Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Massachusetts Fires an Arrow at Robinhood

The Secretary of the Commonwealth filed its first enforcement action under the Massachusetts Fiduciary Rule. Robinhood and its gamification of investing are in its bullseye.

The Massachusetts Securities Division adopted amendments to 950 Mass. Code Regs. 12.200 earlier this year as they relate to the standard of conduct applicable to broker-dealers and agents. The amendments apply a fiduciary conduct standard to broker-dealers and agents when dealing with their customers. The Division said it would begin enforcing the amended regulations on September 1, 2020.

“Each broker-dealer shall observe high standards of commercial honor
and just and equitable principles of trade in the conduct of its business.”
– 950 CMR 12.204(1)(a)

According to the data, Robinhood has almost a half million customers in Massachusetts. Approximately 68% of the Massachusetts customers approved for options trading on Robinhood have no or limited investment experience. One advertisement states:

“I’m a broke college student and investments might help my future tremendously.”

The administrative complaint shoots at Robinhood claiming its infrastructure is inadequate. The outages and disruptions in the platform earlier this year are the indicators. The crux of this prong of the complaint is that Robinhood is continuing to recruit new customers without properly improving its infrastructure. The complaint states 70 outages over the course of 2020.

The second prong of the complaint takes that position that Robinhood’s supply of lists of most popular stocks is an encouragement to purchase the security without consideration of the customer’s suitability.

The third prong is Robinhood’s permission and encouragement for customers to trade. The complaint uses the example of one customer that clicked the investment experience button when creating the account. That customer made 12,748 trades this year. An average of 92 trades a day.

A fourth prong is that Robinhood failed to properly screen customers before allowing them to trade options. Robinhood failed to follow its own policies and procedures.

Wrapping it up, the complaint says that each of these four prongs is a violation of the Massachusetts Fiduciary Standard applicable to broker-dealers.

All of this is just the regulators side of the case. A Robinhood spokeswoman said before the complaint was filed that the company has and will continue to work closely with all regulators.

“Robinhood has opened up financial markets for a new generation of people who were previously excluded.”
“We are committed to operating with integrity, transparency, and in compliance with all applicable laws and regulations.”

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Vaccine Tracker

From xkcd: https://xkcd.com/2398/

Meanwhile on Wednesday, the Securities and Exchange Commission is scheduled to vote on a new advertising rule for registered investment advisers. From the Sunshine Act notice for the meeting;

2. The Commission will consider whether to adopt amendments under the Investment Advisers Act of 1940 to update rules that govern investment adviser marketing to accommodate the continual evolution and interplay of technology and advice, while preserving investor protections. The Commission will also consider whether to adopt amendments to Form ADV to provide the Commission with additional information about advisers’ marketing practices, and corresponding amendments to the books and records rule under the Advisers Act.

The SEC Says Your Algorithm Is Not Good Enough

BlueCrest Capital was wildly successful as a hedge fund for many years. Its principals were wealthy enough that they could start a new fund with their own money and dedicate traders to running that new proprietary fund. That’s okay, even if the trading strategies between the new proprietary fund the existing hedge fund overlap. Compliance can manage the overlap. BlueCrest would need to properly disclose the conflict to investors.

The Securities and Exchange Commission said that BlueCrest failed to properly disclose. The parties agreed to a $170 million settlement.

The SEC order finds that BlueCrest made inadequate and misleading disclosures concerning existence of the proprietary fund, the movement of traders from the hedge fund to the proprietary fund, the use of the algorithm in hedge fund, and associated conflicts of interest.  According to the order, BlueCrest transferred a majority of its highest-performing traders from the hedge fund to the proprietary fund, and assigned many of its most promising newly hired traders to the proprietary fund.

What caught my attention in the order was that BlueCrest failed to disclose that it reallocated the transferred traders’ capital allocations in the hedge fund to a semi-systematic trading system, which was essentially a replication algorithm that tracked certain trading activity of a subset of BlueCrest’s live traders.

As you might expect, the algorithm underperformed the live traders. Why else would there be a SEC case? If the algorithm was better, the SEC would not have bothered. Actually, I bet BlueCrest would have used the algorithm on the proprietary fund if was outperforming the live traders.

