Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

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

Lawyers have often been the brunt of cruel jokes. But now, a recent study reported on by the Bureau of National Affairs shows, lawyers are the target of securities regulators. Why the sudden interest?

For one, cooperation initiatives between regulators and those caught violating securities law convince these people to turn on their lawyer who may have been involved in the offering. After all, clients do not owe their lawyers a fiduciary duty.

Second, lawyers may have malpractice insurance that cover their actions. As such, there is a financial incentive for regulators to target lawyers.

So what can securities lawyers do to protect themselves? Unfortunately, there is no sure fire way to protect yourself as regulators will look in the direction of anyone associated with an offering that results in a securities violation.

The best protection for lawyers is to be vigilant when it comes to client selection. Also, be certain that you are comfortable with the content of the offering to avoid being accused in promulgating a fraudulent statement.

* photo from freedigitalphoto.net

The SEC is actively encouraging companies to contact the SEC before making a public announcement.

The SEC has indicated that it has its Staff reviewing Form 8-K disclosures.  These reviews concentrate on changes in auditors, directors or officers.  The SEC Staff then will follow-up with the company to inquire as to the basis for the announcement and its underpinnings.

Additionally, companies, prior to issuing a Form 8-K or other type of information to the public, should consider that other federal regulators will scrutinize the released information.  As such, companies must be prepared to answer these regulator questions.  These regulators are also looking at the functions undertaken by the company in question.  In particular, the SEC has stressed that it will look for a “culture of compliance,” at the company where everyone seeks an ethical culture.  One part of this inquiry will undoubtedly be internal controls and the status of the company’s compliance officer and the internal audit function.

Thus, companies need to be well-prepared before issuing public pronouncements.

The SEC has given a pretty good report card regarding its examinations of nationally recognized statistical rating organizations, stating there was only one mistake.  This "clean bill of health" comes about a year after the SEC issued a scathing report of all NRSROs.

Although these agencies had been blamed for some of the problems that resulted in the economic meltdown, the SEC Staff noted that most NRSROs addressed the problems noted in its 2011 Report with the exception of one of the smaller NRSROs, who still had a lot of problems.  The SEC noted that it would continue to monitor this segment, and seek to promote a more compliant culture with regular pronouncements.

The SEC believes these actions will stop the madness. . . oh boy.

The SEC's Division of Enforcement is performing well according to its departing director.

The soon to be ex-Enforcement Director credits this strength to his re-organization of the Division based on expertise and the tips received from whistleblowers, among other things.  The Dodd-Frank Act was the impetus for the SEC’s whistleblower program, and the SEC received over 3,000 tips in a year.  Many of these tips relate to disclosure and financial fraud; market manipulation; as well as offering fraud, among other things.  The SEC has also found that these whistleblower complaints come from all over the country and world.

In short, the SEC seems to be waiting for you to blow the “whistle.”

Incredibly over the last several years, both the DOJ and SEC have been relentless in their aggressive enforcement of the Foreign Corrupt Practices Act.  As part of this pursuit, the FCPA's facilitation payment exception might not be as viable as it once was, thereby, defending these actions has gotten that much more complicated.

Many are suggesting that this exception is no longer a complete defense because there is no objective standard as to  what qualifies as a facilitating payment or a routine government action.  The FCPA does not apply to such things as payments facilitating or performance easing relating to routine government actions, including, among other things, the issuing of licenses,  permits, or processing paperwork.  In particular, the SEC does not even consider the facilitation payment exception an affirmative defense. The SEC focuses on what you are paying for, not the verbiage.  Further, larger payments make it less likely for anyone to believe it is a facilitating payment, however, not all licenses are the same, some may be more expensive than others.  Essentially, confusion reigns.

Nonetheless, companies must have appropriate internal controls to police these types of payments.  One aspect of internal controls must be adequate record keeping, ensuring that transactions are properly recorded.  As such, companies must be prepared to respond when these inquiries arise.

That may be the only real defense the company may have.

Companies that acquire or invest in offshore entities or in entities that conduct business overseas may inherit FCPA risks.

Clearly, the DOJ and the SEC are viewing these transactions and the resulting combinations with a jaundiced eye.  These regulators, most likely, will begin investigations, and, possibly, commence actions.  In fact, there have been recent FCPA actions that would fall under this category.

Consequently, acquirers must identify potential FCPA problems during the due diligence process so as to avoid these predicaments.  If identified, the acquiring company may be able to restructure the transaction to avoid assuming that liability.  Possibly, the parties may also submit an FCPA "opinion procedure request" to the DOJ seeking ways to mitigate the potential liability.

Essentially, it is critical that the due diligence process uncover these problems, and the parties address them before the closing.

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. 

Seemingly-- according to FINRA-- broker-dealers are failing in their due diligence efforts relating to knowing their clients, and, as required by FINRA Rule 2090.

