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September 7, 2021

Regulatory Update

SEC Schools Advisors on Best Interest Obligations; “To Do” List for Fixed Income Principal and Cross Trades; Complex Product and Form CRS Fails: Regulatory Update for September 2021

For Investment Advisors

  • REQUIRED READING: SEC Tells Advisors How to Manage Retail Accounts.  This Risk Alert from the Department of Examinations (DOE) refers to wrap programs, but the best practices discussed can apply to all retail advisors.  With references to “fiduciary duty” and “clients’ best interest” sprinkled liberally throughout this alert, RIAs should pay close attention since the SEC provides a roadmap on meeting these duties.  After more than 100 exams with advisors that participate in wrap fee programs, the SEC highlighted the following best practices:
  1. Get Information and Use it to Select the Right Product for Each Client. Advisors should, at a minimum, collect the following information: “retirement goals, current employment status, investment time horizon, stated financial objectives (g., capital appreciation), risk tolerances (e.g., conservative or aggressive), amount to invest, age, income, investment income needs, net worth, savings, planned spending from the account, dependents, liabilities, and other investment assets not managed by the advisor.”  In addition to gathering this information, advisors should have a written process for using it to select an appropriate account type, investment product, and asset allocation.
  2. Schedule Periodic Reminders to Clients to Discuss Material Changes to Investment Goals and Objectives. Clients have a responsibility to keep advisors informed of changes to their financial situation, retirement goals, and risk tolerances.  To make sure this happens, advisors should send periodic reminders to clients with their financial advisor’s name, email address, and phone number.  Make the process easy for clients.
  3. Educate Clients About Fees and Clients About Wrap Fee Programs. The SEC highlighted the importance of discussing with clients the differences between wrap programs and other types of accounts by addressing fees, expenses, and other costs.  The staff also focused on disclosure of conflicts related to wrap fees programs, including telling clients when advisors have an incentive not to trade client accounts because they may have to pay ticket charges.  Firms should also include in their Form ADV Part 2A disclosure that clients may incur more costs by participating in a wrap fee program than by selecting another type of account. Clients should be encouraged to discuss the differences in types of accounts with their financial advisors.
  4. Be Frank About Fees. The SEC wants clients to understand all the fees they are paying.  Specifically, the staff noted that it is a best practice to include disclosures addressing charges imposed by mutual funds or ETFs, including fees embedded in the price of the fund, transfer fees, and additional charges for types of trades, like options trading.  The SEC also highlighted other expenses that should be disclosed to clients, including “transfer taxes, margin account balances, odd-lot differentials, early settlement fees (i.e., fees that may be charged when clients exit investment positions or withdraw cash), and custodial expenses on certain types of investments and services (e.g., spreads, clearing costs, reporting fees, processing fees, or revenue sharing fees).”  Clients who receive a statement with fees and expenses they were not expecting will feel misled by their advisor.  Being upfront about the costs of investing can help avoid disappointment.
  5. Testing to Ensure Financial Advisors are Following the Rules. The firm’s compliance program should include a written process for selecting investment products that are in the client’s best interest, training for investment professionals on the process, and testing to validate the selection.  Testing could include periodic review of account documentation by the compliance team to ensure investments are consistent with the information provided by the client.  Alternatively, a firm could establish an account review committee to review investment selections both initially and annually.  Financial advisors should have guidance on how to select appropriate investment products.  The process should be reviewed to ensure that it is, or is not, working.
  6. Best Execution Testing for Wrap Programs. The SEC has provided some excellent advice on how to perform best execution review for wrap programs. Although advisors must seek best execution, this concept is not always easy to apply to wrap programs.  For example, the SEC noted that if underlying wrap program managers are frequently “trading away,” clients may not be getting best execution, so this activity should be monitored.  Other best practices include monitoring whether wrap accounts are infrequently traded or are being charged commissions inappropriately.
  7. Identifying Infrequently-Traded Accounts for Review. Firms should have criteria for determining when it’s appropriate to move a client from a wrap program to another type of account.  For example, clients in wrap programs with little trading activity may be better off in another type of account. Therefore, advisors should consider a periodic review of client accounts defined as “infrequently traded” to evaluate whether the client would be better off in another type of account.

This Risk Alert makes for fascinating reading.  Although focused primarily on wrap programs, the deficiencies identified apply to all kinds of investment products.  Advisors should read this alert carefully and consider whether they might have similar issues, including whether client accounts are being appropriately monitored, accounts reviews are adequate, disclosures sufficiently describe conflicts, and their compliance programs address risks specific to their business.  Contributed by Jaqueline Hummel, Managing Director.

