When deciding to do business with a Money Services Business (MSB) or a Non-banking Financial Institution (NBFI), banks have to be extremely careful in the current legal and regulatory landscape, as they must take proper precautions against the risk of money laundering and other illegal financial activities using their accounts. 

Join experts from Bates Group, Circle, Cross River, and Veritex Community Bank as we dive into: 

• Bank partner expectations 
• Red flags your bank looks for 
• Market developments 
• And much more, including Q&A session! 

Date: June 20, 2023

Time: 12:00 - 1:00 p.m. ET

Register for this Zoom Webinar

Brandi Reynolds, CAMS-Audit, CCI, CCCE (Host)

Managing Director, MSB, FinTech & Virtual Assets Practice Leader - Bates Group

Bates Managing Director Brandi Reynolds has nearly 20 years’ experience in the financial services industry that includes over eleven years serving as in-house Deputy Chief Compliance Officer. Brandi has received both the Certified Anti-Money Laundering Specialist (CAMS) and Certified Anti-Money Laundering Specialist- Audit (CAMS-Audit) certifications. Since 2015, Brandi has served as outsourced Chief Compliance Officer to a variety of financial institutions. Ms. Reynolds is often sought for her extensive experience in cryptocurrency compliance. She has delivered efficient and effective solutions in areas of compliance program development, compliance monitoring and testing, and training. Her background includes a combination of both anti-money laundering as well as consumer protection compliance.

Mandeep Walia

Chief Compliance & Risk Officer - Circle

Mandeep leads Circle’s compliance and risk management globally. Mandeep has played senior leadership roles driving global compliance and enterprise risk at financial services/fintech companies such as PayPal, LendUp, State Street, and most recently, was the Chief Compliance Officer/Head of Enterprise Risk at Novi — Facebook’s digital wallet business.

Keith Vander Leest

Head of Payments - Cross River

Keith Vander Leest leads the Payments team at Cross River. Payments at Cross River consists of our ACH, RTP, Wires, Push to Card, and Acquiring products offered through our APIs on our bank core COS. Keith joined Cross River in 2020 as Head of Channels. Prior to Cross River Keith was at American Express holding roles on both their issuing and acquiring businesses. Prior to American Express Keith was at First Data. Keith holds a MBA from Purdue University and a Bachelor of Science in Engineering from Calvin University.

Andy Salemi

Executive Vice President & Director of Specialty Finance - Veritex Community Bank

Andy has over 20 years of experience in financial services. He specializes and leads a team at Veritex Bank that helps companies in highly regulated industries grow and prepare for the ever-changing financial landscape. He has help everything from startups to publicly traded firms manage their debit issuance, AML programs, payment and receivable efficiencies: Money transmitters • FinTech • Check cashiers • Currency exchange • International payments (Fx) • Wallet / card issuers / stored value cards • BIN sponsorship • Broker dealers • Nonbank financial institutions (lenders) • Third party service providers • E2 / EB5 • Gaming • Pawn shops • Collections industry. Andy received his Bachelors of Science from DePaul University, Chicago and has his Certified Treasury Professional (CTP) Certification.

John Ashley, CIPP/US, CCRS, CRCMP (Moderator)

Managing Consultant - Bates Group

John Ashley is a Bates Managing Consultant who has over seven years of experience in financial regulatory compliance with startups WorldRemit Corp. and Etana Custody. He specializes in establishing and maintaining robust and productive working relationships with U.S. financial regulators both during license application, and license maintenance. John has experience in compliance program, policy, and procedure development; product compliance; regulatory analysis; and consumer protection programs. In addition, John has experience in the cryptocurrency space, including development of KYC and transaction monitoring programs and procedures specific to cryptocurrency risk. He also specializes in U.S. data privacy compliance and holds a CIPP/US certification from the International Association of Privacy Professionals.

Bates Group is a leading financial services consulting firm, providing end-to-end solutions on compliance and legal matters. Our MSB and FinTech Team offers customized solutions to meet your compliance, licensing, training, and banking needs. From traditional banks to crypto startups, our experienced professionals can guide you through your regulatory challenges. 

How you handle a securities regulatory investigation is critical, and being uninformed or ill-prepared could lead to significant consequences for your client. It is also important to understand your ethical obligations before, during, and after an investigation, as representation lines may become blurred. Register today for this upcoming CLE webinar from the New York County Lawyers Association (NYCLA) Securities & Exchanges Committee.

Our panel of experienced practitioners will discuss:

• the various stages of a securities regulatory investigation
• the initial contact
• demand for documents
• gathering and distilling data
• on the record interviews (OTRs)
• how to avoid full-blown enforcement actions
• how to protect your client’s public CRD, and
• ethical considerations to avoid conflicts of interest and rule violations

Date: June 14, 2023

Time: 12:30 p.m. ET

CLE credit: 1.5 NY Credits: 1 Skills; 0.5 Ethics; Transitional and Non-transitional; 1.5 NJ Credits: 1.5 General

Webinar Details and Registration

Faculty:

• Susan Schroeder, Esq., Partner, Vice Chair, Securities & Financial Services Department, WilmerHale (former Head of FINRA Enforcement)
• Ronald Minkoff, Esq., Partner, Frankfurt Kurnit & Selz
• Robert Herskovits, Esq., Managing Member, Herskovitts PLLC
• Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations, Bates Group LLC

Program Chairs and Moderators:

Susan L. Harper, Esq., Managing Director, Bates Group LLC, Co-Chair, NYCLA’s Securities & Exchanges Committee and Benjamin F. Jackson, Esq., Associate, Cohen Milstein, Co-Chair, NYCLA’s Securities & Exchanges Committee

Bates Managing Director and Virtual Assets practice leader Brandi R. Reynolds, CAMS-Audit, will be a guest speaker at the 2023 1CryptoWorld | Global Crypto Conference. This virtual conference will take place on May 24th, 2023. Ms. Reynolds' panel at 2:30 PM ET will give an overview of the current state of Cryptocurrency Compliance and Regulation, including:

• Overview of the crypto ecosystem
• Regulatory framework
• Stakeholder analysis
• Crypto issues and challenges

This virtual event--open to seasoned investors, blockchain developers, service providers, as well as newcomers--provides a comprehensive look at the latest developments and opportunities in the world of crypto. The program includes keynote speakers, panel discussions, and networking opportunities, where attendees can explore the latest trends, gain invaluable insights, and be part of shaping the future of finance and technology.

Conference Details and Registration

Bates assists firms and counsel throughout their legal, regulatory, compliance and AML matters. Our experienced staff and consultants offer a suite of AML and Compliance consulting services to established and start-up companies in banking, broker-dealer, RIA, Fintech, virtual assets/cryptocurrency, Money Services Businesses (MSBs), and Non-Banking Financial Institutions (NBFIs). We consult, develop programs, manage audits, conduct reviews, design training, and more to meet your specific demands and requirements.

Bates Group Managing Consultant John Ashley (pictured) will be speaking at an upcoming webinar on "Banking Digital Currency," sponsored by the American Bankers Association. Attendees will be able to expand their knowledge of the digital currency space, including regulatory controls and the current regulatory environment.

May 24, 2023 | 3 - 4 PM ET

Discussion Highlights:

• The basics of digital currencies
• The current regulatory landscape for digital currencies
• Discussion of what banks are seeing today with customers buying and selling digital currency through 3rd parties like Venmo, Coinbase or FTX
• Is your bank in the digital asset space? What should you know how you should review? 
• Explore digital related businesses being banked and businesses that may be selling equipment related to mining
• The risks to keep in mind when banks add digital currencies

Speakers:

• Rebecca Schauer Robertson, CAMS-Audit, CFE, CAFP, SVP, Dir. Financial Investigations Unit, Atlantic Union Bank (moderator)

• Mike Gallagher, BSA High Risk Manager, Old National Bank

• John Ashley, CIPP/US, CCRS, CRCMP, Managing Consultant, Bates Group

Webinar Details and Sign-up

Bates Group assists firms and counsel throughout their legal, regulatory, compliance and AML matters. Our experienced staff and consultants offer a suite of AML and Compliance consulting services to established and start-up companies in banking, broker-dealer, RIA, Fintech, virtual assets/cryptocurrency, Money Services Businesses (MSBs), and Non-Banking Financial Institutions (NBFIs). 

Join Bates Group leaders Jennifer Stout, Ira Hammerman, David Birnbaum, and Hank Sanchez (pictured) at the 2023 FINRA Annual Conference, May 16-18 in Washington, D.C., and get solutions for your ongoing compliance, regulatory and litigation matters. 

FINRA's premier event—the Annual Conference provides the opportunity for practitioners, peers and regulators to exchange ideas on today's most timely compliance and regulatory topics. The conference offers industry professionals a variety of sessions related to current trends in technology, cybersecurity, risk management and much more. 

CONTACT BATES TODAY to schedule a time to meet with Bates attendees before, during, or after the conference.

Conference Details and Registration

Bates supports firms navigating compliance with FINRA and SEC rules and matters. Our compliance and regulatory teams include senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems. . Our Securities and Financial Services Litigation practice provides retail and institutional litigation expert witness consultation and data-driven analytic solutions for broker-dealers, RIAs, banks and insurance companies.

Bates is a proud sponsor and exhibitor at the Carolinas RIA Summit, Thursday, June 22, 2023 in Charlotte, NC. Presented by Portfolio Summits, the second annual Carolinas RIA Summit is a one day meeting of insightful panel discussions, presentations, Q&A, and networking.

Stop by the Bates booth and connect with Bates Compliance leaders to learn about practical insights and best practices that can help you maintain a successful compliance program, including:

• Annual Updating Amendment
• Annual Compliance Meeting
• Policies & Procedures
• Annual Review
• Compliance Calendar

While you're there,  pick up materials on compliance solutions for your firm, including individual and firm-wide training on the new Marketing Rule, SEC 2023 Exam Priorities, and more to help you achieve regulatory and compliance success.

Summit Details and Registration

Looking to train your team on the SEC’s New Marketing Rule?

Bates Group and Innova’s online New Marketing Rule Training courses will teach your staff the “dos and don'ts” of the new rule.

Learn More about IAR CE from Bates Group

Join Bates Expert and Director Joe Thomas and Expert Clay Grumke at the SIFMA C&L Society 2023 regional seminar June 14th, 2023, in St. Louis, MO.

Joe and Clay will be on hand to share ideas on the increasingly complex and changing regulatory and compliance arenas, and how Bates can assist your firm with Securities Litigation and Arbitration, Expert Witness Testimony and Consulting, Damages, Regulatory Investigations, Compliance, and more.

Also meet Bates Group independent consulting and testifying experts: former Missouri Securities Commissioner and General Counsel (of two NYSE Member Firms) David M. Minnick; and Jeff Jamieson, former Litigation and Compliance Counsel for major financial institutions (pictured, L-R).

CLE Credit pending for Missouri and New York

Seminar Details and Registration

Bates Compliance Managing Director Rhonda Davis, JD, CAMS, CFE, will be speaking at the NICE Actimize Engage conference, taking place June 6-7, 2023 in New York City. Ms. Davis will appear in the session "Suitability Regulation: Evidencing 'Best Interest' and 'Consumer Duty'” Tuesday, June 6th at 1:30 p.m. ET.

Session Details:

With regulators increasing their focus on retail investor protections, firms need to ensure they have the right systems and programs in place to monitor for client abuse and poor sales practices. We’ll look at a number of regulations, such as Regulations Best Interest, and Consumer Duty, and we’ll share what you need to stay ahead.

Event Details and Registration

Bates supports firms navigating compliance with SEC rules. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

Contact Our Team to Learn More

The use of Artificial Intelligence (AI) and algorithms is becoming increasingly widespread in today's digital environment. This technology can provide many benefits, but it also brings with it a unique set of potential risks that organizations must consider when incorporating AI into their processes, as financial services regulators have noted in recent years.

Compliance risk is one such risk to consider. Compliance risks associated with using AI include the potential for bias or discrimination in decision-making as well as the threat of data breaches due to inadequate security measures. (See, e.g., Bates article “Errors, biases and algorithms: how to interpret automated results” by Alex Russell.) In April 2023, the Federal Trade Commission (FTC) issued business guidance to help companies understand the compliance risks that come with using AI and algorithms, including strategies to manage associated consumer protection risks. We take a look at some of the compliance considerations here.

Assess Compliance Policies and Procedures

Organizations should assess their existing policies and procedures related to privacy and data security to ensure they are designed to address the potential risks associated with AI. Organizations should also consider developing new policies and procedures specific to the use of AI, such as ensuring that algorithms are tested for bias before they are used in decision-making processes.

In addition, organizations must be aware of the potential for malicious actors to exploit AI technology for fraud or other illegal activities. Deep fake technology is a particularly concerning example of this risk: deep fakes can be used to produce false audio or video recordings of people saying or doing things they never actually did or said.

Test Security Vulnerabilities and Threats

One way to gauge consumer trust is through a luring test — a process by which developers can identify possible security vulnerabilities by replicating techniques used by malicious actors. The Federal Trade Commission (FTC) recently released guidelines on conducting luring tests responsibly, urging companies to think carefully about the data collection and storage policies associated with such tests. These include ensuring customer consent before collecting any data and properly disposing of it once the test is complete. Companies should also build safeguards into their systems to protect against unauthorized access and use of customer data. By taking steps to ensure consumer trust in AI engineering, companies can improve not only their products’ performance but also their customers’ satisfaction.

Cybersecurity

Organizations should take measures to protect themselves and their customers from these threats by investing in strong cybersecurity practices, keeping up with technological developments, and monitoring their systems for unauthorized access. By taking proactive steps to address the compliance risks of using AI technologies, organizations can protect themselves and their customers from potential harm.

Conclusion

Through responsible data collection and storage policies, businesses can ensure that their AI engineering meets both user expectations and privacy regulations. Doing so will benefit both companies and consumers in the long run as they continue to take advantage of the advancements made possible by AI technology. Non-compliance can lead to FTC violations as referenced in the April 2023 article regarding the appropriate use of AI.

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, consumer compliance consulting, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training. 

Contact Bates today for services and expertise you can count on

Bates Regulatory and Internal Investigations Managing Consultant Lindsey Dean, CPA, CFE (pictured) will be speaking at the California Department of Financial Protection and Innovation’s Enforcement Division Staff Conference — Wednesday, May 10, 2023 in San Diego, CA — on the topic of financial statement analysis, forensic accounting principles, and how to analyze financial statements to determine the financial health of a company. Ms. Dean recently spoke at the NASAA 2023 Enforcement Training on the “Attorneys’ Guide to Identifying Red Flags in Financial Disclosures.”

Ms. Dean specializes forensic accounting and litigation consulting services and has significant experience in accounting and financial consulting services as they relate to litigation and dispute resolution for companies, government entities, and law firms. Her engagement experience includes financial statement analysis, interpretation of accounting standards and industry-specific authoritative literature, auditor malpractice examinations, and complex liability and damages analyses for a variety of industries, specializing in insurance companies.

Securities and Financial Services Litigation & Consulting

Regulatory & Internal Investigation Services & Consulting

Forensic Accounting & Economic Damages Consulting

Data Analytics Consulting & Analyses Services

Compliance & AML Solutions

Reach out today to have a Bates representative contact you

In a 20-question and answer format, the SEC staff offered its latest guidance[i] on the obligations and duties of care expected of broker-dealers and investment advisers toward their retail clients. The April 24, 2023, Bulletin honed in on the “care obligations” under both the broker-dealer Regulation Best Interest (Reg BI) standard and under the investment adviser fiduciary standard emphasizing that the two standards are derived from the same principles and “yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.” In this regard, the SEC guidance narrows the differences between the two. Here is the latest. 

Two Standards or One?

Core commonalities between the two standards include three “overarching and intersecting components,” according to SEC staff. These components are (i) understanding key elements of the investment product or investment strategy (such as risks, rewards and costs); (ii) regularly updating and understanding the retail customer’s investment profile; and (iii) offering the investor reasonable investment alternatives in their best interest based on (i) and (ii). Staff asserted repeatedly that evaluating whether a recommendation or advice meets the standard is an “objective evaluation, turning on the facts and circumstances.”

Investment Products and Strategies

Staff stressed the importance of understanding investment products, asserting that a broker or adviser will not have a reasonable basis for making a recommendation in the best interest of the investor without such an understanding. Indeed, the Staff reiterated that understanding the firm’s investment products and/or strategies is both a Firm responsibility and the personal responsibility of the representative/advisor. The Staff said that the professional remains on the hook, even where the firm has “compiled an approved list of investments for retail investors.” Relevant factors to understanding these products and strategies may—depending on the facts—include understanding the strategic objectives, (e.g., income, principle preservation or growth); all fees and costs associated with the investment (e.g., commissions, markups, sales loads or charges, advisory or management fees; administrative and service fees, revenue sharing, and transfer agent fees); risks (e.g. potential losses, volatility, margin calls, early repayments); performance expectations (in light of economic conditions); and, special features of the investment (e.g., tax impact).   

Investor Profiles

The Bulletin reminds broker-dealers and advisers to fully understand the investor’s profile, and to continue to obtain updated information. They gave examples of investor information that should be collected, including but not limited to the investor’s “financial situation; [other] investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objective[s] and financial goals;” and, depending on the circumstances, additional information such as “level of financial sophistication; preference for making their own investment decisions … and need or desire for account monitoring or ongoing account management.” They also warned brokers and advisors against providing recommendations or advice without the necessary investor profile (or to document why such information may not be relevant under the circumstances).

Reasonable Alternatives

The Staff made clear that broker-dealers and investment advisers cannot satisfy their duty of care to retail investors if they have not considered “alternatives that are reasonably available to achieve the investor’s investment objectives.” (Staff noted that the SEC has brought enforcement actions against advisers for failing to consider available alternatives when recommending investments.)

The guidance also includes a recommendation that firms implement a process for “establishing and understanding the scope of such reasonably available alternatives,” which should include “evaluation of alternatives prior to investment and consideration of alternative investments throughout the investment period.” Such a process could include a broad array of investments “consistent with the retail investor’s investment profile, and then narrowing to a smaller universe of potential investments or investment strategies.”

Further, the staff said the process should be tailored to the firm’s business model and incorporated into the firm’s policies and procedures. Staff considered an example, however, of a firm that uses an "open architecture framework" business model, with hundreds, or thousands, of product alternatives. In such cases, they said, “a financial professional does not have to evaluate every possible alternative available through the firm.” The staff used this example to describe how facts and circumstances might affect a review of a firm’s alternative available investment policy.

The staff also noted that recommending the "most appropriate" option from a limited menu of investments would not necessarily satisfy an investment professional’s care obligations. Similarly, investment products that are "not identical may still be comparable" as alternative investment options. These examples reinforce the staff’s view that “the scope of alternative investments and investment strategies that might be considered will depend on the facts and circumstances, including but not limited to the nature of the firm’s business, the retail investor’s investment profile, the scope of its relationships with its customers and clients, and the reasonable availability of alternative investments or investment strategies.”

Finally, while the staff acknowledged that documentation of the professional’s evaluation is not specifically required, it would be difficult for a firm or professional to demonstrate compliance of all its obligations without having some documentation of the basis for recommendations. They said that such documentation “can be particularly important where a recommendation may seem inconsistent with a retail investor’s investment objectives on its face and/or poses conflicts of interest for the firm or the financial professional.” 

Complex or Risky Products

Notwithstanding the above, the Bulletin advised that complex or risky products—usually subject to “heightened scrutiny”—may be consistent with a client’s investment profile, and trading objective, but that the broker-dealer or adviser “should consider whether less complex, less risky or lower cost alternatives can achieve the same objectives for their retail customers as part of their overall reasonable basis analysis.” They encouraged firms recommending complex or risky products to (i) establish policies and procedures “outlining the[ir] due diligence process” in order to “help ensure that these products are assessed by qualified and experienced firm personnel; (ii) establish training and supervision procedures “to help ensure financial professionals understand the features, risks, and costs of a complex financial product; and (iii) establish procedures for evaluating reasonably available alternatives with “lower risk or less complex options,” if it would achieve the same objectives.

Dual Registrants

Staff weighed in on whether the Reg BI or the fiduciary standard is applicable for dual registrants. First, they said that the answer depends on facts and circumstances including the account type, considerations of compensation, and “the extent to which the dually registered firm and financial professional made clear to the customer or client the capacity in which they were acting.” Second, they suggested that a dually registered firm should consider whether a recommendation is better suited for the investor’s brokerage account or advisory account. And finally, Staff remarked that, regarding duty of care, either result would be otherwise substantially similar “in terms of the ultimate responsibilities owed to retail investors.”

Conclusion

Many investment advisers have effectively tuned out at the mention of Reg BI, thinking it doesn’t apply to them. Based on the Staff Bulletin, both investment advisers and broker-dealers would be wise to take a strong look at how they evaluate and document the advice and recommendations they give to their clients.

Bates Group’s Compliance team helps firms navigate and achieve compliance with Reg BI and Form CRS, including:

• Disclosure obligations
• Duty of care obligations
• Conflicts of interest obligations
• Additional compliance obligations

We can assist you with:

• Developing and reviewing Reg BI Client Relationship Summary (“Form CRS”)
• Conflicts of interest assessment
• New product approval processes
• Drafting new policies and procedures
• Training for compliance and sales professionals on how to comply with Reg BI and Form CRS
• Litigation support
• Reg BI expert testimony

To speak with a Bates representative about your Reg BI needs, please contact us today.

For those of you that read our article “Navigating the Money Transmitter Licensing Process,” you know that obtaining a license is a daunting task. State licensing requirements have been extremely difficult to navigate, with the details of the money transmitter license process varying from state to state. It is important to note that supervisory oversight also varies.

To alleviate significant pain points for applicants, state regulators have worked on initiatives to provide consistency and harmonization across the nonbanking industry through collaboration among state regulators, industry participants and the Conference of State Bank Supervisors (CSBS). The Money Transmission Modernization Act (MTMA) was created to modernize the money transmission industry by allowing for comprehensive standards and requirements that reduce regulatory burden and encourage innovation, and improved consumer protections that allow for less confusing rules across states. The MTMA was drafted in 2019 and was approved by CSBS in August 2021. It is intended to provide a uniform framework for states to regulate money transmitters.

Under the MTMA, all money transmitters must comply with licensing requirements and are subject to additional regulations intended to protect consumers. These requirements include providing adequate disclosures about fees, rates, and other important information; implementing anti-money laundering measures; creating customer complaint procedures; maintaining adequate capital reserves; and others, based on company size. Additionally, the MTMA contains an article addressing virtual currency, a regulatory topic not currently included in many states’ money transmission laws.

Three Key Benefits of MTMA

Consumer Protection

The MTMA would provide consumers with greater protection against fraudulent activities and enhance their confidence in the money transmission industry. The current regulatory framework often results in confusion for consumers and presents a barrier to entry for new money transmitters. By streamlining the licensing process, the MTMA would make it easier for legitimate money transmitters to enter the market, increasing competition and driving down costs for consumers.

Regulatory Oversight

Regulatory agencies would be armed with greater authority to oversee the money transmission industry, improving regulatory efficiency and reducing compliance costs for money transmitters. The law would encourage the use of a national licensing system for money transmitters, eliminating the need for state-by-state licensing, which is currently a heavy administrative burden for money transmitters. This would enable regulatory agencies to more effectively monitor the industry and take action against illicit activities, such as money laundering and terrorist financing.

Innovation

Innovation is the key to success for many financial institutions. The MTMA has the potential to drive innovation in the financial industry by creating a regulatory framework that encourages experimentation and new technologies. Certain provisions of the MTMA would provide a safe, controlled environment for various money transmitters to test new business models and innovations without being burdened by excessive regulation. This would pave the way for business models like faster payment systems and distributed ledger technologies to be tested and eventually implemented in the wider market, benefiting both consumers and money transmitters.

Legislative Landscape

State legislatures are generally responsible for drafting their own laws related to money transmission services. However, by following the MTMA as a template for their own individual laws, states can ensure that they provide better protection for their citizens who use these services.

The CSBS has already seen success in having many states adopt versions of the model MTMA into their own individual laws. Currently, twenty states have either enacted or proposed legislation to implement the MTMA version developed by the CSBS. The chart below provides a breakdown of the current landscape.

Conclusion

The MTMA is a testament to the power of collaboration between the government and industry leaders. Widespread adoption would bring about significant improvements in regulating money transmitters, thereby safeguarding consumers from potential financial risks while fostering innovation.

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

For more information about Bates Group’s Money Transmitter Licensing and Maintenance services, please contact Bates today.

Meet Bates Group Board Vice-Chair/Senior Executive Advisor Jennifer Stout and Managing Director Paul Lambert at SIFMA’s Private Client Conference, which brings together executives from across private wealth management in a dynamic forum designed to explore the future of wealth management. The conference will feature perspectives on priorities for private wealth management from industry leaders, regulators and scholars.

Through keynote sessions, fireside chats and panel discussions, attendees will discuss topics including:

• The Future of Capitalism with Penny Pennington
• An Industry Disrupted – Insights into the Latest Data and Trends
• Preparing for the Unexpected – The Ins, Outs and Value of Succession Planning
• The Why and How of Great Teams with Andy Bernstein
• John Spence on the Formula for Business Excellence
• Reality vs. Perception in Retirement Planning
• Building a Diverse Talent Pipeline
• Transformation and Evolution – The Evolving Regulatory Landscape
• New Strategies for Enhancing the Financial Advisor of the Future
• On the Ground – Perspectives from Regional and Complex Offices

Register today to join us from May 3–5, 2023 at the Marriott Harbor Beach Resort & Spa. in Fort Lauderdale, Florida.

Conference Details and Registration

Bates is proud to sponsor the Southwest Women in Financial Services (SWIFS) 2023 Spring Symposium, May 2, 2023 at Raymond James headquarters in St. Petersburg, FL.

Full schedule below - RSVP to Setfanie Wayco (swayco@maynardcooper.com).

In FINRA’s 2023 Examinations and Risk Monitoring Report, the regulator highlighted a new category of regulatory obligations and related considerations over manipulative trading (see previous Bates coverage). Manipulative practices in various forms—pump and dump schemes, insider trading, wash sales, layering, front running, trading ahead, spoofing—have been longstanding violations of numerous SEC and FINRA prohibitions. The regulators are now paying extra attention to issues of market manipulation due in part to an increase in wash sales and front running (as pointed out by Greg Ruppert, Executive Vice President, Member Supervision, FINRA, at a recent SIFMA C&L Society luncheon in NYC), as well as to the regulators' use of more sophisticated data analytics to identify potential market abuse. In this article, we look at recent enforcement actions, examination findings, and guidance for firms on the issue.

Enforcement

In 2022, the SEC engaged in high-profile enforcement actions to address abusive market practices. These included prosecutions based on data analytics from the SEC’s Market Abuse Unit (MAU), a group created in 2010 to uncover and detect patterns of suspicious activity. Highlights from last year included (i) insider trading cases against a Chief Financial Officer of a pharmaceutical company (along with his former romantic partner) and a CEO and Chief Technology Officer of a mobile internet company; (ii) manipulative schemes concerning microcap stocks against multiple individuals and entities; (iii) “cherry-picking” trading abuse cases against investment advisers and associated representatives; and (iv) an insider trading and front running scheme wherein a trader at a major asset management firm advised an outside party on market moving trades prior to their execution, leading to $47 million in profits over a six-year period

This year, SEC enforcement cases charging market manipulation are picking up. The most watched cases concern crypto companies and their executives. They include a CFTC action against the Binance Exchange, which concerns, among other things, claims that the exchange participated in market manipulation and used its position to trade against its users. Another recent case includes charges by the SEC against crypto asset executives and their companies for “fraudulently manipulating the secondary market … through extensive wash trading.” (This case also concerns a scheme to pay celebrities to tout the crypto assets without disclosing their compensation.)

FINRA’s most recent enforcement actions are anchored in a host of relevant rules (see below), but often take the form of supervisory failings. One recent settlement imposed fines for not establishing and maintaining a supervisory system, including written procedures, regarding surveilling for potentially manipulative trading (in a case in which the firm had been alerted to a customer’s prior history involving trading and margin calls). Another case concerned a failure to conduct supervisory reviews on “electronic trading customers’ trading activity for any type of potentially manipulative trading, including layering, spoofing, wash sales, or marking the close or open,” relying instead on “third-party broker-dealers to conduct such reviews.” Yet another case concerned a supervisory system “not reasonably designed with respect to detecting potentially manipulative trading involving wash trades, prearranged trading, and marking-the-close.” These actions further the intent of the regulators to prioritize manipulative trading enforcement.

Requirements

Rules to prevent or deter market manipulation are extensive. The SEC prohibitions generally fall into two categories, (i) “pump and dump” schemes and (ii) trading manipulations. The former largely concerns insiders or promoters who obtain ownership or control of a significant block of a stock, then hype the stock, often using press releases, web sites, chat groups, and email. This generates artificial interest from the public, causing prices to rise until the manipulators “dump,” or sell, their own shares to the unsuspecting public and walk away with the profits, leaving investors holding largely worthless stock. 

Trading manipulations take numerous forms, including, for example: arbitrary quotes (where trading patterns do not follow expected patterns of supply and demand); wash sales and matched orders (where the trading does not change beneficial ownership, or expose the trader to market risk, but creates the impression of activity to move prices for a security higher); marking the close (a trading scheme to up a bid or to increase the closing price of the security, to signal to investors a trend in the market or to increase the value of held positions); “domination and control” (a market maker scheme leveraging control of trading in a particular security such that quotes can be set arbitrarily after luring in momentum traders); and layering (where a trader places non-bona fide orders at different price levels in the order book for the purpose of creating a false picture of market supply and demand for other traders).

FINRA rules covering potential market manipulation may implicate requirements against publishing communications about transactions and quotations unless they are “bona fide” (Rule 5210), offers at stated prices (Rule 5220), payments involving publications that can influence market prices (Rule 5230), anti-intimidation or coordination (Rule 5240), “front running” rules that prohibit trading in a security that is the subject of an imminent customer block transaction if you possess related material, non-public market information (Rule 5270), order entry (Rule 5290), and, generally, “other trading practices" Rule 6140). These requirements are all subject to supervisory responsibilities of a firm (Rule 3110) to ensure that associated persons’ trading activities conform. Violations of these rules tend to also implicate FINRA’s catch-all Rule 2010 (Standards of Commercial Honor and Principles of Trade) and/or, generally, Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices).

Examinations

In their summary of exam findings, FINRA identified compliance deficiencies regarding (i) written supervisory procedures (particularly as to monitoring and escalating potentially manipulative conduct); (ii) failures to design and establish appropriate surveillance controls and thresholds; and (iii) surveillance failures, including inadequate monitoring, review and documentation, and training.  

Given the extent of the compliance problem, FINRA recommended steps firms should take to address the above issues. These include boosting monitoring across multiple platforms and products and strengthening supervisory processes. As to surveillance, FINRA zoomed in on specific priorities. The first was to improve monitoring on algorithmic and high frequency trading. FINRA recommended firms focus on surveillance to improve general risk assessment and response; software/code development and implementation; software testing and system validation; and trading systems (see FINRA guidance).

Second, FINRA recommended strengthening surveillance to catch potential momentum ignition trading, including variations of layering/spoofing and marking the close.

Third, FINRA wants firms to enhance their monitoring to detect customers engaging in wash trading (a manipulation strategy whereby a trader buys and sells in a manner that creates the misleading impression of market activity to other investors). FINRA expects firms to monitor accounts—identified in surveillance reports or based on information in account opening documents—that receive liquidity rebates from exchanges.

As for recommendations to improve supervision, FINRA prioritized oversight on exchange-traded products. FINRA recommended ensuring compliance steps to (i) protect material, non-public information from being misused; (ii) review for strategies that may exploit exchange-traded product processes like formation or redemption; and (iii) ensure that the program is tailored to how the firm actually trades these products.

Conclusion

As a policy matter, it is clear that regulators have found trading manipulation rules useful as an enforcement tool in the ongoing market turmoil and regulatory uncertainty of the crypto industry. 2023 should prove to be a pivotal year in how this will evolve.

As a regulatory compliance matter, the elevation of market manipulation as a priority for the SEC and FINRA demands attention to firms’ policies and programs. In this, there is a familiar pattern of regulators setting new expectations, offering guidance and warnings, underscoring their intent in the examination process and ultimately in enforcement action. With more and more sophisticated analytics in use, trading abuse cases are easier to detect and to prosecute. That advantage, of course, is not one-sided.

Alex Russell, Bates Managing Director and Regulatory practice leader cautions that “It is extremely important for firms to understand what regulators may be looking to identify within the data. Understanding that helps firms determine the best way forward in anticipating and resolving any issue.”

Bates has substantial experience with matters involving a variety of alleged market manipulation schemes, including: 

• Wash trading 
• Match trading  
• Front running 
• Painting the tape  
• Banging the close  
• Pump & dump schemes involving thinly traded securities 
• High-frequency trading, such as spoofing and layering, as well as in the context of foreign exchange markets 
• Insider trading

Bates frequently assists clients in internal investigations as well as in investigating allegations brought by U.S. authorities (SEC, CFTC, DOJ), self-regulatory organizations (including FINRA and exchanges), international agencies, and private parties. Our experts and staff bring high-level expertise when conducting detailed evaluations of the trading at issue, comparing the activity identified to (i) the pattern of trading for the security as a whole and (ii) the historical trading of the alleged manipulator(s).

We also work with firms to conduct testing and validation of alert systems to ensure supervision and control systems are working as intended.  

Learn more about how Bates Group can help your firm address manipulative trading investigations and controls.

Bates is proud to announce the appointment of Benjamin R. Pappas (pictured) as Chief Executive Officer, effective immediately. Previously, Pappas was Bates Group’s President, where he was responsible for driving the firm’s overall growth strategy. 

Pappas succeeds former CEO Jennifer Stout, who will be taking up new roles as Vice-Chair of the Board of Directors and Senior Executive Advisor to the firm. Client engagement will remain a key priority for Stout. She will continue to maintain close relationships with clients and will be actively involved in conducting outreach to Bates Group's portfolio of financial firms and counsel.  

Stout said, “It has been an honor serving as an executive leader of Bates Group and working alongside our outstanding staff and wonderful clients. As I proceed in my new roles, I look forward to supporting Ben in his new position, and I am confident in Bates’ continued success.”   

“I am excited to further lead and grow Bates with the goal of providing the best possible experience for our clients and staff," said Pappas, "and I am thrilled to continue to work with Jennifer for the benefit of our clients and firm. Our talented and dedicated team has a long history and reputation for delivering high-quality services to our clients while meeting the evolving needs of our industry. I am proud of all that we have accomplished and will continue to achieve going forward.”   

“Ben Pappas’ skilled and strategic leadership has helped expand Bates Group and our services to our industry and clients in many areas, including growing our compliance practices via acquisition of deep subject-matter expertise-led firms and new hires,” said Rob Lee, Bates Group Board Chair. “The Board and I look forward to our continued work with Ben and the many successes he will bring to the firm.” 

Pappas was appointed Chief Operating Officer (COO) of Bates Group in 2016 and President in 2019. Before joining Bates, he was Senior Vice President and COO of D.A. Davidson Companies’ Equity Capital Markets business. There, he was responsible for implementing strategic growth initiatives and developing an annual financial budgeting and forecasting process.  

Stout’s decades-long leadership at Bates Group includes successfully leading and diversifying Bates from a retail litigation-focused expert consulting firm to a nationwide consulting firm offering services and solutions for litigation, regulatory, AML, and compliance clients at broker-dealer, registered investment advisors (RIA), banks, insurance, money services business (MSB), and digital assets firms.  

