Category: SEC News

The SEC’s Administrative Law Judges are “Officers of the United States”

The Supreme Court issued its decision in Lucia v. Securities and Exchange Commission.  The problem is that the administrative law judges were appointed by an internal panel instead of by the President or the SEC Commissioners. The Appointments Clause of the Constitution is there to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

The Supreme Court re-affirmed a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. Holds a continuing office established by law
  2. Exercises significant discretion when carrying out the functions of that office
  3. Issues decisions with finality

The majority opinion found all three of these to be true with the SEC’s ALJs.

The concurring opinion of Justices Thomas and Gorsuch though that the determination of an “officer” merely has to answer the first prong, proposing a much broader definition of an “officer.” The dissent by Justices Sotomayor and Ginsburg felt the finality part of the third prong was not true for the SEC’s ALJs because the SEC can overrule the decision.

What is the impact of the decision?

For Mr. Lucia, it means he is entitled to a new hearing with a different ALJ. The Supreme Court explicitly stated that Mr. Lucia is entitled to a new hearing with a different ALJ who is properly appointed.

I believe all of the SEC’s ALJs are now properly appointed directly by the SEC. In December, the SEC changed its process in anticipation of this decision. The Solicitor General had decided to agree with the argument of Mr. Lucia that the ALJs are “officers.”

The unanswered question is what happens to those cases decided by ALJs. I suppose there could be many others with adverse findings who are going to ask for new hearings with a different ALJ.

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SALI – the SEC’s Search Action Lookup – Individuals

The Securities and Exchange Commission launched a new tool to help with investor protection: The SEC Action Lookup for Individuals – or SALI. (Is it pronounced “sally”?)

SALI is a database of individuals who (1) have been parties to past SEC enforcement actions and against whom federal courts have entered judgments or (2) the SEC has issued orders.

I would guess this is the SEC’s response to BrokerCheck as it has been trying to level the playing field between brokers and investment advisers. While BrokerCheck could tell you the disciplinary history of a broker, there was not an authoritative source for investment advisers. Of course, there are sources. The Form ADV Part 2 has a disciplinary section. That’s subject to self-reporting and reliant on distribution by the adviser. Less scrupulous advisers may not hand them out.

There is also the larger field of unregistered individuals who have been subject to SEC enforcement actions. SALI will provide a searchable spot for that type of investor review. At least for the data entered which currently only goes back to 2014.

“One of the SEC’s most important tasks is to arm our investors with the tools necessary to identify potential fraudsters. An important risk factor is whether the person you are dealing with has a disciplinary history with the SEC or other regulators,” said SEC Chairman Jay Clayton. “SALI provides Main Street investors with an additional tool they can use to protect themselves from being victims of fraud and other misconduct.”

Does it work?

First, I went and entered my name. No results, as expected. Then I went to SALI and entered “Preston“. It pulled up Caleb Preston and Charles Preston and their mortgage loan fund fraud. It includes links to the complaints, press release and judgment.

Great.

I went to SALI and entered “Cohen”. I was surprised not to see Steve Cohen. After all he was subject to a disciplinary action in 2016. His punishment lapsed at the end of 2017. I tried again with “Tilton”. No results. She won her case. That was true for Cohen. His punishment merely lapsed.

I’m not sure that is the right result for Cohen.  It’s probably the right result for Tilton.

According to the details:

“Your results will not include individuals whose cases are currently pending at the trial court or those against whom no judgment or order has been issued.”

That is true for Tilton. It’s not true or unclear for Cohen.

Regardless of its flaws, it’s great to see a new tool from the SEC. One that I’m sure will get better as the SEC adds more to the search history and clarifies what gets expunged.

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The New Standards for Investment Advisers and Broker-Dealers

One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money.

The Securities and Exchange Commission is trying to help consumers with a trio of proposals.

On the Broker-Dealer side, the SEC is proposing Regulation Best Interest. This would create a new standard of conduct for broker-dealers and their representatives when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The proposed standard of conduct is to

  • act in the best interest of the retail customer
  • at the time a recommendation is made
  • without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer

This new standard would be satisfied if:

  1. broker-dealer, before or at the time of the recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation;
  2. broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence; the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations;
    and
  3. broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

For item 1, there would be a new Form CRS. Broker-dealers would provide this to their clients.