Over the last year or so, the most FINRA rule has been FINRA's know-your-customer rule or Rule 2090.  As many know, FINRA Rule 2090 was modeled after the old NYSE Rule 405(1), requiring broker-dealers to use reasonable diligence in opening and maintaining customer accounts.  Broker-dealers are required to "know the essential facts concerning every customer," so that they may 

• service the customers' accounts;
• make appropriate decisions regarding special handling for the account;
• have appropriate authority from the customer; and
• follow all applicable laws, regulations, and rules.

This Rule must be followed by the broker-dealer at the beginning, during and, if necessary, the end of every customer relationship regadless of the type of account.

FINRA has also developed suitablity rules for transactions found in FINRA Rule 2111.  These rules require the broker-dealer or registered representative to have a reasonable belief when recommending a transaction or investment strategy or associated person "have a reasonable basis to believe that a recommended transaction or investment strategy.  Initially, the security or securities must be suitable for the customer, and based upon the information obtained from the process outlined abobe.  FINRA believes that there will be many factors involved depending upon, among other things, complexity and risk and broker-dealer and registered representative familiarity and knowledge.  FINRA Rule 2111 also requires that the broker-dealer and registered representative know much about a customer's investment profile, including, among other things, age; other investments; financial predicament and needs; tax status; investment objectives, experience, time horizon; liquidity requirements; tolerance for risk; as well as any other customer specific information disclosed to the broker-dealer and registered representative.  Finally, analysis of this information is critical to determine quantitative suitability if there is actual or assumed discretion over the customer's account.

Essentially, broker-dealers and their registered representatives are now on notice that they must know their customers or risk violating FINRA's rules.

This blog entry about hedge fund insurance coverage almost sounds like a car insurance commercial.  Sadly, both are critical in today's modern society.

Given the current regulatory environment, volatile market conditions, and the public perception of the industry, hedge funds face enormous risk in doing business.  Hedge funds should carry both D&O and E&O Liability Insurance to protect directors, officers, managers and the fund itself from liability.

The hedge fund should have coverage for governmental investigations.  Additionally, the hedge fund also needs coverage for when it or its affiliates are alleged to have committed fraud.  However, the hedge fund must be cautious in this particular area because insurance companies, generally, try to avoid such coverage and will construe just about anything as an admission of wrongdoing or responsibility.  Finally, the hedge fund has to ensure that its insurance coverage will pay for defense costs since said costs are usually the most expensive part of the process.

In short, hedge funds cannot just assume that insurance coverage will be there.  Periodic audits and check-ups are required before anything arises.  Like most insurance coverage, you never want to have to use it, but that is why it is there so make sure it will work.

The SEC's Division of Investment Management allowed a sanctioned broker-dealer official to be paid a cash solicitation fee from a RIA.  See J.P. Turner & Co. LLC, SEC No-Action Letter, avail. 9/10/12, and http://www.sec.gov/divisions/investment/noaction/2012/jpturner091012-206-4.pdf.

The SEC Staff allowed the cash fees because the sanctioned official was not engaged in cash solicitation activities in his individual capacity.  The SEC Staff granted the relief noting the firm will conduct any cash solicitation arrangement in compliance with IA Rule 206(4)-3, and will comply with the terms of the administrative order for 10 years. 

This broker has to follow the SEC rules to permit this individual to receive cash fees, any other approach would be a serious violation.

The SEC inspections of RIAs have been showing that certain RIAs have poor controls in place. 

The SEC has been seeing in these inspections that the RIAs have been utilizing poor internal controls in their businesses.  Many of these reports derive from the recent new advisers to hedge and private equity funds.  These RIAs were required to be registered by the Dodd-Frank Act.

Importantly, RIAs must review their controls to ensure proper management.  There really is no excuse for having poor controls in place.

“Big Boy Letters” are usually used to identify that the buyer in a transaction has made its own independent assessment of certain risks involved and that certain information has not been disclosed to the buyer by the seller.  In particular, this means that a party is not relying upon certain representations or the lack of representations.

The critical step in these letters is considering the application of these non-reliance provisions are received by the courts and the SEC.  In particular, the SEC has taken the position that such a letter will not foreclose an insider trading liability case under a misappropriation theory  However, courts and private litigants could effectively eliminate or at least limit the potential liability from these letters.

Essentially, the use of these letters is somewhat uncertain depending upon the context.  Nonetheless, these letters are certainly not a complete "get out of jail free" card, and will depend upon the facts and circumstances of each situation.

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

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

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

Despite past false starts and losses, the SEC has announced that it will continue to bring actions against individuals and control persons.

