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The BD/IA Regulator

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

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.

SEC Charges Broker-Dealer for Failure to Protect Against Insider Trading by Employees

Posted in Broker-Dealer Regulation, SEC Enforcement

The Securities and Exchange Commission for the first time brought charges against a broker-dealer for failure to adequately protect against insider trading by its employees. The charges stem from a broker’s use of a customer’s confidential information to purchase shares in a company being acquired by a private equity firm. (The SEC previously charged the broker with insider trading in a separate action.) The broker-dealer that employed the broker settled charges of violations of the securities laws for failing to adequately establish, maintain, and enforce policies and procedures reasonably designed to prevent insider trading by employees with access to confidential client information.

Since 1988, the federal securities laws have required broker-dealers to establish, maintain, and enforce written policies and procedures, consistent with the nature of their business, to prevent the misuse of material nonpublic information.  The policies and procedures must be tailored to the specific circumstances of the business, and broker-dealers (and investment advisers) must not only adopt such procedures but also vigilantly review, update, and enforce them.

As the SEC’s settlement order points out, broker-dealers obtain material nonpublic information (“MNPI”) in various ways, including through their investment banking business and research operations, or from their customers.  These various channels of obtaining MNPI and the risks of potential misuse make monitoring of trading by the firm, its registered representatives, and its customers critical to complying with the supervision requirements.

Procedural Deficiencies

 In its settlement order, the SEC found that the broker-dealer, failed to establish, maintain, and enforce policies and procedures reasonably designed to prevent the misuse of MNPI, specifically, any MNPI obtained from its customers and advisory clients.  In 2010, the risk became reality when a registered representative of the firm used information from one of his customers before the information was publicly announced.  The representative traded on the basis of that information and also tipped others, including several customers of the broker-dealer.

The SEC found that the principal failure of the firm’s procedures occurred when the compliance group reviewed the representative’s trading after the public disclosure of the acquisition but did not share information about the trading with other compliance groups in the firm or with senior management.

The SEC faulted the firm’s insider trading procedure that required a “look-back” review of trading in employee accounts and in customer and client accounts after announcements that significantly affect the market.  Specifically, the firm’s written guidance regarding the look-back review procedures was insufficient.  Among other things, the firm did not provide appropriate guidance on actions to be taken by employees with respect to:

  • Parameters to be considered by the firm’s control group regarding the daily identification of market-moving news stories to identify securities warranting a trading review, and the documentation of work performed on those trading reviews;
  • Additional review to be conducted by the control group when it found “red flags” such as profits or losses avoided greater than $5,000, trading by an “insider,” or trades in any accounts in the same branch as an insider;
  • The procedure for performing personnel interviews upon identification of “red flags” and for escalating reviews of suspect trading to the control group manager when there was not a “sufficient explanation for the basis of the trade” provided during the review;
  • The documentation of the look-back review performed on trading reviews, which made it nearly impossible for firm management to determine whether the firm’s policies and procedures were followed when conducting the reviews.

The SEC also found that the firm’s policies and procedures failed to address how to consider options trading as part of the look-back reviews.

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ABA Business Law Section Meeting: “Money Market Reform Arrives (Finally): What a Long Strange Trip It’s Been!” (Fri., Sept. 12, 4:00 – 5:30 p.m.)

Posted in Events, Fund Regulation

At the American Bar Association’s Business Law Section’s inaugural Annual Meeting in Chicago, Partner Jay Baris will speak on a panel entitled “Money Market Fund Reform Arrives (Finally): What a Long Strange Trip It’s Been!” This panel will be moderated by Investment Companies & Investment Advisers Subcommittee Chair Andrew Donohue, who served as Director of the SEC’s Division of Investment Management during the late, unlamented financial crisis and will analyze the dramatic history and implications of money market reform in light of the new regulations adopted by the SEC on July 23, 2014. The other panelists are Patrick McCabe, Senior Economist with the Federal Reserve; Sara Ten-Sietoff, Assistant Director in the Rulemaking Office of the SEC’s Division of Investment Management; Robert Plaze, a partner at Stroock, Stroock & Lavan who served at the SEC in various senior positions for nearly 30 years; and Karrie McMillan, former General Counsel of the Investment Company Institute responsible for the ICI’s comments on the 2010 and 2014 rulemakings, who also worked at the SEC.

In addition, Partner Paul “Chip” Lion will become the President of the Business Law Section after the meeting.


PCAOB Again Finds Broker-Dealer Audit Deficiencies. Observation: Experience Is the Best Indicator for Choosing an Audit Firm.

Posted in Broker-Dealer Regulation

For the third year in a row, the Public Company Accounting Oversight Board (PCAOB) has found shortcomings in the audits of broker-dealers, a trend that could lead to firms spending more to get their books reviewed.  The third progress report on the PCAOB interim inspection program of broker-dealer auditors shows auditing deficiencies or a lack of auditor independence in 56 of the 60 audit firms and 71 of the 90 audits inspected in 2013.

