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The BD/IA Regulator

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

The Growth Capital Summit

Posted in Events

This year’s SEC small business capital forum in Washington, D.C. will address the “most sweeping changes to the emerging growth capital market in 80 years.” For our readers in the area, please join Morrison & Foerster on November 19th for an afternoon of pre-forum briefings on the state of legislation, regulation and policy implementation impacting small business finance so that you can be prepared to fully participate in the next day’s meeting.

For more information, please click here.

The Results Are In: Investors Favor Additional Regulatory Protection

Posted in Broker-Dealer Regulation, FINRA Enforcement

On November 6, 2014, FINRA released results from a survey of U.S. investors measuring the demand for additional regulatory protections. The survey polled 1,000 adults and revealed that an overwhelming majority felt that it was important to protect investors and police the markets.  Indeed, 74 percent polled would support additional regulatory protections to safeguard against broker-dealer misconduct, and 56 percent expressed support for these additional protections even if it meant a minimal increase in costs.  Interestingly, the results of the survey revealed that younger investors (ages 21 to 39) and investors at an investment level below $100,000, showed greater support for the additional protections than their older and more heavily invested counterparts.  The survey also revealed that the implementation of increased protections could actually increase participation in the markets, as 56 percent of respondents indicated that additional protections would encourage more investment.

Broker-dealers should pay special attention to the additional protections referenced in the survey, as they may point to areas of increased regulatory attention in the future.  Specifically, the survey indicated that at least half of investors polled perceived the following nine protections as “highly important”:

  • disciplining brokers who break the rules with fines, suspensions, or revocations of licenses;
  • detecting when brokers are making trades that benefit them and not the investor;
  • disclosing to the public all instances of rule breaking by firms or individual brokers;
  • detecting when firms are taking risks that potentially harm their investors and the financial system;
  • detecting when unsuitable securities are being sold to investors;
  • requiring brokers to register publicly and disclose their professional history, including past complaints or problems;
  • monitoring which products firms are selling to investors and when there is a sudden change or unusual product concentration;
  • conducting periodic on-site visits to verify that brokerage firms are following all rules and regulations; and
  • reviewing all brokerage firms’ advertising to ensure compliance with rules.

Notably, the survey presented only one side of the story.  The responses lacked insight from the industry about what benefits, if any, could be gained from the additional protections referenced in the survey.  Nevertheless, it’s clear from the responses that these additional protections are certainly on the minds of investors, and therefore should be taken seriously by the industry, because they certainly will be on the minds of the regulators.

SEC Gives the Nod to Exchange-Traded Mutual Funds

Posted in Investment Adviser Regulation

Barely two weeks after it signaled thumbs-down on two requests to approve non-transparent exchange-traded funds (ETFs), the SEC on November 6, 2014 published a notice of application that would allow the applicant to create “exchange-traded mutual funds,” or ETMFs, a novel structure that is a hybrid between mutual funds and traditional ETFs.

ETMFs feature characteristics of ETFs and traditional mutual funds. Like ETFs, ETMFs would list and trade on a national securities exchange; directly issue and redeem shares only in “creation units,” impose fees on creation units issued and redeemed to Authorized Participants to offset costs; and primarily use in-kind transfers of securities when issuing and redeeming creation units. Like mutual funds, ETMFs would sell and redeem their shares at prices linked to the funds’ net asset value (NAV) and would maintain confidentiality of current portfolio positions.

ETMF shares would trade on an exchange at the next-determined NAV, plus or minus any premium or discount quoted by market makers. The premium or discount would be based on market factors, including the balance of supply and demand for shares, share inventory positions, and volume. Investors would lock in the premium or discount at the time of trade, but the actual transaction price would be based on the ETMF’s actual NAV determined as of the close of business. Thus, investors won’t know the NAV at the time they place an order, but the levels of premium and discount would be fully transparent.

