Securities Law Prof Blog

FINRA Issues Voluntary Interim Form for Funding Portals

 FINRA issued a voluntary Interim Form for Funding Portals designed for prospective crowdfunding portals under the JOBS Act. The Interim Form asks prospective funding portals to provide information including ownership; funding; management; and business model and relationships.

FINRA explains that:

Those intending to become a funding portal may voluntarily submit information regarding their business on the interim form. The information received will help FINRA develop rules specific to crowdfunding portals.

FINRA and the SEC are engaging in an open dialogue about the rules that should apply to funding portals. Once the SEC and FINRA have adopted funding portal rules, FINRA will issue a final funding portal application for FINRA regulation. In applying for membership, crowdfunding portals will not be bound by the responses provided on the Interim Form.

 

 

FINRA Year in Review

FINRA posted on its website a review of its 2012 activities.  It identified 

significant accomplishments in detecting fraudulent activity, implementing cross-market surveillance, increased transparency of securities markets and fulfilling its regulatory mandate to protect investors, assessing $68 million in fines, ordering a record $34 million in restitution to harmed customers and taking measures to ensure market integrity.

Richard Ketchum, FINRA's Chairman and CEO, said, "FINRA fulfilled its role as the first line of defense for investors through a comprehensive and aggressive enforcement program, supported by a realigned and more risk-based examination program and the provision, for the first time, of cross-market surveillance programs that more effectively detected electronic manipulative trading. Protecting investors and helping to ensure the integrity of the nation's financial markets is at the heart of what we do every day."

GAO Reports on Dodd-Frank Rule Making

The GAO released another report on Dodd-Frank rule making and cost benefit analysis, Agencies' Efforts to Analyze and Coordinate Their Rules (GAO-13-101, Dec 18, 2012).  Here is a summary:

Federal agencies conducted the regulatory analyses required by various federal statutes for all 54 regulations issued pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that GAO reviewed. As part of their analyses, the agencies generally considered, but typically did not quantify or monetize, the benefits and costs of these rules. Most of the federal financial regulators, as independent regulatory agencies, are not subject to executive orders that require comprehensive benefit-cost analysis in accordance with guidance issued by the Office of Management and Budget (OMB). Although most financial regulators are not required to follow OMB's guidance, they told GAO that they attempt to follow it in principle or spirit. GAO's review of selected rules found that regulators did not consistently follow key elements of the OMB guidance in their regulatory analyses. For example, while some regulators identified the benefits and costs of their chosen regulatory approach in proposed rules, they did not evaluate their chosen approach compared to the benefits and costs of alternative approaches. GAO previously recommended that regulators more fully incorporate the OMB guidance into their rulemaking policies, and the Office of Comptroller of the Currency and the Securities and Exchange Commission have done so. By not more closely following OMB's guidance, other financial regulators continue to miss an opportunity to improve their analyses.

Federal financial agencies continue to coordinate on rulemakings informally in order to reduce duplication and overlap in regulations and for other purposes, but interagency coordination does not necessarily eliminate the potential for differences in related rules. Agencies coordinated on 19 of the 54 substantive regulations that GAO reviewed. For most of the 19 regulations, the Dodd-Frank Act required the agencies to coordinate, but agencies also voluntarily coordinated with other U.S. and international regulators on some of their rulemakings. According to the regulators, most interagency coordination is informal and conducted at the staff level. GAO's review of selected rules shows that differences between related rules may remain even when coordination occurs. According to regulators, such differences may result from differences in their jurisdictions or the markets. Finally, the Financial Stability Oversight Council (FSOC) has not yet implemented GAO's previous recommendation to work with regulators to establish formal interagency coordination policies.

Most Dodd-Frank Act regulations have not been finalized or in place for sufficient time for their full impacts to materialize. Recognizing these and other limitations, GAO took a multipronged approach to assess the impact of some of the act's provisions and rules, with an initial focus on the act's systemic risk goals. First, GAO developed indicators to monitor changes in certain characteristics of U.S. bank holding companies subject to enhanced prudential regulation under the Dodd-Frank Act (U.S. bank SIFIs). Although the indicators do not identify causal links between their changes and the act--and many other factors can affect SIFIs--some indicators suggest that since 2010 U.S. bank SIFIs, on average, have decreased their leverage and enhanced their liquidity. Second, empirical results of GAO's regression analysis suggest that, to date, the act may have had little effect on U.S. bank SIFIs' funding costs but may have helped improve their safety and soundness. GAO plans to update its analyses in future reports, including adding indicators for other Dodd-Frank Act provisions and regulations.

