Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

The SEC recently announced that its top priority is to increase the number of investment adviser examinations it conducts on an annual basis.  Considering that the SEC only examined 8% of all investment advisers in 2012 (where 40% have never been examined), the SEC could only increase the number of such examinations.

The talk, for the moment, has moved away from the uniform fiduciary duty and designating an SRO for investment advisers.  Instead, the focus is on increasing the budget for the SEC to fund, among other things, its examination process.

The shift in focus back to examinations is only logical.  The debate on the SRO and uniform fiduciary duty standard has taken much time and produced no results.  A reinvigorated examination process will shift the view of the SEC from being do-nothing to do-something.

So what should you expect?  It is likely that the SEC will receive increased funding.  In turn, investment advisers should expect more that 8% being examined in any given year.  

Where that number goes is anyone’s guess, but now is as good a time as any to revisit your compliance policies and procedures.  Make sure your house is in order now, or pay for it later now that the SEC will have the funding and will surely act with a purpose in the examination process.

*photo from freedigitalphotos.net

My partner, Ernest Badway, recently blogged about the dangers of a lawyer referring a client to a rogue stockbroker.  The question for the broker-dealer/investment advisors is how do you uncover rogue brokers or prevent them from infecting your firm.

In all of the years that I have defended broker-dealers and investment advisors in cases involving rogue brokers, I have found that the answer to this question is much like the search for Bigfoot; everyone thinks it exists but cannot see to find it.  So what is a firm to do?

The most fundamental thing a firm can do to prevent/uncover rogue brokers is to foster a culture of compliance.  Firms with such a culture will go a long way to establishing itself as an entity to which rogue brokers need not apply. 

Rogue brokers tend to thrive in those environments where compliance and supervision are not up to snuff.  A firm that promotes a culture of compliance will also encourage other brokers to report up the supervisory chain when they see conduct that one can characterize as "rogue". 

Another useful tool for firms to employ is a regular review of your brokers, coupled with occasional surprise reviews.  Regular reviews are good because they emphasize that the firm is watching its brokers.

Surprise reviews are, in some ways, even better because the truly rogue broker may be able to cover their tracks before a regularly scheduled review.  The surprise inspection takes away this potential luxury.  Also, the firm should let its brokers know that they are subject to no notice surprise inspections.

Unfortunately, some rogue brokers are so good that they may fly under the radar even at firms that promote the culture of compliance; I have seen it happen.  But put the odds in your favor.  Keep tabs on your brokers through regular and surprise inspections, and maybe you will find Bigfoot.

FINRA announced that it is seeking proposed rule changes to make it easier for investors to use BrokerCheck.  See http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/.

These proposed amendments to FINRA Rule 2267, Investor Education and Protection, would require member firms to include a BrokerCheck reference on their websites and those of any associated person.  Additionally, FINRA Rule 8312, BrokerCheck Disclosure, would be amended to allow the public permanent access to BrokerCheck information on state or foreign settled cases against associated persons as well as permit various data downloads.

Essentially, FINRA wants to ensure that BrokerCheck remains a key resource for investors.

The SEC Staff issued a report on the handling of confidential information by broker-dealers.  See http://sec.gov/about/offices/ocie/informationbarriers.pdfProblems.  This report cited various issues, including, but not limited to, the unmonitored viewing of nonpublic data, and informal, undocumented interaction among different groups within these entities.

The report was prepared by the Office of Compliance Inspections and Examinations, and was published to assist broker-dealers in their efforts to safeguard customers' confidential information.  The report illustated a variety of conflicts of interest between the broker-dealer and the customer as well as the potential misuse of this information while also pointing out a variety of methods now used to protect such information by broker-dealers.  The SEC Staff identified particular areas of concern including the fact certain executives had unlimited access to this type of information, and there were gaps in compliance oversight in protecting said information.

Finally, this report was not only to announce these findings.  Most assuredly, the SEC will be looking for these issues in the future, and, if found, there will probably be no leniency.  That is, the SEC will point to this report, and indicate broker-dealers were on notice to correct these failings. 

Over the course of many years, I have been questioned by American BDs as to their responsibilities for sales to people outside the United States.  My response has always been that they are required to obtain an opinion from counsel in those jurisdictions before proceeding.  Most likely, those foreign jurisdictions may have registration requirements before conducting business in their countries. 

Now, the shoe is on the other foot.  We are now seeing non-US issuers selling certain fund interests into the United States.  Those persons, who are selling those securities into the United States, may require SEC registration as well as the requirement to implement compliance program before moving forward.  Further, certain states, such as California, will have various requirements requiring each of these sellers to follow, some of them may not appear at first blush, like California's lobbyist rules.  If the selling issuer does not comply with these items, it opens itself up to potential liability.   

Thus, we strongly recommend that non-US issuers contact American counsel before selling product into the United States.

Private equity companies have recently been hit with a barrage of regulatory subpoenas.

Responding to these subpoenas may cost the private equity firms to expend millions of dollars.  These entities should have D&O liability insurance.  Initially, the entity must make sure that responding to such a subpoena falls within the definition of a claim.  Some policies may not define claim so you may then have to hope that the court reviewing your matter accepts a definition that will encompass a response to the subpoena.

Essentially, be prepared before receiving the subpeona, call your insurance broker (and lawyer) today!

The SEC announced that it will most likely look at four main areas when examining newly registered hedge fund advisers.

