Regulatory Roundup: Churning, RegBI and Victims of Financial Crime

We spend a lot of time focused on regulations and data, however, it is also important to recognize the human impact on the things we are working to detect and prevent. In this month’s deeper dive, we look at churning and the harm it can cause.

Churning is similar to but different from wash-trading. Where wash-trading’s aim is to create fictitious volume, churning generates abnormal fees and/or commissions through excessive buying and selling. In churning, the trading activity is itself the goal.

Earlier this month, Monmouth Capital Management was expelled for churning and excessive trading of customer accounts in violation of Regulation Best Interest (RegBI), failing to supervise its representatives, and providing false and misleading disclosures to retail customers. The Financial Industry Regulatory Authority (FINRA) found that Monmouth, through six representatives, excessively traded 110 accounts, 42 of which were also churned, causing approximately $3.9 million in commissions and trading costs, as well as substantial losses.

This case is the second expulsion from FINRA, based on a violation of RegBI since its introduction in 2020. RegBI was introduced through the Securities and Exchange Commission (SEC) to enhance standards for broker-dealers and investment advisors. At its core, RegBI mandates that financial professionals make investment recommendations that serve the client’s best interest. Previously, brokers were only required to analyze whether a recommended investment was “suitable.” It also introduced the Care Obligation that requires brokers to “exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.”

The impact of the churning was severe; in one instance, a customer’s account had an annualized cost-to-equity ratio of more than 103 percent— meaning the customer’s account would have had to grow by more than 103 percent just to cover commissions and trading costs. In another instance, a customer’s account had a loss of $158,078.

There is no clear line between normal trading and churning. FINRA, in their notice, further differentiates “excessive trading” and “churning” – two terms that are often used synonymously. In this case, amongst other things, a cost-to-equity of above 20% was indicative of excessive trading and a violation of RegBI’s Care Obligation. Though the technical trading activity was the same, churning involved violation of Section 10(b) of the Exchanges Act and had a higher bar which also included control over the accounts and a reckless disregard for the client’s interests. The cost to equity of the churning cases was between 46.5% to 126.7%.

In the United States, a Gold Star Family is one where an immediate family member served in the armed forces and died in the line of duty. Sadly, several of the accounts in this case were owned by Gold Star Families, who had funded their accounts with money they received to support them following the death of their loved one. In one case, an account was opened at Monmouth for the benefit of a 13-year-old child whose father died while on active duty. The account was funded by Servicemembers’ Group Life Insurance (SGLI) payments following the death of the child’s father. Although the account had an average monthly equity of approximately $150,000, Monmouth representatives purchased more than $1.9 million in securities in the account over a 20-month period, generating nearly $80,000 in commissions and trading costs.

This is the second expulsion through RegBI. The first one also involved churning as well as vulnerable individuals. That case included a retired 75-year-old who incurred $101,806 in commissions and realized losses of $131,979, which comprised most of their retirement savings.

We often think of financial crime as defined by sensational fines and risk-filled trading that brings down name-brand institutions. But financial crime has real victims beyond the numbers on a spreadsheet or headlines in a newsfeed.

Regulatory Updates

19 July: The Australian Securities and Investments Commission (ASIC) said it had cancelled the license of the local arm of collapsed U.S. cryptocurrency exchange FTX, effective with provisions, from July 14 until the end of July 12, 2024.  

18 July: SEC chairman Gary Gensler said AI could heighten financial fragility and promote herding behavior among investors, and the proliferation of artificial intelligence means governments will probably have to overhaul regulations to maintain global financial stability. 

17 July: The Financial Stability Board (FSB) published its global regulatory framework for crypto-asset activities. The framework consists of 2 recommendations: high-level recommendations for regulating, supervising, and overseeing crypto-asset activities and revised high-level recommendations for the regulation, supervision, and oversight of “global stablecoin” arrangements. 

