Tag: Securities Regulatory

The Commodity Futures Trading Commission recently proposed new rules to implement statutory provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules relate to the conflicts of interest provisions set forth in section 732 of the Dodd-Frank Act, which amends section 4d of the Commodities and Exchange Act, to direct futures commission merchants and introducing brokers to implemental conflict of interest systems and procedures to establish safeguards within the firm. The proposed rules seek to ensure that any person researching or analyzing the price or market for any commodity is separated by appropriate informational partitions. The proposed rules also address other issues, such as enhanced disclosure requirements.

Section 732 of the Dodd-Frank Act requires that futures commissions merchants and introducing brokers “establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in trading or clearing activities might potentially bias the judgment or supervision of the persons.” While section 732 could be read to require informational partitions between persons involved in any research or analysis and persons involved in trading or clearing activities, the Commission believes that the Congressional intent underlying section 732 was primarily intended to prevent undue influence by persons involved in trading or clearing activities over the substance of research reports that may be publicly distributed.

The proposed rule establishes restrictions on the interaction between persons within a futures commission merchant or introducing broker involved in research or analysis of the price or market for any derivative and persons involved in trading or clearing activities. Further, the proposed rules also impose duties and constraints on persons involved in the research or analysis of the price or market for any derivative by, for example, requiring such persons to disclose during public appearances and in any reports any relevant personal interest relating to any derivative the person follows. The proposed rule also prevents futures commissions merchants and introducing brokers from retaliating against a person for producing a report that adversely impacts the current or prospective trading or clearing activities of the firm.

If the proposed rules are implemented, they would require that futures commission merchants and introducing brokers adopt written conflicts of interest policies and procedures, document certain communications between non-research personnel and provide other disclosures. They would also prevent non-research personnel from reviewing a research report prior to dissemination, except to verify the factual accuracy of the report and provide non-substantive edits. Non-research personnel may only communicate with research personnel through authorized legal or compliance personnel. The firm’s business trading unit may not influence the review or approval of a research personnel’s compensation and may not influence the research personnel. Futures commissions merchants and introducing brokers must keep a record of each public appearance by a research analyst. The proposed rule applies to third-party research reports as well, except where the reports are made available upon request or through a web site maintained by the futures commissions merchants or introducing brokers.

While the Commodity Futures Trading Commission is continuing to receive public comments on any aspect of the proposed rule, the Commission is particularly interested in comments about whether the rules should apply to futures commission merchants and introducing brokers of all sizes or whether the nature of the partitions should depend on the size of the firm.

In the last two months, the SEC and FINRA have, for the first time each, taken Enforcement action — including against a broker-dealer’s chief compliance officer — in regard to the safeguarding of confidential customer information under a 10-year-old SEC rule called “Regulation S-P.”  These actions seem likely to cause a significant shift in how brokers, investment advisers and their firms handle customers’ confidential information, particularly when it comes to a broker or adviser taking his or her “book” of business to another firm.

Overview

Previously, when brokers or advisers left for new firms, they and their new firms usually only had to worry about their former firm suing them for breaches of non-compete, non-solicitation and non-disclosure clauses in their agreements, or suing the new firm for “raiding” the former firm’s agents (and, thus, their customers).

But recent SEC and FINRA actions put brokers, advisers and their firms on notice that each could suffer formal regulatory consequences (including fines and suspensions) from brokers or advisers casually — or clandestinely — taking confidential customer information to their new firms.

Background

The SEC adopted Regulation S-P in 2001 pursuant to a mandate in the Gramm-Leach-Bliley Act of 1999, and amended it in 2005 pursuant to a mandate in the Fair and Accurate Credit Transactions Act of 2003 (the FACT Act).

Broadly speaking, Regulation S-P requires broker-dealers, investment advisers and other financial firms to protect confidential customer information from unauthorized release to unaffiliated third parties.  Included in Regulation S-P is the “Safeguard Rule” (Rule 30(a)), which requires broker-dealers to, among other things, adopt written policies and procedures reasonably designed to protect customer information against unauthorized access and use.

