Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

Recently, FINRA publicized penalties against three companies and associated individuals for failing to implement adequate anti-money laundering procedures.  These fines should serve as a warning to the industry as a whole that FINRA is very focused on AML policies and procedures.

In its announcement, FINRA noted that the firms failed to implement adequate procedures to detect and monitor suspicious transactions.  Key to each finding was that the firms failed to identify red flags of money laundering activities and, in doing so, failed to investigate suspicious activity or file suspicious activity reports.  The fines were in the hundreds of thousands of dollars and individuals were suspended.

So what does this mean for you?  For one, you should take this warning to heart.  FINRA is taking a very strict look at firm AML policies and procedures.

Revisit your policies and procedures now.  Ask yourself this question; do my policies and procedures have those key components designed to identify red flags to detect and prevent money-laundering activity.   If the answer is no, you have work to do, and we can help.

While many brokers breathed a sigh of relief when FINRA withdrew its proposal requiring members to include a “prominent description of and link to” BrokerCheck on their web sites and social media pages, this is probably not the end of this matter.

Many firms complained about the proposal because it presented many administrative nightmares; such as coordinating with all of their social media.  Indeed, FINRA withdrew the proposal due to industry feedback. 

Brokers should not think for a moment that FINRA is going to give up on finding a way to promote enhanced access to BrokerCheck.  After all, Dodd-Frank directed the SEC to find ways to make brokers’ backgrounds more accessible to investors.  

I think that firms should expect a revised proposal that will give a middle ground.  For example, firms may expect FINRA requiring a link to BrokerCheck on the firm’s web page, but not on social media because social media is too difficult to adequately manage.  Either way, you should be prepared to have to promote BrokerCheck in some form.

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

In the years that I have been defending brokers from customer complaints, I have learned that there are a number of things brokers can do to avoid customer complaints.  For some reason, however, brokers frequently make some simple mistakes that result in big problems.

Here is a list of key things you can do to ward off customer complaints:

1. Be selective regarding who you want as a client;
2. Perform due diligence regarding all prospective clients;
3. Make sure you know your customers before they become a customer and when changing investment strategies;
4. Have frequent and honest communications with all clients;
5. Don’t avoid client phone calls;
6. Document all client communications with contemporaneous notes, or follow-up email/letters;
7. Do not pigeon-hole a client into your investing style;
8. Be a good listener;
9. Update client information every year to ensure compliance with point 3; and
10. If a customer complains, seek immediate assistance from your managing principal/compliance; never try to resolve a complaint on your own.

I have also put together guidebooks that cover these topics; you may find them of use for you as well. 

Although the list is useful, one of the more important things for you to do is to have fun.  If you have fun and enjoy what you do, avoiding liability is relatively easy.  It is when you are in a funk or complacent that problems will arise.

Have fun, work hard, and have a successful practice.

* photo from freedigitalphotos.net

A recent study by the Sutherland Asbill law firm revealed that FINRA brought 4% more disciplinary cases in 2012 as compared to 2011.  In doing so, FINRA jacked up its fines another 15%, for a grand total of $78 million.

Besides FINRA showing it still has muscle to flex, what should member-firms take away from this development.  For one, it is important to look at the areas of particular focus for FINRA.

Topping the list of enforcement actions were cases that involved suitability and due diligence; these cases totaled 117 and 62, respectively.  So what should member firms take from this heightened focus on suitability and due diligence.

Firms should take this opportunity to review its policies and procedures when it comes to suitability and knowing your customer.  I have prepared guidebooks that you might find helpful in this regard.

The key to any risk avoidance program is documentation.  Make sure your policies and procedures are well-documented.  In turn, make sure your registered representatives fully document their suitability analysis and due diligence.

Having robust documentation is not a gurantee that FINRA will not come a knocking.  If they do, well-documented policies, procedures, suitability and due diligence will go a long way to avoiding the hammer.

* photo from freedigitalphotos.net

We take a step back and speak directly to attorneys for a change, in particular, those lawyers who may recommend stockbrokers to their clients. 

In New York, attorneys are subject to the tort of negligent referral if they were to refer such a stockbroker, who then causes damage to the client.  Consequently, prior to making any such recommendation, attorneys should consider reviewing a stockbroker’s record prior to recommending such a person to their clientele.  FINRA's BrokerCheck provides a great resource for attorneys.  Essentially, the lawyer should engage in some due diligence as an initial step.  Another potential safety mechanism for lawyers would be to recommend more than one stockbroker when making these referrals.   

Thus, attorneys must be very careful and review all available public information before making these recommendations. 

One of the greatest philosophers of our time, Yogi Berra, must have had the debate over the uniform fiduciary duty standard when he penned this line.  Yes, believe it or not, the debate is about to resume.

The SEC is yet again working on possible recommendations regarding a uniform fiduciary duty for investments advisors and broker-dealers.  In accordance with Dodd-Frank, the SEC is expected to issue a request for information for economic data to determine the viability of such a standard.

All of the debate seems like much ado about nothing.  There is generally widespread industry support for a uniform standard, as long as it takes into account the nuanced differences between investment advisors and broker-dealers.

Although the standard will likely become reality in some form, is all of this time and money being spent on the debate really worth it.  In my years of defending broker-dealers, courts and arbitration panels already have routinely imposed a fiduciary duty standard on broker-dealers.  Indeed, it is common for a broker-dealer's WSPs to state that the associated persons owe a fiduciary duty to their customers. 

It seems to me that the only real benefit of having a uniform standard is to have courts and arbitration panels apply one standard, as opposed to multiple and inconsistent application to a floating standard.  A uniform fiduciary duty will exist, the only question is whether we will all live to see it.

The FINRA Board of Governors is considering implementing new rules that will require brokers to disclose their compensation when they move firms.

In many respects, this will cause issues for those who move firms periodically to obtain bonuses and other compensation increases.  These brokers will be required to disclose to their clientele what their compensation package is, and if has anything to do with the move.   See http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p197599.pdf

Many suggest that such changes, if approved by FINRA, will cause some persons to move to the registered investment advisor framework.  Further, some persons have accused FINRA of entering into a sphere where it need not go.  Moreover, some conspiracy theorists have argued that FINRA is being forced to consider these measures, not for the protection of customers, but, to provide an anti-competitive benefit to FINRA members.  That is, if this information need be disclosed, it could have a chilling effect on brokers switching firms, and, thus, provides a competitive advantage to the current employer.  Essentially, this mechanism, if approved, could lead to compensation being reduced with firms profiting at the expense of their employees.  In any event, the FINRA Board of Governors voted in favor of proposing these new rules, and the comments have already begun to roll-in.