15 July: A federal judge ruled against the SEC case against Ripple Labs seeking to bring greater oversight to the crypto industry prompting SEC Chair Gary Gensler to express disappointment in the ruling. 

12 July: The UK’s Financial Conduct Authority (FCA) Chief Executive, Nikhil Rathi, described a regulatory approach and challenges to AI in financial markets. It shared that applying artificial intelligence (AI) to financial services must go hand-in-hand with better fraud prevention and resilience to hacking and outages. 

12 July: The SEC proposed amendments to Rule 15c3-3 (the Customer Protection Rule) to require certain broker-dealers to increase the frequency with which they perform computations of the net cash they owe to customers and other broker-dealers (known as PAB account holders) from weekly to daily.  

11 July: The FCA continued to investigate unregistered cryptocurrency ATMs in the UK. With an inspection of 34 locations across the U.K., the FCA warned civilians that the use of the machines was an illegal operation, and it is highly unlikely that they will be protected in the instance that things go wrong. 

11 July: The European Securities and Markets Authority (ESMA) published a supervisory briefing on understanding the definition of advice under MiFID II. The briefing covers personal recommendations, investment advice, and issues around communication, such as the use of social media. 

11 July: ESMA published its Final Report on the review of the technical standards for passporting under Article 34 of MiFID II. ESMA’s proposals include targeted amendments to the existing RTS and ITS that would add new information requirements to the list of details investment firms have to provide at the passporting stage. A new investment services and activities passport notification will also provide National Competent Authorities (NCAs) with additional information on a firm’s planned or existing cross-border activities.  

9 July: Virtual Assets Regulatory Authority (VARA) of Dubai issued a market alert regarding ongoing supervisory controls and enforcement actions initiated against BitOasis, a UAE headquartered cryptocurrency platform that aims to offer a secure and regulated infrastructure for clients across the MENA region. BitOasis is under review due to not meeting mandated conditions; thus, VARA is taking enforcement actions to limit BitOasis’ status as non-operational. 

6 July: ESMA launched a Common Supervisory Action (CSA) with National Competent Authorities (NCAs) on sustainability-related disclosures and the integration of sustainability risks. The goal is to assess the compliance of supervised asset managers with the relevant provisions in the Sustainable Finance Disclosure Regulation (SFDR), the Taxonomy Regulation and implementing acts on the integration of sustainability risks. 

6 July: The Canadian Securities Administrators (CSA) published guidance to help fund managers understand and comply with securities law requirements for public investment funds holding crypto assets (public crypto asset funds). 

5 July: The UK FCA is consulting on its guidance on the trading venue parameter. This guidance includes the FSA’s position on some of ESMA’s Q&A on market structure as well as the definition of multilateral systems. 

4 July: The French Autorité des marchés financiers (AMF) examined the systems for valuation of the less liquid assets of UCITS and AIFs. In most of the cases during the AMF’s review period, monitoring the valuation of the assets does appear clearly in the compliance and internal control plans. However, shortcomings were noted in the performance of this monitoring for some of the companies, including the absence of effective control, failure to comply with the planned monitoring frequency, monitoring of the valuation procedure consisting merely in verifying that it exists, a lack of comparison of selling prices with the valuation price, and problems of representativeness of the control samples. 

30 June: The South African Financial Sector Conduct Authority (FSCA) published its 2023 Regulation Plan, which supports transparency surrounding how the FSCA will carry out legislative review and development of the regulatory framework. 

29 June: The CFTC announced the creation of two new task forces: The Cybersecurity and Emerging Technologies Task Force will address cybersecurity issues and other concerns related to emerging technologies (including artificial intelligence). The Environmental Fraud Task Force will combat environmental fraud and misconduct in derivatives and relevant spot markets.

29 June: The EU Association for Financial Markets in Europe (AFME) published its comments on the recent deal between the European Parliament and Council on the MiFID II/R Review. AFME believes there is a suboptimal outcome on the EU CT but supports the removal of provisions related to the pre-trade transparency for bonds.  

