Arising from a $650 Million financing dispute, Pastore LLC, representing a large national investment bank, argued at the Third Circuit on September 29th. The argument was in person in Philadelphia. Pastore LLC has brought a FINRA arbitration to collect the investment banking fee. White & Case had sought to enjoin the securities arbitration in the DE Bankruptcy Court. Pastore LLC’s clients prevailed, and the DE case was dismissed. White & Case’s client appealed to the Third Circuit, arguing that the DE Bankruptcy Court had jurisdiction to hear the case.
Pastore attorneys successfully represented the former CEO of a broker dealer in a regulatory dispute with FINRA. When Pastore was retained, FINRA was seeking a multi-month suspension, thousands of dollars in fines, and was days away from serving a complaint. In the space of a few months, Pastore convinced FINRA to close the case without levying a dollar in fines or a single day of suspension.
A daunting question that Registered Investment Advisers face in formulating their amended and annual form ADV 1 and ADV 2 (Brochure) submissions as required under the Investment Advisors act of 1940 is determining what the components of regulatory assets under management (“RAUM”) are, and providing adequate disclosure to the Securities and Exchange Commission (“SEC”) as to how and why the RAUM of some investment advisors is much less than the actual value of monies or investment vehicles managed.
Assets under management, or AUM, is a general term used throughout the financial industry that can be defined by many standards. AUM represents “investors’ equity” (like shareholders’ equity) and is an accurate representation of investors’ capital at risk (i.e., the amount of money that investors have invested in a manager’s fund(s)). RAUM specifically refers to Regulatory AUM, which the SEC’s standard form of AUM. The SEC developed this metric to have a consistent internal measurement, implementing a mandatory tiered registration of private investment advisers. RAUM is the sum of the market value for all the investments managed by a fund or family of funds that a venture capital firm, brokerage company, or an individual registered investment advisor or portfolio manager manages on behalf of its clients.
In determining RAUM, the SEC specifically states that “In determining the amount of your regulatory assets under management, include the securities portfolios for which you provide continuous and regular supervisory or management services as of the date of filing the Form ADV.” An account that a client maintains with a registered investment advisor is considered a securities portfolio if at least 50% of the total value of the assets held in the account consists of securities. For purposes of this test, an investment advisor may treat cash and cash equivalents (i.e., bank deposits, certificates of deposit, bankers’ acceptances, and similar instruments) as securities. The SEC also requires that you must include securities portfolios that are family or proprietary accounts, accounts for which no compensation for services is received, and accounts of clients who are not United States persons.
The SEC notes that “[f]or purposes of this definition, treat all of the assets of a private fund as a securities portfolio, regardless of the nature of such assets.” The SEC does advise, however, that assets either the under management by another person or entity or assets that consists of real estate or businesses whose operations you “manage” on behalf of a client but not as an investment are excluded from the RAUM calculation.
RAUM also requires that supervision of these accounts be “continuous and regular.” This term is defined by the SEC in two ways. The advisor must have either discretionary authority over investments and provide on-going supervisory or management services, or, if they do not have discretionary authority over the account, they must have on-going responsibility to select or make recommendations based upon the needs of the client, as to specific securities or other investments the account may purchase and sell. If such recommendations are accepted by the client, then the adviser is responsible for arranging or effecting the purchase or sale and satisfies the definition of “continuous and regular”.
The SEC also uses three separate factors to determine whether supervision of assets is “continuous and regular.” The first factor is whether there was an advisory contract in place between the parties. If the investment advisor agrees in an advisory contract to provide ongoing management services, this suggests that you provide these services for the account. Other provisions in the contract, or the actual management practices, however, may suggest otherwise. The second factor is the form of compensation received. If the advisor is compensated based on the average value of the client’s assets managed over a specified period, this suggests that the advisor provides continuous and regular supervisory or management services for the account. The third factor is the extent to which the assets are actively managed or whether advice is regularly provided to the client. Note that no single factor is determinative, and the specific circumstances should be viewed in their entirety.