Many believe that such a focus by the SEC will lead to more litigation.  Further, an individual's ability to defend these actions has been severely limited since the passage of the Dodd-Frank Act.  The Dodd-Frank Act, now, allows the SEC to merely prove as the standard reckless conduct when alleging aiding and abetting violations in stark contrast to the previous standard of proving actual knowledge of the fraud being committed by another party.  Additionally, given the SEC’s recent court injunction setbacks and settlement problems with federal judges, it is possible the SEC may use its administrative courts more, especially since the remedies in both forums are nearly identical.  One exception to this switch may be, however, insider trading.

In short, if you are an individual or control person in the securities industry, there is no escape: the SEC is watching you.

The United States Supreme Court refused to review a federal appeals court ruling approving a $62 million award against a former hedge fund manager, who defrauded hedge fund investors over several years.  See Lauer v. SEC., U.S., No. 12-260, 10/29/12, and http://www.supremecourt.gov/orders/courtorders/102912zor_3f14.pdf.

This was an appeal from the United States Court of Appeals for the Eleventh Circuit that agreed with a federal district court's granting of the SEC's motion for summary judgment on liability and remedies.  The SEC had alleged that the hedge fund manager had misrepresented the true value of the hedge funds, artificially inflating the value of holdings.  Further, the SEC claimed he made false statements in various written and oral communications.  Previously, the district court had frozen the hedge fund managers assets.  The big judgment followed thereafter.

In short, both the United States Supreme Court and the Court of Appeals found there was sufficient evidence to support this judgment.

Settling with the SEC is never easy.

The SEC, routinely, attempts to introduce factual findings from an administrative proceeding against other parties in a subsequent enforcement action.  In particular, the SEC has attempted to use these settements against a non-settling party, sometimes arguingthat that case law will permit it despite the language contained in the SEC settlement agreement stating it could not be used against another person or entity in the proceeding or another proceeding start.  Unfortunately, there is conflicting court decisions where certain courts have held that it could be used while others under the Federal Rules of Evidence have indicated that it could not be used.

Further in SEC v. Pentagon Capital Management PLC, 2010 WL 985205 (SDNY March 17, 2010), the court held that the orders instituting proceedings were admissible to defend against SEC allegations.  The court held, essentially, that these findings could be used against the SEC, but not against the defendants.  The Tambone court did not rule upon the SEC’s opposite claim.

Given the emerging nature of this body of law, struggles will continue leaving an uncertain path for entities and individuals who may be subjected to this application.

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.

RIAs are certainly in the cross-hairs of the SEC.  The SEC, recently, sanctioned a RIA for misrepresenting its use of performance models that were actually hypotheticals relating to backtested performance.  http://www.sec.gov/litigation/admin/2012/ia-3516.pdf.

The SEC alleged that the RIA played with certain computer software models providing a false impression of performance over various time periods.  The SEC claimed these models did not exist during these time periods, but were back-tested hypotheticals.  The SEC accused the RIA of violating the anti-fraud and compliance rules since the RIA was also the Chief Compliance Officer, and had no policies or procedures in place to prevent such a scheme.  The RIA had to pay a six-figure fine, and retain an outside consultant. 

Accordingly, RIAs need to have effective compliance programs to monitor these types of hypothetical models.

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.

Recently, a registered investment adviser and its principal had to pay approximately $500,000 in disgorgement and penalties when they used an affiliated broker-dealer to charge clients higher commission rates.  See http://www.sec.gov/litigation/admin/2012/34-68118.pdf

The SEC found that the RIA and its principal, essentially, mislead their advisory clients by representing the clients were receiving a discount on commissions when the trades were placed through the affiliated BD.  In fact, the SEC stated these advisory clients paid higher rates than the BD charged the RIA, and the RIA and principal pocketed the difference.  The RIA did, however, disclose the potential conflict of interest in its Form ADV, but omitted any discussion on the compensation.  For good measure, the SEC also found the RIA failed to have any best execution review despite such a description contained in the Form ADV.

This enforcement action clearly portrays a more activist SEC on these issues so RIAs and their principals really need to be prepared by ensuring their Form ADVs are accuarate and disclose all conflict of interest information including fees and commissions.  Most likely, this will also be a particular concern during SEC RIA and BD exams, yet another potential hot point.

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

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

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

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

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

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

In regular intervals, SEC Enforcement Director, Robert Khuzami as well as other agency officials, attend conventions and conferences, spouting off about the wonderful progress the SEC and other enforcement agencies have made over the preceeding year. 

In particular, the SEC has consistently defended its settlements before several courts despite the attacks it received from Judge Rakoff.  Further, the SEC changed to its neither admit nor deny policies regarding those who admit guilt in a parallel criminal proceeding, and SEC Enforcement officials defended the use of the obey-the-law injunctions because the SEC believes these injunctions acknowledge misconduct and provide a basis for further actions.  The SEC has also answered questions over the SEC’s non-prosecution or deferred prosecution agreements, and their relevance going forward. 

