Tuesday, March 30, 2010

FINRA Statutory Disqualification, Regulatory Notice 09-19 and the Effect of a Registration Application with the Florida Office of Financial Regulation

In July 2007 the Financial Industry Regulatory Authority (FINRA) was created through the consolidation of the National Association of Securities Dealers (NASD) and the member regulation, enforcement and arbitration functions of the New York Stock Exchange (NYSE). FINRA became the largest independent regulator for all securities firms doing business in the United States, and is responsible for overseeing brokerage firms, their branch offices and registered securities representatives.

Under the Securities Exchange Commission’s authority FINRA promulgates rules of its own as a self regulatory organization (“SRO”). Pursuant to FINRA’s By-Laws (and the By-Laws of the NASD and the NYSE before it) a person may be disqualified from membership. A person disqualified from membership would be prohibited from participation in the securities industry. As part of the consolidation of the regulatory functions of the NASD and the NYSE in the formation of FINRA, in July 2007 FINRA adopted a revised version of the NASD’s definition of disqualification contained in its By-Laws such that any person subject to a statutory disqualification under the Securities Exchange Act Section 3(a)(39) also is subject to disqualification under FINRA’s By-Laws.

Prior to the amendment, the NASD’s By-Laws listed some, but not all, of the grounds for statutory disqualification contained in Exchange Act Section 3(a)(39). However, after the amendment to the NASD’s then existing By-Laws, FINRA’s By-Laws provided that: “A person is subject to a ‘disqualification’ with respect to membership, or association with a member, if such person is subject to any ‘statutory disqualification’ as such term is defined in Section 3(a)(39) of the [Securities Exchange Act of 1934].”

As a consequence of this amendment to the By-Laws, the revised definition of disqualification incorporated three additional categories of statutory disqualification which previously did not exist. One of those additional categories of disqualification comes from the Sarbanes-Oxley Act. Section 604 of the Sarbanes-Oxley Act expanded the definition of statutory disqualification under the Securities Exchange Act of 1934 by creating Exchange Act Section 15(b)(4)(H) and then incorporating it into Exchange Act Section 3(a)(39). As a result of this change, statutory disqualification under Exchange Act Section 15(b)(4)(H) includes a person that:

is subject to any final order of a State securities commission (or any agency or officer performing like functions), State authority that supervises or examines banks, savings associations, or credit unions, State insurance commission (or any agency or office performing like functions), an appropriate Federal banking agency (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813(q))), or the National Credit Union Administration, that --
1. bars such person from association with an entity regulated by such commission, authority, agency, or officer, or from engaging in the business of securities, insurance, banking, savings association activities, or credit union activities; or
2. constitutes a final order based on violations of any laws or regulations that prohibit fraudulent, manipulative, or deceptive conduct.
The revised definition of statutory disqualification became effective as of July 2007. The effect of the revised definition would have been the immediate disqualification of a large number of individuals subject to the new categories of disqualification. In order to remain in the securities industry, these individuals would have had to utilize the then existing NASD eligibility proceedings for persons subject to disqualification; i.e. NASD Rule 9520.

In order to avoid this result, the NASD requested that the Securities Exchange Commission Staff not recommend enforcement action to the Commission under Exchange Act Section 15A(g)(2) or Rule 19h-1(a) for those persons subject to the new definition of disqualification until the NASD could update and improve its eligibility proceedings to address the changes to the definition of statutory disqualification. As a result, the SEC, by Chief Counsel Catherine McGuire, issued a No Action Letter on July 27, 2007, informing the NASD that it would not seek enforcement against the individuals subject to the new categories of statutory disqualification if NASD did not file notice with the Commission for enforcement between the time the amended By-Laws containing the revised definition of statutory disqualification became effective and the effective date of the revised eligibility procedures. This would mean that those persons subject to the revised definition could continue membership in FINRA without going through the application process for eligibility pending the adoption of the revised eligibility procedures.

