10-22-20

SEC Chair and Director of Enforcement Review the Record

SEC Chair and Director of Enforcement Review the Record

In a likely preview of the SEC Division of Enforcement 2020 Annual Report, SEC Chair Jay Clayton and Division of Enforcement Director Stephanie Avakian gave back-to-back speeches regarding the agency’s enforcement record since they took the reins in 2017. In context, these speeches presented a strong accounting of the impact the Division has had on the financial industry during their tenure. The remarks, delivered last month to the Institute for Law and Economics at the University of Pennsylvania Law School, also raised some of the important challenges to the SEC’s enforcement priorities presented by COVID-19. Here are the highlights from their speeches.

Avakian Paints the Big Picture, Shares the Numbers

Director Avakian described the Division’s key goals as investigating and recommending impactful cases that serve to protect investors, and continuing efforts to adapt to market and technological developments in order to operate effectively and efficiently.

During Chair Clayton’s tenure, she reported, the Division brought over 2,500 enforcement actions, received $14 billion ($4.3 billion in 2019, the highest on record) in financial remedies, returned over $3.3 billion to harmed retail investors, and distributed more than $350 million to whistleblowers.

Ms. Avakian described cases brought by the Division in traditional enforcement areas, highlighting the use of innovative data analysis to support investigations and actions. She named a host of financial and issuer fraud cases, key insider trading cases, Foreign Corrupt Practices Act violations, cases involving improper financial reporting disclosure (“involving virtually all aspects of the financial reporting process”), Ponzi schemes, and cases where the Division went after suitability violations by broker-dealers. She also discussed cases brought by the Division that involve complex non-traditional matters and those that implicate market integrity—such as potential fraud in initial coin offerings—and innovative remedies to address misconduct. Further, Director Avakian said the Division sought to “deter wrongdoing by holding individuals accountable.” She stated that in roughly 70% of cases, they had “pursued charges against individuals for misconduct,…including registered individuals, executives at all levels of the corporate hierarchy, including CEOs, CFOs and other high-ranking executives, as well as gatekeepers such as accountants, auditors, and attorneys.”

In continuing to focus on large public companies and financial institutions, Ms. Avakian emphasized the introduction of new approaches to protect retail customers and to further enhance the efficiency and effectiveness of the enforcement program. These include streamlining investigations through targeted requests, better communication with respondents around the benefits of cooperation, and targeted initiatives.

As to the most successful targeted initiatives, Ms. Avakian highlighted the Share Class Selection Disclosure Initiative, a self-reporting program “focused on the recurring problem of advisers failing to disclose conflicts of interest associated with the selection of fee-paying mutual fund share classes.” She reported that “the initiative resulted in the SEC ordering nearly 100 investment advisory firms that voluntarily self-reported to the Division to return nearly $140 million to investors.” (See also Bates reporting on the Share Class Disclosure Initiative.) Ms. Avakian also noted  initiatives that addressed conduct affecting vulnerable investor groups (e.g., Teachers’ and Veterans’ Initiatives) and efforts to better reward whistleblowers, and she commended the Enforcement Division and the SEC's Office of Compliance, Inspections and Examinations for their cooperation on additional efforts to improve efficiency and effectiveness.

Ms. Avakian described the unique circumstances of managing the operations of the Division and discussed at length the Division’s response to "substantial, unexpected challenges" to Chair Clayton’s announced priorities. She cited several Supreme Court cases that negatively affected the Division's enforcement powers (see Bates summary coverage regarding Lucia v. SEC and Kokesh v. SEC) in addition to the challenges of operating during the COVID-19 pandemic. (Since mid-March, the Commission “filed more than 325 new [regular] enforcement actions.”) Ms. Avakian also noted that during the relevant period, the Division opened nearly 150 COVID-related inquiries or investigations.

Chair Clayton Reviews Enforcement Record

In his address, Chair Clayton highlighted the success of the Enforcement Division in bringing meaningful cases to the Commission that had “a substantial impact on investors and the integrity of our markets.” He assessed the oversight, management and performance of the Division against several guiding principles. These included whether the actions (i) rectified harm to retail investors by returning money as "promptly as practicable;" (ii) worked to eliminate widespread fraud; and (iii) strengthened the "integrity and fairness" of the capital markets.

Chair Clayton offered examples of the Division’s work that satisfied these objectives. He noted the SEC’s Retail Task Force for its successful initiatives on Share Class Selection Disclosure and on Teacher and Veteran protections. He underscored the work of the Division in the area of Initial Coin Offerings, pointing out that the subject matter lent itself “to fraud, speculation and widespread harm,” and that the Division responded to these challenges by “issuing an investigative report confirming the application of the securities laws to the use of blockchain or distributed ledger technology to facilitate capital raising and to offers and sales of digital assets that are securities.” He contended that through a series of additional “measured yet timely actions” and the “creation of the Cyber Unit,” the Division “restored order, while leaving room for distributed ledger and other technologies to drive cost savings and innovation.”

Chair Clayton also commended the Division for its efforts during COVID-19, including (i) trading suspensions and enforcement actions against companies that were engaging in fraud (e.g., companies offering preferred access to personal protective equipment and COVID-19 tests) and other COVID-19 related claims; (ii) guidance reminding market participants about corporate controls and procedures; and (iii) the promotion of good corporate governance to ensure compliance, market integrity and investor confidence. Mr. Clayton also noted the important role the Enforcement Division played in the crafting of Regulation Best Interest, “with the interests of Main Street investors front of mind.”

Chair Clayton concluded that, based on the guiding principles, the Division was extraordinarily successful during his tenure (giving it a 12 on a scale of 10), and that, despite the challenges—including judicial limitations on SEC authority, a government shutdown and a pandemic, the Division achieved meaningful and impressive results for retail investors through a “powerful combination of deference, cooperation and support.”

Conclusion

The record is undeniably impressive. At the start of their tenure, it would have been impossible for Chair Clayton and Director Avakian and former Enforcement Co-Director Steven Pieken (who left the agency on August 14, 2020) to have anticipated the many unexpected challenges they were about to encounter. That they managed the operations and processes throughout, while keeping their eyes on a determined pre-pandemic agenda is commendable. It will be interesting to revisit these achievements in December, when the Division’s 2020 Annual Report is released. We will continue to keep you apprised.

Bates features regular coverage of SEC and regulator leadershipalertsand initiatives.

 For additional information, please follow the links below to Bates Group's Practice Area pages:

Regulatory and Internal Investigations

Institutional and Complex Litigation

Big Data

Retail Litigation and Consulting

Bates AML and Financial Crimes

Bates Compliance

Consulting and Expert Testimony

 

For more information about Bates Group’s Regulatory and Investigations practice, please reach out to Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations at arussell@batesgroup.com.


Upcoming Webinar: REG BI – 120 Days On. Where are we now?

Reg BI's implementation occurred on June 30, 2020 and 120 days on, Global Relay and Bates Compliance experts will assess the impact on the industry thus far.

Join our webinar to hear expert opinions from our panel of regulatory specialists:

  • Donald McElligott, VP Compliance, Global Relay
  • Hank Sanchez, Managing Director, Bates Compliance
  • Robert Lavigne, Managing Director, Bates Compliance

Date: Wednesday, October 28, 2020 Time: 11:00 AM Pacific / 2:00 PM Eastern
Duration: 45 Minutes

You will learn:

  • What has happened since REG BI came into effect
  • How it has impacted the technology side of business
  • Common concerns raised by the SEC

Register for this Webinar

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10-13-20

Important Takeaways from SIFMA-Bates Virtual Branch Office Compliance Visits Webinar

Important Takeaways from SIFMA-Bates Virtual Branch Office Compliance Visits Webinar

On Monday, October 5, 2020, nearly 700 Compliance, Supervision, Risk, Legal and Regulatory experts and professionals tuned in to a panel discussion covering virtual branch office inspections and the challenges facing regulators and industry supervision and compliance teams. The webinar, jointly organized by Bates Compliance and SIFMA, reviewed the current requirements and status of branch office inspections, recent regulatory relief, and compliance expectations for on-site inspection requirements going forward. The featured speakers included:

  • Jennifer Stout – CEO, Bates Group (opening remarks)
  • Jill Ehret - Director, Bates Compliance - Bates Group
  • Lou Moschetta - Senior Vice President and Deputy Director of Compliance, Wells Fargo Advisors
  • Joseph Neary - Chief Risk Officer, Cetera Financial Group
  • John O’Neill - Executive Vice President and Chief Compliance Officer, LPL Financial
  • Joseph J. Sheirer - Vice President, Member Supervision Examination Program, FINRA
  • Paul M. Tyrrell - Partner, Sidley Austin (moderator)
  • Kevin Zambrowicz - Managing Director and Associate General Counsel, SIFMA

Here are some of the highlights.

Branch Office Inspections

Led by Sidley Austin partner Paul Tyrrell, the panelists discussed the dramatically altered environment since on-site compliance and regulatory inspections ceased in March 2020 due to the pandemic. Bates Compliance’s Jill Ehret described the significant impact on firm compliance based on differences in firm size, the number of home offices, the sufficiency of technology, and the necessity of new practices and protocols to mitigate risk. SIFMA’s Kevin Zambrowicz mentioned that most branch offices are closed or are providing very limited or no onsite client services, and that so far firms are taking a conservative approach to reopening. He said that many firms are doing what they can to do inspections remotely—for most firms, “the policy…is that corporate travel is restricted,”—and are relying on technology instead of an  on-site examination component. Wells Fargo’s Lou Moschetta expects no on-site inspections for an extended period—“possibly 2nd quarter next year.”

The panelists generally agreed that the FINRA relief that extended the 2020 exam cycle through Q1 2021 was necessary, but that the extension is not long enough to complete the 2020 cycle. Zambrowicz expressed concern about the ripple effects of such a time frame for the 2021 inspection cycle, anticipating going in the direction of extended relief and remote inspections for both 2020 and 2021. Cetera Financial Group’s Joseph Neary stated that the current 2020 and 2021 deadlines are “unrealistic.” LPL Financial’s John O’Neill said that his firm has thousands of locations; as a result, they are “focusing on how to triage which branches we can get to by March 2021,” and are employing risk-based approaches to prioritize offices within a three-year cycle.

Reopening (Hypothetically Speaking)

Zambrowicz discussed efforts to address the “practicalities” of a return to onsite inspections amid re-openings, describing such a process as “exceedingly complicated.” He explained a firm’s duty to have a supervisory system in place, but noted the logistics involved for a firm staffer to visit a location in this environment, including state- and even county-level travel restrictions and the testing and quarantining around even a single visit. He stated that, without even “considering the health concerns of the examiner,” the logistics of the process were “not feasible.” He advocated for the use of remote supervision using existing technology, an approach which has already been embraced by certain regulators who have recognized the need and capability to go remote.

Moschetta furthered the point, saying that a big management concern is the volume of advisers operating from remote locations. “How many will continue to work from home? Could be thousands… No answer to that yet.”

FINRA’s Joseph Sheirer highlighted the temporary relief provided to firms from having to register locations as non-branch offices, saying, “we’ve given a pass on registering these locations, recognizing the challenges of on-site inspections.” He stated that FINRA is facing the same challenges as the industry and that unless there was a customer harm, or a threat to market integrity, the inspections that have been conducted have been all remote: “We are as virtual as you can get.” He noted that  includes remote examinations, branch office visits and enforcement programs, and said that, to date, even “on-the-record” testimony has been handled remotely.

Learning How to Adapt

Bates Compliance’s Ehret described how firms are adapting to current conditions. She said that although the focus has been on the rules and the inspections, “we should be thinking more about the review element,” which does not need to be on site. The more off-site preparation completed during the review phase, the less burden there is on the on-site element. Ehret said that firms are also thinking about other practical changes to (i) address travel limitations, including, for example, using supervisors who are closest in proximity to do onsite reviews, (ii) strengthen pre-visit questionnaires, and (iii) conduct virtual interviews.

FINRA’s Sheirer highlighted the value of recent regulatory notices on remote supervision. The guidance emphasized using a risk-based approach and sharing industry best practices. He agreed that firms should consider and document changes to protocols and practices, including using new communications platforms and enhancements to virtual monitoring and supervision.

Zambrowicz said there were numerous examples of different regulators (e.g., CFTC, NFA) allowing virtual solutions to satisfy on-site requirements. Moderator Tyrrell added that recent interpretive guidance from the NFA represents an “important marker” to that end. Sheirer cautioned that while FINRA is considering making certain relief permanent, “there are still things that benefit from an on-site,” such as the ability to see space sharing that may present conflicts of interest, outside business activities, body language, and the like. Like Ehret, he focused on solutions that could enable off-site inspections, such as enhanced email review and monitoring.

Issues Pre-COVID (and Beyond)

Cetera’s Neary also emphasized pre-exam work, noting how his firm upped its requirements on electronic record keeping, email review, and centralized trading. LPL Financial’s O’Neill pointed out that the results of virtual reviews have been relatively “consistent” with pre-COVID reviews. O’Neill noted “an uptick of email use, which is good for our email review system,” .. O’Neill reiterated that “we’re not necessarily seeing a drop-off in quality or anything… So, we’re trying to look at our program and say, ‘how we can make some of this permanent?’”

Similarly, Moschetta said his firm was seeing the same sort of findings in substance and volume as those found in pre-pandemic on-site review. He said that existing and new technology processes and enhancements generally discover items such as outside business activities, private securities transactions and unreported complaints. Further, he said, the new efforts are helping their partners cope in the field know what to expect and to deliver.

Ehret noted some additional benefits. She said new technology is enabling “look backs, specialized reviews for outside business activities, identification of red flags on social media, and more documentation on office activities that are now subject to additional firm reporting.”

All Roads Lead to Virtual Supervision and Inspections

SIFMA’s Zambrowicz stated the consensus position that the evolution of technology is mitigating the need “to actually be there” and that firms should use the lessons from the current environment to recognize “the opportunities.” He said that “it is a logical next step to go virtual and that the pandemic brought to a head the natural and technological evolution of virtual supervision and inspections.”

Bates Compliance’s Ehret reiterated that most of the work required for an inspection is done prior to an on-site inspection: “The heavy lifting has already been done in review.” The way clients are currently working with their advisers is the way of the future.

SIFMA has made this program available on demand.

For more information or further questions about this program or Bates Compliance's services, please contact David Birnbaum, Managing Director, at dbirnbaum@batesgroup.com or call 917-273-2682.


About Bates Compliance:

Jill Ehret is a Bates Compliance Director based in St. Louis, MO. Ms. Ehret is a seasoned securities industry professional with over 19 years of experience bringing practical, application-based insight and approaches to broker-dealer and registered investment advisor compliance departments and issues.

Bates Compliance’s consulting practice delivers guidance and tailored compliance solutions to our broker-dealer, investment adviser and hybrid firm clients on an as-needed or ongoing basis. Our team—made up of experienced senior compliance, legal and former regulatory professionals—drafts and tests policies, procedures, and supervisory and compliance processes, recommending and implementing changes based on leading practices to enhance compliance and supervisory systems and to remediate regulatory, litigation and internal audit findings. With nearly four decades of working with leading law firms, financial services companies and regulatory bodies, Bates provides support every step of the way.

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09-17-20

FinCen Focus: Customer Due Diligence with Banking Agencies, SARs Warnings and BSA Enforcement

Just a few weeks ago, Bates highlighted a series of Financial Crimes Enforcement Network (FinCEN) compliance communications. They included new FAQs on general requirements under the customer due diligence rule (CDD) and alerts regarding cyber-enabled financial crime and scams involving fraudulent payments denominated in convertible virtual currencies.  

Since then, FinCEN has issued several important public statements. First, it joined the Federal Reserve Board, the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Office of the Comptroller of the Currency (hereafter, the “Agencies”) in clarifying specific Bank Secrecy Act/Anti-Money Laundering  (BSA/AML) due diligence requirements for customers who may be considered “politically exposed persons” (PEPs). Second, FinCEN issued a stern warning to the media and others about the publication of unlawfully disclosed information contained in suspicious activity reports (SARs). Third, FinCEN published guidelines on how it approaches enforcement of the BSA. These enforcement guidelines provide firms with insight into how FinCEN determines an “appropriate” response to violations of the statute. The FinCEN guidance comes on the heels of an updated joint statement on BSA/AML enforcement issued less than a week earlier by the Agencies. Here’s a recap.

CDD REQUIREMENTS ON PEPS

On August 21, 2020, FinCEN and the Agencies issued a statement on the BSA CDD requirements for “politically exposed persons”—a term of art used to describe foreign public officials, their family members or close associates. According to the agencies, these PEPs present a higher risk to financial institutions that their assets may contain the “proceeds of corruption or other illicit activity.”

The Agencies’ statement highlights a financial institution’s obligation to identify and report the suspicious activity of PEPs, particularly transactions that may involve the proceeds from corruption, bribery and money laundering. Consistent with the FAQs issued a few weeks ago, the Agencies clarify that the CDD rule does not create any new requirement or supervisory expectation for customers who are considered PEPs. They reiterate that under the CDD rule, banks must adopt appropriate due diligence procedures and assess the specific PEP relationship under specific facts and circumstances in order to determine the level of risk that may be present. For PEPs, financial institutions should consider assessing the types of services provided, the nature of the transactions, “geographies associated with the customer’s activity and domicile,” the PEP’s authority over government officials and access to government funds.

FINCEN WARNINGS ON PUBLICATION OF SARS

On September 1, 2020, FinCEN issued a short but stern warning about the unlawful disclosure of the contents of SARs. Stating that it was aware of media outlets that intended to publish articles based on such information, FinCEN reiterated that any unauthorized disclosure is a crime prohibited by the BSA which can “compromise law enforcement investigations, and threaten the safety and security of the institutions and individuals who file such reports.” Civil and criminal penalties can be substantial ($100,000 per incident for the former, and up to $250,000 and five years imprisonment for the latter). FinCEN stated that it has referred the information it has obtained to the U.S. Department of Justice and the Treasury Department’s Inspector General.

FINCEN ISSUES ENFORCEMENT GUIDELINES

In a statement issued on August 18,  2020, FinCEN detailed its approach to enforcement of actual or possible violations of the BSA.

The statement affirmed FinCEN’s authority as “administrator of the BSA” with “overall authority for enforcement and compliance.” FinCEN described the scope of its authority stating that it “may take enforcement actions, to include imposing civil money penalties on financial institutions, nonfinancial trades or businesses, and other persons that violate the BSA,” and to impose “civil money penalties on partners, directors, officers, or employees who participate in these violations. In this capacity, FinCEN said it has the authority to conduct examinations and to rely on examinations from other “federal functional regulators” under the BSA framework, but would “not treat noncompliance with a standard of conduct announced solely in a guidance document as itself a violation of law.”

In its statement, FinCEN  identified the actions it might take to respond to various violations, including (i) closing a matter with no additional action; (ii) issuing a warning letter (e.g., on supervision); (iii) seeking an injunction or equitable relief to enforce compliance if it suspects a violation; (iv) requiring remedial obligations in a settlement; (v) assessing a civil money penalty; and (vi) referring a case for criminal investigation or prosecution.

FinCEN also described numerous factors it uses when evaluating the disposition of a case involving compliance with specific BSA requirements (e.g., registration, recordkeeping and reporting) or the “adequacy” of a financial institution’s AML program requirements  (e.g., internal controls, trainings, testing). These factors include (i) the nature and seriousness of the violation; (ii) the impact of the violation on FinCEN’s efforts to carry out its mission, including to combat money laundering; (iii) the pervasiveness of the violation within the organization; (iv) prior history; (v) the extent of any financial gain; (vi) action taken by the institution upon discovery of the violation; (vii) timely disclosure of the violations to FinCEN; (viii) any cooperation with FinCEN and other authorities; (ix) the systemic nature of the violations; and (x) enforcement efforts by other agencies on related activity.

AGENCIES ISSUE GUIDANCE ON BSA/AML ENFORCEMENT

FinCEN’s statement came less than a week after the other Agencies issued joint guidance on when they may exercise their discretion “to issue formal or informal enforcement actions or use other supervisory actions to address BSA-related violations or unsafe or unsound banking practices or other deficiencies.”

On August 13, 2020, the Agencies set forth their enforcement policy, which is anchored in legal requirements that mandate that each Agency prescribe regulations that require insured depository institutions to “establish and maintain procedures reasonably designed to assure and monitor the institution's compliance” with the BSA and to enforce those requirements. The statement reviewed the Agencies’ approach to these obligations, ensuring that financial institution programs include the four original required components (pillars) for compliance programs: internal controls, independent testing, a designated BSA compliance officer, and staff training. The updated guidance now includes a fifth component for compliance programs (risk-based procedures for conducting customer due diligence) which was added by the CDD rule. (See prior Bates coverage here.)

The joint statement details the obligations under this fifth pillar including the requirement that an institution maintain a “Customer Identification Program” with risk-based procedures that enable the institution to form a reasonable belief that it knows the true identity of its customers.” This includes, among other elements, understanding the customer relationship in order to develop a customer risk profile, conducting monitoring, reporting suspicious transactions, and updating customer information regarding beneficial ownership. The statement also clarifies that, for the purposes of issuing mandatory cease and desist orders, the Agencies would evaluate BSA reporting and recordkeeping requirements, as well as CDD requirements, as a part of the internal controls component of the compliance program.

Generally, the Agencies stated that an enforcement action would be initiated for (i) failing to have a written BSA/AML compliance program that adequately covers the program pillars; (ii) failing to implement an adequate BSA/AML program and (iii) having defects in one or more program components. The Agencies highlighted specific types of institutional actions that might trigger an enforcement order. These include (i) rapidly expanding relationships with foreign affiliates or third parties without proper controls; (ii) failing to identify risks relating to money laundering or other illicit financial transactions; (iii) an inadequate system of internal controls to confirm customers' identities; (iv) failure to resolve independent testing deficiencies; (v) inadequate training; and (vi) failure to address a previously reported deficiency, among others.

CONCLUSION

These are important official statements on enforcement practice, procedure and priority. They are also an important indication of how the CDD Rule has affected the regulatory framework. For financial institutions facing possible enforcement action, FinCEN and the banking agencies have provided insight into their deliberations and perspective. Bates will continue to keep you apprised.

 

To discuss this article and/or learn more how Bates can help you navigate BSA/AML issues, please contact:

Edward Longridge, Managing Director and Practice Leader, Bates AML and Financial Crimes at elongridge@batesgroup.com.

Dennis Greenberg, Managing Director, Bates AML and Financial Crimes at dgreenberg@batesgroup.com

 

For additional information, please follow the links below to Bates Group’s Practice Area pages:

Bates AML and Financial Crimes

Artificial Intelligence and AML Optimization

Bates Compliance

Regulatory and Internal Investigations

Consulting and Expert Testimony

Retail Litigation and Consulting

Institutional and Complex Litigation

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09-10-20

NASAA Rounds Out Busy Summer with Active Policy and Enforcement Agenda

NASAA Rounds Out Busy Summer with Active Policy and Enforcement Agenda

The North American Securities Administrators Association (“NASAA”) continues to assert its member states’ interests in fighting for and protecting investors and consumers in the financial markets. Here we have assembled a roundup of recent NASAA actions on enforcement, model legislation and regulatory policy, as well as what to expect going forward.

ENFORCEMENT: PANDEMIC TASK FORCE RESULTS

NASAA announced that, as a result of a coordinated COVID-19 initiative, its enforcement task force disrupted 220 pandemic-related schemes to defraud investors and consumers as of August 19, 2020. The task force uses online investigative techniques to identify websites and social media posts that may be promoting investment fraud, fraudulent offerings or improper, unregistered regulated activities.

NASAA member regulators brought administrative actions, filed cease-and-desist orders, and made referrals to other regulators (and hosting companies) on 154 investment-related and 90 non-investment-related schemes. According to the NASAA task force web page, the pandemic-related schemes are characterized as inducements that (i) prey on fear and anxiety; (ii) promote safety amid uncertainty; (iii) involve cryptocurrencies or cryptocurrency-related investment products, foreign exchange (“forex”) products, or “products generally unfamiliar to inexperienced retail investors”; and (iv) promise monthly payments that would appeal to cash-strapped investors, often referring to returns as “passive income” or “cash flow.”

STATE LEGISLATIVE EFFORTS: NEW MODEL ACT ON WHISTLEBLOWERS

On August 31, 2020, NASAA adopted a new model act “to protect whistleblower confidentiality, prohibit retaliation by an employer against a whistleblower, and create a cause of action and provide relief for whistleblowers retaliated against by their employer.” The model act is intended to “help states provide a safe environment for individuals to come forward to report suspected wrongful securities practices to state securities regulators.” NASAA also highlighted that the Act provides a state’s securities regulator with the authority to make monetary awards to whistleblowers based on the amount of monetary sanctions collected in an administrative or judicial action, up to 30 percent of the amount recovered. Like other NASAA model legislation, the whistleblower act serves as a template for consideration and adoption through legislation or regulation by member jurisdictions.

STATE LEGISLATIVE EFFORTS: PROPOSED STATE RESTITUTION FUNDS FOR VICTIMS OF SECURITIES FRAUD

On July 1, 2020, NASAA proposed a model act for member jurisdictions to create a restitution fund for victims of securities law violations who were awarded restitution but who have not received full payment. Among other elements, the proposed Act would (i) establish a securities restitution assistance fund within the jurisdiction;  (ii) provide examples of funding sources for jurisdictions to consider; (iii) establish eligibility and application processes for restitution assistance; (iv) set limitations on restitution assistance awards; (v) provide that the jurisdiction is entitled to a lien in the amount of the restitution award on recovery; and (vi) grant the jurisdiction rulemaking authority to carry out the purposes of the program. Public comments are now being reviewed for amendments prior to consideration and adoption by the members (likely in September).

REGULATORY POLICY: CHALLENGE TO SEC “ACCREDITED INVESTOR” DEFINITION

In a strongly worded statement, NASAA Past President Christopher W. Gerold expressed disappointment with the SEC for adopting an amendment expanding the definition of “accredited investor” under federal private fund regulations. The SEC recently revised the definition in order to increase the number of sophisticated investors that will have access to private investments. (See Bates Complinance Alert here.)

Mr. Gerold responded to the SEC’s deregulatory move, saying it showed “little regard for the potential adverse effects on investors and the public markets,” and that it “squandered an opportunity to … address long overdue changes to the wealth and income standards defining accredited investors.” He said that “the failure to index these standards to account for inflation has eroded the investor protections they were designed to provide,” and that the Commission “failed to protect seniors or other vulnerable investors from the inherent risks associated with the lack of transparency and liquidity that exists in the private securities marketplace.”

REGULATORY POLICY: OPPOSITION TO DOL INVESTMENT ADVICE PROPOSAL

In a comment letter dated August 6, 2020, NASAA opposed the Department of Labor (“DOL”)’s rule proposal on investment advice for retirement accounts under the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code (“the Code”). (See Bates coverage of the proposal here.) The proposal would (i) create a new “prohibited transaction class exemption” for investment advice that would allow financial institutions and investment adviser fiduciaries to receive compensation that would otherwise be prohibited under ERISA law; (ii) reinstate a five-part test for defining investment advice; and (iii) make changes to a pre-existing prohibited transaction class exemptions consistent with a 2018 Court Order vacating the DOL’s fiduciary duty rule.

In its comment, NASAA encouraged the DOL to rescind the proposal for jeopardizing the security of retirement investors, stating that “taken together, the various aspects of the Proposal will create outcomes that are the opposite of the fiduciary protections that retirement investors deserve, and that Congress intended under ERISA.” Specifically, NASAA argued that under the proposal (i) retirement savers will be misled into believing that the advice they receive adheres to fiduciary standards; (ii) investment professionals will “remain free to offer conflicted, self-interested advice”; (iii) investment professionals could decide to limit their advice to “limited scope transactions” (like rollovers), which could be characterized as discrete and not subject to appropriate scrutiny under the five part test; (iv) the investor will not have any new means to seek relief; and, generally, (v) standards of care will be distorted “through complicated tests, permissive disclosure arrangements, and self-determined controls.”

Should the proposal not be rescinded, NASAA recommends that it should be amended to simplify the five-part test and eliminate harmful loopholes. Specifically, NASAA contends that the DOL “should make clear that providing investment advice regarding rollovers is always a fiduciary act”; tighten the standards on advice concerning “sales contests, proprietary products, and limited product menus”; and strengthen and clarify requirements for minimum disclosure to investors.

REGULATORY POLICY: NASAA SUBMITS ANOTHER ROUND OF COMMENTS ON FINRA PROPOSAL ON BENEFICIARY ARRANGEMENTS

As described in a previous Bates post, NASAA urged FINRA to strengthen a rule proposal that would create a national standard to protect seniors by requiring member firms to review and approve—in writing—an associated registered person being named a beneficiary, executor or trustee, or to hold a power of attorney on behalf of a customer. On July 30, 2020, NASAA filed a letter asking for reconsideration of its prior comment recommendations on FINRA proposed Rule 3241, which it said is “of particular interest to NASAA and its members for its implications for investor protection, particularly for seniors and persons with diminished capacities.”  

In its latest submission, NASAA asserted that (i) “registered persons should be prohibited from being named as beneficiaries or appointed to positions of trust by any customers other than immediate family members”; (ii) registered persons serving in a customer beneficiary and trust position arrangement—even if they are family members—should be required to get written approval from their firms and be subject to clear disclosure requirements; (iii) FINRA should be required to “create clear standards by establishing a baseline of information that registered persons are required to provide, and more specific guidance on considerations for firm approval”; and (iv) any accounts under these proposed arrangements should be subject to heightened supervision.  

NOTABLE: REPORT ON FINANCIAL PROFESSIONALS WITH DIMINISHED CAPACITY

On July 21, 2020, NASAA published a special report on diminished capacity and cognitive impairment that may affect financial professionals. Though the NASAA working group that authored the report could not determine how many professionals were affected, they noted the aging population of the industry and other concerns including alcohol and substance abuse that could impair judgment. The working group described many compliance areas that are implicated. These include issues related to standards of conduct, supervision, books and records, continuing education and fraud. The working group also assessed a variety of “methods and resources” used by firms to address these sensitive situations, highlighting their efforts at training in succession planning and recognizing red flags.

CONCLUSION - LOOKING FORWARD

NASAA’s significant summer activities under the leadership of Past President Christopher W. Gerold continue to demonstrate the association’s critical and assertive role in state legislation, federal and state regulatory policy and enforcement related to the financial markets. As the association transitions its leadership to President Lisa A. Hopkins (West Virginia’s Senior Deputy Securities Commissioner), we can expect continued emphasis on addressing the coronavirus pandemic and its impact on regulators, industry and investors through a new NASAA Crisis Planning and Recovery Committee announced by Hopkins, and a focus on exempt offerings and diversity, equity, inclusion and advocacy. Bates will continue to keep you apprised.

 

ABOUT BATES

Bates Group has been a trusted partner to financial services firms and counsel for over 30 years, providing end-to-end solutions on legal, regulatory and compliance matters. Through our professional staff and roster of over 165 industry experts and consultants, Bates offers services in litigation consultation and testimony, regulatory and internal investigations, compliance, financial crimes, forensic accounting and damages consulting.

For regulatory and compliance solutions, please contact Robert Lavigne, Managing Director - Bates Compliance, at rlavigne@batesgroup.com.

For sensitive or complex regulatory and internal investigations, please contact Alex Russell, Managing Director - White Collar, Regulatory and Internal Investigations, at arussell@batesgroup.com.

For litigation and damages support, please contact Julie Johnstone, Managing Director - Securities and Financial Services Litigation & Consulting at jjohnstone@batesgroup.com.

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09-03-20

Bates Group Summer Roundup – Catch Up on What You’ve Missed and What’s Coming Up This Fall

Bates Group Summer Roundup – Catch Up on What You’ve Missed and What’s Coming Up This Fall
Labor Day is almost here, which means those lazy, remote days of summer are coming to a close. What did you miss when you powered down this summer? 
 
We have a roundup of all the important Bates news, events and alerts from July and August as well as a sneak peek of the next few months to help you head into Fall fully prepared. 
 

NEWS

New FinCen Guidance on the CDD Rule, Cyber Fraud and Virtual Currency Scams Exploiting Twitter - 8/20/20

FINRA Roundup: Guidance on Private Placements, Digital Assets, Virtual Hearings, and Proposals - 8/6/20

Bates Group, Complidata Bring Expertise and A.I. Technology Together to Optimize AML and Compliance - 8/5/20

DOL Proposes New Class Exemption for Investment Advisers - 7/30/20

Welcome to Our New Bates Experts - 7/24/20

Bates Practice Leadership Insights: Julie Johnstone on the Changing Litigation Landscape - 7/22/20

New OCIE, FinCEN Alerts Emphasize Vigilance Against Ransomware, Imposter Scams, Money Mule Schemes - 7/16/20

 

COMPLIANCE AND REGULATORY ALERTS

SEC Issues COVID-19 Compliance Observations and Recommendations for BDs and IAs - 8/17/20

SEC Issues “Private Funds Adviser” Compliance Risk Alert - 7/2/20

 

WEBINARS AND CLE

Webinar: Covid-19 Leads to Novel Compliance Concerns - 8/20/20

CLE Webinar: Capital Market Uncertainty in the Time of COVID-19 and Potential Legal & Regulatory Impact - 8/13/20

CLE Webinar: Anti-Money Laundering and Fraud Risks In the Age of COVID-19 - 7/30/20

Bates Compliance Roundtable: Assessing, Fine-Tuning and Improving Your Business Continuity Plan - 7/15/20

CLE Webinar: Regulatory Exams and Investigations in the Age of COVID-19 - 7/9/20

View all of our On-Demand webinars and CLEs on our Recorded Programs page.

 

COMING UP

September 21-22 - Join Christine Davis, Bates Managing Director of Forensic Accounting and PLI program co-chair, and Edward Longridge, Managing Director of Bates AML & Financial Crimes, at the  PLI Pocket MBA 2020: Finance for Lawyers and Other Professionals CLE Webinar.

September 23-24 - Visit Bates Group's Interactive Virtual Booth at the SIFMA C&L Virtual Forum. Bates is a proud Silver sponsor of this online event. (And yes, we’ll be giving away wine and goodies!)

October 5 - Join SIFMA and Bates Group for our “Virtual Branch Office Compliance Visits" CLE Webinar. (Registration coming soon!)

October 8 - Join us at the annual FSDA Industry Outreach Program. Bates is a proud Platinum sponsor of this online event.

October 13-15 - Join us at the IBDC-RIAC Annual Risk Management Conference. Bates is proud to sponsor and speak at this online event.

October 19-21 - Register now for the 2020 NSCP National ConferenceBates Compliance Manging Director and NSCP Board member Linda Shirkey will be speaking on Day 1 of the conference (Session 3b. IA/PF – Understanding the SEC’s Proposed Advertising Rules). Bates is a proud Gold sponsor of this online event.

 

NEED ASSISTANCE?

For additional information and practice support, please Contact Us today, and follow the links below to Bates Group’s Practice Area pages:
 

Consulting and Expert Testimony

Retail Litigation and Consulting

Institutional and Complex Litigation

Bates Compliance

Regulatory and Internal Investigations

Bates AML and Financial Crimes

Forensic Accounting and Economic Damages

Insurance and Actuarial Services

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08-20-20

New FinCen Guidance on the CDD Rule, Cyber Fraud and Virtual Currency Scams Exploiting Twitter

New FinCen Guidance on the CDD Rule, Cyber Fraud and Virtual Currency Scams Exploiting Twitter

Over the past several weeks, the Financial Crimes Enforcement Network (FinCEN) has issued new guidance on customer due diligence requirements, an advisory on cyber-enabled financial crime and an alert concerning scams involving fraudulent payments denominated in convertible virtual currency. These are significant compliance communications for financial institutions and come on the heels of FinCEN’s recent alerts on imposter fraud and money mule schemes (see previous Bates coverage). Here’s what you need to know.

New FinCen Guidance on the CDD Rule, Cyber Fraud and Virtual Currency Scams Exploiting Twitter

New FAQs on Customer Due Diligence

The CDD Rule, which went into effect in 2018, requires covered financial institutions to develop procedures to identify and verify a customer’s beneficial owners when an account is opened, and to establish risk-based procedures for conducting ongoing due diligence. (FinCEN provides an active topic page on the subject which includes links to exemptive relief rulings and the latest regulatory FAQs.) On August 3, 2020, FinCEN issued new responses to FAQs concerning obligations “related to obtaining customer information, establishing a customer risk profile, and performing ongoing monitoring of the customer relationship.” The core message in this guidance is a reaffirmation that financial institutions must tailor their CDD program around customer risk.

On questions about the collection of customer information, FinCEN responded that the CDD Rule “does not categorically require” the collection of any particular information other than developing a customer risk profile, monitoring, and collecting beneficial ownership information. FinCEN emphasized that the collection of information is directly related to the level of risk, (i.e., where the customer’s risk profile is low, the collection of any specific information may not be necessary in order to understand the customer relationship.)

FinCEN reiterated that the CDD rule requires covered financial institutions to “establish policies, procedures, and processes for determining whether and when, on the basis of risk, to update customer information to ensure that customer information is current and accurate.” Consequently, while the rule does not require specific due diligence, media searches, or the collection of information concerning certain underlying transactions (e.g., identifying information on a “customer’s customer”), the level of risk determines the appropriate level of information that needs to be collected, which, ultimately, would help to alert a financial institution as to suspicious transactions.

Similarly, FinCEN noted that the CDD rule “does not prescribe risk profile categories, and [that] the number and detail of these categories can vary.” FinCEN’s broader guidance is that financial institutions should understand the types of financial crime risks that are consistent with the customer risk profile and that “any program for determining customer risk profiles should be sufficiently detailed to distinguish between significant variations in the risks of its customers.”

Concerning specific schedules for ongoing customer relationship monitoring, FinCEN relayed that there is “no categorical requirement that financial institutions update customer information on a continuous or periodic schedule.” While the specifics of a monitoring program are also based on risk, FinCEN said that a covered financial institution must update customer information as is relevant to assessing that risk and in order to “reassess the customer risk profile/rating.”

New Advisory on Cyber-Enabled Crime

Only a few weeks after FinCEN cautioned institutions about a rise in money mule schemes and imposter frauds that attempt to con investors and other consumers into deceptive transactions, FinCEN issued a new warning alerting financial institutions to indicators of COVID-19-related cyber scams. The advisory reviews “the means by which cybercriminals and malicious state actors” exploit the pandemic through malware, phishing schemes, extortion, business email compromise fraud, and exploitation of remote applications, especially against financial and healthcare systems. The advisory is based on data analysis of suspicious activity reports and law enforcement and other public reports. It describes risks and red flags for financial institutions to protect customers and legitimate COVID-19 relief efforts.

In the advisory, FinCEN identifies numerous red flag indicators and warns financial institutions to guard against:

  • potential vulnerabilities of remote applications and in virtual environments (including potential manipulation of online verification processes and compromised login credentials across customer accounts) that can jeopardize private information, compromise financial activity and disrupt business operations;
  • schemes targeting health care and pharmaceutical providers that seek the collection of personal and financial data (through malware, ransomware, phishing schemes and extortion);
  • schemes targeting municipalities and the health care industry supply chain that attempt to modify or redirect payments to new accounts (“business email compromise” (BEC) fraud schemes).

FinCEN relayed that financial institutions should consider these indicators in context given “the surrounding facts and circumstances, such as a customer’s historical financial activity, whether the transactions are in line with prevailing business practices, and whether the customer exhibits multiple indicators, before determining if a transaction is suspicious or otherwise indicative of potential fraudulent COVID-19-related activities.”

FinCEN advised financial institutions to use specific language on SARs reports and to reference (in specific fields) these COVID-19 related schemes where the circumstances or subject matter matches.

New Alert on Convertible Virtual Currency Scams

In an alert issued in late July, FinCEN addressed concerns raised by a highly public incident exploiting Twitter accounts. The scheme involved the compromise of the Twitter accounts of public figures and organizations in order to solicit fraudulent payments denominated in convertible virtual currency (CVC). The fraudsters claimed that any CVC “sent to a wallet address would be doubled and returned to the sender.”

The Twitter advisory references a prior FinCEN alert on illicit activity involving CVCs and adds to the broader concern about identifying bad actors seeking to exploit CVCs “for money laundering, sanctions evasion, and other illicit financing purposes” (e.g., those involving darknet marketplaces, peer-to peer exchangers, foreign-located Money Service Businesses, and CVC kiosks.) Together, these warnings paint a daunting picture of the finance vulnerabilities posed by virtual currencies.

In the Twitter alert, FinCEN identifies several indicators to help detect, prevent, and report potential suspicious activity related to social media posts. Among others, these include solicitations from individuals or organizations where there is no prior existing business relationship (like from celebrities or public figures) and solicitations requesting donations where the solicitor is not affiliated with a reputable organization.

Conclusion

FinCEN has had a busy summer. The agency has now warned financial institutions to be on alert for a host of threats, from simple to highly sophisticated fraud and malicious activity. The advisory on increased vulnerabilities resulting from operating during the pandemic reminds us how quickly circumstances can turn into opportunities for bad actors and how alert compliance teams must be to keep up. The advisory on virtual currency risk is an indication that there is much more work needed to protect clients in the virtual markets. Finally, FinCEN’s additional CDD Rule guidance highlights how risk-based frameworks require constant tuning in order for compliance professionals to be able to execute the practical details of their programs.

In the meantime, expect FinCEN to keep issuing these advisories. Bates Group will keep you apprised.

To discuss this article and/or learn more how Bates can help you navigate AML, please contact:
Edward Longridge, Managing Director and Pratice Leader, Bates AML and Financial Crimes at elongridge@batesgroup.com.
Dennis Greenberg, Managing Director, Bates AML and Financial Crimes at dgreenberg@batesgroup.com

For additional information, please follow the links below to Bates Group’s Practice Area pages:
Bates AML and Financial Crimes
Bates Compliance
Regulatory and Internal Investigations
Retail Litigation and Consulting
Institutional and Complex Litigation
Consulting and Expert Testimony

New FinCen Guidance on the CDD Rule, Cyber Fraud and Virtual Currency Scams Exploiting Twitter
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08-06-20

FINRA Roundup: Guidance on Private Placements, Digital Assets, Virtual Hearings, and Proposals

FINRA Roundup: Guidance on Private Placements, Digital Assets, Virtual Hearings, and Proposals

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Since our last regulatory update on the adoption of FINRA’s proposal to align its suitability and non-cash compensation rules with Regulation Best Interest (“Reg BI”), the self-regulatory organization issued guidance on private placement communications, recommended that firms provide information to them on digital assets, and proposed a series of new rule changes. Bates examines the details of FINRA’s updated guidance.

Guidance on Private Placement Communications

FINRA issued guidance for members who market private placements to retail investors. Private placements are non-public securities offerings that fall within specific exemptions (Reg D) from SEC registration.

FINRA reported on SEC data showing that issuers make nearly 20,000 Reg D exemption filings each year, of which nearly “4,000 new offerings identify an ‘intermediary,’ such as a broker or finder, as participating.” FINRA requires that members participating in private placements file offering documents (Rules 5122 and 5223), with an estimated 2,000 such filings received each year. FINRA acknowledged the 50% difference between the two regulators and narrowed its guidance to “the subset of private placements marketed by member firms.” Within that subset, FINRA observed that more than 40% of the placements are subject to its rules on retail communications (Rule 2210 - Communications with the Public). FINRA noted that member firms are “increasingly involved in the distribution of private placements” through online platforms and digital advertisements, suggesting that more members will be subject to FINRA communications requirements.

FINRA’s rule requires that communications from member firms must be (i) fair and not contain false, misleading or promissory statements or claims; (ii) disclose the potential risks as well as rewards associated with the investments; (iii) be accurate and (iv) offer a “sound basis to evaluate the facts” about the product. The rule also requires that a registered principal approve each communication.

FINRA observed firm deficiencies in compliance with the communications rule. Specifically, FINRA said that firm communications often fail to balance claims of the benefits of these securities with the potential risks such as their “lack of liquidity” or their “speculative nature.” Other observed communications contained “false, misleading, or promissory statements or claims such as assertions about the likelihood of a future public offering, claims about the future success of the issuer’s business model, inaccurate or misleading assertions concerning the relative risk of the offering, or projections on investment performance.”

FINRA reminded member firms that:

  • They are liable for the distribution of third-party prepared materials if the material is non-compliant with the rule (i.e., not balanced or misleading).
  • Retail communications should not project or predict returns to investors (e.g., yields, future investment performance) however, reasonable forecasts of issuer operating metrics (e.g., sales, revenues or customer acquisitions) are permissible as long as they provides a sound basis for evaluating the facts. FINRA was very specific in its guidance on appropriate issuer operating metrics, including requiring limited time periods, reasonable growth rate assumptions, operating margins within industry averages, and reasonable sales and customer acquisition forecasts in relation to the market.
  • Real estate investment programs fall within the communications rule if they are “designed to provide distributions to investors." FINRA had specific guidance about communications on the metrics around distribution rates.
  • Marketing private placements of real estate, private equity and venture capital often use a performance measure known as the internal rate of return (IRR). FINRA determined that for “completed investment programs” (where the holdings in the pool have matured or been sold), this metric would not violate the communications rule. Further, FINRA would permit the inclusion of IRR in communications materials if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute.

Recommendations on Reporting Digital Assets 

FINRA encouraged member firms to continue to report firm activities related to digital assets. The request is an extension of prior notices to firms (see here and here) to communicate to a firm’s Risk Monitoring Analyst new or planned digital asset activities such as cryptocurrencies, other virtual coins and tokens. FINRA wants to be notified of the following kinds of activities (this list is not exclusive):

  • Management, advisory services and transactions in digital assets directly or in a pooled fund investing in digital assets
  • Transactions in derivatives tied to digital assets
  • Participation in any offerings of digital assets
  • Secondary trading of digital assets
  • Custody arrangements of digital assets
  • Acceptance of cryptocurrencies from customers or mining of cryptocurrencies
  • Clearance and settlement services for virtual coins and tokens
  • The use of distributed ledger technology or any other use of blockchain technology

FINRA Recent Actions

Virtual Hearings: In response to the COVID-19 pandemic, FINRA has administratively postponed all in-person arbitration and mediation proceedings scheduled through October 2, 2020 unless the parties stipulate to proceed telephonically or by Zoom, or the panel orders that the hearings will take place telephonically or by Zoom. FINRA has created a  Virtual Hearing Guide for Arbitrators.  Further, the Office of Hearing Officers (OHO) has administratively postponed all in-person hearings of Disciplinary Proceedings scheduled through October 2, 2020. The OHO staff makes available a Virtual Hearing Guide for Parties

Expungement: FINRA amended the Codes of Arbitration Procedure for Customer and Industry Disputes to apply a minimum filing fee for all expungement requests. The effective date of the amendment is September 14, 2020. The fee applies “irrespective of whether the request is made as part of the customer arbitration or the associated person files a straight-in request, or the requesting party adds a small damages claim.” Under the amendments, FINRA will “apply a minimum process fee and member surcharge to straight-in requests, as well as a minimum hearing session fee to expungement-only hearings held after a customer arbitration or in connection with a straight-in request.”

CONTINUING PROPOSALS

Cutomer Beneficiaries: FINRA proposed adopting a rule on registered persons being named a customer’s beneficiary or holding a position of trust for a customer. (See prior Bates coverage here). The proposal is an attempt to “address potential conflicts of interest that can result in registered persons exploiting or taking advantage of being named beneficiaries or holding positions of trust for personal monetary gain.” The new rule would create a uniform, national standard to govern registered persons holding positions of trust.

Operational Challenges: FINRA introduced certain proposals to address the operational challenges affecting members due to COVID-19. First, FINRA proposed temporarily extending the deadline for completed office inspections for the 2020 calendar year to March 31, 2021, effective immediately.  Secondly, FINRA proposed changes to temporarily amend certain procedural requirements, including timing and method of service. These amendments (i) allow FINRA to serve certain documents by electronic mail; (ii) require parties to file or serve documents by electronic mail in connection with specified proceedings and processes; (iii) provide extensions of time to FINRA staff and other parties “in connection with certain adjudicatory and review processes”; and (iv) allow for National Adjudicatory Council oral arguments  to be conducted by Zoom.

First Look: Upcoming Proposals

In a recent FINRA Board Meeting, the Governors approved three upcoming proposals for future notice and comment: (i) amendments to FINRA corporate financing rules to require members to file retail communications concerning specified private placements (see discussion on related guidance, above), (ii) proposed procedures to address cheating on and eligibility for qualification examinations and (iii) amendments to trade reporting rules to require the identification of certain corporate bond trades (i.e., those “priced off of a spread to a U.S. Treasury Security or that are part of a portfolio trade.”) The latter is intended to provide context on reported trades with “prices away from the current market.”

Conclusion

FINRA remains diligent in a host of areas. Its recent actions on private placements, arbitration, conflicts of interest and COVID-19-related administrative matters present examples of the scope of its mandate and its determination to keep pace. FINRA’s request to be kept apprised of broker dealer activity in digital assets suggests a broader agenda in the area. Bates will continue to monitor developments.


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07-30-20

DOL Proposes New Class Exemption for Investment Advisers

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More than two years after the Fifth Circuit Court of Appeals vacated the Department of Labor’s (“DOL”) fiduciary duty rule, the agency has proposed new regulations on investment advice for retirement accounts under the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code (“the Code”). Under the heading “Improving Investment Advice for Workers & Retirees,” the DOL (i) proposed a new “prohibited transaction class exemption” for investment advice that would allow financial institutions and investment adviser fiduciaries to receive compensation that would otherwise be prohibited under ERISA law, (ii) reinstated the 1975 regulation and its five-part test for defining investment advice, and (iii) made certain changes to its pre-existing prohibited transaction class exemptions consistent with the Court Order vacating the DOL’s fiduciary duty rule. Here are some of the details of the new DOL proposal.

A New Prohibited Transaction Class Exemption

The heart of the DOL proposal is a new class exemption that would be available to registered investment advisers, broker dealers, financial institutions and insurance companies that “provide fiduciary investment advice to Retirement Investors” (e.g., Plan participants and beneficiaries, IRA owners and Plan and IRA fiduciaries[1]). If granted the exemption, these institutions and professionals could receive various types of transaction payments and fees that are currently prohibited under ERISA law, including: “commissions, 12b-1 fees, trailing commissions, sales loads, mark-ups and mark downs, and revenue sharing payments from investment providers or third parties.” The exemption would also apply to advice provided on Plan roll-overs in addition to allowing financial institutions to transact to or from their own accounts.

By this proposal, the DOL is shifting its approach from one focused on narrow exemptions based on specific prohibited transactions to one which is more “principles-based.” The DOL is doing this by conditioning the exemptions on compliance with their “Impartial Conduct Standards.” These standards incorporate three elements: a best interest standard, a reasonable compensation standard and “a requirement to make no misleading statements about investment transactions and other relevant matters.”

According to DOL, each of these elements—which have long histories and pertinent interpretations—will now be aligned and consistent with Reg BI and prevailing securities law. As to the best interest standard, DOL affirms that investor fiduciary advice should be (i) prudent, reflecting the care, skill and diligence under prevailing circumstances and “based on the investment objectives, risk tolerance, financial circumstances, and needs of the retirement investor,” and be (ii) loyal, meaning that the advice does not place the interests of the financial adviser ahead of the interests of the retirement investor. These are familiar considerations for advisers under Reg BI.

Other specific requirements to maintain eligibility under the new broad exemption include written acknowledgements of an adviser’s fiduciary status under ERISA and the Code (see below), written communications regarding the services to be provided and any material conflicts of interest, and the adoption of policies and procedures to ensure compliance with the Impartial Conduct Standards (subject to retrospective review).

The DOL cautioned that financial institutions and professionals would be ineligible or would lose their eligibility for the exemption if, within ten years prior or following, they were “convicted of certain crimes arising out of their provision of investment advice to retirement investors.” The DOL stated, however, that should they be excluded from the broad exemption, these institutions or individuals could always apply for other, more targeted exemptions. The DOL justified this approach by saying that its more focused approach would “provide significant protections for Retirement Investors while preserving wide availability of investment advice arrangements and products.”

Further, the new proposed exemption would require disclosure of the status of the adviser under ERISA and the Code and would require providing an accurate written description of their services and material conflicts of interest. The DOL made clear that the proposed exemption would not “create any new legal claims above and beyond those expressly authorized in ERISA.”

Recognition as an Investment Advice Fiduciary: The Five-Part Test

To become eligible for the new class exemption, the DOL has effectively reinstated its’ 1975 regulation which imposed a five-part test to determine the status of an advisor. (That test had been supplanted by the DOL’s previous—and subsequently vacated—fiduciary rule; by the new proposal, DOL is adding a technical amendment which would formally reinstate the rule and test.)

For an adviser to be considered an investment advice fiduciary under ERISA and the Code, he/she must be authorized or responsible for providing investment advice and receive direct or indirect compensation “with respect to any moneys or other property” of a Plan. Specifically, the test requires the professional to:

  1. provide advice on the Plan or make recommendations on “investing in, purchasing, or selling securities or other property;”
  2. act regularly;
  3. act under an arrangement “with the Plan, Plan fiduciary or IRA owner;”
  4. provide advice which serves as the primary basis for an investment decision; and
  5. Tailor the advice for the individual “based on the particular needs of the Plan or IRA.”

Facts and circumstances will determine if the test is satisfied. Consequently, for a professional to be eligible for the exemption, he/she must establish status as an investment adviser fiduciary under this test.

The DOL’s proposal includes some guidance on the application of the test, particularly pertaining to advice concerning rollovers. For example, the DOL describes instances where an isolated recommendation to take an employee plan distribution and roll it into an IRA may fail the “regular” prong of the test, however advice to do so as part of an ongoing relationship with the client may be enough for that “regular” prong to be satisfied.  

Additional Changes

As noted above, the DOL addressed pre-existing prohibited transaction class exemptions under the new proposal in order to harmonize the results with the court’s decision to vacate the fiduciary rule. Specifically, the DOL removed two exemptions: the "Best Interest Contract Exemption" and the “Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRA” exemption. Certain other prohibited transaction exemptions that were amended in 2016, including most notably a pre-existing exemption for insurance companies and insurance agents, remain in force. However, under the proposal they would revert back to their pre-amendment forms.

The DOL highlighted that the new proposed  exemption does not cover robo-advice arrangements without the interaction of an investment professional.

Conclusion

It is clear that the timing of the DOL proposal was not accidental. It came within days of the implementation date of the SEC’s Regulation Best Interest (“Reg BI”) and shortly after a federal appellate court denied claims by several state attorneys challenging the adoption of that Reg BI regulation. As a result, the DOL made its intention to sync with the new SEC Reg BI standards framework explicit, highlighting that “the best interest standard in the new proposed class exemption is aligned with the conduct standards in the Securities and Exchange Commission's Regulation Best Interest.” Expect many comments on how the DOL’s new rules relate to Reg BI.

The proposed prohibited transaction class exemption is broader and “more flexible” than DOL’s prior exemption regime. It is based, in large part, on the temporary enforcement policy created after the court decision to vacate the DOL fiduciary rule. (FAB 2018-02.) Compliance officers that have modified their frameworks to conform with the Impartial Conduct Standards should be ahead of the curve. But, before drawing what may appear to be straightforward conclusions, it is important to remember that we have been here many times before (and that state actions on investment adviser standards are still alive and kicking.)  Bates will keep you apprised.

 

[1] The term “Plan” is defined for purposes of the exemption as any employee benefit plan described in ERISA section 3(3) and any plan described in Code section 4975(e)(1)(A). The term “Individual Retirement Account” or “IRA” is defined as any account or annuity described in Code section 4975(e)(1)(B) through (F), including an Archer medical savings account, a health savings account, and a Coverdell education savings account.


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07-22-20

Bates Practice Leadership Insights: Julie Johnstone on the Changing Litigation Landscape

As Managing Director for Bates Group's Retail Litigation practice, Julie Johnstone manages and oversees financial litigation and arbitration matters. Her team assists broker-dealer and investment advisers, banks and insurance companies, as well as State and Federal Regulators, throughout the life cycle of their retail litigation matters, from early case assessments, profit and loss reports, damage analyses, and “what if” scenarios, to expert consultation and testimony at hearing, as well as mediation and settlement support. We asked Julie to consider the state of retail litigation in light of the pandemic and to anticipate some of the long-term implications on case management and dispute resolution going forward. Here is a recap of our conversation.

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Question: The pandemic has had a significant disruptive effect on retail investors and the financial markets. Do you expect to see a surge of litigation as a consequence?

Given that the recent market decline was one of the steepest and fastest in history, we are expecting an increase in litigation, especially where investors have incurred realized losses. However, the extent of litigation could be dependent on the shape of the market recovery, and, given that the market has recovered fairly quickly, we would possibly expect to see fewer claims filed involving paper or unrealized losses. Our past experience with market volatility, as well as recent news and our discussions with clients, support this expectation.

When do you anticipate an uptick in litigation activity?

There is always a lag after a market decline before claims are filed, and services are requested at many points throughout the lifecycle of a case—that is, from pre-litigation to resolution. Our clients tell us that their pre-litigation teams are busy. We are also currently working our way through pre-pandemic claims involving strategies to enhance yield, private placements, allocation drift, alternative investments, and others.

What types of retail investor claims do you expect to be filed as result of the pandemic? 

We monitor economic trends, market events in sectors (such as oil and gas) and liquidity issues, generally. These are the kinds of indicators that provide insight for our clients and help us better understand the emerging landscape. Right now, we expect future claims related to margin and securities lending accounts, energy- and airline-related investments, and other sectors impacted by various stay-at-home orders and business closures. In addition, we expect to see claims filed with respect to volatility-linked investments, order execution, vulnerable investor issues, business interruption, employment, general suitability, and allocation issues relating to the overall market decline and volatility, just to name a few.

How will litigation practice change as a result of the pandemic?

Time will tell, but many practice details will be altered. For example, expect greater use of video conferencing in conjunction with the traditional in-person arbitrations. Our experiences under current, temporary conditions, such as managing through the delays and postponements of hearings, may offer some indications about future changes. Permanent norms have not yet been established, but in-person FINRA hearings are still being postponed through September. Where both parties agree, counsel will need to navigate whether to move forward with video hearings or continue to postpone.

Further, we’ve noticed that some of our clients are expecting that claimants might be more motivated to settle the cases that were originally scheduled for hearing during the 2020 summer, rather than having to wait for the matter to be heard at a future date. So, the new environment not only impacts procedures, but it also may have tactical and even strategic consequences as well.

In the Retail Litigation practice at Bates, we have been adapting during this period as we support our clients toward a new normal. For example, our team of experts and case managers is training to effectively use various video conferencing platforms; we have been communicating more with our clients to better understand their needs as they consider pandemic-related challenges and an increasing number of claims; and, as mentioned, we have been proactively exploring issues that are likely to result in litigation our clients will face.

Tell us more about how you are working with clients to prepare for potential litigation.

One way we are helping our clients prepare for the potential increase in litigation is through various CLE webinars, a number of which have been completed, and others which are in development. We are also publishing relevant alerts and communications. These communication efforts concern the latest thinking around financial market issues like the trading of complex products. Recent program headlines include: “Senior and Vulnerable Investor Protection;" "Potential Litigation Claims in the COVID-19 World;” “Regulatory and Litigation Issues in a Post COVID-19 World;” “Introduction to Arbitrator Evaluator & ABCs of Financial Schedules;” “Reg BI for Litigators;" and "Best Practices in Defending Margin-Related Cases." Upcoming webinars and recorded programs are listed online. 

The pandemic has increased uncertainty and some stress, but it has also accelerated change throughout the financial sector. What are the positive consequences coming out of this?

Yes, it has. This has been a very challenging time for many businesses and individuals, and Bates is no exception. As our clients have had to do, we have adapted, and I would say we have done so successfully. Bates shifted to a 100% remote workforce mid-March without missing a single client deliverable. Through the transition, and over the last few months, Bates staff have engaged technology to develop new norms for staying connected and managing work effectively.

What will you be grateful for when this pandemic is over?

The pandemic has offered a time to reflect both professionally and personally. I have reflected on the many things to be grateful for over the last few months. I am grateful to the first responders, for the ability to continue working while so many have lost their jobs, and for the ability to spend quality time with my immediate family. I look forward to seeing my friends and clients in person and to visiting my favorite establishments as they reopen. And, I am hopeful for an economic recovery that allows us all to thrive.

The current crisis presents many challenges. Bates practice leaders, consultants, and experts can help. Please contact:

Julie Johnstone, Managing Director, Retail Securities Litigation

Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations

A. Christine Davis, Managing Director, Forensic Accounting and Financial Crimes

Greg Faucher, Managing Consultant, Insurance and Actuarial Services

Robert Lavigne, Managing Director, Bates Compliance

Edward Longridge, Managing Director, Bates AML and Financial Crimes

 

You may also be interested in:

Bates Practice Leadership Insights: What Compliance Officers are Thinking About Now

Bates Practice Leadership Insights: What AML Officers are Thinking About Now

Bates Practice Leadership Insights: Regulatory Investigations Now and on the Horizon

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07-16-20

New OCIE, FinCEN Alerts Emphasize Vigilance Against Ransomware, Imposter Scams, Money Mule Schemes

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In the past week, the SEC Office of Compliance Inspections and Examinations (OCIE) and the Financial Crimes Enforcement Network (FinCEN) warned financial institutions to guard against specific and increasingly prevalent types of fraud against consumers. These activities have been uncovered through examinations, suspicious activity reports (SARs), law enforcement information and public reporting. OCIE and FinCEN’s alerts follow other federal and state reports (see Bates coverage here and here) urging firms to increase vigilance against similar crisis-related misconduct.

Specifically, OCIE staff cautioned SEC registrants, including broker-dealers, investment advisers and investment companies, as well as registrant service providers, of an increase in the number and nature of ransomware attacks. FinCEN cautioned institutions about a rise in money mule schemes and imposter frauds that attempt to con investors and other consumers into deceptive transactions. Here are the highlights:

OCIE Warns Firms to Monitor for Ransomware

OCIE staff describes “ransomware” as “a type of malware designed to provide an unauthorized actor access to institutions’ systems and to deny the institutions use of those systems until a ransom is paid.” The systems in question usually affect the “integrity and/or the confidentiality” of customer data.

OCIE is concerned about recent reports that the latest attacks directed at both SEC-registered institutions and their service providers are becoming increasingly sophisticated. The purpose of the alert was not to offer a one-size-fits-all approach to protect against ransomware (such a solution does not exist), but rather to highlight recent observations on the subject so that firms can strengthen their “cybersecurity preparedness and operational resiliency.” 

OCIE staff recommends that firms review and update incident response and resiliency policies, procedures and plans. Such a review should include  (i) contingency and recovery plans for various denial of service scenarios, (ii) procedures for notification of an event, incident escalation, and stakeholder communications; (iii)  processes for material event and suspicious activity reports (SARs); (iv) notification procedures for law enforcement and customers; (v) restoration of service processes; and (vi) backup applications to ensure the operation of critical services.

OCIE also wants firms to heighten their awareness of cyber-risk and boost their cybersecurity training and test responses through, for example, phishing email exercises. Further, OCIE wants firms to review and tighten their access management systems with the “least privileged access” in mind. This requires firms to configure controls “so users operate with only those privileges necessary to accomplish their tasks.” Finally, the staff recommends that firms review and strengthen their “perimeter security capabilities” including firewalls, detection systems, email security and web proxy systems in order to manage their network and “prevent unauthorized harmful traffic.”

The OCIE staff referenced other SEC cybersecurity guidance and offered additional links from the Cybersecurity and Infrastructure Security Agency (CISA) of the Department of Homeland Security (see here for an alert describing a particular ransomware threat) and the FBI (see here for a 2019 ransomware alert). Staff reminded firms that cybersecurity compliance was an examination priority.

FinCEN Warns Firms to Look for Imposter Fraud and Money Mule Schemes

FinCEN’s advisory focusing on money mule schemes and imposter scams is a kind of primer on reporting suspicious consumer fraud activity. In the advisory, FinCEN discussed the nature of these particular frauds, relevant indicators that should raise institutional red flags and additional information to be included for SARs reports.

Imposter Scams

FinCEN defines imposter scams as involving an actor “contacting a target under the false pretense of representing an official organization, and coercing or convincing the target to provide funds or valuable information, engage in behavior that causes the target’s computer to be infected with malware, or spread disinformation.”

COVID-19-related imposter scams include bad actors posing as IRS officials, the CDC, the World Health Organization, and non-profit health and academic institutions. FinCEN noted the many tools used by these actors to defraud the vulnerable, the elderly and the unemployed including the use of social media, telephone and robocalls, text messages, websites, and emails, as well as off-line activities such as “door-to-door collections” and flyers.

FinCEN emphasized that the objective of these scammers is primarily to target customers directly. As a result, FinCEN wants financial institutions to be aware of indicators on customer accounts that should trigger firms to be alert. COVID-19 red flags include bad actors offering to “verify, process or expedite” stimulus payments or other benefits under the Economic Impact Payments program, or prepaid debit cards under the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Other attacks seek to obtain confidential financial information for some health-related purpose like contact tracing. FinCEN warns that institutions should be on guard against phishing emails ostensibly coming from government or non-profits, but that use commercial domains (e.g., “dot-com”). Other red flags include solicitations which are publicly unverifiable and often contain errors like misspellings. FinCEN said that these indicators, in context, may be considered suspicious for reporting purposes.

Money Mule Schemes

FinCEN defines a “money mule” as any “person who transfers illegally acquired money on behalf of or at the direction of another.” FinCEN highlighted COVID-19 money mule schemes in three categories: good-Samaritan, romance, and work-from-home, the latter presenting as an offering for a work-from-home job which involves the target agreeing to “move funds through accounts or to set up a new account” on behalf of the “business.”

The agency describes distinctions among an “unwitting or unknowing money mule,” a “witting money mule” and a “complicit money mule,” all defined by the person’s awareness, motivation and level of participation in the larger scheme. FinCEN says that all three types of money mules are deployed in COVID-19 schemes.