Of course, several headlines in recent years have focused on the reported thefts or losses of large caches of confidential customer information from banks and other businesses, so it comes as no surprise that the SEC and FINRA would seek to assert their Enforcement powers in this area.  Each of the recent SEC and FINRA Enforcement actions arose from departing registered representatives taking customer information to new employers without providing said customers with sufficient notice and opt-out procedures under €¨Regulation S-P.

Case Study # 1: Recent SEC Disciplinary Actions

In an administrative settlement dated April 7, 2011, the SEC fined a brokerage firm’s president, national sales manager and chief compliance officer between $15,000 and $20,000 each in regard to the transfer of 16,000 customer names and addresses, account numbers and asset values to a new firm.  It did not matter that customers approved the transfer after the fact, nor did it matter that the transfer occurred because the broker-dealer was winding down its business and thus simply transferring many of its accounts to a new broker-dealer. The SEC found the firm and its senior executives liable for Regulation S-P violations and fined each of them accordingly.

Especially noteworthy is that the SEC fined the firm’s chief compliance officer for “aiding and abetting” these Regulation S-P violations by failing to improve the firm’s “inadequate” written supervisory procedures for safeguarding customer information (the “Safeguard Rule”) after “red flags” arose from prior security breaches at the firm.  (Significantly, those security breaches did not involve other instances of intentional transfer of customer data to a new firm, but rather mostly theft by outsiders of a few RRs’ laptops and the unauthorized access by a former employee of a current employee’s firm e-mail account.)

Case Study # 2: Recent FINRA Disciplinary Action

This past December, FINRA’s National Adjudicatory Council affirmed a $10,000 fine and 10-day suspension ordered by a FINRA hearing panel in a contested hearing against a broker for his downloading confidential customer information from his firm’s computer system onto a flash drive on his last day of employment and then sharing that information with a new firm.  FINRA found the broker’s actions prevented his former firm from giving its customers a reasonable opportunity to opt out of the disclosures, as required by Regulation S-P.  FINRA also found the broker’s misconduct caused his new firm to improperly receive non-public personal information about his former firm’s customers.

Conclusion

These Enforcement actions will change the legal and practical landscape concerning the portability of a broker’s “book” of customers.  From a contractual point of view, brokers and advisers would be well-advised to build Regulation S-P-compliant language into their agreements with their current and new firms if they anticipate ever switching firms again, as these Enforcement actions effectively sound the alarm that the SEC and FINRA will sanction a broker or adviser for furtively taking customer information to a new firm. Likewise, investment adviser and brokerage firms would be well-advised to understand the relevance of Regulation S-P when it comes to brokers or advisers moving to other firms and taking firm customer information with them.

€¨Finally, from a regulatory point of view, a broker’s or adviser’s “former” firm should implement reasonable policies and procedures to ensure compliance with Regulation S-P by all firm personnel, including brokers or advisers looking to leave the firm, and a broker’s or adviser’s “new” firm should take similar care and caution when a broker or adviser brings in confidential information regarding new customers (lest the new firm also be found liable for a Regulation S-P violation, which would have happened in the above FINRA case had the new firm done anything with the customer information it got from the subject broker).

On November 3, 2010, the Securities and Exchange Commission (SEC) voted unanimously to adopt a new rule requiring broker-dealers to implement risk controls before they provide customers with electronic access to the equities markets. The new rule will effectively end so-called “naked” (or “unfiltered”) access by customers to the markets, and is part of a larger effort by the SEC “to help ensure the markets are fair, transparent and efficient.”

Specifically, the rule prohibits broker-dealers from providing customers with unfiltered access to an applicable exchange or alternative trading system (ATS). It requires brokers who directly access an exchange or an alternative trading system — including those who “sponsor” customers’ access to same — to put in place financial and regulatory risk management controls and supervisory procedures that are “reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous.” Among other things, these controls must include the programming and implementation of pre-order-entry filters by brokers in their own systems for orders directed either by them or their customers to the equities markets.