“The Board and I deeply appreciate Jennifer Stout’s leadership,” Lee said. “Jennifer has helped transform Bates into the widely recognized consultancy firm we are today. We are grateful for her continued leadership on the Board, her involvement in our industry, and her support of our clients.”  

Bates Group is a trusted partner to financial services clients, counsel, and non-banking financial institutions, delivering leading industry expertise, knowledge, and data-driven solutions for legal, regulatory, and compliance matters. With a professional staff and a network of more than 175 independent financial industry experts and consultants, Bates offers services in litigation consultation and testimony, regulatory enforcement and internal investigations, AML and compliance, state licensing, forensic accounting, damages, and big data consulting.

On April 3, 2023, The U.S. Department of the Treasury's Office of Foreign Assets Control (OFAC) unveiled a new website to help individuals and entities access information related to sanctions and international trade compliance. The modernized website is designed to make it easier for users to find guidance on specific industries, use the reporting system, stay current on policy updates, and access OFAC's sanctions database quickly and efficiently.

It features an intuitive user interface, with a streamlined navigation menu which allows users to easily search and access hundreds of frequently asked questions (FAQs) through keywords or exact phrase within the FAQs. Additionally, industry-specific pages are available to help users understand how OFAC regulations apply to their area of expertise. For example, investigators can now easily search for guidance related specifically to conducting investigations under OFAC compliance regulations. The improved search engine also allows for more complex searches across all areas of OFAC’s online presence from one centralized location. Furthermore, the new website has been designed to be mobile-friendly, so users can access essential information from any device at any time.

Overall, this update will make it significantly easier for individuals and entities in all industries to navigate OFAC's sanctions database quickly and accurately in order to ensure compliance with applicable laws and regulations.  While the modernized site is user-friendly, users should be aware that OFAC’s legal requirements remain unchanged—and noncompliance could still result in fines or other penalties. Therefore, it is important for all users to familiarize themselves with all relevant regulations before engaging in any activities with foreign countries or entities subject to U.S. economic sanctions programs.

All financial institutions and any business conducting financial transactions are required to meet the Office of Foreign Assets Control (OFAC) compliance obligations. It is essential to have a well-developed BSA/AML/OFAC compliance program in place that manages compliance risks and promotes best practices for your industry. At Bates, our specialists understand and identify all requirements for different types of financial businesses. Many of our consulting experts have CAMS, CAMS-Audit, CFRM, and CRCM certifications, and some are former AML regulators who understand exactly what government officials are looking for.

Learn More

Join Bates at the IBDC-RIAC Risk Management Conference May 7-10, 2023, at the beautiful St. Regis Hotel in Park City, Utah. Our colleague Ira D. Hammerman (pictured above R) will be featured on the panel “A look at the SEC’s and FINRA’s 2023 priorities and guidance for IBDs and RIAs on how to navigate regulatory scrutiny.” Bates is a proud sponsor of the conference.

Bates Group CEO Jennifer Stout (pictured above L) will also be in attendance and would welcome the opportunity to spend time with you. Jennifer has attended the IBDC-RIAC conference for many years and feels it is one of the best conferences for high-quality content specific to firms in the independent space.

Conference Details and Registration

IBDC-RIAC ANNUAL RISK MANAGEMENT CONFERENCE

May 7-10, 2023 - Park City, Utah

Independent Broker Dealer Consortium conferences are the “go-to” event for serious risk-management professionals. It’s where COOs, CEOs and Risk Management Officers interact with leading securities litigators and compliance, cyber security and insurance specialists. Set at one of the premier resorts in the country, attendees are treated to compelling presentations – plus, the absolute smartest methods to address complex issues affecting the industry. Not to mention, IBDC conferences offer luxurious opportunities to relax, network and socialize on the golf course, in the spa or during a variety of unique, privately-scheduled activities.

Your conference registration includes:

• All food and beverage Monday, May 8- Tuesday, May 9.
• May 9 afternoon activity:  spa treatment, round of golf or a Mines and Wines tour of Park City.
• Return transportation from the resort to Salt Lake City airport the morning of Wednesday, May 10.  

Bates is a proud Diamond Sponsor of the Florida Securities Dealers Association (FSDA) Industry Outreach Program "2023: Unmasking Market Opportunities." on April 21, 2023 at the Boca Raton Marriott at Boca Center. The event will begin at 7:45 a.m. with a networking breakfast and then an 8:30 a.m. to 12 p.m. keynote fireside chat with Florida and SEC regulators, commencing with a legal and compliance panel discussion on the new generation of investors, Fintech, ESG, cryptocurrency, market manipulation, and the gamification of the stock market.

This event was originally scheduled for September 2022 but was postponed due to Hurricane Ian.

Register today to join Bates CEO Jennifer Stout at this re-scheduled program. 

CLE, CPA & CFP continuing education credit pending.

Program Details and Registration

Nicholas Bowman, CFP®, CEP®, MSPFP

Premium Financing Life Insurance, Life Insurance and Annuities, Certified Financial Professional / Fiduciary Duties

Nicholas “Nick” Bowman is a Bates Testifying Expert with more than a decade of experience working in the financial services industry. Nick most recently served as a Senior Advanced Markets consultant for Lion Street, a national Producer Group organization with more than $515 million in annual insurance premium sales, $17 billion in assets under management, and in excess of 1,000 financial advisors. In that role, Nick was responsible for reviewing and managing various financial planning pieces, specifically consulting on High Net Worth and Ultra-High Net Worth Estate Planning, and Life Insurance techniques for more than 300 of Lion Street's advisors. His specialties are centered around Creative Life Insurance Planning and Funding, Premium Financed Life Insurance Planning, Jumbo Life Insurance Policy Staging, Inbound Foreign National Planning, Micro Captive Insurance Planning, and Charitable Planning. He also worked on national initiatives centered around Annuity marketing.  

Full Bio

James A. Kamradt

Due Diligence, Sales and Marketing Practices, Suitability

James A. “Jim” Kamradt is a Bates Testifying Expert with 40 years of experience in the financial services industry, whose diverse and accomplished career focused on the alternative investment sector. Jim has held executive management positions in both capital formation and investments, giving him a deep and well-rounded understanding of the industry.

Jim’s years of experience provides him a deep understanding of the industry which allowed him to develop the skills and relationships necessary to navigate its challenges and capitalize on its opportunities. He has both raised and invested billions of dollars in funding for various investment sponsors and has developed deep relationships with broker-dealers and due diligence firms nationwide. In his years of experience in investments, Jim developed and managed portfolios for both domestic and international institutional investors. In addition, he has been involved in the underwriting of investments.

Full Bio

Bridget McNamara-Fenesy, JD

BD/RIA Compliance, Corporate Governance

Bridget McNamara-Fenesy is a Bates Consulting Expert with more than 30 years of experience in the financial services industry. In addition to her deep expertise in legal and compliance regulatory matters, Bridget also has expertise in corporate governance—working directly with corporate boards to fulfill their fiduciary obligations to shareholders and stakeholders. 

Bridget served as President and CEO to M Holdings Securities, a dually registered broker-dealer and RIA.  She also served as President to M Financial’s Asset Management division and its four proprietary mutual funds. In those roles, Bridget was responsible for the successful implementation and execution of all aspects of running the business, from strategy development to operational efficiencies, to compliance and regulatory matters. Bridget also served on M Financial’s Executive Leadership Team and was responsible for the firm’s corporate governance processes.

Full Bio

David M. Minnick

Senior Investors, Broker-Dealer, Registered Investment Adviser/RIA

David Minnick is a Bates Consulting and Testifying Expert based in St. Louis, Missouri. David uses his diverse experience as a Trial Lawyer, Prosecutor, Defense Counsel, Claimant’s Counsel, General Practitioner, General Counsel (of two NYSE Member Firms), Expert Witness, Arbitrator, Mediator, FINRA Senior Enforcement Counsel and as Missouri’s Securities Commissioner to serve financial services clients and their Counsel. He uses his expertise in Retail and Institutional Securities Litigation and Consulting, Regulatory and Internal Investigations, Compliance and Regulatory Reporting in other matters as well.

David has a deep background in fixed income and equity institutional sales, research, and underwriting in the United States and internationally. He has helped train new and experienced brokers, managers, and other supervisors in retail securities businesses, and led the defense of the firm and its people in Court and Arbitration, as well as in Regulatory Inquiries and Investigations. As General Counsel, he led legal and due diligence efforts for mergers and acquisitions as well as Public Company reporting. David has also been responsible for high-stakes litigation and regulatory matters and was an active advisor for employment-related matters, ranging from claims of discrimination, sexual harassment, wage and hour compliance, recruitment, retention and claims of raiding and unfair competition, as well as employment termination and related reporting (RE-3, U-4, U-5). He has tried dozens of arbitrations and jury trials and has advised on several appellate decisions.

Full Bio

Join Bates Group Managing Consultant John Ashley (pictured) along with experts from Alloy and Chainalysis on this new webinar as they discuss regulatory compliance and best practices impacting companies building crypto-enabled products.

Date: Wednesday, April 19, 2023

Time: 1:00 p.m. ET

Program Details and Registration

As new regulatory frameworks and policies around crypto continue to surface around the globe, it’s crucial that crypto companies stay ahead of the curve. Given the current state of crypto, risk management and fraud prevention is top of mind for everyone involved. So how do you build crypto-enabled financial products without skimping on compliance?

This webinar will cover topics including:

• Designing efficient, scalable risk programs to self-regulate and stay ahead of regulatory requirements

• Leveraging compliance as a cost optimization and strategic business advantage

• Understanding how U.S. regulation should be interpreted today

Not able to attend? Register anyway and Alloy will send you the recording.

John Ashley, CIPP/US, CCRS, CRCMP - Managing Consultant, Bates Group

Caitlin Barnett - Director of Regulation & Compliance, Chainalysis

Charley Ma - Head of Growth, Alloy

Bates Compliance Managing Directors Kurt Waccholz, IACCP  and Hank Sanchez, Esq. (pictured above L-R) will be speaking on panels at the NSCP Interactive Compliance Lab on April 18, 2023, at the Fordham University School of Law in NYC. The Compliance Lab is a full day of in-person lab sessions designed to provide real life application through hands-on learning activities. The day will conclude with a networking reception. 

This event is not available for virtual attendance and is closed to regulators and press. Continuing Education (“CE”) credits available for attendees.

Event Details and Registration

Regulatory Change Management (Session 3a, 1-2:30 p.m.)

Featuring Managing Director Hank Sanchez, this session will help compliance professionals understand how to establish and maintain a regulatory change management program from communications plan and stakeholder buy-in to implementation of change. Attendees will be seated in working groups according to their firm’s size and will learn from knowledgeable facilitators, engage in small group discussions, share their thoughts and experiences through the use of case studies, group questions and hypothetical scenarios applicable to each session’s topic. Attendees will leave with practical and useful tools to apply in their workspace.

Influencing Change: Creating a Culture of Integrity and Ethical Leadership (Session 4b, 2:45-4:15 p.m.)

Featuring Managing Director and Compliance Practice Co-Lead Kurt Wachholz, this session looks at how compliance professionals can add value to their firm or organization by developing more than just the “nuts and bolts” of their Compliance & Ethics program. They must also be able to inspire leaders to model ethical decision-making in order to drive necessary culture changes. Compliance officers need to influence multiple stakeholders across the organization convincing them to accept accountability for managing the risks that can arise from their decisions and actions. To be effective, compliance officers need to continuously develop their ability—regardless of their level and authority—to drive these changes.

The following learning objectives will be met, using case studies, examples, group discussions, and other application activities:

• Identify and explore leadership attributes and necessary skills to be an effective Compliance & Ethics leader
• Discuss the fundamentals of behavioral ethics, including ethical fading and ethical framing 
• Explore strategies for influencing colleagues’ decisions and behavior and overcoming resistance —whether they are peers, direct reports, or senior leaders—in order to drive culture change 
• Facilitate strategic, cross-functional collaboration to support innovation, transformation, and value creation for the broader organization

Learn more about our comprehensive guidance and tailored compliance consulting.

Contact Bates Compliance today

In this illustrative and detailed chartbook featuring economic and capital markets analysis for 2022, we take an in-depth look at historical equity and credit market trends and investment fund flows, with special focus on inflation, employment, and fixed income returns. From Bates Group Director Greg Kyle and President Ben Pappas.

Download the Chartbook

On March 27, 2023, the SEC Division of Examinations (“the Division”) issued a Risk Alert focused on compliance deficiencies found in examinations of newly registered advisers. The Division said these advisers may face unique risks, particularly as to conflicts of interest, and cautioned them to review their policies and procedures, disclosures, and marketing practices. The Division also explained—perhaps as guidance for these new registrants—that their examinations were “an opportunity for early engagement between advisers and the staff.” Here’s a brief summary of what that means.

Observations

In pointing out compliance deficiencies observed during recent examinations of new adviser registrants, the Division highlighted deficiencies in three verticals: policies and procedures, disclosure, and marketing.

On Policy

The Division identified failings in procedures and controls, highlighting observed deficiencies in key risk areas, such as portfolio management and billing; the periodic testing and evaluation of compliance with firm policies (e.g., on best execution); and ensuring that advisory personnel were following firm policies. On personnel compliance, the Division underscored its observation that annual compliance reviews often failed to address the adequacy of compliance with procedure or the effectiveness of their implementation. The Division offered several examples, including (i) the use of off-the-shelf compliance manuals not tailored to the advisers’ operations and business lines; (ii) conflicts of interest that occur when advisory personal have multiple roles and responsibilities; (iii) failures to review the use of compliance outsourced to third parties; and (iv) failures to have adequate business or succession plans.

On Disclosure

The Division found many examples of required documents which omitted information, provided inaccurate information, or were untimely delivered. These included documents on required disclosure as to fees and compensation; business operations and scope of services, advisory services offered to clients, (i.e., investment strategy, aggregate trading, and account reviews); conflicts of interest; and disciplinary information.

On Marketing

The Division discovered misleading information in public materials on a host of issues, including on an adviser’s professional credentials, third party rankings, and business performance.

To support newly registered advisers, the Division included a resource chart (pp. 6-7) with links to relevant laws and rules, regulatory actions, guidance, speeches, no-action and interpretive letters, enforcement actions, and educational materials.

Conclusion

As with the SEC’s risk alerts generally, the Division recommends that newly registered advisory firms assess their supervisory, compliance, and/or other risk management systems and make changes to strengthen such systems. The Division emphasizes that the exam process is intended to help staff understand the adviser’s business, operations, investment activities, and compliance program. Equally as important, the Division said that its interviews and other examination procedures are intended “to assist the staff in assessing the adviser’s tone at the top and culture of compliance,” which are “important factors in the staff’s review of the effectiveness of the adviser’s compliance program.” The message for new registrants in the alert is about ensuring they are on the path of compliance the SEC wants to see going forward. Bates will keep you apprised.

Bates supports firms navigating compliance with SEC rules. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

Registered Investment Adviser Services

Broker-Dealer Services

Private Funds

Compliance Program

Supervision

New Marketing Rule Training (IAR-CE approved course)

Advertising and New SEC Marketing Rule Implementation

The Consumer Financial Protection Bureau (CFPB) is the federal agency charged with protecting consumers from unfair, deceptive, or abusive practices and ensuring that banks, lenders, and other financial companies put consumers’ interests first. The CFPB engages in rigorous examinations of financial institutions to ensure that they follow all applicable laws and regulations, have effective compliance management systems in place, and provide meaningful consumer protections.

Examinations help the CFPB assess whether a company complies with consumer financial protection laws and regulations. During an examination, CFPB examiners review company policies and procedures to ensure they meet legal requirements, evaluate the effectiveness of the company’s compliance management system, and assess how well the company is meeting its obligation to protect consumers. Examiners also communicate directly with consumers to understand how products and services are performing in the marketplace.

CFPB, Enforcement Actions and Local Prosecutions

Did you know the CFPB also works with state regulators on examinations and enforcement actions? The Bureau often coordinates examinations with other federal authorities as part of multi-agency reviews that focus on companies with operations across multiple states or jurisdictions. In addition, when appropriate, it shares information from its work with state attorneys general or local prosecutors who may investigate potential violations of state law involving consumer protection issues.

Protecting Your Business and Customer with a Consumer Compliance Review  

In today’s world, it is more important than ever to protect consumers from unfair practices in the market. A consumer protection review is an effective way to do this and ensure compliance with applicable laws and regulations.

By performing a consumer protection review, businesses can be assured they are compliant with all applicable laws and regulations. Additionally, it helps prevent companies from engaging in fraudulent activities, which could potentially lead to costly legal fines or trouble down the line.

When it comes to safeguarding consumers, Bates Group is a leader in providing comprehensive consumer protection reviews. Our team of industry experts and former state and federal regulators helps companies understand the applicable laws and regulations and how to stay compliant in today’s complex environment.

Bates Group offers independent consumer compliance reviews to evaluate compliance processes and procedures, identify areas where there may be gaps or opportunities for improvement, and develop strategies for compliance. Bates has also helped many organizations comply with CFPB guidelines by providing “readiness” reviews before a CFPB examination.

To book your consumer compliance readiness review and independent consumer compliance review, contact Bates Managing Director Brandi Reynolds.

Bates Consumer Compliance Protection Services

Join Bates Group at the Consensus 2023 conference, April 26-28, 2023 in Austin, TX. Sponsored by CoinDesk, Consensus is the world’s largest, longest-running and gathering of the many, differing elements that make up the crypto community, including developers, investors, founders, brands, policymakers and more.

Meet Bates AML & Compliance Managing Director Brandi Reynolds, CAMS-Audit and Managing Consultant John Ashley, CIPP/US, CCRS, CRCMP to learn about our consulting, program development, audits and reviews, training, and other AML compliance services for businesses handling cryptocurrency transactions.

Conference Details and Registration

In response to the threat from cyber actors “who use constantly evolving and sophisticated tactics, techniques, and procedures to cause harmful cybersecurity incidents,” the SEC proposed a new set of comprehensive rules intended to mitigate that risk. The rule proposal imposes substantial new requirements on certain securities market entities and broker-dealers (“covered entities”) and is intended to protect securities markets and investors from cybersecurity threats. The proposal is consistent with the White House’s recent announcement of a new comprehensive National Cybersecurity Strategy and the annual FBI report on cybercrime trends based on 2022 data. Here’s what you need to know.

Policies and Procedures under Proposed Rule 10

On March 15, 2023, the SEC proposed new Rule 10, which would require financial institutions “to establish, maintain, and enforce written policies and procedures that are reasonably designed to address their cybersecurity risks.” Rule 10 would require that policies and procedures include (i) periodic assessments of risk to the firm’s information systems, and documentation of those assessments; (ii) controls to minimize user-related risks and to prevent unauthorized access to information systems; (iii) internal monitoring and oversight over the firm’s information systems, including as to service providers that interact with the information systems; (iv) methods to detect, mitigate and remediate cyber threats and vulnerabilities; and (v) methods to detect, respond to, and recover from a cybersecurity incident.  

All firms would have to review their cybersecurity policies and procedures to ensure they are addressing new and evolving risk.

Reporting under Proposed Rule 10

Under the proposed new rule, covered entities would have to give notice of a significant cybersecurity incident once they have a reasonable basis to think it occurred or is occurring. That written electronic notice must be reported to the SEC by filing new proposed Form SCIR which covers information about the incident and subsequent response and recovery efforts.

A second part of the new Form concerns summary descriptions to be publicly posted on the firm’s website. Broker dealers would be required to provide the form to customers annually, when they open an account, and when the forms are updated. 

New White House National Cyber Strategy

On March 3, 2023, the White House unveiled its National Cybersecurity Strategy, declaring “fundamental shifts in how the United States allocates roles, responsibilities, and resources in cyberspace.” Generally, the new strategy would (i) “shift[ ] the burden for cybersecurity away from individuals, small businesses, and local governments, and onto the organizations that are most capable and best-positioned to reduce risks;” and (ii) “realign incentives” to defend against urgent cyber threats while “investing in a resilient future.”

First, the strategy would expand regulatory requirements in “critical sectors” (i.e., the financial sector) and update federal networks and federal incident response policy. Second, the new strategy would require greater public-private engagement to disrupt malicious cyber activities “through scalable mechanisms,” and it proposes a comprehensive approach to address ransomware. Third, in relevant part, the new strategy would place the burden of mitigating cyber risks to the privacy and the security of personal data on market entities rather than on individuals, and would “shift liability for software products and services to promote secure development practices.” Fourth, to enhance market resiliency, the strategy would prioritize “cybersecurity R&D for next-generation technologies such as postquantum encryption, digital identity solutions, and clean energy infrastructure. Finally, the strategy calls for strengthening international collaboration to counter cyber threats.  Implementation of the strategy across the Federal system is under the authority of the Office of the National Cyber Director.

FBI 2022 Cyber Report

In its annual report on Internet Crime, published in March 2023, the FBI tabulated complaints filed in 2022 with its Internet Crime Complaint Center (“IC3”). The IC3 is the repository for individual complaints involving a host of cyber-crimes (e.g., hacking, trade secret theft, money laundering, extortion, identity theft, etc.). The IC3 correlates these complaints with data from other sources to support their fieldwork, but also to track trends and threats. The latest report on 2022 data reinforces the concerns expressed by the White House about the increase in number and type of risk cybercrimes pose. It also supports the rationale behind the SEC’s proposed rule.

In 2022, the IC3 reported over 800,000 complaints with over $10 billion in losses. In the report, the IC3 highlighted complaints on business email fraud, investment scams, ransomware, and call center fraud. The numbers are significant. The report cites 21,832 business email complaints (primarily related to compromised accounts and fund transfers) with losses in excess of $2.7 billion. Losses from investment fraud complaints more than doubled since last year, rising to $3.31 billion in 2022. Cryptocurrency investment fraud specifically, rose as well, with losses approaching $2.57 billion in 2022. Noted examples of crypto-investment schemes in 2022 include: “liquidity mining” (victims are induced to link their crypto-wallets to a fraudulent liquidity mining application); hacking into a victim’s social media to perpetrate investment fraud; celebrity endorsements and fraudulent inducements; online real estate scams; and online offers of employment that lead to investment fraud.

In addition, IC3 highlighted over 2000 filed ransomware complaints with adjusted losses totaling more than $34 million. In particular, IC3 noted the 870 complaints related to critical infrastructure sectors (notably, 88 directed at the financial services sector and 107 targeting information technologies.) The highest number of complaints in critical infrastructure concerned the health care sector at 210.

According to the report, the top five cyber-related crime types involved (i) tech support (posting a Year-Over-Year increase at over 32,000;) (ii) extortion (at a similar YOY pace at over 39,000;) (iii) non-payment/non-delivery (a significant reduction YOY at 51,000;) (iv) personal data breach (a substantial increase YOY at almost 59,000;) and phishing complaints (by far the most-reported complaints at over 300,000).

Conclusion

The SEC’s proposed new Rule 10 is consistent with the President’s newly announced national cyber strategy. The FBI report underscores the argument that cyber-crime poses a devastating threat to the economy, securities markets and retail investors thereby justifying the new rules and additional compliance requirements on cybersecurity. As acknowledged in the strategy, the administration recognizes how burdensome these new requirements may be. And that will, no doubt, be the subject of many comments on the SEC’s proposed rule. Those comments will be due 60 days after the proposed rule is published in the Federal Register. Bates will keep you apprised.

For additional information on Bates Group's experts, practices and services, please follow the links below:

Cyber Experts

Bates Compliance

RIA Services

Broker-Dealer Services

Consulting and Expert Testimony

Regulatory and Internal Investigations

MSB, FinTech and Cryptocurrency

Retail Litigation and Consulting

Institutional and Complex Litigation

AML and Financial Crimes

Join Bates at the NMLS 2023 Annual Conference, April 3-6, 2023 in Phoenix, Arizona. This virtual and in-person event attracts a growing number of State and federal regulators, state licensees and federal registrants across the broad spectrum of financial services industries, consultants, law firms, and NMLS education providers, who come together to exchange invaluable information on NMLS user and regulatory compliance issues.

Bates Group Director Matt Summers will be speaking on the Wednesday, April 5 panel "What’s Up with the CSBS Money Transmission Modernization Act?" (1:15-2:15 p.m. MST). Panelists will discuss how states are supporting implementation of the Money Transmitter Model Law, its major provisions, and how the law is a major building block towards building networked supervision.

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Fast-moving events in the financial markets are underscoring the need for a workable digital asset legislative and regulatory framework. With the recent collapse of  Signature Bank and Silvergate Bank, two financial institutions synonymous with “innovation” lending, the broader digital asset investor community is in turmoil.

Ongoing volatility continues to reduce overall crypto market value (by over $2 trillion since 2021) and leaves crypto businesses exposed to additional risk. Federal and state regulators have ramped up enforcement efforts in response. Such volatility is the backdrop to this latest roundup on crypto developments.

Legislative Developments

U.S. federal legislators continue to engage in multiple efforts on crypto-assets. On the Senate side, Senators Cynthia Lummis (R-Wyo) and Kirsten Gillibrand (D-NY) will reportedly reintroduce a “slimmed-down” version of their 2022 Responsible Financial Innovation Act and the Digital Commodities Consumer Protection Act in April. The bill would bring digital assets within the regulatory “perimeter” and direct the CFTC to take the lead. Senator Elizabeth Warren is reportedly set to re-introduce the Digital Asset Anti-Money Laundering Act, a bill that would prohibit financial institutions from using digital asset mixers and other means to facilitate illegal and anonymous transactions. (An analytics firm determined that, in 2022, “total cryptocurrency value received by illicit addresses reached $20.1 billion.”) Also in play is the Stablecoin Trust Act, yet to be introduced this term, that would establish a comprehensive regulatory framework for stablecoins that would explicitly allow both “state-and federally chartered entities” to engage in the activity.

Under Republican leadership, the House Financial Services Committee has taken up a series of bills affecting crypto, including (i) the Keep Your Coins Act, which “preserve an individual’s right to privacy when transacting with digital assets,” (ii) the Financial Technology Protection Act, which would encourage new financial technologies to combat terrorism and other illicit activities; (iii) the Blockchain Regulatory Certainty Act, which would “exempt blockchain developers and providers of blockchain services that do not take control of consumer funds from certain financial reporting and licensing requirements;” and (iv) the Keep Innovation in America Act, which would “amend the digital asset reporting provisions in the Infrastructure Investment and Jobs Act.” The bill would modify the definition of “broker” to exclude those who provide facilities in which others effect sales, or who help operate an exchange but who maintain no records on the terms of the sales. The bill also “sets guardrails around the definition of digital asset,” and requires a study “on the treatment of digital assets as cash for purposes of reporting requirements.”

Regulatory Developments

Banking regulators have been highly visible over the past few months raising significant concerns about crypto risks spreading to other sectors of the financial markets and highlighting gaps in current regulation. On January 3, 2023, the Federal Reserve, the FDIC and the OCC issued a joint statement to banking organizations on the risks of engaging in crypto assets related services. These include risks on custody practices, redemptions, and ownership rights, and concentration risks within the crypto-asset sector. In a second joint statement issued on Feb. 23, 2023, the Fed, FDIC, and OCC alerted banking organizations of crypto asset liquidity risks resulting from unpredictable and potentially unstable crypto deposit inflows and outflows. The agencies cautioned banks to establish and maintain effective risk management and controls to cover these liquidity risks.

Additional notable regulatory actions by the Federal Reserve include two significant decisions (in January and February) in which a state-chartered crypto firm was denied applications to offer its customers financial services in both dollars and digital assets through the federal reserve system. The message is that the bank regulators are not yet ready to incorporate crypto into the traditional banking system.

Chairman Jerome Powell testified to that fact, in a March 7, 2023 Hearing before the Senate Banking Committee. He asserted that “there are real concerns about permissionless public blockchains, and the reason is that they've been so susceptible to fraud, to money laundering and all of those things.” He emphasized that stablecoins are not tools "consistent" with sound banking, stating “Like everyone else we’ve been watching what’s been happening in the crypto space and what we see is quite a lot of turmoil, we see fraud, we see a lack of transparency, we see run risk, we see lots of things like that… What we’ve been doing is making sure that the regulated financial institutions that we supervise and regulate are careful and taking great care in the ways they engage with the whole crypto space."

In another significant agency action affecting crypto, on Feb. 15, 2023, the SEC proposed significant amendments to the Custody Rule, which would require holders of crypto assets and crypto asset companies to register with the agency. The rule would expand the definition of "asset class" to include crypto-assets that are not categorized as funds or securities.

Enforcement Developments

Regulators have pursued aggressive enforcement actions consistent with this rhetoric in light of significant market implosions such as those of FTX exchange and the stablecoin TerraUSD. (The SEC filed over 30 significant cases and imposed $242 million in monetary penalties in 2022. See also, SEC 2022 Enforcement Report.) Recent cases include “staking” claims against a crypto exchange, false and misleading statements by celebrities on social media, insider trading (together with the DOJ), recordkeeping and disclosure failures, conflicts of interest and failures to register a securities offering.

The CFTC pursued cryptocurrency derivatives claims, failure to register and unlawful commodity transactions. The CFTC is poised to exceed the 18 actions it brought in 2022. The Treasury Department has also pursued crypto firms for anti-money laundering and sanctions violations, and the IRS has made clear that it will pursue tax evaders after determining that crypto-assets were capital assets for the purpose of imposing capital gains treatment upon sale.

The amped up activity has led crypto advocates to complain the agencies are regulating by enforcement and stifling innovation. SEC Chair Gary Gensler’s response is that “the cryptocurrency industry is playing a game with his agency,” and that crypto companies “are well aware of what they have to do to operate legally within the U.S. but they’ve decided not to do it.”  

Ongoing State Legislative Activity

The states are not waiting for federal legislators or regulators to craft a comprehensive framework on crypto. The National Conference of State Legislatures tracks these crypto-legislative initiatives and reports that thirty-seven states have now “addressed legislation regarding cryptocurrency, digital or virtual currencies and other digital assets in the 2022 legislative session.”

Two prominent approaches on the registration and regulation of crypto – New York (through the issuance of BitLicenses) and recent efforts by New Jersey (Bates has a comparison of the two here) – increasingly appear to be models for other state legislators who are looking for consistency across jurisdictions for crypto businesses based in their state. (See e.g. remarks from David DeCarlo, Illinois’ first regulatory innovation officer.)

Conclusion

The turmoil in the financial markets that cater to crypto and the continuing meltdowns in crypto exchanges and firms represent a defining moment in the evolution of blockchain products and services. Ongoing volatility, highlighted by legal and enforcement developments in the earlier failures of FTX Exchange, Genesis Global, BlockFi Inc. Celsius Network, Voyager Digital, TerraUSD and Three Arrows is affecting investor sentiment and enhancing risk. Federal and state leaders are pouncing on that volatility and are rushing to address the risk.

In testimony before the House Financial Services Subcommittee on Digital Assets and Financial Technology, Peter Grewel, Chief legal Officer at Coinbase, urged the legislators to pass comprehensive legislation that “will result in rules for the intermediaries that provide access to digital assets in order to enable responsible innovation, ensure consumer protection, and safeguard our national security interests.” He argued for a legislative path to (i) protect consumers, (ii) regulate trading and markets, (iii) list new security tokens and raise capital and (iv) ensure financial stability by embracing a faster and cheaper payments system in stablecoins. Whether a divided Congress and ambitious state representatives can make that happen is still uncertain. The need to make that happen is not. Bates will keep you apprised.

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

To learn more about our services or to talk to one of our professionals, contact Bates today.

by Greg A. Kyle, Director and Expert

In the aftermath of the collapse of three banking firms, Silvergate, Silicon Valley Bank and Signature Bank earlier in March, tensions in the banking sector continued over the past week with the shares of a number of regional banks including First Republic, PacWest Bancorp and Zions Bancorp under pressure. During the turmoil-filled week, several questions were raised about the strength of U.S. banks, whether regulators moved quickly enough, the role of venture capitalists, and if the failures were foreseeable.

We’ll start with the last question first.

Were the Banking Failures Foreseeable?

For many, nothing depicts a bank run like the classic film It’s a Wonderful Life. In the film, a bank in small-town middle America was faced with rumours over the safety of depositors’ money. In the movie, the citizens of Bedford Falls worriedly gathered at the doors of the Building & Loan early one morning waiting for it to open. They hoped to withdraw all their cash as rumours were spreading about the health of the institution.

After the seizures of Silicon Valley Bank and Signature Bank by their respective state regulators, there were rumours, internet chatter, and numerous people in the news who—after the fact—stated that the collapse of those two banks were clearly seen months prior. But was the sudden collapse-by-bank-run of Silicon Valley Bank and Signature Bank foreseeable? Despite what some have stated or speculated, the short answer is no.

As students of history, we’ve studied financial crises and bank failures from the Great Depression to today, and one fact that stands out is that, although bank runs have occurred in the past, the two precipitous bank runs that Silicon Valley Bank and Signature Bank faced were as unexpected as they were unprecedented.

The early 1930s was a defining moment for the U.S. banking sector. In the wake of the stock market crash of 1929, the American public was nervous about any other potential financial disasters that could loom on the horizon. This made the period ripe for rumour and speculation and led to the 1930s being marked by a series of bank failures, with over 9,00 banks shuttering their doors between 1930 and 1933. In total, depositors lost over $7 billion in these failed banks—an estimated 20% of all bank deposits in the U.S. at that time. The dramatic impact these failures had on depositors led to the creation of the Federal Deposit Insurance Corporation (“FDIC”) in 1933.[i] Since then, bank failures and bank runs have been much less common.

During the savings and loan crisis of the 1980s to 1990s, nearly 3,000 financial institutions failed. There were sporadic runs during that period, but they were limited. The general view from the FDIC was that “deposit insurance virtually eliminate[d] the risk of bank runs,” with the only bank run of significance during this period being Continental Illinois National Bank and Trust Company in May 1984. At the time, Continental Illinois was the seventh largest bank in the U.S.

It wasn’t until the financial crisis in 2008 that bank failures rose sharply again. Between 2008 and 2010, over 300 banks failed, the majority due to lax credit requirements and significant losses on non-performing assets tied to the commercial and residential real estate markets. In 2008, several major institutions were hit with bank runs or large deposit outflows, the most notable being Washington Mutual at the height of the financial crisis. After the fall of Lehman Brothers in September 2008, WaMu experienced a bank run with $16.7 billion in deposit outflows over an eight day period. Following the collapse of Washington Mutual, Wachovia Bank also experienced significant deposit withdrawals on September 26, 2008, with outflows totaling $5.7 billion on that Tuesday.

Wachovia’s bank run on September 26 amounted to roughly 1.3% of total deposits that day. Washington Mutual’s bank run, while substantial, was spread over an eight-day period and averaged 1.1% of total deposits per day. There were a number of other bank runs in 2008, and the deposit outflows of those banks averaged between 0.2% and 0.8% of total deposits per day.

Fast forward to today. In contrast to the bank runs during the financial crisis, the bank runs on Silicon Valley Bank and Signature Bank were of a magnitude never previously experienced in U.S. history. According to California regulators, SVB experience $42 billion in deposit withdrawals on Thursday, March 9. With a deposit base of $169 billion, the bank experienced a precipitous bank run of 25% of its total deposits in a single day!

Similarly, Signature Bank also appears to have experienced a precipitous bank run. According to a CNBC article, in the wake of SVB’s sudden collapse, Signature Bank experienced $10 billion in deposit withdrawals in just a few hours late on Friday afternoon. With $89 billion in deposits, the late Friday bank run on March 10 amounted to 11% of total deposits. As can be seen in the chart below, the two bank runs experienced by SVB and Signature Bank that Thursday and Friday were, by far, the largest and swiftest runs in U.S. history.

