Official Newsletter of Gordian Compliance Solutions, LLC.

SEC REGULATORY UPDATES

DOL Finalizes Delay of Fiduciary Rule's
Enforcement Provisions


The Department of Labor (“DOL”) finalized an 18-month delay of key enforcement provisions of the fiduciary rule for retirement account advisers, postponing the rule’s full implementation from January 1, 2018 to July 1, 2019.[1] The fiduciary rule went into partial effect on June 9, 2017 and created an "Impartial Conduct Standard" whereby advisers are expected to “act in retirement investors’ best interest, charge no more than reasonable fees and avoid misleading statements.”[2]
 
By delaying the rule's enforcement provisions, advisers need not provide clients with a contractual promise to uphold the Impartial Conduct Standard, although they are expected to follow the standard voluntarily. The DOL justified the delay due to the potential for “significant confusion” among consumers and “undue expense to comply” among advisers.[3] The DOL has stated that it will use the time to further assess the rule and review the 60,000 public comments received from its July 6, 2017 Request for Information.

 
SEC Update on 2016 EDGAR Cyber Intrusion
 
The United States Securities & Exchange Commission (“SEC”) announced that personal information of two individuals was stolen during the 2016 cyber intrusion of the agency’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system.[1] EDGAR is the online portal SEC registered companies use to file forms with the agency. In response, the SEC outlined a five-step plan to assess this intrusion and improve EDGAR, including investigating whether any illicit trading occurred as a result of the intrusion, modernizing the system to address cybersecurity concerns, and reviewing the safety of all sensitive or personally identifiable information.[1] A cybersecurity assessment will be conducted on other SEC systems as well. In the meantime, the agency will continue to provide updates on this investigation. 
 
[1]Chairman Clayton Provides Update on Review of 2016 Cyber Intrusion Involving EDGAR System, United States Securities & Exchange Commission (October 2, 2017)
[2]Id.

SEC to Create Searchable Database
of Bad Actors
 

 
During his recent remarks on governance and transparency, SEC Chairman Jay Clayton stated that the SEC is developing a publicly searchable database of individuals “who [1] have been barred or suspended as a result of federal securities law violations.” Individuals stripped of their registrations often shift their focus to the unregistered space where they become repeat offenders. The new website is intended to stifle bad actors by allowing investors to conduct a background check on them first. Although the database focuses on extreme wrongdoing, it illustrates how acts of misconduct are becoming more accessible to the public and likely to travel with someone throughout their career.
 
[1] Governance and Transparency at the Commission and in Our Markets, United States Securities & Exchange Commission (November 8, 2017)
Enforcement Actions
 
Several high-profile enforcement actions made the headlines this past quarter:
  • Michael Scronic:
    The SEC charged investment adviser Michael Scronic with fraud connected to a Ponzi scheme. At least 42 individuals invested in Scronic’s supposed options trading strategy after he stated he had a successful track record and that funds could be easily redeemed. Between 2010-2017, Scronic suffered at least $15 million in trading loses.[1] Although investors were told fund assets exceeded $21 million, less than $30,000 was in his brokerage account. The SEC is seeking a permanent injunction, disgorgement, and penalties against Scronic.
  • Millennium Management LLC:
    Investment advisory firm Millennium Management LLC violated an anti-manipulation law knows as Rule 105 by short selling U.S. stocks before a follow-on offering and then buying them during the offering.[2] The prohibited transactions created $286,889 in illegal profits. Millennium settled the charges with disgorgement, interest, and penalty of over $630,000.
  • Lawrence DeShetler:
    Texas registered investment advisor, Lawrence DeShetler, was found guilty of defrauding five clients, two of whom were elderly, of $1.9 million.[3] DeShetler lured clients by promising returns that would exceed those of their current investments.  Instead of investing the funds, DeShetler placed the money in bank accounts that were under his sole authority and spent it on personal expenses and real estate construction. Over $850,000 has since been seized and returned to investors. In June, DeShetler pled guilty to federal mail fraud charges. He’s been sentenced to 5 years in prison and ordered to pay over $900,000 in restitution.
  • Bond Price Investigation:
    The SEC is investigating whether hedge funds solicited inflated bond prices in order to falsely increase the value of their holdings. Banks and brokerage firms are suspected of agreeing to these inflated prices in order to win hedge fund business.[4] The SEC’s investigation centers on thinly traded bonds, such as those tied to home loans or other debt, that can be hard to value but also susceptible to price manipulations. These inflated prices allow hedge funds to cushion their portfolios or wipe away losses in the eyes of investors, creating more potential business as well as higher fees. JPMorgan Chase & Co. and Citigroup Inc. are both under investigation as are a number of large and small hedge funds.
 