Importantly, we should note that not every broker moves for the money and bonuses.  Many brokers move firms because the new firm provides a better platform for their clientele, and ensures better execution and services for their clients.  Additionally, some firms have internal issues that cause these brokers to leave their firms-- not the size of the bonus. 

We shall monitor the process and report periodically on its status.

In an interesting no-action letter presented by FINRA, the SEC staff granted relief in that where FINRA saw multiple class ownerships where some of these classes indicate almost a relationship between a broker dealer and a customer, the staff would permit such ownership classes without it affecting SEC Exchange Act Rule 15c3-3.

The SEC would allow such arrangements so long as there is an outside lawyer’s opinion letter indicating it was a good legal standing, that the person is actually an equity participant in the firm, the relationship between the person and the brokerage is spelled out in writing, and that their investment is not considered protected under the securities Laws or Securities Investors Protection Act, this person must reaffirm this in writing each year, and the registered person is appropriately registered.

This no-action letter will permit those who wish to invest in broker dealers who seem to be customers are in fact owners.  See Financial Industry Regulatory Authority, SEC No-Action Letter, (12/10/12), and http://sec.gov/divisions/marketreg/mr-noaction/2012/finra-121012-15c3-1.pdf.

After Hurricane Sandy caused such devastation in the Northeast, FINRA began to question firms as to their business continuity plans and if precautions were in place.

FINRA has asked these firms about their relocation, outsourcing, and alternative trading plans.  FINRA has not received responses, but it expects these firms to respond shortly.  FINRA will likely use these results in its examination program for the upcoming year. 

Although Hurricane Sandy was a tragic event, it does provide an opportunity for BDs to assess their preparedness for the next natural or man-made disaster.

Much like the character in the famous Nathaniel Hawthorne story, FINRA is looking force broker-dealers to wear a mark on all of their social media.  FINRA wants to amend Rule 2267, forcing member firms to have a link to BrokerCheck on the websites and all other forms of social media.

The stated purpose of doing so is to create better consumer awareness for BrokerCheck.  As it currently stands, member firms must annually provide their customers written notice regarding the existence of BrokerCheck and how to access it.  Is this move really necessary?

Unfortunately, studies mandated by Dodd-Frank reflect that consumers are generally unaware of the resource that BrokerCheck has become for consumers to review information about member firms and registered representatives.  In light of these findings, it seems like a safe bet that this rule change will come to pass.

What should member firms do in anticipation for this change? 

Make sure you push the culture of compliance at your firm.  Any reportable events will be more easily found by existing and potential customers.  Do what you can to avoid these events, and wearing the scarlet letter of BrokerCheck will be just another link in social media.

 * photo by Freedigitalphotos.net

The new SEC Chairman wants to prosecute those underwriters who recommend municipal issuers who hae "persistent and material" disclosure delinquencies.

In particular, the SEC may apply a stricter interpretation of previous guidelines that it issued for these underwriters.  Such an interpretation would relate to the issuers' accuracy and completeness pertaining to its disclosures. The SEC may also amend Securities Exchange Act of 1934 Rule 15c2-12, governing broker-dealers and municipal securities dealers disclosure obligations for municipal bond offerings. 

It is likely that there will be no legislative fix, and the SEC may then act accordingly.

The SEC is scrutinizing revenue-sharing arrangements between investment advisers and brokers. 

The SEC has already settled an action where two RIAs and their owner agreed to pay $1.1 million to settle SEC claims over the failure to disclose certain revenue-sharing payments and conflicts of interest to their clients.  See In re Focus Point Solutions, Inc., SEC, Admin. Proc. File No. 3-15011, 9/6/12, and http://sec.gov/litigation/admin/2012/ia-3458.pdf.  The SEC also indicated that this was the first case with others on the horizon.  The SEC established an initiative with the Enforcement Division's Asset Management Unit and its regional offices to investigate fee-sharing agreements between advisers and brokers.

The settled case highlighted this effort.  The matter also serves as a warning for future cases.  In this case, the RIAs and owner failed to tell clients that the RIAs were receiving payments from the brokerage holding the investors' mutual funds.  Coupled with the $1.1 million in disgorgement, the parties also paid penalties totaling $150,000. 

You must use this case as a wake-up call.  RIAs and broker-dealers must review all revenue sharing agreements to ensure proper disclosure.

In previous blogs, I have noted the importance of focusing on certain types of troublesome activity and the use of outside business disclosure forms to unravel or prevent fraud.

There are also a number of other techniques as part of the overall culture of compliance that you can use to prevent/uncover fraud.  In no particular order, these techniques include the following: 

1.          Compliance testing;
2.          Forensic testing;
3.          Monitoring phone usage;
4.          Monitoring internet usage;
5.          Monitoring email usage;
6.          Education and training;
7.          Internal audit; and
8.          Whistleblower hotline.

All broker-dealers and investment advisors should have clearly defined policies pertaining to monitoring the usage of the telephone and electronic media.  Having such policies may dissuade someone from using them for improper purposes.

Likewise, when circumstances warrant, you may need to use forensic testing or internal audits.  When conducting an internal audit, you should strongly consider employing outside counsel to spearhead that effort.

Although using outside counsel comes at an expense, not using one may have adverse consequences for maintaining the attorney-client privilege.  Also, you should strongly consider using a different firm than one under retainer.  By doing so, you can better promote the appearance of independence.

Depending upon the results of the review, you may need to make a disclosures to your regulator.  At a minimum, take action to address any gaps uncovered by the examination.

Finally, employing a whistleblower hotline is consistent with a culture of compliance.  It promotes the reporting of suspicious activity on a confidential basis. 

No system is full proof, but put the odds in your favor.  By doing more on the front end, you are in a better position to protect the firm from the bad acts of a few.

 * Photo from Freedigitalphotos.net

Last week, FINRA issued FINRA RN 12-45 laying out several items members should consider in the aftermath of Hurricane Sandy.

