Securities Law Prof Blog

Lew Reiterates Need for Money Market Fund Reform in Senate Testimony

Treasury Secretary Lew testified today before the Senate Banking Committee on the Financial Stability Oversight Council (FSOC) Annual Report to Congress.  His written testimony identified seven areas of risks to U.S. financial stability:

·         First, market participants and regulatory agencies should take steps to reduce vulnerabilities in wholesale funding markets that can lead to destabilizing fire sales. 
·         Second, significant reform in the housing finance system is still needed.
·         Third, government agencies, regulators, and businesses should take action to address operational risks from internal control and technology failures, natural disasters, and cyber-attacks, which can cause major disruptions to the financial system.
·         Fourth, as recent developments with the London Interbank Offered Rate (LIBOR) have demonstrated, reforms are needed to address the reliance on voluntary, self-regulated, and self-reported reference interest rates.
·         Fifth, financial institutions and market participants should be cognizant of interest rate risk, particularly given the historically low interest rate environment of the past few years. 
·         Sixth, long-term fiscal imbalances that have potential economic and financial market impacts should be addressed.
·         Finally, regulators need to continue to keep a close eye on potential threats to U.S. financial stability from adverse developments in the global economy.

With respect to the first risk, Wholesale Funding Markets, the Secretary's written testimony focused on the need for additional reforms related to money market mutual funds:

The Council remains concerned that vulnerabilities in wholesale funding markets could lead to destabilizing fire sales.  Specifically, run-risk vulnerabilities related to money market mutual funds (MMFs), which became apparent during the financial crisis, still remain, despite an initial set of reforms implemented in 2010.  In November 2012, the Council issued proposed recommendations for public comment to implement structural reforms of MMFs to reduce the likelihood of runs.  Council members should also examine whether similar reforms are warranted for other cash management vehicles. 

 The Secretary's testimony noted that:

The Council is also authorized to issue recommendations to a regulatory agency when financial activities and practices are creating risk for U.S. financial markets.  In November 2012, the Council issued for public comment proposed recommendations to the SEC with three alternatives for reform to address the structural vulnerabilities of MMFs.  The Council is currently considering the public comments on the proposed recommendations.  If the SEC moves forward with meaningful structural reforms of MMFs before the Council completes its process, the Council expects that it would not issue a final recommendation to the SEC.  However, if the SEC does not pursue additional reforms that are necessary to address MMFs’ structural vulnerabilities, the Council should use its authorities to take action in this area.

FINRA Fines LPL for Systemic Email Failures & Misstatements to FINRA

FINRA fined LPL Financial LLC (LPL) $7.5 million for 35 separate, significant email system failures, which prevented LPL from accessing hundreds of millions of emails and reviewing tens of millions of other emails. Additionally, LPL made material misstatements to FINRA during its investigation of the firm's email failures. LPL was also ordered to establish a $1.5 million fund to compensate brokerage customer claimants potentially affected by its failure to produce email.

FINRA found that:

As LPL rapidly grew its business, the firm failed to devote sufficient resources to update its email systems, which became increasingly complex and unwieldy for LPL to manage and monitor effectively. The firm was well aware of its email systems failures and the overwhelming complexity of its systems. Consequently, FINRA found that from 2007 to 2013, LPL's email review and retention systems failed at least 35 times, leaving the firm unable to meet its obligations to capture email, supervise its representatives and respond to regulatory requests. Because of LPL's numerous deficiencies in retaining and surveilling emails, it failed to produce all requested email to certain federal and state regulators, and FINRA, and also likely failed to produce all emails to certain private litigants and customers in arbitration proceedings, as required.

...

FINRA also found that

In addition, LPL made material misstatements to FINRA concerning its failure to supervise 28 million DBA emails. In a January 2012 letter to FINRA, LPL inaccurately stated that the issue had been discovered in June 2011 even though certain LPL personnel had information that would have uncovered the issue as early as 2008. Moreover, the letter stated that there weren't any "red flags" suggesting any issues with DBA email accounts when, in fact, there were numerous red flags related to the supervision of DBA emails that were known to many LPL employees.