Red flags pertaining to COVID-19 that should trigger firms to be alert for money mule schemes include, among others: (i) receipt of transactions that do not fit a customer’s profile (e.g., overseas transactions, purchase of convertible virtual currency); (ii) unsatisfactory answers to “know your customer” inquiries;  (iii) the opening of new bank accounts in the name of a business (possibly at multiple banks) and someone other than the customer transferring funds out of the accounts; (iv) receipt of multiple unemployment insurance payments within the same time period or from numerous employees (with ACH payment names that don’t match the account holder);  (v) deposits that get diverted quickly “via wire transfer to foreign accounts;” (vi) documents related to the “employer” showing the use of a free email server rather than a company-specific email; and (vii) out-of-the-ordinary requests from the customer’s new employer to send and receive funds through the customer’s personal account (especially for individuals claiming to be U.S. citizens or servicemen currently abroad.)

SARs Reporting

FinCEN also provided very specific instructions for filling out SARs reports on COVID-19-related scams. FinCEN advised financial institutions to use specific language and to reference (in specific fields) this imposter scam/money mule scheme advisory on SARs reports where the circumstances or subject matter matches. Proper reporting on this activity, FinCEN states, will improve “law enforcement’s abilities to identify actionable SARs…and pull information to support COVID-19-related investigations.”

Conclusion

These issues are not new, but they have been taking on additional urgency since the advent of the pandemic. “The two alerts reinforce the risk-based approach to firm compliance obligations and highlight the necessity to consider context and a customer’s historical financial activity, among other facts and circumstances, when making determinations on reporting potential suspicious activity,” said Edward Longridge, Managing Director and Head of Practice, Bates AML & Financial Crimes.

 
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06-26-20

Bates Practice Leadership Insights: Regulatory Investigations Now and on the Horizon

Bates continues our practice leadership conversations this week with Alex Russell, Managing Director of Bates’ White Collar, Regulatory and Internal Investigations Practice. Alex’s team supports corporations, financial services firms, law firms and regulators by bringing technical, big data analytics and managerial expertise to a variety of disputes and investigations. He also co-leads Bates’ big data analytics service and manages matters involving the assessment of economic damages. We asked Alex about regulatory investigations, big data and the issues firms and their legal counsel are currently concerned about. Here is a recap of our conversation.

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Question: How has the pandemic affected your clients right now?

Generally, I would say that firms are under considerable and increasing pressures created by market uncertainty. The added pressures come not only as a direct consequence of market declines and volatility, but also from the way that regulators, customers, employees and even litigants react to it—often exacerbating problems by layering on top their own concerns and urgencies. Add to that the very real challenges of working remotely (including issues as disparate as cybersecurity and childcare), and it is fair to say that our clients are operating in a very difficult environment. The top concern that I hear, from nearly everyone, is that there are just not enough hours in the day to get done what needs to get done.

Let’s talk first about regulatory investigations. Do you expect an uptick in investigative activity as a consequence of this market volatility?

Absolutely. But this should not be a surprise. The regulators have been very vocal, in public and private, that they are minding the store and fulfilling their oversight and investigative responsibilities. And they are intent on proving it. At Bates, we are already seeing an uptick in such regulator activity, but as with prior market dislocations, we should adjust our expectations and prepare for these current regulatory investigative priorities to play out over the next several years.

Can you be more specific? What sort of regulatory enforcement matters, for example, should we expect?

Some are very easy to see coming; anything involving leverage for example, whether in the form of margin, the use of options, or leveraged ETFs / structured products themselves. We’ve had ascending markets for so long that leverage has become a normal part of the market again, and may have even been extended into areas that the regulators will deem inappropriate. Fraud claims will also rise, from penny stock’s touting COVID-19 vaccines, to individuals running Ponzi like schemes that are exposed when new investments dry up. Uncertainty creates an opportunity for many different types of fraudsters to take advantage of that confusion to the detriment of investors. The increased pressure on reps to try and sustain the income level they need will tempt some to bend the rules in ways that are sure to prompt action. It seems unlikely that the regulators will stop pursuing the fee-based actions (12b-1, 529, revenue sharing) that they have been pursuing over the last few years, so I expect those to continue as well. We’ve handled well over 30 of those types of investigations and claims for our clients, and we have not seen any indication of those slowing down at all. The list goes on.

What is the outlook in the white collar space?

Market manipulation schemes, in particular penny stock pump-and-dump schemes will show up quite regularly, and have already started to do so. Similarly, insider trading allegations around the use of material non-public information will be a source of steady activity, in addition to many of the same actions (fraud, for instance) that will also be the target of regulatory scrutiny. We’ve been steadily working on insider trading, and market manipulation matters even more so, pre-COVID-19 and expect to handle quite a few more after this. Interestingly, many of our recent pump-and-dump matters have been in a criminal rather than civil context, I am curious to see if that trend reverses itself or if the pandemic will accelerate the trend of criminal indictments.

How will big data shape this conversation?

The analysis of big data will play a critical role in helping to resolve many of the issues being raised. Since these issues will cut across firms as a whole, the analysis would be infeasible without the use of big data. Many of the regulators are already reporting sharp increases in the alerts being generated by big data analysis for market surveillance. For instance, FINRA noted a 200% increase in alerts around best execution, wash sales, spoofing, and layering. Regulators are using the tools of big data analysis to “spot risk bubbling up,” and those same tools can help firms identify risk internally, conduct their own investigation and analysis, and resolve the underlying issues. Big data will be a critical part of identifying what will show up when Regulators examine firm behavior, and in responding to claims made by the regulators on the basis of big data analysis. Enforcement actions will likely intensify as a result of these developments.

In many cases, we have taken on large-scale investigations by serving as a critical external resource for big data and analytics assignments. This lets our clients’ internal personnel focus their resources on their essential, day-to-day tasks.  Since the onset of COVID-19, we have also been asked to provide insight into peer practices and to collate trend information gathered through interaction with the regulators. This has been positively received by our clients, who feel forearmed with useful information prior to interacting with regulatory staff.  Clients appreciate being able to speak with our staff knowing that they have dealt with the same or similar issues on behalf of other clients, and that we have the technical skills to perform efficient, accurate, and insightful quantitative analysis. That combination of skills and awareness of how the regulators are treating certain issues has allowed us to assist counsel in delivering positive outcomes for their clients.

What final thoughts are you offering to clients at this time?

First, work diligently to maintain your pre-pandemic compliance processes and procedures, and document your efforts. Second, keep up with regulators’ current expectations of firm practices. To the extent possible, talk to peers and counterparts in other firms to find out what they are seeing, what is working and what isn’t. Third, review the available data out there and do what you can to form an accurate picture of how the industry is responding to the challenges this crisis has created. Finally, use all available information to forecast developing trends so you can spot the opportunities and avoid the pitfalls.

 

The current crisis presents many challenges. Bates practice leaders, consultants, and experts can help. Please contact:

Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations

Edward Longridge, Managing Director, Bates AML and Financial Crimes 

Christine Davis, Managing DirectorForensic Accounting & Economic Damages

Dennis Greenberg, Managing Director, Third Party Risk Management Services

 
You may also be interested in:

Bates Practice Leadership Insights: What Compliance Officers are Thinking About Now

Bates Practice Leadership Insights: What AML Officers are Thinking About Now

 
Don't miss our Webinar July 9, 2020: Regulatory Exams and Investigations in the Age of COVID-19. Presented by Bates Group and Eversheds Sutherland.

Click Here to Register for this Zoom Webinar

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06-18-20

FINRA Special Alert Offers Observations on COVID-19 Remote Work and Supervisory Practices

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FINRA issued Special Alert Notice 20-16 to share COVID-19-related off-site transition and supervisory practice information. The information was derived from recent FINRA discussions with small, mid-sized and large firms. FINRA cautioned that they “have not yet evaluated these practices in our examination programs,” but, nonetheless suggested that firms consider whether they are “applicable” and whether they would enhance supervisory systems and compliance programs during this period.

Bates has been reporting on COVID-19-related guidance since the pandemic began and maintains a topic page on the subject with links to both federal regulatory sites (including FINRA’s resources page) and Bates news and information. Here we take a closer look at FINRA’s observations on firm efforts to transition to remote work environments and to supervise remote work activities.

Remote Work Environment Transition Practices

FINRA reports that firms took a wide range of steps to enhance their compliance efforts and their ability to serve customers from remote locations. FINRA categorizes these steps in four areas: customer assistance, off-site work protocols, staff communications and cybersecurity.

For customers, firms took immediate steps to provide contact and branch office closure information on their web sites and to route customer calls and requests for appointments through a centralized hub. For employees, firms added procedures to better monitor and to record the location of staff, and to continuously update contact information for “compliance, legal, operations and other departments.”

Some firms adjusted communications practices to minimize the risk that staff “would use personal or unapproved systems and technology to conduct firm business.” FINRA stated, for example, that firms were providing (i) “all-hands” videoconferences on operations; (ii) “clear guidance” on working remotely; (iii) technology hardware “to better equip staff to work from home” and (iv) virtual trainings on new and approved technology platforms and applications.

Further, firms reported that they increased their use of virtual trainings and other efforts with respect to cybersecurity and the confidentiality of firm and customer information. Firms disclosed that they were issuing frequent internal reminders on compliance with material non-public information requirements. In addition, firms communicated precautions around “maintaining a private workspace from home,” including extra care when working near family or friends. Firms also said they were enhancing the oversight of their “critical information” technology vendors.

Remote Work Supervisory Practices

FINRA relayed that while firms expressed confidence that they were “relatively prepared” to supervise associated persons working from home (i.e. through the use of “checklists, surveillance tools, incident trackers, email review and trade exception reports”), some firms described additional steps they took to ensure that their supervisory practices and procedures were followed. These additional steps cover (i) overall supervision, (ii) trading supervision, (iii) supervision over customer communications and (iv) branch inspections.

Firms reported many steps to strengthen general supervision of associated persons working in remote locations. In anticipation of the lock-down, for example, some firms described special efforts to test and perform a “gap analysis” to ensure adequate remote compliance with documentation requirements. Firms also set up processes to identify emerging issues or trends gleaned from “increased alerts, exception reports and customer complaints.” These processes supported additional firm guidance to supervisors acting on these concerns, including coaching and “over-escalating” identified issues.

Some firms strengthened their existing “electronic supervisory checklists with attestations and electronic affirmation via voting buttons.” As to other general supervision issues, firms said they improved their overall communications efforts by requiring frequent and regular senior leadership meetings, opening communications channels between supervisors and compliance staff and by establishing feedback mechanisms from staff to promote best remote office practices.

On trading supervision, firms added to their oversight by tightening controls and adding new special elements to supervisory checklists. Specifically, firms enhanced their oversight capabilities by requiring additional prescreens, additional supervisory approvals (with attestations), additional testing of traders’ remote technical capabilities, and by increasing the frequency and thresholds for certain trade reporting and alerts. Further, some firms reported additional monitoring of supervisory activities and increasing the frequency of “check-ins” with traders.

In addition to supervision of customer communications through existing methods, some firms added several more layers of oversight. These include increasing the frequency of email review, enhancing communication surveillance, expansion of using recorded lines for orders, and disabling certain features of communications platforms in order to ensure full and accurate recordkeeping.

Finally, FINRA asked firms about their branch office inspections. Some firms reported that they created a temporary remote branch office inspection plan which relies on technology and video and electronic document review. Firms made clear, however, that such inspection plans merely defer the required onsite inspections to a later time and that when pandemic restrictions are lifted they will prioritize high-risk, on-site branch inspections.

Conclusion

In this Notice, FINRA documented a broad range of methods firms have devised to transition to remote offices and to supervise associated persons. These steps are, of course, a proactive way for firms to fulfill their obligation to implement a reasonably designed supervisory system appropriate for the firm’s size and business model. FINRA recommends that firms contact their designated Risk Monitoring Analyst with questions about these or other methods undertaken during this time. FINRA is once again setting the expectation that firms need to fully consider their compliance practices carefully during this time. Bates will continue to monitor and summarize these regulatory compliance developments.

Bates Compliance practice leaders and consultants are available to answer your questions on compliance, risk, supervision and audit matters to help you through this period. Please reach out.

Contact:


Join us on July 15th, 2020 for a Bates Compliance Business Continuity Webinar. 

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06-11-20

NASAA Annual Report Flags Cyber Risk, Investment Adviser Exam Deficiencies and Best Practices

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The highlight of the North American Securities Administrators Association’s (“NASAA”) 2020 Investment Advisor Section Annual Report on state-registered investment advisers is the growing concern by state regulators over cybersecurity preparation and practice. Based on firm examinations in 41 U.S. jurisdictions during the first half of 2019, NASAA found that cybersecurity deficiencies are on the rise. The issue has taken on new urgency in the wake of the pandemic.

In the annual report, published during the height of the panedemic, NASAA publicized its members’ adoption of an information security and privacy model rule to address some of these concerns and provided a list of best practices to assist investment advisers in developing and implementing effective compliance procedures. In addition, NASAA offered some general statistics on the condition of the industry and noted committee and project successes over the past year.  Here’s a closer look.

Cybersecurity Remains Top Issue

The main concern in the report—the rise of cybersecurity-related deficiencies across state adviser firms—was based on information that is now nearly a year old. This is significant because the pandemic has only exacerbated many of the issues raised in guidance presented since then. (See, e.g. Bates coverage of SEC Office of Compliance Inspections and Examinations Report.) According to the NASAA report, the top five cybersecurity-related deficiencies among state registered investment advisers were: (i) a lack of cybersecurity vulnerability testing; (ii) a lack of procedures regarding securing or limiting access to devices; (iii) a lack of procedures related to internet connectivity; (iv) weak or infrequently changed passwords; and (v) inadequate cybersecurity insurance.

The data showed that these deficiencies were present in 26% of examinations, up from 23% in the last 2017 analysis. NASAA noted that the problem is acute for the state-registered investment adviser community, given that “three fourths of the nearly 18,000 state-registered investment advisers are 1- to 2-person shops.” Because these advisers have limited resources, they are considered to be particularly vulnerable to attacks.

Alex Glass, Indiana Securities Commissioner and Chair of NASAA’s Investment Adviser Section, suggested that NASAA’s new information security and privacy model rule should help. He stated that the new rule “represents a significant step toward enhancing the cybersecurity and privacy practices of state-registered investment advisers.” As Bates described previously, the new rule requires investment advisers to adopt policies and procedures related to the security of both physical and digital information, including that a firm (i) establish an “organizational understanding to manage information security risk to systems, assets, data and capabilities;” (ii) provide “safeguards to ensure delivery of critical infrastructure services;” (iii) be able to detect, (iv) be able to take action in case of, and (v) be able to restore any capabilities or services after, an “information security event.”

In the annual report, NASAA encouraged firms to review their Cybersecurity Checklist and related Guidance. These documents detail assessment areas that can help to detect cyber vulnerabilities, and to recover from cybersecurity breaches. The material was prepared by NASAA’s Cybersecurity and Technology Project Group, which noted in their status update that it was turning its attention to developing materials “on how firms can prepare and plan to meet demands in a shifting landscape of cybersecurity threats.”

The security and privacy model rule was also part of last year’s agenda of NASAA’s Regulatory Policy and Review Project Group. In their status update for NASAA’s annual report, the Group listed an ambitious agenda including a host of ongoing initiatives on new model rules. These include proposals on investment adviser policies and procedures, a code of ethics, proxy voting procedures, and investment adviser representative continuing education, Further, the Project Group said it was working with investor, advocacy and industry groups on investment adviser fee models, unpaid arbitration awards and drafting guidance on standing letters of authorization, among other topics.

Additional Compliance Guidance

In the annual report, NASAA offered a checklist of best practices to assist firms generally in the development of compliance practices and procedures. The items on the checklist respond to some of the deficiencies found in NASAA’s comprehensive state examinations. The checklist suggests that firms should review their: (i) Form ADVs, (ii) contracts, (iii) policies and procedures for the preparation and maintenance of financial records with electronic data backup; (iv) client profiles and client suitability documentation, (v) written compliance and supervisory procedures manual, including business continuity plans and information security policies/procedures; (vi) privacy policies and (vii) custody safeguards, especially for direct fee deductions.

Comparison of Deficiencies Found in State Examinations

NASAA’s Investment Adviser Operations Project Group compiled a comparison of the state-registered investment adviser firm examination deficiencies over the past biannual periods. The group found that books and records deficiencies (59%) presented the most compliance challenges. Registration deficiencies (49%), contract deficiencies (44%), cybersecurity concerns (26%), and fee-related matters (21%) followed. Overall, NASAA reported that the number of deficiencies in every category except cybersecurity decreased.

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Source: NASAA 2020 IA Section Report

In their status update, NASAA’s Operations Group announced the completion of examiner tools to “help examiners review Form ADV Part 1 and 2 for consistency and agreement with the advisory contract,” as well as a stand-alone Licensing Module “to help licensing personnel review and document issues with investment adviser registrations.”

Additional State Registered Investment Adviser Data

NASAA reminded readers that state regulators oversee all investment advisers with assets under management of $100 million or less. The report provides a host of additional and comparative data on state investment advisers. For example, eighty percent (80%) of state investment advisers are small businesses located in “most every town in every state across the country.” The vast majority of clients—eighty-two percent (82%) of nearly 750,000 clients—are retail investors. Sixteen percent (16%) are high-net-worth individuals. The top services provided by these state advisers to clients are portfolio management for individuals (83%) followed by financial planning services (64%). For a significant majority of clients, adviser fees are charged as a percentage of assets under management (84%). Fifty-three percent (53%) of clients are charged an hourly fee, and fifty percent (50%) are charged on a fixed-fee basis.

Conclusion

The current COVID-19 crisis has exacerbated many of the cybersecurity concerns raised in NASAA’s annual report. Between the SEC OCIE report and this NASAA report, firms should be focusing on how best to tailor their cybersecurity efforts to protect their customers and preparing for the next examination.

 

Bates practice leaders, consultants and experts can help clients’ compliance, risk, supervision, audit and business teams. Contact Bates today:

Robert Lavigne, Managing Director, Bates Compliancerlavigne@batesgroup.com

Rory O’Connor, Director, Bates Compliance (RIA compliance)roconnor@batesgroup.com

Dennis Greenberg, Managing Director, Third Party Risk Managementdgreenberg@batesgroup.com

 
Need cybersecurity support? Learn more about Bates Group’s Cybersecurity Compliance capabilities and Consultants.

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06-09-20

Bates Practice Leadership Insights: What AML Officers are Thinking About Now

Bates continues our practice leadership conversations this week with Edward Longridge, Managing Director of Bates Anti-Money Laundering and Financial Crimes Practice, for his views on the matters most pressing for AML officers right now. Here is a recap of our conversation.

Question: How has the financial anti-money laundering agenda and/or regulatory enforcement framework been affected by the pandemic?  

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Edward Longridge: For AML and fraud departments, two trends have presented themselves since the advent of COVID-19. First, there has been an increase in the number of Coronavirus-related scams, and, in particular, scams targeting the elderly. Fraudsters and money launderers are taking advantage of what they perceive to be opportunities for criminal activity in the current environment. These heightened activities are putting extra pressure on compliance teams to adapt and perform.

Second, the regulators have not taken their foot off the pedal. Expectations, during this time when systems are being stressed, have only increased. While it is true that FinCEN requested financial institutions to contact them if they are having difficulties in the timeliness of Suspicious Activity Report (“SAR”) filings, and though, in certain cases, regulatory exams may be delayed, AML departments must still meet—and indeed exceed—their obligations to fully comply with regulatory rules and expectations. In short, AML and Fraud departments need to be on an increased watch during the pandemic now, and for the foreseeable future.

Question: What should AML officers be focusing on in the next several months? 

There remains uncertainty over how long COVID-19 will last. Even after cities and states reopen, it is anticipated that there will be a large percentage of the population who will opt to work remotely. AML compliance systems will need to adapt to this change as a more permanent reality.

Further, the virus has changed people’s spending habits. This will, no doubt, continue. As a consequence, AML officers should review their transaction monitoring scenarios and rules to tune and adapt them to the changes in transactional behavioral patterns caused by the coronavirus.

Question: Is there a particular area that banks should be paying attention to that may not seem so obvious? 

Yes. Banks should be vigilant over increased fraud attempts and changes in the patterns of their customers’ transaction activity. One area for banks and broker-dealers to pay close attention to is AML volumes. With teams working remotely, firms may find it hard to keep up with the non-stop volume of transaction monitoring alerts which can lead to an increase in backlogs. Banks and broker-dealers should adjust their resources accordingly.

Question: What does post- recovery look like? 

Nobody can realistically foresee all the consequences of what is to follow in the next six months. That said, states will open in phases and will likely take a cautious, staggered approach to avoid a second wave of infections. How successful they will be is unknown.

Financial institutions will need to pay close attention to ensure their offices are compliant with all city, state and federal health guidelines. For example, they may have to reconfigure for social distancing in the office, possibly including redesigned desk space. Firms may also need to rotate their staff between remote and onsite so that not everyone is in the office on the same day. While it is anticipated that regulators will take an understanding approach with financial institutions, AML and financial crimes departments cannot afford to let up.

Question: What type of support are clients looking for now? 

In addition to our ongoing efforts helping clients establish and execute effective AML and financial crimes compliance programs, we are working with a number of parties on third-party risk management. This covers a wide range of topics, including vendor risk management, VPN matters, and cyber security/data security. Several firms have also turned to us recently to help them keep up with their transactional volumes.

Given the prevalence of new scams posed by bad actors, the added stresses placed on compliance programs and systems by remote working arrangements, and the unrelenting demands by regulators to fulfill their anti-money laundering and anti-fraud obligations, firms are under significant pressures. We continue to assist them in these efforts.


The current crisis presents many challenges. Bates practice leaders, consultants, and experts can help. Please contact:

Edward Longridge, Managing Director, Bates AML and Financial Crimes 

Christine Davis, Managing Director, Forensic Accounting & Economic Damages

Dennis Greenberg, Managing Director, Third Party Risk Management Services

 

For further reading, you may also be interested in:

Bates Practice Insights: What Compliance Officers are Thinking About Now

AML Compliance Report: FinCEN Says Hold the Line, FFIEC Updates Exam Manual

White Paper: The Challenges of AML Leadership

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06-05-20

New Capital Market Insights White Paper: Bear Markets, Black Swan Events and Volatility

New Capital Market Insights White Paper: Bear Markets, Black Swan Events and Volatility

The first part of this year has been challenging for the equity markets. With a global pandemic suddenly arising—the likes of which have not been seen in more than 100 years—U.S. economic activity largely halted, and unemployment skyrocketed, reaching in excess of 40 million initial unemployment claims in just 10 weeks. By some estimates, the gig economy, or “1099 workforce,” comprises an additional 20 million people.

Will the economy experience a V-shaped recovery and quickly bounce back or is the recovery likely to be a long, protracted U-shape? That remains a key question. One thing is clear though, life in the time of corona is currently very challenging for people, the economy, and the markets—and much is uncertain.

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The sudden appearance of a severe global pandemic is just the most recent example of a “black swan event” roiling the markets. By definition, black swans are rare and seldom seen, and as such are difficult, if not impossible, to predict. They can be triggered by either unexpected market, economic, or external factors such as geopolitical, war, or terrorist events.

In our new Capital Insights report we examine in detail bear markets, black swan events, and volatility to gain some perspective on how the recent—or current?—bear market compares with historical periods.

Download this white paper

 

Other Bates Research White Papers

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06-04-20

Oil-Related ETP Recommendations: FINRA Reminds Firms of Suitability and New Reg BI Obligations

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Concern about recommendations of complex financial products for retail investors has been at the center of the debate over changing standards for broker-dealers and investment advisers. With full implementation of the heightened Regulation Best Interest (Reg BI) requirements less than a month away, FINRA issued a Notice reminding firms of their sales obligations when offering recommendations on complex oil-related exchange-traded products (ETPs).

The FINRA Notice is straightforward. It describes dramatic volatility in the oil market, related ETP product complexity and risk, suitability obligations and soon-to-be-in-force Reg BI obligations on those firms and registered representatives that trade in these products. FINRA’s Notice, therefore, provides an important case study not only as to the specific expectations of firms that trade oil-related ETPs, but also on how the self-regulator appears to be handling concerns about recommendations to retail clients of complex products in a volatile market. Here’s a closer look.

Oil-Related ETPs

Oil-related ETPs are complex financial products. They are listed securities that “provide exposure” based on “the performance of an index, benchmark, or actively-managed strategy.” As such, they meet the description set forth in a previously issued FINRA Notice as having features that “make it difficult for a retail investor to understand the essential characteristics of the product and its risks.”

FINRA describes these risks in the context of a representative’s ability to explain them to retail investors. Specifically, FINRA cautioned that firms must understand how tracking futures contracts and indices actually works, how certain conditions currently existing in the market, for example, contango and backwardation, can affect performance, and how ETP securities perform relative to the price of the commodity in the cash market. Further, FINRA warned that firms must comprehend (i) differences among varying ETPs in order to advise clients on how they can be used within an investment strategy, (ii) differences and risks based on product structures—such as the difference between commodity pools which hold futures assets and exchange-traded notes which hold debt—and (iii) risks from different ETPs concerning “structural features,” such as those with provisions for accelerated terminations or suspensions of new issuance.

According to FINRA, current market conditions are highlighting these risks. A decline in oil demand (due in part to COVID-19), has led to a plunge in cash market values which has had a significant impact on the market for futures and ETP indices. (FINRA repeatedly warned that firms must understand and explain to retail investors the differences between the spot market and ETPs). Extreme volatility in several oil-linked ETPs has led to ETP terminations and suspensions and has exacerbated investor losses.

Compliance with Suitability and Reg BI

FINRA warned firms that oil-related ETP recommendations require representatives to fully comprehend the terms, features and risks of these complex products. FINRA also advised firms that sales obligations on these complex products require compliance with rules on suitability (Rule 2111), communications with the public (Rule 2210), and supervision (Rule 3110). After June 30, 2020, oil-related ETP recommendations will require compliance with Reg BI.

FINRA noted that both customer-specific suitability and reasonable-basis suitability were “particularly relevant” to oil-related ETPs. The former requires a reasonable basis to believe that a recommendation or strategy is suitable for a specific customer based on a “customer's investment experience, risk tolerance, liquidity needs, investment objectives, and financial situation and needs.” Reasonable-basis suitability requires that the firm “perform reasonable diligence to understand the nature and risks of the transaction or strategy, and then to determine whether there is a reasonable basis to believe that the recommendation is suitable for the investor.”

FINRA pointed out that in less than a month, recommendations of ETPs to retail clients “will be governed” by Reg BI, and firms must act in the client’s best interest at the time the recommendation is made, “without placing the financial or other interests of the firm ahead of the interests of the retail customer.” (See recent Bates article describing FINRA’s recent proposal to modify the suitability rule.)

Public Communications and Supervision

FINRA advised firms that public communications of oil-related ETPs should “balance” the benefits of these securities with “a clear description of the risks,” (including those related to contango an backwardation), and that firms “may not omit any material fact or qualification that would cause such a communication to be misleading.” Specifically, FINRA said that public communications must describe the “speculative nature of futures investments and must explain clearly that the ETP’s price will not track directly the spot price of oil.” Further, FINRA warned firms that risk disclosure in a prospectus “does not cure otherwise deficient disclosure in sales material, even if the sales material is accompanied or preceded by the prospectus.”

On compliance with supervisory obligations, FINRA reminded firms to establish and maintain a reasonably designed and tailored supervisory system that takes into account the complexity of any offering of oil-related ETPs in the context of the firm’s customer base. FINRA relayed that firms must conduct training for registered representatives about the terms, features and risks of these products as well as on the suitability of recommendations, given the “investor’s time horizon, impact of time and volatility on the ETP’s performance.”

Conclusion

FINRA issued this Notice because of volatility in the market for oil-related ETPs, the resulting ETP terminations and suspensions, and consequent investor losses. The self-regulator’s emphasis on sales practice reinforces the message that sales of these complex products meet the requirements of FINRA’s suitability, communications and supervision rules, and fall under the new Reg BI standard commencing at the end of the month. Bates will continue to keep your posted on developments.

 

For more information, please do not hesitate to reach out to Bates:

Julie Johnstone, Managing Director, Retail Securities Litigation 

Robert Lavigne, Managing Director, Bates Compliance

Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations

 

To Learn More About Reg BI, please visit our Reg BI Service page.

Contact us to speak with a suitability or Reg BI expert.

Join us on June 18, 2020 for Bates Group’s Reg BI for Litigators CLE program: Registration Link

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05-21-20

NASAA Seeks to Disrupt Fraud, Moves to Online Exams; FINRA Warns of Pandemic Scams

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State and federal regulators are pressing firms to increase vigilance against crisis-related misconduct and other vulnerabilities in order to protect investors. The North American Securities Administrators Association (NASAA) recently took several public steps in response to COVID‑19 challenges, including forming a COVID-19 Enforcement Task Force that will identify and stop the latest potential threats to investors, publishing an on-line jurisdictional resource to track state securities administrator responses to the pandemic (including links to regulatory relief or operational information by jurisdiction).

Meanwhile, FINRA shared some “insights” for investors against the latest fraudulent schemes by issuing a notice advising that firms take “appropriate measures” concerning heightened investor risk during the pandemic. In those alerts, FINRA details the most prevalent scams and recommended practices for both investors and firms to combat them. Here’s a closer look.

NASAA Coronavirus Task Force to Root Out Fraud

According to President and Chief of the New Jersey Bureau of Securities Christopher W. Gerold, the primary objective of NASAA’s new Task Force is to “proactively identify” and “disrupt, discourage and deter” investment fraud and unregistered regulated activities within member jurisdictions. NASAA structured the new Task Force on its successful “Operation Cryptosweep” model. (As Bates previously reported, those efforts led to the opening of more than 330 inquiries and investigations and brought more than 85 enforcement actions relating to ICOs and cryptocurrencies.) Preliminary steps include reviewing some 200,000 coronavirus-related internet domain names linked to the pandemic and identifying those that pose a threat to investors. NASAA states that the Task Force will use “online investigative techniques to identify websites and social media posts.” According to Joseph P. Borg, NASAA Enforcement Section Chair and Director of the Alabama Securities Commission, “fraudsters are ramping up as a result of this crisis … Our goal is to get and stay ahead of the curve.”

NASAA COVID-19 Scam Alert, State Resources and Examinations

Creation of the Task Force comes on the heels of NASAA publishing an investor scam alert, an online resource guide and a corresponding site update that provides useful state-by-state information detailing regulatory relief and current regulatory operations for state government offices. In a statement issued by NASAA, President Gerold said that across jurisdictions, examinations of firms are continuing but have “shifted from on-site to remote, or are being deferred when necessary,” and he also noted that “nearly all states are providing regulatory relief to licensees/registrants adversely impacted by COVID-19.”

FINRA Alerts Investors and Firms to Pandemic-Related Fraud

In twin publications—one for investors and one for firms—FINRA highlights the risks fraudsters present when seeking to prey on investor vulnerabilities exacerbated by COVID-19. In the publications, FINRA urges that stakeholders remain vigilant against attacks. FINRA’s communications warn against four specific scams: fraudulent account openings and money transfers, imposter scams, IT help desk scams, and email compromise schemes.

FINRA also warns that fraudsters can use stolen or synthetic customer identity information to gain access to an account, and once in control can transfer or divert funds from a customer’s account to the fraudster’s account or rapidly remove stolen funds from the brokerage account. For investors, FINRA recommends monitoring accounts for suspicious activity, which may occur in smaller, less detectable money transfers. For firms, FINRA advises managing the risk by strengthening (i) Customer Identification Programs, (ii) opening and ongoing account monitoring, (iii) account verification (and placing restrictions on fund transfers); (iv) clearing firm collaboration, and (v) suspicious activity report processes.

FINRA also cautions that fraudsters can claim to be brokers and can create a fake online presence. For investors, FINRA recommends independent verification of a firm’s contact information, keeping account information private, refusing callers who seek remote access to personal computer or devices, and use of BrokerCheck. For firms, FINRA advises specific staff training and practices as a 2019 FINRA Notice describes on imposter websites.

FINRA additionally warns that fraudsters may claim to represent a financial firm’s IT Help Desk in order to steal personal customer information. For investors, FINRA recommends verification before providing personal or password information, opening links, or downloading attachments (if by email). For firms, FINRA advises additional training, reporting of suspicious calls or activity, and to contact the official IT Help Desk to “confirm the veracity of the original communication.”

In the publications, FINRA further highlights scams involving those authorized to execute legitimate funds transfers. Schemes involve fraudsters posing as firm leaders requesting one or more fund transfers, for example, related to accounts payable invoices. For investors, FINRA recommends confirmation of any requested fund transfers via telephone and viewing any deviations from standard payment practices as red flags. For firms, FINRA advises alerting staff authorized to disburse funds to monitor for red flags and confirm requests via telephone before acting on them. FINRA also advises that firms consider including email “banners” for any communication coming from outside the firm.

Conclusion

NASAA and FINRA’s pandemic-related efforts make clear that the regulators are continually working to address significant issues and impacts of the pandemic to warn and protect both investors and the industry. Bates will continue to keep you apprised of future developments.


The current crisis presents many challenges. Bates practice leaders, consultants, and experts can help.

Please do not hesitate to reach out.

Julie Johnstone, Managing Director, Retail Securities Litigation 

Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations

Edward Longridge, Managing Director, Bates AML and Financial Crimes 

Robert Lavigne, Managing Director, Bates Compliance

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05-20-20

Bates Practice Leadership Insights: What Compliance Officers are Thinking About Now

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During this transition period between what was and what will be the “new normal,” we thought it timely to provide some current thinking from top Bates’ leaders on clients’ immediate and near-term compliance challenges. While no one knows with certainty what the future holds, these “leadership conversations” are intended to share some insight from experts on the front line. For our first conversation, we caught up with Robert Lavigne, Managing Director and Bates Compliance Practice Leader, and Hank Sanchez Esq., Bates Compliance Managing Director and former SEC and FINRA regulator, to get an understanding of what they are hearing from compliance officers right now, as well as advice for compliance teams in the "new normal." Here is a recap.

Question: What are the top concerns you are hearing right now?

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Bob Lavigne: “Our compliance practice is fielding a large number of implementation questions concerning Regulation Best Interest (Reg BI). We anticipate that most firms are making good-faith efforts to be in compliance by the rule deadline, so we are preparing for—and have been heavily involved in—what we refer to as ‘Day 2’ work. This includes, just to name a few items, tuning product score cards and product rationalizations, supervisory processes, branch office inspections, compliance testing and book and records reviews.”

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Hank Sanchez: “Reg BI remains the top concern. I would only add that we are addressing many questions related to Form CRS (that is, Reg BI Customer Relationship Form disclosures), including process questions concerning how and when to deliver these forms to clients, and ensuring that language in the separate disclosure documents concerning conflicts and fees is clear and adequate.”

Lavigne: “There are of course some firms, usually small- to medium-sized, that have not yet fully prepared for the implementation of the rule. We are currently working with some to help them catch up and be compliant on June 30th.”

Sanchez: “That’s right. Those that are just now trying to catch up can still evidence the necessary ‘reasonable’ attempts to comply, but they will certainly be scrambling to catch up after July. Those firms should understand that the delay may affect their ability to complete the rest of their compliance requirements in the second half of the year.”

Question: How has the Coronavirus affected client efforts to meet the compliance deadline for Reg BI or other compliance goals? 

Lavigne: “Many firms that have diligently prepared policies, procedures and operations to meet Reg BI and Form CRS deadlines are now confronting pandemic-related challenges around training. They are also concerned with their ability to supervise and execute new policies and procedures, in part because more of their employees are working remotely.”

We are also responding to pandemic-related questions on conducting branch inspections, which would typically be done on site.  FINRA requires on-site inspections, but ‘on-site’ is more complicated now. During the pandemic, on-site will likely be remote. Some firms have delayed their branch inspections during the pandemic. Compliance teams have been limited in their ability to review, and will also have to play catch up.” 

Sanchez: “Firms are facing additional technology challenges as a consequence of COVID-19. Some firms did not have the initial ability for compliance staff to access supervision systems immediately when the lockdowns occurred and had to use work-arounds when those problems popped up. Technological issues continue to crop up in many places, including, for example, in trade reporting and surveillance for firms with trade desks.”

Question: What does post-COVID-19 compliance look like?

Lavigne: “As firms make the slow transition out of lockdown mode, they will be forced to address the fact that some ways of doing business simply will not go back to the way they were. From a compliance standpoint, firms must think seriously about the adequacy of their remote working policies and if they are scalable in a new environment.”

Sanchez: “The pandemic is accelerating and intensifying previous trends, but the bottom line is that greater reliance on remote working arrangements can cause serious and even unexpected compliance and supervisory issues, depending on how much business is being done out of someone’s home or other remote location. So, as risk assessments and business continuity plans get updated and firms prepare for contingencies that may keep brokers and advisers out of the office for extended periods of time, firm leadership will have to face the realities of more comprehensive remote compliance. This will cost firms money and maybe require additional staff as well. In the longer term, new roles may need to be defined, new techniques developed, and compliance staff will have to become more proficient in them to fulfill regulatory requirements.”

Lavigne: “I should note that our practice group is also responding to a host of non-Reg BI pandemic-related challenges which we anticipate will last for quite a while. These concerns are quite diverse. We are working on everything from work-life business culture issues to proper use (to ensure forgiveness) and disclosure around PPP loans.”

Question: What are regulators looking for at this time?

Lavigne: “Regulators are looking to see that firms are making a good faith effort at implementing changes right now, as well as looking at how firms are adapting to the changing environment. It is important for firms to make sure that policies and procedures are still being followed and, perhaps as importantly, that compliance efforts are visible throughout the organization. This means reaching out to representatives and branches proactively and in real time.  Being able to evidence your change management and implementation will be key when speaking to a regulator about your Reg BI program.” 

Sanchez: “As a practical matter, if I were a compliance director right now, I’d be most concerned about what didn’t work in the business continuity plan and getting it fixed. Next, I’d be wondering how to do post-mortem testing to ensure things were done properly during the lockdown and to identify what needs to be corrected. For instance, were supervision and surveillance programs up to the task? Did they work? What needs to be corrected? Following that, there should be thorough updates to the firm’s risk assessment (as well as the business continuity plan) to cover any new or foreseeable events—meaning, at a minimum, any shutdown of a home office for any length of time longer than a day or two.”

Lavigne: “Regulators are going to ask you whether the business continuity plan worked or not.  Firms should take the time to review what did and did not work and make sure they address the areas of concern. The answers will matter. Now is the time to address it.

Sanchez: “Beyond these heightened and immediate regulatory concerns, it is abundantly clear that directors must remain on top of firm compliance with respect to anti-money laundering and cyber programs. But it also requires compliance officers to pay attention to those areas where regulators have specifically highlighted their priorities, including continuously addressing privacy-related policies and procedures and ensuring electronic delivery of required forms to customers.”

Question: What is your outlook on the market going forward?

Lavigne: “Keeping up with compliance responsibilities during ‘normal times’ is challenging. These are not normal times. During COVID-19, even the ordinary compliance tasks present unexpected challenges. But COVID-19 also presents an opportunity to take a hard look at the entirety of your compliance and supervisory operations. We suggest that firms take this advantage to reassess old programmatic approaches to compliance and consider supervision and risk mitigation through greater use of data and technology. That may yield cost savings and regulatory benefits long-term.  

Sanchez: “During this time, taking a moment to survey the overall compliance operation would be valuable. Firm leadership should acknowledge what worked well and who made it happen. That they got it right should absolutely be recognized. For those firms that struggled, this is also an important moment. Those firms should engage in an assessment of the role of compliance management within their business. Perhaps, firm leaders may consider providing a compliance greater say when budget conversations turn to systems and staffing upgrades.

Reach out to Robert Lavigne at rlavigne@batesgroup.com and Hank Sanchez at hsanchez@batesgroup.com. For more information, visit Bates Compliance online at www.batescompliance.com.

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05-14-20

AML Compliance Report: FinCEN Says Hold the Line, FFIEC Updates Exam Manual

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At a time when regulators are emphasizing their understanding of, and flexibility concerning, the difficulties facing financial firms as a result of COVID-19, the Financial Crimes Enforcement Network (FinCEN) and the umbrella Federal Financial Institutions Examination Council (FFIEC) are demanding robust compliance with Bank Secrecy Act/ Anti-Money laundering (BSA/AML) requirements. Since Bates’ last report in which FinCEN highlighted warnings about bad actors finding opportunities created by the volatility and fear in the markets, the Network issued additional compliance information to its previous alert, and FFIEC published a long-anticipated update to its BSA/AML Examination Manual. Here are some of the details.

FinCEN Says Hold the Line

Last month, FinCEN issued its second Notice within a month concerning compliance with BSA/AML obligations during the pandemic. While it “appreciate[s]” the challenges financial firms are confronting as a result of the coronavirus, FinCEN reminded the firms that such compliance is “crucial to protecting our national security” and that the agency “expects financial institutions to … diligently adhere to their BSA obligations.”

Beyond that overarching message, FinCEN urged that financial firms stay the course in developing their risk-based compliance programs. In addition, FinCEN provided specific direction for making it easier to support pandemic-related programs and offered other tweaks for easing some compliance challenges.

First, FinCEN advised that loans disbursed to existing customers under the Paycheck Protection Program (PPP) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) do not require re-verification under existing BSA requirements unless flagged by the institution under its risk-based approach. (Existing customers already undergo verification with BSA requirements.) In addition, FinCEN made note of previously limited relief from beneficial ownership requirements for non–PPP-related loans under certain circumstances. (See the Small Business Administration FAQs on beneficial ownership obligations under the CARES Act that FinCEN published on April 13, 2020.)

Second, FinCEN advised that it suspended implementation of a recent rule change scheduled to take effect on April 6, 2020, concerning the use of Currency Transaction Reports forms involving sole proprietorships and entities operating under a “doing business as” (DBA) name. FinCEN stated that financial firms reported difficulty in meeting the implementation timetable.

Third, FinCEN announced a new online contact mechanism for firms to convey COVID-19–related BSA compliance issues. FinCEN also reminded firms to contact “their functional regulator(s) or other BSA examining authority as soon as practicable” concerning BSA compliance concerns.

The Office of the Comptroller of the Currency (OCC) followed up the FinCEN Notice with a Bulletin of its own. OCC offered full support for FinCEN’s risk-based approach to BSA compliance, and actions described earlier, as a reasonable response to pandemic-related concerns. OCC stated that it will take into consideration “the actions taken by banks to protect and assist employees, customers, and others in response to the COVID-19 pandemic, including any reasonable delays in BSA report filings, beneficial ownership verification or re-verification requirements, and other risk management processes” when evaluating a firm’s compliance program. Presumably, that would apply to penalties for violations as well.

FFIEC Updates Examinations Manual

On April 15, 2020, FFIEC, the council of federal and state regulators that includes the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation, OCC, the National Credit Union Administration, the Consumer Financial Protection Bureau, and the State Liaison Committee, announced updates to its manual on BSA/AML compliance examinations. The publication is the instruction manual examiners use for overseeing compliance by financial institutions with regulatory requirements and supervision.

In its joint interagency statement, FFIEC explained that the latest revisions enhance the risk-focused approach to BSA/AML supervision. The regulators were keen on ensuring that evaluations of BSA/AML compliance programs are based on an institution’s risk profile for money laundering, terrorist financing, and other illicit financial activities. The revisions were also meant to clarify language that “distinguishes between mandatory regulatory requirements and supervisory expectations set forth in guidance.” That said, FFIEC stated that the revisions do not add new requirements. 

Specifically, the revisions concern (i) risk profile supervision, testing, and analysis; (ii) adequacy of a compliance program (with sections on internal controls, independent testing, and training, among others); and (iii) adequacy of the risk assessment process, including, bank-related risk categories and risk analysis. The new revisions emphasize the built-in flexibility over the design of BSA/AML compliance programs, risk assessments methods, and formats. In addition, the instructions relay to examiners that risk assessment updates do not have to be regular but rather should be aligned and reflect any changes to a bank’s risk profile.

Conclusion

Despite its second notice providing BSA/AML compliance guidance to financial firms during COVID-19, FinCEN is not offering much relief. If anything, the agency is doubling down on its direction to financial firms that they protect against the increased risks presented by bad actors during this time (i.e., the first Notice imploring that firms continue aggressively monitoring and filing SARs reports), and has offered various tweaks for speeding up the PPP application process or postponing implementation of beneficial owner rules (the second Notice). When placed in context, FinCEN appears to be demanding that financial institutions up their game at a time when those very institutions are dealing with staff and resource constraints including staff operating under quarantine conditions.

FFIEC’s Examination Manual remains the most definitive source for regulators to measure the adequacy of BMA/AML compliance. The revisions recommend a detailed review to ensure that a firm is implementing its risk-based approach in full. Put another way, significant penalties may hang in the balance.

In addressing these issues, Edward Longridge, Managing Director of Bates AML & Financial Crimes, points out that “[d]uring these challenging times with Coronavirus, the regulatory establishment is requiring increased efforts of BSA/AML managers over their programs, particularly related to COVID-19 scams and other types of fraudulent and money laundering activity. The expectation is for BSA/AML programs to step up to meet the challenge posed by bad actors.”

Bates will continue to monitor developments and keep you apprised.

 

For additional information, please follow the links below to Bates Group’s Practice Area pages:

Bates AML and Financial Crimes

Bates Compliance

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Consulting and Expert Testimony

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04-30-20

FINRA Carries On: Focuses on High-Risk Brokers, Broker Beneficiaries, Arb Postponement & Reg BI

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While the COVID-19 pandemic continues to create unusual and difficult challenges for the financial service industry, FINRA continues to move forward with regulatory matters that warrant attention. In this article, Bates reviews recent FINRA developments on high-risk brokers, proposed limitations on brokers acting as beneficiaries, executors or trustees for senior investors, additional COVID-19-related hearing postponements, a recent arbitration proposal related to claims against inactive members and further remarks on Regulation Best Interest (Reg BI).

FINRA Proposes to Hold Firms More Accountable for Bad Actors

On April 14, 2020, FINRA proposed a host of new rules that would strengthen oversight over member firms’ supervision of high-risk brokers. The proposed rules include (i) disciplinary changes that would allow a hearing officer to impose “conditions or restrictions” on firms and require heightened supervisory procedures during an appeal to the National Adjudicatory Council, (ii) changes that would require firms to adopt heightened supervisory procedures for statutorily disqualified brokers during an eligibility review; (iii) changes that would allow disclosure that a firm is subject to the "Taping Rule" through FINRA’s BrokerCheck system; and (iv) changes under membership application and registration rules that would require firms to engage in additional obligations before hiring any person who has final criminal matters or specified risk events during the previous five years to become an owner, control person, principal or registered person of the firm. 

FINRA Highlights Senior Investor Protection Proposal on Brokers Acting as Beneficiaries, Executors and Trustees

In one of her first statements since formally becoming Executive Vice President and Head of FINRA Enforcement on January 17, 2020, Jessica Hopper highlighted an increasingly frequent pattern of brokers who are appointed beneficiaries, executors or trustees on behalf of vulnerable senior clients. She pointed out the risks and potential conflicts of interest associated with these arrangements and noted that investigations into the details often present challenges, particularly in cases where the client has a mental impairment or has died.

Ms. Hopper’s statement is significant, in large measure because she calls attention to a recent FINRA rule proposal that would create a national standard to protect seniors by requiring member firms to review and approve—in writing—an associated registered person being named a beneficiary, executor, or trustee or to hold a power of attorney on behalf of a customer. As part of a firm’s review under the proposed rule, the member firm would be expected to reasonably assess the risks of the arrangement and would have to supervise compliance with any conditions placed upon the approval. (Note: the proposed rule would not apply where the customer is a member of the registered person’s “immediate family,”  which is defined to include “parents, grandparents, mother-in-law or father-in-law, spouse or domestic partner, brother or sister, brother-in-law or sister-in-law, son-in law or daughter-in-law, children, grandchildren, cousin, aunt or uncle, or niece or nephew, and any other person whom the registered person financially supports, directly or indirectly, to a material extent. The term includes step and adoptive relationships.”)  

Not all respondents agree with FINRA’s proposed approach. The North American Securities Administrators Association (NASAA) commented with a recommendation for a stricter standard that would (i) prohibit outright any registered persons from “being named as a beneficiary or appointed to a position of trust by a customer, unless the customer is an immediate family member” (and even then, only under certain conditions), and (ii) implement heightened supervision of all such accounts.

Ms. Hopper emphasized that FINRA will act aggressively to sanction brokers that procure such an appointment through unethical means. While the comment period ended on January 10, 2020, the rule has yet to be adopted, and there is no indication when this will occur. However, a few days after her statement appeared on the agency blog, a FINRA podcast celebrating the five-year anniversary of its Securities Helpline for Seniors covered notable “trends and themes,” including the proposed new rule. It is clearly top of mind.

FINRA Extends Postponement of Arbitration and Mediation Proceedings

On March 17, 2020, Bates reported that FINRA administratively postponed all in-person arbitration and mediation proceedings scheduled through May 1, 2020. On April 20, 2020, FINRA extended that postponement through July 3, 2020. FINRA reminded all parties that “case deadlines will continue to apply and must be timely met unless the parties jointly agree otherwise.” In addition, FINRA announced that it is waiving postponement fees if the parties stipulate to “adjourn in-person hearing dates” between July 6 and September 4, 2020. Written notices are required. Those interested in virtual hearing services were encouraged to contact FINRA case administrators.

FINRA Expands Procedural Options for Claims against Inactive Members

On April 9, 2020, FINRA amended its arbitration rules to “expand the options available to customers” when a firm or associated person becomes inactive during a pending arbitration, or before a claim is filed. Under the new procedures, which go into effect on June 29, 2020, if a member firm or an associated person becomes inactive during a pending arbitration, FINRA will notify the customer claimant of the status change. Within 60 days of receiving notice that a member firm’s or an associated person’s status has been changed to inactive, a customer may withdraw the claim, add a claim or new party or postpone a scheduled hearing. The customer still retains the option to request a default proceeding against an inactive member or associated person.

FINRA Endorses OCIE’s Reg BI and Form CRS Approach

On April 8, 2020, FINRA issued a statement backing up the approach the SEC Office of Compliance Inspections and Examinations (OCIE) will take following the compliance date of June 30, 2020. (See Bates coverage on the OCIE alert here.) FINRA said that, like the SEC, it too will focus on whether firms have made a good-faith and reasonable effort at compliance with Reg BI and Form CRS. As a reminder, FINRA is also seeking to modify its suitability rule to better conform to the new Reg. BI standards. The proposed amendments clarify that pre-existing FINRA rules would not apply to broker-dealer recommendations for retail customers under Reg BI. (See additional Bates coverage.)

Like the assurances given by the OCIE, FINRA emphasized that it would work “with firms and the SEC on issues that may arise in the course of examinations for compliance.”

Conclusion

During this transition period between what was and what will be the “new normal,” FINRA continues on course. The proposal to protect senior investors in cases involving appointed beneficiaries, executors and trustees should be carefully watched, as it is unlikely that so much concentrated attention is coincidental. Similarly, the proposal to impose and strengthen accountability for firm supervision of bad actors communicates that this subject remains a top compliance priority. FINRA’s messaging on Reg BI is part of a continuing effort to harmonize its position with the SEC. FINRA’s long-anticipated amendments to the arbitration rules are necessary to shut down loopholes in this increasingly important aspect of the FINRA agenda. Bates will continue to monitor further developments.


For FINRA arbitration and litigation matters, please note the following services:

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If you are a Bates client and your case is postponed, please be in touch to discuss interim case support needs. Contact Julie Johnstone, Managing Director, Retail Litigation at jjohnstone@batesgroup.com.

 

For Reg BI and Form CRS support, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com or Rory O’Connor, Director at roconnor@batesgroup.com to discuss your current needs one-on-one. (Note: Bates has developed a Training and CLE page for on-demand Reg BI webinars and Reg BI training for your company. Join our Form CRS Countdown Webinar today, 4/30 at 12 pm ET/9 am PT.)

 

Finally, please visit our Bates COVID-19 Practice News & Information page for recent news and regulatory announcements.

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04-21-20

Coronavirus and the Approaching Business Interruption Insurance Storm

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Image: Adobe Stock
 

These are uncertain times for insurers. In a report issued on March 31, 2020, Congressional Research Service (“CRS”) staff noted the likelihood that loss of income from mandatory or voluntary closures, supply chain disruptions, and reduced demand due to social distancing measures may induce businesses of all sizes to seek compensation from insurers.” That was clearly an understatement. Early estimates from the American Property Casualty Insurance Association (“APCIA”) are that some 30 million small businesses claims may be filed. This would be more than ten times greater than the highest number of claims “ever handled by the industry in one year.” In statement released by the APCIA, David A. Sampson, President and CEO of APCIA, offered preliminary estimates of closure losses for small businesses, which have increased to $255 billion to $431 billion per month. “Continuity losses for small businesses are approximately 43 to 72 times the monthly commercial property insurance premiums,” Mr. Sampson said.

Insurance market participants are sounding alarms about a wave of state and federal legislation that would shift onto insurers a significant portion of the burden to compensate businesses from the massive losses resulting from pandemic-related shutdowns. Bates takes a look at these legislative moves, early legal action taken by policyholders seeking coverage for business interruption losses as a consequence of the coronavirus (COVID-19), and the reaction by the insurance industry.  

Types of Business Interruption Insurance Coverage

The CRS report describes various kinds of insurance that cover specific losses due to certain business interruptions. The issues facing insurers are (1) whether the terms of these policies can be potentially stretched to include losses of the kind that may result from government-mandated (“Civil Authority”) pandemic closures, and (2) what might happen if federal or state authorities retroactively require coverage under these policies for COVID-19 claims.  

Commercial property insurance has been a target for legislators mainly because most businesses carry it in some form. Generally, these policies require that the insured suffer a loss of income due to direct physical loss or damage to covered property. Assessments of these losses are fact-specific and subject to significant challenge in court. Christine Davis, Bates Managing Director of Forensic Accounting and a commercial damages testifying expert, explains that “to measure business interruption loss requires taking a number of meticulous steps, including understanding the experience of business before the incident, analyzing the business’s financial records and historical performance, estimating the profits lost during the indemnity period, and gathering the proper documentation that supports the loss calculation.”

That said, many of these policies explicitly exclude losses due to viruses and bacteria - modifications to policies made as a result of unexpected losses suffered during the SARs epidemic. According to the CRS, insurance policies of special relevance include: (1) business interruption insurance (which covers business losses directly or indirectly caused by a covered peril or, in some cases, caused by all risks); (2) business income insurance (which covers sustained loss of income due to a suspension of business operations arising out of a covered risk); (3) contingent business interruption insurance (which covers business losses based on destruction of property owned by others); and (4) civil authority coverage (which covers business interruption losses when a civil authority restricts access to a business premises.)

State governments are aware of the limitations included in many of these policies and are responding to constituent concerns with basic FAQs and other general guidance (see, e.g. this dedicated web page by the New York Department of Financial Services (“NYDFS”); and, more broadly, this database resource provided by NAIC offering State Bulletins and Alerts Regarding Coronavirus). The scope of the problem, however, is so great that these early steps may be seen, in hindsight, as mere placeholders before the real battle over coverage began. 

Federal and State Legislators Seek Coverage for COVID-19 

The real battle includes legislative efforts to compel the industry to cover COVID-19 claims. The first attempt was outlined in a March 18, 2020 letter by a bipartisan group of U.S. House members to four leading insurance trade associations and their response to it. In the letter, the representatives urged the associations “to work with your member companies and brokers to recognize financial loss due to COVID-19 as part of policyholders’ business interruption coverage.”  Similar letters have since been sent  to insurers from state representatives.  

The implicit threat behind these inquiries is that either the federal government or the states will force insurers to cover COVID-19 related claims. The intention is clear and the concerns are real, warned Sheila Murphy, an insurance consultant and expert with Bates Group: “the government is seeking to expand or shift this risk, but insurers have not priced it into their premiums.” In various forms, state legislative bills have now been introduced in New JerseyOhio, MassachusettsNew YorkLouisiana, Pennsylvania, and South Carolina. Though there are differences among the bills, in general they require insurers to retroactively include the coronavirus as a “covered peril” under business interruption policies. In the interim, various state agencies have adopted emergency regulations requiring that property and casualty insurers provide relief to consumers and small businesses with extensions for the payment of premiums and fees under these policies, (see, e.g. NYDFS Emergency Action). 

The U.S. House Financial Services Committee, meanwhile, is considering a draft Pandemic Risk Insurance Act (“PRIA”) patterned after the Terrorism Risk Insurance Act (TRIA). According to Maxine Waters, U.S. House Financial Services Committee Chair, PRIA would “create a reinsurance program similar to [TRIA] for pandemics, by capping the total insurance losses that insurance companies would face.” Recent reports suggest that  PRIA “would be triggered when industry losses exceed the $250 million threshold and aggregate losses would be capped at $500 billion in a calendar year for both insurers and the government.” Further, the bill reportedly states that participating insurers will be charged an annual premium for reinsurance coverage, “based on the actuarial cost of providing such reinsurance coverage, including costs of administering the program.” Insurers, in turn, would agree to provide coverage for insured losses that does not “differ materially from the terms, amounts and other coverage limitations applicable to losses arising from events other than public health emergencies.”  

Other legislative proposals include establishing a compensation fund – currently referred to as the “Federal Business Interruption and Workers' Protection Recovery Fund." Lilian A. Morvay, Bates Insurance expert and consultant , describes such a solution as similar to the 9-11 Victims Compensation Fund or the National Flood Insurance Program. Shestates: “clearly, the pandemic and the losses it is leaving in its wake are unprecedented. In the interest of supporting businesses without bankrupting the insurance industry, this solution would backstop insurers that provide monetary relief to businesses that suffered economic losses.” Under the proposal, insiders say, businesses would “submit claims to their insurers as if business interruption resulting from coronavirus were covered. Insurers would then adjust those claims as normal and determine the appropriate claims payment, which would be funded by the government.”   

Industry Response 

The industry response to the bipartisan letter and state and federal actions has been forceful. Collectively, the insurers are leaving no doubt that they will fight attempts by state and federal legislators (and in court) to force payment for income losses from COVID-19 that their policies were never designed to cover. 

In their letter in responding to House members, the associations asserted that “the proposed retroactive application legislation would fundamentally change the agreed-upon transfer of prospective risk-of-loss exposure to coverage for a known and presently occurring loss, something the parties did not agree to, the insurer did not rate for, and the policyholder did not pay for.”  Following up, the association leadership said that while insurers stand ready to help, “if policymakers force insurers to pay for losses that are not covered under existing insurance policies, the stability of the sector could be impacted.” Siding with the trade associations, the National Association of Insurance Commissioners (“NAIC”) issued their own statement asserting: “while the U.S. insurance sector remains strong, if insurance companies are required to cover such claims, such an action would create substantial solvency risks for the sector, significantly undermine the ability of insurers to pay other types of claims, and potentially exacerbate the negative financial and economic impacts the country is currently experiencing.”  

Conclusion 

In the days to come, there will be a fair amount of reporting on state lawsuits filed by policyholders attempting to challenge existing terms of business interruption policies (see, e.g. herehere and here). For now, these coverage claims may be raised against insurers, agents, and brokers, and are handled on a normal case-by-case basis.

Insurers must brace themselves for these cases. That said, the real concern for insurance industry leadership is the momentum building for state and federal intervention in the sector to address this extraordinary challenge. Only some agreement on a collaborative framework between the industry and the government to respond to the national need could possibly result in a way forward. Absent that, the legal battle will be epic. Bates will keep you apprised.  

 

To learn more about Bates Group’s Insurance & Actuarial Services, including expert consultation and testimony, regulatory and analytics support, annuities, business interruption, D&O insurance, property & casualty, and life insurance, please contact:

Greg Faucher, Managing Consultant, Insurance and Actuarial Practice Leader - gafucher@batesgroup.com

Andrew Daniel, Director, Securities Litigation Expert and Consultant - adaniel@batesgroup.com

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04-03-20

Reg BI: SEC Keeps June 30th Deadline, FINRA Seeks to Amend Suitability Rule

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image: Kristina - stock.adobe.com

Over the past few weeks the coronavirus pandemic has overtaken the nation’s financial agenda and diverted the attention of financial regulators who are struggling to keep up and address urgent market needs. With recent actions to provide temporary delays from certain compliance deadlines and other relief, regulators have worked hard to accommodate the practical difficulties of operating under business contingency plans. These actions have left some firms curious as to whether the rollout of Regulation Best Interest (“Reg BI”) may be affected. Well, the wait is over, and SEC Chair Clayton has finally weighed in. Meanwhile, FINRA has pushed forward amendments to its rules on suitability and non-cash compensation “to provide clarity on which standard applies and to address inconsistencies with Reg BI.” And the SEC has filed a brief in the Second Circuit Court of Appeals arguing for rejection of state petitions for review of the Reg BI final rule. Here’s what you need to know.

The Reg BI Compliance Deadline Will Not Be Delayed 

After reported consideration of requests by broker-dealer advocacy groups like the Financial Services Institute (FSI), SEC Chair Jay Clayton issued a statement saying that the June 30, 2020 compliance date will not be moved. He explained that the agency has been engaged extensively with market participants as well as with FINRA on the implementation of Reg BI and Form CRS, and that “firms with account relationships comprising a substantial majority of retail investor assets have made considerable progress in (1) adjusting their business practices, (2) supplementing and modifying their policies and procedures, and (3) otherwise aligning their operations and preparing for the requirements of Reg BI and the obligation to file and begin delivering Form CRS.” 

That said, Chair Clayton did note that if a firm “is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19” the firm should “engage with us.” He stated that “the Commission and the staff will take the firm-specific effects of such unforeseen circumstances (and related operational constraints and resource needs) into account in our examination and enforcement efforts.” 

Chair Clayton relayed that, following the compliance date, “SEC examiners will be focusing on whether firms have made a good faith effort to implement policies and procedures necessary to comply with Reg BI, while also providing an opportunity to work with firms on compliance and other questions.”  

He also mentioned that the SEC Office of Compliance Inspections and Examinations “will be issuing two Risk Alerts providing broker-dealers with specific information about the scope and content for (i) initial examinations of Reg BI and (ii) Form CRS.” In a nutshell, Chair Clayton was clear: game on.

FINRA Proposes Modifications to Suitability Rules

In its March 12, 2020 rule proposal, FINRA seeks to clarify its existing suitability and non-cash compensation rules in the context of Reg BI. The amendments apply to FINRA Rule 2111 (Suitability), Rule 2310 (Direct Participation Programs), Rule 2320 (Variable Contracts of an Insurance Company), Rule 2341 (Investment Company Securities), Rule 5110 (Corporate Financing Rule - Underwriting Terms and Arrangements), and Capital Acquisition Broker Rule 211 (Suitability).

First, the proposed amendments clarify that these pre-existing FINRA rules would not apply to broker-dealer recommendations for retail customers under Reg BI. Though it may be clear, as FINRA explained, that any broker-dealer in compliance with Reg BI would meet the suitability standard under Rule 2111, FINRA opted to propose to formally limit the application of Rule 2111 to “reduce the potential for confusion.” In so doing, the amendments make explicit that the higher Reg BI standards apply to broker-dealer recommendations for retail customers.

FINRA explained that it is not eliminating the suitability rule altogether. Rather, it is drawing a distinction between Reg BI’s applicability to “retail customers” and the suitability rule’s continuing applicability to “entities and institutions (e.g. pension funds), and natural persons who will not use recommendations primarily for personal, family, or household purposes (e.g. small business owners and charitable trusts.”)

Second, the self-regulatory organization is removing the "element of control from the quantitative suitability obligation," thus removing the requirement that a broker-dealer must exercise control over an account. This is one of the three prongs of the suitability rule (along with “reasonable basis suitability” and “customer-specific suitability”). This change is consistent with considerations contained in Reg BI, which replaces the suitability rule with four “enhanced” obligations: disclosure, care, conflict of interest and compliance.

Third, FINRA is proposing to apply Reg BI’s conflict of interest limitations on sales contests, sales quotas, bonuses and non-cash compensation to its existing rules governing non-cash compensation. The proposed amendments state that going forward, FINRA rule provisions will not permit non-cash compensations arrangements that conflict with Reg BI.

Comments on the FINRA proposal must be submitted by April 15, 2020. Notably, the effective date will be the compliance date of Reg BI.

SEC Defends Reg BI in Court

Back on September 9, 2019, attorneys general of seven states and the District of Columbia sued the SEC, challenging the issuance of Reg BI on numerous grounds. As Bates described previously, the petitioners asserted, in part, that Reg BI is invalid because the SEC exceeded its statutory authority and acted in an arbitrary and capricious manner by issuing the rule. (These are similar arguments as those that were raised in 2018 successfully challenging the Department of Labor’s Fiduciary Duty Rule.) The petitioners asked the Court to vacate and set aside the rule, and to permanently prevent the SEC from “implementing, applying, or taking any action” under it.

On March 3, 2020, the SEC filed a brief responding to these arguments and defending the agency’s issuance of Reg BI. The SEC asserted that the AG’s argument that the agency exceeded its authority in issuing Reg BI “disregards the text of Dodd Frank, which gave the Commission express, but discretionary, power to adopt a rule imposing a standard of care for broker-dealers.” The SEC also defended the process against arbitrary and capricious claims arguing that the “Commission assessed multiple viewpoints and promulgated a standard of conduct tailored to broker-dealers that will enhance protections for investors against potential harms caused by conflicts of interest while preserving investors’ ability to choose the type of relationship and fee arrangement that best suits them.” (Brief at pp.16-17).

The SEC also defended against a claim that retail consumers will be more “confused” by the different standards for broker dealers and investment advisers created by Reg BI. The SEC said that such a claim is unsupported by any evidence.

Finally, the SEC argued that the state AGs are making “only policy arguments” about what they want to see (a uniform fiduciary duty rule for both investment advisers and brokers) rather than what Congress directed the SEC to do (“evaluate multiple alternatives”). The SEC argued that it did exactly what Congress intended when it gave “the Commission broad authority to balance investor protection with access to services.”

