Financial Services Alert - April 22, 2014

We are proud to announce that on April 12, 2014, Margaret Crockett, Counsel in Goodwin Procter’s Financial Institutions Group, was inducted as a Fellow into the American College of Consumer Financial Services Lawyers (the “College”).  Membership in the College is limited to those lawyers whose principal practice is in the field of consumer financial services law, who have achieved preeminence in the field of consumer financial services law and who have made repeated and substantial contributions to the promotion of learning and scholarship in consumer financial services law through teaching, lecturing and published writings. 

Margaret, who has become a recognized expert in deposit account systems, electronic delivery of financial services and the development of mortgage products, focuses her practice on supporting financial institutions of all sizes throughout New England and across the United States.  Margaret joins Goodwin Procter partners Lynne Barr, Chair of the Firm’s Banking and Consumer Financial Services Practice, and Tom Hefferon, Chair of its Consumer Financial Services Litigation Practice, as Fellows.

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert discussing its initiative to assess cybersecurity preparedness in the securities industry.  The initiative, which will include examinations of more than 50 broker-dealers and advisers, will focus on the following areas:

• cybersecurity governance,
• identification and assessment of cybersecurity risks,
• protection of networks and information,
• risks associated with remote customer access and funds transfer requests,
• risks associated with vendors and other third parties,
• detection of unauthorized activity, and
• experiences with certain cybersecurity threats.

The Risk Alert includes a sample request for information with detailed questions in each of the foregoing areas, which “is intended to empower compliance professionals in the industry with questions and tools they can use to assess their firms’ level of preparedness, regardless of whether they are included in OCIE’s examinations.”    The Risk Alert notes that the topics it lists are not exhaustive (or necessarily applicable to all firms), and that “the adequacy of supervisory, compliance, and other risk management systems can be determined only with reference to the profile of each specific firm and other facts and circumstances.”

The Risk Alert follows the announcement of a technology element in OCIE’s 2014 examination priorities and the SEC’s March 26, 2014 Cybersecurity Roundtable.

The SEC settled administrative proceedings against Transamerica Financial Advisors, Inc. (the “Adviser”) over its failure to grant advisory fee breakpoint discounts to certain advisory clients based on the aggregation of related account balances requested in the client account documentation, and related deficiencies in the administration of the related account aggregation feature.  This article provides a summary of the settlement order (the “Order”), whose findings the Adviser has neither admitted nor denied.

Background

The Adviser, which is dually registered as an investment adviser and a broker-dealer, offers investment programs to retail clients through its investment adviser representatives (“IARs”).  In its November 2013 Form ADV, the Adviser represented that it had $3.1 billion in regulatory assets under management in approximately 22,500 client accounts.  The asset-based advisory fee for certain of the Adviser’s investment programs (the “Programs”) was subject to breakpoints that reduced the fee at higher levels of client assets.  The Adviser offered Program clients the opportunity to aggregate their accounts with related accounts – e.g., accounts held by the clients’ “spouses, domestic partners (as recognized by applicable state law) and children under the age of 21, whom reside with the clients” – to assist them in achieving breakpoint discounts.  In some cases, the aggregation feature was offered in account opening documents.  For one program, the Adviser had an internal policy of offering breakpoint discounts to Program clients.  In order to take advantage of the related account aggregation feature, clients had to complete paperwork to request aggregation and identify the relevant related accounts.  The Adviser’s IARs transmitted the completed paperwork to the Adviser’s headquarters where the information was input into the billing system.

2009 Examination of Branch Office

In 2009, SEC staff examined a branch office of the Adviser and found that the office had not properly aggregated certain of its client accounts for the purposes of the Program breakpoint discounts.  In notifying the branch office of its findings, the SEC staff recommended that the Adviser review all advisory accounts for all branch offices to ensure breakpoints were being properly applied firm-wide.  The Adviser attributed the aggregation failures cited by the SEC staff to a mistaken belief on the part of branch office staff that headquarters automatically aggregated accounts without instruction from the IARs.