For example, FINRA suggested that member firms provide office space to those member firms affected by the Hurricane.  Further, member firms housed in temporary space would not need to make an application for a new branch location or have to update RRs' Form U-4 forms.  FINRA did specifically require these firms to contact their FINRA regulatory coordinator as soon as possible.  FINRA also extended the deadlines for completion of CE requirements and qualification examinations for those people living in federally declared disaster areas.  These deadlines now will be extended to December 10, 2012.

Additionally, at the time of this writing, FINRA's NYC offices are still closed, but that may change shortly.  As a result, member firms and RRs should check on any filed information to ensure FINRA has any materials filed by these member firms or RRs.  FINRA is also allowing member firms and individuals the opportunity to ask for more time to respond to investigations or make filings.  However, a request must be made, it will not be automatically be granted or extended.

Finally, we are all in this together, and, at Fox Rothschild, we are prepared to offer assistance where we can.

 A simple review of FINRA’s enforcement proceedings demonstrates a new norm; compliance officers are being held accountable as supervisors for rules violations.  How can a compliance officer avoid being held accountable as a supervisor?

The best way for compliance to insulate yourself is to make sure that there are clear divisions between compliance and supervisory duties.  For one, compliance officers should not be managing the day to day operations of the firm, such as hiring and firing personnel.  Instead, compliance should only make “recommendations” to supervisors when it comes to compliance issues.

Another effective tool is to have separate written supervisory procedure manuals for supervisors and compliance officers.  The firm may call the manuals two different things as well.  For example, you may want to call the compliance manual the “ethics” manual and the other the “supervisors’ manual”. 

Similarly, in those manuals, you should define the roles of those in a supervisory versus compliance capacity.  Depending upon the size of the firm, you may want to consider naming in your manuals the individuals who serve in those capacities.  The manuals should be revised every year to reflect personnel changes.

One last method to consider is for the chief compliance officer to ask the supervisors on a monthly basis whether they are aware of anything requiring a Rule 4530 disclosure. 

This guidance is no guaranty that a regulator will not try to couch compliance as supervision, but doing nothing is not an option.  Define roles, act separately, and protect yourself from being miscast as a supervisor.

The short answer to this question is a very large, NO!

All too often in my defense of registered representative and investment advisors do I see a completed account application as the only indicia of the performance of a know your customer analysis.  From my perspective and years of experience, the account application is only the floor, not the ceiling for the know your customer analysis.

Clearly, the account application is a necessary tool in the information gathering process, but checking off boxes does not give you the whole picture.  What I have found most defendable is where the advisor had his or her own checklists to ensure that they adequately know their customer.

For example, many times account applications do not take into account situational issues that may impact an investment strategy.  Does your customer have dependents?  Does your customer have health issues that would require immediate liquidity needs? Does your customer plan to retire in their near or long-term?

Account applications can never answer all of these questions, but my know your customer guidebook may help you with this information gathering process.  It is impossible to truly “know” everything about your customer, but the question in any lawsuit will be did you do enough for that customer and that investment.  A file full of things that reflect a know your customer analysis is much easier to defend than one with only an account application, which was hopefully not completed in blank.

Take your time, and go beyond the account application.  Ask the tough questions.  Push for answers.  Know your customer, and avoid the risk of a customer complaint.

The SEC recently completed the Dodd-Frank mandated study on financial literacy for retail investors and it revealed, not shockingly, an absence of basic financial literacy.  The study also found that it was important for retail customers to have a better appreciation of the costs associated with their investments, as well as conflicts of interest related to transactions. 

All those years of hearing customers testify of not knowing the difference between a stock and a bond may not have been a lie.  Without basic financial literacy, how can you know your customer to make investment recommendations with a reasonable basis and satisfy the applicable rules.

These issues should not come as a surprise to you because they are fundamental things that both your clients must know and you need to certain that they know. The absence of financial literacy will lead to two bad results.  First, you do not know your customer as required.  Second, if you do not know your customer, you could not have had a reasonable basis for making your investment recommendations.  As such, you will have liability exposure if sued by this client.

So what do you do.  For one, make sure that you do what you can to make your clients financially literate.  Once you have level of comfort that your client possesses some basic understanding of investing, you are then able to make suitable investment recommendations.  Take your time with this analysis; it may be the best way to protect yourself from customer complaints.

Brokers may finally see the light at the end of the expungement tunnel.  Over the last month, registered representatives have received some surprisingly good news relating to their CRD licensing records. 

In August 2012, the United States District Court for the Northern District of California granted a motion by E-Trade Securities LLC to expunge an employee’s CRD records relating to an investor dispute where he had no involvement.  The court stated that there is a FINRA Rule 2080, relating to the expungement of information from the CRD system, provides that a court of competent jurisdiction may direct and order such an expungement, providing that FINRA may participate in the judicial proceeding.  Nonetheless, the court found that there was no substantive legal standard to determine if such a challenge was or was not appropriate.  As a result, the court adopted the standard for expungement that SEC guidance provided, as well as, from case law, Reinking v. FINRA, Western District of Texas, #A-11-CA-813 (Dec. 1, 2011). 

Applying these standards, the court found that the broker’s case easily meets the regulatory purpose standard found in Reinking case some of the allegations were false in that there was no regulatory value in keeping the records active.  As such, the court determined that the records should be expunged from this broker’s record.  See Bridge v. E-Trade Securities LLC, et al., N.D. Cal. No. C-11-2521 E.M.C. (Aug. 7, 2012). 

Additionally, in another California case, this time at the state court level, a California Appeals Court held that a court could erase past public disclosure reports for a broker that were old or irrelevant since it unfairly hurt his livelihood.  The appeals court, thus, allowed the lower court to possibly invoke unusually broad authority to erase details on this broker’s record involving more than a dozen arbitration cases.  The court determined that this was simply the fair thing to do, and that the court did not have to follow any rigorous standards imposed by FINRA.  See Lickiss v. Financial Industry Regulatory Authority, __ Cal. Rptr. 3d __, 2012 WL 3605785 (August 23, 2012).  Although this was a victory for the broker, in that he could proceed with his case, his case must now proceed before the trial court to determine if this information should, in fact, be expunged.  As a result, at least in California, brokers now have the opportunity to ask a Judge to rule that such disclosures on CRD licensing records are simply not fair. 

