What FINRA’s Investor Protection Efforts Will Mean for Broker-Dealers and Reps in 2012

On December 16, Financial Industry Regulatory Authority (FINRA)  issued a Press Release highlighting its regulatory accomplishments during 2011.  FINRA makes clear its goal is two-fold:  protecting investors and bringing transparency to financial markets.  The release demonstrates for senior management, risk management and compliance managers the additional arsenal FINRA is employing to beef up its oversight of broker-dealers and their registered reps.  So far, for reps and their firms, this has meant a significant increase in the number of disciplinary actions this year.  The release identifies  some of the newer tools and sources FINRA has used and will continue to employ to protect investors.

What’s been different about 2011 and what will firms and reps experience more of in 2012?  The press release sheds light on some measures FINRA will be employing, including:

  • Using its Office of Fraud Detection and Market Intelligence (OFDMI) to refer matters involving potential fraudulent conduct to federal and state regulators and law enforcement agencies.  FINRA referred more than 600 matters this year.
  • Reconfiguring its exam program to be more risk-based and ensuring exam teams are more focused on those areas critical to investor safety; including identifying high-risk firms, branch offices, brokers, activities and products through broader data collection.
  • Developing, through its Market Regulation Department, cross-market surveillance patterns that monitors all FINRA, NYSE and NASDAQ markets (80 percent of equity markets) with plans to launch these patterns in 2012.  Earlier, FINRA expanded the Order Audit Trail System (OATS) to include all NMS securities to create a uniform order audit trail to serve as a foundation for the cross-market surveillance program.
  • Expanding the Trade Reporting and Compliance Engine (TRACE) to include securitized products.  The effect was to add more than 1.2 million asset- and mortgaged-backed securities to the current 70,000 TRACE-eligible securities; and introduced securitized products benchmark pricing and aggregated data reports on FINRA’s website.
  • Continuing to push rule proposals that include Back Office Registration, Suitability and Debt Research Conflicts of Interest.
  • Enhancing its examination program by taking a more risk-based approach to focus on areas posing greatest risk to investors.  With this, FINRA has increased the number of its staff in district offices responsible for having a deeper understanding of specific firms, including increased real-time monitoring of business and financial changes.
  • Placing greater emphasis on branch-level activity by increasing the number of branch exams that focus exams at the point-of-sale.
  • For 2012, developing comprehensive cross-market surveillance patterns that will examine trading activity across all markets, including FINRA, NYSE and NASDAQ equity markets, at one time (which account for 80 percent of equity volumee time), rather than having multiple patterns survey each market separately.  This is suppose to help FINRA identify problematic trading more quickly.
  • Finally, FINRA implemented a rule for firms and reps involved in FINRA arbitrations allowing investors to choose all-public panels in customer cases involving three arbitrators.

With New SEC Unit and Data Mining, Advisers Face Closer Scrutiny in 2012

With a renewed focus on analytics and more readily available data, expect the SEC’s scrutiny of investment advisers, including advisers to mutual funds, hedge funds, and private equity funds, to get  tougher.

In December, in a speech before the Consumer Federation of America’s Financial Services Conference, the SEC’s Director of Enforcement, Robert Khuzami, once again emphasized many of the organizational and structural changes that have already occurred and that will continue to impact the way investment advisers and mutual funds will be watched and regulated going forward.  Moreover, advisers may begin to feel the heat from these changes in a deeper, and for their investment adviser reps, and more personal way.  With changes to its organizational structure, the SEC created the Asset Management Specialized Unit to evaluate data and risk-based analytics.  One of the investigative practices the unit is implementing involves adopting a kind of early-warning framework to detect what Khuzami says is the kind of “retail fraud” that may foreshadow more serious problems within assets management and mutual funds.    

Utilizing a retail approach, what might the SEC’s enforcement division be looking at for potential signs of fraud?  Khuzami gives a few examples.  One involves the SEC scouring an adviser’s Form ADV to determine if they’ve lied about their educational achievements, their business affiliations, and their assets under management.  “For us, it’s advisers who lie about graduating Phi Beta Kappa, conceal their association in a past failed business venture, or inflate their assets under management who might well be the same persons who outright steal your money when the markets turn against them,” says Khuzami.

A second approach, for mutual funds, might involve the SEC reviewing databases in an effort to identify poor performance, when at the same time, the fund has relatively high fee arrangements, for them and their sub-advisers.  This, Khuzami says, may suggest excessive fee arrangements that can eat away at the mutual fund investment returns.  See More……

 

After Citigroup, Will Settling SEC Enforcement Actions become Harder? SEC Press Release

The Securities and Exchange Commission’s Director of Enforcement, Robert Khuzami, today, issued a press release regarding a New York federal district court’s recent rejection of an SEC’s settlement with Citigroup.  Khuzami announced that the SEC is appealing the lower court’s ruling to the U.S. Court of Appeals for the Second Circuit.

In the Citigroup case, U.S. District Judge Jed Rakoff refused to accept a settlement between the SEC and Citigroup in a case involving the bank’s sale of mortgage-backed securities that cost investors almost $700 million in losses while the bank garnered profit of about $160 million.  Rakoff ruled that  the underlying allegations were ‘unsupported by any proven or acknowledged facts,’ and rejected a $285 million settlement between the SEC and Citigroup.  The SEC claimed that the settlement reasonably reflected the relief it would likely have gotten had it won at trial.

