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States Challenge Reg-BI, Into the Weeds on Form CRS, NY Updates Privacy Laws, Share Class Selection Violations Reach Private Funds and FINRA Arbitration Puzzle – Custodian Liable for Unaffiliated Adviser Conduct: Regulatory Update for October 2019

For Investment Advisers:  SEC Actions

Risk Alert on Principal and Agency Cross Transactions. The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert warning advisers about cross trading compliance issues under Section 206(3) of the Advisers Act.  This is not surprising, given the complexity of the rules governing principal and cross trading.  Section 206(3) says that it is illegal for an investment adviser, acting as principal for his own account, “knowingly to (a) sell any security to a client or (b) purchase any security from a client, without disclosing to such client in writing before the completion of such transaction the capacity in which the adviser is acting and obtaining the consent of the client to such transaction.”  Advisers are also prohibited from acting as a broker for both an advisory client and the other party to a securities transaction without the client’s written consent.

OCIE noted that advisers engaged in principal transactions either without understanding that they had to comply with Section 206(3) or without providing adequate disclosure or getting client consent beforehand.  Advisers to private funds were also called out for engaging in principal transactions without complying with Section 206(3).  In some cases, advisers failed to recognize that trades between an advisory client and a fund where the adviser had a significant ownership interest were principal transactions.  In other cases, advisers failed to get valid consent from the fund before engaging in the transaction.

Aside from reviewing their policies and procedures on principal and agency cross transactions, firms should train portfolio managers, traders, and operations staff to identify these transactions before they take place and alert compliance. Compliance staff should review trade blotters periodically to look for cross trading activity and confirm whether appropriate procedures are being followed.  SEC exam staff heavily scrutinize principal and cross trading activity, so firms should understand the regulatory requirements and weigh whether the benefits outweigh the regulatory risks.  For many firms, the disclosure and consent requirements are too onerous, so they simply prohibit principal and cross trades altogether.   For more information on cross trading, check out our Regulatory Update for November 2018 in SEC Sees Through Scheme to Circumvent Cross Trading Rules, and Key Takeaways from 2017, under How NOT to do a Cross Trade).  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

For Investment Advisers and Broker-Dealers: SEC and Other Actions

What’s New on Regulation Best Interest and Form CRS? The SEC Publishes Small Entity Compliance Guides for Form CRS and Regulation Best Interest:

Hardin Releases New Webpage dedicated to Regulation Best Interest and Form CRS Relationship Summary. Bookmark Hardin’s latest analysis and collection of articles on all things Reg BI and Form CRS.

Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

The Nitty-Gritty of Form CRS Relationship Summary:

By now, most of you have taken inventory of the products and services your firm offers to retail investors and identified the conflicts of interest associated with each.  See our July Regulatory Update.  Now, it is time to begin crafting your disclosures for Form CRS (Client Relationship Summary), which will be the forefront of a firm’s layered disclosure program.

Form CRS is intended to provide retail investors with disclosures using hyperlinks or codes, and URLs.  This layered approach will allow firms to comply with the page limits of Form CRS and still provide retail investors with access to additional pertinent information, whether Form CRS is delivered electronically or in paper form.  Review the Instructions to Form CRS and the SEC Compliance Guide to Form CRS Relationship Summary.  The guide provides an excellent overview of a firm’s obligations about content, formatting, delivery, updating, filing, and recordkeeping requirements while the Instructions to Form CRS walk you through the details.

The Final Release of Form CRS eliminated a lot of the prescribed language included in the Proposed Rule to allow firms to provide tailored disclosures that more accurately reflect the material conflicts arising from the products and services they offer to retail investors.  Although it’s essential to customized your disclosures, I also recommend that you review the prescribed language included throughout the Proposed Rule, as it is a good indication of the type of disclosure the SEC expects.

