Cryptocurrency update - serious risks still in place  

September 2021, Douglas Schulz invest securities consulting Inc.

 

I co-authored a treatise on bitcoins in November 2018 that was published in two law journals. A lot has happened in three years. I will be the first to admit that millions of people worldwide have collectively made billions speculating in various cryptocurrencies. But as you can see from the article below millions of individuals worldwide have also lost billions of dollars trading in cryptocurrencies. My expertise, since I know longer managed people’s money as a registered investment adviser, is not predicting market trends. But I am regularly called upon I investors and lawyers across the country to render opinions on A) the rules regulations norms and standards of the securities industry; B) render opinions as to the riskiness and suitability of various investments.

As the fact that various cryptocurrencies gone up in value a thousandfold, and that millions and billions of dollars have been made, decrease the risk of investing in these types of investments? No. Regardless of the investment, be it gold, stocks, bonds, commodities, collectibles, and cryptocurrencies, by the mere fact that one of these investments has increased in value decrease the risk of investing in those types of assets.

Yes, there are strong arguments that investing in less capitalized investments, generally increases the risk. But don’t confuse that with the fact that now that the worldwide value of all cryptocurrencies combined is a huge number, lessens the risk.

Regulation – It is a given, that when investing in any investment that is less regulated, and has less oversight, that that investment is generally considered a higher risk investment. Currently we stand on the precipice. The securities exchange commission, SEC, is likely within the year to issue regulations for this first time addressing many issues relating to cryptocurrencies. Now, it’s not that SEC/federal regulations, will by any means all of a sudden make investing in cryptocurrencies safe. Every day securities fraud is committed, and that’s done right in the face of the SEC and FINRA. But is my hope, that the regulations will be comprehensive enough, that the risk of investing in these types of investments, will be lessened to some degree to the average investor. I will keep you posted, when the regulations are finally put into play.

• Ex-Cryptocurrency Fund Manager Sentenced to 7½ Years in Prison
  

Stefan Qin had pleaded guilty to one count of securities fraud after prosecutors said he ran his $90 million Virgil Sigma Fund like a Ponzi scheme

Stefan Qin, who pleaded guilty in February to one count of securities fraud, was sentenced to 7½ years in prison Wednesday.

PHOTO: BILLY H.C. KWOK FOR THE WALL STREET JOURNAL

Sept. 15, 2021 4:16 pm ET

By James Fanelli

A cryptocurrency hedge-fund manager who lied about returns on his $90 million fund and siphoned money from its accounts to cover a lavish lifestyle was sentenced to 7½ years in prison Wednesday.

Stefan Qin, 24 years old, pleaded guilty in February to one count of securities fraud after prosecutors said he ran the fund, Virgil Sigma Fund LP, like a Ponzi scheme for three years until its implosion in late 2020. The U.S. attorney’s office for the Southern District of New York said many of the more than 100 investors in the fund were scammed.

Federal sentencing guidelines called for 15½ to nearly 20 years in prison, but U.S. District Judge Valerie Caproni said at a hearing Wednesday in federal court in New York that those recommendations were draconian.

Mr. Qin’s lawyers had asked for a two-year imprisonment, but Judge Caproni said she needed to give a sentence that dissuaded others from committing similar white-collar crimes. Mr. Qin “frittered away millions of dollars” and wiped out some victims’ savings, she said.

Markets

Prosecutors had recommended a sentence of eight years, noting that Mr. Qin had no known criminal history and had voluntarily returned to the U.S. from South Korea, where he had been living, to face justice when he learned of the federal investigation. Mr. Qin has also cooperated with a court-appointed receiver’s efforts to help locate and claw back investor money, prosecutors said.

A net $65 million was lost in the scheme, according to Judge Caproni. The receiver has located about $5 million, the judge said.

At the sentencing, Mr. Qin’s lawyer, Sean Hecker, said his client had a chaotic family life growing up and had been bullied as an adolescent. The trauma of his childhood affected his decisions, the lawyer said.

Mr. Qin told the judge on Wednesday that he was swept away by the idea that many of his investors—including family, friends and business associates—saw him as a financial wunderkind. When his fund couldn’t meet the promises he made to investors, he said he lied.

“I abused their trust in immoral and illegal ways to boost my success,” he said.

Mr. Qin’s fraud highlights the growing number of scams in cryptocurrency markets operating with little regulation and as bitcoin’s value soars. The Federal Trade Commission said consumers reported losing nearly $82 million to crypto-related fraud in the fourth quarter of 2020 and first quarter of 2021. It was more than 10 times the amount during the same six-month period a year earlier.