In or about April 2009, FINRA released Regulatory Notice 09-19 which set forth the amendments to FINRA Rule 9520 Series to become effective June 15, 2009. The revised FINRA Rule 9520 Series established procedures applicable to firms and associated persons subject to the additional statutory disqualifications as a result of the adoption of the revised definition of disqualification. Under this new construct of the Rule 9520 Series, individuals subject to one of the additional categories of disqualification would need to seek FINRA’s approval to enter or remain in the securities industry by way of an application with FINRA’s Department of Registration and Disclosure (“RAD”) only under certain circumstances. The need to file an application depends on 1) the type of disqualification; 2) the date of the disqualification; and 3) whether the firm or individual was seeking admission, readmission or continuance in the securities industry.

There are likely four different ways that a member of FINRA would know that they are required to file an application with RAD as a result of the application of revised Rule 9520 Series to an order of a state securities commission. First, Regulatory Notice 09-19 states that as of June 15, 2009, FINRA began reviewing its records to identify persons that met any of the additional conditions that would require the filing of an application under the revised Rule 9520 Series. In what manner FINRA has undertaken this review is unknown. Second, an individual could identify on their own that they are subject to an existing order which would require an application with RAD.

Third, if someone is seeking to transfer their registration to a new broker-dealer, then any existing state orders which would require an application with RAD as a result of the revised Rule 9520 Series would be disclosed by the CRD (the central licensing and registration system for the U.S. securities industry and its regulators) when it is reviewed by FINRA. Fourth, if an individual is subject to a new order of a state regulator, then an alert is sent out to all other state regulators as well as FINRA through the CRD. Whether and in what manner FINRA reviews each alert it receives in order to decide to take action against an individual subject to an order of a state securities commission is unknown.

For those subject to a statutory disqualification arising from orders specified in Exchange Act Section 15(b)(4)(H)(i) and Exchange Act Section 15(b)(4)(H)(ii), the following is an outline of the circumstances under which the person must file an application with RAD under FINRA’s revised Rule 9520 Series:

A. If the person is seeking admission or re-admission to the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i), then the person must file an application unless the order imposing a bar on the person is time-limited and the time period is expired. However, if the bar is related to Fraudulent, Manipulative or Deceptive (“FMD”) conduct, then the person must submit an application under the circumstances described in section I.B.
2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then the person must submit an application unless:
i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions) and the sanctions are no longer in effect; or

ii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), the sanctions are no longer in effect, and the order was entered 10 or more years ago.

B. If the person was, as of March 17, 2009, a member of, or an associated person of a member of FINRA or another SRO, and was subject to a statutory disqualification as of that same date and is seeking to continue in the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i); and
i. the bar is no longer in effect and is not related to FMD conduct, then no application is required.

ii. the bar is still in effect and is not related to FMD conduct then no application is required unless there is a “triggering event” - which occurs when the person subject to the statutory disqualification either changes employers or the member firm makes an application for the registration of such person as a principal pursuant to FINRA rules.

iii. the bar is still in effect and is related to FMD conduct, then an application is required.

2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then an application is required unless:

i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are no longer in effect; or

ii. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are still in effect, in which event an application is required only if there is a triggering event; or

iii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are no longer in effect, and the order was entered 10 or more years ago. However, if the order was issued less than 10 years ago, then an application is required if there is a triggering event.

C. If the person was, as of March 17, 2009, a member of, or an associated person of a member of FINRA or another SRO, and is subject to a statutory disqualification that arose after March 17, 2009, and is seeking to continue in the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i), then the person must file an application unless the order imposing a bar on the person is time-limited and the time period is expired. However, if the bar is related to FMD conduct, then the person must submit an application under the circumstances described in section III.B.

2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then an application is required unless:

i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions) and the sanctions are no longer in effect; or

ii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), the sanctions are no longer in effect, and the order was entered 10 or more years ago.
Registration under Florida law is guided by FLA. STAT. §§ 517.12 (2009) and 517.161 (2009). Relevant here, Section 517.12(1) provides that:
No dealer, associated person, or issuer of securities shall sell or offer for sale any securities in or from offices in this state, or sell securities to persons in this state from offices outside this state, by mail or otherwise, unless the person has been registered with the office pursuant to the provisions of this section.
Further, Section 517.161(1) provides that:
Registration under Section 517.12 may be denied . . . if the office determines that such applicant or registrant . . . : (j) Has been convicted of, or has entered a plea of guilty or nolo contendere to, regardless of whether adjudication was withheld, a crime against the laws of this state or any other state or of the United States or of any other country or government which relates to registration as a dealer, investment adviser, issuer of securities, associated person, or branch office; which relates to the application for such registration; or which involves moral turpitude or fraudulent or dishonest dealing;
Section 517.161(1)(j) makes no distinction between crimes that are felonies or misdemeanors. Arguably, this would mean that the classification of the crime would make no difference as to whether the crime would be considered in analyzing the application for registration.

