There is concern over the increasing collaboration between the Securities and Exchange Commission’s Enforcement Division and Office of Compliance Inspections and Examinations.
The SEC views this collaboration as efficient while others view it in the extreme. SEC officials have acknowledged the increasingly close working relationship between OCIE and the Enforcement Division. OCIE assists the SEC’s insider trading enforcement efforts, and the examination function finds evidence. However, some suggest exam function has become confrontational.
Given this dynamic, broker-dealers should consider having counsel present during the examination.
A divided U.S. Court of Appeals for the Second Circuit affirmed the dismissal of securities law antifraud claims against a “trusted” investor in the pump-and-dump scheme perpetrated by two defunct broker-dealers, A.R. Baron & Co. and Bear Stearns Cos. Inc. See Fezzani v. Bear Stearns & Co. Inc., 2d Cir. No. 09-4414-cv, 5/7/13, http://op.bna.com/srlr.nsf/r?Open= jkoo-97hryk.
The court held that the defendant cannot be held primarily liable under the Securities Exchange Act of 1934 Section 10(b) because, unlike the brokerage firms, he did not communicate directly with the defrauded investors. This pump-and-dump scheme was furthered, in part, by parking stock with various investors, including the defendant. The parking involved placing stock in investors’ accounts while A. R. Baron retained the risk of loss by promising to buy back shares, if necessary, at a price guaranteeing a profit for the insider. Parking by the defendant and others painted a false picture of the shares’ value and liquidity and lured potential investors into investing money based on the “illusion of trading activity.” Later, the defendants allegedly dumped their holdings before the stock crashed.
The court explained that, since there is no aiding and abetting liability in private actions, the defendant may be held liable only as a primary violator. In this case, liability was not present because the defendant never had any communications with investors.
In short, the defendant needs to basically communicate with the investor for liability to attach.
A divided Securities and Exchange Commission adopted new rules to strengthen oversight of broker-dealers’ custody of customer assets.
The regulations amend the SEC’s broker-dealer reporting rule Securities and Exchange Act of 1934 Rule 17a-5, requiring firms to file new quarterly reports — Form Custody — containing information as to if and how they maintain custody of their customers’ cash and securities. See http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539740621#.UfmIFmljuSo. The amendments also require the firms — whether they have custody or not — to allow examiners from the SEC and relevant SROs to review their audit work papers, if the documents are requested in writing for purposes of a broker-dealer examination. The firms further must allow their accountants to discuss their findings with the SEC or SRO staff. Broker-dealers must start filing the quarterly reports with the SEC by the end of 2013.
The new rules also come with annual reporting requirements. Broker-dealers that have custody of customer assets annually must file “compliance reports” with the SEC to verify that they are complying with capital requirements, protecting customer assets, and sending periodic account statements to their customers. Firms that do not hold customer assets annually must file “exemption reports” with the SEC. The new reports must be examined in accordance with Public Company Accounting Oversight Board standards. Moreover, broker-dealers that are Securities Investor Protection Corporation members must file annual reports with SIPC to allow the organization to better monitor industry trends and firms. The first annual reports to SIPC are due by the end of the year. The effective date for the other annual reporting requirements is June 1, 2014.
The SEC also finalized rule amendments that would strengthen its broker-dealer financial responsibility rules regarding net capital, customer protection, and books and records. See www.sec.gov/News/PressRelease/Detail/PressRelease/1370539739257#.UfmIe2ljuSo. The amendments will require broker-dealers that maintain customer securities and funds to maintain a new segregated reserve account when the account holder is a broker-dealer. The rules also restrict cash bank deposits pursuant to Exchange Act Rule 15c3-3 to maintain a reserve to protect customer cash; and establish customer disclosure, notice, and affirmative consent requirements for new customer accounts in programs where the customer’s cash in a securities account is placed in a money market or bank deposit product. Finally, all of the rules become effective 60 days after publication in the Federal Register.
In short, broker-dealers are paying for the sins of the Ponzi scammers.
The SEC’s Office of Compliance Inspections and Examinations has issued a report on broker-dealers’ handling of confidential information. The SEC’s examiners looked at broker-dealers’ compliance with the requirements governing the misuse of material nonpublic information, and evaluated new business practices, technologies and controls relating to compliance.
Broker-dealers have access to nonpublic information, and owe a duty of trust and confidence to the client or other involved parties. Registered broker-dealers must have policies and procedures that are reasonably designed to prevent its misuse, and, when broker-dealers are dually registered as investment advisers, they must consider additional controls as well.
