Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

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

I recently blogged about how you can be great at using social media.  Based upon a recent survey, I suspect that not many of you may be following that guidance.

As it turns out, less than 50% of advisers and financial planner acknowledge using social media for their business.  Compliance concerns appear to be the overriding barrier of those surveyed.  The compliance concerns described by the study focused on both prohibitions and uncertainty.

There is not much you can do if your firm prohibits social media for business purposes.  What can be done if the firm allows the use of social media.

For one, the firm should have a defined policy regarding what social media resources are permitted for use.  The firm should review and modify that list on an ongoing basis.  The firm should also set parameters on how social media can be used and must implement appropriate supervision and record-keeping.

There are other resources available as well.  The CFP Board, for example, recently issued a guide on the use of social media that you may find to be a valuable tool as well.

The possibilities of developing your business through social media are within your reach.  As the old commercial use to say, "try it, you may like it".

The DOJ has been making increasing and aggressive use of the Financial Institutions Reform Recovery and Enforcement Act ("FIRREA")

FIRREA was an outgrowth of the savings and loan crisis in the late 80’s and early 90’s.  The DOJ is looking to prosecute and obtain civil penalties by using this statute.  This statute allows the DOJ to bring a civil lawsuit whenever any person violates or conspires to violate about 14 criminal statutes.  The DOJ seeks civil penalties that create a great deal of consternation among financial institutions.  Primarily, the DOJ has used this statute against banks and it will continue to do so.  However, if you have a bank that also has a BD component, one could see issues relating to that operation as well. 

Caution is therefore required for all of those entities.

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.

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 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

Although the SEC’s Dodd-Frank mandated report that there should be a uniform fiduciary duty standard for broker-dealers and investments advisers is nearly two years old, we are no closer to seeing that become a reality.  The question is why. 

Some see the lack of a majority of SEC Commissioners in support a draft request for public input as the cause for delay.  The stall may continue as long as the Commission remain currently constituted.  Others think that the Department of Labor’s forthcoming rule on the definition of a fiduciary under ERISA as a possible development that may break the logjam. 

The real question that must be asked is whether a uniform fiduciary duty standard is even worth the effort.  

In the many cases that I have defended broker-dealers, it is hard to recall any where the claimant did not assert a claim for breach of fiduciary duty.  Moreover, many arbitrators that I have observed make the general assumption that a broker-dealer serves as a fiduciary for its clients.  In addition, some courts have already concluded that broker-dealers are fiduciaries to their customers. 

In my view, the push, to the extent that one even remains, is one of optics.  In other words, there is a perception that the public wants to see there be such a standard so some will continue to push for it.  If anyone analyzed the issue hard enough, they would probably see that broker-dealers are already often held to such a standard, such that the effort to legislate it is one that is not needed.

It has been two months since FINRA Rule 2111 has come into effect.  This new rule requires that there must be a reasonable basis to believe that the recommended transaction or investment strategy involving a security is suitable for a customer, where a strategy can involved the recommendation to buy, sell or hold a security.  So what does it mean to make a suitable investment recommendation?

I have effectively argued in arbitrations that a 100% equity growth investment portfolio was suitable for a investor.  Although this may seem a bit out of whack, the panel did not think so; why.

The key for making suitable investment recommendations is to make sure that you first know your customer.  Equally important, you must document the rationale for making such a recommendation.

From my experience, the more documentation in your file to demonstrate your explanation to the customer of the respective risks and benefits of a proposed investment strategy, the more likely that an arbitration panel will agree that you had a reasonable basis for the investment recommendation. 

To protect yourself, never take a shortcut.  Make sure your fully  document you recommendation in your notes, with prospectus or other written materials.  If you  do, you stand a reasonable chance of prevailing if that same customer decides to bring a claim against you.

Over the years that I have defended broker-dealers, investment advisors and registered representatives, a common theme has steadily emerged.  In many instances, customer complaints can be avoided altogether through the better selection of customers. 

