Compliance Building

All of Your Fiduciary Duty in One Place

Of the trio of regulatory releases from the Securities and Exchange Commission last week, the one targeted at registered investment advisers is a little weird. It sets out the fiduciary duty of investment advisers, sort of, and proposes some new regulations.

One of the problems with the fiduciary duty is that it is not explicitly written into the statutes or regulations of the Investment Advisers Act. The SEC latched on to Section 206 and court cases have followed along. But if you look through the Act or the regulations you will not find a fiduciary duty stated.  Last week’s regulatory release, at least in part, was to “reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

Of course, if this reaffirmation and clarification don’t get codified in the regulations, they are just a secondary source and will stay harder to find. The SEC did ask for comment on whether it would be beneficial to codify this interpretation. I would give that a resounding “yes.”

What does the SEC think are the obligations of an investment adviser’s fiduciary duty?

The Duty of Care and the Duty of Loyalty.

The release draws heavily from the 1963 Supreme Court case SEC v. Capital Gains Research Bureau, Inc. that was the landmark case holding that the Investment Advisers Act imposes a fiduciary standard on registered investment advisers.

Duty of Care

The SEC breaks down the duty of care into three prongs.

  1. the duty to act and to provide advice that is in the best interest of the client,
  2. the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and
  3. the duty to provide advice and monitoring over the course of the relationship.

Acting in the best interest of the client is the big prong and the SEC gives lots of examples of what advisers should be doing.

  • duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, experience, and investment objectives
  • duty to provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile
  • update a client’s investment profile in order to adjust its advice to reflect any changed circumstances
  • have a reasonable belief that the personalized advice is suitable for and in the best interest of the client based on the client’s investment profile.
  • Take into account the costs of an investment strategy
  • Take into account the liquidity, risks and benefits, volatility and likely performance in determining if the strategy is in the best interest
  • Conduct a reasonable investigation into the investment sufficient to not base its advice on materially inaccurate or incomplete information.
  • Independently or reasonably investigate securities before recommending them to clients
Duty of Loyalty

“The duty of loyalty requires an investment adviser to put its client’s interests first. An investment adviser must not favor its own interests over those of a client or unfairly favor one
client over another.”

The SEC makes a point that in not unfairly favoring one client over another, an adviser is not locked into making pro rata allocations of opportunities.

An adviser has to try to avoid conflicts of interest with its clients, and make full and fair disclosure to its clients of all material conflicts of interest that could affect the investment advisory relationship. But disclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty. The disclosure must be clear and detailed enough for the client to understand and make an informed decision.


What do I see as the problems with these standards?

The first is its application to private funds and private fund advisers. The proposal is targeted at retail investors and separately-managed accounts. It skips any mention of the issues related to pooled investment vehicles like private funds. In those cases the client is the fund. For some advisers, there may also be a client that invests in the fund. The needs of the various investors in a fund may vary. The fund is a client and the fund investors may not be clients.

The SEC has danced around the private fund issues of the fiduciary duty and registration requirements for a decade. With the passage of Dodd-Frank, a bigger portion of the SEC’s registered investment advisers are private funds. It seems strange to have omitted them from this release.

I also think this release fails to clarify issues around the disclosure of conflicts in dealing with the duty of loyalty. The SEC hedges its statements. I expect we will see a fair amount of comments on this issue.



The New Standards for Investment Advisers and Broker-Dealers

One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money.

The Securities and Exchange Commission is trying to help consumers with a trio of proposals.

On the Broker-Dealer side, the SEC is proposing Regulation Best Interest. This would create a new standard of conduct for broker-dealers and their representatives when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The proposed standard of conduct is to

  • act in the best interest of the retail customer
  • at the time a recommendation is made
  • without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer

This new standard would be satisfied if:

  1. broker-dealer, before or at the time of the recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation;
  2. broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence; the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations;
  3. broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

For item 1, there would be a new Form CRS. Broker-dealers would provide this to their clients.

For registered investment advisers, there would be a new Part 3 to Form ADV that would be Form CRS.

There is a lot in this package. SEC Chairman Clayton summarized them:

We propose to fill these gaps through (1) mandating clear disclosures — specifically, addressing how BDs and IAs identify themselves to investors and requiring them to provide investors with a standardized disclosure document of no more than four pages in length, highlighting among other things the principal services offered, legal standards of conduct that apply, fees the customer will pay, and certain conflicts of interest that exist, (2) raising the standard of conduct applicable to BDs to make it clear, among other things, that they cannot put their interests ahead of the interests of their retail customers, and (3) reaffirming, and in some cases clarifying, our views on the standard of conduct applicable to investment advisers.

There will be lots of commentary on these proposed regulations from all sides. One of those critics is SEC Commissioner Kara M. Stein:

 I am concerned that this rule will not only confuse retail investors, but also broker-dealers. In particular, the lack of a definition of best interest, the use of similar terms to mean different things, the use of different terms to mean the same things, and the possibility that the SEC and FINRA interpret the same language in their suitability standards differently. All of these concerns would make it difficult for the industry to discern a clear compliance path. Any resulting confusion may well result in higher compliance costs for broker-dealers, which will likely be passed onto the investor. What’s more, the lack of a clear standard is not likely to give investors more confidence in the broker-dealer business model.