Finally, SEC Enforcement officials, among other things, mention that they believe the use of other divisions at the SEC, including, among others, its own specialized units as well as the Office of Compliance Inspection and Examinations, have, essentially, increased Enforcement's ability to bring other cases.  In sum, its not surprising that the laudatory descriptions of the SEC Enforcement program offered by its officials will continue regardless of time, place, manner, or administration.  However, the results are more mixed than such a recitation would leave the reader.

As a service to our readers, the United States Court of Appeals for the Fifth Circuit has rejected the Second Circuit's analysis in Gabelli.  See SEC v. Bartek, at  http://www.ca5.uscourts.gov/opinions/unpub/11/11-10594.0.wpd.pdf.  This issue is ripe for Supreme Court review.

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.

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

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

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

Recently, SEC Commissioner Daniel Gallagher stated that he was not in favor of allowing the Commission to retroactively impose a collateral bar.

Although there certain administrative proceedings have looked into this question, for example, In Re Lawton, where SEC Chief Administrative Law Judge Brenda Murray refused a retroactive application, there has been very little guidance from the Commission as a whole.  Such collateral bars are directly attributable from the Dodd Frank Act that permitted the use of collateral bars. 

This is a very interesting development, and may cause the Enforcement Division to re-think certain positions it has taken in administrative procceedings.  Nonetheless, without a clear pronouncement from the Commission, this will remain an unsettled area of concern for those finding themselves in an SEC administrative proceeding.

In its continuing enforcement onslaught on firms emanating from China, the SEC filed another action in the United States District Court for the Western District of Louisiana against a Chinese company. 

The SEC alleged that the company mislead investors regarding its value in a variety of press releases.  Further, the SEC claims that a number of the company's executives had confessed to skimming money from the company’s bank account. 

This is yet another case in a long line of cases against these types of companies that were formed in China and used in the United States to raise money.  The SEC believes that it has uncovered numerous instances of fraud, and this matter will ultimately be prosecuted.

The SEC is making a statement with this type of case.  It is suggesting that, if these companies wish to continue to operate in the United States, they will be subject to strict regulation by the SEC.  However, it is unclear as to how these companies will respond.

Recently, the SEC Enforcement Director was promoting the SEC’s successes, offering credit to the restructuring and hiring of securities specialists that he undertook. 

The Enforcement Director also indicated that the 37 cooperation agreements the SEC has agreed to have assisted the SEC in obtaining a wide variety of enforcement victories.  The Enforcement Director also suggested that the whistleblower program and the submissions the SEC receives have also assisted in tips.  Of the 37 cooperation agreements, the SEC has initiated 101 cases, including against at least 74 individuals.  Khuzami also gave credit to the deferred prosecution agreements with assisting the agency in its enforcement program.

The SEC has also utilized a number of different mechanisms to combat insider trading.  Along with the Department of Justice, the SEC has used a whole plethora of mechanisms to uncover very complex insider trading schemes. 

Although one is always worried that these self-laudatory discussions turn to a victory lap, the SEC has, in fact, beefed up its prosecutions.  However, time will tell if it has had any significant effect.

Recently, an investor advocacy group petitioned the SEC to prohibit brokerage firms, who offer wraparound accounts, to also provide investment advice through both a duly registered BD and investment adviser. 

This group claims that terminating this practice would resolve a very troubling regulatory issue.  The group also petitioned the SEC to ban mandatory arbitration accounts for individual retirement accounts and allow for a private right of action by investors in a court.  In any event, this group claims that its petition and potential subsequent SEC action were necessary because FINRA has refused to take any action to resolve this problem.

The groupl claims that FINRA refuse to enforce any fiduciary standard for investment advice relating to wrap accounts.  This group believes that such a "non-practice" violates the U.S. Court of Appeals for the District of Columbia Circuit's decision in 2007 in a case entitled Financial Planning Association v. SEC.  The group believes that the D.C. Circuit stated that the SEC exceeded its authority in promulgating a rule exempting from regulation broker-dealers who also provided investment advice to client fee based accounts. 

As a result of FINRA’s inaction, these dully registered wrap accounts are creating conflicts that are not being disclosed.  Further, this group claims that confusion exists in the industry, leaving retail retirement investors without any appropriate legal process for claims of breach of fiduciary duty under the Investment Advisers Act of 1940.

Although it is unlikely this petition will ever be acted upon, it is important to keep in mind that, in an election year, anything is possible, and, who knows, the SEC may consider appropriate action at some time in the future.

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 battle lines are being drawn over Congressman Bachus' bill which would authorize one or more self-regulatory organizations for investments advisers.  Many have believed that FINRA would be the obvious choice to take on this new role.  Not Congresswoman Maxine Waters, the second-highest ranking Democrat on the Financial Services Committee; she favors the SEC keeping oversight over investment advisers.  Her stated preference is to properly fund the SEC so that it can effectuate proper oversight of investments advisers.