Given the history of bank runs, it simply was not reasonable to believe, both in terms of magnitude and velocity, that the sudden precipitous bank runs on SVB and Signature Bank were foreseeable.

Did Venture Capitalists Play a Role?

What could explain the magnitude of the concentrated withdrawals? Rumours abounded that venture capital firms accelerated the collapse of Silicon Valley Bank by allegedly advising their portfolio companies to withdraw funds from SVB, while simultaneously withdrawing their own cash. Due to the concentrated nature of SVB’s depositor base (i.e., heavily concentrated in technology, health care and life sciences companies, with an early-stage focus), it’s plausible that a text or email blast, or other mass digital communication from a credible source (like venture capital firms) could produce an outsized reaction like the rapid and massive withdrawals that SVB experienced on March 9. Even without VC firms recommending to their portfolio companies to move money out of SVB, the concentrated focus on early-stage technology companies could also have impacted the deposit run-off rate (withdrawals). As discussed in our previous Banking Alert, in a rapidly rising interest rate environment, technology companies were experiencing a large-scale decrease in funding opportunities, causing them to burn through capital more quickly than in prior periods.

Quality of Assets – What is the Strength of the U.S. Banking Sector?

It’s worth remembering that plummeting share prices (often panic-driven) are one thing, but fundamentals are another. And, in terms of fundamentals, the banking sector is stronger today than in the past. As we wrote in our last Banking Alert, capital requirements have been strengthened, liquidity is stronger than in the past, and the quality of capital is better today than during the financial crisis.

During the financial crisis, in aggregate only 10% of a bank’s assets were in government fixed income securities (U.S. Treasuries and Government Agency). Today, in contrast, banks have a much stronger asset base with nearly 20% of commercial banking assets in U.S. government securities. When cash is included, the share of high credit quality assets is at 33%, nearly three times what it was in early 2008.

And, when it comes to liquidity coverage using a strict measure such as cash held by banks as a percentage of total deposits, the banking sector is also much stronger today than during the financial crisis. In 2008 at the beginning of the financial crisis, cash held by commercial banks was less than 5% of total deposits. Today, in aggregate commercial bank cash holdings are 18% of total deposits. This does not include high quality liquid assets (“HQLA”) included in available-for-sale securities that banks hold today.

With the rapid rise in interest rates, those banks that did not adequately manage duration or asset-liability matching are seeing higher interest rate risk (and the associated price risk) exposure and unrealized losses. If those high credit quality securities do need to be sold, then unrealized losses can turn into realized losses. However, it’s worth bearing in mind that there is virtually zero credit risk associated with U.S. Treasury and Agency bonds, and these securities, despite changes in interest rates, will mature at par, thus reversing and eliminating the unrealized losses.

Did Regulators Move Quickly Enough, or Were Regulators Asleep at the Wheel?

Although it is too early to draw definitive conclusions, it appears that state regulators moved quickly and decisively to seize the two banks before further damage could be done. With Silicon Valley Bank, the California Department of Financial Protection took immediate possession and closed the bank after seeing the massive, unprecedented deposit outflows on Thursday. In Signature Bank’s case, New York Department of Financial Services seized the bank over the weekend. Although the specific reason was not given, it appears (at least from the CNBC article mentioned earlier) that it was due to significant deposit outflows late Friday, March 10. Each respective regulator acted within one business day to stem losses and minimize damage. In contrast, during the financial crisis, regulators waited days or even weeks as banks were experiencing runs on their deposits before acting.

There has also been some discussion that the roll-back of certain sections of the Dodd-Frank Act led to the collapse of SVB. At this point, that does not appear to be the case. The Dodd-Frank Act was passed in the aftermath of the financial crisis to protect consumers and taxpayers by tightening regulations for banks that were considered systemically important. Originally, the threshold of a systemically important institution was defined as one with total consolidated assets of $50 billion or greater. Banks above that threshold were required to conduct regular stress testing which, among other factors, take into account various economic scenarios and the impact of changing interest rates on a firm’s capital levels, asset prices and earnings. In 2018, the definition of a systemically important bank was changed to only include institutions with assets totaling over $250 billion. Silicon Valley Bank, with total assets of roughly $210 billion, fell under that threshold.

Would maintaining the threshold at $50 billion and requiring regular stress testing have prevented the failure of Silicon Valley Bank and Signature Bank? It appears unlikely. The sudden failure of these two banks were ultimately the result of precipitous one-day bank runs, and the stress tests detailed in the Dodd-Frank Act—and provided by the Office of the Comptroller of the Currency (“OCC”)—do not include bank run scenarios let alone single-day deposit outflows of the magnitude experienced by Silicon Valley Bank and Signature Bank. It should be noted that the Liquidity Coverage Ratio (“LCR”) implemented with Basel III is a requirement of Section 165 of the Dodd-Frank Act. However, in calculating LCR, deposit run-off rates ranging between 3% to 10% over a 30-day period are used. These deposit run-off rates would not be considered a bank run.

Going forward, protecting bank customers against massive bank runs will be an interesting policy debate. Gone are the days of depositors lining up around the block with deposit slips in hand waiting to withdraw their money. In the modern digital era when cash can flow quickly between institutions in a matter of minutes if not seconds, the question becomes how can banks protect themselves from sudden and extreme deposit outflows? What level of liquid assets (i.e., HQLA) relative to the deposit base should banks have on hand in order to meet potential large, single-day outflows? Should the definition of HQLA as detailed in Basel III and adopted by the Dodd-Frank Act be changed? Should the FDIC raise the level of deposit insurance from $250,000 to a higher level? Should regulators, or banks, be able to declare a banking holiday until concerns abate? What other measures can regulators enact to protect consumers and taxpayers from precipitous, massive bank runs in the future?

These are interesting policy and regulatory questions that are unlikely to be decided soon.

Other Thoughts

Did Silicon Valley Bank grow its assets too quickly? There has been some discussion that the rapid growth in SVB’s assets was a red flag of growing problems. However, it would be hard to argue that the rapid growth in assets was abnormal considering the massive increase in deposits that originated in early 2020 with the onset of COVID. Even today, deposit levels have remained very high (see chart below).

According to a report by the Federal Reserve, the ratio of deposits to GDP has remained above 75% since early 2020. That same report identified four trends impacting the sustained high ratio: (i) rapid draw down of commercial and industrial lines of credit; (ii) the Fed’s asset purchases; (iii) fiscal stimulus related to COVID; and (iv) a higher personal savings rate due to COVID. An interesting area for further investigation would be the extent to which the lack of loan demand (i.e., an absence of high demand for bank credit) during the pandemic period may have led to increased purchases of longer duration assets in order to earn a positive spread against a growing deposit base.

In terms of Silicon Valley Bank’s rapid asset growth, although total assets did grow from $71 billion at the end of 2019 to $211 billion at the end of 2022, U.S. government bonds as a percentage of total assets went from 36% in 2019 to over 50% in 2022. At the end of last year, 91% of the bank’s available-for-sale and held-to-maturity securities were in U.S. Treasuries and Agency bonds. It appears that the rapid growth in assets did not translate into a rapid growth in credit-riskier assets, rather a rapid growth in high-quality assets. Further, the bank was considered financially sound by California regulators prior to the precipitous bank run on March 9.

In an effort to restore investor and depositor confidence in First Republic Bank, a consortium of banking entities extended $30 billion in deposits in a major cash infusion to the bank. These included major financial institutions such as JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley and others. The importance of regional and small banks within the overall financial ecosystem was flagged explicitly as a rationale for the move. Larger financial institutions, those dubbed “too big to fail” after the crisis in 2008, experienced a spike in deposits amidst the bank turmoil, perhaps reflecting a belief that they would not be allowed to fail regardless of FDIC protection limits. A further $121 billion poured into money market funds, reflecting additional uncertainty around the banking sector, with nearly $100 billion coming from institutional sources and the remainder from retail investors. These inflows and outflows may have prompted the “vote of confidence” in First Republic by the larger entities.

And Credit Suisse? Internationally, Credit Suisse was offered 50 billion Swiss francs (approximately $54 billion) in liquidity facilities by the Swiss National Bank in an effort to improve its liquidity last Wednesday. The bank had experienced extensive challenges, including the withdrawal by depositors of 123 billion Swiss francs ($133 billion) in the fourth quarter of 2022. In February, the global bank also reported an annual net loss of $7.3 billion, the largest net loss since the global financial crisis. Its shares had declined by about 23% already this year.

Ultimately, UBS announced on Sunday that it would be acquiring Credit Suisse for around three billion Swiss francs, with Credit Suisse shareholders receiving one share in UBS for every 22.48 shares held in Credit Suisse. This value equates to approximately 0.76 Swiss francs per share, or about three billion Swiss francs in total. The Swiss National Bank participated by pledging up to 100 billion Swiss francs in loans to support the transaction, and the absorption of losses on certain assets above a preset threshold meant to reduce the risk to UBS from the acquisition. The move was generally applauded as a step towards additional stability in a rattled global banking system.

Greg Kyle is a Bates Group director and expert based in New York. He uses his extensive background in the securities industry to consult and provide expert witness testimony on matters involving fixed income and credit market performance and analysis including mortgage- and asset-backed securities, equity market and security valuations, sector and asset allocation analysis, and fund risk disclosures. Mr. Kyle still actively analyzes the financial markets and publishes analyses of the economy and the capital markets.

by Greg A. Kyle, Director and Expert

It’s been a chaotic and whirlwind week in the banking sector. On Sunday, March 12, U.S. regulators seized Signature Bank, and on Friday, U.S. regulators seized the assets of Silicon Valley Bank (“SVB”). The seizure of SVB led to one of the largest bank failures in U.S. history and the largest failure of a financial institution since the 2008 financial crisis. SVB, with approximately $209 billion in assets, is the second largest failure, the largest was the collapse of Washington Mutual with approximately $300 billion in assets in 2008. The failure of SVB comes on the heels of Silvergate Capital announcing on Wednesday that it would voluntarily wind down operations and liquidate its bank.

These back-to-back bank collapses in one week spooked the financial markets on Thursday and Friday, leading to a sharp sell-off in a number of banking stocks. Shares of PacWest Bancorp (PACW) fell 37.9% on Friday, Signature Bank (SBNY) shares were down 22.9%, First Republic (FRC) fell 14.8% and Western Alliance Bancorp (WAL) shares were down 13%. Larger banks were also impacted, losing $52 billion in market value during the course of Thursday’s trading.[i]

Adding to market concerns was U.S. Treasury Secretary Janet Yellen’s comments before the House Ways & Means Committee Friday morning in which she stated, “There are recent developments that concern a few banks that I'm monitoring very carefully. And when banks experience financial losses, it is and should be a matter of concern.”[ii]

This has raised questions regarding the stability of the banking system and whether we could be facing a replay of 2008’s financial crisis. Although we cannot predict the future, the banking system is stronger today than during the 2008 financial crisis. For one, capital requirements have been strengthened. In 2008 the average Tier 1 common capital ratio dropped close to 5%[iii], while today, in contrast, Tier 1 capital ratios are on average around 12% as depicted in the chart below from the Federal Reserve. Another factor is that the quality of capital is better today than during the financial crisis. And third, liquidity positions are much stronger. In aggregate, the banking industry’s holdings of liquid assets (liquid assets as a share of total assets) are at 24%, nearly four times higher than in 2008.

So what did happen with SVB and Silvergate Capital that led to their collapse last week? We believe that very different driving factors precipitated the collapse of each bank.

While it’s still too early to draw definitive conclusions, it appears that Silicon Valley Bank’s collapse started with a traditional failure of managing interest rate risk due to a mismatch between its assets and liabilities. This led to a historical issue highlighted in the film It’s a Wonderful Life, as opposed to some new technology-related risks. As subsequent information showed, duration (or cash flow) mismatching increased the bank’s exposure to interest rate risk and led to losses when it sold securities. In addition, the bank was also hit with a classic, if unwarranted, historical run on a bank.

A Primer

First, a primer: In effectively managing interest rate risk, financial institutions use a duration matching strategy to match the duration (maturity) of a pool of assets with the duration (maturity) of a pool of liabilities.[iv] In other words, short-term liabilities should ideally be matched or offset by short-term assets. However, if deposits (liabilities) are all short-term in nature and securities (assets) are all long-term in nature, then to pay back liabilities or deposit withdrawals, an institution may need to sell long-term assets if not enough cash on hand is available to meet liabilities. This may be fine in a period of stable interest rates when there is unlikely to be a significant change in the value of long-term bonds for instance, but if interest rates begin to rise those bonds will begin to lose value as a result.

During periods of very low interest rates, firms may be tempted to purchase longer-term assets despite holding short-term liabilities in order to try and increase the spread being earned (the difference between the rate paid by the bank to depositors and the rate earned on the bonds, for instance). The risk in this strategy is that when interest rates rise and those longer-term securities need to be sold, those securities would be sold at lower prices than when purchased, resulting in sometimes large losses. The longer the duration of a bond, the more sensitive the price is to changes in interest rates.

This is because there is an inverse relationship between interest rates and bond prices. When interest rates rise, bond prices fall, which is in fact what occurred with fixed income securities recently. As the Fed rapidly increased interest rates in 2022 and early this year, bond prices experienced one of their worst declines in prices in nearly a hundred years.

Silicon Valley Bank

Now back to Silicon Valley Bank. On Wednesday, March 8th SVB filed a current report with the SEC providing a mid-quarter update. In the update, the company announced that it sold $21 billion in securities resulting in an estimated $1.8 billion realized loss.[v] On Thursday, March 9th Standard and Poor’s downgraded SVB Financial Group to BBB- citing among other things, a higher than expected “pace of deposit outflows”[vi] in the first two months of 2023. The reason for the higher-than-expected deposit outflows was because of the concentrated nature of its deposit base (customers), about 40% of which were from early-stage technology and life science/health care companies. With a slowdown in venture funding in late 2022 and early this year, those early-stage companies were burning through their cash stockpiles (deposits) at an accelerated rate. In order to meet those withdrawals, SVB sold the $21 billion in available-for-sale fixed income securities which resulted in a $1.8 billion loss.[vii]

The $1.8 billion loss appears to be due to an issue known as duration mismatching and forced selling. The bank’s deposits were virtually all short-term in nature (could be withdrawn at any time). However, the available-for-sale securities were primarily intermediate and longer-term in nature. According to SVB Financial Group’s annual filing with the SEC, at the end of 2022 the firm had $13.8 billion in cash and cash equivalents, and $26.1 billion in available-for-sale securities, primarily in U.S. Treasuries and Agency MBS securities. Of the $26.1 billion, only 4% were in securities with a maturity of one year or less. Roughly 56% were in securities with a maturity between one and five years and approximately 40% were in securities of five years or greater. Remember, the longer the duration (maturity) of a bond, the greater the sensitivity of that bond’s price is to changes in interest rates.

Adding to the bank’s woes, it turned out that there was a precipitous run on the bank on Thursday, March 9th. According to a filing by California regulators on Friday, March 10th, despite the bank “being in sound financial condition prior to March 9, 2023, investors and depositors reacted [to the bank’s prior day’s financial update] by initiating withdrawals of $42 billion in deposits from the Bank on March 9, 2023, causing a run on the Bank.”[viii] This forced California regulators to take possession of the bank and name the Federal Deposit Insurance Corp. (“FDIC") as the receiver.

Silvergate Capital

Unlike Silicon Valley Bank, which had “minimal exposure to cryptocurrency and digital assets”[ix] Silvergate Capital and its subsidiary, Silvergate Bank, was an institution that was heavily concentrated in the cryptocurrency and digital asset sector and made the decision to voluntarily wind down its operations. As a result of the dramatic downturn/meltdown in the crypto sector, Silvergate experienced a 68% fall in customer deposits in the last quarter of 2022 and posted a $1 billion net loss.[x] The heavy concentration in the crypto sector, in addition to governance concerns,[xi] severely weakened its financial position and led to low Tier 1 capital levels.

There were additional issues with Silvergate. On March 1st, the company announced in a regulatory filing with the SEC that it was unable to timely file its annual report for 2022 and that the large losses would “negatively impact the regulatory capital ratios” with the result that the bank could be “less than well-capitalized.”[xii] Silvergate also stated in its SEC filing that it was evaluating its ability to continue as a going concern.

Different circumstances, different fundamentals for Silvergate compared to Silicon Valley Bank.

Signature Bank

On Sunday evening, March 12th, just as this banking update was going to press, New York State Department of Financial Services announced that it was taking possession of Signature Bank and appointing the FDIC as receiver "in order to protect depositors."[xiii] The New York based financial institution had deposits totaling $89 billion as December 31, 2022 and total assets of $110 billion. Although the bank had been considered one of the major banks in the cryptocurrency space, it disclosed in its annual 10-K filing with the SEC that it was focused on reducing exposure to the digital asset sector, and as of December 31, 2022, the bank’s digital asset exposure was 20% of total deposits.

Is Contagion a Risk?

Where does that leave the banking sector as a whole? While high-profile, these three bank collapses do not appear to hint at a larger malaise in the financial sector. It’s worthwhile to remember that bank failures are a relatively common occurrence. Since the financial crisis, the U.S. banking system has experienced over 215 bank failures (although in the last six years, only 18 banks have failed).[xiv]

And—as we pointed out earlier in this update—capital ratios, the quality of assets, and liquidity positions are much stronger today than during the lead-up to the financial crisis. The continued adoption of Basel III capital requirements is also strengthening financial institutions in the U.S.

While there may be risks for individual banks, the risk of contagion and systemic banking failures appears unlikely. Rising interest rates could continue to negatively impact bank profit margins as some banks may not have effectively matched the duration of assets to liabilities leading to interest rate risk. However, unlike 2008, credit risk appears to be minimal as much of the securities being held by banks today consist largely of U.S. Treasuries and other government (Agency) bonds. Also, the majority of banks have a diversified deposit base and solid liquidity position.

To calm fears of a contagion and strengthen public confidence in the U.S. banking system, the U.S. Treasury, the Federal Reserve and FDIC released a joint statement on Sunday evening announcing that depositors in both Silicon Valley Bank and Signature Bank would be fully protected and “will have access to all of their money starting Monday, March 13.”[xv] The terms provided in the joint statement indicated that senior management at both entities had been removed, and that “shareholders and certain unsecured debtholders will not be protected.” The statement also indicated that “no losses will be borne by the taxpayer” and that any such losses will be recovered by a special assessment on banks as in a typical takeover.

The one thing that cannot be foreseeably predicted is the risk of a widespread crisis in confidence in the banking system and a wholesale run on deposits. Then again, panic runs are rarely supported by underlying fundamentals. Bates will continue to keep you apprised.

Greg Kyle is a Bates Group director and expert based in New York. He uses his extensive background in the securities industry to consult and provide expert witness testimony on matters involving fixed income and credit market performance and analysis including mortgage- and asset-backed securities, equity market and security valuations, sector and asset allocation analysis, and fund risk disclosures. Mr. Kyle still actively analyzes the financial markets and publishes analyses of the economy and the capital markets.

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Consumer protection laws are designed to protect consumers from deceptive practices and products. These laws help to keep sellers honest and to protect purchases of goods from fraudulent or deceptive marketing. Consumer protection laws are enforced by the Federal Trade Commission, and businesses that fail to maintain compliance with federal consumer protection laws could face severe consequences. At Bates Group, our team of experienced consultants can provide consumer protection law compliance assistance. Call us today to learn more. 

What are Consumer Protection Laws?

The Bureau of Consumer Protection with the Federal Trade Commission (FTC) is responsible for stopping unfair, fraudulent, and deceptive business practices that negatively impact consumers. Consumer protection laws are varied and multiple, ranging from laws about robocalls, scams, fraud, deceptive advertising, credit reporting, environmental claims, and much, much more. 

Key Consumer Protection Laws

While there are dozens of laws that are designed to protect consumers, there are three that stand out as especially important: 

• Federal Securities Act. The Federal Securities Act was the first piece of legislation passed that was designed to regulate the stock market. There are two primary goals of the legislation: First, to ensure that businesses cannot engage in misrepresentation and fraudulent activities in the securities market, and second, to improve transparency and informed decision-making around investments. Today, investors are entitled to receive financial information regarding securities that are offered for public sale. A breach of the securities act can lead to large fines and even prison time. 
• Fair Credit Reporting Act. The Fair Credit Reporting Act, or FCRA, regulates the way in which credit reporting agencies can collect, share, and use consumer report data. The FCRA gives consumers the right to know when their data is used to deny a loan or line of credit, provides access to one’s own credit report, restricts others’ access to one’s credit report, and more. 
• Dodd-Frank Act. Officially called the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Dodd-Frank Act arose out of the 2008 financial crisis. The act reorganized the financial regulatory system, created new agencies, restricted the emergency lending power of the Federal Reserve, and put in place regulations to prohibit lending companies from taking advantage of consumers. 

Why a Compliance and Risk Management Program is Essential For Your Firm

Compliance with consumer protection laws and regulations is essential to every bank, lender, or MSB. Your company must have a comprehensive and effective compliance program in place to avoid penalties, fraud, losses to customers, and other types of liability.

Every financial company should have a compliance risk-management program that is specifically designed for the company based on size, relative risk, and operational details. There are different components to these programs, such as:

• Policies and procedures for each role in the organization that ensure consumer protection compliance
• Monitoring, internal controls, and audits to test the effectiveness of the program
• Regular risk assessment
• Having proper management information systems
• Oversight from senior management or board of directors
• Training for employees subject to the compliance program

Consumer Compliance Protection from Bates Group

Consumer compliance protection is an essential part of how your business is managed and operated. If a business fails to comply with consumer protection laws, it could face severe consequences. At Bates Group, our consumer protection compliance consultants can help. Reach out to our team today for services and expertise you can count on. 

CONTACT BATES

Bates is proud to be back in person as a returning sponsor of the SIFMA C&L 2023 Annual Seminar, March 12-15 at the Marriott Marquis San Diego Marina. Hosted by the SIFMA C&L Society, hear industry leaders’ perspectives on the current regulatory and enforcement environments, lessons learned thus far, and what they're seeing on the horizon.

Visit us at booth #516 to reconnect with Bates colleagues and to learn about our latest products and services. Speak with our representatives to find out what they are seeing and hearing and how our team of experts can help you with your litigation, regulatory, and compliance matters, including support to address 2023 regulatory priorities, such as:

• Reg BI & Form CRS
• SEC New Marketing Rule (Compliance, Individual and Company Training)
• Supervision, Policies & Procedures, including Replication/ Validation of Alert Systems
• Big Data analysis of specific products (mutual funds), actors (FA theft), or activities (market manipulation)
• BD, RIA, Hybrid, Digital Assets & Cryptocurrency AML, Compliance and Litigation, and more.

While you're there, don't forget to pick up helpful materials (including articles, white papers, and other resources), and take home some fun giveaways.

We look forward to connecting with you at the show!

Conference Details and Registration

Bates Group is a trusted partner to financial services clients, counsel, and non-banking financial institutions, delivering leading industry expertise, knowledge, and data-driven solutions for legal, regulatory, and compliance matters. With a full professional staff and a network of over 175 independent financial industry and regulatory compliance experts, Bates offers services in litigation consultation and testimony, regulatory enforcement and internal investigations, AML and compliance, state licensing, forensic accounting, damages, and big data consulting. Contact us today to learn more.

Contact Bates

Bates Managing Director Ira D. Hammerman was recently featured in ThinkAdvisor (Melanie Waddell) and Law360 (Aaron West) on joining Bates Group. Ira’s move was also mentioned in Politico’s Influencer and SIFMA’s Smart Brief newsletters. Please read more at the links below:

Former SIFMA General Counsel Hammerman Joins Bates Group - ThinkAdvisor

Financial Services Consultant Bates Group Adds Former SIFMA GC - Law360

POLITICO Influence Newsletter - Caitlin Oprysko | 03/06/2023

Read the Bates Announcement

Ira D. Hammerman - Managing Director

In the coming months, the New Jersey legislature is expected to pass the Digital Asset and Blockchain Technology Act A2371/S1756 (“the Act”), a bill that would establish one of the broadest licensing and regulatory frameworks on digital assets in the country. On January 19th 2023, the bill was adopted by the New Jersey Senate Appropriations Committee by a wide margin, virtually guaranteeing its passage. The legislation is being closely watched as it offers companies a more comprehensive alternative to the current standard for the regulation of digital assets prescribed under New York law (see Comparison Chart below). Here’s a short summary.  

The New Jersey Framework 

The Act aims to create an enabling environment for businesses to transact in digital assets and use blockchain technology under rules that protect consumers. The proposed regulatory framework would allow entities to register as "Digital Asset Service Providers" (DASPs) 

in order to engage in transactions involving digital assets, secure their data on blockchain networks, and make use of smart contracts. The new framework would reduce legal uncertainty and enable businesses to reap the benefits of using digital assets and blockchain technology. Consumers would be assured that their transactions will be legally valid, thereby making digital asset usage even more attractive. The new framework is intended to foster an environment that would promote innovation while ensuring proper legal safeguards. If enacted, it will be a significant change to the regulatory framework for organizations providing cryptocurrency services to residents of New Jersey.   

Requirements for Certain Activities  

Under the Act, businesses would require licensure by the bureau if they engage in the following activities: 

• Receiving a digital asset for transmission or transmitting a digital asset, except where the transaction is undertaken for nonfinancial purposes and does not involve the transfer of more than a nominal amount of a digital asset 

• Storing, holding, or maintaining custody of a digital asset on behalf of others, exempting all custodians otherwise regulated as a bank, trust, broker-dealer, or credit union in any state or by the United States or as a money transmitter licensed in New Jersey 

• Buying and selling digital assets as a customer business 

• Performing exchange services of digital assets as a customer business

• Issuing a digital asset

• Borrowing or lending or facilitating the borrowing or lending of customer asset 

The Act shifts regulatory oversight to the New Jersey Bureau of Securities (“the Bureau”), which has been active in enforcing cryptocurrency and blockchain-related matters. Key regulatory provisions of the Act include:  

• Regulation by the New Jersey Department of Banking and Insurance, which is responsible for supervision and enforcement of the Act 

• Clarification that digital assets are not to be considered securities or money transmission instruments 

• Licensing requirements for businesses engaging in virtual currency business activity, including registration fees and other conditions  

• Standards of conduct for virtual currency businesses, such as providing consumer disclosures, maintaining records and safeguarding assets  

• A framework for the use of smart contracts

• Immunity from civil and criminal liability for depositors who are not engaged in virtual currency business activity

• Establishing a digital asset owner’s right to control their own digital assets, including freedom from seizure or confiscation.  

Licensing, Fees, Minimum Capital, Reporting Considerations 

The Act requires all businesses to obtain a license from the State of New Jersey Department of Banking and Insurance before engaging in any activities that involve digital assets or blockchain technology. This includes companies providing retail and custodial services, digital asset trading platforms, digital asset clearing and settlement services, and digital asset storage companies.  

The Act also sets out a number of requirements for licensees, including minimum capital levels that must be held by the company as well as compliance procedures for anti-money laundering and consumer protection programs. In addition to licensing requirements, the Act outlines the obligations of licensees to supervise their operations, report suspicious activity, and maintain records of all transactions.  

Finally, the Act imposes a series of sanctions on businesses who fail to comply with the licensing requirements or associated regulations which includes a penalty of $500 per day, from the first day the department issues a notice of failure to apply a license until a license application is filed with the department. 

Once enacted, the Bureau will issue a form document that all digital asset businesses that conduct business with the people of New Jersey will need to complete and submit along with a $1,000 nonrefundable fee. In addition, the Bureau will require new disclosure and compliance regimes as far as it decides are appropriate, and within the confines of the law. The proposed penalties for failing to abide by the provisions of the license could be as much as $10,000 for a first offense and $20,000 for a second offense, as well as $500 a day for conducting a digital asset business without a license. The Act follows the trend for more aggressive and robust enforcement abilities and compliance regimes for digital assets as governments look to protect consumers and punish bad actors in the space.  

The bureau has said that they will grant or deny any license application within 120 days of receipt of a completed application. 

How Does New Jersey’s Proposed Act Compare to New York's?

Chart compiled by Matt Summers, Director, MSB and State Licensing, Bates Group

Conclusion 

The New Jersey Digital Asset and Blockchain Technology Act is more comprehensive than the New York BitLicense framework. It follows a trend of aggressive and robust compliance enforcement as regulators demonstrate their efforts to protect consumers and punish bad actors.  

It takes into account the custody and control concerns that have led to cryptocurrency frauds and bankruptcies. By creating comprehensive regulations, the New Jersey Act may offer better protection for licensees than the NY framework. Bates will keep your apprised of developments.

Bates can help businesses understand the licensing requirements of the New Jersey Digital Asset and Blockchain Technology Act. Our experienced team of AML, compliance and state licensing professionals, is well-versed in understanding the nuances of this Act and how it applies to distinct types of business operations. We provide a comprehensive assessment, addressing all areas of licensing acquisition and maintenance throughout the United States, including within hard to obtain license states, such as New York.

Contact us today to discuss this article and your licensing needs: 

Contact Bates

 Hear Bates Group's Managing Consultant Lindsey Dean and Alison Jimenez, Independent Expert (pictured above, L-R), speak at the NASAA 2023 Enforcement Training, March 7-9, 2023. Their panel is “Attorneys’ Guide to Identifying Red Flags in Financial Disclosures” on Wednesday, March 8 at 2:10 p.m. CT.

This in-person and online training is a two-and-a-half-day program designed to educate learners on current enforcement-focused hot topics and to help build skills to assist participants to advance along their career paths. This year's Enforcement Training agenda was developed by the NASAA Enforcement Section’s Training Project Group and features speakers from state and provincial securities regulatory agencies and from a variety of industry-related organizations. Attendees are encouraged to select either Track 1 (Investigator) or Track 2 (Attorney) to best fit with their goals and areas of specialty.

In-person registration is closed; Online seats still open.

Program Details and Registration

We are proud to announce that Ira D. Hammerman has joined Bates Group as Managing Director. Mr. Hammerman was Executive Vice President, General Counsel, and Secretary of SIFMA for nearly 19 years before retiring in 2022. Beginning in 2004, he oversaw SIFMA’s legal and compliance-related advocacy, including comment letters, litigation, and regulatory relationships. His tenure covered a wide range of strategic issues impacting the industry, from its response to the Credit Crisis of 2008 to the Dodd-Frank Act of 2010 and from SIFMA’s advocacy on SRO Reform to its pursuit of the best-interest standard of care for broker-dealers, the preservation of the commission brokerage model of financial advice for retail clients, and the industry response to the effects of the COVID-19 pandemic.

Mr. Hammerman was also a member of the Executive Committee of SIFMA’s Compliance & Legal Society where he routinely collaborated with the senior most business, legal, and compliance leaders in the financial services industry and became known for his thought-provoking interviews of high-profile industry regulators and leaders at conferences and events.

“We are extremely honored to welcome Ira Hammerman to Bates Group,” says Bates Group CEO Jennifer L. Stout. “Ira is an icon in the financial services industry — a thought leader and spokesperson with four decades of unrivaled experience navigating legal, compliance, litigation, and regulatory issues and relationships, including nearly two decades as SIFMA’s General Counsel.” 

“I am delighted to be joining the Bates team, where I have known some of the principals for decades, and look forward to serving our client firms and their counsel,” said Mr. Hammerman.

Previously, Mr. Hammerman was a partner of Clifford Chance, where, for 19 years, he represented the financial services industry on securities regulatory and enforcement matters before the SEC, FINRA, and state regulatory authorities. Mr. Hammerman is based in Park City, Utah where he serves as a board member and active volunteer with the National Ability Center, a charitable organization whose mission is to empower individuals of all abilities by building self-esteem, confidence and lifetime skills through sport, recreation, and educational programs.

Full Bio
 

Bates Group is a trusted partner to financial services clients, counsel, and non-banking financial institutions, delivering leading industry expertise, knowledge, and data-driven solutions for legal, regulatory, and compliance matters. With a full professional staff and a network of over 175 independent financial industry and regulatory compliance experts, Bates Group offers services in litigation consultation and testimony, regulatory enforcement and internal investigations, AML and compliance, state licensing, forensic accounting, damages, and big data consulting. Contact us today to learn more.

Contact Us

FINRA proposed amendments to the Codes of Arbitration Procedures for Customer Disputes and Industry Disputes that would affect the arbitrator list selection process. The proposed amendments would also make clarifying changes on administrative practices. The amendments stem from a report published in June, 2022, that was commissioned by FINRA’s Audit Committee of the Board of Governors (“the Lowenstein Report”). Based on an analysis of a recent case involving the arbitrator list selection process, the report made recommendations to better “reflect the neutrality of the DRS [dispute resolution services] forum and to further promote uniformity and consistency among the different DRS regions.” (See prior Bates coverage.)

Arbitrator Selection Process

Substantive aspects of the proposed amendments address potential conflicts of interest in the arbitrator selection process. The proposed amendments would:

• Specifically state that prior to sending to the parties an arbitrator list generated randomly from the DRS roster of arbitrators, the DRS’s Neutral Management Department “shall conduct a manual review for conflicts of interest”;
• Clarify that the Director will exclude arbitrators from the lists after a review of current conflicts of interest not identified within the list selection algorithm;
• Codify that the Director provide a written explanation to the parties of a decision to grant or deny a party’s request to remove an arbitrator; and
• Clarify that the Director may remove an arbitrator for conflict of interest or bias, either upon request of a party or on the Director’s own initiative, any time after the arbitrator ranking lists are sent but before the first hearing session begins.

The proposed amendments would also make procedural and clarifying changes on administrative practices, as to prehearing conferences or special hearings (by video,) and hearing sessions (in person), protection of personal confidential information (redactions); responding to claims (including amendments and third-party claims), motions practice (to ensure all parties have timely filings and notifications), dismissals (insufficient service and awards), and hearing recordkeeping (on distributing copies and executive sessions). If the Commission approves the proposed rule change, FINRA will announce the effective date of the proposed rule change in a Regulatory Notice.

Conclusion

Efforts at ensuring fairness and transparency in processes can only strengthen FINRA’s dispute resolution system as a trusted venue to resolve claims. For practitioners, these detailed changes in practice and procedure must be reviewed thoroughly. Bates will keep you apprised.

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About Bates

Bates stands ready to support clients with their FINRA arbitration matters. Our Securities and Financial Services Litigation practice provides retail and institutional litigation consulting and data-driven analytic support and solutions for broker-dealers, RIAs, banks and insurance companies. Our quantitative analysis and qualitative case strategy, advice, and expert testimony cover the full spectrum of investment activity. We work closely with our clients to examine the issues, markets, industry, regulatory context, historical analogy, and other experts’ work product to develop thoughtful, precise, and dispassionate analysis and testimony based on experience and judgment.

Bates also offers Arbitrator Evaluator™ – your source for FINRA arbitrator selection. It summarizes disclosure reports into one easy-to-read document, helping to streamline your arbitrator ranking and selection process. Powered by 30 years of SAC awards data and FINRA arbitration decisions, Arbitrator Evaluator saves you research time and provides essential information and links to awards for better decision making.

For more information about our services, please visit:
Securities Arbitration and Litigation Services 
Damages Analyses and Data Analytics
Arbitrator Evaluator™ - Arbitrator Ranking and Selection Tool
Expert Consulting and Testimony
Find a Senior Investor Expert
Complimentary "ABCs of Financial Schedules" CLE training for your team - Contact us to schedule.