Morgan Stanley & Massachusetts Settle Charges Related to Facebook IPO

The Massachusetts Securities Division fined Morgan Stanley $5 Million for investment banking’s allegedly improper influence over analysts in the Facebook IPO.  According to the consent order that Morgan Stanley entered into, the practices violated the undertakings made in the 2003 Analysts Settlement. (Download Dkt-2012-0042-Consent-Order)

FINRA Issues Guidance on Suitability Rule's Definition of "Customer" and "Investment Strategy"

FINRA issued further Guidance on FINRA's Suitability Rule (Regulatory Notice 12-55).  Its revised Rule 2111became effective in July 2012, and FINRA previously issued Regulatory Notice 12-25 to address frequently asked questions.  This most recent Notice addresses two issues:  the scope of the terms "customer" and "investment strategy."  FINRA has also created a suitability web page to consolidate information about the Rule.

SEC Approves FINRA Rule Change on Use of Subpoenas and Orders of Appearance in Arbitration

The SEC has approved a non-controversial FINRA rule change relating to the use of subpoenas and orders of appearance in arbitration proceedings.  Specifically, the rule change amends the Customer and Industry Codes of Arbitration Procedure (1) to provide that when FINRA member firms and/or
employees or associated persons of FINRA members who are parties to an arbitration (collectively, “Member Parties”) seek the appearance of witnesses by, or the production of documents from, FINRA members (and individuals associated with the member) who are not parties to the arbitration (collectively, “Non-Party Members”), FINRA arbitrators shall (unless circumstances dictate otherwise) issue orders for the appearance of witnesses or the production of documents, instead of issuing subpoenas; (2) to add procedures for any non-party (Non-Party Member or otherwise) receiving a subpoena to object to the subpoena; (3) to provide that if an arbitrator issues a subpoena to a Non-Party Member at the request of a Member Party, the Member Party making the request is (unless the panel directs otherwise) responsible for paying the reasonable costs of the appearance of witnesses by or the production of documents from the Non-Party Member; (4) to add procedures for any party to an arbitration to file a motion requesting arbitrators issue an order for the appearance of any employee or associated person of a FINRA member (collectively, “Associated Persons”) or the production of documents from such Associated Persons or members; (5) to add procedures for any party to an arbitration receiving a motion for an order and draft order to object to the order; (6) to add procedures for how the party to the arbitration that requested the order must serve the order (if issued); (7) to add procedures for any Non-Party Member receiving an order to object to the order; and (8) to add procedures for how parties to an arbitration must share documents received in response to an order issued to a Non-Party Member. ( Download 34-68404)

PCAOB Concerned About Deficiencies in Audits of Internal Controls over Financial Reporting

The Public Company Accounting Oversight Board today released a report summarizing inspection observations related to deficiencies in registered public accounting firms' audits of the internal control over financial reporting (ICFR) at public companies.  The report, "Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control over Financial Reporting," provides information about the nature and frequency of deficiencies in firms' audits of internal control over financial reporting detected during the PCAOB's 2010 inspections of eight domestic registered firms that have been inspected every year since the PCAOB inspection program began.

The report is based on PCAOB inspections that examined portions of approximately 300 such audits. It describes the most pervasive deficiencies identified in those audits and also includes information on the potential root causes of the deficiencies.

