April and MTD May 2021 Financial Services Regulatory Developments

May 27, 2021

April and MTD May 2021 Financial Services Regulatory Developments

Below are summaries of April and month-to-date May 2021 regulatory developments that may be of interest to investment advisers, broker-dealers and other securities market participants.

SEC Staffing Changes

Gary Gensler becomes new SEC Chair on April 17 and appoints initial senior staff members a few days later. Corporate lawyer Alex Oh is named Director of Enforcement on April 22 and resigns on April 28. The SEC announces a new Chief Economist and DERA Director, along with senior departures at its Whistleblower and Chicago Regional offices.

New Chair. On April 14, the US Senate confirmed Gary Gensler as Chair of the SEC by a vote of 53-45. The vote was largely along party lines, with only three Republican senators voting for Mr. Gensler’s confirmation: Susan Collins (R-ME), Chuck Grassley (R-IA) and newly-elected Cynthia Lummis (R-WY).

Mr. Gensler was sworn in as SEC Chair on April 17. On April 19, Chair Gensler named the following individuals to senior SEC staff positions: Prashant Yerramalli (Chief of Staff), Heather Slavin Corzo (Policy Director), Kevin R. Burris (Counselor to Chair, Director of Office of Legislative and Intergovernmental Affairs), Scott E. Schneider (Counselor to Chair, Director of Office of Public Affairs).[i]

Division of Enforcement. On April 22, the SEC announced the appointment of Paul Weiss partner Alex Oh as Director of the SEC’s Division of Enforcement.[ii] On April 28, the SEC announced Ms. Oh had resigned and that Melissa Hodgman, who served as the Division’s Acting Director from January through April 2021, would return as Acting Director.[iii]

DERA. On May 3, the SEC announced that Jessica Wachter, an academic researcher on financial markets, had been appointed the SEC’s Chief Economist and Director of the SEC’s Division of Economic and Risk Analysis (DERA). Dr. Wachter previously was a professor at the University of Pennsylvania’s Wharton School.[iv]

Chicago Office. On April 16, the SEC announced that Joel R. Levin, the Director of the SEC’s Chicago Regional Office since May 2018, would leave the agency at the end of May. The Chicago Regional Office oversees a nine-state region and is the SEC’s second-largest regional office.[v]

Whistleblower Office. On April 8, the SEC announced that Jane Norberg, Chief of the SEC’s Office of the Whistleblower, was leaving the agency. Ms. Norberg oversaw dramatic growth in the number of awards issued under the SEC’s whistleblower program since becoming Chief in 2016.[vi]

SEC Congressional Testimony

SEC Chair Gensler testifies at a House Financial Services Committee hearing on January market events involving GameStop and certain other stocks. He expects the SEC to publish a report this summer assessing the events, and says the SEC may need to “freshen up” its rule set.

On May 6, SEC Chair Gensler testified at the House Financial Services Committee’s third hearing on the January market events involving GameStop and other so-called meme stocks. His prepared statement to the Committee is at www.sec.gov/news/testimony/gensler-testimony-20210505.[vii]

The January events involved extreme price volatility in GameStop and other heavily-shorted stocks that were avidly discussed on social media, including in Reddit’s WallStreetBets forum. GameStop’s stock went from about $20 per share in early January to over $400 a few weeks later, causing big losses for hedge funds with short positions. The volatility also led the DTCC clearinghouse to require online broker Robinhood and other brokers to post significant additional margin as collateral to secure trade settlement obligations on behalf of clients (DTCC margin requirements for a broker increase along with the volatility of the stocks its clients trade).

In response, Robinhood and some other brokers temporarily prohibited clients from buying GameStop and other volatile stocks in an effort to limit their DTCC margin obligations. Robinhood reportedly also drew on its line of credit and raised more than $1 billion from its investors so it could continue operating.[viii]

In his testimony, Chair Gensler said the SEC expects to publish a report this summer assessing January’s events, which he said the SEC staff is “vigorously reviewing” for any violations. He also said he had directed the staff to consider whether “expanded enforcement mechanisms” are needed, and that he had assigned them the following tasks to assist the SEC in determining appropriate actions, if any, to take in light of these events:

Gamification and User Experience. Prepare request for public input on online trading mobile app features, such as gamification and behavioral prompts, that seek to increase engagement and that may also encourage investors to trade more.
Wholesaler Concentration. Review issues raised by small number of off-exchange wholesalers executing a large proportion of retail equity trade orders. These include potential limiting effects on competition, innovation and execution quality, and a possible increase in market fragility.
Short Selling, Stock Loans and Security-Based Swaps. Prepare recommendations to increase the transparency of short selling and stock loans, and (in light of the recent Archegos family office debacle) consider recommending new disclosure requirements for securities-based swaps.
Broker-Dealers (BDs). Review (i) adequacy of BD disclosures on potential trading restrictions, (ii) sufficiency of clearinghouse (e.g., DTCC) margin and other BD payment requirements, and (iii) whether BDs have appropriate tools to manage their liquidity and risk.
Trade Settlement. Prepare a draft proposal to shorten the current T+2 trade settlement cycle, which could reduce market risks and costs, including clearinghouse margin requirements.

Chair Gensler also discussed payment for order flow, questioning whether it incentivizes brokers to encourage customers to trade more frequently than is in their best interest and noting that Canada and the United Kingdom do not permit the practice.

Registered Funds & Bitcoin Futures

The SEC staff issues a statement on registered fund investments in Bitcoin futures, saying that it will monitor mutual fund investments in Bitcoin futures.

On May 11, the SEC’s Division of Investment Management issued a statement seemingly relaxing a position it took in 2018 on registered fund investments in cryptocurrency and related products.[ix] In 2018, shortly after the start of Bitcoin futures trading on the CFTC-regulated CME, the Division issued a letter warning firms not to seek to launch funds that could “invest substantially” in cryptocurrencies or related products until key compliance questions in the following areas were satisfactorily addressed: valuation, liquidity, custody, arbitrage (for ETFs), and potential manipulation and other risks.[x]

The Division’s May 11 statement doesn’t repeat or explicitly mention this warning, but instead notes the public input the Division received in response to that letter and acknowledges the development of the cash-settled Bitcoin futures market at the CME, noting that it has consistently produced a reportable price for Bitcoin futures.[xi] The May 11 statement, which cautions investors that Bitcoin futures are highly speculative, acknowledges that some mutual funds are now investing, or pursuing investment, in Bitcoin futures, believing this can be done consistent with applicable 1940 Act requirements.

For mutual funds, the May 11 statement substitutes a we’ll-be-watching approach for the 2018 letter’s more strict do-not-proceed admonition, saying a top Division priority going forward will be to monitor, in consultation with the SEC’s Division of Examinations, the compliance of mutual funds that invest in Bitcoin futures. The Division also says it will conduct ongoing analysis of liquidity and valuation issues and assess the ongoing impact of potential manipulation or fraud in underlying Bitcoin markets.

ETFs. The Division of Investment Management’s new, seemingly more permissive approach does not (yet?) extend to ETFs. The May 11 statement says the Division will consider, in light of mutual funds’ experience in the Bitcoin futures market, whether this market can also accommodate ETFs, noting that an ETF (unlike a mutual fund) cannot prevent asset inflows if it becomes too large or dominant in the market.

Also, on April 28, the SEC extended until June 17 a soon-to-expire deadline for its decision on a pending new Bitcoin ETF that would hold actual Bitcoin (not futures), saying it needed more time to consider the matter.[xii]

Closed-End Funds. The May 11 statement acknowledges that closed-end funds, which do not have daily redeemability, do not have the same liquidity challenges as mutual funds and encourages any closed-end fund that seeks to invest in Bitcoin futures to consult with Division of Investment Management staff about related compliance and investor protection issues before filing a registration statement.

Enforcement Wrap-Up

SEC enforcement activity in April and May covered a wide range of topics, including mutual fund share class selection, broker-dealer SAR filings, private fund related conflicts of interest, Ponzi-like fraud, index discloures and public company reporting.

In April and month-to-date May, the SEC Division of Enforcement continued to target securities-related violations in a variety of areas, including by taking action with respect to the following matters:

Mutual Fund Share Classes. On April 15, the SEC settled a proceeding against an investment adviser for recommending and purchasing mutual fund share classes that were not the lowest-cost share classes available to its clients, while a broker-dealer affiliate and certain of the adviser’s personnel received 12b-1 fee revenue from these higher-cost investments. The SEC found the adviser breached its fiduciary duty by failing to adequately disclose the conflict of interest involved and by failing to seek best execution, and also violated Advisers Act Rule 206(4)-7 by failing to adopt and implement adequate written compliance policies relating to share class selection practices. The SEC imposed a $150,000 penalty and ordered the firm to pay disgorgement and interest of $825,058 to clients.[xiii]
Suspicious Activity Reports (SARs). On May 12, the SEC imposed a $1.5 million penalty on a broker-dealer for failing to file approximately 130 SARs, and also for making nearly 300 SARs filings that did not include required “who, what, when, where, and why” narrative information the broker-dealer had regarding the underlying, plan participant account takeover incidents. This matter highlights the importance of broker-dealer compliance with 1934 Act/BSA SARs filing requirements.[xiv]
Private Fund Conflicts of Interest. On May 10, the SEC settled a proceeding against an individual who, as a control person of an investment adviser, invested client assets in a private fund without disclosing multiple conflicts of interest associated with business relationships the adviser had and sought with the fund’s affiliates and with the platform through which the fund was offered. The SEC’s order in this matter imposes a $75,000 penalty, a censure and a cease-and-desist order, and includes a damning excerpt from an e-mail the individual sent regarding one of the conflicts.[xv]
Loan Fraud Scheme. On April 13, a former investment adviser executive pled guilty to criminal charges he committed securities fraud, wire fraud and other Ponzi-like crimes by overstating the value of loans held by a hedge fund his former firm managed, replacing such loans with “fake loans”, and selling the overvalued and fake loans to other clients in order to generate liquidity to pay off earlier fund investors in a Ponzi-like manner. Later in April, the former executive consented to a permanent SEC injunction and an SEC order barring him from the industry.[xvi]
1933 Act Liability for Undisclosed Index Feature. On May 17, the SEC imposed a $9 million penalty on a securities index provider, finding it violated Section 17(a)(3) of the 1933 Act by failing to disclose a feature of an index it provided to another firm for use in determining the value of a volatility-related inverse ETN the other firm offered and sold to its clients.[xvii] The feature was an “Auto Hold” that reset and then froze the reported value of the index if (somewhat ironically) changes in the reported value exceeded certain volatility thresholds, thus indicating a potential error.

A steep stock market decline on February 5, 2018 triggered the feature, resetting and freezing the reported index value and causing the ETN to be erroneously overvalued at certain intervals between 4:00 pm and 5:08 pm. During this time, certain investors purchased the ETN. Also, the overvaluation prevented investors from realizing a valuation-based feature of the ETN had been triggered, enabling the ETN sponsor to call all outstanding ETNs at their actual value (which it did the next morning).

The SEC found the index provider’s nondisclosure of the index’s Auto Hold feature, combined with the time it took to restore reporting of the index’s market value on February 5, 2018, violated 1933 Act Section 17(a)(3), a negligence-based antifraud provision prohibiting any person, directly or indirectly, in the offer and sale of a security, from engaging in a transaction, practice, or course of conduct which operates as a fraud or deceit upon a purchaser.

SEC Commissioner Peirce issued a statement saying she did not support this enforcement action and disagreed with its legal conclusion because, in her view, the index provider had not been sufficiently connected to the offer and sale of the ETN for Section 17(a)(3) to apply to its conduct.[xviii]

6. Public Company Disclosure Failures. On May 3, the SEC imposed a $9 million penalty on a public company for failing to disclose its earnings-management practice of pulling forward customer orders for its products (sports apparel and footwear) in order to meet quarterly revenue and revenue growth estimates, including the adverse effect this was likely to have on revenue in future quarters.[xix] The SEC found this conduct misled investors and violated 1933 Act Sections 17(a)(2) and 17(a)(3) and also 1934 Act Section 13(a) and various public company reporting rules under the 1934 Act.

[i] Gary Gensler Names Initial Senior Staff Members (Apr. 19, 2021), www.sec.gov/news/press-release/2021-68.

[ii] Alex Oh Named SEC Director of Enforcement (Apr. 22, 2021), www.sec.gov/news/press-release/2021-69.

[iii] Alex Oh Resigns from SEC; Melissa Hodgman Named Acting Director of Enforcement (Apr. 28, 2021), www.sec.gov/news/press-release/2021-75.

[iv] Jessica Wachter Named SEC Chief Economist and Director of the Division of Economic and Risk Analysis (May 3, 2021), www.sec.gov/news/press-release/2021-77.

[v] Joel R. Levin, Director of Chicago Regional Office, to Leave SEC (Apr. 16, 2021), www.sec.gov/news/press-release/2021-63.