Those areas are marketing and advertising, portfolio management, conflicts of interest, and client asset safety.  This approach will be followed as a result of certain risk assessments made by the SEC Staff.  Essentially, the SEC Staff does not believe the proverbial "proctology" examination will be conducive to uncovering problems in a quick and efficient manner.  Gee, we could have told you that!!

In any event, these exams will, most likely, be conducted much more quickly than the traditional investment adviser examinations, thereby, extending the SEC's "presence" in this arena.  That may be the SEC's ultimate goal, establishing its imprint in this sphere.

We will monitor these exams to mine more data as they proceed over the next 18 to 24 months.

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.

The SEC, recently, sued a private equity fund adviser for, among other things, allegedly violating Investment Advisers Act of 1940 Rule 206(4)-7, for failing to have procedures requiring verification of client signatures and instructions by a second person.  See http://www.sec.gov/litigation/complaints/2012/comp-pr2012-244.pdf.

The SEC stated that the RIA and its principal made certain unauthorized transactions and used clients’ funds to pay off debt owed by the principal.  The specific violations related to Rule 206(4)-7, involved the RIA’s failure in not having a second set of eyes review client signatures and other instructions.  The SEC believed this would have prevented these defalcations.  Essentially, the SEC argues that a “shadow” is necessary to avoid these unlawful acts.  Interestingly, however, this type of illegal activity alleged seems to take place even with the best of compliance programs.

Nonetheless, RIAs must be vigilant in ensuring that more than one person reviews both client signatures as well as instructions, and, who knows, the “shadow” may just save the firm.

I previously wrote about how the Food and Drug Administration and Department of Justice used the responsible corporate officer doctrine to charge former Purdue Pharma executives and in-house counsel with criminal liability and career-ending debarment for “off-label” drug marketing, even though the charged parties did not personally participate in the conduct or even know about it.  Recent court activity may significantly reduce such exposure for similarly-situated individuals, with ripple effects spreading through many legal sectors, including shareholder suits.

In a game-changing decision released on December 3, 2012, the Second Circuit Court of Appeals reversed the conviction of Alfred Caronia, a pharmaceutical sales representative who had been convicted of conspiring to introduce a misbranded drug into interstate commerce.  The evidence at trial included recordings of Mr. Caronia’s statements to doctors that Xyrem, a drug that the FDA approved for narcolepsy, could also be used to treat various other conditions for which the FDA had not approved the drug.

Mr. Caronia argued that the prosecution violated his First Amendment right to free speech.  The Second Circuit agreed, and in reversing his conviction narrowly read the scope of the Food, Drug, and Cosmetic Act “as not criminalizing the simple promotion of a drug’s off-label use because such a construction would raise First Amendment concerns.”  Mr. Caronia’s conviction relied on off-label promotion, and was therefore invalid.

Depending on one’s perspective, pharmaceutical representatives promoting off-label uses for their products are either modern snake oil salesmen or critical conduits of information to medical treatment providers regarding cutting-edge therapies.  

Setting this debate aside, the Caronia decision could upend the current FDA regulatory and enforcement regime regarding off-label marketing, with wide-ranging effects.  In addition to the government’s revitalization of the responsible corporate officer doctrine, recent years have witnessed:  (1) the government attempt to prosecute in-house counsel for obstructing an off-label marketing investigation; (2) the government require, in settlement of misbranding charges, corporate integrity agreements that prohibit compensation of the sales force based on sales goals; and (3) scores of whistleblower lawsuits, False Claims Act actions, and the follow-on class-action shareholder lawsuits involving off-label marketing.

This could all change if the Supreme Court affirms the Second Circuit or if other appellate courts agree that prosecutions for “off label” marketing violate free speech rights.

The recent news regarding members of the government and military should hammer home the importance behind a robust email review.  At the same time, these incidents reflect the importance of thinking before you press send.

Over the last decade that I have been coaching financial advisors on risk avoidance techniques, issues surrounding email use have become more prevalent.  Email is a great time-saver, but has resulted in many of you becoming intellectually lazy about the substance of your emails.

The most important thing to remember about email is that the “e” does not stand for electronic.  Rather, in my view, it stands for both “ever-lasting” and “exhibit”.

In other words, email will always remain in computer space, only to be recovered by a skilled technician.  Deletions are only temporary.  Think about the substance of your email before you send it because that email will always be available for the world to read.

Also, do not put anything in an email that you would not want blown up as an exhibit in a trial.  If you look at a draft email and think it may be a bit out of line, think how a judge, jury or arbitration panel will think when they look at that email on a wide screen or enlarged poster board at trial.  It is not a pretty sight when it is your email.

By the same token, these recent events should serve as an impetus for firms to revisit their systemic email review.  Think about the trigger words that your systems uses to flag emails.  Revise those triggers over time to focus on ever-changing issues.  What may be an area of focus this year, may not be the next.

Email can be a great tool or a terrible curse.  Only you can decide which it will be by your actions.  Think before you hit send.

* Photo from freedigitalphotos.net

The late great comedian, George Carlin, was made famous by his routine, “The Seven Dirty Words You Can Never Say On Televisions”.  Likewise, fraudsters do not want compliance personnel to ever mention the 13 common dirty traits that may uncover a fraud.