According to the order, the hedge fund algorithm basically made the same trades as the live traders in the proprietary fund, but did so the following day. The algorithm trades ended up being less profitable, resulted in more volatility and had more risk in its portfolio.

There is nothing wrong with this practice as long as it’s disclosed. The SEC order highlights some diligence questionnaires which the SEC found misleading in BlueCrest’s description of its trading strategies and use of algorithms.

The SEC thinks there is a big difference between live traders and algorithms and the use of algorithms needs to be disclosed.

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Compliance Outreach and OCIE Observations

The SEC’s Office of Compliance Inspections and Examination launched a lot info last week. It livestreamed a National Investment Adviser/Investment Company Compliance Outreach and published a Risk Alert on notable compliance issues identified by OCIE related to Rule 206(4)-7.

Peter Driscoll, Director of OCIE, started off the program highlighting three words that should be applicable to your firm’s CCO: Empowered, Seniority, and Authority. He wants firms to think of compliance and the CCO as an essential component to running and advisory business and not just a box to be checked. CCOs should be routinely included in strategy discussions and brought into decision-making early-on for their meaningful input.

Then he mentioned that OCIE was publishing a risk alert right then on compliance programs.

Mr. Driscoll moved the Outreach program to a panel with Dalia Blass from Investment Management and Marc Berger from Enforcement. In discussing private funds, they highlighted the usual hot spots:

  • Valuation
  • Undisclosed conflicts
  • custody rule
  • allocation of expenses

In discussing upcoming regulatory changes, Ms. Blass mentioned the proposed Advertising Rule changes. Sounds like it’s still in process. No mention of a timeline. She also mentioned that there may be some upcoming regulatory changes around valuation and custody.

The second panel was on resiliency, information security and business continuity. This is even more important with so many firms and their employees working remotely.

The second panel focused on undisclosed conflicts. One panelist expressed grave concern over the use of the word “may” when describing conflicts. If there is an actual conflict, “may” is not the right word to use. If a firm always takes a fee, “may” is not the right word to use.

The panelists raised the issue of disclosing PPP loans. It was noted that taking a PPP loan was an indication of financial distress that likely should be disclosed to clients.

Turning to the new risk alert, the focus is the structure of compliance programs. It starts right off with a failure to have adequate compliance resources to support a robust compliance program. That includes having a CCO who devotes adequate time to compliance and is knowledgeable about the Advisers Act. One special note was for firms that had grown in size or complexity, but had not increased their compliance resources accordingly.

The Risk Alert emphasizes the importance of the annual review and documenting the annual review. As it’s coming up to year-end, it’s a good check list as you may be starting to work on your annual review.

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Exchange-Traded Products Initiative

The Securities and Exchange Commission announced a new initiative focused on complex products: The Exchange-Traded Products Initiative. It’s led by the Division of Enforcement’s Complex Financial Instruments Unit. It was developed by Armita Cohen and data analytics specialists Daniel Koster and Jonathan Vogan and has been coordinated by Ms. Cohen.

The first inkling of this initiative was the Morgan Wilshire case in late September. That firm was selling inverse ETFs to its clients. The firm’s representatives were not knowledgeable about the products. The inverse ETF tries to create the opposite returns of an index over a short period of time, typically one day. If held longer, the product stop achieving the originally targeted results.

Like with the earlier case, the five cases announced as part of the Exchange-Traded Products Initiative were complex products but had the patina of simplicity because they were exchange-traded. The products were designed be held in the short-term for limited use.

Instead, the firms were marketing to a broader set of clients and not getting them back out of the product in the short-term. Of course, this means that customers lost money.

The compliance failure was the firms failing to determine if the product was suitable for the client, a lack of training on the product and a lack of appropriate review of the transactions.

Some of this will be increasingly problematic under the new Reg BI standards instead of the older standards for broker-dealers.

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What’s Wrong at Branch Offices?

The SEC’s Office of Compliance Inspections and Examinations ran a sweep it called the Multi-Branch Initiative. It published a risk alert on November 9 with its findings.