Remedial Action Following 2009 Examination

In response to the 2009 examination, the Adviser provided refunds to affected clients of the branch office.  While it did not undertake a review of account aggregation practices at all its branch offices, the Adviser did take the following remedial action:  (i) it issued a firm-wide compliance alert in June 2010 reminding IARs to (a) inform clients of the availability of aggregation and the possible advisory fee reductions, and (b) notify headquarters of client aggregation requests; (ii) it revised Program account opening documents to more clearly document account aggregation requests and to require a client to provide reasons for electing not to aggregate; (iii) it modified its policies and procedures to require IARs to (a) confirm that non-aggregating clients had provided written explanations for non-aggregation and (b) apply the advisory fee reduction schedule for clients that opted to aggregated accounts; and (iv) it committed to send a one-time mailing to apprise clients of the account aggregation policy and the need to notify an IAR of accounts that should be aggregated.  In May 2010, the Adviser added to its Form ADV Part 2 disclosures stating that certain Program participants could aggregate related accounts to achieve breakpoint fee reductions.

2012 Firm-Wide Examination

In February 2012, the SEC staff conducted a firm-wide examination of the Adviser and determined that the aggregation issues identified in the 2009 examination existed on a nationwide basis.  The SEC staff found that the Adviser’s policies and procedures did not adequately delineate which of two teams involved in establishing new accounts was responsible for reviewing new account forms for account aggregation purposes.  Consequently, many new account forms were not reviewed with this feature in mind, and related accounts were not linked to apply the breakpoint discounts.  The SEC staff also found that the one-time mailing to clients on the account aggregation policy referred to above was never sent by the third-party service engaged by the Adviser for that purpose.  Other compliance program failures relating to the Adviser’s account aggregation policy cited by the SEC included:  (1) account opening forms for clients with multiple accounts that were missing an explanation by the client of a decision not to aggregate accounts; and (2) a conflict between two of the Adviser’s compliance manuals, one of which required the application of breakpoints for a client who aggregated accounts while the other only permitted it.

Violations

The SEC found that the Adviser willfully violated Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”), which prohibits an investment adviser from engaging in any transaction, practice or course of business which operates as a fraud or deceit upon a client or prospective client.  The SEC also found that, as a consequence of the account aggregation disclosures made in its Form ADV filed with the SEC from 2010‑2012, the Adviser willfully violated Section 207 of the Advisers Act, which makes it unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the SEC.  Lastly, the SEC found that the Adviser willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require investment advisers to maintain compliance programs reasonably designed to prevent violations of the Advisers Act and its rules.

Remedial Efforts

Following the 2012 examination and a related investigation by the staff of the SEC’s Division of Enforcement, in consultation with the Enforcement Division staff, the Adviser initiated a firm‑wide review of client accounts in the Programs.  Following its review and related notifications to 22,091 clients and former clients, the Adviser ultimately provided refunds and credits totaling approximately $553,624, including interest, to 2,304 accounts of clients and former clients who were overcharged fees.

Sanctions and Undertakings

The Adviser agreed to (i) cease and desist from violating Sections 206(2) and 206(4) of the Advisers Act and Section 207 of the Advisers Act and Rule 206(4)-7 thereunder, (ii) be censured, and (iii) a civil money penalty of $554,624.  The Order notes that no disgorgement was ordered in view of the reimbursements paid to clients noted above.

The Adviser also agreed to retain an independent consultant to conduct a review of its compliance policies and procedures pertaining to account opening forms for its investment programs, advisory fee schedules, advisory fee computation methodologies and account aggregation process for breakpoints.  In addition, the Adviser agreed to (a) post a summary of the Order with a link to the entire Order on the Adviser’s principal website for 12 months, (b) send current Program clients a communication that notifies them of the Order and includes the Order or a link to it, and (c) include for 12 months in its brochure (i) notice of the Order, (ii) a URL where the Order can be viewed, and (iii) an offer to provide the Order upon request.

