Financial Services Alert - February 25, 2014 February 25, 2014
In This Issue

SEC Staff Grants No-Action Relief to Affiliated Securities Lending Agent

The staff of the SEC’s Division of Investment Management granted no-action relief from Section 17(e)(1) of the Investment Company Act of 1940 (the “1940 Act”) to permit an affiliated securities lending agent to negotiate rebate rates on behalf of certain mutual funds, subject to specified guidelines and monitoring procedures. 

Background.  Nuveen Fund Advisors, LLC (the “Adviser”) serves as investment adviser to certain funds (the “Funds”) that participate in a securities lending program for which the Funds’ custodian (the “Bank”) serves as securities lending agent.  By virtue of its ownership of securities of one or more of the Funds, the Bank may be deemed an affiliated person of each Fund as defined in Section 2(a)(3) of the 1940 Act.

Section 17(e)(1) of the 1940 Act and Prior Relief Under the Norwest No-Action Letter.  Section 17(e)(1) of the 1940 Act prohibits an affiliated person of a registered investment company, or any affiliated person of such person, acting as agent, to accept from any source any compensation for the purchase or sale of any property to or for the investment company, except in the course of such person’s business as an underwriter or broker.  In Norwest Bank Minnesota, N.A., SEC No-Action Letter (pub. avail. May 25, 1995) (the “Norwest Letter”), the SEC staff stated that it would not recommend enforcement action under Section 17(e)(1) against an affiliated custodian of a fund if the affiliated custodian was compensated by the fund for providing certain services in connection with a securities lending program.  The fund’s adviser was permitted to delegate to the custodian the tasks of entering into loans with pre-approved borrowers on pre-approved terms and investing cash received as collateral for the loans in instruments pre-approved by the adviser.  The SEC staff took the position that, under these circumstances, the adviser’s delegation of authority to the affiliated lending agent with respect to such matters would present little opportunity for the types of conflicts that Section 17(e)(1) was designed to prevent.  The SEC staff also stated in the Norwest Letter that relief from the prohibition in Section 17(e)(1) would be inappropriate when the lending agent has “unfettered discretion to negotiate loan terms.”

Current Relief.  The Adviser sought no-action relief from Section 17(e)(1) to permit the Bank to negotiate rebate rates with borrowers on behalf of each Fund, subject to guidelines and monitoring by the Adviser and the Board of Directors (“Board”) of the Funds.  The Adviser adopted, and the Board reviewed, guidelines that require the Bank to obtain minimum spreads in negotiating securities loans on behalf of the Funds and to notify the Adviser if a loan earns a spread that is less than the required minimum spread under the guidelines.  The Adviser is responsible for monitoring the continuing appropriateness of the guidelines, and may modify them.  The Bank is also required to monitor market information on rebate rates and report to the Adviser any negotiated rebate amount that is materially more favorable to a borrower than the market rate for a similar loan.  The Adviser provides regular reports to the Board regarding the securities lending activities of the Funds, including with respect to the foregoing matters.

The Adviser asserted that it was not practical for the Bank to submit rebate rates to the Adviser for pre-approval, and that the industry practice for securities loans generally does not involve such pre approval.  Instead, the Adviser argued that appropriate monitoring, oversight and after-the-fact review by the Adviser and the Board should be sufficient to address the conflicts that Section 17(e)(1) of the 1940 Act was designed to prevent.  Based on the guidelines, monitoring and reporting procedures described in the no-action request, the SEC staff agreed with the Adviser.  In granting the relief, the SEC staff reaffirmed its view that relief would be inappropriate where an affiliated lending agent has “unfettered discretion to negotiate loan terms.”  

Nuveen Investment Funds, SEC No-Action Letter (pub. avail. Feb. 13, 2014).

Goodwin Procter represented the parties in securing the no-action relief.