For registered investment advisers, there would be a new Part 3 to Form ADV that would be Form CRS.

There is a lot in this package. SEC Chairman Clayton summarized them:

We propose to fill these gaps through (1) mandating clear disclosures — specifically, addressing how BDs and IAs identify themselves to investors and requiring them to provide investors with a standardized disclosure document of no more than four pages in length, highlighting among other things the principal services offered, legal standards of conduct that apply, fees the customer will pay, and certain conflicts of interest that exist, (2) raising the standard of conduct applicable to BDs to make it clear, among other things, that they cannot put their interests ahead of the interests of their retail customers, and (3) reaffirming, and in some cases clarifying, our views on the standard of conduct applicable to investment advisers.

There will be lots of commentary on these proposed regulations from all sides. One of those critics is SEC Commissioner Kara M. Stein:

 I am concerned that this rule will not only confuse retail investors, but also broker-dealers. In particular, the lack of a definition of best interest, the use of similar terms to mean different things, the use of different terms to mean the same things, and the possibility that the SEC and FINRA interpret the same language in their suitability standards differently. All of these concerns would make it difficult for the industry to discern a clear compliance path. Any resulting confusion may well result in higher compliance costs for broker-dealers, which will likely be passed onto the investor. What’s more, the lack of a clear standard is not likely to give investors more confidence in the broker-dealer business model.

There is over 1000 pages in these proposals. I’ll share more thoughts on them this week.

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Compliance Outreach Program National Seminar 2018

I didn’t manage to get down to Washington DC to be there in person, but I’ve been watching the webcast of the Compliance Outreach Program National Seminar 2018 For Investment Adviser and Investment Company Senior Officers this morning.

This is the agenda and my notes so far.

Introductory Remarks from SEC Directors
Speakers:

  • Dalia Blass, Director, Division of Investment Management
  • Peter Driscoll, Director, Office of Compliance Inspections and Examinations (National Exam Program)
  • Stephanie Avakian, Co-Director, Division of Enforcement

Good policy starts with good information. To get the information you need to interact with others. The SEC wants to engage with compliance professionals to get better information to be able to make better policies.

They wanted to avoid CCO liability, but it was one of the most asked question.

One category are cases where the CCO was actively involved in the malfeasance or engaged in misleading regulators. This is the biggest category.

The second is where the CCO had a clear responsibility to implement a procedure and failed to.

There is a new alert coming out later today on fees and expenses. (Here it is:  Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (PDF))

Insights from SEC Leadership Regarding Program Priorities
Speakers:

  • Paul Cellupica, Deputy Director, Division of Investment Management
  • C. Dabney O’Riordan, Co-Chief, Division of Enforcement, Asset Management Unit, Los Angeles Regional Office
  • Kristin Snyder, Co-National Associate Director, National Exam Program, San Francisco Regional Office

Update on certain National Exam Initiatives
Fiscal year 2018 priorities
Update on certain fiscal year 2017 priorities

A sunshine act notice went out for a meeting on April 18. There is a continuing effort to avoid investor confusion between the different type of financial firms. The subject matters of the Open Meeting will be the Commission’s consideration of:

  • whether to propose new and amended rules and forms to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors.
  • whether to propose a rule to establish a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • whether to propose a Commission interpretation of the standard of conduct for investment advisers.

The SEC will focus on ETFs. All of them are operating on exemptive orders. It makes sense to standarize the platforms instead of ad hoc rulings.

The Volker Rule is still alive and the SEC is going to keep working on it. But it sounds like the SEC wants to simplify it and remove some of the compliance burdens. Given the number of agencies involved, the SEC is just one player.

Fair Act is being considered regarding reports on various companies and wants to extend it to investment companies.

The SEC is considering a revamp of the marketing rules for investment advisers. There will be a particular focus on the anti-testimonial rule and its interaction with social media.