There is over 1000 pages in these proposals. I’ll share more thoughts on them this week.


Most Frequent Advisory Fee and Expense Compliance Issues

Last week, the SEC’s office of Compliance Inspections and Examinations released a risk alert on Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers. It was a bit shocking.

Shocking mostly because the issues are mostly mechanical procedural errors that were contrary to the investment advisory agreement:

  • Using a different valuation method (cost versus fair value)
  • Using the market value at the end of the billing cycle instead of an average value
  • billing monthly instead of quarterly
  • billing in advance instead of in arrears

These are obvious mistakes, but not necessarily adverse to the client.

Others deficiencies did lead to increase costs to investors:

  • Failure to prorate for a partial billing cycle
  • Applying a higher rate
  • Charging additional fees
  • Charging more that the agreed to maximum rate
  • failing to aggregate client accounts for members of the same household which would have qualified the accounts for a discounted fee


Although the Risk Alert is focused on retail investment advisers, private funds do not get by unscathed.

OCIE staff has observed advisers to private and registered funds that misallocated expenses to the funds. For example, staff observed advisers that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contravention of the applicable advisory agreements, operating agreements, or other disclosures.



Happy Patriots’ Day

The Redcoats are coming! The Redcoats are coming!

Patriots’ Day is a Massachusetts state holiday commemorating the opening battles of the American Revolutionary War in Lexington and Concord in April, 1775. In the morning there is a battle reenactment on the Lexington Green of the early-morning engagement between the town’s militia and the British regulars. If you remember back to U.S. history class, that battle was the shot heard round the world.

There is also a re-enactment of the rides of Paul Revere and William Dawes from Boston out to Lexington. (You don’t know about Hawes because Longfellow didn’t write a poem about him.) That ride started out with the “one if by land, two if by sea” signal to Charlestown in case Revere and Dawes were captured.

The more modern day event is the running of the Boston Marathon, starting in Hopkinton and ending 26.2 miles later in Copley Square.

What does this have to do with compliance or business ethics? Nothing. It’s a holiday here in Massachusetts so I am out of the office.

See also:

Weekend Reading: World War II at Sea

I try to keep looking for ways to interact with my kids in new ways. My son loves reading about military history, so I though I would add a book on that topic to my reading list. Reading it together would give us more things to talk about.

Oxford University Press was kind enough to send me a review copy of its upcoming release: World War II at Sea: A Global History by Craig L. Symonds. My son and I jumped in and enjoyed this narrative of the naval war and all of its belligerents, on all of the world’s oceans and seas, between 1939 and 1945.

If that sounds like a lot. It is. At almost 800 pages, it’s a tremendous collection of the events of World War II through the lens of big steel ships.

I have to admit, I knew bits and pieces of World War II history, but I never put it all together to figure out the chronology of events and how they related to each other.

The book opens with 1930 London Conference, an early attempt at an arms treaty. The goal was to limit the tonnage of naval ships to prevent a build up in naval power among Great Britain, France, Italy, the United States and Japan. The arguments over the numbers of battleships at the beginning of the war become out of touch. Mr. Symonds shows how these limitations on naval warfare become misplaced as the strategies and purpose of the navies changed rapidly during the war. WWII brought major technological advances in warfare that radically changed naval strategy. That conference failed to address aircraft carriers. By the end of the war, aircraft carriers were the key naval strength.

World War II at Sea covers all of these major engagements and their interconnection with other aspects of the conflicts:

  • the U-boat attack on Scapa Flow
  • the Battle of the Atlantic
  • the “miracle” evacuation from Dunkirk
  • the battles for control of Norway fjords
  • Mussolini’s Regia Marina, the fourth-largest navy in the world, but ineffective for a lack a fuel
  • Japanese naval power of the Kidö Butai
  • Pearl Harbor
  • Midway
  • the forced neutrality of the French navy and eventual scuttling
  • the landings in North Africa and into Italy
  • the Normandy invasion

I found the story-telling to be top notch. It’s not easy to keep no many battles, ship and personalities in context. I found Mr. Symonds to have done a masterful job of illuminating the mechanics of large-scale warfare in water and the key role it played.

As for my son, he knew most of this information separately. He appreciated so much being put together in place to add more context to the underlying events. He felt it was too brief at times for the areas he wanted to dive more deeply into.

Compliance Bricks and Mortar for April 13

These are some of the compliance-related stories that recently caught my attention.

IA Arrested On Bail For Continuing Fraudulent Scheme by T. Gorman in SEC Actions

A focus of a typical bail hearing is flight risk – is the person charged likely to return for the pending court proceedings and face the charges. Recently, a long established investment adviser was arrested on fraud charges. He had three separate offices in the community. Bail was set and the adviser was released. It was soon revoked. Law enforcement officials discovered that the adviser did indeed return to the community. He also continued to fleece investors. Bail was revoked; new charges were brought; a guilty plea followed. U.S. v. Newsholme, No. 3:17-mj-05015 (D. N.J.). [More…]

Sticking Around Too Long? Dynamics of the Benefits of Dual-Class Structures by Hyunseob Kim and Roni Michaely in the CLS Blue Sky Blog