  • Risk Alert – Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisors from An Examination Initiative. The SEC Division of Examinations (“Exams”) published this July 21, 2021 Risk Alert, as a follow-up to its September 4, 2019 Risk Alert on a similar topic and to its recently concluded examination initiative focused on advisors’ principal and cross trading activities (“cross trading”) involving fixed income securities.  Exams reviewed over 20 RIAs cross trading activities focusing on conflicts of interest and the adequacy of written compliance policies and procedures and disclosures, with almost two-thirds of the firms receiving deficiency letters.  Although the initiative focused on fixed income, the alert should resonate with any firm engaging in cross trading.  Firms are encouraged to read both risk alerts in their entirety to understand the legal requirements, common compliance issues, and resources available to firms engaged in these activities.

Compliance Programs.  Like every good risk alert, the July 21 alert cites inconsistent, overly general, and ineffective policies and procedures as familiar sources of deficiencies uncovered during the exam initiative.  For example, some firms had policies that prohibited crossing or required compliance pre-approval or client consent and disclosure before engaging in cross trades, but the firms’ actions contradicted those policies.  Other firms had procedures that were too general.  For example, a firm agreed to contractual provisions that required it to comply with ERISA restrictions, but it did not implement procedures that included a prohibition on placing cross trades in such accounts.[1]  Other firms had procedures requiring multiple quotes on  proposed cross trades to help establish the trade price, but those procedures fell short because they didn’t instruct employees what to do next – namely, how to determine which price to use if the quotes differed.  Finally, the alert found ineffective testing by firms and specifically called out insufficient analysis of trade blotters to detect unreported principal or cross trades.

How to get it right?  The SEC highlighted several effective policies and procedures related to cross trading.  For starters, firms are encouraged to define covered activities in their policies and procedures, establish specific definitions, and set standards to guide their policies and procedures.  The alert includes a handy matrix with examples of common standards that include periodic reporting to legal and compliance, the use of pre-approval by senior management or compliance, and prohibiting principal and cross trading in ERISA accounts.  Effective testing practices lean heavily on a thorough review of the trade blotter and related documentation to confirm whether prohibited cross trading occurred.  To engage in cross trading, firms should have a process for setting a fair and equitable price and determining that the trade was in the best interest of the participating clients.  Firms should also review trade documentation to identify missing pre-approvals or client consents and whether cross trading occurred in ERISA or other prohibited accounts.

Conflicts of interest.  Another category of common deficiencies pertains to conflicts of interest associated with cross trading.  Examples include cross trades that were not executed at independent market prices contrary to written policies and procedures, others did not appear to seek best execution, and some contained undisclosed markups or other fees.  Firms that accept the risks associated with cross trading are advised to carefully consider their risks – identifying those risks that may be unique to their firm, developing controls to address them, and implementing thoughtful testing to monitor their effectiveness.

Written disclosures.  Over one-third of the deficiencies identified pertained to written disclosures.  To head off similar deficiencies, firms must provide clients with full and fair disclosure of all material facts surrounding principal and cross trades. For example, advisors that permit cross trading should consider disclosures that describe related conflicts of interest, when a firm can engage in cross trades, the costs involved in such transactions (including any compensation received by the advisor), and how the execution price is determined.  Providing well-designed and consistent disclosures in multiple documents is another effective practice.  These documents most commonly include Form ADV, client agreements, separate client correspondence, and private fund offering documents if applicable.  Contributed by Cari Hopfensperger, Senior Director.

For Broker-Dealers

  • Attention FinOps: FINRA Updates Interpretations of Financial and Operational Rules. FINRA added ten new interpretations related to SEA Rules 15c3-1 and 15c3-3, including interpretations to address service arrangements with a parent or an affiliate, and unsecured receivables and their related payables.  In addition, FINRA revised six interpretations, focusing on additional net capital, accrued liabilities for commissions payable, and debit balances collateralized by control or restricted securities.  Finally, FINRA rescinded two interpretations regarding commissions receivable vs. payable, and Federal Reserve Bank as a Non-Customer.  Please be sure your firm’s FinOp receives FINRA Notice 21-27Contributed by Rochelle Truzzi, Senior Director.
  • FINRA Adopts New Rule Addressing the Operation of Inter-dealer Quotation Systems. FINRA notified its members that the OTC Bulletin Board (“OTCBB”) is scheduled to cease operation and the OTCBB-related rules will be deleted, sometime after October 31st of this year. Accordingly, FINRA has adopted new Rule 6439, which will govern members in the operation of inter-dealer quotation systems that regularly disseminate quotations of OTC equity securities on a real-time basis. The new rule, except for paragraph (d)(1)(B), becomes effective on October 1, 2021.  The effective date for paragraph (d)(1)(B) will be announced at a later date.  Member firms who operate an inter-dealer quotation system will need to adopt, implement, and document policies and procedures reasonably designed to comply with the requirements set forth under the new rule.   Contributed by Rochelle Truzzi, Senior Director.

