Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

This has been the week of scandals.  With political forces, lobbyist and lots of deep pockets, our government is a breeding ground for scandals.  The SEC has certainly not been immune.  A few years ago, the SEC made headlines because several of its employees were watching pornography during working hours.  Recently, the former chief inspector in the Inspector General’s office filed a whistleblower lawsuit alleging he was terminated because he raised concerns over two senior officials sleeping together.  The whistleblower also alleged that several officials handed out SEC contracts to friends at influential consulting firms. 

While nothing can eliminate scandals completely, an article on FoxBusiness.com argues that the SEC could fund itself, rather than seek yearly Congressional appropriations.  According to the article, the settlements, penalties and fines collected by the SEC has exceeded its budget in recent times.  For example, between 2005 and 2009, the SEC collected $7.4 billion in transaction and registration fees, while Congress appropriated just $4.5 billion to the agency during that period. 

Changing the nature of the SEC’s funding could certainly insulate it from political pressures of Congress and deep pocketed regulated entities.  It would also insulate the SEC from attempts by some in Congress to defund regulatory agencies, or from budget cuts, like sequestration.  While changing the way the SEC is funded may not prevent sex scandals, it is certainly worth considering for an agency that regulates many entities that are politically connected and active.

I do not envy any attorney who attempts plead a Section 10b-5 claim.  Courts throughout the country have made pleading scienter extremely difficult, and the benefit of any doubt favors the defendants.  Under the PSLRA, a plaintiff must plead a strong interference of scienter by alleging sufficient facts to show that the defendant had both motive and opportunity to commit fraud and/or facts sufficient to show that there is strong circumstantial evidence of intentional or reckless behavior. 

In a recent opinion, the Court of Appeals for the Tenth Circuit dismissed the plaintiffs’ Section 10b-5 claims.  The plaintiffs alleged that the officers made false statements relating to the progress of an important network integration project, which would significantly impact the financial condition of the firm.  The Tenth Circuit acknowledged that the defendants made false statements of material fact relating to the network integration project, but held that competing plausible inferences indicated that the officers may have been merely careless and did not adequately track the progress of the project.

The Tenth Circuit’s ruling is consistent with the trend around the country.  Merely pleading a false statement of material fact is not enough, and courts generally rule in favor of the defendants when analyzing competing plausible inferences.  Plaintiffs’ attorneys can meet this high burden by specific and detailed allegations of intentional behavior – a burden that can be difficult to meet without discovery. 

Hardly a day goes by without hearing horrible stories of a person having their identity stolen and their finances ruined as a result.  The SEC is now stepping into this hornet’s nest by adopting new rules for financial advisors who have the authority to move client funds to third parties. 

The new rules require firms to set up red flag files to track their movement of money and to watch out for identity theft.  Advisory firms must specify the red flags that they use, and how they propose to respond when such red flags are found. 

If firms do not move client funds to third parties, they will still be required to periodically review whether this status has changed, which would require implementation of the red flags.  The SEC noted some basic things that advisors can look for when it comes to possible identity theft. 

Such red flag conduct includes, among others, instructions coming from a client with a new email address; a client saying he has changed an address; a client who wants to invests in a place where he has never invested before; or a client who has requested many credit reports. 

The easiest response by any firm is to call the client to confirm the instructions.  Do not hide behind an email because the email may be bogus.  If the situation is extreme, you may need to contact law enforcement. 

Putting aside the new SEC rules, it is a worthy venture for all firms to look into their policies and procedures when handling client funds to avoid the tragedy that could result from identity theft.  Develop protocols to look for and react to possible identity theft.  Your clients will expect you to do so.

* Photo from freedigitalphotos.net

At a recent conference held by the SEC, a panel highlighted the importance of compliance and ethics for broker-dealers.  The big take away from the conference was that a strong compliance program must have a solid ethical foundation.

In other words, a compliance program is not simply making sure that your representatives check the right boxes on applications.  It has to start with a culture of compliance and leadership from the top down, not the other way around.

It is imperative that upper management set the tone for a culture of compliance by fostering an ethical culture at the firm for others to follow.  Once you set the tone at the top, you can impress that tone throughout your organization, and, hopefully, avoid compliance issues going forward.

* photo from freedigitalphotos.net

This past week, members of the North American Securities Administrators Association lobbied Congress to do away with mandatory arbitration provisions from customer agreements.  In a speech before this group, SEC Commissioner Aguilar expressed that mandatory arbitration agreements must go.  Would this be a bad thing?

Arbitration has be seen as the preference of the industry because of the perception that it is quicker, more cost effective, and likely to be a more favorable forum than a court.  In the hundreds of customer arbitrations that I have handled, this has certainly not always been the case.  Plus, FINRA arbitrations are now being skewed in favor of the claimants.

In arbitration, there is no meaningful way to challenge frivolous claims like you would in a court.  I can think of one arbitration hearing that I had (which lasted 44 days) where being in a court would have been a better course.  At least there I could have gotten some of the claims that were without merit dismissed.

So where does this leave us?  I think that the likely result will be a change, not an outlaw of arbitrations.  Brokers will likely have to provide their customers the option of being in court or arbitration.

From my perspective, this may not be a bad thing.  When faced with bogus claims, which are many, I would always want to be in a court where I have a meaningful way to challenge those claims.  Let me know your perspective.