Bates Compliance is a proud sponsor of the 2023 IAA Compliance Conference, March 12-14, 2023, in Washington, D.C. This year's in-person conference will provide investment advisers with the most current information available on the changing regulatory landscape.

Hear Bates Compliance Managing Director Kurt Wachholz (pictured, L) speak on the panel "Ethics for Advisers: Compliance with Fiduciary Standards - Part 1" on Tuesday, March 14 from 8-9 a.m. The panel will discuss codes of ethics requirements and best practices for monitoring, testing, administering, and enforcing these policies. (CE credit available)

Visit our booth in the exhibit hall and connect with Bates Compliance Director Rory O'Connor (pictured, L) to learn about practical insights and best practices that can help you maintain a successful compliance program, including:

• Annual Updating Amendment
• Annual Compliance Meeting
• Policies & Procedures
• Annual Review
• Compliance Calendar

While you're there,  pick up materials on compliance solutions for your firm, including individual and firm-wide training on the new Marketing Rule, SEC 2023 Exam Priorities, and more to help you achieve regulatory and compliance success. 

CONFERENCE DETAILS AND REGISTRATION

The Bates Compliance team of experienced compliance professionals offers comprehensive guidance and tailored compliance consulting solutions to our investment adviser, broker-dealer, and hybrid firm clients on an as-needed or ongoing basis, assisting them with compliance, risk mitigation, AML, supervision, and internal control functions. Contact us today to learn more.

In late March, 2022, the SEC Division of Examinations (“Exams Division”) set forth strategic priorities for the year to restore “trust necessary for our markets to thrive," during a “time of heightened market volatility.” According to leadership, last year’s emphasis was on “emerging issues, such as crypto-assets and expanding information security threats, as well as core compliance gaps affecting retail investors.” (See Bates 2022 exam priorities summary and chart.)

Ten months later, on February 7, 2023, the Exams Division announced a new focus, reflecting a shift in priorities for 2023 based on the need to adapt to “growing markets, evolving technologies, and new forms of risk.” The emphasis in this year’s SEC priorities announcement remains on protecting retail investors. However, the new priorities reflect the agency’s latest rulemakings, compliance expectations around earlier rulemakings and further adjustments toward “a risk-based approach to examination selection that balances our resources across a diverse registrant base.” In the report, the Exams Division is emphasizing compliance with the new marketing rule, new investment company regulations on derivatives and fair valuation, expectations around Regulation Best Interest (“Reg BI”), and registered investment advisers’ duties as to private funds.

While there is overlap concerning subject matter between last year and this year (see Bates annual priorities comparison chart below), the priority shift toward ensuring compliance with the new rules has important implications for all regulated market participants. Here is our summary of the announced priorities for 2023.

SEC Leadership Messages

In the report, the SEC Exams Division leadership team reported on their efforts over the past year to: (i) respond to continued “market volatility, cyber-events, and market disruptions caused by recent bankruptcies and financial distress among crypto asset market participants;” (ii) promote compliance through risk alerts, exam deficiency communications and the instant priorities report; (iii) communicate about focused exams and enforcement sweep initiatives; (iv) engage in national and regional office proactive outreach; and (v) convey useful observations and information to the policy divisions working on rules and amendments. The leadership team also described internal organizational efforts made possible through the use of specialized working groups (in, e.g., technology, trading practices, complex products and marketing, and others,) to prevent fraud, monitor risk and better inform policy.

The SEC Division leaders also reported that, in fiscal year 2022, it examined approximately 15% of a growing registered investment adviser (“RIA”) population with more than $125 trillion in assets under management, and completed over 360 examinations of broker-dealers. Together with FINRA, the SEC said it examined nearly half of the approximately 3,500 registered broker-dealers during the course of the year.

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Top Areas of SEC Focus for 2023

Highlighted Priorities for 2023

As can be seen in Bates’ 2023 priorities chart above (which maps out the changes in examination priorities since 2015), beyond the announced highlights, the Division expects registered entities to up their compliance efforts, particularly as to risk-based supervision, on all existing priorities. The Division highlighted the following priorities:

Marketing Rule

The Exams Division will examine for written policies and procedures covering the new rule and firms’ practices to ensure those rules are being followed. As described in a previous Bates post, advisers must lock down their documentation and reporting processes, and claims related to performance and services must be able to be substantiated. Advisers will need to be able to back up those claims. The SEC previously noted that they were concerned with, among other things: communications of hypothetical performance; reliability of performance communications; offers to expand a financial relationship; communications related to cross sales; information on investment strategies; and, in general, any adviser/intermediary/third-party distributed material conveyed to the investor.

Regulation Best Interest

The Exams Division stated that it will keep up its scrutiny of broker-dealers and advisers on compliance with their obligations under Reg BI, particularly by reviewing firm practices on management of conflicts of interest of all kinds, practices regarding considerations of investment alternatives vis-a-vis investment goals and account characteristics. The Division emphasized that it will zoom in on recommendations made on complex products, like derivatives and leveraged exchange-traded funds; “high cost and illiquid products, such as variable annuities and non-traded REITs;” and unconventional strategies, among others.  (See also, recent Bates’ post on latest insights into FINRA and SEC Reg BI and Form CRS compliance.) In addition, the Division stated that it will review “agreements that purport to inappropriately waive or limit their standard of conduct, such as through the use of hedge clauses.”

Derivatives and Fair Valuation Rules

The Exams Division said it will test whether funds, including investment companies, mutual funds, exchange traded funds and business development companies, have policies and procedures and appropriate management programs, board oversight, and adequate disclosures to address derivative risk. The report noted that more than 35% of all RIAs (more than 5500) manage nearly 50,000 private funds with more than $21 trillion in gross assets.

The Exams Division will examine funds’ compliance with the new fair value rule, including reviewing board oversight, recordkeeping, and “permitting the funds’ board to designate valuation designees to perform fair value determinations.” The Division also said it will review funds’ valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping and any adjustments that have been made pursuant to the new rule requirements.

Private Funds

Consistent with the above priorities, the Exams Division will review RIA compliance under their fiduciary obligations. The Division said it will look at compliance and risk management programs, fees and expenses, conflicts of interest, marketing and performance advertising, and the “use of alternative data.” This is in addition to reviewing compliance on custody, portfolio strategies, and investment recommendations with a particular emphasis on (i) funds that are highly leveraged; (ii) private funds managed in tandem with business development companies; (iii) those that hold hard to value investments like crypto assets and real estate; and (iv) Special Purpose Acquisition Companies (“SPACs”).

Ongoing Priorities

Carried over from last year, the Exams Division said it continues to prioritize compliance requirements on crypto assets, environment, social and governance considerations, on information security and operational resilience and on anti-money laundering compliance. 

Crypto Assets

The Exams Division will continue to focus “on the offer, sale, recommendation of, or advice regarding trading in crypto or crypto-related assets.” The exams will focus on practices that utilize “technological and on-line solutions to meet the demands of compliance and marketing and to service investor accounts,” from online trading to robo-advisers to automated tools and platforms. The Division cautioned that its exams may reach into an “entity’s history, operations, services, products offered, and other risk factors.”

ESG

The Division will continue to prioritize exams on ESG-related advisory services and fund offerings, particularly as to whether fund disclosures are adequate and accurate, and whether recommendations on ESG products are in the best interest of the retail investor.

Information Security

The Division warned that the risk level is elevated with respect to cybersecurity threats to RIAs, broker-dealers, investment companies, municipal advisers, transfer agents, exchanges and clearing agencies. The Division said it will review recommendations, governance, disclosure and risk management policies and procedures, as well as practices to protect investor information, records, and assets.

The Division highlighted that it will review cybersecurity issues concerning the use of third-party vendors. This includes “the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers.” That also means that the Exams Division will look at firms’ practices to prevent account intrusions and to safeguard customer records and information.

Anti-Money Laundering

Among the perennial compliance concerns the Exams Division prioritized is advisers and broker dealers’ obligations under the Bank Secrecy Act. The Division reported that due to the “current geopolitical environment and the increased imposition of international sanctions,” the risk level is elevated. As a result, the Division will be reviewing firm compliance to ensure that AML programs are tailored to firm risks based on, among other things, location, size, activities, customers, and products and services. The Division also will continue to examine the firm’s programs, policies and procedures to test whether they are “reasonably designed to identify and verify the identity of customers and beneficial owners of legal entity customers, perform customer due diligence, monitor for suspicious activity, and, file Suspicious Activity Reports (SARs) with the Financial Crimes Enforcement Network."

General Compliance Considerations

In the report, the Exams Division reminds registered firms of their general compliance obligations. Though not highlighted by subject matter in this year’s report, they reinforce the message that there will be no let-up in general compliance oversight while underscoring the specific areas of focus identified above. The report contains chapters for RIAs (on compliance with “core functions” as to how RIAs’ operations and practices incorporate current market factors that might impact valuation and reporting accuracy); Registered Investment Companies (on the fiduciary obligations RIAs have toward registered investment companies – particularly, with respect to compensation); and broker-dealers (on supervisory programs over, for example, electronic communications related to firm business.)

Conclusion

A good companion piece to this year’s Exams Division report would be the SEC Enforcement report issued in November 2022 (see, Bates post) which highlighted enforcement actions concerning Reg BI, complex products and strategies, conflicts of interest, and also included descriptions of important cases concerning private funds, cryptocurrency, cybersecurity and ESG. Taken together, firm leadership can get a good sense for how many ways and how quickly compliance failures could blossom into enforcement actions.

On subject matter, this year’s Exams report offers few surprises, as the top priorities relate to recent rulemakings (i.e., marketing rule, fair valuation and derivatives) and not-so-recent prior rulemakings that the SEC expects firms to have absorbed into their compliance programs and culture (i.e., Reg BI). As to expectations around adviser and broker-dealer standards post-enactment of Reg BI, it seems clear that similar considerations now permeate private funds practice as well. This is consistent with observations made last year that the Division’s priorities reflect new rules. As this year’s Bates chart shows, compliance regulation continues to expand to cover more products, more services, and more perceived risk. Bates will continue keep you apprised.

Contact

Bates Compliance 

• Reg BI Services and Support

• RIA Compliance Services

• Broker-Dealer Compliance Services

• Bates Investor Risk Assessment for Vulnerable and Senior Investors

• Anti-Money Laundering and BSA Compliance

• MSB, FinTech and Cryptocurrency

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Bates Group and the Future Leaders of SIFMA's Compliance & Legal Society invite you to participate in an insightful discussion on lessons learned from crises in the financial markets followed by a networking reception.

Register today to join rising talent from across the compliance and legal profession on Wednesday, February 15 from 3:30 - 6:30 p.m. ET at Debevoise & Plimpton's offices in New York City. Bates Director and Expert Greg Kyle (pictured above) will be speaking on the panel.

CLE credit will be available for this program.

Program Details and Registration

Barbara Armeli, Managing Director & Chief Compliance Officer, Charles Schwab & Co.

Andrew Ceresney, Partner, Debevoise & Plimpton

Greg A. Kyle, Director, Consulting & Testifying Expert, Bates Group

Matthew Morningstar, EVP & Head of Litigation and Regulatory Affairs - Compliance, Legal and Risk, LPL Financial

Matt Colongeli, Executive Director, Head of the Consumer Office, Morgan Stanley

Romance scams are a growing concern, as evidenced by The Federal Trade Commission’s report that romance fraud is one of the most costly forms of consumer fraud in the United States.

As AML and compliance professionals, we all know how the scam works, including these typical warning signs:

• The other person is very quick to profess their love to the targeted individual.
• They are constantly asking for financial help, such as wiring money or providing gifts.
• They make excuses about why they cannot meet in person.
• They will not video chat with you.

However, how do you as a compliance professional spot romance scams?

The goal is to identify any unusual or suspicious transactions that could indicate romance scams. These could include:

• Large deposits, withdrawals, and transfers in the victim's accounts.
• Payments made to third parties with no apparent connection to the account holder, such as online payment services or overseas entities.
• Wire transfers that appear to be out of character or done without the account holder's knowledge.

Elderly people are particularly vulnerable to romance scams. Senior  romance scam victims may be less likely to report being scammed out of fear of embarrassment, or they may not even realize they have been taken advantage of until it is too late. Therefore, it is increasingly important to monitor accounts of elders and vulnerable persons more closely for any activity that is not considered normal transaction activity.

Elder Exploitation Red Flags and Bank Secrecy Act Obligations

In an advisory alerting financial institutions of “rampant fraud and abuse targeting older adults,” the Financial Crimes Enforcement Network (FinCEN) highlighted new behavioral and financial red flags last year to help in the identification, prevention, and reporting of suspected elder financial exploitation (“EFE”). 

As detailed in our reporting last year,  FinCEN at that time reminded financial institutions that it is critical for “customer-facing staff to identify and consider [ ] behavioral red flags when conducting transactions involving their older customers,” and that the details should be incorporated in SARs filings. They listed twelve behavioral red flags in all, among them sudden and unusual changes in contact information, an unusual degree of fear or submissiveness by a client toward a caregiver, and unexplainable or unusual account activity. FinCEN listed an additional twelve financial red flags, including sudden or frequent non-sufficient fund activity, customer purchases of large numbers of gift cards or prepaid access cards, and uncharacteristic attempts to wire large sums of money, among others.

The FinCEN advisory also reminds financial institutions of their Bank Secrecy Act obligations, including SARs reporting, currency transaction reporting, reports of cash payments over $10,000 received in a trade or business, foreign bank and financial accounts reporting, and registration of money services business, among others. As FinCEN Acting Director Himamauli Das then stated: “Financial institutions serve on the frontlines in protecting their older customers’ finances, and can play a critical role in helping to identify, prevent, and report suspected elder financial exploitation. Financial institutions’ vigilance matters. Their reporting matters.”

Conclusion

Money laundering investigators should always be aware of romance scams, their indicators, and potential victims. AML and compliance officers have an obligation to monitor and report suspicious activities. Taking the time to investigate any suspicious activities or transactions can help stop romance scammers in their tracks and prevent individuals from falling victim to fraud.  Awareness is key to stopping romance scammers in their tracks and keeping vulnerable individuals safe.

Bates Group is committed to working with your firm to develop strong AML and compliance programs for banks, broker-dealers, money services business and digital asset firms, including virtual and cryptocurrency firms. Learn more about how we can help strengthen your AML and compliance program at the following links below:

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For Litigation support, including elder and senior investor expert consultation and testimony, please visit:

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In its latest annual report on examinations and risk monitoring, FINRA offered the regulator’s perspective on strengthening compliance programs on Regulation Best Interest (“Reg BI”) and the corresponding Form CRS. FINRA included observations from its compliance reviews on each of the core duties under the two-plus-year-old rule, including addressing the care in handling recommendations, conflicts of interest, required disclosure of material facts to retail clients, establishment of supervisory policies and procedures, and all aspects related to preparing a Form CRS. These areas were also the focus of an SEC Division of Examination Alert on broker-dealer compliance with Reg BI and in the SEC’s 2023 Priorities list released earlier this month.

A few weeks prior to the issuance of the FINRA annual report, Bates held a webinar on the same subject, joining colleagues from the legal and compliance community to delve deeper into how broker-dealer firms—including small- and mid-size firms—are adapting their compliance programs in light of repeated communications[1] by the SEC and FINRA that Reg BI will be a focus of their examinations. The insights offered from both the regulatory officials and private consulting community offer perspective on what lies ahead. Here are the takeaways.

FINRA 2023 Report: Highlights on Reg BI and Form CRS

On Reg BI, the FINRA report references the four-duty standard (duties on care, conflicts of interest, disclosure, and compliance) under the regulation. Under the categorical heading “Communications and Sales,” FINRA poses questions, based on examinations to date, prompting broker dealers to consider whether they are covering their obligations under each of these duties.

Reg BI Duty of Care

Under the Reg BI duty of care, FINRA asks broker dealers to consider whether the firm is exercising an appropriate level of diligence, care and skill before making recommendations to retail investors.

• Observations: FINRA observed that firms made recommendations that failed the duty of care standard that were based on inadequate consideration of product risks, costs, account types, the investor’s profile (particularly with respect to retirement accounts,) and alternative products, among others. In a list of “effective practices,”
• Recommendations: FINRA suggested that firms include in their procedures and processes (i) the costs and reasonably available alternatives to recommended products; (ii) outlines of documentation practices; (iii) limitations on complex or higher-risk products; (iv) supervisory steps for reviewing recommendations; (v) heightened scrutiny of investments for retail customers (including mitigation and review processes to identify and categorize product risk and complexity).

Reg BI Conflicts of Interest

Under the Reg BI duty on conflicts of interest, FINRA asked broker dealers to consider whether the firm’s policies and procedures are adequate to identify, monitor for, disclose, mitigate or eliminate any conflicts.

• Observations: FINRA cited firm failings around conflicts arising from compensation incentives, investment strategies (such as only making recommendations of the firm’s proprietary products,) and material limitations on those strategies, that caused “an associated person or the firm to place their interests ahead of the retail customer’s interest.” (The agency provided a “non-exhaustive” list of examples of these practices.)
• Recommendations: FINRA also asked firms to ensure their supervisory procedures (including monitoring for, and imposing penalties on, associated persons who fail to manage for conflicts) are adequate to the task. Among highlighted practices, FINRA suggested that firms use conflicts committees or create “matrices” that “address conflicts across business lines and how to eliminate, mitigate or disclose those conflicts;” and “broadly prohibit” all sales contests.

Reg BI Duty to Disclose

Under the Reg BI duty to disclose, FINRA asked firms to consider whether their disclosures fully and fairly contain all material facts as to the firm’s relationship with their retail clients.

• Observations:  Examples of representative’s failures to adequately disclose transaction fees and costs, investment strategies and other material information) at the time of the transaction. FINRA also prompted firms to consider the adequacy of their controls on electronic disclosure and updates to disclosures around changed circumstances concerning products and recommendations.
• Recommendations: FINRA suggested that firms implement systems for tracking delivery of Form CRS and Reg BI-related documents to retail investors and retail customers in a timely manner and a process to memorialize delivery of required disclosures “at the earliest triggering event.”

Reg BI Duty of Compliance

Under the Reg BI duty of compliance, FINRA questioned firms on whether their policies and procedures (including written supervisory procedures and the provision of staff training) were tailored to address the firm’s retail customers and product and service offerings.

• Observations: FINRA underscored that policies and procedures must be kept updated (particularly for supervision) and tested to ensure adequacy. FINRA emphasized that firms should consider how they will demonstrate (i.e. document) compliance with these requirements.
• Recommendations: FINRA suggested that firms (i) monitor associated persons’ compliance on a monthly basis (at least), and (ii) create systemic alerts for conflicts, high risk products and “account type or rollover or transfer recommendations that may be inconsistent with a retail customer’s best interest.”

FINRA also prompted firms to periodically update their Form CRS to ensure that it is consistent with changes to its business of product offering and ensure that procedures adequately “track and memorialize” the delivery of disclosure documents to retail customers.

SEC Risk Alert

On January 30, 2023, the SEC Division of Examinations issued a Risk Alert on broker dealer compliance deficiencies with Reg BI which mirror many concerns raised in the FINRA Annual Report, including failures to have tailored written policies and procedures, continued use of pre-Reg BI surveillance and training programs, insufficient compliance programs on identifying and mitigating conflicts of interest, and disclosure failures. The SEC reiterated their focus on Reg BI in their 2023 Priorities Report released this week.

Find a Reg BI Expert

Bates Webinar on Reg BI Compliance

Bates and NICE Actimize shared recent experiences with broker-dealer firms navigating compliance with Reg BI.

Rhonda Davis, Managing Director of the BD/RIA Compliance Practice at Bates Group, offered practical advice for responding to regulator expectations and highlighted the “process gaps” that exist for many firms, particularly small- and medium-sized firms. First, she recommended establishing a conflicts committee (or, depending on size, a conflicts officer) to look across all the business lines and consolidate a list of all potential conflicts into an inventory of identified conflicts and how the firm intends to mitigate or eliminate them. This is what regulators are looking to see, she said.

Second, Ms. Davis recommended a more robust effort on disclosure, beyond reliance solely on Form CRS (or, for dual registrants, in combination with Form ADV). She sharedthat the limitations on these forms (page length, required scripts) does not provide enough room to disclose all identified conflicts or to adequately describe products. She noted, “We’ve helped firms write an additional disclosure document such as a ‘Broker Dealer Services Disclosure Summary’ in which we evaluate identified conflicts, identify sources of revenue (e.g., trading execution, mark-up or -down costs, clearing firm costs), and disclose conflicts that may not be disclosed on Form CRS or ADV.”

Third, she recommended customized training relevant to the firm. She cautioned that training by a third-party service provider will usually include some standard elements but may lack the specificity of what is required for a particular firm or for the products they sell. She said, “It is clear that the SEC and FINRA are now looking for very specific training, particularly in the alternative space.” This is echoed in issues that come up in reviewing policy and procedure. She went on to note that “some firms tend to buy off-the-shelf manuals, so what they get is largely templated language that describes the regulation, but fails to specify the who, what, when, where and how the policy is actually implemented and how the activity is supervised.”

Jan Folena (Partner, Stradley Ronon) honed in on the latest lessons from recent enforcement actions, sharing insights on the four Reg BI standards.

• On duty of care, she noted that a recent enforcement action looked at whether the registered representatives fully understood the product they were selling—the benefits, risks, costs and whether the firm offered alternative products. “Unlike the fiduciary requirement for advisers,” she said, “Reg BI looks at the circumstances around the recommendations you are making at the point of sale.”
• On conflicts, she urged firms to (i) identify the areas that create a real or potential conflict, and (ii) understand that the requirement to mitigate any conflict is risky for firms because the term “mitigate” is not defined in the broker-dealer context. She recommended that firms consider avoiding compensation thresholds, minimizing compensation incentives, potentially capping credit to avoid favoring one product over another, but to be careful about limiting investor choices.
• On disclosure, she emphasized that representatives have a duty to disclose material facts about the scope and terms of the relationship with the client, conflicts of interest and any material information about the security being offering including material changes in circumstance—all at the time of sale.
• On the Reg BI duty of compliance, she observed that “compliance violations go hand-in-hand with substantive violations of a rule.” She pointed to the one enforcement case brought to date to emphasize that regulators are looking to see whether a representative understands the product they are recommending. If the SEC concludes that they didn’t understand the product, she said, the representative is out of compliance with the duty of care and SEC will look to flag the firm for a compliance violation. She urged representatives to be able to demonstrate document that they “understand the product, why it was appropriate for the client, and what the alternatives are.”

Anand Maheshwari, Senior Product Manager, NICE Actimize, concentrated his remarks on how automation can help firms comply with Reg BI requirements. In particular, he asserted that automation can help with creating an evidentiary trail to back up a recommendation and show that the representative did what they had to do at point of sale. He said that “automated measures can help compliance officers answer whether advisers recommended x, understanding their customers’ risk tolerances and other circumstances.” He stated that these processes can help to “produce written supervisory procedures, inform audit reports, provide access to product alternatives when recommendations are being made, and create alerts to stop a suspect transaction.” He also suggested that automated processes can help supervisors to better understand training needs.

Conclusion

The FINRA report and the SEC Examinations Division observations and report are must-reads for compliance officers looking to address the full scope of their responsibilities. As to Reg BI, the FINRA and SEC guidance reflects the continuing complexity of complying with the rule more than two years after implementation. That complexity shows up in the Bates-NICE discussion which highlighted that there remains significant uncertainty about how to satisfy the requirements and how to demonstrate that compliance. Shoring up process gaps, making greater disclosures beyond Form CRS, conduct product training , and using technology to evidence that the firm offered alternatives are some recommended steps for firms to consider.  Bates will keep you appraised.

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[1] The SEC issued two bulletins since Reg BI went into effect: one in March, 2022 on broker dealer account recommendations to retail investors, and one in August, 2022 on conflicts of interest. That interpretive guidance was described recently by Aaron Ellias, Senior counsel, SEC Division of Investment Management in an SEC Compliance Outreach National Seminar held in December. He highlighted the following: the “first bulletin reflects staff understanding that selection of account type is an extremely consequential decision for retail investors, particularly given the extent to which characteristics of a particular account type can impact its appropriateness for a given investor and their objectives; we also understand that this decision can be associated with potentially significant conflicts of interest.” The first bulletin’s key takeaway was that “the firm or financial professional have a reasonable basis for their account recommendation based on a reasonable understanding of the retail investor’s profile, as well as the account characteristics.”

Mr. Ellias stated: “the second bulletin addresses the fact that all broker dealers and investment advisers and their financial professionals have at least some conflicts of interest with their retail investors … economic or other incentives to recommend products or services or account types that provide more revenue or benefits for the firm, their financial professionals even where those recommendations may not be in the best interest of their retail investors.” 

Bates Group’s Compliance team helps firms navigate and achieve compliance with Reg BI and Form CRS, including:

• Disclosure obligations
• Duty of care obligations
• Conflicts of interest obligations
• Additional compliance obligations

We can assist you with:

• Developing and reviewing Reg BI Client Relationship Summary (“Form CRS”)
• Conflicts of interest assessment
• New product approval processes
• Drafting new policies and procedures
• Training for compliance and sales professionals on how to comply with Reg BI and Form CRS

To speak with a Bates representative about your Reg BI needs, please contact us today.

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The Securities and Exchange Commission’s Division of Examinations has just released its 2023 examination priorities report, focusing on New Investment Adviser and Investment Company Rules; RIAs to Private Funds; protections for Retail Investors and Working Families; Environmental, Social, and Governance (ESG); Information Security and Operational Resiliency; and Emerging Technologies and Crypto-Assets. The Division publishes its examination priorities annually to provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets. You can read the press release here. 

Stay tuned for our annual commentary and chart, coming soon, on the SEC's 2023 exam priorities and how they may impact your legal, regulatory and compliance matters.

FINRA 2023 Exam and Risk Monitoring Report with Bates Chart and Summary

SEC 2022 Exam Priorities with Bates Chart and Summary

Bates Group AML Compliance and Virtual Assets Managing Director Brandi Reynolds, CAMS-Audit, will appear at the upcoming SWIFS Lunch and Learn "Fireside Chat: Crypto in the News" - Tuesday, February 14, 2023, presented by Southeastern Women in Financial Services.

This 90-minute virutal program will be moderated by Stefanie Wayco (Shareholder, Maynard, Cooper & Gale), and joining Brandi on the panel will be Shannon Eng (Head of Financial Crimes Compliance, Coinbase).

by Brandi Reynolds, Managing Director

Are you a regulated financial institution that operates in New York? If so, it is important to familiarize yourself with the New York State's Department of Financial Services (DFS) Rule 504. The rule was put into place in 2017 and requires companies to establish anti-money laundering (AML) programs that meet the DFS’s specific and strict requirements, and to certify compliance with the regulation annually to the DFS.

What Is NY DFS Rule 504?

The purpose of DFS Rule 504 is to prevent money-laundering activities from occurring within the state of New York. It requires businesses that operate in the state to have AML policies and procedures in place. This includes having designated personnel responsible for implementing these policies, as well as training employees on how to identify suspicious activities and report them accordingly. Additionally, businesses must have systems in place to monitor transactions and track customer information.

The rule also requires businesses to perform customer due diligence (CDD) when onboarding new customers or clients. This involves collecting certain pieces of information about the customer, such as name, address, date of birth, and other identifying information. The purpose of CDD is to verify that the customer is who they say they are, as well as ensure that they are not engaging in any illegal activities or being used by another party for criminal purposes. Businesses must also perform ongoing monitoring of their customers' accounts to ensure that nothing suspicious is taking place. This monitoring must be continuously tested, tuned, and refined to meet the business’s risks. Finally, businesses must maintain records of all transactions so that they can be reviewed periodically for compliance with DFS Rule 504 regulations.

Why Is It Important To Comply With DFS Rule 504?

It is important for businesses operating in New York State to comply with DFS Rule 504 because failure to do so could result in serious penalties or even revocation of their license. Non-compliance could lead to fines or other disciplinary action taken against the business by the regulator responsible for overseeing their operations.  Regulated Institutions should submit the required certification covering the prior calendar year by April 15 of each year via the DFS Portal.

Conclusion

NY DFS Rule 504 is an important set of regulations designed to protect consumers from money laundering activities. It requires businesses operating within the state to have anti-money laundering programs in place and mandates certain procedures such as customer due diligence and ongoing account monitoring be performed regularly by these businesses. Failing to comply with these regulations could result in serious penalties or even revocation of a business’s license or permit which could damage its reputation and put it at risk for civil litigation if customers believe their data was not properly secured or protected from misuse or theft due to lack of compliance with these regulations. For this reason, it is essential that businesses operating within New York understand and comply with NY DFS Rule 504 requirements annually if they want to remain compliant and protect themselves from potential legal action or financial penalties down the road.

Bates Group's consultants have had proven success in helping regulated financial institutions comply with NY DFS 504 requirements. We have decades of experience, making us uniquely qualified to help your institution meet these requirements quickly and efficiently. Our team will work closely with you to understand your business needs and create an audit plan that is tailored specifically for you. We will then conduct a comprehensive review and assess the effectiveness of your compliance program. Contact us today to learn more!

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Erin Baskett, CPA, CGMA

Erin Baskett is a Bates Testifying and Consulting Expert and the founder and CEO of Sine Qua Non Global. She is a financial, compliance, and operational executive with significant experience in accounting, auditing, crypto, business consulting, advisory, private placements, investment banking, traditional brokerage, capital markets, fintech and financial services, with a solid knowledge of U.S. GAAP, tax, IFRS, FINRA, NFA and SEC rules in companies with both domestic and international presence serving both retail and institutional.

Over the past 10+ years, Erin has served as CEO, CCO, COO and/ or CFO across nearly a dozen firms congruently covering traditional brokerage, advisory, fintech and crypto/ NFT. She holds multiple certifications, including Certified Public Accountant (CPA), Chartered Global Management Accountant (CGMA), and Certified Human Resources Specialist (CHRS), and regulatory licenses. 

Full Bio

Patrick Cox

Patrick Cox is a Bates Testifying and Consulting Expert based in San Diego, California, with extensive experience in Retail Securities, Investigations, Cybersecurity, Privacy, and Compliance. He also advises on product due diligence matters, including cryptocurrencies, for regulated entities. Prior to joining Bates, Patrick was Executive Vice President and General Counsel for Advice, Litigation and Regulatory Strategy with LPL Financial, where he was responsible for all litigation, regulatory, and legal advice matters for the firm’s business units. He and his team also conducted internal investigations for the firm’s integrity hotline and other matters. Patrick was an ex-officio member of the firm’s Risk Oversight Committee for many years and provided ongoing advice to members of the Management Committee with reports to the Board of Directors on special issues. 

Patrick spent 20 years representing Morgan Stanley, Ameriprise Financial, and LPL Financial and their employees, and he handled hundreds of matters ranging from wrongful termination, raiding and recruiting, retail arbitrations, class actions, shareholder actions and internal investigations. He also worked on many due diligence and acquisition issues, both at LPL and Ameriprise. Prior to working in-house at Morgan Stanley, Patrick served as a civil litigator, an Adjunct Associate Professor at Fordham University School of Law, a law clerk at the U.S. Court of International Trade, and an Assistant District Attorney in Manhattan. An experienced executive and advocate, he received his Juris Doctor from Fordham and his Bachelor of Arts in English from Loyola Marymount University.

Full Bio

Connie Fenchel, CAMS

Connie Fenchel is a Bates Strategic Advisor and Expert with more than 45 years of government and private sector experience in law enforcement, financial crimes, regulatory compliance, anti-money laundering (AML), and sanctions. Her expertise includes independent reviews and investigations, risk assessments, domestic and international training, expert testimony, and AML program development and remediation.

A former Deputy Director in the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury, Connie led the FinCEN effort to administer the recordkeeping, reporting, and AML provisions of the BSA and USA PATRIOT Act. Before working at FinCEN, Connie has a lengthy career with the U.S. Customs Service in several senior-level positions. Upon retirement from the government, Connie established AML Experts, Inc., an independent consulting firm assisting banks and non-banks in complying with AML laws and regulations. She has worked with hundreds of banks, credit unions, cryptocurrency companies, payment processors, money transmitters, precious metal dealers and others providing consultation and training.

Full Bio

Alison Jimenez, CAMS

Alison K. Jimenez is a Bates Testifying Expert who utilizes her extensive background in the securities industry to consult and provide expert witness testimony on complex financial matters involving Compliance and Anti-Money Laundering. Based in Tampa, Florida, Alison has experience providing quantitative witness testimony in retail securities litigation matters, having testified at FINRA arbitration, private arbitration and federal court proceedings regarding securities analysis and account activity.

She has been retained as an expert on AML issues in federal and state courts, arbitrations, Investor-State Dispute Settlement, and regulatory enforcement actions on a variety of financial crime issues including market manipulation, corruption, Ponzi schemes, and high frequency trading. Alison has also served as an independent auditor to plan and conduct AML audits of financial institutions, verify compliance with PATRIOT Act, Suspicious Activity Report filing requirements and other rules/laws. She holds a master’s degree in economics and is a Certified Anti-Money Laundering Specialist and a Cryptocurrency Tracing Certified Examiner.

Full Bio

Annemarie McAvoy

Annemarie McAvoy is a Bates Testifying and Consulting Expert in financial crimes, including Anti-Money Laundering (AML), Sanctions, Cryptocurrency, Anti-Bribery and Corruption compliance, internal investigations, fraud detection and prevention and crisis management. She has held in-house legal and compliance positions at Citigroup and Morgan Stanley and was a Senior Manager in Ernst & Young’s Financial Crimes Compliance Unit. Early in her career, Annemarie was an Assistant U.S. Attorney for the Eastern District of New York and, later, specialized in large financial crime cases at the Kings County (NY) District Attorney’s Office Rackets/Investigations Unit. She teaches classes on financial crime at Columbia’s Graduate School of International and Public Affairs and has also taught as an adjunct professor at Fordham Law School.

Annemarie has appeared for years as an on-air legal expert for major television and radio networks, is sometimes quoted by media outlets such as the Associated Press and moneylaundering.com, and authored articles published in forbes.com, foxnews.com and Family Security Matters. She is a member of the Association of Anti-Money Laundering Specialists (“ACAMS”) and the NYC Bar Association’s Compliance Committee and its Financial Crimes Subcommittee, as well as its Small Law Firm Committee. She is also a member of the Global Digital and Cryptocurrency Association (“Global DCA”) and its Public Policy and Regulation Committee. Annemarie has successfully completed the Global DCA’s Digital Asset Professional Certification Program, and she is a member of the NJ Digital Assets Working Group.

Full Bio

To make an appointment with one of our 175+ testifying experts covering over 250 unique areas of expertise, please contact Bates today.

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By John Ashley (CIPP/US, CCRS, CRCMP), Senior Consultant

Background

On January 23, 2023, the New York Department of Financial Services (NYDFS) issued new guidance on regulated entities which custody digital assets. The guidance sets forth wide-ranging requirements for these entities, as well as strict limitations on how these entities can use custodied digital assets. This guidance comes at a time of uncertainty for digital assets and cryptocurrencies. 2022 saw the failure of multiple firms dealing in these assets, such as Voyager Digital, Celsius, BlockFi, and (most notoriously) FTX. The guidance issued by NYDFS is likely the first step in a move across regulators to tighten the regulation and supervision of digital asset firms and presents new compliance challenges for these firms.

To Whom Does the Guidance Apply?

The guidance applies to all entities which are regulated by NYDFS, either under its BitLicense regime or as limited purpose trust companies, and which take custody of their customer’s digital assets. The guidance refers to these entities as Virtual Currency Entities that act as custodians, or VCE Custodians.