However, this argument loses some of its persuasive value when FLA. ADMIN. CODE r. 69W-600.0021 (effective March 2, 2010) is considered. Under Rule 69W-600.0021(3)(a) it is stated that “[t]he Office [of Financial Regulation] makes a general classification of crimes into two classes: A and B, as listed in subsections (14) and (15), of this rule.” Class A Crimes are felonies “involving an act of fraud, dishonesty, or a breach of trust, or money laundering, and the Office finds that such crimes constitute crimes of moral turpitude.” Class B Crimes are misdemeanors “that involve fraud, dishonest dealing or any other act of moral turpitude.” Applicants with a single conviction of a “Class A Crime” will not be granted a registration until 15 years have passed since the date on which an applicant was found guilty, or pled guilty, or pled nolo contendere to a crime. Applicants with a single conviction of a “Class B Crime” will not be granted registration until 5 years have passed since the date on which an applicant was found guilty, or pled guilty, or pled nolo contendere to a crime. Two or more offenses are considered a single crime if they are based on the same act or transaction or on two or more connected acts or transactions.

If a conviction upon a violation is not a Class A Crime (felony) or Class B Crime (misdemeanor), there is no guideline imposed by Florida law which sets forth a mandatory waiting period before the applicant is eligible to be granted registration. This does not mean, however, that as a result of the application of the recently enacted Rule 69W-600.0021 that the Office of Financial Regulation will ignore the applicant’s criminal conviction altogether. In fact, FLA. STAT.§ 1611(d) states that “Nothing in this section changes or amends the grounds for denial under s. 517.161.” Rather, the more likely scenario is that as a result of Rule 69W-600.0021 the applicant will not be automatically denied registration because of his or her conviction. Instead, the Office of Financial Regulation will evaluate the application while taking into account any mitigating evidence he or she chooses to present.

If the conviction is for a “crime” despite not falling into the categories of Crime A or Crime B, the next issue is whether it is a “crime” which involves “moral turpitude.” There is only one case out of Florida that has addressed the phrase “moral turpitude” as contained in the Florida Securities and Investor Act. In Winkelman v. Department of Banking and Finance, 537 So.2d 591, 592 (Fla. Dist. Ct. App. 1988), the court found that a conviction upon a plea of guilty to willfully assisting in the preparation of a false income tax return in violation of 26 U.S.C. § 7206(2) was the conviction of a crime which involved moral turpitude. As such, the conviction adequately supported the revocation of the broker’s license. Id. Unfortunately, there was no further discussion as to the requirements or meaning of “moral turpitude.”

However, in other contexts Florida courts have utilized the following definition:
Moral turpitude involves the idea of inherent baseness or depravity in the private social relations or duties owed by man to man or by man to society. It has also been defined as anything done contrary to justice, honesty, principle, or good morals, though it often involves the question of intent as when unintentionally committed through error of judgment when wrong was not contemplated.
Cambas v. Dep’t of Business and Professional Regulation, 6 So.3d 668, 670 (Fla. Dist. Ct. App. 2009) (citing State ex rel. Tullidge v. Hollingsworth, 146 So. 660, 661 (Fla. 1933)).

In Cambas, 6 So.3d at 670, the court was faced with the interpretation of FLA. STAT. § 475.25(1)(f), which is substantially similar to Section 517.161(1)(j) and allows the Florida Real Estate Commission to discipline a real estate licensee who is “convicted or found guilty of, or entered a plea of nolo contendere to, regardless of adjudication, a crime in any jurisdiction which directly relates to the activities of a licensed broker or sales associate, or involves moral turpitude or fraudulent or dishonest dealing.” The Cambas court concluded that leaving the scene of an accident was a crime involving “moral turpitude” as that term is used under Section 475.25(1)(f).