In addition, LPL likely failed to provide emails to certain arbitration claimants and private litigants. LPL will notify eligible claimants by letter within 60 days from the date of the settlement and the firm will deposit $1.5 million into a fund to pay customer claimants for its potential discovery failures. Customer claimants who brought arbitrations or litigations against LPL as of Jan. 1, 2007, and which were closed by Dec. 17, 2012, will receive, upon request, emails that the firm failed to provide them. Claimants will also have a choice of whether to accept a standard payment of $3,000 from LPL or have a fund administrator determine the amount, if any, that the claimant should receive depending on the particular facts and circumstances of that individual case. Maximum payment in cases decided by the fund administrator cannot exceed $20,000. If the total payments to claimants exceed $1.5 million, LPL will pay the additional amount.

 

NASAA Releases Report on IA Switch

NASAA released a report on the regulatory transfer of more than 2100 investment advisers from federal to state oversight, IA Switch Report, The IA Switch: A Successful Collaboration to Enhance Investor Protection.  According to NASAA, the IA Switch "was one of the most significant achievements in the history of the North American Securities Administrators Association (NASAA)."  The Switch stemmed from Section 410 of the Dodd-Frank Act, which raised the assets under management threshold for state regulation of investment advisers from $25 million to $100 million.

The report documents the work that went into the successful completion of the Switch. It draws from a survey completed by state securities regulators on the effect of the Switch;  detailed interviews with NASAA members who were key players throughout the Switch;  and industry feedback.

 

GAO Releases Testimony on Elder Fraud

The GAO released recent testimony on Federal Government Has Taken Some Steps but Could Do More to Combat Elder Financial Exploitation (GAO-13-626T, May 16, 2013).  Here is what the GAO found:

Older adults are being financially exploited by strangers who inundate them with mail, telephone, or Internet scams; unscrupulous financial services professionals; and untrustworthy in-home caregivers. Local law enforcement authorities in the four states GAO visited indicated that investigating and prosecuting the growing number of cases involving interstate and international mass marketing fraud--such as "grandparent scams," which persuade victims to wire money to bail "grandchildren" out of jail or pay their expenses--is particularly difficult. In addition, older adults, like other consumers, may lack the information needed to make sound decisions when choosing a financial services provider. As a result, they can unknowingly risk financial exploitation by those who use questionable tactics to market unsuitable or illegal financial products. Local officials also noted that it is difficult to prevent exploitation by in-home caregivers, such as home health or personal care aides, individuals older adults must rely on.

The GAO goes on to identify ways that federal agencies could support state and local efforts to combat elder fraud.

NASAA Files Amicus Brief in Schwab Class Action Waiver Appeal

Several amicus briefs have been filed in the appeal of FINRA's disciplinary proceeding against Charles Schwab for including in its customer agreement a class action waiver, contrary to FINRA rules.  A FINRA hearing panel ruled that the FINRA rules were unenforceable because they were preempted by the Federal Arbitration Act; the case is now on appeal before FINRA's NAC.  While the docket in the appeal is confidential, NASAA posted its amicus brief on its website.  Professor Jill Gross and I also filed an amicus brief (Download Amicus Brief Final) that is a distillation of our recent law review article, Investor Protection Meets the Federal Arbitration Act, 1 Stanford J. Complex Litigation 1 and also available at ssrn.com.

SEC & FINRA Issue Alert on Pension or Settlement Income Streams

The SEC and FINRA issued an investor alert, Pension or Settlement Income Streams – What You Need to Know Before Buying or Selling Them.  The investor alert informs investors about the risks involved when selling their rights to an income stream or investing in someone else’s income stream.  The alert urges investors considering an investment in pension or settlement income streams to proceed with caution.

