Articles Posted in Compliance

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On January 30, 2014, the Securities and Exchange Commission hosted a compliance outreach program for investment companies and investment advisors. The national seminar, which was jointly sponsored by the Office of Compliance Inspections and Examinations and the Asset Management Unit of the Division of Enforcement, was held at the SEC headquarters in Washington, D.C.

The seminar outlined the priorities of SEC Divisions or Programs as well as general regulatory priorities of the SEC in the coming years. These priorities included the Wrap-Fee Programs, General Solicitation under the JOBS Act, Cybersecurity, and IABD Harmonization. One program of note that will be taking on more importance over the next two years is the Examination Initiative. The National Examination Program intends to review a substantial percentage of registrants that have not had an examination in the last three years. These examinations will take the shape of either a Risk Assessment Exam or a Presence Exam.
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On February 20, 2014, the Securities and Exchange Commission announced that it is launching an initiative, through its Office of Compliance Inspections and Examinations (“OCIE”), to conduct examinations of investment advisers that have been registered with the SEC for 3 or more years but who have never been examined. That same day, OCIE sent letters to all RIAs that have never been examined in order to provide them with information about the new initiative, which is being conducted under the National Exam Program (“NEP”).

The notice letter describes the two distinct approaches of the initiative as “risk assessment” and “focused reviews.” The former approach is designed to allow OCIE to obtain a better understanding of a particular RIA, and may include an overall review of the adviser’s activities with focus on the firm’s compliance program and disclosure documents and underlying facts. The latter, or “focus review” approach, includes a comprehensive risk-based examination of those advisers identified as having a higher risk area of business or operations. The focus-review examinations will focus on one or more of the firm’s compliance program, filings and other disclosure documents, marketing, portfolio management, and/or safety of client assets.

OCIE disclosed that not all RIAs receiving the letter would, in fact, be examined. Firms that receive the letter, however, would be well advised to prepare for an examination in any event, which usually means nothing more than maintaining and sharpening, where necessary, their policies and procedures so that they are adequate to assure compliance with SEC regulations, and contain clear and well-defined processes and responsibilities.
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In a decision last month, the California Court of Appeals may have opened the door for brokers to bypass the Financial Industry Regulatory Authority’s (FINRA) rigid expungement rules in order to remove matters from their CRD records. Currently, brokers must abide by Rule 2080 in order to expunge their records. The FINRA rule allows for expungement only upon meeting one of three tests: (1) the claim is factually impossible, (2) the broker was not involved in the conduct or (3) the information is false. The rule states that a broker who seeks expungement “must obtain an order from a court of competent jurisdiction directing such expungement or confirming an arbitration award containing expungement relief.”

In its recent decision, the California Court of Appeals held that a court may expunge a broker’s CRD record in the interest of fairness and equity, regardless of FINRA’s rule. Edwin Lickiss filed a petition in the court in April 2011 seeking expungement of 17 customer complaints and a regulatory action from his CRD record claiming that they were old and irrelevant and negatively affected his profession. The customer complaints against Mr. Lickiss had resulted in total payments of $831,000, and Mr. Lickiss was required to personally pay a $5,000 settlement. FINRA objected to Mr. Lickiss’s expungement request, stating that he was trying to “sanitize his record and prevent regulators, brokerage firms and investors from learning of this history for what amounts to ‘time served.'” The trial court dismissed the complaint, citing the requirements of Rule 2080. The court of appeals reversed the trial court’s decision, holding that it should have looked to equitable principles instead of FINRA rules.
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The North American Securities Administrators Association (NASAA) released preliminary numbers this month showing that the number of enforcement cases brought by state regulators doubled during 2011. During that year, states brought about 400 cases compared to 208 cases brought during 2010. This increase is due in large part to an expansion of state examinations as a result of the Dodd-Frank financial reform law. Dodd-Frank gave the states examination authority for some approximately 2,400 “mid-sized” advisers (firms with less than $100 million in assets under management) which are required to switch from SEC to state registration.

As a result of the switch, some former SEC firms that haven’t been examined in many years, if ever, by the SEC now find themselves subject to a state examination and can also look forward to being examined by the state more frequently.
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The Financial Industry Regulatory Authority (FINRA) released a Regulatory Notice in May clarifying its new suitability rule, Rule 2111. The rule, which was approved by the Securities and Exchange Commission (SEC) in November 2010, will be implemented on July 9, 2012. The Notice is intended to answer industry questions and provide guidance on the new rule.

According to FINRA, the new rule imposes the same obligations as the predecessor rule and related case law. It is intended to clarify and codify three main suitability obligations.