According to the Executive Summary:

The Board is concerned about the number and significance of deficiencies identified in firms' audits of internal control during the 2010 inspections, which generally involved reviews of the integrated audits of financial statements and internal control ("integrated audits") for issuers' fiscal years ending in 2009. This report describes the most pervasive deficiencies identified in firms' auditing of internal control during the 2010 inspections, and also includes information on the potential root causes of the deficiencies. Although not specifically described in this report, the Board is also concerned that the rate of these deficiencies increased during the Board's 2011 inspections. The Board emphasizes, however, that the findings described in this report should be considered against the broader background that, in many cases, the Inspections staff did not identify significant audit deficiencies in the portions of audits of internal control that were reviewed in 2010 and 2011, an encouraging fact that reflects well on the firms' ability to implement AS No. 5 appropriately when their engagement teams approach the issues properly.

The report is available at PCAOB's website.

FINRA Proposes to Allow Non-Party Associated Persons to Seek Expungement Relief

FINRA, at its December 2012 Board meeting, discussed several rulemaking items, including:

Expungement for Unnamed Persons in Arbitration Claims

The Board authorized FINRA to file a proposal with the SEC that establishes three different procedures that would permit registered persons who are identified for alleged sales practice violations in an arbitration claim, but are not named as parties in that claim (unnamed persons), to seek expungement relief. The unnamed person could seek relief under Rule 12805 by asking a party to the customer-initiated arbitration in writing to seek expungement on his or her behalf. Alternatively, the registered person could initiate In re proceedings under new Rule 13807 at the conclusion of the underlying customer-initiated arbitration case. Finally, the unnamed person could seek expungement relief at the conclusion of the customer’s case by asking the panel for an expungement based on the record compiled in the underlying case. The proposal incorporates many of the comments and suggestions received on Regulatory Notice 12-18, as well as feedback from several FINRA committees. FINRA believes that these proposals provide unnamed persons with a remedy to seek redress concerning allegations that could impact their livelihoods, yet maintains the protections of FINRA’s expungement rules to ensure the integrity of the CRD records.

 Conflicts of Interest Relating to Recruitment Compensation Practices

The Board authorized FINRA to seek comment in a Regulatory Notice on a proposed rule that would require a member firm that provides, or has agreed to provide, to a registered person enhanced compensation in connection with the transfer of employment (or association) of the registered person from another financial services firm (previous firm), to disclose the details of the enhanced compensation to any former customer of the registered person at the previous firm who is contacted about moving or moves their account to the new firm. The proposal would require such disclosure for one year following the date the registered person associates with the new firm. The proposed rule would not apply to enhanced compensation of less than $50,000 or to customers that meet the definition of an institutional account pursuant to FINRA Rule 4512(c), except any natural person or a natural person advised by a registered investment adviser.

Massachusetts Goes After Sales of Unregistered Oil& Gas Securities in its State

Investment News reports that Massachusetts filed fraud charges against two oil and gas operations that allegedly sold unregistered securities to Massachusetts investors.  In one case, Prodigy Oil and Gas allegedly sold at least $464,000 in unregistered securities to one investor and employed a cold-caller who had previously been found guilty of fraud.  Fraud charges against Synergy Oil and two of its executives allege the sale of $35,000 in unregistered securities to two investors.  Massachusetts Secretary William Galvin has been an outspoken critic of the crowdfunding exemption contained in the JOBS Act.  Inv News, Crowdfunding takes early hit in Massachusetts

FINRA Issues Guidance on Private Placement Rules

FINRA posted on its website Frequently Asked Questions About Sale of Private Placements under FINRA Rules 5122 and 5123.

NASAA Gears Up for Internet Fraud In Wake of JOBS Act Crowdfunding

According to the NASAA, "crowdfunding’s presence on the Internet has risen sharply in recent months in anticipation of rules to allow small businesses and entrepreneurs to raise investments online."  NASAA Sees Sharp Spike in Crowdfunding Presence on the Internet

An analysis of Internet domain names by state and Canadian securities regulators found nearly 8,800 domains with “crowdfunding” in their name as of November 30, 2012, up from less than 900 at the beginning of the year. Of these websites, about 2,000 contained content, more than 3,700 had no content and more than 3,000 appeared to be “parked” and serving as placeholders to reserve a domain name for later use or sale. Of the domains with “crowdfunding” in their name, about 6,800 have appeared since April, 2012 when the JOBS Act was signed into law.

