Author: Doug Cornelius

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The One With No Conflicts

Can an investment adviser really say that they don’t have any conflicts of interest? You certainly can’t say that the firm “provides conflict-free advice” on the website when your Form ADV discloses conflicts of interest.

The SEC released orders against nine investment advisers for violations of the Marketing Rule, claiming the firms made untrue claims, unsubstantiated claims, or made statement that lacked required disclosures.

One of these, Droms Strauss, clearly had a disconnect between compliance and marketing.

Compliance put this statement in the firm’s ADV Part2:

The payment of commissions to DSRM may result in a potential conflict of interest. In order to mitigate this conflict DSRM fully discloses such commission arrangements to Droms Strauss clients before the client purchases any such products. Further, all commissions received by Droms Strauss will be contributed to a non-profit charitable organization selected by the client who purchased the commissionable product from a list of charitable organizations selected by Droms Strauss. Droms Strauss’ policy is always to act in the best interest of its clients. Commissions received by DSRM do not offset advisory fees paid to Droms Strauss. Clients are not contractually obligated to use the services of DSRM.

Marketing published an advertisement on the firm’s public-facing website containing the material statement of fact that one of its investment adviser representatives “provides clients with conflict-free advice” without providing any context for this claim.

Interestingly, the SEC order does not take the position that the statement is false. Not (a)(1) “untrue statement of material fact”. But an (a)(2) violation that the firm made a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the SEC.

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The One With $11 Trillion

There are a few different ways to calculate Assets Under Management. The SEC has prescribed ways to calculate Regulatory Assets Under Management. Often AUM and RAUM will differ depending on an adviser’s business model and client base.

But you can’t just make up RAUM.

Rubin Cedric Williams did so at his firm Vista Financial Advisors. He registered Vista Financial with the Securities and Exchange Commission in December 2021. He filed an update in April 2022 which listed the firm’s RAUM as $10 billion.

This large amount caught the attention of the SEC and started a “newly registered” exam with Vista Financial to kick the tires. During the exam Mr. Williams said his RAUM had grown to $180 billion and his sole client was a foreign trust. In April 2023, Vista Financial filed an updated Form ADV listing its RAUM as $11 trillion.

During the examination, Vista Financial produced a spreadsheet and delivered it to the SEC that was supposed to back up its claimed RAUM. One item was a bank account with 140 billion Euros. The SEC checked with the bank. That account never had more than $3500.

The spreadsheet listed $42 billion in a single issuance of US Treasury Bonds. That would have made the firm likely owning every bond in the issuance. Assuming the issuance was even that big. The SEC found no evidence that Vista Financial held any treasury bonds.

Then there is the fraud-ier stuff. Vista Financial purported to hold $3 billion in bonds from a corporation (unnamed in the filings). Vista Financial tried to open a brokerage account with a margin loan allowance using some of those bonds as collateral and citing Vista Financial’s registration with the SEC to support its legitimacy.

I was waiting to find some details behind this 2023 case hoping there would be some explanation for this craziness. Alas, the case has settled and no more detail have emerged. Mr. Williams agreed to be barred from any SEC registered firm.

Was Mr. Williams the scammer or was he being scammed? I was hoping to get an answer.

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More Whistleblower Actions

The Denver office of the Securities and Exchange Commission has rolled up a bunch more whistleblower rule violations. This follows up with last week’s settlement with Nationwide Planning for impeding clients from reporting violations to the SEC.

In response to a Congressional mandate in Dodd-Frank, the Securities and Exchange Commission adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

In prior enforcement actions, the SEC has aggressively pursued actions against firms who have tried to limit the ability of its customers or employees to report violations. Against CBRE, the SEC did not like its form of separation agreement that had a representation that the departing employee had not already filed a compliant. The SEC did not like that Monolith Resources tried to limit whistleblowers by allowing them to report, but not retain any financial rewards for reporting. Nationwide Planning tried to allow clients to talk with the SEC, but only if the SEC started the talk.

In these cases, Smart for Life, LSB, IDEX, Acadia, and Brands Holding took the path of allowing employees to report a violation but preventing employees from getting any financial award from a whistleblower complaint path. The SEC doesn’t like that.

Transunion and AppFolio tried to prevent employees from getting any financial award from a whistleblower complaint. And also addied that the employees give the company notice before disclosing anything.

As with the off-channel communications cases, there is no charge of fraud. The cases merely cite a violation of the rule.

