In a recent Risk Alert, the staff of the Office of Compliance Examinations and Inspections (“OCIE”) of the Securities and Exchange Commission (“SEC”) observed that one of the most frequent deficiencies identified in OCIE examinations was the failure of investment advisers to recognize that they might be deemed to have custody of client assets for purposes of Rule 206(4)-2
(“Custody Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”). On February 21, the staff of the SEC’s Division of Investment Management provided additional guidance under the Custody Rule that addressed three situations where there have been significant questions as to whether an investment adviser has custody of client assets:
- when the adviser has limited authority to transfer client assets pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement (“SLOA”) established by a client with a qualified custodian;
- when an agreement between the client and its custodian appears to provide the adviser with access to client assets—even if the investment adviser is not a party to such agreement; and
- when the adviser has the authority to move money between the client’s own accounts (“first-person transfers”).
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Additional contributor to this post:
Gregory T. Larkin, firstname.lastname@example.org
Recently, FINRA published a report regarding its investor survey (FINRA Investors in the US 2016). The report summarizes findings from an online survey addressing investor relationships with broker-dealers and advisers, investor understanding of fees charged for investment services and investor literacy. The survey finds that a very small percentage of investors own “complex securities,” such as REITs, options and structured notes, which have been a focus of regulatory attention. Most investors own principally individual stocks and mutual funds. More than half of those investors surveyed rely on the services of a broker or other professional adviser for some of their investment decisions, with the percentage being somewhat higher for investors aged 55 and higher. Approximately 16% of those surveyed use robo-advisers. In making investment decisions, 49% expressed a preference for paper deliver of documents. An overwhelming percentage of investors (68%) rely on information from the company in which they are investing in order to make their investment decisions. The investor literacy component of the survey questions revealed that many investors do not have a complete understanding of concepts like short selling and buying stocks on margin, which suggests that broker-dealers and investment advisers have continued work ahead of them in terms of investor education.
On November 14, 2016, FINRA fined a registered broker-dealer $650,000 for failing to safeguard confidential customer data against foreign hackers. Confidential customer information was stored on the firm’s electronic system without adequate protection from cyber hackers, which resulted in the exposure of confidential information for approximately 5,400 firm customers. Although there was no evidence that the exposure of this customer information resulted in any distinct customer harm, FINRA insisted that the firm’s cybersecurity procedures and systems were inadequate. The firm’s prior disciplinary history (similar fine in 2011) was also an important factor in FINRA’s decision to levy this $650,000 punishment.
On November 2, 2016, FINRA announced fines against eight firms, totaling $6.2 million, related to supervisory failures for sales of L-share variable annuities. FINRA has been focused on L-share variable annuity sales, because they are often sold with long-term minimum income riders, which may be incompatible with the higher up-front fees and shorter surrender periods normally associated with the L-share class. Rather than claim that these products were unsuitable for certain investors, FINRA’s enforcement action alleges that firms did not have adequate supervisory systems in place to monitor the L-share variable annuity sales. Moreover, many of the eight fined firms did not have supervisory systems reasonably designed to identify “red flags” related to the L-share variable annuity sales (e.g., the “red flag” of L-shares sold to senior investors with long-term riders).
Industry experts anticipate further FINRA enforcement actions related to the sale of L-share variable annuities, and many firms have gradually been eliminating L-share classes from their fund lineups in response to this recent regulatory scrutiny.
On October 19, 2016, FINRA filed with the SEC a proposed rule change that would amend FINRA Rule 4512 (Customer Account Information), and adopt new FINRA Rule 2165 (Financial Exploitation of Specified Adults). The proposed amendments to FINRA Rule 4512 would require broker-dealers to make reasonable efforts to obtain the name and contact information for a “trusted contact person” for a customer’s account. In addition, new FINRA Rule 2165 would permit (but not require) broker-dealers to place temporary holds on disbursements of funds or securities from the accounts of certain senior investors, as well as other investors with diminished capacity, when there is a reasonable belief of financial exploitation.
This rule proposal fits squarely within FINRA’s recent focus on protecting senior investors, particularly with FINRA’s recent launch of the “Securities Helpline for Seniors,” and should remain a continued regulatory focus moving forward.