The share class initiative is continuing for enforcement. There was an emphasis to fix the problem before the SEC finds out if this has been an issue at your firm.

For exams, there is a focus on retail investors and in particular those saving for retirement. This includes a focus on how firms deal with older clients. The ReTIRE Initiative is still going strong. (They took great stride to point out that private fund investors are often retail investors.)

Exams are still focused on visiting firms that have never been examined. They are continuing the new registrant program.

The SEC has been learning how to use Form PF. It has been helping the SEC to inform its rule-making efforts. The experience with Form PF led to the separately-managed accounts questions on Form ADV.

Question & Answer Session 1
Speakers:

  • Ahmed Abdul-Jaleel, Assistant Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Brian Blaha, Staff Accountant, National Exam Program, Denver Regional Office
  • Sara Cortes, Assistant Director, Division of Investment Management, Investment Adviser Regulation Office
  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office
  • Barbara Gunn, Assistant Director, Division of Enforcement, Asset Management Unit, Fort Worth Regional Office
  • Michael Spratt, Assistant Director, Division of Investment Management, Disclosure Review Office

When you get a document request list, ask questions if you are unsure what it’s asking for. If it’s going to take longer to produce the documents, let them know.

As for thoughts on the private equity fund exams and enforcement cases, does the SEC think the industry has changed? Yes. Limited partners are more informed. It’s not just fund managers, but gatekeepers who have failed to do their job of being a check on fund managers.

There was a fair amount of the liquidity rule. But since it does not apply to private funds, I’ve not been paying much attention to it or the questions about it.

One question was on anti-money laundering. It’s not the SEC who would be issuing the rules. It’s up to FinCEN. The SEC merely provides technical support.

Fees and Expenses Impacting Retail Investors
Speakers:

  • Louis Gracia, Deputy Associate Regional Director, National Exam Program, Chicago Regional Office (Moderator)
  • Adam Aderton, Assistant Director, Division of Enforcement, Asset Management Unit
  • Jennifer Porter, Branch Chief, Division of Investment Management, Investment Adviser Regulation Office
  • Nicole Tremblay, Senior Vice President and Chief Compliance Officer, Weston Financial

Lots of this panel’s material is in the new National Exam Program Risk Alert that came out today: Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers.

One panelist pointed out that “fees are negotiable” is generally not a good fee disclosure. Advisers should have a fee schedule.  If you let one client negotiated fees, you should state that lower fees can be negotiated.

The Sessions continue this afternoon, but I had to step away.

The One With The Fake Returns

Most frauds have some element of fake returns. I picked the case against McKinley Mortgage Co., Charles Preston, and his son, Caleb Preston because the headline in the release included: Private Real Estate Fund with Scheme to Defraud Retail Investors.” Frauds involving private real estate funds catch my attention.

McKinley bought promissory notes secured by deeds of trust or originated new loans, packaged them into investment pools and sold interests in the pools to investors.

According to the complaint, the problems started in 2012 when the sponsors started taking more in management fees and expenses than allowed under the fund documents. According to the complaint, it was an extra $700,000 in 2012 and $1.5 million in 2013. The it grew even bigger in subsequent years.

They also expanded the scope of investments. The fund documents said that up to 25% could be invested in Mexico. They exceeded that amount.

Then they increased the amount of returns from the funds to prospective investors.

Three bad things to do.

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Read SEC.gov on Your Phone

I had given up on trying to access the SEC’s online resources through my phone a long time ago. Frankly, it was hard to use with a full computer screen at times. It was nearly impossible to use on my phone’s small screen.

But the site has been evolving. Broc Romanek pointed out that the SEC’s home page is now mobile friendly. I looked around this morning while riding the train the work (a day off from bike-commuting). Most of the site works much better on a phone.

Of course that is great for consumers who are likely to be less frequent users and trying to get themselves some help. I might have moved the order of things around on the SEC’s home page to make it easier to make a complaint or research financial professionals. But the information is there and easy to find.

For industry users like me, it’s great to be able to find resources while out of the office. While on the SEC’s home page, I noticed that the SEC’s open meeting scheduled for today has been cancelled. There was a rumor circulating that the Commission was going to present updated guidance or a new rule on public company reporting requirements on data breaches. Clearly, that is not happening today.