In summation, AUM is a method used to compute the total market value of investments that are managed by registered investment advisors on behalf of clients. RAUM is the SEC’s regulatory from of AUM. RAUM consists of the accounts that are made up of 50% or more of securities that are continuously and regularly managed by the registered investment advisor overseeing the facilitation and management of the client’s accounts.
 “Assets Under Management,” Investopedia, https://www.investopedia.com/terms/a/aum.asp, accessed February 5, 2021.
 Form ADV Instructions, https://www.sec.gov/about/forms/formadv-instructions.pdf, accessed February 5, 2021.
 “Assets Under Management,” Investopedia, accessed February 5, 2021.
 Form ADV Instructions, accessed February 5, 2021.
 Calculating Regulatory Assets Under Management – Wagner Law Group, https://www.wagnerlawgroup.com/resources/investment/calculating-regulatory-assets-under-management, accessed February 5, 2021.
 Form ADV Instructions, accessed February 5, 2021.
Pastore & Dailey successfully obtained a favorable stipulation and agreement with the Connecticut Department of Banking on behalf of a large national registered broker-dealer. The Department of Banking conducted an investigation into the broker dealer and concluded that the broker-dealer has failed to file a timely U5, included misinformation on a U4, and failed to renew its registration for the calendar year. Following our successful representation, the broker dealer was able to amend its filings and receive a favorable stipulation and agreement with the Department of Banking.
FINRA fined twelve of its largest member firms a combined $14.4 million for violation of its Rule 4511 and SEC Rule 17a-4(f) for their failure to keep hundreds of millions of electronic documents in a WORM or “write once, read many” format. The WORM format is designed to ensure that important firm records including customer records containing Personally Identifiable Information are not altered after they are written.
The firms included Wells Fargo & Co., RBC Capital Markets, LPL Financial, RBS Securities, SunTrust Robinson Humphrey, Georgeson Securities Corp and PNC Capital Markets. FINRA also found that these firms violated its Rule 3110, Supervision, and several other SEC recordkeeping provisions, Securities Exchange Act Section 17(a) and Rules 17a-4 (b) and (c), thereunder.
FINRA noted that such records must be maintained in order to ensure member firm compliance with investor protection rules and that over the last decade the volume of such data being stored electronically has risen exponentially. In a cybersecurity warning, FINRA stated:
there have been increasingly aggressive attempts to hack into electronic data repositories, posing a threat to inadequately protected records, further emphasizing the need to maintain records in WORM format.
P&D is pleased to note that its newest partner, John R. “Jack” Hewitt is one of the country’s foremost cybersecurity authorities, and a major part of his practice is advising broker-dealers, RIAs and banks on their adherence to SEC, FINRA, CFTC and state cybersecurity requirements. Among other things, he advises firms on information security programs, guides them through cyber-incidents and represents them in the event of a regulatory inquiry. Mr. Hewitt regularly conducts cybersecurity audits for broker-dealers and investment advisers, and was the SEC appointed independent outside consultant in the first major SEC cybersecurity enforcement action. He is the author of Cybersecurity in the Federal Securities Markets, a BloombergBNA publication, and Securities Practice & Electronic Technology, an ALM treatise. Mr. Hewitt is the Co-Chair of the American Bar Association, Business Section, White Collar Crime Subcommittee on Cybersecurity.
John R. Hewitt, Partner at Pastore & Dailey LLC, and Jim Ambrosini, Managing Director at CohnReznick Advisory, will be conducting a complimentary Webinar on Thursday, April 20, 2017 at 12:00 PM EDT. Mr. Hewitt is recognized as a national authority in cybersecurity and Mr. Ambrosini is a leader in cybersecurity and technology assurance service offerings at CohnReznick.
