Tag: Securities

Brokers and Advisers Beware: Taking Customer Information Could Get You Fined and Suspended

Securities Industry Practice Alert

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).

 

SEC Adopts New Rule Preventing Unfiltered Market Access

Securities Industry Practice Alert

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.

 

Advisors: Beware of the “Switch” From SEC Oversight to State Regulation

Securities Industry Practice Alert

By July 21, 2011 — the one-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act — investment advisors with less than $100 million in assets under management will be required to register with the states. This impacts all advisors, whether currently registered with the Securities and Exchange Commission. The “switch” to state regulation is likely to raise a number of issues — and confusion — for advisors.

• Advisors with more than $25 million in assets under management previously were able to opt out of federal registration — and state registration as a result — if they had fewer than 15 direct clients. With the passage of Dodd-Frank, that 15-client threshold has been removed outright from the Investment Company Act of 1940. Thus, absent another exemption, many advisors will face federal or state registration for the first time.
• Advisors with clients in multiple states may have to register in multiple states, potentially creating burdensome requirements for advisors. (One exception: an advisor that must register in 15 or more states may choose to remain SEC-registered.)
• States differ on their registration, custody, books and records and other requirements. Just to cite one arcane but significant difference, Connecticut does not require its state-registered investment advisor representatives to have a 65 (or 7 and 66); it instead only requires them to have sufficient “experience.” New York, meanwhile, not only requires the 65 (or 7 and 66), but also mandates that representatives have taken the exams within two years prior to registering with New York. (That means that a neophyte advisor in New York can sail through the state registration process with flying colors, while a more veteran advisor in New York has to file for a waiver on the state’s exams-in-the last-two-years requirement to become registered (if such representative got his or her 65 (or 7 and 66) more than two years ago).

 

SEC Enforcement Staff Gains Subpoena Power (and Other Evolutions in the Division’s Authority and Responsiveness)

Securities Industry Alert

The SEC Enforcement Division (Enforcement or the Division) recently announced a series of changes to its authority and structure that will make the Division more autonomous and quicker to act in its investigations. The changes look to make the Division more agile in all levels of its investigations – from the handling of tips that start investigations to the litigating of fully developed investigations. Based on these institutional changes – coupled with the Division’s and the SEC’s pronounced desire to be more “effective” – we advise clients to take note of these developments and prepare for a tougher, more aggressive regulator.

ENFORCEMENT STAFF’S NEW SUBPOENA POWER

To mandate document production and testimony from securities industry participants (indeed, anyone) in a given investigation, Enforcement attorneys generally need to have in place a “formal order of investigation” for the matter. Until now, to obtain that formal order, staff had to craft a convincing summary of a case; obtain approval from Enforcement management for the presentation of the formal order to the five commissioners themselves; and then delicately wait for a review by and meeting of those commissioners to grant the formal order of investigation in a case. In our experience, such procedures could stall the progress of an investigation for several months – even in cases where a respondent may be willing to cooperate with the Enforcement staff, but for legal reasons needed staff to present them with a subpoena before they could comfortably do so.

That logjam in the process has now been removed. On August 5, 2009, the SEC amended its rules to delegate to the Director of Enforcement the authority to issue formal orders of investigation (SEC Release No. 34-60448). Furthermore, in a speech that day, the new Director of Enforcement, Robert Khuzami, announced that he would soon be delegating that authority to senior officers throughout the Division. To emphasize the change this means for Enforcement investigations, we quote Khuzami himself:

Thus, Staff will no longer have to obtain advance Commission approval in most cases to issue subpoenas; instead, they will simply need approval from their senior supervisor. This means that if defense counsel resist the voluntary production of documents or witnesses, or fail to be complete and timely in responses or engage in dilatory tactics, there will very likely to be a subpoena on your desk the next morning. [Emphases added.]

BEEFING UP STAFF

Enforcement has recently been adding trial attorneys with the express purpose of presenting a more imposing presence to respondents in its investigations. As Khuzami stated, “It is imperative that we convey to all defendants in SEC actions that we are prepared to go to trial and we will win, as evidenced by our eight trial wins since April…. “The Division has also recently tripled its paralegal and support personnel so as to free investigators to perform more “front-line” work and to relieve them from routine administrative burdens.