This issue of unfiltered access has been the subject of much debate, especially involving the high-frequency trading firms that use algorithms and high-speed and high-capacity computers to capture minimal and fleeting arbitrage (and other quantitative) opportunities in the markets. Some observers have estimated that such activity constitutes upwards of 70 percent of the volume traded in U.S. equity markets today.

Broker-dealers have eight months — which includes 60 days from publication of the rule in the Federal Register plus an additional six months — to comply with this new rule.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law by President Obama on July 21, 2010. The official purpose of the law is to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices and for other purposes.”

The Dodd-Frank Act actually affects multiple industries and legislation, containing numerous amendments to existing laws and creating several new laws as well. Clearly, this legislation will have consequences for years given that it calls for – by one count – 355 new rules to be written by federal agencies; 47 studies to be conducted (many preceding the rulemaking); and 74 reports to be made to Congress. Essentially, while the Dodd-Frank Act has been enacted, it is still very much a “work-in-progress.”

We have summarized the areas that the Dodd-Frank Act covers below:

• Title I (Sec. 101, et seq.): Financial Stability
  Financial Stability Act of 2010
  This law creates the Financial Stability Oversight Council (FSOC) to identify systemically significant institutions and regulate them at times more strictly than banks and bank holding companies (BHCs) currently are, regardless if the BHCs cease owning an insured depository institution so as to try to escape such regulation.
• Title II (Sec. 201, et seq.): Orderly Liquidation Authority
  Addresses “too big to fail.” A new “orderly liquidation authority” (OLA) allows the Federal Deposit Insurance Corporation (FDIC) to seize control of a financial company whose imminent collapse has been found to threaten the entire U.S. financial system. In such instance, the FDIC may seize the entity and liquidate it under the new OLA, preempting any proceedings under the Bankruptcy Code. Only liquidation may occur – not reorganization. Insurance companies remain state-regulated, and, thus, may not be so seized and liquidated, but their holding companies and unregulated affiliates may. Rating agencies, lenders and other potential creditors of a financial institution will now have to consider the effect of the OLA as well as the Bankruptcy Code on an institution that may become subject to Title II when deciding whether to extend or maintain credit.
• Title III (Sec. 300, et seq.): Transfer of Powers to the Comptroller of the Currency, the Corporation and the Board of Governors
  Enhancing Financial Institution Safety and Soundness Act of 2010
  Eliminates the Office of Thrift Supervision (OTS), allocating its thrift and thrift holding company oversight responsibilities among the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency (OCC). Assessments for a depository institution’s Deposit Insurance Fund will now be based on total liabilities, not just deposit liabilities. FDIC coverage is now extended to $250,000.
• Title IV (Sec. 401, et seq.): Regulation of Advisers to Hedge Funds and Others
  Private Fund Investment Advisers Registration Act of 2010
  Effective one year from enactment of the Dodd-Frank Act, this title eliminates the “fewer than 15 clients” exemption that most hedge funds and investment advisers (collectively, IAs) use to avoid SEC registration as investment advisers. Further, the assets under management (AUM) minimum threshold of $25 million that allowed IAs to register with the SEC as opposed to one or more states has been increased to $100 million. However, new exemptions were crafted for “private funds” (with AUM over $150 million), “venture capital funds” and “family office advisers,” among other new exempt categories. The new act also significantly increases record-keeping and reporting obligations for both registered and unregistered IAs. Finally (among many other things), this new act disallows an “accredited investor” to include the value of his/her “primary residence” in determining whether said investor meets the $1 million net worth test, and authorizes the SEC to adjust the “accredited investor” standards every four years.
• Title V (Sec. 501, et seq.): Insurance
  Federal Insurance Office Act of 2010
  Nonadmitted and Reinsurance Reform Act of 2010
  Creates the “Federal Insurance Office” (FIO) within the Department of Treasury to monitor the U.S. insurance industry, especially for systemic risks, and negotiate insurance-related agreements on behalf of the United States with foreign governments. However, the states retain primary authority over U.S. insurers.
• Title VI (Sec. 601, et seq.): Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions
  Bank and Savings Association Holding Company and Depository Institution Regulatory Improvements Act of 2010
  Provides for heightened regulation, supervision, examination and enforcement powers over depository institution holding companies and their subsidiaries, including derivatives and “repos.” Contains the often discussed “Volcker Rule,” prohibiting any “banking entity” from engaging in proprietary trading, or sponsoring or investing in a hedge fund or private equity fund. However, the Volcker Rule was watered down with late-added exceptions to its prohibitions. Systemically significant non-bank financial companies are not strictly subject to the Volcker Rule, but do incur additional capital requirements and certain limits on their activities.
