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FINRA Updates Registration Rules, NFA Writes Disclosures for Virtual Currencies and SEC Stays Busy with Actions against RIAs: Regulatory Update for September 2018

For Investment Advisers:  SEC Actions

SEC Goes Ahead with Administrative Proceedings:   With little fanfare, the SEC issued an order to terminate its previous stay on pending administrative proceedings before its Administrative Law Judges (“ALJ”) on August 22, 2018.  The SEC issued the original order after the U.S. Supreme Court held that the process for hiring SEC’s administrative law judges (“ALJs”) was unconstitutional in its 7-2 decision on June 21, 2018, in Raymond J. Lucia vs. Securities and Exchange Commission. The Commission’s order ratified the appointment of its ALJs and granted to all parties in current proceedings the opportunity for new hearing before a different ALJ.  The SEC also vacated prior opinions issued in nearly 130 matters pending before the Commission, listed on Exhibit A to the order. Contributed by Jaqueline M. Hummel, Partner and Managing Director

For Broker-Dealers:  FINRA Actions

FINRA’s Consolidated Registration Rules become effective on October 1st:  With all the buzz around FINRA’s revised exam structure, FINRA members may have lost sight of FINRA’s new registration and designation requirements that are effective October 1stSee FINRA Regulatory Notice 17-30The to-do list includes the following:

Check out our blog post for more details.  Contributed by Rochelle Truzzi, Senior Consultant

For Hedge and Private Fund Managers:  NFA Action

NFA Requires New Disclosures on Virtual Currencies:  Responding to current regulatory concerns about virtual currencies, the National Futures Association (NFA) issued an interpretative notice that includes new disclosure requirements for NFA members that are Commodity Pool Operations (“CPOs”), Commodity Trading Advisors (“CTAs”), Futures Commissions Merchants (“FCMs”) or Introducing Brokers (“IBs”) that engage in virtual currency transactions for their customers. NFA’s big concern is that customers may not fully understand the nature of virtual currencies and virtual currency derivatives, the risks associated with these products and the NFA’s limited oversight role.  The new disclosure requirements become effective on October 31, 2018.  NFA member firms should be on the lookout for educational guidance from the NFA on these new requirements.  Contributed by Cari A. Hopfensperger, Compliance Consultant

Lessons Learned from Recent SEC and FINRA Cases:

Another Wrap Program Provider Cited for Not Disclosing Cost of Trading Away. Lockwood Advisors has become yet another casualty in the SEC’s Office of Compliance Inspections and Examination’s (OCIE) focus on wrap programs. Not surprisingly, in this case, the SEC found that Lockwood violated the Compliance Program Rule (Rule 206(4)-7 of the Advisers Act) for failing to perform due diligence on portfolio managers in its wrap programs regarding their “trading away” practices.  The SEC also faulted Lockwood for not providing key information about “trading away” to clients and advisers in its wrap programs.  The SEC acknowledged Lockwood’s ongoing remedial efforts, including its promise to update its policies and procedures to remedy the issues, and fined the firm $300,000.

The case mirrors the findings in prior wrap fee cases against Raymond James & Associates, Robert W. Baird & Co., Riverfront Investment Group, LLC and Stifel, Nichols & Company, Inc.  In a wrap fee program, commissions for trades executed by the associated wrap fee program’s broker-dealer are generally included in the annual wrap fee.  When a wrap program portfolio manager “trades away,” or uses another broker-dealer to execute a trade, clients may be charged a commission in addition to the wrap fee.  In the cases discussed above, the wrap program sponsor did not give clients and their advisers enough information to determine the true cost of trading away.  The lesson learned from all of these cases is that advisers must understand, monitor and disclose actual client costs for the client to make an informed decision.  Wrap program sponsors should get data from portfolio managers about how often and why they trade away, best execution analysis, and a breakdown of the commission costs.  This information should be shared with advisers using the program.   Contributed by Jaqueline M. Hummel, Partner and Managing Director

Is Self-Reporting to the SEC Worth It?  In a somewhat baffling SEC administrative action, an investment adviser discovered a compliance issue and took reasonable steps to fix it, including self-reporting, and still received a hefty fine and other sanctions from the SEC.  Knowledge Leaders Capital, LLC (“Knowledge Leaders”) used client commissions, or “soft dollars,” to purchase research software from a company owned by the firm’s CIO.  An internal committee approved the payments.  Over a period of years, the firm paid about $1 million for the software. The conflict?  The CIO of Knowledge Leaders was on the committee approving the soft dollar payments, and, as owner of the software, determined how much to charge for it. There was no disclosure in the firm’s Form ADV Part 2A of the conflict of interest.