Conclusion

Following SEC Chair Clayton’s statement, firms must now set aside any hope for a Reg BI reprieve through a temporary order of relief. FINRA’s proposed amendments leave little doubt that Reg BI will likely be the controlling standard on recommendations to retail customers. That said, as Bates noted previously, getting past the compliance deadline—and a possible Second Circuit decision—does not end the conversation. There is still the conflicting fiduciary regulation promulgated by states like Massachusetts to contend with. But, the momentum toward an end game continues and firms must continue to stay the Reg BI course.


Bates Group’s Compliance team helps firms implement Reg BI and navigate compliance concerning investor and consumer protection standards. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com.

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03-26-20

Enforcement Warnings in the Age of the Coronavirus

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As regulators struggle to adjust to the stress that the coronavirus pandemic is placing on the markets, fraudsters are viewing it as an opportunity. That is one clear and consistent warning emanating from federal enforcement agencies over the past month. Last week, Bates described early compliance guidance, regulatory assistance and relief offered by various financial agencies to address some of the difficulties that firms are having, like, for example, fulfilling their reporting and recordkeeping obligations under newly activated business contingency plans. This week we take a look at the latest enforcement warnings and guidance from financial regulators, who are sounding alarms over the added threats that exist in the current volatile environment.

FinCEN Says File your SARs!

On March 16, 2020, the Financial Crimes Enforcement Network (FinCEN) warned financial firms to be alert to malicious or fraudulent transactions. FinCEN requested that institutions affected by the pandemic notify them “as soon as practicable” about any potential delay in filing suspicious activity reports (SARs) as required under the Bank Secrecy Act (BSA). Increasingly, regulatory enforcement strategies rely on these filings (see e.g., Bates’ recent article on senior financial exploitation), and FinCEN is emphasizing the importance of continued compliance and the filing of these reports.

Look Out for Scams

Since the outbreak of the pandemic, FinCEN has noted emerging trends related to imposter scams (impersonations of government officials to steal personal financial information), investment scams (promotions of companies claiming the ability to detect, prevent or cure the virus), and product scams (fraudulent marketing that make false health claims concerning unapproved products). These have yet to result in enforcement actions, but that may only be a matter of time. In any case, tracking these trends requires regulatory reliance on SARs reports which makes continued filings imperative.   

Likening the coronavirus to a natural disaster, FinCEN recommends financial institutions review its 2017 Advisory, which describes other types of potential fraud that FinCEN has reason to believe will possibly occur in the days ahead (i.e. benefits and charities fraud and cyber-related fraud).  FinCEN also notes that it received reports of potential insider trading – a subject highlighted by the widely reported news that two U.S. Senators sold millions of dollars of stock holdings shortly after private government briefings and just prior to the recent market downturn.

SEC on Heightened Alert for Insider Trading

The subject of trading on inside information has been top of mind for the Co-Directors of the SEC’s Division of Enforcement. In a statement issued on March 23, 2020, Stephanie Avakian and Steven Peikin reminded market participants of the importance of following corporate controls to ensure market integrity. Specifically, they noted the significant COVID-19 relief the Commission provided to firms, which allowed for certain delayed submission of earnings reports and certain required SEC disclosure filings. (For more on this SEC March 4, 2020 compliance relief, see here). The Co-Directors warned that this scenario can lead to more people having access to “material nonpublic information” and emphasized the importance of complying with “obligations to keep this information confidential.” This includes maintaining “disclosure controls and procedures, insider trading prohibitions, codes of ethics, and Regulation FD [Fair Disclosure] and selective disclosure prohibitions,” which protect against the “improper dissemination and use of material nonpublic information.” The Co-Directors made clear that these warnings applied to all registrants including broker-dealers and investment advisers. The expressed concern about more insiders holding material non-public information for longer periods of time should be a warning to firms that the SEC will be looking even closer at the effectiveness of existing controls. 

Other Federal Agency Messages

Consistent with the Co-Directors’ statement and FinCEN’s release, other SEC Offices have communicated additional messages that impact enforcement and institutional concerns. For example, the Office of Compliance Inspections and Examinations (OCIE) announced that a firm’s “reliance on [the SEC’s COVID-19] regulatory relief will not be a risk factor utilized in determining whether OCIE commences an examination.” This assurance shows that OCIE will not use these temporary measures to add to a firm’s compliance stress.

As early as February 4, 2020, the SEC Office of Investor Education and Advocacy (OIEA) warned investors about fraud involving claims that a company’s products or services will be used to help stop the coronavirus outbreak. The OIEA also raised issues around “so-called research reports” that make predictions that contain a specific stock target price and “pump and dump” schemes that involve microcap stocks. While these are familiar scams that firms were already alerted to in the OIEA’s Examination Priorities Report (see previous coverage), firms should take note of the enhanced attention the SEC is paying to them given the extreme circumstances afforded fraudsters in the current environment.

Similarly, in an advisory issued on March 18, 2020, the CFTC Office of Customer Education and Outreach (OCEO) warned against fraudsters seeking to profit from coronavirus-related market volatility. The Office urged investors to protect themselves “by learning to recognize common mental biases” and common fraud tactics including (i) promises of oversized returns, (ii) pressure to act “before market conditions change,” (iii) phony credentials, (iv) bogus testimonials, and (v) scams that involve some free gift in exchange for private information.

Conclusion

Financial regulators do not yet know what the new normal will look like.  They warn that bad actors are probing new opportunities created by the volatility and the fear in the markets brought on by the COVID-19. Enforcement officials are also trying to adapt to the temporary loosening of certain compliance reporting and disclosure obligations provided to help market participants cope with their contingent capabilities. As the SEC Co-Directors make clear, relaxing compliance for some of these requirements may create new opportunities for mischief and fraud – particularly as they relate to potential for dissemination of material non-public information. On both counts, regulator guidance emphasizes vigilance and communication. But the landscape is changing quickly. Bates will keep you apprised.

 

For additional information, please follow the links below to Bates Group's Practice Area pages:

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03-19-20

Financial Regulatory Guidance, Assistance and Relief Roundup

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The volume and urgency of general coronavirus news can seem overwhelming. For financial professionals, separating the facts from the hype is important. Since our last post, financial regulators have pushed out reminders about ongoing compliance obligations, deadline extensions, various general investor “tips” and notifications as to how, for example, the agencies are coping with their own organizational issues. (Note: they remain “fully operational and committed” to their respective missions.)

The challenge for financial firms and investors is to keep on top of the latest communications, understand what is actionable and what is not, and ensure that compliance and supervision processes are in place to manage the crisis. Bates continues to monitor it all. Here’s a recap of the latest compliance guidance, regulatory assistance and relief offered by the SEC, FINRA, NFA and MSRB. (Next, we will look at the latest enforcement warnings and guidance from other financial regulators.)

SEC Gets Practical

 
SEC Offers Compliance and Disclosure Reminders

In late January, SEC Chair Jay Clayton reminded issuers that the coronavirus and its impacts may be material to investment decisions and to make sure that they pay attention to proper disclosures. A few weeks later, SEC leadership, together with the Public Company Accounting Oversight Board, advised market participants to ensure that their financial reports and auditing processes were in order so that they could reflect unforeseen circumstances consistent with their obligations. That joint statement also offered assurance that the agency would grant relief from filing deadlines (i) beyond the control of the issuer, and (ii) in cases where filings cannot be completed on time or with the appropriate level of review and attention. These statements were general reminders, but were issued in the context of agency concerns about companies that had operations and subsidiaries doing business in China. 

SEC Offers Compliance Filing Flexibility

In the past few weeks, the SEC’s posture became significantly more concrete. With the growing realization that the coronavirus had the potential to make it more difficult to gather required information, on March 4, 2020, the SEC issued an Order granting 45 days’ conditional relief from compliance filing obligations to companies that may be challenged in assembling and providing required reports to trading markets, shareholders and the SEC (particularly to companies operating in affected areas like China). The SEC again reminded companies to provide investors with any insight that may be considered a material development and to take the necessary steps to avoid selective disclosures. (See related Alert concerning SEC communications extending the filing and delivery of the Form ADV due to COVID-19)

SEC Offers Board and Shareholder Compliance Relief

On March 13, 2020, the SEC issued two Orders (see here and here) effectively providing relief for funds and investment advisers whose operations may be affected by the coronavirus “due to restrictions on large gatherings, travel and access to facilities, the potential limited availability of personnel and similar disruptions.” Under the Orders, the SEC is expressly granting permission for boards of directors of registered management investment companies and business development companies to fulfill their obligations “by any means of communication that allows all directors participating to hear each other simultaneously during the meeting;” (i.e. virtual board meetings.) The formal relief comes on the heels of the SEC Division of Investment Management's March 4th, 2020 statement that the agency “would not recommend enforcement action if fund boards do not adhere to certain in-person voting requirements in the event of unforeseen or emergency circumstances affecting some or all of the directors” as a result of “the current and potential effects of COVID‑19.”

SEC Offers Warnings on Coronavirus Fraud

The SEC Office of Investor Education and Advocacy issued an alert to warn investors about fraud involving claims that a company’s products or services will be used to help stop the coronavirus outbreak. (Bates will cover enforcement issues in more detail in our next post.) In particular, the Office noted that investors should be wary of “so-called research reports” that make predictions that contain a specific target price and of any “pump and dump” schemes that involve microcap stocks.

 

SEC, FINRA, MSRB and NFA Cover Business Continuity

In a March 3rd, 2020 statement, the SEC Division of Investment Management advised investment advisers and funds “to evaluate their business continuity plans (“BCPs”) and valuation procedures, among other relevant policies, procedures and systems.” This recommendation was underscored the next day by the derivatives self-regulatory organization National Futures Association (“NFA”), and a week later by FINRA, which detailed the essential elements of such a plan under prescribed rules.

On March 4, 2020, the NFA reminded its members to review their BCPs to ensure that they can adequately address risks associated with the coronavirus to “clearing firms, telecommunications networks, third party providers, internal departments, mail or email services, utilities, etc.,” and to “assess the risks a pandemic poses to those relationships, and understand how a pandemic may materially impact their businesses.”  The NFA also urged firms to make sure they had up-to-date contact information for key employees.

With far more specificity, on March 9, 2020, FINRA issued a broad Regulatory Notice covering member obligations under FINRA Rule 4370 which requires: (i) members to create, maintain and review procedures to address an emergency or significant business disruption, (ii) that the BCPs be reasonably designed to enable the member to meet its existing obligations to customers, and (iii) that the BCPs take into consideration existing relationships with other broker-dealers and counter-parties. In the Notice, FINRA reminded firms to consider whether their BCPs “are sufficiently flexible to address a wide range of possible effects in the event of a pandemic in the United States.” Considerations include staff absenteeism, travel or transportation limitations, risks associated with remote offices and telework arrangements, cybersecurity and technology interruptions or slowdowns.

The landscape is shifting dramatically. FINRA will continue to make interpretive and no-action decisions quickly in the coming days. For detailed updates, FINRA has set up a dedicated Coronavirus related web page to provide information on rule compliance extensions, notices and other guidance for member firms, investors and other stakeholders. The site is an important reference as FINRA continues to respond to a range of concerns (e.g. from broad investor alerts to member applications and mediation and arbitration postponements).

Supervision and Control Issues under BCPs

FINRA urged member firms to review supervisory control policies and procedures under their BCPs to ensure effective communications with customers and to support customer access to funds and securities during the crisis. These supervisory concerns are highlighted because of branch office rule limitations and as a result of the rush to alternative and telework arrangements. Notably, FINRA informed member firms that it is temporarily suspending requirements to update Form U4 information for registered persons who are temporarily relocated; and to submit branch office applications on Form BR for temporary office locations or space-sharing arrangements.

Similarly, on March 16, 2020, NFA told its members that they would allow associated persons to temporarily work from home under their business contingency plans, provided that the firm (i) institutes adequate supervisory methods, (ii) meets its recordkeeping requirements and (iii) "ensure[s] that these procedures are documented."

MSRB addressed the same issues concerning remote supervision in a March 10th, 2020 Notice on the “Application of Supervisory Requirements in Light of Coronavirus.” The Notice covered MSRB rules that require broker-dealers and municipal advisors to implement a system to supervise municipal advisory activities, and asserts that under the rules, firms may incorporate remote supervision using technological resources.

 

Conclusion

As the coronavirus takes its course, regulators will be getting more and more specific with their compliance guidance, regulatory assistance and relief. Bates will continue to monitor and summarize these regulatory developments.


We know that the current crisis is a challenging time for you, your families and your businesses. Our practice leaders, consultants and experts are available to answer your questions and be a source of knowledge to in-house and outside counsel, and our clients’ compliance, risk, supervision, audit and business teams to help them through this period. Please do not hesitate to reach out to us for any reason.

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03-12-20

Regulators Are Gaining Traction in the Fight Against Elder Financial Exploitation

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Bates Group has been tracking regulatory and enforcement developments on senior financial exploitation. Two recent publications and recent sweeping enforcement actions suggest that the phenomenon is becoming better understood and addressed. The Financial Crimes Enforcement Network (FinCEN) published a strategic analysis after reviewing Suspicious Activity Reports (SARs) filings over a six-year period. The North American Securities Administrators Association (NASAA) issued a statement and a legislative update based, in part, on an enforcement analysis showing that the Model Act to Protect Vulnerable Adults is gaining traction. And the Department of Justice, FBI and Postal Inspector jointly announced the results of “the largest coordinated sweep of elder fraud cases in history.” Here’s a closer look.

FinCEN Analyzes SARs Filings on Senior Financial Exploitation

In December 2019, FinCEN analyzed SARs filed from October 2013 through August 2019 concerning senior financial exploitation. The analysis also reviewed a statistically random sample of SAR narratives contained in these filings between 2013 and 2017. Suspicious activity reported in elder financial exploitation SARs amounted to $21.8 billion during the six-year period, with the number of SAR filings peaking at 7,500 per month by August 2019. FinCEN also found that the total dollar amounts at issue increased annually. In 2014, the total amount reported was $2.2 billion—by August 2019, the amount surpassed $5 billion.

According to the report, “MSBs and depository institutions accounted for the majority of the filings and of the increase, while casino, insurance company, securities and futures, and ‘other’ filers’ reporting trended upward, but accounted for substantially fewer filings per month. Depository institution and securities and futures SARs saw a steady upward filing trend, while MSB SAR filings trended down in 2018 and early 2019.“

The amount reported on a per-SAR basis fluctuated over time. By year, the highest average amount was $70,809 in 2015, and the lowest average amount per SAR was $40,790 in 2017. Breaking these numbers out, however, FinCEN noted that when accounting for type of activity, the average amounts reported for theft (primarily from depository institutions and brokerage firms) were more than double that for scams (mostly from money services businesses.)  For theft, the average per SAR filing was $50,084 with the median amount $15,964. For scams, the average was $25,432, and the median was $6,105. Citing Census Bureau data, FinCEN asserts that these losses reflect as much as 28 percent of the median net worth of households aged 65 or over. 

Distinctions between theft and scams are important as well from the point of view of proposed legislative remedies. Scams (in particular, romance, emergency/persons in need, and prize/lottery scams,) are often characterized by instances where the victim does not know the perpetrator. Fraud and theft, on the other hand, implicates family members (46% of the cases) and non-family member caregivers (20% of the cases). Further, victims of theft often suffer from some cognitive decline or other incapacitation, making the crime even more egregious. FinCEN’s findings clarify the broad spectrum of abuse captured under the term “financial exploitation” and suggest effective responses using a variety of tools.

NASAA Highlights Success of Model Act

In a press release accompanying a 2020 legislative text and commentary on NASAA’s Model Act to Protect Vulnerable Adults From Financial Exploitation, NASAA President Christopher W. Gerold touted the success of the organization’s ongoing effort. He asserted that the Model Act is “on course to become operative in a majority of states” in 2020 and that the success of these measures will result in “additional reporting leading to more enforcement actions and greater protections for seniors and other vulnerable adults.” (Note: New Jersey enacted the “Safeguarding Against Financial Exploitation Act," a statute based on NASAA’s Model Act, on January 13, 2020.)

As described previously, the Model Act (i) “offers broker-dealer and investment adviser firms qualified immunity for delaying disbursements when the firm reasonably believed financial exploitation would result,” and (ii) requires mandatory reporting by an agent or representative upon reasonable belief of senior financial exploitation. NASAA reports that 25 jurisdictions have now enacted some form of the legislation.

Referring to its enforcement report issued last year and covering data from 2018, NASAA asserted that 14 jurisdictions received 426 reports from broker-dealers and investment advisers regarding the potential financial exploitation of a vulnerable adult. Further, these notifications led to 81 investigations which resulted in 57 delayed disbursements and 32 enforcement actions. Finally, NASAA reports that the states that have enacted the Model Act have seen a “drastic increase” in the number of reports of potential financial exploitation.

For detailed consideration of sections of the Model Act, the accompanying legislative commentary for 2020 is an important read. In it, NASAA describes the intention behind many of the definitional terms used in the Act and offers important legislative history and synopses of public comment. Further, NASAA stated that a designated committee “will undertake a review of the implementation and efficacy of the Model Act in the 25 states where the law has been adopted,” in order to “gather information about how effective the laws have been in protecting vulnerable adults from financial exploitation.” These feedback mechanisms are very important to measure the success against the intentions behind the Model Act.

Federal Enforcement Action

On March 3, 2020, the Attorney General, FBI Director and Chief Postal Inspector announced the results of a coordinated enforcement effort that targeted elder fraud schemes. This year, the agencies racked up impressive prosecutions of more than 400 defendants who allegedly caused more than a billion dollars in damages. Unlike last year’s sweep, which focused on technical support scams and mass mail fraud, this year’s enforcement efforts targeted the “threat posed by foreign-based fraud schemes that victimize seniors in large numbers.” Attorney General Barr explained that reduction of transnational fraud schemes on older Americans has become a Justice Department priority. The agencies highlighted going after the “money mule network that facilitates foreign-based elder fraud” and said that actions were taken against over 600 money mules nationwide in an effort to stop the flow of money from seniors to perpetrators.

In addition, FBI Director Christopher Wray commended the work of the Transnational Elder Fraud Strike Force. Established in June 2019, the Strike Force has been meeting with “industry, victim groups, and law enforcement at the federal, state, and local levels to identify the most harmful schemes victimizing American seniors and to bolster preventive measures against further losses,” said Director Wray. 

In the joint announcement, the Justice Department noted additional resources are being made available on senior fraud, including (i) an interactive map showing state-by-state prosecution and educational efforts and (ii) information on a new National Elder Fraud Hotline, for reporting suspected fraud. The latter is to be staffed by case managers who can refer callers to appropriate agencies and services (including the FBI for internet-related scams and the Federal Trade Commission for consumer complaints).

Conclusion

FinCEN and NASAA’s latest efforts to document and analyze their initiatives on elder financial exploitation are important in the ongoing efforts to understand the scope of the problem. FinCEN’s review of available data from SARs filings reinforces prevailing notions that seniors may face an “increased threat to their financial security by both domestic and foreign actors.” NASAA’s updated legislative commentary of key definitions and clauses within the Model Act allows states that have already enacted similar laws—and those that are contemplating enacting such laws—to have the benefit of the latest reasoning based on the latest data. The most recent law enforcement sweep (as evidenced by the interactive map) shows how data sharing, interagency coordination and federal-state collaboration is having an impact.


Learn how to protect your company and its most vulnerable investors with Bates Investor Risk Assessment. For more information concerning financial issues related to vulnerable and senior investors, senior investor expert witnesses, financial crimes, damages analysis, and compliance solutions, please contact Bates Group today.

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03-05-20

Facing the Coronavirus: Financial Industry Preparations, Reassurances and Contingencies

Facing the Coronavirus: Financial Industry Preparations, Reassurances and Contingencies

If you’ve been in meetings about investor communications, business travel, or other contingency planning over the past few days and weeks, you are not alone. Since the outbreak of the coronavirus (also referred to as COVID-19) and more recently, the precipitous volatility of the financial markets, financial firms have been deluged with questions from just about every stakeholder group about how to respond. Regulators are weighing in as well. Bates looks at some of the efforts to prepare and reassure everyone out there.

The Markets

Despite early attempts by Federal Reserve Board Chair Jerome Powell to reassure investors that the central bank is “closely monitoring developments and their implications for the economic outlook” and that the Board “will use our tools and act as appropriate to support the economy,” the Fed took more definitive action earlier this week by lowering the target range for the federal funds rate by 1/2 percentage point in an attempt to protect the economy from potential disruptions.

Political actors have been vocal about pressuring the Fed to do more. The President reportedly urged the central bank to be more aggressive cutting rates and suggested that Congress cut taxes. As we went to print, Congress, however, appears to be closing in on a bipartisan $8.3 billion appropriation to combat the virus. Presidential candidates, most notably former candidate Senator Warren, are advocating for substantial fiscal stimulus to address the current situation and potential spread. The Senator wrote letters to CEOs of the globally systemic important banks demanding they provide information regarding “how you evaluate the risks to your institution and its customers associated with coronavirus, the extent to which your institution is exposed to those risks and prepared to absorb their impact, and how you are monitoring the developments going forward.”  

Firm Management  

For all market participants, the priority is to make preparations to keep transactions and other financial functions operating. A spokesperson from the NYSE stated they are carefully monitoring the spread of COVID-19, and that the exchange has “robust contingency plans, tested regularly, to enable continuous operation of the NYSE exchanges should any facilities be impacted.”

Many financial firms have restricted business travel in Asia and Italy, required employees in those areas work from home, and placed other restrictions on travel and attending conferences. Some U.S. firms are restricting travel, as well. Reuters quotes financial sources discussing the preparation of back-up facilities, “splitting up critical teams into rotating shifts and physically distancing staff from one another.” Ultimately, the plans ensure that employees know what they need to do to keep the company operating. 

Backing up how prepared market participants are, Kenneth Bentsen Jr., CEO of the Securities Industry and Financial Markets Association (“SIFMA”), in an interview with Reuters relayed that  “most firms have playbooks for handling a range of business disruptions, including pandemics.” He stated that the “industry is reviewing and updating contingency plans in order to minimize any potential disruption to the financial markets that could be caused by personnel being unable to work onsite.” Plans include potentially “moving staff to backup locations away from major cities.” Bentsen conveyed that “our job is to do as much preparedness as we can . . . and to be as resilient as possible. That's been up and running for several weeks now, and we're prepared."

SEC  

On March 4, 2020, the SEC issued an Order that “provides publicly traded companies with an additional 45 days to file certain disclosure reports that would otherwise have been due between March 1 and April 30, 2020.”  In the release accompanying the Order, the SEC makes clear that companies should “continue to evaluate their obligations to make materially accurate and complete disclosures in accordance with the federal securities laws.”

To receive the relief under the newly issued Order, companies must submit a summary report explaining “why the relief is needed in their particular circumstances.” The Commission stated that it “may extend the time period for the relief, with any additional conditions it deems appropriate, or provide additional relief as circumstances warrant.” 

The SEC Division of Investment Management also issued a statement saying that it is actively monitoring the current and potential effects of the virus on investment advisers and funds. The staff noted, however, that it “would not recommend enforcement action if fund boards do not adhere to certain in-person voting requirements in the event of unforeseen or emergency circumstances affecting some or all of the directors,” as a result of “the current and potential effects of COVID‑19.” Division staff stated that its no-action position applies to board meetings held between March 4 and June 15, 2020 (with extensions as circumstances warrant.)  

Retail Investors

For retail investors, regulators have been offering up advice when considering investment concerns. On February 28, 2020, FINRA issued “Investor Tips for Turbulent Markets,” a 5-step primer for when “the stock market gets rocky” to “elevate your financial security.” While not explicitly referencing the advent of the health crisis, the primer contains key steps to “‘steady your pulse during market downturns.”  These key points include (i) revisiting financial goals to guide a sound investment approach; (ii) diversify across, and within, the major asset classes relative to your overall portfolio; (iii) automating payments to strengthen financial security; (iv) understanding the impact of changing interest rates; and (v) protecting against fraud by working with registered representatives and using FINRA’s BrokerCheck.

Conclusion

The global nature of the coronavirus challenges the broader economy in ways that are as yet unknown. Messages of preparations, reassurance, and contingency plans by market leaders are helpful to “steady the pulse” as stakeholders move forward. Bates will continue to monitor developments.

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02-28-20

Massachusetts Adopts New Fiduciary Rule; SEC Releases Reg BI FAQs;  NAIC Approves Annuity Regulation

Massachusetts Adopts New Fiduciary Rule; SEC Releases Reg BI FAQs;  NAIC Approves Annuity Regulation

As the June 30, 2020, date for compliance with the Regulation Best Interest (“Reg BI”) draws near, federal and state regulators are increasingly vocal in warning market participants about how they should treat client investors. Fortunately, the regulators have provided a constant flow of guidance and resources designed to help firms prepare. Unfortunately, however, a chance still exists that geography will affect compliance. In this article, we look at the latest developments by state regulators to push a more stringent fiduciary standard, new SEC staff considerations on Reg BI questions, and important developments in the National Association of Insurance Commissioners (“NAIC”) model regulation on conflict of interest rules for insurance agents and representatives selling annuity products.

Massachusetts Adopts Fiduciary Rule

On February 21, 2020, the Massachusetts Securities Division (“the Division”) of the Office of the Secretary of the Commonwealth officially adopted its proposed “Amendments to Standard of Conduct Applicable to Broker-Dealers and Agents.” The final regulation, effective March 6, 2020, and enforceable starting September 1, 2020, applies a fiduciary conduct standard to broker-dealers when dealing with customers. (Note: the Division adopted amendments concerning disclosure obligations for investment advisers effective back in June of 2019. Enforceable as of January 1, 2020, the amendments require that investment advisers registered in Massachusetts provide clients and prospective clients with a one-page, stand-alone Table of Fees for Services.)

The final regulations were revised to “make clear that the existing suitability standard still applies to any relationships or transactions expressly excluded from the fiduciary standard.” As a previous Bates post describes, the revised version adds “language expanding a potential breach of fiduciary duties to commodity and insurance products;” establishes a presumption that a fiduciary duty exists simply by the title used by an advisor; and requires that an advisor go beyond disclosure or mitigation of a conflict of interest by requiring efforts to actually avoid such conflicts.

Based on comments received, the standards were adopted despite significant pushback, even from Massachusetts Governor Charles Baker (see here). Broker-dealers and agents registered in Massachusetts that fail to comply with the newly adopted fiduciary standard will be deemed in violation of their obligation of “utmost care and loyalty” and considered to be operating a “dishonest or unethical practice” under Massachusetts law.

SEC Issues New FAQs on Reg BI Compliance

On February 11, 2020, SEC staff modified their Frequently Asked Questions (“FAQs”) documents on Reg BI and CRS Forms. Though staff member answers are not official “rules, regulations or SEC statements” and “have no legal force or effect,” compliance professionals should not ignore them. The documents are available on the SEC website. The Reg BI FAQs cover by category the following: Retail Customer, Recommendation, Disclosure Obligation, Care Obligation, Conflict of Interest Obligation and Compliance Obligation. The CRS FAQs cover Retail Investor, Relationship Summary Format, Delivery Requirements, Amendments to the Relationship Summary, Disciplinary History, and Plain English; and Fair Disclosure.

Among several scenarios, the latest answers clarify (i) the applicability of Reg BI obligations and CRS Form requirements for accredited investors, (ii) whether CRS forms must be sent or resent to customers if the type of account changes, and (iii) issues concerning state and federal registrations.

NAIC Approves Model Regulations

On February 13, 2020, NAIC announced approval of final revisions to the Suitability in Annuity Transactions Model Regulations. Bates has been following the NAIC deliberations to revise standards and procedures for providing recommendations to consumers on transactions involving annuity products. In general, the model regulation requires that an agent demonstrate in writing a recommendation is in the consumer’s best interest and must identify, manage, and disclose material conflicts of interest. In our previous post, we note that NAIC’s Life Insurance and Annuities Committee approved final revisions (i) that spell out that any producer of such products must satisfy obligations of care, disclosure, conflict of interest, and documentation, (ii) that the model regulation does not require a fiduciary relationship between the producer and the customer, and (iii) that the model regulation provides a safe harbor for producers that comply with the Reg BI. For compliance purposes, the revised model also enhances supervision regime. NAIC President Ray Farmer stated that “nearly every state has adopted the model, which has been protecting consumers for 15 years. I encourage my colleagues to work with their state legislatures to pass these updates to provide even stronger protection” for consumers purchasing annuities.

CONCLUSION

There are no surprises among the developments. Processes undertaken by various authorities are leading to different, but anticipated results; some that can coexist (i.e., SEC and NAIC) and some that may ultimately be a bit more challenging for firms (Massachusetts fiduciary duty standards and Reg BI).

Despite the request Kenneth Bentsen Jr., president and chief executive of SIFMA for Massachusetts, issued, to “delay action for at least 18 months and then assess whether any further steps are necessary,” the Division appears to have done the opposite, setting an effective date almost 2 months earlier than the Reg BI compliance date. The stage is set for a possible legal battle about whether state or national standards will prevail.

The NAIC’s Reg BI-friendly model regulation for annuity products appears to accommodate some of the differences between the states and the federal agencies.

Firms have little choice but to prepare for Reg BI and should consider their own business practices in light of the detail offered by the SEC FAQs. For broker-dealers whose customers are in Massachusetts, the March 6th effective date for the regulation is fast approaching. For all, the Reg BI June 30 compliance date is just around the corner.


Bates Group’s Compliance team helps firms through the implementation phase of Reg BI and navigating compliance concerning investor and consumer protection standards. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com.

For information about Bates Group’s Insurance and Actuarial practice services, please contact Bates Managing Consultant, Greg Faucher.

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02-20-20

FINRA Talks Dispute Resolution - Offers Tips and Advice to Counsel and Arbitrators

On February 3, 2020, the New York County Lawyers Association hosted its “21st Annual FINRA Listens and Speaks” panel. The panel members discussed recent statistics, proposed regulations, and tips for counsel and arbitrators on the agency’s dispute resolution efforts. Katherine Bayer, Northeast Regional Director of FINRA’s Dispute Resolution Office, and Arthur Baumgartner, Senior Case Administrator, FINRA Dispute Resolution, delved into details of the inner workings of the Office and responded to comments from moderator and arbitrator Martin Feinberg. Bates takes a closer look at what you need to know.

Recent Statistics

FINRA’s case load has been on the decline for a number of years. In 2019, 3,757 new claims were filed – a decrease of 13 percent from 2018. Customer cases made up 63 percent of the filings and intra-industry cases made up the remaining 37 percent. On average, cases took 14.2 months to conclude – no change from the prior year. However, cases that went through to hearing averaged 16.9 months (slightly longer than the year before), and cases decided on the pleadings alone – with no hearing – averaged 5.8 months, which was a decline from the previous year.

A new category of “special proceeding” cases focusing on small claims were resolved in an average of 7 months. The 1-day telephonic hearings using a single arbitrator went into effect a year and half ago. In 2019, 46 customer cases were decided under the special proceedings. Director Bayer stated that she believes that it is likely the number of these cases will increase as they become better known.

In 2019, 16 percent of the cases closed by award, a low figure and one trending downward. Each year since 2016, the number of cases closed by award went down. Cases closed by settlements and through mediations of customer cases, however, represented 74 percent of the cases adjudicated, which has increased year over year. Mediation case filings also went up last year, with 592 new mediation cases filed (up from 16 percent from the prior year). Director Bayer noted that cases from San Juan, Puerto Rico comprised of more than a third of the mediation case filings. Mr. Feinberg noted that this statistic was the result of the filings from disputes on Puerto Rico bonds.

Rule and Proposed Rule Changes

Director Bayer highlighted a number of recent rule and proposed rule changes affecting FINRA dispute resolution. Those include:

  • New rules extending the time for non-parties to object to an Order of Subpoena or Order of Production of Documents (to 15 days upon receipt from 10 days upon service).
  • Proposed changes to member application program (MAP rules) related to pending arbitration claims and awards. The proposed rule change would create a rebuttable presumption that an application for new membership should be denied if the applicant is subject to a pending arbitration claim. The presumption can be overcome by a demonstration of the ability to satisfy an unpaid claim, unpaid award, or unpaid settlement.
  • The above proposed rule also applies to an existing member seeking a specified change in ownership or control of business operations. Resolution would require a “materiality consultation” – to ensure that the member seeking the change can satisfy an unpaid claim or award. Director Bayer noted that the issue addresses when a firm sells its assets to another firm, and the new firm declines any liability for previously unpaid claims or awards. The rule also requires that an applicant notify any pending arbitration claim before a decision on an application. Comments were completed on January 21, 2020. FINRA is expected to act on it soon.
  • Proposed changes placing restrictions on non-attorney representatives (NARs) practicing in a FINRA dispute resolution. Law school clinics, family members, and non-compensated friends are not subject to the restrictions in the proposed rules. FINRA will file a formal amendment with the SEC sometime soon. Director Bayer also clarified that under FINRA rules, an out-of-state lawyer can practice in a FINRA dispute resolution proceeding subject to state law restrictions. Mr. Feinberg noted that the original reasoning behind NARs concerned fully qualified, non-lawyer union representatives representing individuals in a labor dispute.
  • Proposed changes to amend the Code of Arbitration Procedures to expand a customer’s option to withdraw an arbitration claim and file in court in situations where the member firm becomes inactive before a claim is filed, or during a pending arbitration claim. The current rule states that a customer is not required to arbitrate a dispute involving a terminated member. The proposed rule allows a customer to amend pleadings, postpone hearings, and receive refunds of filing fees. Staff is in the process of reviewing comments.
  • Proposed rule change to the Code of Arbitration Procedures to increase various arbitrator fees and honoraria. To cover the fees, the proposed rule would increase member surcharges in case processing under certain circumstances. The proposed amendments are to be filed soon with the SEC.

Director Bayer also announced the inclusion of case-specific contact information to be delivered at the time the Notice of Panel is announced. The contact sheet includes names of the case administrator, case coordinator (who handles scheduling), and a case specialist (who handles the case when its first is filed, when the answer is filed, and, in general, the motions docket).

Tips for Counsel:

  • Director Bayer emphasized the importance of, the improvements to, and the expectations for arbitrators to utilize the FINRA arbitration portal. Director Bayer encouraged arbitrators to trust the portal for documents sent and received that will automatically provide a confirmation in the submissions folder. She stated that it speeds up the process, prompts required disclosures (and disclosure updates), and creates automated processes that generate required notices to parties and updates relevant arbitrator disclosures in other cases.
  • Send Submission Agreement with your Answer. Arbitrator Feinberg stated, “distributing an Answer without a Submission Agreement can do great harm to the parties later on after the case closes and if claimant wants to vacate an award.”
  • Provide copies of Settlement Agreements to FINRA – they are relevant in expungement proceedings.
  • “No action” letters (e.g., from an investigation) should not be submitted as evidence in customer arbitration cases.

Tips for Arbitrators:

  • Complete and execute the Arbitrator Oath on the portal – it starts the disclosure process.
  • Make disclosures early and throughout the life of the case. Director Bayer stated that “everything is out there these days.” If you are not sure, it is best to disclose.
  • Avoid withdrawals. Withdrawals are very disruptive to the parties. Director Bayer explained that FINRA staff track withdrawals and patterns emerge, particularly close to hearing dates, FINRA may remove the arbitrator from the roster.
  • In ruling on motions that include fees (e.g., adjournments), arbitrators should be deciding at the time of the decision who should be responsible for the fee or on any waivers of fees. Director Bayer stated that deferments on assessment of fees may cause problems at the end of the case.
  • Rulings on motions (e.g., a Motion to Compel) should not be made before an initial pre-hearing conference (even though the arbitrator may have the authority to do so after the filing of the Oath).
  • Avoid ex parte communications, or any interaction – no matter how innocent – that may be interpreted as bias.

Diversifying Arbitrator Panels

Director Bayer reported that her Office is beginning to see results of outreach efforts to find diverse candidates to serve as arbitrators. She said an outside firm conducts a voluntary confidential demographic survey of the arbitration population. The results are then published on the FINRA website. In the 2019 survey results published in January, significant increases occurred in the diversity of the new arbitrator roster: 39 percent were women, 19 percent African American, 6 percent Latino, 3 percent Asian, and 4 percent LGBT.

Conclusion

The “FINRA Listens and Speaks” panel is an important outreach effort to communicate current thinking on arbitration processes and procedures. The decline in case filings is noteworthy given the longevity of the strong markets. FINRA’s efforts to diversify its arbitrator roster is laudable. FINRA distinguishes itself as one of the few forums in the country that has made progress in addressing and tracking the issue. Director Bayer and Administrator Baumgartner’s tips for practitioners and arbitrators demonstrate a continuing commitment to improve and clarify FINRA’s adjudicatory process. Their repeated admonitions to “trust the portal” should not be ignored. 

Learn more about Bates Group’s Litigation Services, including expert testimony, damages analysis, and our Arbitrator Evaluator™ selection tool.

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02-12-20

New OCIE Report Offers Best Practices for Firms to Enhance Cyber Preparedness and Resiliency

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A few weeks ago, Bates reviewed the SEC Office of Compliance Inspections and Examinations ("OCIE") recently issued 2020 examinations priorities. That report reminded registered entities to address potential vulnerabilities in compliance programs and practices in order to minimize retail investor and market risks. On the heels of that report, OCIE has issued a new report on “Cybersecurity and Resiliency Observations” to reemphasize that cybersecurity is a top examination priority and that registered entities should be assessing their practices and procedures to ensure adequate compliance. Bates Research takes a closer look at what OCIE wants you to know.

Increasing Threats, Serious Consequences

The OCIE issued its new cybersecurity observations report based on concerns about (i) increasingly aggressive and sophisticated “cyber threat actors,” (ii) increasing firm reliance on technology, and (iii) the rising potential for negative consequences to investors, market participants and the financial markets. Based on 2019 examinations, the report offers best practices on a wide range of cybersecurity controls and operations.

Support from the Top: Governance and Risk Management

OCIE asserts that effective governance and risk management programs (i) demonstrate strong and engaged leadership, (ii) effectively assess and prioritize cybersecurity risk, (iii) have written policies and procedures to address that risk, and (iv) have practices that implement and enforce those policies.

Specifically, OCIE recognized programs that demonstrate appropriate board- and senior-level engagement, including those in which senior leaders demonstrate their commitment “to improving their organization’s cyber posture through working with others to understand, prioritize, communicate, and mitigate cybersecurity risks.”

OCIE highlighted risk assessment methodologies tailored to an organization’s business model and wants firms to consider a wide spectrum of vulnerabilities from “remote or traveling employees” to “geopolitical risks.” Firms should expect that the OCIE will examine for policies and procedures that (i) establish adequate testing and monitoring, informed by cyber threat intelligence; (ii) respond to such testing and monitoring with continuous updates and (iii) provide updated information to stakeholders and to regulators.

Access Rights and Controls

Firms should also expect that the OCIE will examine to ensure that a firm has appropriate controls in place to limit access to sensitive client information. This means an organization’s systems should demonstrate that managers (i) understand the location of client information, (ii) restrict access to that data only to authorized users; and (iii) take steps to prevent and monitor for unauthorized access.

OCIE said it observed firm strategies in which managers limited access during “onboarding, transfers, and terminations;” implemented “separation of duties for user access approvals” and created periodic recertification procedures, among others. Similarly, OCIE identified best practices for access monitoring, including procedures for logins, user name and password changes, hardware and software changes and for the investigation of system anomalies.

Data Loss Prevention

OCIE said that firms should ensure the protection of sensitive data from unauthorized users. OCIE highlighted “capabilities” used by firms to (i) scan for vulnerabilities in internal and external systems (including applicable third party providers,) (ii) “control, monitor, and inspect network traffic,” (iii) “detect threats on endpoints” (e.g. maintaining system logs and applications for aggregation and analysis), (iv) “patch” software and hardware from virus and malware threats, (v) maintain inventories of all hardware and software, (vi) secure data and systems through encryption and network segmentation, (vii) identify and block the transmission of suspicious behaviors and (viii) secure legacy systems and equipment.

Mobile Security

OCIE highlighted firm strategies to secure mobile devices and mobile applications. These include establishing clear policies and procedures and requiring the use of mobile device management (MDM) technology applications for authorized users. OCIE also noted firm best practices that “prevent printing, copying, pasting, or saving information to personally owned computers, smartphones or tablets as well as sufficient employee training on mobile device policies.

Resiliency and Incident Response

OCIE expects firms to have incident response plans that include “timely detection and disclosure of material information” in the event of a cyber incident. Specifically, OCIE noted effective programs that incorporate: (i) scenario planning (e.g. denial of service or ransomware); (ii) systems for regulatory and suspicious activity reporting (SARs) and compliance; (iii) adequate notifications concerning data breaches to customers, clients and employees; (iv) staff preparedness plans and (v) incident response testing.

The OCIE also stated that resiliency plans should be based on assessed risks and business priorities, so the firm is in the best position to maintain its core business operations and systems in the event of an incident. This includes determining system and process substitutions during disruptions, maintaining back up data, and assessments of the “effects of business disruptions on both the institution’s stakeholders and other organizations.”

Vendor Management

OCIE highlighted firm best practices for vendor management. These include, among others, required due diligence during vendor selection, ongoing relationship monitoring, assessments of vendor services within the firm’s ongoing risk processes, and vendor protection of client information.

Employee Training

OCIE expects that firm employees undergo training about cyber risks to help “build a culture of cybersecurity readiness and operational resiliency.” OCIE observed firms that have robust policies, procedures, training guides and training programs that incorporate specific examples of threats (e.g. phishing emails) to help employees prevent breaches, and to identify and respond to suspicious behavior. OCIE recognized firms that continuously evaluate and update their training programs based on cyber threat intelligence.

Conclusion

The new OCIE report  emphasizes that cybersecurity remains a key SEC priority, particularly when it comes to customer data protection, disclosure and compliance (see previous Bates alert). Though OCIE offers these very specific observations on “cybersecurity preparedness and operational resiliency,” it says that there is no such thing as a “one-size-fits-all” cybersecurity program. However, in light of the fact that this very detailed template represents the second OCIE warning in a matter of weeks, it would be prudent for firms to review whether they are appropriately assessing, monitoring and managing their cybersecurity risk.

 

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

AML and Financial Crimes

Insurance and Actuarial Services

Consulting and Expert Testimony

 
Learn more about Bates Group’s Data Security

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02-11-20

Private Placement Alert: GPB Private Funds Under Scrutiny

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Bates Group is alerting counsel that we are seeing cases filed where firms sold private funds issued by GPB Capital Holdings LLC. It is alleged that firms selling these funds were negligent and failed to perform adequate due diligence when approving these funds for sale, misrepresented and omitted material information when recommending and/or selling these funds to their clients, had conflicting interests in selling the GPB Capital Funds, negligently supervised the sale of these funds and breached the fiduciary duty owed to their clients.

GPB Capital Funds include:
  • GPB HOLDINGS, LP;
  • GPB HOLDINGS II, LP;
  • GPB AUTOMOTIVE PORTFOLIO, LP;
  • GPB COLD STORAGE, LP;
  • GPB WASTE MANAGEMENT FUND, LP;
  • GPB HOLDINGS III, LP;
  • GPB HOLDINGS QUALIFIED, LP;
  • GPB NYC DEVELOPMENT, LP;

Bates Group Support:

Bates staff and experts have provided both consulting and testimony services in matters involving private placement funds. Bates experts have opined on the rules and regulations associated with public and private securities offerings,  the adequacy of disclosures in offering documents, the adequacy of due diligence undertaken by firms selling private funds, a determination of the product’s suitability for sale by the firm, a determination of the suitability of individual recommendations made, the adequacy of sales supervision, and an assessment of whether the firm and its representatives met their fiduciary obligations to accredited and retail investors.

Bates has also performed quantitative analyses examining the feasibility of investments at issue producing the expected or advertised returns, including calculating a probability-weighted expected value of return amongst other hypothetical scenarios.

Our experts have provided in-depth knowledge and analysis concerning trading strategies involving alternative investments and the role of these strategies within an overall investment objective, as well as the relative risks for the client in engaging in these types of strategies. We have also provided analysis and testimony in support of matters involving strategies employed to generate additional yield in a client’s portfolio, across a variety of investment products, as well as damages calculation and alternative damages calculation.

Specifically, Bates can assist in the following ways:
  • Examining the relationship between the general partner and the lead broker-dealers to assess if there was a conflict of interest in brokering, selling, and underwriting the funds.
  • Assessing whether the offerings were appropriately registered under the Securities Act of 1933 and Section 12(g) of the Securities Exchange Act of 1934.
  • Assessing the adequacy of disclosures in the private placement memorandum and other offering documents, including the adequacy of risk disclosure and whether there were any material misstatements and omissions.
  • Assessing the suitability of the products and the suitability of the recommendation.
  • Analyzing the trading in brokerage accounts to determine the P/(L) associated with investments in the funds at issue.
  • Contextualizing the fees and commissions that were charged in light of alternative products of a comparable nature and examining the likelihood of the investments at issue generating the expected or advertised returns.
  • Examining the changes in the investor’s portfolio risk and expected return when investments in the funds at issue are considered as part of an overall investment strategy; forecasting the probability of a loss and the probable size of a loss at the time of purchase.
 
Please contact us today if you have any questions or need assistance:
 

Andrew Daniel, Securities Litigation Expert and Director – adaniel@batesgroup.com

Alex Russell, Managing Director, Practice Leader, Regulatory Enforcement & Complex Litigation – arussell@batesgroup.com

Julie Johnstone, Managing Director, Practice Leader, Retail Litigation – jjohnstone@batesgroup.com

Peter Klouda, Securities Litigation Expert and Director, Retail Litigation – pklouda@batesgroup.com

 
Learn More About Bates Group’s Securities Litigation Practice

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02-05-20

U.S. Anti-Money Laundering Updates

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Photo by Pepi Stojanovski on Unsplash

 

The Treasury Department’s Office of Comptroller of the Currency (OCC) issued an Annual Report to Congress highlighting, among other things, the past year’s Bank Secrecy Act (BSA) and anti-money laundering (AML) efforts and setting out strategic priorities and policy initiatives for the new year. The Comptroller says he wants to reduce the burden of BSA and AML compliance, while protecting the financial system. Meanwhile, (i) financial institutions continue to watch the Senate Banking Committee to see if there will be movement on the ILLICIT CASH Act, a bill containing provisions on beneficial ownership that would have significant implications for AML/BSA compliance, (ii) the Association of Certified Financial Crime Specialists (ACFCS) shared some interesting AML 2019 enforcement data compiled by a number of private companies, and (iii) there were some unusual AML-related enforcement actions worth noting. Here’s a closer look.

OCC Report

The OCC Report states plainly that BSA/AML compliance risk remains high. In response to these risks, the OCC highlights three main points. First, it references two previously published joint bulletins (see here and here) that (i) encourage financial institutions to consider innovative approaches in meeting their BSA/AML compliance obligations, and (ii) “address instances in which banks may decide to enter into collaborative arrangements to share resources” to manage these obligations. (The latter provides examples of how “shared personnel, technology and other resources may be beneficial for certain financial institutions – e.g. Community Banks.) The new Report re-emphasizes these themes by acknowledging the global nature and the dynamic of the current technological environment. The Comptroller stated that as innovative solutions continue to evolve, particularly related to identifying suspicious activity and terrorist financing, his Office will focus on encouraging financial institutions to adopt them to manage compliance risks.

Second, the Comptroller reinforces the goal of working with other regulators to ensure that financial institution BSA/AML compliance risk management systems “be commensurate with the risk associated with a bank’s products, services, customers, and geographic footprint.” The Report references OCC’s participation in a Financial Crimes Enforcement Network (FinCEN) working group to improve the transparency of the regulator’s “risk-focused approach to BSA/AML supervision.” Regulators agreed to “tailor examination plans and procedures based on the unique risks of each bank, thereby allowing banks to allocate compliance resources commensurate with their risks.” In 2020, the Comptroller states, OCC will work with other agencies to update the Federal Financial Institutions Examination Council’s (FFIEC) BSA/AML Examination Manual . Notably, the OCC report comes on the heels of publication of the SEC’s Office of Compliance Inspections and Examinations (OCIE) annual report which stated that the OCIE will examine BSA/AML compliance in particular for customer identification programs and customer due diligence, beneficial ownership, and Suspicious Activity Report (SARs) compliance. (See Bates’ OCIE Priorities review here.)

Third, the Comptroller stated that the Office is committed to advocating for updating the “nearly 50-year-old BSA/AML regime.” Referencing 2019 testimony by the Deputy Comptroller, the Report asserts that regulations should be updated “to address rapidly evolving risks, including the inappropriate use of shell companies, and to make better use of technology to protect the financial system from illicit activity.”

ILLICIT CASH Act

OCC’s advocacy for updating the BSA/AML regime finds expression in the Improving Laundering Laws and Increasing Comprehensive Information Tracking of Criminal Activities in Shell Holdings Act (“ILLICIT CASH Act”), a bill which would strengthen the authority of FinCEN. (See previous Bates article here.)

As described in its legislative summary, the bill “comprehensively updates the BSA for the first time in decades and provides a coherent set of risk-based priorities in statute.” Specifically, the bill requires the reporting of beneficial ownership information for domestic shell companies and creates federal reporting requirements that mandate all beneficial ownership information be maintained in a comprehensive federal database, accessible by federal and local law enforcement. A similar bill, sponsored by Congresswoman Carolyn Maloney, titled the Corporate Transparency Act (“CTA”), passed the House of Representatives. To date, the ILLICIT CASH Act resides in the Senate Committee on Banking, Housing, and Urban Affairs, which last held a hearing on it on December fifth.

AML 2019 Enforcement

The Association of Certified Financial Crime Specialists (ACFCS) shared AML enforcement data for 2019. UK software company Encompass concluded that AML enforcement penalties totaled US $8.14 billion globally, nearly doubling the amount that was handed out in 2018. In the United States, they said, regulators assessed 25 penalties totaling $2.29 billion.

FinCEN and SARs

ACFCS also noted a widely reported plea deal by a former senior adviser at FinCEN. (See also here.) The United States Attorney for the Southern District of New York brought charges against the employee for “conspiring to unlawfully disclose Suspicious Activity Reports” to reporters concerning “among other things, Paul Manafort, Richard Gates, the Russian Embassy, Maria Butina, and Prevezon Alexander.” Under the BSA, disclosure of a SAR by a government employee is a felony.

Conclusion

The OCC remains committed to its collaborative approach to regulating for BSA/AML risk. It has embraced and encouraged adoption of innovation and technology as the solution, while working with its regulatory counterparts to require that financial institutions tailor their resources to their business models, products, services and customers. The OCC also seeks regulatory changes in the BSA/AML regime that will extend government reach, capture more data and boost their regtech approach. If passed, the ILLICIT CASH Act may serve that purpose. The consistent rise in AML enforcement cases and penalties may evidence the success of that approach. However, the FinCEN case suggests that even the best approach comes with unexpected consequences. Bates will keep you apprised.

To learn more about Bates Group’s AML and Financial Crimes services, please contact Edward Longridge at elongridge@batesgroup.com.


This week: Meet Bates AML Leaders at booth #8 at SIFMA's Anti-Money Laundering and Financial Crimes Conference, Wednesday and Thursday, February 5-6, 2020 in New York City. Hear Bates AML and Financial Crimes Managing Director Edward Longridge speak on the panel "Wherever You Go, There You Are: Money Laundering in an International Context," 12:55 - 1:55 p.m. on Thursday, February 6th.

For additional information, please follow the links below to Bates Group's Practice Area pages:

Anti-Money Laundering and Financial Crimes

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Consulting and Expert Testimony

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01-23-20

FINRA Reorganizes for More Coordinated Exams, Highlights Priorities for 2020

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(photo: FINRA.org)

In his cover note accompanying FINRA’s annual Risk Monitoring and Examination Priorities letter, FINRA President and CEO Robert Cook (pictured) reminded members of significant enhancements to the examination program going forward.

Mr. Cook first described the recent reorganization of member firms into one of five business model categories: Retail, Capital Markets, Carrying and Clearing, Trading and Execution and Diversified This consolidation permits FINRA to assign each firm “a single point of accountability” that will have the “ultimate responsibility” for risk monitoring, assessment and “planning and scoping of exams tailored to the risks of the firm's business activities.”

Second, Mr. Cook highlighted the organization’s extensive efforts in preparing firms to comply with new regulations—particularly Regulation Best Interest (“Reg BI”)—that will be examination priorities for FINRA in 2020. To that end, he underscored the letter’s inclusion of practical questions that firms should consider in order to “assess and, if necessary, strengthen their compliance, supervisory and risk management programs.”

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Top FINRA Exam Priorities for 2020

See highlights of FINRA’s continuing and emerging concerns on our 2020 FINRA chart below, which keeps track of articulated priorities from year to year.

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© 2020, Bates Group LLC
Source: 2020 FINRA Regulatory and Examination Priorities Letter (Compiled by Alex Russell, Managing Director)
 

Reg BI Tops the List

Reg BI was front and center in this year’s letter. FINRA emphasized that it will continue to offer transition resources as it “reviews firms’ preparedness” prior to Reg. BI’s June 30 implementation date. After that date, however, FINRA will examine broker dealers for compliance with the new regulation, the corresponding interpretations and the new Customer Relationship Summary (“Form CRS”) requirement.

Specifically, FINRA stated it will consider in its examinations whether: (i) adequate processes and procedures are in place to assess broker dealer best interest recommendations; (ii) the firm and associated persons are applying those standards; (iii) account monitoring adequately applies to both explicit and implicit hold recommendations; (iv) recommendations to retail customers are following “express new elements of care, skill and costs;” (v) customer recommendations take into consideration reasonably available alternatives; (vi) controls are in place to prevent excessive trading; (vii) adequate disclosures are provided for; (viii) conflicts of interest are adequately covered in policies and procedures; and (ix) filing and delivery of Form CRS is adequately addressed.

Sales Supervision and Communications

FINRA reiterated past priorities, saying that it will examine supervisory obligations over the sales of complex products (private placements, variable annuities and certain fixed income products). In 2020, FINRA highlighted that it will look closely at private placement retail communications to see how firms are fulfilling their supervisory obligations when using digital platforms (texting, messaging, social media or other applications). The letter states that FINRA will consider whether private placement communications are fair, reasonable and not misleading and whether they omit material facts, adequately explain risks, or contain false statements or promises. In addition, FINRA said it will examine these communications to ascertain whether they fully explain issuer metrics or projections on performance.

On the use of digital communications tools, FINRA asks firms to review their practices and programs to ensure that a representative’s digital communications comply with review and retention requirements and to consider whether their supervisors can recognize—and follow up on—the “red flags” of unapproved communications channels.

Cybersecurity

FINRA states that “cybersecurity has become an increasingly large operational risk.” As a result, FINRA advises firms that it will examine policies and procedures to ensure that customer records and information are adequately protected. FINRA also reminded firms that cybersecurity controls should be appropriate to the firm’s scale of operations and business model. Specifically, the FINRA letter prods firms to consider their “technology governance programs” to determine whether they are “expose[d] to operational failures” that may compromise their ability to comply with a range of rules and regulations. In this respect, FINRA will evaluate the adequacy of firms’ business continuity plan to ensure that the firm has the procedures and capacity to “maintain customers’ access to their funds and securities, as well as manage back-office operations, to prevent delays or inaccuracies relating to settlement, reconciliation and reporting requirements.” FINRA stated that it will examine testing and for tracking information technology problems.

Additional FINRA examination priorities for 2020 include:

  • Trading Authorizations – FINRA will examine whether firms have the systems and supervision in place to address trading authorizations, discretionary accounts and key transaction descriptors. This includes whether firms can detect and address registered representatives exercising discretion without written client authorizations.
  • Bank Sweep Programs – FINRA will examine a broker dealer’s use of bank sweep programs (sweeping investor cash into partner banks or mutual funds) to ensure that such services are not misrepresented, and that any program arrangements as well as cash management alternatives are adequately communicated to the customer.
  • Digital Asset Investments – For firms that are considering engaging in digital asset investment activities, FINRA will examine whether they are filing the appropriate documentation for engaging in such activity, and whether their marketing and retail communications present a fair and balanced look at the risks presented. FINRA is also concerned with technology-related risk and cautioned that it will review automated systems associated with market access (such as monitoring for trading behavior, adjustments to credit limit thresholds, third party vendors and training).
  • IPO Practices – FINRA will examine a firm’s compliance with rules restricting the purchase and sale of initial equity public offerings, and on new issue allocations and distributions. FINRA wants firms to review their practices and procedures to ensure that (i) they can adequately detect and address issues of “flipping” or “spinning;”(ii) IPO allocation methodologies and “calculations of aggregate demand” are fully explained; (iii) there are adequate controls to prevent allocations to restricted persons; and (iv) the firm records and verifies information for customers receiving these allocations.
  • Best Execution – FINRA will continue to focus on compliance with best execution rules as they pertain to routing decisions and procedures for the handling of odd lots, treasuries and options (all subjects of enforcement actions in 2019). Further, FINRA said it will review processes related to handling of customer orders, including how the firm addresses conflicts of interest concerning now prohibited types of remuneration.

FINRA will also continue to examine priorities highlighted in the past, including adequate supervision and compliance over anti-money laundering and fraud, insider trading and manipulation across markets and products.

Conclusion

The priorities contained in this year’s FINRA letter are consistent with those contained in the annual report issued by the SEC’s Office of Compliance Inspections and Examinations (see recent Bates coverage). Similar to the OCIE report—which should be considered in tandem with this letter—the FINRA priorities emphasize the importance of firms preparing for Reg. BI and, more generally, for addressing vulnerabilities in compliance programs and practices. FINRA’s recent consolidation and reorganization and the identification of a “single point of accountability” should prompt firms to engage with them sooner, particularly over preparations for Reg BI, to ensure they are moving toward full compliance with these priorities.

 
For more information concerning Bates Group's Practices and services, please visit:

Bates Compliance Solutions

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Broker-Dealer Compliance Services

RIA Compliance Services

Retail Litigation and Consulting

Regulatory Enforcement and Internal Investigations

Bates Investor Risk Assessment for Vulnerable and Senior Investors

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01-22-20

Download The New Reg BI White Paper from Bates Research and Bates Compliance

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Understand what Reg BI requires now — and what more you must implement before the final deadline. 

Download our new white paper: "SEC’s Regulation Best Interest Perspectives on Firm Compliance."

 

This new two-part article, from Bates Compliance Reg BI leaders and our Bates Research team, is an overview of the current state of play on the impending SEC Reg BI rule: how we got here, what the rule requires and what firms need to have in place before the final compliance implementation date on June 30, 2020.

Regulators have announced that they will be reviewing firm’s preparedness and will examine firm’s compliance with Reg BI, Form CRS and related guidance following the deadline. It is therefore imperative that firms have a Reg BI plan in place and develop core compliance and supervisory processes and components now to achieve regulatory expectations and overcome scrutiny.


Learn More:

 
The Bates Compliance Reg BI Team is available to advise, guide and implement a selective or full suite of Reg BI services.
Explore other White Papers from Bates Research to help you understand the legal, regulatory and compliance issues at hand.

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01-16-20

OCIE to Prioritize Reg BI Compliance in 2020 Examinations

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The SEC Office of Compliance Inspections and Examinations ("OCIE") set out their 2020 examinations priorities in an annual report issued last week. The report reminds registered entities that all its priorities are within the SEC’s mandate to protect investors, facilitate capital formation, and maintain fair, orderly and efficient markets. The report is, in effect, a notice to the industry and chief compliance officers to address potential vulnerabilities in compliance programs and practices in order to minimize retail investor and market risks.

This year, OCIE leaders highlighted a wide variety of continuing and emerging concerns. Bates Group tracks these risks and articulated priorities from year to year (see chart below).

OCIE 2020 PRIORITIES

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SEC Examination Priorities Year-To-Year Comparison Chart 2020
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© 2020, Bates Group LLC
Source: OCIE 2020 National Exam Program Examination Priorities (Compiled by Alex Russell, Bates Group LLC)

OCIE explained that these priorities should be viewed in light of the rapidly changing registered investment adviser market, the recently adopted rules on broker-dealer and investment adviser conduct standards (Regulation Best Interest) and other significant financial technology and market developments. A good portion of the report is dedicated to explaining this context. Here’s what OCIE had to say.

Registered Investment Advisers: Beware

OCIE leadership explained that examination coverage for RIAs was increasingly imperative, given (i) that the OCIE is “the primary, and often only, regulator responsible for supervising this segment of financial firms;” (ii) that the number of RIAs it supervises is now 13,475, up from 11,500 five years ago; and (iii) that RIAs now have $84 trillion in assets under management, up from $62 trillion five years ago. Examinations of RIAs constituted 2,180 of the 3,089 examinations OCIE completed in FY 2019. By contrast, OCIE examined 350 broker-dealers, 110 securities exchanges, 90 municipal advisors and transfer agents and 15 clearing agencies. These numbers do not include OCIE examinations of the Financial Industry Regulatory Authority (FINRA).

Notably, the OCIE pointed out that its examination coverage rates over registered investment advisers (RIAs) may suffer in 2020 due to perennial staff shortages. However, the Office made clear that it prioritizes keeping pace with year-over-year increases in examination rates for RIAs. In FY 2018, OCIE’s examination coverage of RIAs was 17 percent, and in FY 2019 it was 15 percent. OCIE made a point of noting that the decline in the past year was the result of a 35-day lapse in appropriations, and that examinations of RIAs actually increased by 10 percent over a five-year period.

Regulation Best Interest: Be Ready

Compliance with Regulation Best Interest (Reg BI) interpretations related to the standard of conduct for investment advisers and the new Client Relationship Summary (Form CRS) are major 2020 examination priorities. The OCIE reminded firms that the compliance date for Reg BI and Form CRS is June 30, 2020, and to expect that OCIE will “engage” during its examinations on firms’ progress toward implementation of the new rules. This is significant, in part, because the SEC continues to clarify Reg BI obligations (see e.g. the revised FAQs just issued by the Division of Trading and Markets).

OCIE stated that it has already “integrated” the Reg BI interpretations into its examination program for RIAs. Beyond the compliance implementation date, its examinations will include an assessment as to a firm’s actual Reg BI implementation, “including policies and procedures regarding conflicts disclosures, and for both broker-dealers and RIAs, the content and delivery of Form CRS.”

OCIE restated past examination priorities as they relate to retail investors. (See Comparison Chart above.) These include a focus on certain complex products and vulnerable investors. Consistent with its Reg BI focus, OCIE stated that its 2020 examinations will look at disclosures relating to fees, expenses and conflicts of interest and the “controls and systems [intended] to ensure those disclosures are made as required and that a firm’s actions match those disclosures.” This includes supervision of outside business activities and “any conflicts that may arise from those activities.”

For RIAs, OCIE plans to examine whether they have fulfilled their fiduciary duties of care and loyalty. The OCIE relayed that it “has a particular interest” in the accuracy and adequacy of disclosures provided by RIAs concerning offers to clients on new and emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.

For broker-dealers, OCIE highlighted that examinations will focus on transfer agent handling of microcap distributions and share transfers, sales practices, and supervision of high-risk registered representatives. More generally, OCIE emphasized that it will assess recommendations and advice given to (i) seniors and “those targeting retirement communities” and (ii) teachers and military personnel. In conjunction with Reg BI compliance issues, OCIE said it will focus on higher-risk products like private placements, as well as on non-transparent products such as mutual funds and ETFs, municipal securities and other fixed income and microcap securities.

Industry and Technology Risk: Be Careful

The theme of information technology risk cited in the report is broad. OCIE will be “monitoring industry developments and market events” to assess broad risks and consequences for both firms and retail investors.

For registered entities, OCIE said it will examine the use of technology by third-party vendors and information security in general, including proper configuration of network storage devices and retail trading information security. The OCIE also emphasized that it will examine for (i) SEC registration eligibility, (ii) cybersecurity policies and procedures, (iii) marketing practices, (iv) adequacy of disclosures, and (v) the effectiveness of compliance programs. For RIAs in particular, OCIE said it will focus on the protection of clients’ personal financial information including on governance and risk management, access controls, data loss prevention, vendor management, training, and incident response and resiliency.

As to retail investors, on digital assets and electronic investment advice, OCIE will be examining for (i) investment suitability, (ii) portfolio management and trading practices, (iii) safety of client funds and assets, (iv) pricing and valuation, and (v) supervision of employee outside business activities.

Resources and Examinations

OCIE leaders acknowledged the resource challenges to fulfilling its mandate and said that it will continue to invest in expertise, technology tools and data analytics to “identify potential stresses on compliance programs and operations, conflicts of interest, and … issues that may ultimately harm investors.” OCIE implied that it will use these tools to determine how to select firms for examinations and remarked that “broker-dealers may be selected for examination based on factors such as employing registered representatives with disciplinary history, engaging in significant trading activity in unlisted securities, and making markets in unlisted securities.”

For RIAs, OCIE said it would look at selecting firms that have never been examined or have not been examined for years in order to determine whether compliance programs “have been appropriately adapted in light of any substantial growth or change in their business models.” In addition, OCIE stated that it will “prioritize examinations of RIAs that are dually registered as, or are affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers.” It will examine compliance programs to address best execution risk, prohibited transactions, fiduciary advice, and conflict disclosures related to these arrangements. OCIE will also examine firms that use third-party asset managers to advise clients in order to consider the extent of these RIAs’ due diligence practices, policies, and procedures. OCIE promises to be diligent about narrowly targeting and protecting the investor information it collects and noted some of the cross-border compliance issues it faces in covering almost a thousand off-shore RIAs that manage over $10 trillion in assets.

Other Highlights

The OCIE also emphasized that it will be examining for the following:

  • Anti-Money Laundering (AML) ProgramsOCIE seeks to prioritize examining broker-dealers and investment companies for compliance with their AML obligations. In particular, the Office will review for customer identification programs and customer due diligence, beneficial ownership compliance, and Suspicious Activity Report (SARs) compliance. OCIE will also review to ensure timely and independent tests of AML programs.
  • Algorithmic Trading – OCIE will examine for controls and supervision around the use of automated trading algorithms, explaining that broker-dealers have expanded their use into multiple asset classes, which has the “potential to adversely impact market and broker-dealer stability.” This includes “the development, testing, implementation, maintenance, and modification of the computer programs that support their automated trading activities and controls around access to computer code.”
  • Broker-Dealers that Hold Cash and Securities – OCIE will be examining to determine if broker-dealers are safeguarding these assets “in accordance with the Customer Protection Rule and the Net Capital Rule,” and to check for compliance with internal processes, procedures, and controls.
  • MSRB – OCIE will prioritize review of municipal advisor fiduciary duty obligations to clients, fair dealing with market participants, and the disclosure and conduct of municipal advisers regarding conflicts of interest.” OCIE also said it will review for compliance with recently adopted MSRB rules on advertising.
  • FINRA – OCIE plans to continue to conduct risk-based oversight examinations of FINRA, including oversight of the examinations FINRA conducts of certain broker-dealers and municipal advisors.

