SoFi, when the “Fi” stands for “fine”

SoFi Wealth, the robo-adviser ran into trouble when it substituted third-party ETFs with SoFi-sponsored ETFs in its platform.

According to the SEC order, SoFi Wealth failed to provide its clients with full and fair disclosure of its conflicts of interest relating to the transactions, including that it:

  1. SoFi had a preference for placing clients into SoFi’s newly-created proprietary ETFs rather than third-party ETFs, and SoFi’s economic interest in these proprietary ETFs presented a conflict of interest for SoFi Wealth,
  2. SoFi was investing client assets in these proprietary ETFs to help market the SoFi brand as having a broader array of services and products than previously offered, and
  3. SoFi intended to use client assets to capitalize the new SoFi ETFs with significant investment on their second day of trading, making the ETFs more liquid and favorable to the market.

It’s not that an adviser can’t us its own funds or ETFs in client portfolios. It just needs to properly disclose the conflict. SoFi did not.

SoFi’s compliance group probably should have read the J.P. Morgan case from 2015. Morgan got in trouble for having a preference for investing client assets in proprietary funds and not disclosing the conflict.

The complaint once again has the SEC quibbling over the use of the word “may.” The disclosure said that SoFi would select a mix of ETFs “that represent the broad asset allocation determined by these strategies, which may include ETFs for which SoFi is the sponsor.” The SEC issue was that the SoFi investment committee had already approved the replacement of third-party ETFs with SoFi ETFs. I hate that the SEC quibbles over the use of “may.” I don’t see how the word “may” really changes anything in the disclosure.

The big problem was that SoFi replaced the ETFs in client accounts. That means it sold the old choice and had the client buy the new one. No big deal in IRAs. But it is a big deal in taxable accounts. It triggered over $1.3 million in taxable gains for the clients and offered no material benefit to the client.

All the benefit ran to SoFi whose ETFs were now bigger and more liquid.

SoFi had sweetened the pot by waiving the expense fees of the ETF. Again good for the ETF holders, but it would take some time to make up for the taxable gain.

Some compliance lessons. Be careful using the word “may” in disclosures. Don’t replace third-party choices with proprietary choices in taxable accounts unless you also disclose the tax issue.

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SPAC, SMACK, SHAQ?

SPACs are the current tulips of the markets. Everyone wants a piece of one. Celebrities are joining the rush. As noted in the title, Shaq has one. Actually Shaq is on his second SPAC.

Almost 250 SPAC IPOs were completed in 2020, raising total gross proceeds of approximately $75 billion That was about half of the number of IPOs and half of the capital raised in IPOs.

There are lots or reasons for companies to become liquid and raise capital through a SPAC. There is certainty in pricing. Private company founders and their backers don’t have to spend months worried about how much capital will be raised in an IPO. They negotiate the capital raise with the SPAC executives.

The downside is that the private company may not have been through the compliance wringer to make sure it’s ready for the rigors of being a public company.

The SEC is catching up and has released a series of statements and policy notices about SPACs. The Division of Corporate Finance pointed out that these newly crafted public companies have to focus on their books and records and their financial controls. The public SPACs have to meet these standards. But since they are just sitting on a pile of cash, their controls can be very simple. It’s really the controls of the acquired company that will be in operation.

A public statement by the SEC’s Chief Accountant also pointed to the financial controls, governance, and audit controls that creates faith in the public markets.

One item that the SEC has started to focus on is the treatment of the warrants involved in the SPAC combination. The reason that sponsors are jumping on the SPAC bandwagon is the promote granted to the SPAC organizers in the form of warrants.

The Securities and Exchange Commission last week began privately telling accountants that warrants, which are issued to early investors in the deals, might not be considered equity instruments, according to people familiar with the matter.

It’s the special sauce that has helped lubricate the SPAC engine. It’s not a bubble in valuation. It’s a bubble in method.

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Massachusetts Fires an Arrow at Robinhood

The Secretary of the Commonwealth filed its first enforcement action under the Massachusetts Fiduciary Rule. Robinhood and its gamification of investing are in its bullseye.

The Massachusetts Securities Division adopted amendments to 950 Mass. Code Regs. 12.200 earlier this year as they relate to the standard of conduct applicable to broker-dealers and agents. The amendments apply a fiduciary conduct standard to broker-dealers and agents when dealing with their customers. The Division said it would begin enforcing the amended regulations on September 1, 2020.

“Each broker-dealer shall observe high standards of commercial honor
and just and equitable principles of trade in the conduct of its business.”
– 950 CMR 12.204(1)(a)

According to the data, Robinhood has almost a half million customers in Massachusetts. Approximately 68% of the Massachusetts customers approved for options trading on Robinhood have no or limited investment experience. One advertisement states:

“I’m a broke college student and investments might help my future tremendously.”

The administrative complaint shoots at Robinhood claiming its infrastructure is inadequate. The outages and disruptions in the platform earlier this year are the indicators. The crux of this prong of the complaint is that Robinhood is continuing to recruit new customers without properly improving its infrastructure. The complaint states 70 outages over the course of 2020.