The release goes on to say

Anticipating an increase in online fraud stemming in part from passage of the JOBS Act, NASAA created a task force on Internet fraud investigations shortly after the enactment of the JOBS Act to monitor crowdfunding and other Internet offerings. The group is currently coordinating multi-jurisdictional efforts to scan various online offering platforms for fraud, and, where authorized, will coordinate investigations into online or crowdfunded capital formation fraud.

SEC & FINRA Offer Suggestions on Year-End Investment Considerations

The SEC's Office of Investor Education and Advocacy and FINRA issued an Investor Alert to provide individual investors with a few suggestions for year-end investment planning, including

• Review your asset allocation
• consider rebalancing
• tax considerations
• check out your investment professiona
• locate your financial records.

Year-End Investment Considerations for Individual Investors

FINRA Charges President of TWS Financial with Affinity Fraud Directed at Polish Community

FINRA has filed a complaint against Roman Sledziejowski, President and owner of Brooklyn, NY-based brokerage firm TWS Financial, LLC, charging him with defrauding three customers of more than $4 million through a scheme, carried on primarily outside the securities firm, involving converting client funds to his personal use while providing falsified account statements to his customers. Sledziejowski, a Polish-born investment manager, and his firm TWS Financial, catered to the Polish investment community in Brooklyn, and all of his victims were natives of Poland. On November 9, 2012, TWS Financial filed an application to withdraw its broker-dealer registration.

In its complaint, FINRA alleges that between June 2009 and August 2012, as part of his scheme, Sledziejowski instructed the customers to wire funds from their bank accounts or brokerage accounts to Innovest Holdings LLC, a company wholly owned and controlled by Sledziejowski, separate from the broker-dealer, which, in turn, owned TWS, for various purported investment purposes, including acquiring a Polish bank and buying stock in a vodka company. In other instances, Sledziejowski wired funds directly from the customers' TWS brokerage accounts to Innovest Holdings without their knowledge or consent. In order to mask his misconduct, Sledziejowski provided customers with falsified account statements or "account snapshots," which were fictional accounts of their holdings in their TWS brokerage accounts or the values of those accounts. Additionally, when some of his customers raised questions about the value of their brokerage accounts or sought to withdraw funds from their accounts, Sledziejowski wired funds from Innovest's bank accounts back to their bank or brokerage accounts. To date, more than $3 million of the customers' funds remain unaccounted for. Sledziejowski also refused to comply with FINRA's request to appear for testimony to answer questions related to the misconduct in question.

Cantor Settles CFTC Charges for Allowing Customer Funds to Become Under-Segregated

The CFTC and Cantor Fitzgerald & Co. settled charges for failing to maintain sufficient funds in its customer segregation account for a period of three days, for failing to provide the CFTC timely notice of its under-segregation, as required, and for related supervisory failures. The CFTC order imposes a $700,000 civil monetary penalty and a cease and desist order on Cantor, and requires Cantor to undertake certain improvements to its internal controls to prevent future under-segregation violations and notification failures.

Cantor, as a registered FCM, is required to segregate customer funds from its own funds and on a daily basis compute the amount of customer funds required to be segregated. The CFTC order finds that, on three consecutive days, January 24 to January 26, 2012 (the “relevant period”), Cantor failed to maintain adequate segregated customer funds due to an inadvertent transfer of $3 million from its customer segregated funds account, instead of from Cantor’s house account, as intended. According to the order, on each of the three days, Cantor made the daily required computation to determine the amount of customer funds it needed to be on deposit to meet its segregation requirements. However, Cantor failed to realize it was under-segregated until January 27, 2012, when the Cantor operations department employee primarily responsible for determining Cantor’s daily segregation requirements returned to work after being out unexpectedly. The Cantor operations department immediately corrected the segregation deficiency and the firm came back into compliance with its segregation requirements by transferring the $3 million back into the customer segregated funds account.

The order also finds that Cantor had related supervisory failures by not having an adequate system of internal controls and procedures to ensure that daily segregation calculations were reviewed and deficiencies noted, appropriately escalated, and addressed. Cantor also lacked sufficient procedures and training concerning the regulatory requirements relating to segregation of customer funds and failed to have adequate procedures and controls relating to the transfer of funds to and from customer segregated funds accounts.

