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The BD/IA Regulator

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

Commissioner Piwowar Slams “Dodd-Frank Politburo” for Overstepping Authority

Posted in Fund Regulation

In a speech on July 15, 2014, SEC Commissioner Michael S. Piwowar expressed his views about the Financial Stability Oversight Council (FSOC) operating in secrecy as it tries to expand its regulation of financial institutions and the capital markets.

Commissioner Piwowar opened his speech with a number of phrases about FSOC, calling it, among other things:

  • The Firing Squad on Capitalism
  • The Vast Left Wing Conspiracy to Hinder Capital Formation
  • The Bully Pulpit of Failed Prudential Regulators
  • The Dodd-Frank Politburo
  • The Modern-Day Star Chamber
  • The Unaccountable Capital Markets Death Panel

But how does Commissioner Piwowar really feel about FSOC?

FSOC members include the chairs of various commissions and boards (including the SEC), but not the individual commissioners or board members.  Commissioner Piwowar complained that FSOC rebuffed his attempt to attend its meetings as a non-participating guest, which, he said, was disappointing but not surprising.  But, he said, FSOC also shut out Congressman Scott Garrett, the Chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises, from FSOC meetings.  He called this action “shocking, appalling and downright insubordinate.”

Commissioner Piwowar accused FSOC, led by the “alpha dog” Board of Governors of the Federal Reserve Board, of starting a turf war by asserting broad regulatory authority over matters that are exclusively in the SEC’s jurisdiction, thus compromising the SEC’s mission to protect investors, maintain fair, orderly and efficient markets, and promote capital formation.

As an example of the Federal Reserve Board’s “attempt to gain authority over capital markets actors,” the Commissioner cited FSOC’s “much-discussed hubris” in recommending money market fund regulatory reforms.  “It would be comedic,” he said, “if not in such a serious context, that it did so while publicly acknowledging” that the SEC is best positioned to implement money market fund reforms.

To sum up, the Commissioner called for more transparency at FSOC, and said he supported efforts by Representative Garrett to make FSOC “accountable and transparent.”

The Commissioner, however, stopped short of accusing FSOC of trying to regulate the SEC as a Systemically Important Financial Institution.


PCAOB Issues Guidance to Auditors of Broker-Dealers

Posted in Broker-Dealer Regulation, PCAOB

On June 24, 2014, the Public Company Accounting Oversight Board (PCAOB) released staff guidance to help auditors of brokers and dealers registered with the Securities and Exchange Commission (SEC) plan and perform audits in accordance with PCAOB standards as mandated by the Dodd-Frank Act and SEC rules.

In July 2013, the SEC adopted amendments to Rule 17a-5 under the Securities Exchange Act of 1934 annual reporting rules for brokers and dealers.  The amendments, among other things, require audits of brokers and dealers to be performed in accordance with the standards of the PCAOB for fiscal years ending on or after June 1, 2014.  Prior to the effective date of the amendments, those audits were performed under generally accepted auditing standards.

This staff guidance was developed primarily to assist auditors of smaller brokers and dealers that have less complex operations in adhering to PCAOB standards. Because some auditors of smaller, less complex brokers and dealers will be applying PCAOB standards for the first time, the publication includes a “Getting Started” chapter, which introduces these auditors to certain PCAOB standards and rules. “To enhance investor protection, broker-dealer auditors must now meet PCAOB requirements,” said PCAOB Chairman James R. Doty. “This guidance is tailored to help auditors of smaller broker-dealers develop a cost-effective, scaled approach to their audits.

Under SEC rules, broker-dealers are required to maintain minimum levels of net capital and take steps to safeguard customer securities and cash.  These financial responsibility rules help serve the SEC’s overriding function of protecting investors.  The roles of the auditors, under the PCAOB standards, will enhance the quality of information provided to the SEC and in turn improve regulatory oversight of broker-dealers who serve the investing public.

