Subject to Inquiry: White Collar, Congressional, SEC, Energy Enforcement & Other Government Inquiries

Evidently, some broker-dealers and compliance officers did not get the message that FINRA is serious about firms’ obligations to conduct a reasonable investigation of issuers and the securities they recommend in private placements.  FINRA has been rather busy the first half of 2011 bringing enforcement actions against broker-dealers and compliance officers that failed to conduct reasonable investigations into private placements.  This should not be surprising given that FINRA identified private placements as one of its examination priorities in both its 2010 and 2011 Annual Regulatory and Examination Priorities Letters.  FINRA also issued Regulatory Notice NTM 10-22 in April 2010, describing broker-dealers’ obligations to conduct reasonable investigations in private placements.

Since January 2011, FINRA has brought actions against at least five broker-dealers and ten individuals for either failing to conduct adequate due diligence into private placements or failing to implement adequate supervisory systems and procedures for private offerings.  These actions consistently involve the following shortcomings:

• Reviewing solely the issuer’s unverified and uncorroborated statements in the offering document;
• Failing to obtain or review the issuer’s financial statements;
• Failing to visit the issuer’s facilities or meet with its key personnel;
• Failing to research the background information on the offering’s officers;
• Failing to use the services of third-party due diligence providers; and
• Failing to identify in supervisory procedures the specific due diligence steps to be taken and firm personnel responsible for such steps.

FINRA requires that firms have written procedures outlining the steps it will undertake in conducting due diligence on its securities products.  These due diligence procedures should be designed to help firms understand the inherent risks of these products and to determine whether these products are suitable for its customers.  FINRA stated in a recent Letter of Acceptance, Waiver and Consent that “[d]etailed and robust written procedures are particularly important for private offerings, because there is no registration of the securities with the SEC and public information regarding the offering may be limited.”

Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, recently said the agency will continue its focus on sales of private placements to determine whether the selling firms fulfilled their responsibility to customers.  Broker-dealers should note FINRA’s fixation in this area.  If your firm engages in private placements, it would behoove you to assess whether your internal controls, supervisory systems and risk management practices properly address your due diligence obligations. 

The SEC will not implement a uniform fiduciary standard for retail investment advice in Spring of 2011, contrary to the recommendations of the Commission’s staff.  The SEC’s staff recommended adoption of a uniform standard in its Study on Investment Advisers and Broker-Dealers, submitted to Congress on January 21, 2011, but resistance from SEC Commissioners Kathleen Casey and Troy Paredes was heard loud and clear by members of the U.S. House and Senate.

Currently, broker-dealers and investment advisers are subject to different standards of care under federal law when providing investment advice about securities.  Investment advisers are regulated under the Investment Advisers Act of 1940 as fiduciaries who have a duty to serve the best interests of their clients, including an obligation not to subordinate clients’ interests to their own.  Broker-dealers, however, are regulated under the Securities Act of 1933 and the Securities Exchange Act of 1934, specific Exchange Act Rules, and FINRA Rules, among others.  Generally, broker-dealers are not subject to a statutory fiduciary duty, but rather a standard requiring suitability, fairness and transparency.

The Study’s Findings and Recommendations

-Uniform Fiduciary Standard – adoption of a standard of care “no less stringent than currently applied to investment advisers under [the] Advisers Act.”

-Harmonization of Regulation – SEC to engage in rulemaking to develop a more consistent regulatory regime.

The Opposition

Commissioners Casey and Paredes, in opposition to the Study, stated that it “does not identify whether retail investors are systematically being harmed or disadvantaged under one regulatory regime as compared to the other and, therefore, the Study lacks a basis to reasonably conclude that a uniform standard or harmonization would enhance investor protection.”  In three separate letters to the SEC, members of the U.S. House and Senate have urged the SEC to conduct a cost-benefit analysis of what changing the standard for broker-dealers will mean for investors.

As a result, it is unclear whether any new rules will ultimately result from the SEC’s Study.  However, we can be certain that they will not go into effect until late 2011, at the earliest.  At a recent Investment Company Institute (ICI) conference, a senior advisor to SEC Chairman Mary Schapiro and coordinator of the fiduciary study, Jennifer McHugh, said that SEC action will “likely occur later in the year.”  She added that the Commission had not formed a “rulemaking team” and continues to meet with outsiders “to get their reaction, rather than [move] straight to rulemaking.” 

Allison D. Charney contributed to this post. 

The SEC recently approved FINRA’s proposed rule change relating to the outside business activities of registered persons.  New FINRA Rule 3270 merges NASD Rule 3030 and NYSE Rule 346, both of which will be deleted. 

