Last year the U.S. Securities and Exchange Commission (“SEC”) approved Regulation Best Interest (“Reg BI”).[1] Reg BI requires broker-dealers and their associated persons to act in “the best interest” of a retail customer when recommending a securities transaction or investment strategy. Reg BI applies not only to broker-dealers but also to investment advisors.[2] It will take effect in June of 2020.[3]

According to the SEC’s Final Rule release, Reg BI enhances a BD’s standard of conduct beyond the existing “reasonable basis” suitability obligation[4] by requiring a BD to act in the best interest of its retail customer at the time of making a recommendation, and proscribes placing the BD’s financial interests ahead of that of its customer.[5]  Satisfying this enhanced obligation requires the BD to address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest.  The SEC made clear the best interest standard cannot be satisfied through disclosure alone.[6]  Thus, when mere disclosure of conflicts is insufficient, BDs may need to mitigate or eliminate the conflict of interest altogether.[7]

The SEC divided the Reg BI standard into four obligations: (1) disclosure, (2) care, (3) conflict of interest, and (4) compliance.

  1. Disclosure Obligation: BDs must deliver certain prescribed disclosures before or at the time of the recommendation.  Disclosures must be in writing and include all material facts associated with the recommendation. For example, a disclosure obligation would include the following:
  • That the firm or representative is acting in a BD capacity;
  • The material fees and costs that apply to the retail holdings and accounts, including when and why a fee will be imposed;
  • The type and scope of the services to be provided, including material limitations on the securities or investment strategies (g., limited product menu, proprietary products only, payments from third parties, compensation arrangements, etc.); and
  • The material facts relating to conflicts of interest associated with the recommendation that might sway a BD to make an interested recommendation.
  1. Care Obligation: The BD must exercise reasonable diligence, care, and skill in making a recommendation to a retail investor.[8] Thus, the BD must understand the potential risks, rewards, and costs associated with the recommendation and hold a reasonable belief the recommendation is in the customer’s best interest.   Satisfaction of the care obligation is evaluated as of the time it is made, not in hindsight.[9]  In addition, a series of transactions is viewed as a whole, rather than evaluating each transaction in isolation.

Following the SEC’s adoption, industry advocate SIFMA acknowledged the enhanced nature of the Care Obligation, noting it is:

stronger than the existing suitability standard because it: (1) explicitly requires that the recommendation be in the customer’s best interest and that the BD does not place its interests ahead of the customer; (2) explicitly requires that cost be a consideration; (3) applies the quantitative suitability requirement irrespective of whether the BD has actual or de facto control over the customer’s account; and (4) requires the BD to consider “reasonably available alternatives” as part of having a “reasonable basis to believe” that the recommendation is in best interests of the customer.[10

  1. Conflict of Interest Obligation: This obligation goes further than standard measures such as simply establishing, maintaining, and enforcing policies and procedures reasonably designed to address conflicts of interest. Now, the BD must eliminate certain compensation incentives altogether. For instance, a BD must identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or types of securities within a limited period of time.[11]
  1. Compliance Obligation: This obligation requires the BD to establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Reg BI as a whole. Thus, a BD’s policies and procedures must address conflicts of interest as well as the firm’s compliance with the BI disclosure and care obligations.[12]

Along with Reg BI, the SEC concurrently adopted Form CRS under both the Exchange Act and the Advisers Act.[13]  Form CRS requires BDs and investment advisers to deliver to retail investors a concise relationship summary.  The CRS must be written in a standardized question and answer format and describe the nature and scope of services the firm provides, the types of fees a customer will incur, the conflicts of interest faced by the firm, and the firm’s (and its associated person’s/IARs) disciplinary history.[14]  The CRS will include principal fees and costs the investor will pay directly or indirectly, the applicable standard of conduct and associated conflicts.