The Risk Alert is mostly a collection of typical compliance problems:

  • Custody of client assets
  • Fees and expenses
  • Oversight and supervision of supervised persons
  • Advertising
  • Code of ethics
  • Portfolio Management
  • Oversight of investment recommendations
  • Mutual fund share class selection and disclosure issues
  • Wrap fee program issues
  • Rebalancing Issues
  • Conflicts of Interest Disclosures
  • Trading and allocation of investment opportunities

A few things were related to the multi-branch or heightened by that geographic spread of offices. The big issue is that policies and procedures were inconsistently applied across offices. That makes me think that the physical presence of compliance personnel may be a positive factor of compliance. A compliance professional once called this “Compliance by walking around.”

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Combined Financial Statements and the Custody Rule

Advisers to private funds, usually rely on the audited financial statement method to satisfy the Custody Rule. The Chief Accountant’s Office of the Division of Investment Management released a “Dear CFO Letter” last week that raises issues about using combined financial statements to satisfy the custody rule.

You may have missed this possibly important compliance change because this is not a usual source for compliance. Frankly, it’s not easy to find on the SEC Website. Go to the Accounting Matters Bibliography and scroll to the bottom of the page. Let me know if you can otherwise find it on the SEC website.

Paragraph (b)(4) of the Custody Rule permits an adviser to comply with certain aspects of the Custody Rule if an account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) is subject to an annual audit and that audit is distributed to investors within120 days of fiscal year end.

Here is what seems to be the meat of the Dear CFO Letter:

“For purposes of compliance with the audit exception, however, we do not believe an investment adviser can prepare combined financial statements for multiple PIVs in reliance solely on the common management basis in ASC 810-10-55-1B. For example, in the staff’s view, if the economics of each PIV are different and not pro rata (e.g., certain PIVs only participate in certain investments or have differing fee arrangements or rights), the combined financial statements may provide less clarity about an investor’s ownership than if separate financial statements were provided to all limited partners (or members or other beneficial owners) in each PIV.

“The staff believes that if an investment adviser uses combined financial statements to rely on the audit exception, the investment adviser should consider whether:

  • Each PIV has the same management;
  • There is clear evidence of legal ownership of each investment individually with each PIV or there are contractual agreements which clearly show the assignment of investments held on a combined basis to each PIV;
  • Investments and investment gains and losses, including income and expenses, are allocated pro rata to each PIV;
  • Each PIV has the same management fee and performance fee structure (e.g., allocations work on a combined basis, calculated based on one hurdle on the combined basis, including combined fair values and contributions/distributions);
  • The financial highlights are the same for each PIV; and
  • The combined financial statements will
    • Present a statement of changes for each PIV separately and a combined aggregate total; and
    • Provide clear disclosure of each PIV’s pro rata percentage ownership of the combined basis, total commitments of each PIV, and aggregated commitments on a combined basis.”

I think this means that many private fund managers are going to have to revisit their custody analysis. This is going to add on some legal costs and audit costs.

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Van Halen and Compliance

With the passing of Eddie Van Halen, I thought it appropriate to re-publish this great story about Van Halen and Compliance that I first wrote in 2009. [Spoiler alert] Those brown M&M’s served a real purpose.

You may have heard the story about Van Halen’s banning of brown M&M’s from its dressing room. I chalked it up to the pampered life of rock stars. (Especially, when compared to the more mundane life of a chief compliance officer.)

I just listened to the latest episode of  This American Life which revealed that the provision was not about pampering. It was about compliance.  Host Ira Glass talked with John Flansburgh (from the band They Might Be Giants) and he explained why the M&M clause was actually an ingenious business strategy. They recounted an except from David Lee Roth’s autobiography, Crazy from the Heat:

Van Halen was the first band to take huge productions into tertiary, third-level markets. We’d pull up with nine eighteen-wheeler trucks, full of gear, where the standard was three trucks, max. And there were many, many technical errors — whether it was the girders couldn’t support the weight, or the flooring would sink in, or the doors weren’t big enough to move the gear through.The contract rider read like a version of the Chinese Yellow Pages because there was so much equipment, and so many human beings to make it function. So just as a little test, in the technical aspect of the rider, it would say “Article 148: There will be fifteen amperage voltage sockets at twenty-foot spaces, evenly, providing nineteen amperes . . .” This kind of thing. And article number 126, in the middle of nowhere, was: “There will be no brown M&M’s in the backstage area, upon pain of forfeiture of the show, with full compensation.”