Lessons Learned 

  • When Products are This Complicated, Training is Not Enough. UBS had to pay investors more than $8 million for failing to prevent “unsuitable investments in volatility-linked-exchange products (ETPs)” over two years, according to the SEC’s settlement order.  This case makes intriguing reading since, in a lot of ways, UBS did a lot of things right. But, unfortunately for UBS, two mistakes undermined all of its other risk management efforts and caused harm to clients.

The security at issue is the iPath S&P 500 VIX Short Term Futures Index Total Return Exchange Traded Note, or VXX.  According to the SEC, VXX is designed to provide exposure to the implied volatility of the S&P 500 by replicating a strategy of continuously maintaining a rolling portfolio of one and two-month futures contracts on the CBOE volatility index (the “VIX”).  To illustrate the complexity of the product, the SEC included some quotes from the prospectus supplement, which contained words like “contago” and “backwardation.”  Without going into detail, VXX was only meant to be held for very short periods, such as a day or two.  The value of VXX generally goes down when held for extended periods, which is precisely what happened to UBS’ clients.

UBS recognized the complexity of VXX and put guardrails around its sale.  For example, the product committee only allowed sales of VXX to customers with a very high net worth and an aggressive risk profile. In addition, only a select group of experienced financial advisors were allowed to invest client assets in VXX, and only after they completed an online training module on commodity futures-linked securities.  UBS also limited client holdings in volatility ETPs (like VXX) to 3% of account assets and set up a system to flag accounts that exceeded this limit.

Despite these precautions, about 1,882 client accounts held VXX for extended periods and lost a lot of money.  Why?  One reason is that the monitoring system did not work. First, the CUSIP for VXX changed after a reverse split, and the system for monitoring VXX in client accounts was not updated with the new CUSIP for five years.  Second, the financial advisors did not understand how to use VXX or manage its risks, despite their training and all the internal memos stating that the VXX should only be held for a couple of days.  Ultimately the SEC found UBS failed to have policies and procedures to address “holding period risk” and therefore violated Section 206(4) and Rule 206(4)-7 of the Advisers Act.

This case illustrates the fact that firms should not rely on training modules when dealing with complex issues. Instead, training should be reinforced with adequate supervision.  Second, although there is enormous value in using systems to monitor and flag issues, the systems are only as good as their programming.  Someone should be asking why if a monitoring system never sends up the red flag.  Contributed by Jaqueline Hummel, Managing Director.

The SEC adopted Form CRS on June 5, 2019, which required SEC-registered investment advisors and broker-dealers to file Form CRS with the SEC and begin delivering them to prospective and new retail investors by June 30, 2020.  Initial Form CRS delivery to existing retail investors was mandated by July 30, 2020.  In addition, firms were required to prominently post their current Form CRS on their website, if they had one.

The SEC Division of Examinations contacted the 21 investment advisors in mid-October regarding their failure to file, deliver, and post Form CRS.  A second follow-up was made to announce an examination relating to each firm’s failure to comply with Form CRS rules.  In a few of these cases, the filings of Form CRS happened as late as June 2021, almost a full year after the initial required filing date of June 30, 2020, had passed. As a result, firms were ordered to cease and desist from violating the Advisers Act Section 204 and Rules 204-1 and 204-5, censured, and required to pay civil money penalties.  Those penalties ranged from $10,000 for smaller investment advisors to $97,523 for larger firms.  The six broker-dealer firms were contracted by FINRA contacted in mid-September to October 2020 to remind them of their regulatory obligations.  All six broker-dealers filed their Form CRS late, but in two of these cases, the initial Form CRS filing occurred as late as June 2021.  The broker-dealers violated Section 17(a)(1) of the Securities Exchange Act of 1934 and Exchange Act Rule 17a-14.  Fines for the broker-dealers ranged from $10,000 to $50,000.

The monetary penalties totaled over $900,000 for all 27 violations.  The SEC is sending a message to investment advisors and broker-dealers to take regulatory deadlines and disclosure requirements seriously.  “Registration with the SEC as an investment advisor or broker-dealer comes with mandated filing and disclosure obligations,” said Gurbir S. Grewal, Director of the SEC’s Enforcement Division. “Today’s cases reinforce the importance of meeting those obligations and providing retail investors with information that is intended to help them understand their relationships with their securities industry professionals.”  Investment advisors and broker-dealers should not wait for a second warning before resolving a noted deficiency.  Resources are available for firms that need assistance in complying with Form CRS filing/delivery requirements.  Contributed by Trish Kulhan, Associate Director.

