Recent SEC Enforcement Actions Reinforce the Importance of Effective Supervision, Policies, and Procedures for Broker-Dealers and Investment Advisers

by King & Spalding

A summer of Securities and Exchange Commission settlements involving registered broker-dealers and investment advisers demonstrates that the SEC remains firmly committed to regulating the conduct of these firms.  These settlements illustrate the Commission’s determination to hold large financial institutions accountable, even when employees go “rogue,” and reinforce the importance of designing and implementing internal controls that are reasonably tailored to detect and prevent employee misconduct.

Supervision of Markups and Related Customer Communications

On June 12, 2018, the SEC issued a settled order charging a broker-dealer with failing to maintain supervisory policies and procedures reasonably designed to prevent and detect excessive mark-ups in sales of non-agency residential mortgage-backed securities (“non-agency RMBS”),  and misleading statements in connection with such sales. Although the Commission acknowledged the firm’s policies and procedures addressing both excessive markups and false and misleading statements, it found those policies and procedures lacking.

In faulting the firm’s procedures with respect to false and misleading statements, the SEC emphasized the relative opaqueness of the non-agency RMBS market, the perceived inadequacy of the firm’s review of its employees’ electronic communications (which, among other things, generally sampled approximately one percent of the relevant communications and did not include procedures specifically designed to detect false or misleading statements), and the fact that the firm did not detect any of the misleading communications cited in the order.  With respect to excessive markups, the SEC faulted the firm for using a “drop-down menu” of codes to record how compliance personnel had resolved automatically-generated alerts that flagged trades suggesting potentially excessive markups, as well as for instructing its compliance personnel to consider only FINRA rules and guidance on excessive-markups without also considering the potential for fraudulent conduct even where FINRA rules and guidance are complied with.

Without admitting or denying the SEC’s findings, the firm agreed to be censured, to comply with certain remedial undertakings, to pay a civil penalty of approximately $5.2 million, and to disgorge approximately $10.5 million in firm profits (including interest) to be reimbursed to affected customers – most or all of which were sophisticated market participants known as “qualified institutional buyers (or “QIBs”).

Supervision of Third-Party Disbursements from Client Accounts

On June 29, 2018, the SEC issued a settled order against another firm for lacking policies and procedures reasonably designed to prevent its financial advisors from misappropriating funds from client accounts through outgoing distributions sent to third-party accounts for an advisor’s own benefit, and for failing to reasonably supervise one particular advisor who used such means to misappropriate more than $5 million from four advisory clients. Specifically, the Commission faulted the firm for permitting financial advisors to initiate outgoing disbursements of up to $100,000 per day per client account to third-party recipients based solely on the advisor’s attestation of having received the client’s verbal request.  According to the settled order, the firm’s procedures lacked any effective means of authenticating or testing whether a client had actually made a disbursement request, such as by obtaining a verifiable client signature, calling the client (or a sample of clients) to verify distributions to third parties below $100,000, recording customer telephone calls requesting third-party disbursements, or requiring that such calls be made to or from a firm telephone so that a firm record would be readily available.

Without admitting or denying the SEC’s findings – and having previously reimbursed its affected customers and developed “significant enhancements” to its relevant policies and procedures – the firm agreed to a censure, a cease-and-desist order, and a $3.6 million civil penalty. The firm also undertook to certify to its implementation of certain policy enhancements.

Supervision of Unsuitable, Excessive, and Unauthorized Trades

The SEC also announced on June 29, 2018 another settled order charging a different firm with failing to supervise three of its brokers who had previously been charged with, among other things, recommending unsuitable transactions, churning customer accounts, and making unauthorized trades. The Commission also charged two individual firm supervisors in separate settled orders issued the same day.  In its settled order against the firm, the SEC again acknowledged that the firm had written supervisory procedures addressing all three types of misconduct at issue, but faulted the firm for permitting a “lax compliance environment” in which its registered representatives “were not reasonably monitored or disciplined, procedures were not followed, and indications of potential misconduct were not acted upon by the supervisors.” More specifically, the SEC order found that the firm had “failed to put in place reasonable mechanisms for supervisors to use to monitor registered representatives for compliance with their reasonable basis and customer-specific suitability obligations” and failed to adequately train the two charged supervisors or to implement any procedures reasonably designed to identify whether they were reviewing customer accounts for churning. The Commission further found that the two supervisors failed to properly utilize exception reports and alerts to monitor the three previously-charged brokers. 