The main drawback of a dual-class share structure is, of course, that insiders who control the firm with voting rights that are disproportionately greater than their cash flow rights can easily take advantage of dispersed outside shareholders. (Co-founders Bobby Murphy and Evan Spiegel, for example, jointly own 45 percent of Snap shares but control more than 70 percent of votes.) Since managers-insiders control more votes relative to their cash flow rights, they may have less incentive to maximize a company’s performance and more incentive to collect perks or build an empire that is not in the best interest of other shareholders. [More…]

SEC preparing cryptocurrency fraud crackdown, Jay Clayton’s biggest enforcement move yet by Charles Gasparino in Fox Business

Since taking office, Clayton’s enforcement staff at the SEC has brought as many as nine cases involving cryptocurrency fraud, but people at the commission and securities lawyers familiar with the agency’s enforcement agenda said investigators are working on dozens more. Those cases have been trickling out in recent months, but according to securities lawyers a deluge of enforcement actions is expected sometime this year, given the immense caseload under scrutiny. [More…]

$7 Billion Hasn’t Moved The Needle on Financial Crime by Lionel Laurent Bloomberg / The Washington Post

Pan-European crime-busters Europol reckon only about 5 percent of transactions firms identify as suspicious is reported to the authorities, of which 10 percent leads to further investigation. That’s a conversion rate of less than 1 percent, suggesting banks are prophylactically over-reporting data rather than providing valuable information that that can lead to arrests. [More…]

What Drives Misconduct: The EPA Example by Matt Kelly in Radical Compliance

The lessons that compliance professionals can learn from embattled EPA administrator Scott Pruitt are many. Some are so obvious we need to step back and deconstruct them to understand why his behavior is so corrosive to the organization he supposedly wants to lead. Other lessons are more subtle, and raise the possibility that Pruitt might not get fired, despite ethical misconduct all over the place.

All these lessons, however, are of the most important sort: about how an executive loses his grip on constituencies he or she needs to run an organization effectively. That’s what your bosses dread the most, so let’s go exploring. [More…]

Is this compliance idea as bad as it sounds? by Richard L. Cassin in the FCPA Blog

In a securities filing by one of Canada’s uranium miners, the company said the CEO is responsible for “administering and interpreting” the anti-bribery policy, under the oversight of the audit committee. Should the CEO sit on top of compliance? Can he or she ever make decisions about compliance that aren’t business driven? [More…]


Compliance Outreach Program National Seminar 2018

I didn’t manage to get down to Washington DC to be there in person, but I’ve been watching the webcast of the Compliance Outreach Program National Seminar 2018 For Investment Adviser and Investment Company Senior Officers this morning.

This is the agenda and my notes so far.

Introductory Remarks from SEC Directors

  • Dalia Blass, Director, Division of Investment Management
  • Peter Driscoll, Director, Office of Compliance Inspections and Examinations (National Exam Program)
  • Stephanie Avakian, Co-Director, Division of Enforcement

Good policy starts with good information. To get the information you need to interact with others. The SEC wants to engage with compliance professionals to get better information to be able to make better policies.

They wanted to avoid CCO liability, but it was one of the most asked question.

One category are cases where the CCO was actively involved in the malfeasance or engaged in misleading regulators. This is the biggest category.

The second is where the CCO had a clear responsibility to implement a procedure and failed to.

There is a new alert coming out later today on fees and expenses. (Here it is:  Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (PDF))

Insights from SEC Leadership Regarding Program Priorities

  • Paul Cellupica, Deputy Director, Division of Investment Management
  • C. Dabney O’Riordan, Co-Chief, Division of Enforcement, Asset Management Unit, Los Angeles Regional Office
  • Kristin Snyder, Co-National Associate Director, National Exam Program, San Francisco Regional Office

Update on certain National Exam Initiatives
Fiscal year 2018 priorities
Update on certain fiscal year 2017 priorities

A sunshine act notice went out for a meeting on April 18. There is a continuing effort to avoid investor confusion between the different type of financial firms. The subject matters of the Open Meeting will be the Commission’s consideration of:

  • whether to propose new and amended rules and forms to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors.
  • whether to propose a rule to establish a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • whether to propose a Commission interpretation of the standard of conduct for investment advisers.

The SEC will focus on ETFs. All of them are operating on exemptive orders. It makes sense to standarize the platforms instead of ad hoc rulings.

The Volker Rule is still alive and the SEC is going to keep working on it. But it sounds like the SEC wants to simplify it and remove some of the compliance burdens. Given the number of agencies involved, the SEC is just one player.

Fair Act is being considered regarding reports on various companies and wants to extend it to investment companies.

The SEC is considering a revamp of the marketing rules for investment advisers. There will be a particular focus on the anti-testimonial rule and its interaction with social media.

The share class initiative is continuing for enforcement. There was an emphasis to fix the problem before the SEC finds out if this has been an issue at your firm.

For exams, there is a focus on retail investors and in particular those saving for retirement. This includes a focus on how firms deal with older clients. The ReTIRE Initiative is still going strong. (They took great stride to point out that private fund investors are often retail investors.)

Exams are still focused on visiting firms that have never been examined. They are continuing the new registrant program.

The SEC has been learning how to use Form PF. It has been helping the SEC to inform its rule-making efforts. The experience with Form PF led to the separately-managed accounts questions on Form ADV.