Things to remember:

  • All firms (BD and RIA) that offer services to retail investors must provide them with Form CRS.
  • Retail Investor for purposes of Form CRS has been re-defined as a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes. The new definition includes accredited investors.
  • Firms must use reasonable page size, font size and margins (8.5”x11” paper; at least 11-point font; minimum of .75” margins on all sides) for Form CRS.
  • Amended Recordkeeping rules [204-2(a)(14)(i) and 17a-3(a)(24)] require firms to make and preserve a record of the dates that each relationship summary was provided to each retail investor, client, or prospective client. Consider adding this item to all account opening checklists, client engagement letters, direct business checklists, and private offering subscription agreements.
  • A firm must re-deliver Form CRS to existing retail investor clients before or at the time: (1) the firm opens a new account that is different from the investor’s existing account; (2) when the firm recommends a roll-over from a retirement account to an IRA; or (3) when recommending a new service or investment outside of a formal account (e.g., variable annuities, direct investment in a mutual fund, or private placement).
  • Form CRS must be prominently displayed on a firm’s website (if it has one).
  • If Form CRS is delivered as part of a package of documents, it must be on top.

Contributed by Rochelle A. Truzzi, Senior Compliance Consultant.

Seven States and D.C. Challenge the SEC’s Regulation Best Interest. New York, California, Connecticut, Delaware, the District of Columbia, Maine, New Mexico, and Oregon filed a lawsuit in federal court to stop implementation of Regulation Best Interest (“Reg BI”).  XY Planning Network (“XYPN”), a coalition of fee-only financial planners, also filed suit against the SEC.  Both complaints cite the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) which directed the SEC to adopt regulations to impose the fiduciary standard applicable to investment advisers on broker-dealers when providing personalized investment advice to retail investors.  Broker-dealers have historically been held to a suitability standard, which falls short of fiduciary standard.  The complaint argues that over time, the lines between the services provided by broker-dealers and investment advisers have become blurred, leaving retail investors confused and “at increased risk of being harmed as a result of the different level of protections they receive based on the different accounts they have.”

The states’ complaint asserts that the SEC’s failure to comply with the Dodd-Frank mandate will ultimately harm the states and the District of Columbia that filed the lawsuit since investors will receive conflicted advice and ultimately lose money on their invested assets.  Investors who earn less money will pay less in tax revenues.  The complaint also argues that the states and D.C. will have an increased financial burden since their citizens will have less retirement income and require public assistance.

Similarly, XYPN ‘s lawsuit alleges that Reg BI will provide broker-dealers with an unfair competitive advantage over registered investment advisers providing financial planning services.  The complaint states that under the new rule, broker-dealers will offer the same financial planning services while at the same time having a lower level of responsibility to clients with less legal exposure.  The XYPN complaint uses many of the same arguments as the complaint filed by the states, mainly that the SEC failed to adopt a uniform fiduciary standard for broker-dealers and investment advisers providing investment advice to retail investors.

Don’t expect the legal battles to end any time soon.  Several states have already announced their intention to pass laws to impose a fiduciary standard on broker-dealers when providing advice to retail investors on how to invest their retirement assets.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

New York Updates Privacy Laws. On July 25th, New York signed into law the Shield Act and the Identity Theft Protection and Mitigation Services Act.  The Shield Act amends NY’s current data breach notification law and imposes more expansive heightened data security and data breach notification requirements on companies and goes into effect March 21, 2020.  The Identity Theft Protection and Mitigation Services Act establishes the minimum amount of long-term protections credit reporting agencies must give to consumers who are affected by a data breach and was effective on September 23, 2019.  Contributed by Doug MacKinnon, Senior Compliance Consultant.

For Broker-Dealers:  SEC Actions

FINRA launches the “new”  FINRA recently launched a new   FINRA’s goal of the redesign was to “improve the experience for everyone who visits the website, through an enhanced search function and a clearer navigation throughout the site.”  FINRA sought to improve visitors’ experience on its website by developing clearer navigation and an enhanced search function.  Please note that after the initial rollout of the new, saved links to Regulatory Notices, FINRA Rules, and information pages were not working.  However, it appears that the majority of those issues have now been corrected.  Contributed by Doug MacKinnon, Senior Compliance Consultant

For Mutual Fund Managers:  SEC Actions

The Division of Investment Management posted Accounting and Disclosure Information (ADI) 2019-08 on improving principal risks disclosure in mutual fund summary prospectuses. Most significantly:

  • The SEC encourages funds to order the principal risks by significance to the fund, rather than alphabetically.
  • Funds should also tailor principal risk disclosures for the fund, rather than relying on generic risks, and omit risk disclosures that are not applicable to the principal risks.
  • The SEC reminds funds that the intent of the summary prospectus is to provide a “concise summary of key information.” Therefore, more detailed information about a fund’s principal strategy risks should be placed in the prospectus and risks related to non-principal strategies should be placed in the statement of additional information.  Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

For Hedge Fund Managers:  SEC and CIMA Actions

The Cayman Islands Data Protection Law. The Cayman Islands Data Protection Law, 2017 becomes effective September 30, 2019.  Built upon the privacy principles associated with other data protection laws from around the globe, it establishes a framework of rights and duties about the processing of individuals’ personal data.  The law regulates the processing of all personal data in the Cayman Islands and affects any entity established in the Cayman Islands, including investment funds, that processes personal data.  The law applies regardless of whether such processing takes place within the Cayman Islands or whether the personal data relates to Cayman individuals.  The following articles outline the law and its requirements for offshore funds domiciled in the Cayman Islands, including that funds must deliver an updated privacy notice to all limited partners in impacted funds.

Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

Lessons Learned from SEC and FINRA Cases

Late Allocations and Unsupervised Personal Trading Lead to Cherry Picking Violations. An investment adviser representative (“IAR”) associated with Laurel Wealth Advisors, Inc. (“LWA”) traded the same securities for clients as well as his personal accounts using block trades in an omnibus account.  The IAR then delayed allocation of certain trades until after execution and allocating more favorable trades to his own accounts to the detriment of his client accounts.  During the time of the IAR’s misconduct, LWA had a procedure requiring employees to pre-clear personal trades; however, the SEC found it was not implemented until 2015.  Additionally, the brokerage firm used by the IAR suspended and then ultimately prohibited the IAR from trading in the omnibus account after its internal monitoring detected repeated late allocations.  The SEC found that LWA failed reasonably to supervise the IAR who engaged in this cherry-picking scheme and failed to implement policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.

Allocations should be performed following firm policy, and procedure should include a check and balance on any decisions that differ from the firm’s standard allocation method, the timing of the allocation, and any post-trade changes to the initial allocation decision.  Periodic compliance testing, typically by sampling, should be designed to verify that allocations are made following the firm’s policy and procedures.  Additionally, firms cannot escape the reality that there is a regulatory risk in allowing employees to trade for their own accounts in the same securities as clients.  Firms that do permit this practice should establish preclearance procedures and compliance testing to identify irregularities.  Policies and procedures are only aspirational if they are not implemented.  Finally, compliance and operations can both achieve stronger results with collaboration and open communication.  When a service provider (trading partner in this case) raises a red flag about the firm’s, an IAR’s, or any employees’ activities, compliance should be informed and review these actions for potential compliance violations.  Contributed by Cari A. Hopfensperger, Senior Compliance Consultant.

SEC Brings Share Class Selection Case Against Private Funds. In an administrative proceeding against Levati Wealth Management (LWM), the SEC found violations of fiduciary duty, disclosure obligations, and best execution.  LWM recommended and invested client assets in non-traded real estate investment trusts, business development companies, and private placements (collectively, “Alternative Investments”).  The Alternative Investment share classes sold to LVM clients charged a seven percent commission.  What LWM failed to tell clients was that investment adviser representatives of LWM (who were also registered representatives of a broker-dealer) received those commission.  LWM also did not disclose that Alternative Investments had share classes that did not charge a commission, which would have saved these clients money.   Consequently, LWM was required to pay disgorgement of close to $1 million and a civil penalty of $150,000.

It should come as no surprise that the SEC is extending its share class initiative to private funds.  No matter what product you are recommending to clients, as an investment adviser, you have a fiduciary duty to select the share class that is best for your clients.  Contributed by Jaqueline M. Hummel, Partner and Managing Director.

