Securities Regulation and Litigation Lawyer & Attorney : OverRegd Blog : Lindquist & Vennum Law Firm, Minneapolis and Denver

The North American Securities Administrators Association will be holding a public forum on securities industry arbitration, on June 24 in New York City. 

NASAA, which is the organization of heads of securities departments from each of the American states and territories, as well as the Canadian provinces and Mexico, has long perceived industry securities arbitration as unfair to investors.  The organization has advocated for substantial changes in the arbitration system, including abolition of mandatory arbitration.

NASAA's position on securities arbitration is abundantly clear in the title of the upcoming forum:  Arbitration is Broken:  How Can it be Fixed?  According to NASAA, the forum "will feature a panel of legal and regulatory experts, academics, and consumer advocates who will address the manner in which arbitrations are conducted; whether the selection, qualification, and composition of arbitration panels is fair; and whether the arbitration process should be an option, not a requirement, for investors. Panelists also will discuss the Arbitration Fairness Act of 2007 and current research exploring consumer views on securities arbitration."

Registration for the forum is free, on a first-come-first served basis.  Registration details are on NASAA's website.

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On May 14, FINRA released proposed Rule revisions, reflecting its efforts to merge the old NYSE and NASD rulebooks, refining and clarifying previous rules, and offering a few new wrinkles. The proposed revisions are open for comment until June 13.

The four separate proposed revisions relate to (1) Financial Responsibility (largely relating to net capital issues); (2) Supervision and Supervisory Controls; (3) Books and Records (consolidating and modifying various books and records rules, including in regards to client accounts and complaints); and (4) Investor Education and Protection (extending the scope of current FINRA Rule 2280). The new proposals contain extensive changes and additions, including many consolidations or relocations of existing rule provisions. 

Although there are specific changes in each of the four areas noted above, the changes to FINRA’s Supervision and Supervisory Controls rules (current Rules 3010 and 3012, which will be renumbered 3110 and 3120) are probably the most extensive and dramatic. Highlights include:

     ***  Proposed Rule 3110 provides much-needed clarification regarding the supervision of current Rule 3012’s provisions for supervision of “producing managers.” The new Rule will, more simply, prohibit “supervisory personnel” from (1) supervising themselves; and (2) being supervised by anyone who reports to or whose compensation is determined by the supervised person. The current, rather confusing, language requiring supervisory review of such managers' client accounts by “senior” or “otherwise independent” personnel will be removed.    Proposed Rule 3120 otherwise continues Rule 3012’s testing, verification, and certification requirements, though it now specifies additional information that firms with gross revenues over $150 million must include in the annual report to senior management.

     ***  Current Rule 3010(b)(3), requiring “heightened office inspections” for offices that generate 20% or more of a business unit’s revenue will be completely deleted. Instead, the new Rule 3110 provides a more principles-based approach that requires a firm to have written procedures reasonably designed to “prevent the inspection from being lessened in any manner due to any conflicts of interest.”

     ***  Current Rule 3040 (regarding private securities transactions) will be deleted, and incorporated into new Rule 3110. The proposed rule removes any distinction, for supervisory purposes, between private transactions for which an associated person is compensated and those for which no compensation is paid. Moreover, the new Rule provides a qualified exemption for firms from the supervisory rules regarding private transactions with regard to associated persons who complete the transaction as part of their separate employment by a bank, so long as the member firm is notified of the activity and receives written assurance from the bank that it has reasonable supervisory procedures for such activities.

     ***  New Rule 3110 clarifies that firms must institute written procedures for written customer complaints, dropping the NYSE’s inclusion of procedures for oral complaints. 

     ***  New supplementary material to the rule clarifies, among many other things, that member firms are to follow the previous NYSE Rule 342.21 requirement that firm’s insider trading policies contain specific procedures for reviewing and investigating trades effected for the firm’s account and the accounts of firm employees and family members.