Congresswoman Waters thinks that the SEC charging a reasonable user fee would be the most cost effective approach.  This approach was also endorsed through the cost analysis of Boston Consulting Group who concluded that funding a new SRO or having FINRA serve in that capacity would be significantly more expensive than properly funding the SEC.  Conversely, FINRA has circulated its own cost analysis, which attacks the Boston Consulting Group study arguing that it underestimated FINRA's ability to leverage existing staff, district offices and technology.  In other words, the ramp-up costs for FINRA to be the SRO are not as great as that being claimed.

As the debate heats up, cost will likely be a driving factor to the decision regarding who will serve as the SRO for investment advisers.  Considering the institutional knowledge that the SEC has over investment advisers, it seems to me that the most likely and cost effective approach will be a better funded SEC serving as the SRO.  The one thing that has remained clear throughout the debate, however, is that investment advisers will have an SRO at some point.  That will surely be a reality.

In response to the Supreme Court’s decision in Morrison v. National Australia Bank where the Supreme Court said that there was no private right of action for lawsuits that involved transnational fraud, the SEC has taken a position that has angered some. 

As many know, the Dodd-Frank Act confirmed the SEC's jurisdiction as it relates to potential foreign involvement.  However, the SEC was not so quick to support such a stance for private litigants.  In particular, the SEC believes that Congress could either clarify the Morrison test or take no action.

This no action position has engendered much criticism from SEC Commissioner Aguilar.  Commissioner Aguilar believes that Congress should revert to the pre Morrison test of conduct and effect, and ignore the Supreme Court’s s decision.

Accordingly, it will be interesting to see if Congress responds to this recommendation from the SEC, since it required the SEC , through the Dodd-Frank Act, to conduct this study and make this report to Congress. 

Recently, SEC Chairman, Mary Shapiro, was called to task for the high number of reported administrative proceedings by Congress.  In particular, the SEC was accused of reporting follow on administrative proceedings as if they were new actions when it announced the yearly enforcement statistics. 

Such reporting gives the indication that the SEC is bringing more cases than  theoretically possible.  Essentially, the SEC is being accused of "double-counting," bringing an injunction action and an administrative proceeding arising from the same facts.  Certain reports indicate that the SEC reported 30% of its 735 enforcement actions were merely follow on administrative proceedings to previously filed injunctive actions.  (By the way, the number of enforcement actions in 2011 was the highest ever filed by the SEC.)  Various members of Congress have questioned this practice and believe it provides a false impression.

In sum, although technically accurate, the SEC effectively is providing incomparable information.  There is little extra work necessary to bring a follow on administrative proceeding to a previously filed injunctive action, without much additional regulatory benefit.  In any event, I suppose Disraeli was correct, “there are lies, damn lies and then there are statistics.”

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.

Recently, the SEC announced that it would take steps to bar felons and bad actors from any Regulation D offering. 

This rule was mandated by the Dodd-Frank Act, and the SEC issued the proposal last May 2011.  This new rule may be in place before the end of this year, but there is no certainty on timing at this point.  This new rule is part of an overall effort by the SEC to attempt to remove bad actors from early stage offerings since these offerings usually involve raising capital for small companies.

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.

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.

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.

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!!

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

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

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

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

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

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

Here is the link:  http://bit.ly/xQWwJn

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.

At a recent conference, federal regulators, including the DOJ and the SEC, stated that they are aggressively pursuing investigations into private equity and hedge funds and their FCPA compliance. 

Most likely, we  will see a spike in enforcement issues for these funds regarding the FCPA as the new year begins.  The government will undoubtedly look to see if these funds have significant FCPA compliance programs, and if there is any activity that implicates a violation of the FCPA. 

Although the SEC and DOJ have suggested a concern over compliance programs, the SEC and the DOJ will still look to prosecute if such a prosecution is merited.

Responding to numerous complaints, especially, regarding companies operating from the People’s Republic of China, the SEC has determined that it will tighten the listing requirements for companies involved in reverse mergers.  In particular, these new regulations will effect those companies listed on the Nasdaq, New York Stock Exchange, and the NYSE Amex. 

As many know, a reverse merger occurs when a shell company is acquired by a private company, and the two entities merge.  The SEC has estimated that since 2007, more than 600 of these “back door registrations” have occurred. 

The SEC had determined that obtaining reliable information from these types of entities, has not been easy.  In fact, the SEC was forced to suspend trading in many of these reverse merger companies since there was outdated or inaccurate financial information.  It is believed that, with these heightened requirements and the necessity to file the information prior to these companies becoming listed, the SEC will provide greater protections to investors. 