With the effective date fast approaching, FINRA and the SEC are providing a variety of support and information to help firms ensure compliance.  In October, FINRA announced that it will be conducting “preparedness reviews” of broker dealers to help firms comply with Reg BI.[15]  FINRA also has posted a Reg BI and Form CRS Firm Checklist that includes questions to help firms assess their obligations under Reg BI and Form CRS.[16]  The checklist also explains key differences between FINRA rules and Reg BI and Form CRS. In addition, the SEC has provided compliance guides, commission interpretations, and recent guidance on complying with Reg BI and Form CRS. [17]

Firms should be well on their way in analyzing and implementing Reg BI given its June 2020 “very ambitious” compliance period.[18]  Enacting and enforcing appropriate policies and procedures will significantly mitigate regulatory and litigation risk arising from this new regulation.

[1] Regulation Best Interest: The Broker-Dealer Standard of Conduct, SEC Release No. 34-86031, File No. S7-07-18 (June 5, 2019) (“Final Rule”), available at https://www.sec.gov/rules/final/2019/34-86031.pdf.

[2] Final Rule, p. 2.

[3] Final Rule, p. 371.

[4] See FINRA Suitability Rule 2111, available at https://www.finra.org/industry/suitability.

[5] See Final Rule, p. 1.

[6] See Final Rule, pp. 1, 5, and 280.

[7] See Final Rule, pp. 317 and 326.

[8] See Final Rule, p. 14.

[9] See Final Rule, p. 15. In this regard, evaluation of the care obligation at the time of the recommendation is a carry-over of the suitability analysis.  Compare generally, Reg BI with FINRA Rule 2111.

[10] SIFMA, Reg BI Final Rules and Guidance: Preliminary Summary (Jun. 10, 2019), available at, https://www.sifma.org/wp-content/uploads/2019/06/Preliminary-Summary-Reg-BI-Final-Rules-Guidance-06-10-2019.pdf.

[11] Id.

[12] Id. In this regard, a firm should consider how or by what actions it will undertake to meet the new obligations.

[13] See Final Rule, p. 16. See also Form CRS Relationship Summary; Amendments to Form ADV, Exchange Act Release No. 86032, Advisers Act Release No. 5247, File No. S7-08-18 (June 5, 2019) (“Relationship Summary Adopting Release”), available at https://www.sec.gov/rules/final/2019/34-86032.pdf.

[14] Relationship Summary Adopting Release, fn. 6.  A new Form ADV part 3 will describe the requirements for the relationship summary and will be required by amended Advisers Act Rule 203-1.

[15] FINRA Provides New Reg BI and Form CRS Resources to Assist Member Firms in Complying with SEC Rules by June 30, 2020, FINRA News Release (Oct. 8, 2019), available at https://www.finra.org/media-center/newsreleases/2019/finra-provides-new-reg-bi-and-form-crs-resources.

[16] FINRA, Reg BI and Form CRS Firm Checklist, available at https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf.

[17] See e.g., the Final Rule; Regulation Best Interest: A Small Entity Compliance Guide (modified Sept. 23, 2019), available at https://www.sec.gov/info/smallbus/secg/regulation-best-interest; Frequently Asked Questions on Form CRS (modified Nov. 26, 2019), available at https://www.sec.gov/investment/form-crs-faq.

[18] See Statement at the Open Meeting on Regulation Best Interest and Related Actions, Commissioner Hester M. Peirce (June 5, 2019), available at https://www.sec.gov/news/public-statement/peirce-statement-open-meeting-regulation-best-interest.

The Fifth Circuit overturned a U.S. District Court’s approval of a settlement between Ralph Janvey, the Receiver for Stanford International Bank, and various insurance company Underwriters, under which the Underwriters had agreed to pay $65 million to the Stanford Receivership estate.  Writing for the Court, Judge Edith H. Jones held that the District Court abused its discretion in approving the settlement because the injunction issued by the District Court (referred to as a “bar order”) nullified claims by third-party coinsureds to policy proceeds without an alternative compensation scheme.  The settlement also improperly released third-party tort and statutory claims against the Underwriters that the estate did not own.