Raymond James Agrees to Pay $15 Million for Improperly Charging Retail Investors. The SEC found that Raymond James did not have a reasonably designed process for identifying advisory accounts that were inactive for more than a year, and by failing to apply the correct pricing data on certain unit investment trusts (“UITs”) they overcharged some clients.  The SEC also determined that Raymond James recommended that its brokerage customers should sell their UITs before maturity and buy new UITs, regardless of suitability, resulting in those customers incurring higher commissions. In settling this matter, the SEC said investment advisers and broker-dealers have ongoing obligations to their clients and failures related to these obligations.   Raymond James was ordered to disgorge $12 million in fees, commissions and interest, and pay a $3 million civil penalty.  Contributed by Doug MacKinnon, Senior Compliance Consultant.

FINRA Arb Panel Puzzle: TD Ameritrade Fined for Failure to Oversee Investment Adviser.   Michael Bayliss, an investment adviser, established the Wealth Strategies Opportunity Fund (the “Fund”), a private placement, and convinced 16 people to invest $2.6 million.  Mr. Bayliss instructed his clients to open accounts at TD Ameritrade as custodian.   Bayliss was not registered or affiliated with TD Ameritrade.  The fund went under, and last year the state of Nevada charged Bayliss with securities fraud.  However, the arbitration was brought against TD Ameritrade and did not name the adviser.  The claimant, a radiologist, alleged that TD Ameritrade failed to conduct appropriate due diligence on Mr. Bayliss or the Fund and sought $407,050 in compensation.  The arbitration panel awarded the claimant $728,816.

The interesting (or backward) thing about this award is that TD Ameritrade, the custodian, was liable for the actions of an unaffiliated adviser.  TD didn’t recommend the security, was not required to supervise Bayliss for suitability, and had no obligation to conduct due diligence.  Yet not only did the case go against TD, but it also had to pay even more than the claimant was seeking.  This case proves that you don’t always know what you are going to get when dealing with an arbitration panel.  It also indicates that clearing firms are likely to feel more and more pressure to prohibit private placements from being custodied or transacted on their platforms.  Contributed by Doug MacKinnon, Senior Compliance Consultant.

Advisers Can Add Two New Disclosures to Form ADV: Administrative Fees and Markups. The SEC brought suit in federal court against Cetera Advisors, LLC (“Cetera”), a dually registered investment adviser and broker-dealer. The SEC alleges that Cetera violated its fiduciary duties by having its investment adviser representatives recommend and invest assets in share classes that paid 12b-1 fees when cheaper share classes were available, and for failing to disclose these 12b-1 fees and revenue sharing payments Cetera received from fund companies. But the news flash here is that the SEC claims Cetera also failed to disclose the conflicts of interest that resulted from (i) some mutual funds paying Cetera a fee for performing administrative duties, such as handling client inquiries and maintaining client accounts, and (ii) for charging mark-ups on non-transaction services provided to client.  Advisers should start checking their Form ADV disclosure to make sure they include similar disclosures, if applicable. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

SEC Fines B-D $250,000 for Failing to Detect Rep’s Fraudulent Quotes. The SEC settled with Mosaic Capital, LLC, f/k/a/ AOC Securities, LLC (“AOC”) for its failure to establish or implement policies and procedures to detect a fraudulent valuation scheme.  Frank Dinucci Jr. (“Dinucci”), a trader for AOC, provided artificially inflated price quotes or marks for certain mortgage-backed securities to a significant customer of AOC.  The customer, a private fund adviser, used those marks to boost the value of the securities it held and then report inflated net asset values to fund investors.  In return, the adviser promised to send securities trades to Dinucci.  AOC’s CEO, Ronaldo Gonzalez, knew that Dinucci was providing customers with price quotes, but failed to develop any policies or procedures to supervise the activity.  To make matters worse, a significant portion of this activity occurred during a one-year period where Dinucci was prohibited from any association with any broker-dealer.  Although AOC filed a Form U5, terminating Dinucci’s registration, Dinucci continued to work out of AOC offices and provide price quotes to customers, with AOC’s permission.

The takeaway from this case is that broker-dealers should regularly take inventory of the services they offer to clients and ensure policies and procedures exist to monitor those services to timely identify violations of securities laws.  Contributed by Rochelle A. Truzzi, Senior Compliance Consultant.