In a footnote, the Cambas court noted that crimes which Florida courts had previously determined constituted acts of moral turpitude with regards to disciplining real estate licensees included, but were not limited to: bookmaking, Carp v. Florida Real Estate Comm’n, 211 So.2d 240 (Fla. Dist. Ct. App. 1968); manslaughter, Antel v. Dep’t of Professional Regulation, Florida Real Estate Comm’n, 522 So.2d 1056 (Fla. Dist. Ct. App. 1988); and possession of a controlled substance with intent to sell, Milliken v. Dep’t of Business & Professional Regulation, 709 So.2d 595 (Fla. Dist. Ct. App. 1998). See Cambas, 6 So.3d at 671 n.2. The court noted that crimes which Florida Courts had previously determined did not constitute moral turpitude included, but were not limited to: unlawful possession of lottery tickets, Everett v. Mann, 113 So.2d 758 (Fla. Dist. Ct. App. 1959); possession of a controlled substance, Pearl v. Florida Board of Real Estate, 394 So.2d 189 (Fla. Dist. Ct. App. 1981); and battery and criminal mischief for setting off a smoke bomb as a political protest, Nelson v. Dep’t of Business & Professional Regulation, 707 So.2d 378 (Fla. Dist. Ct. App. 1998). See Cambas, 6 So.3d at 671 n.2. What can be gleaned from these cases is that there is no hard and fast definition of the term “moral turpitude,” and the conclusion seems to turn on the crime committed along with the facts and circumstances of each case.

However, under Rule 69W-600.0021(1): “[a]s part of the application review process, the Office is required to consider an applicant’s law enforcement record when deciding whether to approve an application for registration as an associated person.” And “the Office may request additional information from the applicant to determine the status of a criminal event, the specific facts and circumstances surrounding a criminal event, or to address other issues determined relevant to the review of the law enforcement record.” Therefore, it appears that the Office of Financial Regulation will look past the face of the conviction in order to ascertain the “specific facts and circumstances” surrounding the charges against him. “The burden of persuasion remains upon the applicant to prove [his or] her entitlement to the license.” Dep’t of Banking and Finance, Div. of Securities and Investor Prot. v. Osborne Stern and Co., 670 So.2d 932, 934 (Fla. 1996).

If the convicted individual’s application for registration is denied by the Office of Financial Regulation, then the effect on his or her status with FINRA will be determined by the outline set forth above. The reasons for denial would be stated in the Office of Financial Regulation's order, as FLA. STAT. § 517.161(3) (2009) provides that “[i]n the event the office determines to deny an application or revoke a registration, it shall enter a final order with its findings on the register of dealers and associated persons; . . . ”

A denial would presumably be based upon the determination that the guilty plea or verdict was a plea to a crime involving “moral turpitude.” Therefore, there would arguably be a finding of “dishonesty” such that the denial of the registration could be considered an order under Exchange Act Section 15(b)(4)(H)(ii) because it would pertain to “fraudulent, manipulative, or deceptive” conduct. However, the precise language of Exchange Act Section 15(b)(4)(H)(ii) provides that there must be a “final order of a State securities commission that constitutes a final order based on violations of any laws or regulations that prohibit fraudulent, manipulative, or deceptive conduct.”

Therefore, the order denying the application would likely fall under Exchange Act Section 15(b)(4)(H)(i) and whether and under what circumstances the applicant would be required to file an application with RAD would depend on whether the order denying his or her application for registration would be considered a bar that is “still in effect” after the date it is entered. There is uncertainty as to the duration of an order denying the registration because the conviction does not amount to a conviction of a felony or misdemeanor. Therefore, under Rule 69W-600.0021 there is no automatic time period for which he or she would be barred and prevented from reapplying. In other words, there is no “bar” because in theory the applicant could submit another application for registration as soon as his or her previous application is rejected. The more plausible interpretation by FINRA is that an order denying the application for registration is a bar that is still in effect until the time his or her application for registration is granted since the applicant would be prohibited from engaging in the securities industry in the state of Florida during that time.