STREAMLINING THE INVESTIGATIVE PROCESS

In an effort to expedite cases, the Division is streamlining both its management structure and its investigative process, as follows (among other things):

• Redeploying “branch chiefs” from their current mid-level managerial functions to conducting investigations again, resulting in a flatter structure and more front-line decision-making.
• Delegating the power to approve all routine case decisions from the national Deputy Director to the Division’s senior officers located throughout the country.
• Shortening the required length and detail of internal memoranda that recommend specific Enforcement actions (so-called Action Memos), reducing the number of reviews they must undergo and shortening the time of those reviews.
• Severely limiting the availability of “tolling agreements” (wherein respondents agree to “toll” (i.e., pause) the application of a statute of limitations in a matter in return for more time from Enforcement staff to respond to staff requests and a delay by staff in making formal filings in the case).
• Creation of an “Office of Market Intelligence” to be responsible for the collection, analysis, risk-weighing, triage, referral and monitoring of the hundreds of thousands of tips, complaints and referrals that the SEC receives each year.
• Hiring the Division’s first Chief Operating Officer, who will take over the Division’s technology, project management and the collection and distribution of funds obtained in Enforcement cases.

NEW SPECIALIZED INVESTIGATION UNITS

Enforcement will soon be establishing specialized units of select attorneys, staff and resources to focus on practices, transactions, products, markets and regulatory regimes. Each will have a Unit Chief and will be staffed across the country, receiving focused, advanced training. The Division will also be hiring experts from industry for these units. The five units currently planned are:

• Asset Management Unit – €¨To focus on investment advisors, investment companies, hedge funds and private equity funds and look for violations in relation to disclosure, valuation, portfolio performance, due diligence and diversification, transactions with affiliates, misappropriation, conflicts of interest and others.
• Market Abuse Unit€¨ – To focus on large-scale market abuses and complex manipulation schemes by institutional traders and market professionals, among others, and look for violations in relation to markets, equities, debt securities and derivatives, and across different markets, products, corporate announcements and other market events.
• Structured and New Products Unit€¨ – To focus on complex derivatives and financial products, including CDS, CDOs and securitized products, looking for violations typically masked by the complexity of the products, the limited availability of trading information and the prevalence of private offerings.
• Foreign Corrupt Practices Act Unit€¨ – To focus on U.S. companies bribing foreign officials for government contracts and other business, working more closely with foreign counterparts and taking a more global approach to these violations.
• Municipal Securities and Public Pensions Unit – €¨To focus on offering and disclosure issues, tax and arbitrage-driven activity, unfunded or underfunded liabilities and “pay-to-play” schemes (in which money managers and advisors pay kickbacks and give other favors in return for the right to sub-advise the funds).

INCENTIVIZING COOPERATION

Khuzami is a former federal prosecutor, so it is natural for him to state that he deems it “critical” that Enforcement increase its incentives to individuals to cooperate in investigations. He has announced four initiatives in that regard (all still works-in-progress):

• Enhance Individuals’ Cooperation€¨ – Establish and announce standards to evaluate cooperation by individuals in enforcement actions.
• Criminal Immunity€¨ – Seek authority for the Division Director to submit immunity requests to the Department of Justice.
• Non-Target/Subject Assurances – €¨Explore ways to provide witnesses in the appropriate cases with verbal assurance early on in a case that Enforcement does not intend to file charges against them.
• Deferred Prosecution Agreements€¨ – Recommend to the Commission that the SEC enter into Deferred Prosecution Agreements, in which Enforcement agrees to forego an enforcement action against an individual or entity subject to full cooperation, a waiver of statutes of limitations and/or compliance with certain undertakings.

Some of these plans and initiatives are already in place. Others are in progress, and the rest are still in the conceptual stage. Some of these changes will make investigations more difficult for respondents, but others will accrue to some respondents’ benefit.

Regardless, clients should take heed that the Enforcement Division – indeed, the SEC as a whole and all other financial regulators – is undergoing changes that will make it more proactive and vigorous in its evaluations of and judgments about professionals in the securities industry.

 

The FRR Report Proposes a Resolution Regime to Aid Failing Firms

Securities Industry Alert

On June 17, 2009, the U.S. Department of the Treasury (Treasury) released a five-part report titled “Financial Regulatory Reform A New Foundation: Rebuilding Financial Supervision and Regulation” (FRR Report). The FRR Report, as well as a speech by President Obama, outlined a proposal designed to amend supervision and regulation within the financial system, including, among other things, focusing on creating tools that will assist the Treasury in aiding failing firms during future financial crises.

The current financial system only provides two resolution mechanisms for an interconnected bank holding company (BHC) or another non-bank financial firm nearing failure during a financial crisis. These mechanisms include: (1) obtaining emergency funding from the federal government (like AIG); or (2) a bankruptcy filing (like Lehman Brothers). If the proposals are enacted, the Treasury authority would be expanded to aid failing firms under the current framework by proposing the creation of a “resolution regime.”The “resolution regime” will not replace bankruptcy in the normal course of business but rather will empower the Treasury with the authority to determine how to orderly sustain a failing BHC or non-bank firm. However, the Treasury’s augmented powers will only arise if a “systemic risk exception” is triggered and after consultation with the President.

