Wednesday, November 25, 2009


The SEC and CFTC recently issued two joint orders related to securities-based futures contracts which went into effect on November 17 and November 19, 2009, respectively. As the recent SEC press release explains, “[t]he first joint order excludes certain foreign and domestic volatility indexes that are based on broad-based security indexes from the definition of "narrow-based security index". As a result of the joint order, futures on foreign and domestic volatility indexes that meet the criteria contained in the joint order are treated as "broad-based security indexes" and subject to the exclusive jurisdiction of the CFTC. Options on such volatility indexes are subject to the federal securities laws and the jurisdiction of the SEC…The second joint order allows security futures products to be based on any security that is eligible to underlie an exchange-listed security option, including certain unregistered debt securities.”

The joint orders are consistent with the Joint Report of the SEC and CFTC on Harmonization of Regulation issued on October 16, 2009, which assessed problems with the current regulatory schemes of the two agencies. Specifically, the Joint Report identified significant differences between securities markets and futures markets, and recommended legislative and regulatory actions to address the inconsistencies.

A complete copy of the joint order that went into effect on November 17, 2009 can be found here. A copy of the November 19, 2009 joint order can be found here.

Tuesday, November 24, 2009


The SEC's Office of Inspector General (OIG) issued a report making recommendations to improve the Office of Compliance Inspections and Examinations’ (OCIE) process for selecting investment advisers and investment companies for examination. The report focused on the reasons OCIE did not perform an examination of Bernard Madoff Investment Securities, LLC’s (BMIS) investment advisory business soon after the firm registered as an investment adviser in 2006.

The OIG noted that OCIE’s practice is to assign each registered investment adviser a “low,” “medium,” or “high” risk rating, which is initially based on each adviser’s response to certain questions in Part 1 of the Uniform Application for Investment Adviser Registration (Form ADV). When BMIS registered as an investment adviser in 2006, BMIS was classified as “medium risk,” based on its answers to the questions provided on its Form ADV Part 1. BMIS filed two subsequent Form ADVs in 2007 and 2008. Each of the three Form ADVs received by the Commission resulted in BMIS being assigned a “medium risk” designation in 2006, 2007, and 2008. The OIG found that only firms categorized as “high risk” trigger routine OCIE examinations within three years of receiving the “high risk” rating.

The OIG found that a contributing factor to OCIE’s failure to conduct an examination of BMIS’s advisory business was Enforcement’s and OCIE’s broker-dealer examination unit’s failure to communicate with OCIE’s investment adviser unit. An OCIE Branch Chief testified that BMIS might have been subject to a “cause exam” immediately after it registered had the investment adviser examination staff been informed that Madoff had made misrepresentations to Enforcement and OCIE broker-dealer examination staff.

The OIG also found that OCIE’s risk rating process did not adequately weigh an investment adviser’s level of assets under management and the number of clients that receive investment advisory services. The OIG’s belief is that advisers with more assets under management and more clients who receive advisory services should receive progressively higher risk scores.

The report presents 11 specific recommendations designed to improve OCIE’s process for selecting investment advisers and investment companies for examination:

1. OCIE should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.

2. OCIE should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.

3. The Division of Enforcement and OCIE should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.

4. OCIE should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.

5. When the OCIE becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.

6. OCIE should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.

7. OCIE should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.

8. OCIE should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.

9. OCIE should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV: Performance information; A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities; A hedge fund’s current auditor and any changes in the auditor; and the auditor’s opinion of the firm.

10. The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with OCIE and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.

11. OCIE should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.

A complete copy of the OIG's report can be found here.

Wednesday, November 18, 2009


By Executive Order dated November 17, 2009, President Obama established a new interagency Financial Fraud Enforcement Task Force (“Task Force”). The Task Force, led by the Department of Justice and chaired by Attorney General Eric Holder, will work with state and local law enforcement agencies to strengthen efforts to “investigate and prosecute significant financial crimes and other violations relating to the current financial crisis and economic recovery efforts, recover the proceeds of such crimes and violations, and ensure just and effective punishment of those who perpetrate financial crimes and violations.”

In particular, the Task Force will serve the following functions:

(1) Provide advice to the Attorney General for the investigation and prosecution of financial fraud and other financial crimes and violations;

(2) Make recommendations to the Attorney General for action to enhance cooperation among all levels of government responsible for the investigation and prosecution of significant financial crimes and violations; and

(3) Coordinate law enforcements operations with representatives of State, local, tribal and territorial law enforcement.

Robert S. Khuzami, Director of the Division of Enforcement for the SEC, acknowledged that the Task Force will help the government “mount an even better-organized and more collaborative response to the pain and losses caused by the financial crisis.” He also noted that “[t]he creation of the Task Force occurs at a time that we at the SEC have taken a series of steps to optimize our effectiveness. These will make us an even more effective partner to other Task Force members.

