SEC Files Another Action Centered on Trading in Opaque Markets

The Commission filed another action centered misrepresentations made in opaque trading markets for mortgage backed securities. Unlike its earlier actions in this area, however, the case settled simultaneous with filing. In the Matter of Deutsche Bank Securities Inc., Adm. Proc. File No. 3-18367 (Feb. 12, 2018).

The action is based on the trading of commercial mortgage backed securities from 2011 to 2015 by the registered broker-dealer and the head of its trading desk for those securities, Benjamin Solomon. During the time period the firm traded CMBS in the secondary market. Frequently the purchase and sale of the securities took place within minutes or hours. Little risk was involved for Deutsche Bank. Since the market for the securities “is opaque and lacks easily accessible information on the prices at which CMBS trade, the broker-dealer arranging the sale of CMBS often provides information about the current market price of the bond,” according to the Order.

During the relevant period certain salespeople made false and misleading statements, often in coordination, while negotiating with customers. In many instances the misrepresentations were made through electronic chats or were captured on Bloomberg chats. Examples of the misrepresentations are cited in the Order. Those include instances where during negotiations over the price the firm sales person or trader misrepresented the price paid for the security in order to induce the customer to make a purchase at a specific price. In other instances where there were negotiations regarding the sale of a bond, the sales person would falsely claim to be negotiating its acquisition from a counter party and a certain price.

In several instances when Mr. Solomon was supervising the trading desk he learned of, or participated in, misstatements to customers of the bank involving the CMBS traders. Again, the Order quotes electronic messages showing that the traders involved misrepresented pricing information to customers in order to induce a transaction. Based on this conduct the Order alleges that those involved violated Securities Act Section 17(a) and Exchange Act Section 10(b).

During the period Deutsch Bank had policies and procedures which required clear and fair communications with customers. That requirement was also reflected in the firm’s code of business conduct. Nevertheless, the Bank failed to reasonably implement the policies. The compliance and surveillance procedures and systems were not reasonably designed to prevent and detect CMBS Desk traders and salespeople making false representations during trade negotiations, according to the Order.

The surveillance efforts were also not effectively implemented since they used generic price deviation thresholds in monitoring trades to flag potentially suspicious transactions rather than tailoring the procedures to specific types of securities. Accordingly, the supervisory systems and procedures were not reasonably designed or implemented to prevent and detect the kind of misrepresentations involved here.

In resolving the matter Deutsch Bank cooperated with the Commission’s investigation and undertook remedial actions. The bank implemented improved procedures and conducted an internal investigation. The firm also agreed to certain undertakings which included making payments to certain customers totaling $3,727,743 – the amount of profit made by the bank.

In resolving the action the firm agreed to the entry of a censure, to pay disgorgement of $1,476,245, prejudgment interest of $123,741 and a penalty of $750,000. Mr. Solomon will be suspended from the securities business for a period of 12 months and pay a penalty of $165,000.

This is not the first case centered on trading mortgaged backed securities in opaque markets. Previously, the U.S. Attorney’s Office and the SEC initiated similar actions. See, e.g. U.S. v Litvak, No. 13-cr-00019 (D. Conn. Jan. 25, 2013); U.S. v. Shapiro, 15 cr 00115 (D. Conn. Sept. 3, 2015); SEC v. Shapiro, Civil Action No. 15-cv-07045 (S.D.N.Y. Sept. 8, 2015); SEC v. Im, Civil Action No. 1:160 cv 00313 (S.D.N.Y. May 17, 2017). Each of these cases centered on trading a specific type of mortgage backed securities. In each the traders made false statements similar to those made by the salespeople at Deutsche Bank. The criminal cases generally resulted in not guilty verdicts, although in each the jury did return a guilty verdict on at least one count. The Commission cases are in litigation. The defense presented in each generally focused on claims that the misrepresentations were not material to the traders because of the nature of the markets as discussed in here. While the U.S. Attorney’s Office appears to have stopped filing criminal cases, as the Deutsche Bank proceeding illustrates, the Commission has persisted.

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SEC Announces New Cooperation Initiative for Advisers

The SEC’s Division of Enforcement announced a new cooperation initiative addressed to investment advisers who have failed to disclose conflicts arising from the receipt of 12b-1 fees from mutual funds. In essence, the initiative offers advisers who failed to make the proper disclosures significant incentives to self-report, repay investors and resolve the issues in a manner which is reminiscent of Division’s very successful outreach to those involved with municipal offerings – the Municipalities Continuing Disclosure Cooperation Initiative or MCDCI through which 85 firms self-reported in 2016. See Share Class Selection Disclosure Initiative (Feb. 12, 2018).

The Share Class Selection Disclosure Initiative or SCSDI seeks to build on a series of six enforcement actions brought by the Commission in which investment advisers who are also registered broker-dealers, or who worked in conjunction with an affiliated broker-dealer, failed to disclose that they were being paid 12b-1 fees by a mutual fund. Investors were then put into fund shares that were more expensive than others available that did not carry the fees. As the SCDI announcement emphasizes, the actions on which it is based made it clear that disclosure which states there “may” be fees and there “may” be conflicts when there are both are not sufficient – the fees and conflict must be fully disclosed.

The SCSDI, consistent with the Division’s retail investor focus, seeks to leverage the resources of the Enforcement Division by essentially resolving the cases based on self-reporting and using a standard set of terms without conducting the usual investigation. The terms detailed in the announcement (and reflected in a form attached which can be used for self-reporting) are:

Self-report: The adviser must self-report and fully disclose the conduct;

Deadlines: The adviser must make the report on or before June 12, 2018;

Standard terms: The adviser must agree to the standard terms which include: a cease and desist order based on Advisers Act sections 206(2) and 207; paying disgorgement and prejudgment interest to clients involved; agreeing to implement a series of undertakings which include correcting all disclosure documents, moving clients to the lower cost shares, updating the pertinent policies and procedures and notifying clients; and certifying compliance to the Commission; and

No penalty: In return the Commission will agree not to recommend a penalty.

There is no assurance that any associated individuals or other entities involved will not be charted. OCIE will also continue to focus on the question of conflicts and share selection in its inspections, according to the announcement. Any advisers discovered who chose not to participate in the initiative may be named in an enforcement action in which the sanctions will likely be more severe than under the SCSDI.

The Initiative can be a win-win for the Enforcement Division and the advisers involved. For the advisers it avoids the burdens and costs of an enforcement investigation and insures a guaranteed result which is less severe than what might be expected absent the Initiative. For the SEC it offers the resolution of what could be a series of cases – the MCDCI resulted in 85 self-reporting firms – without the time and expense of an enforcement investigation. Stated differently, it is an effective way to leverage scarce resources and focus on retail investors – two key goals of the program announced by Enforcement in November 2017.

While the proposal is creative, and may prove to be very effective, there is one caveat – the individuals and perhaps affiliated entities involved. By self-reporting the conduct, advisers will be detailing facts that undoubtedly involves individuals and perhaps affiliated entities. As the Initiative makes clear, it does not apply to those individuals and entities. What the adviser gains – certainty and no penalty — could become significant sanctions for individuals at the advisory and/or an affiliate. This is particularly true given the focus on holding individuals accountable.

Finally, while naming individuals and other entities would be inconsistent with five of the cases cited in the announcement on which the initiative is built, one case cited in the announcement did in fact name an individual and another entity as Respondents. Accordingly, naming individuals or entities other than the self-reporting adviser in an enforcement action would be consistent with the Initiative’s terms and past practice. This potential may undercut the effectiveness of what could otherwise be a very effective initiative.

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