To the firm’s credit, Knowledge Leader’s took the suggestion of its CCO in 2016 and hired outside counsel to investigate and to review the firm’s compliance policies and procedures as well as a third-party compliance consultant to help in this effort.  The firm also returned to its clients all the money used for the soft dollar payments for the software.  The firm hired a new CCO, changed its reporting structure and reported the issue to the SEC.

Despite all its efforts, Knowledge Leaders still received a $50,000 fine and had to hire a second consultant to review work already completed.  Based on this outcome, the case makes you wonder whether it is worth it to self-report.  Perhaps the take-away is that the CIO was not personally held liable or fined because he supported the remedial actions.   Contributed by Jaqueline M. Hummel, Partner and Managing Director


Adviser in the Land of Swimming Pools and Movie Stars Gets Burned for Holding on to Pre-Paid Fees. It’s a common story.  Two investment adviser representatives leave a firm for greener pastures and take clients with them.  Clients following the representatives send termination notices to the former firm to receive refunds of their pre-paid, unearned advisory fees, as required by the advisory contract.  In the case of Beverly Hills Wealth Management, LLC’s (“BHWM”), however, the firm refused to live up to the terms of its contract, making clients jump through additional hoops and wait months before issuing the $131,000 due in refunds.  It eventually took an SEC deficiency letter and a meeting with enforcement staff to get BHWM to cough up the last of the refunds.

In the administrative settlement order, the SEC spent a lot of time discussing BHWM’s financial woes, emphasizing the firm’s failure to disclose its financial impairment in the Form ADV Part 2A.  BHWM had been struggling financially since March 2013, unable to generate enough income to pay its expenses, and was borrowing to make ends meet.  The SEC showed no sympathy for the firm’s precarious financial state, imposing a fine of $100,000 on the firm, and an additional $50,000 fine on BHWM’s owner.  The firm was also required to post the SEC’s order prominently on its website for the next 12 months, send a copy of the order to all existing advisory clients, and disclose its financial difficulties in its Form ADV Part 2A. As fiduciaries, advisers are expected to refund any unearned fees when clients terminate the relationship and file an accurate Form ADV. The lesson learned here is that the SEC has no tolerance for advisers that misrepresent themselves to the public and repeatedly resist their duty to refund client fees. The firm’s lack of cooperation with the staff might also have contributed to the amount of the fines.  Contributed by Jaqueline M. Hummel, Partner and Managing Director and Heather D. Augustine, Senior Compliance Consultant 


Adviser Preyed on Professional Athletes, Hid Conflict of Interest. As a fan of the HBO series Ballers starring Dwayne Johnson, I am fascinated by cases involving the National Football League Players Association (NFLPA) Financial Advisors Registration program.  The goal of the program is to benefit the players by “providing them access to a qualified group of financial advisors that have met certain eligibility criteria.”  Since the program started in 2002, however, it has had some significant failures. (Check out this article on fraudsters in the program, and our prior post involving a similar case).  A recent example involves Jinesh “Hodge” Brahmbhatt, owner of Jade Private Wealth Management (“Jade”), a state-registered advisory firm that specialized in offering financial services to professional athletes.  When Brahmbhatt needed financing to start his firm, he worked out a deal with Fuad Ahmed (“Ahmed”), founder of Success Trade, Inc. (“STI”), and its subsidiary, Success Trade Securities, Inc. (“STS”), an online broker-dealer.  Ahmed and Brahmbhatt established a brokerage relationship between Jade and STS, and some Jade employees, including Brahmbhatt, became registered representatives of STS.  STI, also in financial straits, issued private notes to raise capital.  Brahmbhatt and Jade recommended the STI notes to clients, who purchased approximately $20 million. According to an investigation by Yahoo! Sports, players involved included:  San Francisco 49ers tight end Vernon Davis, Cleveland Browns cornerback Joe Haden, former Washington Redskins running back Clinton Portis, former Chicago Bears defensive end Adewale Ogunleye, Miami Dolphins defensive lineman Jared Odrick, Oakland Raiders defensive tackle Pat Sims, Minnesota Vikings defensive tackle Fred Evans and Detroit Pistons guard Brandon Knight.

Jade’s clients were not informed of Brahmbhatt’s (and Jade’s) conflict of interest resulting from selling the notes of the parent company of Brahmbhatt’s broker-dealer, STI.  At the same time, STI made payments of more than $1.2 million to Jade and Brahmbhatt, which were used for payroll, operating expenses and Brahmbhatt’s personal obligations.