While the percentage of audits with inspection observations dropped slightly from that of previous years, PCAOB is concerned about the continuing high number and the nature of the observations. Net capital, customer protection, revenue recognition, fair value estimates and, fraud risks are specific areas demonstrating weak audit procedures. According to the PCAOB, many of the same audit problems keep cropping up year after year.

The PCAOB’s findings also show that auditors handling audits of broker-dealers need to develop a broader broker-dealer client base. Observations were identified in 100 percent of audits selected for inspection by auditors that had only one broker-dealer audit client. The percentage dropped slightly to 92 percent for firms that audited two to 100 broker-dealers. Observations for firms that audited more than 100 broker-dealers were even lower, at 63 percent.

Robert Maday, PCAOB leader of the broker-dealer inspection program, has strongly advised firms that audit broker-dealers need to reconsider their audit approach, including the establishment of independence rules that prohibit bookkeeping or financial statement preparation by the auditor.

PCAOB scrutiny will elevate broker-dealer audit standards and could reduce the supply of auditors, as the smaller auditors that can’t meet the higher bar are eliminated from the sanctioned auditing specialists. It is clear to industry players that another obvious effect of the heightened scrutiny will be to will raise additional regulatory costs and increased audit fees.

The PCAOB’s responsibility of monitoring broker-dealer auditors grew out of the Dodd-Frank financial reform law. The provision was at least partly a response to Bernard Madoff’s years-long fraud on investors and other schemes used to rip off investors.

One likely reason broker-dealers are stumbling is that they are still getting used to the auditing requirements. The net-capital and customer-protection rules are among the most complicated in securities compliance, and must be recalculated as a broker-dealer’s business model changes.

It is important that broker-dealers select an auditing firm that understands the industry and, ideally, that makes the broker-dealer industry a priority.

Ninth Circuit Brookstreet Decision Upholds Control Person Liability

Posted in Broker-Dealer Regulation, SEC Enforcement

The Ninth Circuit recently found the principal of a broker-dealer liable for the extensive and aggravated sales practice violations of the firm’s registered representatives.  In its unpublished decision (not to be cited as precedent), the Circuit Court squarely applied control person liability in upholding summary judgment on behalf of the SEC.  The decision should remind firms and their principals that in certain circumstances principals can be held liable for the misconduct of their subordinates.

The SEC commenced the action in 2009, charging Brookstreet Securities Corp. and Stanley C. Brooks, the firm’s CEO, president, chairman of the board, and owner, with fraud for systematically selling risky mortgage-backed securities to customers with conservative investment goals.  According to the SEC, Brookstreet and Brooks developed a program through which the firm’s registered representatives sold particularly risky and illiquid types of collateralized mortgage obligations (CMOs) to more than 1,000 seniors, retirees, and others for whom the securities were unsuitable.  Brookstreet and Brooks continued to promote and sell the risky CMOs even after Brooks received numerous warnings that these were dangerous investments that could become worthless overnight.  The fraud resulted in severe investor losses and eventually caused the firm to collapse.

In 2012, the District Court granted the SEC’s motion for summary judgment, holding Brookstreet and Brooks liable for violating the anti-fraud provisions of the federal securities laws, enjoining them from future violations, and imposing a penalty of over $10 million.

In upholding Brooks’ liability for the conduct of the firm’s brokers, the Ninth Circuit squarely applied principles of control person liability.  The court found that Brooks controlled the primary violators, who made unsuitable sales and misrepresentations, due to:

  • His position as an officer;
  • His involvement in the day-to-day affairs of the firm;
  • His involvement in the CMO program.

The court also found that Brooks was not entitled to the good faith defense to control person liability that is available to persons who can show that the firm’s supervisory system was adequate and reasonably applied.  The court noted that Brooks knew about the sales of CMOs to retail customers and yet took three years to establish suitability standards.  During this period, he was on notice about the NASD’s guidance advising its members that CMOs were suitable only for sophisticated investors with a high-risk profile and detailing a broker’s responsibility to educate clients about the risks of CMOs.  (The Ninth Circuit also vacated the penalty imposed by the District Court and ordered the District Court to conform the penalty to the proof tendered to the court.)

The Ninth Circuit decision reminds firms that they and their principals risk liability for the actions of a firm’s registered representatives if they do not adopt an adequate supervisory system and exercise their responsibilities under it.  Firms should also be aware that control person liability is a key tool used by regulators to hold accountable those who were in a position to detect and prevent wrongdoing and, if they were aware of it, did not stop the conduct or, if they were unaware, did not adequately supervise those who directly committed the violations.  The industry can count on the securities regulators’ continued use of this tool.