The alert explains that

Anyone receiving a monthly pension or regular distributions from a settlement following a personal injury lawsuit may be targeted by salespeople offering an immediate lump sum in exchange for the rights to some or all of the payments the person would otherwise receive in future.  Typically, recipients of a pension or structured settlement will sign over the rights to some or all of their monthly payments to a factoring company in return for a lump-sum amount, which will almost always be significantly lower than the present value of that future income stream.

The investor alert contains a checklist of questions to consider before selling away an income stream.

FINRA Fines 3 Firms for Failing to Establish AML Programs

FINRA announced that it has fined three firms a total of $900,000 for failing to establish and implement adequate anti-money laundering (AML) programs and other supervisory systems to detect suspicious transactions. FINRA also fined and suspended four executives involved.

FINRA imposed the following sanctions:

• Atlas One Financial Group, LLC – Miami, Florida – fined $350,000; Napoleon Arturo Aponte, former Chief Compliance Officer and AML Compliance Officer, fined $25,000 joint and severally with the firm, and suspended for three months in a principal capacity
• Firstrade Securities, Inc. – Flushing, New York – fined $300,000
• World Trade Financial Corporation (WTF) – San Diego, CA – fined $250,000; President and Owner Rodney Michel fined $35,000 and suspended in all capacities except as a financial operations principal for four months; Chief Compliance Officer Frank Brickell fined $40,000 and suspended from association in all capacities for nine months; trade desk supervisor and minority owner Jason Adams fined $5,000 and suspended for three months in a principal capacity

 

NASAA Writes SEC About Class Action Waivers

The North American Securities Administrators Association (NASAA) has addressed a letter to SEC Chair White to comment on Charles Schwab's class action waiver that it now includes in its brokerage agreements.  Although the class action waiver violates FINRA Rules, a FINRA hearing panel recently concluded that FINRA could not enforce its rules against Schwab because they were "anti-arbitration" in violation of the Federal Arbitration Act.  The Hearing Panel's decision is currently on appeal before FINRA's internal appellate body.  NASAA reiterates its long standing opposition to mandatory arbitration of customers' disputes and reminds the SEC that "Section 921 [of Dodd-Frank] provides the SEC the authority, by rule, to prohibit or impose limitations on the use of mandatory arbitration clauses in broker-dealer and investment adviser customer contracts."

NASAA concludes by "commend[ing] the SEC for taking several steps over the years to improve the arbitration forum and process, and encourage[ing] the SEC to take further action to ensure that investors who are forced into arbitration receive the fairest forum possible."

FINRA Names New VP for Risk & Strategy

FINRA has a new Executive Vice President, Risk and Strategy.  Carlo V. di Florio, currently Director of the SEC's Office of Compliance Inspections and Examinations (OCIE), is joining FINRA and will lead its Office of Risk, Emerging Regulatory Issues, Enterprise Risk Management and Strategy.  According to the FINRA press release, "Di Florio will have overall responsibility for ensuring that FINRA has effective processes for assessing the most significant risks to the investing public and the integrity of our markets, and developing strategic responses to mitigate, manage and monitor those risks and industry trends."

FINRA Names Chief Economist

FINRA announced the appointment of a Chief Economist and Senior Vice President, who will report directly to FINRA CEO Richard Ketchum.  Jonathan S. Sokobin is currently Acting Deputy Director, Research and Analysis in the Office of Financial Research at the U.S. Treasury Department.  The appointment is further demonstration of the importance of cost-benefit analysis in financial regulation.  According to the press release,

The Office of the Chief Economist will work closely with the Office of General Counsel and other departments in developing new rules and analyze the costs and benefits of existing and potential rulemakings. In order to facilitate that effort, the Office will be responsible for gathering and analyzing data on securities firms and markets.

 

FINRA Withdraws Proposed Rule Change to Require Link to BrokerCheck on Broker Websites

FINRA withdrew a proposed rule change to Amend FINRA Rule 2267 (Investor Education and Protection) that would have required members to include a prominent description of and link to FINRA BrokerCheck on their websites, social media pages and any comparable internet presence.  The proposed rule change was published for comment on January 25, 2013, and the SEC received 24 comment letters.  No explanation was given for the withdrawal (Release No. 34-69440; File No. SR-FINRA-2013-002).

