Header graphic for print

The BD/IA Regulator

Providing securities regulatory, enforcement and litigation trends for broker-dealers, investment advisers and investment funds

Big Regulatory Changes in Store for Funds and Advisers? No One Knows for Certain, but Here’s Our Best Guess

Posted in Broker-Dealer Regulation, Fund Regulation, Investment Adviser Regulation

While no one knows for sure what the future holds for investment management regulation, the tea leaves indicate that we may expect a slowdown on new regulations, some pullback on parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), and an abundance of uncertainty. Here, we provide some observations for investment companies, their independent directors, investment advisers, broker-dealers and other service providers that want a peek at how we see the future unfolding.

Read our client alert.

CFTC Approves Final Rule Amendments to CPO Financial Report Regulations

Posted in Fund Regulation, Investment Adviser Regulation

On November 21, 2016, the U.S. Commodity Futures Trading Commission (CFTC) approved final rule amendments to its regulations that allow commodity pool operators (CPOs) to use certain additional alternative generally accepted accounting principles, practices or standards in preparing financial statements for non-U.S. commodity pools and that exempt commodity pools from the audit requirement for Annual Reports covering the “stub period,” subject to conditions, and that further exempt audited financial reports for “insider” pools.  The rules, which will become effective on December 27, 2016, are available here.

Alternative Accounting Standards for Non-U.S. Pools

Under the final rule amendments, a CPO will be permitted to use generally accepted accounting principles, practices or standards followed in the United Kingdom, Ireland, Luxembourg and Canada when preparing Audited Financial Reports, and, in an expansion from the rules as proposed, when preparing account statements and Form CPO-PQR reports, for commodity pools that are organized in those jurisdictions.  These standards are in addition to International Financial Reporting Standards currently permitted under CFTC regulations in preparing financial statements for non-U.S. pools, and are permitted, in another modification from the proposal that only addressed distribution of Annual Reports under CFTC Reg. 4.22, in distribution of Annual Reports and account statements under CFTC Reg. 4.7 as well.  CPOs intending to use one of the alternative accounting principles, practices or standards must file a notice containing certain representations with the National Futures Association (NFA) generally within 90 days of the end of the pool’s first fiscal year.

“Stub Period” Relief from Audited Annual Report Requirement

In addition, the final rule amendments provide “stub period” relief from the audited Annual Report requirement where the pool’s first fiscal year is short, subject to certain conditions.  Specifically under the final rule amendments:

  • The pool’s first fiscal year must be four months or less, measured from the date on which the CPO first received funds from a participant other than an “insider,” as described below. Note that as proposed, the period was three months or less measured from the date of fund formation; the modification in the final rules thus provides more expansive relief.
  • The pool must have no more than 15 participants and no more than $3 million in gross capital contributions (increased from $1.5 million as proposed) throughout the stub period. For this purpose, “insiders” are excluded from the number of participants and $3 million cap on contributions.
  • The CPO must obtain, prior to the date when an audited Annual Report is required to be distributed, a waiver from each participant in the pool (other than the CPO, the pool’s commodity trading advisor (CTA), any person controlling, controlled by, or under common control with the CPO or CTA, or any principal of the foregoing) of their right to timely receive an audited Annual Report for the pool’s first fiscal year. The waiver must be substantially in the form specified in the regulations, and may be included in the pool’s subscription agreement so long as it is on a separate page and is signed and dated separately by the participant.
  • The CPO must file a notice with NFA certifying that the CPO meets the conditions of the exemption and has obtained the required waivers from participants.
  • The stub period Annual Report must prominently disclose on the cover that it is unaudited in reliance upon the exemption.
  • The audited Annual Report for the pool’s first full fiscal year of operation must cover the initial stub period in addition to the full fiscal year and disclose that it covers that period.

For purposes of the above requirements, an “insider” means:

  • The pool’s CPO, its CTA, any person controlling, controlled by, or under common control with the CPO or CTA, and any principal of the foregoing;
  • A child, sibling, or parent of any of these participants;
  • The spouse of any participant described above;
  • Any relative of a participant specified above, their spouse or a relative of their spouse, who has the same principal residence as such participant; and
  • An entity that is wholly owned by one or more participants specified above.

Relief from Audited Annual Reports for Certain Pools

Under the final rule amendments, a CPO will not be required to distribute an audited Annual Report for a year in which a pool’s participants are limited solely to one or more of the following:

  • the pool’s CPO;
  • its CTA;
  • any person controlling, controlled by, or under common control with the CPO or CTA; or
  • any principal of the foregoing.

In order to rely upon this relief, the CPO must obtain written waivers from the participants of their right to receive an audited Annual Report for that fiscal year and keep those waivers as records under CFTC rules.