The staff guidance highlights relevant requirements for SEC-required broker and dealer audits and attestation engagements and provides staff guidance on the application of PCAOB standards to these engagements. The publication is intended to help auditors plan and perform audits of brokers and dealers in accordance with PCAOB standards. Additionally, this publication highlights some of the significant provisions of SEC Rule 17a-5 and PCAOB standards and rules applicable to audits of brokers and dealers.

There were 783 registered auditors that issued audit reports on 2012 year-end financial statements of broker-dealers that were filed with the SEC, as of May 2013.  Given the number of auditors with broker-dealer clients, the guidance will affect a substantial number of auditing firms.

FINRA Announces and Publishes Its Sweep of Order Routing Practices

Posted in Broker-Dealer Regulation, FINRA Enforcement

FINRA announced this week that it is conducting a review of its member firms’ order-routing processes and procedures and the execution quality of customer orders in exchange-listed stocks.    We previously reported in this blog that an academic paper on this subject had gotten the attention of FINRA and the SEC.  That article, by professors at Notre Dame and the University of Indiana, concluded that many brokers route customer limit orders to the exchange that pays them the highest rebates, but that those exchanges do not necessarily provide best execution on their trades.

FINRA has now gone public with its sweep by posting its “Targeted Examination Letter” on the FINRA website.  The letter, issued by FINRA’s Market Regulation Department, covers a review period for this year to date, and pointedly asks firms to explain how they determine the best market to which to route their orders so that the resultant price is as favorable as possible.  The remainder of the sweep letter’s requests seek more specific related information that is clearly designed to determine if fears raised by the academic paper are warranted, including:

  • An explanation of how the firm makes its exchange order-routing decisions for non-marketable limit orders, and for market and marketable limit orders;
  • A statement of whether the firm passes exchange maker/taker fees on to its customers;
  • An explanation of how the firm reviews the execution quality of customer non-marketable, as well as market and marketable, limit orders that the firm routes to exchanges, and whether the firm has a committee that reviews the execution quality of such orders; and
  • A statement of whether the firm routes customer market and/or limit orders to other broker-dealers for execution, whether the firm receives a payment and/or other remuneration for such routing, and how such decisions are made.

Even if your firm is not targeted by FINRA for this sweep, we recommend reviewing the sweep letter, since the issues raised by it are likely to arise in future cycle exams.  In addition, it’s a fair bet that FINRA is likely to use the findings of these exams as the basis for future guidance or rule-making in this area.

FINRA Sanctions a Broker for Violating Japanese Insider Trading Law

Posted in FINRA Enforcement

On July 2, 2014, FINRA announced that it barred a former equity trader from the securities industry based on its finding that he violated Japanese insider trading law by trading in the securities of a Japanese company listed on the Tokyo Stock Exchange, resulting from a tip that the trader received indirectly from an insider in Japan.  While this case is framed as a violation of FINRA’s catch-all standard of “commercial honor and just and equitable principles of trade,” it demonstrates U.S. regulators’ continuing hunger for sanctioning insider trading violations, including cases outside the United States.

According to FINRA, in September 2010, the trader used his firm’s proprietary trading account to take a short position in Tokyo Electric Power Company Inc. (TEPCO), which is listed on the Tokyo Stock Exchange.  The trader, who was based in New York, entered into the position based on information that TEPCO was planning a secondary offering.  The information was provided by a consultant, to whom the trader paid a monthly fee in order to receive information about Japanese securities.  FINRA made conclusory findings that the trader was aware that the information he had received from the consultant was material “nonpublicized” information that came from a person in the sales department at the firm that was underwriting the secondary offering.

The trader ultimately took a more than $2 million short position in TEPCO – one of the largest positions that he had ever taken in a security in his proprietary account at his then trading firm.  When he covered his short position after public announcement of the secondary offering, the trader netted approximately $206,000 in profits for himself and his firm over the two-week trading period.

