Today, the United States Supreme Court sent shock waves through the securities industry as well as the United States Securities and Exchange Commission’s (“SEC”) enforcement program when it held that SEC administrative law judges (“ALJ”) are “inferior officers,” and must be chosen pursuant to the appointments clause of the United States Constitution.  That is, the President with the advise and consent of the United States Senate may appoint “all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”  See United States Constitution Article 2, Section 2, Clause 2.  Although this decision was centered on an appeal involving an SEC ALJ, it may also effect other federal agencies that use in-house judges.

Initially, the case involved a former investment adviser who was sanctioned by an SEC ALJ.  See Lucia v. SEC, https://www.supremecourt.gov/opinions/17pdf/17-130_4f14.pdf.  The United States Court of Appeals for the District of Columbia had held that SEC ALJs were not subject to the appointments clause; however, the United States Court of Appeals for the 10th Circuit had found differently.  Justice Elena Kagan authored the opinion and found that the SEC’s ALJs were very similar to tax court trial judges where the Supreme Court had previously found those judges to be inferior officers subject to the appointments clause.

Now that the Supreme Court has opened this door with the finding ALJs are inferior officers, the SEC’s ALJ’s will have to be appointed pursuant to the appointments clause in the future, and it calls into question what, if anything, will happen to the ALJs at other federal agencies.  Further, there will be the question of prior SEC cases, the Supreme Court stated that not every appointments clause violation requires a new hearing.  However, time will tell.

Additionally, although Justice Kagan specifically said it was not being addressed in this case, we may also shortly see that, since the SEC’s ALJs are now considered inferior officers subject to the appointments clause, they may also now be subject to removal by the SEC Chairman for good cause.  Such a result may provide significant power to the president to fire such ALJs at will, maybe even in a Tweet.  As for Mr. Lucia, well, he now gets a re-trial before either the full SEC or a new ALJ appointed pursuant to the appointments clause, who will determine if his “Buckets of Money” program is real or made-up.

In short, the Supreme Court has upended how the SEC does business.  Of course, we will follow how the SEC responds.

 

 

Recently, the SEC’s Director of Corporation Finance provided long overdue insight on cryptocurrencies.  In particular, he indicated that Bitcoins, Etherium, and other such coins functioning on certain decentralized platforms are not securities.  Our partner, Kristen Howell, authored a fascinating and informative alert on this topic.  See https://www.foxrothschild.com/publications/sec-bitcoin-is-not-governed-by-securities-laws/.  We commend it to anyone interested in this area.

Essentially, the SEC Staff has taken the position that, various cryptocurrencies operating from a central control group, who target passive investors, will be engaging in a securities offering while less centralization focusing in on purchasing goods or services will be less likely to be considered a security.  The SEC Staff also suggested that those interested in this field should consider seeking formal interpretive or no-action letter guidance so as to avoid the potential pitfalls.  The SEC Staff also indicated that securities registration may end up being required if there is a central group/promoter offering an increase in value; raising excess funds that are more than necessary for the actual network; having purchasers looking for a greater return than the current value; and a directed sales effort.

Thus, it is critical to seek out legal counsel before engaging in cryptocurrency networks and offerings.

For those interested in a description of the DOJ’s new corporate resolution policy, we strongly urge you to review our partner, Matt Lee’s, recent posting on this topic.  See https://www.foxrothschild.com/white-collar-compliance-defense/publications/the-justice-departments-new-corporate-resolution-policy-an-end-to-piling-on/.

In rapid succession, the SEC has issued warnings and announced sanctions against registered investment advisers for fee and expense practices, false statements regarding assets under management, and misleading performance data.  No one should be surprised that the SEC is actively seeking to uncover transgressions in the RIA field.

Initially, the SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert outlining a variety of RIA failures concerning the proper calculation and disclosure of fees and expenses.   See https://www.sec.gov/ocie/announcement/risk-alert-advisory-fee-expense-compliance.  In particular, the alert detailed a series of failures that OCIE found in its examinations of RIAs, among other things, RIAs failed to properly value assets, overbill, use incorrect fees or time periods.

Similarly, the SEC also sanctioned a principal of a closed RIA for falsely stating it was subject to SEC registration.  See https://www.sec.gov/litigation/admin/2018/ia-4875.pdf.  Although we believe it admirable for someone to want to achieve SEC RIA registration status, you want to be accurate when you make this claim.  Apparently, this individual was not, and lying to the SEC will always incur its wrath.

Finally (and this is a pet peeve with us), the SEC also sanctioned a RIA for using misleading performance data.  See https://www.sec.gov/litigation/admin/2018/ia-4885.pdf.  The RIA was caught using hypothetical back-tested performance data– a pretty big no-no.  We are constantly advising RIA clients of the pitfalls in using any type of performance data, and this case illustrates how closely the SEC will look at its use.

In sum, RIAs have to be careful the SEC is watching.

 

 

Not one for making people feel at ease, the SEC’s Division of Investment Management has indicated that it is not comfortable with investment companies investing in cryptocurrencies and similar products.

In a letter sent to industry groups, the SEC’s IM Director indicated that the Staff had numerous concerns over funds investing in these instruments.  The concerns boiled down to 5 categories:  valuation, liquidity, custody, arbitrage, potential manipulation and other risks.

The SEC Staff is concerned that funds will not be able to properly value the crypto-assets in question, or reduce them to cash if necessary.  Further, the SEC Staff had serious questions concerning if a fund custodian would be able to properly validate the very existence and location of the assets as well ensure that there would be no arbitrage opportunities for insiders that could harm investors.  Similarly, the SEC Staff was also concerned about the potential for volatility in the cryptocurrency market as recently witnessed in South Korea.