Conclusion  

In its report, OCIE leadership deliver several messages to the firms it examines, including identifying the hallmarks of effective compliance.  Most importantly, they underscore that the people and compliance programs play a critical role and really do matter.  Effective compliance requires (i) establishing a culture of compliance for the firm; (ii) a commitment by firm executives that compliance is “integral” to firm success: and (iii) “tangible” support for compliance in all operations and throughout all levels of the firm. They stress that the chief compliance officer must be fully empowered with the “responsibility, authority, and resources to develop and enforce policies and procedures of the firm.” And, finally, they remind firms that compliance should be “incorporated” into firm operations and business developments, including product innovation and new services.

 

For more information concerning Bates Group's Practices and services, please visit:

Bates Compliance Solutions

Reg BI Services and Support

RIA Compliance Services

Broker-Dealer Compliance Services

Bates Investor Risk Assessment for Vulnerable and Senior Investors

Bates AML and Financial Crimes

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

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01-10-20

FINRA Releases 2020 Risk Monitoring and Examination Priorities Letter

FINRA Releases 2020 Risk Monitoring and Examination Priorities Letter

FINRA has announced their regulatory and examination priorities for the upcoming year. You can read the letter, with an introduction by FINRA President and CEO Robert Cook, here. New for this year is a focus on Regulation Best Interest (Reg BI) and Form CRS (Client Relationship Summary).

Stay tuned to the Bates News page for our commentary on FINRA’s 2020 objectives and how they may impact your legal, regulatory and compliance matters.

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01-09-20

Massachusetts State Fiduciary Rule and NAIC Annuity Standards Proposals Continue to Move Forward

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Photo by Ken Lund under CC BY-SA 2.0

Bates Group continues to track a host of issues affected by the adoption of Regulation Best Interest (“Reg BI”), the 2019 package of rules and interpretations from the SEC setting standards of conduct for broker-dealers and independent advisers. These include a variety of state responses to the federal regulation, as well as Reg BI impacts on issuers of other complex financial products sold through brokers and advisers, specifically, recommendations to consumers on transactions involving annuity products. Here are some of the latest developments.

Massachusetts Introduces Revised Fiduciary Regulation Proposal

In prior posts, Bates Group reviewed legal challenges to the new federal regulation from state attorneys general, state legislative and regulatory initiatives (see here and here) designed to provide an alternative regulatory framework to protect in-state investors, and the North American Securities Administrator Association (“NASAA”) cautious position toward both these state approaches.

Just before the new year, the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth formally proposed a revised uniform fiduciary conduct standard for broker-dealers, agents, investment advisers and investment adviser representatives that provide financial advice to clients and client prospects in the state. In general, the regulation establishes a fiduciary duty and makes a violation of that duty a sanctionable "unethical or dishonest conduct or practice."

The revised proposal differs in several respects from the preliminary proposal issued last June. One legal analysis notes that, among other things, this new version adds “language expanding a potential breach of fiduciary duties to commodity and insurance products;” establishes the presumption that a fiduciary duty exists simply by the title used by an advisor; and requires an advisor to go beyond disclosure or mitigation of a conflict of interest by requiring efforts to actually avoid such conflicts. The proposed regulation also requires ongoing monitoring of accounts by registrants; bans sales contests, sales quotas, and other incentive programs; further clarifies duty of loyalty and care obligations, as well as existing suitability standards.

The breadth of the proposal has elicited strong reaction. Massachusetts Secretary William Galvin argues directly that Reg BI fails to provide investors the protection they need from harmful conflicts of interest and that his state proposal is the only way to truly strengthen investor protections. In response to the proposal,  Kenneth Bentsen Jr., president and chief executive of the Securities Industry and Financial Markets Association (“SIFMA”) in a public statement said, “We are very concerned that the proposal exceeds the state’s authority, will diminish investor access to advice, products and services and will increase investor costs. We respectfully suggest that you delay any decision making until after Reg BI is fully implemented and the SEC, FINRA, and the Division and other state regulators have the chance to examine firms for compliance.” SIFMA recommended that the Division delay action for at least 18 months and then assess whether any further steps are necessary.

Secretary Galvin’s move to introduce the revised state regulation sets in motion the formal process by which Massachusetts’s fiduciary rule may be finalized and adopted. In so doing, Massachusetts becomes the next state to reach this juncture, (New Jersey’s rule proposal was first,) setting the stage for an inevitable legal battle over whether state or a national standards will prevail.

NAIC Committee Approves Revisions to Annuity Standards

Bates has also been following the efforts of the National Association of Insurance Commissioners (“NAIC”) to revise standards and procedures for providing recommendations to consumers on transactions involving annuity products. As we previously covered, an NAIC Working Group has been attempting to develop a framework that would revise its “Suitability in Annuity Transactions Model Regulation with the federal Reg BI standards and accommodate 2019 New York regulations (Regulation 187) which require insurers to establish policies and procedures so that broker-dealers put the “best interest” of consumers ahead of their own.

On December 30, 2019, NAIC’s Life Insurance and Annuities Committee took an important step by approving revisions to the model regulation. In general, the revisions specify that the producer must satisfy obligations of care, disclosure, conflict of interest and documentation.

The regulators specifically pointed out that the model regulation does not require a fiduciary relationship between the producer and the customer and that it provides a safe harbor for producers that comply with the SEC’s Regulation Best Interest. (Notably, New York voted against it at Committee.) That said, the model regulation requires an agent to be able to demonstrate that a recommendation is in the consumer's best interest (the basis of which must be included in a written record), and must identify, manage and disclose material conflicts of interest. The model regulation now heads to the NAIC Executive Committee and Plenary for a final vote before the states may consider its adoption.

Conclusion

The Massachusetts and NAIC processes demonstrate the difficulty in reaching consensus around investor and consumer protection standards. The Massachusetts proposal will serve to build momentum for states to adopt fiduciary standards on broker-dealer recommendations to their clients. These state fiduciary rules, however, will face their test in court. No doubt the NAIC’s Reg BI-friendly model regulation for annuity products may possibly face similar state-by-state reactions and similar legal tests. Meanwhile, firms are left with heavy compliance burdens and lingering uncertainty.

 

Bates Group's Compliance team can help your firm through the implementation phase of Reg BI and navigating compliance concerning investor and consumer protection standards. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com.

For information about Bates Group’s Insurance and Actuarial practice services, please contact Managing Consultant Greg Faucher.

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01-07-20

SEC Office of Compliance Inspections and Examinations Announces their 2020 Examination Priorities

SEC Office of Compliance Inspections and Examinations Announces their 2020 Examination Priorities

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has announced their exam priorities for the upcoming year. You can read the press release here.

Stay tuned to the Bates News page in the upcoming weeks for our expert commentary on the SEC's 2020 objectives, how they compare to other years, and how they may impact your legal and compliance matters in the future.

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12-12-19

Banking Agencies Clarify SARs Requirements for Hemp, Possibly Paving the Way for Cannabis

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Photo by Matteo Paganelli on Unsplash
 

A key to understanding new Bank Secrecy Act (“BSA”) guidance on the “legal status of commercial growth and production of hemp” can be found in provisions of the Agriculture Improvement Act (the “Farm Bill”) signed into law in December of last year. As Bates has noted, bipartisan support for legalization of hemp agricultural products was driven in part by Senate Majority Leader Mitch McConnell (R-KY), who included the provisions into the legislation and pointed out that “the crop is being grown in 101 out of 120 counties in Kentucky.” That legislation distinguished and removed hemp (though not marijuana) as a controlled substance under law, and directed the USDA, together with the U.S. Attorney General, to regulate its production.

Interim rules, issued by the USDA in late October 2019 (to accommodate the 2020 planting season), established a federal licensing approval plan that allows state departments of agriculture and tribal governments to submit plans for monitoring and regulating hemp production. They also establish a federal plan for producers that do not have a USDA-approved plan in their state or territory. The regulations (i) require retention of information “on the land where hemp is produced,” (ii) testing hemp to ensure that certain chemicals (i.e. THC) do not exceed levels that, by law, would make them a controlled substance, (iii) procedures for disposal of hemp that violates those levels, and (iv) other licensing and registration requirements.

Regulatory Clarification under BSA

Given this context, the Federal Reserve Board, the FDIC, FinCEN, the OCC and the Conference of State Bank Supervisors issued a statement clarifying BSA obligations under these new USDA interim rules. (The interim period runs from October 31, 2019 until November 1, 2021.)

The guidance makes clear that banks are no longer obligated to file Suspicious Activity Reports (SARs) on customers that produce hemp, since hemp is no longer on the controlled substance list. However, the agencies also make clear that institutions must still comply with BSA requirements, and, therefore, financial institutions serving hemp producers must establish and maintain effective compliance programs that address the complexity and risks involved in the production of hemp. As with other regulated entities, this means compliance with customer identification, suspicious activity reporting, currency transaction reporting, and risk-based customer due diligence, including the collection of beneficial ownership information for legal entity customers. Consequently, these financial institutions must still file SARs based on suspicious activity.

Potential Impact of BSA Clarification

The agencies’ issuance of a clarifying statement on BSA obligations related to hemp production provisions under the Farm Bill and USDA interim rules, paves the way for similar regulatory adjustments should the Secure and Fair Enforcement Banking Act of 2019 ("SAFE Banking Act") become law.                                                                                           

As described in a previous Bates Research post, the SAFE Banking Act creates a safe harbor for depository institutions that provide banking services to state-licensed cannabis businesses. As with hemp before the Farm Bill, financial institutions must file SARs for cannabis firms, regardless of the legal status of cannabis under state law. Should the SAFE Act—which recently passed in the House of Representatives—become law, proceeds from cannabis businesses would not be considered proceeds from illegal activity. That would open the door to the same kind of regulatory adjustments as the newly clarified treatment for hemp production.

Similarly, should the "Marijuana Opportunity Reinvestment and Expungement Act of 2019" (“the MORE Act”)—which passed a vote out of the House Judiciary Committee—become law, cannabis would be removed from the list of federally controlled substances and could potentially be dealt with under the treatment now afforded hemp. (See Bates coverage of the MORE Act here.) Though the MORE Act and SAFE Banking Act have made progress in the House, time is running out for action on the bills by the Senate. Bates will continue to keep you apprised of developments in this area.

 

To learn more about Bates Group’s Financial Crimes and AML services, please contact Managing Director Edward Longridge at elongridge@batesgroup.com

Ed will also be speaking at SIFMA's Anti-Money Laundering and Financial Crimes Conference, February 5-6, 2020 in New York, NY. Visit the Bates booth to meet Ed and discuss AML and Financial Crimes solutions for your firm.

 

For additional information, please follow the links below to Bates Group's Practice Area pages:

Bates AML and Financial Crimes

Bates Compliance

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Consulting and Expert Testimony

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12-05-19

Do The SEC Enforcement Directors’ 2019 Successes Preview Their 2020 Priorities?

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(photo: SEC Enforcement Division Co-Directors Stephanie Avakian and Steven Peikin)
 

Despite “significant headwinds,” including “adverse” holdings in Supreme Court cases and a significant disruption in Congressional funding in the beginning of the year, Co-Directors of the SEC Enforcement Division Stephanie Avakian and Steven Peikin announced that their efforts in FY 2019 have been successful. In a recently published Annual Report, the Directors described enforcement actions that held wrongdoers accountable, removed bad actors, stopped frauds and prevented losses. The report also highlighted that many of the enforcement actions resulted in harmed investors being made whole. According to the report, SEC enforcement in 2019 concentrated on two priorities: retail investor protection and combatting cyber threats. Here are some of the key observations.

Share Class Disclosure

The report highlighted “extraordinary results” from the agency’s Share Class Selection Disclosure Initiative, an effort intended to protect retail investors from failures by investment advisors to disclose conflicts of interest on different share class compensation schemes. (See here for our review of the latest alert on the SEC’s efforts concerning investment advisor compensation issues.)  According to the report, the SEC, to date, has ordered 95 investment advisor firms that self-reported their disclosure failures to return $135 million to impacted investors. While the Division of Enforcement did not impose civil penalties in these cases (part of the incentive to report under the initiative), participating firms were required to align their practices and disclosures going forward.

The division was very active in “standalone” cases to protect retail investors. The numbers detailed in the report reflect this priority.  Of the 862 enforcement actions brought in 2019, 526 were standalone actions brought in federal court or as administrative proceedings. (The others include “follow on” actions tied to other regulators or criminal authorities, and proceedings to deregister public companies that were delinquent in Commission filings.) The number of standalone cases breaks down as follows: investment advisory/investment company issues (constituting the greatest increase in enforcement actions at 36%), securities offerings (21%), issuer reporting/accounting and auditing matters (17%), broker-dealers issues (7%), insider trading (6%), and market manipulation (6%). Other areas include FCPA (3%) and Public Finance (3%). The charts below provide the numerical breakdown for comparison with FY 2018.

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(source: U.S. SEC)
 

Furthermore, the division reported a total of $3.248 billion in disgorgement of ill-gotten gains, with additional penalties of $1.101 billion.  This represents, in aggregate, a $404 million (10%) increase year-over-year.

The SEC also noted recent retail investor protection efforts under its Retail Strategy Task Force (“RSTF”). The RSTF is comprised of enforcement personnel from around the country and works with SEC staff employing data-driven analytics to help identify financial market practices that can harm retail investors. It also supports retail investor advocacy and outreach. The report underscored new initiatives to educate teachers, veterans and active duty military personnel on the basics of savings and investment, fees and expenses, retirement programs, and “the red flags of investment fraud.”

Cyber Enforcement Activity and Digital Assets

As part of its cybersecurity focus, the division counted victories in investigating “violations involving distributed ledger technology, cyber intrusions, and hacking to obtain material, nonpublic information.” Specifically, the division described its increasingly sophisticated capability and developing approach to distributed ledger accountability and misconduct. The division said that recent settlements with issuers of digital assets (ICOs) helped to establish registration and reporting frameworks for future resolutions. The commission also brought actions against third parties for violating securities laws regarding the offer, sale and promotion of digital asset securities. Legally, the SEC stated that its enforcement actions in this space “send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.”

Market Integrity Issues

Among its broad efforts on cybersecurity the commission conducted investigations of public companies and regulated exchanges for potential violations of system compliance rules intended to ensure the security of the technology infrastructure of U.S. securities markets. The SEC said that in the last few years, it initiated investigations associated with accounting rule irregularities that pointed to such violations and concluded that “having sufficient internal accounting controls plays an important role in an issuer’s risk management approach to external cyber-related threats.” Further, the SEC described actions it took against financial institutions for improper conduct that undermined market integrity in connection with the “pre-release” of American Depository Receipts (ADRs).

Reporting and Trading

The SEC emphasized its developing use of analytics to identify trade-related impropriety. According to the report, for example, the identification of the overseas hackers who accessed the SEC’s EDGAR system to steal nonpublic information for use in illegal trading “showcased” the agency’s expanding capabilities to identify patterns in the suspicious activity. Central to this approach is the importance of accurate financial and other disclosures—“the bedrock of our capital markets”—critical to the detection, remediation and punishment of misconduct by individuals and corporations. The report went on to list a number of cases that focused on financial statement integrity, the accuracy of issuer disclosures, and the demonstrable willingness by the agency to punish significant corporate wrongdoing.

Additional Context

The Co-Directors lauded the efforts of the division, but noted that they were also limited by decisions from the Supreme Court, notably the 2017 holding in Kokesh v. SEC, which “continues to impact adversely the Commission’s ability to return funds to investors injured by long running frauds.” In that case, the court found that disgorgement constitutes a “penalty,” and is therefore subject to the five-year statute of limitations. As a result, the SEC cannot seek that remedy for ill-gotten gains older than five years. The Division calculated that the ruling forced it “to forego approximately $1.1 billion” and added that it does not include the impact Kokesh has had on SEC resource allocations, which were redirected toward cases with greater potential for recovery.

The Co-Directors also noted the impact of Lucia v. SEC, a 2018 decision that found the way the agency appointed Administrative Law Judges violated the “appointments clause” of the U.S. Constitution. The ruling forced a stay, and approximately 200 administrative proceedings were reassigned. Though many of the matters resolved without the need to have a rehearing, there were others that required a full rehearing before new ALJs and the co-directors said they anticipate additional rehearings in the next fiscal year.

Conclusion

It is clear that the Division of Enforcement has been aggressive this year, despite continued limitations on resources, evolving standards for retail investors and significant legal and cyber-regulatory developments. The Co-Directors provide a clear picture of the management challenges as well as the importance and reliance on data analytics to keep up with the changes. The SEC is likely to issue its Examination priorities soon, and it will be interesting to see if the enforcement trends identified in this report will be reflected in those priorities. Bates Research will continue to keep you apprised.

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11-21-19

SEC Zeroes in on Investment Adviser Compensation Conflicts

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(photo credit: U.S. SEC under CCPL 2.0)
 

On October 18th, 2019, more than a year after the launch of the SEC Share Class Disclosure Initiative and targeted enforcement activity, the SEC Division of Investment Management issued information clarifying conflicts of interest raised by different types of investment adviser compensation. In a new set of FAQs, SEC staff reviewed general conflicts of interest disclosure requirements and offered insight on the “material facts” that need to be disclosed concerning mutual fund share classes and an adviser’s receipt of revenue-sharing payments. Here’s a closer look.

Why It’s Important

In a recent regulatory alert, we highlighted recent actions targeting investment advisers by the SEC Enforcement Division. The noted actions were aimed at potential conflicts of interest that arose from revenue-sharing payments and other forms of representative compensation or cost offsets. In general, the actions test whether investment advisers are adequately disclosing potential conflicts of interest consistent with the fiduciary obligations owed to their clients.

These enforcement efforts follow on the heels of the Share Class Disclosure Initiative, an undertaking intended to encourage firms to self-report past violations relating to certain mutual fund share class selection conflicts, and to promptly return money to harmed clients. As Bates has cautioned, the enforcement activity sends firms a strong message to make sure that disclosure concerning revenue-sharing arrangements and other forms of compensation are consistent with SEC interpretations.

New FAQs

The new FAQs cover (i) general compensation disclosure obligations for investment advisers related to recommended investments, (ii) “material facts” that advisers should disclose concerning mutual fund share classes,” and (iii) disclosure requirements related to an adviser’s receipt of revenue-sharing payments. The FAQs also make clear that any amendments to share class or revenue-sharing arrangements made in annual updates are required to be highlighted on Form ADV.

General Compensation Disclosure

The FAQs restate the overarching principles that advisers must disclose financial incentives when recommending investments that are tied to compensation, and that the nature of the compensation affects the disclosure. Staff noted that conflicts are “especially pronounced” when certain share classes of the same funds that do not bear these fees are available.

The FAQs also describe more detailed disclosure obligations required under Form ADV, including the provision of “sufficiently specific facts” to enable clients to give informed consent. This includes “‘information not specifically required by’ the Form or more detail than the Form otherwise requires.”

Importantly, staff made clear (i) that merely reporting that the adviser “may” have a conflict is not adequate disclosure “if the conflict actually exists,” and (ii) that “an adviser should consider these disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment.”

Material Facts on Mutual Fund Share Classes

According to SEC staff, when recommending a mutual fund share class which is tied directly or indirectly to compensation, material facts include the existence and effect of different financial incentives that may lead to conflicts (e.g. those arising from shared incentives between the adviser and a clearing broker, various limitations on share class transactions within a fund, or adviser practices concerning transactions after the initial recommendations). It is also material to disclose how the adviser addresses the conflict, (e.g. on practices related to differences between share classes with different compensation structures for 12b-1 and transaction fees; or whether the adviser “has a practice of offsetting or rebating some or all of the additional costs to which a client is subject.”) The FAQs make clear that these examples are not comprehensive but rather should serve the broader message that all compensation arrangements are on the table.

Material Facts on Revenue-Sharing Payments

An investment adviser is required to disclose any arrangement they may have with anyone who provides an economic benefit for providing investment advice or other advisory services for clients. Under Form ADV, the adviser is obligated to “describe the arrangement, explain the conflicts of interest, and describe how it addresses the conflicts of interest.” The FAQs highlight examples of arrangements in which there are financial incentives provided to the adviser or shared between the adviser and clearing brokers, custodians, funds’ advisers or other service providers. SEC staff warns that such disclosures “should be concise and in plain English.”

Bates Experts Reflect

While the FAQs state explicitly that the interpretations provided do not alter or amend applicable law nor create any new or additional obligations for advisers, the SEC is clearly sending a message that the agency will continue its focus on disclosure and adviser compensation.

Bates Group Securities Litigation & Regulatory Enforcement Managing Director Alex Russell highlights several aspects of the new FAQs. He notes the SEC staff’s expansive view of adviser compensation (e.g. to include areas where a firm saved costs as well as earned fees) and the application of these staff interpretations to investments more broadly. He points out staff’s expectation as to the ongoing nature of the disclosure obligation “beyond point of sale,” underscoring the FAQ warning that “an adviser should consider these disclosure obligations with respect to both recommendations to purchase and recommendations to continue holding an investment.”

Bates Group Managing Director of Compliance Robert Lavigne urges firms to work on the language of their disclosures to ensure not only that they are “concise, direct, appropriate to the level of financial sophistication of the adviser’s clients and written in plain English,” but that they also be explicit and specific (hence, the admonition against the use of the word “may” when a conflict of interests exists). Getting this right will require a deep dive into advisers’ policies and practices as firms can no longer rely on longer disclosures or references to “potential conflicts” to withstand examination or enforcement scrutiny.


About Bates:

Bates Group stands ready to support firms to ensure that their revenue sharing arrangements and other forms of compensation are consistent with SEC interpretations. Bates is actively engaged in providing assistance to firms responding to enforcement inquiries, providing analysis of large volumes of data to identify accounts that have been impacted by revenue-sharing arrangements, without inappropriately remediating those that have not been impacted.

Recently, on behalf of over twenty major national and regional financial institutions, Bates provided important assistance to firms and their counsel participating in the SEC’s Share Class Selection Disclosure Initiative and related SEC Examinations, as well as to firms addressing FINRA’s recent 529 Share Class Initiative. As a result, those companies have avoided unwarranted remediation costs as well as reputational harm.

 

Contact:

Alex Russell, Managing Director, Securities Litigation and Regulatory Enforcement 

Robert Lavigne, Managing Director, Bates Compliance

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10-31-19

FINRA Issues 2019 Report On Exam Findings

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FINRA issued its annual Report on Examination Findings and Observations on October 16th. Like last year’s Report, the 2019 version highlights selected firm compliance violations and provides “observations” on how firms can improve their programs and address “perceived weaknesses that elevate risk.”

The report is divided into four general categories of regulatory oversight: (i) supervision and sales practices, (ii) firm operations, (iii) market integrity, and (iv) financial management. Within each category, FINRA selected key areas of concern that have been the subject of significant regulatory activity over the past year—primarily, rule changes and enforcement. This year, the FINRA report leads with supervision, pre-Regulation BI suitability, anti-money laundering and cybersecurity. By prioritizing these high-profile subjects in this way, the Report puts firms on notice regarding the types of enforcement actions regulators might bring going forward. Here, we take a closer look at these priorities and note additional compliance concerns raised in the Report.

Supervision, Sales Practices and Firm Operations

The new examinations report emphasizes adequate supervision across all categories, underscoring many of the newly adopted and amended rules. FINRA warned that firms are expected to evaluate which new and amended laws and regulations apply to their business, and that firms should put in place adequate supervisory procedures and training programs to comply with these expectations.

Specifically, FINRA cited a host of failures to update processes and written supervisory procedures related to, for example, new fixed income mark-up disclosure requirements, new trusted contact person information requirements, new requirements on temporary holds and record retention requirements (related to the financial exploitation of specified adults) and new anti-money laundering program requirements (including FinCen’s Customer Due Diligence rule obligations).

In addition, FINRA found supervision failures related to branch activities. These failings include inadequate understanding of products and services offered through these branches, failures to conduct adequate branch inspections and failures to take corrective action.

Other supervisory failures noted in the Report include inadequate recordkeeping and reporting, as well as failures to establish and maintain processes to detect or prevent the falsification of documents.  FINRA also found supervisory failures on restricted trading of insider accounts, margin accounts and options accounts.

Suitability

The Report highlights a perennial area of focus, suitability. This year, however, FINRA emphasized that its review of suitability failures concerned pre-Regulation Best Interest standards and did not address issues raised by the new regulation.

The highlighted failures signal that FINRA will continue to examine the suitability of recommendations “in light of a customer’s individual financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors” as a high priority issue. The Report identifies specific supervisory failings. These include inadequate (i) processes necessary to identify patterns of unsuitable recommendations related to exchanges and their corresponding products, fees, costs and product values, (ii) supervisory systems that were not designed to detect red flags on unsuitable transactions,  (iii) supervision over changes to customer account information and (iv) supervision of trading activity that raise suitability red flags.

FINRA also took action against registered representatives that recommended unsuitable complex options strategies to customers who did not have the sophistication to understand the options, and against brokers for failing to implement trade limits and other controls to identify and prevent trading in options that exceeded customer pre-approved investment levels.

Anti-Money Laundering

FINRA focused on two areas of AML compliance concern. First, it identified deficiencies in systems and processes necessary for adequate AML transaction monitoring. FINRA found (i) failures to tailor such monitoring to address the firm’s particular business, (ii) failures to detect and report suspicious activity, and (iii) failures to detect red flags that might indicate an intent to manipulate stock prices or that may indicate a need to verify wire transfer instructions. Second, FINRA expressed concern for registered representatives’ overreliance on clearing firms to handle transaction monitoring and suspicious activity reporting.

CyberSecurity & Digital Communications

In the form of “observations,” FINRA notes how cybersecurity attacks are on the rise, both in terms of volume and sophistication. As a result, the self-regulatory agency wants firms to be vigilant and ensure the development and implementation of effective policies and procedures that address the protection of customer records and information. To this end, FINRA reminded firms to tailor their programs in the context of their business model and risk profile.

Specifically, FINRA advised firms to (i) develop, implement and maintain cybersecurity controls for branch offices in order to protect confidential data; (ii) document policies and procedures for vendors and third parties that provide services and handle sensitive client information; (iii) establish response plans for cybersecurity incidents; (iv) employ data protection encryption for all confidential information; (v) timely apply system security patches and establish appropriate data access controls (including two-factor authentication) to ensure protection of confidential information; (vi) ensure robust cybersecurity training;  and (vii) implement change management procedures as necessary to protect sensitive information.

As to examination findings on digital communications, generally, FINRA urged firms to establish policies and processes to identify and respond to red flags when registered representatives were using prohibited channels (personal texting, social media or other sharing applications) in connections with firm business.

Other Examination Highlights

UTMA and UGMA Accounts: FINRA found that some firms did not have adequate supervisory systems in place to ensure that registered representatives knew key facts about their UTMA/UGMA Account customers, and did not have proper monitoring in place to effect timely transfers of responsibility for the account (such as on the date of majority). FINRA also criticized certain firms for allowing custodians to “withdraw, journal and transfer money from UTMA/UGMA accounts months, or even years, after the beneficiaries reached the age of majority.”

Business Continuity Planning: FINRA found that firms had not adequately prepared or maintained required business continuity plans. FINRA found deficiencies in identifying key “mission-critical” systems, such as for order management of trading desks, or vendor systems that processed and managed financing transactions, such as securities lending and repurchase agreements. FINRA also found business continuity plans that (i) contained outdated emergency contact information and principal registrations, (ii) failed to update operational changes, and (iii) failed to ensure sufficient capacity to handle higher levels of activity in the event of a business disruption.

Fixed Income Mark-up Disclosure: FINRA reaffirmed concerns raised in the 2018 Report regarding new rules associated with providing transaction-related pricing information to retail customers for certain trades in corporate, agency and municipal debt securities. This year, FINRA found disclosure inaccuracies (including mislabeling) of registered representative’s sales credits and concessions, and warned against “mischaracterizations” of certain charges which should be reflected as firm compensation. Other deficiencies were found in the miscalculation of “prevailing market price” determinations and inaccurate reporting of execution times.  

Best Execution: FINRA identified issues with the quality of firms’ required execution reviews of customer orders. FINRA reminded firms that such reviews must be performed, at a minimum, on a quarterly basis and on a security-by-security, type-of-order basis. FINRA examinations also uncovered conflicts of interest and related disclosures deficiencies.

Conclusion

FINRA intends for the 2019 Report to be reviewed carefully. While the Report is not intended to be comprehensive, firms would be remiss if they do not consider their own programs and practices in light of the identified compliance failings and concerns. Bates will continue to track regulatory developments and enforcement actions to help you stay ahead of the curve.

 

For additional information and assistance, please follow the links below to Bates Group's practice pages:

Bates Compliance

Bates AML and Financial Crimes

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Consulting and Expert Testimony

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10-25-19

New Federal Legislation Progressing on BSA, Beneficial Ownership and Cannabis Financing

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Photo by Colin Watts on Unsplash

On September 26, a bipartisan group of Senators led by Tom Cotton, (R-AR) and Mark Warner (D-AR), formally introduced their bill to strengthen the authority of the Financial Crimes Enforcement Network (FinCEN) to fight money laundering. As Bates Group reported back in June, the Improving Laundering Laws and Increasing Comprehensive Information Tracking of Criminal Activities in Shell Holdings Act (“ILLICIT CASH Act”) would, among other things, establish federal reporting requirements that mandate all beneficial ownership information be maintained in a comprehensive federal database, accessible by federal and local law enforcement. The Act would also require the reporting of beneficial ownership information for domestic shell companies. A similar bill, sponsored by Congresswoman Carolyn Maloney, titled the Corporate Transparency Act (“CTA”), passed a vote in the House of Representatives this week, 249-173. 

The House of Representatives also passed its version of the Secure and Fair Enforcement Banking Act of 2019 ("SAFE Banking Act"). As described in a Bates Research article early this August, the SAFE Banking Act would remove legal uncertainty for regulated banks and credit unions that provide banking services to cannabis businesses. The bill provides a safe harbor from federal anti-money laundering and regulatory enforcement actions for insured depository institutions.

These bills have the potential to significantly impact AML/BSA compliance programs. Here’s a closer look.

The Illicit Cash and corporate transparency Acts

In a recent Bates Research article on FinCEN, we noted that Director Kenneth Blanco publicly appealed for legislators to overhaul the BSA and provide additional federal authority to close loopholes left open by the Customer Due Diligence (“CDD”) Rule. Director Blanco advocated for more efficient law enforcement access to personal identity information. In particular, he was seeking the authority to collect beneficial ownership information at the “corporate formation stage” to prevent “sophisticated criminals of all kinds, including terrorists,” from establishing shell companies that “mask and further their criminal activity, to invest and buy assets with illicit proceeds.”

The ILLICIT CASH Act and the CTA respond directly to Director Blanco’s concerns. As described in the official legislative summary, of the ILLICIT CASH Act, the bill “comprehensively updates the BSA for the first time in decades and provides a coherent set of risk-based priorities in statute.” The Act (i) establishes “a comprehensive federal database, with strict privacy protections, accessible by federal and local law enforcement” and (ii) requires shell companies to report their beneficial owners, in order to prevent “exploitation of U.S. companies.” Further, the bill (iii) requires and improves “routine coordination, communication and feedback among financial institutions, regulators, and law enforcement to identify suspicious financial activities;” (iv) encourages greater data sharing “so that patterns of suspicious activities can be more easily tracked and identified;” and (v) provides new processes to encourage innovation.

Other highlighted provisions of the Act concern:

  • recruitment and retention of top talent and the creation of a “hub” of investigatory expertise at FinCEN;
  • the hiring of a Treasury liaison to improve communications about AML rules, regulations, and examinations;
  • the sharing of metrics on AML data and trends from financial institutions for law enforcement purposes;
  • the periodic feedback by regulators to financial institutions on their suspicious activity reports;
  • the protection of personally identifying information;
  • new recordkeeping requirements on foreign banks and new rules that compel them to comply with subpoenas;
  • updates to certain statutory definitions to include digital currency.

The House action on the CTA reflects real movement on the issue. Like the ILLICIT CASH Act, the CTA requires all corporations and LLCs to disclose their true “beneficial owners” to FinCEN and to create a federal database of beneficial owners. The proposed database is expected to be available to law enforcement agencies, and to financial institutions (with customer consent, consistent with “Know-Your-Customer” compliance obligations.)  Otherwise, the bill exempts those entities already covered under SEC or state regulation.

The formal introduction of the ILLICIT CASH Act in the Senate and the passage of the CTA in the House are significant developments. These bipartisan legislative successes will dramatically empower both state and federal law enforcement.

The SAFE Banking Act

The formal purpose behind the SAFE Banking Act is “to increase public safety by (i) ensuring access to financial services to cannabis-related legitimate businesses and service providers and (ii) reducing the amount of cash at such businesses.” The SAFE Banking Act accomplishes this by creating a safe harbor for depository institutions that provide banking services to state-licensed cannabis businesses. Further, under the SAFE Act, proceeds from such businesses would not be considered proceeds from illegal activity. This means that these loans, and collateral provided by financial institutions, are effectively protected from anti-money laundering laws and the risk of asset forfeiture.

As a consequence, the SAFE Banking Act serves as an open invitation for financial institutions to fully engage in providing financial products and services to cannabis businesses. For the cannabis businesses themselves, the Act allows them full access to capital outside of cash transactions—this serves the goal of reducing reliance on cash for these businesses.

Other notable provisions of the Act:

  • prohibit regulators from taking adverse or corrective supervisory action on loans made to cannabis businesses, including their owners and employees, or real estate and equipment leased to them;
  • protect from criminal, civil and administrative forfeiture any loans or other financial services provided to cannabis businesses or owners of real estate or equipment leased or sold to them;
  • impose new obligations on FinCEN to provide written guidance and examination procedures for financial institutions that provide services to cannabis businesses;
  • promote diversity and inclusion in the cannabis industry. 

The passage of the SAFE Banking Act by the House of Representatives is a major step toward the normalization of cannabis-related businesses. That said, the Act does not legalize cannabis, which remains a Schedule I drug under federal law—it merely carves out a safe harbor for state-licensed businesses.  Consequently, even after the SAFE Act becomes law, some risk remains that an institution may continue to be in violation of federal law. This remains a point of contention and a source for other legislative initiatives, but it does not diminish the opening up of the cannabis marketplace. 

Conclusion

“The bipartisanship exhibited with respect to the ILLICIT CASH Act and the SAFE Banking Act is notable,” said Bates AML and Financial Crimes Managing Director Edward Longridge. “Though these legislative efforts have not yet reached fulfillment, they do seem to be moving steadily down the path to becoming law. Until then, financial institutions must continue to comply with the prevailing AML frameworks.” Bates will keep you apprised as these and other legislative developments play out.

To learn more about Bates Group’s Financial Crimes and AML services, please contact Edward Longridge at elongridge@batesgroup.com.

 

For additional information, please follow the links below to Bates Group's Practice Area pages:

Anti-Money Laundering and Financial Crimes

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

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10-10-19

FinCEN Leaders Highlight Innovation, Identity Information and “Culture” as Keys to AML Approach

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In two speeches delivered in September 2019, leaders of the Financial Crimes Enforcement Network (FinCEN) laid out their thinking behind the agency’s current regulatory approach to combatting money laundering and terrorist financing. FinCEN Deputy Director Jamal El-Hindi focused on innovation and reform of the Bank Secrecy Act (BSA) and emphasized compliance implementation and supervision in the non-bank financial institution (NBFI) sector. He also addressed federal coordination with state supervisors and delivered a message on the need to develop a “culture of compliance” in the context of national security.

In the second speech, FinCEN Director Kenneth Blanco described the use of financial data to fight money laundering and the vulnerability and abuse of personally identifiable information (PII) by bad actors. He too, urged financial institutions to embrace compliance as the surest way to prevent fraud and combat financial terrorism. Together, these speeches offer a clear picture of how FinCEN expects financial and technology firms to approach their compliance efforts. In this article, Bates takes a closer look at FinCEN’s message.

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FinCEN Deputy Director Jamal El-Hindi

In his prepared remarks for the September 11, 2019, Money Transmitter Regulators Association Conference, Deputy Director El-Hindi discussed how the current Bank Secrecy Act/Anti-Money Laundering (BSA/AML) framework can be improved through regulatory reform. He emphasized three points: (i) a full embrace of the opportunities presented by fintech and regtech innovation, (ii) greater supervision and oversight into technology firms engaged in the financial markets, and (iii) the establishment of a culture of compliance for the purpose of national security.

Regulatory Innovation

Endorsing innovation as the key to their go-forward strategy, the FinCEN Deputy advocated for greater collaboration between government and industry to help “detect and safeguard against illicit activity.” He positioned FinCEN as a leader among regulators on innovation initiatives and cited a recent joint policy statement that encourages banking institutions to create pilot programs that “expose gaps in banking anti-money laundering compliance programs.”

Non-Bank Supervision

Mr. El-Hindi shared that FinCEN is actively prioritizing the oversight of NBFIs by: (i) leading examinations of currency exchangers and other specialty providers, (ii) working to identify and collate new sources of data (geographical, operational, and transactional) that can be used to track trends and vulnerabilities, and (iii) strengthening the risk assessment framework for compliance. He repeatedly emphasized FinCEN’s efforts to collaborate with foreign counterparts that have similar regulatory regimes (Canada, the U.K., Australia, et al.) as well as other federal and state examiners.

Culture and Compliance

The Deputy Director described how FinCEN expects financial firms with international reach to be leaders in fostering a culture of compliance. At the same time, he also acknowledged the challenges: international cultural differences, corruption, cross border regulatory regimes with different “underpinnings,” and certain unique elements of the U.S. financial and legal system. He offered an update to FinCEN’s 2014 Guidance on the subject, advising that (i) financial leaders must be engaged and must provide the necessary human and technological resources to address the risk, (ii) revenue interests should not compromise compliance, (iii) there should be greater sharing of information within an organization, and (iv) there should be independent compliance testing to ensure effectiveness. He urged business leaders not to take the benefits of cooperation and collaboration for granted.

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FinCEN Director Kenneth Blanco

In his remarks prepared for a September 24th, 2019 Federal Identity (FedID) Forum and Exposition, Director Kenneth Blanco applied many of the themes discussed in Mr. El-Hindi’s address to the management and use of identity information. The Director emphasized the fundamental nature of identity information to the regulatory framework affecting every aspect of our “lives, our businesses, and how we interact with customers and vendors in person and online.” Beyond a description of FinCEN’s mandate, his speech was devoted to how FinCEN is concentrating on securing identity information and how bad actors leverage it for gain.

Identity Information as the Key to the AML/CFT Regulatory Framework

Director Blanco explained how FinCEN requires financial institutions to “understand whom they are doing business with and to continue to monitor their risk throughout the business relationship.” He described how identity information—as informed through reporting and recordkeeping—is critical to law enforcement in order to ferret out illicit transactions and money laundering. (Reports are made available to approximately 12,000 authorized law enforcement and regulatory users all over the country.)  He emphasized that the importance of beneficial ownership information, in particular, cannot be understated in terms of national security. He lauded the Customer Due Diligence Rule (CDD Rule) as essential to a “system in which we can identify the trail of transactions and actual account owners” and disrupt illicit activities and dismantle criminal and terrorist networks. 

He described how the CDD Rule closed “regulatory gaps” but went on to call for further legislative measures. Specifically, he recommended new rules that would require the “collecting of beneficial ownership information at the corporate formation stage.” This would prevent “sophisticated criminals of all kinds, including terrorists,” from establishing shell companies that “mask and further their criminal activity, to invest and buy assets with illicit proceeds.” He noted that, currently, “there is no federal standard requiring those who establish shell companies in the United States to provide basic, but critical information at company formation.” (See here for a recently introduced Senate bill to improve AML laws.)

Illicit Use of Personally Identifiable Information

Director Blanco offered sobering statistics to describe the extent of the problem of illicit use of personal information. He speculated that “there is a high likelihood that most users of the U.S. financial system have had some information about themselves, whether PII or login information, compromised at some point.” He said that FinCEN receives over 5000 “account takeover” reports every month and estimates that this type of cybercrime may account for $350 million dollars in losses each month. Though banks are the most common targets, he said, “institutions like insurance companies, money services businesses, and casinos” are also affected.* He went on to describe several other cyber fraud typologies or schemes that involve “seemingly legitimate financial activity while creating a degree of separation from traditional fraud detection efforts.” These include: automated clearing house fraud, credit card fraud and wire fraud all enabled through the use of synthetic identities and through account takeovers via fintech platforms.

The common link in these schemes is the compromise of vulnerable business processes like weaknesses in verification and authentication systems for processing payments. Mr. Blanco shared that financial institutions filed SARs that revealed over 600,000 compromised social security numbers affiliated with identity theft.  He relayed that institutions must consider the “entire attack surface and risk exposure to such illicit activity and misuse.” Further, he said that beyond system processes and vulnerabilities, firms should “evaluate the threat posture already affecting them or that has the potential to affect them, such as the availability of customer credential information available for sale on places like darknet marketplaces.”

Innovation and Emerging Technology

Director Blanco reaffirmed Deputy Director El-Hindi’s embrace of innovation, noting potential technology solutions involving digital identity and for improving inclusion, privacy, security, and cost-effectiveness for individuals and organizations. He also expressed a belief that technological innovation holds the key to strengthening the current regulatory framework and may not only improve the fulfillment of a financial institution’s due diligence obligations, but also provide law enforcement with ways to better investigate illegal activity. (Expanding the number of technical indicators in SARs reporting requirements, he said, was a step in that direction.) 

Conclusion

Taken together, these two speeches provide a revealing overview of the approach FinCEN is taking toward addressing and deterring illicit activity. The fulsome embrace of technological innovation is matched by a determination to enlist the private sector—through regulation and promotion of a compliance culture—in the cause. Director Blanco’s appeal for additional authority to close loopholes in the collection of beneficial ownership is noteworthy. Bates will continue to monitor regulatory and legislative efforts at BSA reform.  

 

To learn more about Bates AML and Financial Crimes services, please contact Edward Longridge, Managing Director, Bates AML & Financial Crimes at elongridge@batesgroup.com


* Director Blanco dedicated an entire address to the application of the AML/CFT framework to casinos at the August 13, 2019 Las Vegas Anti-Money Laundering Conference.

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09-26-19

NASAA Enforcement Report Shows Increased Investment Adviser Actions, Focus on Crypto, Senior Fraud

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2019-2020 NASAA President Christopher Gerold
 

In its 2019 annual enforcement report, the North American Securities Administrators Association ("NASAA") highlighted statistics from its 2018 state enforcement activities. The data show that the state securities regulators secured more than $1 billion in restitution and fines as well as significant criminal penalties. The report also notes that state regulators nearly doubled enforcement actions against investment adviser firms. Here, Bates Research takes a closer look.

THE DATA

In terms of sheer numbers, NASAA reports that 5,320 investigations and 2,067 enforcement actions were initiated by state regulators in 2018. NASAA notes that these figures do not include “extensive efforts” to resolve complaints and referrals by state regulators on an informal basis. Fines issued by U.S. members reached $490 million and restitution came to over $558 million. Some $10.5 million was ordered for investor education and another $11.6 million for other costs. The report also detailed aggregate criminal penalties including incarceration (estimated at 1048 years) and probation (estimated at 705 years). 

In a continuation of longer-term trends, NASAA enforcement actions were evenly divided between registered and unregistered targets. Of the registered licensed respondents, however, NASAA noted an increase in the proportion of actions against investment adviser firms (up to 17% from 4% in 2014). Actions against investment advisers represented the largest percentage by category, and the report cites license revocations, bars and suspensions on almost 1000 individuals and firms. The report also notes that these actions do not include more than 4,500 registration withdrawals that occurred because of state-raised concerns. NASAA says that the actions against investor advisers reflects increased attention paid to addressing “bad actors” within the industry.

As to regulatory investigations, NASAA reported an increase against unregistered individuals (over 700) which represents a doubling of the effort since 2015. NASAA suggests that this effort will likely continue due, in part, to a “sustained” focus by regulators on crypto- fraud.

REPORT HIGHLIGHTS

Cryptocurrency Fraud

In the report, NASAA highlighted its extensive efforts to coordinate enforcement efforts against fraud related to cryptocurrencies and blockchain technology. Reviewing some of the successes of its 2018 initiative “Operation Cryptosweep,” NASAA restated that its task force opened more than 330 inquiries and investigations and brought more than 85 enforcement actions relating to ICOs and cryptocurrencies.

As Bates Group reported only a few weeks ago, NASAA’s continuing efforts to date have netted “130 new investigations into questionable cryptocurrency-related investment offerings” and “35 pending or completed enforcement actions since the beginning of this year.” NASAA warned firms that state and provincial securities laws and regulations apply to the sales of cryptocurrency-related investment products, and to be particularly wary of “dealing with promoters who claim their offering does not have to be registered with securities regulators.”

Senior Financial Exploitation

NASAA also provided some data concerning financial abuse against seniors. In total, member jurisdictions brought 141 enforcement actions and initiated 365 investigations involving a total of 758 senior victims. Of these, the cases involved schemes that targeted seniors to buy unregistered securities (249), traditional securities (193), variable annuities (44), affinity fraud (39), indexed annuities (18) and life settlement products (5). The remaining 145 cases involved lottery and sweepstakes scams, identity theft and internet romance scams, to name a few.

NASAA also summarized the growing influence of its 2016 Model Act to Protect Vulnerable Adults from Financial Exploitation which (i) “offers broker-dealer and investment adviser firms qualified immunity for delaying disbursements when the firm reasonably believed financial exploitation would result,” and (ii) requires mandatory reporting by an agent or representative upon reasonable belief of senior financial exploitation. NASAA reports that 23 jurisdictions have enacted some form of the legislation. Of those, 14 jurisdictions received 426 reports from broker-dealers and investment advisers regarding the potential financial exploitation of a vulnerable adult. According to NASAA, these notifications initiated 81 investigations which led to 57 delayed disbursements, and 32 enforcement actions.

CONCLUSION

NASAA’s annual report serves to remind firms of the role that state securities regulators play in the protection of their resident investors and the reach and impact of their enforcement efforts—two messages underscored by NASAA’s new President Christopher Gerold in his inaugural address. The aggregate numbers are a warning to firms to ensure that their compliance policies and procedures adequately cover state regulations that focus, in particular, on senior financial exploitation and cyber-fraud. Bates Group will continue to keep you apprised.  

ABOUT BATES

Bates Group has been a trusted partner to financial services firms and counsel for over 30 years, providing end-to-end solutions on legal, regulatory and compliance matters. Through our professional staff and roster of over 165 industry experts and consultants, Bates offers services in compliance solutions for IAs and BDs, AML and financial crimes, regulatory and internal investigations, litigation consultation, damages consulting and expert testimony.

To learn more, contact:

Robert Lavigne, Managing Director, Bates Compliance - rlavigne@batesgroup.com

Rory O'Connor, Director, Bates Compliance - roconnor@batesgroup.com

Edward Longridge, Managing Director, Bates AML and Financial Crimes - elongridge@batesgroup.com


Meet Bates Compliance at the IAA 2019 Leadership Conference, September 25-27 in Nashville, TN. 

Bates Compliance is a proud sponsor of the 2019 NSCP National Conference, October 21-23 at the Hilton Baltimore. Booth #33

Bates Compliance will also be exhibiting at IMPACT® 2019, November 4-7 at the San Diego Convention Center.

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09-19-19

FINRA Requests Feedback on Senior Financial Protection Rules

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FINRA is asking its members a series of questions about the utility of rules and processes to curb financial exploitation of senior investors. In a new Regulatory Notice, FINRA asks for feedback about the experiences member firms are having applying Rule 2165 (temporary holds on disbursements) and Rule 4512 (trusted contacts) that were put in place just last year, as well as Rule 3240 (borrowing from, and lending to customers). FINRA indicated that responses to its questions will be evaluated as part of its retroactive rule review process and will be used to consider whether “additional tools, guidance or changes” are necessary.

Bates Research closely follows regulatory and enforcement developments on senior financial fraud. The growing utilization of Suspicious Activity Reports (SARs) is changing regulators’ understanding of the scope and nature of the problem by increasing the data available for measurement and analysis. As highlighted in the latest FINRA Notice, these studies “indicate that financial exploitation of seniors is often perpetrated by strangers, family members and caregivers—rather than by broker-dealers or other financial services organizations—[but] broker-dealers and other financial services organizations have an important role to play in protecting senior investors.” According to FINRA, the rules under review provide a way for member firms to deal with situations where there is “a reasonable basis to believe that financial exploitation has occurred, is occurring, has been attempted or will be attempted.” In this article, we recap those rules and consider the questions posed by FINRA in its latest Notice.

FINRA Rule 2165

FINRA Rule 2165 permits members to place temporary holds on disbursements of funds or securities from the accounts of specified customers where there is a reasonable belief of financial exploitation of these customers. (FINRA provided guidance on this rule in a FAQ published in January 2018.) The hold only applies to “suspicious disbursements” and not to the buying and selling of securities within an account.

Rule 2165 provides a member firm with a safe harbor from FINRA enforcement when the firm exercises discretion to place holds on disbursements. The Rule also prescribes certain supervisory procedures, the automatic initiation of an internal review of facts and circumstances, and oral and written notification of any hold (including the basis for the determination) to all parties authorized to effect transactions in the account within two business days. The temporary hold may only be extended by the firm for an additional 10 business days if so ordered by a state regulator, agency or court of competent jurisdiction.

FINRA is seeking comment on the safe harbor provision of Rule 2165, specifically, whether it should (i) apply to transactions in securities; and (ii) be extended “to apply where there is a reasonable belief that the customer has an impairment that renders the individual unable to protect his or her own interests…irrespective of whether there is evidence that the customer may be the victim of financial exploitation by a third party.” FINRA is also asking for comments on whether the temporary hold period should be extended, whether there should be a different mechanism to obtain an extension, and for examples of unintended consequences when placing or attempting to place a temporary hold on disbursements of funds. Finally, FINRA is asking for feedback on the reporting of Rule 2165 incidents including whether further guidance is needed to address Forms U4 and U5 reports.

FINRA Rule 4512

FINRA Rule 4512 requires members to make reasonable efforts to obtain the name and contact information for a “trusted contact person” when a customer account is opened or updated. There are a number of explicit disclosures and requirements for someone to be named a trusted contact person. For example, the trusted contact person must be at least 18 years old and must be formally authorized by the client to assume the responsibility to address possible financial exploitation, to confirm specifics about the customer’s current contact information or health status, or to identify any legal guardian, executor, trustee, or holder of power of attorney.

FINRA is now seeking information on firms’ experiences with Rule 4512. In particular, FINRA wants to know the methods by which firms have been obtaining trusted contact person information, the receptivity of clients to any outreach, and related examples including any experience of identified senior financial abuse where the firm did not have trusted contact information.

FINRA Rule 3240

In addition to these Rules, the agency is also reviewing FINRA Rule 3240 which covers permissible lending arrangements between registered persons and customers. The Rule prohibits borrowing money from or lending money to customers “unless the member firm has written procedures,” and then only under narrow conditions. Rule 3240 requires notification to the firm by a registered person entering into such an arrangement and for the firm to pre-approve it in writing. Because of the potential for misconduct as it relates to seniors, FINRA is asking whether any modifications should be made to the rule.

Additional Important Inquiries

In related inquiries, FINRA is asking whether it should consider prohibitions or limitations on allowing registered persons to be named beneficiaries, executors, powers of attorney, or trustees on the accounts of non-family member customers. FINRA is also asking for feedback on whether to amend its Sanctions Guidelines to incorporate as a “principal consideration” the customer’s age or impairments when determining appropriate sanctions.

Conclusion

The increasing awareness of the extent and severity of senior financial exploitation brings with it an urgency to take regulatory action. Such action may translate into a further tightening of the regulations, additional supervisory requirements and greater oversight. Bates Compliance Managing Director Robert Lavigne says: “even though FINRA is performing a retroactive rule review, it will expect member firms to have a fully matured senior investor program in place. This is a good time for firms to review and tighten their procedures relating to the protection of senior investors.”

The reply period for the FINRA inquiries runs until October 8, 2019. Bates will continue to keep you apprised.


Learn how to protect your company and its most vulnerable investors with Bates Investor Risk Assessment. For a broad view of the changing federal and state legislative and regulatory landscape on senior investors, download our complimentary white paper. For more information concerning financial issues related to vulnerable and senior investors, senior investor expert witnesses, financial crimes, damages analysis, and compliance solutions, please contact Bates Group today.

 

Coming Up:

Look for Bates Compliance leaders at the SIFMA C&L Charlotte Regional and the IAA Leadership Conference in Nashville. 

Bates Compliance is a proud sponsor of the 2019 NSCP National Conference, October 21-23 at the Hilton Baltimore. Booth #33

Robert “Bob” Lavigne will be discussing the broader questions and compliance implications of the FINRA rules at the upcoming SIFMA Internal Audit Annual Conference, October 27-30 in Miami.

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09-12-19

States Sue SEC in Latest Challenge to Reg BI

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The SEC’s adoption of the Regulation Best Interest (“Reg BI”) package in June was a defining moment in the long-running debate over the standard of care for broker-dealers and investment advisers. It triggered compliance schedules and required registered broker-dealers and advisory firms to develop internal policies and procedures in order to satisfy the new standards. The passage of Reg BI, however, did not quell the ongoing controversies over the appropriateness and adequacy of standards and investor protections.

Like its Department of Labor Fiduciary Duty Rule predecessor, Reg BI is undergoing a variety of challenges from numerous quarters. In past posts, we have reviewed some of the more serious challenges that impact broker-dealers and investment advisers. Most notably, state securities regulators are asserting their shared authority over financial market products and services by promulgating new state rules that offer their in-state-resident investors greater protection than afforded under Reg BI. New Jersey, Maryland, Nevada and New York, among others, have taken the lead in issuing proposed rules that would impose a uniform fiduciary standard of care for broker-dealer recommendations to retail investors. As discussed, these proposals, echoing the DOL Fiduciary Rule, will likely face federal preemption challenges and will require a judicial determination as to their sustainability. 

This week, Reg BI suffered another state challenge, this time in the form of a lawsuit filed against the SEC by seven State Attorneys General (“State AGs”). Here’s a closer look.

State of New York, et. al. v. SEC and Walter “Jay” Clayton III

On September 9th , the State AGs from New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon and the District of Columbia brought a declaratory and injunctive action against the SEC and Walter “Jay” Clayton III (in his capacity as SEC Chair) in the United States District Court for the Southern District of New York.

State Policy Position

The State AGs argue that Reg BI (i) “undermines” consumer protections for retail investors, (ii) “increases the confusion about the standards of conduct that apply when investors receive recommendations and advice from broker-dealers or investment advisers,” and (iii) allows brokers to hold themselves out as trusted advisers despite inherent conflicts of interest. SEC Chair Clayton has publicly addressed several of these concerns.

State Legal Arguments

As a matter of law, the State AGs allege, first and foremost, that the SEC disregarded the 2010 Dodd-Frank Act mandate that requires broker-dealers to act under the same standard of conduct as investment advisers and without regard to their own financial interests. The critical Dodd-Frank section at issue, Section 913 (Study and Rulemaking regarding Obligations of Brokers, Dealers and Investment Advisers), is explicit, say the AGs, in requiring that the standards be “harmonized” and that the standard for brokers “…shall be the same as [empasis added] the standard of conduct applicable to an investment adviser under section 211 of the Investment Advisers Act of 1940.” The plaintiffs also argue that the SEC disregarded the findings of the agency’s own study required under Section 913 of the Dodd-Frank Act by “fail[ing] to apply a uniform fiduciary standard to both broker-dealers and investment advisers.”

Second, the State AGs emphasize that Section 913 amended both the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 to authorize the Commission to promulgate rules regarding the standards of conduct. The State AGs contend that the Commission cannot base its authority to issue Reg BI on provisions of the Exchange Act that flow from those amended authorities and that do not authorize the Commission to disregard the standard of conduct mandated by that section.

Finally, the State AGs argue that, as a matter of law, Reg BI exceeds the SEC’s statutory authority and that it is arbitrary and capricious under the Administrative Procedures Act. The State AGs are asking the Court to vacate and set aside the rule, and to permanently prevent the SEC from “implementing, applying, or taking any action” under it.

States Claim Reg BI Harm

In terms of harm caused by Reg BI, the State AGs argue, in part, (i) economic harm due to lower tax revenues as a result of the diminished value of investment and retirement accounts beset by conflicts of interest; (ii) additional economic costs, including the need to provide public assistance, “in meeting the unmet needs of retirees and other residents in their states”; and (iii) a reduction in the “strong quasi-sovereign interest” that states have in maintaining the economic well-being of their residents.

Conclusion

If there is a feeling of déjà vu, that should come as no surprise. Only eighteen months ago, the Fifth Circuit vacated the Fiduciary Duty Rule after a finding that the Department of Labor exceeded its statutory authority by promulgating it.

That is not to say that the same outcome is expected on Reg BI. Though the SEC has not yet even filed an answer, the policy arguments are not new. (The states may likely reassert them again, along with their authority to issue higher standards on behalf of their in-state residents, in any future preemption case.)

In the meantime, “firms should not slow their efforts or their implementation preparation for Reg BI compliance,” says Robert Lavigne, Managing Director, Bates Compliance. Bates will continue to keep you apprised.


Bates Group's Compliance team can help your firm through the implementation phase of Reg BI. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com.

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08-15-19

NASAA Roundup: Crypto Crackdown, Reg BI, New Warnings on Complex Products

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The past few months have been a particularly busy time for state financial regulators and enforcement officials. At almost every turn, the complicated and overlapping relationship between federal and state officials is being tested. A review of recent activities by the North American Securities Administrators Association (NASAA) provides several examples. In this article, Bates recaps recent NASAA developments on cryptocurrency, fraud enforcement, Regulation Best Interest (Reg BI), and supervision of complex financial products (i.e. non-traditional Exchange Traded Funds).

NASAA Updates Cryptocurrency Enforcement Activity

In April, 2018, NASAA launched a multi-state enforcement initiative to crack down on fraud related to Initial Coin Offerings (ICOs) and cryptocurrency-related investment products. The strategic effort, nicknamed “Operation Cryptosweep,” was lauded by both state and federal regulators. This week, NASAA announced that the continuing effort has netted “130 new investigations into questionable cryptocurrency-related investment offerings” and “35 pending or completed enforcement actions since the beginning of this year.”

NASAA claims that the advent of Facebook’s Libra proposal, together with the “near tripling in value of some cryptocurrencies and the sharp increase in market capitalization for all cryptocurrencies” are creating an environment that “attracts white-collar criminals, bad actors, and other promoters of illegal and fraudulent securities schemes.”

NASAA President Michael Pieciak (pictured above) cautioned firms selling cryptocurrency-related investment products to understand that state and provincial securities laws or regulations may apply to these sales, additionally warning investors about “dealing with promoters who claim their offering does not have to be registered with securities regulators.” NASAA also produced a series of investor videos highlighting issues around crytpto-fraud.

NASAA and Regulation Best Interest

In our last report on state reaction to the SEC adoption of Reg BI, Bates Research noted the caution NASAA has taken in support of its members’ differing approaches to effective standards for protecting their state constituents. Then, as now, NASAA continues to highlight the shared responsibility of both federal and state authorities to protect investors from harm.

In filings to varying state agencies in June and July, NASAA touts the goals of Reg. BI while also supporting states that are proposing higher standards. In June, NASAA filed a comment letter in response to the New Jersey Bureau of Securities rule proposal to impose a (higher than Reg BI) fiduciary standard on all investment professionals. In the letter, NASAA described the longstanding legal framework that supports its members’ efforts to protect resident investors, stating that any “reading by the industry of broad preemption of state authority in the federal securities laws is simply an overreach.” NASAA also emphasized the authority of the New Jersey Bureau to enact these protections, and argued that “the securities industry has proven itself adaptive and can accommodate these new regulations.”

In a virtually identical comment letter submitted in response to a proposed rule by the Massachusetts Securities Division to impose a fiduciary standard of conduct on broker-dealers, NASAA stated: “the Rule Proposal is a valid exercise of state regulatory authority because it would not be impossible to comply both with the Rule Proposal and the federal securities laws…”

NASAA’s narrowly formed comments do not resolve the underlying issue of different standards between the federal government and certain states, and different standards for different states. But it does afford NASAA members the widest possible latitude to set their own standards and have a voice in the long-running debate. Prior to enactment, NASAA argued that legal questions of federal preemption over state law should be resolved in court. NASAA’s ongoing position, as asserted in its comment letters, seems to assume that future resolution in court is inevitable.

NASAA Cautions Firms on the Suitability of Non-Traditional ETFs

In a new Report, NASAA reviewed broker-dealer sales practices for non-traditional Exchange Traded Funds products. The products include Leveraged ETFs, which hold out the promise of returning multiples on the performance of the index or benchmark they track, and Inverse ETFs, which allow traders to benefit from price declines in an index. As defined in the Report, a third product, Leveraged Inverse Funds, “seek to achieve a return that is a multiple of the inverse performance of the underlying index.”

After surveying 118 broker-dealers on their experiences with these leveraged and/or inverse ETFs, NASAA recommended that firms review and update their supervisory procedures as they apply to these products.

Specifically, NASAA found that a number of firms are not adequately addressing and monitoring customer suitability concerns and holding periods. NASAA President Peiciak went so far as to say that “Broker-dealers should carefully consider whether to permit purchases of leveraged and/or inverse ETFs in retail customer accounts.”

For those firms that continue to sell these complex products, NASAA recommended “tailored supervisory procedures” to address the heightened risks associated with leveraged and/or inverse ETF transactions.

New Leadership

In June, NASAA announced that New Jersey Securities Bureau Chief Christopher W. Gerold will succeed Michael Pieciak to serve as NASAA’s president for the 2019-2020 term. Mr. Gerold served as Bureau Chief since 2017 and will assume the leadership of NASAA in September.

Conclusion

NASAA is playing a critical role in defining the evolving relationship between federal and state authorities. It is noteworthy that Mr. Gerold hails from New Jersey, the leading state asserting its authority in the ongoing battle over broker-dealer standards. The battle over preemption will advance during his term. With each of these issues, from enhanced collaboration over cyber enforcement to adequate oversight on complex products, Mr. Gerold, like his predecessor, will be challenged to navigate the relationship between the state and federal authorities and in many instances among NASAA members. Bates will continue to keep you apprised.

 
Look for Bates Managing Director Hank Sanchez at the NASAA 2019 Annual Meeting, September 8-10 in Austin, Texas.

About Bates

Bates Group has been a trusted partner to financial services firms and counsel for over 30 years, providing end-to-end solutions on legal, regulatory and compliance matters. Through our professional staff and roster of over 165 industry experts and consultants, Bates offers services in litigation consultation and testimony, regulatory and internal investigations, compliance, financial crimes, forensic accounting and damages consulting.

Bates Group's suite of Reg BI services helps firms navigate Reg BI implementation. To learn more, visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance Solutions, at rlavigne@batesgroup.com.

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08-08-19

Variable Annuities Regulatory Update: Will NY’s Reg. 187 Victory Impact SEC, NAIC Proposals?

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Last October, when considering the myriad federal and state authorities engaged in regulating variable annuities and rewriting standards, Bates retirement, insurance and annuity consultant Michael Lacek cautioned:

“it remains to be seen whether the requirements imposed by the [new] New York regulation will differ materially from the ‘best interest’ regulations currently under consideration by the SEC and the NAIC [National Association of Insurance Commissioners]  … but, for now, companies should be looking to be in compliance with the actual New York rules coming on-line.”

That pragmatic advice turned out to be warranted as the New York Supreme Court last week upheld the “Suitability and Best Interest in Life Insurance and Annuity Transactions” regulation (a/k/a Regulation 187) in the face of legal challenges brought by several associations and insurance agent groups. In this article we take a look at what the decision means, recent developments in both the SEC and NAIC efforts to rewrite standards, and we update you on the latest in the legal battle over commission trails for brokers selling variable annuities.

New York State Suitability and Best Interest Rule for Variable Insurance Brokers Survives Legal Challenge

As previously covered, Regulation 187 is the first state regulation to require insurers to establish policies and procedures so that broker-dealers would put the “best interest” of consumers ahead of their own when making any variable annuity and life insurance product recommendations. On July 31, 2019, the New York State Supreme Court issued a decision to uphold the constitutionality of the regulation. That was one day before the regulation, as applicable to variable annuity products, went into effect. (The effective date for life insurance products is February 1, 2020.)  In a lengthy opinion that could possibly be appealed, the Court stated that the regulation “specifically seeks to prevent insurers and producers from recommending a product designed to maximize compensation to seller and one that may be otherwise properly disclosed and suitable, but not in the best interest of the consumer. As such, … [the regulation] was properly considered …and is not unconstitutional.” (at p. 42)

“That means that broker-dealers licensed by New York State and selling variable annuity products must now comply with Regulation 187 requirements,” said Bates insurance regulation consulting expert Sheila Murphy. “These include performing suitability reviews, disclosing compensation information (e.g. fee- or commission-based) and product information, as well as prohibiting a broker from representing that a recommendation is part of financial planning or investment advice without proper professional certifications.) The regulation also requires compliance with written procedures on transaction documentation, on preventing financial exploitation or abuse, on supervision and training, and other features on the sales or servicing of the annuity product.”

Reportedly, reaction has been muted. The Life Insurance Council of New York Inc. said, "although we remain hopeful that its implementation will have a positive influence on the annuity market in this state, we don't yet know what effect it will have, especially when taking into consideration that it appears likely that many states and the SEC will be taking a different approach.”