The guidance does not apply to regulated entities which do not take custody of customer digital assets.

What Does the Guidance Require?

The guidance is intended to offer clarity in regard to NYDFS’s expectations for regulated entities—their custody procedures, processes, practices, and controls over customer digital assets. These expectations can be broken down into four areas:

1. Accounting Controls

The guidance requires that customer digital assets are separately accounted for and segregated from corporate assets. Notably, this applies to both on-chain (e.g. keeping customer assets in a separate wallet from corporate assets) and off-chain (e.g. separated on a VCE Custodian’s internal ledgers). This requirement effectively means that NYDFS requires that customer assets not be commingled with other assets, like commingling prohibitions found in Massachusetts and Nevada regulations. NYDFS notes that it will only accept two methods by which customer assets are separated from corporate assets. VCE Custodians can opt to keep each customer’s assets in a separate wallet/ledger account under that customer’s name. Alternatively, VCE Custodians may keep assets in an omnibus wallet/ledger account which contains only custodied customer assets; however, if a VCE Custodian opts to use this method, it must have controls which can establish an audit trail to identify individual customer assets and transactions. VCE Custodians must establish written policies and procedures regarding these controls and be prepared to reconcile on-chain activity with internal ledger accounts at any time, upon the request of NYDFS.

2. Use of Custodied Digital Assets

The guidance requires that when a VCE Custodian takes custody of a customer’s digital assets, it will do so only for the purpose of custody, and not for any other purpose. The guidance explicitly bans the use of customer funds as collateral for corporate loans, or their use as extension of credit (a major focus of the allegations against FTX). Finally, the guidance expressly requires VCE custodians to act on customer instructions—by extension, this requires VCE Custodians to honor a customer’s withdrawal request at any time. (Blocking customer withdrawals has been a characteristic of all the major cryptocurrency bankruptcies of 2022 and may have lost hundreds of thousands of customers access to billions of dollars in assets).

3. Sub-Custodial Arrangements

NYDFS views the use of sub-custody agreements by VCE Custodians as a material change in the VCE Custodian’s business model. As such, the VCE Custodian is required to go through the NYDFS’s approval process prior to using a sub-custody arrangement. As with other material business model changes, NYDFS expects to receive and review the VCE Custodian’s updated risk assessment and policies and procedures relative to this change before considering approval. In addition, NYDFS will require the VCE Custodian to submit the proposed service agreements governing the arrangement. This is by no means an exhaustive list, and VCE Custodians can expect that NYDFS will require additional documentation and information during the approval process.

4. Disclosures

Disclosures provided by VCE Custodians to their customers must (i) contain the terms and conditions associated with the VCE’s products and services; (ii) must be provided in writing; and (iii) must be accepted prior to entering into an initial transaction with a customer. The disclosures must make clear that the relationship is purely custodial, and it should include details regarding the VCE Custodian’s controls for the segregation and accounting of customer assets, how the VCE Custodian will use the custodied assets, and the limitations on such use. Disclosures should also note, as applicable, the use of sub-custody arrangements and any associated risk.

How Companies Can Comply with the Guidance

Firms operating as VCE Custodians in New York should assess their policies, procedures, and controls surrounding the custody of customer assets to ensure they are compliant. This assessment should include a review of procedural documentation, documentation of any unwritten or poorly described controls, and an assessment of the firm’s operational model. Firms should ensure that their custodial model meets one of the two forms acceptable to NYDFS and that their disclosures are appropriately up to date and compliant. In addition, firms should assess their compliance resources and their ability to comply with and manage an examination by NYDFS, and they should include in this assessment the possibility of ad hoc visitation or requests by NYDFS to demonstrate compliance, including the production of asset tracing and audit trails.

John Ashley (CIPP/US, CCRS, CRCMP) is a Senior Consultant in Bates Group's Money Services, Fintech and Digital Assets Compliance and AML Practice. He can be reached at jashley@batesgroup.com.

Bates Group’s MSB, FinTech, and Virtual Assets practice offers guidance and services for Money Services Businesses and financial institutions, fintech, digital asset, including virtual and cryptocurrency firms. Our subject matter experts work directly with firms and counsel to design and implement policies and programs and to ensure they are AML-compliant.

Our MSB and AML Teams help obtain and maintain Money Transmitter Licenses nationwide, including BitLicense and engage with firms to development and support BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.

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In its 2023 annual report on examinations and risk monitoring, FINRA provides its latest overview of firm compliance obligations. Divided into five discrete topical categories—financial crimes (a new breakout category this year), firm operations, communications and sales, market integrity, and financial management—FINRA’s priorities are further delineated into numerous subcategories. The Annual Report includes findings and observations from the recent oversight activities of FINRA’s Member Supervision, Market Regulation, and Enforcement programs, and:

• Identifies the relevant rule(s);
• Highlights key considerations for member firms’ compliance programs;[1]
• Summarizes noteworthy findings or observations from recent oversight activities;
• Outlines effective practices that FINRA observed through its oversight activities; and
• Provides additional resources that may be helpful to member firms in reviewing their supervisory procedures and controls, and fulfilling their compliance obligations.

As always, FINRA encourages member firms to use the Annual Report (and its other published resources) to, among other things, (i) assess the applicability of the provided information to a firm’s business model; (ii) incorporate relevant topics into firm risk assessments; (iii) identify gaps in existing compliance programs; and (iv) improve training. The 24 substantive subcategories offer up important guidance. In this article, Bates summarizes FINRA’s 2023 Annual Report priorities. Our annual chart offers insight into how newly observed risks have added to and affected those priorities year over year.

The Annual Report identifies FINRA’s top examination priorities for member firms:

• Adherence to their obligations pursuant to Regulation Best Interest and Form CRS[2]

• Compliance with best execution obligations and disclosure regulations on order handling in certain stocks and listed options
• Current regulatory obligations regarding complex products and options communications, and disclosure (including on crypto asset products) and supervisory controls related to the opening of options accounts;
• Cybersecurity risk management (FINRA stated that it has specialized teams devoted to reviewing firm controls, conducting investigations of cyber-related fraud, and examining crypto-asset activity.) At the recent New York SIFMA C&L Society luncheon on the FINRA 2023 Priorities—featuring Robert Cook (President & CEO) and Greg Ruppert (EVP, Member Supervision)—it was relayed that firms should consider where they are using technology that it did not use before, including services offered via Application Programming Interface (APIs) and outside of the firm. Members should also review the Division of Examination’s alert on identity theft and FINRA’s Regulatory Notice 22-29 on ransomware. FINRA also emphasized that cybersecurity is not just the C.I.S.O.’s responsibility.
• Obligations as to mobile apps, specifically whether firms adequately disclose or distinguish “between products and services of the broker-dealer and those of affiliates or other third parties”
• Compliance with Consolidated Audit Trail reporting requirements including “timely submission of reportable events and corrections, reporting complete and accurate CAT records, and effectively supervising third-party vendors.”

Top Areas of FINRA Focus for 2023

See highlights of FINRA’s continuing and emerging concerns on our annual comparison chart below, which keeps track of articulated priorities from year to year. (Items highlighted in gold are new for 2023; summary continues after chart.)

© 2023 Bates Group LLC
Source: 2023 Report on FINRA’s Examination and Risk Monitoring Program
(Compiled by Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations)

New Format and New Topics

The Annual Report lists member firm compliance obligations by topic now under five categories. Financial crimes, the newest category, incorporates previous sub-topics (e.g., cybersecurity and technology governance under SEC Regulation S-P) concerning compliance policies and procedures to safeguard customer records and information, as well as FINRA rules on business continuity planning and supervision.

This new category also incorporates “anti-money laundering, fraud and sanctions” obligations concerning policies and procedures required under FINRA rules (e.g., detection, suspicious activity reporting, testing, training, and customer due diligence) for compliance under the Bank Secrecy Act (BSA) and its implementing regulations (e.g., maintaining a Customer Identification Program (CIP); verifying the identity of legal entity customers; etc.). The Report notes that member firms should stay apprised of progress being made to implement the Anti-Money Laundering Act of 2020.

A new sub-topic for FINRA, under the category financial crimes, focuses on manipulative trading, which implicates rules on impermissible trading practices (e.g., use of deceptive devices, publication of transactions and quotations, order entry and execution practices.) The new sub-topic also emphasizes supervisory obligations to ensure a process for the review of securities transactions “reasonably designed to identify trades that may violate the Exchange Act, SEC rules or FINRA rules prohibiting insider trading and manipulative and deceptive devices.”

The remaining new sub-topics fall under the general category of market integrity and include FINRA rules on (i) fixed income and fair pricing that apply to transactions (including fixed income and municipals) generally requiring that a dealer charging a mark-up or mark-down do so based on the prevailing market price; (ii) reporting and order handling of fractional shares; and (iii) short sale and closeout requirement exceptions for bona fide market making activity.

Conclusion

FINRA’s Annual Report provides important guidance for compliance officers. This latest Annual Report reinforces the reach and depth of FINRA’s rules and brings to light practices member firms can consider for maintaining effective compliance programs.

Last year, Bates recommended that member firm compliance reviews shift from an annual review to ongoing reviews.  In that light, this year’s Annual Report illustrates FINRA’s continuing efforts to guide compliance officers in navigating the expanding set of rules. As new developments arise, Bates will keep you apprised.

Contact us to discuss how we can assist with your FINRA Compliance and Regulatory Investigations and Enforcement Matters

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We’re excited to share that Brandi Reynolds (Managing Director, Practice Lead) and John Ashley (Senior Consultant) of Bates' MSB, FinTech and Crypto team (pictured below) have combined their expertise with other AML, cryptoasset and law enforcement professionals to create an innovative new certification for financial crimes in the crypto space. Introducing the “Certified Cryptoasset Anti-Financial Crime (AFC) Specialist" Certification (CCAS) from ACAMS.

With the CCAS certification, individuals and entire cryptoasset compliance functions can step up their game in financial crime prevention and demonstrate their abilities to manage risk and comply with regulations surrounding financial crime in the rapidly evolving crypto space.

CCAS is made up of three interactive ACAMS certification courses covering AML foundations, cryptoasset and blockchain, and risk management in the crypto space, and includes e-learning courses, an electronic study guide, flash cards, review questions, and a practice exam. There are even optional Live Online classes to help professionals prepare for the exam.

 

Interested in getting CCAS certified? Check out the course and sign up here:

Bates assists firms and counsel throughout their legal, regulatory, compliance and AML matters. Our experienced staff and consultants offer a suite of AML and Compliance consulting services to established and start-up companies in banking, broker-dealer, RIA, Fintech, virtual assets/cryptocurrency, Money Services Businesses (MSBs), and Non-Banking Financial Institutions (NBFIs). Our MSB and AML Team supports clients with their BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews. We also provide practical guidance for obtaining and maintaining money transmitter licenses, identifying state requirements, coordinating with state regulators, submitting state reports, identifying risk, detecting suspicious or unusual activity, and preventing exposure associated with money laundering and terrorist financing.

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TODAY: Join Bates Managing Director Brandi Reynolds (Practice Leader-MSB, FinTech & Crypto), speaking on the "State of Cryptocurrency As We Head Into The New Year" webinar at the ACAMS Colorado Chapter January 2023 Virtual Event.

Tuesday, January 24, 2023

Online, 12 p.m. MST, 2 p.m. EST

One ACAMS Credit

Program Details and Registration

Businesses that are interested in engaging in virtual currency activities in Louisiana must now take steps to file for a license from the state. The new Virtual Currency Business Activity License is designed to protect consumers, investors, and other stakeholders from fraudulent and deceptive business practices related to cryptocurrency activities by requiring licensees to meet certain qualifications and maintain specific records of their activities.

To obtain a license, applicants must demonstrate they have sufficient financial resources and management capabilities to properly and lawfully conduct the business activities; provide proof of a bond or other form of security; ensure the company abides by all applicable laws regarding data protection, consumer protection, anti-money laundering (AML) and countering terrorism financing (CTF); and provide ongoing reports of all transactions, including those conducted with external parties. Furthermore, businesses must also have an actively functioning website with help desk services available as well as a mailing address where customers can send any customer inquiries or complaints.

With the July 2023 deadline fast approaching, businesses should file for their Virtual Currency Business Activity License as soon as possible in order to remain compliant with Louisiana regulations.

Bates assists clients in obtaining state virtual currency and money transmitter licenses, as well as with compliance following licensure and the start of operations. Contact us today to discuss your needs with a Bates Compliance licensing specialist.

View the New License Checklist

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January is National Human Trafficking Prevention Month, dedicated since 2010 to raising awareness about human trafficking and educating the public about how to identify and prevent it. This crime is facilitated by human smugglers, who victimize vulnerable individuals, often by making false promises related to immigration or employment.

The Financial Crimes Enforcement Network (FinCEN) issued a recent alert reminding financial institutions of the critical role they play in helping to fight human smuggling and human trafficking by identifying suspicious behavior and sharing crucial intelligence with law enforcement officials. The alert provides red flag indicators to help financial institutions better identify transactions potentially related to human smuggling and reminds financial institutions of their Bank Secrecy Act (BSA) reporting obligations.

Read the FinCEN Alert

Bates cares about this issue. We are committed to working with your firm to develop strong AML and compliance programs for banks, broker-dealers, money services business and digital asset firms, including virtual and cryptocurrency firms. Learn more about how we can help strengthen your AML and compliance program at the following links below:

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Bates Group is a proud Bronze sponsor of the New York State Bar Association Women In Law Section (WILS) 19th Annual Edith I. Spivack Symposium and Kay Crawford Murray Memorial Award Luncheon. This two-day event will be held Thursday, January 19 and Friday, January 20, 2023, during the NYSBA Annual Meeting.

Thursday, January 19, 2023

9:00 AM – 4:15 PM — 19th Annual Edith I. Spivack Symposium - "The Perpetual Geder Pay Gap: How Unequal Pay Negatively Impacts Women, Society, and the Profession"

• This program is elegible for 6.0 MCLE Credits (3.5 Credits Areas of Professional Practice; 2.0 Credits Ethics and Professionalism; 0.5 Credit Diversity Inclusion and Elimination of Bias)

1:00 PM – 2:15 PM — Luncheon and presentation of Kay Crawford Murray Memorial Award - honoring an outstanding attorney who recognizes the value of diversity and mentoring in the legal profession

4:15 PM – 5:30 PM — Networking and cocktail reception

Friday, January 20, 2023

10:30 AM – 11:45 AM — Reception

NYSBA Annual Meeting Info & Registration

All New York banking organizations—and all New York licensed branches and agencies of foreign banking organizations (“Covered Institutions”)—must get approval from the New York State Department of Financial Services (“NYDFS”) prior to engaging in virtual currency-related activity. The NYDFS clarified its expectations on that requirement in the form of an industry guidance letter dated December 15, 2022. A few weeks earlier, NYDFS proposed a rule on costs related to supervision and examinations and how they will be assessed on virtual currency businesses. Here are the highlights.

Virtual Currency Activity

In its guidance, NYDFS reaffirms the definition of virtual currency contained in the 2015 statutory definition and explains its regulatory interest in protecting state residents. In short, entities that engage in “the direct or indirect offering or performance of any other product, service, or activity involving virtual currency that may raise safety and soundness concerns for the Covered Institution or that may expose New York customers of the Covered Institution or other users of the product or service to risk of harm” must get approval from the regulator.

By “virtual currency business activity,” the NYDFS is referring to conduct involving (i) receiving or transmitting virtual currency (with certain exceptions, i.e. for non-financial purposes or a nominal amount); (ii) holding or custodying virtual currency on someone’s behalf; (iii) buying and selling virtual currency; and/or (iv) providing virtual currency exchange services. NYDFS offers examples of activities that fall within this definition. They include a broad range of activity such as providing digital wallet services, lending activities backed by virtual currency assets, helping customers to participate on a virtual currency exchange, holding virtual currencies on a customer’s behalf, any stablecoin services, and traditional banking services that may utilize public blockchain technology.  

The guidance applies to covered institutions wanting to initiate virtual currency activity as well as to institutions wanting to add any new or significantly different virtual currency-related activity, even an activity that may involve a third party. (NYDFS recommends that institutions who want to add to their existing virtual currency activity notify their NYDFS point of contact to “enable the Department to review and seek additional information or clarification, and impose any supervisory requirements, if needed.”)

Submissions: Required Information

Covered institutions must provide a written submission of proposed activity that would allow the regulator to make a “comprehensive assessment” that the activity would be “appropriate for a covered institution to undertake.” The submission must be provided to NYDFS 90 days prior to engaging in the activity.

NYDFS laid out the types of information it expects in any submission. These include:

1. A comprehensive business plan – NYDFS lists eight elements: (i) the legal entities that will be used; (ii) information on the operating model and technology; (iii) information about the use of any third-party service providers; (iv) costs and revenue targets; (v) the target customer base and fees; (vi) information on the expected impact on users; (vii) a formal project plan (e.g. budgets, schedules, staffing, etc.); and (viii) a comprehensive risk assessment and monitoring framework (see below).
2. A risk management framework – NYDFS wants institutions to submit information “to identify, measure, monitor, and control all risks arising from the activity (e.g., risks as to operations, credit, market, capital liquidity, cyber security, technology, third party provider, strategic, legal and reputation).
3. A governance framework – NYDFS wants to see all materials related to internal board/management approvals of the proposed virtual currency activity; all the designations for oversight; explanations on how the risks would be integrated into the institution’s overall governance framework; and all related controls and compliance processes.
4. A customer protection approach – NYDFS wants to see policies and procedures, sample agreements with users (whether by the institution or a third-party provider), disclosures, and a representative sample of marketing materials.
5. A financial analysis – NYDFS wants submissions to include an explanation describing any anticipated impact the new virtual currency activity may have on the entity’s capital and liquidity position.
6. A legal and regulatory analysis – NYDFS wants to see the legal analysis underlying the internal approval process for the activity, including the reasoning that would permit the activity and attendant legal risks.

Bates offers services in State Licensing Acquisition and Maintenance

Paying for it All

On December 1, 2022, NYDFS announced a proposed regulation establishing how supervisory and examination costs will be assessed on virtual currency businesses. If approved, virtual currency institutions will be billed five times per year: quarterly and with an adjusted bill at end of the fiscal year. Licensed firms would have to pay within 30 days; dually-registered institutions under both state banking regulations and cryptocurrency regulations will be billed separately. Superintendent of Financial Services Adrienne A. Harris commented, “the ability to collect supervisory costs will help the Department continue protecting consumers and ensuring the safety and soundness of this industry.”  

Conclusion

While there is considerable overlap across the categories of information that NYDFS wants institutions to submit, doing so may not be a simple task, and approval is not assured. As applied to virtual currency businesses, NYDFS approvals and licensure have far-reaching impact. As designed, this state process is sure to be the subject of broader debate over the future of virtual currencies. Meanwhile, the proposed rules on assessments and costs related to supervision and examinations are more than mere housekeeping; they indicate that the state agency is gearing up to take a hard look on virtual currency activity in 2023 and beyond. Bates will keep you apprised.

Bates Group’s MSB, FinTech, and Virtual Assets practice offers guidance and services for Money Services Businesses and financial institutions, fintech and cryptocurrency firms. Our subject matter experts work directly with firms and counsel to design and implement policies and programs and to ensure they are AML-compliant. Our MSB and AML Teams help obtain and maintain Money Transmitter Licenses nationwide, also engaging with clients for BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.

 

Contact Bates today to learn how we can support your Virtual Currency compliance and state licensing acquisition and maintenance needs.

Banks are quickly realizing that it’s time to embrace crypto customers. With the rise of digital banking, more people are choosing to store their funds in cryptocurrencies, and banks need to be able to accept these customers as part of their services. However, there are some important considerations that banks should make as they begin to accept cryptocurrency customers.

Knowledge of the Regulatory Landscape

The regulatory landscape surrounding cryptocurrencies is constantly changing. Banks need to stay abreast of all changes in order to remain compliant with regulations and protect themselves from potential fines or other penalties. Knowing what regulations apply, how they affect the bank’s operations, and how they could potentially change in the future will help banks ensure that they are operating within legal boundaries when dealing with crypto customers. Knowing, for instance, which cryptocurrency companies are required to be registered as money services businesses and/or money transmitters, is crucial to complying with current regulations.

Various regulatory guidance is already in place, such as the Financial Crimes Enforcement Network (FinCEN)’s 2013 guidance and the 2019 FinCEN advisory on illicit convertible virtual currencies (CVC).

Risk Management Strategies

Banks need to have a thorough understanding of the risks associated with crypto customers and develop strategies for managing them effectively. This includes understanding the customer’s risk profile and developing policies for onboarding crypto customers that take into account their individual needs and goals. Banks should also create procedures for monitoring customer accounts in order to mitigate risk related to money laundering, fraud, or other suspicious activity.

Bates Services for MSBs, FinTech and Crypto

Customer Education

As cryptocurrencies gain more traction with the public, banks need to provide education on how cryptocurrencies work so that customers can make informed decisions about their investments and transactions. This includes educating customers on topics such as wallet security and storage options, transaction fees, trading platforms, and potential risks associated with investing in cryptocurrencies. Providing this type of education can help banks establish trust and credibility with their crypto customers while also helping them navigate the complex world of digital currencies safely and securely. 

Conclusion

As banks continue to accept crypto customers into their services, it’s essential that they consider all aspects of managing this new clientele , including knowledge of the relevant regulatory landscape, risk management strategies, and customer education initiatives. Taking these steps will help banks ensure compliance with applicable regulations while providing a secure environment for conducting business with cryptocurrency holders. Ultimately, this will help build trust between banks and their crypto clients so that everyone can benefit from this new type of banking relationship.

Bates works with banks and crypto companies to provide Anti-Money Laundering (AML) and compliance solutions in the banking and cryptocurrency space. Our consultants have a wealth of experience in the cryptocurrency industry and assist crypto companies in navigating the complex world of obtaining and maintaining banking relationships. We will work with you to develop a tailored solution that meets your specific needs and helps you obtain and maintain the banking relationship you need to succeed.

Contact Bates today to learn more about how we can support your banking and crypto firm needs.

Brandi Reynolds, CAMS-Audit

Managing Director, BSA/AML Compliance, FinTech & Virtual Assets

breynolds@batesgroup.com

864.809.7718

FINRA has announced the publication of the 2023 Report on FINRA's Examination and Risk Monitoring Program. The comprehensive report from FINRA’s regulatory operations covers 24 topics addressing issues that "remain perennially important, with updates to reflect evolving risks, industry trends and findings from FINRA’s recent oversight activities." Four of those topics are new for the 2023 report — Manipulative Trading; Fixed Income – Fair Pricing; Fractional Shares; and Regulation SHO.

Additionally, the report introduces a new Financial Crimes section, consisting of three topics — Cybersecurity and Technological Governance; Anti-Money Laundering, Fraud and Sanctions; and Manipulative Trading — highlighting FINRA’s increased focus on protecting investors and safeguarding market integrity against these ongoing threats. Other key topics include: Cybersecurity, Complex Products, Reg BI and Form CRS, and Mobile Apps.

Stay tuned for our annual commentary, coming soon, on FINRA’s 2023 objectives and how they may impact your legal, regulatory and compliance matters.

The likely answer is “no,” based on the latest FINRA targeted sweep. Beginning in August 2021, FINRA examined firms to assess the sufficiency of their practices and controls over options accounts. FINRA recently issued an update based on the results, including new guidance on what they want you to consider in order to enhance your supervision and revise your compliance programs. The guidance takes the form of questions to consider for firms offering options trading to ensure they are aware of their regulatory obligations. Here’s an overview.

Three Key Areas

The targeted exams were directed at retail firms and other diversified firms that offer their clients options trading. FINRA focused on three key areas: options trading approvals, relevant disclosures, and trading supervision. For each, FINRA identifies the relevant rules and poses questions to prompt firms to consider how to tailor a program to their own business.

Options Trading Approvals

FINRA identified different approaches firms might take to approve options accounts: manual review, automated review, or a combination of the two. Regardless of the approach, FINRA will examine how a firm approves an options account subject to its Know Your Customer (KYC), Options, Margin, and Customer Account Information rules. These rules require due diligence procedures for option account approval. FINRA questions would prompt a firm to review for options account application completeness, accuracy, consistency with available customer information, and updates to profiles to ensure the customer remains eligible to trade. FINRA asks firms to consider (i) minimum approval criteria, (ii) eligibility at different options trading levels, (iii) red flags warnings, (iv) compliance with Regulation Best Interest, and (v) other systems and controls to address errors and options trading application rejections or resubmissions.

Disclosures

FINRA identified all the disclosures obligations associated with options accounts and trading, including those required under FINRA rules on public communications, options communications, and other disclosure rules (including margin statements or other options information). FINRA questions prompt firms to review their entire communications approach to customers. Questions center on (i) disclosure of risk in promoting options products and services; (ii) representations regarding potential losses; on disclosure material at account opening (and any supplemental material on complex options strategies (as necessary); (iii) requests to increase options trading levels; and (iv) disclosure consistent with Regulation Best Interest compliance.

Trading Supervision

FINRA urged firms to ensure their options trading and account opening procedures processes, systems and controls align with their overall risk profile under FINRA rules on supervision and options. FINRA questions prompt firms to consider (i) the adequacy of their review processes (is there a specialized review group for options trading?); (ii) the frequency of their reviews (e.g., on options trading activity, trading levels, and eligibility); (iii) the sufficiency of their monitoring and surveillance; and (iv) the adequacy of review and response concerning trading restrictions and red flags.

Conclusion

After a targeted sweep, FINRA’s guidance on supervision over options trading should be taken as more of a warning than a general update. Internal consideration of this guidance demonstrates both responsiveness and good faith as to regulatory priorities should FINRA come knocking. Bates will keep you apprised.

Bates has the experts and consultants to support your options supervision needs. We help you address FINRA’s questions and concerns with the assistance of our experienced former Administrative Managers, Branch Office Managers, and Central Business Review Professionals who will work with your option trading review processes, the frequency of your reviews, the sufficiency of your monitoring and surveillance, and, very importantly, the response to trading restrictions, red flags, and alerts.

In addition to providing options policy & procedure and supervision services, Bates experts also frequently consult and testify in litigation/arbitration matters involving options trading.

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Bates Group's Brandi Reynolds, CAMS-Audit, CCI, CCCE (Managing Director, BSA/AML Compliance, MSBs, FinTech, and Virtual Assets), is featured in the latest issue of CrossTech Magazine, the magazine of the cross-border payments industry. Inside, read about Brandi's experience as an industry leader and learn about the Independent Review, Licensing Support, Compliance Consulting, Training, and other services offered by Brandi and her Bates team.

Read Online Now!

Bates Group's MSB, FinTech, and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering, and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

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The SEC Division of Examinations (“Division”) issued a risk alert for registered broker-dealers and investment advisers  that offer or maintain “covered accounts” in order to better protect retail customers from identity theft. The alert was issued because recent firm examinations revealed practices “inconsistent” with Regulation S-ID, (“Identity Theft Red Flag Rules”) which could subject retail investors to identity theft and financial loss. Several weeks earlier, the SEC Office of Investor Education and Advocacy (“Office”) issued a risk alert to inform investors how to handle investment accounts if they become victims of identity theft or a data breach. Here’s an overview.

Deficiencies in Regulation S-ID Compliance

Under the SEC rule, if a firm holds a covered account (i.e. an account that a financial institution maintains, primarily for personal, family, or household purposes), it must have a compliance program that can “detect, prevent, and mitigate identity theft.” The rule also provides guidelines to assist entities in the formation of the programs necessary to satisfy the obligation.

These guidelines require firms to develop a program to assess whether the rule is applicable by determining whether the firm offers or maintains covered accounts. If it does, firms must have a written program tailored to the size of the firm and the scope of its activities. The firm must have policies and procedures, updated periodically, that are reasonably capable of identifying, detecting, and responding to known red flags concerning identity theft. And finally, firms must administer and oversee the program elements to ensure the protection of investor’s personal information. Such administration must include Board participation, Board and senior management supervision, adequate training and oversight on related third-party service providers.

In its examinations, the Division observed numerous deficiencies in implementing each of these requirements. The Division cited examples where firms failed to identify covered accounts (including online accounts), failed to adequately assess risks related to covered accounts or failed to document those assessments, and failed to periodically update these accounts, all of which affected the firm’s ability to develop red-flag controls.

In addition, the Division found compliance programs that were not appropriately tailored to the firm’s business or were missing essential program elements. These program deficiencies included failures to identify red flags; failures to detect and respond to red flags and failures to update identified red flags—in one case after changing methods for opening and accessing accounts. Another specific case involved a firm that had undergone a business reorganization but had failed to incorporate new covered accounts into the existing compliance program. On matters of governance and program administration, the Division cited multiple types of reporting failures to the Board and senior management, inadequate training, and failures to monitor and control third-party service providers as to identity theft. 

Investor Instructions after Identity Theft or Data Breach

The Investor Office alert was an update to a July 2021 publication on ways to safeguard personal financial information. Information at risk included social security numbers, account numbers, phone numbers, and account passwords. The alert focused on what to do after such private data was compromised.

The Office recommended several immediate steps for investors to take, including contacting the financial institution, changing online account passwords, closing compromised accounts, activating multi-factor authentication (if available), and monitoring investment accounts for suspicious activity. The Office also recommended placing a credit freeze or fraud alert with the national credit bureaus and to consider creating an identity theft report which could help with debt collectors and business accounts. The Office described the process for submitting a theft report, which involves filling out an FTC online complaint form, drafting an FTC identity theft affidavit, and then contacting local authorities with the affidavit. 

Conclusion

At year’s end, the SEC Divisions are accumulating data from their exams and reports and sharing their findings and assorted guidance. These alerts, however, highlight areas broker dealers and investment advisers should note, given the likelihood they will be targeted in an examination. Combatting identity theft remains a high priority. Bates will keep you apprised.

Bates supports firms navigating compliance with SEC rules. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

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The SEC recently held a National Seminar on compliance for investment advisers and investment company senior officers. Of the many important panels in the day-long program, one was devoted to the SEC’s expectations on investment adviser compliance with ESG requirements. The panel included representatives from the Divisions of Examinations, Investment Management and Enforcement, as well as a Chief Compliance Officer of a sustainable investing asset management company. A week later on November 22, 2022, the SEC announced a $4 million dollar settlement with a large investment adviser for ESG-related compliance failures. In the Order, the SEC found that the firm (i) failed to timely “adopt written policies and procedures governing how … [they]… evaluated ESG factors as part of the investment process until some time after the strategy was introduced;” and (ii) failed to consistently follow its own written policies and procedures once adopted prior to February 2020.  

Here we look at the takeaways from the seminar, which covered SEC exam concerns, an ESG disclosure proposal update, recent enforcement activity, and a CCO’s advice on ESG compliance.

SEC Seminar on ESG Compliance Obligations

Moderator Cindy Eson, Associate Regional Director for the Division of Examinations, began the panel discussion by describing the state of the ESG investment adviser market. She said that advisers are responding to increasing demand from investors by offering products and services that incorporate ESG strategies in their investment decisions. She highlighted current estimates on the size of the market saying that over 800 ESG funds with three trillion dollars in investable assets are currently in play. But she also underscored the many political controversies permeating every aspect of the field and the uncertainty that follows. By example, she shared that a significant number of Senators have written to law firms that handle ESG matters notifying them that they should prepare for congressional investigations. In another instance, she pointed to a lawmaker who issued requests for information from six investor research firms about how they calculate issuers’ ESG scores.

Examination Observations

Andy Sohrn, Manager, SEC Division of Examinations, highlighted several observations on ESG compliance raised in recent examinations. He acknowledged the compliance challenges that result from the lack of a standard definition for ESG but focused on the practical steps advisers should be considering as they incorporate ESG factors (negative screening or filtering, positive screening, socially responsible investing strategies, integration of ESG into traditional analysis, issuer engagement, impact investing and proxy voting) into their policies, processes and practices. In anticipation of exams, Mr. Sohrn focused on three recommendations.

1 - Specificity in Disclosure and Marketing

First, he highlighted the importance of specificity in disclosures and marketing. He said the lack of a definition of ESG makes the need for specificity in disclosure critical and described how a simple ESG claim like“we exclude fossil fuel companies from our portfolio” can run afoul of an examination without greater specificity; (e.g., did the disclosure specify traditional oil and gas companies only? companies that may have subsidiaries in the industry? companies that are also consumers of fossil fuels?) He said that examinations revealed examples of the use of negative screens for ESG that were based on a politically divisive issue which should have been a material consideration but was not disclosed; and an instance where an adviser told fund investors that a company scored highly on each ESG rating, but failed reveal that the scores were provided by a third party which blended composite scores and contained no breakdowns for how the companies scored in each of the categories. 

2 - Reliance on Third-Party Data Providers

Second, Mr. Sohrn highlighted the added risk to ESG investment advisers from reliance on third-party data providers. He suggested that advisers understand fully the information a third-party data provider can give, what the advisers need from such a data provider to actually implement their ESG strategy, and what the adviser must disclose to its investors about that reliance. He reminded advisers that different data providers can come to different conclusions and recommendations regarding companies and, also, that there can be gaps in the data which can affect their recommendations and their disclosure obligations.

3 – Branding and ESG Strategy

Third, Mr. Sohrn highlighted that firms that rebrand existing funds or strategies into ESG funds or strategies ensure that the new name fairly and accurately represents the funders ESG strategy. He cautioned that sometimes “the marketing people get ahead of the portfolio management people and compliance people.” He concluded with a general warning that the more that ESG is integral to a firm’s business—the more it is advertised or marketed as part of the firm’s strategy—the more risk there is, and the more likely it is that examiners would expect a firm to have policies and procedures to address that risk.

Status Update on SEC ESG Disclosure Proposal

Sara Cortes, Senior Special Counsel, SEC Division of Investment Management, offered the latest on the SEC’s proposal to require “registered investment advisers, certain advisers exempt from registration, registered investment companies, and business development companies” to disclose information on ESG investment practices and strategies in fund registration statements, prospectuses, annual reports, and adviser brochures. (See previous Bates post). Ms. Cortes described the rulemaking as clarifying how much disclosure is necessary in various categories. She said that concerns raised in received comments include: (i) that some of the categories intended for regulatory purposes could be used by firms for marketing purposes, (ii) that a number of the rules were highly prescriptive, and (iii) that smaller advisers could be asked to bear unacceptably high compliance costs. In closing, she said that the proposed ESG rules reaffirmed existing obligations under the Compliance rule.

Enforcement Observations

Kimberly Frederick, Assistant Director, SEC Division of Enforcement (Asset Management Unit) emphasized that ESG compliance enforcement remain focused on broader regulatory requirements of materiality and disclosure. She described how the SEC built a special climate and ESG Task Force in March 2021, which currently has two dozen staff selected for their experience in financial reporting, issuer disclosure, investment adviser matters. She said the Task Force “proactively” works to identify ESG compliance and related misconduct and uses big data and other tools to analyze disclosure and compliance matters relating to investment advisers’ and funds’ ESG strategies.

Ms. Frederick described notable SEC ESG cases, including (i) a 2020 action against Fiat Chrysler for making materially misleading statements about the emissions from their vehicles which resulted in a $9.5 million fine; (ii) a 2022 case involving a NY robo-adviser that marketed itself as providing services that complied with Sharia law (The firm did not have written policies and procedures setting forth how it would do so and agreed to pay a $300,000 penalty and to hire an independent compliance consultant.); and (iii) an enforcement action against an adviser for representing that all holdings in a mutual fund had undergone an ESG review, even though that was not the case, resulting in a $1.5 million penalty.