Like ETFs, only Authorized Participants could buy and sell ETMF creation units, based on the next-determined NAV, with transactions effected in-kind through “baskets” of securities that are included in the portfolio. But the baskets will not necessarily mirror all the ETMF’s portfolio holdings. That is, to protect confidentiality of holdings, the baskets will not reflect portfolio positions that the ETMF is currently buying or selling. The portion of the basket attributable to the confidential holdings instead will consist of cash. The ETMF’s adviser will determine which portfolio positions to exclude from the basket based on what it believes to be in the best interest of the portfolio.

The purchase and redemption price of creation units will reflect transaction costs of the ETFMF. These costs include costs of clearance and settlement and trading costs.

Like ETFs, the ETMFs will arrange for third parties to publish an intraday indicative value (IIV) of the ETMF’s shares. But, unlike ETFs, the IIV would not provide pricing signals for market intermediaries that seek to estimate the difference between the current value of the ETMF’s holdings and the trading price. Because retail investors transact in shares at the next-determined NAV, intermediaries do not assume intraday market risk in their share inventories.

Why did the SEC reject non-transparent ETFs but does not seem concerned that ETMFs will keep their portfolio holdings confidential? In short, because ETMFs will trade shares based on the next-determined NAV, the market makers could not engage in arbitrage and will assume no intraday market risk in their inventory positions. No intraday risk, in turn, means that there would be no need for market makers to engage in intraday hedging activity, thus eliminating the need to know up-to-the-minute portfolio holdings.

If they are freed from the requirement to provide daily portfolio transparency, ETMFs can take advantage of cost and tax efficiencies with protections that ETF shareholders can realize.

The regulatory relief that the SEC will grant to ETMFs differs from ETF orders only with respect to Section 22(d) of the Investment Company Act of 1940 and related Rule 22c-1, concerning NAV-based trading. The difference in regulatory relief arises due to the portion of the trading price that is the negotiated amount of the premium or discount. In all other respects, the order for ETMFs will resemble orders issued to traditional ETFs.

The SEC set a deadline of December 1, 2014 for interested persons to request a hearing.

SEC’s Champ: Staff to Focus on Alt Fund Risk Disclosures

Posted in Investment Adviser Regulation

The Division of Investment Management again has turned its attention to alternative mutual funds, this time ensuring that they adequately disclose risks to retail investors. 

In a speech to the SIFMA Complex Products Forum on October 29, 2014, Norm Champ, the Director of the SEC’s Division of Investment Management, called for alt funds (and all funds that use alternative strategies) to assess the accuracy and completeness of their disclosures, including whether the disclosure is presented in an understandable manner using plain English.[1]

Although alt funds accounted for only 2.3 percent of total mutual fund assets as of the end of 2013, they represented 32.4 percent of the inflows of the entire mutual fund industry. As of the end of September 2014, alt funds account for $242 billion of industry AUM. This growth has attracted the SEC’s attention.

Champ’s comments may be a harbinger of enforcement investigations and proceedings to come, as the Office of Compliance Inspections and Examinations (OCIE) drills down on valuation, liquidity, and leverage – areas that present heightened risks for alt fund investors.

In his October 29 speech, rather than addressing potential substantive regulation of these areas, Champ focused on risk disclosure. Acknowledging that concise risk disclosures are more difficult to draft when funds use complex investment strategies, he nonetheless emphasized the importance of ensuring that disclosure gives the “average investor” information needed to make informed investment decisions. This push for concise disclosure arises in the context of concerns that “there could be a disconnect” between the strategies and risks that alt funds disclose versus the strategies that these funds actually employ.

To be sure, we can expect that OCIE will zero in on how alt funds disclose their strategies and inherent risks, and compare the disclosures to what it finds when it looks under the hood, especially when funds employ derivatives, including futures. What kinds of disclosures will OCIE look for? According to Champ:

An alternative mutual fund should, for example, disclose material risks relating to volatility, leverage, liquidity and counterparty creditworthiness that are associated with trading and investments in alternative investment strategies, such as derivatives, that are engaged in, or expected to be engaged in, by the fund.

This means that funds should not simply list investment strategies and risks. Rather, funds must disclose “a complete risk profile of the fund’s investments taken as a whole” and reflect “anticipated alternative investment or asset usage.”