I have seen the desire to increase assets under management effectively cloud the judgment of the advisor.  So the question becomes, how can you avoid risk through better customer selection.  As set forth more fully in my risk avoidance guidebook, the key to risk avoidance is to avoid the problem clients before they become clients. 

Who are the types of customers you want to avoid?  First, is what I call the free agent.  This is the customer who bounces from advisor to advisor over the years, constantly looking for a desired answer that probably does not exists.  Do not make the mistake of thinking that you have all of the answers. 

Second, beware of the potential customer with unrealistic expectations.  The clearest example of unrealistic expectations is the customer who wants high returns but without significant risk to principal.  This is a client living in a dream world.  Although this may seem obvious, I have represented the same advisors in multiple cases because they gave into trying to meet unrealistic client expectations.

The third type of potential problem customer is one who does not fit your personal investment style.  Many advisors have, after years of training and experience, developed an area of investment expertise.  Yet, all too often these same advisors try to pigeon-hole all of their clients into their unique investing style.  This never works.  The better course is to refer a customer who does not fit your style to a colleague, who will likely return the favor with referrals of his own.

In these challenging times, better customer selection is more and more important.  With a bit more due diligence on the front end of the relationship, you may be able to avoid the risk of a customer complaint on the back end.

The SEC’s obligation to review its proposed rules through a cost-benefit analysis has been under fire for quite some time.  More recently, the SEC has been especially criticized in failing to apply this approach in a meaningful way when it came to its review of a potential uniform fiduciary duty standard for those who provide investment advice.  This criticism has resulted in the repeated delays of any rule-making on the uniform fiduciary duty.

To address this issue, Representative Garrett (R-N.J.) has advanced a bill that would reinforce the cost-benefit analysis.  Although the timing of this legislation may result in it being delayed until after the election, the goal is for the SEC to “clearly identify” the issue that the proposed rule intends to address; include the SEC’s chief economist in the costs-benefit analysis; and assess potential regulatory alternatives to rule-making.

The proposed legislation is not that far off from the SEC’s internal guidance, directing staff to enhance economic analysis as part of the rulemaking process for both congressionally mandated and discretionary rulemaking.  Representative Garrett does not believe that the SEC internal mandate goes far enough to ensure the adequate application of the cost benefit analysis, which is why he wants it defined by statute. 

Wherever you fall on this debate, the one thing that the fiduciary duty debate has demonstrated is that the SEC is taking a more measured cost-benefit approach to its rule-making.  Doing so can be seen as a bit of self-preservation on the part of the SEC, but it will also likely lead to better rule-making and, in turn, rules that will withstand scrutiny.

The Department of Labor's head of the Employee Benefits Security Administration recently announced that the DOL is going to coordinate with the SEC on fiduciary policy, but that the DOL and SEC will maintain and pursue their own regulations.  This statement has garnered confusion and concern by many in the industry, as it should.

The primary concern with such a statement is that the SEC and DOL operate under different fiduciary duty standards.  The securities laws focus on disclosure, while the retirement law fiduciary duty that the DOL enforces prohibits conflicts of interest.  As such, how can the DOL and SEC coordinate their respective fiduciary policies when they operated under different standards.  In response to such concern, the DOL stated that there would not be one standard, but that the two will be compatible.

The DOL like the SEC has been struggling with its own fiduciary duty standard, resulting in it withdrawing a proposed fiduciary duty rule in September 2011.  Dodd-Frank vested the SEC with the authority to develop a uniform fiduciary duty standard over anyone who provides retail investment advice.  The SEC has yet to develop such a standard and has tabled doing so through the balance of 2012.

The overall uncertainty created by the respective inability of the SEC and DOL to develop a fiduciary duty standard leaves many in the retirement planning arena in the dark, leading some opponents to question whether this is even necessary.  The bad apples ultimately float to the top and can be removed from the barrel through enforcement mechanisms.  While the debate rages, confusion reigns.  Either clear rules should be adopted or the process abandoned.  The state of unrest does not help anyone.