[1] Investment Adviser Charged in Multi-Million Dollar Options Trading Scheme, United States Securities & Exchange Commission (October 5, 2017)
[2] Millennium Settles Charges of Illegal Short Selling in Advance of Stock Offerings, United States Securities & Exchange Commission (October 31, 2017)
[3] Investment Advisor Who Preyed on Elderly Sentenced to 5 Years, Texas State Securities Board (November 2, 2017)

Broker-Dealer Updates

FINRA Releases First Report on Exam Findings
 
The Financial Industry Regulatory Authority (“FINRA”) issued its first report on compliance concerns identified during recent broker-dealer examinations.[1] Topics were chosen based on their potential impact on markets and investors as well as their frequency of occurrence. The report focuses on six highlighted observations and five additional observations. A description of each topic and FINRA’s suggested best practices are outlined below:
 
Highlighted Observations
 
1. Cybersecurity
Developing strong processes to regularly assess cybersecurity risks and providing detailed, timely resolution to known issues:
  • Managing employee access and providing training and testing exercises
  • Assessing vendors’ cybersecurity preparedness
  • Developing oversight structures and segregation of duties, including on the branch level
  • Integrating tools and systems to prevent data loss
2. Outside Business Activities and Private Securities Transactions
Ensuring that registered representatives notify firms of proposed outside business activities (“OBAs”) and private securities transactions (“PSTs”) for compensation:
  • Frequent representative training and required written notice of proposed activities
  • Well-designed and executed review procedures, including at the branch level
  • Requiring representatives to complete open-ended questionnaires and attestations
  • Adequately defining “compensation”, properly determining if PSTs exists, and only approving transactions that the firm can supervise
3. Anti-Money Laundering Compliance (“AML”) Program
Implementing a risk-based AML program that’s tailored to the firm’s business model and size:
  • Independent testing of customer accounts and trading activity to assess monitoring efforts
  • Employee training tailored for each position, including non-AML staff as needed
  • Preventing data gaps in monitoring systems and ensuring that customers excluded from AML checks are re-included as needed
  • Sufficiently funding an AML program so that policies and procedures can be carried out
4. Product Suitability
Firms are required to only recommend strategies or securities that they reasonably believe are in the client’s best interest, particularly in regards to Unit Investment Trusts (UITs) and Multi-Share Class or Complex Products:
  • When suggesting a UIT roll over, firms must inform clients of potential fees and charges
  • Short-term UIT trading activity should be monitored for potential abuse and the firm’s definition of “short-term” should be limited in scope
  • Complex product recommendations must match the client’s investment time horizon and should be subject to supervisory reviews
  • Registered representatives should receive training on product suitability and not be solely reliant on written procedures or compliance bulletins
5. Best Execution
Customer orders must be executed to the client’s advantage and broker-dealers must not allow order routing inducements to interfere with this obligation:
  • Execution of customer orders should be subject to regular and rigorous reviews
  • Existing order routing and execution arrangements should be compared to competitive alternatives and include non-financial considerations such as execution speed, price movement, and reliability
  • Documentation of the review process and findings should be maintained for internal decision making or for review by a regulator
6. Market Access Controls
Firms with market access must implement controls to prevent trade errors that could destabilize their own financial condition or that of other market participants:
  • Firms must set reasonable pre-trade financial thresholds and not trade excessively
  • Capital and credit usage must be adjustable according to set procedures and any adjustments documented
  • Firms should conduct a market impact check and compare order size to daily volume
  • Firms must establish “hard” blocks and oversee outside vendors’ thresholds for fixed income orders
  • Market controls must be periodically tested and subject to an annual CEO attestation
     
Additional Observations

1. Alternative Investments Held in Individual Retirement Accounts
FINRA identified common situations where firms failed to apply necessary requirements for alternative investments in IRAs:
  • Failing to establish custody requirements as per the SEC’s “Customer Protection Rule”
  • Incorrectly including customer positions on account statements that were not in the firm’s custody
  • Not performing required quarterly verifications and being unable to prepare net capital and reserve formula computations in accordance with SEC rules
2. Net Capital and Credit Risk Assessments
Properly assessing the credit worthiness of non-convertible debt or money market instruments under the SEC’s “Net Capital Rule”:
  • Adequate design and documentation of policies and procedures for assessing and monitoring credit worthiness
  • Assessing minimal credit risks for all securities and not applying a de minimis threshold
  • Properly applying haircut charges as described in SEC no-action letters
  • Using benchmarks to determine creditworthiness in line with the Net Capital Rule
  • Applying affiliate credit ratings that are current and consistent with market data
3. Order Capacity
Entering the correct capacity code when reporting off-exchange trades to FINRA:
  • Developing record keeping and order entry systems
  • Maintaining written supervisory procedures regarding trade reporting rules
  • Properly training and supervising employees regarding order marking and reporting
  • Correctly reporting riskless principle and agency transactions
4. Regulation SHO
Meeting obligations for short sale practices under Regulation SHO:
  • Review and verification of third party order management systems for open sell orders
  • Receipt of third-party vendor trading records for supervisory reviews of order marking
  • Ensuring locates are not provided after shares are depleted and properly documenting depletions
  • Timely updates of “easy to borrow” lists and identifying fails to deliver and “hard to borrow” securities
  • Maintaining written procedures regarding failed transaction settlement dates and closeout obligations
5. Trace Reporting
Compliance with FINRA’s Trade Reporting and Compliance Engine (“TRACE”) for institutional sales of fixed income securities:
  • Properly reporting all TRACE eligible securities, even those not found on FINRA’s master list at the time of transaction
  • Timely reporting of TRACE transactions (within a 15 minute time frame) based on time trade was entered into and not the time of execution
  • Establishing and maintaining a supervisory system that facilitates compliance with TRACE reporting obligations
Although the report highlights specific remedial practices, FINRA has emphasized that these are suggestive in nature and do not broaden current regulatory requirements for broker-dealers. If you have any questions about how these practices may apply to your firm, please contact your Gordian consultant.
 
[1]Report on FINRA Examination Findings, Financial Industry Regulatory Authority (December 6, 2017)
 
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