Ms. Frederick reiterated that these cases were all about materiality and disclosure and said the takeaway is simple: “Say what you mean, and mean what you say.” She concluded that “if an adviser is marketing itself as having an ESG-driven or influenced investment process, it must make sure its marketing materials are not misleading, and it has to adopt policies and procedures reasonably designed to match its investing.”

A CCO Point of View: Consistency Matters

Several direct observations came from John Boese, Chief Compliance Officer at Impax Asset Management LLC. He remarked that an exam covering ESG was like a “routine exam on steroids,” and that his recent experience was that the exam was “as much of a fact-finding mission as it was an exam.” He asserted that the SEC is looking to see whether “you’re saying it,” and if you are, then “if you are doing it,” and further, “if you are consistent in all your filings and marketing and disclosures.” On ESG best practices, he suggested: “don’t create compliance traps in your prospectuses; don’t say things that you are not going to be able to do. You have to make sure that your prospectus is consistent with your website which is consistent with your ADVs and with your marketing.”

He also recommended (i) that compliance be an ad hoc member of every department in your organization; (ii) that firms create specific policies and procedures around ESG; and that (iii) compliance professionals be able to test those procedures, “not only for a firm’s own protection, but for compliance’s as well.”  

Policies and Procedures: Recent ESG Settlement

These observations were on display in a matter announced a week after the seminar. The SEC Order stated that the investment adviser “had several policies and procedures failures involving the ESG research its investment teams used to select and monitor securities.” Specifically, the SEC found that, for a time, “the company failed to have any written policies and procedures for ESG research in one product,” and “failed to follow its own policies and procedures” once they were established. These alleged failures included internal requirements for employees to complete questionnaires on companies to be included in ESG investment portfolios prior to their selection. In its settlement, the adviser agreed to a cease-and-desist order, a censure, and a $4 million penalty.

Conclusion

As the market for ESG investing grows, attention to compliance around related materiality and disclosure will intensify. Meanwhile, the SEC’s ESG disclosure proposal keeps winding its way through the rulemaking process. Notwithstanding the controversies surrounding ESG investing, and the political uncertainties hovering over it, the SEC has organized itself for sustained attention to investment adviser compliance. Both the panelists and the recent enforcement settlement make that clear. Bates will keep you apprised.  

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Today’s financial fraudsters are more well-funded, technologically savvy, and agile than they've ever been before. So how are the top risk & compliance teams preparing for fraud in 2023?

In this webinar, join Bates Group Senior BSA/AML/OFAC Compliance Consultant John Ashley along with industry-leading voices from Unit21, Chainalysis, and Helix for their insights into the biggest fraud trends for 2022 and their predictions for where fraud is headed in 2023. Sign up today to reserve your spot!

Date: Thursday, December 15th, 2022

Time: 10 a.m. PT / 1 p.m. ET

Topics:

• How 2022 was unique as compared to 2021 and 2020 (as a “post-pandemic” year)

• The main fraud trends that played out in 2022 and why these trends occurred

• What to look out for in 2023 (and beyond) regarding fraud

• Tips for successfully managing fraud risk in an ever-changing landscape

Webinar Details and Registration

In its annual report of legal actions taken in Fiscal Year 2022 (ending September 30, 2022), the SEC noted its “robust enforcement” efforts to “impose penalties designed to deter future violations, establish accountability from major institutions, and order tailored undertakings that provide potential roadmaps for compliance by other firms.” The SEC underscored these key messages by highlighting (i) aggregate metrics on the agency’s enforcement efforts; (ii) the expanded use of enforcement tools brought to bear (namely, data analytics and whistleblowers); (iii) the resolutions of specific high-profile cases involving disclosure and gatekeeping activities; and (iv) enforcement successes in categories of cases involving evolving risk.

Annual Metrics

The numbers bear out just how robust SEC enforcement efforts have been. Representing a 9% increase year-over-year, the SEC filed 760 actions in 2022, including 462 new "stand alone" securities law cases, 129 cases involving compliance filing delinquencies, and 169 administrative proceedings against individuals that follow from criminal convictions or civil orders. In an addendum to the announcement, the SEC broke down these figures by percentage, revealing, for example, that 17% of filed cases were brought against broker dealers and 23% of filed cases were brought against investment advisers or companies.  In the aggregate, the SEC ordered payment in these cases (including civil awards, disgorgement and interest) totaling $6.4 billion, a significant increase over the $3.9 billion in 2021. The SEC figures also show an increase in the aggregate amount of money distributed to harmed investors ($937 million in FY 2022 vs. $521 million in FY 2021, but still shy of a high of $1.197 billion in 2019).

Data Analytics, Cooperation, and Whistleblowers

To underscore the message of its expanded strategic use of multiple resources to go after misconduct, the SEC described how it leveraged “the entire enforcement toolkit,” referring to the use of data analytics, “cooperators,” and whistleblowers.

On big data, the SEC used sophisticated techniques to “review and triage[ ] more than 38,500 tips, complaints, and referrals of possible securities law violations submitted by the public, self-regulatory organizations, and others.” The agency cited a wide range of cases using evidence derived from this method, including “hacking to trade,” “pump and dump” schemes, and “insider trading,” among others. On cooperation, the SEC highlighted cases in which the company “tangibly” helped with an agency investigation or by providing evidence. (The agency emphasized how it takes into account such cooperation when ordering remedies.) On whistleblowers, the SEC pronounced that their use is “an integral part of the enforcement program.” In 2022, the agency said it processed 12,300 tips and gave out $229 million over 103 awards. The agency also cited cases that emphasized its efforts to safeguard whistleblower anonymity and protect against retaliation.

Visit Bates Regulatory and Internal Investigations Practice

Categories of Enforcement Action

In its recap, the SEC distinguished several categories of cases. Among them: financial fraud and issuer disclosure along with so-called “gatekeeper” actions involving auditors, lawyers and transfer agents. Emphasizing personal accountability, the agency cited cases where it pursued issuers and employees who misled investors by making material and inaccurate disclosures, as well as going after “auditors and their professionals” for failures that led to improper disclosures, or other misbehavior.

As to broker-dealers and investment advisers, the SEC highlighted recent enforcement activity around Regulation Best Interest (Reg BI), special purpose acquisition companies (SPACs) and against institutions involving the “misuse of complex products and strategies.” The agency broke down the cases undertaken during the year, tackling a range of evolving risk. By category, the SEC highlighted enforcement actions involving:

1. cryptocurrency (including registration violations, fraud, and insider trading); of note, the SEC said it had doubled the number of positions to its Crypto Assets and Cyber Unit to boost investigations of potential misconduct.
2. cybersecurity (primarily compliance violations on recordkeeping and protecting personal information); the SEC emphasized the importance of ensuring that firms keep up with “technological developments” and its effect on business practices.
3. complex products (concerning inadequate training of advisors, misleading communications and fraudulent schemes); the SEC pursued cases of fraud involving both complex products and strategies.
4. environment, social and governance (ESG) issues (related to misleading disclosures and breaches of fiduciary duty); the SEC was careful to demonstrate how its efforts were tied to “time-tested principles concerning materiality, accuracy of disclosures, and fiduciary duty, as codified in federal statutes, regulations, and case law”.
5. private funds (concerning conflicts of interest, fees and expenses, custody violations, and protection of nonpublic information); the SEC highlighted the growth in assets managed by private funds as the agency went after private fund advisors and associated individuals.
6. public finance (including cases for disclosure violations and misleading statements, registration rule violations, and pay-to-play violations); the SEC noted cases against broker dealers, investment advisers and – for the first time – underwriters (for registration violations).
7. market abuses (focusing on insider trading, market manipulation, and other illegal trading practices); the SEC underscored that its efforts served to defend both market integrity and victimized investors.
8. Foreign Corrupt Practices Act (FCPA) violations (including misrepresentations to investors); these cases were brought against US issuers that committed bribery and other prohibited practices abroad. 

Conclusion

The aggregate metrics on the agency’s enforcement efforts, the emphasis on expanding the use of data analytics, cooperation agreements and whistleblowers, and the attention paid to compliance gatekeepers represent amplified messaging intended to alert both legislators and market participants. Most striking in the report are references to how the SEC “recalibrated penalties for certain violations, including prophylactic remedies, and required admissions where appropriate.” The agency stated that it increased these penalties to “deter future misconduct and enhance public accountability,” citing examples of orders (i) imposing additional billions of dollars in penalties for recordkeeping violations; (ii) requiring “undertakings” (including “retention of compliance consultants”) to ensure compliance policies and procedures and internal controls; (iii) requiring that gatekeeping (such as auditing) firms keep up with their continuing education courses; and (iv) requiring admissions of fault. These remedies go beyond proportional penalties for compliance or rule violations; they—like the report in general—reflect a very intentional message that “the fines were not just a cost of doing business,” thus once again raises the stakes. Bates will keep you apprised.

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Register today to join FSDA President and Bates Group CEO Jennifer Stout at the in-person FSDA-SIFMA C&L Forum and networking event in St. Petersburg, Florida. Featuring welcome remarks from Jonathan N. Santelli, Executive Vice President and General Counsel, Raymond James Financial; panels on developments in privacy law and ESG in financial services (see below); a fireside chat with Jennifer Stout moderated by SIFMA EVP/GC Saima Ahmed; and closing remarks by SIFMA’s Ira Hammerman.

Hosted by the SIFMA C&L Society and FSDA and sponsored by Raymond James. CLE credit is available for this live program.

December 7, 2022

8:00am - 12:00pm EST

Raymond James | St. Petersburg, FL

Registration and Details

Featured Panels:

Developments in Privacy Law

Moderator: Ellyn Angelotti Kamke, Assistant General Counsel, Corporate Transactions and Financial Operations, Raymond James Financial

Panelists:

• Olga Greenberg, Partner, Eversheds Sutherland
• Jarod Koopman, Executive Director, Cyber and Forensic Services, IRS-Criminal Investigation
• Rob Patchett, Global Chief Privacy Officer and I.T. Chief Compliance Officer, Raymond James Financial

 

Fireside Chat

Moderator: Saima Ahmed, Executive Vice President and General Counsel, SIFMA

Speaker: Jennifer Stout, President, FSDA and CEO, Bates Group

 

The Evolution and Explosion of Environmental, Social, Governance (ESG) Issues in Financial Services

Moderator: Samantha Trebesch, Head of Sustainable Investing, Raymond James Private Client Group

Panelists:

• Ranah Esmaili, Partner, Sidley Austin
  Kelly L. Gibson, Partner, Morgan Lewis
• Erica Gerson, Partner, Steptoe 
• Trish Flynn, VP, Chief Compliance Officer, PGIM Portfolio Advisory

As financial firms are starting to face the first round of enforcement actions from regulators under Regulation Best Interest (Reg BI), the “grace period” that followed the rule’s implementation data has come to an end.

The SEC has announced that Reg BI will be a high priority for Examinations and Enforcement in 2023, and firms need to have the right people, processes, and technology in place in order to remain compliant.

Join Bates Group and NICE Actimize for our upcoming webinar: “Reg BI Compliance: What You Need to Know to Stay Ahead.” Featuring Rhonda Davis, JD, CAMS, CFE, Managing Director, Bates Compliance; Jan Folena, Partner, Stradley Ronon (formerly with the SEC); Anand Maheshwari, Senior Product Manager, Suitability Surveillance, NICE Actimize; and moderated by Ozzie Berrios, Suitability Compliance Regulatory Expert, NICE Actimize. Register today for this complimentary event.

Date: Friday, December 9, 2022

Time: 1 p.m. ET/10 a.m. PT.

Watch On Demand

Regulatory and enforcement activity has been brisk since nine federal agencies issued a “Comprehensive Framework for Responsible Development of Digital Assets” in response to President Biden’s Executive Order to collaborate on a “whole of government approach.” As previously described, the Framework has done little to affect what federal agencies were already doing: asserting their jurisdictions, monitoring investor-related and market risks, and aggressively applying and enforcing rules on illicit finance and compliance violations.

The intensity is up. There are many voices across the spectrum competing for attention – a consequence of many factors, among them (i) the current and dramatic volatility in the digital asset markets that included losses estimated at $2 trillion in market value over the last year, (ii) the unfolding bankruptcy of crypto exchange FTX, (iii) state actors (both legislators and regulators) seeking to fill the void created by the lengthy federal deliberative process, and (iv) a national election, which has implications for both administrative and legislative developments on crypto. 

The following topics are some of the latest regulatory and enforcement developments on our radar right now.

FSOC Reports on Crypto Risk and Regulation

In an October Report on digital asset financial stability risks and regulation, the Financial Stability Oversight Council (“FSOC”) identified gaps in the regulation of crypto asset activities. The FSOC membership includes the heads of Treasury, the Federal Reserve, OCC, CFPB, SEC, and CFTC as well as advisors that include a designated state insurance commissioner, a designated state banking supervisor, and a designated state securities commissioner. In the report, FSOC recognized that the existing regulatory system covers large parts of the crypto asset ecosystem, but then identified three gaps in that regulation.

First, the report found that “crypto-asset businesses do not have a consistent or comprehensive regulatory framework and can engage in regulatory arbitrage.” The Council stated that some of the businesses have affiliates or subsidiaries that may operate under different regulatory frameworks. The identified risk was that no one regulator would have visibility into the risks across the entire business. Second, FSOC found that “the spot markets for crypto-assets that are not securities are subject to limited direct federal regulation;” and would not be subject to regulations to “ensure orderly and transparent trading [or] prevent conflicts of interest and market manipulation.”

Third, FSOC questioned whether “vertically integrated market structures can or should be accommodated under existing law.” FSOC stated its concern that retail investors could be exposed to risky practices used by such trading platforms (for example, “automated liquidation”).

In an effort to address the gaps, the Council made recommendations to (i) enact legislation that would strengthen member agencies rulemaking authority over the spot market for crypto assets that are not securities; (ii) address regulatory arbitrage (including legislation on stable coins) and provide agencies with the authority to oversee the activities of all crypto asset entities; and (iii) bolster member agencies capacities related to crypto asset data and expertise. 

CFPB Reviews Consumer Crypto Complaints 

In a November report, the CFPB analyzed more than 8,300 consumer complaints for crypto assets covering the period between 2018 through 2022. The CFPB described how crypto is increasingly marketed to consumers and incorporated in financial products such as credit cards, debit cards, prepaid cards (offering crypto “rewards”) and various other product offerings on crypto payment platforms. The CFPB said that the rate of complaints increased over those years with the greatest number coming from California. The agency reported that crypto complaints and fraud reports have increased at other federal agencies, citing the SEC, which received 23,000 tips, complaints, and referrals since 2019 and the FTC, which reported a sixty-fold increase over the amount of crypto asset losses since 2018.

The CFPB found fraud (more than 50 percent of all complaints) to be the top issue, with a large number related to scams inducing consumers to turn over account access. Schemes cited include: romance scams (accounting for the highest individual reported losses), “pig butchering” (fraudsters posing as financial successes and “coaching victims through setting up crypto asset accounts,” and scams involving social media influencers that lure in victims. The CFPB also highlighted transaction issues that made up about 25 percent of the complaints. Schemes cited included: “SIM swap” hacking, which allows fraudsters “to intercept SMS messages to exploit two-factor authentication,” phishing attacks, and other social engineering hacks. The CFPB highlighted complaints against platform exchanges, as well with customers raising account access issues, liquidation policy issues, customer service issues, and unexpected fees and other costs. 

Treasury Requests Comment on Digital Asset Illicit Finance 

In late September, the Treasury Department asked for input on digital-asset-related illicit finance risks as part of its response to the Executive Order and Framework (previously mentioned). Among the subjects included in the Request for Comment were general questions on a broad range of topics, including the scope of illicit financing risks associated with digital assets; how technological innovation might present new risks or mitigate existing ones; how to “more effectively deter, detect, and disrupt the misuse of digital assets;” the relevancy of existing AML/CFT regulatory obligations or additional alternative obligations that  should be imposed; and how to improve state-state and state-federal coordination for AML/CFT regulation and supervision. SIFMA, in a notable response, argued that banks and broker-dealers have the experience and know-how to effectively monitor the use of digital assets and that they are in the best position to take advantage of new technologies to manage illicit financing risks. SIFMA highlighted that AML regulations over money transfer transactions are effectuated by these intermediaries and with some modification can apply to all digital transactions. SIFMA cited emerging distributed ledger technologies as potentially helping manage illicit finance risks through tracking customer and transaction data.

Enforcement Activity Ramps Up

Federal agencies have zoomed in on pursuing enforcement actions involving crypto assets. The CFTC issued its annual enforcement results that highlighted 18 actions involving digital assets, [which] represents “more than 20% of all actions filed during FY 2022.” The CFTC-cited examples where that it charged (i) a digital asset exchange with illegally offering futures transactions on its unregistered platform, with attempting to manipulate the price of its native token and for failing to implement a Customer Identification and Anti-Money Laundering program; (ii) a registered entity with making false or misleading statements of material facts during an evaluation of the potential self-certification of a bitcoin futures contract; (iii) an unregistered software company for illegally offering leveraged and margined retail commodity transactions in digital assets and for failing to adopt a customer identification program as part of a Bank Secrecy Act (BSA) compliance program.

The SEC issued its own enforcement report which noted developments in the crypto asset securities space. The report stated that in May, 2022, the SEC doubled the size of the staff dedicated to a group it renamed the Crypto Assets and Cyber Unit. The SEC highlighted three cases – the first against a lending platform for failing to register a retail crypto product. This type of case continues to reflect the agency’s ongoing contention that crypto assets are securities under the legal Howey test. A recent decision handed down by a U.S. District Court determined that tokens sold by digital asset company LBRY were securities requiring registration with SEC because the offerings of LBC tokens led investors to have “a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of others.” The SEC Report also highlighted an enforcement action against individuals in a fraudulent crypto-ponzi scheme, and an insider-trading case against individuals touting crypto assets about to be offered on a crypto trading platform.

In addition, FINRA recently announced a targeted examination on crypto assets. In letters sent to targeted firms, FINRA stated that it will be examining retail communications concerning a firm or its affiliates’ crypto assets, or services involving a transaction or a holding of a crypto asset. The examinations will focus on the period July 1, 2022 through September 30, 2022.

Notable Recent Crypto Enforcement Actions: Virtual Currency Exchange

The Treasury’s Office of Foreign Assets Control (“OFAC”) and FinCEN settled actions against Bittrex, Inc., a virtual currency exchange based in Bellevue, Washington. The cases represented the largest actions against a virtual currency company and the first parallel enforcement action by OFAC and FinCEN. The agencies found “willful violations” of sanctions compliance programs and BSA/AML risk-based compliance control requirements, including SARs reporting and transaction monitoring failures. Bittrex agreed to settle with OFAC its potential civil liability for 116,421 violations of sanctions programs for $24,280,829.20. It agreed to settle with FinCEN for $29,280,829.20 for violations of the BSA and FinCEN’s implementing regulations.

Virtual Currency Mixer

Back in August, OFAC sanctioned Tornado Cash, a virtual currency mixer that was accused of laundering more than $7 billion worth of virtual currency since 2019. The virtual currency mixer is a decentralized technology (“DeFi”) protocol designed to increase the privacy of its users and operated through smart contracts on the Ethereum blockchain. OFAC alleged that the protocol facilitated illegal and anonymous transactions “by obfuscating their origin, destination, and counterparties, with no attempt to determine their origin.” According to OFAC, the company “repeatedly failed to impose effective controls designed to stop it from laundering funds for malicious cyber actors on a regular basis and without basic measures to address its risks.”

The decision to designate the protocol remains controversial.  On October 12, 2022, Coin Center, a non-profit advocacy group focusing on cryptocurrency and decentralized technologies, sued the Treasury Department and OFAC over sanctioning Tornado Cash, claiming that the decision to do so was unlawful, was arbitrary and capricious, and that it violated the constitutional right to privacy. Coin Center argued that OFAC did not have the authority to sanction “an idea, a tool or a technology.”

Conclusion

In lieu of a comprehensive plan across all government sectors on digital assets, policy debates are playing out through regulatory and enforcement activity. The President’s efforts to create such a plan are made ever more difficult by the current market conditions including the recent bankruptcy of the FT crypto exchange, the speed of technological developments, and the hardening of the positions of the agencies – each elbowing the other for a share of the oversight (as the FSOC risk report suggests.)

The nine individual reports that make up the Framework served to articulate the core issues and national interests at stake. The recent activity highlighted above – the reports, Treasury’s request for information, the enforcement determinations – activity that does not even cover state or federal legislative efforts (more on that to come) – are generating momentum that serves the status quo. Such evidence, whether it’s the latest tallying of consumer complaints or the jurisprudence being developed in the name of investor protection or national security or combatting illicit finance, will be of continued use in bolstering or tweaking existing positions. All of it may or may not be affected by the results of the election. In the interim, Bates will continue to monitor developments. 
 

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

Contact Bates

To learn more about our services or to talk to one of our professionals, reach out to us directly today at contact@batesgroup.com.
 

FINRA has remained focused on ensuring that eligible customers received Rights of Reinstatement (“ROR”)[1] benefits where appropriate. Just recently, we were retained by another large firm looking to leverage the depth of our experience gained through many engagements assisting our clients with Rights of Reinstatement issues since the targeted examination announcement in 2020.

FINRA continues to scrutinize firms’ policies and procedures through examination and enforcement to ensure they are working as intended, and that investors are receiving the benefits they are due. FINRA also expects remediation in any instances where the policies or procedures did not work as intended.

We encourage firms to continue to review the effectiveness of and update their rights of reinstatement related procedures considering this ongoing regulatory focus and make updates to policy or remediation where necessary. Firms should be tracking mutual fund transaction activity and verifying that clients received the benefit of the ROR, as well as considering mutual fund trading in the context of their obligations under Reg BI.

Regulatory Investigations and Enforcement

Bates Group supports firms subject to an inquiry or examination related to ROR by importing the firm’s mutual fund trading activity into our programmatic analysis environment, reviewing for ROR-eligible trading activity, and identifying records evidencing that the ROR benefit that we identified as due (whether a front load waiver or CDSC rebate) were handled contemporaneously via various record sources. Any remaining missed benefits are then quantified and summarized at the investor or account level. Bates will also provide insight into how FINRA has responded to various issues in prior ROR matters, assisting with any requests for additional information or support, until a result is agreed upon. Bates will then prepare a repayment file, including calculating prejudgment interest, for the firm to use.

Since President Biden issued an Executive Order in March 2002 directing agencies to collaborate on a “whole of government approach” for ensuring the responsible development of digital assets, the market has been anticipating the release of the broader framework. As we noted in a previous post, the Executive Order was well received, in large measure because it laid out a high-level set of unobjectionable goals. Among them: consumer and investor protection, financial inclusion, mitigation of illicit finance and national security risks; consideration of a U.S. central bank digital currency ("CBDC"); and the promotion of technological innovation prioritizing “privacy, security, combating illicit exploitation, and reducing negative climate impacts.”

The Framework, issued on September 16, 2022, remains a high-level mix of broad directives by nine separate federal agencies which support these goals. Here are the highlights.

Illicit Finance

The Framework reinforces the current U.S. role in anti-money laundering in the “digital asset ecosystem” while acknowledging that “digital assets have facilitated the rise of ransomware cybercriminals; narcotics sales and money laundering for drug trafficking organizations; and the funding of activities of rogue regimes.”

The Framework would strengthen U.S. efforts to mitigate these risks by proposing that the President consider legislation amending the Bank Secrecy Act. The Framework names a few of these proposed amendments including (i) “anti-tip-off statutes, (ii) a law against, and increased penalties for, unlicensed money transmitting to apply explicitly to digital asset service providers—including digital asset exchanges and nonfungible token (NFT) platforms,” and (iii) allowing the Department of Justice “to prosecute digital asset crimes in any jurisdiction where a victim of those crimes is found.” The Framework commits Treasury to complete an illicit finance risk assessment on decentralized finance by the end of February 2023 and on non-fungible tokens by the end of July 2023. Further, Treasury committed to greater outreach to stakeholders (including through a Request for Comment) to encourage more feedback on combatting “anti-money laundering, terrorist financing; hacks that result in losses of funds; and fragilities, common practices, and fast-changing technology that may present vulnerabilities for misuse.”

U.S. Central Bank Digital Currency

The Framework continues the ongoing debate about the whether the Federal Reserve should issue a Central Bank Digital Currency (CBDC) and how. The Framework reiterates the potential advantages of a US CBDC including “enabling access for a broad set of consumers,” fostering “economic growth and stability, protect[ing] against cyber and operational risks, safeguard[ing] the privacy of sensitive data, and minimiz[ing] risks of illicit financial transactions.”  The Framework moves forward with recommendations for additional research and development and “experimentation and evaluation.” In the Framework, Treasury committed to lead an interagency working group to further consider the implications of a US CBDC.

Protecting Investors

Strengthening disclosure and more aggressive and collaborative investigations and enforcement, particularly by the SEC, CFTC, and CFPB to combat fraud and scams are the primary recommendations to protect investors in cryptocurrencies. The Framework also encourages the FTC and CFPB to increase their efforts to monitor consumer complaints and share the data. Beyond that, the Framework recommends that regulators issue more guidance on emerging risks, and for the Financial Literacy Education Commission (FLEC) to lead efforts to raise public awareness of these risks.  

Innovation

The regulators agreed to “foster” innovation in the digital asset market by committing to (i) offer regulatory guidance and assistance to technology entrepreneurs (through programs like tech sprints and Innovation hours), (ii) “kickstart fundamental research on topics such as next-generation cryptography, transaction programmability, cybersecurity and privacy protections, and ways to mitigate the environmental impacts of digital assets,” and (iii) work to inform, educate and train “diverse groups of stakeholders on safe and responsible digital asset use.” In addition, the DoE and EPA committed to track the environmental impacts of digital asset use, developing performance standards and “providing local authorities with the tools, resources, and expertise to mitigate environmental harms.” The Commerce Department offered to host stakeholder forums to allow for discussion on new federal regulation, standards, technical assistance and research. 

Access to Financial Services

Without much detail, the Framework states that the President will consider “agency recommendations to create a federal framework to regulate nonbank payment providers.” Otherwise, the emphasis was placed on the development of instant payment systems including the coming launch of “FedNow,” a Federal Reserve Board effort to “enable financial institutions of every size, and in every community across the U.S., to provide safe and efficient instant payment services in real time.” The expectation is that payment providers would offer innovative technologies that will help to expand access. The Framework also encouraged more research in “technical and socio-technical disciplines and behavioral economics” to encourage accessibility.  

Financial Stability                            

The Framework highlights that the Treasury Department will continue to help financial institutions “identify and mitigate cyber vulnerabilities,” share data, develop analytical tools, and collaborate with other agencies on tracking and analyzing digital asset market strategic risk.

Global Competitiveness

The Framework highlights the current work being done in international bodies (e.g., G7, G20, OECD, FSB, FATF, and the International Organization for Standardization) by the United States with respect to policies and regulation for digital assets. The Framework emphasizes the importance of U.S. values, namely “data privacy, free and efficient markets, financial stability, consumer protection, robust law enforcement, and environmental sustainability,” to the dialogue. The Framework states that the U.S., through the Departments of State, Treasury, and USAID, will further these values and offer technical assistance to help build out global “digital asset infrastructure and services.” 

Conclusion

The Framework for regulating digital assets is very broad and reaffirms, in large part, what the agencies are already doing in the space. In that sense, the emphasis on more aggressive enforcement of existing rules is worth noting. Meanwhile, the new “whole of government approach” takes nothing off the table nor does it centralize oversight. In this regard, it does not provide the kind of direction that market participants have long called for.

Kicking the can further down the road, of course, presents its own risks. But perhaps—given current market conditions—the Framework prevented additional deleterious effects that more definitive directives might have provoked. That said, taking nothing off the table continues a pattern that does little to address longer-term digital asset development and the lack of regulatory certainty. The main takeaways are: more regulatory scrutiny based on existing rules and holdings, more uncertainty regarding future federal and state legislative mandates that are proceeding apace (notwithstanding this deliberative federal effort), and more potential enforcement jeopardy for firms. 

Bates will continue to keep you apprised.

Bates Group’s MSB, FinTech, and Virtual Assets practice offers guidance and services for Money Services Businesses and Non-Banking Financial institutions, fintech and cryptocurrency firms. Our crypto subject matter experts work directly with firms and counsel to design and implement policies to ensure they are AML-compliant. Our MSB and AML Teams help obtain and maintain Money Transmitter Licensing, and they also engage clients with BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.

Join Bates at the 2022 Securities Industry Symposium, on Wednesday, November 16, 2022. Sponsored by Greensfelder, Hemker & Gale, P.C. and the Bar Association of Metropolitan St. Louis.

The Symposium is an afternoon of highly informative discussions and networking opportunities with other securities professionals and will include interviews of Missouri Securities Commissioner Douglas Jacoby, NASAA President and Iowa Deputy Administrator for Securities Andrew Hartnett, and Gregory Markovich, FINRA Senior Director of its Cyber Enabled Fraud group, as well panels on current events for dual registrants and cybersecurity, which includes Bates Cybersecurity Expert Patrick Cox (pictured).

The symposium is accredited for 4.6 MO CLE hours.

Event Details and Registration

Bates Group is a proud sponsor of CrossTech World 2022 (formerly IMTC), November 15-17, 2022, at the Seminole Hard Rock Hotel & Casino in Miami, FL. Join our Bates MSB, FinTech & Virtual Assets team members Brandi Reynolds, Rob Ayers, Catherine Snyder, and Erin Dobbins (pictured above, L-R) for three days of compliance courses, trading workshops, panels, round tables, and networking for international financial services companies and service providers.

Don't miss the Crypto Investment & Trading Workshop "Using Crypto in Payment Companies: Crypto Basics Regulatory & Compliance," with Bates Managing Director Brandi Reynolds, on Tuesday, November 15 from 9:15-10:00 a.m. Brandi will also appear on the Compliance Officers' Discussion Forum: Regulatory Updates as moderator on Wednesday, November 16 from 11:45 a.m.-12:30 p.m., and later as a panelist on the Compliance Officers' Discussion Forum: Crypto Trends from 12:30-1:15 p.m. 

Also representing Bates at the conference is Rob Ayers, Business Development and Consulting Expert for MSBs and FinTech. He will be participating in the moderation of the Payment Track 2 Roundtable "Partnerships in the Banking Industry - Rails and Networks" on Wednesday, November 16 from 4:30-5:15 p.m.

CrossTech World (formerly IMTC) is the signature event of the Cross Border Transfers & Payments Industry. The conference brings together international financial services companies from around the world, as well as new sectors that are changing the face of the industry, including Remittance Service Providers (RSP), money transfer companies (MTO), money services business (MSB), mobile money operators (MMO), payment institutions, bill payment companies, Telcos, digital wallets, foreign exchange firms (Forex), and providers of products and services to the industry.

Conference Details and Registration

What is the rule?

The Beneficial Ownership Information (BOI) Reporting Rule establishes requirements for business entities—such as corporations or limited liability companies—who are created or registered in the U.S. to disclose information regarding their beneficial ownership to FinCEN.

Who must comply?

Generally, the rule applies to any domestic (registered in the U.S.) or foreign (incorporated abroad but registered to do business in any jurisdiction in the U.S.) company. A good rule of thumb is that the rule applies to any company who has filed a registration document with a state Secretary of State, Department of Corporations, or similar government agency.

Are there exemptions?

Yes – the rule follows the Corporate Transparency Act of 2020 and lists 23 types of entities which are exempt from reporting requirements, as they are already subject to substantial oversight at the federal or state level. Examples include banks, credit unions, insurance companies, any money services transmitting business and money services business (MSB) registered with FinCen, and entities registered with the Securities and Exchange Commission.

What is a beneficial owner?

FinCEN defines a beneficial owner as any individual who (either directly or indirectly):

1. Exercises substantial control over a reporting company or
2. Owns or controls at least 25% of the company

How do businesses comply?

Reporting companies must identify themselves to FinCEN and report the following information for each of their beneficial owners:

1. Name
2. Date of Birth
3. Address
4. Photo ID information and a copy of the ID

Beneficial owners may also opt to provide this information directly to FinCEN. If they do so, they will be issued a “FinCEN identifier” which reporting companies may submit to FinCEN in lieu of submitting the required beneficial ownership for that individual.

FinCEN will continue to publish guidance and instructions on how reports are to be filed and on how businesses can comply between now and the effective date of the rule.

When must business be compliant?

The rule becomes effective on January 1st, 2024. Reporting companies will have one year to file their initial reports. Reporting companies created after the effective date will have to comply 30 days after their creation or registration.

Source: Federal Register 87-189

John Ashley (CIPP/US, CCRS, CRCMP) is a Senior Consultant in Bates Group's Money Services, Fintech and Digital Assets Compliance and AML Practice. He can be reached at jashley@batesgroup.com.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

Visit The MSB Practice Page

Bates is a proud Networking sponsor of the 18th annual National Association of Women Lawyers (NAWL) General Counsel Institute, November 9-11, 2022, in New York City.

Now in its eighteenth year, GCI is a multi-day program of networking, education, and inspiration designed for senior in-house women counsel. Sessions with the general counsel of major corporations and other inspirational speakers foster frank, collegial discussions about career advancement, while workshops on key topics with leading experts provide opportunities to refine skills and expertise. GCI provides a unique environment to connect with other women counsel, share the highs and lows of in-house life, and build legal and leadership skills.

Conference Details and Registration

Connect with Bates Managing Director Jennifer Cunningham at the conference to discuss your securities litigation and arbitration needs, or reach out now to schedule a time to meet:

Under a proposed new rule, the SEC would require investment advisers to conduct due diligence and monitor “covered services” outsourced to third-party providers. The proposal would also amend Form ADV to include recordkeeping requirements as to the outsourcing of these "covered functions." The Commission said it recognizes that investment advisers are increasingly relying on outsourced sources to perform many functions in support of advisory services and, as a result, “more needs to be done to protect investors.” A Fact Sheet accompanying the proposal helps to break it down. Here’s what you need to know.

“Covered Functions”

The proposed new rule defines “covered functions” as those (i) necessary to the provision of advisory services and to comply with the securities laws, and (ii) that might cause a material negative impact on an adviser’s clients “if not performed or performed negligently.” Covered services may include, for example, third parties that provide portfolio management services, models related to investment advice, indexes, and trading services or software. (The proposal makes exceptions for “clerical, ministerial, utility, and general office functions or services.”)  

Due Diligence

Under the due diligence obligation in the proposed rule, the adviser must determine that the service provider would be appropriate to perform the covered function. Due diligence considerations include: the nature and scope of the covered function; potential risks and how to mitigate them; whether the service provider has the “competence, capacity, and resources necessary” to provide the service; any material subcontracting arrangements; any compliance coordination with the service provider; and issues that may arise in the event of a termination by the provider concerning the covered function. Ongoing due diligence would require that the adviser monitor the provider’s performance and keep books and records of these preliminary and ongoing oversight efforts.

Third-Party Record Keepers

The proposed rule adds special requirements when the service being provided is for advisor recordkeeping. Under this circumstance, the adviser must “obtain reasonable assurances” (i) that the service provider’s systems and processes satisfy the advisers’ obligation as to the recordkeeping rule; (ii) that the recordkeeping rule itself is being complied with (that the records are being created); (iii) that access to electronic records are provided; and (iv) that records are continually available even if the relationship with the provider ceases.

The proposal is open for comment for 60 days.

Bates supports firms navigating compliance with SEC rules. We work with your firm to address investment adviser concerns and to support efforts to conform to oversight, monitoring, recordkeeping and disclosure requirements. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

Visit Bates Compliance to Learn More

Bates is proud to be a sponsor of the 4th annual Raymond James Valor golf outing on November 5, 2022.