• Title VII (Sec. 701, et seq.): Wall Street Transparency and Accountability
  Wall Street Transparency and Accountability Act of 2010
  Gives the SEC and CFTC primary authority over the swaps markets, and requires that certain swaps be exchange-traded, centrally cleared and publicly reported. The definition of “swap” is left open to review and amendment, as are many other related aspects.
• Title VIII (Sec. 801, et seq.): Payment, Clearing and Settlement Supervision
  Payment, Clearing and Settlement Supervision Act of 2010
  Grants the Federal Reserve (and SEC and CFTC) new authority and responsibility for systemically significant “financial market utilities” and various clearing entities.
• Title IX (Sec. 901, et seq.): Investor Protections and Improvements to the Regulation of Securities
  Investor Protection and Securities Reform Act of 2010
  This is a wide-ranging section impacting broker-dealers, investment advisers, credit rating agencies, structured finance products and, last but not least, executive compensation and corporate governance (for all public companies, not just financial institutions). At the SEC, it establishes an “Investor Advisory Committee” and “Investor Advocate;” bolsters whistle-blower awards and protections; and authorizes monetary penalties in cease-and-desist proceedings. For broker-dealers and investment advisers, the SEC is to conduct studies regarding customer issues and impose new rules (including a likely new “fiduciary duty” for brokers regarding their retail customers, instead of the current, lesser “suitability” standard). Amendments were also made to laws regarding short-selling and stock lending. Credit rating agencies will undergo significant reform to eliminate conflicts of interest, increase their accountability and increase transparency (especially regarding asset-backed securities). As for executive compensation and corporate governance, the law mandates non-binding shareholder votes on executive compensation and golden parachutes; independence of compensation committees; disclosures of executive compensation, incentive-based compensation and chairman-CEO relationships; and “clawbacks” of erroneously awarded compensation. It also limits broker voting and increases proxy access for shareholders.
• Title X (Sec. 1001, et seq.): Bureau of Consumer Financial Protection
  Consumer Financial Protection Act of 2010
  Establishes the Bureau of Consumer Financial Protection (BCFP) within the Federal Reserve. The BCFP will be the consumers’ watchdog, with authority to write and enforce rules regarding mortgages, credit cards, credit scores and other consumer products. However, the examination and enforcement authority will only extend over very large banks and non-bank financial institutions. The BCFP will not have authority over insured depository institutions and credit unions with assets of $10 billion or less. This act also caps credit card fees. (Excluded businesses will include retailers, accountants, real estate brokers, lawyers and auto dealers.)
• Title XI (Sec. 1101, et seq.): Federal Reserve System Provisions
  This title limits Federal Reserve emergency lending authority, and permits the GAO to audit the recent financial crisis lending as well as future emergency and discount window lending and open-market transactions.
• Title XII (Sec. 1201, et seq.): Improving Access to Mainstream Financial Institutions
  Improving Access to Mainstream Financial Institutions Act of 2010
  This law authorizes the Treasury Secretary to establish certain grants and other programs to improve access to basic financial products for underserved communities.
• Title XIII (Sec. 1301, et seq.): Pay It Back Act
  This provision reduces TARP funds from $700 billion to $475 billion; prohibits new TARP funding programs; requires certain repaid TARP funds to reduce the deficit; and prohibits recycling repaid funds back into the program.
• Title XIV (Sec. 1400, et seq.): Mortgage Reform and Anti-Predatory Lending Act
  Mortgage Reform and Anti-Predatory Lending Act
  Expand and Preserve Home Ownership Through Counseling Act
  The laws require increased disclosure upon origination of residential mortgage loans, and significantly increases regulation of mortgage loan origination and servicing. Mortgage originators will have registration requirements, and must make good faith determinations about the ability of a consumer to repay a loan. “Steering” incentives will be prohibited (e.g., “steering” a consumer to loans with higher fees). New caps will be imposed on late fees. Finally, the federal government will make $1 billion available to borrowers to help pay their mortgages ($50,000 cap per homeowner) and another $1 billion to local governments to redevelop foreclosed and abandoned homes.
• Title XV (Sec. 1501, et seq.): Miscellaneous Provisions
  This title contains miscellaneous sections regarding, among other things, IMF loan policy; disclosures regarding Congo minerals; safety reporting for coal mines; resource extractors to disclose payments to foreign or U.S. governments; an assessment of the effectiveness of federal inspectors’ general; and a study of deposits at banks.
• Title XVI (Sec. 1601): Section 1256 Contracts
  This title excludes interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, credit default swaps, and similar agreements from Section 1256 of the Internal Revenue Code that would have inappropriately treated gains and losses in same.