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Last month, the Certified Financial Planner Board of Standards issued updated Standards of Professional Conduct for CFP-certified financial planners. Those standards take effect on July 1, 2008.

The new CFP Standards highlight the increasing convergence, from a regulatory standpoint, between the once clearly distinct worlds of broker-dealers and investment advisors. Many registered securities representatives, particularly experienced reps, have earned and use the CFP designation in their practice. Many of those same CFP-certified reps also have their own Registered Investment Advisor firm, or are investment advisor representatives of a RIA or a dually-registered securities firm. As the CFP itself states, the new Standards apply to every CFP-certified financial professional, regardless of that professional’s licensure under the B-D or IA schemes, or both.

So what do the updated standards do? Although the CFP strengthened a number of its standards related to data gathering, disclosure, analysis, and monitoring, the bottom line is that the standard of care has been significantly ratcheted up: whereas the CFP required before, at minimum, a standard of “reasonable and prudent professional judgment” it now states that a CFP certificant “shall at all times place the interest of the client ahead of his or her own.” In other words, a fiduciary obligation.

Not surprisingly, advocates from the B-D world see this as a further erosion of the distinction between the obligations and business models of broker-dealers and investment advisors; the Financial Services Institute, for example, has urged its independent broker dealer members to raise concerns with the CFP Board regarding the standards.

Groups like the FSI will and should fight hard to insure that standards and legal requirements make sense for firms, representatives, and clients. However, the trend is clear. State securities regulators will continue to press for a fiduciary obligation for B-D firms and representatives. There is movement at the federal level for significant change in the financial services regulatory scheme, with the Treasury Department’s recent “Blueprint for a Modernized Financial Regulatory Structure" the clearest example. Dual-registration will increase, and traditional broker-dealers will continue to expand “hybrid” platforms to serve both B-D and IA models. Nobody can say for sure where this is going, but it is clear that the next few years will see substantial changes in the way securities firms are regulated.

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It is axiomatic that smaller firms do not have available the cadres of specialized compliance personnel that larger firms do. Out of necessity, senior compliance staff at smaller firms may be called upon to handle a multitude of home office functions in addition to compliance, and to serve in multiple capacities. Unfortunately, cost efficiency, not necessarily expertise is the driver of these decisions. This burden may fall especially hard on compliance personnel since they are viewed as being Renaissance-like in their intimate understanding of all things brokerage and/or financial. Unfortunately, that perception may be more perceived than real.

This model is especially common at smaller firms, and senior compliance personnel are called upon often to act in dual capacities: compliance overseer, and, frequently, as the person designated to approve the opening of new accounts and to grant approval with respect to the sales of certain products, such as variable annuities. While we may all appreciate the expediency and necessity of the need to wear multiple hats in a smaller shop, these latter functions may be interpreted by FINRA as line supervisory duties, and cause the compliance officer to be viewed as a business supervisor for regulatory purposes. 

In a pure and ideal world, Compliance is not a line-function, compliance officers are objective and impartial in their assessments and recommendations, and their evaluations are not tied innately to revenue considerations. While the failure to factor in the impact of compliance decisions on the fate and fortunes of the company is a luxury most compliance officers (and their firms) can ill-afford, traditionally, compliance has been used as a tool to identify problems or issues which must be remedied by the business unit responsible for the revenue activity. In that model, compliance is called upon later to examine and report on the performance of these managers. 

However, when the compliance officer is cast in the role of both cop and “perpetrator,” the oversight chain loses its tensility. In essence, who is left to oversee the function when the compliance officer is carrying out dual roles: compliance officer and supervisor? The end repercussion is that the compliance officer creates potential failure to supervise liability for him/her self, and may be called to task by a regulator or arbitration panel for failing to perform either of his/her assigned duties to industry standards.  The logical and ultimate repercussion may be a charge of a failure to supervise or similar dereliction of duty allegation.