Recently, the SEC announced that it was reconsidering a proposal first explored in 2007 that would amend net capital requirements, and update the financial responsibility rules for member firms.  The SEC has reopened the comment period for this 2007 proposal.  But is it worth it?  In light of what happened commencing in 2008, can a 2007 proposal really have any meaning.  That is the question that the comment period must answer.

The proposal would require firms to carry reserve funds where the firm holds proprietary accounts of another firm in order to cover claims made against those accounts.  The proposal would also prohibit firms from counting cash deposits at affiliated banks and a portion of funds at non-affiliated banks toward their reserve.

This proposal has been criticized due to the lapse of time and corresponding change in circumstances.  Among other issues cited with this proposal is that it would have a more negative than positive effect and does not adequately take current circumstances into account.  As such, the proposal does not sufficiently weigh the cost-benefit of implementation.  Further, the limitation on what can be counted toward the reserve has come under fire because it could increase costs and operational burden on some firms.

Although bolstering the financial viability of broker-dealers is the laudable goal of this proposal, the real issue is whether this dated proposal is the right course toward further stability.  Rather than trying to fit a square peg in a round hole, should the SEC take a fresh look at this issue so that current circumstances and the cost-benefit are adequately assessed.  For what is at stake, it seems to me the logical answer is yes.  The SEC waited five years to address this proposal, what is a little more time to make sure it is done right.

One of the major issues an investor, who happens to be a victim of a ponzi scheme faces, is what is the proper measure of recovery, if any recovery is available.  One school of thought is that the victim should receive the value of the investment as they believed it to be at the time the fraud is uncovered; this method frequently based upon information contained in fraudulent account statements.  The other school of thought is net equity; or, the value of the investment, minus money the investor received in return from the scheme over time.  This method is derived from the books and records of the scheme.

On its face, the first method would allow victims to profit from a fraud.  Yes, they are victims, but should they profit.  Most commentators, the Madoff Trustee and the SEC all think that the answer to that question is no.  Now, the United States Supreme Court may have input on the viability of that position. 

There is currently an appeal pending, but not yet accepted, to the Supreme Court to challenge the Second Circuit Court of Appeals’ ruling that upheld the Trustee’s net equity method to calculate what a ponzi scheme victim should be allowed to recover.  The SEC has recently filed brief with the Court asking it not to take the appeal, but to leave the Second Circuit’s opinion stand. 

Although this issue will remain uncertain until the Supreme Court takes some action, either accepting or denying the appeal, the long-term answer should be one based upon the equities.  Victims need an avenue to recover, but they should not profit from a fraud, just like the fraudster should not have profited from the victims.  Net equity return would appear to be the fairest methodology to all concerned.  Now it is up to the Supreme Court to decide.

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.

The Department of Labor has a rule pending that would impose a fiduciary duty standard for investment advice pertaining to retirement plans.  Like the resistance faced by the SEC in its attempt to create a uniform fiduciary duty for retail investment advice, the DOL has faced similar resistance, with calls for a cost-benefit analysis before imposition of such a standard.

Opponents to the rule say that the cost will not outweigh the benefits of this heightened standard of care.  Skeptics of the pending rule suggest that it will drive brokers out of the IRA market so that they can avoid being confronted by a fiduciary duty standard.  Some critics believe that the DOL is targeting a non-existent problem.  Others claim that the rule would deprive small investors from obtaining IRA advice as brokers leave the business. Advocates of the fiduciary duty assert that such a rule will require brokers to provide unbiased advice.

Wherever the DOL lands on this issue, I believe that it should, like the SEC, conduct a cost-benefit analysis to really determine if (1) such a rule is needed and (2) do the benefits of the rule outweigh the costs incurred to impose such a rule.  Only after the completion of this analysis could we objectively say it is a good thing and will be deployed in a cost effective manner.

In late February, a judge from the United States District Court for the Southern District of New York approved a settlement where a former executive and analyst cooperated with the SEC in a widespread insider trading investigation. 

The SEC agreed that, given the cooperation, there was no need to impose a small penalty.  As such, these employees, who provided substantive information on expert networking firms to the SEC, were, therefore, rewarded.