Even before the economic turmoil of the last two years, private placements were a principal source of funding for small and mid-sized businesses. Given the recessionary effects on the commercial credit-based lending market, now, more than ever, private placements are playing an even greater role in facilitating the capital needs of these businesses.

The Financial Industry Regulatory Authority’s (FINRA) latest regulatory guidance, Notice to Members 10-22, reminds broker-dealers of their obligations when recommending securities exempt from registration pursuant to the U.S. Securities and Exchange Commission’s (SEC) Regulation D, promulgated under the Securities Act of 1933 (Securities Act), as well as suggesting a renewed focus by FINRA on monitoring broker-dealers’ anti-fraud compliance in the post-bailout economy.

Pursuant to the Securities Act, any offer to sell securities must either be formally registered with the SEC, or meet an exemption from this registration obligation. Regulation D permits three exemptions from the registration requirements. See 17 CFR § 230.501 et seq. These exemptions allow some securities issuers to offer and sell their securities without having to register the securities with the SEC. While the inquiry into whether a particular offering is exempt under Regulation D involves a careful analysis of objectively ascertainable criteria regarding both the activities of the issuing company and the investors, Regulation D offerings, generally, include:

(1) When a given issuer only offers and sells up to, in the aggregate, $1 million worth of their securities in any 12-month period;

(2) When a given issuer only offers and sells up to, in the aggregate, $5 million of their securities in any 12-month period and the investors meet the definition of “accredited investor” by establishing certain sophistication and wealth standards, or the investor is one of up to 35 “non-accredited investors” as specifically defined in the regulatio; or

(3) When a given issuer satisfies the so-called “safe harbor” from registration under the Securities Act by establishing that, although the offering’s aggregate dollar value was not limited, it was made only to “accredited investors,” and up to 35 non-accredited investors that exhibit a degree of financial sophistication.

Further, Regulation D issuers are limited in both advertising to and the solicitation of investors. For example, these issuers, among other requirements, must complete and file the SEC Form D, an abbreviated notice, containing the names and addresses of the company’s officers and stock promoters, as well as the date of the first issuance.

While there are probably many reasons for an increased FINRA broker-dealer surveillance program in connection with Regulation D offerings, FINRA Notice to Members 10-22 clearly articulates the suitability obligations that every broker-dealer involved in this particular type of securities issuance must follow.  FINRA’s guidance on Regulation D offerings also foreshadows that those broker-dealers who do not revisit their organizational compliance protocols will be at a substantial risk of regulatory enforcement action.