Valor, the Veterans' Inclusion Network at Raymond James, sponsors this annual golf tournament and raffle to benefit local veterans and their families.

Event Details and Registration

NASAA, the North American Securities Administrators Association, published their 2022 Enforcement Report detailing data collected from 48 jurisdictions in 2021. This annual publication serves several purposes. Primarily, it is an attempt to aggregate the efforts undertaken by state regulators to protect the public from fraud. NASAA reports that in 2021, its members collectively investigated 7,029 cases (new and ongoing), engaged in 196 criminal complaints, filed 80 civil cases, and handled 1,284 administrative actions.

A second purpose of the report is to highlight emerging trends in specific types of cases. As Joseph Borg (NASAA 2021-2022 Enforcement Section Chair, pictured) states in his introduction, the report flags concerns about complex theft and misapplication, real estate and energy scams, cryptocurrency, non-fungible tokens, and metaverse schemes. Attention to these developments serves to reinforce the message that NASAA members are alert to increasingly sophisticated efforts by bad actors to take advantage of new technology. Third, the report repeatedly reminds their audience that NASAA members are on the front lines in fighting efforts to defraud investors and does so aggressively even as it navigates socio-economic challenges (like the pandemic).

The focus of the report—as in years past—is on aggregated metrics on investigations and enforcement actions. Here are the highlights.

State Licensing and Compliance

NASAA focused on metrics concerning licensure, including application denials, conditional approvals, suspensions, revocations, and barring professionals from conducting business in the state. As a tool used by securities regulators to “prevent bad actors from entering the industry” and to control those engaging in misconduct, NASAA reports that in 2021, 232 applicants were denied licenses, 278 applicants received conditional approvals, 26 professionals had their licenses suspended, 50 had licenses revoked and 61 individuals were barred from doing business in their respective states. These numbers all represented significant increases from the prior year. The report added that some 4,880 individuals withdrew their applications for licenses, many as a result of being presented with evidence from investigations or to avoid an enforcement action. This, too, represented an increase year-over-year and suggests a kind of deterrence that the regulators have created based on their effective licensing “gatekeeping” efforts.  

Compliance cases involving licensed broker-dealers (678 investigations and 140 enforcement actions) and licensed investment advisers (478 investigations and 267 enforcement actions) encompassed the full range of oversight including on supervision, suitability, unauthorized and excessive trading, cybersecurity, and books and records.  

State Investigations and Enforcement on Products and Schemes

NASAA reported that the top products and schemes subject to state investigation and enforcement in 2021 concerned digital assets, internet and social media, promissory notes, real estate, stocks and equities, and Ponzi schemes.

The regulators said investigations related to suspect securities linked to digital assets increased by 70% year over year. They stated that “the importance and sheer volume of the work cannot be understated.” NASAA reported that state regulators opened 215 investigations of illegal or fraudulent securities offerings related to digital assets and initiated 89 enforcement actions for “misconduct involving products incorporating digital assets.” NASAA said that scams tied to cryptocurrencies and digital assets are the top threat to investors in 2022.

NASAA also reaffirmed the significant trend of bad actors’ increasing use of the internet and social media to market harmful products. The regulators said they opened 127 investigations of suspect securities offerings marketed through the internet and social media and 106 enforcement actions against promoters that use the internet and social media to market their scams.

On enforcement actions related to promissory notes, the report stated that these cases reflect attempts to take advantage of investors seeking safer investments as promissory notes purport to provide stability in a volatile marketplace. The state regulators said that “there were more enforcement actions involving promissory notes than any other products – and it was not even close.” Notably, the regulators warned that schemes incorporating promissory notes represented “a top threat to retail investors for 2023.”

As to concerns about the metaverse, cryptocurrency and non-fungible tokens, NASAA’s report was more future-oriented than a presentation of 2021 data. The report highlights the concern that “bad actors may be able to use the new technology to more effectively conceal their identities, launder money, market and sell illegal goods and impersonate trustworthy parties.” The report states that “fraudsters are now leveraging widespread interest in the metaverse to promote illegal securities offerings and deceive retail investors.”

Elder Financial Exploitation

Referring to the adoption of the NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation (some form of which is law in 33 jurisdictions), NASAA said that 1428 reports were received by financial professionals, of which 356 investigations were opened and 54 enforcement cases were initiated. These were marked increases year over year attesting to the success of the Model Act. On suspected senior financial fraud, NASAA members reported fielding 1,320 tips and complaints (beyond those from financial professionals), opening 605 investigations and filing 304 enforcement actions. These ranged “from traditional sales of unregistered securities to an increasing number of illegal promotions tied to precious metals, frauds perpetrated through social media and the internet, romance scams and other schemes designed to exploit older investors.”

Conclusion

The bottom-line aggregate numbers on state investigations and enforcement actions leave an impression. NASAA’s annual enforcement report positions itself as one moment in a continuum (past, present, and future) of state efforts to protect state constituents. However, the report best serves as a reminder to firms of the reach of state regulators into every aspect of their license to do business and their relationship with clients. The warnings on current and future threats from the metaverse and digital assets tied to securities are less of a snapshot reflecting 2021 data and more an assertion of state regulator jurisdiction over new products, new markets and new marketplaces. The aggregate numbers—$312,097,734 in restitution and $145,567,334 in fines and penalties—are too big to ignore. By publishing this data, NASAA’s message couldn’t be clearer.

Bates Group is a trusted partner to our financial services clients, counsel, and non-banking financial institutions, delivering superior quality and results on a cost-effective basis. We provide solutions for your legal, regulatory, AML, and compliance matters. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

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Money services businesses (“MSBs”) are required to conduct independent reviews to ensure their anti-money-laundering (“AML”) programs comply with Bank Secrecy Act (“BSA”) requirements. Under the BSA, MSBs must develop programs that identify and assess AML risks associated with their products, services, customers, and geographic locations and must take reasonable steps to manage them. Longstanding FinCEN guidance makes clear that the purpose of the reviews is to monitor the adequacy of these programs, especially in light of the recent expansion of BSA regulatory obligations under the Anti-Money Laundering Act of 2020. In this article, Bates offers tips to guide MSB firms in preparing for a review, including key review elements, timing, and selecting the right reviewer. 

What are the key elements for an independent review?

Independent reviews are concerned with assessing whether anti-money laundering risks for MSBs are being addressed. Policies, procedures, internal controls, recordkeeping, reporting, and training are all elements of an independent review. The reviewer must conduct tests to ensure that internal controls and transactional systems are working as intended and to identify weaknesses and potential fixes. To be thorough, the review must cover all actions taken by the compliance team on AML-related risk, on each of the above elements, and also on supervision of program controls and transactional systems.

When should independent reviews take place?

As formalized risk assessments are not required for MSBs, there is no mandated frequency for conducting independent reviews, but they must be periodic and appropriate to the level of risk. As these assessments change, the review period might change. “Given the changes to FinCEN regulations, MSBs should be proactively working on their programs and putting in place the oversight necessary to ensure compliance,” recommends  Brandi Reynolds, Bates AML & Compliance Managing Director and head of Bates Group’s MSB, Fintech and Virtual Asset practice.

Who should conduct  the independent review?

The independent review must include an unbiased assessment of each element of an MSB’s AML program. Under current guidance, a formal audit by a certified public accountant or third-party consultant is not necessarily required, but independence and thoroughness are key. (Remember, an internal assessment cannot be performed by an AML compliance officer, nor can it be someone who reports to the compliance officer.) Brandi points out that “the need for independence and the increasing complexity of AML regulatory obligations means that persons with the requisite knowledge and experience must oversee or conduct these reviews, in order for them to be considered adequate.”

Conclusion

Independent reviews on AML risk are becoming more important, not only to ensure compliance with current regulation and the documentation of all efforts undertaken, but also to uncover systemic weaknesses and to provide corrective recommendations for management. “In a changing AML regulatory environment, MSBs should be ensuring that their independent review framework is up to the task. These reviews are a critical tool in the regulator’s examinations,” said Brandi.

Bates Group  offers comprehensive independent review services that ensure your business will achieve AML compliance. Our reviewers are experienced in risk assessment and will thoroughly analyze policies, procedures,and processes. Components of your AML compliance program that we can review and analyze include: 

• Recordkeeping requirements under the BSA;
• Verification of policies, procedures, and processes in light of the BSA record retention requirements;
• Training initiatives;
• Compliance with USA PATRIOT Act sections 314(a) and 314(b), if necessary;
• FFIEC expanded procedures, if needed for your company;
• Suspicious activity monitoring and reporting (SARS);
• Remote deposit capture
• Customer identification requirements;
• AML Independent Reviews;
• Cash shipments, when appropriate;
• Funds transfer recordkeeping
• Monetary instrument sales recordkeeping

Our AML compliance independent review professionals manage even the most complex of review processes. We will thoroughly analyze your AML compliance program and accurately document our findings in a compliant manner. We know how much is on the line for your business when establishing a compliant AML program.

To learn more about our services for independent reviews or to talk to one of our professionals about our company’s reputation or commitment to our clients, reach out to us directly today at contact@batesgroup.com.

Join us for a new webinar "Money Services Business Best Practices + Your Crypto Company" on October 18, 2022, at 1 p.m. ET. Presented by the Money Services Business Association (MSBA), this complimentary webinar presents key elements crypto companies should consider for their AML program:

• Building an Effective AML program 
• Know your Customer/Transactor 
• Reporting and Monitoring (Chapter V) 
• Compliance Certifications (Chapter VIII)

Register Here

Bates Senior MSB Consultant John Ashley, CIPP/US, CCRS, CRCMP (pictured) will be speaking on the panel, along with BitAML President Joseph Ciccolo.

Bates Compliance is a proud exhibitor at this year's NSCP National Conference, October 17-19, 2022, at the Gaylord National Hotel and Conference Center in National Harbor, MD. Visit us at Booth #25 to meet with Bates representatives, learn more about our broad range of compliance and AML services, and pick up some goodies!

We can assist with:

• New Marketing Rule implementation
• Reg BI Client Relationship Summary (“Form CRS”)
• Policies and Procedures and Code of Ethics Manuals
• ESG policy development and disclosures
• BSA/AML Compliance
• Compliance Program Review
• Gap Analysis / Risk Assessment
• Rule 206 (4) -7 Annual Review
• Business Continuity and Disaster Recovery Plans
• Trade Blotter Analysis
• SEC Examination Preparation and Assistance
• Custody Review
• IARD Account Administrator and Annual Amendment Filing
• Amendments to Form ADV
• Due Diligence Review
• Cyber guidance
• FinTech and Virtual Assets
• Ongoing Consulting Assistance as Needed

Don't miss Bates Managing Director Hank Sanchez, Esq. (pictured) speaking on panel 10b: "Preparation for Disasters and Other Unexpected Events," on Wednesday 10/19 at 10:15 AM.

Not attending the NSCP conference this year? Please reach out to us to discuss your compliance needs at contact@batesgroup.com or call 503-670-7772.

Bates Group Money Services Business (MSB) and money transmitter expert Rob Ayers will be representing Bates in London at the 2022 International Association of Money Transfer Networks (IAMTN) Annual Summit. October 11-12, 2022.

This event will welcome financial services firms, payment processors, and fintech innovators from all over the world to discuss innovations that are changing cross-border payments, remittance digitalisation patterns by regions, and technologies such as open-banking and blockchain.

Rob will be moderating several panels throughout this 2-day event, including:

• Remittance digitalisation patterns - What can each market learn from the other?
• Blockchain as a new infrastructure for cross-border payments?
• Increasing customer expectations
• An investor's outlook on the remittance industry

Conference Details and Registration

Bates Group is proud to be a part of INFiN MoneyTrends 2022, October 10-13 in Austin, Texas. This 4-day event for Non-Bank Financial Institutions will offer networking, workshops and panels exploring the current state of the industry including FinTech, PayTech, LendTech and RegTech solutions.

Learn from Bates AML leaders Connie Fenchel and Brandi Reynolds (pictured) as they break down key anti-money laundering and compliance topics and review regulatory requirements and best practices. (Breakout Session V - Wednesday, 10/12 2:30-3:30 PM

In assisting MSBs to fulfill their compliance obligations, Western Union and Bates are also teaming up to offer conference attendees an intensive BSA/AML Compliance Training Session on Tuesday, October 11th. This two-hour session will highlight a variety of topics including best practices for maintaining your bank account, transaction monitoring, cybersecurity, risk assessment of information systems, federal and state legislative developments, the obligations of chief information security officers (CISOs), access privileges, and reporting requirements. We will also provide key tips for prevention, detection, and responding to cyberattacks. Certificate of Compliance issued for successful completion of this course. (Separate registration required - space is limited!)

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On September 30, 2022, FinCEN published a final rule and related Fact Sheet on the reporting requirements for beneficial ownership information (“BOI”). This is the first of three sets of rules intended to implement the Corporate Transparency Act, contained in the Anti-Money Laundering Act (“AMLA”) which became law on January 1, 2021. The new reporting rule, as described below, requires reporting companies to submit accurate reports to FinCEN on beneficial ownership. In future rulemakings, FinCEN will address (i) access and safeguards on reported BOI and (ii) revisions to the Customer Due Diligence (“CDD”) Rule affected by this new reporting rule.

The new BOI reporting rule is intended to “help combat money laundering, terrorist financing, corruption, tax fraud, and other illicit activity.” It covers who must file, what must be reported, and when. It goes into effect on January 1, 2024. Until then, FinCEN will be developing reporting forms and other guidance to help companies with their reporting compliance (including, for example, a Small Entity reporting guide). Here are some of the highlights of the new reporting rule.

Who does it apply to?

The rule applies to domestic and foreign reporting companies, including corporations, limited liability companies, partnerships, and legal arrangements like trusts and other entities, created in or registered to do business in the United States. (Note: FinCEN stated that it estimates the rule will apply to tens of millions of entities and that more than “two million corporations and limited liability companies are being created under the laws of the states each year.”)

Who is a Beneficial Owner under the rule?

The rule requires information about the beneficial owners of these companies, that is, the person(s) who ultimately own or control a company. Beneficial owners are those who directly or indirectly exercise “substantial control,” or own (or control) at least 25 percent of the ownership interests over the company. The rule provides guidance and examples on the term “substantial control.” Reporting companies are required to identify two categories of individuals: (i) the beneficial owners of the entity and (ii) those who filed applications “with specified governmental authorities (e.g. state or foreign authorities) to create the entity or register it to do business.”

What must every BOI Report include?

The rule requires the identification of the reporting company and four pieces of information about the beneficial owner. These include the beneficial owner’s (i) name, (ii) birthdate, (iii) address, and (iv) “an identifying number and issuing jurisdiction from an acceptable identification document” (with a copy of the document). A reporting company may seek an identifying number directly from FinCEN.

Additional Deadlines

FinCEN stated that reporting companies in existence before the effective date will have one year (until January 1, 2025) to file their reports. Any company created after the effective date will have to file a report within 30 days of registering. Also, reporting companies have 30 days to update or correct information in a previously filed report. That period begins on the date when the company becomes aware of any inaccuracy.

Conclusion

The January 1, 2024, effective date—and the filing deadline a year later—provide a long lead for companies to comply with the new requirements. In the interim, companies should anticipate that additional regulations (on safeguarding BOI and on the CDD rule) as well as upcoming guidance and finalization of forms will impact the compliance processes necessary to implement the rule. FinCEN estimated that it would likely “cost the majority of reporting companies only $85.14 to prepare and submit an initial BOI report.” Bates will keep you apprised.

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. We provide solutions for your legal, regulatory, AML, and compliance matters. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Compliance delivers guidance and tailored compliance consulting solutions to our broker-dealer, investment adviser and hybrid firm clients on an as-needed or ongoing basis. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems. 

Bates Group is a proud sponsor of the South Carolina Bitcoin Blockchain Conference, October 5-7, 2022, in Charleston, SC. The conference will focus on Economic Development, Education, and Policy Guidance. Bates Managing Director Brandi Reynolds will be there as a panelist and moderator.

The conference features speakers from South Carolina and across the nation, workshops, hardware and art showcases, and a Q&A session with SEC Commissioner Hester Peirce, SC State Treasurer Curtis Loftis, and SC State Senator Tom Davis. On October 6th in the Blockchain Hall, hear Bates Managing Director Brandi Reynolds on the compliance & regulatory overview panel "Bitcoin and Digital Assets Regulation By Enforcement" and later as moderator of the "Women in Bitcoin" panel in the Bitcoin Hall.

Conference Details & Registration

Each year, the SEC and FINRA release Exam and Risk Monitoring Reports highlighting continuing and emerging concerns for the year. These agency communications serve as a potential notice of subjects scrutinized for future examinations. We often hear the question, “How should I (or my team) best prepare for a regulatory examination?” We’ve got the answers.

In this guide, Bates Compliance Managing Director Linda Shirkey and Senior Consultant Shelley Dragon walk you through the exam process. Here, they break down what you need to know (including the various stages of an exam—before, during, and after), including: anticipation and preparation, first contact, document production, interviews, and findings.

 

Preparation Before the Exam

In anticipation of an examination, we recommend five ways to prepare:

1) Review your Form ADV filings, Client Agreements and Manual. Make sure that you are doing what you say you are doing. Specifically, are your representations and actions in sync?

2) Review your Manual for recent regulatory changes. This is a particularly important exercise in light of the SEC’s annual examination report. (Note: there has been significant scrutiny by the SEC on Form CRS recently. See Bates alert on recent enforcement actions.)

3) Review a recent SEC/State document request list with your team. Create a “roadmap” for preparing those documents and a presentation on the Firm to give the examiners.

4) Review your last findings letter/annual review report. Have the findings been remediated?

5) Consider conducting a fee audit. High on every regulator’s priority list, related to multiple rules, are conflicts, compensation, and funding arrangements. Do your fees match your agreements? Are all fees disclosed?

 

First Contact

Your first contact with a regulator begins with a short phone interview regarding the firm’s business and confirming information provided by the firm on Form ADV. Also covered are logistics: confirming the CCO’s email for sending a document request list; the scope of and nature of the exam (focused, limited, remote); scheduling issues (when documents are due); interview/onsite dates; and an introduction of the lead examiner and their contact information.  

Document Production

In general, the more organized the document production, the more relaxed the examiners are as the examination proceeds. We suggest a few tips to help you respond effectively. Foremost, be sure to understand what is being requested in terms of types of documents and time frames. Call the examiner for clarity, if needed. Establish a clear production process, e.g., designate the internal team, limit control over calls, select one person to manage the effort, determine who will produce what and how, and plan for regular check-ins with the team. Also important is to determine what outside help may be warranted—particularly related to data gathering and analytics—and engage them. Check, as early in the process as possible, that the data being produced is responsive to the requests and inform counsel or subject matter consultants if material issues start to show up. If red flags do appear, begin remediation immediately. For any other unusual data, prepare an explanation. Keep track of what was produced to the SEC and for which document request.  

Interviews – Before, During, and After

It is important to prepare and practice for interviews—be able to present an overview of the firm, read and reread the firm’s Form ADV and compliance manual, and prepare staff (in particular, the full senior management team). This means practicing interview skills—like how to answer the likeliest or most feared question or issue—and offering coaching on interviewing techniques.

The Chief Compliance Officer (“CCO”) should attend all interviews and should ensure that examiner concerns are addressed through regular outreach. On the first day, the CEO should give the firm presentation, introduce senior staff, and ensure that scheduling needs are coordinated. Documents requested during interviews should be tracked and timely produced. 

After the interviews, there may be follow-up questions or more document requests. The CCO and document manager should follow through (and allow for more interviews if warranted). If material items were identified during the onsite or interviews, begin remediation (if not already underway), possibly by correcting the manual, changing procedures, revising the Form ADV and/or client agreements, or by conducting staff training.

Findings and Next Steps

The lead examiner will call and read the findings letter. This is not a negotiation. The findings letter will follow that call, and the firm will be given a deadline to respond (usually about three weeks.) Every request for a change must be responded to in the order it was requested, even if the response is to “respectfully disagree.” Any changes made in response to the findings should be appended to the response letter.

Internal follow-up should include a review to ensure that all changes were implemented and then tested in six-month intervals to make certain the changes made are still in place.

Conclusion

Regulators expect that firms undertake a comprehensive review of their exam findings, observations and recommendations. Knowing and anticipating the process will help you better prepare and get through the exam successfully.

To learn more about how Bates Compliance services can help your firm, please contact:

In a new Risk Alert issued by the Division of Examinations, the SEC reminded investment advisers to review their written policies and procedures on the new marketing rule before the November 4, 2022 compliance deadline. This was not an idle suggestion. Staff stated that they will be conducting “a number of specific national initiatives” to ensure compliance with the new rule. They warned that after that deadline, advisers will not be able to rely on conformance with the old advertising and cash solicitation rules.

As discussed in Bates’ previous post on compliance preparation for the marketing rule, there’s a lot to review, because the new marketing rule consolidates previous SEC guidance, no-action letters and exam findings on questions concerning recommendations, testimonials, and the presentation of performance metrics. Here’s the latest on what the SEC wants you to know.

Key Areas for Review

The SEC stated that it will focus on four areas: (i) policies and procedures, (ii) the “substantiation requirement,” (iii) the “performance advertising” requirement and related prohibitions, and (iv) books and records requirements.  

Policies and Procedures: Staff expects firms to have “objective and testable means, reasonably designed to prevent violations of the final rule in the advertisements the adviser disseminates.” They suggested policies and procedures for conducting an internal pre-review and approval of advertisements, reviewing samples of advertisements based on risk, and pre-approving advertising templates.

Substantiation Requirement: Staff expects advisers to “have a reasonable basis for believing they will be able to substantiate upon demand” – through a contemporaneous record demonstrating that basis – material statements of fact in advertisements. They also noted that failure to provide such substantiation would create the presumption that “the adviser did not have a reasonable basis for its belief.”

Performance advertising: Staff said they will review a firm’s representations and prohibitions communicating performance. They referenced prohibitions on (i) gross performance (in the absence of net performance); (ii) performance results that do not refer to specific time periods; (iii) statements suggesting the SEC “approved or reviewed any performance results”; (iv) performance results from a subset of portfolios within an advertised offering with substantially similar investment policies, objectives, and strategies; (v) performance results “of a subset of investments extracted from a portfolio,” under certain conditions; (vi) hypothetical performance; (vii) and predecessor performance, under most conditions.

Books and recordkeeping: Staff said they will review marketing rule and amended books and record requirements that advisers make and keep certain records, “such as records of all advertisements they disseminate, including certain internal working papers, performance related information, and documentation for oral advertisements, testimonials, and endorsements.” They will also review Form ADV submissions for the information on marketing practices now required under the rule.

Conclusion

This alert serves mainly to remind advisers of the upcoming compliance deadline and the broad oversight, recordkeeping, and disclosure requirements under the rule. The SEC stated that it “encourages advisers to reflect upon their own practices, policies, and procedures and to implement any appropriate modifications to their training, supervisory, oversight, and compliance programs.” Upon engaging in that reflection, let us know if we can help.

Bates supports firms navigating and implementing the SEC’s New Marketing Rule. We work with your firm to address investment adviser concerns and to support efforts to conform to oversight, recordkeeping and disclosure requirements under the new rule. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

Visit Bates Compliance to learn more.

At summer’s end, the North American Securities Administrators Association, Inc. (“NASAA”) reminded financial professionals that state regulators remain a force to be reckoned with in an increasingly complex financial marketplace. Describing a need to protect elderly investors from unsuitable products, a need to protect average investors from the risks of confusing contract terms and misleading marketing communications, and to address ongoing and persistent complaints of fraud, NASAA proposed revisions to its Guidelines on Real Estate Investment Trusts (“REITs”). The regulation of publicly offered REITs that do not list their securities on a stock exchange (“non-traded REITs”) is not preempted by federal law and remains subject to substantive state securities law and state registration requirements. The proposed guidelines will be closely watched for the potential to add additional stringent requirements to existing federal regulations on financial professionals and complex products. 

Proposed Revisions

On July 12, 2022, NASAA requested public comment on amending its 2007 policy on REITs. The comment deadline on the proposal closed on September 12, 2022. The revisions have been in the works for several years—the latest set focuses on four updates.

The first proposed change would revise the standards of conduct applied to financial professionals that recommend or offer non-traded REITs to retail investors. These revisions would update the guidelines for brokers by enhancing the suitability standard to match the SEC’s Regulation Best Interest (“Reg BI”) standard. The guidelines keep the suitability section as “applicable when recommendations are made to non-retail customers.” NASAA recognized that REIT programs have been offered through investment advisers, “although still somewhat less popularly than through brokers.” The new guidelines would specifically prohibit indemnification to associated persons, investment advisers, or investment adviser representatives for violations of federal or state laws.

The second proposed change would adjust the net income and net worth required for investors. These adjustments are based on inflation, but the proposal requires REIT investors to have either (a) the combination of a minimum annual gross income of $95,000 and a minimum net worth of $95,000 or (b) a minimum net worth of $340,000.

The third proposed change would set a standardized concentration limit which would prohibit a total investment in the issuer that exceeds 10% of the investor’s liquid (cash, cash equivalents, and marketable securities) net worth. The new guidelines would impose the 10 percent concentration limit on the issuer, its affiliates, and other non-traded direct participation programs. NASAA stated that the concentration limit “accomplishes the goal of diversification to reduce the risk of loss from a single investment or single investment type.”

The fourth proposed change would prohibit REIT sponsors from making distributions from gross proceed distributions. (Within the REIT industry, NASAA states, it is relatively common—albeit “controversial”—for sponsors to market REITs as income-producing, and then to use investor proceeds from such offerings to fund cash distributions.) NASAA argues that the practice is potentially confusing and deceptive for investors, because “these are not liquidating distributions, but rather are distributions performed while simultaneously raising capital in the non-traded REITs offering to create the phantom ‘yield’ that was promised.”

Find a Bates REITs Expert

Impact on Other Guidelines

The proposed revisions to the REIT guidelines have implications for other NASAA guidelines under development. NASAA stated it is engaged in updates to its “Omnibus Guidelines, Asset-Backed Securities, Commodity Pools, Equipment Leasing, Mortgage Programs and Real Estate Programs (other than REITs),” as well as a “proposal for inaugural guidelines applicable to business development companies.” Integrating the Reg. BI standard into the guidelines while keeping the suitability standard present familiar compliance challenges. NASAA’s first report on Reg BI compliance raised many concerns. Should the proposed REIT requirements concerning concentration limits, net worth and income be imposed on other products regulated by states, compliance on recommendations could get exceedingly complicated.

The proposed guidelines have a long way to go before they are complete and face another long process before states adopt them. Bates will keep you apprised.

Bates Group’s experts offer consulting and testifying expert testimony. including for REITs, Reg BI and suitability. Find your expert today with our online Expert Search, or visit our Financial Securities Litigation & Consulting and Damages and Analysis services to support your net case ..

Contact us at contact@batesgroup.com or call 503-670-7772 to learn how we can support your team and your clients.

As the size of the private funds market has grown, regulators have been increasingly concerned about the risk posed to investors. In its 2022 annual Report, the SEC Examinations Division prioritized focusing on the “heightened risk to investors, registrants and the markets” of investing through private funds (see previous Bates coverage). In the Report, the Division estimated that 35% of registered investment advisers manage about $18 trillion in private hedge funds, private equity funds, and real estate funds. The sheer size of the market—and the state of the current disclosure framework covering it—has motivated regulators from both the SEC and CFTC to propose additional rule amendments to increase the regulatory oversight of private fund advisers and the funds they advise.

On August 10, 2022, the agencies jointly proposed to amend Form PF, a form they originally adopted in 2011, for reporting confidential information by SEC-registered investment advisers, as well as those registered with the CFTC as a Commodity Pool Operator (“CPO”) or Commodities Trading Adviser (“CTA”). The information collected on Form PF is intended to provide the Financial Stability Oversight Council (“FSOC”), an agency of the Treasury Department established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the necessary insight needed to assess systemic financial risks from private fund activity. The proposal, at 300 pages, is directed toward enhancing the FSOC’s abilities and to “bolster” the SEC’s regulatory oversight. Here are the highlights.

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

Bates Compliance

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

MSB, FinTech and Cryptocurrency

Regulatory and Internal Investigations

Retail Litigation and Consulting

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Erin Baskett, CPA, CGMA

Brokerage, Investment Advisory, Cryptocurrency Consulting

Erin Baskett is a Bates Consulting and Testifying Expert and the founder and CEO of Sine Qua Non Global (SQN-Global.com). She is a financial, compliance, and operational executive with significant experience in accounting, auditing, business consulting, capital markets, and financial services, with a solid knowledge of U.S. GAAP, tax, IFRS, FINRA and SEC rules in companies with both domestic and international presence. Erin holds multiple certifications, including Certified Public Accountant (CPA), Chartered Global Management Accountant (CGMA), and Certified Human Resources Specialist (CHRS), and regulatory licenses.

Full Bio

Patrick Cox

Fintech and Cybersecurity, Employment Matters, Broker-Dealer Sales Practice

Patrick Cox is a Bates Testifying and Consulting Expert based in San Diego, California, with extensive experience in Retail Securities, Investigations, Cybersecurity, Privacy, and Compliance. Prior to joining Bates, Patrick was Executive Vice President and General Counsel for Advice, Litigation and Regulatory Strategy with LPL Financial, where he was responsible for all litigation, regulatory, and legal advice matters for the firm’s business units. He and his team also conducted internal investigations for the firm’s integrity hotline and other matters. Patrick was an ex-officio member of the firm’s Risk Oversight Committee for many years and provided ongoing advice to members of the Management Committee with reports to the Board of Directors on special issues. 

Patrick spent 20 years representing Morgan Stanley, Ameriprise Financial, and LPL Financial and their employees, and he handled hundreds of matters ranging from wrongful termination, raiding and recruiting, retail arbitrations, class actions, shareholder actions and internal investigations. He also worked on many due diligence and acquisition issues, both at LPL and Ameriprise. Prior to working in-house at Morgan Stanley, Patrick served as a civil litigator, an Adjunct Associate Professor at Fordham University School of Law, a law clerk at the U.S. Court of International Trade, and an Assistant District Attorney in Manhattan. An experienced executive and advocate, he received his Juris Doctor from Fordham and his Bachelor of Arts in English from Loyola Marymount University.

Full Bio

Frederick Egler

Operational Risk Management, Insurance/Reinsurance, Banking

Frederick Egler is a Bates Testifying Expert specializing in risk, compliance, and litigation management responsibility for all divisions of diversified financial services organizations. He has been responsible for claim and contingency resolution as well as risk mitigation measures, including development, implementation, and evaluation of risk identification and assessment programs, policies and procedures, internal controls, and appropriate financial disclosure and accounting treatment for a wide variety of risk events and contingencies. Frederick is is also available for consultation on insurance and reinsurance underwriting and claims management, including structure and management of captive insurers, creation and maintenance of enterprise insurance programs as part of overall risk mitigation strategy, and issues relating to coverage and claims management.

Full Bio

Brian Warshaw

Broker-Dealer Operations, Introducing Firm Operations, Transaction Processing

Brian Warshaw is a Bates Testifying Expert who started his career over 41 years ago as a Branch Operations Manager with Merrill Lynch. Brian’s career allowed him extensive experience in branch and core home office service and operations throughout the US and overseas markets. His in-depth knowledge of the rules, regulations and the practical application of them created a career growing executive responsibilities culminating in his last position in Rockefeller Capital Management (RCM) as head of Wealth Management Operations. Under Brian’s direction, Rockefeller (an UHNW-focused company that clears through National Financial Services) went from $15 billion AUM to $100 billion over 3 years.

At Merrill Lynch, Brian created a Branch Operations Manager training program (used worldwide), managed the sale of Merrill Lynch International Wealth Business to Bank Julius Baer (migrating $300 billion in assets), and managed all financial transaction processing through the Merrill Lynch core books and record systems. He was directly responsible for the margin department, tax reporting, cash management processing, trading, securities pricing, and fraud control, among other oversight. In his last full year at Merrill Lynch, Brian’s areas were audited 147 times with no violations found.  

Brian is a Past President of the SIFMA Credit and Margin Section, a former member of the FINRA Margin Committee, acted as an Arbitration and Legal Matter Subject Matter Expert on behalf of Merrill Lynch and FINRA and held FINRA Series 99, 7, 24 and 28 licenses.

Full Bio

Bates Welcomes Paul Lambert, Former Bank of America Chicago Market President and Merrill Lynch Midwest Division Executive, as a Strategic Advisor and Consulting Expert - Bates Group

We've Moved! Bates Relocates to Lincoln Center in Portland - Bates Group

Bates Group Expands its National MSB, FinTech, and Cryptocurrency Practice - Bates Group

Bates Welcomes New Consulting and Testifying Experts – June 2022 - Bates Group

Bates Managing Director Julie Johnstone Quoted in InvestmentNews Article on Reg BI and FINRA Arbitration - Bates Group

Bates Managing Director Brandi Reynolds Quoted on the Pending Regulatory Framework for Crypto and Virtual Assets - Bates Group

See All Bates News & Events

August

• On the Radar with FINRA: Remote Offices, Expungements, Customer Account Transfers, Digital Signature Forgeries - Bates Group
• New Developments for New York BitLicense Holders and Applicants - Bates Group
• Is Past Really Prologue When It Comes to Your Mutual Fund Share Class Selection, Conflicts, and Disclosures? - Bates Group
• SEC Staff Offers Additional Guidance on BD and IA Conflicts of Interest - Bates Group
• The SEC Marketing Rule - What You Need to Know - Bates Group

July

• FINRA Proposes Updates to Supervisory Rule on Home Offices - Bates Group
• Reg BI Makes FINRA’s Dispute Resolution Stats List and Other Notable Arbitration Developments - Bates Group
• SEC Case finding CCO “Aided and Abetted” Raises New Questions; Is a Liability Framework Next? - Bates Group

June

• Fighting Elder Financial Exploitation: FinCEN Releases Behavioral and Financial Red Flags, NASAA Publishes Guidance on POAs, CFTC Releases Warnings - Bates Group
• A Comprehensive Bi-Partisan Approach to Cryptocurrency: New Senate Bill Seeks to Establish Digital Asset Framework and Legal Oversight - Bates Group
• Regulatory and Legislative Action on SPACs Gaining Momentum: SEC Rule Proposal and Senate Legislation Introduced; Class Actions Growing - Bates Group
• Non-Fungible Tokens: a Beginner’s Perspective - Bates Group
• SEC Proposes Amendments to ESG Disclosure Rules and Forms - Bates Group

Here's a fun song to get you moving and grooving with that summer feeling.

• September 7^th - ACAMS Chapter Meeting: Cryptocurrency from A to Z webinar – Brandi Reynolds, Managing Director, AML & Compliance, is speaking.
• September 13^th - Southeast Women in Finance (SWIFs) Virtual Lunch and Learn, Fireside Chat: Crypto in the News – Brandi Reynolds is speaking.
• September 19^th - SIFMA C&L Regional Seminar, Charlotte, NC – Meet up with Bates Leaders and Experts.
• September 19-22^nd - MTRA Annual Conference, Fort Worth, TX – Meet Bates AML Expert and Strategic Advisor Connie Fenchel.
• September 30^th - FSDA Industry Outreach Program , Boca Raton, FL – Join Jennifer Stout, Bates CEO and FSDA President. Bates is a diamond sponsor.
• October 5-7^th - South Carolina Blockchain Conference , Charleston, SC – Brandi Reynolds is speaking.
• October 17-19^th - NSCP National Conference, National Harbor, MD – Managing Director Hank Sanchez is speaking. Visit the Bates Compliance Booth # 25 and connect with Director Rory O’Connor.
• October 10^th - IAMTN Summit 2022, London, UK – Bates Advisor and Consultant Rob Ayers is speaking.
• October 10-13^th - InFin Money Trends 2022, Austin, TX – Brandi Reynolds and Connie Fenchel are presenting.
• November 3-6 - NAWL General Counsel Institute, New York City, NY – Join Bates Managing Director Jennifer Cunningham and Bates Expert Sheila Murphy. Bates is a sponsor.