It appears that the SEC is following through on its promise to allow for cooperation to be a benchmark in avoiding certain penalties.

Ernie will be moderating a panel on investigating and responding to data breaches.  The discussion will include the required specialized skills and active coordination with a company’s IT personnel and external IT experts. Among the various federal laws to be considered when  protected private information has been improperly accessed  are the HIPAA/HITECH, and/or Gramm-Leach-Bliley Act.  The panel will also discuss the difficulty in preserving and maintaining the attorney-client and work-product privileges, among other considerations. This panel will address how such investigations differ from other types of investigations, what some of the reporting triggers involved are, and strategies for how companies can manage the negative publicity and litigation that such an event may engender.

Registration information is at: http://www.americanbar.org/calendar/2012/05/internal_corporateinvestigations2012.html

Colin O'Keefe at LXBN TV recently asked me a few questions about crowdfunding, the hype around it and what it might really look like.  At first glance, I look kind of pissed off - do I always scowl like that? - and more interested in something happening on the table.  But - despite appearances - I honestly enjoyed myself and appreciated the opportunity to discuss this exciting development. 

Looking at the interview again, I'm reminded of something my Dad likes to tell me:  "Jim, you have a face for radio." 

Again, the interview is here, and you can find my crowdfunding coverage here.  As the SEC starts to propose rules on crowdfunding, check back here for more detailed coverage on the latest developments.

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.

The House passed the JOBS (Jumpstart Our Business Startups) Act today, a package bill aimed to make it easier for small businesses and start ups to raise capital.  This is obviously a momentous occasion, right?

Not quite.  As it turns out, the House has already passed most (4 out of 6) of the provisions of this bill in separate bills, including the Crowdfunding Act that I've been crowing about since October.  All those bills sailed through the House with ease only to disappear in the Bermuda Triangle that is the Senate.

The JOBS Act will loosen some of the Securities Act regulations, meaning it would be easier for small and mid-cap companies to "ramp up" capital formation on their way to a full and proper IPO.  All neat stuff worthy of serious debate and consideration, and maybe even a vote if we're lucky.   

The House passed the JOBS act 390-23 (apparently there are 23 Representatives who HATE JOBS).  The White House fully supports it.  So what's the hold up?

That "cooling saucer" we call the Senate, that's what.  At this point, legislative milk is turning into ice cream.  Senate Leader Harry Reid has no apparent interest in passing this bill, and he risks a political debacle if he doesn't get his act together (see: the previous paragraph).  I'm not saying that there aren't any legitimate concerns about the impact this act would have on securities market and the potential for fraud - there are.  And certainly the SEC is too preoccupied with Dodd-Frank implementation to swiftly promulgate regulations to gap fill the would-be statute.  And don't get me wrong: this is obviously a bit of political grandstanding by the GOP (any time someone passes a bill they already passes, you can be assured politics, not policy, is the driver). 

But, C'MON already. This week alone, I've worked with some partners here at Fox as they've found devilishly clever ways to help startup clients find (and negotiate with) VC and angel investors.  My experience helping these hardworking and bright entrepreneurs fight to find investment has certainly made me more sympathetic to their struggle.

Post Blog Post Note:  Then again, maybe not.  The Economist this week also ran an two interesting pieces on why our small business fetish may be holding us back, and how programs designed to help small businesses may retard their incentives for growth.  Check them out here and here.

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.

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.

We wanted to make everyone aware of a great resource published by Fox Rothschild's Securities Industry and Labor & Employment practice groups.  It is called the National Survey on Restrictive Covenants.  You can access a copy by entering or clicking on the following link:  http://emarketing.foxrothschild.com/reaction/RSGenPage.asp?RSID=3H1FlS0GKN33lpQjC7nN5rf9QYXnH3iRCz_uLuiWHMc.  This survey is a quick reference for in-house counsel and human resource professionals.

Among other criticism lodged against the SEC was its inability to conduct routine examinations of investments advisors beyond a small sampling in any given year.  Dodd-Frank required an analysis of whether investments advisors should have their own self-regulatory organization to conduct some examinations because the SEC lacked the resources to comprehensively examine them.  Three options are being considered; (1) provide additional funding to the SEC; (2) give the responsibility to FINRA; or (3) create a new SRO.