Other Approaches: the SEC and NAIC

In February, Bates reported that the SEC extended to March 15, 2019 the comment period for a proposal to change existing disclosure rules for variable annuity products. The proposed rule would allow issuers of variable products to fulfill compliance obligations by preparing and delivering a “reader-friendly” summary prospectus and layered disclosure. As previously discussed, the central features of the proposal were generally embraced by the financial community (most of the later comments were from private market participants), but were deemed insufficient, or in need of further clarification, by investor advocates (e.g. see comments by the AARP recommending, among other things, greater disclosure and standardization).  Interestingly, commenters, perhaps anticipating the passage of Regulation Best Interest (Reg. BI) (adopted three months later) urged the SEC to ensure “collaboration with federal, FINRA, and State regulators for all types of securities products to avoid marketplace disruption and harm to consumers.” (See, e.g. comments by the Association for Advanced Life Underwriting at p.2, and, more generally, concerns raised by the Financial Services Institute). The comment period is now closed. Though the SEC proposal is generally within the framework of Reg. BI, the details of how these two regulations may affect each other and the regulatory burdens they place on broker dealers is still playing out.

NAIC Keeps on Keeping on

The need to harmonize standards on variable annuities with SEC Regulation Best Interest and the New York regulations was the subtext of debate at the National Association of Insurance Commissioners (NAIC) conference last week. According to a summary of the August 3rd meeting, the Annuity Suitability Working Group discussed a framework for including a best interest standard of conduct in the revisions to its “Suitability in Annuity Transactions Model Regulationwith the goal being to complete the annuity sales model by December. But, there is reportedly still significant disagreement among the state regulators about “what best interest means,” particularly in light of the effective New York regulation. For many participants, the New York regulation contains too many elements of the now-defunct Department of Labor fiduciary rule and is considered unacceptable. The chair of the Annuity Suitability Working Group, Jillian Froment, was quoted summing up the broader debate: “We set up the guardrails that 'best interest' is something more than suitability but it’s less than fiduciary…We’re trying to decide what is a best-interest standard and evaluate that against both suitability and fiduciary."

Movement in Ohio, Update on Commission Trail Suits

While regulators debate the finer points, the legal controversy over Ohio National Financial Services’ (“Ohio National”) strategic decision to pull out of the market for variable annuities and to stop paying trail commissions continues. As discussed previously, in September 2018, Ohio National announced that after acomprehensive strategic review of [its] businesses, taking into account the continuously changing regulatory landscape, the sustained low interest rate environment, and the increasing cost of doing business …the company will no longer accept applications for annuities or new retirement plans, while continuing to service and support existing clients in both businesses.”

Ohio National’s attempt to replace the older contracts with new "servicing agreements" spurred several suits with all sides pressing for the courts to weigh in on the rights, duties, and liabilities of the parties. Those suits, including a class action, have recently survived legal challenges and are heading to trial. At the same time, last week, another broker dealer firm sued Ohio National alleging, similarly, that they are entitled to the trail commissions as deferred up-front commissions. Ohio National, in turn, has sued a number of parties to avoid arbitration before FINRA.

Conclusion

“For variable annuities brokers, the regulatory picture is complicated and uncertain. Compliance with the now effective New York regulation remains the most prudent course,” says consultant MIchael Lacek. Given the uncertainty as to (i) the outcome of the NAIC debate on model rules, (ii) final rules from the SEC, (iii) changes in the market for variable annuity products, and (iv) legal outcomes in the dispute over trail commissions, Bates will keep following developments.

More information about Bates Group’s Insurance and Actuarial practice services

 

Bates Insurance Consultants and Experts 

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08-01-19

Cannabis: Federal and State Efforts Picking up Steam

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The growing global cannabis market is estimated to reach $66.3 billion by 2025, up from $13.8 billion in 2018. (Another estimate is even higher, projecting that the market will reach $89.1 billion by 2024.) That kind of growth is spurring congressional and state legislators to seek to normalize the market for marijuana-related businesses (MRBs) and speed up the resolution of federal-state legal conflicts. In this article Bates looks at some of the recent federal legislative and state developments on what appears to be real momentum toward a fully functioning and legitimate market. 

Federal Law and Anti-Money Laundering

Judging by the sheer number of cannabis-derived items now for sale, from topical creams and therapeutic remedies (like CBD) to edibles, extracts and other products, consumers have ready access to an ever-growing assortment of goods all tied to an activity that is federally proscribed in the United States.

The manufacture, sale and possession of marijuana is illegal under the federal Controlled Subtances Act (CSA). Technically, revenue generated by any business transaction in cannabis could be considered criminal proceeds. In 2014, for anti-money laundering (AML) purposes under the Bank Secrecy Act, the Financial Crimes Enforcement Network (FinCEN) recognized “recent state initiatives to legalize certain marijuana-related activity…” and instructed financial institutions that transact with such business to comply with specific restrictions as to the filing of Suspicious Activity Reports (“SARs”).

According to the most recent FinCEN Marijuana Banking Update, as of March 2019, 493 banks and 140 credit unions were providing financial services to MRBs (an increase from 438 banks and 113 credit unions several months prior). Further, according to the latest report, these financial institutions submitted 81,725 SARs concerning MRBs.

Federal Legislative Developments

Several forms of a legislative solution have been taking shape, namely the Secure and Fair Enforcement Banking Act (the "SAFE Banking Act"), the Strengthening the Tenth Amendment Through Entrusting States Act (the "STATES Act") and the just-introduced Marijuana Opportunity Reinvestment and Expungement Act (the “MORE” Act).

The SAFE Banking Act

The SAFE Banking Act was drafted to remove legal uncertainty for regulated banks and credit unions that provide banking services to cannabis businesses. The bill provides a safe harbor from federal AML and regulatory enforcement actions for insured depository institutions. Under the SAFE Act, proceeds of an MRB would not be considered proceeds from illegal activity. Beyond offering a safe harbor for these institutions, the intention is to protect the financing of marijuana-related real estate, the broker-dealer custody of cannabis-related stocks and investor returns.

Of the three proposed solutions, the SAFE Banking Act is furthest along in the legislative process. At a U.S. Senate Committee on Banking, Housing and Urban Affairs hearing on July 23, 2019, Senators from both sides of the aisle expressed support for the bill. Chair Mike Crapo (R-In) called recent federal enforcement initiatives against MRBs inappropriate because “law-abiding businesses were targeted strictly for operating in an industry that some in the government disfavored.” Senator Jeff Merkley (D-OR), a SAFE Banking Act cosponsor, said the Act would reduce the legal uncertainty perpetuated by FinCEN’s 2014 guidance. He noted support for the passage of the SAFE Act from Governors, the  National Association of Attorneys General, the American Bankers Association, the National Association of State Treasurers, and all 59 state Bankers Associations.

Opposition to the bill was expressed by advocates concerned with the "massive public policy and public health ramifications" of “highly potent products targeted at younger audiences” and the "abysmal job of regulating the drug" by the states. Other opponents argued that the Act would increase money laundering and black market activity.

The STATES Act

The STATES Act would amend the Controlled Substances Act by restricting federal enforcement against state cannabis activity. The STATES Act would protect the manufacture, production, possession, distribution, dispensation, administration and delivery of cannabis by those who are complying with state law. The Act would also prevent forfeiture of any assets and exempt funds derived from state-legal cannabis businesses. The bill is intended to empower states to freely implement their own cannabis laws. It is not yet clear how FinCEN’s AML provisions would apply under the Act. At the least, SARs would be required to be filed in any case of non-state compliant MRB activities.

The MORE Act

The newest entrant in the legislative arena, the MORE Act, was introduced by Representative and Chair of the Judiciary Committee Jerrold Nadler (D-NY) and Senator Kamala Harris (D-CA). Like the STATES Act, the MORE Act would modify the CSA to exclude marijuana. That said, it goes much further. The MORE Act provides for the expungement and resentencing of convictions for marijuana crimes, prevents federal agencies from using cannabis to deny access to benefits or citizenship status for immigrants, specifies that federal agencies may not use marijuana use as a criteria for granting or denying a security clearance, and levies a five percent federal tax on marijuana products. The MORE Act also directs cannabis-generated tax revenue toward a number of efforts including combatting “racially motivated enforcement.” (These efforts would be managed by a new Department of Justice “Cannabis Justice Office.”)

Other Federal Action

On July 25, the Senate Committee on Agriculture, Nutrition, and Forestry heard testimony from officials with the U.S. Department of Agriculture, Food and Drug Administration and Environmental Protection Agency. The hearing covered similar themes as the Senate Banking Committee about access to financial services by businesses involved with the crop and its derivatives. Testimony included examples of businesses that have been denied credit lines and insurance policies due to a lack of guidance from federal regulators. Notably, the bipartisan support for legalization of hemp through the Agriculture Committee is driven, in part, by Senate Majority Leader Mitch McConnell (R-KY) who included the provisions into agriculture legislation and pointed out that the crop “is being grown in 101 out of 120 counties in Kentucky.”

State Developments

State developments are coming at a rapid pace and take many forms from legislation fully embracing the burgeoning industry to more cautious decriminalization. Collectively, all of these legislative initiatives are significant in that they chip away at longstanding perceived taboos on the drug and help to change public opinion.

A few recent examples: on July 29, New York Governor Cuomo signed into law a bill decriminalizing marijuana use. Echoing some of the provisions of the MORE Act, the new law reduces unlawful cannabis possession to a misdemeanor punishable by a fine, and establishes a process for individuals with certain cannabis convictions to have their records cleared both retroactively and for future convictions. The New York law makes it the 27th state to legalize or decriminalize cannabis, following similar efforts in Hawaii by a few weeks. In late June, Illinois Governor J.B. Pritzker signed a recreational cannabis legalization bill. According to one source, the state, which already had “over 73,000 qualifying patients in medical cannabis programs,” expects that “the recreational segment will eclipse the medical segment” and will “generate upwards of USD 2.5 billion annually.”

That may be true, but it all still depends on reducing the federal restrictions on financing and fully opening the industry to outside investment. According to one analysis, this remains the main hurdle for cannabis companies, with state legislators trying to find ways to encourage interstate investment (Oregon and Colorado) or protect or spur intrastate investment (Arizona and California). Along with the state legislative activity, there are a multitude of municipal efforts, from local taxation and licensing to packaging and advertising regulation.

Conclusion

State legislators keep pushing the boundaries of the legal cannabis market. Federal legislators appear to be coming together with solutions that offer ways to address a variety of compliance issues for investors and for the finance of cannabis businesses. Freeing regulated financial institutions to safely participate in the market by resolving state-federal legal conflicts would certainly spur the growth of the industry.

Based on the comments at the recent Senate hearing, the SAFE Banking Act, with its narrow focus on a safe harbor, appears to have significant support. But all the legislative initiatives would raise the temperature on AML Compliance programs as cannabis-related transactions shift to regulated institutions (subject to KYC and BSA requirements). That includes, of course, continuing obligations to file SARs on all marijuana-related activity and strict adherence to FinCEN guidance, as well as additional considerations for ensuring that MRBs are operating as qualified legitimate businesses. Bates will keep you apprised as these and other legislative battles play out.

To learn more about Bates Group’s Financial Crimes and AML services, please contact:

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Edward Longridge, Managing Director, Financial Crimes 

elongridge@batesgroup.com

 

For additional information, please follow the links below to Bates Group's Practice Area pages:

Anti-Money Laundering

Bank Secrecy Act

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Consulting and Expert Testimony

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07-25-19

FinCEN Updates Advisory on Business Email Fraud: Billions Thought to Have Been Stolen

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After analyzing data collected in Suspicious Activity Reports (SARs), the Financial Crimes Enforcement Network (FinCEN) issued an update to a 2016 Advisory alerting financial institutions on how best to combat criminal schemes that compromise business email accounts. The problem of criminals targeting business fund transfers is not small. So-called “Business Email Compromise” (BEC) scammers possibly stole billions of dollars from companies and individuals in 2018, more than in prior years, according to a new FinCEN Financial Trend Analysis of the SARs data. In this article, Bates considers the informed guidance in FinCEN’s new 2019 Advisory to financial institutions, as well as some of the salient conclusions drawn from the trend analysis report.

FinCEN’s 2019 Advisory on Email Compromise Fraud

As reflected in the SARs filings, the problem of BEC fraud has grown. In 2016, BEC accounted for under 500 reports per month, with the attempted thefts averaging about $110 million over that period. By 2018, nearly 1,100 reports per month were generated with attempted thefts averaging over $300 million for the same period. According to the 2019 Advisory, since the last advisory was issued, “FinCEN has received over 32,000 reports involving almost $9 billion in attempted theft from BEC fraud schemes affecting U.S. financial institutions and their customers. This represents a significant economic impact on the businesses, individuals, and even governments that are targeted by these schemes.”

FinCEN concluded that the sectors most targeted by BEC fraudsters are (i) manufacturing and construction, (ii) commercial services and (iii) real estate. That led FinCEN to caution industries with “public-facing information about their business transactions and processes”—i.e. education, real estate and agriculture—that they are particularly vulnerable to BEC crime.

In the updated advisory, FinCEN reaffirmed the “typologies” of BEC schemes contained in its original advisory. These include, among others, hacking into accounts, spear phishing, specialized malware, “spoofing domains to send familiar-looking messages seemingly from a trusted party,” vendor impersonation and the like.

In the update, FinCEN discussed broadening the definitions of BEC to cover (i) more affected entities and (ii) any type of email fraud that may be used to misdirect payments or other things of value, including personal or business data and forms. As to the latter, FinCEN warned financial institutions that “risk from BEC fraud extends to the authentication and authorization processes for receiving sensitive data about the organization or their customers.” FinCEN noted enforcement actions taken against, for example, criminals that stole Personally Identifiable Information (PII) and Wage and Tax Statement (W-2) forms.

As to broadening the definition of “payments,” FinCEN now includes virtual currency payments, automated clearing house transfers, and purchases of gift cards, to name a few. (Note: This is consistent with FinCEN’s recent advisory on cryptocurrencies. See Bates’ coverage here.) 

Regarding broadening the category of entities affected by BEC, FinCEN warned of an increasing trend by criminals to not only target high-net-worth individuals through their financial institutions, but also to attack non-business entities, including non-profits and government agencies that use email to transact payments between partners, customers, and suppliers.

For government agencies, FinCEN reports that the SARs reflect the targeting of pension funds and payroll accounts, as well as other contracted services. For non-profit institutions, FinCEN references attacks against educational institutions (“appealing targets for BEC criminals”) because these institutions engage in high-dollar tuition, endowments, grants and construction transactions. FinCEN also warned financial institutions that they themselves could be victims of BEC schemes. In particular, FinCEN noted enforcement actions in 2018 in which criminals spoofed bank Internet domains and sent messages to bank employees with payment instructions containing fraudulent SWIFT reference numbers.

The Financial Trend Report

The Financial Trend analysis compared changes in the data since 2016. The primary findings included the identification of the three sectors hardest hit by BEC scams mentioned above and the diversification of their targets (non-profit, government and financial institutions) in 2018.

FinCEN also found that of the many types of BEC fraud schemes, fraudulent vendor invoice scams grew to 39 percent in 2018 (from 30 percent in 2017) and accounted for 41 percent of total transaction amounts. FinCEN asserted that fraudulent vendor invoicing was the most common form of BEC crime last year. Only a year earlier, the most frequent BEC method used by criminals (based on the SARs reports) involved emails impersonating a company executive (a scam which declined over 20 percent year-over-year.)

The 2018 figures are instructive, as this Trend Report graph illustrates:

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FinCEN concluded that the emergence of one type over the other was “likely due to awareness of such schemes in the business community.” Further, FinCEN surmised that scammers have turned to fraudulent vendor invoices and the targeting of certain industries because those methods are more lucrative. For example, FinCEN concluded that the average transaction amount related to a vendor or client invoice was $125,439, versus scams involving the impersonation of a CEO ($50,373).  With these observations, FinCEN offers an early glimpse at the sophistication and versatility of BEC scammers. The report also shows the potential of SARs data—which will only get more robust as more data is collected—to inform enforcement and regulatory policy.

Conclusion

FinCEN offered a number of conclusions based on the SARs data. Generally, BEC criminals target certain sectors of the economy more than others (manufacturing, commercial services and real estate); they do so with particular types of scams aimed at particular vulnerabilities inherent in that sector; they prioritize those markets that offer the greatest return per scam, and they react to changing market business conditions.

FinCEN’s Financial Trend Report is both an exercise in mining data from SARs reports and a demonstration of how that information impacts the direction of law enforcement. For the BEC analysis, the data indicates that there have been substantial changes in how the scam has developed over the last few years. According to Bates Group’s Financial Crimes Managing Director Ed Longridge, “The advisory is an example of how those findings may translate into regulatory priorities. It is important for firms to adapt their compliance policies, payment and reconciliation procedures, training and internal controls to both report and work to prevent this type of financial fraud.”


To learn more about Bates Group’s AML and Financial Crimes services, please contact:

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Edward Longridge, Managing Director, FinancialCrimes 

elongridge@batesgroup.com

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07-19-19

Is the Increase in Option-Related Cases Affecting Your Firm and Clients?

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Bates Group is alerting counsel that we are seeing an uptick in option-related cases where firms offered their clients strategies to increase the yield in their investment portfolio, often involving options trading in order to earn premium income to enhance a portfolio’s regular returns.

Examples of these strategies include covered call writing, zero cost collars and the use of so-called “iron condors” – cashless options trading strategies used to generate premium income in addition to the yield on an investor’s current portfolio, while offering downside protection from potential losses.


Bates Group Support:

Bates staff and experts have provided both consulting and testimony services in matters involving options trading within a client account. Bates experts have opined on the appropriateness of the options trading, as well as the role the option positions play within the client’s overall investment strategy and portfolio of holdings. Bates has performed quantitative analyses examining the likelihood that an option position bought or sold by a client will end in a gain or loss, providing a single figure capturing the probability weighted expected value from the purchase or sale of the option position.

Bates experts have also provided in-depth knowledge and analysis concerning commonly employed options trading strategies and the role of these strategies within an overall investment objective, as well as the relative risks created for the client. Bates consultants and experts have also provided analysis and testimony in support of matters involving premium generation strategies employed to generate additional yield on a client’s portfolio, such as those involving iron condors or other means by which the held portfolio serves as collateral for options-related, income-focused trading.

Specifically, Bates can assist in the following ways:

  • Analyzing the trading in claimant’s brokerage accounts to determine the P/(L) associated with the strategy, and quantifying out-of-pocket losses. 
  • Assessing if the strategy changed over time, where the strategies may have failed, and explaining how any losses occurred. This can include an evaluation of whether the stated strategy was deviated from in a meaningful way, leading to losses.
  • Assessing the adequacy of internal and external disclosures.
  • Assessing the net premium received versus the level of risk involved in a position.
  • Estimating position risk and return; forecasting the probability of a loss and the probable size of a loss at the time positions were written. 
  • Assessing the suitability of the strategy and the suitability of the size of the strategy mandate.

The Bates team of consulting and testifying experts bring a clear understanding of the theory behind how these strategies work from an academic and industry perspective, from a business side and in-house perspective during the client education phase, and from a sales practice aspect when clients invest using this strategy.

Contact:

Andrew Daniel, Securities Litigation Expert and Director - adaniel@batesgroup.com

Julie Johnstone, Managing Director, Retail Litigation - jjohnstone@batesgroup.com

Peter Klouda, Securities Litigation Expert and Director, Operations - pklouda@batesgroup.com

Alex Russell, Managing Director, Litigation & Regulatory Enforcement - arussell@batesgroup.com

Learn More About Our Securities Litigation Practice

 

For more information about option-related case support or any of Bates Group's other practice areas and services, click the link below and a Bates representative will be in touch.

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07-18-19

SEC Chair Responds to Seven Criticisms of Regulation Best Interest

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In previous posts, Bates Group looked at early reaction from SEC Commissioners and key industry players to the adoption of the new standards and interpretations that will impact the conduct of broker-dealers and investment advisers toward their retail clients. Additional articles have considered some of the reactions of state-level securities officials concerning the new rule in defense of their own state residents.

Since then, the U.S. House of Representatives weighed in and voted for an amendment to a Financial Services Appropriations bill to “prohibit[] the Securities and Exchange Commission from implementing, administering, enforcing, or publicizing the final rules and interpretations of the Securities and Exchange Commission rule entitled ‘Regulation Best Interest [Reg BI]: The Broker-Dealer Standard of Conduct’ …along with the other related issued guidance and interpretations.” House Financial Services Committee Chair Maxine Waters urged the SEC to rescind the rule, which “will only create confusion” for investors.

The amendment is not likely to pass the Senate. Senate Banking Committee Chair Mike Crapo is on record supporting the regulation, and SEC Chair Jay Clayton is not going to be rescinding the rulemaking anytime soon.

As this week’s formal publication of Reg BI in the Federal Register makes clear, the dates for implementation and compliance are set, even as the debate over the new rule package continues. In this article we review Chair Clayton’s endorsement of the regulation, and his point-by-point rebuttal of the criticism that it has received since agency adoption.

Seven Criticisms, Seven Responses

In his speech titled: Two Strong Standards that Protect and Provide Choice for Main Street Investors, Mr. Clayton acknowledged criticism from “those in support of our efforts and from those who would have preferred a different approach,” but decried criticism that “is false, misleading, misguided, … [or] is simply policy preferences disguised as legal critiques.”

Mr. Clayton stated and then rebutted the following claims:

1. That the Reg BI standard of conduct will not do enough to protect retail investors.

Mr. Clayton argued that Reg BI not only substantially enhances the standard of conduct for broker-dealers, but also affords an investor the ability to choose between a broker-dealer transaction-based model and an investment adviser portfolio-based model. He said that Reg BI “affirmatively requires broker-dealers to act in the best interest of their retail customers and not place their own interests ahead of the customer’s interests.” Further, he argued that Reg BI requires the broker-dealer to comply with four component obligations: those of disclosure, care, conflict of interest, and compliance in order to ensure this higher standard. (See here for details of these obligations.)

2. That Reg BI is deficient because it does not define “best interest.”

Mr. Clayton stated that the SEC concluded that the best approach to ensuring high standards was principle-based rather than prescriptive. He argued that a determination as to whether a broker-dealer acted in a customer’s best interest would be better assessed on an objective basis after reviewing “the facts and circumstances of how the specific components of the rule [particularly the Care Obligation] are satisfied.”

3. That the fiduciary interpretation weakens the existing fiduciary applied to investment advisers by not requiring advisers to “put clients first.”

Contrary to this claim, Mr. Clayton contends that the fiduciary guidance provided in the regulatory package actually “reaffirms the important protections that the fiduciary duty, under the Advisers Act, has long provided and will continue to provide.” He stated that the interpretation restates and formalizes what the law already requires consistent with “decades of administering this standard.”

4. That the fiduciary interpretation weakens the existing fiduciary duty applied to investment advisers by not requiring advisers to avoid all conflicts.

Mr. Clayton dismisses this claim. He says that there is no “independent legal requirement for an adviser to seek to avoid all conflicts,” and that Reg BI goes far in addressing broker-dealer conflicts of interest.

5. That the standards of conduct under Reg BI and the fiduciary interpretation can be satisfied by disclosure alone.

Mr. Clayton asserted that “Reg BI cannot be satisfied by disclosure alone.” He reiterated that the conflict of interest obligation is just one of the four obligations owed by broker-dealers under the rule and that broker-dealers “will also need to comply” with the “care obligation, which applies to every single recommendation, regardless of whether a broker-dealer has disclosed, mitigated, or eliminated its conflicts of interest.” Further, he said, an investment adviser owes both a duty of care and duty of loyalty, and, as a result, cannot fulfill these duties through disclosure alone.

6. That Reg BI is a weak standard because it does not require broker-dealers to monitor a customer’s account or impose an ongoing duty.

Mr. Clayton argued that imposing such an ongoing requirement would rob investors of the ability to choose whether they want those services and whether to incur the cost of those services. Further, he said, “Reg BI adopts a specific and tailored approach that recognizes that it would be inappropriate to apply certain generally applicable obligations of investment advisers (e.g., duty to monitor) in the context of a transaction-based relationship.”

7. That the relationship summary (CRS) will not accomplish its goals of addressing investor confusion regarding the differences between broker-dealers and investment advisers.

Noting the extensive and “even unprecedented” level of investor testing of elements of the customer relationship summary, Mr. Clayton said that it will provide “material assistance to retail investors in understanding the duties they are owed by financial service providers.” He said that “no existing retail disclosure provides this level of transparency and comparability across SEC-registered investment advisers, broker-dealers, and dual registrants.” Further, Mr. Clayton stated that “the design of the final form will result in more meaningful comparisons among firms that will be more relevant to retail investors—because they will be considering the actual services, fees and conflicts of firms in a format that allows comparability between and among firms.”

Conclusion

Given the long history of the standards debate and the final demise of the fiduciary duty rule, strong criticism of any revised approach was to be expected and will likely continue. Despite this, deadlines are set and firms should continue working to meet them. Bates will keep you apprised of developments.


Bates Group helps firms navigate the compliance challenges presented by the new Reg BI requirements. Please visit our Reg BI service page to learn more about our Reg BI implementation support, or contact Robert Lavigne, Managing Director, Bates Compliance Solutions, at rlavigne@batesgroup.com.

For more information about Bates Group, click the link below to fill out our contact form, and a Bates representative will be in touch with you soon.

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06-27-19

AML Legislative Update: Seeking Transparency, House and Senate Propose Beneficial Ownership Database

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As described in Bates’ last review of congressional initiatives on Anti-Money Laundering / Countering the Financing of Terrorism (AML/CFT), the House Financial Services Committee has adopted an aggressive legislative agenda aimed at modernizing and closing loopholes in the framework. This month, a bipartisan group of Senate Banking Committee members introduced their own legislation to address current gaps inhibiting the fight against illicit financing of criminal activity. A key interest of both the House and Senate is the expansion of the use of “beneficial ownership information” of the type now collected under the Customer Due Diligence (CDD) rules that went into effect last year. In this article, Bates reviews the developing congressional legislative efforts to detect and deter financial crime.

The House and Senate Bills

The proposed requirement reintroduced earlier this year is to collect ownership information is contained in a House reform bill entitled the Corporate Transparency Act (CTA) introduced by Congresswoman Carolyn B. Maloney (D-NY). The bill would require all corporations and LLCs to disclose their true “beneficial owners” to FinCEN and to create a federal database of beneficial owners. The CTA is intended to address the use of shell companies for illicit purposes, and, according to an explanatory House staff memorandum, the proposed database that would house this information would be available “only to law enforcement agencies, as well as to financial institutions, with customer consent,” consistent with “Know-Your-Customer” compliance obligations. Otherwise, the bill exempts those entities already covered under SEC or state regulation. On June 12th, 2019, the House Committee on Financial Services voted to pass Congresswoman Maloney’s (D-NY) Corporate Transparency Act out of committee. It now moves to the House for a full vote.

Introduced in June 2019, the bipartisan Senate legislation is called the Improving Laundering Laws and Increasing Comprehensive Information Tracking of Criminal Activities in Shell Holdings Act (ILLICIT CASH Act). Like their House counterparts, the sponsors of the bill, Mark Warner (D-VA), Tom Cotton (R-AR), Doug Jones (D-AL) and Mike Rounds (R-SD) expressed concern that “the United States has become one of the go-to destinations for the creation of anonymous shell companies, allowing human traffickers, terrorists, money launderers, sanctions evaders, kleptocrats, and other criminals to promote criminal activities here in the United States undetected.” This conclusion is drawn in part from a recent Senate Banking Committee hearing in which law enforcement officials testified that they would be better able to address illicit financing if they were able to easily identify the beneficial owners of these companies. Case examples of these concerns were presented in testimony by Kenneth A. Blanco, Director of the Treasury Department Financial Crimes Enforcement Network.

Noting also that the Financial Action Task Force (FATF) “identified the United States as an outlier among developed nations for failing to disclose and track shell company ownership,” the Senators committed to working “to close our nation’s doors to shady shell companies and illicit financial activity.”

The proposed Senate legislation contains a wide array of provisions in alignment with the House bill, first among them being the establishment of federal reporting requirements mandating that all beneficial ownership information be maintained in a comprehensive federal database and readily accessible by federal and local law enforcement. Other provisions include (i) the hiring of additional financial investigators and technology experts at FinCEN, plus salary increases, (ii) data development and sharing among law enforcement agencies and financial regulators, (iii) new authority to compel foreign banks to cooperate and to comply with subpoenas subject to contempt sanctions, (iv) additional safeguards to protect personally identifying information, and (v) legislative updates to ensure applicability to digital currency. 

Conclusion

The bi-partisan vote on CTF by the House Financial Services Committee and bipartisan announcements on the introduction of the Senate of the ILLICIT CASH Act is significant and demonstrates a serious leadership determination to address the gaps in beneficial ownership information. . Should that happen, the expansion of the use of beneficial ownership information would bring the United States in line with the anti-money laundering framework of the international community and be a potential help to law enforcement. The American Banking Association has voiced their support for both bills, and lawmakers are requesting public feedback on the proposed Senate bill by July 19th, 2019. Bates will keep you apprised.

 

To learn more about Bates Group’s AML and Financial Crimes services, please contact:

Edward Longridge, Managing Director, Financial Crimes - elongridge@batesgroup.com

Christine Davis, Director, Forensic Accounting and Financial Crimescdavis@batesgroup.com


For more information about Bates Group, click the link below to fill out our contact form, and a Bates representative will be in touch with you soon.

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06-20-19

Massachusetts Proposes State Fiduciary Rule; Trade Groups Ask New Jersey to Pause its Process

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Last month, Bates described a New Jersey proposal to apply uniform fiduciary standards to broker-dealers and investment advisers for recommendations and advice they may give to New Jersey investors. At the time of its introduction, the state proposal was positioned—quite explicitly by Governor Phil Murphy and Attorney General Gurbir Grewal—as a challenge to the anticipated adoption of a proposed federal standard. In this respect, the New Jersey proposal followed in the footsteps of other states, including Maryland, Nevada and New York, in making the case for a higher standard of care as applied to broker-dealer recommendations and in asserting the authority of the state to protect resident investors from harm.

Two weeks ago, the SEC adopted the long-awaited Regulation Best Interest (“Reg BI”), a package of rules and interpretive guidance affecting both broker-dealers and investment advisers and directing broker-dealers to act in the “best interest” rather than under a uniform fiduciary standard of care toward a retail client.  (See here for a summary of the provisions of Reg BI and for some early reactions.) The SEC action has not stopped the states from pursuing their own higher standards. Last week, Massachusetts became the latest state to propose a uniform fiduciary standard for broker-dealers and advisers when dealing with its residents. This article takes a closer look at the Massachusetts proposal and the federal/state power struggle.

Massachusetts Joins the Fray

On June 14, 2019, the Massachusetts Securities Division solicited public comments on a proposal to establish statewide fiduciary conduct standards for broker-dealers, agents, investment advisers, and investment adviser representatives. In a broadside against Reg BI, Secretary of the Commonwealth William Galvin listed his problems with the Reg BI package, including its: (i) failure to establish a strong and uniform standard, (ii) failure to define key terms like “best interest” and setting “ambiguous requirements” for addressing “longstanding conflicts,” (iii) failure to prohibit known problematic practices in the securities industry, and (iv) alleged contradiction of “years of data gathered by studies and reports on disclosure and the conduct standards applicable to broker-dealers.”  

The proposed Massachusetts fiduciary standard would apply to “recommendations, advice, and to the selection of account types,” including “recommendations to open IRA roll-over accounts, as well as recommendations to open accounts involving asset-based or transaction-based remuneration.” Further, the proposed conduct standard “allows for the payment of transaction-based remuneration if the remuneration is reasonable, it is the best of the reasonably available remuneration options, and the care obligation is satisfied.” The comment period runs until July 26, 2109.

Nasaa and sifma on reg bi

NASAA remains cautious in its response to the adoption of Reg BI, deferring a public conclusion until after additional membership discussion and additional review “against our comment letters.” In its first comment letter, dated August 23, 2018, NASAA noted its “members’ shared responsibility with the SEC for oversight of the firms and individuals that will be impacted by the Proposals,” and the need for the SEC to “clarify[] and expand[] the scope of the new conduct standard for broker-dealers, specifying the types of practices that would be prohibited under the new broker-dealer standard, establishing clearer lines of demarcation between investment advisory and broker-dealer activities, preserving investor rights and remedies, improving the effectiveness of proposed Form CRS, and expanding how the Commission proposes to move forward on the use of certain professional titles.”

As NASAA reminded in a 2017 filing (see Enclosure 2) on a matter before the Massachusetts Office of the Secretary of the Commonwealth Division of Securities: “the intersections of federal and state securities laws and the scope of federal preemption of state securities regulatory authority are complex and, in some areas, unsettled.” Preemption would “strip the Division of its legitimate regulatory authority over broker-dealers operating in the Commonwealth of Massachusetts and potentially do damage to the ability of other states to exercise their legitimate police powers as preserved by Congress.”

In a comment letter on the New Jersey rulemaking, SIFMA,  a strong supporter of Reg BI, makes the case that “A state-by-state approach…would result in an uneven patchwork of laws that would be duplicative of, different than, and possibly in conflict with federal standards.” SIFMA urged the Bureau “to pause its rulemaking process, review Reg BI, and reevaluate its proposal before deciding whether it is necessary to proceed with an additional state regulation.” Further, SIFMA warned that “the proposal would generally incentivize firms to curtail their brokerage services in New Jersey. Earlier this year, some broker-dealers expressed similar concerns over Nevada’s fiduciary duty proposal, arguing that “the liabilities and compliance costs associated with an ongoing fiduciary duty would make it impractical to offer the basic brokerage services favored by low- and middle-income investors.”

A group of trade associations have also expressed concerns regarding the New Jersey proposal, joining SIFMA in "encouraging the Bureau to pause its process and reevaluate its Proposal in light of Reg BI." New Jersey has since called a public hearing, and the comment period for the proposal has been extended to July 18th, reportedly following "70 requests from industry groups opposing the New Jersey measure."

In a supplemental comment to the Reg BI proposal, and in response to a SIFMA request that the SEC take up the issue of preemption, NASAA successfully urged the SEC to decline “to weigh-in on the scope of federal preemption of state regulatory authority in any final Commission Reg BI rulemakings,” further arguing that the issue is “more properly reserved for the courts.” The SEC did not take up the preemption issue in its final rule adoption.

Conclusion

The Massachusetts proposal (and other state proposals) are significant obstacles on the road to acceptance of Reg BI as the final word. While it is likely that the issue of federal preemption will be resolved in court, any final outcome is not self-evident. Bates will keep you apprised.


Bates Group’s compliance consultants can help your firm through the implementation phase of Reg BI. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance Solutions, at rlavigne@batesgroup.com.

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06-13-19

SEC Adopts Regulation Best Interest: Early Reaction and its Impact

SEC Adopts Regulation Best Interest: Early Reaction and its Impact

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On the day the SEC approved a set of regulatory proposals affecting the obligations that broker-dealers and investment advisers owe retail investors, Commissioner Hester Peirce issued a “plea” to critics to “take a fair look at what it says before you proclaim it a success or failure.” In this article, Bates reviews the core elements of the rules and related guidance, and some of the early reactions.

Regulation Best Interest

Regulation Best Interest ("Reg BI") is actually part of a package of rules and interpretive guidance directing broker-dealers to act in the “best interest” of the retail client when recommending a securities or investment strategy. To fully understand the scope of the package, all of its parts must be considered. Here are some of the highlights under the new rule:

Under the new standard, a broker-dealer who makes recommendations to a retail client must satisfy obligations related to (i) disclosure, (ii) diligence, skill and care, (iii) conflicts of interest and, generally, (iv) compliance.

The disclosure obligation requires a broker-dealer to provide in writing to a retail client all “material facts” about the broker-dealer’s relationship with that client. This includes disclosing that the broker-dealer is acting in the capacity of a broker or dealer but not as an investment adviser; the type and scope of services to be provided; the costs of those services; any “material limitation” on a recommendation or investment strategy; and all material conflicts of interest.

The care obligation requires a broker-dealer to exercise reasonable “diligence, care and skill” when making investment recommendations. In order to satisfy the Reg BI obligation, a broker-dealer must understand and communicate the “risk, rewards and costs of any recommendation;” have a reasonable basis to believe that the recommendation is in the best interest of the client and, therefore, not place the interests of the broker-dealer over that of the client; and that any series of transactions are not “excessive,” given the client’s investment profile.

The conflicts of interest obligation requires a broker-dealer to create written policies and procedures and to monitor, mitigate and/or eliminate potential perceived conflicts. A conflict is defined as “an interest that might incline a [broker-dealer] . . . consciously or unconsciously . . . to make a recommendation that is not disinterested.” Consequently, the obligation requires firms to eliminate sales contests and sales quotas, or other techniques that are based on the sale of specific securities in a limited period of time and/or to prevent incentive compensation that may lead to broker-dealers prioritizing their interests over those of a client.

The compliance obligation is an important enforcement provision requiring a broker-dealer to establish, maintain and enforce their written policies and procedures reasonably designed to obtain compliance with the entirety of the Reg BI package.

Client Relationship Summary

A key requirement under the Reg BI package is that both broker-dealers and investment advisers must provide a Client Relationship Summary form (“Form CRS”) to their retail clients. The SEC provided for significant flexibility in the design of a firm’s Form CRS, as it is intended to provide simple and understandable information to retail clients about their relationship with their financial professional. That said, the form is specific in a number of ways. For example, the Form CRS must include information on fees and costs incurred by the client, compensation structures and relationship models of the firm, types of services offered, the differences between investment advisers and broker-dealers and perceived general conflicts of interest. It also prohibits broker-dealers from using the term “advisor” or "adviser" when communicating with retail clients.

Additional Guidance on Investment Advisers

In addition to the core elements required under Form CRS, the SEC also published interpretive guidance that further distinguishes this new best interest standard from that of the fiduciary duty requirement owed to retail clients by registered investment advisers. The fiduciary duty requirement owed under the Investment Advisers Act requires an investment adviser to satisfy both a duty of care and a duty of loyalty. The new guidance explains that an investment adviser’s duties apply to the entire adviser-client relationship. The guidance also refers to an investment adviser’s relationship to institutional clients and provides additional clarity on full and fair disclosure and informed consent.  Additionally, the guidance provided clarification that the best interest standard under Reg BI would only apply to recommendations made by the broker-dealer unless the broker-dealer has disclosed or stated there would be an ongoing duty of care to the client for those recommendations.

More Clarity on “Solely Incidental” Advice

The SEC also provided interpretive guidance on Investment Advisers Act registration exemptions for broker-dealers who provide certain investment advice that would otherwise make these broker-dealers subject to the regulations required for investment advisers. The guidance clarifies that if a broker-dealer’s advice is "solely incidental" to the conduct of their business, and if they don't receive "special compensation," broker-dealers would be exempt from investment adviser registration requirements under the Investment Advisers Act. According to the new guidance, if such advice is “reasonably related to the broker-dealer’s primary business of effecting securities transactions,” then the advice would be “solely incidental” and within the exemption.

Commissioner Reaction

In a definitive vote, the SEC Commissioners voted 3-1 in favor of the proposed rules and guidance issued under Reg BI. Acknowledging the “courage and commitment” of the staff in delivering the final 750+ page package, Chair Jay Clayton restated the SEC’s objectives: “to bring the required standards of conduct for financial professionals and related mandated disclosures in line with reasonable investor expectations; and … to preserve retail investor access (in terms of both choice and cost) to a variety of investment services and products.” The Chair and the other SEC Commissioners supporting the package—some with notable reservations—stated that the rule achieves both objectives. Dissenting, Commissioner Robert J. Jackson Jr. disagreed, saying broadly that Reg BI (i) fails to put retail clients first, (ii) fails to be based on a proper cost benefit analysis, (iii) fails to protect America's savers from conflicted advice, and (iv) does not raise the standard for investment advice.

Early Reaction

Upon the adoption of the new rule, SIFMA President and CEO Kenneth E. Bentsen, Jr. applauded the new framework, saying it “will impose a materially heightened standard of conduct for broker-dealers when serving retail clients.” He noted that in some instances, the duties imposed on broker-dealers under the rule go further than those required of investment advisers. Specifically, he said, that “not even the so-called fiduciary standard under the Investment Advisers Act includes the obligation to eliminate or mitigate conflicts.”

He also recognized that “compliance with the rule will not be easy … and the costs to implement will no doubt be significant, but we believe, worthwhile to uniformly enhance investor protection to the level investors should and do expect, while preserving investor choice and access to investment advice.” 

Reportedly, the Public Investors Arbitration Bar Association, the Consumer Federation of America (“CFA”) and Better Markets all contended that the new rule package would not raise broker advice obligations above the existing suitability standard. In a statement released by the CFA, director of investor protection Barbara Roper said, “the SEC is throwing ‘Mr. and Ms. 401(k)’ under the bus.” Among other concerns, she said that Reg BI will make “it easier for brokers to mislead their customers into believing they are getting trusted, best interest advice when they are actually getting investing recommendations biased by toxic conflicts of interest.”

Conclusion

Bates has been covering the efforts to reform broker-dealer best interest standards for many years (see here, for example), and it was no surprise that Commissioner Peirce’s admonition against prematurely judging the new regulation went unheeded.

That said, the adoption of the Reg BI package still only represents the beginning of a long journey toward achieving the aims articulated by Chair Clayton. As he reminded us: “there are an estimated 43 million American households that have a retirement or brokerage account; there are over 2,700 SEC-registered broker-dealers that provide services to retail investors, with nearly $4 trillion in total assets and almost 139 million customer accounts; there are over 8,000 SEC-registered investment advisers that provide services to retail investors, with over $41 trillion in assets under management and over 40 million client accounts; and there are approximately 960,000 women and men employed by broker-dealer and investment advisory firms that provide services to retail investors.”

The significance of the new rules is undeniable. There will no doubt be many compliance, enforcement and litigation stops likely along the way.


Bates Group can help firms with their Reg BI needs and services. Please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance Solutions, at rlavigne@batesgroup.com.

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06-06-19

Cryptocurrencies Regulatory Update: FinCEN Guidance, SEC and Commissioner Commentary

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The state of play in cryptocurrency regulation continues to reflect legitimate tensions between promoting innovation and entrepreneurship and maintaining sound markets and investor protection.

In previous articles, Bates Research has described some of the definitional challenges that directly affect which agencies govern which crypto assets.  For example, the SEC asserts jurisdiction over virtual digital offerings presented as securities (under certain legal tests,) while the CFTC maintains authority when the digital assets present as commodities and options. FinCEN covers digital assets by extending money transmission regulations for businesses subject to Bank Secrecy Act (“BSA”) and Know Your Customer (“KYC”) obligations. State and international regulators sometimes take conflicting positions as they attempt to control how these new technologies may affect their economies. In short, regulators are alternatively encouraging, threatening and enforcing compliance as new business models push the boundaries of traditional commerce.

In this article, we review recent developments including new guidance and a recent advisory issued by FinCEN, anticipated guidelines from the Financial Action Task Force (“FATF”) and the latest developments at the SEC. 

FinCEN Issues Guidance and an Advisory

Last month, FinCEN issued interpretive guidance affirming its regulatory approach and warning financial institutions about the threat of virtual currencies used to support criminal activity. Specifically, FinCEN took two steps in order “to provide regulatory certainty for businesses and individuals.” First, the agency consolidated current FinCEN regulations, administrative rulings and preexisting guidance and explained how they apply to “Convertible Virtual Currencies” (CVCs) businesses. Second, FinCEN issued warnings “to assist financial institutions in identifying and reporting suspicious activity related to the criminal exploitation of CVCs for money laundering, sanctions evasion, and other illicit financing purposes.”

The FinCEN guidance starts by defining key concepts including the definition of money transmitters and “money transmissions…that substitute for currency.” This is important, as the definitions serve to distinguish FinCEN’s authority over money services businesses (“MSBs”) from those of the SEC (derived from the definition of “securities”) and the CFTC. (derived by definitions related to commodity futures.)

FinCEN then explains its current regulatory scheme involving money transmission under the BSA. The agency restates key requirements including written AML compliance policies, the collection of KYC information, the monitoring of transactions by a designated officer, the filing of SARs and adequate record-keeping. Remaining sections summarize FinCEN’s most recent guidance on the application of money transmission regulations to transactions denominated in CVC; highlight certain patterns of activity that raise concern and demonstrate how different business models that utilize CVCs are covered. As Director Kenneth A. Blanco stated: “our regulatory approach has been consistent and despite dynamic waves of new financial technologies, products, and services, our original concepts continue to hold true. Simply stated, those who accept and transfer value, by any means, must comply with our regulations and the criminal misuse of any methodology remains our fundamental concern.”

The companion FinCEN advisory provides examples of “prominent typologies” and details some thirty red flags for compliance professionals. The advisory identifies information important to enforcement agencies contained in SARs. The guidance and advisory warns of suspect conduct related to peer-to-peer transactions, custodial wallets, crypto ATMs (physical CVC kiosks), anonymity-enhanced CVC transactions, money transmission performed by internet casinos, decentralized applications (dApps), crypto-payment processors and mining pool operators.

Sigal Mandelker, Under Secretary of the Treasury for Terrorism and Financial Intelligence offered some additional perspective. Of the more than 47,000 SARs received by the Treasury Department since 2013, she said, “half of these SARs were filed by virtual currency exchangers or administrators themselves…. Nobody [] wants to see innovative products and services misused to support terrorism and weapons proliferation.”

FATF Interpretive Guidance Coming in June

Expected later this month, the Financial Action Task Force (FATF) will finalize certain updates to its international standards and provide clarifying interpretive notes. Specifically, the intergovernmental standards-setting body will recommend that virtual asset service providers require the identities of both the sender and recipient of every virtual asset transmittal of funds. To date, the industry has not reacted favorably to this recommendation, declaring that bad actors would simply move toward unregulated markets. But as one influencer remarked, stricter standards would “actually legitimize crypto-currencies globally … and set the stage for the conventional financial sector to use the technology, in line with established regulatory frameworks.”

Additional Developments From the SEC

In April, William Hinman (SEC Director, Division of Corporation Finance) promoted a newly published framework “for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.” Though the framework is intended to be an analytical tool for assessing whether the securities laws “apply to the offer, sale, or resale of a particular digital asset,” – and officially “not a rule, regulation, or statement of the Commission.” The framework serves as yet another guide by the SEC to define what is and is not within the jurisdiction of the agency and, therefore, whether an entity must register and be subject to applicable registrations. The framework reaffirms that covered entities include those that offer, sell, distribute, market, buy, sell, trade, facilitate exchanges and offer financial services concerning digital assets.

The overall SEC approach, which included the issuance of an SEC registration exemption letter, was criticized by SEC Commissioner Hester Peirce, who compared the agency’s approach to Jackson Pollack splashing paint across a canvas. Though she acknowledged preliminary steps by the agency that provide some clarity on the legal test, she encouraged greater guidance by the regulators and warned that “without a functional secondary market, which encompasses broker-dealers and trading platforms that can legally trade digital securities, and advisers and funds that can buy and hold the assets, the primary market in the U.S. will wither, and retail investors will not enjoy the protection our securities laws offer.”

Conclusion

While there is continuous movement to strengthen the definitions that anchor agency authority and jurisdiction, as evidenced by FinCEN’s new guidance and advisory, the upcoming FATF interpretive guidance, and additional information pushed out by SEC staff, there is also great debate in the market on the slow pace toward a holistic regulatory approach to fintech. Bates will keep you apprised.

For information on how we may help, please follow the links below to Bates Group's Practice Area pages:

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Bank Secrecy Act

Bates Compliance Solutions

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Retail Litigation and Consulting

Institutional and Complex Litigation

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05-30-19

NASAA Members Adopt Investment Adviser Information Security Model Rule Package

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Only a few weeks ago, Bates described an SEC Office of Compliance Inspections and Examination (OCIE) Risk Alert that highlighted privacy and information security issues raised during examinations of registered investment advisers and broker-dealers. The Alert urged registrants to pay closer attention to all aspects of SEC regulations that obligate firms to safeguard client information.

The SEC has not been the only regulatory agency to express concern over data privacy and information security. As Bates reported last October, the North American Securities Administrators Association (NASAA) proposed a new model rule for consideration by state regulators that would require state-registered investment advisers to adopt new policies and procedures in order to safeguard client information. The model rule was based in part on the results of NASAA’s 2017 supervisory examinations of state registered firms and on NASAA’s evolving Cybersecurity Checklist.

Fast forward to last week: NASAA announced that its members voted to adopt the model rule package “which now is available for individual jurisdictions throughout the United States to implement through regulation.” That announcement is significant. State implementation of the model rule package may have serious enforcement implications. In this article, we take a closer look at what those could be.

NASAA’s Model Rule Package

The NASAA model rule package has three parts:

First, the package contains the Investment Adviser Information Security and Privacy Rule (the model rule) which requires investment advisers to adopt policies and procedures related to both the physical and the cybersecurity of information. Generally, an investment adviser must protect and safeguard confidential client records including from any release of such records where harm might result. Specifically, the model rule requires a firm’s policies and procedures to (i) identify and establish “organizational understanding to manage information security risk to systems, assets, data and capabilities;” (ii) provide “safeguards to ensure delivery of critical infrastructure services;” (iii) be able to detect, (iv) be able to take action in case of, and (v) be able to restore any capabilities or services after, an “information security event.” The Model Rule also requires review and maintenance of these policies and procedures as well as the annual delivery of a firm’s privacy policy to clients.

Second, the package consists of amendments to NASAA’s Recordkeeping Requirements which mandate that investment advisers maintain additional records, including (i) copies of an investment adviser’s “Physical Security and Cybersecurity Policies and Procedures and Privacy Policy,” (ii) “all records documenting the investment adviser’s compliance with” these policies and procedures and their annual review, and (iii) records of any violation of the state rule and “of any action taken as a result of the violation.”

The third element of the package concerns enforcement and non-compliance. It amends NASAA’s Unethical Business Practices and Prohibited Conduct Rules to include failing to establish, maintain, and enforce practices and procedures to the list of unethical business practices/prohibited conduct. Practically speaking, once embraced by a state, the model rule will place a significant burden on investment advisers. Failure to comply with information security practices or procedures, a security incident, the release of confidential information, or some other data breach could trigger a determination that a firm engaged in an unethical business practice or prohibited conduct thereby subjecting an investment adviser to penalties and consequences.

According to Michael S. Pieciak, NASAA President and Vermont Commissioner of Financial Regulation (pictured above), this model rule package “provides a basic structure for how state-registered investment advisers may design their information security policies and procedures.” The model package is intended, he said, “to create uniformity in both state regulation and state-registered investment adviser practices.”

Potential Impact of New Rule Package

In its 2019 Annual Report, NASAA offers a snapshot of the current status of those potentially affected by the model rule. The Report cites some 17,500 state-registered investment advisers. Of that number, NASAA states that 80% operate out of one- or two-person “shops,” and almost 19% operate in businesses with between 3 and 10 representatives. Further, the data shows that 99% of the businesses serve main street/retail investors. In the NASAA release, Andrea Seidt, Chair of NASAA’s Investment Adviser Section, points to the potential impacts for companies and small shops when faced with a security breach, saying "The reputational damage and loss of client trust that often follows an information security breach can be devastating to the bottom line of any business, especially small businesses.”

Given any overlapping obligations required under federal law (e.g. SEC regulations), the compliance burden on independent advisers continues to grow. State-registered investment advisers should anticipate that they will need to conform their current policies and practices to NASAA’s model rule and stay alert to the adoption of the model rule in their state. Bates will continue to keep you apprised of both state and federal developments.

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions

Regulatory and Internal Investigations

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Institutional and Complex Litigation

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Financial Crimes

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05-23-19

SEC Office of the Investor Advocate Releases New Report on Efforts to Protect Seniors

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An Engagement Adviser[1] in the SEC Office of Investor Advocate (OIA) has prepared a valuable overview report on the SEC’s efforts to protect seniors from financial exploitation. The 25-page paper highlights the agency’s examination, enforcement and regulatory policy, in addition to its education and outreach activities. The paper also offers suggestions for financial firms and financial service providers to consider when reviewing their compliance processes and procedures.

Bates follows regulatory and enforcement developments on senior financial exploitation issues closely. In addition to tracking current events across the wide spectrum of state and federal regulators and legislators, Bates Research published its own white paper on senior fraud last September. In that paper—citing to some of the previous work done by the OIA Adviser—we described some of the compliance challenges facing firms as they confront a complex and evolving regulatory environment. In this article, we review key observations from this latest OIA report which hones in, specifically, on the SEC’s approach to combating senior financial fraud.

SEC Compliance Inspections and Examinations

The OIA Adviser summarized the “evolution of industry policies, procedures and practices” as a way of understanding the agency’s current regulatory framework. The summary is also important in order to appreciate the urgencies, the multiple actors and the historical progression of the issue.

Of more practical significance, perhaps, is the review of the most recent risk examinations of broker-dealers, investment advisers, and other entities conducted in several ways by the Office of Compliance Inspections and Examinations (OCIE), including OCIE’s findings on the recurring gaps in compliance. These include (i) failures to tailor policies to a firm’s specific business models and client bases and (ii) policies and procedures that lack necessary specificity.

The Adviser provided many specific examples, including firms’ wholesale adoption of policies and procedures from other entities, improper delegations of core responsibilities to third parties without documentation and vaguely defined criteria for identifying senior customers. Other examples highlighted uneven procedures designed for some products (like insurance, IRAs and retirement products) but not others, deficiencies in monitoring and supervision, and inadequate training. He described issues related to diminished capacity, retirement account management, trusted points of contact and changes to account beneficiaries. In so doing, the report provides a helpful checklist for compliance officers as they review their policies and procedures.

SEC Enforcement Cases

The author also reviewed a handful of Enforcement Division cases (in particular those derived from the data driven investigations by the Retail Strategy Task Force) concerning fraudulent schemes against seniors. These were selective but include prosecuted Ponzi, boiler room, pyramid, theft and misappropriation of funds and securities price (or volume) manipulation schemes. Among the sources the agency draws on to “ferret out” these schemes are suspicious activity report filings (see Bates article here for a review of a recent CFPB Report on SARs filings and elder financial exploitation), the tips and referrals hotline, and programs to encourage and reward whistleblowers. 

Regulatory Policy and Public Education

In a brief review of SEC-related regulatory policy, the report touches on FINRA rule amendments on “Customer Account Information” and “Financial Exploitation of Specified Adults.” It emphasizes that these regulatory changes are part of the new toolkit designed to help regulators combat senior financial fraud and notes, generally, the importance of the NASAA Model Act, state laws and Congress’ Senior Safe Act of 2018. It also describes the importance of the no-action letter process for the mitigation of potentially serious impacts of the amended rules on broker dealers, as well as the SEC efforts to educate the public through a series of activities ranging from live events and town halls to webinars and other online content. Highlighting the work of Office of Investor Education and Advocacy (OIEA), the importance of access to background checks for financial professionals is also underscored.

OIA Warns of Continuing Challenges

The report also cautions that there are demographic, market and technological challenges that will continue to impact the fight against financial fraud. The lure of the scam, the aging of the American population, issues of cognitive impairment, shifts from defined-benefit to defined-contribution retirement plans (that require retirees to more actively manage their own savings), a continuing low interest rate environment (which “tempts” investors to reach for yield)—these are all trends that are part of the landscape. In addition, he cites the challenges that are presented by new technologies, which give fraudsters new ways to exploit seniors but also allow “the SEC and others to work smarter and more effectively in combatting elder abuse.”

Another interesting observation is the challenge presented by the sheer size of the problem and the heavy financial and emotional toll it inflicts. The OIA recognizes that this creates an urgent desire for action on the part of legislators, regulators and law enforcement. In doing so, however, they must acknowledge the complexity of balancing the rights of the elderly to make their own financial decisions (and to have access to their accounts and to privacy) against the efforts and rules intended to protect the vulnerable from suspected financial exploitation, “even if it comes at the expense of the individual’s autonomy.”

Conclusion

The value of the OIA report lies in its collation of all the various activities undertaken by the SEC on a single priority: curbing senior financial exploitation. As to its guidance for financial firms, the OIA offers general, but common-sense recommendations. These include greater attention to: (i) tailored policies, procedures and practices that specifically address seniors; (ii) better awareness of the growing list of federal and state requirements, safe harbors and rules; and (iii) training employees on the signs of and steps to take regarding financial exploitation.

The OIA also recommends that financial firms “go beyond compliance and strongly consider taking voluntary action, if warranted, to protect seniors.” Such voluntary action would include more aggressive intervention in pausing disbursements in suspicious circumstances, engaging with trusted contacts when health or cognitive decline questions emerge, notifying authorities and extensive training.  

As the SEC and other regulators raise expectations on firms for more risk-based compliance, the OIA report is helpful. Its overview of the many elements of regulatory intervention helps firms to understand the broader view of the regulator and, therefore, to better anticipate and prepare for regulatory oversight on senior financial exploitation. Bates will continue to keep you informed.

 

For more information concerning financial issues related to vulnerable and senior investors, including senior investor expert witnesses, damages analysis, and compliance, please contact Bates Group today.

Financial institutions may also be interested in Bates Investor Risk Assessment to protect your vulnerable and elder investors and firm while meeting regulatory expectations.

 


[1] Stephen Deane, Engagement Adviser in the SEC Office of the Investor Advocate.


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05-16-19

FINRA on AML, Departing Registered Representatives, New Proposed Rules for Firm Misconduct

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Over the last month, FINRA issued guidance on anti-money laundering (AML) compliance and customer communications concerning departing registered representatives. FINRA also proposed a rule adding obligations to firms with a significant history of misconduct. In this article we take a closer look at these moves and the stepped-up expectations that flow from them.

Compliance and Anti-Money Laundering

Concerned with emerging areas of risk, particularly with respect to digital assets, FINRA published new AML guidance “to assist broker-dealers in complying with their existing obligations.” The new guidance highlights conditions under which brokers must monitor and report suspicious activities under a firm’s written AML compliance program, as required by FINRA Rule 3310.

As noted in Bates’ recent Compliance Alert, circumstances that require the filing of reports include the detection and reporting of transactions by a broker-dealer that “involves or aggregates funds or other assets of at least $5,000, and the broker-dealer knows, suspects or has reason to suspect that the transaction” (i) contains funds from an illegal activity; (ii) is designed to evade regulations under the BSA; (iii) does not appear to have a "reasonable explanation;" or (iv) might be facilitating criminal activity. Broker-dealers must report such activity by filing suspicious activity reports (SARs).

The FINRA guidance enumerated examples of potential money laundering “red flags” for firms to consider incorporating in their compliance programs. FINRA highlighted these examples under various categories, including customer due diligence and interactions with customers, deposits of securities, securities trading, money movements, insurance products and other indicators of suspicious customer behavior. The sheer number of red flags—likely taken from examinations—should urge firms to review the myriad potential vulnerabilities in their existing compliance program.

Compliance on Communications Concerning Departing Brokers

Concerned that customers may be less than fully informed about the maintenance of their assets in the event that their registered representative leaves a firm, FINRA offered guidance on what firms must do under these circumstances. FINRA recognized how different business models (customer advisory center, group service or one-on-one) may affect customer relations. However, they expect that all firms must “promptly and clearly communicate to affected customers how their accounts will continue to be serviced” and “provide customers with timely and complete answers, if known, when the customer asks questions about a departing registered representative.”

Specifically, FINRA expects firms to have appropriate policies and procedures in place to ensure direct communication and continuity for the client should their registered representative depart. Firms are obligated to update these policies annually and make them available to all customers. Among the required elements, firm policies must include providing a customer with points of contact, ongoing trade instructions and answers about the departing representative themselves. FINRA expects firms to clearly communicate to customers an option to stay with the firm (and be serviced by a newly assigned registered representative or someone else) or to transfer the assets to another firm. FINRA also stated that the firm must provide the departing registered representative’s contact information, so long as the departing representative consented to such disclosure. That said, FINRA noted that any information provided about the departing representative must be “fair, balanced and not misleading.”

Proposed New Rules For Firm Misconduct

Concerned with the heightened risks that firms with “a significant history of misconduct” pose to investors, FINRA proposed new rules that would identify these firms and then place additional obligations on them. The proposed new Rule 4111 (the Restricted Firm Obligations Rule) would require these designated firms to (i) make deposits of cash or qualified securities that cannot be withdrawn without FINRA's written consent, (ii) be subject to restrictions on operations deemed necessary or appropriate to protect investors, or (iii) be subject to a combination of both those obligations.

A further proposed rule outlines expedited procedures that allow for the review of determinations under the Restricted Firm Obligations Rule, providing members the right to challenge any new obligations that may be imposed. FINRA states that the determination is based on specified numeric disclosure event thresholds “developed through a thorough analysis” and relative to “the number of events at similarly sized peers.”

At the 2019 FINRA Annual conference, Robert W. Cook, President and CEO of FINRA, said that “the goal is to use objective criteria” when determining whether a firm must comply with additional obligations. He said that FINRA’s chief economist found, when focusing testing on the objective criteria, that the number of miscondent events is high. “Firms that have been caught in a funnel may have as many as nine times events than their peers,” said Cook.

Beyond the numbers, Mr. Cook shared with the conference audience that FINRA considered other factors including information from the member applications program (MAP), the firm’s regulatory history and examinations. He also said that there would be dialogue with the firm including as to the types of things they are doing that pose the greatest risk to investors and ask the firm to “put aside greater capital to cover future unpaid arbitration awards.”

The proposal states that restricted firms, “while small in number, present heightened risk of harm to investors…their activities may undermine confidence in the securities markets as a whole.” Mr. Cook echoed this rationale, stating, “we want to be sure that FINRA is doing everything we can to address this outsized risk and the high numbers of misconduct issues” they represent.

 
To learn more about Bates Group’s services, please contact:

Edward Longridge, Managing Director, Financial Crimes - elongridge@batesgroup.com

Robert Lavigne, Managing Director, Bates Compliance Solutions - rlavigne@batesgroup.com

 

See here for a recent conversation on AML compliance issues with Bates Group’s Managing Director of Financial Crimes, Edward Longridge.

Visit us at the 2019 FINRA Annual Conference this week at Booth #7.

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05-09-19

Safeguarding Client Information: OCIE Wants Firms to Increase Efforts

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In a new Risk Alert, the SEC’s Office of Compliance Inspections and Examination (OCIE) highlighted privacy and information security issues raised during examinations of registered investment advisers and broker-dealers. The OCIE wants registrants to pay closer attention to all aspects of Regulation S-P, the SEC’s rule that obligates firms to safeguard client information. In addition, the OCIE wants firms to be more diligent about integrating their overall compliance efforts and to better communicate privacy policies to their retail investors—particularly as they relate to electronic and web-based platforms. As Bates Research described in a  previous post, the OCIE is prioritizing the protection of retail investors (see its annual report on market risk). Securing customers’ personal information is at the heart of that protection. In this article, we takes a closer look at the new Alert and the OCIE’s emphasis on improving Regulation S-P compliance.

SEC Rules and OCIE Exam Results

As FINRA states, “protection of financial and personal customer information is a key responsibility and obligation of FINRA member firms.” Regulation S-P requires firms to enact written policies and procedures to protect the confidentiality, security and integrity of client information. The Safeguards Rule requires these policies to “address administrative, technical and physical safeguards.” Among other things, this rule obliges firms to protect against anticipated “threats or hazards” and against any unauthorized access to personal information. Further, the regulation requires firms to issue privacy notices to clients on firm information-sharing practices, to further explain customer rights to opt-out, to develop programs to prevent identity theft and to address potential risks of bad actors intent on stealing account assets or accessing a client account to manipulate the market.

OCIE reports that it found gaps in firm compliance with many of these obligations. The most common deficiencies included failures to have written policies and procedures related to the administrative, technical, and physical elements as required under the Safeguards Rule. But OCIE found many specific failings including, for example, failures in the provision of the required notices, inaccuracies in the content of the notices, failures to provide opt-out information on sharing non-public personal information, as well as policies containing blank spaces that registrants left incomplete.

Just as significant, OCIE reports that many of the written policies were “not reasonably designed” to protect client’s personal information. The agency highlighted a host of examples including failures (i) to protect customer information on personal devices; (ii) on the use of personally identifiable information (“PII”); (iii) in the training and monitoring on the use of unsecured networks and encryption in electronic communications; and (iv) related confidentiality when employing outside vendors. More broadly, the OCIE found examples of firms failing to keep an inventory of all the systems that may access PII; inadequate incident response plans; PII that was stored in unsecure locations, customer login credentials that had been too widely disseminated; and failures to ensure that former employees terminated access rights to PII after their departure.

CyberSecurity

The Regulation S-P issues addressed in the OCIE Risk Alert implicate broader concerns about protection of financial information and cybersecurity. As Bates has reported before, both FINRA and NASAA have addressed related issues (see here and here). Recently, SIFMA published a thinkpiece on battling current risks associated with cybersecurity for financial firms. It points out that “cybersecurity is not just about building defenses around a perimeter…but have expanded to include malicious or destructive attacks, that go beyond stealing money and data.” 

The author concludes that firms must not only address the issue through compliance but through the development of a culture of cyber resiliency:

“Security is not just IT or compliance’s problem, it is everyone in the organization’s problem. And the key to mitigating cyber risk is having everyone in the organization concerned about cyber awareness. Financial services employees understand cyber resiliency is critical to meeting client expectations, delivering client services and safeguarding client data…There is evidence to show that there is a benefit to all parties if they work together—collaboration, not silos—to protect the firm from cyber attacks and the reputational risk from an incident. Training and ongoing communication changes the mentality of employees.”
 

The underlying message of the OCIE’s Risk Alert is that firms must engage in a deep dive to ensure that adequate firm policies exist and are being implemented in a way that can effectively address the risk. SIFMA’s opinion piece takes this a step further, arguing effective risk management requires cultural change that supports but goes beyond integrating administrative, technical and physical safeguards under Regulation S-P.

Conclusion

When the OCIE sends out an alert, it is providing information to help firms adopt and implement effective policies and procedures under the applicable regulation—in this case Regulation S-P. The Alert is also a strong message that the agency has made the subject a priority, thus increasing the likelihood that enforcement efforts are not far behind.