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Another $49 Million in Fines for Texting

The Securities and Exchange Commission continues its relentless assault on firms that have allowed employees to use text messages, WhatsApp, private email, or other “off-channel communications.”  Last week, six rating agencies were caught in regulatory crosshairs. 

Moody’s, S&P, Fitch, HR Ratings, A.M. Best, and Demotech had to pay $49 million in fines to the SEC. 

The SEC’s off-channel task force is tracing messages from one firm to another and slapping fines on each link in the chain for violations. There are no findings of frauds. These fines are merely for record-keeping violations.  

These cases do mark a new segment of record-keeping violations. These six firms are Nationally Recognized Statistical Rating Organizations and are subject to Rule 17g-2(b)(7) applicable to NRSROs.

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Broker-Dealer and Investment Advisers Hit with Violation of Whistleblower Protections

In response to a Congressional mandate in Dodd-Frank, the Securities and Exchange Commission adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

In prior enforcement actions, the SEC has aggressively pursued actions against firms who have tried to limit the ability of its customers or employees to report violations. Against CBRE, the SEC did not like its form of separation agreement that had a representation that the departing employee had not already filed a compliant. The SEC did not like that Monolith Resources tried to limit whistleblowers by allowing them to report, but not retain any financial rewards for reporting.

A recent case is the first I recall that is taken against a broker-dealer or investment adviser. The order found that Nationwide Planning Associates, Inc. and investment adviser NPA Asset Management, LLC, and state-registered investment adviser Blue Point Strategic Wealth Management, LLC, impeded brokerage customers and advisory clients from reporting securities law violations to the SEC.

The offending language:

“The Recipient represents that [she / he] shall forever keep completely confidential all of the above terms of this Agreement and shall direct all those in privity with them (including their attorneys, CPAs, etc.) to keep the same completely confidential. The Recipient further represent[s] that [she / he] will forever refrain from any discussion, narration, or disclosure of any transaction, circumstance, conversation, or any other aspect of the Recipient relationship with any and all of the Company, with any person or entity.” …

“The confidentiality and non-disclosure provision does not prohibit the Recipient from responding to any unsolicited inquiry (i.e., an inquiry not resulting from or attributable to any actions taken by Recipient or by any third party at Recipient’s direction) about the Agreement or its underlying facts and circumstances initiated by any state, federal or self-regulatory commission or authority that regulates the business or activities of registered investment advisers or their representatives.”

I believe its okay to have the confidentiality provision in the first paragraph, as long as you have a carve-out for reporting to regulators.

These firms tried to get cute by saying the confidentiality provision didn’t apply if the regulators initiated the inquiry. It would still prevent reporting to the regulators by the client.

That’s an impediment to reporting an a violation of Rule 21F-17.

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Explicit Anti-Money Laundering/Countering the Financing of Terrorism Rules Put in Place for Investment Advisers 

Investments advisers had been excluded the definition of “financial institution” under the Bank Secrecy Act. At least until today. The Financial Crimes Enforcement Network at Treasury issued a final regulation today that changes that exclusion. Most registered investment advisers are now included in the definition and will have to comply with the strict requirements of the Bank Secrecy Act.

The compliance date is January 1, 2026.

“The final investment adviser rule will apply anti-money laundering/countering the financing of terrorism (AML/CFT) requirements—including AML/CFT compliance programs and suspicious activity reporting obligations—to certain investment advisers that are registered with the U.S. Securities and Exchange Commission (SEC), as well as those that report to the SEC as exempt reporting advisers. The rule will help address the uneven application of AML/CFT requirements across this industry.”

Registered investment advisers will need to get up to speed on filing Suspicious Activity Reports and the other requirements of the BSA.

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Another Terrible Pay-to-Play Case

Just in time for a governor to be selected to the presidential ticket, the Securities and Exchange Commission levied a big fine for violating the Pay-to-Play Rule for Investment Advisers.

Obra Capital Management was the sponsor and adviser to a closed-end, private fund. The Michigan Public Employees’ Retirement Fund made a $100 million commitment to the fund in 2017. The state had no right to withdraw from the Obra fund.

In 2019 Person1 made a $7150 campaign contribution to a Michigan government official. Person1 was not employed by Obra at this time. Presumably, the official was Governor Whitmer, although not specifically stated in the Order. The Governor meets the definition of an elected official who can indirectly influence investment decisions.