CFPB Releases Report on Senior Designations

On April 18 the Consumer Financial Protection Bureau released its report on Senior Designations for Financial Advisers.  Congress directed that its Office for Older Americans study the issue of "senior designation" titles used by financial advisers and make recommendations.  The Bureau

found that the use of senior designations is extremely confusing for consumers. There are more than 50 different senior designations currently used in today’s marketplace with senior designees recommending or selling a variety of products, such as securities, investment opportunities, financial products, and insurance products like annuities and long-term care insurance.

*    *    *

The recommendations in this report seek to reduce consumer confusion and protect consumers
by improving the: (1) dissemination of information and consumer education around senior
designations; (2) standards for the acquisition of senior designations; (3) standards for senior
designee conduct; and (4) enforcement related to the misuse of senior designations. The Bureau
believes that adoption of these recommendations will help older consumers avoid financial
advisers who would misuse their designations to sell inappropriate investment and financial
products.

FINRA Approves Proposed Rule Changes for Submission to SEC

The FINRA Board of Governors approved several proposed rule changes that will be submitted to the SEC for review and approval.

The Board approved a proposal to publicly disseminate 144A transactions in TRACE-eligible securities for those asset types currently subject to dissemination.  FINRA is taking this step after reviewing the comments submitted in response to its September 2012 Regulatory Notice and in light of JOBS Act provisions. FINRA believes that making this information publicly available will help market participants determine the quality of their executions and help firms comply with their regulatory obligations.

FINRA also approved two proposed rule changes related to securities arbitration:

Arbitration Panel Composition
The Board authorized FINRA to file with the SEC proposed amendments to FINRA Rule 12403 to simplify the panel selection rules. Rather than requiring the customer to elect a panel selection method, parties in all customer cases with three arbitrators would have the same selection method. Under this method, all parties would see lists of 10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. The rules would permit four strikes on each of the public arbitrator lists. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the non-public list. Alternatively, if the parties leave on the non-public list one or more of the same non-public arbitrators, the parties could have a majority public panel—that is two public and one non-public arbitrator.

Discovery Guide Used in Investor Arbitration Proceedings
The Board authorized FINRA to file with the SEC proposed amendments to the Discovery Guide used in customer arbitration proceedings to provide general guidance on e-discovery issues and product cases, and to clarify existing provisions relating to affirmations. Specifically, FINRA would amend the Discovery Guide introduction to:

1.include guidelines for arbitrators to consider when deciding disputes relating to the form of e-discovery;
2.add guidance on product cases to explain, among other matters, that these cases are different from other customer cases and that the Document Production Lists may not provide all of the documents parties usually request in a product case; and
3.clarify that a party may request an affirmation when an opposing party makes a partial production.

 

FINRA Fines Merrill $1 Million for Best Execution Failures in Non-Convertible Preferred Shares Transactions

FINRA fined Merrill Lynch, Pierce, Fenner & Smith Inc. $1.05 million for failing to provide best execution in certain customer transactions involving non-convertible preferred securities executed on one of its proprietary order management systems (ML BondMarket), and for failing to have an adequate supervisory system and written supervisory procedures in place. Merrill Lynch was also ordered to pay more than $323,000 in restitution, plus interest, to customers who did not receive best execution for their trades in non-convertible preferred securities. Additionally, FINRA has required Merrill Lynch to revise its written supervisory procedures regarding ML BondMarket best execution obligations within 30 business days.

FINRA found that Merrill Lynch had programmed a faulty pricing logic into ML BondMarket that only incorporated quotations published on the primary listing exchange for that non-convertible preferred security. As a result, in instances when there was a better quote on a market other than the primary listing exchange, that quote was not reflected on ML BondMarket. The firm instead executed 12,259 transactions in non-convertible preferred securities with its customers on ML BondMarket at prices that were inferior to the National Best Bid and Offer (NBBO).