 

Visit Bates Group at the 2019 FINRA Annual Compliance, Booth #7, on May 14th-17th in Washington D.C. and learn more about our compliance and regulatory solutions for your firm.

 

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Financial Crimes

Insurance and Actuarial Services

Consulting and Expert Testimony

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05-02-19

New Jersey Makes Its Move, Proposes Financial Services Fiduciary Standard

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On April 15th, the New Jersey State Bureau of Securities proposed applying uniform fiduciary standards to broker-dealers and investment advisers for recommendations and advice they give to New Jersey investors. The new, no-nonsense proposal is certainly aggressive. Any breach of a fiduciary duty owed to a customer under the proposed regulation would be deemed a “dishonest and unethical practice.”

The proposed New Jersey rule was expected—New Jersey Governor Phil Murphy (pictured above) and Attorney General Gurbir Grewal have been promoting it since at least September 2018 and issued a pre-proposal of the rule in October. Notably, these early steps were taken only months after the SEC introduced Regulation Best Interest, and some six months after the Fifth Circuit struck down the Labor Department’s version of a fiduciary duty rule, (see Bates’ discussion of these actions at the time.) Regarding timing, SEC Chair Jay Clayton said that Regulation Best Interest will be issued sometime in 2019, with many expecting that it will happen this summer.

The formal promulgation of the new rule has garnered a lot of attention for both its terms as well as its proactive approach to the SEC efforts. In this article, Bates describes this state proposal rule and considers some of the implications and reaction to the New Jersey move.

The State Makes Its Move

In introducing the bill, New Jersey’s leaders threw down the investor protection gauntlet. Arguing that the proposal offers “some of the strongest investor protections in the nation,” Governor Murphy stated: “At a time when the federal government is undermining the consumer protections implemented in the wake of the 2008 economic crash, we are committed to ensuring our residents and families are protected from predatory financial practices." Attorney General Grewal added, “If the federal government won’t act to protect investors, then we will.”

The state leadership left little doubt about its position. The proposal criticizes the suitability standard as inadequate and vulnerable to conflicts of interest and excessive fees. Dual registration is criticized as confusing and blurring the lines between advisory services and sales. The Acting Director of the Division of Consumer Affairs was blunt: “nothing short of [the fiduciary standard] provides investors with the protections they deserve.”

The Proposal

The proposed rule requires all registered investment professionals to act as a fiduciary when providing advice “or recommending an investment strategy, the opening of or transfer of assets to any type of account, or the purchase sale or exchange of any security.” The term fiduciary includes both a duty of care and a duty of loyalty. The former requires the registered professional to make a reasonable inquiry into the risks, costs, and conflicts of interest related to any recommendation or advice, and to understand the “customer’s investment objectives, financial situation and needs, and any other relevant information.” The duty of loyalty is intended to ensure that any advice be made without regard to the financial interest of the investment professional or any other third-party.

The proposed rule lays out several presumptions, conditions and clarifications which establish guideposts for expected behaviors. For example, existing incentive practices, such as sales contests or anything that might lead to a conflict of interest, would be considered presumptively invalid. Existing disclosures of conflicts of interest practices by themselves would not be sufficient to satisfy the duty of loyalty required by the proposed standard. As to transaction-based fees, they are still allowed under limited conditions.

Further, the rule defines how long and in what instances the fiduciary duty lasts. For specific recommendations by a broker-dealer, for example, the fiduciary obligation “extends through the execution of the recommendation and, therefore, would not be considered an ongoing obligation.” This is distinguishable from obligations related to advice for investment advisers and dual registrants, for whom the obligation would be applicable to the entire customer relationship on an ongoing basis.

As noted, failure to act in accordance with this fiduciary duty when making a recommendation or providing investment advice would constitute “a dishonest or unethical business practice.” Comments on the proposal are due by June 14, 2019.

States’ Rights

To the extent that the New Jersey proposal represents an assertion by a state to use its authority to protect its resident investors from harm, New Jersey joins other states, such as Maryland, Nevada and New York that have, in various forms and with limited success, joined the fight. (See, e.g. here and here.) The New Jersey proposal may add momentum to these state efforts to impose standards on broker dealers and investment advisers.

Given that likelihood, the New Jersey proposal highlights legal questions of federal preemption over state law. A fight over federal preemption ensures that federal courts will be needed before any final resolution. Initial preemption concerns were already discussed in a SIFMA comment letter requesting that the SEC adddress it, and a NASAA response asking the SEC to bypass the question and let the courts determine such questions.

Conclusion

It is easy to see the New Jersey proposal as merely the latest skirmish in a long-running battle to address serious systemic and conflict of interest issues in financial services. On substance, however, the proposed New Jersey fiduciary standard can very much be viewed as a direct challenge to SEC Regulation Best Interest. Under a section titled “Federal Standards Analysis,” the New Jersey Bureau states clearly that its “proposed new rule will exceed [the SEC-proposed] standard.”

In an op-ed titled SEC Proposal Packs an Investor-Protecting Punch  supporting Regulation Best Interest, SIFMA’s CEO Ken Bentsen wrote a direct appeal to the Commissioners: “Ultimately, the SEC proposal represents a true best-interest standard with real teeth. We urge the SEC to present a final rule at their earliest opportunity….After more than a decade of debate, the time to finalize the rule is now.”

As the debate continues, Bates will keep you apprised of developments.

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04-25-19

Federal Legislators Target Mandatory Arbitration

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Longstanding opposition to mandatory arbitration is finding renewed momentum as federal legislators introduce bills to limit or even eliminate the binding provisions in consumer, employment and financial contracts. In the name of protecting consumers, employees and investors, legislators introduced the Forced Arbitration Injustice Repeal Act (“FAIR Act”), the Arbitration Fairness for Consumers Act (“AFC”) and the Investor Choice Act (“ICA”). This recent activity is in addition to persistent calls by House and Senate members to ensure greater fairness and transparency in FINRA’s arbitration process.

Given the importance that mandatory arbitration plays in the overall framework of dispute resolution for financial firms and professionals, these bills reflect a wave of political action not so easily dismissed. In this article, Bates Research looks at the new legislation, some reactions by industry groups and recent developments on the broader subject, including continued pressure on FINRA.

A Concerted Attack on Mandatory Arbitration?

The Investor Choice Act - For broker-dealers and advisers, the proposed ICA may be the most explicit of the new proposals. Sponsored by Representative Bill Foster (D-IL), the bill would amend securities laws to prohibit mandatory pre-dispute arbitration agreements. The underlying premise of the bill is the assertion that “brokers, dealers, and investment advisers hold powerful advantages over investors,” and that “mandatory arbitration clauses…leverage these advantages to severely restrict the ability of defrauded investors to seek redress.” The bill would give investors a choice to use arbitration “if they judge that arbitration truly offers them the best opportunity to efficiently and fairly settle disputes,” but would also allow investors to “be free to pursue remedies in court should they view that option as superior to arbitration.” Other provisions would amend securities laws and the Investment Advisers Act to prohibit the listing of any security that mandates arbitration between an issuer and its shareholders. (Made explicit is the prohibition against any such provision in an issuer’s bylaws, registration statements, or other governing documents). Further, the bill would make preexisting mandatory arbitration clauses in contracts void.

The Arbitration Fairness for Consumers Act - The AFC, introduced by Senator Sherrod Brown (D-OH), would be applicable to contracts involving real or personal property, services (including services related to digital technology), securities and other investments, money and credit. As applied to consumer financial products or service disputes, the AFC would prohibit mandatory pre-dispute arbitration agreements and any “practices that interfere with the right of individuals and small businesses to participate in a joint, class, or collective action related to a consumer financial product or service dispute.”

The Forced Arbitration Justice Repeal Act - The FAIR Act, sponsored by Hank Johnson (D-GA) in the House and Richard Blumenthal (D-CT) in the Senate, would amend federal arbitration law to prohibit pre-dispute arbitration agreements related to “future employment, consumer, antitrust, or civil rights disputes.” Similar to the above bills, it would “prohibit agreements and practices that interfere with the right of individuals, workers, and small businesses to participate in a joint, class, or collective action” related to these areas.

Notably, the Supreme Court just handed down its latest decision in Lamps Plus, Inc., et. al. v. Varela, a case involving this very issue. In a 5-4 decision, the majority found that companies may use unambiguous contractual arbitration provisions to prevent class actions in arbitration proceedings. The Supreme Court stated that class arbitrations were “markedly different” from “traditional individualized arbitration.” Citing previous case law, the majority reasoned that “in individual arbitration, 'parties forgo the procedural rigor and appellate review of the courts in order to realize the benefits of private dispute resolution: lower costs, greater efficiency and speed, and the ability to choose expert adjudicators to resolve specialized disputes.'” (at pp. 7-8). The majority concluded that the parties, by consenting to the individual arbitration provisions, did not agree to “'sacrifice[] the principal advantage of arbitration.'” The proposed legislation would likely overturn this decision.

In addition, several previous bills are expected to be reintroduced in the near future, including the Restoring Justice for Workers Act, which would prohibit mandatory pre-dispute arbitration under the National Labor Relations Act, and the Ending Forced Arbitration of Sexual Harassment Act, which would do away with mandatory pre-dispute arbitration of sex discrimination claims.

Industry Reaction

Under Dodd-Frank, the SEC has the authority to review arbitration for both consumer products and securities. To date, it has not done so and has not addressed formally the recent legislative proposals. On the record, however, is the U.S. Chamber of Commerce, which opposes, in particular, the ICA. In a April 2019 statement, Thomas Quaadman, Executive Vice President of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, argued that “many of the criticisms of arbitration are based upon the flawed premise that alternative mechanisms—such as litigating through the courts—provide better outcomes for consumers and investors and give them a meaningful and realistic option for resolving a dispute. In fact, the opposite is true.” He cited FINRA estimates stating that “the average arbitration dispute is settled in a little over a year…[which]…stands in stark contrast to class action lawsuits which can drag on for years without a resolution.” FINRA states that “When an arbitration case goes to a hearing, it can take up to 16 months for an award to be determined.”

SIFMA also opposes the legislative efforts. In testimony submitted to the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, SIFMA defended FINRA’s arbitration forum, stating that it “stands above because it incorporates substantive and procedural protections comparable to court-based litigation, and thereby ensures fair case outcomes for retail customers.”

In addition to this commentary before the House Subcommittee, the Senate Judiciary Committee held a hearing this month titled “Arbitration in America.” (Click the following links to listen to the testimony or to read about the hearing.)

FINRA Developments

While FINRA has not commented officially on these bills, the self-regulatory organization has been working on transparency concerns and alleged perceived issues of unfairness in its arbitration system for a long time. For example, as part of its efforts to improve its arbitration process (see, e.g. Bates’ review here), FINRA approved for SEC consideration, amended procedures related to new guidance on expungement of customer dispute information and related fees. This recommendation follows FINRA’s 2017 proposal, Regulatory Notice 17-42, which would establish a roster of trained and experienced arbitrators from which a panel would be selected to decide expungement cases.

Issues around the FINRA expungement process are part of aggressive oversight and legislative activity by Senator Elizabeth Warren (D-MA). In a letter sent by the Senator in March 2019, she pressed FINRA on when it plans to submit these proposed expungement regulations to the SEC for approval. Beyond this, Senator Warren previously proposed legislative reforms that would require FINRA to address unpaid arbitration awards. Last year she proposed that FINRA establish a relief fund for unpaid arbitration awards “issued against brokerage firms or brokers regulated by the Authority.”

Other FINRA steps continue at a deliberate pace. At the end of last year, FINRA made available “in one place on its website a list of firms and individuals responsible for unpaid customer arbitration awards” in order to “make this information more readily accessible to investors.” In addition, FINRA issued a rulemaking proposal which would, if approved by the SEC, prevent non-attorneys (“NARs”) from being compensated for representing parties in arbitration cases (see also Bates’ discussion here). These actions reflect the industry’s movement toward addressing the overall political perception that the arbitration process is not adequately protecting investors.

Conclusion

Collectively, the proposed legislation reflects a consistent, increasingly partisan position on binding arbitration. Mandatory arbitration has now become part of the current debate on financial and consumer services, as well as employee-employer relations. As applied to financial services, the bills put pressure on the SEC, and FINRA in particular, to demonstrate the adequacy of their arbitration system.

Whether mandatory arbitration under law is perceived as perpetuating a system that provides a reasonable and effective solution for dispute resolution, or a system that is rigged to immunize firms from costly litigation (or otherwise fails to offer meaningful recourse to injured investors and consumers), it is not going away anytime soon. In the meantime, Bates will keep you updated.

 

Learn more about Bates Group’s Litigation Services, including expert testimony, damages analysis, and our Arbitrator Evaluator™ selection tool.

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04-05-19

Spotlight: Q&A with R. Gerald (“Jerry”) Baker, Bates Group Senior Compliance Consultant

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Bates Research interviews our most senior experts to get their perspective on the latest regulatory and compliance concerns affecting clients today. We sat down recently with R. Gerald (“Jerry”) Baker, a Consultant with Bates Compliance Solutions who has over 45 years of financial services and compliance experience, and asked him to share his observations on some of the current challenges confronting broker dealers and RIAs, including trends, resource constraints and individual and firm accountability.

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Bates Research: Jerry, thanks for sharing your time with us. Let’s start with a bit about you and your background—please share with us some of the highlights.

Jerry Baker: Glad to be with you. I’ve been fortunate to have had an extensive career in our industry. It started on the operations or “back office” side, followed by financial reporting and administrative roles. For a short period I was also a registered representative with two major firms.

My compliance career began in 1966, and I remained in compliance up until my retirement in 2001. I served as the Chief Compliance Officer (“CCO”) for First Union Securities following its acquisition of EVEREN Securities (formed by the consolidation of five broker-dealers owned by Kemper Corporation). Prior to that I served as the CCO for Prescott, Ball & Turben, Roney & Co. and briefly Morgan Stanley. I also co-chaired both SIFMA C&L working groups on its White Papers the Role of Compliance and The Evolving Role of Compliance, and I am a contributing author in the book Modern Compliance. From 2001 until 2014, I served as Executive Director and Special Advisor to SIFMA’s Compliance & Legal Society and was the recipient of the SIFMA C&L Alfred J. Rauschman Award in 2011. In the past fourteen years I have also served as the Independent Consultant required in a number of SEC enforcement settlements.

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BR: You are currently working with clients facing serious compliance challenges. What areas do you see as the most troubling for broker-dealers or RIAs today?

JB: From a year-to-year perspective, broker-dealers and RIAs must pay attention to subject matter priorities that agencies identify through their examinations findings. As a general matter, though, firms are always challenged by costs and resource constraints, which are often affected by their size.

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BR: Let’s talk about specifics. What are some of the top subject matter concerns you are seeing?

JB: There were many highlighted agency priorities this year. Take elder financial exploitation, for example—every industry regulator, including state regulators and attorneys general have announced robust compliance and oversight programs focused on elder abuse by broker-dealers and investment adviser firms and their registered representatives. They’ve prioritized this in their respective examination programs and, as recently seen, they will take both administrative and criminal action against firms and individuals for misconduct affecting seniors.

I am also seeing a good deal of concern with compliance on Mark Up/Mark Down. These compliance issues are particularly challenging and complicated for non-traded securities. I’ve seen this firsthand with closed-end bond funds. I would not be surprised to see more enforcement actions against not just wrong-doers, but also against supervisory and control persons. I warn compliance professionals that they should not feel they are in a safe harbor.

In addition, I would say that regulators are increasingly concerned about compliance with, and the adequacy of, disclosure. Look no further than FINRA’s recent regulatory initiative on 529 Plan Share Class enforcement for a sense of things to come. From a compliance point of view, the not–so-simple point is that firms should be mindful to present the requisite knowledge, support and supervision for all the types of businesses or services they offer.

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BR: Tell us more about what you meant by resource challenges for firms.

JB: Resource constraints are a challenge for every firm, regardless of size. That is to say, how should they best commit financial and software development to regulatory support and compliance programs? Regulators have made it very clear that every firm will be held to a high standard to develop, implement and maintain compliance, supervisory and other internal control programs designed and tailored to its businesses and business model. In the last few years many firms have streamlined their compliance and internal control programs in an effort to manage expenses while still meeting regulatory expectations. A number of times they fall short, which raises questions about the depth of their programs and, therefore, increases risk exposure.

Deep down, firms are always trying to find the right balance as to the resources—personnel, technology as well as outside resources—they can commit. This can present big problems for many firms. Sometimes, they learn the hard way that their “adequate” system” may not meet regulatory expectations. Firms that recognize the potential risk often retain independent third parties to help evaluate the efficacy of their compliance, internal control and supervisory systems. Of course, the best time to do this is before a regulatory action occurs.

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BR: How are these resource and compliance challenges you are seeing affecting RIAs?

JB: I see particular challenges regarding costs and resources in the RIA space. Independent RIAs often do not have the financial or personnel resources to develop meaningful internal supervisory and compliance oversight programs. Even when there is someone named and delegated with these responsibilities, too often the person does not have the necessary experience for the role or the authority that is needed. I have seen an overreliance on cookie-cutter, third-party service providers for support. In many instances this “one-size-fits-all” approach is inadequate because it fails to match the firm’s businesses or business model.

A similar issue, where attempts to keep costs down actually winds up costing more in the long run, is in the area of clearing and operations. Support for these functions is frequently provided by an unaffiliated broker-dealer who has very limited compliance responsibilities. In recent assignments, I’ve seen firms subscribe to the bare minimum of support in an effort to keep costs low.

Some perspective is important here. The independent RIA may be a registered representative with an unaffiliated broker-dealer. The broker-dealer sees the RIA business as an outside business activity and wants to limit its oversight liability in these cases, but FINRA has made it clear that the broker-dealer has supervisory responsibility for what is considered an outside business activity. The dual-registrant business model has its own unique supervisory and compliance challenges, too. Some firms design separate supervisory and compliance structures for each business, while many, particularly those with limited resources, use the same compliance resources for both.

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BR: Robert Cook, President of FINRA, announced at the January 2019 SIFMA C&L luncheon that FINRA is developing its examination program and staffing based on a firm’s size, businesses, resources and regulatory history. Would that address the concerns you are raising?

JB: It would help in many ways. However, it’s important to note that over many years, both FINRA and the NYSE (and legacy NASD), have proposed this concept. Their efforts have never fully materialized or met their intended goals. Hopefully, the newly announced effort will be developed and implemented because both the industry and FINRA will benefit.

As to firm size, it is important to understand that regulators don’t look at how big your firm is as they are focused on the businesses and services you offer and the resources you have versus what they believe are necessary to meet your regulatory obligations.

Certainly having the right budget to meet these obligations is critical. But, as all firms know, they are challenged to manage with what they can afford. This is where Bates and its services often come into play. We can make an assessment of a firm’s supervisory, compliance and internal control systems and also provide support on an as-needed basis to assist in developing, implementing and monitoring programs. This is what I do—conduct independent, first-hand reviews on prioritized areas. That usually results in an initial report, assessment and enhancement recommendations and other evaluations on implementation and continued monitoring.

BR: Thank you very much, Jerry. We appreciate your compliance insights.

 
About Bates Group’s Compliance Solutions

The Bates Compliance Solutions team of experienced industry professionals provide comprehensive offerings for broker-dealer and registered investment adviser clients, assisting them with supervision, compliance, risk assessments, WSPs, AML, and internal audit functions. BCS can perform as-needed or ongoing reviews and guidance to meet your regulatory compliance obligations. Our seasoned professionals closely review and test policies and procedures, supervisory and compliance processes, and the related practices involved in operating your business, recommending changes and industry standards to supplement and enhance clients' compliance and supervisory systems, and to remediate the results of regulatory, litigation, and internal audit findings and decisions.

 
For additional information and assistance, please follow the links below to our Practice Area pages:

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04-04-19

U.S. House Moves to Address AML/BSA Framework

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On March 13, 2019, the U.S. House of Representatives adopted a resolution declaring that “the lack of sunlight and transparency in financial transactions poses a threat to our national security and our economy’s security.” On the same day, a subcommittee of the House Financial Services Committee (HFSC) considered legislative proposals aimed at modernizing the Bank Secrecy Act (BSA) and closing loopholes in the Anti Money Laundering/Countering the Financing of Terrorism (AML/CFT) framework, including building on the use of beneficial ownership information collected under Customer Due Diligence (CDD) rules that went into effect last year. In this article, Bates Research continues its review of developing Congressional legislative efforts to detect and deter financial crime.

The House Resolution

The House resolution, sponsored by HSFC Chair Maxine Waters, formally supports efforts to close loopholes that allow for corruption, terrorism, and money laundering. It resolves to (i) encourage transparency “to detect, deter, and interdict individuals, entities, and networks engaged in money laundering and other financial crimes;” (ii) urge compliance with BSA and AML laws and regulations; and (iii) affirm that “financial institutions and individuals should be held accountable for money laundering and terror financing crimes and violations.”

According to the resolution, the estimated amount of money laundered globally in one year is 2-5% of global GDP, somewhere between $800 billion and $2 trillion. By adoption, the House acknowledges broad vulnerabilities in the U.S. financial system due to its “scale, efficiency and complexity,” and “increasing interrelatedness.” The House further acknowledges that sophisticated “money launderers, terrorist financiers, corrupt individuals and organizations, and their facilitators” have proven their ability to adapt and “avoid detection.”

Beyond these broad justifications, the resolution cites very specific concerns that were identified by the Financial Action Task Force (FATF) in 2016, but which have yet to be addressed. These concerns include (i) money laundering by “designated non-financial businesses and professions,” namely, casinos, dealers in precious metals and stones and art and antiquities dealers, and (ii) money laundering in commercial and residential real estate, particularly as it relates to the influx of illicit money from Russian oligarchs through anonymous shell companies. The resolution also establishes the concern that high-profile enforcement actions against financial institutions “raise troubling questions about the effectiveness of U.S. domestic anti-money laundering and counterterrorism financing regulatory, compliance, and enforcement efforts.”

HFSC Subcommittee Considers Proposals to Strengthen the BSA/AML/CFT Framework

A week prior to the resolution, the HFSC majority staff provided a preparatory briefing memorandum in anticipation of a March 13th hearing by the Subcommittee on National Security, International Development, and Monetary Policy. The memorandum laid out three significant legislative proposals for discussion. The first is an extensive reform bill offering substantial changes to the BSA (the BSA Reform Bill), the second is titled the Corporate Transparency Act, and the third is called the Kleptocracy Asset Recovery Rewards Act.

As described in the memorandum, the BSA reform bill “would reform the structure, capabilities, and oversight of BSA/AML to keep pace with changing priorities, adapting threats, and new technologies.” These threats include, to name a few: lone-actor terrorists, nuclear weapons proliferation, cyber-attacks, and the opioid crisis, as well as “longstanding threats like human trafficking, [that] have been magnified and accelerated through the advent of technologies such as virtual currency and dark-web online marketplaces.”

The BSA reform bill is massive, with three titles. Title I would broaden the Treasury Department’s authority to strengthen FinCEN, while requiring greater relationship building and information sharing among agencies and financial and non-financial institutions. It would also require Treasury to “engage on the development and review of regulation, including the evaluation and oversight of new technologies where there may be a civil liberties concern.” Title II would allow sharing of Suspicious Activity Reports (SARs) with foreign law enforcement, codify existing guidance on interagency information sharing, improve examiner training, close loopholes related to the (above-mentioned) designated non-financial businesses and professions, and real estate shell companies, “require reports on the value of BSA data,” enhance protections for whistleblowers, and require DOJ to report to Congress on the use of deferred prosecution agreements. And Title III would, among other things, codify an interagency statement encouraging innovative approaches for financial institutions to meet their compliance obligations.

The Corporate Transparency Act of 2019 would require all corporations and LLCs to disclose their true “beneficial owners” to FinCEN. This is not a new idea, (see Bates post here) but it would be a significant expansion of the entities that are already required by Federal or state law to disclose their beneficial owners. The proposal is intended to address the use of shell companies for illicit purposes. According to the memorandum, the beneficial ownership database would be available “only to law enforcement agencies, as well as to financial institutions, “with customer consent,” consistent with “Know-Your-Customer” compliance obligations.”

The Kleptocracy Asset Recovery Rewards Act would establish a program to “incentivize individuals to notify the U.S. government of assets in U.S. financial institutions that are linked to foreign corruption.” The proposal would allow authorities to recover and return the assets and pay the rewards.

Conclusion

The adoption of the House resolution, the amalgamation of legislative proposals—both old and new—and the considered rollout (the memorandum, the hearings, the timing) by HFSC leadership reflect a seriousness and determination to address identified gaps in the BSA/AML framework. In a recent joint letter by SIFMA, the Institute of International Bankers, the American Bankers Association, the associations supported efforts by the HFSC to fix the "outdated" BSA/AML regulatory framework including by creating a federal registry of the beneficial owners of legal entities. This suggests that there may be some momentum from the industry behind the effort. It’s not a clear sign of bipartisanship yet, but these efforts cannot be ignored. Bates will keep you apprised.

 
To learn more about Bates Group’s AML and Financial Crimes services, please contact:

Edward Longridge, Managing Director, Financial Crimes - elongridge@batesgroup.com

Robert Lavigne, Managing Director, Bates Compliance Solutions - rlavigne@batesgroup.com

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03-28-19

NASAA Update: Legislative Agenda, President Provides Testimony on Regulation Best Interest

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The North American Securities Administrators Association (NASAA) has been in the public eye this month as state regulators (i) issued a set of federal legislative priorities and (ii) provided written testimony to the U.S. House Financial Services Committee concerning the need for greater clarity on the SEC proposed Regulation Best Interest.

In previous posts (see here, and here) Bates Group has emphasized the importance of state players to many of the key regulatory and enforcement issues being debated in Congress and before federal agencies. We noted that when taking office as NASAA president in September 2018, Vermont commissioner of financial regulation Michael Pieciak (pictured above) acknowledged that the top priority of its members—“head and shoulders” above all others—is “to fight preemption and preserve our [state] authority.” As if to underscore that point, in his written statement submitted to Congress last week, Mr. Pieciak recited “recently compiled enforcement statistics showing that in 2017 alone, state securities regulators conducted nearly 4,790 investigations, leading to more than 2,000 enforcement actions, including 255 criminal actions.” More specifically, he reported that NASAA members undertook “150 enforcement actions involving broker-dealer agents, 187 actions involving investment adviser representatives, 120 involving broker-dealer firms, and 190 involving investment adviser firms.”

In this article, we look at NASAA’s 2019 legislative and regulatory priorities and summarize Mr. Pieciak’s latest take on the SEC’s efforts to find an acceptable compromise on broker standards of conduct.

NASAA Sets its 2019 Legislative Agenda

The NASAA 2019 legislative agenda reflects the dual oversight by the federal government and the states over similar financial market issues. The agenda is organized under four principles: (i) putting investors first, (ii) ensuring integrity of the markets by combatting fraud, (iii) promoting capital formation and market transparency and (iv) reaffirming the rights and protections of investors in the modern securities marketplace. When it comes to many of the policy prescriptions, these categories often overlap.

More Protection for Main Street Investors

To protect main street investors, NASAA advocates for "enhanced standards of conduct for broker-dealers," encouraging more rigorous oversight and regulation of new financial technologies (such as cryptocurrencies and ICOs), and for more attention to be paid to intergenerational investor issues (including senior financial exploitation and millennial investor education).

Strengthening State Regulators to Fight Fraud

With respect to fighting fraud, NASAA supports solutions that maintain the enforcement independence of state securities regulators, including enhancing remedies (such as eliminating the five-year statute of limitations on certain disgorgement actions) and beefing up civil penalties; providing state security regulators access to Suspicious Activity Report filings (SARs) and ensuring effective oversight of private placement brokers and finders (including refraining from taking any action that could limit state oversight).

Promoting Capital Formation

On encouraging capital formation, NASAA asserts that its members are positioned to “provide a level of accessibility to small businesses and investors that is unavailable from any federal regulators.” As a result, the state regulators support legislation that would (i) direct the SEC to coordinate with the states more closely in order to unify or harmonize federal and state exemptions and (ii) ensure that state regulators have the information needed to police the private offering marketplace to discourage fraud and protect retail investors (primarily through amendments to strengthen Rule D filings). Other NASAA priorities include supporting efforts to exempt merger and acquisition brokers from federal registration requirements and to limit adjustments to federal crowdfunding laws. Finally, NASAA wants Congress to modernize the definition of accredited investor “to more accurately measure investor sophistication and improve regulatory oversight.”

Rebalancing the Power Relationship in Arbitration

Regarding further empowerment and protections for investors in today’s marketplace, NASAA takes the position that “broker-dealers enjoy powerful advantages over retail investors in dispute resolution.” As a consequence, NASAA advocates for improving the dispute resolution process by banning the use of mandatory pre-dispute agreements by broker-dealers and investment advisers that limit investors’ ability to pursue recourse in any forum. Also recommended are stronger provisions to “make harmed investors whole” by requiring broker dealers to pay arbitration awards, and by safeguarding shareholder rights by imposing limits on “dual-class shares” and increasing the oversight of proxy advisers.

NASAA Continues to Press for Improvements on SEC Regulation Best Interest

In his written remarks to the now-Democratic-controlled U.S. House Committee on Financial Services, NASAA President Michael Pieciak restated the history of NASAA’s involvement in enhancing broker standards of care (having supported in the past, for example, the move to impose a fiduciary standard on brokers recommending to investors securities or investment strategies). In his submitted testimony, Mr. Pieciak reaffirmed NASAA’s longstanding position in support of raising the "standard of care" to "reflect the evolution of how financial advice is delivered to customers." He argued that the standard of care must go beyond the adoption of a "conflicts disclosure regime," and must require brokers to fully serve the best interests of the investor. In previously submitted comments on the SEC’s Best Interest Rule, NASAA recommended clear definitions of the new standard, application of the standard to all investors, and including "cost" as a required factor when explaining recommendations.

Mr. Pieciak’s written submission to the Finance Committee primarily concerned proposed interpretive guidance that would accompany the new regulation. He warned that, as written, the guidance sends “conflicting messages” about what is permissible under the proposed rule, which undermines the goal “to develop a standard that eliminates and mitigates conflicts such that investors receive the maximum benefit of their investments.”

Specifically, Mr. Pieciak recommended that any guidance must address specific conduct: that sales contests are inconsistent with the standard; revenue-sharing arrangements between brokers and product manufacturers must be carefully examined; that broker-dealers must not be allowed to give certain customers preferential treatment; that broker-dealers should not be allowed to meet their "best interest" obligations by "recommending securities from a limited menu of products without any comparison whatsoever;" and that “nothing should be permitted to limit an investor's recovery rights under the new standard.”

Mr. Pieciak communicated NASAA’s position that any guidance should make clear that “self-serving incentives and conflicts are prohibited,” and that “investors must be steered toward products that serve their best interest, which will most often be the best-performing, cost-effective products.” He emphasized that “the SEC should close any misinterpretation that could allow the industry to continue business-as-usual and yet [still] comply with the rule.” Such an outcome, he said, would undermine the rulemaking.”

Conclusion

NASAA’s legislative agenda and Mr. Pieciak’s remarks reflect assertive positions on proposed regulation and robust enforcement, as well as a strong defense of state jurisdictional interests. NASAA members remain significant players in the ultimate resolution of many key issues as state regulators continue to push alternative solutions in the absence of federal final action. Bates will continue to keep you apprised of both state and federal developments.

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03-14-19

Justice Department Coordinates Largest Ever Elder Fraud Sweep:

260 Global Defendants said to have Targeted 2 Million Americans, Mostly Elder

 

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On March 7th, federal and state enforcement agencies announced they had embarked on a massive crackdown on financial fraud directed at seniors. As part of the “sweep,” the Justice Department (DOJ) reported the filing of criminal or civil charges against hundreds of alleged offenders as well as the launch of targeted public education efforts throughout the country. According to the United States Attorney General, the coordinated actions reached into every federal district across the country and served to underscore the government’s efforts to protect a vulnerable population and address this complex and widespread problem.

In our last post, Bates Research highlighted the Consumer Financial Protection Bureau’s analysis of five years’ worth of Suspicious Activity Reports (SARs) as they relate to elder financial exploitation. The use of the information contained in these financial institution filings represents an attempt by regulators to create and use data to better understand the scope of the problem and to inform enforcement and public education efforts. In this article, we look at current efforts on the enforcement side, as represented by the actions undertaken last week.

Law Enforcement Narrows its Focus and Increases Collaboration

The Attorney General disclosed that the enforcement sweep emphasized two types of schemes: technical support scams and mass mail fraud. To some extent, this emphasis distinguishes the current announced action from an enforcement crackdown undertaken last February. The prior action covered a broad range of activities from telemarketing to investment fraud, and included, for example, so-called “lottery phone scams,” "grandparent scams,” “romance scams,” "IRS imposter schemes” and “guardian schemes.” Though the Justice Department continues to bring cases against perpetrators of a variety of fraudulent acts targeting seniors, the action announced last week focused on bringing down specific networks and international actors. According to the Attorney General, in the aggregate, this year’s coordinated sweep resulted in 260 defendants being charged for victimizing more than 2 million Americans to the tune of nearly three quarters of a billion dollars.

It is also notable that the level of coordination and the number of agencies involved in this year’s sweep represents an expansion over last year’s effort. Among others, the sweep included the FBI, Immigration and Customs Enforcement’s Homeland Security Investigations, the Federal Trade Commission (FTC), The National Association of Attorneys General, the Secret Service and the Postal Inspection Service.

“Technical Support” Scams

“Technical support” schemes are perpetrated by scammers calling the victim (or using internet pop-up messages) and warning them about computer problems such as viruses or malware. According to the FTC’s Consumer Sentinel Network, over 142,000 complaints have been filed about technical support scams (see Bates coverage about recent findings from this database). It was the number-one fraud category reported by seniors to the Sentinel Network and therefore an imperative for the DOJ.

A specific focus of the sweep centered on so-called “runners,” “money mules,” or “payment gateways.” These participants collect the money from the victim and steer them to call centers (mostly identified in India). The DOJ stated that the FBI and Postal Service “took action against over 600 alleged money mules nationwide” and Secret Service agents seized “elder fraud proceeds in transit from victims to perpetrators.”

In a Fact Sheet, the DOJ described examples of the charges filed against the alleged perpetrators of these technical support fraud schemes. The charges include, among others, wire fraud, aggravated identity fraud, conspiracy to commit money laundering, mail fraud and bank fraud. In addition, the DOJ’s Consumer Protection Branch and the Postal Inspection Service brought “infrastructure”-related charges focused on U.S. citizens facilitating the operation of implicated call centers. The actions included injunctions against entities and individuals to prevent them from conducting or facilitating the fraudulent scheme.

Mass-Mailing Fraud and Transnational Fraud

The second focus of the elder fraud enforcement sweep concerned global, mass-mailing fraud schemes. The DOJ and the U.S. Postal Service pursued actions against direct mailers that defrauded millions of elderly victims out of hundreds of millions of dollars. The schemes involved direct personalized mailings that promised something of value (money or prizes) if the victim sent cash (purportedly for fees or taxes). Law enforcement brought actions that included both criminal charges and civil injunction lawsuits.

Many of the cases cited by DOJ involved national boundaries and transnational organizations. Some of the defendants in these cases were extradited from Canada, Cayman Islands, Costa Rica, Jamaica and Poland. In other cases, like the mass mailing fraud, the perpetrators were apprehended in Spain.

The Attorney General lauded the domestic and international law enforcement collaboration as key to the success of the effort. In announcing this sweep, the DOJ reminded that “The charges are merely allegations, and the defendants are presumed innocent unless and until proven guilty beyond a reasonable doubt in a court of law.”

Conclusion

The enforcement sweep is a statement by law enforcement agencies that they are (i) prioritizing the protection of vulnerable seniors from financial exploitation; (ii) increasing collaboration across federal agencies and across state and international boundaries; and (iii) improving their capabilities and effectiveness. These messages parallel the ones regulators are sending as they improve their data collection methods through enhanced financial institution disclosure.

But the progress made from last year to this year on the enforcement side, and the mining and collation of new sources of information that mandatory disclosure offers on the regulatory side, means it’s possibly only a matter of time. The educational outreach ties it all together. That said, the numbers of fraudsters (that we know of) and their creativity, as exemplified in this announcement, is telling. It is important for companies to continue to be vigilant in protecting their most vulnerable investors.

Bates Group closely follows regulatory and enforcement developments on senior financial fraud. For a view of the changing federal and state legislative and regulatory landscape on senior investors, download our complimentary white paper. Learn how to protect your company and its most vulnerable investors with Bates Investor Risk Assessment. For more information concerning financial issues related to vulnerable and senior investors, senior investor expert witnesses, financial crimes, damages analysis, and compliance solutions, please contact Bates Group today.

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03-07-19

New CFPB Report finds SARS Filings on Elder Financial Exploitation Quadrupled from 2013 to 2017

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A recent analysis by the Consumer Financial Protection Bureau (CFPB) of Suspicious Activity Reports (SARs) related to elder financial exploitation provides the most detailed look to date at the size and scope of this issue. The Report, issued by the CFPB’s Office of Financial Protection for Older Americans, covers SARs filings between 2013—the date the Financial Crimes Enforcement Network (FinCEN) introduced the category on its electronic forms—and 2017. According to the CFPB, the Report represents the first publicly available analysis of the non-public data provided by financial institutions on senior financial abuse.

Bates Group has been following the issue of senior financial exploitation for some time. The findings from the CFPB analysis affirm previous reports that senior financial abuse is pronounced, but that the current number of SARs filings “likely represent a tiny fraction of actual incidents.” In this article, we review the findings and recommendations contained in the new Report.

The SARs Data

The CFPB Report was based on an analysis of the over 180,000 SARs on elder financial exploitation filed during the period. The numerical data paints a dramatic picture, with activities totaling more than $6 billion. Over the period of review, the number of relevant SARs filings quadrupled to over 63,000 by 2017. By that year, financial institutions reported suspicious activities totaling $1.7 billion.

Almost 80 percent of the SARs filed involved an actual monetary loss to older adults or the financial institution. The findings from these SARs can be broken down into two broad categories affecting: (i) individuals and their losses, and (ii) institutions and their actions.

For older adult victims in general, the average amount lost was $34,200, though losses exceeded $100,000 in 7% of the SAR cases. The CFPB states that, on average, losses were about $50,000 when the older adult knew the suspect and about $17,000 when the suspect was a stranger. Further, senior adults ages 70 to 79 had the highest average monetary loss at $45,300. Thirty three percent of the victims categorized in the SARs were seniors over the age of 80. (For a description of many of the types of financial exploitation, please see previous Bates Research article here.)

As for the financial institutions that submitted the SARs, by 2017, money service businesses comprised 58 percent of the filings, while depository institutions accounted for most of the remainder. The average loss incurred by all institutions was approximately $16,700. For the suspicious activity related to a money service businesses, the CFPB found that 69% of the SARs were scams by strangers, where the average monetary loss (including both individuals and institutions) was $32,800. When the suspicious activity was related to depositary institutions, only 27% of the SARs involved strangers, but the average monetary loss, primarily related to checking and savings accounts, was $48,300.

Another important finding was that under a third of financial institutions actually reported the suspicious activity to a local, state, or federal authority. For money services businesses, the CFPB states that only 1% reported the SARs to authorities.

CFPB Recommendations

The CFPB SARs analysis confirms that the problem of senior financial fraud is prevalent. The information and filing of these SARs is lauded as a “useful and untapped resource for monitoring elder financial exploitation.” The failure to report the suspicious activity to law enforcement or state adult protective services, however, is seen as a significant gap in protections for consumers and represents “a missed opportunity to increase investigation and prosecution.”

The CFPB also concludes that using SARs offers law enforcement a way to tailor “interventions” and develop new strategies in response to the types of suspects and activities, e.g. money services versus depository institutions. As a result, CFPB suggests that law enforcement should mine the Treasury database of SARs, on its own, to enhance investigations and initiate prosecutions.

Conclusion

The CFPB Report is notable for its use of SARs as a new data source to measure aspects of the problem of senior financial exploitation. Last October’s Federal Trade Commission’s Report (see Bates’ coverage) came to similar conclusions on information it collected primarily through the Consumer Sentinel Network, an online database that provides law enforcement agencies with secure access to consumer reports on fraud. Both the FTC and the CFPB are explicit in stating that these databases are not capturing the full scope of the problem.

There is clearly potential, however, in the different informational tools that are now becoming available. These new data sets can provide new and deeper insights into the problem of elder financial exploitation. One of the most significant data points in the CFPB Report, for example, is the increase in the filing of SARs from an average of about 1,300 filed per month in 2013, when the category of elder financial exploitation was added to electronic SARs filings, to about 5,300 filed per month in 2017. As more SARs are filed annually, and as they begin to reflect a greater share of the problem, we should expect the conclusions drawn from them to be more grounded.

 

Bates Group closely follows the regulatory and enforcement developments on senior financial fraud. For a view of the changing federal and state legislative and regulatory landscape on senior investors, download our complimentary white paper. Learn how to protect your company and its most vulnerable investors with Bates Investor Risk Assessment. For more information concerning financial issues related to vulnerable and senior investors, senior investor expert witnesses, financial crimes, damages analysis, and compliance solutions, please contact Bates Group today.

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02-25-19

Planning Your Response to FINRA’s 529 Initiative — Q&A with Bates Managing Director Alex Russell

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Bates Research recently conducted a Q & A session with Alex Russell, Managing Director of Securities Litigation & Regulatory Enforcement at Bates, to discuss FINRA's new 529 Share Class Initiative. Alex talks about responding by FINRA's deadline and potential pitfalls firms should keep in mind when preparing their response.

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Bates Research: What is FINRA's 529 Plan share class initiative -- and deadline?

Alex Russell: FINRA is providing firms with an opportunity to review their activity in and around 529 plans, allowing firms to self-report where supervisory violations may have occurred during the period of January 2013 through June of 2018. Similar in nature to the SEC’s Share Class Selection Disclosure Initiative last year, FINRA is concerned that share class recommendations were made to clients that are inconsistent with the accounts’ investment objectives. In particular, FINRA is asking firms to ensure that 529 plan recommendations took into account breakpoint discounts, sales charge waivers, and other fees in determining suitability. Depending on the facts and circumstances of each client (in particular the age of the plan beneficiary) FINRA believes that economically disadvantageous share classes may have been selected, wherein the expenses incurred by the client are greater than they need to be. Firms must provide a response by April 1, 2019 in order to participate in the self-reporting initiative. 

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BR: What is required to be included a firm's response?

AR: Firms must provide written notification to FINRA by 12:00am EST on April 1, 2019 of their intent to self-report.  A firm that has submitted their intent to self-report then has until May 3, 2019 to provide the following information back to FINRA:

  1. A list of the 529 plans sold by the firm, including the 529 plan name and the dates the firm offered each 529 plan.
  2. The total aggregate principal amount invested in each 529 plan sold by the firm during the disclosure period.
  3. A description of the firm’s supervisory systems and procedures relating to 529 plan sales during the disclosure period.
  4. A description of the changes to the firm’s supervisory systems and procedures that the firm has implemented or will implement in order to strengthen compliance with its supervisory obligations. To the extent the firm identifies changes that have not yet been implemented, the firm should identify the individual supervisor at the firm who is responsible for the implementation.
  5. The firm’s assessment of potential impact on customers of supervision weaknesses, including a description of the firm’s methodology for assessing impact on customers and a description of the firm’s proposal to make restitution payments to harmed customers.
  6. Any other information the firm believes would assist Enforcement in understanding the firm’s assessment of an account’s expected investment horizon, the suitability of the firm’s recommendations, or the reasonableness of the firm’s supervisory system regarding share class recommendations

Bates has been actively assisting clients with item 5 above.

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BR: What are some of the nuances/pitfalls in planning a firm's response?

AR: There are a number of challenges firms face in assessing the potential impact on clients related to 529 plan share class purchases.  One of which is data availability from plan sponsors – sponsors may have difficulty producing the relevant data, especially for older time periods, given different record retention policies, plans changing hands, etc.  Of particular note, while the review period is January 2013 to June 2018, FINRA notes that the period for calculating restitution may extend further into the past (as alluded to in footnote 16 to Notice 19-04) making getting data all the more difficult.  Beyond that firms must also decide whether to review for possible supervisory failures on a client specific basis, or to apply a “statistical approach” that would group multiple clients into different impact categories and proceed to analyze the potential harm to those clients on an aggregated basis.  Considerations such as whether to use a standard estimate for fee differentials, or breakpoints as of a certain point in time, versus using the exact fee rate differentials during the entire review period as well as the breakpoints in place at the time of purchase give firms even more to consider.  Careful curation of the data, as well as access to historical information on share classes, are crucial to successful reporting and are both areas Bates can assist with.

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BR: What are the risks for not responding?

AR: FINRA’s Member Supervision and Enforcement divisions will continue to examine and investigate member firms’ activity around 529 plans throughout 2019.  Firms who choose not to self-report that are later found to have supervisory failures related to 529 plans during the course of an exam will likely result in additional sanctions beyond those made available for firms that do self-report under the initiative.  Under the umbrella of the initiative Enforcement will recommend that participating firms make restitution payments to all impacted clients and accept a censure, but will face no fine.  In some instances, Enforcement may decide that no formal action is necessary and may resolve the matter informally or with no further action taken.  Both the potential for an informal resolution, no further action, or the absence of a fine in the event that action is taken, create a strong incentive for firms that believe they may have had 529 plan supervisory failures during the relevant period to self-report.

 

Support for Firms:

Bates has deep and proven experience and expertise in share class disclosure matters. Most recently, on behalf of over a dozen major national and regional financial institutions, Bates provided important assistance to firms and counsel participating in the SEC’s Share Class Selection Disclosure Initiative and related SEC Examinations.

To support firms facing FINRA’s 529 Plan disclosure and remediation initiative, Bates Group can help by providing solutions to identify and address accounts and clients impacted by share class selection. Bates performs data analysis, examines regulatory reporting, reviews share class selection policies and disclosure practices, identifies methodology and impacted accounts, performs calculations and provides remediation amounts. Most importantly, after consultation with counsel, Bates' disclosure and remediation plan culminates in a report which can be used directly with regulators. For more information, see our original alert here.

Bates is ready to help you and your firm. Please contact us today.

Alex Russell, Managing Director, Securities Litigation and Regulatory Enforcement 
email: arussell@batesgroup.com phone: 971-250-4353
 
David Birnbaum, Managing Director
email: dbirnbaum@batesgroup.com phone: 917-273-2682
 
Robert Lavigne, Managing Director, Bates Compliance Solutions
email: rlavigne@batesgroup.com phone: 508-868-6741
 
Scott Lucas, Managing Director, Regulatory and Internal Investigations
email: slucas@batesgroup.com phone: 971-250-4344

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02-21-19

Latest Developments in Variable Annuities and Life Insurance

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In our last review of developments concerning variable annuities and life insurance, Bates discussed the SEC’s issuance of a comprehensive new rule proposal intended to create a “layered disclosure approach” for regulating these products. That proposal was issued against the backdrop of an ongoing debate among state insurance regulators on revising model legislation on “Suitability in Annuity Transactions.” The National Association of Insurance Commissioners (NAIC) remains determined to create these standards and procedures for providing suitable recommendations to consumers, despite the likely impact and continuing uncertainty created by the unresolved SEC proposed Best Interest rulemaking.  

In this article, we update the most recent SEC action on variable contract disclosure as well as some important private sector activity, notably Ohio National Financial Services’ (“Ohio National”) strategic decision to pull out of the market for variable annuities.

SEC Extends Comment Period for Proposed Rule on Variable Contracts

On February 14th, the SEC announced that it was offering a brief, one-month extension for market participants to provide comments on its proposal to change existing disclosure rules and allow issuers of variable products to fulfill certain compliance obligations by preparing and delivering a “reader-friendly” summary prospectus (see Release and Fact Sheet). The comment period was extended to March 15th .

To date, commenters have been supportive of the concepts of simple summary and layered disclosure. Most communicated that, for various reasons, an extension was warranted. The American Council of Life Insurers, for example, said it needed additional time to consider the “regulatory, structural and financial implications of the proposals for life insurers, salespersons and consumers,” and that “each of these considerations must be analyzed against unique fact patterns, business models, and organizational structures.” The independent, non-profit investor advocacy organization Better Markets expressed concerns about whether simplified disclosure would have any impact at all on investors.

Such a short timetable may or may not result in a commitment by the SEC to do more testing. But as this process continues in its ordinary course, other developments in the variable annuities market may also become a factor.

Market Players Make Decisions

One of these factors may be the continuing fall-out from a move taken by Ohio National, a Cincinnati-based mutual insurance company. In September, 2018, Ohio National announced that after acomprehensive strategic review of [its] businesses, taking into account the continuously changing regulatory landscape, the sustained low interest rate environment, and the increasing cost of doing business …the company will no longer accept applications for annuities or new retirement plans, while continuing to service and support existing clients in both businesses.”

Sheila Murphy, a Bates insurance regulation consulting expert, notes: “most annuity issuers did not anticipate the continued low-interest rate environment they find themselves in. Given the current market, it is likely that issuers will continue to look for ways, such as eliminating trail commissions, to reduce expenses and increase revenues. Such actions may have unforeseen consequences for both market participants and for customers. It won’t be long before a regulator will ask whether a broker will give the same level of advice on an annuity with no trail commission.”

Reportedly, the Ohio National decision already has led to concerns that other insurance carriers would stop writing new business in variable annuities and that advisers and broker dealer firms will not “honor obligations to distributors who selected a trail rather than upfront commission during an annuity sale.” The Ohio National decision is not going down easily. While there are varying opinions as to whether other issuers may or may not pull out of the variable annuities business, one thing is for certain: Ohio National’s attempt to replace the older contracts with new "servicing agreements" which exclude trail commissions is being met with legal resistance by some advisers. All sides are pressing for the courts to weigh in on the rights, duties, and liabilities of the parties.

Conclusion

The specific dispute over commission trails is raising a number of very serious compliance issues, including the regulatory dilemma created if advisers attempt to engage clients without a formal brokerage agreement or insurance relationship in place. More broadly, however, the dispute is serving to highlight some of the key issues regulators have been raising concerning the complexity over variable annuity products and whether investors have any idea what the costs of these products are. Alluding to the recent FINRA 2019 Examination Priorities Letter, one commenter described it like this: “The environment for high-commission variable annuities sales gets a little less friendly by the day…[as] regulators are looking for product sales where pricing and commissions appear excessive, and instances where advisors are doing costly swaps of clients’ existing contracts for new [variable annuities] that add little or no client benefit but generate new commissions and fees.”

Federal and state regulators are already at heightened attention on these investment products. They are (i) in the midst of new proposed rules on variable annuity products and suitability; they are (ii) communicating their concern through Enforcement Priorities Letters; and they are (iii) taking enforcement actions. (Note FINRA’s recent settlement in a case involving failure to supervise and train registered representatives concerning the recommendation and sale of share class variable annuities.) The Ohio National strategic decision and the consequent lawsuits over commissions and how they are handled are not tangential to regulator concerns. Bates will keep following the developments.

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02-13-19

The State of Play on Cryptocurrency Regulation

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For legislators and regulators, writing rules for crypto-related assets requires balancing the tension between innovation and entrepreneurship, and between sound markets and investor protection. In previous articles, Bates Research has described some of the definitional challenges which directly affect which agencies govern crypto assets: the SEC asserts jurisdiction over most initial coin offerings (ICOs) as securities (but not Bitcoin or Ether), while the CFTC asserts jurisdiction over Bitcoin futures and options. To FinCEN the subject is simply a currency (and, thereby, subject to Bank Secrecy Act [BSA] and Know Your Customer [KYC] obligations); to the IRS, it’s just another capital asset. Regulators of all stripes continue to issue warnings, advisories, guidance and in some cases—as in NASAA’s crypto-sweep—take enforcement actions that remind everyone that the States also have an interest in asserting their authority. In this article, we review recent developments in the ongoing debate over regulating crypto, including legislative proposals, and regulatory activity by leadership at the SEC, the CFTC and FINRA.

SEC Commissioner Hester Peirce on First Principles

In a February 8th speech titled “Protecting the Public While Fostering Innovation and Entrepreneurship: First Principles for Optimal Regulation,” SEC Commissioner Hester Peirce described the challenges facing regulators that want to apply old models of regulation to cryptocurrencies. She argued that applying securities laws and legal tests (as to what is or is not a security) to virtual currencies and ICOs will negatively impact cryptocurrency development and investment.

The Commissioner raised many questions as to whether tokens are securities for purposes of raising funds. In a pointed comment, she explained that “enforcement actions are not my preferred method for setting expectations for people trying to figure out how to raise money.” Then she announced that the SEC staff is working on "supplemental guidance" to "help people think through whether their crypto-fundraising efforts fall under the securities laws."

Beyond the token issue, however, Commissioner Peirce questioned how certain crypto trading platforms may differ from exchanges or alternative trading systems designed for traditional securities. She also questioned how traditional regulation may need to change to accommodate these differences. Further, she raised important questions about the regulation of exchange-traded products based on Bitcoin or other cryptocurrencies.

In a final cautionary note she stated: “We owe it to investors to be careful, but we also owe it to them not to define their investment universe with our preferences.”

CFTC Setting Stage for Ethereum Futures

On December 11, the CFTC announced that it was seeking public comments to better understand “the technology, mechanics, and markets for virtual currencies beyond Bitcoin, namely Ether and its use on the Ethereum Network.” Currently, Bitcoin is the only regulated network trading in futures. The outcome of this CFTC effort may be a futures trading framework for Ether that will likely impact the agency’s broader approach to virtual currency futures, options and swaps. Such a result would further strengthen the CFTC’s authority to define and regulate such classes of crypto assets. 

FINRA Seeks Feedback, but Wants Compliance

As Bates Group described previously in July 2018, FINRA issued regulatory guidance stating it was monitoring developments in the digital asset market. As a result, FINRA requested that firms notify it if they or their associated persons or affiliates, “engage[], or intend[] to engage, in any activities related to digital assets…” The Notice stated that firms must disclose “purchases, sales or executions of transactions in digital assets, pooled funds that invest in digital assets; or derivatives tied to digital assets.” FINRA said that firms should provide these updates to their regulatory coordinator until July 31, 2019, along with disclosure of any facilitation activities such as clearing or settlement of digital assets.

In its 2019 Risk Monitoring and Priorities Examination Letter, FINRA alluded to this effort, saying that “some firms have demonstrated significant interest in participating in activities related to digital assets.” FINRA asserted that it will be reviewing “firms’ activities through its membership and examination processes related to digital assets and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls to mitigate the risks associated with such activities.” Specifically, FINRA noted it will “consider how firms determine whether a particular digital asset is a security and whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations.”

Legislative Proposals

Congressional representatives have also jumped into the debate. While regulators are asking for more input from the market, legislators are offering sweeping solutions. Though the current climate would not suggest that legislation that could significantly alter the crypto landscape can pass, several bills—some bipartisan—were introduced in the waning days of the last Congress. Perhaps the most-discussed bill comes from Representatives Darren Soto (D-FL) and Warren Davidson (R-OH), who introduced the Token Taxonomy Act.

The bill, expected to be reintroduced in the new Congress, would, among other things, (i) amend securities laws to exclude digital tokens from the definition of a security, (ii) adjust taxation of virtual currencies held in individual retirement accounts, (iii) create a tax exemption for exchanges of one virtual currency for another, and (iv) create an exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash. The bill also serves to define the term “digital token” and to clarify the application of securities laws to certain companies that use blockchain.

The Token Taxonomy Act is a reaction to startups fleeing offshore and to the downturn in the market. That downturn, is generally perceived to be due to SEC securities designations and other uncertainties and costs of U.S. regulation. SEC Commissioner Peirce referred to this legislation in her recent address, noting that Congress has the power to clear up many uncertainties by “simply requiring that at least some digital assets be treated as a separate asset class.”

Other bipartisan bills introduced last year, such as the Virtual Currency Consumer Protection Act and the Virtual Currency Market and Regulatory Competitiveness Act were also intended to reduce regulatory uncertainty, bring business back to the United States, and examine ways to encourage the development of the market.

Conclusion

The debate over current and future government regulation of cryptocurrencies may come down to reworking the definitions and legal tests that force them uncomfortably into traditional regulatory categories. It is also possible that the future may be a prolonged period of uncertainty punctuated by enforcement interpretations, conflicting agency guidance and short-lived rules. There is even a possibility that some legislative action could create an entirely new alternative regulatory framework. What can be discerned from Commissioner Peirce’s insight, the CFTC and FINRA market inquiries, and the recently proposed legislative fixes, is that any or all of these outcomes are possible.

The best that market participants can do is to keep up with these developments, do their best to anticipate regulators’ expectations, and attempt to develop compliance risk frameworks accordingly.

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02-07-19

New Congress, New Priorities for Financial Services in 2019

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Congresswoman Waters (L), Senator Crapo (R)
 

The priorities of the congressional committees that oversee financial services are changing. The contours of that change are beginning to take shape as Democrats take control in the House of Representatives and leadership from both parties announce committee assignments. This article takes a look at the agendas of Representative Maxine Waters (D-CA), the new Chair of the House Financial Services Committee, and Senator Mike Crapo (R-Idaho), Chair of the Senate Banking Committee. Their dynamic will set the stage for potential political confrontation, possible bipartisan legislation, and certain administrative and regulatory oversight impacting the financial services industry.

Background

It would be hard to overstate the breadth of jurisdiction of the committees these two lawmakers oversee. Together they have oversight over the Federal Reserve, CFPB, the FDIC, the Office of the Comptroller of the Currency, the SEC, HUD, and the Federal Housing Finance Agency, to name only a few. They also have oversight over national security and law enforcement at the Treasury and Commerce Departments, including the Committee on Foreign Investment in the United States (CFIUS); and the Office of Terrorism and Financial Intelligence, (including OFAC and FinCEN, among others). The leadership of these two Committees influence the policy priorities and enforcement actions of these regulators.

House Financial Services Committee

Maxine Waters is not a newcomer to the House Financial Services Committee (HFC). She served on the HFC, the Committee that oversees all U.S. financial services affecting securities, insurance, banking and housing since 1991. Since 1995, she has served as either Ranking Member or Chair of every Subcommittee of the Committee.

Since her appointment as Chair, Representative Waters moved quickly to set her agenda. On January 24th, 2019 Chair Waters announced new leadership for HFC Subcommittees. (She even changed some Subcommittee names and created a new Subcommittee on Diversity and Inclusion.) See here for the appointments and preliminary statements of the Subcommittee Chairs from New York, Missouri, Ohio and Texas. A few days later, Chair Waters announced membership assignments.

New Agenda Prioritizes Consumers, Housing, FinTech and Diversity

In her first meeting, Chair Waters highlighted the broad themes of consumer protection, expanding affordable housing, encouraging responsible innovation in financial technology and promoting diversity in—and financial access to—the financial services system as the key agenda items for the Committee.

On consumer protection, Chair Waters stated that she will seek to strengthen Dodd-Frank financial regulation that protects consumers and investors. She has been a frequent critic of administration efforts to weaken the Consumer Financial Protection Bureau and made clear that she will be using HFC oversight to ensure regulators are fulfilling their obligations as well as holding bad actors accountable.

On housing, Chair Waters said the Committee will focus on affordability and homelessness. She intends to re-raise a bill to provide $13.27 billion in new funding over five years to federal programs and initiatives on the issue. On housing finance, she wants to reform Fannie Mae and Freddie Mac to ensure that underserved borrowers and communities have access to affordable mortgage credit, as well as access to affordable rental housing, and ensure rigorous enforcement of fair housing laws. She said the HFC will be conducting robust oversight of the administration’s activities in the Department of Housing and Urban Development (HUD).

On FinTech, Chair Waters stated that she will focus the Committee on ways to foster "responsible innovation with the appropriate safeguards in place to protect consumers and without displacing community banks and credit unions." In this regard, her focus is on “opportunities for those who have been excluded from access to responsible credit.” Similarly, Chair Waters expressed her intention to shut down abusive payday lending practices and protect minority communities from lending discrimination.

In a speech earlier this year, she also described areas of international concern that the HFC would address, including reviewing governance at the International Monetary Fund and World Bank, Russia sanctions, reauthorization of the expiring Terrorism Risk Insurance (TRIA) and the Charter of the Export-Import Bank.

Senate Banking Committee

Senator Mike Crapo (R-ID) continues his role as Senate Banking Committee (SBC) Chair in the new Congress. His announced priorities reflect continuity, yet with an open offer for bipartisanship. On January 29, 2019, he set forth specific goals to (i) advance bipartisan legislative efforts, and (ii) ensure Committee oversight and federal agency implementation over legislation enacted in the last Congress, notably, the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA), Foreign Investment Risk Review Modernization Act (FIRRMA), and the Countering America’s Adversaries Through Sanctions Act (CAATSA).

On housing, Chair Crapo’s agenda includes finance reform of Fannie Mae and Freddie Mac, enhancements to HUD’s Family Self-Sufficiency program and streamlined compliance for Public Housing Authorities.

On capital markets reform, Chair Crapo said that he will continue to press for some thirteen bills that would encourage capital formation, reduce burdens for small businesses and improve corporate governance.

On digital security, Chair Crapo relayed that the Committee will consider legislative solutions so that consumers would have more control over their financial data and that any privacy breach would be disclosed to consumers in a timely way. As for FinTech, the Chair committed the SBC to work to ensure that the regulatory landscape welcomes innovation. He pledged that the Committee would “consider appropriate ways to advance innovation and coordination to protect the integrity of the U.S. financial system in a smart way.”

On access to financial services, Chair Crapo said the Committee will continue to examine whether regulation should be tailored for financial companies to ensure they can adequately deliver credit to local communities. He also said the Committee will conduct oversight of financial companies that might “use their market power to manage social policy by withholding access to credit or services to customers and industries they disfavor.” On consumer credit, the Chair noted that the Committee would explore targeted reforms of the credit bureau system, such as improving consumers’ ability to interface with credit bureaus and to dispute inaccuracies.

On international affairs, Chair Crapo stated that the Committee will conduct oversight of agencies tasked with national security and law enforcement missions. He pointed out that the Committee held hearings last year that “lay the groundwork for modernizing the decades-old anti-money laundering and beneficial ownership regime.”

Finally, the Chair stated that SBC will review the efficacy of many expiring programs as part of the reauthorization process for programs such as TIRA (which expires at the end of 2020); the National Flood Insurance Program (NFIP) (which expires end of May); the Export-Import Bank’s charter expires (which expires the end of September 30); the Fixing America’s Surface Transportation (FAST) Act (which expires the end of 2020).

Conclusion

Despite the fact that these leaders are considered to be at two opposite ends of the political spectrum, they both have significant records of legislative success. As their overall agendas suggest, there are identifiable areas of alignment. There may also be areas of common ground on data privacy and security, FinTech, anti-money laundering and housing reform. Their preliminary nods to reaching across the aisle may be nothing more than that, but there may emerge a few bipartisan surprises in 2019.

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01-24-19

FINRA Highlights Online Platforms, Mark-Up Disclosure & Compliance, RegTech in 2019 Exam Priorities

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In his latest annual priorities letter to members, FINRA Chief Executive Officer Robert Cook emphasized that FINRA will be monitoring firm developments “to identify risks and assess their prevalence and impact.” He noted that the 2019 letter highlights new areas of focus that will allow member firms to determine whether certain issues “are relevant to their businesses” and how they might be best addressed. For the upcoming year, these areas include (i) the distribution of securities through online platforms; (ii) firm compliance with recently effective requirements on mark-up or mark-down disclosure for fixed income transactions; and (iii) firm use of new regulation technology (RegTech) to address compliance risks and challenges.

In addition, Mr. Cook explicitly stated that these highlighted areas do not affect the ongoing monitoring and enforcement efforts detailed in previous priorities letters. In this article, Bates will review the highlights from FINRA’s newly released 2019 Risk Monitoring and Examination Priorities Letter. We once again list and compare the new priorities to preceding years in the attached Bates’ 2019 FINRA Chart.

New Areas of Focus

Securities Distributions through Online Platforms

FINRA is concerned with a host of issues tied to growth in the use of online distribution platforms used to sell and trade securities. According to the letter, FINRA will evaluate how firms that use online distribution platforms “conduct their reasonable basis and customer specific suitability analyses, supervise communications with the public and meet AML requirements.” FINRA also stated that it will review certain specific risks, including those associated with (i) offering documents or communications with the public that omit material information or may contain false or misleading statements, (ii) promises of claims of high targeted returns, (iii) sales to non-accredited investors and non-compliant escrow arrangements; and (iv) excessive or undisclosed compensation arrangements between firms and the issuers.

Mark-up Disclosure for Fixed Income Transactions

In the latest letter, FINRA highlighted its intention to review compliance with mark-up or mark-down disclosure obligations on fixed income transactions effective on May 14, 2018. This does not come as a surprise. In its December 2018 Examination Report (covered by Bates here), FINRA found that firms were facing challenges implementing the new rules, including putting in place confirmation review processes, systems and vendors, as well as inadequate disclosure in Order Entry Systems, customer confirmations, transactions in certain structured notes, and incorrect designations of institutional accounts. In the priorities letter, FINRA stated it will review behavior to determine whether a firm is attempting to avoid their obligations concerning mark-up and mark-down disclosures.

For additional resources, FINRA directs firms to an available Mark-up/Mark-down Analysis Report that provides, among other things, trade details and “graphical displays of data across longer periods of time for trend analysis.” FINRA also refers readers to its Bond Facts Tool for “security-specific product data to help retail investors understand the quality of their fixed income securities transactions (e.g., the time, price and size of other transactions in the same bond).”

Regulatory Technology

Consistent with the intent to monitor firms in order to identify new types of risk and assess their impact, FINRA stated it will use the upcoming period to examine a variety of innovative regulatory technology tools that firms are using for compliance. Specifically, FINRA indicated that it seeks to address risks, challenges and regulatory concerns relating to supervision and governance, third-party vendor management, safeguarding customer data and cybersecurity.