Additionally, the SEC Staff raised concerned that the cryptocurrency markets lack regulation, and could be subject to market manipulation and potential fraud.  These investments also potentially lend themselves to cybersecurity issues such as hacking and the lack of safeguards to protect against these invasions.  The SEC Staff also suggested that funds would not be able to sufficient risk disclosures and transparency in their prospectuses to cover their requirements, and, thus, the funds would like the appropriate risk disclosures to their shareholders.  Finally, the SEC Staff was concerned that there would not be appropriate suitability determinations by those who market and sell these funds– broker-dealers and registered investment advisers– that would ensure their suitability and fiduciary obligations when recommending cryptocurrency investments to the public.

In sum, this may be the millionth (note: exaggeration) time this year, the SEC has made it known that it does not like cryptocurrency investments.  Clearly, the SEC is trying to send a message, therefore, those interested in cryptocurrency markets should beware.

In a recent speech, new SEC Chairman Jay Clayton warned lawyers, who advice clients on bitcoins and initial coin offerings (“ICOs”), to be aware the SEC is lurking out there waiting to pounce.  Of course, he did not say it exactly like that, but he might as well have used those exact words.

Clayton stated that the SEC Staff is monitoring (he called it being on “high alert”) lawyers, who advice clients on these transactions.  Apparently, the SEC believes that certain lawyers may be advising clients to skirt the federal securities laws in the process.  In particular, he mentioned that ICOs were becoming more problematic.  ICOs are essentially mechanisms to raise capital for start-ups.  Additionally, despite the SEC’s pronouncement to the contrary that ICOs and bitcoins are governed by the federal securities laws, Clayton claims the SEC Staff has seen lawyers structure ICOs resembling securities transactions, and then claim the bitcoins are not securities.  For the record, the SEC has already brought several enforcement actions in this space to stop fraudulent activity.

Nonetheless, Chairman Clayton’s remarks are extraordinary because, given the lack of a judicial or statutory framework in this area, he is essentially suggesting lawyers have to be more certain as a legal matter in their opinions than Congress, the courts, and even his own agency.  Such a position is remarkable, and represents a titanic shift in the SEC’s previous policy of only going after lawyers who engage in fraudulent conduct.  I warned of this very possibility in an article I wrote several years ago, and the new administration apparently wants to continue the practice.  See http://www.foxrothschild.com/publications/the-empire-strikes-back-the-secs-new-assault-on-lawyers/.

Finally, Chairman Clayton’s warning is a sad commentary on the failure of a government regulator to actually address the real issue, and instead scapegoat a likely target.  Instead of twisting and misinterpreting Shakespeare’s famous and often misused quote “let’s kill all the lawyers” (Henry VI,” Part II, act IV, Scene II, Line 73), it would have been probably more worthwhile for Chairman Clayton to outline a set of new SEC specific rules or regulations in this area so that lawyers would be able to provide a definitive framework for their clients, who undertake ICOs or other bitcoin transactions.

Nearly a year ago, FINRA adopted Rule 2165 (Financial Exploitation of Specified Adults) and amended Rule 4512 (Customer Account Information). This new rule and amended rule were ways to address the myriad of issues dealing with senior clients.

With nearly a year gone by, FINRA has now published responses to frequently asked questions involving Rules 2165 and 4512. The responses to the FAQs are broken down into the following categories.

  1. Placement of temporary holds.
  2. Extensions of temporary holds.
  3. Trusted contact.
  4. Disclosure.

For anyone who has any senior clients, a review of these FAQs is necessary because they reflect FINRA’s ongoing focus of senior clients. Reviewing the FAQs will only take a few minutes, defending yourself in a lawsuit brought by a senior will take years. How would you rather spend your time?

The SEC recently put out an Investor Bulletin on wrap fees. Although this guidance is steered toward consumers, there are lessons to be learned by firms who offer such programs.

The SEC specifically posed the question of what does the fee cover. Included in that list of possibilities are:

  1. Investment advice.
  2. Brokerage costs.

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  3. Administrative expenses.
  4. Other fees and expenses like those associated with mutual funds.
  5. Third party service provider costs and trading away.

So what can a firm take away from this bulletin? For one, now is as good a time as any to make sure that your wrap fee disclosures are complete and up to date.

In the first instance, do you even have written disclosures that you can provide customers? If you do, do they detail the services being provided and the fees being charged. If the answer to either question is no, you have work to do.

FINRA recently issued a report regarding its examination findings. FINRA issued this report so that firms can gain insight from the work of FINRA’s examination of other firms.

Among the FINRA’s findings are the following areas that need additional attention:

  1. Cybersecurity, including access management, risk assessments, vendor management, branch office security, segregation on internal duties and data loss prevention.
  2. Outside business activities and private securities transactions, including failure to provide notice to firms, notice reviews and post private securities transaction approval conduct.
  3. Anti-money laundering compliance programs, including maintaining adequate policies and procedures for suspicious activities, responsibility for AML monitoring, exclusions from data feeds used for AML monitoring, resources for AML monitoring and independent testing for AML monitoring.
  4. Product suitability, including unit investment trusts, multi-share class and complex products and training.
  5. Best execution.
  6. Market access controls, including establishing pre-trade financial thresholds, implementing and monitoring aggregate financial exposures, tailoring erroneous or duplicative order controls, implementing effective fixed income financial controls, reliance on vendors for fixed income financial controls, and effective testing for fixed income financial controls.

This list and the items in it should provide other firms with the benefit of hindsight. Review the report and then self-critique your firm. Do you have any of these issues? If so, implement modifications and adjustments to address them.