Wednesday, October 27, 2010

CFTC Unveils New Rules for Market Manipulation

Now that the dust has settled from the passing of Dodd-Frank, federal agencies are beginning the arduous task of complying with its laundry list of new provisions, which require various rulemakings and studies to be completed over the next year. The Commodities Futures Trading Commission is no exception.

The CFTC is currently working on rulemaking in 30 different topic areas. The most recent rule proposals were announced Tuesday, October 26, 2010. The new rules are focused on preventing manipulative and disruptive trading in commodities markets, such as precious metals, natural gas, and agricultural products.

The CFTC’s new rules regarding market manipulation create a new prohibition that bans all fraud-based market manipulation derived from “intentional and reckless conduct” that deceives or defrauds market participants, including making false or misleading statements of material facts, omitting material facts, and knowingly providing false or misleading information regarding crops or conditions that affect commodities. According to Commissioner Bart Chilton, the new rule is intended to be a “broad, catch-all” for violations that would otherwise fall through the existing “gaps” in market manipulation rules.

Currently, there is a four-prong test for manipulation that requires (1) showing that prices were outside the bounds of normal supply and demand (i.e. “artificial”), (2) proving that the actor has the ability to cause an “artificial price”, (3) showing that the actor took actions to cause the artificial price, and (4) that those acts be intentional.

On its face, the new rule language lowers this existing standard for proving manipulation from specific intent to recklessness. The penalties include a $1 million fine or triple the monetary gain, whichever is greater, and restitution to customers.

If approved, the proposed rules will expand the CFTC’s authority to the OTC market. These rules come partly in response to the recent allegations of manipulation in the silver market. (The CFTC announced that it would release more information on its investigation soon.) Although partially aimed at the OTC precious metals markets, the proposed rules are not intended to reach into retail OTC precious metals transactions.

The comment period for the new rules will be open for 60 days.

Friday, October 22, 2010

FINRA Issues Regulatory Notice on Sales Practices for Commodity Futures-Linked Securities

On October 20, 2010, FINRA issued Regulatory Notice 10-51 regarding sales practice obligations for commodity futures-linked securities. FINRA notes that in recent years, securities that offer exposure to commodities have become increasingly popular to retail investors - presumably due to a low correlation with other asset classes and enhanced portfolio diversification. FINRA notes that commodity futures-linked securities can be an effective tool for gaining exposure to this asset class that in some cases can be difficult for investors to access.

FINRA recognizes, however, that in some cases the performance of the commodity futures-linked security can deviate significantly from the performance of the referenced commodity. This deviation can produce unexpected results for investors who are not familiar with futures markets, or who mistakenly believe that commodity futures-linked securities are designed to track commodity spot prices (i.e., the immediate delivery value of the commodity).

Therefore, FINRA issued Regulatory Notice 10-51 to remind firms that offer commodity futures-linked securities that they must ensure that communications with the public about these securities are fair and balanced, that recommendations to customers are suitable, and that their registered representatives adequately understand and are able to inform their customers about these securities before they recommend them. FINRA notes that under NASD Rule 2210, firms must ensure that all communications with the public are fair and balanced, and provide a sound basis for evaluating the facts about any particular security or type of security, industry or service.

FINRA states that firms should not suggest that a commodity-futures linked security offers direct exposure to the commodity's spot price, overstate the degree of correlation between the the spot price and the commodity-futures linked security, or understate the risks inherent in investing in commodity futures. Firms should also not overstate the hedging value value of commodity futures-linked products, or commodities generally, for, by example, implying that their performance is always negatively correlated with equities or other asset classes. That a prospectus may convey such information does not excuse the firm's duty to ensure that its communications regarding the product are fair, balanced and not misleading.

Moreover, FINRA notes that NASD Rule 2310 requires that, before recommending the purchase, sale or exchange or a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer. For commodity futures-linked securities, the registered representative and retail customer should discuss, among other things:
  • The commodity, basket of commodities or commodities index that a given product tracks;
  • The product's goals, strategy and structure;
  • That commodities prices, and the performance of commodity futures-linked securities, can be volatile;
  • That the use of futures contracts can affect the performance of the product as compared to the performance of the underlying commodity or index;
  • The product's methodology, including its strategy, if any, for managing roll yield and other factors that may affect performance; and
  • The product's tax implications. (Commodity pools have different tax implications than mutual funds or exchange-traded notes.)
In sum, due to the volatility of commodities prices and, correspondingly, the performance of commodity futures-linked securities, and due to the prospect that commodity futures-linked securities may produce unexpected results for investors who are not familiar with futures markets, firms should take the necessary precautions to ensure that the sales of commodity futures-linked securities comply with federal securities laws and FINRA rules. A complete copy of Regulatory Notice 10-51 can be found here.