Question & Answer Session 1

  • Ahmed Abdul-Jaleel, Assistant Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Brian Blaha, Staff Accountant, National Exam Program, Denver Regional Office
  • Sara Cortes, Assistant Director, Division of Investment Management, Investment Adviser Regulation Office
  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office
  • Barbara Gunn, Assistant Director, Division of Enforcement, Asset Management Unit, Fort Worth Regional Office
  • Michael Spratt, Assistant Director, Division of Investment Management, Disclosure Review Office

When you get a document request list, ask questions if you are unsure what it’s asking for. If it’s going to take longer to produce the documents, let them know.

As for thoughts on the private equity fund exams and enforcement cases, does the SEC think the industry has changed? Yes. Limited partners are more informed. It’s not just fund managers, but gatekeepers who have failed to do their job of being a check on fund managers.

There was a fair amount of the liquidity rule. But since it does not apply to private funds, I’ve not been paying much attention to it or the questions about it.

One question was on anti-money laundering. It’s not the SEC who would be issuing the rules. It’s up to FinCEN. The SEC merely provides technical support.

Fees and Expenses Impacting Retail Investors

  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Adam Aderton, Assistant Director, Division of Enforcement, Asset Management Unit
  • Jennifer Porter, Branch Chief, Division of Investment Management, Investment Adviser Regulation Office
  • Nicole Tremblay, Senior Vice President and Chief Compliance Officer, Weston Financial

Lots of this panel’s material is in the new National Exam Program Risk Alert that came out today: Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers.

One panelist pointed out that “fees are negotiable” is generally not a good fee disclosure. Advisers should have a fee schedule.  If you let one client negotiated fees, you should state that lower fees can be negotiated.

The Sessions continue this afternoon, but I had to step away.

Fraudulent Coin Offerings

I’ve been highly critical of cryptocurrency. It doesn’t act like a currency: people are not using it to actually buy goods and service (at least not legal goods and services).  The world of coin offerings has been the wild west. In many instances, the sponsors are just ignorant of the securities law implications of their coin offering structures. Others are scams or turn quickly into scams.

The most recent coin offering to come crumbling down is the CTR Token sponsored by CentraTech. The SEC charged Sohrab Sharma and Robert Farkas with masterminding the fraudulent Initial Coin Offering.

What was the case for using Centra? I read through the whitepaper and it’s full of nothing. There is some nonsense abut currency conversion and storing coins in the Centra Wallet. As near as I can tell the only thing Centra Token did was get the boxer Floyd Mayweather to endorse it.

Centra Tech claimed that it was producing a debit card backed by Visa and MasterCard that would allow you to instantly convert hard-to-spend cryptocurrencies into U.S. dollars.  The SEC alleges that Centra had no relationships with Visa or MasterCard.

Sharma and Farkas stated that funds raised in the Initial Coin Offering would help Centra Tech build a suite of financial products. This turned it into a securities offering because the offering claimed that token holders would be paid “rewards” of 0.8% of the total revenue that Centra earned from Centra Card transactions. That makes the ICO a securities offering.

This goes back to the Howey definition of a “investment contract” as “investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.” If it meets the definition of “investment contract” its a security.

“Endorsements and glossy marketing materials are no substitute for the SEC’s registration and disclosure requirements as well as diligence by investors.” – Steve Peikin, co-director of the SEC’s Division of Enforcement.

My Favorite part of the fraud is the use of fictional executives. “Michael Edwards” was listed as the Chief Executive Officer and Co-Founder of Centra, with an impressive LinkedIn profile. He had an M.B.A. from Harvard University and an extensive career in banking, most recently as a Senior VP at Wells Fargo. Edwards was not a real person. A photo of Edwards used in an early version of Centra’s website was that of a Canadian professor of Physiology and Pathophysiology with no relationship to the company. Later versions of the marketing materials included instead a picture of one of Defendant’s relatives purporting to be of “Edwards.”

The big surprise is that it took the SEC this long to build a case. The New York Times put together a profile of the company in October that was full of red flags.

Several weeks ago Sharma and Farkas received subpoenas from the SEC about the Centra ICO.  I would assume that they realized their time was short. According to the SEC’s complaint, Farkas made flight reservations to leave the country around April 1. That must be what put the SEC and the Department of Justice on an accelerated schedule. Farkas was arrested before he was able to board his flight.  Sharma was also arrested.

As of March 30, Centra’s bank accounts were depleted and most of its employees had been terminated according to the SEC complaint.


Compliance Bricks and Mortar for April 6

These are some of the compliance-related stories that I’ve been reading.

Mulvaney’s CFPB plan is dangerous by Rob Blackwell in American Banker

On Monday, Mulvaney called for four major reforms to CFPB: putting it on Congressional appropriations; creating a dedicated inspector general (currently the Federal Reserve’s inspector general oversees it); giving the president more oversight of the bureau; and, most importantly, subjecting all major new rules to Congressional approval. This fourth suggestion, a version of the so-called REINS Act that some conservative Republicans have been pushing for years, is by far the most dangerous and far-reaching. [More…]

Ethical Decision-Making in Business: Why Good People Do Bad Things by Laura Petrolino

This means it’s now more important than ever to be very clear about our ethical decision-making processes.
Where do we draw the line?
How do we work with our team and clients to make decisions?