In the Matter of Transamerica Financial Advisors, Inc., SEC Release No. 34-71850 April 3, 2014.

On April 15, 2013, the Basel Committee on Banking Supervision (the “Basel Committee”) issued final rules (the “Final Rules”) concerning the supervisory framework for measuring and controlling large exposures, setting tighter limits on single counterparty (or a group of connected counterparties) credit risk exposures for all banks.  The Final Rules set the general exposure limit to 25% of a bank’s Tier 1 capital, instead of the existing limit of 25% of a bank’s total capital, for all banks.   However, a stricter limit of 15% of Tier 1 capital is imposed on banks that have been designated as global systemically important banks (“G-SIBs”), the higher-end of the 10-15% range suggested in the proposed version of the Final Rules (the “Proposed Rules”) issued by the Basel Committee in March 2013.  A country may, of course, impose limits on its banks that are more stringent than those of the Basel Committee.

The Final Rules also incorporate changes to the Proposed Rules’ definition of a large exposure, such that large exposure is defined as the sum of all exposure values of a bank to a counterparty (or to a group of connected counterparties) equal to or above 10% of a bank’s eligible capital base, instead of the Proposed Rules’ 5% threshold.  Other changes in the Final Rules to the Proposed Rules include a replacement of the proposed 1% granularity threshold for exposures to securitization vehicles (which would have required banks to first assess whether any underlying exposure represented more than 1% of the transaction, and then, if so, look-through to the underlying exposures to counterparties and adding these to any direct exposures to the same counterparties), with a materiality threshold (which instead relates the underlying exposure value to the capital base of the bank, but still requires adding such exposures to the same counterparty) of 0.25%.

The new supervisory framework will take effect beginning January 1, 2019. 

The Basel Committee also stated that it plans to review setting a large exposure limit to qualifying central counterparties related to clearing activities, which are currently exempted under the Final Rules, following an observation period that will conclude in 2016.

On April 10, 2014, Comptroller of the Currency Thomas J. Curry presented remarks concerning risk management and related corporate governance issues before the American Bankers Association Risk Management Forum.  Comptroller Curry focused his presentation on the OCC’s “heightened expectations” for risk management and corporate governance, which were described in the January 28, 2014 Financial Services Alert.  He stated that the OCC’s “heightened expectations” program (the “HE Program”) applies exclusively to large, complex banks, i.e., those with consolidated total assets of $50 billion or more (“Large Banks”),” and requires Large Banks to “develop a risk appetite statement that defines both quantitative and qualitative parameters for a safe and sound operating environment at their particular bank.”  The HE Program, noted the Comptroller, also, among other things, calls upon members of a Large Bank’s board of directors “to exercise sound independent judgment,” actively oversee the bank’s compliance program, participate in an ongoing training program for bank directors and conduct an annual self-assessment of the board’s effectiveness.

Comptroller Curry responded to community banks’ concerns that the HE Program would be applied to banks that are smaller than Large Banks by saying that the OCC would only apply the HE Program to a bank with less than $50 billion in consolidated assets “in extraordinary circumstances,” i.e., if the OCC determined that the bank’s operations were highly complex or present a heightened risk.  The financial press has recently reported that the OCC is reviewing the public comments on its proposed HE Program and is expected to make some changes to the HE Program and the related proposed guidelines, which would be adopted as a new Appendix D to the OCC’s safety and soundness regulations that appear at 12 C.F.R. Part 30.  It has been reported by the financial press that changes to the proposed OCC guidelines would likely be focused on clarifying that the guidelines are not intended to apply to smaller banks and on providing some assurance to bank directors that, although they are expected to oversee their bank’s compliance performance, they are not required by the OCC to “ensure” their bank’s compliance with applicable regulations.