The second prong of the complaint takes that position that Robinhood’s supply of lists of most popular stocks is an encouragement to purchase the security without consideration of the customer’s suitability.

The third prong is Robinhood’s permission and encouragement for customers to trade. The complaint uses the example of one customer that clicked the investment experience button when creating the account. That customer made 12,748 trades this year. An average of 92 trades a day.

A fourth prong is that Robinhood failed to properly screen customers before allowing them to trade options. Robinhood failed to follow its own policies and procedures.

Wrapping it up, the complaint says that each of these four prongs is a violation of the Massachusetts Fiduciary Standard applicable to broker-dealers.

All of this is just the regulators side of the case. A Robinhood spokeswoman said before the complaint was filed that the company has and will continue to work closely with all regulators.

“Robinhood has opened up financial markets for a new generation of people who were previously excluded.”
“We are committed to operating with integrity, transparency, and in compliance with all applicable laws and regulations.”

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Compliance Outreach and OCIE Observations

The SEC’s Office of Compliance Inspections and Examination launched a lot info last week. It livestreamed a National Investment Adviser/Investment Company Compliance Outreach and published a Risk Alert on notable compliance issues identified by OCIE related to Rule 206(4)-7.

Peter Driscoll, Director of OCIE, started off the program highlighting three words that should be applicable to your firm’s CCO: Empowered, Seniority, and Authority. He wants firms to think of compliance and the CCO as an essential component to running and advisory business and not just a box to be checked. CCOs should be routinely included in strategy discussions and brought into decision-making early-on for their meaningful input.

Then he mentioned that OCIE was publishing a risk alert right then on compliance programs.

Mr. Driscoll moved the Outreach program to a panel with Dalia Blass from Investment Management and Marc Berger from Enforcement. In discussing private funds, they highlighted the usual hot spots:

  • Valuation
  • Undisclosed conflicts
  • custody rule
  • allocation of expenses

In discussing upcoming regulatory changes, Ms. Blass mentioned the proposed Advertising Rule changes. Sounds like it’s still in process. No mention of a timeline. She also mentioned that there may be some upcoming regulatory changes around valuation and custody.

The second panel was on resiliency, information security and business continuity. This is even more important with so many firms and their employees working remotely.

The second panel focused on undisclosed conflicts. One panelist expressed grave concern over the use of the word “may” when describing conflicts. If there is an actual conflict, “may” is not the right word to use. If a firm always takes a fee, “may” is not the right word to use.

The panelists raised the issue of disclosing PPP loans. It was noted that taking a PPP loan was an indication of financial distress that likely should be disclosed to clients.

Turning to the new risk alert, the focus is the structure of compliance programs. It starts right off with a failure to have adequate compliance resources to support a robust compliance program. That includes having a CCO who devotes adequate time to compliance and is knowledgeable about the Advisers Act. One special note was for firms that had grown in size or complexity, but had not increased their compliance resources accordingly.

The Risk Alert emphasizes the importance of the annual review and documenting the annual review. As it’s coming up to year-end, it’s a good check list as you may be starting to work on your annual review.

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Exchange-Traded Products Initiative

The Securities and Exchange Commission announced a new initiative focused on complex products: The Exchange-Traded Products Initiative. It’s led by the Division of Enforcement’s Complex Financial Instruments Unit. It was developed by Armita Cohen and data analytics specialists Daniel Koster and Jonathan Vogan and has been coordinated by Ms. Cohen.

The first inkling of this initiative was the Morgan Wilshire case in late September. That firm was selling inverse ETFs to its clients. The firm’s representatives were not knowledgeable about the products. The inverse ETF tries to create the opposite returns of an index over a short period of time, typically one day. If held longer, the product stop achieving the originally targeted results.

Like with the earlier case, the five cases announced as part of the Exchange-Traded Products Initiative were complex products but had the patina of simplicity because they were exchange-traded. The products were designed be held in the short-term for limited use.

Instead, the firms were marketing to a broader set of clients and not getting them back out of the product in the short-term. Of course, this means that customers lost money.

The compliance failure was the firms failing to determine if the product was suitable for the client, a lack of training on the product and a lack of appropriate review of the transactions.

Some of this will be increasingly problematic under the new Reg BI standards instead of the older standards for broker-dealers.

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What’s Wrong at Branch Offices?

The SEC’s Office of Compliance Inspections and Examinations ran a sweep it called the Multi-Branch Initiative. It published a risk alert on November 9 with its findings.

The Risk Alert is mostly a collection of typical compliance problems:

  • Custody of client assets
  • Fees and expenses
  • Oversight and supervision of supervised persons
  • Advertising
  • Code of ethics
  • Portfolio Management
  • Oversight of investment recommendations
  • Mutual fund share class selection and disclosure issues
  • Wrap fee program issues
  • Rebalancing Issues
  • Conflicts of Interest Disclosures
  • Trading and allocation of investment opportunities

A few things were related to the multi-branch or heightened by that geographic spread of offices. The big issue is that policies and procedures were inconsistently applied across offices. That makes me think that the physical presence of compliance personnel may be a positive factor of compliance. A compliance professional once called this “Compliance by walking around.”