Directors and compliance programs: a look at the law by Jeff Kaplan in Conflict of Interest Blog

In an article to be published in the Temple Law Review – and summarized on the Harvard Law School Corporate Governance Forum – Professor Donald C. Langevoort of the Georgetown University Law Center takes a look at the role that Caremark has played over the last 20 years in encouraging directors to promote compliance at their respective companies. It is a thoughtful and informative piece that is strongly recommended for those who advise boards on C&E matters. Among other things, it can help such advisors avoid making the mistake that I nearly did, and instead  focus on the legal expectations that matter most to boards. [More…]

SEC Discusses Online Trading Platforms — With a Word of Caution by Stephen J. Crimmins in The CLS Blue Sky Blog

On March 7, 2018, the Securities and Exchange Commission’s Enforcement Division and its Trading & Markets Division issued a joint “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets.” The release appeared to be the strongest signal yet of a broadening of the SEC’s enforcement and regulatory interest beyond its focus over the last year on the need for certain coin offerings to be registered or to qualify for an exemption as private placements. [More…]


The 2017 World Series Champions, the Houston Astros, had their home opener on Monday evening. After 56 years and a few minutes of frustration (more on that later) the World Series (WS) banner was unveiled. As it is metal it could not be unfurled. It was a moment every Astros fan had literally waited their lifetime to see. Yet even with this triumphant moment the hometown heroes provided a few distinct lessons learned for the compliance practitioner, one around red flags. [More…]

Frequently Asked Questions Regarding Customer Due Diligence Requirements for Financial Institutions

On April 3, the Financial Crimes Enforcement Network published Frequently Asked Questions Regarding the Customer Due Diligence Requirements for Financial Institutions. The questions are about Customer Due Diligence Requirements for Financial Institutions, published on May 11, 2016, as amended on September 29, 2017. FinCEN is labeling it the CDD the Rule.

The CDD Rule requires financial institutions to identify and verify a legal entity’s “beneficial owners” when an accounts is opened. The CCD Rule’s mandatory compliance date is May 11, 2018.

I don’t think the CDD Rule applies specifically to the investors in private equity funds or to investment advisers in general. But the SEC has been threatening to impose a know-your-customer, anti-money-laundering, Customer Due Diligence requirement on investment advisers. I think it’s worth looking at the rule to see how the broader industry is addressing this.

The big change is for legal ownership of entities. The CDD requires the identification of anyone who directly or indirectly owns more than 25% of the equity interest in the entity and at individuals who have managerial control of the entity. The new FAQ makes it clear that a financial institution can dig deeper than 25%.

For banks, the CDD process has to be run each time a new account is opened. Each time a loan is renewed or a certificate of deposit is rolled over, the bank is establishing another banking relationship and a new account is established. Covered financial institutions are required to obtain beneficial ownership information of a legal entity that opens a new account or renews a product, even if the legal entity is an existing customer. For financial services or products established before May 11, 2018, Covered financial institutions must obtain certified beneficial ownership information of the legal entity customers of the new or renewed products.

The FAQ goes deep. It’s worth reading to think about how your firm should amend its AML procedures.


What is Pre-Marketing?

In establishing a new investment vehicle, a sponsor needs to find a pool of interested investors. Given the varying rules around fundraising in different jurisdictions, the sponsor may chose to look for support in one place over another. The big problem is the time and cost it takes to get a proposed investment registered in a jurisdiction may not be worth that time and money if no investor from that jurisdiction ends up being interested.

This is a particular problem with private equity funds when the terms of the fund may still be fluid in the early days of the fundraising process. The terms of a private placement are more often negotiated with prospective investors than a registered offering.

The question in many jurisdictions is what constitutes activities that amounts to marketing, triggering the registration process.

In the US the activities are fairly clear. You need to only direct the discussions to accredited investors and it can’t be so broadly distributed that it could be considered general marketing or general solicitation. Generally, for a private fund sponsor’s formation efforts, the sponsor wants to keep the number or prospective investors small to get a sense that the terms are right and that there is market for the product.

The European Union had been more difficult under the AIFMD rules. As much as the EU is trying to standardize the AIFMD rules across its member countries, the requirements still vary widely from member country to member country.

Last month the EU indicated that it’s looking at defining pre-marketing under the AIFMD rules. Currently, AIFMD regulates “marketing” to investors. It does not specifically regulated “pre-marketing”. Without any specific rule to base it on, member country to member country has been setting general framework on where the line is between marketing and pre-marketing.

The new regulatory regime could be good or bad for fund sponsors. If it’s drawn too narrowly, it will keep fund sponsors away from. It will disproportionately affect smaller sponsors who are not prepared to spend the money with uncertainty of potential investors. Larger sponsors will have more time and money to comply.


Research on Insider Trading

Just to revive any anger you have left from the 2008 financial crisis and its aftermath, a new academic paper found evidence of insider trading among corporate insiders at leading financial institutions during the Financial Crisis. That’s on top of other research that brokers leak information or front run trades.

One research paper on political connections comes from the private meetings between government officials and financial institutions during the financial crisis which eventually lead to the Troubled Asset Relief Program.

Any corporate insiders with knowledge of those discussion could have known how much money was involved and which financial institution would get it. With financial institutions staring into a pit on destruction and some being dangled a rope to safety, one could have made a good chunk of cash if you knew which company to bet on and which ones to avoid.  The government was making hundreds of billions of dollars available.