So, how does the compliance officer/supervisor build firewalls under these circumstances? In the first instance, the head of the particular business unit with the greatest stake in the transaction at issue should not be isolated from the decision making process . Rather, exceptions to firm policy may be forwarded to him/her for resolution, although if this person is consistently faulty or lax in granting approvals, this may ultimately not help the compliance officer avoid sanction for failed supervisory effort. 

Perhaps a better alternative is to establish a Compliance Committee consisting of compliance and senior business unit personnel to address “exceptions” and sensitive intra-firm compliance issues. Under this scenario, the Committee would meet at least monthly, but more frequently if necessary. To be effective, clearly defined standards must be established by the firm with regard to the appropriateness of certain activity. For instance, with regard to sales of variable annuities, no sales would be permitted to retirement accounts or to customers over a designated age or in amounts that would appear excessive based on the customers identified financial circumstances. Exceptions may not be unilaterally granted by the compliance officer who is asked to review and approve an annuity application. Rather, the request for an exception would be submitted to the Compliance Committee for review, consideration, and approval. Thus, the business unit leaders with, in theory, the highest level of expertise would sit in judgment of the request for an exception, and it becomes a group rather than individual decision of either the compliance officer or the one business person who stands to gain the most from the transaction if it is permitted to go forward regardless of its merits. Once established, the Compliance Committee may provide a number of additional valuable benefits to the company, enabling senior management to both learn of and address myriad problems at an early stage, and to take as necessary pro-active steps to interdict the problem before it spins out of control. 

The benefit to the compliance officer who is wearing multiple hats is obvious: he or she potentially limits personal regulatory exposure. But the firm benefits too, and if its actions are later cited as inadequate, the group decision making concept, unless the Committee is simply a rubber stamp, allows for the argument that business judgment, not disinterest or disregard of the rules, dictated the decision.  Firms are still permitted, in the exercise of their business judgment, to make mistakes or reach different decisions than a regulator who judges the events after the fact. If the Committee decisions are well vetted and reasonable under the circumstances, significant defenses may be available to address later second-guessing by a regulator or an aggrieved investor.

Jonathan M. Harris
Lindquist & Vennum P.L.L.P.
Minneapolis, Minn.
(612) 371-2492
jharris@lindquist.com

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The recent slew of lawsuits brought against some of the nation's largest broker-dealers that sold Auction Rate Securities ("ARS") to customers has not gone unnoticed. The SEC and FINRA, on the heels of the lawsuit filings, have each launched independent investigations of their own into the sales and marketing practices employed by firms selling ARS. And commentary submitted in recent days suggests emphasis of the investigations will, at least in part, lead to focus on the suitability of the sales.

In a March 31, 2008 investor alert, FINRA discussed the impact the collapse of the ARS market has had on investors. Significantly, a large portion of its discussion concerned the liquidity of the securities and how "due to recent developments in the credit market—including downgrades in the credit ratings of bond issuers and bond insurers—a significant number of auctions have failed, leaving some investors who counted on immediate access to their funds wondering about their options." FINRA also recently sent a survey to brokerage firms specifically inquiring about who the firm sold ARS to (i.e. retail individual, high net worth individual, non-professional institutional, or professional institutional customer) and whether the firm was willing to offer margin loans to customers using ARS as collateral. And in Regulatory Notice 08-17, effective April 1, 2008, FINRA added "three new product categories for use by member firms in reporting customer complaints relating to auction rate securities."

Taken together, these actions leave little doubt that firm ARS sales and supervision may come under the lens of regulatory inquiry for the foreseeable future and likely remain one of the main topics of inquiry for 2008, given the fact hundreds of billions of dollars of ARS were sold.