Mr. Hewitt and Mr. Ambrosini will discuss the New York State’s Department of Financial Services (DFS) regulation, effective as of March 1, 2017, providing an overview of the regulation, a summary of what controls must be in place, how to implement controls using a risk-based approach, key DFS regulation issues, and how to develop a roadmap towards compliance.
Please join us for this Webinar on April 20, 2017 at 12:00 PM EDT by registering below:
Pastore & Dailey successfully argued for the correction of a bond trader’s Form U5 before a FINRA Arbitration Panel. This trader’s former employer, a worldwide banking institution, misrepresented the reason for the termination of his employment. Pastore & Dailey convinced the Panel to rule that the wording must be changed to reflect the reality. Contested expungement hearings are rare, and the re-writing of a U5 by a panel in such a situation is extraordinary. Pastore & Dailey is pleased that it could achieve this result, the correct result, for its client.
As of today, in the retirement and savings plan matters, money managers are not required to register as fiduciaries. The Department of Labor (“DOL”) is about to clarify the situation by wiping out the difference that exists between financial advisors and broker dealers in regard to their responsibilities in retirement advices.
A fervent debate is currently on regarding whether the fiduciary duty should be applicable to broker dealers. Under section 3(21)(A)(ii) of the Employee Retirement Income Security Act (“ERISA”), a fiduciary advisor is a person who “renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan … .” In other words, the fiduciary advisor has to act solely in another party’s interests. The main corollary of this principle, for the fiduciary, is to avoid any conflicts of interest between itself and its clients.
Recently, the United States Supreme Court clarified the scope of the fiduciary duty under ERISA – Tibble v. Edison International, No. 13-550 (U.S. 2015). The Supreme Court expressed that a fiduciary “has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the fiduciary’s duty to exercise prudence in selecting investments at the outset.”
Some financial services providers do not seem concerned about the possibility of a higher standard – i.e., they already support these basic safeguards in their work policy. Others who are under the pressure of their executives demanding large profit-return, seem to “forget” some of these principles and claim that they will not be able to serve their clients or stay in business if such a rule came into effect.
Who Takes the Lead?
Although initially the Securities and Exchange Commission (“SEC”) regulated broker dealers and investment advisors, it has delegated a large part of its prerogatives related to the broker dealers to the Financial Industry Regulatory Authority (“FINRA”). Nevertheless, when investment advice and securities transactions are related to savings and retirement plans the DOL also has a say in the matter.
Industry groups have widely expressed their concerns with the idea of a fiduciary standard commitment for broker dealers. The fact that the DOL is conducting the project understandably makes the financial services industry skeptical as the connection between them and the DOL is much less privileged than with the SEC or FINRA.
Financial services providers would welcome a consistent and coordinated interpretation of this new standard by the DOL and SEC; divergence between regulators would not serve anyone and would confuse both providers and clients. Trustees believe the industry and investors would be better served if the SEC took the lead and the DOL incorporated the standard guidelines in its interpretation of ERISA.
The Crisis Aftermath
Investment advisors – who provide investment advices – undertake to strictly respect the fiduciary duty. The objectives and interests of their clients must be their priorities when they suggest securities acquisitions. Any conflict of interest must be avoided or at least fixed in the Clients favor.
As opposed to advisors, broker dealers – who only execute securities transactions – have so far not been required to follow the fiduciary duty principle. However, as they suggest the purchase of securities, they are held to submit suitable products to their clients in regard to their financial situation and investment objectives. However, FINRA “suitability” standard does not mean that the products sold must be the best in respect to the purchaser profile.
During the latest financial crisis, many people learned the hard way that, even though those brokers were managing their savings, they were not fiduciaries and, consequently, were not held by the fiduciary duty. Thereafter, Congress adopted the Dodd-Frank Wall Street and Consumer Protection Act, with the intent to have the SEC examine the need of a new uniform federal fiduciary rule both for brokers and advisors. The SEC did so, and in 2011 released that a uniform standard would be appropriate.