Moreover, a fund should “assess on an ongoing basis the completeness and accuracy of alternative investments-related disclosures in its registration statement in light of its actual operations.” The goal is to ensure that risk disclosure in fund prospectuses and marketing materials are in synch with a fund’s actual current strategies.

Our take: Champ’s speech could indicate the direction of OCIE examinations and enforcement referrals in the coming months. It seems likely that the staff will compare how funds disclose risks to how those funds actually manage their portfolios, and try to identify anomalies. This approach, in turn, will increase pressure on fund directors, who must “assess on an ongoing basis” whether (i) fund disclosures are consistent with what funds are actually doing, (ii) the disclosures reflect the fund’s overall risks, and (iii) the average investor can understand those disclosures.

That said, the speech, by itself, does not indicate whether we can expect the staff or the SEC to issue or propose any additional substantive guidance on the regulation of derivatives and leverage.


[1] Morrison & Foerster LLP was one of the sponsors of the SIFMA Complex Products Forum.

SEC: Non-Transparent ETFs Not Ready for Prime Time

Posted in Fund Regulation

The SEC has given a preliminary thumbs-down to non-transparent exchange traded funds (ETFs).  In two separate notices issued on October 21, 2014, (found here and here), the Commission stated that applications to allow actively managed ETFs to withhold daily disclosure of portfolio holdings did not “meet the standard for exemptive relief” under Section 6(c) of the Investment Company Act of 1940.  Accordingly, the Commission took the unusual step of preliminarily denying the applications.

The Reasons for ETF Transparency

ETFs – typically structured as open-end investment companies – can only function with an SEC order that exempts them from rules that would otherwise make it impossible for them to operate.  One reason is that open-end funds must redeem their shares based on investor demands at the current net asset value.  For this reason, shares of open-end funds are not traded on exchanges.  For ETFs to trade their shares on securities exchanges, they must obtain an exemption from several rules, including the requirement that investment companies redeem their shares at the current NAV.

ETFs typically sell shares in large “wholesale” lots called “creation units” to “authorized participants,” who in turn allow those shares to be traded on an exchange.  Similarly, the ETFs redeem shares only from the authorized participants in “redemption units.”  In creating this alternative mechanism for buying and selling shares, the SEC imposes conditions to ensure that shares trade on exchanges at close to their actual net asset value.  Authorized Participants typically buy creation units by contributing like securities, which may be combined with cash. To ensure that the market and NAV prices are similar, the SEC requires, among other things, daily portfolio transparency.  That is, if investors know what is in the ETF’s portfolio, the extent of any discount or a premium in market trades is minimized.

The Two Current Proposals

At least two ETF sponsors proposed to create actively-managed ETFs that would not follow the universal practice of disclosing their portfolio holdings on a daily basis.  The proposed ETFs would publish an intraday indicative value (IIV), which is an approximation of the ETF’s NAV.  The IIV, published every 15 seconds, would be a way to minimize discounts and premiums.

The reason for the proposals was that the sponsors of the proposed ETFs do not want to disclose their portfolio holdings.   Accordingly, they proposed an alternative mechanism involving a “blind trust” for each authorized participant.  The proposals would allow retail investors (but not institutional investors) an alternative “back-up redemption option” that would allow them to redeem their shares directly from the ETF, rather than selling them on an open market, in the event of a significant deviation of the closing market price from the NAV.  Retail shareholders using this option would be subject to a redemption fee of up to two percent. 

The SEC’s Preliminary Denial

In preliminarily denying the proposals, the SEC said that the proposed structure, combined with enhanced prospectus disclosure, “falls short of providing a suitable alternative to the arbitrage activity in ETF shares that is critical to helping keep the market price of current ETF shares at or close to the NAV per share of the ETF.” 

Among other things, the SEC said that even dissemination of the IIV every 15 seconds is inadequate for purposes of making efficient markets, and “could result in poor execution.”  Moreover, the SEC cited lack of meaningful standards for IIV methodologies, and a lack of accountability for responsibility to ensure the accuracy of IIV calculations.  The SEC cited other issues with the reliability of the IIV, including tracking errors and inaccuracies during periods of market stress.