Although not as funny as George Carlin, focusing on these traits may be the key to a firm’s survival.  In no order of significance, you should look for people who do the following:

1.         Never takes a vacation;

2.         Live beyond their means;

3.         Too much debt relative to income (creditors calling the place of employment);

4.         Possess an attitude that they are above the system;

5.         Suspicious of having others check their work;

6.         Extreme behavior changes to either extreme (depression and euphoria);

7.         Set unrealistic personal goals;

8.         Unexplained spike in production;

9.         Spouse loses a job;

10.       Divorce (i.e., a property distribution);

11.       Drug or alcohol abuse;

12.       High number of elderly clients (or any other affinity group concentration); and

13.       Consistently offering new product lines for investing.

So what does the list of 13 suspect behaviors mean for member firms and investment advisers?  You must do all you can to know your personnel as well as you need to know your customers before making an investment recommendation.

The better you know your team, the better prepared you will be to notice any of these ugly traits.  You will notice erratic behavior or behavior that is simply out of the norm.

Certainly everyone going through a divorce or an alcohol problem are not fraudsters, but traits in combination may be the sign of trouble.  Do more due diligence over your personnel when any of these traits arise.

Protect yourself and the firm.  There are fraudsters under every rock.  You just need to identify those rocks needing to be turned over. 

*Photo from Freedigitalphotos.net

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 an interesting no-action letter, the SEC Staff stated it would not recommend enforcement action if a company did not register as an investment adviser where the company provided investment advisory services solely to its parent company and subsidiaries.  See Allianz of America, Inc., dated May 25, 2012, at http://www.sec.gov/divisions/investment/noaction/2012/allianzamerica052512-203a.htm.

The SEC Staff found that this entity need not register with the Commission as an investment adviser.  The Staff stated that, although Section 202(a)(11) of the Investment Advisers Act required anyone providing advice to others regarding securities for compensation to be registered with the SEC, this entity claimed it did not advise non-affiliated third parties, but only its parent company and wholly owned subsidiaries.  Further, the entity provided to the SEC Staff no-action letter and exemptive relief authority where other companies in similar situations were not required to be registered.  Accordingly, the SEC Staff granted the request of no action relief. 

In sum, if you can keep it in-house, registration will not be necessary.

At least, they can the health care and environmental arenas.  Under the responsible corporate officer (RCO) doctrine, the ability to control corporate conduct is sufficient to hold officers criminally liable, even if the officers did not participate in the misdeeds or have actual knowledge of them. 

The D.C. Circuit recently revisited the RCO doctrine in a case arising from Purdue Pharma's guilty plea to felony misbranding of OxyContin.  Some company executives were also charged despite their lack of participation or knowledge of the alleged conduct, and pleaded guilty to misdemeanor misbranding. 

As is frequently the case in regulated industries, a parallel administrative proceeding commenced, and the individuals received 20-year industry exclusions.  The exclusions were later reduced to 12 years and may be reduced even more on remand to the agency, but still reinforce the need for corporate officers to know what's happening at lower levels of the corporate hierarchy.

RCO doctrine does not exist as such in the securities world.  However, the comparable civil concept of control person liability does apply and is utilized by the SEC.  The lessons of the Purdue case apply equally in the securities world.  They are:

1. Ignorance of misconduct by subordinates is not always a defense for corporate officers.  
2. Robust compliance programs, with visible-top level support and regular testing, can prevent violations or at least detect them early enough to mitigate risk and allow the entity to consider self-reporting in an effort to avoid or minimize criminal or regulatory exposure.
3. When violations occur, resolving regulatory or criminal charges may not conclude all liabilities for a particular occurrence.  As in the Purdue case, criminal convictions can form the basis for parallel regulatory action, such as debilitating exclusions.
4. In such parallel proceedings, facts admitted or proved in an initial proceeding may bind in the later matters.
5. When navigating such exposure, the guidance of experienced counsel is a must.

A copy of the D.C. Circuit's opinion may be found here.  A more detailed analysis is here.

The SEC has announced that it is extending the deadline for investment advisers to comply with its pay-to-play rule ban against third-party solicitations in order to have an "orderly transition".  The SEC is making this accommodation to account for its delay in defining the term "municipal advisor", which is exempted from the ban.  This extension will allow investment advisers and third-party solicitors additional time to adjust their respective compliance policies and procedures.

The pay-to-play rules were adopted to curb such practices.  It bars investment advisers from paying third-parties to solicit governmental customers, unless the solicitor is registered with the SEC as an investment adviser or broker-dealer subject to similar restrictions.  In June 2011, the SEC included municipal advisers to the rule's list of exempted solicitors, but the SEC has yet to define "municipal advisors", making full compliance an impossible task. 

Notwithstanding the definitional gap, the extra time will allow investment advisers and third-party solicitors the capacity to develop their policies and procedures for their pay-to-play rules.  Investment advisers and third-party solicitors should use this window to their advantage to further develop their policies and procedures, lest you be unprepared for when the SEC finally defines a municipal advisor.

ComplianceEX recently published an article by Julie DiMauro regarding the debate, albeit not as pronounced as of late, over whether broker-dealers should be subject to a fiduciary duty standard of care similar to that of registered investment advisers. The article highlighted one investment adviser group (the Committee for Fiduciary Standard) who is lobbying Congress to adopt a strong fiduciary duty standard.  Conversely, according to ComplianceEX, the Financial Services Institute is promoting a universal standard of care, rather than a fiduciary duty.