The Stanford Financial Ponzi scheme defrauded more than 18,000 investors who collectively lost over $5 billion.  The proposed settlement was intended to end years of litigation between the Receiver and the Underwriters with respect to insurance coverage under policies issued to Stanford entities.  The Underwriters disputed the amount of available coverage and also contended that various policy exclusions applied.  The proposed settlement contained the following terms: Continue Reading Fifth Circuit Overturns Receiver’s Settlement Barring Third-Party Claims Against Stanford Financial Insurers

An opinion this week from the Southern District of New York, SEC v. Alderson[1] [click here], held that an RIA’s communications with lawyers associated with its third-party compliance consultant were not protected by the attorney-client privilege or the attorney work-product doctrine. As a result, the district court compelled disclosure of over 230 communications passing between the RIA’s in-house counsel and its third-party compliance firm (staffed with licensed attorneys) before and during the course of an examination of the RIA by the Securities and Exchange Commission (“SEC”).[2] This ruling raises important considerations for an RIA or broker-dealer when engaging outside compliance consultants and lawyers, especially if the firm intends for certain of or all of those communications to be cloaked with privilege.

Background

In Alderson, the SEC accused two IARs of violating § 206 of the Investment Advisors Act by misrepresenting the tax consequences, failing to disclose a conflict of interest about compensation, and other acts or omissions, concerning the transfer of U.K. pension assets to overseas retirement plans that qualified under the U.K. tax authority’s regulations as a Qualified Recognized Overseas Pension Scheme (“QROPS”).[3] The two IARs had previously worked for the RIA and invested clients into the RIA’s QROPS program, but were no longer affiliated with RIA at the time of the lawsuit filing. Continue Reading An RIA’S Communications with Attorney Consultants Associated with its Outside Compliance Firm are Always Privileged, RIGHT? Well, That Depends . . .

KPMG must pay $50 million after the Securities and Exchange Commission charged the accounting giant with cheating on training exams and using purloined information concerning audit inspections to be conducted by the Public Company Accounting Oversight Board (PCAOB).  KPMG agreed to the $50 million penalty and also accepted a public censure as part of the settlement.

The findings in the SEC’s cease-and-desist order—which KPMG has admitted—are that now-former members of KPMG’s Audit Quality and Professional Practice Group improperly obtained lists of particular audit engagements that the PCAOB planned to inspect.  KPMG obtained the confidential information from multiple individuals who had worked in the PCAOB’s inspections group, some of whom joined KPMG after leaving the PCAOB.  KPMG personnel then used the information to revise audit work papers to minimize the chances that the PCAOB’s inspections would turn up deficiencies.  These misdeeds resulted in a substantial improvement to KPMG’s 2016 inspection results.  The SEC charged six accountants individually, including these former KPMG personnel, in January 2018 for this conduct. Continue Reading Audit Firm to Pay $50 Million Penalty for Using Information Pilfered From PCAOB

Celadon Group Inc. announced a settlement with the SEC and the DOJ over allegations of accounting fraud.[1]  The company agreed to pay restitution of over $42 million in connection with a Deferred Prosecution Agreement with the DOJ, and to pay disgorgement of roughly $7.5 million in a parallel SEC settlement.  The disgorgement obligation is deemed satisfied by payment of the $42 million restitution amount.

The SEC and DOJ alleged that a Celadon subsidiary tried to cover up financial difficulties by falsely reporting inflated profits and assets.[2]  According to the government, Celadon had an aging fleet of hundreds of trucks whose book value greatly exceeded their fair market value.  Had Celadon sold the trucks on the open market, it would have had to recognize a loss on its financial statements.

To fix this problem, between June and October 2016, the Celadon subsidiary allegedly entered into a series of transactions with a third party to trade Celadon’s trucks for trucks owned by the third party.  Rather than sell at arms’ length, Celadon management allegedly sold the trucks at intentionally inflated values, and bought trucks from the third party at similarly inflated prices.  Celadon then booked the trucks at the inflated values.

According to the government, these inflated sales and assets were used to conceal multi-million-dollar losses from investors.  Celadon management allegedly misrepresented to the public that the trucks involved in the transactions were bought and sold at fair market value and properly accounted for.