NASD Rule 2310 requires that broker-dealers “have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.” This means where broker-dealers take an active role in suggesting investments to their clients, the broker-dealer must undertake a level of due diligence regarding the needs, risks and expectations of the investor prior to making a recommendation.  Practically speaking, this investigation must be well documented and include disclosure forms from the broker-dealer to the investor.

Regulation D offerings have, however, historically presented an “opportunity” for some broker-dealers to avoid their suitability obligations due to the emphasis upon the sophistication of the investor inherent in Regulation D offerings. Simply stated, some broker-dealers may have stopped short of performing a complete and thorough suitability analysis for Regulation D offerings based upon the erroneous belief the investor being an “accredited investor” satisfied the broker-dealer’s obligations pursuant to Regulation D and NASD Rule 2310.  FINRA Notice to Members 10-22 makes clear that a broker-dealer must undertake a complete suitability determination when recommending Regulation D offerings to a customer, and the “accredited investor” determination is only a small piece of that analysis.

FINRA Notice to Members 10-22 provides five factors any broker-dealer recommending a Regulation D offering to a customer must satisfy. FINRA specifically states that, “[i]n order to ensure that it has fulfilled its suitability responsibilities, a BD in a Regulation D offering should, at a minimum, conduct a reasonable investigation concerning” an examination of:

(1) The issuer and its management;

(2) The business prospects of the issuer;

(3) The assets held by or to be acquired by the issuer;

(4) The claims being made; and

(5) The intended use of the proceeds of the offering.

FINRA Notice to Members 10-22 at p. 8.  FINRA also acknowledges that “a single checklist of possible practices for a BD engaged in a Regulation D offering will not suffice for every offering . . . [.]”  Id.  Accordingly, broker-dealers must examine a host of potential issues when recommending investments in Regulation D securities to customers, and sound compliance protocols are of critical importance.

Securities Industry Practice Alert

Securities Regulatory Practice Alert

In response to a request by FINRA, the SEC provided interpretive guidance as to its financial responsibility rules’ application to a broker-dealer that is formed and operated as a series limited liability company (LLC) under state law.

The SEC staff described a Series LLC structure as consisting of a Master LLC and a series of ownership classes within that Master LLC. The structure of this entity operates as the Master LLC being the only formal legal entity to be registered as a broker-dealer. Other than the registration, the entity would have no business operations while the various Series LLC, under the aegis of the Master LLC, would operate the broker-dealer operations as well as other institutional activities. There would be separate assets and liabilities for each of the entities but all would be reported in a consolidated financial statement when filing financial reports with the SEC.

When assessing FINRA’s request, the SEC reviewed three sets of its rules: the Net Capital Rules, Exchange Act Rule 15c3-1; the Financial Reporting Rules, Exchange Act Rule 17a-5; and the Customer Protection Rules, Exchange Act Rule 15c3-3. For example, the SEC stated that the Net Capital Rules required any capital contribution to be “subject to the risks of the business.” Essentially, these risks could not be transferred between the entities. Further, all the liabilities would be recognized when computing the broker-dealer’s net capital, and thus the assets would not be available for treatment as non-allowable. Additionally, all liabilities would be deducted from allowable assets when computing the firm’s net capital.

Additionally, the SEC staff reviewed the effect of the Series LLCs on the Financial Reporting Rules. The SEC staff stated that, if these Series LLCs reported financial positions on a consolidated basis, the ability to effectively supervise its financial position would be greatly diminished. The SEC staff would not be able to determine the controlling series specific assets or obligations to pay specific liabilities.

The SEC staff also said that the Series LLCs would not be able to comply with the requirements of the Consumer Protection Rules since those Rules require the broker-dealer to carry the customer account positions and customer reserves. The SEC staff believes Series LLCs would make it difficult because the assets and liabilities of each series would be in separate entities. Finally, the SEC staff also determined that, under the Securities Investor Protection Act, if there were to be a liquidation, it would be difficult to find the entities that actually controlled the assets.