 

 

FINRA Charges JTF with Fraud in February 2012 Sales of AWSR Stock

 FINRA filed a complaint against John Thomas Financial (JTF), of New York, NY, and its Chief Executive Officer, Anastasios "Tommy" Belesis, charging fraud in connection with the sale of America West Resources, Inc. (AWSR) common stock, intimidation of registered representatives, trading ahead, failing to provide best execution for customer orders and various other violations. The complaint also names Michele Misiti, Branch Office Manager; John Ward, trader; Joseph Castellano, Chief Compliance Officer; and Ronald Vincent Cantalupo, Regional Managing Director.

JTF and many of its customers owned AWSR stock as a result of participation in the company's private financings. According to the complaint, on Feb. 23, 2012, the price of AWSR common stock, which at the time was thinly traded on the OTC Bulletin Board, spiked higher, by over approximately 600 percent, opening at 28 cents per share, peaking at $1.80 per share and eventually closing the day at $1.29 per share. On the same day, JTF sold 855,000 shares, the majority of its proprietary position in AWSR, reaping proceeds of more than $1 million.

The complaint alleges that while JTF sold its shares at the height of the price spike, the firm received at least 15 customer orders to sell more than one million shares, yet only entered one of these orders for execution on Feb. 23, 2012. Instead, JTF and Belesis prevented the orders from being executed on the same day they were received and some customer orders were executed the following day or days after at prices grossly inferior to those obtained by the firm while other customer orders were not entered or executed at all. AWSR is now in bankruptcy and the customers' investments are virtually worthless.

In addition, the complaint alleges that JTF and Belesis, through Misiti and Castellano, lied to the firm's registered representatives and customers about the reasons the customer shares could not be sold on Feb. 23, 2012, including that there was a problem with the clearing firm's trading systems, there was insufficient volume on that day to fill the orders, and the shares could not be sold because they were restricted under the Securities Act of 1933.

 

FINRA Board Scheduled to Consider Changes to Customer Arbitration Rules

At its April 18 meeting the FINRA board of governors will consider a proposed rule change to the Customer Code of Arbitration, to make it easier for customers to select a panel consisting of all public arbitrators (in claims over $100,000).  Currently, the default option is a panel consisting of two public and one industry arbitrator, and a customer must make an election to select an all-public panel option.  The proposed rule change, as described on the FINRA website:

The Board will consider proposed amendments to FINRA Rule 12403 (Cases with Three Arbitrators) to simplify the arbitration panel selection rules. Rather than requiring the customer to elect a panel-selection method, parties in all customer cases with three arbitrators would get the same selection method. All parties would see lists of 10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. The proposed rules permit four strikes on each of the public arbitrator lists. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the non-public list.

When FINRA first proposed giving customers the option of selecting an all-public panel, I applauded the concept, but worried that pro se claimants might lose the option inadvertently by failing to make the election within the prescribed time period.  I suggested that the default should be an all-public option and that customers could elect to include one industry arbitrator.  FINRA was not receptive to my suggestion.

Since adoption of the all-public option, FINRA has stated that customers are electing for an all-public panel more frequently than it had anticipated, so this proposal may be in response to that.  In any event, it is a welcome development, and I hope that the Board of Governors will view the proposal favorably.

The board of governors will also consider amendments to the Discovery Guide relating to e-discovery, described as follows:

The Board will consider proposed amendments to the Discovery Guide used in customer arbitration proceedings to provide general guidance on e-discovery issues and product cases. The guidance, which would appear in the introduction to the Discovery Guide, would emphasize flexibility in the discovery process. FINRA is not proposing to amend the Document Production Lists, which specify documents that are presumptively discoverable in customer cases. The proposed amendments would also clarify existing provisions in the introduction relating to affirmations.

