Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

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.

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

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

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

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

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

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.

Late last week, one of my colleagues sent me an e-mail where he copied 8 other people, half of them I could not identify if my life depended upon it.  I then heard about the person who had a Twitter account with over 17,000 follwers, and was now being sued by his former employer over ownership of the account-- really, does anyone think the person knows 17,000 people?  Firms and persons working in financial services industries generate trillions of e-mails every year, encompassing the mundane to the critical. 

These firms and their employees also seem to be involved in numerous civil, regulatory and criminal investigations and litigations.  Much of the vast amount of money in legal fees paid to defend these firms and their employees (sums that sometimes greatly exceed the GDP of several developing countries) often relate to e-mail review and production.  General counsels and firm management looking for ways to save money on these bills should, initially, read my article that was published in the New Jersey Law Journal, outlining the "CC" problem and ways of clamping down on this terrible plague afflicting our society, http://www.foxrothschild.com/newspubs/newspubsArticle.aspx?id=4294970187.

Once read, please do your part in stopping this madness because the dollar you save maybe your own!!

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.

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.

The SEC and FINRA issued new broker-dealer branch inspection guidelines to securities firms so as to improve their supervision systems.

In particular, the SEC and FINRA have advised broker-dealers to use risk analysis to identify if individual, non-supervising branches should be inspected more frequently.  The SEC and FINRA will be using risk analysis to identify such requirements for future inspections.  Currently, FINRA requires a minimum three year cycle, but may conduct more frequent branch inspections. 

Firms are required to conduct re-audits when routine inspections reveal a high level of repeat deficiencies or serious deficiencies.  In many cases, these inspections will then allow for audits or cause examinations. 

Securities firms should use surveillance reports, as well as technology and investigative techniques to identify the risks.  Both the SEC and FINRA recommend custom approaches for these inspections, and comprehensive check lists developed from previous findings, trends and internal reports.  Further, the SEC and FINRA advised that firms should conduct unannounced branch inspections either randomly or based on risk factors.  These surprise exams may result in a more realistic picture of the firm’s systems and reduce the risk of certain individuals, who may try to falsify, conceal or destroy records. 

The firm should also use qualified senior personnel for these examinations, and make branch office inspection findings part of management information or risk management systems.  Additionally, the results should be placed in a comprehensive compliance database so as to be helpful in supervision, especially as it relates to independent contractor registered representatives in national firms.  Branch and compliance managers should also be provided with these findings, and they should be required to take and document any corrective action.  The firm should also track all corrective action in response to these findings. 

Finally, the SEC and FINRA are recommending that firms elevate the frequency of branch inspections, and their scope, particularly, where registered personnel conduct business activities other than broker-dealer associated person activities.  Essentially, if the firm permits activity, or business  away from the firm, its supervisory systems should be more vigilant.

These new guidelines demonstrate the focus for SEC and FINRA investigations in the upcoming year.  As such, firms should prepare and consider their response now before it is too late.

FINRA recently provided its statistical results and highlights for 2011.  Among the more significant items that FINRA noted, FINRA has brought, to date, 1,411 enforcement actions and levied fines totaling more than $63 million.  FINRA also expelled 17 firms, barred 317 individuals and suspended 432 registered representatives.

FINRA's Office of Fraud Detection and Market Intelligence (OFDMI) also referred more than 600 matters involving potential fraudulent conduct to federal and state regulators and law enforcement.  Of significance with these statistics is that OFDMI used real-time surveillance techniques to uncover potential fraud and insider trading. 

Finally, FINRA has enhanced its securities firm examination program to detect potential fraud, and increased its staff in FINRA district offices who will focus on member firms.  FINRA also announced that it is focusing in greater detail on branch office exams.  In short, FINRA has focused on areas posing the greatest risk to investors, designating those issues as "urgent".

So what does this all mean for member firms and their registered representatives.  Like the SEC and CFTC, FINRA is working its way out of criticisms that it sustained in the fallout from the financial crisis of 2008, and has ramped up its oversight of firms and representatives as a means to that end.  FINRA's comments regarding 2011 all point to the fact that member firms must be even more diligent than ever when it comes to supervision and compliance.  As the year winds down, now is as good a time as any to revisit compliance policies and procedures to ensure they remain current and are followed in a uniform manner.  Otherwise, you may be a FINRA statistic next year.

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

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

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

My colleague, Josh Horn, has written an amazing article that should be on every compliance officer’s desk.  It details methods for investigating and responding to ponzi schemes. 

In this day and age, we are met with another Ponzi scheme occurring or being uncovered almost every day.  Josh’s article is an exceptional primer since it details the steps for a proper investigation, as well as, disseminating the investigation results to the appropriate authorities.  Further, Josh lays out an approach to avoid litigation, and, if litigation does strike, responding to it.  This article appeared in the September – October 2011 Special Edition for the National Society of Compliance Professionals, in its publication, N.S.C.P. Currents, and may be viewed at www.foxrothschild.com/newspub/newspubArticle. aspx?id=4294970030.

I hope everyone considers it.

The Second Circuit Court of Appeals has ruled that the Financial Industry Regulatory Authority (“FINRA”) cannot seek to enforce a monetary fine through a judgment with the court.  What does this mean for broker-dealers?

In 1998, NASD, FINRA’s predecessor, brought an enforcement proceedings against a broker-dealer.  After a hearing, a panel concluded that the firm engaged in illegal short selling and market manipulation.  It expelled the broker-dealer and imposed a fine.  After the firm refused to pay the fine, FINRA pursued the fine through the federal court, which upheld FINRA’s right to collect its fines through a judgment against the broker-dealer.

On appeal, the Second Circuit determined that Congress did not intend to authorize FINRA to enforce its fines through judicial proceedings.  If FINRA wanted the ability to do so, FINRA would have to have pursued proper rule-making, which it failed to do.  FINRA has stated that it is weighing its options, which would include an appeal to the Supreme Court.

This decision is significant in as much as FINRA is without judicial process to enforce a fine against a broker-dealer who refuses to pay, but this does not mean that FINRA is without recourse.  First, FINRA will, in all likelihood, will attempt to pursue rule-making to enable it to seek judicial relief.  Second, FINRA has the threat of additional sanctions against member firms for failing to pay a fine, such as the ultimate sanction of expulsion; a sanction that the panel already imposed in this case.  As such, the  absence of judicial recourse should not provide broker-dealers with a rationale for not paying a fine.  If you do, you may wind up being much worse off.

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.