Tuesday, October 19, 2010


On October 14, 2010, the U.S. Department of Labor issued a final rule requiring the disclosure of certain plan and investment-related information, including fee and expense information, to participants and beneficiaries in participant-directed individual account plans (e.g., 401(k) plans). The regulation is intended to help ERISA plan participants better manage their retirement savings by ensuring that they have the information they need to make informed decisions about their investments.

The Department of Labor estimates that 72 million people are invested in participant-directed retirement plans nationwide, compiling a total of nearly $3 trillion in assets. A “participant-directed plan” is one that provides for the allocation of investment responsibilities to participants or beneficiaries. While participants in these plans are responsible for making their own investment decisions, “current law does not require that all workers be given the information they need to make informed investment decisions or, when information is given, that it is furnished in a user-friendly format.” This is particularly true with respect to the fees and expenses associated with certain investment choices.

The final rule aims to assist plan participants in this regard, and will impact plan sponsors, fiduciaries, participants and beneficiaries, as well as the service providers of such plans. To be sure, the final rule provides that when a plan allocates investment responsibilities to participants or beneficiaries, the plan administrator must take steps to ensure that such participants and beneficiaries (1) are made aware of their rights and responsibilities with respect to the investment of their assets, and (2) are provided sufficient information regarding the plan and the plan's investment options to make informed decisions with regard to the management of their individual accounts. The plan administrator must also provide each participant with certain plan-related and investment-related information.

In addition, the final rule provides that the investment of plan assets is governed by the fiduciary duties set forth within ERISA Section 404(a)(1)(A)-(B), which require plan fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficiaries. Accordingly, the regulation requires plan fiduciaries to:

• Provide plan participants with quarterly statements of plan fees and expenses deducted from their accounts;

• Provide plan participants with core information about investments available under their plan, including the cost of these investments;

• Use standard methodologies when calculating and disclosing expense and return information to achieve uniformity across the spectrum of investments that exist in plans;

• Present the information in a format that makes it easier for plan participants to comparison shop among the plan's investment options; and

• Provide plan participants with access to supplemental investment information in addition to the basic information required under the final rule.

A complete copy of the final rule can be found here. In addition, for a concise overview of the final rule, please click here.

Tuesday, October 12, 2010

NASAA Identifies Top Broker-Dealer Compliance Issues

The North American Securities Administrators Association (NASAA) identified the top compliance deficiencies and offered a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures. The securities examiners from 30 states provided information to compile the report. These examinations took place between January 1, 2010, and June 30, 2010.

The examinations focused on number of different areas: Sales Practices, Supervision, Operations, Books & Records, and Registration/Licensing. From the 290 examinations reported, 567 deficiencies were found. The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies). The top five deficiencies were: 1)failure to follow written supervisory policies and procedures (57 instances), 2) advertising and sales literature (46 instances), 3) variable product suitability (38 instances), 4) maintenance of customer account information (37 instances), and 5) suitability (34 instances).

