they opened for clients, executives of the bank have said. As of the end of 2016, clients of Bank of America Corp.’s BAC 0.57% wealth unit, which includes Merrill Lynch and private bank U.S. Trust, had some $40 billion in such loans outstanding, up 140% from 2010. Morgan Stanley’s customers had $30 billion in these loans, more than double from 2013. UBS Group AG and Wells Fargo also have made billions of dollars in such loans, people familiar with those banks said. Morgan Stanley’s finance chief, Jonathan Pruzan, said while discussing earnings this month that the bank expects more clients to take out loans in the months ahead. “That’s been a real key driver of our wealth business,” he said. The growth of securities-backed loans has drawn the attention of regulators, who have questioned the brokerages’ marketing and sales efforts as well as the suitability of the loans. Merrill opened more than 121,000 such loan accounts between 2010 and 2014 with more than $85 billion in total credit extended, according to a Financial Industry Regulatory Authority settlement order last year. In the matter, Finra alleged that Merrill didn’t fully explain the risks of securities-backed loans and used risky or concentrated investments as collateral. Merrill settled its case without admitting or denying the allegations. Merrill reported its securities-lending oversight lapses to Finra initially and cooperated with the regulator’s inquiry, according to Merrill representatives. They said the firm has improved its procedures. In another regulatory action, the Massachusetts securities watchdog last year accused Morgan Stanley of developing a sales program that encouraged brokers to pitch these loans regardless of whether clients needed them. Brokers involved in the incentive program were given scripts coaching them to offer securities-backed loans to clients who said they needed to pay taxes or cover expenses for a wedding or a graduation party, or if they mentioned “purchasing a luxury item like a car or yacht,” according to the regulator. “It’s not healthy for the industry,” said William Galvin, Massachusetts’ top securities regulator, who has been investigating how firms motivate brokers to push these loans. Brokerages “should be more concerned about this,” he said, “but they’re in favor of competition and seeing who can get more loans.” Morgan Stanley agreed to a $1 million settlement with the regulator in April without admitting or denying wrongdoing. A Morgan Stanley spokesman said Massachusetts found no evidence that any clients were harmed or that any of the loans were unsuitable or unauthorized. “We have taken steps to strengthen and clarify our policies and controls around such initiatives,” he said. Write to Michael Wursthorn at Michael.Wursthorn@wsj.com Appeared in the July 28, 2017, print edition as 'Borrowing With Stock Soars as Market Rises.'
RISK & COMPLIANCE JOURNAL. The Morning Risk Report: How Brokers, Firms Can Fight Frivolous Finra Complaints By Ben DiPietro Jul 11, 2017 6:57 am ET The Financial Industry Regulatory Authority in June 2016 began requiring brokers and registered investment advisors to link to its BrokerCheck site, where consumers can research any complaints filed against them. While many of those complaints are serious.
WALL STREET’S CANNED COMPLIANCE
Commentary by Douglas Schulz
January 30, 2018
Below is an excellent article Wall Street Journal, discussing how some brokerage firms and Investment Advisors, are utilizing “Canned” compliance and supervisory systems. The dictionary defines “Canned” as it is utilized here as; “a.) Use repeatedly with little or no change: canned speech. b.) Totally unoriginal; devoid of individuality.”
As a securities regulatory expert (CRCP – Certified Regulatory Compliance Professional - certified by the Wharton School of Business and FINRA), I am regularly hired to consult and advise on the issue if a broker-dealer or an investment advisor’s compliance and supervisory systems are adequate under the various securities regulations. My experience is that many of the smaller broker-dealers and investment advisors in the last few years are starting to rely on outsourcing some of their compliance and supervisory duties. As this article points out, they are buying “canned” generic compliance and supervisory systems. This is clearly not in the best interest of the individual investor.
THE MORNING RISK REPORT: SEC IN TEXAS FLAGS ‘CANNED’ COMPLIANCE PROGRAMS
Jan 30, 2018 7:33 am ET
Too many companies are relying on “canned” compliance programs that don’t apply to their needs, regulators in Texas told investment firms this month. Lawyers say the news highlights the fact that while expectations have changed over the years, some companies still see compliance systems as an off-the-shelf product that will work for one firm as well as for another.
Staff from the Securities and Exchange Commission’s Fort Worth, Texas, office raised the concern during conference calls this month to inform investment advisers and investment companies about issues that came up during the regional office’s 2017 examinations of such firms, as well as likely enforcement priorities for 2018, Shamoil T. Shipchandler, director of the Fort Worth office, told Risk & Compliance Journal. “We had some indications that there were companies buying off-the-shelf programs and not customizing them to their needs,” Mr. Shipchandler said. Having a compliance program that is tailored to a company’s business is critical, said William H. Devaney, co-head of the law firm Baker McKenzie’s global compliance and investigations group, because every company—even those in the same industry—faces different dangers.