If you were wondering, ComplianceBuilding.com is set up to be mobile-friendly. Let me know if it doesn’t work on your phone.

The SEC is Open on March 31

That headline is incorrect. I can’t speak for the entire SEC, especially with Congressional funding in jeopardy between now and then.

However, The IARD system is operating on March 31. If you have to file your Form ADV, it is due to be filed by March 31.

Back in 2013, March 31 fell on a Sunday and the IARD system did not work on the weekends back then. According to the calendar, the IARD system is now operating every day.  So, for you procrastinators, you don’t get extra time over the weekend to finish your Form ADV.

If you are the listed contact, you should have received this email:

IARD Availability on March 31 for Form ADV Annual Updating Amendment Deadline

Please be advised that the Investment Adviser Registration Depository (IARD) system will be open on Saturday, March 31, 2018, from 8am-6pm Eastern Time.  On that date,advisers will be able to submit filings, including amendments to Form ADV.  If an adviser’s fiscal year ended on December 31, 2017, that adviser will be able to file its Form ADV Annual Updating Amendment on March 31, 2018, in order to meet the requirement to file within 90 days after the end of its fiscal year.  If you have questions, please email [email protected].

If you have not noticed, there have been some significant changes to Form ADV.  See the Changes to Form ADV. It’s going to take some extra time to complete the filing this year.

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The Department of Justice Threw Out the Use of Guidance Documents

President Trump has set de-regulation as one of his priorities. We saw this in his Executive Order that required the repeal of two regulations before enacting a new regulation. The Department of Justice is embracing this mandate.

Associate Attorney General Rachel Brand issued a memorandum  limiting the use of agency guidance documents in affirmative civil enforcement cases. This is an extension of November 15, 2017 memo from Attorney General Sessions that prohibits the DOJ from promulgating guidance documents that create rights or obligations that are binding on regulated parties.

The Brand Memo applies to affirmative civil enforcement cases.  I was not sure what those were. I found out that they are civil lawsuits on behalf of the United States is to recover government money lost to fraud or other misconduct or to impose penalties for violations of Federal health, safety, civil rights or environmental laws. This would include ADA lawsuits, environmental clean up lawsuits, as well as healthcare reimbursement fraud.

The November memo from the Attorney General was intended to attack guidance that gets implemented as a de facto regulation without going through the formal notice and comment rulemaking process.

Any guidance documents now have to follow five principles:

  1. Guidance has to disclaim any force of law, and avoid language suggesting that the public has obligations that go beyond those set forth in the applicable statutes or legislative rules.
  2. Guidance must clearly state that they are not final agency actions, have no legally binding effect on persons or entities outside the federal government, and may be rescinded or modified.
  3. Guidance should not be used to coerce persons into taking any action or refraining from taking any action beyond what is required by the terms of the applicable statute or regulation.
  4. Guidance should not use mandatory language such as “shall,” “must,” “required,” or “requirement”, except when restating with citations to statutes or regulations.
  5. To the extent guidance set out voluntary standards, they should clearly state that compliance with those standards is voluntary and that noncompliance will not, in itself, result in any enforcement action.

This leaves me scratching my head on how this might affect guidance from the Securities and Exchange Commission that the compliance professionals rely on.

The Brand Memo clearly states that it applies to DOJ litigators in using other agencies’ guidance documents. Although, it limits itself to affirmative civil enforcement cases. I would have to assume that this may bleed over into the DOJ’s prosecution of cases referred from the SEC.

Guidance cuts both ways. Attorney General Sessions is clearly focused on guidance that imposes more obligations on regulated parties. But I think that is a simplistic way to look at things. Some of the guidance provides safeguards that help firms navigate uncertainty in the legislation and regulations.

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Federal Shutdown and Compliance

With Congress showing more of its ineptitude, it was unable to pass spending legislation over the weekend. There are reports of limited impact over the weekend. With today’s start of the work week, thousands of federal employees will be home instead of doing their jobs.