Based on the examinations project, the NASAA produced a list of best practices:
  1. Develop effective standards and criteria for determining suitability.
  2. Ensure that exception reports are generated when necessary and that “red flags” are documented and resolved in a timely manner. If the BD elects to electronically recreate an exception report, the BD must not only be able to recreate the report but also document how the exception was resolved.
  3. Develop, update and enforce written supervisory procedures. BDs should also ensure that staffing and expertise are commensurate with the size of the BD and type(s) of business engaged in by the firm.
  4. Develop a branch audit program that includes a meaningful audit plan, unannounced visits, a means to convey audit results and a follow-up plan for requesting that the branch take corrective action.
  5. Firms must ensure that adequate procedures are in place to prohibit and detect unauthorized private securities transactions (selling away). If this activity is permitted, the firm’s written supervisory procedures should be adequate to monitor this activity on an ongoing basis.
  6. Outside business activity requests from registered representatives must be received and reviewed by the firm prior to the activity. The firm and its registered representatives are obligated to report the outside business activity on the representative’s Form U-4. The firm should have a supervisory procedure in place to address its approval/denial process.
  7. Advertisements and sales literature must be balanced, make full and fair disclosure, and be approved, as necessary, prior to use.
  8. Seminar notices/advertisements, seminars and seminar materials utilized must be approved by the BD prior to use and the seminar being held. Additionally, any guest speakers and their materials must also be reviewed and approved prior to the seminar. In instances where registered representatives routinely conduct seminars, a supervisory representative of the firm should randomly attend the seminar for compliance purposes.
  9. Correspondence, both electronic and hard copy, must be effectively monitored by the BD including a system of capturing and maintaining e-mails sent by registered representatives from websites and Internet Service Providers outside the firm.
  10. Upon receipt of a complaint, the firms must acknowledge receipt, update the registered representative’s Form U-4, if required, and conduct and document a thorough review of the customer’s allegations. In situations where the firm discovers wrongdoing, the firm should redress customer harm. Failure to do so may result in enhanced penalties under NASAA guidelines.
The NASAA press release announcing the 2010 Broker-Dealer Coordinated Examination Report can be found here.

Congress Listening to Cosgrove Law, LLC Blog: Repeals Provision in Dodd-Frank

In an August 2, 2010 blog, our firm’s fearless leader, David B. Cosgrove, wrote about the SEC’s stingy grants to information requests pursuant to the Freedom of Information Act (“FOIA”). Our firm takes the stance that industry confidential information is certainly worth protecting, but protecting it cannot go so far as to enfeeble the right to access provided by the FOIA. Well, it seems the Senate is finally taking heed and agreeing with us.

On Wednesday, September 22, 2010, the Senate Judiciary Committee unanimously approved a bill (S. 3717) that repeals Section 929I, of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”), which permits the SEC to withhold certain records from the public. The House concurred the following day and the legislation is awaiting signature from President Obama.

Section 929I states that the Securities and Exchange Commission (“SEC”) cannot be compelled by FOIA requests to disclose records or other information obtained from its registered entities if this information is used for “surveillance, risk assessments, or other regulatory oversight activities” as defined by the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1941.

Proponents of Section 929I fought to keep this language in the Act and justified their position by stating that the Act’s language codified existing practice and was intended to guarantee that certain protections already given to financial institutions will be extended to other types of entities.

However, the Senate stated that it voted to repeal this Section in order to “restore stability and accountability to [the] financial system.” The Senate further justified its action by stating that exemptions to the FOIA’s disclosure requirements should be narrowly applied to uphold the public interest is transparency and accountability. Cosgrove Law, LLC is excited that the Senate has finally tuned into its blog and is taking it seriously.

Friday, October 1, 2010

FINRA Proposes to Make Option of All Public Arbitration Panels Permanent

On September 28, 2010, FINRA announced that it will file a rule proposal with the SEC next month that would allow all investors filing arbitration claims to have the option of an all-public arbitrator panel. Currently under FINRA Rule 12401, on claims greater than $100,000 there are three arbitrators. Under FINRA Rule 12402, if the panel consists of three arbitrators, one will be a non-public arbitrator and two will be public arbitrators. The revised rule will allow the investor filing the arbitration to select the option of having an all-public arbitration panel.

This rule proposal will expand to all investors a two year FINRA pilot program that has provided for investors filing an arbitration claims against certain firms the option of choosing the all-public panel of arbitrators. FINRA Chairman and Chief Executive Richard Ketchum stated that "Giving each individual investor the option of an all-public panel will enhance confidence in and increase the perception of fairness in the FINRA arbitration process[.]" FINRA notes that since the program began in October 2008, of the 560 cases given the power to eliminate all non-public arbitrators only 50% have elected to do so.

The effect on the results of arbitration due to having all-public arbitration panels is yet to be determined. FINRA spokesman Nancy Condon said that among the small sample size of 17 cases heard by all-public panels, investors were awarded damages 71 percent of the time. The Reuters story containing the quote from FINRA spokeswoman Nancy Condon can be found here. FINRA reports that of the 555 arbitration cases heard and decided through August of 2010, 279 of the cases (approximately 50%) resulted in cases where the customer received damages. The FINRA dispute resolution statistics can be found here.

The FINRA news release announcing the rule change can be found here.