At the same time, the DOL – which enforces among others the ERISA – implemented its own set of regulations in this matter with the intent to put some safeguards in place regarding retirement and savings accounts. In its new regulations, it focuses mainly on the conflict of interest facet of the fiduciary duty in respect to retirement accounts.
Two Week Extension
In 2010, the DOL wished to expand the definition of Fiduciary Duty under the ERISA but, eventually, overwhelmed by the industry pressure, had to withdraw it. In February 2015, President Obama asked the DOL to move ahead on its fiduciary rule.
Although Senators from both sides asked the DOL to extend the comment period, arguing that the matter is too complex to be commented in 75 days, the latter extended the period only for two weeks. Rule makers bode that a longer extension of this period could be prejudicial for their project.
The Commodity Futures Trading Commission recently proposed new rules to implement statutory provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules relate to the conflicts of interest provisions set forth in section 732 of the Dodd-Frank Act, which amends section 4d of the Commodities and Exchange Act, to direct futures commission merchants and introducing brokers to implemental conflict of interest systems and procedures to establish safeguards within the firm. The proposed rules seek to ensure that any person researching or analyzing the price or market for any commodity is separated by appropriate informational partitions. The proposed rules also address other issues, such as enhanced disclosure requirements.
Section 732 of the Dodd-Frank Act requires that futures commissions merchants and introducing brokers “establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in trading or clearing activities might potentially bias the judgment or supervision of the persons.” While section 732 could be read to require informational partitions between persons involved in any research or analysis and persons involved in trading or clearing activities, the Commission believes that the Congressional intent underlying section 732 was primarily intended to prevent undue influence by persons involved in trading or clearing activities over the substance of research reports that may be publicly distributed.
The proposed rule establishes restrictions on the interaction between persons within a futures commission merchant or introducing broker involved in research or analysis of the price or market for any derivative and persons involved in trading or clearing activities. Further, the proposed rules also impose duties and constraints on persons involved in the research or analysis of the price or market for any derivative by, for example, requiring such persons to disclose during public appearances and in any reports any relevant personal interest relating to any derivative the person follows. The proposed rule also prevents futures commissions merchants and introducing brokers from retaliating against a person for producing a report that adversely impacts the current or prospective trading or clearing activities of the firm.
If the proposed rules are implemented, they would require that futures commission merchants and introducing brokers adopt written conflicts of interest policies and procedures, document certain communications between non-research personnel and provide other disclosures. They would also prevent non-research personnel from reviewing a research report prior to dissemination, except to verify the factual accuracy of the report and provide non-substantive edits. Non-research personnel may only communicate with research personnel through authorized legal or compliance personnel. The firm’s business trading unit may not influence the review or approval of a research personnel’s compensation and may not influence the research personnel. Futures commissions merchants and introducing brokers must keep a record of each public appearance by a research analyst. The proposed rule applies to third-party research reports as well, except where the reports are made available upon request or through a web site maintained by the futures commissions merchants or introducing brokers.
While the Commodity Futures Trading Commission is continuing to receive public comments on any aspect of the proposed rule, the Commission is particularly interested in comments about whether the rules should apply to futures commission merchants and introducing brokers of all sizes or whether the nature of the partitions should depend on the size of the firm.
In the last two months, the SEC and FINRA have, for the first time each, taken Enforcement action — including against a broker-dealer’s chief compliance officer — in regard to the safeguarding of confidential customer information under a 10-year-old SEC rule called “Regulation S-P.” These actions seem likely to cause a significant shift in how brokers, investment advisers and their firms handle customers’ confidential information, particularly when it comes to a broker or adviser taking his or her “book” of business to another firm.
Previously, when brokers or advisers left for new firms, they and their new firms usually only had to worry about their former firm suing them for breaches of non-compete, non-solicitation and non-disclosure clauses in their agreements, or suing the new firm for “raiding” the former firm’s agents (and, thus, their customers).