[vi] Jane Norberg, Chief of the SEC’s Office of the Whistleblower, to Leave Agency (Apr. 8, 2021), www.sec.gov/news/press-release/2021-59.

[vii] Video of Chair Gensler’s testimony, including his responses to questions (hearing: “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Part III”), is at www.financialservices.house.gov/videos/.

[viii] New York Times, “Robinhood, in Need of Cash, Raises $1 Billion From Its Investors” (Updated Feb. 1, 2021), www.nytimes.com/2021/01/29/technology/robinhood-fundraising.html.

[ix] Staff Statement on Funds Registered Under the Investment Company Act Investing in the Bitcoin Futures Market (May 11, 2021), www.sec.gov/news/public-statement-investing-bitcoin-futures-market.

[x] Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings (Jan. 18, 2018), www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.

[xi] On May 3, the CME Group announced it was launching “Micro Bitcoin” futures contracts, which are much smaller in size (i.e., 1/10^th of 1 Bitcoin) than the 5-Bitcoin-sized futures contracts that have traded on the CME since December 2017. “CME Group Announces Launch of Micro Bitcoin Futures” (May 3, 2021), www.cmegroup.com/media-room/press-releases/2021/5/03/cme_group_announceslaunchofmicrobitcoinfutures.html.

[xii] Self-Regulatory Organizations; Cboe BZX Exchange, Inc.; Notice of Designation of a Longer Period for Commission Action on a Proposed Rule Change to List and Trade Shares of the VanEck Bitcoin Trust under BZX Rule 14.11(e)(4), Commodity-Based Trust Shares (April 28, 2021), www.sec.gov/rules/sro/cboebzx/2021/34-91695.pdf. On March 24, 2021, Fidelity filed an S-1 with the SEC to register a new ETF, the “Wise Origin Bitcoin Trust”, that also will hold actual Bitcoin if approved by the SEC, www.sec.gov/Archives/edgar/data/1852317/000119312521092598/d133565ds1.htm.

[xiii] Mason Investment Advisory Services, Inc. (Apr. 15, 2021), www.sec.gov/litigation/admin/2021/ia-5719.pdf.

[xiv] GWFS Equities, Inc. (May 12, 2021), www.sec.gov/litigation/admin/2021/34-91853.pdf.

[xv] Peter J. DeCaprio (May 10, 2021), www.sec.gov/litigation/admin/2021/ia-5732.pdf.

[xvi] SEC Charges IIG Co-Founder Martin Silver with Fraud (Apr. 15, 2021), www.sec.gov/litigation/litreleases/2021/Lr25070.htm; Martin Silver, CPA (Apr. 19, 2021), www.sec.gov/litigation/admin/2021/ia-5723.pdf.

[xvii] S&P Down Jones Indices LLC (May 17, 2021), www.sec.gov/litigation/admin/2021/33-10943.pdf.

[xviii] Statement on S&P Dow Jones Indices LLC (May 17, 2021), www.sec.gov/news/public-statement/peirce -statement-sp-dow-jones-indices-051721.

[xix] Under Armour, Inc. (May 3, 2021), www.sec.gov/litigation/admin/2021/33-10940.pdf.

NOTE: This report is dated May 18, 2021 (FS Spotlight #3) and is for general informational purposes only and is, or may be, attorney advertising. It is not intended as legal advice and should not be relied upon as such. The author believes statements of fact in the report are correct as of the report date, but this is not guaranteed and the author has no obligation to update or correct any statement. To save space and enhance readability, the report uses the following abbreviations: “1933 Act” is the Securities Act of 1933, as amended; “1934 Act” is the Securities Exchange Act of 1934, as amended; “1940 Act” is the Investment Company Act of 1940, as amended; “Advisers Act” is the Investment Advisers Act of 1940, as amended; “BSA” is the Bank Secrecy Act, as amended; “CCO” is Chief Compliance Officer; “CEA” is the Commodity Exchange Act of 1954, as amended; “CFTC” is the Commodity Futures Trading Commission; “CME” is the Chicago Mercantile Exchange; “ERISA” is the Employee Retirement Income Security Act of 1974, as amended; “ETF” is exchange-traded fund; “FINRA” is the Financial Industry Regulatory Authority; “NFA” is the National Futures Association; “OCC” is the Office of the Comptroller of the Currency; “OFAC” is the Office of Foreign Assets Control; “Reg. 9” is OCC Regulation 9; and “SEC” is the Securities and Exchange Commission.

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