Intriguingly, Reuters also reports that the number of broker requests for expungement to date nearly matches the total number filed last year.  This is indicative of the overall trend by brokers to clean their records. 

In sum, these two cases represent a watershed for brokers seeking to clean up their CRD disclosures.  Although some commentators are suggesting that this may open up the flood gates and possibly provide for other states to follow suit, we believe that the more appropriate approach would be for FINRA to propose new rules and regulations to streamline the process so that such information would be removed from the public disclosure files, especially when it is old and irrelevant.

In recent days, industry and investor advocates have been fighting over the general solicitation and advertising exemptions in private placements that went into effect with the JOBS Act.

Further, these advocates are also discussing the definition of the accredited investor standard.  Investor groups are looking to tighten these standards while industry advocates are seeking flexibility.  This dispute has led to the Securities Industry and Financial Markets Association weighing in on the matter, and informing the SEC that it should not impose a higher burden other than the current requirements of Rule 506 and the reasonable belief standard.  Other groups have also asked the SEC to develop a flexible and principles-based standard when it comes to an interpretation. 

Additionally, other disputes have arisen over the question of the JOBS Act's impact on foreign issuers operating in the United States.  Some are suggesting that those companies may or may not be subject to US jurisdiction.  There is no particularized fault line going one way or another at this time as to how that would work.

In short, the JOBS Act continues to be a quagmire with no easy solutions or answers. 

Within thirty days after a registered representative leaves a member-firm, the member-firm must file a U-5 with FINRA stating the reasons for the departure.  Those instances where the registered representative leaves on her own accord without any controversy are easy. 

The challenge you face is when the reasons for departure are not so clean.  In those instances, you may be faced with a dilemma regarding what to state because an adverse statement on a U-5 may make a registered representative unemployable. 

Depending upon where you are situated in the country, U-5 reporting may be absolutely protected speech (meaning you cannot be sued for its content) or speech entitled to a qualified privilege (meaning you can be sued under certain circumstances).  Regardless of what law applies, you should exercise caution when completing a U-5. 

The most important thing when completing the U-5 is to make sure that you accurately detail the reason for termination, but do so without editorializing about the former associated person.  The last thing you want to do is create a scenario where the former associated person sues you for some improper remark.

At the same time, you must have a description that states the reasons for departure.  If the detail is vague, another member firm may look past the U-5 and associate with a registered representative who should be out of the industry.  In that case, you may be buying yourself only temporary piece or mind; the subsequent member firm and/or FINRA may have an issue with you for an incomplete description.

The completion of a U-5 can be tricky business, but it is best to err on the side of caution and include a clear, succinct and accurate description of the reasons for termination.  If you have done your homework on the front end when you decided to separate from the registered representative, then you should not be concerned about that person or another member firm looking back at you in the future.

On July 9, FINRA Rule 2111 took effect, but it has lead some to question whether this suitability rule is simply “fiduciary duty light”.  In other words, a placeholder until the SEC finally defines the uniform standard.  FINRA’s pre-live guidance on this rule has only fueled this debate, leaving the industry to scramble to modify its policies and procedures to address a potentially moving target.

As reported by Dan Jamieson of the Investment News, FINRA’s May guidance (Regulatory Notice 12-25) has done little to quell the debate.  In its guidance, FINRA set forth a “best interests” standard of care for the rule.  The guidance further provided that the rule would apply to potential clients and to investment products that were not securities.  FINRA claimed that it was simply interpreting the new rule consistent with prior enforcement actions. 

A number of industry people saw the guidance as just another way of stating that the rule imposes a fiduciary duty through its “best interests” standard of care because the FINRA rule makes no reference to “best interests”.  Equally disturbing, the guidance imposes obligations on the industry to supervise non-securities activities (i.e., mortgages or insurance), leaving some to question whether FINRA overreached with its jurisdiction.

FINRA’s late guidance is surely going to lead to uncertainty at broker-dealers regarding what conduct to supervise and how to supervise it under the new suitability rule.  Some broker-dealers have undoubtedly had to revisit the policies and procedures developed in anticipation of the new rule.  Unfortunately, they may have to further revisit those new policies because, in the end, suitability may actually equal fiduciary duty.  Only FINRA can resolve this confusion, but the question is when and how.

Our partner, Josh Horn, was recently quoted on the rise of FINRA enforcment proceedings.  Great analysis from Josh.  Here is the link:  http://www.foxrothschild.com/newspubs/newspubsArticle.aspx?id=15032386143

Chairman Ketchum is seeking new areas of growth for FINRA.  At FINRA's annual meeting, Ketchum stated that he wanted to see FINRA take on the role as regulator for both retail professionals and institutions.  He also wants greater market transparency through the use of audited quote and trade systems.  Ketchum stated that he wants to see investors increase their use of BrokerCheck -- the system the public can use to check the background of registered representatives and broker-dealers -- so the investing public can better protect itself.  Despite this push from FINRA to grow its reach, the number of broker-dealers has been in decline.

One reason for this decline could be the increase in user fees that FINRA charges.  Another reason for the decline is the attractiveness of the registered investment adviser model, who are currently subject to SEC or state oversight depending on their size.  The SEC only examined 8% of RIAS last year, while FINRA examined 58% of its members in the same time period.  As such, RIAs are generally opposed to FINRA become their SRO, asserting that the FINRA rules-based business model does not mesh with their fiduciary duty business model.  The apparent decreased oversight of RIAs may be the ultimate reason for the decrease in broker-dealers and the increase in RIAs, which, in turn, is the likely reason that FNRA is pushing to become the SRO for RIAs.

From Ketchum's remarks, FINRAs growth model can be seen as a transparent effort to demonstrate to Congress and the SEC that it has the capacity to take on new and greater tasks.  In other words, to support FINRA's claim that it is the best choice to become the SRO for RIAs.  This political debate will likely rage on through the summer; all the while FINRA will try to do more and more to increase the perception that it is the best choice.  In the end, the most likely choice still seems to be a better funded and more active SEC.  We shall see . . .  

In its January 2011 study, the SEC recommended the enhancement of BrokerCheck, a resource available on FINRA's web page for the public to review information pertaining to brokers, registered representatives and investment adviser representatives.  As part of its mission of protecting the investing public, this week, FINRA rolled out an enhanced BrokerCheck.