Therefore, if the order is considered a bar that is still in effect (based on experience the more likely interpretation), then applicant would fall under B.1.ii. of the outline contained in Section I. As such, the applicant would be required to file an application with RAD only if a “triggering event” takes place during the time the order is still in effect. The time the order is “still in effect” could be until the applicant is eventually registered in Florida. On the other hand, if the denial of the application is not considered to be a bar that is still in effect (based on experience the less likely interpretation), then B.1.i. of the outline contained in Section I will govern and the applicant would not be required to submit an application with FINRA under any circumstances.

Thursday, March 18, 2010

Ninth Circuit Court of Appeals Addresses “Scienter” Requirement Under Securities Exchange Act of 1934 and Rule 10b-5

On February 17, 2010, the Ninth Circuit Court of Appeals issued a decision addressing the “scienter” requirement for securities fraud under Securities Exchange Act of 1934 and Rule 10b-5. “To establish a violation of section 10(b) and Rule 10b-5, the SEC is required to ‘show that there has been a misstatement or omission of material fact, made with scienter.’” Ponce v. SEC, 345 F.3d 722, 729 (9th Cir. 2003) (quoting SEC v. Fehn, 97 F.3d 1276, 1289 (9th Cir. 1996)).

In the case, the NASD found that Alvin and Donna Gebhart, securities salespersons, committed securities fraud by making false statements to clients in connection with the sale of promissory notes used to finance the conversion of mobile home parks to resident ownership. The Gebharts sold the promissory notes to their clients without conducting any independent investigation into the program. They failed to obtain any financial statements, to ascertain who the owners, officers, or shareholders of the company performing the conversion were, to determine what compensation would be paid to the company or their officers, or to verify that trust deeds securing the notes being recorded or obtain copies of recorded trust deeds. In lieu of an independent investigation, the Gebharts relied on the representations of a former associate of Alvin Gebhart.

Between October 1996 and the program’s collapse in 2000, the Gebharts sold nearly $2.4 million in promissory notes to 45 of their clients, earning about $105,000 in commission. The sales were based on several statements by the Gebharts that, it later became clear, were false. The Gebharts told their clients that the notes were a proven investment that offered substantial returns and were secured by recorded deeds of trust. They said that in the worst case scenario their clients would be part owners of the mobile home parks and would be able to recover their investments. In fact, the trust deeds were not recorded and the parks were significantly over-encumbered.

The Gebharts failed to disclose that their statements were based on information provided by someone to them rather than through their own, independent investigation. At the time of the collapse of the program in the middle of 2000, there were approximately $3,670,000 in outstanding promissory notes, of which only $605,000 were secured by recorded deeds of trust. At the time, the Gebharts’ clients had over $1.5 million invested in outstanding notes.

As a result of these events, in 2002 the NASD’s Department of Enforcement filed a complaint against the Gebharts asserting that the Gebharts had made materially false and misleading statements to their clients in violation of section 10(b) of the Securities Exchange Act of 1934, SEC Rule 10b-5 and NASD Conduct Rule 2120. A NASD hearing panel found that the Gebharts had acted in good faith and therefore rejected the fraud charges, but the NASD National Adjudicatory Council (NAC) reversed. The NAC found that the Gebharts had committed fraud, imposed a lifetime bar on Alvin Gebhart and imposed a one-year suspension and a $15,000 fine on Donna Gebhart.

The Gebharts challenged the decision, and the case eventually came before the Ninth Circuit on their petition for review. The Gebharts contended that 1) the SEC applied an erroneous legal standard for scienter, and 2) the SEC’s finding of scienter was not supported by substantial evidence.

With regard to the first issue, the court noted that scienter may be established by showing that the defendants knew their statements were false, or by showing that defendants were reckless as to the truth or falsity of their statements. Although the Court could consider the objective unreasonableness of the defendants’ conduct to raise an inference of scienter, the ultimate question was whether the defendant knew his or her statements were false, or was consciously reckless as to their truth or falsity.

The court noted that the SEC certainly considered the objective unreasonableness of the Gebharts’ actions as part of its analysis. The Gebharts made “no effort” to corroborate the representations that the parks were not overly encumbered. The SEC recognized that scienter turned on “an actor’s actual state of mind at the time of the relevant conduct.” Based on the evidence as a whole, the SEC determined that the Gebharts “knew they had no direct knowledge of the truth or falsity” of their statements, and made their statements “despite not knowing whether they were true or false.” The court determined that the SEC correctly applied the appropriate scienter standard.

