WHAT STATE REGULATORS CONSIDER BEFORE AN ENFORCEMENT ACTION

Broker-Dealers, have you ever thought about what a state regulator considers when initiating an enforcement action?

There are a number of considerations that a state regulator takes into account in a regulatory action. Below are a few of them taken from the NASAA Broker-Dealer Section Report on Principal Considerations for Regulatory Actions. We urge you to contact us if you have been contacted by a regulator. Hiring counsel experienced in these matters and doing so promptly can greatly help you going through an investigation and/or an enforcement action.

• Did the firm have adequate written supervisory policies and procedures in place to identify and prevent the alleged misconduct? The regulator will consider whether the firm’s internal compliance procedures were sufficient to detect the misconduct by reviewing the firm’s WSPs. If the firm’s procedures were inadequate, has the firm adopted new and more effective internal controls and procedures designed to prevent the misconduct?

• Did the firm conduct a thorough review of the misconduct? A regulator will consider what steps the firm took to reasonably identify the extent of the misconduct and identify all the parties involved. Did the firm spend the time and resources required to find the problem and address it?

• Were there “red flags” present that the firm missed? Are the firms WSPs adequate in regards to “red flags”? Remember, adequate WSPs are supposed to prevent and detect misconduct and identifying red flags and having procedures in place to address them is a good tool in your prevention and detection efforts.

• How did the firm respond to the State’s requests in the investigation and did they cooperate? This doesn’t mean you have to jeopardize any defense. But having good counsel to help you respond to a regulator’s inquiry and advocate on your behalf is an important component when on the receiving end of an enforcement action.

These are just a few of the considerations. You can see how important it is to have knowledgeable counsel to help you respond to an audit or enforcement inquiry. If you find yourself contacted by a regulator we urge you to contact us to ensure you have experienced counsel assisting you.

WILL WE BE SEEING CHANGES TO RULE 506 TRANSACTIONS?

Recently, Cosgrove Law members attended the North American Securities Administrators (NASAA) annual conference in Denver. One of the topics presented focused on the hotly contested issue of Rule 506 transactions.

The Securities and Exchange Commission, in response to criticism that compliance with federal securities laws disadvantages small business, promulgated Regulation D. Rule 506 is one of the rules created and provides an exemption from registration under Section 4(2) of the 1933 Act. This exemption is the most frequently used exemption from Regulation D. Rule 506 limits the number of purchasers to 35, but there is no limit on the number of offerees. In determining the total number of purchasers, an offeror can exclude the same classes of accredited investors and related persons/entities as in Rule 505. However, unlike the other provisions in Regulation D, Rule 506 does not cap the cumulative amount of offered securities. Most states have a corollary provision to Rule 506 in their state securities laws that includes the same or similar exemption.

Ultimately, Regulation D is intended to simplify, clarify, and expand the already existing limited offering exemptions from registration. These regulations are also supposed to facilitate uniformity between state and federal exemptions, which would effectively level the playing field for costs of raising capital in small business. In 1996, Congress passed the National Securities Markets Improvement Act of 1996 (NSMIA) to further promote uniformity.

However, some argue that this legislation is a federal attempt to preempt state legislation and actually poses a threat to investors’ state law protections. To support their argument, proponents specifically claim the NSMIA effectively restrains state regulators’ authority and ability to oversee securities markets, especially Rule 506 transactions because covered securities are no longer subject to substantive state review. As such, state regulators are having a more difficult time catching early-stage fraud.

Others argue that despite the NSMIA, states still have enough regulatory and oversight authority for securities transactions under Rule 506 exemptions. They note that NSMIA permits states to require filings and fees for the offer and sale of covered securities in their state. Furthermore, because the NSMIA only preempts state securities registration requirements, states still can impose requirements on broker-dealer registration, which allows states to examine whether action is required in connection with a particular offer or transaction. Therefore, although covered securities are not subject to state law review, states still have authority under blue-sky laws to oversee offerings involving covered securities.

Following the wake of several financial scandals recently, there has been a push for reform, so undoubtedly, this debate will continue.

DO INVESTORS PAY THE PRICE IN SHAREHOLDER CLASS ACTION SUITS?

A recent article in BusinessWeek raised an interesting argument about the logic of shareholder class action suits. After the Bank of America settlement agreement was rejected by New York Federal District Court Judge Rakoff, an interesting perspective in opposition of shareholder class action suits emerged. In the settlement between BofA and the SEC, Rakoff criticized the SEC for not providing adequate justification for not filing suit against BofA executives who were allegedly responsible for the false and misleading information, but instead pursuing a civil action against the corporation. Rakoff pointed out that the shareholders, who were the victims of the misconduct, would also be the ones ultimately responsible for paying the settlement.