SEC Staff Provides Additional Guidance for Private Fund Advisers on “Knowledgeable Employees”

The staff of the SEC’s Division of Investment Management (the “Staff”) provided additional guidance (the “Guidance”) on the scope of the “knowledgeable employee” category of investors who may be disregarded in determining whether or not a pooled investment vehicle (a  “Private Fund”) may rely on the exclusion from the definition of investment company by Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “1940 Act”).  Rule 3c‑5 under the 1940 Act permits a knowledgeable employee of a Private Fund, or a knowledgeable employee of an affiliated person that manages the investment activities of a Private Fund (an “Investment Manager”), to invest in the Private Fund without (a) being counted for purposes of the 100-person limit if the Private Fund intends to rely on Section 3(c)(1) or (b) being a “qualified purchaser” if the Fund intends to rely on Section 3(c)(7).  The Staff had previously provided guidance in this area in American Bar Association, SEC No-Action Letter (pub. avail. Apr. 22, 1999) (the “ABA Private Funds Letter”) and PPM America Special Investments CBO II, L.P., SEC No-Action Letter (pub. avail. Apr. 16, 1998) (the “PPM America Letter”).

Principal Business Unit Status

In part, the Guidance addresses the category of knowledgeable employee consisting of any “Executive Officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity” of a Private Fund or its Investment Manager.  “Executive Officer” means the “president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions” for a Private Fund or an Investment Manager.  The Guidance provides confirmation of the following general interpretive principles relating to this category:

  • “[W]hether a business unit, division, or function qualifies as a principal business unit, division, or function should be determined through an analysis by the investment manager of the relevant facts and circumstances regarding the investment manager’s business operations.”
  • “While not all business units, divisions, or functions are necessarily principal, it is possible that several business units, divisions, or functions could each be a principal unit, division, or function depending on the facts and circumstances.”
  • “[A] business unit, division, or function need not be part of the investment activities of a [Private] Fund in order to be considered principal, nor is the size of the investment manager or a particular department determinative as to whether a function should be considered principal.]”

The Guidance goes on to state that under the following circumstances, an Investment Manager’s information technology (“IT”) department or its investor relations department could be a principal business unit under Rule 3c‑5 such that the individual in charge of the unit could be a knowledgeable employee:

IT Department 

  • The Investment Manager “employs one or more technologically driven trading models,” and its “IT professionals are charged with building the models and systems that translate certain quantitative signals into trade orders”; or
  • The Investment Manager “employs technology professionals to build performance and risk monitoring systems that interact with the investment program.”

Investor Relations

Investor relations personnel “conduct substantive portfolio reviews with investors and . . . respond to substantive due-diligence inquiries from institutional investors and consultants.”  Principal business unit status would not, however, apply if the investor relations department “merely assisted in arranging meetings between an investment manager’s investment staff and prospective investors, disseminated investor communications written by senior executives outside of the investor-relations department, or performed other relatively administrative tasks.”

Executive Officer Status

The Guidance confirms that an individual can be an “Executive Officer” for purposes of Rule 3c-5 without having a senior officer title, provided the individual “makes policy through day-to-day involvement in the development and adoption of an investment manager’s policies.”  The Guidance also provides that an individual may be an Executive Officer on the basis of participation in collective policy-making activity by serving as “an active member of a group or committee that develops and adopts an investment manager’s policies, such as the valuation committee.”  The Guidance cautions, however, that “individuals who merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group would [not] be engaged in making policy and, therefore, such individuals generally would not be executive officers under the rule.”

Participation in Investment Activities

The Guidance also addresses a second category of knowledgeable employee defined in Rule 3c‑5(a)(4)(ii).  This category consists of each employee of a Private Fund or its Investment Manager who, in connection with that person’s regular function or duties, participates in the investment activities of the Private Fund, other Private Funds, or investment companies whose investment activities are managed by the Investment Manager, provided that the employee has been performing those functions and duties for or on behalf of the Private Fund or the Investment Manager, or substantially similar functions or duties for or on behalf of another company for at least 12 months (a “Participating Employee”).  

The Guidance revises the Staff’s views expressed in the ABA Private Funds Letter regarding the possible knowledgeable employee status of (a) certain research analysts and (b) personnel not directly charged with investment management responsibilities.