Without admitting or denying the SEC’s findings, the firm agreed to be censured, to retain an independent consultant to review its relevant policies and procedures, to disgorge approximately $194,000 (plus interest) and to pay an equivalent amount as a civil penalty.

Preventing Misuse of Material Nonpublic Information

On July 23, 2018, the SEC issued a settled order charging a broker-dealer with violating Section 15(g) of the Exchange Act by failing to maintain and enforce policies and procedures reasonably designed to prevent the misuse of material, nonpublic information. The specific information at issue concerned individual buy orders placed by firm customers who were public-company issuers effectuating their previously-disclosed stock buyback programs, which information was accessible to certain firm traders who could potentially misuse it or share it with other firm customers who might potentially misuse it.  Notably, the settled order expressly disclaimed any allegation of actual unlawful trading, although the Commission did find that firm traders sometimes shared the relevant nonpublic information with other firm customers.  Moreover, as in the cases described above, the Commission expressly noted that the firm had “established” relevant policies and procedures, yet faulted the firm for not “maintaining and enforcing” those policies and procedures.

In particular, the SEC found that the firm failed to maintain and enforce its policies and procedures aimed at preventing the firm’s execution and sales traders from disclosing material nonpublic customer buyback order information internally to other traders or externally to other customers, failed to create effective information barriers between the firm’s equity trading desks, and failed to adopt measures to protect confidential customer information.

As examples, the SEC noted that the head execution trader on the firm’s U.S. equity trading desk was given direct access from his own workstation to the order management system for the firm’s international trading desk, which received and executed the relevant stock buyback orders, and that he also routinely disseminated such information to traders on his desk.  The SEC likewise found that the firm more generally failed to maintain and enforce effective information barriers between its international desk and its U.S. desk to prevent the sharing of issuer buyback order information, citing the fact that almost every morning before the market opened, traders on the international desk provided the head execution trader on the U.S. desk with unexecuted buyback order information. Finally, the SEC expressed concern with the firm’s office layout because both its international desk and U.S. desk had personnel, including execution and sales traders, located on the same floor, thus enabling U.S. desk personnel to overhear international desk personnel discussing buyback order information.

Supervision of Trading in Proprietary Accounts

On August 16, 2018, the SEC issued a settled order against a dually-registered broker-dealer and investment adviser for failing to reasonably supervise three of its traders with a view towards preventing mismarking of trades and unauthorized trading in the firm’s proprietary accounts. According to the SEC’s settled order, the firm’s supervisory failure led to millions of dollars in unreported losses and improperly-reported gains, and ultimately caused the firm’s books and records, and those of its publicly-traded parent company, to be inaccurate.

The SEC’s order described several failures in the firm’s supervisory procedures, electronic systems, and employee training that resulted in the underlying violations, as well as the firm’s prolonged failure to detect them. For example, the SEC found that a relevant employee was not trained to distinguish between legitimate hedges and speculative trades and that desk-specific written supervisory procedures did not require desk heads to review the traders’ marks, marking methodologies, or relevant inputs, or to take other steps to verify the accuracy of the valuations. Without such monitoring, according to the settled order, the desk heads had no practical ability to ensure that traders marked positions appropriately. The SEC further found that the firm’s desk-specific written supervisory procedures did not require desk supervisors to review trade blotters or daily P&L reports or to otherwise monitor trade activity for compliance with the procedures.

Without admitting or denying the SEC’s findings, the firm agreed to cease and desist from committing or causing violations of the books-and-records provisions of Securities Exchange Act section 17(a) and SEC rules thereunder, the firm’s publicly-traded parent company agreed to cease and desist from violating the books-and-records provisions of Securities Exchange Act section 13(b)(2)(A), and both entities agreed to pay a $5.75 million civil penalty jointly and severally.


With these settlements, the SEC has reemphasized its determination that broker-dealers and investment advisers must maintain and enforce robust compliance policies and procedures to protect their customers. When employees commit misconduct (either intentionally or inadvertently), the SEC will carefully evaluate whether firms could have operated differently so as to detect and prevent the misconduct.  Some of these cases should also serve to remind firms that the SEC is willing to bring enforcement actions even when there is no evidence of customer harm.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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