A recent study by the Boston Consulting Group has found that it would cost investment advisors twice as much money to pay an SRO than it would to properly fund the SEC.  In a related study, BCG found that the overwhelming majority of investment advisors surveyed preferred to have continued SEC oversight than have FINRA act as their SRO regardless if it cost more to properly fund the SEC.  Investment advisors even preferred the creation of a new SRO over giving oversight responsibility to FINRA.

The key take away from this study is economics.  In this age where the public is clamoring for more oversight, the least expensive avenue to pursue that oversight is to have the SEC funded in a manner that would allow it to conduct more meaningful examinations across a greater sector of investment advisors.  Plus, this course avoids the unnecessary overlap, bureaucracy and increased costs if FINRA's jurisdiction is expanded to include investment advisors.  Where money talks, investment advisors should expect that the SEC will maintain oversight over you.  But do not expect the status quo; you should expect increased funding and a dramatic increase in examinations over a greater segment of investment advisors.  In the end, the devil you know is better than the devil you do not know.

In law, America tends to follow in the footsteps of its older sister, Britain.  Sure, sure, we went our own way with that little Constitution thing back in the day.  But as of late, and particularly in the world of securities law and corporate governance, we've been following in their footsteps a bit.   Wall Street is still learning to grapple with say-on-pay; the City has dealt with it for a decade now.  Last year the SEC signalled (but hasn't yet said - oh, how they tease accounting nerds!) that we would eventually follow the rest of the world and adopt IFRS.  So US boards might want to take note of the recent arguments across the pond that shareholders need more power to regulate boards and executive pay.

Last week, both British behemoths of business reporting, the Financial Times and the Economist, ran stories highlighting what the FT called a "Crisis in Capitalism".  The takeaway:  inequality between top executives and average workers threatens to undermine Anglo-American faith in capitalism, which currently hovers at a level just slightly above Russia's.  These articles consistently return to variations of one particularly stirring statistic:  in 1965, the average CEO made 24 times the average worker; as of 2010, the average CEO made 325 times the average worker.  More and more Brits and Yanks feel the system is rigged, and such feelings are the roots of Ron "End the Fed" Paul's strong primary showings and the lingering Occupy movement (if these two groups could agree on the way to best ruin the economy, we'd be in trouble).

And in case you had forgotten, the SEC plans to unveil rules this year enacting Section 953 of Dodd-Frank, which requires proxy statements to disclose a comparison between median employee pay and the CEO's pay.   Fuel, I would like you to meet Fire.  Any corporation with ongoing labor problems would be wise to review their executive remuneration packages before an embarassing statistic pops up mid-collective bargaining.  As an added bonus, this same provision requires disclosing the relationship between executive compensation actually paid and the financial performance of the issuer.  So, done wrong, Section 953 compliance has the potential to piss off both labor and capital. 

In England, companies have dealt with stronger shareholders for a long time now.  There, boards adopt proactive communication strategies to appease angry shareholders (who can fire directors that they dislike, unlike in America where you can merely not reelect a director).  Moreover, changing compensation practices to emphasize long-term shareholder returns will please the shareholder advisory firms like ISS. 

That all said, even if the UK makes significant changes to its corporate governance rules, I wouldn't expect the US to follow suit this time.  We don't have the political will or the political ability that Britain does.  First, David Cameron is leading the call for reducing corporate excess; I don't think we'll see Mitt Romney doing that anytime soon.  Second, the British government's ability to quickly pass legislation is the kind of stuff that makes American political scientists stare off into the distance and sigh wistfully. 

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As an addendum: you know what makes writing a well-linked blog difficult?  Wikipedia's blackout.  Well played, Mr. Wales...

A congressman recently introduced a bill that would create a private right of action against foreign companies for violations of the Foreign Corrupt Practices Act.  This would allow for companies to sue foreign companies for any damages stemming from the violation of this law. 