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FINRA Priorities Comparison Chart 2019

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© 2019, Bates Group LLC
Source: 2019 FINRA Regulatory and Examination Priorities Letter (Compiled by Alex Russell, Bates Group LLC)

 

Additional Priorities

The Bates Chart above provides context and comparison for FINRA examination priorities year over year. Though there are fewer identified priorities in this year’s list, there are clearly additional nuances to many prior categories. As a result, this chart serves as a useful reference for firm compliance review. In the 2019 monitoring and enforcement letter, FINRA bundles several of these risks together into broad categories.

Sales Practice Risk

The first category is “Sales Practice Risk,” under which FINRA prioritizes the examinations of a firm’s programs to ensure the suitability of its’ recommendations, particularly regarding complex products, mutual funds, variable annuities, share classes, trade in margin accounts and private securities transactions. (See here for a general Bates discussion on suitability from the 2018 FINRA exam findings.)

FINRA also recommits to prioritizing the protection of senior investors. In 2019, FINRA reemphasizes examining for fraud, sales practice abuses and financial exploitation. In this regard, FINRA noted that it will continue to assess firms’ supervision of accounts “where registered representatives serve in a fiduciary capacity, including holding a power of attorney, acting as a trustee or co-trustee, or having some type of beneficiary relationship with a non-familial customer account.”  

Operational Risk

A second category for examination includes: “Operational Risk,” under which FINRA emphasizes its interest in the supervision of digital assets. For those firms engaging in such business, FINRA makes it clear that it will consider how firms determine whether a particular digital asset is a security and whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations. Other operational risk concerns include examinations of firms to ensure compliance with FinCEN’s Customer Due Diligence (CDD) Rule, which went into effect last May. FINRA stated that its exams this year will focus on suspicious activity monitoring systems.

Market Risk

Under the broad category of Market Risk, FINRA identified best execution compliance (particularly as it relates to order flow and potential conflicts of interest), market manipulation (through enhanced surveillance with an emphasis on correlated Exchange Traded Products), market access (focusing on controls and limits to sponsored access orders), short sales (examining structured aggregation units), and short tenders (including how firms account for their options positions when tendering shares). 

Financial Risk

Finally, under the Financial Risk category, FINRA exams will focus on credit risk, notably, policies and procedures for identifying, measuring and managing risk exposures and the extent to which firms identify and address risks when they extend credit to their customers and counterparties. In addition, FINRA will be evaluating the adequacy of a firm’ funding and liquidity including whether firms are updating their stress test assumptions in light of increased volatility in the market and business activities and arrangements.

Conclusion

This report evidences a shift in FINRA’s annual practice of highlighting examination priorities to alert firms to be prepared to demonstrate adequate compliance on serious issues raised in FINRA’s prior enforcement report and by newly effective regulation. The change in the name of the report and Mr. Cook’s emphasis show that FINRA is adjusting its examination priority notice to incorporate a changing reality. In short, technology developments are moving at such an accelerated pace that FINRA must now monitor firm activity through the exam process just to better understand the nature of emerging risk and how to react to the sweeping technological change.

 

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

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01-22-19

FINRA Announces 2019 Regulatory and Examination Priorities

FINRA Announces 2019 Regulatory and Examination Priorities

FINRA has announced their regulatory and examination priorities for the upcoming year. You can read the letter, with an introduction by FINRA President and CEO Robert Cook, here.

Stay tuned to Bates Research for our commentary on FINRA’s 2019 objectives and how they may impact your legal, regulatory and compliance matters.

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01-17-19

New FINRA Report Details Effective Practices for Broker-Dealer Cybersecurity Compliance

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Right before the new year, FINRA published a report on specific cybersecurity compliance concerns raised in recent broker-dealer examinations. The report provides important guidance for broker-dealers to ensure that their compliance programs adequately address particular risks. Specifically, FINRA highlights best practices among firms on (i) branch office controls; (ii) limiting phishing attacks; (iii) mitigating insider threats; (iv) testing compliance networks for security weakness; and (v) controlling risks related to mobile devices. In this article, Bates reviews these elements and what they may mean for your compliance program.

Branch Offices

FINRA expressed concerns over branch office cybersecurity compliance, stemming in part from the autonomy given to branch offices. FINRA observed that such autonomy inhibits the ability of a home office to maintain supervisory control and consistency across a firm. Among others, FINRA cites examples of branches that hire non-approved vendors, purchase assets (such as software) that may not be compatible firm-wide, that fail to follow cybersecurity protocol, and that allow representatives to work from home without adequate technological cybersecurity support.  

FINRA’s primary recommendation is for firms to evaluate whether they need to enhance their branch cybersecurity to protect customer information. Categorically, FINRA says firms should strengthen (and organize) comprehensive written supervisory procedures (WSPs) in order to better define minimum branch cybersecurity controls. This includes, for example, providing branches a list of required and recommended hardware and software options and settings, and lists of approved vendors. In addition, FINRA wants firms to formalize the oversight of these offices by designating a branch office cybersecurity supervisor. Second, firms should develop an inventory of branch-level assets, including data, software and hardware. Such an inventory would serve to help evaluate vulnerabilities to potential attack, and to direct appropriate policy, technical and physical controls to mitigate those risks. Third, firms should maintain branch technical controls, particularly concerning identity and access management protocols for registered representatives. Finally, firms should implement robust review programs in order to “ensure that branches are consistently applying cybersecurity controls across a firm’s branch network.”

Phishing Attacks

FINRA observed that firms are aware of the threat posed by phishing attacks, including both general emails and sophisticated and targeted attacks (aka “spear fishing” or “whale fishing”), but could do more to mitigate the risks. Given the danger that victims may release confidential or personal information, respond with unauthorized wire transfers, or infect systems with malware, ransomware or other viruses, FINRA advises creating or upgrading anti-phishing policies. Among many suggestions, FINRA wants firms to better train and alert system users in how to identify phishing emails, not to open attachments in suspicious emails, and to notify IT administrators and compliance staff of any incidents. Perhaps most importantly, FINRA wants customer-facing employees who have access to valuable personal and financial information, to confirm wire transfers with customers, and to ensure resolution and remediation after an attack.

Insider Threats

Recognizing that insiders are “in a unique position to cause significant harm to an organization,” and that “the vast majority (95-99 percent) of higher revenue firms and 66 percent of mid-level revenue firms” said they address insider threats in their programs, FINRA outlined best practices for managing the exposure potentially created by insiders. These include significant attention to access policies and practices for executive leadership and management, heightened technical controls for individuals with privileged access, technical controls and data loss prevention (DLP) tools, training for all insiders, and measures to identify potentially abnormal user behavior in the firm’s network. FINRA also highlighted firms that cultivated a culture of compliance that encourages suspicious activity reporting and the regular review of higher-risk individuals, “especially in environments where it is difficult to maintain segregation of duties.”

Penetration Testing

FINRA highlights the importance of penetration testing as part of a broker-dealer’s cybersecurity programs. These tests serve to analyze a firm’s network and applications for vulnerabilities and technical gaps. FINRA notes that “100 percent of higher revenue firms include penetration testing as a component in their overall cybersecurity program,” but recognizes that penetration tests “are highly relevant to firms that provide online access to customer accounts.” That said, it is clear that the ability to identify, assess, classify risk and mitigate any security issues through this process is what FINRA wants to see for all firms. To that end, FINRA suggests that firms (i) adopt a risk-based approach to penetration testing; (ii) perform due diligence in the selection of vendors; (iii) establish contracts that prescribe vendor responsibilities; (iv) manage and follow up on test results; and (v) rotate testing providers “to benefit from a range of skills and expertise.”

Mobile Devices

In the report, FINRA addressed the risk of attacks on sensitive customer and firm data through the use of smart phones, tablets and laptops. FINRA noted the particular risk to retail investors who are performing a greater variety of transactions on mobile devices, including trading, money transfers and account monitoring. Here too, FINRA recommends developing a host of policies and procedures to address the protection of customer information and circumscribe the use of personal devices by employees for business without firm approval. FINRA referenced a number of requirements to improve security, including the implementation of password standards, authentications methods, and the installation of security software for mobile devices that are used for firm business. In addition, FINRA noted certain practices firms were using proactively, including the monitoring of the marketplace for malicious applications (in particular ones that can impersonate a firm’s mobile application) and greater communication with the firm’s customers on how they might mitigate risks on their own devices.

Conclusion

In the new report, FINRA makes clear that its current focus on specific technology risks should be considered in the “context of a holistic firm-level cybersecurity program,” the elements of which are contained in FINRA’s 2015 Cybersecurity Practices. That is an important caveat and a telling example of how fluid the compliance oversight of technology risk has become. Combined with instructions for small firms to update their Cybersecurity Checklist based on the new recommendations (contained in the Appendix of the new report), and additional warnings that FINRA’s observations are “not intended to express any legal position, [nor] create any new legal requirements or change any existing regulatory obligations,” the report is a reminder that firms remain responsible for creating compliance programs that address diverse and developing risks in a dynamic environment without any real certainty that they will be enough to withstand regulatory scrutiny.

 

For additional information and assistance, please follow the links below to relevant Bates Group's Practice Area pages:

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01-03-19

OCIE to Prioritize Protection of Retail Investors in 2019 Examinations

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The SEC Office of Compliance Inspections and Examinations ("OCIE") will prioritize risks to retail investors in this year’s examinations. That concern is a distinguishing highlight of a new report summarizing OCIE assessments of regulatory issues, market risks and policy developments. OCIE’s conclusions are based on information derived from 2018 examinations, regulator concerns and public comments aired at OCIE outreach programs, as well as tips, complaints and referrals shared with the agency during past year.

Additional featured priorities include continuing risks and concerns related to fee disclosures, share class, and wrap fee programs, anti-money laundering, cybersecurity, digital assets, FINRA and MSRB operations, and issues of compliance by registrants involved in critical market infrastructure. In this article, we review the new report, contrast this year’s priorities with those of the past few years (See Bates Group’s year-to-year SEC OCIE priorities chart, below) and consider some implications so that firms might better prepare and, if necessary, adjust their compliance systems accordingly.  

Why the Report Matters: A Leadership Message

Primarily, the OCIE report serves as an information alert to market participants. Citations to a list of the OCIE’s oversight responsibilities (i.e. more than 13,200 investment advisers, 10,000 mutual funds and exchange traded funds, 3800 broker dealers, 330 transfer agents, 7 active clearing agencies, 21 national securities exchanges, 600 municipal advisors, FINRA, MSRB, the Securities Investor Protection Corporation, and the Public Company Accounting Oversight Board) serves as a not-so subtle reminder of the broad scope and reach of OCIE operations.

Similarly, OCIE leadership reminds us of how aggressive the organization can be. Reciting a list of year-over-year 2018 accomplishments, the report states that the OCIE completed over 3,150 examinations, (a 10 percent increase,) expanded coverage of investment advisers (a 17 percent increase,) increased examinations of investment companies (a 45 percent percent increase,) and conducted over 300 examinations of broker-dealers. The message is clear: firms must take these priorities seriously.

Changes in the Market: An Affirmation of the Risk-Based Approach

OCIE recognizes that the markets it oversees are changing rapidly. A number of metrics are used to make this point. As to investment advisers, OCIE notes a 5 percent increase in the number of registered investment advisers and approximately $84 trillion in assets under management by these advisers. More than 3,700 advisers have over $1 billion dollars in assets under management. The report states that over a third of the investment advisers manage a private fund; more than half have custody of client assets; almost two thirds are affiliated with other financial industry firms; and almost 12 percent provide advisory services to a mutual fund, exchange traded fund, or other registered investment company. As to the broker-dealer community, despite an overall decline, the OCIE reports that almost 100 new firms registered in 2018, about 10 percent were dually-registered as investment advisers, and broker-dealers operated more than 156,000 branch offices.

The OCIE states that it is responding to these market changes by (i) continuing to use a risk-based approach for examining registrants, and (ii) “increasingly leveraging technology and data analytics as well as human capital to fulfill its mission.” Generally, the risk-based approach includes a review of a registrant’s operations and the products it offers. The results are “examinations that address aspects of the SEC’s regulatory oversight, such as the disclosure of services, fees, expenses, conflicts of interest for investment advisers, and trading and execution quality issues for broker-dealers.” OCIE stated that its risk-based examinations are based on “four pillars: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.” On its increased reliance on technology, OCIE said it is “continually adding to and refining the expertise, tools, and applications that help identify areas of risk, firms that may present heightened risk of non-compliance, and activities that may harm investors.”

OCIE 2019 Priorities

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SEC Examination Priorities Year-To-Year Comparison Chart
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Source: OCIE 2019 National Exam Program Examination Priorities (Compiled by Alex Russell, Bates Group LLC)
 

Bates Group has been tracking the OCIE examination priorities for the past five years (see year-to-year comparison above). The most distinguishing difference in OCIE’s announced priorities for 2019 is the elevation of concern for risk in the products and services sold to Main Street investors. As is apparent in the chart, refocusing on the retail investor allows for firms to reconsider how each of its compliance programs may affect that target audience. Here are a few of the particulars:

Retail Investors

The OCIE focus on the retail investor is consistent with the strategic direction the SEC has taken during the past year. (See here for additional Bates coverage on the SEC Final Strategic Plan.) The 2019 report states that the OCIE will focus examinations on the following categories, among others:  

  • Disclosures related to the calculation of fees, expenses and other charges investors pay for products and services. The OCIE said it would select firms with practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges. The OCIE stated further that it “will continue to evaluate financial incentives for financial professionals that may influence their selection of particular share classes,” and will pay particular attention to investment advisers that participate in wrap fee programs.
  • Conflicts of interest - The OCIE was particularly concerned with (i) the use of affiliated service providers and products, (ii) securities-backed non-purpose loans and lines of credit, and (iii) borrowing funds from clients.
  • Custody risks - The OCIE will examine firms for compliance with the Customer Protection Rule which ensures that assets are safeguarded and accurately reported, and prevents them from being used by broker-dealers as working capital.
  • Senior investors and those saving for retirement, particularly the ability to identify financial exploitation. (See here for Bates’ review of risks associated with senior investors and to download our complimentary Elder White Paper.)
  • Portfolio management and trading - the OCIE indicated that it will assess “whether investment or trading strategies of advisers are: (1) suitable for and in the best interests of investors based on their investment objectives and risk tolerance; (2) contrary to, or have drifted from, disclosures to investors; (3) venturing into new, risky investments or products without adequate risk disclosure; and (4) appropriately monitored for attendant risks.”
  • Risks associated with mutual funds and exchange-traded funds - OCIE stated it will focus on risks associated (1) funds that track custom-built or bespoke indexes; (2) ETFs with little secondary market trading volume; (3) funds with higher allocations to certain securitized assets; (4) funds that underperform relative to their peer groups; (5) funds managed by relatively new advisers in the Registered Investment Companies (“RIC”) space; and (6) advisers that provide advice to both RICs and private funds with similar investment strategies. (See here for Bates’ considerations on a recent OCIE alert on mutual funds and ETFs.)
  • Risks re: Microcap Securities - The OCIE will examine broker-dealers that sell stocks of companies with a market capitalization of under $250 million. The chief concern is with the risk of manipulative schemes, short sales and fraud concerning the publication of OTC equity security quotes

Other Highlights

The OCIE also reemphasized several examination priorities that had been highlighted in the past (see year-to-year comparison above). These include:

  • Anti-Money Laundering (AML) - OCIE will examine broker dealers to determine whether their AML programs are in compliance with their regulatory obligations, “including whether they are meeting their SAR filing obligations, implementing all elements of their AML program, and robustly and timely conducting independent tests of their AML program. (Note: Keep an eye out for a new Bates Research publication on the top AML cases brought by regulators in 2018.)
  • Cybersecurity - The OCIE will prioritize examination of compliance with cybersecurity rules in all of its examination programs. In particular, the OCIE will look to ensure the proper configuration of network storage devices, information security, governance, and policies and procedures related to retail trading information security.
  • Digital Assets - The OCIE will “focus on portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.”
  • FINRA and MSRB - The OCIE will continue to monitor the regulatory oversight programs conducted by FINRA and the MSRB, including their operations, internal policies, procedure and controls. OCIE also stated it will review the quality of FINRA’s examinations of broker-dealers.
  • Compliance and risk by certain registrants - For entities that provide services considered critical to the functioning of the capital markets, OCIE examiners will review transfer operations, including clearing agencies, exchanges and agents, recordkeeping and the protection of funds and securities. In addition, OCIE will examine internal audit and surveillance programs.
Conclusions

The OCIE warns that the highlighted priorities “are not exclusive” and that the scope of any given examination is the result of a firm specific risk based analysis. That said, the overall message of the report could not be clearer. For market participants under the scope of authority of the OCIE mandate: get every aspect of your compliance programs that cover retail investors in order. 

 

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions

Bates Investor Risk Assessment for Vulnerable and Senior Investors

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Financial Crimes, AML and Forensic Accounting

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12-21-18

SEC Office of Compliance Inspections and Examinations Announces 2019 Examination Priorities

SEC Office of Compliance Inspections and Examinations Announces 2019 Examination Priorities

SEC Office of Compliance Inspections and Examinations (OCIE) has announced their exam priorities for the upcoming year. You can read the press release here.

Stay tuned to Bates Research in the upcoming weeks for our expert commentary on the SEC's 2019 objectives and how they may impact your legal and compliance matters.

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12-13-18

FINRA Issues 2018 Report on Examination Findings

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In its second annual effort to highlight areas of compliance concern, FINRA published a 2018 Report on Examination Findings. The thorough report details selected observations and findings from broker-dealer firm exams that have “potential significance, frequency and impact on investors and the markets.” Last year’s report led with compliance concerns on anti-money laundering, cyber-security, best execution and outside business activities. In retrospect, these areas of focus were a warning of the kinds of enforcement actions regulators would bring throughout 2018.

The primary areas of focus in this year’s report are suitability for retail customers, private placements, abuse of the authority a client gives to a registered representative, and fixed income mark-up disclosure. FINRA also included within the report case studies that highlight examination findings from a targeted examination (sweep) of volatility-linked products. This article takes a closer look at these FINRA priorities—with links to current Bates Research articles on the substantive issues—and additional FINRA findings on compliance issues raised by this year’s examinations.

Suitability for Retail Investors

In the broadest sense, the theme of the FINRA report is a concern for retail investors and the suitability of products and services offered to them. In its examination of broker-dealer firms, FINRA found (i) continuing instances of unsuitable recommendations to retail investors and (ii) “deficiencies in some firms’ supervisory systems for registered representatives’ activities.”  

FINRA found infractions of all three required suitability obligations: reasonable-basis, customer-specific and quantitative suitability. FINRA found instances where registered representatives “did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations.” In other cases, FINRA found failures to “take into account …cumulative fees, sales charges or commissions” and unsuitable recommendations that resulted in excessive trading or overconcentration in certain complex products (including non-traded real estate investment products [REITs]) and “volatility linked products” (such as leveraged and inverse exchange-traded products [ETPs]), illiquid securities, “variable annuities, “switches” between share classes, and Unit Investment Trusts [UITs]).  As to suitability concerns regarding these latter volatility-linked products, FINRA noted challenges with supervisory systems and other operational issues in instances “when a broker-dealer or associated person has ‘actual or de facto control’ over a customer’s account.” In such instances, FINRA reminded firms of recent guidance on bad actors requiring “special supervisory procedures.”

Private Placements

An increasing concern highlighted by the FINRA report is the failure of firms to conduct reasonable diligence and to supervise brokers engaged in private placements. FINRA found that certain firms failed to perform such due diligence prior to recommending private placement offerings to retail investors. FINRA reminded firms of their obligation to conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.” Such diligence, FINRA said, works to mitigate conflicts, ensures that offerings are suitable for investors and informs appropriate and comprehensive disclosures. FINRA also warned firms not to over-rely on third parties that provide due diligence reports and to watch for conflicts of third-party diligence providers.

Abuse of Authority

FINRA highlighted the risks for retail investors who give registered representatives the authority to act on their behalf to engage in discretionary trading, “to act as trustees or co-trustees, hold Powers of Attorney or serve as executors or beneficiaries.” FINRA warned of the material risk to the retail investor from unsuitable or excessive trading; they found numerous instances where certain firms exposed investors to unnecessary risks and failed to establish controls to mitigate those risks. For example, FINRA found failures in the authorization process to engage in discretionary trading; expired authorizations; mismarked order tickets that obscure unauthorized discretionary trading; failures to comply with securities’ threshold limitations or other trading restrictions; and other intentional deceptions including falsifying authorization and suitability forms and abuse of trustee status when trading in a customer’s account.

Fixed Income Mark-up Disclosure

FINRA also found that firms were facing challenges implementing new FINRA and MSRB rules on fixed income mark-up disclosures. These challenges include putting in place appropriate confirmation review processes, systems and vendors. The new rules require firms to provide transaction-related mark-up or mark-down information to retail customers for certain trades in corporate, agency and municipal debt securities. FINRA found lapses related to inadequate disclosure in Order Entry Systems, inaccurate disclosures on customer confirmations, disclosure failures related to transactions in certain structured notes, incorrect designations of institutional accounts, and assorted vendor related problems. FINRA cautioned that “firms should consider reviewing samples of their confirmations for all of the required disclosure elements, including the mark-up or mark-down, the time of execution” and security-specific links. FINRA said that firms should also consider whether they are maintaining consistent and correct disclosures for fixed income transactions executed across different vendors, platforms or trading desks.

Other Observations

As noted by Susan Schroeder at a recent 2018 SIFMA C&L New York Regional Seminar, FINRA continues to be concerned about compliance challenges on a host of other issues. Here are the ones designated in the report:

AML – FINRA recognized continuing compliance challenges fulfilling anti-money laundering obligations, particularly in light of the May 11, 2018 effective date of FinCEN’s Customer Due Diligence (CDD) rule. FINRA found general inadequacies of certain firms’ overall AML programs: misallocations of AML trade monitoring responsibilities, failures in data integrity in automated surveillance systems, and inadequate resourcing for AML programs, among others.

Net Capital Rule and Liquidity Requirements – FINRA found compliance issues with net capital rules designed to protect against monetary losses in the event of a “broker-dealer failure.” FINRA also found deficiencies with firms’ liquidity risk management programs which are designed to protect customers by ensuring that a firm can continue to operate under “stressed” conditions.”

Segregation of Client Assets – FINRA found that certain firms failed to comply with the Customer Protection Rule, which ensures that customer cash is not intermingled with the firm’s proprietary business activities.

Operations Professional Registration – FINRA found that some firms continued to permit unregistered staff to engage in activities that would require Operations Professional registration.

Customer Confirmations – FINRA found that certain firms did not maintain adequate supervisory programs relating to confirmations or comply with certain confirmation disclosure requirements for transactions in equity securities.

DBAs and Communications with the Public – FINRA found compliance deficiencies related to requirements to maintain controls, provide adequate disclosures, monitor retail communications, websites, social media accounts, seminars and external email accounts used by representatives when communicating on the firm’s behalf.

Best Execution – FINRA found certain firms that receive, handle, route or execute customer orders failed to meet their duty of best execution in equities, options and fixed income securities trading. The deficiencies included failures to perform execution quality assessments in competing markets, failures to conduct adequate reviews on a type-of-order basis, and failures to consider factors like speed of execution, price improvement and the likelihood of execution of limit orders.

TRACE Reporting – FINRA found that certain firms engaging in institutional sales of fixed income securities did not comply with TRACE reporting rule requirements.

Market Access Controls – FINRA found that certain firms failed to maintain effective pre-trade financial controls or make required intra-day adjustments of pre-trade financial thresholds and oversight of third-party vendors.

Conclusion

The 2018 Report on Examination Findings should be reviewed carefully by broker-dealer firms. It is not just a checklist of every compliance item FINRA is currently assessing, it is a warning to firms about what to watch for in terms of regulatory enforcement. Bates will continue to track regulatory alerts and enforcement actions to help you stay ahead of the curve.

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Financial Crimes

Consulting and Expert Testimony

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12-06-18

Compliance in the Age of Robo Investment Advice

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In late August, four registered financial service firms settled SEC charges of misleading retail investors about the efficacy of their quantitative models. The SEC alleged that the firms promoted, offered, sold and managed mutual funds, variable life insurance products and annuity investment portfolios that used a faulty “proprietary quant model.” Without admitting or denying the charges, the firms agreed to refund $97 million to retail investors.

Questions about the proper use and regulation of algorithmic models in advisory services are raised with more urgency these days, most recently at the SIFMA New York Regional conference held in early November. In this article, Bates Research takes a closer look at this case and existing SEC compliance guidance on robo-advisory services as well as some of the enforcement concerns in this rapidly expanding marketplace.

instructive

In the case referred to above, the SEC found a host of disclosure issues. These included failures to disclose: (i) that the model was developed by an inexperienced junior analyst; (ii) that the day-to-day manager of the products was not (as communicated) an experienced asset manager; (iii) certain errors when they were discovered, (iv) the decision to discontinue use of the model; (v) errors in model methodology and accuracy; and (vi) known risks or to verify that the models worked as intended. In separate proceedings, the SEC found that the Global Chief Investment Officer and the former Director of New Initiatives were personally responsible for the compliance failings related to the development and use of models.

Notably, according to the Order, the “[r]espondents cooperated with the Commission’s investigation throughout its entirety, and their efforts assisted the Commission staff in its collection of evidence...” That cooperation took the form of voluntarily retaining a compliance consultant “to conduct a comprehensive, independent review related to their respective compliance policies and procedures, internal controls and related practices, with an emphasis on product development, use of investment models and algorithms, due diligence, disclosures in prospectuses and marketing materials, and enterprise compliance functions and the operation of those controls within and among the Respondents.” In addition, the SEC recognized that “[r]espondents began revising and improving their compliance and due diligence policies and procedures related to the use of models and the creation and use of marketing communications, product development, and investment management.”

Existing Guidance for Investors and Firms

The case raises many of the concerns the SEC expressed in an Investor Bulletin and a Guidance Update on robo-advisers in February 2017. In the Bulletin, the SEC Office of Investor Education and Advocacy (“OIEA”) acknowledged that “automated digital investment advisory programs” allow individual investors to create and manage their investment accounts for potentially less money in fees and account minimums, than through a traditional investment adviser. OIEA described a simple process, whereby an investor would complete a questionnaire on financial goals, investment horizon, income, assets, and risk tolerance. Based on such information, a robo-adviser would create and manage an investment portfolio. All of it would be accessible to the investor from a web-portal or mobile device. OIEA’s general advice to investors was to do research, understand the products contained in a robo-advised portfolio, consider how much human interaction is preferred, ask good questions and identify personal investment goals.

OIEA also advised investors to remember that firms providing robo-advisory services have to be registered as investment advisers with either the SEC or one or more state securities authorities. It is this point that underscores the compliance obligations for such firms contained in the industry-issued guidance.

The SEC industry guidance focused on (i) the substance and presentation of disclosures to clients about the investment services offered; (ii) a firm’s obligation to gather client information to support a robo-adviser’s duty to provide “suitable advice;” and (iii) “the adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.” This last area includes the adoption, implementation, and annual review of written policies and procedures “that take into consideration the nature of the firm’s operations and the risk exposures created by such operations;” the designation of a competent and knowledgeable chief compliance officer to be responsible; and additional written policies and procedures that address testing of the algorithmic code, monitoring, oversight of third parties, cybersecurity and the protection of client accounts.

Panelists at the 2018 SIFMA New York Regional Conference deliberated on the compliance challenges presented by the current guidance. One panelist expects regulators to further test the industry on ensuring that the algorithms used are working the way they are supposed to. Others raised practical questions about how compliance officers should best supervise robo-products. Responses ranged from reliance on greater use of IT testing teams, to ensuring that a firm’s legal, compliance and business teams are in sync with each other, particularly before the launch of any new algorithmic trading products. All the while, these panelists were concerned with the kinds of disclosures that adequately communicate—in plain English—the risks and the benefits to the investor.

The Future of Robo-Advising

Though it has been only a short while since the SEC issued its guidance, investments in robo-offerings have grown and the application and use of algorithmic programming expanded. A new report by Charles Schwab cites data that predicts “digital advice users will increase from roughly 2 million to 17 million by 2021.” The report asserts that the use of robo-advisers will have a bigger impact on financial services in the future (say 45 percent of Americans surveyed) than cryptocurrency (29 percent), artificial intelligence (28 percent), or big data (21 percent). Those are the kinds of findings that make regulators take notice.

Perhaps the most striking finding from the survey is that seventy-one percent of people say they want a robo-adviser but also access to human advice, and almost half of those surveyed who are not using a robo-adviser today said they would be more likely to use one if it has quick and easy access to human support. This finding cuts across generational investors. According to the survey results, baby boomers would be more likely to use a robo-adviser if they feel like their information in the service is secure, if the fees are lower than a traditional financial adviser, if the mobile app is easy to use, and if the service has a low investment minimum.

Bates Director of Institutional and Complex Litigation Alex Russell, a specialist in algorithmic trading and testing validation, observed, “If these findings pan out, regulators will ramp up their scrutiny of algorithmic trading platforms.”

Conclusion

The rapid growth and investment in robo-products and advisory services is garnering increasing attention. The recent SEC case puts compliance officers on notice that enforcement regulators are watching.

Bates will continue to follow these market developments. For more information on how Bates Group might help, contact Alex Russell, Director of Institutional and Complex Litigation at 971-250-4353. Mr. Russell provides consulting services related to quantitative financial modeling, trading systems, and derivative strategies and products within both the retail and institutional securities litigation practice areas.

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11-29-18

Best Practices When Working with Expert Witnesses

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Your relationship with your consulting or testifying expert is a critical component to your case. Mastering best practices when working with an expert will better support your case.

We recently polled several of Bates’ financial industry experts, many of whom are former general counsels, branch managers and regulators, to summarize best practices when working with consulting and testifying experts. Here's what they had to say.

Best Practice #1: Engage Your Expert Early  

Engage your expert sooner rather than later in order to gain their best insights and to inform your strategy. Overwhelmingly, our experts say their matters fare better specifically when they can bring their expertise to bear in: (a) your early case evaluation process; (b) before mediating; (c) before determining what documents and materials your client should have; and (d) before determining what documents and other materials you should demand during discovery. One Bates expert notes:  “As a witness, it is important to have access to all pleadings and relative documents early or as they become available, particularly if the client wants a full analysis and assistance in developing the strategy for potentially trying or mediating a case.” Finally, keep in mind that experts’ schedules book up quickly, often months in advance. Make sure you reach out to an expert early to determine their availability before agreeing to hearing or trial dates.

Best Practice #2: Be Alert to Your Expert’s Warnings and Strategic Counsel

An expert is an expert because of their knowledge and experience. To hire an expert and ignore or fail to incorporate their counsel could possibly lead to a critical mistake or oversight of a material issue. As one trial expert stated: “Many attorneys, by the time I am retained, have already decided how to defend their case and are convinced of the strengths and weaknesses. These attorneys are simply ‘checking a box,’ because procedure may require them to have an expert.” This often leads clients to “ignore warnings that invariably surface again later, much to everyone’s detriment.”

This expert further pointed out that: “The best counsel to work with are those that don’t know what they don’t know. These are attorneys who recognize the complexities and nuances of, for example, the retail securities industry, and are willing to learn everything they can to improve their chances for a reasonable settlement or a minimal award. These attorneys value an expert’s input, expertise, advice and opinions. Importantly, they are willing to listen when offered candid criticisms of their cases. This can be truly valuable to counsel.”

Best Practice #3: Do Your Homework

Attorneys and their clients need to do their homework to ensure that there are no contrary sources that may compromise their cases. As one Bates expert stated: “Clients need to have thorough discussions with the experts so they don’t have any memorialized opinions, such as white papers, articles, or accessible transcripts that conflict with the issues of their matter. A client also needs to clearly understand the expert’s background and have thorough discussions about any red herrings in their past that opposing counsel could use to reduce the effectiveness of their role and testimony.” 

Best Practice #4: Be Penny Wise, but not Pound Foolish

Costs are always a concern for an in-house counsel client and outside counsel. As one expert commented: “Clients and counsel too often, in an effort to limit costs, wait until after mediating before retaining an expert or until the deadline for exchanging witness lists and documents is upon them. In my experience, that is a mistake both from a preparation and cost point of view, particularly in cases where you are seeking to settle before hearing or trial. The extra investment incurred by retaining an expert early is typically minimal and more than made up by insights gained during Early Case Evaluation, before mediating and during discovery.”

Best Practice #5: Expert Attendance at the Full Hearing is Beneficial to Your Case

Experts are part of a trial team. To limit their access during the process is to deny their ability to spot problem issues or provide insight. As one substantive expert shared: “A strategy that is becoming more prevalent is the idea that, as an expert, I can be equally effective when attending only one hearing session in order to testify, as opposed to all of the preceding days of the hearing. It is critically important for me to hear and see the testimony of other witnesses, the tactics of opposing counsel, and the reactions and questions of the panel. While I recognize that costs are an issue, I firmly believe that hearing attendance costs for the expert are among the best dollars that can be spent by the client.”

For over 30 years, Bates Group’s quantitative and substantive experts and consultants have been engaged on thousands of financial services cases. Bates Group experts render analysis and support clients on cases concerning industry and sales practices, complex products, and damages assessments, to name a few.

 

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11-08-18

The Regulatory Landscape is Changing for Variable Annuity and Life Insurance Contracts

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Significant regulatory developments are taking place in the variable annuity and life insurance market that are intended to encourage investors to make more informed decisions about these financial products. Along with the SEC’s announcement of an extensive new rule proposal that would leverage technology and create a “layered disclosure approach” to variable annuities and life insurance contracts, the SEC Office of Investor Education (“OCIE”) issued a Bulletin that offers a basic primer on these instruments.

The issuance of the new proposed rules comes a week after state insurance regulators met to revise the National Association of Insurance Commissioners (NAIC) “Suitability in Annuity Transactions Model Regulation.” (See Bates' article on recent deliberations.) The model regulation sets forth standards and procedures for providing appropriate recommendations to consumers “that result in transactions involving annuity products.” Here is a closer look at these recent developments.

SEC Proposes Rule Changes to Improve Disclosure on Variable Contracts

Weighing in at 480 pages, the new SEC proposal is a disclosure initiative intended to help investors understand key terms, fees and risks associated with variable contracts. The proposal creates a “layered approach to disclosure” similar to the approach which has been in use for mutual funds since 2009. The idea is to require issuers of variable contracts to provide basic information in a “summary prospectus” format with links to additional and more detailed information accessible by the consumer. For existing holders of these variable instruments, issuers would be required to provide an updated summary prospectus which would contain a brief description of changes to the contract that occurred during the previous year along with all the basic information contained in the new summary. SEC Chair Jay Clayton stated that "providing key summary information about variable annuities and variable life insurance contracts to investors is particularly important in light of the long‑term nature of these contracts and their potential complexity."

The proposed amendments affect existing disclosure rules and forms and would permit an issuer of a variable product to satisfy their legal compliance obligations through the delivery to an investor of this “reader-friendly” summary prospectus. Technical aspects of the proposal include: (i) required links to the full statutory contract prospectus; (ii) use of the Inline eXtensible Business Reporting Language format for the submission of other required disclosures; and (iii) revocation of certain rules and forms that have been superseded by law or that have been rendered moot. Comments on the proposal and on the provided samples of the summary prospectus must be submitted before February 15, 2019.

OCIE Investor Bulletin

The OCIE issued a primer on variable life insurance that provides a general description of how variable contracts work and how such a long-term policy is meant to satisfy a consumer’s insurance needs, investment goals and tax planning objectives. The Bulletin describes the features of the contract, including death benefits, accrued cash value that varies according to the amount of premiums paid, fees and expenses, and investment options offered under the policy. The Bulletin also explains the risks of such contracts, including the risks from policy lapse, investment loss and insurance company failure. Perhaps most important, the OCIE urges consumers to review the policy prospectus and to “be prepared to ask your financial professional questions about whether the policy is right for you.” Such guidance relates directly to the ongoing discussion of the suitability obligations of those financial professionals.

Latest Developments on Amending NAIC “Suitability in Annuity Transactions Model Regulation.”

As discussed previously, the NAIC Annuity Suitability working group has been working on revisions to the model regulation since late July. The intent of the working group is to update a rule that would enhance the standard of care for sales of variable annuity products. On October 25, 2018 the working group published the latest revisions to its draft of the model rule which reflect the deliberations from its most recent meetings. Among other things, the draft proposal would require an agent to act with reasonable diligence, care, skill and prudence on behalf of clients and to disclose conflicts of interest as well as cash and non-cash compensation.

Against the backdrop of the SEC’s proposed Best Interest rulemaking, (see Bates’ research articles here and here,) the working group reportedly continued to debate many of the thorny definitional issues that may impact the final model regulation. These include (i) whether a recommendation must be “consistent with” or must be “in furtherance” of a client’s objectives and needs, (the new draft keeps the “consistent with” language”); (ii) the applicability of the model regulation to “in-force” transactions, (the new draft does not apply to in-force policy transactions); (iii) the degree to which a producer must consider recommending other products, (the new draft does not contain references to other products available through the producer); and (iv) the allowable extent to which a producer’s interests may be considered, (the latest draft states that the producer may not place the producer’s or the insurer's financial interest “ahead of the consumer’s interest”).

Conclusion

Given the reprioritized focus on protecting retail investors by both federal and state regulators, enhanced or simplified disclosure of some kind is a certainty. The new SEC disclosure rule on variable contracts is one step in that direction. Publication of the OCIE primer on variable contracts (not a coincidence) serves not only as a useful resource, but also a reminder of the wider debate on raising standards for issuers. It is, of course, unlikely that any final NAIC model regulation on annuity standards will be issued before the SEC resolves its broader rulemaking on Best Interest. According to Mike Lacek, Bates’ Retirement, Insurance and Annuity Consultant, “the NAIC deliberations reflect a real tension underlying efforts to produce a simple rule that can do it all. Until such time as these issues are resolved in a comprehensive and coherent way, companies will have to continue to address the on-going compliance challenges they present.” Bates will continue to monitor developments.

 

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10-31-18

Federal Trade Commission Reports on Senior Consumer Fraud

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In a new report to Congress, the Federal Trade Commission (“FTC”) compiled its latest data on the widespread problem of financial fraud perpetrated against elderly consumers. The agency also highlighted 2017-2018 enforcement actions and described its outreach and education initiatives to combat senior financial abuse.

The FTC report, titled “Protecting Older Consumers, 2017-2018,” was prepared as required by the 2017 Elder Abuse Prevention and Prosecution Act (see Bates coverage here.) The FTC is mandated to gather that information under the agency’s consumer protection authority. By statute, the agency is empowered to (i) prevent unfair or deceptive acts affecting commerce; (ii) seek relief for conduct injurious to consumers; (iii) establish rules designed to prevent unfair or deceptive acts or practices; (iv) compile information and conduct investigations, and (v) prepare reports and recommendations to Congress. The report attempted to parse out effects on seniors from its consumer data. This article highlights the findings in the latest FTC report.

Data and Analysis

The information used in the report was collected primarily through the FTC’s Consumer Sentinel Network (“Sentinel Network,”) an online database that provides law enforcement agencies with secure access to consumer reports on fraud. The FTC report states that law enforcement agencies use the network to help identify patterns and trends and problematic business practices of targets under investigation.

Of the nearly 1.14 million submissions to the database in 2017 that related to fraud, almost half included age-related information from which the FTC conducted its analysis. According to the data provided by that portion of the information, total fraud loss reported by consumers ages 60 and older was $252 million. (Note, the FTC’s figure represents consumer fraud and represents a fraction of losses reported by the Department of Justice and SIFMA.)

The primary conclusions from the FTC analysis is that (i) seniors were more likely to report fraud than younger people (over 60-year-old consumers were twice as likely to report fraud as compared to those aged 20-29), (ii) seniors were less likely to indicate that they had lost money (over 60-year-olds indicated a monetary loss 18-20% of the time as compared to 40% for those aged 20-29,) and (iii) the dollar amounts lost for seniors were much higher than the dollar amounts lost for younger people (see chart below.)

MEDIAN INDIVIDUAL MONETARY LOSS REPORTED BY AGE

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Source: “Protecting Older Consumers, 2017-2018,” report to Congress, Federal Trade Commission.

There was no conclusion drawn on the causes for these disparities. The report did suggest that seniors may be more willing to help fight fraud and therefore to report more, that younger consumers may be more inclined to file fraud reports only in instances where they suffered a financial loss, and that the size of the losses reflect older adults having access to more assets through retirement accounts, home equity, social security or pension benefits.

Other Observations on the Sentinel Network Data

The FTC also provided analysis of the Sentinel Network complaints based on types of schemes. The agency concluded that seniors were five times more likely to be defrauded by technical support scams, prizes/sweepstakes/lottery scams, family and friend imposter frauds, and real estate and timeshare resale offers than younger consumers. In contrast, the FTC concluded that seniors were less likely than young consumers to lose money in shop-at-home or catalog sales and government imposter scams and counterfeit check scams.

The FTC reported that seniors lost far more money than young consumers in phone scams. Average losses exceed $1000 for seniors over 60 that were contacted by phone.

MEDIAN LOSS REPORTS BY AGE AND METHOD OF CONTACT

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Source: “Protecting Older Consumers, 2017-2018,” report to Congress, Federal Trade Commission.

Finally, the report analyzed the data as a function of payment method. The report concluded that credit cards and wire transfers were the transaction methods of choice and that wire transfers accounted for an overwhelming amount of the losses incurred by seniors.

TOP PAYMENT METHODS AND TOTAL AMOUNT PAID (Ages 60+)

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Source: “Protecting Older Consumers, 2017-2018,” report to Congress, Federal Trade Commission.

Law Enforcement

The Elder Abuse Prevention and Prosecution Act requires the FTC to report on enforcement actions “over the preceding year in each case in which not less than one victim was an elder or that involved a financial scheme or scam that was either targeted directly toward or largely affected elders.” Though the 63 cases cited in the report were not exclusively about seniors, the agency listed scams (in an appendix) that the agency stated include older adults.

The FTC highlighted cases involving (i) marketers who sold phony debt relief services in Florida); (ii) a tech support scam in Alabama; (iii) misleading claims about pain and memory enhancement supplements; (iv) massive fraud payments through a money transfer system over many years; (v) deceptive prize promotion mass mailings, and (vi) telemarketing fraud related to credit card fraud protection insurance.

Outreach and Education

Finally, the FTC report outlined its outreach and education initiatives in an effort to demonstrate compliance with its senior protection responsibilities under the law. Specifically, the agency highlighted its Every Community Videos Program, which disseminates individual stories and tutorials about financial fraud, and its Pass It On Campaign, a program designed to encourage passing on tips on recognizing and reporting fraudulent schemes.

Conclusion

This new report reinforces common understandings about the threats posed to seniors by consumer fraud. The report is somewhat compromised by the limitations on the data and the parceling out of seniors from the rest of the sample. That said, the FTC asserts that the data from the Sentinel Network informs law enforcement strategy on how to direct resources. Based on the FTC report, therefore, greater scrutiny related to wire transfer agents and credit card fraud may occur. As to protecting seniors against specific types of fraudulent schemes, more accessible information and educating seniors to identify and report scams is the message.

Bates Group closely follows the regulatory and enforcement developments on senior financial fraud. For Bates’ most recent view of the changing federal and state legislative and regulatory landscape on senior investors, download our complimentary white paper. For more information concerning financial issues related to vulnerable and senior investors, including senior investor expert witnesses, damages analysis, and compliance, please contact Bates.

Financial institutions may also be interested in Bates Investor Risk Assessment to protect your vulnerable and elder investors while meeting regulatory expectations.

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10-25-18

SEC Finalizes Its Four-Year Strategic Plan

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In June, Bates reported on an SEC Draft Strategic Plan for Fiscal Years 2018 - 2022. The development of the plan is required by federal statute as a means to assess “agency performance and improvement.” The issuance of the Draft Plan was immediately followed by the submission of testimony by SEC Chair Jay Clayton before the House Committee on Financial Services. At that hearing, Chair Clayton expounded on the short draft strategy, describing in greater detail the future agenda for the agency. Now, after the required comment period, the agency’s Final Strategic Plan has been released. Chair Clayton describes the 11-page plan as a “forward-looking framework” that focuses “on the most important goals and initiatives” for fulfilling the agency’s mission. Here’s a closer look.

The Plan

The final strategic plan identifies three core goals: (i) to “focus on the long-term interests of Main Street investors”; (ii) to respond effectively to new risks from technological “developments and trends in evolving capital markets”; and (iii) to enhance the agency’s “analytical capabilities and human capital development.” These contrast with the much lengthier (60-page) 2014 - 2018 Strategic Plan which sought to “establish and maintain an effective regulatory environment”; to “foster and enforce compliance with the federal securities laws”; to “facilitate access” to useful investment information for investors; and to better manage “human, information and financial capital.”

Goal 1: Refocusing on the Long Term Interests of Retail Investors

The first strategic goal reflects an important reorientation toward the concerns of retail investors. The new plan references the changing marketplace for retail investors including, for example, the changing retirement landscape – the evolution away from 401k plans, and the lack of clarity among retail investors seeking professional advice (“Best Interest”). The plan also referenced the decline in the number of opportunities for Main Street investors to invest in public companies, particularly with respect to emerging and growth sectors, given the decline in the number of companies raising capital through the public securities markets.

As a result, the SEC prioritized a number of long-term efforts to support retail investors. Most notably, the SEC committed to “pursue enforcement and examination initiatives focused on identifying and addressing misconduct that impacts retail investors.” In this regard, the SEC acknowledged that the evolving market continues to provide opportunities for “securities manipulation, fraud, and abuse, while also giving new life to age-old scams like Ponzi schemes.” The SEC committed to expand its enforcement efforts, including, specifically, “in the area of securities custody and penny stock trading.”

The agency also committed to strengthening its focus on retail investors by (i) enhancing outreach, education, and consultation efforts, in order to better understand “the channels retail and institutional investors use to access capital markets and to more effectively tailor policy initiatives to them; (ii) modernizing disclosure (including improvements to the EDGAR system) so that retail investors, can access readable, useful, and timely information to make informed investment decision; and (iii) identifying ways to increase long-term, cost-effective investment options available to retail investors, including by expanding the number of SEC-registered companies.

Goal 2: Adapting to Technology Risk and a Changing Market

The Plan’s second strategic goal reflects an acknowledgement that “increased use of, and reliance on, technology has introduced new risks and, in some cases, amplified better known market risks.” A number of factors are said to be driving the need to better respond to technological risk, such as: (i) increased dependence on data security and transmission to the functioning of the securities markets; (ii) investors moving toward data analytics to inform their investments; (iii) market participants embracing new technologies to improve efficiency and security; and (iv) the vulnerabilities that result from interconnected and interdependent markets. The SEC Strategic Plan seeks to address the consequent “regulatory and oversight challenges” that cyber security and new entrants into the market, like initial coin offerings, pose.

To that end, the Plan prioritizes expanding market knowledge and oversight capabilities to identify, understand, analyze, and respond effectively to these new developments and risks; to fix outdated rules; to address “cyber and other system and infrastructure risks”; and to better prepare for market technological emergencies and crises.

Goal 3: Enhancing Analytical Capabilities

The Plan’s third strategic goal, a commitment to enhance the agency’s analytical capabilities, is a recognition that the changing technological demands of the marketplace requires greater expertise and leadership. To that end, the SEC outlined the following initiatives: (i) recruiting, retaining, and training staff with the right mix of skills and expertise; (ii) building out agency infrastructure to expand and leverage risk analytics and data management programs in order to set regulatory priorities; (iii) continue enhancing the “analytics of market and industry data to prevent, detect, and prosecute improper behavior,” and investing in data and tools to strengthen enforcement efforts; (iv) improving risk management controls to deal with threats to the security, integrity, and availability of the SEC’s systems and sensitive data; and (v) better collaboration and information sharing across the agency.

Conclusion

The new SEC Strategic Plan has not changed much from the draft released in June. Comments demonstrated institutional interests in sync with the SEC Plan. (See, e.g. MSRB’s interesting discussion on retail investor protections and recent enforcement rulemakings.) Some commenters wanted to address more specific concerns – the Financial Services Institute took the opportunity to reinforce their argument for a two-tier disclosure regime pursuant to any forthcoming Best Interest rule. And the U.S. Chamber of Commerce argued that the SEC concentrate on four items: Public Company Regulatory Reform; Modernizing Existing SEC Rules; Disclosure Reforms; and Standards of Conduct for Investment Professionals.

Because the SEC delivered a shorter, yet higher-level plan, it managed to steer clear of many controversial and thorny policy issues. But the document does provide takeaways that indicate important shifts in thinking away from the agency’s previous stated priorities. These include an intentional reorientation to focus on the retail investor; an open-minded approach to better address the many risks raised by innovation and new technology; and a recognition that the infrastructure and personnel of the agency must (and will) improve to adapt to technological change. Market participants would be well advised to stay on a compliance course in sync with these priorities.

Bates Research will continue to keep you apprised.

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10-18-18

New York DFS Asserts Itself in National Annuities Standards Debate

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In a few weeks, a working group of the National Association of Insurance Commissioners (NAIC) will meet again in a continuing effort to complete a revision to the organization’s Suitability in Annuity Transactions Model Regulation. The goal of the working group remains a revision of the standards and procedures for providing appropriate recommendations to consumers “that result in transactions involving annuity products.”

The working group began its efforts in reaction to the Labor Department’s fiduciary rule, which raised investment advice standards for all retirement accounts. Since that time, the fiduciary rule suffered a mortal blow, replaced by new federal regulatory proposals on a yet-to-be-agreed-upon “best interest” standard. The SEC proposals affect the NAIC working group deliberations generally and due to the agency’s regulation of certain insurance products like variable annuities and registered fixed-indexed annuities. Despite the changing context, the working group carried on its deliberations, though its progress took a further detour in July when the New York Department of Financial Services (NYDFS) issued a final regulation establishing its own “best interest” standard of care for recommendations of both annuity products and life insurance products.

New York Department of Financial Services Makes Its Move

The NYDFS final rule requires insurers to establish policies and procedures so that brokers and dealers would put the interests of consumers ahead of their own when making any product recommendation. In a statement released by NYDFS Superintendent Maria T. Vullo, NYDFS stated that the rule “will fill in regulatory gaps to protect New York consumers from the elimination of the federal Department of Labor’s Conflict of Interest Rule, which the Trump Administration failed to protect…” Superintendent Vullo went on to say that the new regulation sets “reasonable limits on compensation and compensation transparency.”

The New York regulation is the first in the United States to impose a "best interest" standard. It requires that insurance companies and distributors selling these products in New York implement new and rigorous policies and procedures by an effective date of August 1, 2019. According to Bates retirement, insurance and annuity consultant Michael Lacek, the impacted policies and procedures include, among others: (1) producer compensation, (2) product offering line-up, (3) collection of specified "suitability" information, (4) suitability review of life insurance, as well as annuity products, (5) supervision, (6) producer training, (7) customer disclosures, and (8) transaction documentation.

NAIC Ongoing Deliberations

The Annuity Suitability working group has been working on a draft of proposed revisions to the model regulation since late July, having issued requests for comments on sections devoted to definitions and the duties of insurers and producers. According to a summary of their last (August) meetings, the working group continues to disagree over key terms including the definitions of “consumer” and “material conflict of interest” and whether any new revisions should apply to current (in-force) annuity owners. These are not idle disagreements. As summarized discussion of the four suggested definitions of “material conflict of interest” resulted in a lack of unanimity about what constitutes a conflict of interest, how to measure its materiality and whether it could be interpreted to include compensation.”

In addition, at the August meeting, Superintendent Vullo made a direct appeal for the inclusion of life insurance in the revisions to the NAIC Model Regulation. The superintendent acknowledged that the working group on annuity suitability had interpreted its existing mandate to apply only to annuities, but asked that the Life Insurance and Annuities Committee, the authorizing NAIC authority, reopen the discussion on inclusion of life insurance in the revisions. She reportedly received a commitment that a discussion of life insurance suitability would be taken up during the next round. Further, according to the summary, several members of the working group have shown interest in revising the draft of the model regulation after conducting a “regulator only in-person meeting.” If the Life Insurance and Annuities Committee agrees with the New York Superintendent, final revisions to the NAIC Model Regulations are not imminent. 

Conclusion

The current deliberations over the scope of the revisions and the standards at issue take place within the broader federal debate over higher standards for broker-dealers of regulated financial products and the intentions of state actors, like those in New York, that regulate fixed annuities, unregistered fixed-indexed annuities and most life insurance.

According to the Chair of the working group, there is hope that a final rule may be ready by NAIC’s fall national meeting in mid-November. Recent deliberations and a newly issued preview of the upcoming meeting suggests that without significant additional compromise, the Annuity Suitability working group may not be ready to present by then.

 “It remains to be seen whether the requirements imposed by the New York regulation will differ materially from the ‘best interest’ regulations currently under consideration by the SEC and the NAIC,” says Bates’ Michael Lacek. “For now, companies should be looking to be in compliance with the actual New York rules coming on-line.”

Bates will continue to monitor developments in order to assist companies in implementing these changing regulatory requirements.

 

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10-04-18

NASAA Update: New Leadership, Cybersecurity Model Act for IAs and Heightened Supervision for BDs

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On September 25th, Michael S. Pieciak, Commissioner of the Vermont Department of Financial Regulation (pictured above), took the reins as the 101st president of the North American Securities Administrators Association (“NASAA”). That same day, NASAA’s Investment Adviser Section proposed a model rule that would require investment advisers to adopt policies and procedures regarding information security. NASAA also published the results of a series of “coordinated examinations of broker-dealer firms” that reviewed the heightened supervision plans of firms for registered representatives. Here’s a closer look at these developments.

New Leadership and Priorities

At the 2018 Annual Meeting in Anchorage, Michael S. Pieciak began his one-year term as president of NASAA. Mr. Pieciak, who formerly served as president-elect and chair of the organization’s Corporation Finance Section and Fintech and Capital Formation Committees, announced NASAA’s new leadership team which includes Past President Joseph Borg, Director of the Alabama Securities Commission, and President-elect Frank Borger-Gilligan, Assistant Commissioner of the Tennessee Department of Commerce and Insurance.

In his remarks, Mr. Pieciak set forth his priorities. He stated that cybersecurity, cryptocurrency, financial technology, multi-jurisdictional enforcement matters, standards of care and senior financial fraud would remain primary concerns.

He noted, however, that recent member survey results found that the “preservation of state authority stood head and shoulders above all others as the top priority for our members.” He said that such a concern is well placed, given “broad preemption legislation in recent decades, and renewed threats in recent months.” He pledged to pursue “modernizing our association and promoting uniformity” as the most effective ways… to fight preemption and preserve our authority.” He acknowledged that “determining the most effective strategies… will take considerable thought, time, collaboration and discussion.” As a result, one of his first acts was to direct the NASAA Board to establish a Strategic Planning Committee to review bylaws, committee structure, policies and procedures.

Mr. Pieciak, NASAA’s first millennial president, also voiced his commitment to “focus on millennial investor education, awareness and protection.” He emphasized its importance and tasked NASAA’s Investor Education Section “to expand its ongoing generational outreach initiatives to include resources specifically designed for this younger generation.”

New Proposed Model Rule on Information Security

Also on September 25, NASAA released a new model rule that would require state-registered investment advisors to adopt new policies and procedures regarding information security. The proposal references findings from NASAA’s 2017 Coordinated Investment Adviser Examination Report as well as recent education initiatives, specifically the 2017 Cybersecurity Checklist. The Checklist was intended “to provide direct guidance on ways the [investment adviser] firms can identify, respond, and recover from cybersecurity weaknesses and/or breaches.”

The proposal has three parts. First, the “Proposed Information Security and Privacy Rule” would impose new requirements related to both the physical security of information as well as require the annual delivery of a firm’s privacy policy to clients. Second, a “Proposed Recordkeeping Rule Amendment” would amend the existing NASAA model recordkeeping rule to require that investment advisers maintain the additional records required by the new information security rule. Third, the “Proposed Unethical Business Practices (‘UBP’) Rules Amendment” would amend the existing UBP Model Rules to add to the list of prohibited and unethical conduct a failure to establish, maintain, and enforce a required policy or procedure. The comment deadline is November 26.

NASAA states that the Rule Proposal has three objectives: (i) to address the “need for investment advisers to have policies and procedures” to deal with data privacy and security issues; (ii) to provide a “basic structure for how state-registered investment advisers may design their information security policies and procedures;” and (iii) “to create uniformity in both state regulation and state-registered investment adviser practices.”

New Guidance for Broker-Dealers on Heightened Supervision

In another significant development, NASAA released the findings of examinations of broker-dealer firms on their heightened supervision plans for high-risk registered representatives. NASAA conducted 165 exams of 121 broker-dealers. The results, contained in the Coordinated Examination Report, suggest that firms have more work to do to address the issue.

Nine of the firms had no policies or procedures related to heightened supervision. Thirty-four firms had not established criteria for assessing whether heighten supervisions would be appropriate for new hires and or current associated representatives. About half of the firms that did have heightened supervision procedures did not have policies and procedures in place for removal of a representative from heightened supervision. Among other findings, NASAA representatives said that “less than 25 percent of the examined firms maintained supervisors on site who were responsible for enforcing heightened supervision plans” and “about 20 percent of firms (both large and small) failed to enforce the procedures they had developed.”

As a consequence of these findings, NASAA advised broker-dealer firms to (i) designate individuals with the necessary experience and authority to enforce the plan; (ii) ensure appropriate written documentation that evidences the “representative’s awareness of the conditions of the plan and the supervisor’s awareness of his responsibilities;” (iii) provide periodic review to ensure the effectiveness of any plan; and (iv) ensure that removal procedures are in place. In addition, NASAA recommended that a firm should design its plan so that it would address any underlying conduct subject to review, ensure that the representative’s records are incorporated into any review, and establish the frequency of reviews.

Conclusion

President Pieciak pledged his commitment to fight federal preemption and preserve the authority of state securities regulators. The findings contained in the 2017 and 2018 examination reports suggest how important a role NASAA has in understanding the current state of play at investment adviser and broker-dealer firms. The timing and proposed model rule on information security for investment advisers and the new guidance on heightened supervision for broker-dealers provides a strong indication of how active NASAA intends to be as it asserts its authority within the regulatory framework. Bates will continue to keep you apprised of both state and federal developments.

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09-20-18

FINRA Report Cites Greater Use of RegTech, Warns of Regulatory Implications

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Despite RegTech’s “potential to fundamentally transform how securities industry participants perform their compliance obligations,” RegTech tools also raise “new challenges and regulatory implications” that affect “supervision, vendor management, data privacy and security.” That is the explicit assumption underlying a new FINRA white paper summarizing the results of the SRO’s extensive outreach on the subject.

It also serves as the framework for FINRA’s latest round of requests for comments on how new technologies may affect the regulator’s longstanding goals of maintaining investor protection and market integrity. Comments on the white paper are due on November 30th 2018. Bates Research takes a closer look.

FINRA Establishes a Baseline

FINRA’s white paper is significant in several ways. It serves as a baseline summary of a number of FINRA outreach initiatives underscoring the government’s priority of welcoming technological innovation in the financial marketplace (see, e.g. Bates’ News here). It serves as a marker of the current state of RegTech innovation. It also narrows the definitions of generally used terms and captures informed perspectives on concepts that have until recently been mostly aspirational.

FINRA defines RegTech as a subset of financial technology (FinTech) with an emphasis “on the development of technology tools in the financial industry linked to promoting regulatory compliance.” This is, to some extent, a limitation on the generally accepted understanding of the term, which also includes the use by regulators of technology tools such as “cloud storage and computing, big data analytics, machine learning and natural language processing to enhance its market surveillance and other regulatory functions.” That said, the white paper frames the discussion of RegTech in a way that lends itself to further parsing and possible future regulation.

The paper focuses in three areas: (i) key findings from discussions with market participants, including “broker-dealer firms, vendors, RegTech associations, academics and various other key players;” (ii) the current application of technology tools in key compliance areas; and (iii) and a listing of some of the perceived implications concerning the adoption of these RegTech tools.

Key Findings from FINRA Outreach

RegTech has arrived. That is the chief conclusion of FINRA’s outreach effort. The white paper cites one survey that found that “half (52 percent) of respondents considered that RegTech solutions were affecting how they managed compliance in their firms with almost a fifth (17 percent) reporting they have already implemented one or more RegTech solutions.” Another citation makes this point: “[t]he global demand for regulatory, compliance and governance software is expected to reach USD 118.7 billion by 2020.” FINRA concluded that the “confluence of significant regulatory and technological changes over the past few years (stemming, in part, from the post financial crisis regulation) has created incentives for firms to rethink how compliance functions operate.”

Key Current Compliance Applications

The white paper lists a variety of technologies that have been deployed to date for various compliance functions. They include artificial intelligence, natural language processing, big data and advanced analytics, cloud-based computing, robotics process automation, distributed ledger technology, application program interfaces (APIs) and biometrics.

The white paper highlights five areas where the applications of RegTech are currently used to bolster compliance programs:

  1. surveillance and monitoring - firms are utilizing cloud computing, big data analytics and AI/machine learning to obtain more accurate alerts;
  2. customer identification and AML compliance – firms are utilizing tools that use biometrics, distributed ledger technology, sophisticated data analytics and real-time transaction monitoring for KYC and other purposes;
  3. regulatory intelligence – firms are experimenting with natural language processing and machine learning to read and interpret new and existing regulatory requirements, and then offer gap analyses to help identify potential deficiencies within an organization’s compliance program;
  4. reporting and risk management – firms are automating processes concerning risk-data aggregation, risk metrics creation and monitoring for enterprise and operational risk management; and
  5. investor risk assessment – firms are experimenting with data aggregation and machine learning in combination with behavioral sciences to determine an investor’s risk appetite and tolerance.

FINRA touts the benefits of current RegTech efforts as strengthening a firm’s ability to adopt a proactive risk-based approach to regulatory compliance. It highlights the potential ability of firms to look at data across the organization that could help “break down silos” and “limit potential compliance gaps.” Further, it states that the most widely used form of RegTech today is the automation of processes that increase effectiveness and efficiencies.

Implications

FINRA also considers various implications of all this innovation. The SRO recognizes that firms will encounter risks and “operational challenges” that have implications for (i) supervisory control systems, (ii) outsourcing structures and vendor management, (iii) governance structures; (iv) customer data privacy; (v) interoperability and compatibility of multiple systems; (vi) data quality; (vii) security risk and (viii) personnel training, to name a few. In a broad cautionary note, FINRA warns that “broker-dealers may wish to consider both the benefits and risks associated with any specific tool and consider steps to mitigate risks where applicable.”

Conclusion

The FINRA white paper offers a peek at the challenges regulators face when trying to encourage and embrace technology innovation responsibly. It is certainly true that “RegTech tools may facilitate the ability of firms to strengthen their compliance programs, which in turn has the potential to create safer markets and benefit investors.” It is also true that these tools may present “challenges and regulatory implications” that may overwhelm a firm’s ability to have confidence in its ability to maintain compliance obligations. So, while all of FINRA’s answers seem to lie in the promise and potential of RegTech, FINRA is now beginning to ask tougher questions. Bates Group will keep you apprised.

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09-13-18

New Education Requirements on the Horizon for Broker Dealers and (Maybe) Investment Advisers

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FINRA is seeking input on proposed changes to the Securities Industry Continuing Education Program (“CE Program”) just as the SEC is considering responses to its request for comments on whether investment advisers should be subject to similar obligations. Here are the latest developments.

Keeping Up with the “Increasing Complexity of Products and Services”

FINRA requested comment from member firms and other interested parties on enhancements to the CE Program proposed by the Securities Industry/Regulatory Council on Continuing Education (“CE Council”). The CE Council, made up of representatives of the securities industry (including SROs like FINRA), develops uniform continuing education requirements for more than 600,000 securities professionals to ensure they “have the knowledge and skills necessary to help investors and promote the integrity of the U.S. capital markets.” In issuing their proposed enhancements, the CE Council described the “increasing complexity of products and services offered through the U.S. financial markets” and the consequent need to provide timely, effective training to registered persons

Proposals for the Regulatory Element

The CE program is made up of a Regulatory Element and a Firm Element. The Regulatory Element is intended to address new rules and industry standards to “educat[e] registered persons on significant regulatory issues facing the industry.” Proposed enhancements to the Regulatory Element include (i) narrowing the program by creating “targeted learning units” that are more relevant to the registrations held by individuals. The Council is also proposing to make the Regulatory element more timely by (ii) making it an annual requirement rather than every three years (after the second anniversary of an initial registration). Finally, the Council suggests that there are additional efficiencies to be gained by (iii) improving the functional aspects of element systems (notably, the Central Registration Depositary “CRD” and “Financial Professional Gateway”) and by (iv) coordinating the modular approach for the Regulatory Element with the requirements of the Firm Element.

Questions about the Firm Element

The Firm Element program addresses “products, services and strategies offered by the firm as well as firm policies and industry trends.” The CE Council proposed fewer Firm Element enhancements, but asked for more feedback. Specifically, the Council asked for information (i) on the value of the current guidance it provides to help firms meet their obligations; (ii) on current firm education practices (including those containing content outside the CE Program like AML training); (iii) on redundancies or “opportunities for reciprocity with other securities or related credential programs;” and (iv) on how firms develop or acquire the content to meet Firm Element requirements. FINRA reminded its members that should the CE Council recommend program changes, FINRA would issue the requisite Notice with the specific details and any related rule changes. Comments on the CE Councils questions are due by November 5, 2018.

SEC Asks Whether IAs should be Subject to CE Requirements

As part of the SEC Best Interest Rule proposal, (at page 28; see also the latest Bates article on NASAA reaction to the proposal,) the SEC requested comment as to “whether there should be federal licensing and continuing education requirements for personnel of SEC-registered investment advisers.” Though there is general appreciation for the importance of continuing education for investment advisers, two significant groups reacted strongly against the proposed federal mandate.

In a comment submitted by the Investment Adviser Association, President and CEO Karen Barr said that “federal licensing and continuing education requirements are unnecessary and inappropriate.”

She stated: “the Commission’s request fails to appreciate that all adviser personnel are subject to a range of compliance requirements and already receive training on the laws, regulations, and fiduciary obligations applicable to advisers.” President Barr went on to remind the Commissioners that “states license and impose examination or competency requirements on investment adviser representatives.” She also questioned (i) “the Commission’s legal authority to adopt licensing requirements for personnel of investment advisory firms”; and (ii) whether the Commission has “the infrastructure or resources to administer such a program,” strenuously opposing “the Commission turning to FINRA to administer the program.”