With regard to the second issue, the Gebharts also argued that the SEC’s finding that they acted with scienter was not supported by substantial evidence. The substantial evidence standard applies to the SEC’s finding of scienter, and means more than a mere scintilla but less than a preponderance of evidence. In other words, it means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.

The Gebharts pointed out that there was some evidence supporting an inference that they genuinely believed that they had an adequate basis for their statements. Significantly, the Gebharts themselves invested substantially in the notes. See 8 Louis Loss & Joel Seligman, Securities Regulation 3691 n.558 (“[I]nvestment of one’s own money tends to negate scienter, since it ‘belies any known or obvious danger.’ ” (quoting Hoffman v. Estabrook & Co., 587 F.2d 509, 517 (1st Cir. 1978))). Substantial evidence, however, supported the SEC’s finding of recklessness. The Gebharts based their statements on representations by Mr. Gebhart’s former associate and conducted no meaningful independent investigation to confirm the truth of their representations. It was therefore reasonable for the SEC to infer that the Gebharts were consciously aware that they lacked sufficient information for their statements.

Friday, March 12, 2010

FINRA CLOSES COMMENTS ON REGULATORY NOTICE 09-70: PROPOSED CHANGES TO REGISTRATION AND QUALIFICATION REQUIREMENTS

In December 2009, the Financial Industry Regulatory Authority (“FINRA”) proposed changes to the consolidated FINRA rulebook, which incorporated the National Association of Securities Dealers (“NASD”) rules on registration and qualifications. These changes were proposed pursuant to FINRA Regulatory Notice 09-70: “FINRA Requests Comment on Proposed Consolidated Registration and Qualification Requirements” (“Proposal”).


Essentially, the purpose of the Proposal is to streamline NASD Rules 1021 and 1031. Under the NASD, these rules governed registration requirements of representatives and principals. Under current FINRA rules, investment bankers and broker-dealers of FINRA member firms must register. Additionally, FINRA member firms may register any individuals that engage in legal, compliance, internal audit, or back-office operations. The primary effect of the proposal would significantly broaden the current “permissive” registration categories to allow member firms to register certain persons employed by member firms or their financial services affiliates. Because of this expansion, FINRA also would introduce new stand-alone registration categories:

(1) active registration, for individuals engaged in investment banking or securities activities

(2) inactive registration, for individuals engaged in the “bona fide” business purpose of the member

(3) retained associate registration, for individuals functioning as financial services affiliates.

The actual text of the Proposal can be accessed here.


The comment period was slated to end February 1, 2010, but was extended to March 1, 2010. Twenty-one organizations submitted comments, voicing opinions ranging from full support to complete abandonment. The organizations included investment firms such as Edward Jones and T.Rowe Price and industry associations like the North American Securities Administrators Association, Inc. (“NASAA”) and the Securities Investment and Financial Markets Association (“SIFMA”). Most of the comments voiced general overall support, but suggested small changes to help effectuate a more efficient transition. See SIFMA Comment and Edward Jones Comment. The NASAA was one of the few who voiced complete abandonment of the acquisition of NASD rules into the consolidated FINRA rulebook. The primary objection to the Proposal is FINRA’s lack of guidance on the appropriate substance of a registered inactive person’s education and continuing education requirements. However, NASAA suggests this issue could be solved by continued use of FINRA’s current qualification examination waiver process, which would be superseded by the new rules. Further, the NASAA believes these three new registration categories constitute radical changes that are structured for the convenience of member firms not investor protection.


FINRA has not yet filed its rule proposal with the Securities and Exchange Commission, which may suggest the organization will make changes before its submission.

Friday, March 5, 2010

NEW PROPOSED SECURITIES RULES IN FLORIDA

The Florida Office of Financial Regulation (“Office”) recently updated some of its securities rules. The Office submitted notice for several proposed rule changes that are primarily to keep its rules up-to-date with the most current federal laws and cross references. For example, references to NASD had to be switched to FINRA after the SEC approved their consolidation back in 2007. Despite these “housekeeping” changes, there are a few noteworthy proposals that are substantive in nature. The substantive proposals come pursuant to House Bill 483 that passed during the 2009 Florida legislative session. The purpose of the bill was to increase investor protection through an expansion of certain agency powers. House Bill 483 became effective July 1, 2009, but the Office of Financial Regulation is beginning to submit its proposals for the supplementary rules.