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Van Halen and Compliance

With the passing of Eddie Van Halen, I thought it appropriate to re-publish this great story about Van Halen and Compliance that I first wrote in 2009. [Spoiler alert] Those brown M&M’s served a real purpose.

You may have heard the story about Van Halen’s banning of brown M&M’s from its dressing room. I chalked it up to the pampered life of rock stars. (Especially, when compared to the more mundane life of a chief compliance officer.)

I just listened to the latest episode of  This American Life which revealed that the provision was not about pampering. It was about compliance.  Host Ira Glass talked with John Flansburgh (from the band They Might Be Giants) and he explained why the M&M clause was actually an ingenious business strategy. They recounted an except from David Lee Roth’s autobiography, Crazy from the Heat:

Van Halen was the first band to take huge productions into tertiary, third-level markets. We’d pull up with nine eighteen-wheeler trucks, full of gear, where the standard was three trucks, max. And there were many, many technical errors — whether it was the girders couldn’t support the weight, or the flooring would sink in, or the doors weren’t big enough to move the gear through.The contract rider read like a version of the Chinese Yellow Pages because there was so much equipment, and so many human beings to make it function. So just as a little test, in the technical aspect of the rider, it would say “Article 148: There will be fifteen amperage voltage sockets at twenty-foot spaces, evenly, providing nineteen amperes . . .” This kind of thing. And article number 126, in the middle of nowhere, was: “There will be no brown M&M’s in the backstage area, upon pain of forfeiture of the show, with full compensation.”

So, when I would walk backstage, if I saw a brown M&M in that bowl . . . well, line-check the entire production. Guaranteed you’re going to arrive at a technical error. They didn’t read the contract. Guaranteed you’d run into a problem. Sometimes it would threaten to just destroy the whole show. Something like, literally, life-threatening.

Van Halen used the candy as a warning flag for an indication that something may be wrong. I see some lessons to be learned.

Diamond Dave talking about those Brown M&Ms

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SEC Continues to Be Concerned About COVID

The Office of Compliance Inspections and Examinations released a new risk alert last week on COVID-19 compliance risks for broker-dealers and investment advisers. OCIE broke the concerns into six categories:

  1. protection of investors’ assets;
  2. supervision of personnel;
  3. practices relating to fees, expenses, and financial transactions;
  4. investment fraud;
  5. business continuity; and
  6. the protection of investor and other sensitive information.

On first impression, that looks like a typical list of things that OCIE is concerned about and that fund managers should be concerned about, with or without trying to deal with COVID. OCIE did a good job of looking at these typical issues through the lens of disruptions caused by the COVID pandemic and fewer (or no) people in the office.

As for the protection of investor assets, OCIE wants firms to make sure someone is checking the mail for correspondence from investors. There has been a rise in phishing attacks, so firms should take additional steps to verify instructions from clients or investors.

Obviously, supervision has become more difficult as workers are now spread between the office and home. A lot of compliance comes from walking around the hallways.

As to fees, OCIE raises the issue that firms are facing financial pressure and may push fees to generate revenue.

There was a wave of fraud from companies purporting to have COVID cures and to be able to supple COVID fighting materials like PPE. Don’t sell them to your clients.

I assume most firms had some form of business continuity plan in place. I would guess that very few specifically addressed what to do during a pandemic. Office fires, people getting hit by a bus, power failures are all in the plan. Pandemics? Less likely.

Protecting personal information is just as important, regardless of where people are working. If you have someone working at home with PII, maybe they need a shredder for documents. Watch for phishing attacks. The usual.

Read all the details in the alert.

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Lots of Private Fund CCOs Wear Multiple Hats

Read some great research by Regulatory Compliance Watch. Bill Myers wrote a story summarizing the Form ADV data for over 4500 private fund advisers. Of that, at least 2800 had more than one job at the firm.

Only 622 listed the title for their CCO as only compliance officer. The most common other hat was CFO, followed by general counsel.

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A Remarkable Decision from the Supreme Court

I’m sure many people are surprised at the decision from the Supreme Court that federal employment discrimination law protects gay and transgender employees. Title VII of the Civil Rights Act of 1964 prohibits employment discrimination “because of sex.”

Even if Congress did not have discrimination based on sexual orientation or transgender status in mind when it enacted the Civil Rights Act over a half century ago, the Supreme Court ruled that Title VII’s ban on discrimination protects gay, lesbian and transgender employees.

If you’ve been involved in discrimination training as part of your compliance program, you know that fewer than half of the states currently ban employment discrimination based on gender identity or sexual orientation. The Supreme Court decision is is a major victory for LGBT employees.

The decision is particularity remarkable given that President Trump has been able to appoint two justices during his term, giving the court what is usually a more conservative tilt, and seeming less likely to expand the interpretation of civil rights laws. President Trump’s first pick to the high court, Neil M. Gorsuch, is responsible for writing decision. I’m sure he’s quit surprised that his pick has written the most impactful ruling for gay rights since same-sex marriage was codified as a constitutional right in 2015.