29 June: The Council and the European Parliament reached an agreement on the review of the MiFID/MiFIR legislation. The agreement entails the creation of a real-time anonymized top-of-book pre-trade tape, in addition to real-time transaction data.  

Fines & Enforcement Actions

The Swedish Finansinspektionen (FSA) identified that the Swedish crypto company Goobit has had shortcomings in its work against money laundering and terrorist financing. The FSA has issued a penalty fee of SEK 2 million for these violations. Further information is in Swedish only.

The SEC charged Merrill Lynch, Pierce, Fenner & Smith Incorporated and its parent company BAC North America Holding Co. (BACNAH) for failing to file hundreds of Suspicious Activity Reports (SARs) from 2009 to late 2019. Merrill Lynch agreed to pay a $6 million penalty to settle the SEC charges, and, in a parallel action, Merrill Lynch agreed to pay a separate $6 million fine to settle charges brought by the Financial Industry Regulatory Authority (FINRA).  

The FCA has fined Bastion Capital London Limited £2,452,700 for serious financial crime control failings in relation to cum-ex trading. They failed to manage the risk of being used to facilitate fraudulent trading and money laundering. Bastion executed trading to the value of approximately £49bn in Danish equities and £22.5bn in Belgian equities on behalf of Solo Group clients. The trading appears to have been carried out to allow the arranging of withholding tax reclaims in Denmark and Belgium. In addition, Bastion executed a series of trades on behalf of 11 Solo Clients in four days. Opposite positions were then executed by the same clients within hours at significantly different prices. This resulted in a loss of €22.7m for 1 Solo client to the benefit of the remaining 10 Solo Clients. Bastion ignored or failed to notice a series of red flags in relation to these trades, which had no apparent economic purpose except to transfer funds from the Solo Group’s controller to his business associates.  

The Monetary Authority of Singapore (MAS) reported four Individuals were convicted and sentenced to imprisonment for false trading in the shares of Koyo International Limited (Koyo). Between August 2014 and January 2016, the scheme members obtained control of 53 trading accounts opened in the name of 15 individuals to buy and sell Koyo shares at progressively higher prices. They did so with the aim of attracting a buyer to acquire the company via a reverse takeover. During this period, the share price rose from a low of $0.16 to a high of $0.40. It plummeted to $0.056 after the Singapore Exchange issued a “Trade with Caution” alert in view of the unusual trading activities, and trading curbs were imposed by several brokerages. Following the crash, account holders suffered losses of approximately $3.28 million. 

Three Florida men were charged with insider trading of a shell company’s stock before it announced plans to merge with a social media firm launched by former President Donald Trump. 

The Hungarian Energy and Public Utility Regulatory Authority (MEKH) found that Prvo Plinarsko Društvo d.o.o. (PPD) had engaged in market manipulation of the natural gas market, breaching Article 5 of the EU Regulation on Wholesale Energy Market Integrity and Transparency (REMIT). MEKH was fined approximately EUR 1.4 million. According to MEKH’s decision, PPD’s bidding behavior was manipulative and gave misleading signals for the market demand for the wholesale energy product.  

The SEC obtained a preliminary injunction, asset freeze, and other emergency relief against Legend Venture Partners LLC. The SEC alleges that Legend ran boiler room operations. The boiler rooms were staffed by a vast network of unregistered sales agents who made cold calls and raised at least $35 million. 

The SEC charged Celsius Network Limited and Founder Alex Mashinsky. Charges included unregistered offering, false and misleading statements, and market manipulation. For market manipulation, the SEC claimed that Celsius artificially increased and supported the price of CEL through manipulative buybacks far more than public disclosure. 

The Commodities Futures Trading Commission (CFTC) charged Celsius Network Limited and Founder Alex Mashinsky with “fraud and material misrepresentations in connection with the operation of its digital-asset-based finance platform.”

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