One such substantive change is Proposed Rule 69W-1000.001, which creates a set of disciplinary guidelines in accordance with House Bill 483. The rule expands the disciplinary power of the Office of Financial Regulation to impose additional sanctions against individuals and firms that are subject to regulation under the Florida Securities and Investor Protection Act (“Securities Act”). Under the new rule, the Office has the power to impose cease and desist orders in conjunction with any sanction laid out in the Securities Act and raises the levels of minimum fines. The rule also sets out an extensive and comprehensive factors list to determine the appropriate sanction.


Proposed Rule 69W-600.0011 was also added pursuant to House Bill 483. Under this proposed rule, applicants could be subject to registration disqualifying periods for dealers, issuer dealers, investment advisors, as well as “relevant persons.” “Relevant persons” for purposes of the rule include “any direct owner, principal, or indirect owner that is required to be reported on behalf of the applicant on a Form BD or a Form ADV.” A Form BD is required for the application for broker-dealer registrations, and a Form ADV is required for applications for investment advisor registration. Grounds for disqualifying periods are based upon criminal convictions, pleas of nolo contendere, and pleas of guilt, regardless of whether there was an adjudication. The disqualifying periods range from five years to fifteen years depending on whether the crime is a classified as “Class A” or “Class B.” Class A crimes are felonies involving an act of fraud, dishonesty, breach of trust, money laundering, and any other crime involving a question of “moral turpitude.” Class B crimes are misdemeanors involving “fraud, dishonest dealing or any other act of moral turpitude.” Pleas receive a disqualifying period of three years. There is also a provision allowing registrants to submit any evidence of mitigating factors that may reduce the length of disqualification.


The Office of Financial Regulation is charged with safeguarding private financial interests of the public through licensing, chartering, examining, and regulating depository and non-depository financial institutions and financial service companies in Florida. It also serves to protect consumers from financial fraud and preserve the integrity of Florida’s markets and financial service industries.

Thursday, March 4, 2010

CFTC CHAIRMAN DISCUSSES OVER-THE-COUNTER DERIVATIVES REFORM: A SUMMARY OF DERIVATIVES REGULATIONS THAT MAY BE YET TO COME

On March 1, Commodities and Futures Trading Commission (“CFTC”) Chairman, Gary Gensler, spoke to the Institute of International Bankers about over-the-counter (“OTC”) derivatives reform. On March 2, he spoke before the Women in Housing and Finance organization. In his addresses, Mr. Gensler discussed the history of derivative markets, the need for comprehensive regulation in these markets, and the regulatory reforms that should be implemented. The CFTC is charged with monitoring and regulating the futures and commodity options exchanges in order to protect market participants and promote fair trading.


In 1981, the first derivatives transaction took place. Throughout the 1980s, these instruments were tailored one at a time to meet specific risk management requirements of two sophisticated parties—usually a dealer and a corporate customer. Parties negotiated a deal each time they needed to hedge a specific financial risk; they were not widespread public investment tools. Because these transactions did not take place on regulated exchanges, but rather existed purely in company accounting books, the information available to the public about pricing was not readily available. Further, this lack of information made it difficult to understand the magnitude of interconnectedness between financial institutions. Over the next decades, the notion of derivatives as a hedging tool became increasingly popular, causing contracts to be more standardized and easier to negotiate and trade. Upgrades in technology further influenced the popularity of derivatives by facilitating easy electronic trading. At its peak, before the financial crisis, the derivatives market had a notional value of $300 trillion in the U.S., whereas in the 1980s, the notional value of the derivatives market was only $1 trillion.


Since their inception, these financial hedging tools remained largely unregulated. In the aftermath of the financial meltdown, it became known how OTC derivatives can increase risk when unregulated, instead of functioning properly as a risk hedger. Their risk-added is even more dangerous when coupled with the limited availability of pricing information and a lack of transparency. It is for these reasons that Chairman Gensler advocates comprehensive reform of OTC derivatives.