Private investor suits are usually brought by large institutional investors and are separate from any government actions brought against a company. These suits garner settlements much larger than those typically seen in government actions. Shareholder class action suits against corporations have generally been thought to provide additional corporate policing to deter fraud and as a way for shareholders to hold corporations accountable for their misdeeds. However, Rakoff and other proponents argue the opposite: shareholders pay the price for the corporate misdeeds, while executives and other wrongdoers escape the costs.

They claim, rather, that class action suits pit shareholders against each other. Shareholders who acquire a company’s stock generally do so in an aftermarket transaction, not directly from the stock offering of a company. This effectively means investors who sold their stock at a loss are bringing suit against the shareholders who did not sell their shares or who acquired shares after the price drop. Former SEC Commissioner and Stanford University law professor, Joseph A Gundfest, notes that these aftermarket fraud cases end up causing “a wealth transfer among equally innocent third parties.” According to Judge Rakoff, this is precisely the setup in the BofA suit and is also the reason why he rejected the settlement.

Therefore, the shareholders who still hold the stock end up paying the settlement and attorneys’ fees. This “circularity” of funds circumvents those who actually perpetrated the fraud and places the cost with the shareholders still holding the stocks. This is a direct contradiction to the original purpose of compensating investors for their losses due to fraudulent behavior and does not deter fraud. As such, advocates of this view believe that financial system reforms should include new rules about shareholder lawsuits that target corporate executives rather than aftermarket investors. However, this is a view that remains largely in the academic arena, not the public. Currently, the new proposals in the legislature do not include any such reforms.

The full article can be found here.

SEC CHAIRMAN SCHAPIRO TESTIFIES REGARDING THE OVER-THE-COUNTER DERIVATIVES MARKETS ACT OF 2009

SEC Chairman Mary L. Schapiro appeared before the House Committee on Agriculture on September 22, 2009, to testify regarding the regulation of over-the-counter (“OTC”) derivatives. In particular, she spoke about the Over-the-Counter Derivatives Markets Act of 2009, which was proposed in August by the Department of the Treasury. Ms. Schapiro noted that the recent financial crisis had revealed serious weaknesses in U.S. financial regulation, including a lack of regulation of OTC derivatives.

Ms. Schapiro noted that the framework provided by the Treasury proposal is designed to achieve four broad objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties. However, she laid out several broad areas in which the proposal could be strengthened to further avoid regulatory gaps and eliminate regulatory arbitrage opportunities.

One of Ms. Schapiro’s suggestions was aimed at minimizing regulatory arbitrage and gaming opportunities by regulating swaps like their underlying “references.” Ms. Schapiro noted that gaming, or regulatory arbitrage, possibilities abound when economically equivalent alternatives are subject to different regulatory regimes.

Under the Treasury’s proposal, regulatory responsibility for securities-related OTC derivatives would be divided between the SEC and the CFTC. Regulatory responsibility for other OTC derivatives would be given to the CFTC. Ms. Schapiro noted that although this could help to eliminate differences within the broad and varied world of “swaps,” it could result in significant regulatory differences between “swaps” products and the currently “regulated” securities and futures products. These regulatory differences could perpetuate existing regulatory arbitrage opportunities that encourage the migration of activities from the traditional regulated markets into the differently regulated swaps market.

Ms Schapiro suggested that the Treasury’s proposal be modified so that all securities-related OTC derivatives be regulated more like securities; and commodity and other non securities-related OTC derivatives be regulated more like futures. This would result in securities-related OTC derivatives and the underlying securities being regulated consistently. Ms. Schapiro suggested that Congress could implement this strategy by extending the federal securities laws to all securities-related OTC derivatives and extending the Commodity Exchange Act to all commodity-related and non-securities related OTC derivatives. This could significantly reduce the arbitrage opportunities between the regulated markets (securities or futures) and the differently regulated swaps market.

A complete copy of Ms. Schapiro’s testimony before the House Committee on Agriculture can be found here.

NOTES FROM NASAA ANNUAL CONFERENCE

Cosgrove Law members attended the North American Securities Administrators (NASAA) annual conference last week. The conference provided us with great opportunities to interact with state regulators from around the country and directly hear from these regulators about their issues. They focused on a wide variety of topics involving broker-dealers and investment advisers because the regulatory changes being discussed at the federal level was on everyone’s mind. Where these discussions will lead and what effect any regulatory changes might have on everyone is not known at this time. What we did take away is that all of us need to be aware of the changes being proposed e.g. the Consumer Financial Protection Agency, understand the implications to our businesses, and be ready to implement best practices to ensure compliance.