Research Analysts.  The Guidance provides that a research analyst “who researches only a portion of the portfolio of a [Private] Fund and provides analysis or advice to the portfolio manager with respect to such portion of the [Private] Fund’s portfolio is participating in the investment activities of the [Private] Fund for purposes of the rule,” and “could be a knowledgeable employee under rule 3c-5(a)(4)(ii).”  The ABA Private Funds Letter stated that “some research analysts (e.g., a research analyst who researches all potential portfolio investments and provides recommendations to the portfolio manager)” could be knowledgeable employees.

Non-Portfolio Management Employees.  The Guidance provides that Investment Manager employees performing the following functions could be considered Participating Employees, provided they regularly perform such functions or duties and have been doing so for at least 12 months:

  • Risk/Analytics - “a member of the analytical or risk team who regularly develops models and systems to implement the [Private] Fund’s trading strategies by translating quantitative signals into trade orders or providing analysis or advice that is material to the investment decisions of a portfolio manager (in contrast to someone who merely writes the code to a program used by the portfolio manager);”
  • Trading - “a trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process and whose analysis or advice is material to the portfolio manager’s investment decisions based on the trader’s market knowledge and expertise (in contrast to a trader that simply executes investment decisions made by the portfolio manager);”
  • Tax – “a tax professional who is regularly consulted for analysis or advice by a portfolio manager typically before the portfolio manager makes investment decisions and whose analysis or advice is material to the portfolio manager’s investment decisions, such as when a tax professional’s analysis of whether income from an offshore fund’s investment may be considered ‘effectively connected income’ is material to a portfolio manager’s decision to invest in certain debt instruments (in contrast to a tax professional who merely prepares the tax filings for the [Private] Fund); and”
  • Legal – “an attorney who regularly analyzes legal terms and provisions of investments and whose analysis or advice is material to the portfolio manager’s investment decisions, such as where the attorney’s legal analysis of tranches of a distressed debt investment is material to a portfolio manager’s decision to invest in the loan (in contrast to an attorney who negotiates agreements that effectuate transactions evidencing the investment decisions of the portfolio manager or an attorney or compliance officer who evaluates whether an investment is permitted under a [Private] Fund’s governing documents).”

Knowledgeable Employee Status from Managing Separate Accounts.  The Guidance provides that an employee of an Investment Manager may qualify as a knowledgeable employee under Rule 3(c)‑5(a)(4)(ii) on the basis of participation in “the investment activities of separate accounts (or a portfolio (or portion thereof) of a separate account) for clients that are ‘qualified clients’ [as defined in Rule 205-3 under the Investment Advisers Act of 1940] and are otherwise eligible to invest in the private funds advised by the [Investment Manager] and whose accounts pursue investment objectives and strategies that are substantially similar to those pursued by one or more of those private funds.”  The Staff had previously provided guidance in the PPM America Letter that an employee of an Investment Manager could also be a knowledgeable employee on the basis of participating in the investment activities of a pooled investment vehicle that is excluded from the definition of investment company by Section 3(c)(2), 3(c)(3), or 3(c)(11) of the 1940 Act.

Employees of Filing and Relying Advisers

The Guidance provides that if a filing adviser and its relying adviser(s) (as defined below) collectively conduct a single advisory business and otherwise meet the conditions of American Bar Association, Business Law Section, SEC No-Action Letter (pub. avail. Jan. 18, 2012) (the “ABA Form ADV Letter”), then a knowledgeable employee of the filing adviser or any of its relying advisers that otherwise meets the applicable conditions may be treated as a knowledgeable employee with respect to any Private Fund managed by the filing adviser or any relying adviser.  As discussed in the January 24, 2012 Financial Services Alert, the ABA Form ADV Letter permits an adviser (the “filing adviser”) to file a single Form ADV for itself and each other adviser that it controls or is under common control with (each such other adviser being a “relying adviser”) when, among other things, the filing and relying advisers (1) individually are eligible for federal investment adviser registration and (2) collectively conduct a single advisory business.