Now, with the new listing rules, these companies will have to endure a one year trading period in the over the counter market, or other U.S. or foreign regulated exchange after the reverse merger.  These companies will also have to provide additional financial and other records to the SEC prior to listing.  Further, the company will be required to keep a minimum share price for a period of time of at least 60 trading days before its application and listing are approved.  However, certain companies will be exempt from the new rules where the reverse merger companies are listing as part of a firm commitment underwriting, public offering or whose mergers occurred previously and where the company has already filed annual reports with audited financial information.

In sum, the SEC is cracking down on these reverse merger companies because it believes the companies are fraught with fraud.  Those wishing to conduct these types of transactions should be advised accordingly.

Please join us for this program on Thursday, January 5, 2012. 

C:\Documents and Settings\ebadway\Local Settings\Temporary Internet Files\OLK8F\cle_GovernmentAndInternalInvestigations.html

It’s December, so its time for the usual blizzard of End-of-the-Year lists, reviews, recaps and predictions.  Since I was already digging through a heap of these on corporate law, I figured I would save you the trouble of doing the same.  So here it is, your corporate governance Review and Preview Review, highlighting the major regulatory themes of 2011 and expectations for 2012.

2011 Review

Say-on-Pay (SOP): This was the inaugural year for Section 951 of the Dodd-Frank Act, which requires public companies to hold advisory shareholder votes on named-executive compensation practices.  Already, it’s had a major impact on the relationship between pay and performance, leading many compensation committees to reduce the amount of non-performance-based pay, increase shareholder alignment and increase disclosure in the Compensation Discussion and Analysis required in proxy statements. 

In 2011, over 40 companies received negative say-on-pay advisory votes.  That sounds bad, until you realize that this is less than 2% of companies holding a SOP vote.  That said, 10 of these 44 companies have be subsequently struck with shareholder derivative suits, leading some to believe that negative votes lead to lawsuits.    Personally, I wonder if this is more correlation than causation, but it’s a trend to watch out for regardless.  Still, the average SOP vote received 92.1% approval. 

According to ISS, the major contributory factor to a negative vote was pay-for-performance concerns.  Basically, a combination of higher pay but lower performance compared to peer firms caused shareholders to express their displeasure.   

Anti-Anti-Takeover: “Among governance proposals, the biggest story of this year was the greater support for shareholder proposals that seek board declassification. These resolutions averaged 73.5% support, up more than 12% from 2010, and won majority support at 22 out of 23 large-cap firms.”  Moreover, shareholders and proxy advisors both fought to remove poison pills – according to a Conference Board survey, now only 20% of companies have a shareholders rights plan in place. 

2012 Preview

Say-On-Pay: Laurel Hill’s Francis Byrd wants compensation committees to “prepare with a similar level of intensity as last year” noting that institutional investors revise their voting guidelines annually.  He's right, they do, and have: the Glass Lewis Proxy Season Preview warns “absent evidence that a board is actively engaging shareholders on [say-on-pay votes] and responding accordingly, we will recommend holding compensation committee members accountable.”  The ISS 2012 Policy Update goes into gross detail on how exactly it will determine whether an executive is getting paid too much.  Tax gross seem to be in the crosshairs of many governance advocates this year.

Clawbacks: §954 of Dodd-Frank will lead to a clawback requirement for companies listed on the national securities exchanges.  Listed companies need to develop and implement a policy providing for the clawback of a named-executive officer’s incentive-based compensation awarded during a 3-year period preceding an accounting restatement.  954 overlaps somewhat with SOX 304, but unlike SOX it does not require misconduct and only claws back the “extra” compensation erroneously awarded, rather than everything. 

Clawbacks will be one of the hardest of Dodd-Frank’s governance provisions to implement, and it intends on tackling it sometime during the first half of 2012.  Some companies have already begun to update their previous clawback policies in expectation for this change, but many compensation committees still need to address this issue in the coming year. 

Anti-Management Entrenchment: Activist Shareholders and hedge funds will continue the fight to remove poison pills and declassify boards. 

Proxy Access: SEC revisions to Rule 14a-8 came into effect in September, and a few activist investors have already filed proposals.  Expect more of these in 2012.  Both Glass Lewis and ISS say they will review these proposals on a case by case basis. 

Environmental and Social Issues: We can expect continued fallout from the Supreme Court’s Citizen United decision.  Already, a collection of big names in the academic world – the folks who wrote everyone’s Sec Reg book, basically –  has petitioned the SEC for a rulemaking to require corporations to disclose spending on political activity.  Laurel Hill notes that public pension funds and labor-related pension funds are looking to make more proposals this year.  Glass Lewis will vote in favor of proposals requiring more disclosure. ISS is changing its policy from case-by-case to generally being in favor of these proposals. 

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

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

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

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

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

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

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.

Everyone loves small businesses, even if they might not be the job-creating economic saviors we want them to be.  No one likes bailing out Wall Street, but Main Street?  That’s something we can all agree on!