A “systemic risk exception” would be activated if a firm’s failure would pose a severe risk to the entire financial system.The exception would permit the “resolution regime” to take any action justified, not only cost-effective alternatives, including, among other things, establishing a conservatorship or receivership for a failing firm, providing loans to a failing firm or BHC, purchasing assets from a failing firm, guaranteeing the liabilities of a failing firm or BHC or making equity investments in a failing entity. Although the authority to decide whether to resolve the failing firm will reside with the Treasury, the Federal Reserve Board (FRB), FDIC and even the SEC may initiate the process.

In addition to the “resolution regime,” the FRR Report also recommends that the Treasury be provided with the authority to oversee the FRB’s ability to extend emergency funding. It is proposed that Section 13(3) of the Federal Reserve Act be amended to require the Treasury Secretary’s prior written approval before the FRB provides any credit extensions to individuals, partnerships or corporations in “unusual and exigent circumstances.” This proposal will broadly extend the Treasury’s supervisory authority over the FRB.

The FRR Report’s proposals will produce vast changes to the supervision and regulation of the financial system. Significantly, the creation of a “regulatory regime” may severely impact the level of self-control struggling BHCs and non-bank firms would possess during future financial crises.

 

SEC Proposes Amendments to Investment Advisers Act

Securities Industry Practice Group Alert

On May 20, 2009, the United States Securities and Exchange Commission (“Commission” or “SEC”) issued Release No. IA-2876, proposing certain amendments to the Investment Advisers Act of 1940 (“Advisers Act”). These proposed amendments, among other things, would require registered investment advisers (“RIAs”) who maintain custody of client funds or securities to undergo an annual surprise examination by an independent public accountant. This independent public accountant would be required to verify client funds and securities, and issue a written report to the RIA opining upon whether the controls in place for the custody of client assets are satisfactory. The SEC believes these amendments would provide the Commission with better information about RIAs’ custodial practices, and provide additional safeguards under the Advisers Act when an adviser (or its affiliates) has custody of client funds or securities. These proposed requirements are an obvious outgrowth of the Madoff scandal.

These proposed amendments are merely another step in the regulatory approach to RIAs various regulators have pursued since the financial scandals broke. For example, examiners from both the SEC and the various states have stepped up their RIA examination programs of RIAs even before these proposed amendments, typically focusing in on various records maintained by RIAs.

However, RIAs, with a little preparation,may be able to avoid many issues including those potentially posed by the proposed new amendments. We are advising our RIA clients to focus and manage their record-keeping with an eye towards the regulators’ interests. From our experience, regulators are looking at four broad categories of documents that they believe will provide them with insight into RIAs’ operations and whether clients are being protected. The individual categories and the documents generally requested follow:

1.   Financial:

—¦ accounts payable

—¦ monthly journals (receipts and disbursements)

—¦ general ledgers

—¦ trade tickets and investment blotters

—¦ brokerage statements (business and personal)

—¦ bank registers and statements (checking, money market and savings)

—¦ credit card statements

—¦ financial statements (income statements and balance sheets)

—¦ tax returns

2.   Administrative:

—¦ RIAs’ articles of incorporation

—¦ compliance and supervisory procedures manuals

—¦ lists of names and addresses forW-2 and Form 1099 employees

—¦ IAR current registrations

—¦ regulatory files (e.g., FINRA Forms U-4)

—¦ investment advisory agreements

—¦ disclosure documents (ADV Part II amendments)

—¦ POA authorizations

—¦ custody authorizations – no custody of funds except hedge funds

—¦ discretionary trading authorizations

—¦ IA fee debit authorizations

—¦ hard dollar fee schedules

—¦ soft dollar compensation agreements

—¦ arbitrations, complaints and litigation files

—¦ personal security transactions

—¦ unrelated business transactions

—¦ solicitors’ agreement

—¦ lists of names and addresses of paid referral networks

—¦ Privacy and Code of Ethics statements

—¦ Anti-Money Laundering documentation

—¦ Insider Information statements

—¦ do not call files

—¦ data processing (hardware and software) files

3.   Advertising:

—¦ advertising files

—¦ sales literature

—¦ financial illustrations

—¦ client newsletters

—¦ web pages and e-mail

—¦ mutual fund prospectuses

4.   Client Records:

—¦ lists of names and addresses of clients where the RIAs must identify discretionary, custodial or other types of accounts

—¦ client files

—¦ brokerage new account forms

—¦ investment advisory agreements

—¦ disclosure agreements (ADV-Part II)

—¦ authorizations (including custody, trading, disbursement and IA fees)

—¦ powers-of-attorney

—¦ suitability-risk profile worksheets

—¦ correspondence and e-mail files

—¦ account statements

As a result, well before these proposed amendments, federal and state RIA regulators have been actively investigating and examining RIAs and their business. Accordingly, we recommend that, in interacting with regulators, it is best to begin preparing before “they come a knockin’.”