In the SEC action, Celadon settled to charges of violating the antifraud, reporting, record-keeping, and internal-controls provisions of the federal securities laws.  In the DPA with the DOJ, Celadon resolved a single count of conspiracy to commit securities fraud.  Upon expiration of the DPA, the criminal charge will be dismissed with prejudice.

 

______________________________________

 

[1]              http://otp.investis.com/clients/us/celadon/usn/usnews-story.aspx?cid=671&newsid=60873

[2]              https://www.sec.gov/news/press-release/2019-60; https://www.justice.gov/opa/pr/celadon-group-inc-enters-corporate-resolution-securities-fraud-and-agrees-pay-422-million

Securities litigation frequently raises the question of what conduct constitutes a primary violation of the federal securities laws, specifically, Rule 10b-5 and the various other antifraud provisions.  Must one make a false statement in order to be primarily liable?[1]  The Supreme Court held in Janus Capital Group, Inc. v. First Derivative Traders that only those who “make any untrue statement of material fact” may violate Rule 10b5-(b).[2]  Other questions include whether one who merely disseminates a false statement, without actually writing or “making” the statement, can be primarily liable.  And what are the contours of “scheme” liability under Rules 10b-5(a) and (c)?  The Supreme Court recently clarified some of these difficult questions in Lorenzo v. SEC. [3]

Background: Janus and Primary Liability of “Makers” of Untrue Statements

As mentioned, the Supreme Court held in Janus that only those who “make any untrue statement of material fact” may violate Rule 10b5-(b).[4]  The Court wrote that the “maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”[5]  For example, the Court noted, a speechwriter does not control the content of the speech; that content is exclusively within the control of the person who delivers it.  Under this analysis, the speechwriter is not a “maker” of the speech and therefore could not be held primarily liable under Rule 10b5-(b), even if all other elements of the violation were satisfied.[6]  Left undecided in Janus was whether one who disseminates a statement, with scienter but without control over its content, may be liable under any part of Rule 10b-5. Continue Reading Janus Meets Its Maker: The Supreme Court Expands Primary Liability in Lorenzo v. SEC

The Securities and Exchange Commission (SEC) recently announced other notable examples of the scrutiny being applied to investment advisers’ disclosures of conflicts of interest.  The criticism is notably sharp on issues involving fees and costs associated with advisory services.

Of course, there are the well-publicized actions involving the disclosure of 12b-1 fees pursuant to the share class initiative. On March 11, 2019, the SEC announced that 79 investment advisory firms had agreed to return over $125 million to clients in connection with the SEC’s “Share Class Initiative.”[1]

For purposes of this short post, we’ll detail the SEC’s March 5, 2019 regulatory action involving Valley Forge Asset Management, LLC (Valley Forge).  The SEC’s action, which resulted in over $5 million in sanctions, centered on Valley Forge’s disclosures to its clients about the brokerage options available to its clients and specifically the costs and services associated with Valley Forge’s own brokerage firm.  The action is a reminder of the importance of assessing whether a conflict, or potential conflict, is actually present or just “may” be present.  In that regard, we continue to caution that an investment adviser’s use of “may” in connection with conflicts disclosures increases its regulatory risk. Continue Reading You WILL (not May) Face the Heat

The Financial Industry Regulatory Authority (“FINRA”) recently published its Risk Monitoring and Examination Priorities Letter (the “Letter”) for 2019 and signaled its intent to expand the scope of its priorities and exam program. Unlike previous years, FINRA’s 2019 Letter took a “somewhat new approach” by identifying materially new areas of emphasis.[1] Admittedly, FINRA will continue to examine longstanding priorities detailed in prior letters,[2] but in adding “Risk Monitoring” to the title to the Letter, FINRA notified the industry it planned to broaden its exam program into three materially new priorities: (1) online distribution platforms, (2) fixed income mark-up disclosure, and (3) regulatory technology.[3]  These three new areas of focus are buttressed by other highlighted items in FINRA’s 2019 Letter: sales practice risks, operational risks, market risks, and financial risks.  At the same time, FINRA cautioned industry recipients that “[u]nlike previous Priorities Letters, we do not repeat topics that have been mainstays of FINRA’s attention over the years.”  Thus these “mainstays” are also given consideration.  The following briefly summarizes many of the important and emerging issues highlighted by FINRA:

Mainstay Areas of Exam Focus

FINRA’s 2019 Priorities Letter makes clear its exams will continue to focus on what it terms “mainstay” topics.  In fact, FINRA highlights this admonition in the first paragraph of its 2019 Letter.  And as to be expected protection of securities customers will continue to be a bedrock exam principle.  Thus protections for the customer vis-à-vis the transaction process or relative to the strength of the firm remain key areas of inquiry.  Firms should focus then on compliance obligations related to suitability, complex products, mutual fund and variable annuities share classes and break points; use of margin; OBAs and especially disclosures about such activities; private securities transactions; private placements; communications with the public; AML; best execution; fraud (including microcap fraud), insider trading and market manipulation; net capital and customer protection; trade and order reporting; data quality and governance; recordkeeping, risk management and supervision related to these and other areas. Continue Reading What You Should Know About FINRA’s Exam Priorities for 2019

As a follow-up to our last post on the status of the EB-5 Program, the EB-5 Program has been renewed, at least for the short-term.

After the government shutdown ended, and on the evening of Valentine’s Day, Congress pushed the spending bill through to renew the EB-5 Program until September 30, 2019.[1]  Because the EB-5 Program does not have permanent legislation authorization, it will continue so long as Congress periodically renews the program. However, whether the program will continue in the long-run is still up in the air in light of growing criticisms of the Immigrant Investor Program.[2] For now, however, the EB-5 Program will continue at least until the fall of this year.

Stay tuned for more coverage of EB-5 developments.

 

Contacts:

Jamie Lacy
817.420.8274
jlacy@winstead.com

Toby Galloway
817.420.8262
tgalloway@winstead.com

Ronak V. Patel
512.370.2892
rvpatel@winstead.com

[1] See H.J. Res. 31, available at https://rules.house.gov/conference-report/-H.J.%20Res.%2031.

[2] See EB-5 February 15th Update: What Investors Can Expect For the Future of EB-5 (Feb. 25, 2019), available at, https://www.prnewswire.com/news-releases/eb-5-february-15th-update-what-investors-can-expect-for-the-future-of-eb-5-300796643.html.

The Financial Regulatory Authority (FINRA) recently announced an initiative it presents as an effort to promote member firms’ compliance with rules applicable to the recommendation of 529 plans. FINRA’s initiative is designed, first and foremost, to encourage firms to engage in a self-assessment specific to their 529 plan sales as well as the supervision of such sales.  But, as with similar regulatory initiatives, this program only affords firms a degree of protection as to any issues identified by the firm if the firm self-reports to FINRA and takes corrective measures.  The decision to self-report always requires a considered approach guided by experienced securities regulatory counsel.  Of course, that calculus is dramatically impacted by the announcement of such an initiative. Thus, to avoid (or least minimize) problems with FINRA, member firms are encouraged to review their practices as well as supervisory procedures and controls with an eye on the key areas of regulatory concern.

Key Considerations

A primary factor to consider is whether your firm’s supervisory system accounts for unique aspects of 529 plans.  A supervisory system that works well for monitoring stock recommendations is not necessarily going to be reasonably designed for supervising 529 plan recommendations.  To address this key issue, firms should ensure their procedures and systemic controls are designed to:

  • Identify specific attributes relevant to the suitability of 529 plans offered by the firm and communicate these attributes to supervisory personnel;
  • Ensure the systems are designed to factor in account and/or household holdings to identify the applicability of breakpoints and other share class considerations;
  • Flag share-class recommendations that are potentially unsuitable and/or more expensive for the customer by incorporating meaningful, data-driven controls; and
  • Adequately follow-up on flagged transactions, including communications with clients by supervisory or compliance personnel.

Continue Reading 529 Problems, but FINRA Ain’t One