Six months later, in mid-2020, Obra hired Person1 to a position that would be considered a “covered associate” under the Pay-to-Play Rule. After being hired, Person1 sought return of the campaign contribution and was successful in getting it back.

That return of funds did not meet the requirements of the Rule.

Obra was censured and had to pay a $95,000 fine.

Seems like the SEC didn’t care that Michigan’s investment decision had already been made, or that the contribution was made well before employment, or that the contribution was made in accordance with state campaign restrictions, or that there was no evidence of deception, fraud or malfeasance.

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Another Half-Billion in Fines for Texting

The Securities and Exchange Commission and the Commodity Futures Trading Commission levied another $475 million in fines against broker-dealers, investment advisers and commodities firms. Ameriprise, Edward D. Jones, LPL and Raymond James each paid a $50 million fine. Millions in fines because firm employees were texting with clients and business partners.

The order against P. Schoenfeld Asset Management LP provided some insight on the SEC’s approach toward investment advisers and fund managers. PSAM is registered as an investment adviser. It is not broker-dealer or dually registered as a BD-IA.

The SEC points out four areas of records that are required under the IA record-keeping requirements:

(a) any recommendation made or proposed to be made and any advice given or proposed to be given;
(b) any receipt, disbursement, or delivery of funds or securities;
(c) the placing or execution of any order to purchase or sell any security; or
(d) predecessor performance and the performance or rate of return of any or all managed accounts, portfolios, or securities recommendations.

PSAM’s policy was that ’employees were “prohibited from conducting PSAM business using any other electronic communication services . . . or accounts not provided by PSAM”’. That is probably broader than the SEC record-keeping rule requires.

Even with its stricter policy, PSAM appears to have breached the record-keeping requirements. The Order refers to “pervasive off-channel communications.” The SEC examiners found records in these other platforms that were required to be retained. As an example, off-channel communications were sent to and from PSAM clients, counterparties, and other financial industry participants.

It sounds to me like SEC examiners looked at personal devices.

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The One with Insufficient Compliance Resources

The Bank Secrecy Act requires broker-dealers to file suspicious activity reports. Under the SAR Rule (31 C.F.R. § 1023.320(a)(2)), every broker-dealer has to file a report for a transaction of at $5000 that

  1. Involves funds derived from illegal activity or is intended or conducted in order to hide or disguise funds or assets derived from illegal activity
  2. Is designed to evade any requirements under the Bank Secrecy Act
  3. Has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage
  4. Involves use of the broker-dealer to facilitate criminal activity

That’s all a bit vague. So FINRA has produced a list of more actionable items, most recently compiled in FINRA Regulatory Notice 19-18 (May 2019).

There are vendors who sell software that will monitor transactions and flag those that meet the criteria in the FINRA Notice.

OTS Link used one of those automatic surveillance systems. For the first six months of 2021 the system raised over 1800 alerts for transactions to be reviewed. For those 300 alerts a month, the compliance team at OTS Link only devoted 5 hours a month. No surprise, they failed to investigate any or file any SARs.

In the Order, the SEC says that if OTS Link had properly surveilled transactions it would have spotted:

(a) a large volume of thinly-traded, low-priced securities;
(b) a sudden spike in investor demand for, coupled with a rising or decreasing price in, thinly-traded, low-priced securities;
(c) suspicious manipulative, pre-arranged or wash trading activity;
(d) subscribers who were publicly known to be the subject of criminal, civil or regulatory actions for crime, corruption, or misuse of public funds.

In response to the SEC exam, OTS Link added two people to its AML compliance team and hired a third-party compliance consultant to review the program.

The SEC order mandates additional reporting and levied a $1.19 million fine. You either pay for compliance or you PAY for compliance failure.

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The One with the Model Portfolio on the Website

The Marketing Rule, Advisers Act Rule 206(4)-1, Section (e)(1) defines hypothetical performance as “performance results that were not actually achieved by any portfolio of the investment adviser and includes, but is not limited to:

  • Targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.
  • Performance derived from model portfolios;
  • Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and
  • Targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.”

It’s okay to use hypothetical performance in your marketing materials, IF (that’s a big if) the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement. (See section (d)(6)(i) of the Marketing Rule)

In the release, the SEC states

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives. (See page 220)

Earlier this spring the SEC brought enforcement actions against five firms for publishing hypothetical performance on their websites. The SEC just found another firm who published returns from model portfolios on its website. See IA Release 6646.

It’s become very clear that model portfolio returns do not belong on a firm’s website.

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