Similarly, in his comment letter, NASAA President and Director of Alabama Securities Commission, Joseph Borg stated: “State securities administrators license these individuals; the SEC does not...The SEC already regulates thousands of broker-dealers and investment advisers. It should not stretch its limited resources even further by taking on direct regulatory responsibility for hundreds of thousands of investment adviser representatives. Rather, state securities regulators should continue performing this function. NASAA and its members have developed robust rules and processes (including a testing regime) to oversee investment adviser representatives.”

Conclusion

Efforts to address the increasing complexity of products and services in the financial marketplace through more concentrated and focused continuing education are laudable. Bates has written extensively of the many evolving challenges facing the industry that require real understanding and a continuous updating of expertise. The CE Council and FINRA are asking important questions that are reasonably intended to keep practitioners current in a fast-changing environment. The SEC inquiries, and the consequent reaction by the IAA and NASAA, remind us that the efforts to streamline and enhance the CE program are taking place in the midst of a broader debate on the appropriate regulation of broker-dealers and investment advisers. By the time a proposed rule change is ready, we may know whether the SEC will continue to pursue federal licensure and continuing education for investment advisers. Bates will continue to keep you up-to-date on developments.

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09-05-18

What’s In A Name? NASAA Weighs In On Regulation Best Interest

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The North American Securities Administrators Association (“NASAA”) encouraged the SEC “to make significant revisions to its April 18 Regulation Best Interest and related proposals (“Reg. BI”) before adopting them in order to best serve the interests of investors.”

In NASAA’s comment letter on Reg. BI, NASAA President and Alabama Securities Commission Director Joseph P. Borg emphasized that, “given our members’ shared responsibility with the SEC for oversight of the firms and individuals that will be impacted by the Proposals, NASAA is anxious to work closely with the Commission.” President Borg went on to say that he hoped that the “constructive comments are well received and considered fully.”

NASAA represents state, provincial and territorial securities administrators covering all 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico. NASAA cautioned the SEC to take it slow, be deliberate and, most importantly, to consider “significant improvements” in order to “promulgate final rules that will serve the best interest of investors as the Commission intends.” Bates Research takes a closer look at NASAA’s concerns and its recommendations to the SEC.

The Regulation Best Interest Proposal

As summarized in a previous Bates Research article, Reg. BI comprises three proposals. In brief, proposal one would require a broker-dealer to act in the “best interest” of a client investor and would require suitability determinations, disclosures of “key facts” that may suggest conflicts of interest, and further compliance obligations. Proposal two would provide interpretive guidance for advisers who have fiduciary obligations to investors. Proposal three would require that both broker-dealers and investment advisers provide a new Client Relationship Summary (“CRS”) to retail investors. The CRS defines differences between investment advisers and broker-dealers, based on the types of services offered, and delineates legal standards of care.

Start With the Name

In general, NASAA’s comments urge more definitional clarity. NASAA recommends that the SEC re-label the new regulation as the “Broker-Dealer Standard of Conduct” to reduce the likelihood of any confusion between a broker-dealer’s best interest duties and an investment adviser’s fiduciary duties.

NASAA responded to the proposed SEC approach to broker-dealer standards of conduct with recommendations to clarify and make more expansive the obligations of broker-dealers. For example, NASAA recommends that the broker-dealer’s duty should “encompass all investors and all securities products.” NASAA also recommends greater specificity, including that the SEC (i) clarify the requirements necessary to satisfy the new standards by adding specific factors that must be met; (ii) broaden the broker-dealer conflict of interest mitigation and disclosure obligations; and (iii) address current practices involving certain financial incentives by making them “per se incompatible” with the new standards. (The latter includes a ban on sales contests at broker-dealers and a ban on any preferential treatment to certain customers for investment opportunities.

Clearer Interpretive Guidance From the SEC

NASAA also recommends that the SEC provide much clearer interpretive guidance. The intent behind its guidance recommendations is to set more definitive borders between investment advisory and broker-dealer activities. For example, NASAA wants the SEC to spell out in greater detail how and which titles a broker-dealer may use when holding themselves out in the market. NASAA opposed the SEC position that a broker-dealer could satisfy its best interest duties by recommending securities from a limited number of firm-only products.  NASAA contends that firms need to consider competing asset classes and investment strategies outside their own offerings when counseling clients. This includes considering factors such as cost, complexity, liquidity and risk. NASAA also wants the SEC to spell out clear guidance on the rights and remedies investors will have in pursuing violations of the new standard. While so doing, NASAA wants the SEC to “expressly declare that the new standard is not intended to preempt any state laws or regulations.”

Form CRS: Is It Really Necessary?

NASAA’s official recommendation is that Form CRS undergo testing “to evaluate its usefulness to investors and, at such time as the form is adopted, allow firms some flexibility in implementing the disclosures so as to tailor the content for their customers’ needs.” NASAA, however, also believes that it would be better to simply revise Form ADV and Form BD to “incorporate investor education objectives into these existing forms, rather than bolting an entirely new form onto the existing disclosure structure.” According to NASAA, “Form ADV and Form BD are long overdue for reformatting and rewriting” and updating them “would be the best long-term solution to the problem of investor confusion” and would “reduce or eliminate duplication across these various forms.”  

Finally, with regard to future investment adviser registrations and continuing education requirements, NASAA recommended that the SEC defer to state securities regulators.

Conclusion

NASAA members are significant players in the ultimate resolution of these issues. NASAA’s comments represent a respectful, but firm approach that seeks clarity while asserting state interests. It is clear, however, that the SEC’s proposed rule would look very different than it currently does if the agency were to adopt NASAA’s “significant improvements.” NASAA acknowledged the challenge that the SEC faces:

“The Commission seeks through the Proposals to raise the duties of care owed by broker-dealers, address the confusion among investors regarding the differing conduct standards, and make clearer the various aspects of the fiduciary duty standard applicable to investment advisers, without favoring or disfavoring the broker-dealer or investment advisory business models. We recognize that threading this needle is not easy.”

Bates will continue to follow important developments in this story.

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08-15-18

Treasury, OCC and FINRA Set the Stage for Fall Fintech Debate

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As the summer winds down, regulators are positioning themselves for more oversight of the financial technology (“fintech”) sector. On July 30, the U.S. Treasury Department released a national agenda on how it intends to regulate fintech companies, encourage innovation and harmonize federal efforts with state regulators. The Office of the Comptroller of the Currency (“OCC”) followed up the Treasury report with an announcement that it will begin to accept applications for special-purpose national bank charters for certain types of fintech companies. And on the same day as Treasury came out with its recommendations, FINRA issued a “Special Notice” seeking comment on fintech innovation in the broker-dealer industry. How are these developments going to impact the industry? Here’s a closer look.

Treasury Weighs In

In a new report designed to “facilitate U.S. firm innovation by streamlining and refining the regulatory environment,” the U.S. Treasury Department made over 80 recommendations to “enable U.S. firms to more rapidly adopt competitive technologies, safeguard consumer data, and operate with greater regulatory efficiency.” The report, titled “A Financial System That Creates Economic Opportunities: Nonbank Financials, Fintech, and Innovation,” contains recommendations that work together to form a comprehensive national framework for companies active in the fintech sector. The report was compiled to address recent trends and data on the financial services industry.

Here are a few of those statistics (From page 5 of the report):

  • More than 3,330 new technology-based firms serving the financial services industry were founded from 2010 to the third quarter of 2017, 40% of them are focused on banking and capital markets.
  • $22 billion has been raised to finance these firms in 2017, a thirteen-fold increase since 2010
  • Technology-based firms account for 36% of all U.S. personal loans, up from less than 1% in 2010.
  • Fintech services reach 80 million members, while consumer data aggregators serve more than 21 million customers.

In addition, the report highlights key trends that led to the Treasury recommendations, including:

  • the rapid growth of technology-enabled platforms to address banking challenges;
  • the combination of non-bank, stand-alone solution providers and new platforms that provide support for, or interconnectivity with, traditional financial institutions through partnerships, joint ventures or other means;
  • the entrance of large technology companies with access to large stores of consumer data into the financial services industry; and  
  • the reaction to “technology-enabled competitors” by mature firms which have launched new platforms aimed at reclaiming market share.

Treasury: Core Recommendations

The core recommendations of the Treasury report include (i) supporting the issuance of special purpose national bank charters; (ii) enabling bank sponsorships and partnerships with third-party fintech companies; (iii) supporting the development of mechanisms to enable consumers to provide third parties with access to information; (iv) harmonizing federal and state fintech regulatory regimes; and (v) encouraging the development of a regulatory “sandbox” for financial innovation.

The Treasury report also makes specific recommendations on a host of important issues affecting fintech, including: the Payday Lending Rule (Treasury recommends that it should be rescinded); the retail payments system (Treasury says fix it and make it faster); data access (Treasury recommends governance reform, improve disclosures and regulate it); and wealth management and digital financial planning (Treasury recommends designate a single regulator or maybe a special SRO to oversee financial planners), to name a few. For additional detail, please note this additional Treasury-prepared fact sheet. The Treasury acknowledged the significance of digital currencies and blockchain, but opted to defer recommendations until other federal efforts in this area are complete.

OCC Follows Suit

Coinciding with the publication of the Treasury report, the OCC announced that it would begin to accept applications for special-purpose national bank charters. OCC also issued guidelines in the form of a Licensing Manual Supplement: Considering Charter Applications from Financial Technology Companies, which “describes OCC policies and procedures used in the charter application process and…discusses the factors that the OCC considers in deciding whether to grant a charter.”

States Are Not Enthusiastic

In a section of the report titled “Aligning the Regulatory Framework to Promote Innovation,” Treasury identifies several approaches to provide “clarity and flexibility” for firms seeking to provide financial services. One is that state regulators harmonize “the existing patchwork of state licensing and oversight of nonbank financial services companies.” In this regard, Treasury supports establishing a “Fintech Industry Advisory Panel” to improve state regulation, align multi-supervisory processes and redesign the Nationwide Multistate Licensing System. Treasury also recommends that states work to coordinate financial service examinations for individual firms.

These recommendations come with a not-so-subtle warning. “Treasury recommends that if states are unable to achieve meaningful harmonization across their licensing and supervisory regimes within three years, Congress should act to encourage greater uniformity in rules governing lending and money transmission to be adopted, supervised, and enforced by state regulators.” (p. 70)

States are already expressing substantial discomfort with this approach as well as with Treasury’s support of federal special-purpose bank charters. Critics argue that: (i) states will lose state charter revenue to the federal government; (ii) states are better at regulating consumer-facing financial entities; and (iii) “because national charters preempt state regulations, national banks may not be held accountable to the same kinds of consumer protection laws that state banks are, like usury limits.” These and other objections will likely be litigated by state regulators upon the OCC’s acceptance of its first application.

FINRA Asks for Feedback

On July 30, FINRA issued a Special Notice asking market participants how it could best support fintech innovation while protecting investors. Specifically, FINRA requested comment on the provision of data aggregation services, supervisory processes concerning the use of artificial intelligence and the development of a taxonomy-based, machine-readable rulebook. Comments are due by October 12, 2018. The Special Notice is the latest effort by FINRA’s Innovation Outreach Initiative, which was set up in 2017 to enable FINRA to better track fintech developments.

Conclusion

The Treasury report, the OCC Policy Statement accepting fintech charter applications, early reaction by the states and FINRA’s request for comments provide a framework for the debate to come. All of these perspectives laud the potential for innovation and prioritize enabling it. The data and trends that were cited to support Treasury’s recommendations serve to highlight the importance of reducing encumbrances to fintech platforms in order to pass potential benefits through to consumers and investors. But there were few, if any, statistics or trends cited on the downside risk tradeoffs to consumers and investors. Headlines suggest that financial firms will bear the compliance and enforcement burdens that come from the uncertainty created by the regulatory regime to come. That said, the foundation has been laid for the fall debate over national regulation of fintech. Bates Group will keep you apprised of new developments.

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08-09-18

SEC Regulation Best Interest: Next Round

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As the deadline for comments on SEC Regulation Best Interest draws to a close, echoes from the debate on the Department of Labor (“DOL”) fiduciary rule can be heard in new concerns being raised before the Commission. In a recent speech getting a lot of attention, SEC Commissioner Hester Peirce undertook an analysis of the proposed regulation. Bates Research takes a look at that and some other notable recent reactions.

Regulation Best Interest Refresher

The SEC Best Interest Rule (“Reg. BI”) has three parts. The first part requires a broker-dealer to act in the “best interest” of a client investor. This new standard would require suitability determinations, disclosures of “key facts” that may suggest conflicts of interest, and further compliance obligations. The second part provides additional interpretive guidance for advisers who have fiduciary obligations to investors under law. The third part requires that both broker-dealers and investment advisers provide a new Client Relationship Summary (“CRS”) to retail investors. The CRS highlights key differences between investment advisers and broker-dealers, based on the types of services offered, and delineates legal standards of care. The short form also defines certain terms that may confuse investors (e.g., the difference between “adviser” and “advisor”) and restricts their use.

Commissioner Hester Peirce Addresses Reg. BI Concerns

As described previously, despite the vote in favor of releasing the package of proposals, a number of Commissioners expressed reservations about the particulars. In a recent address titled: What’s in a Name? Regulation Best Interest v. Fiduciary, Commissioner Peirce expanded on her previously stated objections. Terms like “best interest” and “fiduciary,” she argued, are fundamentally inexplicable as to the obligations broker-dealers and advisers owe to clients. She stated that “a fiduciary under the Employee Retirement Income Security Act (“ERISA”), for example, means something other than a fiduciary under the Investment Advisers Act of 1940.” She also cited DOL guidance reflecting the broadening of the “definition of ‘fiduciary’ for purposes of its 2016 rulemaking.” Commissioner Peirce asserted that the definitions are so malleable that proposed Reg. BI would arguably "subject broker-dealers to an even more stringent standard than the fiduciary standard outlined in the Commission’s proposed interpretation.”

She contended that using such terms may not only be confusing, but may actually prove to be “harmful” to the market and to investors and ultimately may cost more. 

The consequence is that the rule may motivate brokerage firms to deregister, as investors flee to advisers who offer their services on a fee basis rather than a transaction basis. She put it this way:

“We are already seeing this dynamic at work. Brokers are taking a hard look at the existing regulatory framework coupled with FINRA arbitrations in which sometimes a fiduciary standard is applied. Then they look over the fence to the adviser world with its principles-based fiduciary standard, less frequent exams, absence of arbitration, and predictable revenue streams. Having engaged in this comparative exercise, many firms and individual financial professionals say farewell to FINRA, hop on the fiduciary bandwagon, and never look back. Regulation Best Interest could exacerbate this trend.”
 

Commissioner Peirce recommends an alternative whereby a new rule would be built on the foundation of the current "suitability standard," which has proven to be both understandable and effective. Further, she argued, any standard to be imposed on broker-dealers should be explicit and not implied.

Other Reactions

The Commission received thousands of comments on proposed Reg. BI. Organizationally, advocates staked out familiar positions first formulated by their advocacy or objection to the DOL Fiduciary Rule. SIFMA, for example, issued a statement after a June 14th Investor Advisory Committee Meeting supporting the new rule:

“SIFMA commends the SEC for proposing a new best interest standard under the Exchange Act that not only clearly and significantly raises the bar from the current suitability standard under FINRA Rules, but also incorporates the intended principles and goals of the former DOL fiduciary rule that it is replacing. By any measure, the SEC’s proposed best interest standard materially exceeds the existing FINRA suitability standard to the benefit, and for the protection, of retail customers.”
 

In their substantive comment submitted on August 7, SIFMA stated that “certain key changes must be made to the Proposals to make them workable for the industry and to avoid unintended consequences, such as decreased choice for retail investors and a shift away from the brokerage model.”  

SIFMA's proposed detailed modifications to the rule could, if implemented, harmonize certain definitions with FINRA, such as the definition of a “retail customer.” Further, SIFMA suggested clarification and guidance on certain disclosures and other obligations, including “material conflicts of interest.” SIFMA also recommended the adoption of “a simplified and more flexible approach” for the Proposed Form CRS.

The Investment Adviser Association (“IAA”) stated that it supported the “goals” of the rule, but requested substantial changes to it. As to the proposed Advisers Act Interpretation, IAA rejected the position that it was either necessary or beneficial to codify the fiduciary duty in a rule, since the “principles based duty has successfully served as the bedrock principle of investor protection of clients of investment advisers for more than 75 years.”

As to Reg. BI, IAA recommended that the Commission make the “scope and application of Reg. BI” clearer, ensure that “advisory activities that broker-dealers agree to provide a retail client, including ongoing monitoring for purposes of recommending changes in investments, …be covered by either Reg. BI or the Advisers Act fiduciary standard,” and “define advice that is considered not to be “solely incidental” to brokerage activities.” 

With respect to Proposed Form CRS, the IAA commented that it “may exacerbate the investor confusion it is intended to address” and urged the SEC to conduct investor testing and publish the results of the Form to ensure its effectiveness. Further, IAA also recommended that the SEC display educational comparisons between investment adviser and brokers on the SEC’s website and streamline the proposed Form to “focus on critical aspects of the relationship and services being offered by each firm to investors.”

A contrary position on Reg. BI was voiced by Senators Elizabeth Warren, Sherrod Brown and Cory Booker in a letter to FINRA President Robert Cook on July 20. They asked him to provide FINRA's interpretation of the SEC's proposal. They raised concerns that the proposed standard “is long, complicated, and, in some important ways, ambiguous…[and that] SEC Commissioners themselves disagree about whether it is similar to the DOL rule and "definitely a fiduciary principle," or whether it "essentially maintain[s] the status quo."

Conclusion

These reactions represent round one in the battle to develop acceptable standards for broker-dealers and advisers. Many of these positions are extensions of long-standing disagreements voiced during the fights over the DOL fiduciary rule. But the spectrum of opinions presented by these comments will serve to frame the rounds to come – and, in the end, may lead to some new (and possibly some old) approaches on this hotly debated issue. Bates will keep you apprised.

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07-26-18

Eight Recent Developments on Cryptocurrency

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Activity around the regulation of cryptocurrency continues apace. Only a short time ago, we reported on Operation Cryptosweep, a coordinated effort by NASAA and state securities regulators to crackdown on fraudulent cryptocurrency-related investment products. Today, we review a number of newsworthy developments that may affect the regulation of a technology that has defied easy categorization and oversight. Here’s a roundup:

1. Russian Agents, Bitcoin and the 2016 Presidential Campaign

The revelation contained in the Special Counsel’s indictment of Russian intelligence agents, that Bitcoin was used to finance and obscure an operation intended to undermine the 2016 U.S. elections, has begun to reverberate in policy debates. It served as the backdrop to recent congressional hearings and prompted a letter by Representative Emanuel Cleaver to FinCEN to “initiate an investigation of the cryptocurrency industry and articulate further guidance to help prevent financial crimes” such as those implicated in the Russia probe.

2. Congressional Hearings on Digital Currency and Policy

Meanwhile, in two separate hearings, representatives debated fundamental questions about the government’s role in the development of the digital currency markets and whether the Federal Reserve should issue its own form of cryptocurrency. At a July 18th hearing before the House Financial Services Subcommittee on Monetary Policy and Trade, academics and experts debated the viability and security of digital currencies, the pros and cons of a "widely accessible, retail-oriented central bank digital currency that could be used by the public for person-to-person and retail transactions," and the potential effects of such currencies on traditional banking structures.

At a House Committee on Agriculture hearing on the same day, Daniel Gorfine, Director, LabCFTC and Chief Innovation Officer, warned against "hasty regulatory pronouncements" that might “miss the mark, have unintended consequences, or fail to capture important nuance regarding the structure of new products or models." Former CFTC Chair Gary Gensler expressed an alternative concern that failure to enact reasonable regulation would “trigger a brain drain of crypto entrepreneurs from the US.” Witnesses testified uniformly that digital assets did not fit neatly into existing regulatory frameworks. (1)

3. Executive Order Establishing a Task Force on Market Integrity

On July 11th, President Trump signed an Executive Order establishing a Task Force on Market Integrity and Consumer Fraud. The Task Force, under the direction of the Attorney General, will be made up of regulators and cabinet secretaries who will provide guidance and coordination in fighting financial fraud, specifically—and for the first time—including cyber fraud.

4. CFA Institute Introduces Crypto Into Exam Curriculum

The CFA Institute, the global association of investment professionals that administers industry certifications, just added cryptocurrency and blockchain as a new subject category to its Chartered Financial Analyst Exams. The new subject matter, named “Fintech in Investment Management,” falls under the Level I and II Exam categories. As one report noted, this development “might be the definitive sign that cryptocurrencies have arrived on Wall Street.”

5. CFTC Issues Guidance on Cryptocurrency Futures Trading

Since our last review of federal regulatory activity, the CFTC issued guidance for exchanges and clearinghouses to list virtual currency products. The guidance is intended to help with the design of management programs that address risks associated with virtual currency derivative products. Specifically, the guidance provides for (i) enhanced market surveillance, (ii) close coordination with the CFTC, (iii) the application of the large trader reporting threshold for any virtual currency derivative contract, (iv) a mandatory request for comment on issues relating to a proposed listing, and (v) a required CFTC staff governance review concerning adherence to internal governance procedures for new contract approval.

6. CFTC Warns Customers on Purchasing Digital Coins

On July 16th, the CFTC issued a customer advisory on Initial Coin Offerings and other crypto-related transactions. The agency warned virtual currency customers “to use caution and do extensive research before purchasing virtual coins or tokens.” Specifically, the CFTC urged customers to treat any coin or token that includes “any promises or guarantees of future value as a ‘red flag.’” The CFTC recommended customers “conduct extensive due diligence on any individuals and entities listed as affiliates of a digital coin or token offering,…ask whether the digital coins or tokens are securities and if the offering is registered” with the SEC, and find out “what rights the digital coin or token provides.” 

7. FINRA Asks Firms to Report Cryptocurrency Activities

On July 6th, FINRA issued a regulatory notice encouraging each member firm “to promptly notify FINRA if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets, such as cryptocurrencies and other virtual coins and tokens.” The notice requires member firms to provide updates to their regulatory coordinator about any crypto related activities until July 31, 2019.Among other activities firms must disclose are “purchases, sales or executions of transactions in digital assets, pooled funds that invest in digital assets; or derivatives tied to digital assets.” The FINRA notice also recommends “disclosure regarding custody of digital assets; acceptance of cryptocurrencies from customers; mining of cryptocurrencies; the acceptance of orders in cryptocurrencies and/or other virtual coins and tokens; quotations in cryptocurrencies and other virtual coins and tokens.” Lastly, FINRA expects firms to disclose any provision or facilitation of “clearance and settlement services for cryptocurrencies” or “recording cryptocurrencies and other virtual coins and tokens using distributed ledger technology or any other use of blockchain technology.”

8. International Developments

The Financial Stability Board, ("FSB") the international organization established by the G20 to monitor and make recommendations about the global financial system, published a framework to monitor the financial stability implications of developments in crypto-asset markets. The framework sets out the metrics that the FSB will use to monitor developments in crypto-asset markets as part of the FSB’s ongoing assessment of vulnerabilities in the financial system. The metrics include the use of data on liquidity, trading volumes, pricing, clearing and margining for crypto-asset derivatives. As stated in the framework, “the use of leverage, and financial institution exposures to crypto-asset markets are important metrics of transmission of crypto-asset risks to the broader financial system.” The report also recaps the work of other international standards-setting bodies such as the Committee on Payments and Market Infrastructures, IOSCO and the Basel Committee on Banking Supervision.

Conclusion

Certain developments, both small and large, domestic and international, feed the sense that the forward march of blockchain is inevitable. Regulators seem attuned to the complexities and the challenges that cryptocurrency presents. It is not yet clear, however, how the pieces will fit together, or if an intervening political event will cause disruption. Bates Group will continue to monitor the regulatory landscape and keep you apprised of these fast moving developments.


(1) For additional discussion on regulatory classification of digital currency as commodities at the hearing see here. For a recent analysis about the classification of certain products as a security see here.

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07-19-18

FINRA Dispute Resolution Updates (and More)

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FINRA recently issued a new fraud warning to member firms, highlighted certain changing rules and procedures for arbitrators, reminded arbitrators to stay current on their disclosures and offered up year-to-date statistics on dispute resolution. Here’s a summary.

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FINRA Issues New Fraud Warning

In its ongoing efforts to advise member firms of new risks and new forms of fraud, FINRA issued an Information Notice warning of a new imposter scam. This one involves fraudsters impersonating FINRA personnel in order to obtain a firm’s confidential or other information. FINRA is urging firms to “verify the identity of [any] caller or sender before providing any information or responding to an email.”

Recent incidents include a firm receiving a call from an imposter using a phony FINRA telephone number and email who was seeking contact information of firm personnel. Other incidents concern suspicious calls made from outside the United States seeking sensitive information. FINRA reminded firms that it “does not use overseas telephone numbers or foreign email domains” and urged member firms to be wary of communications that do not end in @finra.org or that contain attachments or embedded links. Further, FINRA recommends contacting a Regulatory Coordinator if any questions arise “regarding the legitimacy of any communication that purports to be from FINRA.”

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Update: Rules Affecting Small Claims Adjudications and Fees

A number of rule changes concerning procedures and fees were highlighted in the latest issue of the FINRA arbitration and mediation newsletter, The Neutral Corner.

Proposal for Small Claims Adjudications

In May, the SEC approved rule changes that would create a new option for small claims (less than $50,000) adjudications. Claimants will still have the option to proceed under current procedures, which allow for in-person hearings without time limits and permit questioning of opposing parties’ witnesses.

Claimants will now also have a new available option of a “Special Proceeding,” in which an arbitrator may hear the case by telephone conference call, (unless the parties agree to another method) and claimants have time limitations to present their cases (two hours for presentation, a half hour for rebuttal and closing). Arbitrators will also have time limits on follow-up questions (three hours). Under the new procedures, the parties may not question an opposing party’s witnesses or call an opposing party as a witness, and the hearing will be completed in one day with no more than two hearing sessions. The Special Proceeding is a format intended to quicken the pace of arbitrations and to reduce costs. The new rule is effective September 17, 2018. FINRA says it will offer training to arbitrators on the Special Proceeding.

Proposal on Late Cancellation Fees for Prehearing Conferences

A new FINRA rule change would impose fees for the late cancellation of a prehearing conference. The fees would be imposed if a party or parties to a FINRA arbitration cancel a scheduled conference on short notice (i.e., within three business days). In such circumstance, FINRA would issue a $100 per-cancellation fee per each arbitrator, and a $100 honorarium for each arbitrator that was scheduled to attend the conference. FINRA extended the time for further SEC action on this rule change until August 1, 2018.

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Update: Arbitrator Disclosure

The Neutral Corner published answers to several questions on disclosure obligations, and FINRA reminded arbitrators to update their disclosure reports (“ADRs”) regarding any activity on social media.

FINRA responded to one question by confirming that it proactively reviews ADRs and conducts internet searches “on Google, publicly available information in databases such as Lexis and state and federal court sites to ensure that required information has been disclosed on the ADR.” FINRA also stated that “for arbitrators who have CRD records, we compare the information in CRD against the ADR.” FINRA urged arbitrators to update their disclosure reports by providing current information to parties so as “to minimize the likelihood of future motions to vacate.”

As to social media, FINRA stated that “even if you no longer use the accounts [on Twitter, Linked In or any other social media] or have never posted information on them, you should disclose them.” FINRA expressed an intention to “alert parties upfront of any information available about arbitrators and let them determine whether they think it might affect an arbitrator’s ability to serve impartially.”

Finally, FINRA noted that “even if arbitrators are not currently assigned to cases, their disclosure reports may be sent to parties in their hearing locations during arbitrator selection.” As a result, FINRA asserted that “arbitrators are encouraged to review and affirm regularly the accuracy of their disclosure reports using the DR Portal.”

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FINRA Highlights Dispute Resolution YTD Statistics

Also highlighted in the The Neutral Corner were some year-to-date trends deduced from FINRA’s published Dispute Resolution Statistics site. FINRA noted that from January through May 2018, there was a 40 percent increase in arbitration case filings compared to the same five-month period in 2017 (from 1,365 cases in 2017 to 1,908 cases in 2018). Claims initiated by customers also grew by 32 percent year over year. Intra-Industry cases increased by 54 percent year over year.  Topping the list of the 15 Controversy Types in Customer Arbitrations so far this year is Breach of Fiduciary Duty (997 cases, up from 714 same time, last year) followed by Suitability (870 cases, up from 606 as of May, 2017) and Misrepresentation (844 cases, up from 593 same time, last year.) Topping the list of the 15 Controversy Types in Intra-Industry Arbitrations though May of this year is Breach of Contract (141 cases, down from 175 same time, last year) followed by Promissory Notes (107 cases, down from 116 cases same time, last year) and Libel, Slander and Defamation (78 cases, up from 44 cases by this time last year).

 

Conclusion

In the last few weeks, FINRA has provided arbitrators with best practice recommendations, procedural rule reminders and updated dispute resolution statistics. Bates Group will continue to track these and other arbitration-related procedural developments.

Visit Bates Group's Securities Litigation & Consulting Practice page and learn about Arbitrator Evaluator™, the next generation of intelligent analytics for identifying and selecting the best arbitrators for your customer and intra-industry cases.

 

Join Bates Group at PLI’s Securities Arbitration 2018 program on September 26, 2018.

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07-12-18

Private Placements Drawing Attention

Private Placements Drawing Attention

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A recent analysis undertaken by the Wall Street Journal (“Journal”) found that securities firms selling private placement investments employ an “unusually” high number of high risk brokers. The reporting has raised red flags for regulators who have committed themselves and their agencies to weeding out bad actors and recidivist brokers that, in some cases, allegedly targeted senior investors. The Journal report has led Massachusetts securities regulators to look into a handful of firms that sell private placement investments within the state. Such scrutiny comes at the close of the comment period for FINRA’s “bad actor” rule proposals. Here are the latest developments.

Wall Street Journal Report

Investigative journalists from the Journal, who purportedly reviewed over 1 million regulatory records, “identified over a hundred firms where 10% to 60% of the in-house brokers had three or more investor complaints, regulatory actions, criminal charges or other red flags on their records.” The reporters reviewed some 320,000 private placement filings, also known as “SEC Regulation D” filings, from 2008-2018 and found that these firms collectively sold investors more than $60 billion worth of private placements investments. The growing market for private placements in 2017 was more than $710 billion, according to the report, and “sales for the first five months of this year are on track to top that record-setting tally,” according to the Journal.

Only about “4 out of 10 brokerages sell private placements,” however, the analysis found that “these brokerages account for more than half of the 94 firms that FINRA expelled since 2013.” Furthermore, the Journal reported that most of the firms that employ these troubled brokers were small- to mid-size. The bigger firms, they noted, “have proportionally fewer brokers dealing direct with investors.”

Legal and industry insiders are quick to point out, however, that “the fact that a broker-dealer employs agents with a disciplinary history does not necessarily mean that private placements are being sold through improper sales practices or to accounts for which such investments may not be suitable.” (Other criticism of the Journal analysis can be found here.)

In a follow up Journal article, NASAA expressed a commitment to “work even closer with federal law enforcement to target bad actors.” FINRA reaffirmed existing commitments to making private placements an examination priority and an area of focus in the oversight of the brokerage industry, and SEC Chair Jay Clayton stated at a recent public forum in Atlanta that the SEC is “looking at our private placement rules; they can use a sprucing up.”

Massachusetts Inquiry

Responding to the Journal analysis, on July 2, 2018, Secretary of the Commonwealth William F. Galvin announced that the State of Massachusetts will further look into the sales of private placement investments. Secretary Galvin asserted:

“Private placements are risky investments that reward the salesperson handsomely with high commissions. Firms offering these to the public, especially seniors, have an obligation to see that they are sold to benefit the investor, not the broker. Individuals with a history of disciplinary actions magnify the risk of unsuitable sales in connection with private placements.”

FINRA High Risk Broker Proposals: Comments Are In

The comment period for FINRA’s proposed rules on high risk brokers expired on June 29. The self-regulatory organization will now determine whether to issue final rules or amend the proposals based on the comments, which were varied. As previously reviewed by Bates Group, the proposals would: 1) reinforce certain firm supervisory obligations concerning associated persons with a history of past misconduct, 2) impose new restrictions on member firms that hire or employ high-risk brokers and 3) revise quantitative suitability standards.

Conclusion

The Journal analysis was an inconvenient reminder that issues inherent in the hiring of high risk brokers will never be fully eliminated. Now that more attention is being paid to private placements by at least one state regulator, and it is on federal regulators’ radars, it may be time to expect an increase in regulatory activity. Bates will keep you apprised.

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06-28-18

SEC Roundup: Strategic Plan Unveiled, Town Hall Kick-Off, Supreme Court & ALJs, New Elder Report

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Just as the SEC was articulating a long-term agenda before Congress and pursuing a first-of-its-kind proactive investor advisory public outreach, the agency was forced to react to a new ruling by the Supreme Court declaring SEC hiring practices for Administrative Law Justices unconstitutional. In this article, we break down these recent developments and highlight a new independent analysis on elder financial exploitation published by the SEC Office of the Investor Advocate.

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SEC Issues Draft Strategic Plan, Chair Clayton Testifies

On June 20th, the SEC issued a "Draft Strategic Plan" for FY 2018 through FY 2022. As required by federal statute, the plan sets forth the long-term priorities of the agency. The SEC draft plan is oriented to the protection and education of retail investors. The plan prioritizes improving SEC education and outreach efforts in order to expand investor understanding and access to the capital markets. It also calls for increasing investment opportunities available to retail investors. For firms, it emphasizes enforcement and exam initiatives and the streamlining of disclosure requirements.

The draft plan sets forth various steps the agency would take to keep pace with evolving markets and to improve operations and overall agency effectiveness. Among them, the SEC would expand its use of analytics to address cyber security risk and would enhance the monitoring of clearing, settlement and electronic trading. The draft plan also prioritizes improving the training, development and deployment of human capital. The SEC has invited public comment.

On June 21st, SEC Chair Jay Clayton followed up with testimony before the House Committee on Financial Services. Articulating the core principles in the draft plan, the Chairman prioritized the agency’s commitments to serve Main Street investors; to innovate and respond to market developments and trends; and to leverage staff expertise and data and analytics to improve performance (for more on SEC analytics, see Bates News coverage “Former SEC Enforcement Chief Discusses How Big Data Drives Investigations and Prosecutions”) . He also cited recent successful initiatives that demonstrate these commitments. Among others, he referred to initiating the “Best Interest” rulemaking proceedings to enhance the standards of conduct for broker-dealers and investment advisers (see Bates News report here), clarifying the application of federal securities laws to digital assets, mutual fund disclosure initiatives, and harmonizing rules governing security based swaps.

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SEC Investor Advisory Committee Holds (Out-of-) Town Hall on Regulation Best Interest and Proposed Form CRS

On June 13, all five SEC Commissioners attended an “Investing in America” Town Hall in Atlanta, Georgia “to meet with, and hear from, Main Street investors.” In large part, the SEC “message” was the meeting itself, which communicated the new strategic priority and demonstrated the agency’s commitment to travel outside of Washington D.C. to meet with the investing public. The Investor Advisory Committee agenda included discussions of the SEC’s proposed Regulation Best Interest and proposed Form CRS Relationship Summary.

As reported, Chair Clayton emphasized how critical it is for investors to determine whether or not a financial professional is registered, because “the risks you are taking in dealing with them go up dramatically” if they are not. He urged attendees to understand “how each is compensated”…because “when you understand someone’s incentives, you have a much better relationship with them.” Mr. Clayton asserted that the SEC is working to develop databases of investment professionals who have had “bad actions” and to making that information more available and accessible to the public. The other Commissioners raised various investor issues of concern including portfolio diversification and risk associated with ETFs (Commissioner Piwowar) and FinTech and digital information protection (Commissioners Stein and Peirce).

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Supreme Court Throws a Curve

In the midst of the SEC’s strategic planning and public outreach, the Supreme Court issued a ruling affecting the agency’s administrative proceedings. The Supreme Court found that the practice employed by the SEC for hiring Administrative Law Judges (“ALJs”) was unconstitutional. In Lucia v SEC, the Supreme Court determined that ALJs are "Officers of the United States" and must be appointed consistent with the provisions set forth in the constitution, that is “by the President, the head of a department, or a court of law." The SEC must now determine how to “cure” the constitutionality question and how to proceed with pending and future administrative proceedings. As a result, on June 21st, the SEC issued an Order staying all proceedings before an administrative law judge ("ALJ") for 30 days, “or [until] further Order of the Commission."

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One Additional Noteworthy Development

As part of a series of independent reports published by the Office of the Investor Advocate, SEC Engagement Advisor Stephen Deane authored a white paper on elder financial exploitation. In the paper, Mr. Deane concluded that three interrelated risk factors contribute to the crisis: the health effects of aging, financial and retirement trends and demographic trends. He found that financial impairment is one of the earliest signs of cognitive and physical decline. Compounding these infirmities are the relative wealth of older generations and financial and pension trends that reflect the shift from defined wealth plans to defined contribution plans. He notes: “the shift … has placed responsibility onto the elderly themselves to manage their retirement savings—ironically, just at a time in their lives when their ability to do so may become impaired.” Mr. Deane argues that the dramatic increase in the demographic size of the elderly population threatens “to spur parallel growth in elderly financial exploitation.” The well-resourced paper winds up asking some very challenging ethical questions about the difficulty in developing regulatory remedies to address this growing issue. 

Conclusion

The SEC’s open draft plan and inclusive public outreach campaign are noteworthy attempts to gain support for an agenda that prioritizes the protection and education of Main Street investors in the face of a technologically evolving market, cyber threats and dwindling regulatory resources. The Supreme Court decision serves notice that the challenges can come from anywhere. The white paper reminds us that the fundamental issues are not going away. Bates will keep tracking these strategic and tactical issues as they arise. For review of the SEC’s 2018 National Exam Program Priorities please see this webinar led by Bates Compliance Solutions Managing Director Bob Lavinge.

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06-20-18

FinCEN, NFA and Congress: Customer Due Diligence and AML, BSA Developments

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On May 11, the Financial Crimes Enforcement Network’s (FinCEN) Customer Due Diligence Requirements for Financial Institutions (CDD Rule) became fully effective (see Bates Alert). The CDD Rule requires covered financial institutions to develop procedures to identify and verify a customer’s beneficial owners when an account is opened, and to establish risk-based procedures for conducting ongoing customer due diligence.

Since the effective date of the CDD Rule, the National Futures Association (NFA) proposed amendments to its compliance rules on anti-money laundering (AML). The amendments would require futures commission merchants' (FCM) and introducing brokers' (IB) anti-money laundering programs to have "risk-based procedures" for conducting ongoing customer due diligence consistent with FinCEN’s CDD Rule.

In Congress, new financial legislation was introduced in the House that would increase reporting thresholds for financial institutions that are subject to the Bank Secrecy Act (BSA) and provide a temporary safe harbor for violations of the CDD Rule. And at Treasury, FinCEN issued a detailed advisory reminding U.S. financial institutions of their regulatory obligations regarding senior foreign political figures and suspicious activity reporting. The advisory underscores the importance of the CDD Rule in enforcement efforts against these figures. Here are some of the details.

NFA Proposes Amendments to AML Rules, Issues Advisory

In a letter to the CFTC dated June 15th, the NFA proposed amendments to its compliance rules on anti-money laundering that would require AML programs for futures commission merchants (FCMs) and introducing brokers (IBs) to include "risk-based procedures" for conducting ongoing customer due diligence. The amendments to NFA Compliance Rule 2-9(c) and the corresponding Interpretive Notice would require FCMs and IBs to identify and verify the identity of beneficial owners; understand the nature and purpose of customer relationships in developing a customer risk profile; conduct ongoing monitoring to report suspicious transactions and maintain and update customer information. NFA stated that the “guidelines set forth should provide FCMs and IBs with the tools needed to develop an effective anti-money laundering program.” The proposals are to be effective ten days after receipt of this submission by the CFTC, unless the Commission notifies NFA that the Commission has determined to review the proposals for approval.

Two weeks prior, on May 22nd, the NFA issued a Notice to its members that failure to comply with NFA’s AML program requirements may subject the offending FCM or IB to disciplinary action. Specifically, the Notice reminded members to (i) “provide training for all appropriate personnel at least every 12 months on the firm's AML policies and procedures, the relevant federal laws, and NFA guidance,” (ii) “conduct independent testing of the adequacy of the AML program by firm personnel or by a qualified outside party at least every 12 months,” (iii) “document these testing results, report results to the firm's senior management or internal audit committee or department, and ensure that any deficiencies noted are addressed and corrected.”

Congressional Legislation Introduced

A week after the implementation date for the CDD Rule, the House Terrorism and Illicit Finance Subcommittee met to consider enforcement questions raised by the new regulation. On June 12th, Congressmen Chairman Steve Pearce (R-NM) and Blaine Luetkemar (R-MO) introduced the “Counter Terrorism and Illicit Finance Act.” The legislation increases reporting thresholds for financial institutions subject to the BSA and includes temporary safe harbor provisions for certain violations of the CDD Rule. As described by the Congressmen in an editorial in the American Banker, the legislation will adjust Suspicious Activity Report (SAR) and Currency Transaction Report (CTR) thresholds to reduce the compliance burden on small financial institutions and law enforcement while enhancing the effectiveness of the database. Specifically, the bill would raise the transaction-based threshold required for filing a CTR from $10,000 to $30,000. For filing a SAR—transactions involving a suspicion of money laundering, terrorist financing or other illegal activities—the threshold would be raised from $5000 to $10,000. The bill would also generally allow the sharing of SARs among financial institutions and their foreign branches, subsidiaries and affiliates for the purpose of combatting money laundering.

The bill would create an 18-month safe harbor for violations of the CDD Rule. The safe harbor provision would exempt from enforcement action any person who demonstrates a "good faith" effort to comply with the Rule. If enacted, the proposed safe harbor is temporary and would apply to violations committed between May 11, 2018 and November 11, 2019.

FinCEN Issues Advisory on AML Compliance

On June 12, FinCEN issued an “Advisory on Human Rights Abuses Enabled by Corrupt Senior Foreign Political Figures and their Financial Facilitators.” The advisory explains the risks to financial institutions for providing banking services to "politically exposed persons" and their financial facilitators, and describes the types of suspicious transactions that can trigger reporting obligations under the BSA. Specifically, the advisory gives guidance on the methods used to hide proceeds of illicit international activities, such as transactions involving government contracts originating from or going to shell companies that appear to lack a general business purpose, and corruption in the real estate sector. The advisory also provides case studies on the types of suspicious activities that raise red flags such as moving funds repeatedly around different countries with no ties to the politically exposed figure or their financial facilitators. The advisory recommends that financial institutions incorporate these red flags into their suspicious activity identification and reporting process. Further, the advisory underscores the CDD Rule’s objective to identify the beneficial owners of shell companies that may be used to launder illicit funds through the U.S. financial system.

Conclusion

The threshold adjustments and temporary safe harbor provisions contained in the newly proposed legislation, and the actions taken by FinCEN and the NFA serve to solidify the CDD Rule as the indispensable tool in the enforcement arsenal. Firms will need to ensure that their AML programs are reviewed and revised as necessary to ensure compliance with the CDD Rule.

Learn more about Bates' AML Compliance Services and AML Investigations. For more information, please contact Bates Group by phone at (503) 670-7772 or email Robert Lavigne, Bates Compliance Solutions Managing Director at rlavigne@batesgroup.com or Geoff Winkler, Director, Financial Crimes, (gwinkler@batesgroup.com) to set up an appointment today.

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06-14-18

Special Report – Fraud in the Workplace: New Data Reveals Top Controls to Detect and Prevent Fraud

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by Geoff Winkler - Director, Financial Crimes

Last month, the Association of Certified Fraud Examiners (ACFE) issued its 2018 Report to the Nations on Occupational Fraud and Abuse ("Global Fraud Study"). In the Global Fraud Study, the ACFE analyzed 2,690 cases reported by Certified Fraud Examiners from January 2016 through October 2017, covering 125 countries and over $7.1 billion in losses. The findings of the Global Fraud Study are concerning given the limited focus that most businesses place on fraud prevention.

The Use of Anti-Fraud Controls

Organizations that are victims of fraud may suffer reputational risk, financial harm and increased regulatory scrutiny*. Given these threats, most organizations attempt to prevent fraud from ever occurring in the first place. There are a number of anti-fraud controls that help prevent, deter and detect fraud, including the 18 entity-level examples used by the ACFE in the Global Fraud Study:

  • Anti-fraud policy
  • Code of conduct
  • Dedicated fraud department or function
  • Employee support programs
  • External audit of financial statements
  • External audit of internal controls over financial reporting
  • Formal fraud risk assessment
  • Fraud training for employees
  • Fraud training for management/executives
  • Hotline
  • Independent audit committee
  • Internal audit department
  • Job rotation/mandatory vacation
  • Management certification of financial statements
  • Management review
  • Proactive data monitoring/analysis
  • Rewards for whistleblowers
  • Surprise audit

Despite the use of anti-fraud controls, organizations are not immune from fraud. The graph below (Fig. 17) illustrates fraud prevention measures that certain Global Fraud Study participants had in place at the time fraud was committed against them.

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According to the study, the five most common types of anti-fraud controls in place included a code of conduct (80%), external audit of financial statements (80%), internal audit department (73%), management certification of financial statements (72%) and external audit of internal controls over financial reporting (67%). The least common types of anti-fraud controls in place included rewards for whistleblowers (12%), job rotation/mandatory vacation (19%), proactive data monitoring (37%), surprise audits (37%), formal fraud risk assessment (41%) and dedicated fraud department, function, or team (41%). 

The Absence or Weakness of Anti-Fraud Controls 

According to the Global Fraud Study, “understanding the factors that can lead to fraud is the foundation of preventing future occurrences.” As shown in Figure 22 below, nearly 50 percent of all study respondents reporting perceived the lack of (30%), or ability to override (19%), internal controls to be the main factors that allowed the fraud to occur.

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The lack of management review (18%), poor tone at the top (10%) and lack of competent personnel in oversight roles (8%) also played roles in allowing the fraud to occur.

Assessing the Value of Anti-Fraud Controls: Reduction in Median Loss

The fact that organizations analyzed in the Global Fraud Study still experienced fraud, despite a number of anti-fraud controls present, may lead organizations to question the value and expense of implementing these controls and prevention measures.

The Global Fraud Study, however, provides some concrete evidence that anti-fraud controls can have a major impact on actual dollars lost as well as the duration of the fraud. As Figure 18 shows, there are six anti-fraud controls that, when in place, reduced an organization’s median loss by 50 percent or more. They include code of conduct (56%), proactive data monitoring/analysis (52%), surprise audits (51%), external audit of internal controls over financial reporting (50%), management review (50%) and hotline (50%).

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Some of the fraud prevention methods that organizations typically implement, including independent audit committees (61%) and external audit of financial statements (80%), yielded the smallest percentage reduction in the median loss at 20 percent and 29 percent, respectively.

Controls to Reduce Duration of the Fraud

In addition to a significant reduction in median loss, anti-fraud controls were also shown to have a significant impact on the duration of the fraud. The two anti-fraud controls that had the greatest reduction were proactive data monitoring/analysis (58%) and surprise audits (54%), while another ten anti-fraud controls were shown to reduce the duration by 50 percent (see Figure 19 below).

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As with the reduction in median loss, there are a few anti-fraud controls that, while widely used, had less impact on the duration of the fraud. These include employee support programs and external audit of financial statements that, despite a use rate of 54% and 80% respectively, only had a 33% and 38% reduction on the duration of the fraud.

Key Takeaways on the Use of Anti-Fraud Controls

The Global Fraud Study is useful in providing some context on the prevalence of fraud in the market and how effective organizational responses to that threat have been. Here are some key takeaways:

Tone at the Top

Any anti-fraud control system is only as effective as the management that oversees and monitors it. In order to be successful, everybody in the organization, from management on down, must support the established controls and create an atmosphere of compliance with them.

Organization-Specific

Organizations create anti-fraud controls that are appropriate for that specific organization. No two organizations, even in the same industry, are the same, and, therefore, you cannot just take what another organization is using and implement it within your organization. This may mean hiring a consultant to give you an outside perspective to help you find areas that are currently being missed.

Training

The best anti-fraud control system in the world will not be effective unless everyone responsible for its implementation and adherence fully understands the system and their designated roles. Training is a critical element to success. All current staff and new hires must be trained and must be aware of policies to document and escalate up the chain of command when red flags occur.

Did I Mention Training?

Training is not a “one-and-done” commitment – it must be revisited on a regular basis. This underscores the organization’s commitment to continuously combatting the threat of fraud and ensures that everyone involved in the process continues to play their part in keeping the system working.

Don’t Become Complacent

Complacency at any level regarding the threat of fraud may be one of the most difficult challenges an organization may face. The only thing worse than an organization that doesn’t think it needs anti-fraud controls because “they don’t have fraud” is one that may create a great program, but fails to implement or then doesn’t review it regularly for effectiveness and completeness. As we all know, any organization that has been around for any period of time has likely experienced fraud, but may not know about it if it was never detected or is still on-going. Just as likely is that perpetrators (both internal and external) determined to commit fraud will find ways to circumvent existing anti-fraud controls. The more complacent the operation, the easier it is to bypass the controls. That is why it is critical to continue to evaluate, update and create new anti-fraud controls.

A managerial commitment to fraud prevention, organization specific controls, continuous training and retraining and fighting complacency: these are the critical elements to an effective fraud prevention and control program.

Bates Group offers consulting services to support effective fraud control efforts. If you are concerned that your financial institution may need assistance in any of the areas mentioned, or if you have questions about other services we offer, please visit Bates Group Financial Crimes practice online.

 

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* In addition to regulatory scrutiny that normally occurs when a large fraud is discovered, the Securities and Exchange Commission, as part of their 2018 priorities, has placed a greater emphasis on issues related to retail fraud. For a full review of the SEC priorities, please see the webinar led by Bates Compliance Solutions Managing Director Bob Lavinge.

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06-07-18

FINRA Shares Exam Findings, Deficiencies That May Trigger Further Scrutiny

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Continuing our coverage of FINRA’s 2018 Annual Conference, regulators and firm compliance professionals participated in discussions in a session titled “Common Examination Findings and Effective Compliance Practices.” The regulators offered insight and perspective on preparation for future examinations and best practices for medium/large firms. The session took place almost six months after the publication of FINRA's 2018 Regulatory and Examination Priorities Letter, which was based on the 2017 Report on FINRA Examination Findings (see Bates review here). The broad discussion prioritized recent regulatory activity concerning supervisory obligations and high risk brokers (see Bates’ report here) and offered additional insight into the regulator's evolving approach to regulatory and compliance management. Here are some highlights.

A Hard Look at the Exam Process

At the conference, FINRA executives seemed fully aware of the burdens the current exam process places on firms. President and CEO Robert Cook communicated FINRA’s intention to move to a “risk-based monitoring program” where “the riskiest [firms] will be reviewed annually.” He stated his intention to move to examinations where the “depth of the exam program will be tailored to the depth and size of firm.” Michael Solomon, FINRA’s Senior Vice President and Senior Regional Director - North East Region, described the need to complete examinations in a timely manner in order to alleviate the burdens. He provided detail of a risk based approach by identifying nine “salient” risks that might affect the examinations process. These include segregation of assets, operations, market risk, credit risk, liquidity, accuracy of capital, money laundering, sales risk, and fraud and deception.

Problem Areas and Best Practices

Scott Gilbert, Senior Director, Sales Practice, FINRA New York District Office, shared best practices and described specific problem areas for high impact firms that have been attracting the attention of FINRA regulators. According to Mr. Gilbert, these include:

  • Gifts and Entertainment – Regulators continue to review this area for improper influence and corruption.
  • Investment Banking and Research – Firms should be considering whether investment banking is influencing research.
  • Supervision of Electronic Communications – In particular, whether there is adequate training and supervision, especially if supervision has been outsourced. Regulators are also concerned that reviewers understand key terms and concepts that they are reviewing.
  • Supervision and Exception Reports – Regulators are looking at whether an exception report highlights a particular activity, and whether the supervisor escalates concerns up the chain of command. Also, if the firm has centralized supervisory functions, regulators are looking at whether supervisors have the substantive knowledge base and appropriate experience (for example, to supervise remotely).
  • Mutual Funds – In particular, improper switching of share class.
  • Written Supervisory Procedures (WSPs) and Regulatory Change Management – Regulators want to make sure firms have a regulatory change management process in place to determine whether firms are addressing potential gaps or conflicts in policies and procedures. Also, is there an escalation processes in place to address inconsistencies?
  • Supervision Over Branches, Visitation and Compliance – Regulators are looking at the adequacy of supervision over firm branches.
  • Automated Surveillance Systems – Regulators are concerned about data integrity and encourage best practices to address concerns over automated surveillance systems, legacy systems, feeds and other parameter changes to catch red flags.
  • Initial Public Offering (IPO) Allocations – Regulators want to see processes for avoiding conflicts of interest and improper quid pro quo IPO allocations.
  • Debt Mark Up / Mark Down – Regulators have begun to review firm controls to ensure compliance and accuracy of disclosures under recently effective rules.

Specific FINRA Exam Deficiencies

Michael Solomon, FINRA Senior Regional Director, honed in on some specific findings the regulators had regarding exam deficiencies, specifically:

  • Outside Business Activities (OBAs) and Private Securities Transactions (PSTs) – This category caused the largest number of exceptions in FINRA exams in 2017. A primary problem is that registered persons or associated persons often fail to notify their firms of OBAs.
  • Anti-Money Laundering (AML), Fraud, Sales Deception – There remains a lack of AML policy and procedures across business lines, as well as continuing failures to monitor suspicious activity and filing of suspicious activity reports (SARs).
  • Excessive Trading – FINRA looks for red flags based on numbers of transactions, amount of losses and whether there is proper documentation of interactions with clients.
  • Short Term Unit Investment Trust (UIT) Trading – Firms need to consider what the product is, how it can be sold and adequate protections against representatives “gaming the system.”
  • Suitability – FINRA sees inappropriate sales of complex products and weak controls over sales to seniors. (NOTE: Mr. Solomon stated that FINRA will be looking at suitability in the sales of mutual fund share classes; variable annuities; products that may have an over concentration by security and sector (e.g. oil and gas); non-traditional Exchange Traded Funds (ETFs); inappropriate short term products held on a long term basis (or vice versa); products inconsistent with the terms of a prospectus; the suitability of customer roll overs from a 401k to an IRA; and C or A shares of 529 accounts.)
  • Uniform Transfers to Minors (UTM) – Does the firm have adequate policies in place to comply with the provisions of the Uniform Transfers to Minors Act? Mr. Solomon stated that FINRA will review to ensure that a custodian is not controlling these accounts after the minor becomes an adult.
  • Fraud in Travel and Expense Reports – Firms continue to have deficiencies in policies related to travel and expense reporting, in particular, fraud in connection with dinner receipts and ride-sharing services like Uber and Lyft.

Small Firm Considerations

While many of the above concerns apply to small firms as well, a Conference session on Exam Findings and Effective Compliance Practices for Small Firms emphasized ensuring appropriate training and sound policies related to cyber programs and suitability. FINRA reminded these firms of the existence of a cyber review team available to small firms for guidance.

Conclusion

The issues raised at the conference provide a snapshot of the enforcement and policy direction FINRA is heading midway through the year. The 2018 FINRA Priorities Letter remains the broadest checklist for organizations to prepare for Examinations, but the above gives all firms and counsel a window on regulator expectations and potential triggers they may invite further scrutiny.

 

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions
Regulatory and Internal Investigations
Retail Litigation and Consulting
Institutional and Complex Litigation
Financial Crimes
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05-30-18

NASAA’s Crypto Crackdown, Signs Information-Sharing Agreement with CFTC

NASAA’s Crypto Crackdown, Signs Information-Sharing Agreement with CFTC

In a series of significant investigatory and enforcement actions, the North American Securities Administrators Association (NASAA) engaged in a coordinated effort to crackdown on fraudulent cryptocurrency related investment products. NASAA, whose members represent state, provincial, and territorial securities regulators in the United States, Canada and Mexico, launched “Operation Cryptosweep” in an attempt to gain information about fraudulent Initial Coin Offerings (ICOs) and to identify the individuals and companies behind the plethora of cryptocurrency related investment products. In another important enforcement development, NASAA entered into a cooperation agreement with the Commodity Futures Trading Commission (CFTC) to share information that could be the basis of enforcement actions under federal or state law.

NASAA Casts a Wide Net

With the launch of Operation Cryptosweep, NASAA took significant steps toward a more public and assertive role in the debate over the emerging regulatory framework for cryptocurrency. Previously, NASAA members conducted public outreach initiatives to warn investors in their jurisdictions of the risks associated with ICOs and cryptocurrencies. In addition, member jurisdictions engaged in a dozen enforcement actions regarding these types of products.

Operation Cryptosweep leapfrogs that approach as it involved a highly coordinated strategic effort by NASAA members from more than 40 jurisdictions throughout the United States and Canada. The initiative included nearly 70 inquiries and investigations and has so far resulted in 35 pending or completed enforcement actions since early May. (See here for a list and the status of current investigations.) To date, NASAA investigators found about 30,000 crypto-related domain name registrations executed in the past two years. That scale suggests the vast potential of activity. NASAA President Joseph P. Borg concluded that there is a “persistently expanding exploitation of the crypto ecosystem by fraudsters [which] is a significant threat to Main Street investors in the United States and Canada.” President Borg referred to the NASAA initiative as “just the tip of the iceberg” in countering this threat.

Federal Regulators were quick to praise the multi-state jurisdictional effort, including SEC Chairman Jay Clayton, who stated: “The enforcement actions being announced by NASAA should be a strong warning to would-be fraudsters in this space that many sets of eyes are watching, and that regulators are coordinating on an international level to take strong actions to deter and stop fraud.”

CFTC Chairman J. Christopher Giancarlo went further in praising the NASAA initiatives by reaffirming the joint jurisdictional responsibility of federal and state regulators. He said: “we accept regulatory overlap between state and federal authority for fraud and misconduct that preys on the significant public attention that surrounds virtual currency. It is critical to have as many cops on the beat when it comes to pursuing bad actors that harm our consumers in what is otherwise a promising area of innovation.”

NASAA and the CFTC Agree to Share Information

On the same day as NASAA announced the results of Operation Crytosweep, President Borg joined CFTC Chairman Giancarlo to announce the signing of a Memorandum of Understanding (MOU) between NASAA and the CFTC. The confidential information sharing agreement creates a framework for cooperation between the state and federal regulators and could have an impact on enforcement actions under both state and federal law. President Borg noted that “NASAA members are unique among all federal and state regulators in that they can bring enforcement actions for both securities law and commodities law violations.” He also stated that “individual jurisdictions will be required to sign the MOU in order receive its benefits, including investigative leads from the CFTC’s Office of the Whistleblower or other tips, complaints and referrals the CFTC offers to provide to NASAA members.” CFTC Chairman Giancarlo concurred explaining that: “information-sharing is key to cooperative enforcement operations, and by working together, we can ensure that the rapidly evolving financial technology space has the appropriate oversight to pursue bad actors, protect market participants, and allow for market-enhancing innovation.”

Conclusion

Taken together, NASAA’s coordinated moves demonstrate a clear intention to assert state interests in the debate over the future regulatory framework for cryptocurrency investor protection. (See here for a Bates’ discussion on some of the jurisdictional issues raised among federal regulators and recent statements calling for more collaboration.) The positive responses by federal regulators to NASAA’s Operation Cryptosweep, and the information sharing agreement between NASAA and the CFTC, reflect a willingness by federal regulators to enhance and combine enforcement tools to combat cyber fraud. The welcome reception to these moves also reflects the political skill of NASAA’s leadership. Bates will continue to highlight regulatory developments.

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05-24-18

FINRA Rolls Out Proposal for High Risk Brokers, Addresses Examination Enhancements

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FINRA issued a series of significant proposals over the past few weeks that would 1) reinforce certain firm supervisory obligations concerning associated persons with a history of past misconduct, 2) impose new restrictions on member firms that hire or employ high-risk brokers and 3) revise quantitative suitability standards. These proposals have significant implications going forward. Comments are due at the end of June. These and other issues were discussed at FINRA’s 2018 Annual Conference this week in Washington, D.C. Here are some of the highlights.

FINRA Proposes Guidance on Enhanced Supervision

In Notice 18-15, FINRA provided guidance to firms on implementing heightened supervision for associated persons with a history of past misconduct. The guidance explains how firms should tailor their supervisory procedures in order to catch and deter any recurrence of an individual's past actions. FINRA stated that this guidance is one of “several FINRA initiatives focused on associated persons …. that pose a risk to investors and the firms that employ them.” As such, the guidance is intended to be considered in light of “a combination of guidance, rule changes, and FINRA examination and surveillance programs.”

In the new guidance, FINRA stresses that an effective heightened supervision program should include several elements. FINRA expects: experienced principal oversight of identified associated persons who have a history of misconduct, appropriate training for the individual (and principal), and written notifications about the plan to both the associated person and principal. FINRA also expects there to be routine and periodic evaluations of supervisory procedures to ensure they are appropriately tailored for each identified associated person. To that end, FINRA issued a warning, stating: “the failure to assess the adequacy of its supervisory procedures in light of an associated person’s history of industry or regulatory-related incidents would be closely evaluated in determining whether the firm itself should be subject to disciplinary action for a failure to supervise…”

The proposed supervisory guidance references the simultaneously-issued proposed regulations on high risk brokers (see below) and anticipates considerations being undertaken by the SEC’s proposed Best Interest Rule. (See Bates Group review here and here)

More on Supervision from the Annual Conference

At this week's conference, FINRA representatives offered additional insight on heightened supervision. In a session on “Exam Findings for Medium/Large Firms,” FINRA representatives underscored the importance they place on Supervision and Exception Reports. In particular, FINRA representatives stated that they will look at whether an Exception Report highlights a particular activity and whether or not a supervisor is escalating the matter up the chain or not. Consistent with the proposals, FINRA representatives stated their intention to focus on centralized supervisory functions and whether individuals have the correct experience and knowledge base.

FINRA Proposes Strengthening Oversight of High Risk Brokers

In Notice 18-16, FINRA proposed a set of rule amendments to enhance its oversight and control over employers and high risk brokers. The amendments would affect FINRA rules on disciplinary proceedings and disciplinary review processes, eligibility proceedings, broker check disclosure and membership proceedings. Here are some specifics:

FINRA proposes to allow a Hearing Panel to impose conditions or restrictions on the activities of member firms and brokers while a disciplinary proceeding is on appeal to the National Adjudicatory Council (NAC) and to require member firms to adopt heightened supervisory procedures during the appeal process.

The proposal requires member firms to adopt heightened supervisory procedures for brokers during a statutory disqualification period while an eligibility request is under review. As explained in the Notice, events triggering statutory disqualification include certain misdemeanors and all felony criminal convictions for a period of 10 years from the date of conviction; temporary and permanent injunctions (regardless of their age) involving a broad range of unlawful investment activities; bars (and current suspensions) ordered by the SEC or a self-regulatory organization (SRO); and findings that a person willfully has made or caused to be made false statements of a material fact to an SRO. A person who is subject to a statutory disqualification may seek to enter, reenter, or in the case of incumbents, continue in the securities industry. FINRA also filed a proposed rule change SR 2018-018 increasing the fees for statutory disqualified applications, effective May 30, 2018.

The amendments would also require disclosure of the status of a member firm as a “taping firm.” FINRA rules require a recording of registered persons by certain firms. Further, the proposed amendments would require member firms to notify FINRA when “a natural person” seeking to become an “owner, control person, principal or registered person of an existing firm,” has had a final criminal action or two or more final “adjudicated discloser events” in the prior five years.

FINRA Proposes to Revise Proof Required in Quantitative Suitability Cases

In Notice-18-13, FINRA proposed rule changes that would revise the required legal elements necessary to prove churning or excessive trading (quantitative suitability) in a customer’s account. Currently, an investor must prove that the trading in an account was recommended by the broker, that the broker was “in control” over the account, and that the trading was excessive in light of the customer’s trading profile. The proposed revision removes the “control” element required to prove a violation. The proposed revision would not change the obligations to prove that the suspect transactions were recommended and that the level of trading was excessive and unsuitable given the customer’s investment profile.

FINRA argued that “because [it] must show that the broker recommended the transactions … culpability for excessive trading will still rest with the appropriate party even absent the control element.”

FINRA asserted further that it “is concerned that the control element serves as an impediment to investor protection and an unwarranted defense to unscrupulous brokers.”

Additional Takeaways from the 2018 Annual FINRA Conference

In remarks at the Annual FINRA Conference, President and CEO Robert Cook described the need to change the risk-based examination process, acknowledging that “our [FINRA] exams run too long and back up to the next exam.” He reported that the “in-depth exam program will be tailored to the depth and size of firm” and said “the riskiest will be reviewed annually.” Mr. Cook also stated that FINRA has been developing a "risk based monitoring program” to further address company concerns including concerns about high risk brokers. He shared feedback from FINRA 360 Roundtables on enhanced compliance tools and greater communications support for small firms. Mr. Cook also emphasized the importance of keeping the lines of communication open with members.

Michael Solomon, Senior VP and Senior Regional Director for FINRA also weighed in on examination issues. In a conference session on medium/large firm examination deficiencies, Mr. Solomon reported that examinations will utilize nine risks factors which are "most salient for firms, including: segregation of assets, operations, market risk, credit risk, liquidity, accuracy of capital, money laundering, sales risk, fraud and deception.” Solomon noted that FINRA will use the nine risk factors to assess every firm "so that there is consistency nationally."

Conclusion

FINRA’s three Notices are part of a coordinated effort to strengthen the organization’s hand in dealing with a small percentage of bad actors that have a disproportionate impact on investors. The implication of these proposals, as confirmed by FINRA representatives at the annual conference, is that FINRA intends to be much more proactive in holding firms accountable for their associated persons. Comments are due by June 29. 

 

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