At Least One Audited Annual Report Required

Notwithstanding any of the relief provisions described above, a CPO will be required under the final rule amendments to distribute an audited Annual Report at least once during the life of a pool.

Case-by-Case Relief May Still Be Obtained

The final rule release notes that CPOs may continue to request relief from financial reporting requirements from the CFTC staff, although the CFTC intends that staff restrict the issuance of any such relief from the standards adopted in the final rules to exceptional circumstances involving unique situations.

U.S. District Court: Fund Trustees Cannot Rely on Attorney-Client Privilege in Section 36(b) Case

Posted in Fund Regulation, Investment Adviser Regulation

A federal district court has ordered mutual fund trustees to produce privileged documents to a plaintiff who sued an investment adviser accused of charging excessive investment advisory fees. The November 21, 2016 order may pave the way for plaintiffs in “excessive fee” cases to brush aside the attorney-client privilege and learn what independent trustees discussed with their legal counsel in executive session meetings.

Read our client alert.

FINRA Fine Addresses Broker Compensation and Conflicts of Interest

Posted in Broker-Dealer Regulation, FINRA Enforcement

A recent enforcement action by FINRA underscores the regulator’s continuing concern regarding how financial advisers are paid to sell investment products.  In a case announced on November 28, 2016, a member firm settled charges brought by FINRA and agreed to pay a fine of $1,750,000.  The FINRA case includes a wide range of allegations involving failure to supervise, train and monitor the sales process for variable annuities.  At the heart of the case, however, are concerns about how the firm compensated its sales force.  These types of concerns are likely to be of interest to a wide range of broker-dealers, no matter what types of financial products they offer to investors.

FINRA found that the firm’s financial advisers were incentivized to roll over retirement funds into various proprietary products, including accounts which would pay ongoing fees to the firm.  If a financial adviser was also registered as an investment adviser representative, he or she could also receive a share of the ongoing management fees paid by the account.  By contrast, the financial advisers would not be compensated if they recommended that the customers invest in non-proprietary products. According to FINRA, the implementation of sales incentives favoring proprietary products was quickly followed by a marked increase in the sale of certain proprietary products, in some cases generating more than 600% growth.

Well after implementing the new sales incentives, the firm required customers to sign a disclosure document which provided general disclosures about the compensation payable to its financial advisers, including the fact that compensation would be “more favorable” for the sale of proprietary products.  The specific compensation terms were not disclosed.

The case is notable because of the significant fine levied in the absence of any charges that the firm or its financial advisers committed fraud or sold unsuitable products in substantial amounts.  FINRA stated that the firm’s “compensation policy created a conflict of interest between registered representatives and customers…”  FINRA also found that the firm failed to identify and reasonably address this conflict of interest, which involved an inherent risk that financial advisers would act imprudently, rather than in the interests of their customers.  The stark incentives to sell proprietary products, coupled with the extraordinary growth of these sales after adoption of the incentives, were no doubt seen by FINRA as exactly the kind of conflicted conduct which needed to be deterred, even where there was no demonstrable fraud or violations of the suitability requirements.

The case is consistent with FINRA’s recent focus on conflicts of interest as demonstrated by its sweep examination in 2015, and its 2013 report relating to conflicts of interest.  Moreover, the issues raised in the case resonate with the Department of Labor’s new fiduciary standards, which would expressly require brokers dealing with retail retirement investors to avoid compensation systems which misalign the interests of financial advisers and their customers.

The lesson for broker-dealers and other investment firms: think carefully about the structure of your compensation policy.  Where sales incentives appear to create a potential for conflicts of interest, take actions to mitigate and disclose the conflict.  Continually monitor financial adviser behavior and respond quickly to indications that a particular compensation policy may be improperly affecting the advice that financial advisers provide to clients.

NYSE Proposes Rules to Effect T+2 Settlement Cycle

Posted in Broker-Dealer Regulation

U.S. regulators and self-regulatory organizations have been moving towards a T+2 settlement cycle for secondary market transactions. In November 2016, the NYSE took its own expected steps in this direction, with a series of proposed rule changes. The NYSE’s rule filing may be found at the following link: https://www.nyse.com/publicdocs/nyse/markets/nyse/rule-filings/filings/2016/NYSE-2016-76.pdf.

To effect the T+2 settlement cycle, the NYSE would adopt a series of related rules:

  • Rule 14T (Non-Regular Way Settlement Instructions);
  • Dealings and SettlementsT (Rules 45–299C);
  • Rule 64T (Bonds, Rights and 100-Share-Unit Stocks);
  • Rule 235T (Ex-Dividend, Ex-Rights);
  • Rule 236T (Ex-Warrants);
  • Rule 257T (Deliveries After “Ex” Date);
  • Rule 282.65T (Buy-in Procedures); and
  • Section 703.02T (Part 2) of the Listed Company Manual (Stock Split/Stock Rights/Stock Dividend Listing Process).