The scheme came apart when FINRA brought a complaint against STI and its owner, Ahmed, for fraud in the sale of the promissory notes.  Brahmbhatt failed to cooperate with FINRA’s investigation and was banned for life by FINRA.[1]  The SEC then piled on with a case against Brahmbhatt for breaching his fiduciary duty by failing to disclose the conflict of interest in connection with the sale of the STI notes.  In the settlement order, Brahmbhatt was banned from the industry and required to pay disgorgement of $1.2 million and a civil penalty of $150,000.  Ramnik Aulakh, Jade’s Chief Operating Officer, was also banned from the industry and required to pay a civil penalty of $50,000 for his participation in the scheme.

This is yet another of many recent cases where the SEC has targeted advisers for failing to disclose conflicts of interest, which, in this case, included Jade’s recommendation to its clients to purchase notes of an affiliated entity in exchange for kickbacks.  Aside from the obvious lesson for advisers that disclosing conflicts of interest is important, there are a few other lessons to be learned.  First, a seal of approval from a national organization (like the NFLPA) is worthless without supervision and meaningful sanctions.  Second, the SEC reserves its toughest sanctions for fiduciary breaches where an adviser takes advantage of his clients’ lack of financial acumen and uses their money for personal gain.   Contributed by Jaqueline M. Hummel, Partner and Managing Director


Surveillance System Glitches Cost Ameriprise $4.5 million:   Supervising more than 9,700 representatives and 3,800 branch offices is a big job.  Ideally, a firm would need to coordinate remote and home office efforts, using people and systems to effectively monitor activity.  And this is how Ameriprise Financial Services, Inc. (“Ameriprise”) set up its supervisory and compliance programs, combining field-based supervision with a centralized supervisory authority.  Despite these efforts, however, five registered representatives of Ameriprise were able to exploit holes in these systems and steal money from clients.  A mother-daughter team was able to avoid detection over a five-year period and stole approximately $1 million from clients.  All in all, the representatives stole about $1.6 million from clients from 2008 through 2013 before their crimes were discovered.

Ameriprise used automated surveillance tools (as well as human compliance officers) to help detect fraud.  Two of these tools, the Fraud Early Detection System (“FEDS”) and an automated transaction-based analysis tool (“Analysis Tool”), did not work as advertised, allowing some of the fraudulent activity of the five representatives to go undetected.

The SEC, with its 20/20 hindsight, determined that Ameriprise violated Section 206(4) of the Advisers Act and Rule 206(4)-7 (the “Compliance Program Rule”), because its compliance program was not “reasonably designed to prevent violations” of the Advisers Act, and fined the firm $4.5 million.  As in other cases where the SEC finds violations of the Compliance Program Rule, liability is imposed without any discussion of what made the compliance program “unreasonable.”  If only five representatives out of more than 9,700 were able to exploit the flaws in the automated surveillance tools and avoid detection by compliance officers, it would seem that Ameriprise compliance program had a pretty decent track record.  Given the size of the fine, however, it is likely that the SEC is sending a message to advisers that automated monitoring systems are only as good as their programming.  The key lesson to be learned is that tools used to detect fraud should be tested periodically to ensure that they are working as intended.  Contributed by Jaqueline M. Hummel, Partner and Managing Director


Adviser’s Weak Controls led to Inflated Asset Values and Unauthorized Trading and $5.75 Million SEC Fine:  In a case that made big news, Citigroup Global Markets Inc., a dually registered broker-dealer and investment adviser, settled charges of failure to supervise its traders with the SEC.  The case makes for fascinating reading, demonstrating that even large organizations with sophisticated supervisory processes can make mistakes. The case involved mismarking of illiquid securities by three different traders at different trading desks that went undetected, as well as some unauthorized speculative trading.

There are many lessons to be learned from this case; I am highlighting only a few here.  Citigroup’s traders dealt with securities that did not have a readily available market value.  At the same time, they were responsible for marking the value of these securities and had some discretion in determining the values.  At least two of the traders also received performance-based bonuses.  The lure of a large bonus and the ability to manipulate performance numbers can prove to be an irresistible temptation to cheat.  Moreover, front line supervisors were not held accountable for the traders’ valuations, making it easier for the traders to evade detection.  Finally, corporate programs aimed at cost management eroded the ability of the last line of defense, the valuation control group, to catch the mispricing.