Knowledgeable Employee Determinations – Recordkeeping

The Guidance instructs investment managers to “maintain in their books and records a written record of employees the investment manager has permitted to invest in a [Private] Fund as knowledgeable employees and should be able to explain the basis in the rule pursuant to which the employee qualifies as a knowledgeable employee.” 

Managed Funds Association, SEC No-Action Letter (pub. avail. Feb. 6, 2014).

SEC Staff Provides Guidance on Unbundling Proxy Proposals to Amend Fund Charters

The staff of the SEC’s Division of Investment Management issued a Guidance Update discussing its position that a single proxy proposal to amend an investment company charter must be “unbundled” to provide a separate vote for each proposed material amendment contained in the proposal.  Cautioning that there is no bright line test for materiality, the Guidance Update instructs funds to consider whether “a given matter substantively affects shareholder rights”  in determining materiality.  The Guidance Update provides the following provides examples of proposals the staff has commented should be presented separately:

  • amend voting rights from one vote per share to one vote per dollar of net asset value;
  • authorize a fund to involuntarily redeem small account balances;
  • authorize a fund to invest in other investment companies;
  • change supermajority voting requirements;
  • authorize the board to terminate a fund or merge with another fund without a shareholder vote; and
  • authorize the board to make future amendments to the charter without a shareholder vote.

The Guidance Update notes that (a) a soliciting party is not prohibited from conditioning a proposal on the adoption of other proposals if permitted by state law and (b) the staff has not objected to “bundling” proxy proposals that are ministerial in nature (e.g., proposals involving editorial or non-substantive changes to fund documents) or otherwise immaterial with a single material matter.

SEC Examination Staff Launches Never-Before Examined Adviser Initiative

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) sent a letter to advisers that have not yet been examined by the SEC as part of an initiative to examine a significant percentage of them, with a focus on those that have been registered with the SEC for three or more years.  This initiative, which excludes advisers subject to the Presence Exam initiative for newly registered private fund advisers, is an element of the National Examination Program’s 2014 priorities, which were described in the January 21, 2014 Financial Services Alert.  The press release announcing the initiative notes that starting later this year, OCIE will invite SEC-registered investment advisers who have yet to be examined to attend regional meetings where they can learn more about the examination process. 

FinCEN Issues Guidance for Financial Institutions Seeking to Provide Services to Marijuana-Related Businesses

The Financial Crimes Enforcement Network (“FinCEN”) issued guidance (the “Guidance”) to clarify FinCEN’s expectations as to how financial institutions (“FIs” and each an “FI”) will meet their compliance requirements under the Bank Secrecy Act (the “BSA”) when FIs seek to provide services to marijuana-related businesses (“M-R Businesses”).  FinCEN issued the Guidance in light of actions by 20 states and the District of Columbia to legalize certain marijuana-related activities and related guidance by the U.S. Department of Justice (“DOJ”) concerning its marijuana-related enforcement priorities.

Federal Law and the Cole Memo Priorities

The Federal Controlled Substances Act (“CSA”) prohibits the manufacture, distribution or dispensing of marijuana.  As mentioned above, however, 20 states and the District of Columbia have recently legalized certain marijuana-related activities.  To address these developments, the DOJ issued a memorandum (the “Cole Memo”) to all United States attorneys providing guidance to Federal prosecutors concerning marijuana activity enforcement under the CSA.  The Cole Memo lists eight enforcement priorities:

  • Preventing the distribution of marijuana to minors;
  • Preventing revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels;
  • Preventing the diversion of marijuana from states where it is legal under state law in some form to other states;
  • Preventing state-authorized marijuana activity from being used as a cover or pretext for the trafficking of other illegal drugs or other illegal activity;
  • Preventing violence and the use of firearms in the cultivation and distribution of marijuana;
  • Preventing drugged driving and the exacerbation of other adverse public health consequences associated with marijuana use;
  • Preventing the growing of marijuana on public lands and the attendant public safety and environmental dangers posed by marijuana production on public lands; and
  • Preventing marijuana possession or use on federal property.