So, when I would walk backstage, if I saw a brown M&M in that bowl . . . well, line-check the entire production. Guaranteed you’re going to arrive at a technical error. They didn’t read the contract. Guaranteed you’d run into a problem. Sometimes it would threaten to just destroy the whole show. Something like, literally, life-threatening.

Van Halen used the candy as a warning flag for an indication that something may be wrong. I see some lessons to be learned.

Diamond Dave talking about those Brown M&Ms

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Do What You Said You Would, Or You’re No Longer a CCO

Rule one following a regulatory examination is to implement the changes you told the regulators you said you would. GGHC failed to do so and it was the CCO’s fault. Then the CCO did the worst thing in compliance.

GGHC was duly registered as a broker-dealer and an investment adviser. It used both transaction based fees and annual fees for different accounts.

“As disclosed in its new account documents, GGHC “uses an aggressive growth style of investing . . . . [which] results in significant fluctuations and at times will result in significant losses in the short term.” GGHC also discloses that this type of investment style may involve active portfolio changes and therefore a high turnover, and as a result, the effective annual fee GGHC charges its advisory clients is often higher than the fees charged by comparable advisers. GGHC discloses commissions charged on each of its trades in trading confirmations provided to its clients, either as a separate line item or embedded in the price of the relevant security.”

Churn is a concern with the accounts using the transaction fee model. During a FINRA exam, the regulator wanted GGHC to beef up its review of cost-to-equity ratio and turnover ratios. GGHC agreed and amended its procedures to review cost-to-equity ratios monthly, document the reviews and escalate all accounts with a cost-to-equity ratio above 6%.

The firm amended its procedures but didn’t conduct the reviews. None of the accounts with cost-to-equity above 6% was escalated.

The SEC came in the following year for an examination. As you would expect, the SEC examiners focused on the cost-to-equity reviews. Rather than admit that she didn’t conduct the reviews, the CCO lied and produced doctored documents.

The exam resulted in a referral to enforcement. The CCO also sent doctored documents to the enforcement lawyers lying about the reviews. The CCO was finally subject to sworn testimony and admitted to altering the documents by whiting out the as of date and making later handwritten annotations.

Bad actions. Bad result for the firm and the CCO. The firm got hit with a $1.7 million fine and the CCO got barred.

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Buy Assets From a Foreign Bank Without Violating the FCPA

A quirky feature of the Foreign Corrupt Practices Act is that you can ask the Department of Justice to opine on whether your proposed action would violate the FCPA. Generally, one or two of these FCPA opinions pop up each year. It’s been a six-year drought since the last one.

Some of the FCPA opinions have provided great insight into how the DOJ thinks about FCPA compliance. This latest is not one of those. I scratch my head wondering why the Requestor even bothered.

The Requestor planned to buy some assets from a state-owned foreign bank. Another subsidiary of that state-owned foreign bank helped with the transaction and wanted to get paid a fee. The opinion was on whether it was okay to pay that fee.

Sure, the parties are state-owned and the people working at them should be treated as government officials under the FCPA for compliance purposes. The FCPA doesn’t prevent US firms from entering into transactions with foreign companies, even if the company is state-owned. You just can’t pay a bribe to the people involved.

There is nothing in the facts that says any individual is getting paid a fee. The money is all going to a company. The opinion includes a statement that the Requestor has no belief that any of the money will be diverted to an individual.

The Requestor received legitimate services from the company, the payment is commensurate with the services and there is no indicia of corrupt offers.

The latest release notes that three prior releases all addressed this topic: 09-01, 97-02, and 87-01. They each had a declination when the payment was going to the government entity and not to an individual.

The fee to be paid was only $237,500. I would guess that the Requestor paid almost as much in legal fees to get the FCPA opinion.

Whatever uncertainty the Requestor had in making the payment I guess has been erased. We can pile this fact pattern into the stack of things that are okay to do.

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