Khuzami’s press release argues that Rakoff has created a “new standard” that is “at odds with decades of court decisions that have upheld similar settlements by federal and state agencies across the country. ”  He is correct that courts have routinely approved SEC settlements in which a defendant does not admit or expressly deny liability, thus providing incentives for both the SEC and defendants.  However, Citigroup’s failure to acknowledge wrongdoing is actually what bothered Judge Rakoff.  Rakoff concluded that the settlement “is neither fair, nor reasonable, nor adequate, nor in the public interest.”

In a period when the public has become ever more skeptical about the fairness of financial bailouts and deals between governmental agencies and banks, Judge Rakoff’s decision appears to channel that same skepticism.  Might this be the beginning of the end of the SEC’s practice and policy of settling cases with defendants without requiring the defendant to admit to liability of some kind, even if modest?  For at least one judge, that appears to be the case.  And, if it is the beginning of a trend, this could mean more trials and fewer settlements.  If so, the danger of changing the SEC’s settlement approach to these cases could prove time consuming and expensive not just for the SEC and defendants but also for federal judges like Judge Rakoff.

SEC Announces 2012 Compliance Program to Focus on Compliance for Senior Management

For next year, the SEC has announced it will be enhancing its CCO Outreach program to include both chief compliance officers and senior personnel of investment advisers and investment companies will.  The program will occur on Jan. 31, 2012, at the SEC’s Washington D.C. headquarters and will also be webcast.  By adding senior personnel, the SEC says the change is aimed at emphasizing the need for compliance awareness at all levels of an organization.  Program topics will include compliance and enterprise risk management, trading, custody, Dodd-Frank reform and enforcement issues.

Registration materials and other information about the national seminar are
available at: http://www.sec.gov/info/complianceoutreach/complianceoutreachns2012.htm.

THE RECURRING DUE DILIGENCE FAILURES WITH PRIVATE OFFERINGS

FINRA Sanctions Eight More Firms.  FINRA’S  recent announcement that it had sanctioned eight more firms and 10 individuals, and ordered restitution totaling more than $3.2 million, for selling interests in private placement offerings without having a reasonable basis for recommending the securities is yet another warning to firms that fail to conduct adequate due diligence on alternative investment products.

NASD Conduct Rule 2310 requires member firms, when making a recommendation to a customer to purchase or sell a security, to have reasonable grounds to believe that the recommendation is suitable for the customer.  What this means, under FINRA rules, is that member firms who sell alternative investments such as Regulation D offerings must be able to demonstrate that they have an understanding of the potential risks and rewards of the security.  That demonstration must go beyond simply reading prospectuses, private placement memoranda, and other scripts passed along from issuers or participants in the offering process.

The eight firms and their reps FINRA snctioned sold interests in several high-risk private placements, including those issued by Provident Royalties, LLC, Medical Capital Holdings, Inc. and DBSI, Inc., which ultimately failed, causing significant investor losses.  The oft-forgotten message FINRA makes with these cases is that firms have at least two continuing responsibilities with alternative securities offerings.  The first is that member firms need first to document for themselves, and convey to their clients, an understanding of the inherent risks of private offerings; and the second is, after doing so, ask themselves whether these products are suitable for their customers.  Failing to conduct adequate due diligence makes this impossible to do since a selling firm may have no reasonable grounds to believe that the Regulation D offfering is suitable for any customer.

As with these cases, FINRA has shown no reservation in imposing supervisory liability , under Rule 3010, on principals of these firms for failing to conduct meaningful due diligence prior to approving such offerings for sale to customers.

FINRA AND SEC GUIDANCE: EFFECTIVE RISK MANAGEMENT FOR BRANCH AUDITS

In its continual focus on the importance of effective risk management for broker-dealers (as well as investment advisers) the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and FINRA have issued a National Exam Risk Alert aimed at providing broker-dealer firms with information on developing effective policies and procedures for branch office inspections.  In addition to reminding firms of their supervisory obligations under FINRA’s supervision rule, the alert notes some common deficiencies found during SEC and FINRA examination of branch office audit practices and emphasizes the need for firms to adopt a comprehensive risk approach to compliance practices. 

The Alert, including FINRA’s Regulator Notice 11-54 , contains a number of best practices that Chief Compliance Officers and other compliance professionals of broker-dealers should consider incorporating as part of their mandated supervisory oversight of branch offices.  The Alert warns that some practices FINRA and SEC examiners have observed, including

  • firms utilizing generic examination procedures for all branch offices, regardless of business mix
  •  leveraging  novice or unseasoned branch office examiners who lack the experience or understanding of the business to challenge assumptions, and
  •  devoting minimal time to each exam and little, if any, resources to reviewing the effectiveness of the branch office exam program

will not be tolerated.  In short, the alert is a reminder that the SEC and FINRA view branch office inspections as integral to determining whether a firm’s culture of compliance eliminates risks to the firm and its clients or contributes to violations of the securities laws.