The paper examines conduct at 497 financial institutions between 2005 and 2011. The researchers focused on individuals who had previously worked in the federal government. In the two years prior to the TARP, these people’s trading gave no evidence of unusual insight. But in the nine months after the TARP was announced, they achieved particularly good results. The paper concludes that “politically connected insiders had a significant information advantage during the crisis and traded to exploit this advantage.”

The other research paper on order flow leakage uses data from 1999 to 2014 from Abel Noser, a firm used by institutional investors to track trading transaction costs. The data covered 300 brokers, but the researched focused on the 30 biggest. 80-85% of the trading volume flowed through those 30.

The researchers found evidence that large investors tended to trade more in periods ahead of important announcements. That would be hard to explain, unless they have access to inside information.

The most innocent access to information would be brokers that “spread the news” of a particular client’s desire to buy or sell large amounts of shares. That helps with market-making. A less innocent explanation is that they give this information to favored clients to boost their own business.

Of course, large institutions can be both beneficiaries and victims of this  information leakage. But in general they are net gainers to the lowly retail investor who does not have access to this information. It further leads to a conclusion that the markets are rigged and they should not participate at all.

One common theme to these papers is the use of big-data and analytics to find these trends and identify weaknesses in the systems. We have seen cases from the SEC’s Division of Economic and Risk Analysis attacking frauds. It may be useful for the SEC to focus on these systemic problems.


  • Insider trading has been rife on Wall Street, academics conclude in The Economist
  • Political connections and the informativeness of insider trades by Alan D. Jagolinzer, Judge Business School, University of Cambridge; David F. Larcker, Graduate School of Business, Rock Center for Corporate Governance, Stanford University; Gaizka Ormazabal, IESE Business School, University of Navarra; Daniel J. Taylor, the Wharton School, University of Pennsylvania. Rock Center for Corporate Governance at Stanford University, Working Paper No. 222.
  • Brokers and order flow leakage: evidence from fire sales by Andrea Barbon, Marco Di Maggio, Francesco Franzoni, Augustin Landler. National Bureau of Economist Research, Working Paper 24089, December, 2017; and “The Relevance of Broker Networks for Information Diffusion in the Stock Market” by Marco Di Maggio, Francesco Franzoni, Amir Kermani and Carlo Summavilla. NBER Working Paper, No 23522, June, 2017

Compliance Bricks and Mortar for March 30

For those of you with that responsibility, I hope you have your Form ADV filed or ready to go. Meanwhile, here are some other compliance-related stories that recently caught my attention.

It’s Not Cricket – Ethics on the Pitch by Tom Fox in FCPA Compliance & Ethics

Is it cricket? Or isn’t it cricket? That might be a question many Americans are asking these days while the rest of the sporting world is embroiled in one of Cricket’s biggest scandals ever; which decidedly isn’t cricket. Confused yet? The scandal involves the highest levels of the Australian national Cricket team, who concocted a scheme to scruff the ball on piece of yellow tape in the pants pocket of the bowler, Cameron Bancroft. He was instructed to do so by (now former) team captain Steve Smith and (now former) vice-captain David Warner. All three have been thrown off the team. Now here is the best part, bowler Bancroft scruffed the ball on yellow tape on the pitch, not only in view of the entire playing field but all the fans in the stands. Better yet, he was caught on international television doing the deed. [More…]

Will SEC Rule Curb Corporate Political Spending Disclosure? by Mara Lemos Stein in the’s Risk & Compliance Journal

A provision in the latest U.S. government spending bill bars the U.S. Securities and Exchange Commission from mandating corporate disclosure of political spending but it won’t stop the trend of increased transparency around the issue, said two advocates for more transparent corporate governance. [More…]

Is the Cryptocurrency Bubble About to Burst? by Glenn Luinenburg and Jennifer Zepralka in WilmerHale Launch

We previously discussed ICOs and the Securities and Exchange Commission’s (SEC) Report of Investigation on the DAO. But there are still open questions about other types of ICOs, where it may not be squarely an investment, but instead the token has some use other than just providing a return to the holders. That’s where the SEC’s Munchee case in December gave us some more color and in our recent QuickLaunch University webinar on the future of ICOs and cryptocurrencies, we discussed this case and other developments and offer a few key takeaways if you are invested in or planning to launch an ICO: [More…]

Should compliance officers be optimists? by Jeff Kaplan in Conflict of Interest Blog

I think the case for optimism has grown – particularly in the past year. By this I mean not that things are looking better than in the recent past but that the need for an optimistic cast of mind may be at an all-time high. [More…]


Use of Data in Proving Fraud

The Securities and Exchange Commission’s case against Robert Magee and Valor Capital was a straight forward cherry picking case. What caught my eye was the data and statistical analysis that the SEC used to prove its charges.

Magee was doing the wrong thing by order block trades in an omnibus trading account and then allocating the trades to his personal account and client accounts at the end of the day. That procedure is ripe for compliance failure without a preset decision on who gets the trades. The concern will always be that the securities that increased during the day will be allocated to favored accounts and those that went down would be allocated to others.

The SEC ran the numbers to prove its point.

From July 2012 to January 2015, Magee’s personal accounts posted first-day profits of 0.876%. Those were 459 trades of which 376 were profitable on the first day.

Meanwhile, the client accounts posted a -2.309% return on the first day during roughly the same period. Those were 1,365 trades of which only 219 were profitable on the first day.