According to Chairman Gensler, there are three main components that will result in effective reform:

  1. Explicitly Regulate Derivatives Dealers
  2. Implement Transparent Trading Requirements
  3. Organize Clearinghouses to Clear Standard Derivatives

Derivative Dealer Regulations. Chairman Gensler believes that having an explicit regulatory framework of derivatives dealers will lower risk. First, the regulations should impose certain capital and margin requirements to mitigate risk to the public. Second, business conduct standards should be put in place to protect against fraud, market manipulation and abuse, which will in turn promote market integrity. Finally, derivatives dealers should have standardized recordkeeping and reporting requirements. Such requirements would bring transparency to the system and provide more accurate pricing information to the public.


Transparency in Trading. Chairman Gensler asserts that trading must be transparent in order to improve how current markets function, create better market liquidity and lower hedging costs. In order to have trading transparency, he advocates that there must be centralized trading venues. These venues would be better equipped to asses and manage risk of OTC derivatives and provide transparency because all derivatives trading would have to have cleared positions based on a reliable market price. The reliable market price would be a by-product of having central trading venues.


Central Clearinghouse for Standard Derivatives. Currently, derivatives are primarily listed on company books, not with a central source, which creates unknown levels of interconnectedness between financial institutions and contributes to the issue of “too big to fail.” Therefore, Chairman Gensler believes that it is imperative to have a central clearinghouse to understand how institutions are connected, because a central clearinghouse would provide transparency about these relationships and reduce interconnectedness of banks since derivatives would flow through the clearinghouse instead of bank balance sheets. It is estimated that 75% of derivatives traded are standard derivatives transactions. Such transactions, because of standardization, can therefore be monitored and cleared though one central clearinghouse. Those derivatives transactions that are highly specialized and tailored would remain outside the scope of the clearinghouse (but within the dealer regulations) and would still be allowed to trade bilaterally. Further, Gensler concedes that there would be other exceptions, but exceptions should remain narrow and explicit.


In closing, Chairman Gensler reiterated the necessity for OTC derivatives regulations because “the central lesson from the crisis is that an interconnected financial system facilitates the spread of risk from institution to institution, threatening the entire economy.”


Currently, the House of Representatives is considering H.R. 3300, the Derivative Trading Accountability and Disclosure Act, which would implement many of the changes Chairman Gensler suggests. The Senate also introduced Senate Bill 3714, Derivatives Trading Integrity Act of 2008, which focused primarily on introducing a regulated exchange for certain types of derivatives. However, that bill was never reconsidered.

SEC AND IRS UNDERTAKE COOPERATIVE EFFORTS TO ENHANCE COMPLIANCE BY THE SECURITIES INDUSTRY WITH MUNICIPAL BOND ENFORCEMENT

On March 2, 2010, the SEC and the IRS executed a Memorandum of Understanding (“MOU”) outlining their commitment to enhance compliance by the municipal securities industry with the rules and regulations each agency is responsible for enforcing. The MOU provides that the SEC and the IRS will work cooperatively to identify issues and industry trends, and develop strategies to enhance performance of each agency’s responsibilities within the tax exempt bonds/municipal securities industry.

The MOU specifically aims to (1) improve coordination and information sharing between the SEC and the IRS, and (2) promote educational and outreach events within the two agencies and the tax exempt bonds/municipal securities industry as a whole. To aid in the agencies’ cooperative efforts, the MOU provides for the creation of a Tax Exempt Bond/Municipal Securities Committee, which will coordinate discussions between the agencies regarding policy, procedure and compliance issues within the industry. In addition, the SEC and IRS agree to share information regarding, among other things, market risks, practices, and events relating to tax exempt bonds/municipal securities that may be of interest to the other agency. The agencies also agree to consider training opportunities addressing laws, policies, procedures and other issues the agencies encounter in completing their respective missions.

Through cooperative relationships such as this, the SEC and other regulatory agencies are better suited to protect investors by ensuring that they obtain the information necessary to make informed investment decisions and by ensuring that the securities industry operates in accordance with the laws put in place to protect investors.

A complete copy of the MOU can be found here.