The primary focus of those who oppose an uniform fiduciary duty standard is that converting to this standard would come at a great cost to broker-dealers and, in turn, the investing public.  The opponents contend that converting to a fiduciary duty standard will require additional documentation and registration requirements, as well as enhanced liability under the new standard.  All of this will come at a cost; a cost that will surely be passed on to the investing public.  This increase in cost, some say, may result in broker-dealers requiring higher minimum investments as a hedge against those costs.  The downside of this requirement could be that some segment of the public may lose an avenue for investment.

The article shows that the debate is long from over and likely to heat up once again when the SEC receives more pressure for the results of its cost-benefit analysis regarding a uniform fiduciary duty standard.  Such a study will surely show that there will be a large increase in the costs to broker-dealers to convert to this new standard of care.  In the end, the more likely result will be no uniform fiduciary duty, but a much more aggressive FINRA through rule-making and enforcement.  The old adage of be careful what you wish for may be coming to roost for broker-dealers. 

Just a few short weeks ago, the SEC launched an administrative action against an on-line futures and options brokerage and clearing agency, as well as its senior executive for engaging in a naked short selling scheme. 

The allegations, effectively, declared that the firm had failed to deliver certain securities as part of this scheme.  The SEC claimed that the firm had failed to deliver the securities as required within the three-day period. 

However, lawyers for the firm have argued that the SEC is engaging in a new rule making endeavor with this enforcement action.  The defendants' lawyers have argued that the transactions all were consistent in that all transactions were timely covered.

In short, the SEC seems to be pursuing this matter with a great deal of vigor.  It will be interesting to see if the Court accepts the SEC's interpretation on naked short selling.

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.

OCIE is intending to review newly registered hedge and private equity fund advisers by focusing in on certain priorities.

In particular, OCIE will review due diligence practices; fraud indicators; unknown service providers; problem custody arrangements; insider trading and front running issues; and preferential treatment to determine if there are conflicts of interest.  OCIE also intends to take a global approach and not look at any one particular issue.  OCIE's focus will, most certainly, focus in on complex entities with high frequency trading.  Such a review will include an SEC staff examination of fund governance; compliance, audit and management functions; protection of assets; and the transmission of performance data and advertising. 

These principals will guide the OCIE staff in conducting examinations along with the new OCIE examination manual. 

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.

There was plenty of debate when the SEC adopted its new whistle blower bounty program.  Many commentators thought that the program would result in an onslaught of whistle blowers directly reporting to the SEC instead of first contacting the subject corporation.  The Quarterly Fraud Index reported, however, that the opposite may actually be taking place.  The new program appears to have caused many corporations to improve their internal reporting mechanisms.  If this effort continues, the fear of a mad rush to the SEC may have been irrational.

Among other things, the study found that the concern over the implementation of the program caused many companies to revamp their internal reporting policies and procedures.  By re-focusing on these internal reporting programs, the corporate world has also seen an increase of internal fraud reporting, as opposed to an influx of reports to the SEC.  Another positive result out of the whistle blower program is organizations implementing predetermined investigative templates and procedures, which will allow companies to act much quicker within the 90-day window in which a whistle blower can secure his standing with the SEC.   Along these lines, many companies have predetermined arrangements with third-party providers, such as law firms and auditors, to avoid any time lag once they receive a report of fraud.

If these corporate reforms continue, I believe that companies will be able to steer fraud reporting to an internal platform and not be as exposed to the SEC whistle blower program as originally feared.  The SEC whistle blower program has to be lauded to the extent that it was the impetus of corporate reform, but further study is needed to determine if the reporting ends with an internal report or continues to actual reporting to the SEC.  Only then can we say that the SEC's whistler blower program resulted in wide-spread corporate reform

The SEC issued an alert intending that firms detect and prevent unauthorized trading in brokerage and advisory accounts. 

This release related to certain risks the SEC’s Office of Compliance Inspections and Examinations found in its investigations and examinations.  OCIE had reports of unauthorized trades and rogue trading by traders, portfolio managers, brokers and others.  The SEC warned firms that they must take action to ensure that such trading does not occur in the future.

Accordingly, firms must be cognizant that the SEC is looking at these issues, and will bring actions if need be.

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.

Like many others, my interest in the JOBS Act really started with crowdfunding.  This is probably because securities law is an imposing tangle of archaic acts, byzantine regulations and repetitive rules.  (Securities lawyers commonly say things like “…Rule 506 under Regulation D, promulgated pursuant to Section 4(2) of the ’33 Act…” and expect you to understand/stay awake).  Crowdfunding, however, is the hip, internet-based, exciting new thing!  It’s like that Kickstarter thing your cousin, the “performance artist”, keeps posting about on Facebook!  Everyone is talking about crowdfunding, so it MUST be awesome, right?  Well, not so fast: a lot of media coverage and law blogs doesn't mean a law will live up to the hype (I admit my own guilt).   So, what impact will Crowdfunding really have once the SEC passes all its rules? 

I’m leaning towards not much.  First, they have 270 days to enact the rules, but as this guy explains quite well, you really shouldn’t bother writing that down in your calendar: the SEC will be late. More to the point, some think this will be the panacea to our economies ailments, while others expect it to pretty much license fraud.  Obama called this a “game changer” and I agree, but - to make a football analogy - this is more like a “two-point conversion” game changer than a “forward pass” game changer.  Most start ups will eschew crowdfunding for more traditional fund raising methods.