In such an action, the company would merely allege that the FPCA had been violated, and that the plaintiff did not receive the particular benefit received by the defendant.  This legislation has been introduced in other sessions, and failed.  Although there is little chance of passage, it does indicate that there are concerns on many different fronts with the FCPA.  For example, many corporate interests have criticized the FPCA for not having clarity or certainty, including, but not limited to, several unclear definitions that exist within the statute that the government has used to expand its enforcement approach. 

Accordingly, although the bill will not likely become law, it does provide an opportunity, possibly, for the government to provide for a review to allow for more clarity with this particular statute.

I read this interesting piece on the NYTimes.com today, "Pushing Back on Clawbacks" which describes how D&O insurers are now offering protection against a clawback.  The companies argue that "the policies don’t undermine financial reforms because they don’t cover fraud or intentional wrongdoing."  Sure, you could have made that argument a few years ago when SOX was the only financial reform in town, but not anymore.

Dodd-Frank's clawback provision (Sec. 954) is specifically aimed at faultless mistakes: whenever a reporting company issues an accounting restatement, it clawsback the compensation awarded in error.  Compare this to SOX Sec. 304, which requires misconduct and claws back all all incentive-based compensation, and you can see how Dodd-Frank is both broader (no misconduct required!) yet also narrower (just the difference between what you got and what you should have got).  

Sec. 954 was intended to force directors and officers to think longer term than before.  Its goal is to prevent perfectly legal methods of goosing short-term profits (and thus bonuses tied to them or share prices) at the expense of long term growth potential. 

Federal regulators have not yet issued rules on Sec. 954, but they intend to during the first half of the coming year.  They will also address the new executive compensation disclosure requirements, which includes a requirement to disclose the company policy on hedging against incentive based compensation.  I would be shocked if the SEC does not include clawback insurance as an example of "hedging."  But I wouldn't be surprised if it allows companies to continue to take out these insurance policies, leaving the matter to shareholders to vote on with their say-on-pay votes.

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.

As I have described in my previous two blog entries, where I discussed the retention and preparation of an expert report and deposition, this blog entry concludes with a discussion of trial preparation and testimony. 

I was prepared by trial counsel to provide testimony. Much of the testimony was a replay of my deposition testimony, but I was clearly focused in on providing a response to the expert testimony proffered by opposing counsel.  I also spent much time discussing the legal and factual basis for my report. 

Unlike most cases, this case did not settle so I was called to testify in the middle of the trial.  This was a non-jury trial, and my testimony was solely before the court.  Interestingly, we were in a court room that, absent a jury, was still filled to capacity with summer interns and other court personnel. 

On the morning of my testimony, we arrived at court at the appointed hour.  Prior to my testimony, opposing counsel made a motion to strike my expert testimony as not necessary for the purposes of this trial.  I was somewhat floored that such a motion had not been made before I arrived.  Nonetheless, after some argument, the court decided that he would hear my testimony and my testimony, and so it began. 

I spent approximately an hour and a half on direct examination, and another hour of cross-examination.  As a practicing lawyer with almost twenty years experience, it was interesting to be on the receiving end of questioning and cross-examination -- an experience I will not soon forget.  My testimony ended around lunchtime, and I was excused by the court.

This experience was insightful for me in that, when you are preparing for a case, you sometimes fail to realize the effect that the preparation has on those who are being called to testify.  I learned from my experience to better prepare individuals when I call them as witnesses.  Further, functioning as an expert witness, although seemingly scary, was rewarding.  I would strongly recommend serving as an expert, and, as for me, I look forward to my next retention.

Over the years, I have noticed that, as we get more complicated in describing financial terms and the process that makes Wall Street tick, I have always been able to rely upon a called Understanding Wall Street, authored by Jeffrey B. Little and Lucien Rhodes.  This well written, common sense book, is an effective tool for the securities practitioner.  Although it is not an academic treatise, the book provides a wonderful synopsis for a variety of terms that one encounters in a typical securities practice.

Understanding Wall Street provides an exceptional resource in a pinch to the harried practitioner.

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.