Providing Financial Services to M-R Businesses

In the Guidance, FinCEN states that an FI that is considering providing financial services to an M-R Business should assess the risks involved by conducting customer due diligence that includes: 

  1. verifying with the appropriate state authorities whether the business is duly licensed and registered;
  2. reviewing the license application (and related documentation) submitted by the business for obtaining a state license to operate its M-R Business;
  3. requesting from state licensing and enforcement authorities available information about the M-R Business and related parties;
  4. developing an understanding of the normal and expected activity for the M-R Business, including the types of products to be sold and the type of customers to be served (e.g., medical versus recreational customers);
  5. ongoing monitoring of publicly available sources for adverse information about the M-R Business and related parties;
  6. ongoing monitoring for suspicious activity, including for any of the red flags described in this Guidance; and
  7. refreshing information obtained as part of customer due diligence on a periodic basis and commensurate with the risk.

In addition, as part of its customer due diligence an FI should consider whether the activities of the M-R Business violate state law or implicate one of the priorities listed in the Cole Memo.

Filing of Suspicious Activities Reports on M-R Businesses

In the Guidance, FinCEN next discusses an FI’s obligation to file a suspicious activity report (“SAR”) under the BSA in connection with the FI’s provision of financial services to an M-R Business.  Because Federal law prohibits the sale and distribution of marijuana, an FI is required to file a SAR in connection with providing financial services to an M-R Business (even if the M-R Business is duly licensed under state law).  To make SAR filings related to M-R Businesses most useful to enforcement authorities, the Guidance instructs an FI to consider the facts and circumstances of the M-R Business and indicate in the FI’s filing whether the filing is a “Marijuana Limited,” “Marijuana Priority” or “Marijuana Termination” SAR filing.  The simplest SAR related to an M-R Business is a “Marijuana Limited” filing, which should be filed if the FI does not believe that the M-R Business is violating state law or any of the Cole Memo priorities.  Where an FI believes that, based upon its customer due diligence, the applicable M-R Business may be violating state law or that the M-R Business’s activities may implicate one or more of the Cole Memo priorities, the FI is instructed by FinCEN to file a “Marijuana Priority” SAR.  In the event the FI has determined to terminate its relationship with an M-R Business, the Guidance instructs the FI to file a “Marijuana Termination” SAR, which should set forth the FI’s basis for terminating the relationship.  Next, the Guidance provides an extensive list of “red flags” that are intended to help an FI to assess whether a SAR filing related to an M-R Business should be filed as a “Marijuana Priority” SAR.

Currency Transaction Reports

The Guidance confirms that FIs must report currency transactions related to M-R Businesses in the same manner as they would report them for any other business.  Accordingly, for example, an FI “would need to file [Currency Transaction Reports] on the receipt or withdrawal by any person of more than $10,000 in cash per day.”  FinCEN also notes in the Guidance that M-R Businesses are not eligible for an exemption under the BSA currency transaction reporting requirements.


While FinCEN has provided useful information to FIs in the Guidance regarding reporting requirements and FinCEN’s expectations as to how an FI will conduct customer due diligence of a potential M-R Business client, the manufacture, distribution or dispensing of marijuana remains an illegal activity under Federal law, and bank regulators are highly likely to review transactions with M-R Businesses with a high level of scrutiny and some skepticism.  We expect that, although some mid-sized or smaller banks will begin to make loans to M-R Businesses, most FIs will decide that the current risks and costs of doing business with M-R Businesses exceed the likely rewards and will refrain from doing business with M-R Businesses unless or until Congress takes action to legalize transactions with M-R Businesses under Federal law.

Goodwin Procter Alert: OFAC Issues New Foreign Sanctions Evaders List

Goodwin Procter Alert from the firm’s National Security & Foreign Trade Regulation Practice discusses the new Foreign Sanctions Evaders List (“FSE List”) from the Office of Foreign Assets Control (OFAC), that U.S. companies and others should consult when engaging in cross-border transactions.