First, we need to ask: what kind of issuer will use crowdfunding?  Not the guys who are looking to ramp up an already humming business, they already have venture capitalist to turn to.  And remember that the JOBS Act also amended Reg A (allows a company to sell up to $50 Million in securities with minimal disclosures and no restrictions on advertising) and Sec. 12(g) of the ’34 Act (now companies can have up to 2000 investors without being forced to go public, and employees don’t count towards the limit).  One the SEC makes rules on these changes, a company can offer up to $50 Million in stock, advertising however it likes, using a Regulation A circular, provided that it keeps non-accredited investors under 500 and total number of investors under 2000.  $50 Million divided by 2000 investors is a mere $25,000 per investor – not an extravagant amount by any means, and this might deepen the venture capital markets.  For many more established or promising start ups, this will present a much more appealing opportunity.  The “start up” that already has a product and some employees probably won’t resort to crowdfunding.

Crowdfunding is limited to $1,000,000 dollars, gleaned from any number of investors.  Issuers (and the funding portals) are prohibited from advertising the offering, beyond director investors to the website (it will be interesting to see whether Facebook and Twitter links will be considered advertising or mere directing).  And if the issuer wants to raise over $500,000, it will need to release audited financial statements.  That means dropping a few grand on a CPA, on top of the whatever fees the funding portal will charge (and issuers would be remiss to do any of this without an attorney).  The transaction costs will be high.  If the issuer wants to raise somewhere between $100,000 and $500,000, then the financial statements need only be “reviewed”, which is slightly less pricey.  On top of those requirements (and the basics like names of officers and addresses), issuers will need to describe the purpose of the fundraising, a description of the ownership and capital structure of the issuer and file annual reports with the SEC, including financial statements.  And, do note, the SEC is empowered to make “any other requirements…for the protection of investors and in the public interest.”  That means that the SEC could make any of these requirements more onerous and costly.  Again, given that Mary Schapiro and Luis Aguilar have pooh-poohed the concept generally, expect the SEC to add some regulatory meat to the statutory bones.

Normally, a start up gets going using the founder’s own funds, and the money he can beg, borrow or steal from his friends and family, and sometimes they find an “angel investor” – some wealthy person willing to give them a shot in the form of a few thousand dollars.  Crowdfunding will be popular among the start ups that can’t find this kind of “seed money”.  Younger entrepreneurs, whose friends are all also broke, are more likely to turn to crowdfunding.  In addition, crowdfunding will be huge for entrepreneurs living outside of seed-money friendly areas.  It will also help individuals with really solid ideas of how to return 20% on the dollar, which isn’t the sort of return that excites many angel investors (think pizza shop in a small town without so much as a Dominos).  And, to be frank, it will help the socially awkward types who can’t sell their vision face-to-face. 

Crowdfunding isn’t the democratization of equity investment; it’s the democratization of angel investment.  Most of us will still be unable to invest in the next Facebook or Google, because they’ll skip crowdfunding altogether.  I suspect most crowdfunding offerings will end up being for less than $100,000 (meaning the issuer only needs to provide self-certified financial statements and last year’s tax return, plus the other rules).  It will be for just enough to make a prototype or launch a beta version.  In other words, just enough to attract a venture capitalist.

For investors, crowdfunding means a lot of chances to lose some money.  Some will get to support the next must-have app for your phone, but more will probably invest in a bar or restaurant (an industry famous for failures), or with tech-geeks without a lick of business acumen.  I’m okay with this, to be honest.  Some will invest for philosophical reasons (support only small/local businesses), others will gamble (better here than a casino), but I think most will do it almost for fun (another venue for those who “dabble” or “play” in the stock market).  And there are limits on how much someone can lose.  The Act uses “income or net worth” in setting limits, which will allow some retirees with over $100,000 saved to potentially risk the greater of 10% or $20,000.  Potential for fraud is restricted by investment limits, the fact that issuers need to use a broker or a funding portal*, and that said fraudsters need to give the SEC their name, address, etc. (generally not a good criminal plan, giving the Feds your personal info).  More importantly, the Act requires brokers/funding portals to ask and receive answers from the investors, making sure they understand the risks.  I’m pretty sure that no other group of investors have to pass a quiz before they can invest.  That’s a lot of work for something that should be understood as allowing the Average Joe to invest $100 in a company a few times a year.

Crowdfunding will be good for the little guy start up.  Investors who decide to go into crowdfunding should do so understanding the risks, and should model themselves after angel investors, who often invest in a dozen companies in the hopes that one strikes it big. 

Crowdfunding will be fun and exciting, don’t get me wrong, and I intend to invest this way myself.  For some, it really will be a game changer, but only if the game is already really, really close. 

* This is really an aside: Funding portals and brokers acting as crowdfunding intermediaries will need to register with the SEC and register with an applicable self-regulatory organization.  There are already a few nascent organizations coming together to create a funding portal SRO.  Thus, these guys will face the type of serious and undoubtedly complex regulations not unlike those that broker-dealers already face.  In addition, if a funding portal wants to skip registration as a broker-dealer, it will need to be a member of a national securities association, which means a battery of tests and not-insignificant fees.  Most importantly, they will be exposed to all sorts of liabilities, which will make prudent portals wary of shady start-ups.  The net effect will mean that a crowdfunding boiler room will have a similiar likelihood of getting caught as any other, only for a lot less potential payout.

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.

Gail Collins weighed in on the JOBS Act today in a column glibly titled “The Senate Overachieves”.  Normally, I love her work – everything she does is glib, and I honestly feel there is a glib shortage in America – but this time I believe her winking nonchalance has descended into full-on flippancy.  Worse than that, I’m pretty disappointed that she couldn’t work into the column that Mitt Romney once drove to Canada with the dog strapped to the roof.  But I digress.