Market participants may comment on the rule changes, in particular, as to whether any additional changes may be needed or desirable to affect the move to a shorter settlement cycle.

*  *  *

For a discussion of the SEC’s proposed rule changes to facilitate T+2 settlements, please see: http://www.bdiaregulator.com/2016/09/twenty-three-years-later-one-day-shorter-sec-proposes-t2-rule-amendment/.

For a discussion of FINRA’s related proposed rule changes, see: http://www.bdiaregulator.com/2016/03/finra-and-t2-the-rule-roll-out-begins/.

For a discussion of the potential impact of T+2 settlements on the structured products industry, please see our January 2016 issue of Structured Thoughts, which can be found at: https://media2.mofo.com/documents/160115structuredthoughts.pdf.

The SEC and FINRA Preview 2017 Enforcement Priorities at SIFMA’s C&L New York Regional Seminar

Posted in Cybersecurity/Privacy, FINRA Enforcement, SEC Enforcement

On November 2, 2016, several representatives from the SEC and FINRA spoke at SIFMA’s C&L New York Regional Seminar, including from the SEC, Stephanie Avakian, Deputy Director, Division of Enforcement, and from FINRA, Susan Axelrod, Executive Vice President, Regulatory Operations, and Susan Schroeder, Senior Vice President, Enforcement.  At a general session on enforcement during the seminar, Ms. Schroeder highlighted three areas, among others, that FINRA would focus on in 2017: (1) AML (particularly with respect to microcap companies); (2) senior citizens (particularly with respect to POAs and trusted contact persons); and (3) cybersecurity.  At the same general session on enforcement, Ms. Avakian highlighted the following five areas, among others, that the SEC would focus on in 2017: (1) the use of data analytics to analyze complex products and embedded derivatives (emphasizing that firm representatives must understand the risks of complex products and explain them to customers and adequate disclosure must be provided); (2) insider trading; (3) conflicts of interest with respect to investment advisors; (4) accounting issues; and (5) cybersecurity, including cyber-related disclosure failures and information theft for purposes of gaining a competitive advantage (emphasizing the need to control access and protect information).

In addition, during the seminar’s keynote address, Ms. Axelrod mentioned that FINRA’s 2017 exam priorities will focus on, among other things, (1) the hiring of problematic brokers (emphasizing that firms should re-examine the supervision of their brokers and adopt best practices) and (2) appropriate discounts/breakpoints (emphasizing that firms should take action and make corrections on their own as the identification of an issue is not by itself sufficient).

Ms. Axelrod stated that FINRA expects to release its 2017 exam priorities letter in January 2017, and we will continue to monitor FINRA statements on exam priorities on our BD/IA Regulator blog.

Morrison & Foerster Sponsorship: Structured Products Europe Conference 2016

Posted in Events, Fund Regulation

Thursday, November 17, 2016
8:30 a.m.  – 6:00 p.m.

The May Fair Hotel
Stratton Street
London, United Kingdom W1J 8LT

The 12th annual Structured Products Europe conference will bring together top UK and European senior executives from investment banks, regulators, private bankers, issuers, index providers, asset managers, IFAs, pension funds and insurance companies. The conference will provide a unique opportunity to convene and discuss the most pressing issues in the structured products Pan-European market.

Partner Peter Green will speak on a panel entitled “Update on PRIIPs – What Will Happen Next?” Topics of discussion will include:

  • Is PRIIPs likely to be delayed in light of the recent RTS rejection?
  • The overall impact of PRIIPs on the market: issuance volumes, distribution patterns, investor attitudes to SPs;
  • The effectiveness of the risk ratings system;
  • Which outstanding questions need to be answered before the regime (PRIIPs) goes live?; and
  • How lenient will regulators be for non-compliance?

Partner Peter Green and Partner Jeremy Jennings-Mares will also host a panel entitled “Morrison & Foerster Bootcamp: Structured Products and Brexit.” The bootcamp will explore the impact of the UK’s referendum vote to leave the UK on the European structured products markets. The timing of the UK’s exit from the EU and future relationship between the UK and the rest of the EU remains uncertain and the bootcamp will provide an update on recent developments. Other issues to be considered will include:

  • What impact has the vote had on the structured products market in the UK and the rest of the EU to date and what is the future outlook?
  • Have any particular products benefitted or been adversely affected more than others?
  • Passporting issues that will arise as a result of the UK’s exit from the EU. Can MiFID II help?
  • Will the UK replicate PRIIPs after leaving the EU?
  • Impact on other relevant EU financial regulation including the Benchmark Regulation, the Prospectus Directive and EMIR; and
  • Future developments – will the UK and the EU approach to regulation of structured products diverge over time?

For more information, or to register, please click here.