FINRA Fines Firm and Former AML Compliance Officer For Failures to Comply with Anti-Money Laundering Obligations

On February 4, 2014, the Financial Industry Regulatory Authority, Inc. (“FINRA”) accepted a Letter of Acceptance, Waiver and Consent (the “AWC”) from a member firm (the “Firm”) and its former anti-money laundering (“AML”) compliance officer (the “AML Compliance Officer”) regarding alleged failures to comply with FINRA’s AML rule.  FINRA found that from January 1, 2009 through June 30, 2013 (the “Relevant Period”) the Firm and the AML Compliance Officer failed to have an adequate AML program in place to monitor and detect suspicious activity in low-priced securities (“penny stocks”).  FINRA also found that the Firm failed to (i) sufficiently investigate potentially suspicious penny stock activity, (ii) establish an adequate supervisory system to prevent the distribution of unregistered securities and (iii) conduct adequate AML testing and training.  This article summarizes FINRA’s findings, which the Firm and the AML Compliance Officer neither admitted nor denied in connection with executing the AWC.


The Firm’s primary business is as a custodian bank.  The Firm operates pursuant to an exclusion from broker-dealer registration but was a member of the New York Stock Exchange and became a FINRA member in 2008. 

FINRA Rule 3310 requires member firms to develop and implement a written AML program reasonably designed to achieve and monitor the member’s compliance with the requirements of the Bank Secrecy Act (the “BSA”) and the regulations thereunder.  This Rule also requires that AML programs include, at a minimum, (i) policies and procedures that can be reasonably expected to detect and cause the reporting of transactions required under the BSA, (ii) policies, procedures and internal controls reasonably designed to achieve compliance with the BSA and the regulations thereunder, (iii) annual testing for compliance, (iv) designation of an individual or individuals responsible for overseeing the AML program and (v) ongoing training for appropriate personnel.  In addition, the BSA obligates financial institutions, such as the Firm, to investigate customer activity on a risk basis.

During the Relevant Period, the Firm directly executed sales or, as custodian, delivered the securities underlying the sale of at least six billion shares of penny stocks.  In addition, the Firm conducted penny stock transactions on behalf of certain customers in known bank secrecy havens.  FINRA asserted that omnibus accounts transacting in higher-risk activities, such as suspicious penny stock transactions, merited additional scrutiny, particularly such transactions that involved customers in known bank secrecy havens.

The Violations

Set forth below is a summary of FINRA’s findings with respect to the specific violations:

  • Failure to Establish and Implement AML Policies and Procedures.  FINRA found that, during the Relevant Period, the Firm and the AML Compliance Officer violated FINRA Rule 3310(a)(and its predecessor, NASD Conduct Rule 3011(a)) and FINRA Rule 2010 by failing to establish and implement policies and procedures that were reasonably designed to detect and cause the reporting of potentially suspicious activity.  Specifically, FINRA found that the Firm’s AML program failed to adequately monitor and detect, and sufficiently investigate, potentially suspicious penny stock activities and transactions that were brought to the Firm’s attention.  Although the Firm had a compliance program that included suspicious activity surveillance, FINRA also found that the Firm and the AML Compliance Officer failed to establish an adequate surveillance system to review penny stock transactions conducted through the Firm and to tailor the Firm’s AML procedures to adequately detect, investigate and report suspicious activity, particularly patterns of suspicious penny stock activity, or red flags related to penny stock transactions.  In making these findings, FINRA asserted that the Firm and the AML Compliance Officer were aware of the heightened risks associated with penny stock activity and the Firm’s severely limited ability, when it was dealing with financial institutions in bank secrecy havens, to obtain information about beneficial owners of those stocks or the circumstances under which the shares were acquired.  In addition, the Firm failed to meet its SAR reporting and updating requirements.
  • Failure to Adequately Supervise Activity in Foreign Financial Institution Accounts.  FINRA found that, during the Relevant Period, the Firm violated FINRA Rule 3310(b) and FINRA Rule 2010 by failing to establish and implement policies, procedures and internal controls reasonably designed to achieve compliance with the BSA, which, among other things, requires all financial institutions to conduct risk-based due diligence on correspondent accounts for foreign financial institution customers (“FFIs”).  Specifically, FINRA found that the Firm did not adequately conduct periodic activity reviews of the accounts for FFIs to determine whether securities activity was consistent with the information provided by the account holder at the account’s inception, including the type, purpose and anticipated activity, and whether accounts were being used for higher risk activity than originally forecast by the customer.
  • Failure to Conduct Adequate AML Testing.  FINRA found that, during the Relevant Period, the Firm failed to conduct adequate AML testing.  FINRA Rule 3310(c) requires member firms to arrange independent testing for compliance with its AML program.  Although the Firm conducted such tests, FINRA found that the tests failed to address the primary risks associated with the Firm’s brokerage business involving penny stocks, including the identification of any of the shortcomings in the trade monitoring and asset movement monitoring related to penny stocks.  FINRA also found that, during certain years of the Relevant Period, the tests failed to address penny stock activity despite such activity involving high risk transactions for the Firm’s customers.
  • Failure to Conduct Adequate AML Training.  FINRA found that, during the Relevant Period, the Firm failed to conduct adequate AML training.  FINRA Rule 3310(e) requires that member firms provide ongoing training for appropriate personnel.  FINRA found that the Firm failed to adequately train its AML staff to understand the purpose of alerts relating to penny stock activity generated by the Firm’s automated AML surveillance systems and to understand the risks involved with penny stock activity, noting the Firm did not provide its AML staff with adequate materials regarding the risks and red flags associated with penny stock activity or adequate training for AML staff on how to accurately review and detect suspicious activity related to penny stocks.
  • Failure to Establish, Maintain and Enforce a Supervisory System to Achieve Compliance with Section 5 of the Securities Act of 1933. FINRA found that the Firm violated NASD Conduct Rule 3010 by failing to establish, maintain and enforce a supervisory system that is reasonably designed to achieve compliance with applicable securities laws and regulations and NASD Rules.  In connection with the sale of a security, Section 5 of the Securities Act of 1933 requires that a registration statement be in effect for such security or the security be exempt from registration.  FINRA found that the Firm was aware that customers were depositing and selling large blocks of penny stocks and, contrary to its obligations under NASD Conduct Rule 3010 and FINRA regulatory guidance, failed to ensure that adequate supervisory reviews were performed to determine whether the securities sold were registered or being sold subject to an exemption.  Specifically, FINRA found that the Firm failed, prior to the sale of penny stocks, to take appropriate steps to conduct a searching inquiry in two situations.  First, in connection with the sale of securities deposited without a Rule 144 restrictive legend, the procedures failed to instruct Firm employees to inquire, in the face of red flags, as to whether the penny stocks were actually subject to a restriction.  FINRA cited examples of customer transactions involving the deposit and immediate sale of large blocks of securities and news sources indicating that such securities were subjects of “pump and dump” schemes.  Second, in connection with the sale of securities deposited with a restrictive legend, the Firm failed to establish and implement adequate written supervisory procedures to fulfill its obligations to conduct a searching inquiry to determine whether the securities were eligible for immediate resale to the public.  According to FINRA, the Firm primarily relied on attorneys and transfer agents selected by the penny stock issuer to lift the restrictive legends, in direct contravention of regulatory guidance.


The Firm consented to a censure and a fine of $8 million.  The AML Compliance Officer consented to a one-month suspension from association with any FINRA member in any capacity and a fine in the amount of $25,000.

Corrective Actions

In addition to consenting to a censure and a fine of $8 million, the Firm took certain corrective actions, which included ceasing sales of penny stocks, conducting an internal audit review of trade surveillance, enhancing employee training and periodic reviews of certain accounts and adopting additional policies and procedures to enhance compliance with its obligations under Section 5 of the 1933 Act.  Based on a strategic business review, the Firm stated in an accompanying Corrective Action Statement that it had decided to close its equity brokerage business effective June 2014, which the Firm asserted would eliminate the risks associated with executing transactions in penny stocks.