Securities regulation is a serious matter (and kind of my job).  That doesn’t mean we can’t have fun discussing it, but great zingers can only go so far.  Dismissing reforms because they let smaller businesses avoid excessively expensive auditing requirements makes sense, even if this means reducing (by a small amount) Sarbannes-Oxley’s reach.  Just because Sarbannes-Oxley and Dodd-Frank were passed to correct egregious regulatory gaps doesn’t mean that they cannot still overreach.  If anything, it makes just such overreaching more likely.

Crowdfunding does present a larger potential for hucksters to shill worthless stock.   But that is still fraud, and still illegal, regardless of the medium used to do it. 

For what it’s worth, I think a lot of securities regulation are misguided attempts to treat symptoms of the problems rather than the problems themselves.  So long as there are massive incentives to innovate new products and skirt regulatory requirements, firms will do so, and will pay their lawyers handsomely to make it happen within the confines of the law.

Rather, I believe that approaches towards fixing the fundamental flaws in the market must be addressed.  No recession or crisis will be caused by minimized auditing of mid-cap companies, or small start-ups raising a few hundred thousand over the internet.  As I noted in my last post, regulations that incentivize companies to stay small in order to avoid disproportionately larger regulatory burdens are counterproductive.

Instead, we need to work to realign the incentives of market participants with the incentives of the economy in general.  The Economist mentioned the interim Kay review last week, “it is easy to forget what the main economic functions of the equity markets are supposed to be.”  I agree with John Kay, the review’s author: the markets should promote long-term growth, not short-term profits.  And, for what it’s worth, Warren Buffet, Judge Richard Posner and Nassim Taleb, among others, also agree (oh my, am I clumsy! Just dropping those names all over the place!).

So, Gail’s barbed wit hit the wrong target this time, not unlike how some regulations aimed to prevent awful abuses end up frustrating legitimate businesses from growing.  The JOBS Act has its flaws too: the "emerging growth companies" that get to avoid some of the registration requirements of the '33 Act are defined to include companies with $1 Billion in revenue.  If you make $1 Billion, you aren't emerging anymore.  You've emerged.  But these call for sensible amendments, not lambasting the entire bill. 

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.

We want to take this opportunity to urge all investment advisers for private equity and hedge funds, as well as venture funds, leveraged buyout funds and the like, that the time the SEC permitted for these entires to transition to registered investment adviser status will expire on March 30, 2012.  That is, registration will be required at that time. 

Notably, there is a revised Form ADV that investment advisers will be required to complete with many descriptions being in “plain English.”  Further, it is essential that there be a quality compliance program in place headed by a chief compliance officer.  The SEC has made it very clear that it will require proper supervision for all of these newly registered investment advisers.

As a result, we strongly urge these investment advisers to contact us to discuss the impact of these registration requirements as well as for assistance that we may be able to offer to them.

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.

In late January, FINRA informed member firms' chief compliance officers of key issues facing the securities industry.  In particular, FINRA noted that it was updating and improving its regulatory programs, focusing on risk based examinations, investigations and enforcement.  FINRA indicated that it will continue to collect data and review this data to ensure that it appropriately uses its enforcement regulatory and examination resources in the upcoming year.

FINRA announced that its examination priorities were set against the economic environment that investors have faced since 2008.  As a result, it will focus on the increased risk of aggressive yield chasing, inappropriate sales practices and product offerings, unsuitability, misappropriation and fraud.

One FINRA’s primary sales practice and business conduct focuses will concern retail customers over a number of different products, including mortgage-backed and commercial mortgage-backed securities, uncommon non-traded REITs, municipal securities, exchange traded products, variable annuities, structured products as well as private placement securities and unregistered securities, among others.  Interestingly, FINRA will also focus in on various church bonds and promissory notes that are issued as well as life settlements.  FINRA will continue its efforts to stamp out micro cap fraud that it has seen in a number of the markets that it regulates.  Reverse mergers will also continue to play a part in both FINRA as well as the SEC’s enforcement programs.  As many know, Chinese issuers have been the target in these reverse merger cases, and the SEC and FINRA will continue their heightened enforcement approach.

FINRA will continue to monitor when firms permit their registered representatives to engage in private securities transactions and outside business activities.  Moreover, FINRA will assuredly review supervision integrity and internal controls.  Information technology and cyber security will also be prime elements of review as is outsourcing and fees coupled with the use of foreign finders.

FINRA will also consider branch office inspections to be a critical aspect of its examination program.

FINRA is also very concerned about social media and electronic communication and will continue to monitor this aspect of broker dealer operations in the future. 

Interestingly, there are a number of initiatives relating to FOCUS information as well as leverage and liquidity that FINRA examiners will review when analyzing firm balance sheets and financials.  Of course, examinations of rogue trading will continue given certain newsworthy events, and FINRA will look for internal controls and risk management systems to stop this type of practice from going forward.  FINRA will also review the pricing of illiquid or hard to value securities as well as margin lending practices and the custody of assets relating to collateralizing margin loans.

Net capital expense sharing arrangements, withdrawal of capital, inaccurate books and records and protection of customer funds and securities will also be reviewed as well.  SEC Exchange Act Rule 15c3-3 will also be and examination priority for the upcoming year as will be SEC Exchange Act Rule 15c3-5, the market access rule, and its application to broker dealers and customers, who engage in an exchange or alternative trading system.

