Morrison & Foerster has published the September edition of the Investment Management Legal + Regulatory Update. To read the full newsletter, click here.
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.
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.
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.
The SEC is not wasting any time making sure that newly registered municipal advisors are introduced to their regulator. On August 19, 2014, the SEC announced a two-year examination initiative for municipal advisors that registered with the SEC in accordance with final municipal advisor rules that became effective on July 1, 2014. OCIE’s National Examination Program (NEP) stated that the initiative will include “focused, risk-based” examinations of municipal advisors registered with the SEC but not with FINRA.
The examinations will address municipal advisors’ compliance with both the final SEC municipal advisor rules and Municipal Securities Rulemaking Board rules as they become final.
The examination initiative will proceed in three phases: (1) an “engagement” phase, during which the NEP will reach out to newly registered municipal advisors to inform them of their obligations under the Dodd-Frank Act and related rules, (2) an “examination” phase, during which the NEP staff will review selected municipal advisors’ compliance programs in one or more identified risk areas, and (3) an “informing policy” phase during which the NEP will report its observations to the SEC. OCIE said that the particular risk areas that may be included in its examinations will include registration, fiduciary duty, disclosure, fair dealing, supervision, books and records, and training/qualifications.
The NEP noted that the results of OCIE’s examinations are typically used by the SEC “to inform rule-making initiatives, to identify and monitor risks, to improve industry practices and to pursue misconduct.” In other words, municipal advisors should expect that these examinations will result in additional SEC guidance to municipal advisors regarding how they conduct their businesses.
At this time, there is no indication of how examination participants will be selected, but OCIE has announced that it plans to examine a “significant percentage” of new municipal advisors. Newly registered municipal advisors should plan to participate in OCIE’s compliance outreach program, which will take place later this year, to learn about compliance issues and practices, and to understand what to expect from an OCIE examination.
Hell hath no fury like a regulator (allegedly) lied to. This week, the SEC brought civil charges, and the U.S. Attorney for the Southern District of New York brought criminal charges, against a broker-dealer and its founder for falsifying books and records to hide capital deficiencies from SEC examiners, as well as for violating net capital requirements. The cases are in litigation, so the following account is based on the government’s allegations.
The SEC’s enforcement action, brought as an administrative proceeding, alleges that the firm and its head attempted to disguise the firm’s extensive and repeated net capital insufficiencies. The respondents improperly off-loaded liabilities onto the books of an affiliated firm, and improperly treated non-marketable stock as an allowable asset. According to the SEC, the affiliated firm did not have sufficient resources to pay for the liabilities, which related to services actually performed for the firm. The SEC discounted an expense-sharing agreement between the firm and the affiliate as a sham.
More seriously, however, the principal tried to hide the broker-dealer’s true financial condition by providing the SEC examiners with “falsified documents” that sought to mask the extent of the firm’s liabilities. The CEO of the broker-dealer was thus charged criminally for his alleged obstruction of the SEC examination and for making false statements and false filings. The charges carry maximum prison sentences of 20 years and 5 years, respectively.
When announcing the SEC’s case, senior SEC officials pointed to “the SEC’s critical work in overseeing broker-dealers and other regulated entities” (Enforcement Director Andrew Ceresney), and the importance of the net capital rule in monitoring the financial health of brokerage firms (NY Regional Office Associate Director Amelia Cottrell). The U.S. Attorney and other criminal justice representatives likewise highlighted the defendants’ attempts to “blow smoke in the eyes of the SEC” by maintaining false books and records, and creating falsified documents in response to SEC requests.
Everybody knows that a regulated entity must maintain accurate books and records, and accurately report its financial condition. Everybody knows that a firm should not aggravate a situation by lying to examiners and falsifying documents. The lesson of these cases is that once a firm steps over the line and decides to attempt to deceive the regulators, it opens itself up to criminal prosecution. The Department of Justice is willing and able to support its civil partner and seek criminal sanctions for such conduct. Moreover, perhaps slightly less obvious but equally crucial, this case highlights the need for all firms and their personnel to be meticulous and vigilant about the accuracy of information provided to the SEC—lest an examination blossom into an enforcement action and explode into criminal charges.
In an area of broker-dealer practices with relatively little guidance—the appropriate level of commissions or mark ups on securities trades—FINRA recently brought another in a series of cases that provides insight into the regulator’s view on additional transaction-based fees. In this particular case, FINRA found that a broker-dealer characterized a $60.50 charge on its customer trade confirmations, which was in addition to or instead of a commission, as “miscellaneous” and/or as an “additional fee.” However, much of this fee, FINRA found, was not attributable to any specific cost or expense the firm incurred in executing the transaction. FINRA found, in effect, that the fee was a commission by another name, and the firm thus understated the amount of the total commissions that it charged on its securities transactions.
According to FINRA’s settlement order, a substantial portion of the charge was not reasonably related to any specific cost or expense the firm incurred in executing each transaction, or determined by any formula applicable to all customers. Instead, a substantial portion of the charge represented a source of additional transaction-based remuneration or revenue to the firm, and was effectively a minimum commission charge. By claiming that the charge was in addition to or in place of a designated commission charge, the firm mischaracterized and understated the amount of the total commissions the firm charged.
FINRA found that the firm violated NASD Conduct Rule 2430, which requires charges for services performed—including miscellaneous services such as collection of moneys due for principal, dividends—or interest; exchange or transfer of securities; appraisals, safe-keeping, or custody of securities; and other services to be reasonable and not unfairly discriminatory between customers. FINRA also found that the firm violated Securities Exchange Act Rule 10b-10, which requires broker-dealers to disclose specified information in writing to customers at or before the completion of a transaction.
The firm consented, without admitting or denying the findings, to a fine of $50,000 (which was imposed for these and several other violations), and to comply with the undertakings and revise its written supervisory procedures. The undertakings are significant, since they reflect FINRA’s view as to the proper way to disclose commissions. In brief, FINRA required the firm, going forward, to identify any transaction-based charge that constitutes remuneration to the firm as a commission or markup/markdown, and not as any charge or fee for postage, handling, or any miscellaneous, additional fee; and to the extent that any transaction-based charge does represent a service performed or a cost incurred by the firm that is not included as part of the reported commission or markup/markdown, required the firm to properly disclose it. FINRA also required the firm to revise its written supervisory procedures to address the requirements of this undertaking and provide relevant training to all associated persons.
FINRA previously announced, in a September 7, 2011 press release, five similar actions against firms that FINRA fined as much as $300,000. The cases resulted from a targeted review of improper fees charged by broker-dealers in which FINRA found that the firms were routinely charging customers – as much as $100 per trade in addition to the disclosed commissions – for handling fees that far exceeded the actual cost of the direct handling-related services the firms incurred in processing securities transactions. There is little doubt that a review of firms’ fees and markups/markdowns remains an important part of FINRA exams, and its exam procedures likely will continue to include a review of “additional” or “miscellaneous” fees.