“I think in years gone by, a canned compliance program was the norm,” said Stephen G. Huggard, co-chair of the white-collar and government-enforcement practice group at the law firm Locke Lord. The news service Ignites earlier reported on the Forth Worth outreach effort and a Locke Lord summary of one of the calls. There was a “misguided belief that a compliance program was a compliance program,” Mr. Huggard said. Bigger, more sophisticated companies have moved beyond that view, he said, while other companies are changing their stances. “I would say they’ve been incentivized by government investigations and enforcement actions.”
On January 11, 2018, the Fort Worth, Texas, Regional Office (“FWRO”) of the U.S. Securities and Exchange Commission (“SEC”) held a first-of-its-kind call to increase transparency by discussing the 2017 regional examination findings and previewing some likely priorities for 2018.1 With over 2,000 participants, the teleconference reached capacity leaving many unable to participate. The hour-and-a-half-long call was structured into three parts: (1) discussion of the National and Regional Examination Programs; (2) investor risk highlights; and (3) a question and answer session. For those in the financial services industry in the Dallas-Fort Worth Metroplex, the sampling of topics covered provides key insights of what is likely to come in the new year.
National & Regional Examination ProgramsConcurrent to the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) National Exam Program (“NEP”), the Regional Exam Program identifies and tests specific areas that may be unique to the region. Through the 139 exams administered in the region in 2017, the FWRO identified 11 areas of deficiency. Much of the call, however, focused on two specific deficiencies:
1. Compliance Policies & Procedures. The FWRO reported that compliance-related citations pursuant to the Compliance Rule, 17 C.F.R. § 275.206(4)-7, were included in almost 50 percent of regional delinquency letters in 2017. Too frequently, firms used “canned” compliance policies that were not tailored to the firm’s own business dealings. Often, the FWRO found compliance programs containing policies that were inapplicable to the firm’s business operations and, in some instances, included the name of another firm instead of their own. As a result, many firms were already in violation of their own policies. The FWRO reminded listeners that the Compliance Rule requires annual review to address any compliance issues from the previous year, as well as any changes in applicable laws. Moreover, the FWRO noted that it was “no fan” of chief compliance officers that wear other hats in the firm or report to the general counsel instead of the firm’s CEO. Finally, the FWRO also mentioned it would be examining how firms affected by Hurricane Harvey implemented their business contingency, continuity, succession, and/or disaster plans.
2. Anti-fraud Provisions & the Fiduciary Duty. 33 percent of regional delinquency letters in 2017 cited anti-fraud and fiduciary duty related violations. The FWRO emphasized that Section 206 of the Investment Advisers Act of 1940,2 as the Supreme Court interpreted it SEC v. Capital Gains Research Bureau, Inc.,3 imposes both a fiduciary duty to expose all conflicts of interest and an affirmative obligation of utmost good faith to place a client’s needs above that of an adviser’s. The FWRO also counseled firms to reevaluate their fiduciary duties to their clients to avoid misleading them, citing to the administrative decision of In re: Lawrence M. Labine,4 to warn of the interplay the anti-fraud provisions have with those trying to switch hats between a registered investment adviser representative and a registered representative of a broker. Furthermore, double billing and advisory fees would continue to be investigative priorities both nationally and regionally, according to the FWRO.
Investor Risk Highlights
Although time did not permit for much detail, the FWRO also highlighted areas of investor risk that would likely be priorities this year, including:
1. Abuse and improper use of Initial Coin Offerings (“ICOs”).
2. Federal government employee retirement investment scams.
3. Failure to disclose potential associated risk and loss of securities-based loans to consumers.
Question & Answer Session
Before ending the call, the FWRO fielded questions. Of particular interest were:
1. Will the SEC adopt the Department of Labor’s fiduciary rule? The FWRO replied that SEC Chairman Jay Clayton has been vocal about his interest in taking a lead on the establishment of an overall fiduciary rule and that the Chairman will likely work with sister regulators to create a harmonized rule.
2. What triggers an “on-site” administration versus a “desk” administration of an examination? While this has historically been based on a time cycle, the FWRO answered that this determination is now risk based. After a risk analysis using data from both the D.C. and regional risk and surveillance offices around August or September, the FWRO discusses priorities with the national SEC office. Then, the FWRO develops regional priorities and an exam plan for the fiscal year that includes a range of exam types.
3. Are Exempt Reporting Advisers (“ERAs”) being examined routinely or for cause this year? The FWRO confirmed that these examinations would likely be for cause only. Moreover, while the FWRO does not anticipate ERAs will be a national or regional priority, many ERAs are involved with ICOs and, thus, may come to the SEC and FWRO’s attention in that manner.
The FWRO closed by expressing its hope that calls like this will be the first step in its continued effort to increase transparency and communication with the financial services industry in the region and that similar calls will likely occur biannually.
1 Telephone Call with Shamoil T. Shipchandler, et al., Director, Fort Worth Regional Office, U.S. Sec. & Exch. Comm’n (Jan. 11, 2018).