The Securities and Exchange Commission is still operational. At least in the short-term.

SEC Operating Status

Should there be a federal government shutdown after January 19, the SEC will remain open for a limited number of days, fully staffed and focused on the agency’s mission.

Any changes to the SEC’s operational status will be announced here. In the event that the SEC does shut down, we will pursue the agency’s plan for operating during a shutdown. As that plan contemplates, we are currently making preparations for a potential shutdown with a focus on the market integrity and investor protection components of our mission.

The SEC has a chunk of cash in reserve to keep operational. Some of its services are outsourced and will keep operating.

EDGAR

The Commission’s EDGAR system is operated pursuant to a contract and thus will remain fully functional as long as funding for the contractor remains available through permitted means. SEC personnel will be able to process requests for EDGAR access codes and password resets; answer questions about fee-bearing EDGAR filings and other emergency questions regarding EDGAR submissions. However, the Divisions of Corporation Finance, Investment Management, and Trading and Markets, and the Office of Compliance Inspections and Examinations will be unable to process filings, provide interpretive advice, issue no-action letters or conduct any other normal Division and Office activities. As a result, new or pending registration statements or applications for exemptive relief will not be processed regardless of the status of any review of those filings.

IARD

The Commission’s IARD system is operated pursuant to a contract and thus will remain fully functional and will continue to accept filings as long as funding for the contractor remains available through permitted means. However, the Office of Compliance Inspections and Examinations will be unable to approve applications for registration by investment advisers, the Division of Investment Management will be unable to provide interpretive advice regarding the Advisers Act, rules, or forms, or consider applications for exemptive relief under the Advisers Act. As a result, new or pending investment adviser applications will not be processed. The IARD system will continue to accept annual and other-than-annual amendments to Form ADV, Form ADV-W, and Form ADV-E filings.

It seems like any exams scheduled for this week could still happen. If you are looking start drafting your Form ADV filing, that system is still operational.

If the shutdown drags over into next week, the SEC will start its shutdown program. Anyone taking bets on that happening?

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The SEC Administrative Law Judges Are Heading to the Supreme Court

The use of administrative law judges by the Securities and Exchange Commission has been strained since the jurisdiction was expanded under Dodd-Frank. There have been a series of cases challenging the ALJs under the the Appointments Clause of the Constitution. The problem was that the judges were appointed by an internal panel instead of by the President or the SEC Commissioners.

An advertising case that led to an adviser being barred is now headed to the U.S. Supreme Court. In the Lucia case, the lower court used a three prong test to determine if an ALJ is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

On Jan. 12th, the Supreme Court granted an appeal to hear Lucia v. SEC. This was likely based on two factors.

One was a split in the courts on whether the SEC’s administrative law judges were properly appointed. The 10th Circuit Court of Appeals came to the opposite conclusion in Bandimere v. SEC. That court used a different three part analysis to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;
(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and
(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

The second was that the Department of Justice decided that the ALJ appointment process was flawed. That position dropped in the Solicitor General’s Brief on Writ of Certiorari for Lucia the argument is now to hear the case and overturn the Lucia ruling.

“[T]he government is now of the view that such ALJs are officers because they exercise ‘significant authority pursuant to the laws of the United States.’ Buckley v. Valeo, 424 U.S. 1, 126 (1976)”

In response, the SEC ratified all the ALJ appointments. This should fix the problem and erase the constitutional problem.

In the reply brief, Lucia argued that the government’s change of its position and its revised procedures did nothing for him.

“Although the government now agrees that SEC ALJs are Officers, it has afforded petitioners no redress for having subjected them to trial before an unconstitutionally constituted tribunal… On the contrary, petitioners remain subject to draconian sanctions—including a lifetime associational bar—resulting from the tainted proceedings below”

It looks like the SEC has fixed the problem with its ALJs going forward. The problem will be what to do with all of the cases that have already been decided. It seems likely that the SEC is going to agree that the ALJs were a problem. The big question is how to fix that problem for the cases that have already been adjudicated. I would guess that there are a lot of cases that going be expunged, people no longer barred and cash fines repaid.

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