As the basis for the trader’s misconduct, FINRA recited Japanese law (Article 166 of Japan’s Financial Instruments and Exchange Act) that “prohibits a person who has received from a corporate insider material, nonpublicized information from selling or purchasing securities of a listed company.”  By trading in TEPCO, the trader allegedly violated Article 166.  FINRA does not claim that the trader violated U.S. insider trading prohibitions.  Although at the time of the settlement order, the trader had been out of the industry for more than two years, FINRA based its jurisdiction on the facts that the broker’s conduct occurred while he was registered with a FINRA member firm, and that the action was being filed within two years of the last amendment to the broker’s notice of termination on Form U5.  The trader settled the action, without admitting or denying FINRA’s charges, by agreeing to a bar from associating with any FINRA member.  FINRA does not appear to have taken any related action against the trader’s then-firm.

Although FINRA’s role in civil and criminal insider trading enforcement typically involves generating referrals and providing support to the SEC or DOJ, in this case, FINRA took the lead role by using a violation of foreign law as a basis for asserting its regulatory interest.  The enforcement action does not represent a particularly controversial application of FINRA’s “just and equitable” powers under Rule 2110.  Nevertheless, this case should serve as a reminder to the industry that FINRA can and will use violations of foreign laws as a basis for its formal disciplinary proceedings.  The fact that it could do so here in a case involving insider trading is just icing on the regulators’ cake.

SEC Staff Offers Guidance Regarding Investment Advisers and Proxy Advisory Firms

Posted in Investment Adviser Regulation

The SEC’s Division of Investment Management and Division of Corporation Finance published joint guidance on June 30, 2014 regarding investment advisers’ responsibilities in voting client proxies, and two exemptions from the federal proxy rules that are often relied upon by proxy advisory firms.

The staff noted that the guidance may require investment advisers and proxy advisory firms to make changes to their systems and processes.  In this regard, the staff stated its expectation that these changes should be made promptly, “but in any event in advance of next year’s proxy season.”

To read the full alert, click here.


SEC Staff Closes Loophole on BDC Asset Coverage Requirements

Posted in SEC Enforcement

In a Guidance Update published on June 30, 2014 by the SEC’s Division of Investment Management, the staff closed a loophole that allowed business development companies (BDCs) with wholly owned Small Business Investment Company (SBIC) subsidiaries to avoid meeting asset coverage requirements when the SBIC subsidiaries issue debt that is not guaranteed by the Small Business Administration (SBA).

Sections 18(a) and 61(a) of the Investment Company Act of 1940 (1940 Act) generally require BDCs to meet asset coverage requirements when they issue “senior securities,” including debt instruments.  A BDC may be deemed an indirect issuer of any class of “senior security” issued by its direct or indirect wholly owned SBIC subsidiaries.

The SEC has regularly granted BDCs limited exemptive relief from these asset coverage requirements.  The relief allows the BDCs to treat certain indebtedness issued by their wholly owned SBIC subsidiaries as indebtedness not represented by senior securities for purposes of determining the BDC’s consolidated asset coverage.  The SEC exemptive orders are, in part, based upon the representation that SBIC subsidiaries are subject to the SBA’s regulation of leverage.

The staff said that it learned that some BDCs have sought to rely on this limited relief in connection with SBICs that have not issued indebtedness that is held or guaranteed by the SBA.

Although in most cases the representations and condition in the orders have not explicitly required that an SBIC subsidiary have issued indebtedness held or guaranteed by the SBA, the staff said that this requirement is implicit in the rationale for the relief because the SBA’s independent oversight of SBIC debt makes the protections of the 1940 Act unnecessary.  The staff said that when an SBIC subsidiary issues debt that is not backed by the SBA, the subsidiary is not subject to the full oversight of the SBA, and thus the protections of Section 18(a) are required.

Going forward, the staff will require that BDC applications for relief from the Section 18 asset coverage requirements include a condition providing that:

[A]ny senior securities representing indebtedness of an SBIC Subsidiary will not be considered senior securities and, for purposes of the definition of “asset coverage” in section 18(h), will be treated as indebtedness not represented by senior securities but only if that SBIC Subsidiary has issued indebtedness that is held or guaranteed by the SBA.

We expect that as BDCs grow in popularity and assets, the staff will issue more regulatory guidance for BDCs.