FINRA exams will also focus in on member firms’ information barriers, and if those barriers are being followed to safeguard customer and material non-public information.  Additionally, FINRA will look at fixed income securities and focus on high frequency trading strategies as well as market maker quoting obligations, OATS issues, and the appropriate coding of orders.  Further, FINRA will review the oversight and redemption process for exchange traded products as well as municipal securities and conflicts of interest in the sale and marketing of complex investments.

Finally, FINRA believes that, by publishing these key risk areas, it will enhance its enforcement and examination programs as it moves forward in the new year.

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.

A year ago, the SEC published its study commissioned under Dodd-Frank and recommended the implementation of a uniform fiduciary duty standard.  Much debate has prevailed since that announcement.  Will registered representatives be subject to the same fiduciary duty as investment advisors?  Will registered representatives be subject to some form of hybrid fiduciary duty standard?  According to a recent SEC announcement that went without much fanfare, in 2012, at least, the answer will be none of the above.

The SEC has punted once again on making a definitive conclusion regarding the implementation of a uniform fiduciary duty standard.  Broker-dealers should not assume that there will never be such a standard, only that a formal adoption will be at least another year away.  In that time, the SEC will surely complete the long-debated cost benefit analysis of the need for such a standard.  Indeed, the SEC may ultimately conclude that the adoption of FINRA Rule 4530 and the changes to the suitability and know your customer standards were more than adequate such that there may be no need to have a formal standard.  Registered representatives may already be effectively subject to their own fiduciary duty.  Indeed, depending upon where you reside, courts have already concluded that you are subject to a fiduciary duty.

Regardless of what happens in 2013, once thing is for certain.  FINRA is increasing its enforcement efforts and will surely focus on conformity with its new rules.  The safest course for broker-dealers is to make sure you have adequate compliance programs to address this heightened regulatory environment, or you will be totally unprepared when there is a formal uniform fiduciary duty standard.

If you had asked me yesterday whether there were a lot of securities lawsuits last year, I would have said, "Oh, absolutely."  And I would have been absolutely wrong.  Lawsuits were up in 2011 compared to 2010, but still below the recent average.  As the NYTimes reports, according to a new report by Stanford Law and Cornerstone Research, "188 federal securities class-action suits were filed last year, compared with 176 filed the prior year. Even then, that figure trails the annual average of 194 filings for the period from 1997 to 2010." 

I'm guilty of what Daniel Kahneman calls "WYSIATI" (What You See Is All There Is).  First off, I (and you too) only see what gets reported, like the new crop of lawsuits related to Chinese reverse-mergers.  Obviously, we don't see what doesn't get reported, i.e. the not-filed lawsuits.  Moreover, now that this kind of thing is my job, I'm way more sensitive to reports about securities lawsuits (unlike most normal people, I won't skip an article with a headline like "Corporation's MD&A in 10-K sparks 10b-5 Claim").  This is the same little tick in our thinking that makes a teenager's parents overreact to news stories about the latest drug and/or sex fad sweeping the nation.  Already sensitive to a particular danger, a news report (especially a sensationalist one) about an isolated incident sticks in our minds and makes us overestimate the size of the danger. 

This study only measured the number of fraud claims, so there are still a bunch of other securities-related lawsuits that aren't counted here.  That said, the takeaway remains that lawsuits remained steady because the IPO and merger markets remained soft last year.  That, OR the securities industry was just way more honest last year.  I'll let you decide which theory sounds better.

The SEC adopted a rule requiring hedge fund and private equity fund advisors to report systemic risk data.  The new Form PF was jointly developed by the SEC and the CFTC in consultation with members of the Financial Stability Oversight Council, to satisfy Dodd Frank Act Sections 404 and 406. 

In particular, for hedge, private equity, and liquidity funds, the information required on the Form PF is tiered so that detailed information will be required from larger private advisors as opposed to smaller ones.  The minimum reporting requirement will be for those funds with $150 million dollars of assets under management, and smaller private fund advisors will not be required to file the form at all.  Further, there will be additional information required of those advisors managing at least $1.5 billion dollars.  According to the SEC, this requirement will only effect approximately 230 advisors in the United States.  Many of these advisors will have 60 days from the end of the quarter to prepare this information while smaller advisors will have 120 days to file such information.  For the largest advisors, filings must begin by June 15, 2012, while all others must file after December 15, 2012.

Of course, there is no certainty that this information will be effectively used to assess risk, or that there will be any benefit from these filings.

The SEC released two new rules yesterday: one on mine safety (I wonder how many securities lawyers have ever set foot in a mine) and the other changing the net worth standard for accredited investors.  Both new rules come to us courtesy of Dodd-Frank. 

Because mine safety disclosure isn't really my forte, I'll focus on accredited investors.  Under the new rule, set to become effective in February, individuals will no longer be able to include the value of their primary residency as an asset in the calculation of net wealth for accredited investor status.  So pay heed, all you issuers hoping to avoid registration purusant to Reg D of the '33 Act!  That guy who spends everything trying to make his house the best on the block?  Instead of being an "accredited investor", he might be just "that guy with the really gaudy house."  On the flipside, the rule no longer treats your mortgage as a liability either (with a few exceptions), so the net impact of the change will be diluted in many instances.

And there are, of course, other ways an individual can qualify as an accredited investor (earning over $200,000 a year, for example), so this shouldn't hurt Reg D offerings much, but it's definitely something to watch out for. 