 

FINRA Charges Online Broker with Fraud in Sales of Promissory Notes to Athletes

FINRA filed a Temporary Cease-and-Desist Order (TCDO) to halt further fraudulent activities by Washington, D.C.-based Success Trade Securities, Inc. and its CEO & President, Fuad Ahmed, as well as the misuse of investors' funds and assets. FINRA also issued a complaint against Success Trade Securities and Ahmed charging fraud in the sales of promissory notes issued by the firm's parent company, Success Trade, Inc., in which Ahmed holds a majority ownership interest. FINRA filed the TCDO, to which Ahmed and the company agreed, thus immediately freezing their activities, based on the belief that ongoing customer harm and depletion of investor assets are likely to continue before a formal disciplinary proceeding against Success Trade Securities and Ahmed will be completed.

 Success Trade Securities is an online broker-dealer that operates through Just2Trade and LowTrades.

In its complaint, FINRA alleges that Success Trade Securities, Ahmed and other registered representatives at the firm sold more than $18 million in Success Trade promissory notes to 58 investors, many of whom are current or former NFL and NBA players, while misrepresenting or omitting material facts. Specifically, FINRA's complaint alleges that Ahmed and Success Trade Securities misrepresented that they were raising $5 million through the sale of promissory notes and continued to make this representation, even as the sales exceeded the original offering by more than 300 percent. Most of the notes promised to pay an annual interest rate of 12.5 percent on a monthly basis over three years, with some notes promising to pay interest as high as 26 percent.

 

 

SEC Approves FINRA's Tightening of "Public Arbitrator" Definition

The SEC approved a FINRA proposed rule change to amend the definition of "public arbitrator" in its Customer and Industry Codes of Arbitration.  Specifically, the proposed rule change would (a) exclude persons associated with a mutual fund or hedge fund from serving as public arbitrators and (b) require individuals to wait for two years after ending certain affiliations before they may be permitted to serve as public arbitrators.   This amendment is another tightening of the definition of "public arbitrator" to exclude individuals with close ties to the securities industry.  SEC, Release No. 34-69297; File No. SR-FINRA-2013-003, Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving Proposed Rule Change to Amend the Customer and Industry Codes of Arbitration Procedure to
Revise the Public Arbitrator Definition (Apr. 4, 2013)

FINRA Proposes to Amend Rule Regarding Public Release of Disciplinary Complaints

FINRA has filed with the SEC a proposed rule change amending FINRA Rule 8313 (Release of Disciplinary Complaints, Decisions and Other Information) to make more information about disciplinary proceedings available to the public.  The SEC has put the proposal out for public comment. (Download 34-69178[1])

The proposed rule change generally would establish general standards for the release of disciplinary information to the public that would provide greater information about FINRA's disciplinary actions.  It would also clarify the scope of information subject to Rule 8313.

Rule 8313(a) currently provides that in response to a request FINRA shall release any identified disciplinary complaint or decision to the requesting party.  Absent a specific request for an identified complaint or decision, the rule provides publicity thresholds for the release of information to the public.  Thus, disciplinary information currently available in the FINRA Disciplinary Actions online database is limited by Rule 8313's publicity thresholds.  The proposed amendment would eliminate the publicity thresholds and in their place adopt general standards for the public release of the information and increase access to information about disciplinary actions.  Specifically, proposed Rule 8313(a)(1) would provide that FINRA shall release to the public a copy of, and at FINRA's discretion information with respect to, any disciplinary complaint or disciplinary decision issued by FINRA.  Subject to limited exceptions, FINRA would release the information in unredacted form. (Download 34-69178-ex5[1])

Massachusetts Fines Deutsche Bank Securities $17.5 Million for Conflicts in Marketing CDOs

The Commonwealth of Massachusetts fined Deutsche Bank Securities $17.5 million for conflicts in marketing collateralized debt obligations (CDOs) in a matter settled by a consent order.  According to the allegations, DBSI, which underwrote approximately $32.2 billion of CDOs between 2004-08, failed to disclose conflicts of interest arising from its various roles in proposing the structure for, co-investing in, and serving as the structurer for, a $1.56 billion hybrid CDO.  Specifically, DBSI did not disclose that a proprietary trading group within the firm partnered with a hedge fund to determine how the CDO would be structured and marketed.