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The BD/IA Regulator

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

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.

SEC Launches Exam Initiative for Newly Registered Municipal Advisors

Posted in Investment Adviser Regulation, Municipal Advisors

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.

Lying to Examiners Can Lead Quickly to Criminal Charges

Posted in Broker-Dealer Regulation, SEC Enforcement

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.