The creation of the Task Force is yet another example of the combined efforts by federal, state and local agencies to aggressively combat financial fraud and other wrongdoings, and to provide investors and the public with a more stable financial system to help prevent another financial meltdown.

In accordance with the terms of Obama’s Executive Order, the Attorney General will convene the first meeting of the Task Force within the next 30 days. A copy of the Order can be found here.

Sunday, November 15, 2009


The anticipated escalation of securities and investment fraud cases prompting criminal charges got off to an unexpected start with the acquittal of two Bear Stearns hedge fund managers last week. Regardless, financial industry members and their attorneys should continue to defend civil investigations and suits and administrative actions with an eye on the possibility of an indictment. Administrative enforcement personnel are in constant referral contact with criminal enforcement agencies such as the US Postal Service and the FBI. It is still all too common for either pro se defendants or targets, or defendants with counsel lacking financial or white-collar defense experience, to "T-up" a criminal prosecution by blindly participating in, or refusing to participate in, a civil or administrative action. Of course, in some cases, such as the Rothstein case coming out of Ft Lauderdale this month, the civil defendant and FBI target would have to be utterly clueless not to contemplate the advent of an indictment. But as the line between civil and criminal cases becomes less clear, and the public and political pressure to bring criminal cases persists, the brazen attorney or arrogant defendant may be in for a rude surprise.

Litigating a civil matter with an eye towards a potential criminal case is not an easy task. For example, asserting the privilege against self-incrimination in a civil or administrative matter is not without significant consequence, but the cost-benefit analysis of such an invocation should be evaluated and given serious and learned consideration. On the other hand, certain conduct in a civil matter--such as a lack of cooperation, witness tampering, or continuing on with the very conduct the regulator considers illegal--may frustrate the regulator or civil litigant to the point of seeking the involvement of a criminal enforcement agency. There are dozens of such points of decision or strategy during the course of any civil investigation or litigation. As such, there are seldom clear answers or boilerplate strategies. But the odds of making it through the treachery without blowing up yourself (or your client)are pretty slim if you don't even realize you are walking through a legal minefield. Remember, even an acquittal is only partial solace and seldom redemtive. The months of stress and distraction, public disgrace and incredible financial burden are not cured by the rare acquittal garnered by the Bear Stearns defendants. The line between civil and criminal investment or securities fraud is in the eyes of the beholder, and the beholder is the government until the case is submitted to the jury.

Thursday, November 5, 2009


On November 3, 2009, the Financial Planning Coalition sent a letter to members of the House Financial Services Committee expressing the Coalition's concern regarding an amendment to the Investor Protection Act of 2009 (“IPA”), which was passed by the Committee on October 25, 2009. The amendment would extend FINRA’s authority to cover investment advisors who are associated with broker-dealers already under FINRA’s authority.

The Coalition, made up of the Certified Financial Planner Board of Standards, Inc., the Financial Planning Association, and the National Association of Personal Financial Advisors, is concerned with how the amendment extends FINRA’s authority to approximately 88 percent of investment adviser representatives and implicates application of the fiduciary duty to investment advice. The members and stakeholders of the Coalition’s respective organizations believe that the issue warrants greater deliberation and through the letter are urging the committee to conduct a more thorough examination before allowing the delegation of authority from the SEC to FINRA, a self-regulatory organization ("SRO") that has no experience overseeing advisers or enforcing the provisions of the Investment Advisers Act of 1940.

The Coalition believes that the amendment would be inconsistent with the Committee’s intent with respect to the IPA because, among other things, the Committee has already approved an amendment that would change the assets under management threshold for SEC registration of advisers which would shift responsibility for the oversight of some 4,200 advisers from the SEC to the states, freeing up substantial SEC resources to enhance oversight of advisers under its jurisdiction. Moreover, the IPA allows the SEC to collect user fees from advisers to cover the costs of compliance examinations. This, along with the IPA’s authorization for a doubling of the SEC’s budget over the next five years and the shifting of the oversight burden to the states, would provide the SEC the funding necessary to oversee advisers.

The Coalition also states that the SEC is more appropriate as a primary regulator for advisers for several reasons. First, the SEC has been overseeing advisers for seven decades under a principles-based approach designed to regulate those providing advice, while FINRA has no experience in regulating investment advice. FINRA’s rules-based regulatory approach and focus, while fine for the brokerage community, is not readily adaptable to advisers. Moreover, FINRA oversight of advisers who are associated with broker-dealers would create a new, parallel system of regulation for advisers. The Coalition argues that this could create a new opportunity for regulatory arbitrage, with advisers and brokers making decisions on their business models based on a preferred regulatory model. Finally, FINRA is an SRO comprised of broker-dealers and would be inclined to bring a broker’s perspective to adviser regulation. The Coalition believes that this conscious or subconscious conflict of interest could result in a broker bias in FINRA oversight of advisers, and otherwise increase the differences in how broker-associated advisers are regulated versus independent advisers.

A copy of the Coalition's letter to the House Financial Services Committee can be found here.