For additional information and practice support, please Contact Us today and follow the links below to Bates Group’s Practice Area pages. Our team is always delighted to take your calls at 503-772-6770.

Consulting and Expert Testimony

Securities and Financial Services Litigation

Data Analyses and Analytics

Bates Compliance

MSBs, FinTech, and Virtual Assets

Regulatory and Internal Investigations

Bates AML and Financial Crimes

Forensic Accounting and Economic Damages

Annuity, Insurance, and Actuarial Services

Continuing to grow and expand its national reach, Bates Group welcomes Paul Lambert as a Strategic Advisor and Consulting Expert. A 30-year financial services veteran at Bank of America Merrill Lynch, Paul was most recently Bank of America Chicago Market President and Merrill Lynch Midwest Division Executive, overseeing 14 Midwestern states with 2,500 advisers across 110 offices. In those positions, Paul successfully shaped strategy, served clients across the entire company, improved revenue and financial performance, fostered a well-supervised business that prided itself on strong compliance, and drove record employee engagement. At Bates, Paul will be working with senior leadership to expand our client engagement across the business.

Paul also served as a Regional Managing Director, leading Merrill’s ultra-high net worth business in the Midwest, and as Director of the Merrill Lynch New York Capital Complex, based in Albany, New York, where he earned special recognition as one of the Capital Region’s “Best Places to Work” in 2005 and 2006, as well as the 2007 Capital Region Human Resources Association “Spectrum Award” for promoting diversity and inclusiveness in the workplace. Paul has also held many national strategy, leadership, and coaching roles.

Paul joined Merrill Lynch in 1992 as a Financial Advisor in the Rochester, New York office where he founded and grew a wealth management business to a team of six associates working with more than 400 HNW clients and $200 million in assets. He maintains FINRA Series 3, 7, 8, 31, 63, and 65 licenses and is also a Certified Investment Management Analyst (CIMA) and Chartered Retirement Planning Consultant (CRPC).

Outside of financial services, Paul has served on the Board of Trustees for the Art Institute of Chicago, Chicago Community Trust, Civic Committee of the Commercial Club of Chicago, and Albany Medical Center. He also helped develop and launch We Rise Together, an initiative to promote an equitable and just recovery post-pandemic.

“We are looking forward to working with Paul, a highly accomplished executive and industry leader whose insights and decades of exceptional success will benefit Bates clients across the board,” said Bates Group CEO Jennifer Stout.

Read Paul's Full Bio Here.

FINRA remained active this summer with a series of important proposed rule changes and risk-related compliance reminders. Here’s a summary to keep you up to date.

Recent Proposed Rule Changes

Remote Offices: FINRA has been methodically moving toward allowing the use of remote offices on a permanent basis. Previously, Bates described a recent proposal to FINRA Rule 3110 (“Supervision”) to allow a home office to be considered a non-branch “residential supervisory location.” (The proposal was published in the Federal Register on August 2, 2022, and the deadline for comments was August 23, 2022.)

On August 9, 2022, FINRA published a new proposal to create a pilot program allowing broker-dealers to conduct remote annual office inspections. The new proposal amends FINRA rules on supervision to set up a pilot which would effectively extend previously granted COVID relief from the requirement of on-site inspections. (That relief is due to expire by the end of the year.) FINRA limited participation in the pilot program by excluding high-risk firms. Another limitation in the proposal requires firms to conduct a risk assessment for each office designated for remote inspection and to have related written supervisory procedures for that assessment. The comment deadline is September 6, 2022.

Expungement: On July 29, 2022, FINRA proposed amendments to the Code of Arbitration Procedure to change the process for the expungement of customer dispute information. The 300-page proposal recounts the history of FINRA’s expungement rules and explains how the new amendments would balance the interests of (i) state and federal securities regulators—to have accurate and relevant information; (ii) investors—to have access “to accurate and meaningful information about associated persons with whom they may entrust their money”; (iii) broker-dealer firms—to have information for employment decisions; and (iv) the brokerage community—to have “a fair process to address inaccurate customer dispute information.”

The new rules would impose additional requirements for expunging customer dispute information. Among them: a “straight-in request” must be decided by a randomly selected three-person panel of experienced public arbitrators with enhanced expungement training, a request must provide notification to state securities regulators who can participate in the hearing, and a request must include a requirement for unanimous agreement of the panel to issue an award containing expungement relief. The proposal would also update procedures for requesting expungement of customer dispute information during simplified arbitrations. (The proposal was published in the Federal Register on August 15, 2022 and the deadline for comments is September 6, 2022.)

Compliance and Risk Reminders

Customer Account Transfer Contracts: On August 8, 2022, FINRA reminded members of their obligations on customer account transfer contracts (FINRA Rule 11870) between broker-dealer firms. Customer account assets move between broker-dealers through a system established for such account transfers (“ACATS”). In the Notice, FINRA reminded members to (i) expedite and coordinate their activities when a customer gives authorized instructions to transfer securities account assets; (ii) not remove an asset from the ACATS system unless it is a “nontransferable asset” (i.e., “an asset that is a product of a third party – e.g., mutual fund/money market fund – with which the receiving member does not maintain the relationship or arrangement necessary to receive/carry the asset for the customer's account”; and (iii) for a receiving member who removes a nontransferable asset using the new “receiver-delete” function in the ACATS system (i.e., a function that a receiving member may use “to designate an asset as a nontransferable asset and remove it from the list of assets to be transferred,” to provide the customer with a list of the nontransferable assets and a request in writing including instructions from the customer with respect to the disposition of the assets. FINRA stated that member obligations “do not end with the designation of an asset as nontransferable” when using the receiver-delete function. FINRA also stated that members must remember to request, in writing, instructions for the disposition of nontransferable assets, and “to expedite and coordinate their response to customer instructions with respect to the transfer of customer account assets.”

Digital Signature Forgery and Falsification: FINRA reminded firms that allow digital signatures “to have adequate controls to detect instances of signature forgery or falsification.” Many of the issues raised concern registered representatives and associated persons attempting to manipulate third-party digital platforms to forge or falsify customer signatures. To help mitigate the risks for firms, FINRA’s Notice details current regulatory obligations, and highlights digital signature scenarios reported to FINRA.

FINRA identified regulatory obligations under FINRA Rule 2010 (“standards of commercial honor and just and equitable principles of trade”), FINRA Rule 4511 (“books and records”), and FINRA Rule 3110 (“Supervision”), describing how signature forgery or falsification violates each. Signature forgery and falsification scenarios were identified in account opening documents and updates, account activity letters, discretionary trading authorizations, wire instructions and internal firm documents related to the review of customer transactions. To combat the problem, FINRA suggested that firms be attentive to potential signature forgery or falsification issues during customer inquiries or complaint investigations, digital signature audit trail reviews, e-mail correspondence reviews, administrative staff inquiries, and customer authentication supervision reviews.

Conclusion

Proposed rules on remote offices and expungement reflect efforts to make processes and procedures current in a changing marketplace. The updates address a broad set of stakeholders and attempt to take advantage of new technological tools. The FINRA compliance Notices demonstrate a recognition that firm’s need to constantly review obligation and procedure to remain in compliance with the consequences of constantly changing market and regulatory conditions. Bates will keep you apprised.

Email us at contact@batesgroup.com or call 503-670-7772 to speak with a Bates representative about how we can help you with your FINRA case, ongoing compliance, or project compliance needs.

The Consultants and Experts at Bates stand ready to support clients with their FINRA matters. Bates Compliance delivers guidance and tailored compliance consulting solutions to our broker-dealer, investment adviser and hybrid firm clients on an as-needed or ongoing basis. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems. Our Securities and Financial Services Litigation practice provides retail and institutional litigation consulting and data-driven analytic support and solutions for BDs, RIAs, banks and insurance companies. Our quantitative analysis and qualitative case strategy, advice, and expert testimony cover the full spectrum of investment activity, employment, and regulatory matters.

In 2015, the New York Superintendent of Financial Services came up with a response to the growing popularity of Bitcoin and other cryptocurrencies. The idea was a new charter based on the historic template for bank and trust charters. Called BitLicense, it came with many of the trappings of a bank or trust charter, including:

• Mandatory minimum capital
• Periodic examination by State examiners 
• Periodic reporting to the Superintendent
• Required policies and procedures (e.g., anti-money laundering, risk management and disaster recovery)
• Controls on new product and service offerings
• Regulation of changes in control

Similar to a bank charter, the procedure to obtain the license included fees payable to the State and a long application. The application included complete personal financial disclosure required of individuals associated with the proposed entity. Fees to professionals (lawyers, economists, or other advisors) have been estimated by outside observers to total $100,000 or more.

Also like a bank charter, the BitLicense process is daunting. Despite the challenge and expense, 20 firms signed up for one immediately, though not all of them completed the process. As of late 2021, according to industry newsletter CoinDesk, there were 25 firms authorized to operate under the regulation, including 6 that chose a limited purpose trust option license. Notably, the CoinDesk list shows there were no new licenses approved through September of 2021. Another news article published in May, 2022 cites 22 firms as license holders.

The list of license holders is revealing. The group includes Square, the payments company established by Twitter founder Jack Dorsey. Others on the list intend to use the BitLicense for options trading, and several licensees are providing services as fintechs in the payment services area.

The six firms that have received a limited purpose trust license appear to be interested primarily in providing custody services. Fidelity is the best-known name of the group, adding crypto custody to its array of other financial and investment services. One other, Paxos, is an issuer of cryptocurrency.

A Cloudy Future

The current inflation-riddled environment is a problem for any new business. For a crypto-based business, the difficulties have been magnified by serious declines in the value of cryptocurrencies. For example, Bitcoin has fallen from over $68,000 in November 2021 to around $20,000 in late June 2022. Terra, an issuer of “stablecoins” based on the U.S. Dollar, failed to hold its value at $1.00. A successor, Luna, has also failed to the point of being virtually worthless. CoinBase, the leading cryptocurrency exchange, may be the subject of a short squeeze that threatens its existence.

All of this is resulting in major financial pain to owners of crypto, issuers of crypto and of crypto-backed assets (such as ETFs), and companies serving the crypto industry, like the BitLicense holders. This last group can expect New York examiners—among other regulators—to peer into their books and records and to demand corrective action to respond to any noted deficiencies.

The FDIC is not likely to be involved, so any failure will pose only a minimal threat to the banking system. There is a significant threat to the BitLicense holders, however, because New York examiners will follow examination procedures based largely on those created by the FDIC. The corrective action might include a demand for additional capital, civil money penalties, management changes and closure of the institution.

Bates Offers AML and Compliance Services for Cryptocurrency and Virtual Asset Firms

New Developments

In mid-May 2022, Adrienne Harris, superintendent of New York's Department of Financial Services, announced that she was speeding up the BitLicense process. The Superintendent reported that her office had revised processes and approved three licenses this year compared to only one in 2021. (The previous process had taken years from application to approval.) There was not a statement on the length or other aspects of the revised process.

What to think about BitLicense?

The BitLicense has been controversial from the start. Proponents argue that it brings some order to a chaotic market. They also argue that it brings important consumer protections to an inherently risky endeavor. Opponents see it as just more regulatory overreach while noting that the BitLicense erodes some of the anonymity that has been a compelling selling point for crypto assets. Notwithstanding these opinions, New York continues to move forward in issuing BitLicenses. While there are only a few BitLicenses active, the State has granted more of them in the last 8 years than it has commercial banking licenses. For those seeking a BitLicense, new regulatory and process revisions are a welcomed start.

Paul Nelson is a Consulting Expert at Bates Group with more than 45 years of involvement with the regulatory and legal compliance issues facing banks and nonbank financial services providers. His five years as a Senior Attorney and Acting Regional Counsel with the Comptroller of the Currency formed the basis of his education in the principles of bank regulation as practiced in the U.S.

Paul has also served as a General Counsel of the U.S. House Banking Committee and as a registered lobbyist in private practice. In his long history in financial services regulation, Paul has represented clients in courts, before both federal and state financial regulatory agencies, the U.S. Congress, the NASD (now FINRA), and arbitration panels.

Bates Group has recently relocated our corporate headquarters from Lake Oswego to Portland. Our new address is:

2 Lincoln Center

10220 SW Greenburg Road, Suite 200

Portland, OR 97223

Phone: (503) 670-7772

Please remember to update your contact information and records to reflect our new main office address. We will continue to provide the same industry-leading services as we settle into our new location!

Did Shakespeare get it right? Let us help you put the past in the past.

“What’s past is prologue.” This line from Shakespeare’s “The Tempest,” written over 400 years ago, has come to mean that history can provide context for events happening today.

About four (not 400) years ago, we reported on a discussion forum on SEC examination and enforcement initiatives where the OCIE Director expressed concern that their warnings related to appropriate share class recommendations and other related forms of compensation were not being heeded despite numerous enforcement actions, settlements, and repeated statements that mutual fund share class selection, conflicts, and disclosure were an important regulatory priority.

• Recently, FINRA Enforcement concluded a matter involving a major financial services firm with a large fine, finding that clients purchased Class C mutual funds when Class A shares were available at substantially lower costs. Jessica Hopper, EVP & Head of FINRA’s Department of Enforcement reminded and encouraged firms to “proactively detect, fix, and remediate these types of supervisory issues.”

 

•  A few months ago, the SEC settled charges against a registered investment adviser (“RIA”) for a breach of fiduciary duty to its advisory clients as a result of investing wrap fee clients in higher cost mutual fund share classes then were otherwise available while failing to disclose conflicts of interest associated with those investment recommendations. The SEC concluded that the RIA breached it duty of care, including its duty to seek best execution, by causing wrap fee clients to invest in fund share classes that charged 12b-1 fees when share classes of the same funds presented a more favorable value to clients.

These are just two examples of this type of regulatory action—there are more. So, is past inevitably prologue, or can we truly leave it in the past?

Yes, William Shakespeare, the past can still be prologue, but Bates can help clients put the past in the past.

We have provided consulting support to clients and counsel on over 70 share class and related matters involving fees and other forms of compensation generated by investor mutual fund holdings including revenue sharing, missed rights of reinstatement benefits, annual expense ratios, the 12b-1 subcomponent of those same annual expense ratios, and avoided transaction costs, just to name a few. 

• Bates was retained on behalf of dozens of financial institutions in evaluating whether to self-report under the SEC’s Share Class Disclosure Initiative, as well as by those who reported, and by many who did not report and subsequently found themselves defending investigations and enforcement actions.  
• We have worked with clearing firms to gather required data, conducted a thorough evaluation of instances in which a lower cost share class was available and the client qualified for that lower cost share class, calculated the difference in fees charged, identified exceptions in the population where disclosures were sufficient or another factor justified the share class selected, and provided final reporting numbers for client use with the SEC (after discussion with counsel).  
• We also assisted clients by providing metrics and reporting that contextualized the behavior of specific FAs, branches, account types, and other key indicators.  
• We were also retained by dozens of financial institutions in evaluating whether to self-report under FINRA’s 529 Plan Share Class Initiative, those who reported, and those pursued by FINRA after the close of the Initiative.  
• We worked with plan sponsors to gather required data, identified C-share activity where the beneficiary was less than 12 years of age, evaluated breakpoints and expense ratios offered by the share classes at issue (A and C) to determine the breakeven point wherein C-share investors were potentially harmed, and calculated that harm based on the expense ratio differential. We identified exceptions in the population where the rationale for the C-share purchase was sufficient, and after discussion with counsel provided final reporting numbers for use with FINRA.

In service of these projects, Bates employs a team of programmers who combine subject matter expertise with the ability to process and analyze large amounts of data. Bates has also developed proprietary databases related to historical mutual fund information, including fee rates, etc., which are necessary to support an accurate review of potential harm. And, where necessary, our team of former Supervisors will review suitability determinations made for thousands of individual clients. Bates’ experience allows our clients and their counsel to be confident that they have isolated only those investors who may have incurred harm, and the amount of that harm. That process includes getting the right data and setting it up correctly, identifying ways to reduce the at-issue population, quantifying any available offsets to the damages, reviewing the subject transactions for suitability, and providing final reporting.

Let us help you put the past in the past. Contact us today to learn more: 

David Birnbaum, Managing Director

dbirnbaum@batesgroup.com or  917-273-2682

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

arussell@batesgroup.com or  971-250-4353

On August 3, 2022, SEC staff issued new guidance addressing conflicts of interest under the Regulation Best Interest (“Reg BI”) standard for broker-dealers and the fiduciary standard for investment advisers. While the staff bulletin states clearly that the guidance is intended only to be a reflection of internal views on the subject, its tone, comprehensiveness (replete with numerous examples), and even its pragmatic question-and-answer format warrant careful attention. From the outset, the bulletin advises broker-dealers and investment advisers to “review their business models and relationships with investors to address conflicts of interest specific to them.” That would entail thoroughly reviewing a firm’s practices and procedures on all things that might create a conflict of interest, and then making adjustments consistent with this guidance. Here’s an overview.

Core Principles under Reg BI and the Fiduciary Standard

The guidance reaffirms the basic principles that underlie the different standards required of broker-dealers and investment advisers. The SEC defines a “conflict of interest” under both standards as “an interest that might incline a broker dealer or investment adviser – consciously or unconsciously – to make a recommendation or render advice which is not disinterested.”  

Under Reg BI, broker-dealers owe four duties to retail clients: disclosure, care, conflicts of interest and compliance. (For a detailed discussion of Reg BI requirements and firm compliance, see Bates’ White Paper). The bulletin reiterates that the duties on conflicts of interest under Reg BI require that broker-dealers who make recommendations to retail clients have written policies and procedures reasonably designed to (1) identify and disclose, or eliminate, all conflicts of interest; 2) identify and mitigate conflicts by associated persons; (3) identify and disclose securities investment strategies that may place the interest of the broker-dealer ahead of the interest of the retail customer; and (4) identify and eliminate certain “sales contests, sales quotas, bonuses, and non-cash compensation.” These requirements to identify, mitigate and eliminate conflicts exist under the other Reg. BI duties (compliance and disclosure) as well as in the care obligation, which requires a broker dealer to have “a reasonable basis to believe that each recommendation or series of recommendations made is in the best interest of the particular retail customer and does not place their financial or other interests ahead of the interest of the retail customer.”

For investment advisers, the bulletin reaffirms the core obligations under the fiduciary standard, including the duties of loyalty and care. Under the former, staff describe the obligation to eliminate conflicts of interest and make full and fair disclosures so that clients can give informed consent. Under the latter, they reiterate that investment recommendations must be in the client’s best interest, grounded in a “reasonable understanding of the client’s objectives." Also emphasized is the importance of written policies and procedures and recordkeeping, without which “it would be difficult for an investment adviser to demonstrate how it complies with its fiduciary obligations.”

New Guidance on Conflicts of Interest

The new bulletin includes an examination of the practical issues arising from these duties. This guidance is organized around (i) identifying conflicts, (ii) eliminating conflicts, (iii) mitigating conflicts and (iv) disclosing conflicts. While the guidance differentiates obligations under the two standards where applicable, the focus is directly on how to achieve these four compliance objectives.

Identifying Conflicts: Have An Ongoing Process and Procedure

The SEC acknowledges that all broker-dealers and investment advisers “have at least some conflicts of interest with their retail investors,” but that the “nature and extent” of these conflicts varies, often related to a firm’s business model. The bulletin lists various examples of conflicts stemming from arrangements on compensation, revenue or other benefits to the firm or its affiliates.

The bulletin emphasizes the importance of having ongoing processes and procedures to identify conflicts. The expectation is that broker-dealers develop, maintain, and periodically review policies and procedures to identify conflicts on an ongoing basis. Investment advisers must also identify “other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations.” They also note that disclosure of a conflict alone is not enough to satisfy the best interest or fiduciary obligations.

Eliminating Conflicts:

Broker-dealers and investment advisers may have to eliminate a conflict if it prevents them acting in the best interest of the retail investor. As to broker-dealers, Reg BI explicitly requires written policies and procedures “reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.” Investment advisers are warned that, if the “nature and extent” of the conflict makes it difficult for the adviser to provide full and fair disclosure, and if the conflict cannot be mitigated, the adviser should eliminate the conflict or refrain from providing the advice or recommendation. Based on several examples, the bulletin concludes that if a particular practice incentivizes a “financial professional[] to place the firm’s or the financial professional’s interest ahead of the retail investor’s interest, the firm may need to revise its incentive program to reduce or eliminate the conflict.”

Mitigating Conflicts:

A detailed section of the guidance deals with how a firm should mitigate a conflict of interest, primarily dealing with compensation, financial incentives, and other benefits, followed by a list of factors that should be considered when mitigating a conflict. Among those are (i) the extent to which a firm’s revenues vary based on the type of account, products, and services recommended; (ii) the extent to which incentives may encourage financial professionals to recommend products that are more profitable for them or the firm; and (iii) the payment structure for financial professionals. As a result, the bulletin reiterates that firms should consider whether their compensation programs could incentivize financial professionals to make recommendations that place their interests ahead of the interests of their retail investors. The SEC is persistent in reminding firms that conflicts must be addressed at the firm level as well as at the associated person level (as required by Reg BI).

The guidance repeatedly asserts that it is important to periodically review and test policies and procedures to “ensure the on-going adequacy and effectiveness of a compliance program.” That requires documenting the ways in which the firm mitigates conflicts of interest.

Disclosing Conflicts: Use “Plain English”

The SEC warns that disclosures should not be a “check the box” exercise, rather, that disclosures “should be specific to each conflict, in ‘plain English,’ and tailored to, among other things, firms’ business models, compensation structures, and products offered at different firms.” For broker-dealers, the bulletin emphasizes full and fair disclosure of all material facts that might “incline the firm or its financial professional to make a recommendation or provide advice that is not disinterested.” Investment advisers must “make full and fair disclosure of all conflicts of interest which might incline an investment adviser–consciously or unconsciously–to render advice which is not disinterested such that a client can provide informed consent to the conflict” (emphasis added). In cases where the conflict is “difficult to disclose comprehensibly,” staff states that the firm should address it through mitigation or elimination.

Get the Latest on Reg Bi and Form CRS

Facts to Disclose in Various Conflict Scenarios: Recommendations

Compensation Arrangements:

Firms should disclose facts about (i) the nature and extent of the conflict; (ii) how the conflict could affect the recommendation; (iii) the source and scale of compensation; (iv) how the firm is compensated (e.g., revenue sharing, cash sweep); and (v) the costs and fees to be incurred by the investor as a result.

Proprietary Product Recommendations:

The SEC recommends disclosure as to whether the firm or an affiliate manages, issues, or sponsors the product, as well as any additional fees and compensation related to that product or incentives to sell the product, among others. In cases where conflicts arise from compensation received from third parties, staff recommends (i) disclosure of the existence and effects of third-party incentives, (including if the offering is from a limited product menu based on preferred providers, see below); (ii) any agreements with a clearing broker for products offered on their platform; (iii) agreements to maintain assets with a specific custodian; and (iv) arrangements where the firm is compensated through revenue sharing or product fees.

Managed Accounts and Wrap Fee Programs:

On conflicts arising from separately managed account and wrap fee programs, the bulletin recommends disclosing any compensation from program sponsors or affiliates, any higher costs to the investor for participating in the program, and any material facts on how the account is managed, including manager’s financial incentives, (e.g., incentives to invest assets in share classes that provide higher compensation to the firm.)

Policies and Procedures

The guidance cautions firms to be continuously and periodically monitoring for conflicts of interest as well as testing the adequacy and effectiveness of their policies and procedures. In this regard, they emphasized, it is especially important for a firm to “document[] the measures it takes to address and monitor conflicts of interest.”

Guidance on Product Menus

The bulletin devotes a section of its conflict of interest guidance to firms that make recommendations based on a product menu. A product menu may limit offerings to, for example, proprietary products, a specific asset class, or to products that involve revenue sharing or third-party arrangements (see above). The recommendation is for firms to

consider establishing product review processes for these menus. Such processes would, among other things, (i) identify and mitigate conflicts associated with products offered through them; (ii) evaluate the use of “preferred lists”; (iii) establish training requirements for financial professionals as to certain products; and (iv) establish periodic product reviews. The SEC notes that broker-dealers “must identify and disclose any material limitations placed on the securities or investment strategies that may be recommended to a retail customer and any conflicts of interest associated with such limitations.” Further, the guidance states that a dual registrant “should disclose any circumstances under which its advice will be limited to a menu of certain products offered through its affiliated broker-dealer or affiliated investment adviser.”

Conclusion

A staff bulletin of this nature should be seen as a roadmap for firms to prepare for examinations. It argues that “identifying and addressing conflicts should not be merely a ‘check-the-box’ exercise, but a robust, ongoing process that is tailored to each conflict.” The conflicts guidance shows how complex a challenge that can be. Carefully addressing each duty as applied to a broker-dealer or investment adviser business model as prescribed by these recommendations affords the best possibility to withstand SEC scrutiny. Bates will keep you apprised.

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Bates Managing Director Julie Johnstone was quoted in a recent InvestmentNews Article on the increase of Reg BI Customer Cases in FINRA Arbitration. Bates Group's prior reporting on the matter was also recognized in the article.

Read the Full Article at InvestmentNews

Bates Managing Director Brandi Reynolds (CAMS-Audit) is quoted in a new ACAMS Insights article discussing efforts to develop a federal regulatory framework for crypto and virtual assets. The article, published August 12, 2022, looks at proposed legislation in the U.S. Senate and House aimed at "preventing the use of cryptocurrency in illicit finance" and "developing 'principles-based guidance' on how anti-money laundering, sanctions and cybersecurity rules apply to cryptocurrency," among other goals.

Read the Full Article at ACAMS Insights: "Is Crypto a Security, Commodity or Means of Payment? All Three, Say Lawmakers"

Bates Group’s MSB, FinTech and Cryptocurrency practice offers guidance and services for fintech and cryptocurrency firms. Our subject matter experts work directly with firms and counsel to design and implement policies to ensure they are AML-compliant. Our MSB and AML Teams also implement, manage, and maintain Money Transmitter Licensing processes and engage clients with BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.

The mandatory compliance deadline for the SEC marketing rule—which replaced the former Advertising Rule and the Cash Solicitation Rule—is November 4, 2022. Advisers should be reviewing, revising, and preparing to implement procedures and policies to prevent potential violations. There’s still time, but there’s also a lot to consider, as the rule consolidates previous SEC guidance, no-action letters and exam findings on questions concerning recommendations, testimonials, and the presentation of performance metrics. Here’s what you need to know.

Scope

The marketing rule is grounded in a new definition for “advertising” and covers any direct or indirect communication by an investment adviser offering services to prospective clients or new services to current clients. Seven prohibitions apply to advertisements under this definition: (i) untrue statements or omissions of material facts; (ii) untrue or misleading implication or inference; (iii) unsubstantiated material statement of fact; (iv) description of benefits without a “fair and balanced” discussion of risk; (v) “unfair or unbalanced” reference to specific advice; (vi) “unfair and unbalanced” performance (or time periods); and (vii) otherwise misleading statements.

Compliance Changes

The core message of the new marketing rule is that advisers must lock down their documentation and reporting processes. Claims related to performance and services must be able to be substantiated, and advisers are on notice that they will need to be able to back up those claims with documentation on demand. Experts say that advisers who can’t substantiate a claim will be presumed not to have a reasonable basis for making it.

The rule is written to be broadly applied. The SEC highlighted that they are concerned with, among other things: communications of hypothetical performance; reliability of performance communications; offers to expand a financial relationship; communications related to cross sales; information on investment strategies; and, in general, any adviser/intermediary/third party distributed material conveyed to the investor. The SEC also makes clear what few items the rule does not cover. These communications include extemporaneous or unprepared remarks, routine communications such as account statements or transaction reports, even white papers—or other content that does not contain any offer—that would be contained in a required notice or filing.

View Our Webinar: Deconstructing the SEC’s New Marketing (and Solicitor) Rule

Preparing for the Compliance Deadline

Advisers that are currently evaluating the processes and procedures necessary for full compliance with the marketing rule should be assessing their own advertising practices as defined under the rule. As mentioned, those communications include the way in which a firm communicates performance (i.e., related, extracted, hypothetical and predecessor performance) and the compliance requirements that apply to each, as well as the metrics the firm uses to communicate performance (e.g., gross and net numbers and/or 1-, 5-, and 10-year time intervals) to ensure consistency and not be misleading. The SEC will home in on these as they assess whether an adviser is offering “full and balanced disclosure” to investors.

Advisers should also be preparing marketing rule compliance processes and procedures if they utilize testimonials and endorsements in advertising. Testimonials are given by a current client or investor, endorsements are given by a party who is not a current client or investor (e.g., a service provider or family member). The SEC will be taking a close look at potential conflicts to paid quoters, particularly when payment involves waiving fees or other compensation. Conflicts must be prominently disclosed by explaining the terms of the compensation arrangements. (Testimonials or endorsements by broker-dealers have differing disclosure requirements depending on whether the intended audience is retail or not.) Compliance training will be required to ensure that advisers are aware of their obligation to gather testimonials or endorsements by service providers or outside parties, and to understand the rules around direct and indirect compensation to those providing them.

Disclosures and satisfying set criteria are required under the marketing rule before third-party ratings can be used in an advertisement. Use of third-party ratings raises concerns about the use of a fair and balanced methodology and on the need to substantiate claims. As a result, required disclosures should include the date of the rating, the period covered, the identity of the third party that created and tabulated the ranking, and if an advisor was paid directly or indirectly to participate.

When an adviser provides material to intermediaries for distribution, participates in its creation, uses the material in communications, and highlights, prioritizes, or deletes portions of the material, the material is considered advertising under the definition of the rule. These “affirmative actions” require significant compliance preparation, including employee training on, for example, what they’re allowed to do on social media. (Note: it is not considered advertising if modifications to the material were made by third parties, if unedited commentary was merely posted on an adviser’s website, or if procedures prohibiting employees to conduct business via social media are in place.)

Conclusion

The new marketing rule imposes significant oversight, recordkeeping, and disclosure requirements on investment advisers. It applies to all communication media (including e-mail blasts and social media posts). The November 4, 2022, implementation deadline is fast approaching, and the rule requires substantial changes to compliance processes and procedures that were previously designed for the former Advertising Rule and the Cash Solicitation Rule. The long lead time for compliance preparation is coming to an end. The SEC expects advisers to be ready—are you? Bates can help.

Bates supports firms navigating and implementing the SEC’s New Marketing Rule. We work with your firm to address investment adviser concerns and to support efforts to conform oversight, recordkeeping and disclosure requirements under the new rule. Our compliance team includes senior compliance staff and former regulators with expertise in the development of policies, procedures, supervisory and compliance processes, and best practices to enhance compliance and supervisory systems.

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Join Bates and Innova Learning as we present the SEC’s New Marketing Rule in fun and interactive Mad Men-themed animated format. In our NASAA-approved course (administered on the Prometric platform), we walk you through the new Marketing Rule, pose questions to help you determine whether your advertising and marketing fall under the new rule or not, and provide examples of communications under the new rule. Upon completion, we will report the credit to FINRA, NASAA’s approved vendor for program tracking.

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FINRA has filed with the SEC proposed changes to FINRA Rule 3110 to add new Supplementary Material 3110.19 (Residential Supervisory Location). The changes allow a home office to be considered a non-branch “residential supervisory location” under certain conditions. As detailed in numerous Bates’ posts (see, e.g., here and here), the pandemic moved regulators to issue relief from strict regulatory requirements to firms in order to allow employees to work from home, including the use of new technology and communications to permit remote supervision. By this proposal, FINRA is adapting to a new, post-pandemic “blended workforce” model, one in which employees work at both conventional offices and in their private residences—and which FINRA acknowledges is likely to “endure.” Further, FINRA noted that “technological advances in surveillance and monitoring capabilities” have enabled such greater “workplace flexibility.” The proposal, therefore, is considered a reassessment of “the manner in which firms may effectively and efficiently carry out their supervisory responsibilities considering evolving business models and practices, advances in technology, and regulatory benefits.”

The proposed amendment—to classify some private residences as non-branch locations, subject to specific limitations—“aligns” the classification of non-branch locations with certain exclusions, which, according to FINRA “will not result in a loss of the important regulatory information that the rules were designed, in part, to provide regarding the locations or associated persons.”

Bates Offers Supervision and Compliance Support - Learn More

Under the proposal, “residential supervisory locations” would be subject to several limitations. Among them are: (i) that only one associated person can conduct business at the location; (ii) that the location is not held out to the public as an office (and that the associated person cannot meet with clients or prospects there); (iii) that no customer funds or securities are handled there; (iv) that the associated person is assigned to a specific branch office; (v) that all electronic communications are made through the member’s electronic system; and (vii) that books and records must be maintained.  

The proposed rule also elaborates on what makes a non-branch office ineligible to be designated a “residential supervisory location.” These factors generally concern member firms that are considered “restricted firms” or “taping firms,” or associated persons who are subject to mandatory heightened supervision, statutory disqualification, or otherwise subject to an investigation, proceeding, complaint or other action for failure to supervise another person that is subject to their supervision.

FINRA pointed out that once a home office has been designated a “residential supervisory location,” inspections would be required on a regular periodic schedule (likely once every three years, as opposed to annually), as is required of other supervisory branch offices.

Bates will keep you apprised as the proposal goes through rulemaking.

Bates Compliance delivers guidance and tailored compliance consulting solutions to our broker-dealer, investment adviser and hybrid firm clients on an as-needed or ongoing basis. We also offer remote branch office inspections - Learn More.

Hank Sanchez, Managing Director

hsanchez@batesgroup.com or  504-450-9632

David Birnbaum, Managing Director

dbirnbaum@batesgroup.com or  917-273-2682

Join Bates Group and the South Carolina Emerging Tech Association for a drink & evening of all things crypto! Whether you're brand new to crypto or are a seasoned trader, everyone is welcome! Meet members of Bates' MSB and learn more about our crypto and AML services.

Date: July 26, 2022

Time: 5:00 pm ET

Location: RJ Rockers Brewing Co., Spartanburg, SC 

Co-sponsored by Bates Group, Voyager, and Bitrefill.

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Bates Group and MSBA celebrate the return of MSBA's Summer Lunch & Learn Series this Wednesday, July 13, 2022 at 1:00 p.m. ET.

John Ashley, CIPP/US, CRCMP (pictured), a Senior Consultant with Bates' MSB, FinTech and Cryptocurrency practice, joins other compliance experts to address takeaways and applications from Chapters 1-6 of The Best Practices for US MSBs.

Topics will include: 

• Defining MSBs 
• Building an Effective AML Program
• Knowing your Customer/Transactor, Agent and Counterparts
• Reporting & Information Sharing

Event Details and Registration

There will be a second session on Wednesday, July 27, 2022.

Bates Group’s MSB, FinTech and Cryptocurrency practice offers guidance and services for fintech and cryptocurrency firms. Our subject matter experts work directly with firms and counsel to design and implement policies to ensure they are AML-compliant. Our MSB and AML Teams also implement, manage, and maintain Money Transmitter Licensing processes and engage clients with BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.