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Commissioner Lori Richards revealed the SEC’s “Top 10 Compliance Issues for 2008” during the general session at the 40^th annual SIFMA national conference yesterday in Orlando, Florida.  According to Ms. Richards, the top 10 areas of scrutiny in SEC board exams in 2008 will be:

1. Valuations.
2. Firm controls over non-public information.  In particular, the SEC is interested in whether the firm has identified the type and sources of non-public information to which it is privy, and whether the firm has implemented and properly tested procedures for protecting that information.
3. Retail sales practices – with an emphasis on protecting seniors.
4. Supervision. 
5. Net capital/internal controls (which will receive increased focus given recent developments).  Ms. Richards noted that 20% of the exams last year uncovered errors in net capital calculation.
6. Trading.
7. Fixed Income.
8. Rating agencies.
9. Conflicts of interest.  The “hot list” for this area includes payments by advisors to broker dealers to appear on “recommended advisor lists,” and broker-dealers who sell interests in affiliated hedge funds.
10. Anti-money laundering.
11. Information/account security (refusing to be limited to just 10 areas, Ms. Richard actually named 11 key areas of scrutiny for 2008).  The SEC is particularly interested in whether broker-dealers have adequate control over their customers’ assets and information, and what controls broker-dealers adopt when they outsource regulating activities.  According to Ms. Richards, the SEC will focus on midsized firms this year. 

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Today is the opening day of the annual SIFMA conference, held this year in Orlando. This morning's general session, moderated by Gary Lynch, executive vice president and chief legal officer of Morgan Stanley, included panelists James Brigagliano of the SEC; Richard Ketchum of NYSE Regulation, Inc.; John Moloney of Moloney Securities Company Inc.; and Mary Schapiro, Chief Executive Officer of FINRA. SIFMA's kick-off topic was "NYSE and NASD Merger -- How is it Working?"

Mary Schapiro (FINRA) commented that the merger has gone well and has met her expectations at this stage, noting:

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The SEC voted unanimously yesterday to propose a new rule intended to enhance the SEC's ability to crack down on naked short sales and failures to deliver shares that are used in such sales, Reuters reported. 

Short selling involves sales of borrowed shares, in the hope of repurchasing them later at a lower price. Naked short selling involves sales without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed.

The SEC adopted Regulation SHO four years ago in an effort to curtail short-selling abuses. However, the SEC’s enforcement powers under Regulation SHO are limited. Stating the obvious, SEC Chairman Christopher Cox explained, “Reg SHO can’t be effective without enforcement.” According to Mr. Cox, the SEC's new proposed rule is designed to give Regulation SHO “teeth.” Under the new proposal, the SEC would create an antifraud rule specifically targeting targets sellers who intentionally deceive broker-dealers or purchasers about their ability to meet delivery deadlines. 

The SEC is seeking public comment on its proposal.

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John B. Torkelsen, an expert witness heavily utilized by the Plaintiffs' securities bar over the past several years to "testify on such issues as damages allegedly suffered by plaintiffs' classes and the appropriate value of settlements reached in several class action cases around the country," entered into a plea agreement before the Eastern District of Pennsylvania Federal Court, in which he plead guilty to perjury, admitting that "he lied to numerous federal judges across the county who were presiding over securities class actions."

Boiled down, Torkelsen had told various courts that he was an independent expert, yet certain law firms that hired him did so on a contingent fee basis and then concealed the payment arrangement from the courts. According to a Department of Justice litigation release, in furtherance of the scheme, the firms would then "submit to courts requests for reimbursement of fees already paid to Torkelsen when, in fact, the fees had not been paid and would not be paid unless the court awarded fees to the law firms; cause Torkelsen to submit declarations in which he falsely stated under oath that he had been retained on a non-contingent basis when, in fact, he had been retained on a contingent basis; cause Torkelsen to write-off fees he had incurred in class actions in which the law firms did not obtain a successful result; and cause Torkelsen to submit inflated fee requests in other class actions, billing for work that Torkelsen did not actually perform, in order to allow Torkelsen to make up for fees he did not recover in unsuccessful class actions."

Dishonesty has no place in the courtroom. At the end of the day, plaintiffs and defendants alike, as well as their counsel, are well-served by removal of such elements.

A detailed discussion of this case can be found on the Department of Justice's website at www.usdoj.gov/usao/cac/pressroom/pr2008/020.html

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