New York Sues Credit Suisse For Misrepresentations about Residential Mortgage-Backed Securities

The New York AG filed a Martin Act complaint against Credit Suisse Securities (USA) LLC and its affiliates for making fraudulent misrepresentations and omissions to promote the sale of residential mortgage­-backed securities (RMBS) to investors.

According to the complaint, Credit Suisse deceived investors as to the care with which they evaluated the quality of mortgage loans packaged into residential mortgage-backed securities prior to 2008. RMBS sponsored and underwritten by Credit Suisse in 2006 and 2007 have suffered losses of approximately $11.2 billion. Credit Suisse led its investors to believe that the quality of the loans in its mortgage-backed securities had been carefully evaluated and would be continuously monitored. In fact, it failed to adequately evaluate the loans, ignored defects that its limited review did uncover, and kept its investors in the dark about the inadequacy of its review procedures and defects in the loans. The loans in Credit Suisse’s mortgage-backed securities included many that had been made to borrowers who were unable to repay the loans, were very likely to default, and ultimately did default in large numbers.

This complaint is the most recent enforcement action by the Residential Mortgage-Backed Securities Working Group, a state-federal task force created by President Obama earlier this year to investigate those responsible for misconduct contributing to the financial crisis through the pooling and sale of residential mortgage-backed securities.

Bank of New York Mellon "Feeder Fund" Settles Charges Relating to Madoff

A Bank of New York Mellon unit, Ivy Asset Management, will pay $210 million to settle claims that it concealed its doubts about Bernard Madoff's business operations.   This resolves litigation brought by the New York AG, the U.S. Dept of Labor and investors.  Ivy was a "feeder fund" that directed clients' funds to Madoff.  According to the New York AG's press release:

Internal Ivy documents reveal the firm’s deep but undisclosed reservations about Madoff. One email from an Ivy principal to his subordinate stated: "Ah, Madoff, you omitted one possibility - he’s a fraud!"
 
Despite its reservations, Ivy did not disclose its suspicions to clients for fear of losing the fees Ivy received through the Madoff investments. Instead, it falsely told them that "we have no reason to believe there is anything improper in the Madoff operation," and that Ivy's only concern about Madoff was the difficulty of managing the enormous pool of assets he had under management.

 New York AG, A.G. Schneiderman Obtains $210 Million Settlement With IVY Asset Management In Connection With Madoff Ponzi Scheme

FSOC Issues Proposed Recommendations for Money Market Fund Reform

The Financial Stability Oversight Council issued proposed recommendations calling for additional regulation of money market mutual funds for public comment.  The Council issued three alternatives for consideration:

•Alternative One: Floating Net Asset Value.  Require MMFs to have a floating net asset value (“NAV”) per share by removing the special exemption that currently allows MMFs to utilize amortized cost accounting and / or penny rounding to maintain a stable NAV.  The value of MMFs’ shares would not be fixed at $1.00 and would reflect the actual market value of the underlying portfolio holdings, consistent with the requirements that apply to all other mutual funds.

•Alternative Two: Stable NAV with NAV Buffer and “Minimum Balance at Risk.”  Require MMFs to have an NAV buffer with a tailored amount of assets of up to 1 percent to absorb day-to-day fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a stable NAV.  The NAV buffer would have an appropriate transition period and could be raised through various methods.  The NAV buffer would be paired with a requirement that 3 percent of a shareholder’s highest account value in excess of $100,000 during the previous 30 days — a minimum balance at risk (MBR) — be made available for redemption on a delayed basis.  Most redemptions would be unaffected by this requirement, but redemptions of an investor’s MBR itself would be delayed for 30 days.  In the event that an MMF suffers losses that exceed its NAV buffer, the losses would be borne first by the MBRs of shareholders who have recently redeemed, creating a disincentive to redeem and providing protection for shareholders who remain in the fund.  These requirements would not apply to Treasury MMFs, and the MBR requirement would not apply to investors with account balances below $100,000. 