Prosecutors said Mr. Qin billed Virgil Sigma as an adherent of a highly profitable low-risk strategy specializing in arbitrage trading using 40 cryptocurrency exchanges. He made public appearances, including in the media, to falsely promote glowing returns. The Wall Street Journal profiled Mr. Qin in 2018 and repeated some of his false claims.

In reality, Mr. Qin used Virgil Sigma funds to pay off redemption requests from investors, to cover the rent on his luxury apartment in New York City and to make risky investments unrelated to cryptocurrency, prosecutors said. As he drained Virgil Sigma’s accounts, he dipped into the assets of another cryptocurrency hedge fund that he ran, the prosecutors said.

This is Not Investing!  GameStop, Robinhood, WSB, Reddit, etc.

February 8, 2021 by Douglas Schulz, Invest Securities Consulting Inc.

 

Anyone who regularly reads the financial papers, much less is an active trader in various markets, is well aware that there is a new speculative fever that is the rage in numerous markets. In this short post from someone who has been investing and trading in various markets since the sixth grade (over 55 years ago), let me put it in perspective for some of you who have not been trading quite as long.

Gambling versus investing.  Here’s a link for a definition and distinction between the two:

https://www.investopedia.com/articles/basics/09/compare-investing-gambling.asp#:~:text=True%2C%20investing%20and%20gambling%20both,and%20over%20the%20long%20run.

Gambling, for most people, is and should only ever be a hobby and nothing more. I started playing poker when I was in the first grade. Many of us go to Las Vegas or occasionally to a local casino. We go there to gamble. We know in advance that the game is stacked in favor of the house. And for most of us, over the years, we lose money. But we don’t care because, unless we have a gambling problem, we never lose enough money to ruin our fun, much less our financial well-being. Now, there are more serious gamblers and there are even famous professional gamblers. We learned about them in the TV series, Maverick. And today, online poker tournaments are viewed by millions.

Gambling is speculating.  Here’s a formal definition for the word speculation:

Speculation

By ALAN FARLEY

 Reviewed By GORDON SCOTT 

 Updated Dec 28, 2020

What is Speculation?

In the world of finance, speculation, or speculative trading, refers to the act of conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain or other major value. With speculation, the risk of loss is more than offset by the possibility of a substantial gain or other recompense.

An investor who purchases a speculative investment is likely focused on price fluctuations. While the risk associated with the investment is high, the investor is typically more concerned about generating a profit based on market value changes for that investment than on long-term investing. When speculative investing involves the purchase of a foreign currency, it is known as currency speculation. In this scenario, an investor buys a currency in an effort to later sell that currency at an appreciated rate, as opposed to an investor who buys a currency in order to pay for an import or to finance a foreign investment.

Without the prospect of substantial gains, there would be little motivation to engage in speculation. It may sometimes be difficult to distinguish between speculation and simple investment, forcing the market player to consider whether speculation or investment depends on factors that measure the nature of the asset, expected duration of the holding period and/or amount of leverage applied to the exposure.

A gambler or a speculator knows in advance that the likelihood that he can lose either all or a large percentage of the amount of money he is wagering is high. But for that higher risk, this person is seeking commensurate higher returns. That is the potential reward for the higher risk, often referred to as the risk-reward ratio.

 

Professional gamblers and professional speculators are not willy-nilly throwing their money away, though. Were it not for a lot of analysis, evaluation, and skill involved in speculating, those individuals would lose all their money relatively quickly. Professionals take what we call calculated risk. They hone their skills and do their homework before they participate.

 

But this is not investing. Yes, if you went to the link I provided above, you learned that the definition of investing and gambling is somewhat similar, in that both are investing for an expected return. In the licensed and professional world of investing, investment management and investment advice is a long-term process. Through proper diversification and a long list of investment tools, the risk is much less than in gambling or speculation. Yes, there can be losses, but normally in a properly structured and diversified portfolio, the more accepted risk is for a lesser return, not a loss of principal.

GameStop, Robinhood, Etc.

The investment history books are full of famous fever investing and speculative bubbles, but this short post does not have room for them: tulip bubble, railroad bonds, hunt silver debacle, technology and telecom bubble. Herd mentality.

As we start 2021, we are in a unique situation. We are in an extended boom economic cycle which started roughly 11 years ago in 2009. Real estate, stocks, bonds, gold, silver, mutual funds, ETF’s, bitcoin and a fairly long list of investments increased significantly in value in this roughly 10-year bull market. As a result, millions of investors have seen a significant increase in their net worth. In addition to this, the world is flush with cash, as governments have been pouring cash into the economy to brunt the effects of the coronavirus. With lots of cash and liquidity, you have millions of investors and, importantly, speculative traders who have more than enough money to “play with”.