FINRA Rule 3270 prohibits any registered person from being an employee, independent contractor, sole proprietor, officer, director or partner of another person, or being compensated, or having the reasonable expectation of compensation, from another person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member. 

Two of the most significant changes relate to the timing of the required notice and a member’s prior written consent.  Consistent with NYSE Rule 346, Rule 3270 requires a registered person to provide prior written notice of outside business activity to the member (NASD Rule 3030 had required prompt written notice), but Rule 3270 differs from NYSE Rule 346 in that it does not require a member’s prior written consent. 

Upon receiving prior written notice of outside business activity, firms must consider whether the proposed activity will: (1) interfere with or otherwise compromise the registered person’s responsibilities to the firm and/or the firm’s customers or (2) be viewed by customers or the public as part of the firm’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.  Based upon this review, firms must determine whether to impose any conditions or limitations on the registered person’s outside business activity.  Firms must also determine whether the proposed activity is an outside business activity or if it should be treated as an outside securities activity subject to the requirements of NASD Rule 3040.  Firms must also keep a record of their compliance with the requirements of the Rule.

Firms that permit outside business activities should consider revising their procedures to either: (1) require a minimum notice period or (2) require written consent, before a registered person can commence with outside business activity.  A minimum notice period will reduce the risk that a firm may not have enough time to review and object to the registered person’s proposed outside business activity before he or she commences such activity.  In addition to periodic attestations regarding outside business activities, firms should require registered persons to notify the firm in the event of a material change to his or her business activities.

FINRA recently announced that the SEC approved its proposal to expand the amount of information about brokers and former brokers available to the public through BrokerCheck on FINRA’s website.  In addition to expanding the types of information available, information regarding former brokers will be publicly available for a longer period of time under the proposal approved by the SEC. 

FINRA’s proposal will be implemented in two phases, which are scheduled to be completed by the end of this year.  BrokerCheck will be expanded as follows:

• For currently registered brokers and those that have been terminated from employment with a broker-dealer within the preceding 10 years, BrokerCheck will disclose all customer complaints, arbitrations or litigations dating back to 1999 that have not been adjudicated in more than two years or that have been settled for amounts that were lower than the reporting threshold (currently $15,000). 
• The full records for former brokers will be publicly available for ten years from the time they leave the securities industry, rather than the current two years.
• Information regarding former brokers’ criminal convictions or pleas of guilty or nolo contendere; civil injunctions or findings of involvement in a violation of any investment-related statute or regulation; and arbitration awards or civil judgments involving alleged sales practice violations reported to FINRA since 1999 will be permanently available to the public.

FINRA will also formalize the process to dispute the accuracy of factual information disclosed through BrokerCheck.  FINRA will review all written submissions, along with available supporting documentation, disputing the accuracy of the factual information.

While the expansion of publicly available information regarding current and former brokers will undoubtedly benefit investors, it raises potential concerns for brokers.  Customer complaints, even ones lacking merit, and other matters that brokers thought were behind them, may now come back to haunt them.  It behooves brokers and former brokers to review the accuracy of the information disclosed through BrokerCheck once FINRA’s expansion is complete.  The information may be dated, inaccurate or incomplete. 

In May 2008, FINRA issued Regulatory Notice 08-24 seeking comments on its proposed supervision rules.  FINRA received at least 47 comment letters in response.  At FINRA’s Annual Conference, on May 28, 2010, FINRA staff stated that they anticipate filing a rule proposal with the SEC in as soon as two weeks.

The rule proposal is part of FINRA’s consolidation of NASD’s and NYSE’s rulebooks.  Many of the proposed changes involve the adoption of rules with minor variances from existing NASD or NYSE rule language.  Other proposals, however, represent significant changes from the current rules.  Two proposals in particular have garnered a lot of discussion and debate:  Proposed FINRA Rule 3110(a)(2), which addresses review of business activities by a supervisory principal, and Proposed FINRA Rule 3110(b)(3), which addresses supervision of outside securities activities. 

Current NASD Rule 3010(b) requires a firm to have supervisory procedures for all business activities in which it engages.  Proposed FINRA Rule 3110(a)(2) would require the designation of a registered principal to supervise each type of business in which the firm engages, regardless of whether registration as a broker-dealer is required for that activity.  FINRA staff stated during the Annual Conference that the upcoming rule filing will revise this proposal so that a registered principal will only have to be designated to supervise those types of business that require registration.  Even so, firms would still have to employ policies and procedures reasonably designed to achieve compliance with applicable rules for all business activities, including the anti-fraud provisions of the federal securities laws. 