The Staff is concerned about the lack of documentation regarding material nonpublic information provided to senior executives, and incentives relating to business success. The absence of monitoring or other controls raises serious concerns about the broker-dealers’ ability to prevent the misuse of the information in firm and customer trading. The Staff also found that, in some instances, broker-dealers were not conducting focused reviews on the trading that occurred after traders were provided with material, nonpublic information. The Staff found various gaps in oversight at most of the broker-dealers, for example, some broker-dealers did not conduct any reviews when the information came from activities outside of their investment banking department. The Staff also noted that these concerns are not necessarily violations, but broker-dealers should consider this issue when reviewing their policies and procedures.
The Staff also pointed out effective practices as well. For example, some broker-dealers created tailored exception reports to reflect the different types of information they receive, and expanded the range of instruments they reviewed for misuse of material nonpublic information.
In short, the Staff will, most likely, monitor these practices in future examinations for potential enforcement actions.
The California Court of Appeals reversed a lower court’s refusal to compel a dissatisfied investor to arbitrate its dispute with a former associated person of a now defunct FINRA member firm. See Ronay Family Limited Partnership v. Tweed, Cal. App., D062195, 5/23/13.
A FINRA rule rendering a claim against a former member ineligible for arbitration does not apply to the former member’s APs. According to the court, the dispute arose after plaintiff lost money on investments it made through the broker-dealer based on the advice of a defendant and his firm, a former FINRA member firm. At all relevant times, the individual was registered with FINRA as a broker-dealer associated person. FINRA Code of Arbitration Rule 12202, states that certain actions are ineligible for arbitration claims by or against inactive members. The court said FINRA Rule 12202 applies only to claims against former members, and an associated person in good standing with FINRA.
The appeals court concluded that there are exceptions to the rule. In this case, the court explained the rights and duties of the parties regarding arbitration initially were defined by the arbitration agreement, the right to enforce it as parties, and the right to compel arbitration of certain controversies. The court agreed that the arbitration would proceed in accordance with the parties’ agreement to abide by FINRA arbitration rules, including Rule 12202, and the court must apply FINRA Rule 12202, not the general rules governing an agent’s or a third party beneficiary’s contractual rights. The court noted that by its terms, Rule 12202 makes claims ” ‘by or against a member’ whose FINRA membership has lapsed” ineligible for arbitration, says nothing about arbitrating for customer’s claims against associated persons or others. Concluding that FINRA Rule 12202 applies only to members, the court said if FINRA had wanted to deprive both members and associated persons of the right to compel arbitration when a member loses its membership, it could have done so.
This case demonstrates the strong presumption for arbitration.
The Securities and Exchange Commission announced three new enforcement initiatives, including a task force aimed at rooting out potential fraud involving issuer disclosures and audit failures. See http://www.sec.gov/news/press/2013/2013-121.htm.
The SEC said its Financial Reporting and Audit Task Force will expand the Enforcement Division’s efforts to identify securities law violations relating to the preparation of financial statements; issuer reporting and disclosures; and audit failures. The SEC also announced a Microcap Fraud Task Force, and a new Center for Risk and Quantitative Analytics. The SEC claims that financial fraud is frequently detected through issuer restatements. These restatements have declined in recent years through the quality controls instituted by the Sarbanes-Oxley Act of 2002.
The financial reporting task force will focus on identifying and exploring areas that may be susceptible to fraudulent financial reporting, reviewing financial statement restatements and revisions, analyzing industry performance trends, and using risk-based analytical tools such as the Accounting Quality Model to identify financial statement issues. The task force will include enforcement attorneys and accountants from across the country, and collaborate closely with the Division’s Office of the Chief Accountant, the SEC Office of the Chief Accountant, the Division of Corporation Finance, and the Division of Economic and Risk Analysis.
The microcap task force will focus on fraud in the issuance, marketing, and trading of microcap securities. The task force will develop and implement strategies to detect and fight microcap fraud, especially by focusing on “gatekeepers,” such as attorneys, auditors, and broker-dealers, and other significant participants. The Center for Risk and Quantitative Analytics will support and coordinate the division’s risk identification and assessment, and data analytic activities. A key objective of the Center for Risk and Quantitative Analytics will be to assist Staff members, bringing them analytical techniques and computing capacity with special expertise in data mining while assisting in targeting investigations.
These changes indicate the SEC’s efforts to “stay ahead of the curve.”