With these improvements, the public now has access to the following: (1) centralized access to licensing and registration information for current and former brokers and brokerage firms, investment adviser representatives and firms; (2) the ability to search for and locate professionals based upon main and branch offices within a ZIP code radius; and (3) expanded educational content, including new search icons to enhance searching of commonly referenced terms.  FINRA is also currently reviewing responses to its request for comment on how better facilitate and increase use of BrokerCheck.

So what does this all mean?  In short, more and more information will be publicly available on BrokerCheck and the consuming public will come to rely on BrokerCheck even more for the selection of their financial professionals.  In turn, financial professionals must be even more dillgent to make sure that the information available on BrokerCheckwill not negatively reflect on them.  FINRA's goal is to protect the public and BrokerCheck will be an even greater tool going forward.

The SEC’s Office of Compliance Inspections and Examinations announced that it will increase their examinations of newly registered private fund advisers starting this summer. 

These examinations are being done in conjunction with those hedge fund and private equity advisers previously registered with the Commission as a result of the Dodd-Frank Act.  The SEC Staff made it abundantly clear that these newly registered advisers will be examined, pursuant to a set of risk factors and not by the traditional OCIE exam cycle.  The OCIE Staff will also look at the level of risk and determine the number of times new registrants will be examined in the future.  For this determination, the SEC Staff will look at past regulatory or legal violations; aberrational performance; the size of the fund determines the risk; the advisors complexity; problems internally; when the last exam occurred; and significant changes and assets for business.  Nonetheless, the SEC Staff cautioned that they will look at both quality and quantity factors, and that these risk factors are very similar to those already in place for previous registrants. 

In short, OCIE intends to utilize risk based assessment examinations in the future.

Recently, the SEC's newest commissioner, Commissioner Daniel Gallagher, discussed certain of his beliefs, including, among other things, that the SEC should use its exemptive authority derived from the Investment Advisers Act of 1940, to provide some relief for hedge fund and private equity investment mangers from the registration provisions of said Act. 

Gallagher believes that the full registration regime should not have been imposed upon investment managers for hedge fund and private fund advisers.  Essentially, he believes that the SEC should use its exemptive power to provide some "balm" to their predicament.  He also indicated that the SEC should rethink certain registration requirements if it does not promote capital formation.

Additionally, Commissioner Gallagher commented on the recent case of Theodore Urban, and his belief that the Commission should clarify when it believes that legal personnel are considered supervisors.  As many may know, the Commission deadlocked over the case, requiring the dismissal of the charges.  Commissioner Gallagher believes that it is important for the SEC to provide the standard for charging in-house counsel and other legal personnel in these matters.  Commissioner Gallagher hopes that the SEC will clarify this position through a Section 21A Report under the Securities Exchange Act of 1934.  He, however, said that there has not been a suitable case to do so as of yet. 

Commissioner Gallagher also has indicated that he believes that the SEC needs to provide a better framework to work with in-house legal and compliance officers of broker-dealers and investment advisers.  He believes that the SEC should utilize these individuals to accomplish its mission.  He also thinks that, if these individuals are engaged, as opposed to challenging them, or causing them liability, the SEC would be more likely to uncover fraud and protect investors.

Finally, as we move forward, it will be interesting to see if Commissioner Gallagher will influence the SEC to change.

Much has happened in nearly one since since the Dodd-Frank Act became effective, and much more remains.  According to the recent thoughts of one commentator, Kyle Colona of Compliance EX, Dodd-Frank may be doomed to fail as it faces it first year of existence.

Colona noted five factors working against the full implementation of the law: (1) the CFTC and SEC are far behind schedule; (2) the regulatory authority under the Act is shared by too many entities; (3) recent comments from the Federal Reserve Bank suggest that the Volcker Rule may not become law because of its impossibility to implement; (4) the financial services industry has unleashed a full-scale effort to defeat the full implementation of the Act; and (5) certain banks are trying to influence the public that implementation of the Volcker Rule would be bad.

I think that there is now a sixth factor that may work against the full implementation of the Dodd-Frank Act; namely, a presidential election this fall.  With the politicalclimate becoming more and more focused on the election, it is only natural that there would be less attention devoted to a law that the financial services industry is committed to pealing back or doing away with altogether.  If the President loses the election, there are some who believe that Dodd-Frank may be in trouble.  Even if the President prevails, it is unlikely that there will be full implementation because attention will surely be focused elsewhere.

Although it is unlikely that there may ever be full implementation of the Act, we need to still anticipate that many provisions of the Act will come to pass.  For example, at some point, the SEC will finally commit to the adoption of the uniform fiduciary duty rule and there will be a decision on who will serve as the SRO for investment advisors.  Dodd-Frank is not dead; it just may limp along for the next year.

FINRA recently commented on its enforcement actions and fines over 2011.  If anything, the statistics show that broker-dealers are on notice of two things: (1) FINRA is aggressively pursuing enforcement actions; and (2) FINRA is seeking larger fines in enforcement proceedings.  As such, now is as good a time as ever for broker-dealers to revisit their compliance programs to ensure that they are running a tight ship in an effort to avoid an unfriendly call from big brother. 

FINRA' issued $68 million in fines in 2011, up from $45 million in 2010.  The greatest component of these fines was found in a surge from penalties for improper advertising, comprising $21.1 of the total fines issued.  The report FINRA issued also reflects a step-up in enforcement proceedings.  There were 1,488 disciplinary actions in 2011, compared to 1,310 for 2010.  In addition, FINRA increased the number of barred brokers from 288 in 2010 to 329 for 2011.

The easy answer for this step-up in enforcement actions and fines if that FINRA is continuing to address the regulatory failings arising out of the Maddoff and Stanford ponzi schemes.  In essence, this increased activity is a reflection of prior criticisms that FINRA was a paper tiger.  So what does this mean for broker-dealers.

For one, FINRA's report shows that particular attention should be devoted to firm advertising.  Firms should take a critical look at what they are internally telling their registered representatives versus what is being told to the public.  Moreover, with the increased use in social media, firms need to ensure that any use of social media conforms with the firms' advertising and document retention policies.  Finally, with the adoption of Rule 2111, firms should also focus more on suitability, because FINRA will certainly look to determine if firms are complying with the new rule. 

FINRA's report clearly shows that firms must be ever vigilant when it comes to compliance.  If not, you too may be the subject of an enforcement proceeding and fines.