The SEC also had issues with the proposed frequency of portfolio reporting.  It said that a “back-up redemption option,” which would allow retail investors to redeem shares at the current day-end NAV under certain conditions and with the payment of a fee, “does not remedy the defects” with the proposal.  The SEC said it believed that the lack of sufficient information about the portfolio could result in potential disruption of orderly trading and to market confidence.

Is the idea of a non-transparent ETF dead?  The SEC said that the applicants could request a hearing to argue their case and overcome the SEC’s carefully explained objections to the proposed ETFs.  In the absence of a request for a hearing, the SEC will deny the applications.  It seems likely that, at least for now, the SEC considers non-transparent ETFs not ready for prime time.

SEC Staff Finds that Broker-Dealers Still Are Not Conducting Adequate Section 5 Reviews

Posted in Broker-Dealer Regulation

The staff of the SEC recently addressed broker-dealers’ obligations when engaging in transactions in unregistered securities by issuing FAQs and a Risk Alert that reported the results of examinations of a number of broker-dealers’ practices in handling unregistered securities.  The SEC’s core focus in these areas is curbing and preventing activities that undermine, or threaten to undermine, well-functioning markets, including fraud, manipulation, and money laundering.

As background, Section 5 of the Securities Act of 1933 (“Securities Act”) requires all offers and sales of securities in interstate commerce to be registered, unless an exemption from registration is available.  Section 4(a) of the Securities Act contains certain exemptions, including an exemption commonly relied upon by broker-dealers for “brokers’ transactions executed upon customers’ orders on any exchange or in the over-the-counter market but not the solicitation of such orders.”

The FAQs clarify the obligations of broker-dealers seeking to rely on the exemption in Section 4(a)(4) to conduct a “reasonable inquiry” into the facts surrounding a proposed unregistered sale of securities before selling the securities, in order to form reasonable grounds for believing that a selling customer’s part of the transaction is exempt from Section 5.  The FAQs provide non-exhaustive factors that the SEC may consider to be part of this inquiry, and address a broker-dealer’s obligations in specific situations.

The accompanying Risk Alert summarizes the SEC staff’s examinations of 22 broker-dealers identified as being frequently involved in the sale of the securities of microcap companies.  Specifically, the examinations assessed the firms’ compliance with obligations to (1) perform a “reasonable inquiry” in connection with customers’ unregistered sales of securities when the firms relied on Section 4(a)(4)’s exemption, and (2) file suspicious activity reports (SARs), as required under the Bank Secrecy Act and the Securities Exchange Act of 1934, in response to “red flags” related to such sales.

As evidenced by the FAQs and Risk Alert, the SEC and FINRA are highly focused on Section 5 compliance and related issues of anti-money laundering compliance and microcap manipulation.  Please review our feature in Law360 for more detail about the SEC’s findings and for our suggestions to broker-dealers in light of the regulators’ enhanced focus on this area.

Referral Fees and Commission Sharing – When May Broker-Dealers Share Their Fees with Non-Brokers?

Posted in Broker-Dealer Regulation, SEC Enforcement

FINRA recently filed proposed rule changes with the SEC addressing when broker-dealers may pay referral fees or otherwise share compensation with persons who are not registered as broker-dealers.  The proposed rule changes are subject to the SEC’s approval.  If approved, new Rule 2040 and related conforming changes to other FINRA rules will go into effect 45 to 90 days after publication in the Federal Register.

The Registration Requirements

Under the Securities Exchange Act of 1934 (the “Exchange Act”), persons who receive transaction-based compensation in connection with the purchase or sale of securities must generally be registered as broker-dealers or licensed as associated persons of a registered broker-dealer. In most cases, registered broker-dealers are not permitted to share their transaction-based compensation with persons who are not properly registered or licensed.