Two Broker-Dealers to Pay $4.65 Million in Penalties for Providing Deficient Blue Sheet Data. Stifel, Nicolaus & Co., Inc. has agreed to pay $2.7 million, and BMO Capital Markets Corp. has agreed to pay $1.95 million to settle charges for providing incomplete and inaccurate securities trading information to the SEC.  According to the SEC, both Stifel and BMO made numerous blue sheet submissions containing missing or inaccurate data, mainly due to undetected coding errors.  The SEC charged that neither firm had adequate processes to test the accuracy of its submissions and, in the case of Stifel, to verify that data was being reported on all transactions.  Both firms admitted the findings and agreed to be censured.  The SEC will continue to focus on firms that fail to provide accurate and complete Blue Sheet data.  Contributed by Doug MacKinnon, Senior Compliance Consultant.

Worth Reading

Filing Deadlines and To-Do List for October 2019


  • Form 13H: Amendment to Form 13H due promptly for advisers that already have a Form 13H filing obligation and have changes to any of the information reported. Recommended due date: October 10, 2019.  (Note: Neither the SEC nor its staff has provided guidance on the definition of “promptly” for Form 13H.)
  • Form PF for Large Liquidity Fund Advisers: Large liquidity fund advisers must file Form PF with the SEC on the IARD system within 15 days of each fiscal quarter end. Filing for Q3 2019 is due October 15, 2019.
  • Blue Sky Filings (Form D): Advisers 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 Hardin Compliance Consulting offers a convenient and economical blue sky filing service to help firms manage this complicated monthly task?  Learn more here and give us a call to discuss your needs further.  Due October 15, 2019.


  • FINRA Accounting Support Fee: Quarterly invoice to support the GASB budget.  Based on the municipal securities the firm reported to the MSRB.  De Minimis firms (that owe less than $25) will not receive an invoice.  Invoices are sent to the firm via WebCRD’s E-Bill.  Due date to be determined.
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of August 31, 2019, 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 Date October 1, 2019.
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of February 28, 2019.  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 Date October 1, 2019.
  • Customer Complaint Quarterly Statistical Summary: For complaints received during the 3rd Quarter, 2019.  FINRA Rule 4530 requires Firms to submit statistical and summary information regarding complaints received during the quarter by the 15th day of the month following the calendar quarter.  Due date October 15, 2019.
  • Rule 17a-5 Quarterly FOCUS Part II/IIA Filings:  For Quarter ending September 30, 2019. FINRA requires member firms to file a FOCUS, (Financial and Operational Combined Uniform Single) Report Part II or IIA on a quarterly basis. Clearing firms and firms that carry customer accounts file Part II and introducing firms file Part IIA.  Due Date October 24, 2019.
  • Quarterly Form Custody:  SEC requires that member firms file Form Custody pursuant to Securities Exchange Act Rule 17a-5(a)(5) for the quarter ending September 30, 2019. Due Date October 24, 2019.
  • Supplemental Statement of Income (“SSOI”): For the quarter ending September 30, 2019.  FINRA requires firms to submit additional, detailed information regarding the categories of revenues and expenses reported on the Statement of Income (Loss) page of the FOCUS Report Part II/IIA.  Due date October 29, 2019. 
  • Supplemental Inventory Schedule (“SIS”): For the month ending September 30, 2019. 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 date October 29, 2019. 
  • Annual Audit Reports for the Fiscal Year-End August 31, 2019. FINRA requires that member firms submit their annual audit 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 date October 30, 2019. 
  • SIPC-3 Certification of Exclusion from Membership: For firms with a Fiscal Year-End of September 30, 2019, 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 date October 30, 2019. 
  • SIPC-6 Assessment: For firms with a Fiscal Year-End of March 31, 2019.  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 date October 30, 2019. 
  • SIPC-7 Assessment: For firms with a Fiscal Year-End of August 31, 2019.  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 date October 30, 2019. 
  • Form OBS: For the Quarter ending September 30, 2019.  Unless subject to the de minimis exception, all clearing, self-clearing, and carrying firms and those firms that have a minimum dollar net capital requirement equal to or greater than $100,000 and at least $10 million in reportable derivatives and other off-balance sheet items must submit Form OBS as of the last day of a reporting period within 22 business days of the end of each calendar quarter via eFOCUS.  Firms that claim the de minimis exemption must affirmatively indicate through the eFOCUS system that no filing is required for the reporting period.  Due date October 31, 2019.

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