The new SEC Rule 13h-1, the large trader reporting rule, became effective. 

Starting on April 30, 2012, broker dealers will be required to maintain records of large trader trading, similar to records maintained relating to the electronic blue sheet system.  Further, supplemental information will also be required.

This new large trader rule could implicate investment advisers, banks, broker dealers, insurance companies and foreign entities.  All may be required to self-identify by filing a Form 13H with the SEC, and provide unique information to the SEC.  Broker dealers will also be required to maintain information relating to these trading records supplemented with the time of order, execution and the trader’s ID number if the SEC so requests.  Broker dealers will also be required to file a Form 13H if they are large traders.

Although the definition of a large trader is enunciated in the rule, there is some factual assessment that goes into it.  That is, it relates to any person, who directly or indirectly, exercises investment discretion over one or more accounts through NMS securities and registered broker dealers in a certain activity level.  The large trader must file an initial Form 13H promptly after it crosses the trading thresholds, and it has been considered that promptly means within ten days.  There are also annual filings that must be done within 45 days after each calendar year.  Confidentiality was also critical in assessing this information, and the SEC expects firms to realize that it will maintain the confidentiality of said information.  However, it may have an obligation to disclose it to Congress, other federal agencies and pursuant to a federal court order. 

Accordingly, firms should be aware that these issues may arise, and should be ready to file and maintain the appropriate records.

The SEC published a small entity compliance guide for investment advisers relating to the new Form PF.  These new reporting requirements affect SEC registered investment advisers with at least $150 million dollars in assets under management.  Some of these new guidelines will also apply to CFTC commodity pool operators and commodity trading advisers.

The SEC registered advisers will be divided into 2 groups, small advisors and large advisers.  The definitional requirements for large advisers are specific and may require certain calculations, however.  Clearly, large advisers have assets under control of anywhere between a billion dollars and more.  For the purposes of the Form PF, all other advisers would be considered small private advisers.

Generally, an investment adviser is a small business pursuant to the Investment Advisers Act and the Regulatory Flexibility Act if it has assets under management of less than $25 million dollars.  As such, these advisers will, generally, have no reporting requirements on a Form PF.  However, for those advisers, who are not defined as a small business, there may be certain reporting requirements.  For example, advisers with over $150 million dollars in private fund assets under management, but are not large advisors must file a Form PF once a year within 120 days at the end of the fiscal year.  Large private advisers must file a Form PF within 60 days.  Moreover, the requirements for advisers with over $150 million dollars, but who are not large advisers, are less than those of large private fund advisers.  Essentially, the more money you have under management, the more information you must provide.

In short, advisers should consult with securities counsel to ensure accurate reporting in the future.

FINRA recently announced that, in the first quarter, it will issue a risk control assessment survey to all member firms.  Although this is a voluntary program, member firms should strongly consider their participation.  Your efforts on the front-end may alleviate the work you would otherwise perform during an examination.

The purpose of the survey is for FINRA to better understand member firm business models, the risks attendant with those models and the controls intended to manage those risks.  According to FINRA, responses to this survey will afford it the ability to conduct more focused examinations.  In other words, the program will give examiners a better understanding of your firm before arriving on site and allow the examiners to streamline the examination.

According to FINRA, firms who do not participate will not suffer negative consequences.  However, those non-participating firms should expect FINRA to spend more time during an examination.  FINRA plans to conduct this survey on an annual basis; the content will change as new risks emerge and as priorities evolve.

Even though answering the survey will take time to complete, streamlining the examination process is a laudable goal.  If the time spent on completing the survey results in a more focused and shorter examination, it seems to me that the decision to participate in the survey should be a forgone conclusion.

Although the SEC’s rulemaking deferral regarding the uniform fiduciary standard has gained much press, the SEC's other rulemaking initiatives pursuant to the Dodd-Frank Act march on, and will have a significant effect on broker dealers and investment advisors in the upcoming year.

In particular, the SEC has scheduled a joint SEC-CFTC report to Congress on stable value contracts, and the adoption of rules pertaining to trade reporting, data elements and real time public reporting for security-based swaps.  Further, the SEC and CFTC will define key terms for swap products and intermediaries as well as security-based swap clearing agencies.  The SEC will also look to register and regulate security swap based data repositories and for mandatory clearing of security-based swaps.  Additionally, the SEC will look at the end user exceptions for the mandatory clearing of security-based swaps. 

The SEC will also consider a permanent rule to register municipal advisors this year.  However, certain controversial rules relating to conflict materials rule finalization and resource extraction disclosures as well as corporate governance rules relating to executive compensation claw backs, performance disclosure pay, compensation ratio and hedging policies have been pushed forward to the first part of this year.  Moreover, the SEC still has not set up certain offices that the Dodd-Frank Act required including, but not limited to, the credit ratings and municipal securities oversight function offices.  Currently, the SEC believes these functions are being performed by its Division of Trading and Market's Staff. 

In sum, the SEC’s Dodd-Frank Act rule making is still ongoing and will continue as it moves forward.

The GAO has indicated to the SEC that it should consider the codification of the analyst conflict pact it entered into with other regulators in 2003.

As many recall, in 2003, a group of regulators, including the SEC, struck a deal with a number of Wall Street firms concerning their equity research analyst's conduct.  These firms agreed to pay $1.4 billion in penalties and disgorgement.  The GAO is now recommending that the SEC codify this pact (although at the time, the NASD and NYSE finalized rules relating to this pact), in the SEC’s rules and regulations. 

The SEC responded through its Director of Trading and Markets Division, who indicated that the SEC Staff believes this recommendation makes sense, and will plan accordingly. 

The SEC's delay in adopting an uniform fiduciary duty will only be prolonged but yet another analysis that the SEC will commission.  Chairman Schapiro recently announced plans to issue a public request for information regarding "retail financial advice and the regulatory alternatives".  With respect to the adoption of the uniform fiduciary duty standard, the SEC suggested that it was still in the information gathering stage of rule-making.  Interpretation; the SEC is no closer to adopting a uniform fiduciary duty standard.  Although the SEC has not ruled rule-making for 2012, it is not likely.