Notably, FINRA’s proposal creates an exception for bank-related securities activities of dual employees that are exempt from registration as a broker or dealer.  Accordingly, under Proposed FINRA Rule 3110(b)(3), member firms will not have to supervise bank-related securities activities of dual employees, provided that the member receives written notice of, and approves, such activities.  However, member firms must receive written assurance that the bank or supervised bank affiliate will: (1) have a comprehensive view of the dual employee’s securities activities; (2) employ policies and procedures reasonably designed to achieve compliance with the anti-fraud provisions of the federal securities laws; and (3) give prompt notice to the member of any dual employee’s violation of such policies and procedures.

There will be an opportunity to submit additional comments to the SEC after FINRA files its proposal.

In a May 7, 2010 speech at SIMFA Compliance & Legal Division’s Annual Seminar, Rick Ketchum, the Chairman and CEO of FINRA, said we can expect FINRA to “move forward with a [fixed income research] proposal this year.”  While there have been sweeping changes to the rules governing equity research in recent years, the changes (including the Global Settlement) do not apply to fixed income research because of the significant differences in how fixed income and equity analysts operate.

In May 2004, the Bond Market Association (BMA, which later merged with the Securities Industry Association to form SIMFA) issued “Guiding Principles to Promote the Integrity of Fixed Income Research” (pdf), which was designed to help firms manage potential conflicts of interest that may arise in the context of fixed income research.  However, the NASD and the NYSE (which have since merged to form FINRA), stated in a joint report issued in December 2005 (“Joint Report by NASD and the NYSE On the Operation and Effectiveness of the Research Analyst Conflict of Interest Rules” (pdf)) that they did not believe it was appropriate at that time to codify the BMA’s Guiding Principles or to extend the rules governing equity research to fixed income research.  Rather, NASD and NYSE said they would monitor firms’ voluntary acceptance of the Guiding Principles and would consider further rulemaking after assessing the effectiveness of voluntary compliance.

In his speech, Ketchum stated: “While the BMA principles have served the industry well, we have seen through our examination process that they have not been universally adopted and, of course, they didn’t address the interaction of analysts and the trading desks.  This is a perfect area for the industry to work with us to identify the best practices that have been implemented to address the obvious conflicts that exist in this area.”  FINRA has clearly signaled that fixed income analysts can expect a proposal for “dramatic regulatory changes” this year. 

You need to follow along closely because this can get a bit confusing.  As we all recall, in 2003, judgments were entered against 12 of the largest Wall Street firms that issued research and engaged in investment banking, commonly referred to as "The Global Settlement."  The Global Settlement imposed signficant restrictions on interactions between the research analysts and investment bankers at these firms in order to stymie the bankers from influencing analyst coverage decisions. 

The Global Settlement provided that with respect to any provision that had not been expressly superseded by subsequent rulemaking within five years, it was the expectation of the parties that, "the SEC would agree to an amendment or modification of such term, subject to Court approval, unless the SEC believes such amendment or modification would not be in the public interest."

Ultimately, the parties agreed to seek Court approval to modify specific provisions, rather than all, of the Global Settlement.  In an order issued March 15, 2010 (pdf), U.S. District Judge William H. Pauley III approved all of the parties proposed modifications, with the exception of one.

WSJ reported on March 17, 2010

On March 1, 2010, FINRA issued its 2010 annual examination priorities letter to all FINRA member firms. (pdf). This year's letter is no different from past years in that it highlights areas that FINRA's examination program will be focusing on throughout the coming year.  These areas include some that we see from year-to-year; e.g., information barriers, variable annuities, protection of customer information and IT/Cyber-Security, anti-money laundering and outsourcing, to name a few.  Some of the newly identified areas of focus from the prior year are fraud detection, pandemic preparedness/business continuity planning, accounting and spreadsheet controls and short sales and Regulation SHO compliance. 

This year's letter does bring some changes from past letters.  Historically, the letter identified areas of focus of FINRA's Market Regulation and Member Regulation Departments.  This year's letter also includes topics that are of heightened importance to the Enforcement Department as well.  However, the letter does not delineate which are the priorities of the examination programs versus the Enforcement Department.

One of the most significant pronouncements in the letter is regarding firms that are registered as both broker-dealers and investment advisers.  FINRA states that it is their longstanding position that "firms must supervise, as private securities transactions, their registered representative's investment adviser business to the extent that those representatives participate in the execution of a transaction on behalf of their advisory client."  FINRA warns that its examiners may review the investment advisory activities of a dually registered firm or individual to ascertain that the firm is properly supervising those activities to ensure compliance with FINRA rules.