But recent SEC and FINRA actions put brokers, advisers and their firms on notice that each could suffer formal regulatory consequences (including fines and suspensions) from brokers or advisers casually — or clandestinely — taking confidential customer information to their new firms.
The SEC adopted Regulation S-P in 2001 pursuant to a mandate in the Gramm-Leach-Bliley Act of 1999, and amended it in 2005 pursuant to a mandate in the Fair and Accurate Credit Transactions Act of 2003 (the FACT Act).
Broadly speaking, Regulation S-P requires broker-dealers, investment advisers and other financial firms to protect confidential customer information from unauthorized release to unaffiliated third parties. Included in Regulation S-P is the “Safeguard Rule” (Rule 30(a)), which requires broker-dealers to, among other things, adopt written policies and procedures reasonably designed to protect customer information against unauthorized access and use.
Of course, several headlines in recent years have focused on the reported thefts or losses of large caches of confidential customer information from banks and other businesses, so it comes as no surprise that the SEC and FINRA would seek to assert their Enforcement powers in this area. Each of the recent SEC and FINRA Enforcement actions arose from departing registered representatives taking customer information to new employers without providing said customers with sufficient notice and opt-out procedures under €¨Regulation S-P.
Case Study # 1: Recent SEC Disciplinary Actions
In an administrative settlement dated April 7, 2011, the SEC fined a brokerage firm’s president, national sales manager and chief compliance officer between $15,000 and $20,000 each in regard to the transfer of 16,000 customer names and addresses, account numbers and asset values to a new firm. It did not matter that customers approved the transfer after the fact, nor did it matter that the transfer occurred because the broker-dealer was winding down its business and thus simply transferring many of its accounts to a new broker-dealer. The SEC found the firm and its senior executives liable for Regulation S-P violations and fined each of them accordingly.
Especially noteworthy is that the SEC fined the firm’s chief compliance officer for “aiding and abetting” these Regulation S-P violations by failing to improve the firm’s “inadequate” written supervisory procedures for safeguarding customer information (the “Safeguard Rule”) after “red flags” arose from prior security breaches at the firm. (Significantly, those security breaches did not involve other instances of intentional transfer of customer data to a new firm, but rather mostly theft by outsiders of a few RRs’ laptops and the unauthorized access by a former employee of a current employee’s firm e-mail account.)
Case Study # 2: Recent FINRA Disciplinary Action
This past December, FINRA’s National Adjudicatory Council affirmed a $10,000 fine and 10-day suspension ordered by a FINRA hearing panel in a contested hearing against a broker for his downloading confidential customer information from his firm’s computer system onto a flash drive on his last day of employment and then sharing that information with a new firm. FINRA found the broker’s actions prevented his former firm from giving its customers a reasonable opportunity to opt out of the disclosures, as required by Regulation S-P. FINRA also found the broker’s misconduct caused his new firm to improperly receive non-public personal information about his former firm’s customers.
These Enforcement actions will change the legal and practical landscape concerning the portability of a broker’s “book” of customers. From a contractual point of view, brokers and advisers would be well-advised to build Regulation S-P-compliant language into their agreements with their current and new firms if they anticipate ever switching firms again, as these Enforcement actions effectively sound the alarm that the SEC and FINRA will sanction a broker or adviser for furtively taking customer information to a new firm. Likewise, investment adviser and brokerage firms would be well-advised to understand the relevance of Regulation S-P when it comes to brokers or advisers moving to other firms and taking firm customer information with them.
€¨Finally, from a regulatory point of view, a broker’s or adviser’s “former” firm should implement reasonable policies and procedures to ensure compliance with Regulation S-P by all firm personnel, including brokers or advisers looking to leave the firm, and a broker’s or adviser’s “new” firm should take similar care and caution when a broker or adviser brings in confidential information regarding new customers (lest the new firm also be found liable for a Regulation S-P violation, which would have happened in the above FINRA case had the new firm done anything with the customer information it got from the subject broker).