The SEC has advised the House Financial Services CapitalMarkets subcommittee that it has three economists working on the initiative.  Among other things, the economists have reviewed available market information for the retail financial advice market, including the differences between broker-dealers and registered investments advisers.  Notwithstanding the work of the economists to date, the SEC noted that the rule-making associated with the uniform fiduciary duty will require an analysis of information that may not be publicly available such that it will be particularly important for the SEC to solicit the public to provide information and/or empirical data.

Of the information that the SEC will seek in its public request for information, broker-dealers should expect that some of the data sought will cover a cost-benefit analysis of whether the adoption of a uniform standard will outweigh the cost of doing so.  Although delayed, the SEC is, it appears, trying to have a full and complete analysis to ultimately justify a uniform fiduciary duty.  In light of the manner in which many courts and arbitration panels treat broker-dealers, this whole exercise could be seen as making something "official" that has already been in place for many years.  The question that remains is whether the cost to make the standard an "official" one is worth it considering the prevailing view of many that it may already exist.

For anyone reading this post, you appreciate the value of social media.  It looks as though FINRA is finally prepared to do so as well.

FINRA recently proposed changes to its rules governing communications with investors.  In doing so, FINRA has proposed easing its requirements of pre-approval for a broker-dealer's use of social media.  Chief among the proposed changes would be the authorization of registered representatives communicating with clients via social media without a supervisor's prior approval.  Without pre-approval, a registered representative could engage in interactive , real-time communications with customers via a social media site.

Assuming this proposal is adopted, this is a positive step for FINFRA.  Nevertheless, I think that broker-dealers and registered representatives still must be wary of using social media to communicate in real-time with their clients.  First, the member firm will surely still be required to maintain copies of these communications consistent with its record retention obligations.  Keeping track of the potential volume of such communications creates a record-keeping nightmare.  Second, broker-dealers should consider restricting their registered representatives from making investment recommendations through interactive social media because of suitability concerns.  The risk of an investment recommendation being disseminated via social media is that anyone accessing that source could argue that it was an investment recommendation made by the firm and pursue a claim against the firm in the event of a loss. 

In my experience defening member firms and registered representatives, the types of claims asserted are only limited by the creativity of the lawyers.   Do not be a victim.  If FINRA specifically endorses inter-active communciations via social media without pre-approval, be certain that you have meaningful policies, procedures and protocols to maintain proper records and avoid open-ended recommendations to the public.

Although the use of social media has been embraced by many industries, it is of particular concern for investment advisors and broker-dealers.

In many situations, the use of these outlets touch upon several areas.  For investment advisors and broker-dealers, the advertising requirements under the Investment Advisors Act of 1940 and certain Securities Exchange Act of 1934 provisions may be implicated when one uses social media, including various features on Linked In or Facebook.  Additionally, recordkeeping is a critical function required by both acts since this information must be maintained.  Further, it is likely that those who work for either and use social media sites, may require supervision.  Additionally, when one uses these types of communications, there are various regulations that require the firms to monitor these third party communications to ensure that, among other things, non-public information is not disclosed.  Firms would also be required to apply their audit function to these media policies and procedures internally, to determine if the procedures are effective.  Moreover, the SEC, FINRA and the states may begin to regulate these types of social media in amore forceful manner. 

As such, although social media venues may present certain benefits, the risk is palpable.

FINRA proposed a rule for SEC approval that would require FINRA’s membership, involved in a private stock offering, to provide detailed information on the transaction to investors prior to the sale, as well as to file such information with FINRA 15 days before the first sale.

This proposed Rule 5123 would require that offering materials used in these offerings, as well as the amount and type of compensation provided to a variety of people, be filed with FINRA.  Further, any amendments would have to be filed with FINRA within 15 calendar days after the date the document is provided to a current or prospective investor.  This new rule is also to be used in conjunction with Rule 5122, requiring certain disclosures in private placement offerings issued by the FINRA member or its affiliates.  Nonetheless, the proposed Rule 5123 would exempt certain types of private placements sold to certain purchasers, including, but not limited to, institutional accounts, qualified purchasers, qualified institutional buyers under the Securities Act of 1933, Rule 144(a), and investment companies.

In sum, FINRA is taking an aggressive approach on reviewing private placements, thus, this or some variation of this new rule is likely to be approved by the SEC.

FINRA, recently, announced that it was developing a cross market surveillance system that will allow it to detect and stop improper conduct.  This was reported by FINRA Chief Executive Officer, Richard Ketchum. 

This new system will expand FINRA’s surveillance and enforcement of the New York Stock Exchange, as well as its own order audit trail system to include New York Stock Exchange data.  FINRA believes that, with the combination of both, it will be able to effectively monitor equity trades and data to allow it to see patterns ahead of or in conjunction with the market, as opposed to reviewing it after the fact.  Ketchum suggested that this new surveillance system would possibly assist FINRA in achieving the SEC’s goal for a consolidated audit trail system. 

This new system may significantly reduce FINRA’s expenditures on examinations, and bring to light unscrupulous activity in the market in time to protect those effected.

The Securities Industry and Financial Market Association (“SIFMA”) indicated to its membership that those who engage expert networks – entities referring paid industry professionals to third parties for fees – should have in place policies, procedures, and training for their employees or others who engaged those services.  These expert networks have drawn regulatory attention, especially in insider trader investigations. 

These expert networks have found themselves in certain insider trading cases where it was alleged they tipped hedge funds or other investors in return for a cash payments.  Of course, this is more the breach than the rule, and the vast majority of expert networks would never do such a thing.  However, expert networks have become important in the financial system since they assist broker-dealers to design or implement investment strategies.  Nonetheless, broker-dealers should take precautions, as well as devise procedures to ensure that there is not even an appearance of impropriety. 

In sum, SIFMA believes that its membership should have policies to find and detect “red flags.”  These red flags will allow broker-dealers to ensure that their policies are being followed, especially, regarding material non-public information.  See Best Practices for Use of Expert Networks at http://www.sifma.org/uploaded files uploadedfiles/issues/legal_compliance_and_administration/expert_networks/expert-network-policy-bestpractices.pdf.

Recently, an unregistered broker-dealer was able to retain its finder’s fees in a lawsuit brought by a SEC Receiver.  The Receiver was appointed as a result of an SEC action brought against an investment advisory group.  The Receiver sought to recover a finder’s fee, claiming that the party was acting as an unregistered broker-dealer for the defendant charged in the SEC action. 