•Alternative Three: Stable NAV with NAV Buffer and Other Measures.  Require MMFs to have a risk-based NAV buffer of 3 percent to provide explicit loss-absorption capacity that could be combined with other measures to enhance the effectiveness of the buffer and potentially increase the resiliency of MMFs.  Other measures could include more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements. The NAV buffer would have an appropriate transition period and could be raised through various methods.  To the extent that it can be adequately demonstrated that more stringent investment diversification requirements, alone or in combination with other measures, complement the NAV buffer and further reduce the vulnerabilities of MMFs, the Council could include these measures in its final recommendation and wouldreduce the size of the NAV buffer required under this alternative accordingly.

The Council’s proposed recommendations are not mutually exclusive and could be implemented in combination to address the structural vulnerabilities that result in the susceptibility of MMFs to runs.  The Council also is seeking public comment on other potential reforms of MMFs that meet the objectives of addressing the structural vulnerabilities inherent in MMFs and mitigating the risk of runs. 

The public comment period will run for 60 days.

FINRA Increases Transparency in the TBA Market for Agency Pass-Through Mortgage-Backed Securities

FINRA announced that it "significantly increased transparency" in the "To-Be-Announced" (TBA) market for agency pass-through mortgage-backed securities. This market represents more than $270 billion traded on an average daily basis in 8,400 trades. Through the Trade Reporting and Compliance Engine (TRACE), FINRA has begun disseminating TBA transaction information, including the CUSIP, time of transaction, price, size and other related information.

In addition to the TBA market, the SEC approved a FINRA proposal to publicly disseminate transaction information in agency pass-through mortgage-backed securities traded "specified." This market represents approximately $19 billion traded on an average daily basis in 3,000 trades. FINRA will announce the effective date of this proposal in a forthcoming Regulatory Notice. Together, the market for agency pass-through mortgage-backed securities traded TBA and specified represent more than 93 percent of par value traded in all asset- and mortgage-backed securities.

TRACE was established in July 2002 to create a regulatory database and bring transparency to the corporate bond market.

 

 

FINRA Expels Hudson Valley Capital Management & Bars CEO for Defrauding Clearing Firm and Customers

FINRA has expelled NY-based Hudson Valley Capital Management and barred Chief Executive Officer, Mark Gillis, from the securities industry for defrauding its clearing firm and customers by using their funds and securities to cover losses caused by Gillis' manipulative day trading.

FINRA found that in 2012, Hudson Valley, acting through Gillis, used the firm's Average Price Account to improperly day trade millions of dollars of stock. Gillis then manipulated the share prices of these stocks and withdrew the proceeds of his day trading through accounts he controlled. When Gillis' fraudulent trading caused significant losses in the firm's account, he covered those losses by making unauthorized trades involving customer accounts. Gillis purchased thousands of shares of securities in the open market in the firm's account and allocated these shares to customers at markups between 177 percent and 280 percent. Gillis also converted a customer's funds to pay for an unauthorized stock purchase and caused another customer to sustain a loss of approximately $400,000. When confronted about unauthorized trades that occurred in their accounts, Gillis lied to two customers about the transactions to hide his misconduct, and lied to FINRA staff during sworn testimony.

Gillis' scheme caused a net capital deficiency for Hudson Valley in excess of $350,000.

 

Chamber to Geithner: Don't Mess with Money Market Funds

The U.S. Chamber of Commerce, in a letter to Treasury Secretary Timothy Geithner, expressed its concern about Treasury's request that the Financial Stability Oversight Council (FSOC) use its authority, under Dodd-Frank 120, to recommend changes to the SEC's regulation of money market funds.  Such action would, it warns, "create uncertainty, weaken financial regulation, harm investors, and damage the capital formation process needed for businesses to grow and create jobs."

The Chamber faults the SEC for "failing to do any of the necessary work to study the impact of prior money market mutual fund reforms and identify any additional needed changes."   The Chamber requests that Treasury withdraw its request and instead encourage the SEC to consider a different approach.  The Chamber understands that the SEC is moving forward with a study of the impact of the 2010 reforms.   Only after completion of that study and any proposed course of action by the SEC should the Council consider using its authority under Dodd-Frank 120.

Download Chamber letter to Geithner[1]