On Wednesday, a subcommittee of the House Committee on Financial Services advanced a few interesting bills aimed at reducing regulatory burdens for small cap corporations. 

While some were approved by voice votes, suggesting broad bipartisan appeal, two ran down party lines, portending a difficult path ahead. 

Surprisingly, the subcommittee’s Democrats voted against H.R. 2930, or the “Entrepreneur Access to Capital Act,” a bill which will undoubtedly go by the pithier “Crowdfunding Act.”  (Note: by “undoubtedly” I mean “hopefully,” and by “pithier” I mean “coined-by-Jim-Saksa”).  “Crowdfunding” refers to the idea of letting a large number of investors give small amounts of money to a start up without the hassle of registering with the SEC.  Right now, non-profits can raise money this way from websites like Kiva and DonorsChoose.  Crowdfunding basically says: why not let start-ups raise capital this way, too?  (For a quick introduction to the concept, read Annie Lowrey’s article on Slate).  This bill would allow new businesses to raise up to $5 million before triggering registration requirements, provided that individual investments were limited to the lesser of $10,000 or 10% of the investors income.  These smaller companies could make general solicitations online without having to go through the pains of an IPO. 

I’m dumbfounded by Democratic opposition to this bill.  Crowdfunding has an innate connection to the green and creative economies – markets that Democrats like to support with public funds.  Why don’t we skip the Leviathan/middle man and let a community of small investors give their money directly to risky small ventures?  Moreover, at least one Democrat seems to dig the idea: there’s a version of it in President Obama’s Jobs Act.  And the same Democrats who voted no on Crowdfunding then voted yes for a few complementary bills.    

One, H.R. 2167, raises the shareholder threshold for mandatorily registering with the SEC from 500 to 1,000 shareholders (for companies with market capitalization under $10 million).  Both this and the Crowdfunding act address the complaint that regulatory costs related to raising capital is too high for many small businesses – and the need to protect investors too low – to justify obligatory SEC registration.  If anything, the Crowdfunding bill is less deregulatory, as its individual investor amount limits protect potentially naïve investors from betting everything on the next Pets.com. 

Another bipartisan winner, H.R. 2940, directs the SEC to expand the registration exemptions under Rule 506, allowing issuers to market securities to accredited investors via general solicitation under Regulation D.  This law change is potentially huge.  Right now, Rule 506 allows a company to raise an unlimited amount of money from an unlimited amount of accredited investors (plus 35 non-accredited individuals, provided that they are “sophisticated”, which sadly has very little to do with being able to appreciate the delicate complexities of Louis XIII de Rémy Martin).  The only real limitation preventing this from becoming a way to do a wealthy-person-only IPO (minus a whole host of reporting requirements) is the prohibition on general solicitation.  Think about this: the Crowdfunding Act could help the next Facebook get off the ground; this law could help the current Facebook stay underground. 

Finally, the “Small Company Job Growth and Regulatory Relief Act” also passed down party lines, but Democratic opposition was less-than-unexpected this time around, as it aims to substantially weaken Section 404(a) of the Sarbanes-Oxley Act.  Section 404 requires management and the external auditor to both sign off on the adequacy of a reporting company’s internal controls in its 10-K.  Right now, the SEC exempts companies with market capitalization rates under $75 million.  Representative Fincher’s bill wants to raise that amount just a teensy bit, to $500 million.  Personally, I don’t see Democrats backing a bill that makes life easier for CEOs and CFOs anytime soon.

These bills have only just emerged from subcommittee, so they are all a long ways away from passage.  The House Committee on Financial Services must give them the OK before it can be put before the entire House, and then a companion bill must make its way through the Democratically-controlled Senate.  Regardless, should any of these bills make it through the legislative warzone that is the 112^th Congress, they could have a major impact on how small businesses raise initial capital. 

In a recent letter from SEC Enforcement Director, Robert Khuzami, to United States Senator Charles Grassley, the SEC for the first time said that the destroyed documents did not have any effect on current or future investigations. 

In fact, Khuzami said that the SEC saved electronic data allowing them to "connect the dots" for current investigations.  Further, the Enforcement Director minimized the value of some of the documents that were destroyed, and said the information could be re-obtained  from public information.  Nonetheless, Khuzami acknowledged that some of the investigations' preliminary documents, regarding investigations into major banks and Madoff, were, in all likelihood, destroyed.

However, as Senator Grassley pointed out, the SEC may say the documents were not significant, but no one will ever know since the documents are gone.  This was, of course, not the reaction the SEC hoped to obtain from Congress.  Instead, the SEC will continue to operate under a cloud regarding the loss of  this material.

In short, the SEC needs to provide a credible and appropriate reason for this destruction as well as implement procedures to ensure that it will not occur in the future.  Until such time, the SEC should expect continued skepticism over its operations.

