In a very rare event, the SEC alleged that the CCO of Cadaret Grant was responsible for the firm’s failure to supervise the recommendation and sale of the product.
The SEC alleged that while Cadaret Grant maintained policies that stated it would provide training to registered representatives concerning these types of products, the firm never provided any training.
In addition, the firm’s policies prohibited long-term investment in these types of products, but failed to enforce them. It is important to note that the SEC alleged that Cadaret Grant did not allocate sufficient resources to compliance and supervision.
During the relevant period, Cadaret Grant amended its policies to require that representatives recommending these types of leveraged products participate in telephone conferences with a principal to discuss the products, receive training and document the holding period of the products to ensure that they did not violate the product’s prospectus.
However, Cadaret Grant failed to enforce the training or the holding period requirements of these enhanced policies. Eventually, Cadaret Grant prohibited the purchase of these products altogether and failed to enforce that policy as well.
What Should Firms Be Considering?
In light of this recent enforcement action (and the emphasis on these issues during examinations), CCOs, broker-dealers and investment advisers should all be considering these supervisory issues.
Below is a high level issues list for these key stakeholders to consider as they revisit their policies and procedures. We don’t claim that this is an exhaustive list and stakeholders should consider their specific facts and circumstances.
Initial Decision to Permit or Prohibit Recommendations and Sales
- Firms should develop policies that are appropriately tailored to their business. Firms should consider outright prohibitions of these products, unless they are prepared to supervise their recommendation and sale.
- If a firm will permit its representatives to recommend exchange-traded products, then it must develop policies and procedures to supervise these activities. Many of these policies may track policies and procedures that firms already have in place for conducting due diligence on other investments.
Policies and Procedures
- Which individuals or group of individuals will conduct the initial due diligence of the investment(s)? For example, will it be investment analysts, an investment committee or a third-party due diligence provider?
- Will the firm’s due diligence involve testing to determine how it will perform under various market conditions? What will be the firm’s testing methodology? If testing will not be performed, which steps will the firm take to verify how the product will perform under various market conditions?
- What is the approval process for approving a specific type of product and the specific product in question? (e.g., unanimous approval of the investment committee and management committee)
- Who will be responsible for ongoing due diligence of these products and at what frequency?
- Who is permitted to recommend and select the approved investment? Are any specific licenses required?
- Will the firm require specific training prior to permitting a representative to recommend or select an investment? Who will be responsible for verifying that training has been completed prior to participation?
- Are there requirements for a client to be eligible to purchase the product in question? Who is responsible for making these determinations?
- Are there thresholds on the amount of the product the representative can recommend or purchase, in terms of dollars or percentage allocation of a client portfolio?
- What are the holding period limitations of the product in question and who is responsible for monitoring them?
- Will the firm institute any policies or procedures relating to disclosure about the product to customers or clients?
- Will the firm require any representations from clients prior to investing in the product?
- Does the firm have computer software or technology that can identify or “flag” instances where specific products are being recommended or selected by representatives?
- Consider blocking investment into securities with day-long or similarly short holding periods unless exceptions are provided.
- If representatives are allowed to conduct their own due diligence on an entire universe of investments, consider limiting that universe through centralized due diligence. Also consider identifying holding periods for representatives so that they are readily familiar with the holding period for complex products.
- Consider procedures to supervise any approved investing in products that have day-long holding periods. What procedures will ensure that positions are closed by the end of the day or that reasonable explanations are provided for positions that extend over multiple days.
- Consider requiring representatives to establish proof that they understand the specific product in question and its prospectus.
Max Schatzow is an Associate at Stark & Stark’s Princeton, New Jersey, office and a member of the firm’s Investment Management & Securities practice. He regularly counsels financial service entities including investment advisors, broker-dealers and private investment companies on registration, compliance, liability and litigation issues.