Over the years, the NYSE, NASD and FINRA have issued multiple rules and interpretations enforcing registration requirements and creating several important exceptions. The proposed rule changes would consolidate these rules and interpretations into new FINRA Rule 2040. While the proposed rule would not implement any substantive changes from the current set of rules and interpretations, it does include a few features which may have significant implications.

The Proposed Rule

Proposed FINRA Rule 2040 starts with the general principle that no member firm or associated person may, directly or indirectly, pay compensation to an unregistered firm or unlicensed person, if the receipt of such compensation would cause the recipient to be subject to the broker-dealer registration requirements of the Exchange Act. In the rule proposal, FINRA makes it clear that it is the SEC, and not FINRA or other self-regulatory organizations, which is responsible for defining what conduct triggers the broker-dealer registration requirements of the Exchange Act. The SEC has repeatedly emphasized that the receipt of transaction-based compensation in connection with the purchase or sale of securities most likely means that the recipient must be registered as a broker-dealer. Thus, commission sharing or the payment of referral fees calculated as a percentage of the broker-dealer’s transaction-based compensation, will in almost all cases be prohibited. On the other hand, compensation which is clearly not transaction-based, such as an hourly consulting fee paid to an IT consultant, would be permitted.

Resolving Uncertainties

Of course, compensation arrangements may come in all sizes and flavors and sometimes it is not readily apparent if a proposed compensation arrangement would require the recipient to be registered as a broker-dealer. For example, what about a referral arrangement which pays the finder a flat fee of $1,000 for every successful referral, irrespective of the size of the account or the value of commissions generated by the account?

To assist broker-dealers in resolving the question of whether a particular compensation arrangement requires registration, FINRA has included supplementary material with proposed Rule 2040. The supplementary material advises that broker-dealers should document the basis for their determination that a payment may be made to an unlicensed person. Where there is uncertainty, member firms are advised to seek support for their conclusion by (i) relying on published SEC no-action letters and interpretations, (ii) seeking no-action relief from the SEC or (iii) obtaining a legal opinion from independent legal counsel. Although the supplementary material indicates that the foregoing methods of supporting a conclusion are non-exclusive, it would not be surprising if the enumerated methods become the industry standard most compliance departments will require in order to avoid second-guessing by the regulators. These registration issues are often difficult to analyze and in many cases it may not be practical or cost-effective to seek no-action relief or an independent legal opinion. This uncertainty may push broker-dealers to adopt a conservative position when confronted with any question as to whether payment to an unlicensed person is permitted.

Proposed Exceptions

There are two important exceptions to the general prohibitions set forth in proposed Rule 2040 that would both continue to support existing practices permitted under the current rules. The first exception allows broker-dealers to pay referral fees to foreign persons for the referral of foreign nationals. Based on comments received by FINRA on its first draft of proposed Rule 2040, the ability to compensate foreign brokers for referrals is viewed as very important by many U.S. broker-dealers. In order for this exception to apply, the U.S. broker-dealer must determine that the foreign recipient of the referral fee is not required to register as a broker-dealer in the U.S. The foreign recipient should be conducting its business entirely outside the U.S., except as permitted under SEC Rule 15a-6. The U.S. broker-dealer must also determine that the payment would not violate the laws of the country in which the recipient is located and that the foreign recipient is not a “disqualified” person under the Exchange Act. See Section 3(a)(39) of the Exchange Act. Finally, written disclosure of the fact that a referral fee is being paid must be made to and acknowledged in writing by the client. This exception is presumably predicated on the theory that foreign nationals operating outside the U.S. would not be subject to U.S. broker-dealer registration requirements.

The second exception would permit the payment of commissions to retired account executives or registered representatives (“representatives”). This exception is designed to incentivize retiring representatives to transition their business to other representatives at the firm. Under this exception, a retired representative may continue to share in commissions and other compensation generated by accounts he or she serviced at the firm even after the representative has retired and is no longer licensed as an associated person. In order to be eligible for this exception, the representative must enter into a contract prior to retirement with the member firm that provides for the post-retirement payments. Following retirement, the retired representative will not be able to solicit new business, open new accounts or service any existing accounts.