Blue Sky Compliance for Investment Advisers-NASAA’s findings from Audit Sweep

NASAA coordinated a comprehensive audit sweep by the states of Investment Advisers this year. At the conference, they presented their findings and the deficiencies they most often found. Registration, Books and Records, Unethical Business Practices, Supervision, Privacy policy and Fees and Custody were the most frequent violations uncovered, but inaccurate ADV filings were the number one deficiency found. We can assume that States will now be closely looking at Investment Adviser ADV filings. Are your ADV filings compliant? Is your firm ready to face a regulator’s scrutiny? Are you aware of FINRA’s recent releases for changes to the IARD/CRD system? If not, or you just want to ensure your current practices are compliant, contact us to review and analyze your firm’s registration practices.

CREDIT RATING AGENCIES TO UNDERGO GREATER SCRUTINY

On September 17, 2009, the SEC voted unanimously to adopt or propose several measures aimed at improving the overall quality of credit ratings. The proposals are intended to provide a more robust regulatory framework for Nationally Recognized Statistical Rating Organizations (“NRSROs”) by (1) requiring greater disclosure; (2) fostering competition; (3) helping to address conflicts of interest; (4) shedding light on rating shopping; and (5) promoting accountability.

In particular, the SEC has agreed to consider six proposals related to NRSROs:

• A recommendation to adopt rules to provide greater information concerning ratings histories — and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.

• A recommendation to propose amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.

• A recommendation to adopt amendments to the Commission's rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.

• A recommendation to reopen the comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.

• A recommendation to require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any "preliminary ratings" were obtained from other rating agencies — in other words, whether there was "ratings shopping"

• A recommendation to seek comment on whether we should amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

SEC Chairman Mary S. Schapiro stated that the proposed measures “are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security.” In 2006, with the passage of the Credit Rating Agency Reform Act, the SEC was given exclusive authority over rating agency registration and qualifications.

A copy of Ms. Schapiro’s opening statement before the SEC Open Meeting can be found here.

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MISSOURI’S NEW SENIOR PROTECTION ACT PACKS A STRONG PUNCH

On August 28, 2009, Missouri’s new “Senior Protection Act” took effect with the goal of better protecting investors from fraud. The Act, which gained bipartisan support from Missouri legislators, was influenced by Secretary of State Robin Carnahan’s pledge to enact stronger protections for those particularly susceptible to fraud—seniors and disabled investors.

The Senior Protection Act creates harsh penalties for those who wish to take advantage of these individuals. In particular, the Act establishes a minimum penalty of $50,000.00 for anyone who commits criminal securities fraud against an elderly or disabled person—with the maximum penalty being $1,000,000.00 and up to ten years in prison—along with an additional penalty of up to $5,000.00. The Act defines an “elderly person” as a person sixty years of age or older.

The newly-enacted Senior Protection Act can be found here, under Missouri Revised Statute § 409.5-508.

SEC CHAIRMAN SCHAPIRO ACKNOWLEDGES THE MADOFF FRAUD AND EMPHASIZES THE SEC’S COMMITMENT TO CHANGE

The Executive Summary of the Inspector General’s report regarding the Bernard Madoff fraud was released on August 31, 2009. In a statement issued by SEC Chairman Mary L. Schapiro upon the release the report, Ms. Schapiro acknowledged the Madoff fraud as a failure by the SEC to protect investors. However, Ms. Schapiro emphasized the SEC’s quick and drastic reaction in the wake of the fraud, stating that the SEC has since been “reviewing [its] practices and procedures, addressing shortcomings, and implementing the lessons learned.” Ms. Schapiro anticipates that the changes implemented by the SEC will help the agency better detect fraud in the future, thus preventing the financial turmoil caused by the Madoff fraud.

Our previous blog entry discussing some of the SEC's recent changes can be found here. In addition, click here for an in-depth analysis of the SEC’s post-Madoff reforms.

BROKER-DEALER FIRM CEOs ON CLOSE WATCH

SEC Chairman Mary Schapiro issued an order yesterday to broker-dealer firms addressing concerns regarding the recruiting methods for broker-dealer registered representatives. Ms. Schapiro noted that some types of recruiting methods, such as enhanced compensation practices wherein firms provide large up-front bonuses and enhanced commissions for sales of investment products, may in turn lead to greater risks for investors. In particular, recruiting methods based on these types of financial rewards create the risk that broker-dealer registered representatives will act in their own interest when selecting investment products for their customers, thereby violating their obligations to investors.

As such, Ms. Chapiro issued the order to remind broker-dealer firms, and in particular their CEOs, of the “significant supervisory responsibilities [they] have under the federal securities laws to oversee broker-dealer activities, particularly with respect to sales practices.”

A copy of the order can be found here.