  • Three Blind Mice – The Latest Trio of Share Class Selection Disclosure Cases. Another month and another round of settlements between the SEC and investment advisors for violations related to mutual fund 12b-1 fees.  The SEC announced the following disgorgements, prejudgment interest, and civil penalties: ISC Advisors, $716,300; Coburn & Meredith, $299,340; and First Heartland Consultants, $1,045,528.  Each settlement echoed a similar theme – inadequate disclosures of conflicts of interest and fees; best execution failures caused by using higher-cost mutual funds and share classes; and failing to adopt and implement compliance policies and procedures reasonably designed to prevent these violations.  In two of the settlements, the SEC also noted the firm had failed to participate in the SEC’s 2018 Share Class Selection initiative.  Contributed by Doug MacKinnon, Director.
  • Classic Example of Suitability Violations Involving Structured Products. The SEC instituted an administrative proceeding against member firm Integral Financial, LLC and its supervising principal for failure to implement supervisory procedures.  Without adequate supervision, registered representatives at the firm were able to make “unsuitable recommendations of highly complex and high-risk variable interest rate structured products to ten retail investors” over two years.  In addition to the complexity and risk components of the product itself, the concentration level and liquidity issues made these products even more unsuitable for the investors involved.  This is an excellent piece for firms to include as part of their firm element continuing education program under the title, “What Not to Do!”   Contributed by Rochelle Truzzi, Senior Director.

 Worth Reading, Watching, and Hearing

Filing Deadlines and To-Do List for September 2021


  • Blue Sky Filings (Form D). Advisors to private funds should review fund blue sky filings and determine whether any amended or new filings are necessary.  Generally, most states require a notice filing (“blue sky filing”) within 15 days of the first sale of interests in a fund, but state laws vary. Did you know that Foreside Financial offers a convenient and economical blue sky filing service to help firms manage this complicated monthly task?  Give us a call at 1-866-251-6920 or email us at to discuss your needs further.  Due September 15, 2021.


  • Rule 17a-5 Monthly and Fifth FOCUS Part II/IIA Filings: For the period ending August 31. Filing required for firms required to submit monthly FOCUS filings and those firms whose fiscal year-end is a date other than a calendar quarter. Due September 24, 2021.
  • Supplemental Inventory Schedule (“SIS”): For the month ending August 31. The SIS must be filed by a firm that is required to file FOCUS Report Part II, FOCUS Report Part IIA, or FOGS Report Part I, with inventory positions as of the end of the FOCUS or FOGS reporting period, unless the firm has (1) a minimum dollar net capital or liquid capital requirement of less than $100,000; or (2) inventory positions consisting only of money market mutual funds. A firm with inventory positions consisting only of money market mutual funds must affirmatively indicate through the eFOCUS system that no SIS filing is required for the reporting period. Due September 29, 2021.
  • Annual Reports for Fiscal Year-End July 31, 2021: FINRA requires that member firms submit their annual reports in electronic form. Firms must also file the report at the regional office of the SEC in which the firm has its principal place of business and the SEC’s principal office in Washington, DC. Firms registered in Arizona, Hawaii, Louisiana, or New Hampshire may have additional filing requirements. Due September 29, 2021.
  • SIPC-7 Assessment: For firms with a fiscal year-end of July 31.  SIPC members are required to file the SIPC-7 General Assessment Reconciliation Form together with the assessment owed (less any assessment paid with the SIPC-6) within 60 days after the Fiscal Year-End. Due September 29, 2021.
  • SIPC-3 Certification of Exclusion from Membership: For firms with a fiscal fear-end of August 31 AND claiming an exclusion from SIPC Membership under Section 78ccc(a)(2)(A) of the Securities Investor Protection Act of 1970. This annual filing is due within 30 days of the beginning of each fiscal year. Due September 30, 2021.
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of February 29. SIPC members are required to file for the first half of the fiscal year a SIPC-6 General Assessment Payment Form together with the assessment owed within 30 days after the period covered. Due September 30, 2021.


Form N-MFP.  Form N-MFP (Monthly Schedule of Portfolio Holdings of Money Market Funds) reports information about the fund’s holdings as of the last business day of the prior calendar month and must be filed no later than the fifth business day of each calendar month.  Due date is September 8, 2021.



[1] The connection between contractual obligations with clients and firm policies and procedures was also called out more broadly in the alert: “The lack of any policies and procedures to meet a contractual obligation rooted in legal requirements could result in an advisor breaching its fiduciary duty to its advisory client”.  Firms would be wise to consider any other customized contractual obligations in place with clients that are related to legal requirements and if there are gaps in their procedures.  For example, advisors with state or municipal retirement plan clients often have regulatory restrictions called out in contractual provisions that could be addressed in compliance policies and procedures.

This article is not a solicitation of any investment product or service to any person or entity. The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.