Of course, the disparate results could be based on good luck. The SEC ran some stats and found that the probability that disproportionate allocation of favorable trades was due to chance was less than one in 100,000 during one period and less than one in a trillion during another period.

Valor’s brokerage firm terminated its relationship because it suspected the cherry-picking. The subsequent brokerage firm did the same. The third brokerage firm did not permit the use of an omnibus account to execute trades. The Texas state securities regulator reprimanded and fined Magee in August 2016 for no pre-allocating block trades.

According to the SEC’s press release, this is the fourth action arising out of an enforcement initiative to combat cherry-picking led by the SEC’s Los Angeles Regional Office and supported by the agency’s Division of Economic and Risk Analysis.  The previous actions were against Jeremy Licht of JL Capital Management, Gary Howart of Howarth Financial, and Joseph B. Bronson of Strong Investment Management.


Dividing Up Clients On Form ADV

For those of us working with registered investment advisers, the deadline for filing Form ADV is quickly approaching.

I’ve heard a few people struggling to classify their clients. I put together this chart to help me think about it.



With the recent changes to Form ADV, I see the SEC carving client accounts into two big buckets: Separately Managed Accounts and Pooled Investment Vehicles.

Each of those big buckets is separated into further classifications.

I found the name “separately managed accounts” to be confusing because it sounds a lot like the insurance term “separate accounts.”

I heard a lot of uncertainty on how to treat a fund of one. It could be a pooled investment vehicle. Or it could be a separately managed account. I have not heard anything to help draw the line. The best advice I’ve heard is to just be consistent. If you treat the fund of one operationally like you treat your other funds, then label it that way on the Form ADV. If you treat it operationally like you treat your separately managed accounts, then label it that way on the Form ADV.

For real estate managers, it sounds like they have some investment vehicles that are not private funds. Some of this discussion goes back to the 2012 thoughts on whether to register with the SEC or not. A straight real estate investment with a couple of investors with major action consent sounds like it falls out of the “private fund” definition. That real estate investment does not have securities, so it should fall outside the definition of an investment company. Even if it were so treated, it would be entitled to the 3(c)5 exemption. That would keep it outside the “private fund” definition.


The One With The Fake Returns

Most frauds have some element of fake returns. I picked the case against McKinley Mortgage Co., Charles Preston, and his son, Caleb Preston because the headline in the release included: Private Real Estate Fund with Scheme to Defraud Retail Investors.” Frauds involving private real estate funds catch my attention.

McKinley bought promissory notes secured by deeds of trust or originated new loans, packaged them into investment pools and sold interests in the pools to investors.

According to the complaint, the problems started in 2012 when the sponsors started taking more in management fees and expenses than allowed under the fund documents. According to the complaint, it was an extra $700,000 in 2012 and $1.5 million in 2013. The it grew even bigger in subsequent years.

They also expanded the scope of investments. The fund documents said that up to 25% could be invested in Mexico. They exceeded that amount.

Then they increased the amount of returns from the funds to prospective investors.

Three bad things to do.


How Compliant Should You Have to Be?

BMW issued a voluntary recall of all BMW i3 electric cars ever sold in the U.S.  and has sent a stop-sale order to its U.S. dealers for any new or used i3 vehicles. There have only been 30,000 sold. That’s not very many, but it’s all of them. The reason is a “compliance issue” with federal regulators over a failed National Highway Traffic Safety Administration crash test.

Compliance issue caught my attention in connection with its electric car. (I don’t drive a BMW and think the i3 is a weird looking car.)

“While BMW’s compliance testing showed results well below the required limits, more recent testing has shown inconsistent results. Consequently, BMW has issued a recall and is working with the agency to understand the differences in the test results.”

This is not a Volkswagen fake-testing issue. The company saw slightly different results than the government tests.

The test failures are very specific. The tests resulted in a marginally higher neck load on 5% of the population. That 5% is adult females who are around five feet tall and weigh about 110 pounds. The failure also only applies to someone sitting in the driver’s seat and not wearing a seatbelt.

Being in New England, I’m reminded that “Live Free or Die” New Hampshire is the only state that does not mandate seat belt use. In every other state there is a law requiring seat belt use.

To protect petite women who live in New Hampshire, BMW has to recall all of the i3 cars. It’s a tough penalty for getting the company’s crash results wrong.

Of course, the answer would seem to be: “Wear a seatbelt.”

That leaves me with a libertarian conundrum. Impose a regulation requiring seatbelt use? or impose a regulation requiring additional design cost so that people don’t have to wear seat belts?

Where is the best place to impose compliance?


Compliance Bricks and Mortar for February 23

These are some of the compliance-related stories that caught my attention this week.