The traders also engaged in unauthorized, speculative trading.  According to the SEC’s order, the traders were granted access to a trading platform without permission from their supervisors.  Periodic checks of who has access to, and is using, trading systems is a good control to avoid these situations.  Such checks should include providing a list of those with access to their supervisors and asking why access is needed.   Another interesting facet of this case is that the three traders’ illicit behavior was uncovered when they went on vacation.  Do not discount the effectiveness of old school practices such as mandatory out-of-office policies.  Contributed by Jaqueline M. Hummel, Partner and Managing Director


Adviser’s Valuation Practices Cross the Line in Cross Trading Case:  Advisers that engage in cross trading on behalf of clients, even on a limited basis, must ensure that both sides of the trade get a good deal.  And this is where things can get tricky, as Hamlin Capital Management, LLC (“Hamlin”) found out, receiving a censure and a $900,000 fine as a consequence of its cross-trading practices.  The firm also agreed to reimburse $609,172 to affected clients.

Hamlin invested in thinly-traded municipal securities on behalf of its clients and routinely used cross trading to provide liquidity for terminating clients. For context, at least 97% of the firm’s sales during one year reviewed by the SEC were cross trades. The firm had also adopted written policies and procedures as well as Form ADV disclosures addressing the activity. Except, and unfortunately, its policies were insufficient, its disclosures inaccurate and the firm failed to fully implement, test or review them.

One major issue for Hamlin was the fact the firm could, in some cases, influence the pricing of the security.  The firm dealt in thinly-traded municipal bonds and generally priced the municipal bonds at month-end using bid quotes provided by the underwriting broker-dealers of the bonds. The firm periodically challenged these bid quotes and the underwriting broker-dealer sometimes revised its bid price in response to the adviser’s challenges. The SEC found that Hamlin had inadequate supporting documentation of these challenges, particularly in cases where the adviser-recommended price was significantly higher than recent secondary market trades.  The adviser later implemented a valuation committee, but the prior absence of oversight of the valuation process resulted in the portfolio manager being, what the SEC described as, “unilateral and unsupervised” in his ability to raise price challenges and ultimately materially change the price of certain securities.

These valuation practices contributed to cross trading violations as the firm executed over 15,000 cross trades during a roughly five-year period.  The SEC found that the cross trades favored the adviser’s buy-side clients because they avoided, as the SEC noted, “paying the full bid/ask spread they would have paid in an arms-length, independent market transaction” and deprived their sell-side clients of their portion of these savings.  As Hamlin could have found out by studying the Western Asset Management Company case from January 2014, using the average or the mid-point of the bid/ask price would have helped mitigate this conflict.  The SEC also found that because some cross trades were executed using adviser-influenced prices that were inflated, buy-side clients paid substantially more for these bonds than the current market price. Using an independent source for a current price would have prevented this issue.

Cross trading can be appropriate when the adviser can ensure that it is in the best interest of buying and selling clients and when it appropriately and accurately discloses the practice. However, as this case demonstrates, advisers engaging in cross trading should enter into the practice with their eyes wide open and assign it an appropriately elevated risk level, as it is perennially scrutinized by regulators given the potential for misuse.  Finally, this case serves as another cautionary tale that compliance manuals and risk assessments are not one-time exercises – compliance must work with others internally to ensure that policies and procedures are fully implemented and tested on an ongoing basis.  Contributed by Cari A. Hopfensperger, Compliance Consultant

Worth Reading:

Six Legal Risks That Will Zap You When Publishing Content.  Sara Grillo provides this excellent resource on advertising issues, and why you should beware of grabbing content from the internet.

Doug Cornelius discusses the SEC’s List of Firms Using Inaccurate Information to Solicit Investors, a/k/a PAUSE, Public Alert:  Unregistered Soliciting Entities.

SEC’s “Best Interest” Standard Draws Thousands of Comments:  NAPA provides nice summary of comments on the SEC’s latest proposal.

Why Your Compliance Programs are a Million-Dollar Waste of Time:  Although the title makes me want to cry, Hui Chen and Eugene Soltes discuss better ways to measure the effectiveness of compliance programs.

Why Being Lazy is Actually Good for You:  Writer of productivity books, Chris Bailey, explains how day-dreaming unleashes creativity.

Filing Deadlines and To Do List for September


No regulatory filings.


Rule 17a-5 Monthly and Fifth FOCUS Part II/IIA Filings:  For period ending August 31, 2018. For firms required to submit monthly FOCUS filings and those firms whose fiscal year-end is a date other than a calendar quarter. Due date is September 26, 2018.



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[1] Fuad Ahmed and his firm were ordered to pay $13.7 million in restitution to investors.  Ahmed’s firm, Success Trade Securities, Inc. was expelled from FINRA membership and Ahmed has been barred for life from the industry.