The court, ultimately, ruled that the Receiver’s action was untimely, and had violated the statute of limitations.  The Receiver was unable to convince the court that the action should have been equitably tolled because the Receiver had not been appointed before the statue of limitations had run.  Essentially, the court determined that, although the defendant was not a registered broker-dealer, the defendant in the SEC case could have determined if the finder was a registered broker-dealer, and, since there was no allegation of fraud, the court allowed the finder to keep the finder’s fee because it would not run afoul of the Securities Exchange Act of 1934. 

This action is interesting because not all cases involving unregistered broker-dealers will result in the forfeiture of finder’s fees.  In this case, the SEC Receiver was unsuccessful in convincing a court to force repayment.  Unfortunately, however, the SEC did not comment on this action.  Nonetheless, this matter may be indicative of future matters involving unregistered broker-dealers or finders, and the retention of their fees.

Recently, UBS announced that it had terminated a former trader, who was also arrested by British police.  Apparently, this rogue trader cost UBS over to $2.25 billion.  UBS was in the process of eliminating a number of jobs to save money on its balance sheet, but this loss will likely wipe out the savings.

However, the real lesson from this scandal is that firms, such as, UBS, need to be ever vigilant in their compliance and regulatory programs. Such losses are hard to keep secret unless it is apparent that the person engaging in such conduct kept this information from his or supervisors.  UBS will undoubtedly undergo an audit, and the findings will be used to prevent this from reoccurring.  Nonetheless, many in the industry should learn from UBS' mistakes, and pounce on the opportunity to review their compliance programs in an effort to ensure procedures are in place to detect such conduct.

In sum, firms have an obligation to not only detect this type of fraud, but to prevent it from occurring in the first instance.  The only way to avoid such issues is to prepare before they occur.

Reuters recently reported that the SEC and FINRA were asking trading firms specific details regarding their trading strategies and/or their secret computer codes. 

This new effort by the SEC and FINRA is part of a joint investigation into suspicious market activity as well as to examine compliance with securities regulations.  The specific requests relating to computer code, obviously, have irked many in the industry since the requests have to do with targeting stock trading firms and hedge funds.  These inquiries relate to trading information and computer coding information that may have been shared or “borrowed” with others, and used for illegal activity.  Clearly, the SEC and FINRA are focusing on this information to better understand the trading markets, but, of course, if they find anything of an illegal nature, it may result in enforcement examinations.

FINRA executives, recently, told a SIFMA conference that FINRA did not make these requests “lightly.”  However, this worries many since the information is privileged and proprietary, and may find its hands into competitors.  Although, the SEC and FINRA both have policies in place to protect such information, once the information is out, companies may find themselves in a predicament.  Counsel should certainly handle these particular issues.

By way of overview of the currently regulatory environment, FINRA highlighted that member firms have an obligation to maintain records of business communications regardless if those communications appear on social media. FINRA also reminded member firms that the use of static social media for a business purpose requires pre-approval by member firm. Conversely, interactive electronic forums do not require member firm pre-approval, but the firms have to adopt risk-based supervisory procedures that utilize post-use review. With respect to links to third-party sites, FINRA cautioned that a member firm cannot establish a link with a site that the firm knows or has reason to know contains false or misleading information. Finally, FINRA reminded member firms that they must adopt procedures to manage data feeds to their own websites to ensure the accuracy of the information contained in such data feeds.

In response to specific questions, FINRA reminded firms that firms and associated persons cannot sponsor a social media site or use a communication device that automatically erases or deletes its content. Such a site or device is counter to the record retention obligations of Securities Exchange Act Rule 17a-4. Likewise, the use of a personal device for business purposes must be set up to allow for the retention of regulated communications. Moreover, the record retention obligation does not vary if a firm or registered person is using a static or interactive website.

As to the debate between interactive and static content, FINRA cautioned that interactive content can become static if it is copied or posted to a static forum. In that instance, there must be pre-approval of the posting. Similarly, a material change of static content will require new approval by the member firm.

Finally, FINRA provided guidance where member firms co-brand a third-party site such as where a member firm places a logo on a third-party site. In that scenario, FINRA stated that a member firm is responsible for the content of the entire third-party site. A firm would not be responsible for the content of a third-party site where the firm does not adopt or become entangled with the content of that site and the firm does not know or have reason to know that the site contains false or misleading information.

I believe that all of this guidance, although helpful, is serving as nothing more than a warning to member firms. Either have proper supervision in place for the use of social media, or the full weight of FINRA will come to bear. It is critical that member firms have a uniform compliance system to ensure regulatory compliance and reasonable supervision over the use of social media by the firm and associated persons or be forewarned that FINRA may be coming to visit.

In January 2001, the Securities and Exchange Commission (“SEC”) recommended the implementation of a uniform fiduciary duty standard for broker-dealers and registered investment advisors. Significant debate has followed regarding the potential parameters and scope of such a duty. Recently, the Securities Industry and Financial Markets Association (“SIFMA”), a lobbying group for large broker-dealers, proposed a framework for a uniform fiduciary duty.

Although SIFMA reiterated its support for such a standard, it also recommended against applying the fiduciary duty found in the Investment Adviser Act of 1940 to broker-dealers, stating that it would adversely impact “choice, product access and affordability of customer services”. Among other things, SIFMA proposed a new fiduciary duty for broker-dealers to accommodate broker-dealer conduct that would otherwise be in violation of the 40 Act.

In doing so, SIFMA recommended that, in its rulemaking, the SEC “provide the necessary rule-based guidance regarding when the fiduciary duty begins and ends and what disclosures and consents, if any, are necessary to satisfy the duty where a broker-dealer gives “advice involving principal trading, structured products, hybrid accounts, complex investment strategies, concentrated positions, and receipt of commissions and differential loads for different products.” To implement this standard, SIFMA proposed that it be articulated in the initial customer agreement. SIFMA also recommended that the fiduciary duty apply on an account-by-account basis.

By implementing a new fiduciary duty standard unique to broker-dealers, SIFMA believes that the SEC will properly take into account the distinctions in the law between registered investment advisers and broker-dealers while taking customer service into account. It remains to be seen if SEC heeds this call to action, or if the SEC simply rubbers stamps the 40 Act fiduciary duty standard to broker dealers.