Now that the year is drawing to an end and we reflect back on our successes and, dare I say, failures over the last year, financial advisors and brokers should take the time now to review their respective client portfolios. This review should be your standard practice as you plan for next year.
The premise of any such review is to ask yourself, do I still know my customers. If the answer is no, you may be in trouble if you do not take immediate action. This is why a year-end review makes so much sense.
As part of any year-end review, get in touch with your customers; preferably face-to-face, but at least by telephone. That review should include getting the answers to questions like the following:
- Have my clients’ investment goals and objectives changed?
- Have the risk profiles for my customers changed?
- Have there been any changes to my customers’ earnings, positive or negative?
- Does my client need her investments to now generate income instead of growth?
- Have there been any changes to my clients’ employment status; i.e., retiree or change in job?
- Have there been any life changes that may impact my customers’ investment approach; i.e., marriage, divorce, death of a spouse or partner, or health issues?
Granted, there are many more questions that could be asked, but you get the point. The year-end presents you with an opportunity to make sure that you know your customer for the coming year. By doing so, you, at the same time, have the ability to market your services to your client.
Doing a KYC analysis is not all bad. It helps you prepare for the future and show each one of your clients that you take a personal interest in them. A happy client is a client that will provide you with more assets under management; a win, win situation from my perspective.
* photo from freedigitalphotos.net
The Securities and Exchange Commission has not reached a conclusion if there will be change to the Exchange Act Rule 10b5-1 stock trading plans, if it should amend the rule, or to provide additional guidance.
Given the SEC’s focus on insider trading, the Enforcement Division would “love to catch” a chief executive officer abusing an Exchange Act Rule 10b5-1 plan. Exchange Act Rule 10b5-1 stock trading programs allow corporate insiders to trade their companies’ securities without violating Exchange Act Rule 10b-5. Exchange Act Rule 10b5-1(c) provides an affirmative defense against insider trading liability if corporate executives demonstrate that the trades were made pursuant to an Exchange Act Rule 10b5-1 plan.
The SEC already regulates corporate inside stock transactions by baring short-swing profits. The Sarbanes-Oxley Act of 2002 also requires executives to report within two business days to the Commission if they buy or sell their companies stock.
The fact that the executives may fare better in their insider transactions than the average shareholder is not that surprising. Although Exchange Act Rule 10b5-1(c) provides an affirmative defense, it is not insurance. If a particular transaction raises the staff’s suspicions, the executive would have to show that his or her trade was legitimate.
In sum, Exchange Act Rule 10b5-1 plans are under the SEC microscope.
The Florida Supreme Court concluded that the state’s statute of limitations governing civil actions or proceedings applies not just to judicial actions, but to arbitrations as well. See Raymond James Financial Services Inc. v. Phillips, Fla., No. SC-2513, 5/16/13.
The court said that the investors commenced arbitration proceedings in 2005, contending the broker-dealer’s branch office manager invested their assets into non-diversified, high-risk entities, causing a significant loss in value between 1999 and 2005. The investors alleged federal and state securities law violations, and claimed that the broker-dealer negligently failed to supervise the branch office manager. The broker-dealer moved to dismiss the allegations as untimely under the relevant limitations periods. The NASD — now FINRA — appointed an arbitration panel and scheduled a hearing on the dismissal motion. However, before the hearing, the investors filed a declaratory judgment action in Florida state court, alleging, among other matters, that Florida’s statute of limitations did not apply to arbitration proceedings. Although the lower courts agreed with the investor, the supreme court concluded that it applied to arbitrations, pointing out that arbitration is utilized in various contexts—not just arbitrations governed by FINRA.
In sum, investors will no longer be able to extend the filing of their actions in Florida.
The Securities and Exchange Commission Division of Trading and Markets granted relief for institutional asset managers participating in a brokerage firm’s client commission arrangements. See Carolina Capital Mkts. Inc., SEC No Action Letter, avail. 7/30/13; http://www.sec.gov/divisions/marketreg/mr-noaction/2013/carolinacapital-073113-15a.pdf.
Specifically, the Staff said it would not object if instructional asset managers receive eligible third-party brokerage and research services based on commission generated in transactions in fixed income securities affected by the firm on an agency basis, based on the safe harbor in Securities Exchange Act of 1934 Section 28(e).
Consequently, the Staff said it will not recommend enforcement action against such institutional asset managers; provided that all applicable conditions of the Exchange Act Section 28(e) safe harbor are met.