Over the last few days, a handful of eye-roll-inducing, easily-ignored activists calling themselves Occupy Wall Street grew into a large, multi-state movementthat demands our attention.  Thousands of protesters now gather in New York, Boston, Chicago, LA and other cities, protesting… well, something.  The inchoate mass lacks a singular focus –  activists carry signs ranging from “Pepper Spray Goldman $achs” ($ instead of S – clever!) to tried-and-true standbys like “Free Mumia” and “Meat is Murder.” 

Still, these protests are united by an undercurrent of anger at an economic system that has, in their eyes, rewarded the investment banks while the rest of us suffer through a recession that they caused.  It’s good old fashioned populism - the slightly late liberal counterpart to the Tea Party Movement. 

Both Occupy Wall Street and the Tea Party are reactions to the 2008 financial crisis and its long, ugly aftermath.  We shouldn't expect Occupy Wall Street to fade away anytime soon, as it has the potential to become a powerful, polarizing brand on the left, just like the Tea Party has been on the right.  With unions joining the protests in solidarity, this isn't just another excuse for kids who couldn't score Burning Man tickets to beat on some bongos: it's the start of a liberal movement which is seperate and distinct from Barack Obama.  As long as the economy remains in the doldrums, we can expect populist anger to remain frothy and available in every flavor. 

Noticeably and not-unexpectedly, few of the news reports I have read quote either Tea Party members or Wall Street Occupiers waxing philosophical on the latest rules and regulations emerging from the Dodd-Frank act.  While corporations, the SEC, the CFTC and others discuss how to implement what many call the most sweeping financial reforms since 1934, a large and diverse public does not seem satisfied.  Can we expect further legislation in the build up to the 2012 elections? 

In “This Time is Different” Carmen Reinhart and Ken Rogoff analyzed the financial crises of the last 800 years and found that they create a long period of sloth-like growth.  Normally, unemployment remains high for four to five years.  So far, they have been dead-on: good for them, bad for everyone else. 

And perhaps really bad for anyone hoping for less economic uncertainty.  Robust recovery appears to be over a year away.  A suddenly re-energized left, with elements of Ron Paul libertarianism thrown in, combined with a mobilized Tea Party could cause some havoc if they can inspire Congress to channel this incoherent anger.  More likely, however, is even more partisan gridlock, at least until November 2012.  Either way, the yawning disconnect between policy makers and the public continues to grow without signs of abating anytime soon, and that will make it even harder for businesses already mired in economic uncertainty. 

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

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

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

Recently, the SEC was severely criticized for violating the Department of Treasury’s offset program when it sent a notice of intent to use this program to a wrong address of a securities violator.  This program allows government agencies to seize various assets that may be attributable to those it has a judgment against. 

The Court criticized the SEC because it ignored the defendant’s filing of a change of address.  Instead, the SEC sent the notice to the defendant’s last known address – the one he had used before he started serving a prison term for securities fraud.  A fact the SEC knew well since it had provided the evidence as part of the criminal investigation.

As a result, the Court ordered the SEC to cease using this program, and reimburse the defendant for monies wrongfully seized.  The Court required the SEC to use the proper notice if it plans on using the Treasury’s program again.

In an interesting speech, SEC Chairman Mary Shapiro stated that she believes securities violations are often the result of peer pressure and not individual greed. 

Chairman Shapiro was referring to the recent guilty verdicts in the Galleon insider trading matter, as well as numerous other insider trading convictions.  Chairman Shapiro seemed to suggest that individuals are engaging in insider trading to “return a favor,” or enhance their reputations in their businesses.  Further, she claims that the penultimate approach to performance is a motivating factor for many, and the old adage that “everybody was doing it” is a driving force.

Although Chairman Shapiro seems to sincerely believe her words, this may be an overly simplistic approach to insider trading.  Many individuals, who have been convicted, earned large sums of money, and it is unlikely that they were solely motivated to increase their reputational standing or that they were returning favors to friends.  At the very least -- or to be as generous as possible to Chairman Shapiro -- peer pressure may play some part, but the overwhelming evidence seems to suggest that the pursuit of money plays a much larger role in insider trading.

Recently, the SEC charged an ex-board chairman, who bought shares in his company, prior to the company’s announcement that it intended on buying back said shares. 

The SEC charged him with fraud, alleging that he  purchased shares of his company stock prior to the announcement of the buy back, causing the company to overpay $36,000 to repurchase its own securities.  He allegedly realized a $124,000 profit, and, apparently, according to the SEC’s allegations, did not file a proper Form 4 so as to avoid SEC detection.  The SEC alleged that the former board chair’s broker had, actually, informed him that he needed to file such a form. 

This case demonstrates the SEC’s increased vigilance of corporate directors and officers, and the SEC will continue activity at regulating their conduct.