And then you add to that the fevered pitch created by some of the incredible escalation in prices of a long list of securities.  Many of these fast movers are in technology, but even the carmaker, Tesla, has seen its market capitalization in stock price go up exponentially, making Elon Musk now the richest man in the world.

As a securities professional for over 40 years, I am not trying to put a damper on anyone’s fun. But I feel obligated to my readers to post this warning: Don’t confuse speculating or gambling with investing.

Even though some of this trading might be considered speculative or gambling; that does not mean that these speculators, have any fewer rights under the securities regulations than what you might consider conservative investors have. Under the SEC, FINRA, and state securities regulations, these traders have an absolute right to expect their orders to be filled, professionally, accurately, timely, and fairly.

The securities regulations and laws, make this quite clear. And that even goes for trades made at online/Internet brokerage firms such as Ameritrade, Fidelity, and Schwab.

 

Goldman Sachs – Bigger, Better Crooks

Commentary by Douglas Schulz

October 27, 2020

It is natural for Americans to trust bigger, more prominent companies, especially when it comes to banks and brokerage firms. These firms knowing this reliance, market heavily to push the “trust” factor. So, the question is: “Is this misguided trust?” In my book on Wall Street written in 2002, I state that you might want to steer clear of small brokerage firms and investment advisors, because if there is fraud or abuse, you may not be able to recover your losses. When the lawsuits pile up, these smaller firms just close shop.

But do not misinterpret that advice as indicating that the larger and even the largest firms are any less crooked. Remember those well-known, behemoth Wall Street firms such as Dean Witter, E.F. Hutton, PaineWebber, Lehman Brothers, and Bear Stearns? Even Merrill Lynch relented to being bought out by Bank of America due to its massive losses in the subprime scandal. Just ask yourself, “Where did all these firms in recent memory go?”

Chalk another one up for the books: Goldman Sachs can now be added to the list of bigger, better crooks. See the Bloomberg article below. And this is, by no means, the only infractions on the part of Goldman Sachs the last few years.

And just for your edification - I threw in a recent headline of one of the other Big Boys on Wall Street, J.P. Morgan. If I took the time to add the scandals, infractions, and wrongdoing on the part of Wells Fargo and Morgan Stanley, this would be an exceptionally long post, indeed.



1MDB scandal likely to cost Goldman Sachs around $5B

Oct. 20, 2020 2:28 AM ET - The Goldman Sachs Group, Inc. (GS) By: Yoel Minkoff, SA News Editor9 Comments

• Goldman Sachs (NYSE:GS) has reached a long-awaited pact with the U.S. Justice Department to pay more than $2B for its role in Malaysia's 1MDB scandal, and the deal may be announced within days, Bloomberg reports.

• It follows an agreement in July to settle a related probe with Malaysia, in which the bank promised to pay $2.5B (and slashed its Q2 results to reflect the charges). Malaysia dropped criminal charges against the company in early September.

• In all, Goldman may pay roughly $5B once accords with Malaysia, the Justice Department and other agencies are tallied together.

• The bank has long blamed rogue employees for the scandal, claiming it had no idea the money it helped raise would be diverted from development projects. One former Goldman Sachs partner, Tim Leissner, pleaded guilty in the U.S. to conspiring to launder money and violating foreign bribery laws, while another executive was charged with foreign bribery offenses.


Inside the JPMorgan Trading Desk the U.S. Called a Crime Ring

The U.S. says the precious metals desk at JPMorgan was a racketeering operation. Now the bank is poised to pay a record penalty for spoofing, or planting fake orders into the market to steer others into buying or selling at prices that favor the bank.  

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Raymond James Agrees to Pay $15 Million for Improperly Charging Retail Investors

Commentary by Douglas Schulz

October 2019

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.

U.S. SECURITIES AND EXCHANGE COMMISSION

 

FOR IMMEDIATE RELEASE

2019-178

Washington D.C., Sept. 17, 2019 —

_______________________________________________________________________________________________________________________________

Volatility Returns

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 regulations.

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.

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.

WEALTH MANAGEMENT

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.

    

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.

 

•  In RISK & COMPLIANCE JOURNAL.
  

THE MORNING RISK REPORT: SEC IN TEXAS FLAGS ‘CANNED’ COMPLIANCE PROGRAMS

By Henry Cutter

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.”

Readers can subscribe to The Morning Risk Report here: http://on.wsj.com/MorningRiskReportSignup. Follow us on Twitter at @WSJRisk.

 

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.

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1 Telephone Call with Shamoil T. Shipchandler, et al., Director, Fort Worth Regional Office, U.S. Sec. & Exch. Comm’n (Jan. 11, 2018).