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.

The Dodd-Frank Act required that security based swap dealers or major security based swap participants to register with the SEC.  These swap based entities are required to register with the SEC while all others are under the jurisdiction of the CFTC. 

The SEC proposed rules requiring these entities to register electronically with the SEC on a Form SBSE, similar to the Form BD for broker-dealer registration.  CFTC swap entities register using the shorter Form SBSE-A.  Additionally, the SEC will require that these forms be updated promptly if there are any inaccuracies.  There will also be something new according to one SEC Commissioner.  The rules may require a knowledgeable senior officer to provide a certification as to the firm’s financial, operational and compliance capabilities.  This person will also have to disclose how the firm arrived at those conclusions.  Further, non-U.S. swap entities will have to identify a U.S. Agent, and submit an opinion of counsel that the SEC will be able to access its books and records, as well as a requirement to submit to an on-site inspection. 

The swap dealer registration proposal will be open for a 60 day comment period, and all are encouraged to consider commenting.

In a recent FIRNA arbitration decision, a firm suffered a set back when it was unable to recover damages on a promissory note. 

One of the interesting facets of this particular case is that, at the hearing, the member firm amended it damage claim to nearly $100,000 more than the number in its statement of claim.  Although the firm believed that it had the information to support its claim, the sole FINRA arbitrator denied the claim in its entirety.

Unfortunately, the FINRA arbitrator – keeping with FINRA procedure – did not disclose the reasons for rejecting this claim.  One wonders if it will, ultimately, start a trend with FINRA arbitrators.  Distinguished securities attorney, David Robbins, represented the broker in this action, and his skills in obtaining such a result speak for themselves.  However, time will tell if David’s success will be replicated.

Thought you might be interested in a recent podcast I did concerning my securities law practice.  http://web.me.com/cordpar/Client_Development_Tips/Law_Consulting_Coaching_Podcast/Entries/2011/10/28_Developing_a_Securities%2C_White_Collar_and_Complex_Litigation_Practice.html

The SEC recently joined the FDIC, the OCC and the Federal Reserve in advancing the Volcker Rule for public comment.  The Volcker Rule is shaping up to be one of Dodd-Frank’s most contentious and confusing new regulations.

Volcker Rule proponents hope that it will, like the late-great Glass-Steagal Act before it, rein in risk-relishing bankers by prohibiting short-term proprietary trading of securities.  Opponents fear it will be overly broad, capturing market-making activities and needlessly raising the cost of capital.  Both want big changes, clouding any predictions on what the final version will look like. 

So, basically, Wall Street has a few months to respond to a 298-page rule proposal jointly issued by four Federal regulators that asks nearly 400 questions which could cost millions of dollars.  Hence the impression some folks get that the only thing certain about the Volcker Rule is the uncertainty surrounding it.  Some analysts seem terrified of this zombie regulation – once dead, now crawling out of the grave with a sickly hunger for brains profits.         

Then again, this resurrected rule might not be so scary.  Stock prices of the major US financial institutions that will fall under its purview remained steady despite the announcement.  The Volcker Rule really is just the watered-down second coming of the law from 1933 until 1999.  The uncertainty of the law is really only found around its margins – trying to determine exactly where market-making ends and proprietary trading begins.  In other words, the devil – that scary boogieman, uncertainty – remains in the details. 

Sure, it seems like everyone is unhappy with the proposal, which took over a year to draft but only minutes to attract detractors.  It has either too many exemptions or too few, depending on who you ask.  But I’ve found that when two groups that never seem to agree on anything suddenly agree on something, you should take that something and do the exact opposite.  A rule that upsets everyone for different reasons tends to be one that is moderate, sensible and likely to have a real and lasting impact.   

In the mean time, we will follow the developments closely.  Histrionics about how awful/amazing the finalized rule will look aside, it will be one of the more arcane of Dodd-Frank's new regulations.  Anyone falling under its penumbra would do well to tread cautiously and with counsel.

Ernest Badway will be speaking at a Citrin Cooperman event on October 27, 2011, on the topic of Advisors and Fund Managers. Please contact Alyssa Parrilla, 212.697.1000 Ext. 1838, aparrilla@citrincooperman.com, to RSVP. 

While the overwhelming majority of the advisory say-on-pay votes required by Dodd-Frank succeed, a number of the boards surprised by a “nay-on-pay” vote now face shareholder derivative lawsuits.  So far this year, negative say-on-pay votes have sparked nine derivative lawsuits, and some commentators expect these numbers to rise in 2012.  Corporate boards – especially those of companies with disappointing shareholder returns – should be careful when they draft say-on-pay proxies. 

Given the odds that a company’s stock price is less-than-stellar these days, boards will want to ensure that they provide shareholders plenty of context for the vote.  In other words: don’t be like the guys over at Exar, who doubled the CEO’s pay but failed to explain in an executive summary how their pay-for-performance plan worked.  (It didn’t help that they treated abstentions as ‘no’ votes, either – H/T Mark Poerio’s Executive Pay and Loyalty blog.)

Instead, companies should take pains to detail how their compensation package works and address anything that might not sit right with investors – like why management’s pay made a jump even though the stock price took a dump.  There can be perfectly legitimate and rational reasons for an executive’s compensation to rise despite poor stock price performance.  To avoid embarrassing no votes and litigation, companies should ensure that these reasons find their way into the proxy statement.

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.