The first obligation is reasonable-basis suitability, which has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.

The second obligation is customer-specific suitability, in which the broker must have a reasonable basis to believe that a recommendation of a security or investment strategy is suitable for the particular customer based on the customer’s investment profile.
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The Securities and Exchange Commission (SEC) approved the Financial Industry Regulatory Authority’s (FINRA) Rule 5123 on June 7, 2012. The text of the final rule can be found here. The rule is creates some obligations for broker-dealers when they are engaged in selling private placements of securities. Due to a number of concerns, the SEC did not approve the rule until FINRA made a number of changes to the originally proposed rule. The final rule, which includes three amendments, was approved on an accelerated basis. The rule does not apply to all private placements. Sales to institutional accounts, qualified purchasers, investment companies, and other classes of purchasers are excluded.

The original proposal would have required broker-dealers involved in a private placement transaction to disclose to each of the investors prior to the sale the anticipated use of the proceeds from the offerings and the amount and type of offering expenses and offering compensation. If the disclosure documents did not include this information, the broker-dealer would have had to create a document for the investor containing the information. The proposal also required each broker-dealer to file the document with FINRA within fifteen days of the date of the first sale. If there were any amendments to the documents, then the amendments would also have to be filed with FINRA within fifteen days.
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Commissioner Luis A. Aguilar of the Securities and Exchange Commission (SEC) spoke at the recent NASAA/SEC Rule 19(d) Conference in Washington D.C. He addressed the importance of cooperation and collaboration between federal and state securities regulatory agencies in order to improve investor protection. Commissioner Aguilar also expressed a desire to have a continuing collaborative relationship between the SEC and the North American Securities Administrators Association (NASAA). “I continue to be interested in exploring more opportunities and avenues for the SEC and NASAA to partner and leverage our collective resources to protect investors,” Commissioner Aguilar said, “At a time when regulators are under greater constraints than ever, it makes sense for us to come closer together to further our common goals.”

Commissioner Aguilar discussed four areas in which the SEC and NASAA have worked together to improve investor protection. These areas include the transition of advisers to state regulation, crowdfunding, financial exploitation of the elderly and the creation of the Investor Advisory Committee.
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The Missouri Securities Commissioner, Robin Carnahan, issued an advisory release to alert entrepreneurs of the impact of the new crowdfunding exemption contained in the recently passed Jumpstart Our Business Startups (JOBS) Act. The exemption will allow entrepreneurs to use crowdfunding over the Internet to raise capital for small businesses. The purpose of the alert is to inform entrepreneurs of the changes and issues that arise with the passage of the exemption.

The purpose of the exemption is to allow small business owners to raise $1 million in a 12-month period through any medium, including the Internet. Under the exemption, investors whose net income is less than $100,000 can only invest the greater of $2,000 or 5% of their annual income, while investors whose net income is greater than $100,000 may not invest more than the greater of 10% of their annual income or $100,000. The crowdfunding exemption also requires that crowdfunding securities be sold through a broker or a “funding portal,” which will be defined by rules to be adopted by the Securities and Exchange Commission (SEC). Also, the broker or “funding portal” and the small business will still be responsible for making proper disclosures to the SEC and potential investors.
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The Financial Industry Regulatory Authority (FINRA) has proposed a rule which would allow individuals who are not named as parties to a customer-initiated arbitration case to seek expungement relief by initiating “In re” expungement proceedings. Currently, unnamed persons do not have a prescribed way to seek these types of expungements, and must seek relief by:

  • Asking their current or former firm that is a party to the arbitration to request expungement on their behalf;
  • Seeking to intervene in the arbitration filed by the customer; or
  • Initiating a new arbitration case in which the unnamed person requests expungement relief and names the customer or firm as respondent.

According to Regulatory Notice 12-8, “FINRA believes that the current options do not always adequately address a number of issues that can arise in connection with expungement requests.”
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As a result of the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), mid-sized firms of less than $100 million in assets under management should make the switch from Securities and Exchange Commission (SEC) oversight to state regulatory oversight. Most advisers know that under the newly adopted SEC rules, mid-sized advisers that were SEC registered prior to Dodd-Frank must remain SEC registered through the first quarter of 2012, and then complete their switch to state regulation by June 28, 2012. Firms wishing to switch should have already completed the state registration process to become effective in the state or states in which the adviser is registering.

It was estimated by this time that 3,200 firms would have made the switch to state regulation. However, spokesman John Nester for the SEC announced that as of April 5, a little more than 1,900 firms claimed that they were no longer eligible for SEC registration and needed to make the switch.
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