Morgan Stanley Smith Barney and Citigroup Global Markets will pay nearly $3 million each to settle charges that they made false and misleading statements to investors about a foreign exchange trading program from August 2010 to July 2011. At the time of the alleged violations, Citigroup held a 49 percent ownership interest in Morgan Stanley Smith Barney. Registered representatives from both firms pitched the trading program, CitiFX Alpha, to Morgan Stanley customers in written and oral presentations using the program's past performance and risk metrics.
The SEC alleged, however, that the sales presentations were materially misleading because they failed to adequately disclose that the investors could be taking on substantially more leverage than disclosed in the marketing presentations. The sales presentations also failed to disclose that the firms would charge markups on each trade.
The firms pitched the program to investors who had no experience in foreign exchange trading and who did not understand the concept of a notional amount. Many of these investors did not understand that the cash they posted to their foreign exchange accounts merely served as collateral, or that there was a difference between the notional amounts they traded and the amount of collateral they posted to their accounts. Investors often posted collateral equal to as little as 10 percent of their notional amounts, and experienced substantial losses trading in such highly leveraged accounts.
The SEC found that the firms each violated Securities Act §17(a)(2), which prohibits obtaining money or property by means of any material misstatement or omission in the offer or sale of securities. Negligence is sufficient to establish a violation of this section. It is not necessary for the SEC to show scienter or fraudulent intent.
Without admitting or denying the SEC findings, each firm agreed to pay disgorgement of $624,458, prejudgment interest of $89,277.34, and a civil money penalty of $2,250,000.
The SEC also granted both firms’ request for a waiver of the “ineligible issuer” provision of Securities Act Rule 405. Under Rule 405, issuers that are or have been subject to specified administrative orders related to violations of the antifraud provisions of the federal securities laws in the previous three years cannot qualify for “well-known seasoned issuer” (WKSI) status.
This is a significant sanction, as WKSIs have many advantages as compared to other issuers under the SEC’s 2005 securities offering reform initiative. WKSIs may register securities under automatic shelf registration statements that are effective upon filing, and may automatically file effective post-effective amendments to register additional securities and pay registration filing fees on a “pay as you go” basis. Furthermore, WKSIs may freely communicate with the market through the use of free writing prospectuses.
The SEC, or the Corporation Finance staff, acting under delegated authority, may grant waivers from Rule 405’s ineligible issuer provisions “for good cause.” Although the Commission regularly agrees to most waiver requests, automatic disqualification waivers have become somewhat controversial recently. In particular, Commissioner Kara Stein has issued several strong dissents in waiver cases, and criticized the practice in public statements. In one case, involving a waiver claim by Royal Bank of Scotland Group, plc, in April 2014, she asserted that “if we are going to abrogate our own automatic disqualification provision on these facts, then we should consider discarding these disqualification and bad actor provisions entirely, along with the pretense that they have any real meaning.”
In April 2014, the Division of Corporation Finance released a “Revised Statement on Well-Known Seasoned Issuer Waivers,” setting forth the criteria that the division will consider when reviewing waiver claims. The factors are:
In light of these factors, it is not surprising that the SEC granted the waivers. In this instance, the misrepresentations were not connected to any disclosures filed by the firms with the SEC or generally distributed to investors. The underlying violation did not require proof of fraudulent intent, as the negligent failure of the representatives to provide proper disclosures was sufficient to impose liability under §17(a)(2). The wrongdoing was also not widespread throughout the firms, as the misconduct was limited to the local registered representatives.
Both firms undertook remedial steps to prevent further violations, including a review of the program’s marketing materials. Each firm subsequently discontinued their participation in the trading program in late 2011.
SEC Release No. 33-10288 (Jan. 24, 2017) (Citigroup); SEC Release No. 33-10290 (Jan. 24, 2017) (Smith Barney); Morgan Stanley Smith Barney LLC, SEC No-Action Letter (Jan. 24, 2017); Citigroup, Inc., SEC No-Action Letter (Jan. 24, 2017).
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