 

FRR Report Proposes Three New Regulatory Agencies

Securities Industry Alert

On June 17, 2009, President Obama announced a proposal to redesign the financial system of supervision and regulation. Coupled with this announcement, the U.S. Department of the Treasury released a report titled “Financial Regulatory Reform A New Foundation: Rebuilding Financial Supervision and Regulation” (FRR Report).

Significantly, Section One of the FRR Report, titled “Promotion of Robust Supervision and Regulation of Financial Firms,” focuses on creating a stronger and more consolidated regulatory framework to identify and manage firms that pose potentially significant risks to the entire financial system. To accomplish this seemingly insurmountable feat, there are proposals to create three new regulatory agencies: (1) the Financial Services Oversight Council (FSOC); (2) the National Bank Supervisor (NBS); and (3) the Office of National Insurance (ONI). As part of this new approach, the FRR Report advocates increased transparency of hedge funds and legislation to reduce the consequences of money market fund runs.

FINANCIAL SERVICES OVERSIGHT COUNCIL

The proposed FSOC will be an independent agency with authority to gather information from any financial firm whose size or “interconnectedness” may pose a threat to the system if it were to fail. As such, some firms that may own insured depository institutions will not be exempt from FSOC scrutiny if those firms pose significant risks to the overall system. The FSOC’s duties will include:

• Coordinating information sharing between regulatory agencies;
• Identifying and advising the Federal Reserve Board (FRB) of firms that pose prospective threats to the stability of the financial system;
• Reducing supervisory gaps; and
• Providing a forum for jurisdictional disputes between regulators.

The FSOC membership will include the Secretary of the Treasury; the chairs of the FRB, SEC, CFTC and FDIC; and the directors of the National Bank Supervisor, the Federal Housing Finance Agency, and the Consumer Financial Protection Agency. Despite this coordination, the actual possession and implementation of regulatory power will still predominantly remain with various regulators.

NATIONAL BANK SUPERVISOR

The FRR Report also proposes the creation of the NBS, a federal banking agency within the Treasury Department. Presently, four federal agencies have authority over depository institutions:

1. Office of the Comptroller of the Currency (OCC), regulating national banks;
2. Office of Thrift Supervision (OTS), regulating savings and loan associations;
3. FRB, representing member banks; and
4. FDIC, covering all insured depository institutions.

The current system allows a bank to select its own regulator or, to be more precise, regulatory reporting structure. However, the NBS’ creation will amend that system since the NBS will supervise and regulate all federally chartered depository institutions as well as all national branches of foreign banks. Effectively, the NBS will succeed the OCC and OTS, but the FDIC and FRB will largely continue their same roles.

OTHER PROPOSED CHANGES IN THE FRR REPORT

If the FRR Report’s recommendations are enacted, banks and bank holding companies (BHC) would also have their capital and other requirements strengthened. For example, the SEC’s Supervised Investment BHC Program would be eliminated, causing all investment banking firms seeking consolidated supervision by a regulator to be subject to the FRB. Another proposal would allow the Treasury Department to reassess existing regulatory capital requirements for banks, issue new executive compensation standards and implement more forward-looking loan loss provisions. Stronger firewalls to protect the federal safety net were also recommended.

Other legislation proposals would increase transparency in both the insurance and hedge fund industries, requiring all hedge funds, private equity firms and other private pools of capital advisers to register with the SEC under the Investment Advisers Act of 1940. No longer will investment advisers be exempt from registration through current client or definitional exceptions if these proposals are approved. If passed, these entities will be subject to increased disclosure, record keeping and supervision. Another proposal would create the ONI within the Treasury to monitor the insurance industry. The ONI would gather information and identify regulatory gaps that may lead to future financial crises.

Finally, the FRR Report also proposes increased regulation of money market funds (MMF), special mutual funds that generally avoid large credit risks and volatility. However, as was seen with the Lehman Brothers failure, an MMF run—multiple investors simultaneously recalling their assets when the financial institution may not have sufficient reserves—may occur, resulting in severe liquidity issues. To strengthen the MMF regulatory framework, the FRR Report proposes that the SEC:

• Require MMFs to maintain larger liquidity buffers;
• Reduce the maximum weighted average maturity of MMF assets;
• Tighten the credit concentration limits applicable to MMFs;
• Improve the credit risk analysis of MMFs; and
• Empower MMF boards of directors to suspend redemptions in extraordinary circumstances.

In sum, these new proposals may result in changes to the entire supervisory and regulatory structure of our domestic financial system. Creation of new government agencies such as the FSOC, NBS and ONI will certainly impact the regulatory structure and investigations. Thus, clients will need to carefully understand the changes, especially the broader power of the FRB, in contemplating future business decisions.