SEC’s Division of Enforcement is Not Taking a Summer Break, Widespread Audit Failures by Private Fund Auditor, Revenue Sharing and Conflict Disclosure Charges Continue, Whistleblower Policy Failures and More: Lessons Learned and Worth Reading, Watching and Listening for August 2021

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Lessons Learned

And the Award for Largest Financial Penalty Ever Issued by FINRA Goes to... Robinhood Financial, LLC (“Robinhood”). Last month, the firm was ordered to pay an unprecedented $70 million in fines and restitution for “systemic supervisory failures” that resulted in “widespread and significant harm” to customers. The violations noted in the AWC spanned several critical components of their compliance program, including customer identification, account approval, supervision, best execution, communications with the public, and more. Robinhood was sanctioned for distributing false or misleading information to customers, not exercising due diligence before approving customers to trade options, failing to create a reasonably designed business continuity program, failing to report thousands of customer complaints, failing to establish or maintain an adequate customer identification program, and failing to display complete market date information. A firm must consider its size and scope of products and services when developing its compliance program. The wise man builds his house upon a rock. Contributed by Rochelle A. Truzzi, Senior Director.

Auditors Charged with Widespread Private Fund Audit Failures. The SEC recently settled an action with audit firm, Stockman Kast Ryan & Co. LLP, Ellen S. Fisher, CPA and David H. Kast, CPA, finding “widespread audit failures” in several private fund audits conducted by the firm. These include the firm’s issuance of reports for audits that were not properly conducted in accordance with PCAOB standards and the firm’s failure to meet PCAOB independence standards. More specifically, the firm conducted audits of funds that included a review of valuation decisions for certain hard-to-value assets. Not only did the audit work itself fail to satisfy PCAOB standards of an appropriate review, but oversight was also found lacking in the engagement quality review process. The independence violations stemmed from one of the firm’s tax partners serving as atrustee or general partner for multiple investors in private funds audited by the firm, and from the firm providing bookkeeping services to one of the funds it audited. In all, these failures caused some of their private fund clients to violate the Custody Rule.. Although the SEC’s action was against the auditor (and certain of its principals), advisers should take this latest real life example to heart - RIAs are advised to conduct reasonable and ongoing due diligence on its auditors or potentially risk getting entangled in regulatory issues outside its walls. Contributed by Cari Hopfensperger, Senior Director.

TIAA CREF Learns Greed is Not So Good, Paying $97 Million Fine for Disclosure Failures. The SEC continues to hammer advisers for failing to disclose conflicts of interest, as shown by this case against Teachers Insurance and Annuity Association of America (“TIAA”), one of the largest providers of employer-sponsored retirement plants (“ESP”) catering to non-profit institutions. TIAA developed a wrap-fee advisory program, the “Portfolio Advisor” offered to retirement plan participants. Essentially, TIAA wanted to keep plan participants’ retirement nest eggs once they decided to leave their current plan due to retirement or a job change. So, TIAA created a Portfolio Advisor to capture those IRA rollovers and used both carrots and sticks to get its Wealth Management Advisors (”WMAs”) to sell the product to investors.

To ensure the WMAs met their fiduciary obligations to clients, TIAA adopted written policies and procedures requiring WMAs to present clients considering a rollover with the four options, including (i) leaving their assets in the current ESP, (ii) rolling assets over into an individual retirement account (including the Portfolio Advisor Accounts), (iii) rolling assets into a new employer’s plan, or (iv) taking a lump-sum distribution. Unfortunately, the memo from compliance did not make it to the sales team. The SEC’s administrative action asserted that WMAs received lucrative bonuses and pressure from their managers to sell the Portfolio Advisor for five years.

The lesson learned from this case is that even large institutions with adequate legal and compliance resources can still get it wrong. Although there will always be pressure to maintain and increase assets under management, advisors should put their clients’ interests first. Contributed by Jaqueline M. Hummel, Managing Director.

SEC Continues to Hammer Advisors on Disclosure Failures in Revenue Sharing Cases. In addition to the eye-popping $97 million fine against TIAA discussed above, the SEC reported three more cases involving disclosure failures and fiduciary breaches in June and July, including Kestra Private Wealth Services, LLC, St. Germain Investment Management, Inc., and Crown Capital Securities, L.P. These cases all involve a registered investment adviser with a broker-dealer affiliate. So, where did these advisors go wrong? The SEC findings included:

  • Fiduciary breaches for failing to disclose revenue-sharing arrangements, where an affiliated broker-dealer received a revenue share for certain mutual funds and cash sweep vehicles.
  • Best execution breaches for selecting mutual fund share classes that paid revenue sharing to an affiliated broker-dealer, when cheaper share classes of the same funds were available
  • Compliance program rule (Rule 206(4)-7) violations for failing to adopt and implement procedures to disclose these conflicts of interest, to make recommendations of mutual fund share classes and cash sweep options that were in the best interests of clients.
  • Crown Capital Securities had the added distinction of failing to self-report under the SEC’s Share Class Selection Disclosure Initiative.

Most advisors should be acutely aware of the issues cited in these cases. In most exams, the SEC Division of Examinations reviews a firm’s general ledger, specifically looking for sources of revenue other than advisory fees. Firms should understand their revenue streams, especially when the funds are coming out of their clients’ pockets. Finally, the SEC has expanded an advisor’s best execution obligations to include recommendations of cash sweep options. Advisors should regularly review cash sweep options to determine whether they are the best options from the client’s perspective. Contributed by Jaqueline M. Hummel, Managing Director.

Does Your Compliance Manual Violate Whistleblower Rules? In an administrative proceeding against Guggenheim Securities, LLC. (“GS”), the SEC found the firm willfully violated SEA Rule 21F-17 by including verbiage in its compliance manual stating, “Employees are strictly prohibited from initiating contact with any Regulator without prior approval from the Legal or Compliance Department. This prohibition applies to any subject matter that might be discussed with a regulator[…]. Any employee that violates this policy may be subject to disciplinary action by the Firm.”

This prohibition was intended to address the proper handling of inbound regulatory inquiries. GS adopted a separate Whistleblower Policy that complied with Rule 21F-17. Nonetheless, the SEC determined that the firm violated the spirit of Rule 21F-17, which prohibits any person from taking any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation. The finding resulted in a civil money penalty of $208,912. This determination was reached despite the SEC’s acknowledgment that it was “ unaware of any specific instances in which a GS employee was prevented from communicating with SEC staff about potential securities law violations.”

How many of us have included similar language in our manuals, all with good intent? Luckily, the administrative proceeding also describes Guggenheim’s remedial efforts, which can assist you in updating your procedures manual. Contributed by Rochelle A. Truzzi, Senior Director.

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