FINRA warns public about fake . . . FINRA
by Richard L. Cassin

The Financial Industry Regulatory Authority (FINRA) warned about con artists posing as FINRA to make phony investment pitches. Scammers are using FINRA’s name and logo in letters that say FINRA is guaranteeing investments. The letters include a fake signature from FINRA president and CEO Robert W. Cook. [More…]

When The Sport of Curling Should Make Your Hair Curl
by Adam Turteltaub

In the You Can’t Make This Up Department, reports out of Korea indicate that a Russian curler has tested positive for a banned substance.  Yup, doping in curling. Doping in sports is not so surprising these days.  Doping from a Russian athlete, not so shocking either.  But doping in curling?  Really?  Curling?  I mean, seriously?  Have you watched the sport?  I don’t deny that it’s harder than it looks, it is probably quite physical, and I know I couldn’t make the US Olympic curling team, but really? [More…]

2018 Cross-Industry Compliance Staffing and Budget Benchmarking and Guidance Survey
by the Society of Corporate Compliance and Ethics

On the following pages are a series of data tables that can be used to benchmark compliance program budgets and staffing by several factors. As you review the data, keep in mind that this data should be considered directional in nature. Different companies of the same size will likely have very different histories in terms of compliance issues and risks. [More…]

Six Do’s and Don’ts of Due Diligence Questionnaires
by Kristy Grant-Hart

Due diligence questionnaires are a critical tool for understanding third-parties. But they can quickly get out of control, putting unreasonable burdens on the answering party, and at worst, invading the privacy of individuals in wholly unnecessary ways. How do you balance the legitimate need for information with the reality that no questionnaire can fully protect the company from the possibility that the third-party will misbehave? Here are three do’s and don’ts when it comes to due diligence questionnaires. [More…]

SEC’s Jackson questions rationale for dual-class ‘forever shares’
By Mark S. Nelson, J.D.

New SEC Commissioner Robert Jackson hit the ground running in his first substantive speech as a commissioner by taking on the topic of the proliferation of companies that have adopted dual-class share structures. Jackson’s speech in San Francisco at a Silicon Valley event on M&A, antitrust, and governance issues comes at a time when initial public offerings (IPOs) have become scarcer and an abundance of private capital allows growing start-ups to remain private longer, thus giving the founders of some companies that do go public the leverage to demand share structures that may protect their jobs. For Jackson, though, the question is one of how long a company should retain a dual-class structure post-IPO rather than a debate about the merits and demerits of such structures. He said the outcome of the debate over dual-class structures may have long term implications for Main Street investors. [More…]


The Limit of Whistleblowers

The Supreme Court just decided a case that limits the whistleblower anti-retaliation provisions in Dodd-Frank. The Court handed down its decision in Digital Realty Trust v. Somers.

Dodd-Frank defines “whistleblower” as a person who provides “information relating to a violation of the securities laws to the Securities and Commission.” 15 U. S. C. §78u–6(a)(6). A whistleblower is then eligible for an award if original information provided leads to a successful enforcement action. Under Rule 21F, a whistleblower has to go through particular steps to be able to claim an award, but the anti-retaliation protections apply whether or not the requirements, procedures and conditions to qualify for an award are satisfied.

Mr. Somers reported suspected securities-law violations to senior management of Digital Realty Trust. He was fired. He did not alert the SEC prior to his termination. He didn’t file an administrative complaint within 180 days that is required under the Sarbanes-Oxley whistleblower protections. Nonetheless, he brought suit against the company with a claim of whistleblower retaliation.

The Supreme Court stuck with the clear definition in Dodd-Frank. A whistleblower for securities law violations must report the violation to the SEC to have protection from retaliation.

The Supreme Court pointed out that there is a different definition of whistleblower under the CFPB part of Dodd-Frank. Under 12 U.S.C. §5567(a)(1), a “covered employee” who provides information to the company, the FBI, or any other State, local, or Federal, government authority or law enforcement agency relating to a violation of a law subject to the CFPB’s jurisdiction gets whistleblower protection.

Mr. Somers argued that the limiting whistleblower definition should only apply to eligibility for awards. The Court completely disagreed with that argument and relied on the plain language of the statue. There were two concurring opinions, but they only took different approaches to whether the Court should take into consideration legislative history as part of statutory interpretation. The two concurring opinions agreed with the result, leaving Mr. Somers as a non-whistleblower. The ruling settled a split between the Ninth and Fifth Circuits, reversing the Ninth Circuit’s decision.

There is an obvious impact on compliance programs. As much as we might hope that employees who think there is a problem would tell someone internally first, there is much more incentive to go directly to the SEC.

It’s all confusing in application. A tip left with the SEC is kept anonymous, so a company would not know the identity of the whistleblower. A company could fire an employee who left a tip without knowing that the employee did so. Without a requirement that the employee also tell the company, the company is in the dark and may not even be aware of the problem.

The other piece missing in the arguments is whether there even was an actual securities law problem at Digital Realty Trust.


Read on Your Phone

I had given up on trying to access the SEC’s online resources through my phone a long time ago. Frankly, it was hard to use with a full computer screen at times. It was nearly impossible to use on my phone’s small screen.

But the site has been evolving. Broc Romanek pointed out that the SEC’s home page is now mobile friendly. I looked around this morning while riding the train the work (a day off from bike-commuting). Most of the site works much better on a phone.

Of course that is great for consumers who are likely to be less frequent users and trying to get themselves some help. I might have moved the order of things around on the SEC’s home page to make it easier to make a complaint or research financial professionals. But the information is there and easy to find.

For industry users like me, it’s great to be able to find resources while out of the office. While on the SEC’s home page, I noticed that the SEC’s open meeting scheduled for today has been cancelled. There was a rumor circulating that the Commission was going to present updated guidance or a new rule on public company reporting requirements on data breaches. Clearly, that is not happening today.

If you were wondering, is set up to be mobile-friendly. Let me know if it doesn’t work on your phone.


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