James Eccleston Articles

White Paper on the Role of Compliance Underscores its Critical Investor Protection Function

SIFMA (the Securities Industry and Financial Markets Association) has released its White Paper on the Role of Compliance.  Published internally in 2005, and released to the public recently, the white paper nonetheless contains pertinent and timely guidance for compliance departments at financial services firms.  Let’s examine the key points of SIFMA’s white paper.

Compliance departments at firms are critical to the investor protection function.  The white paper states the critical importance of having a “well-staffed, experienced and adequately funded” compliance department.  That department also should coordinate with the firm’s legal department as well as the internal audit and risk management departments at the firm in order to order to “maintain an effective overall compliance program.”  According to the white paper, the compliance department should report to the firm’s general counsel, risk management or directly to the executive
office.  Notwithstanding, the white paper observes that securities regulators are looking to compliance officials to act “proactively” to detect and prevent wrongdoing, and have “urged” compliance personnel to move beyond their traditional advisory roles.

So what are the typical compliance functions?  According to SIFMA’s white paper, there are several.  Let’s highlight the more important ones.  First, compliance department personnel “provide regulatory and compliance advice to business and control units on an ongoing basis.”  According to the whitepaper, in essence that means that the compliance department must respond to questions and issues as they arise.  It also means that the compliance department must proactively keep business
units of the firm apprised of regulatory developments and firm policy changes.

Another important function is to assist firm management with the “development of policies, procedures and guidelines designed to facilitate compliance with applicable laws and
regulations.”  Compliance also needs to disseminate compliance alerts and notices to firm business units.  Finally, compliance needs to work with business units to design policies and procedures that reflect new business products, services or trends.

Third, monitoring and surveillance is a “critical ongoing” compliance department function.  What this involves, according to SIFMA, is a detailed review of business activities, as well as surveillance of business transactions as well as communications, to identify potential issues relating to, among
other things, the handling of customer accounts, proprietary trading, employee/employee-related training and employee communications.  One particular aspect is the goal to help “identify, at their early stages patterns of improper behavior or activities, material or systematic weaknesses and potential product-related problems.”  Notably, compliance personnel (as well as business line management) should “escalate” red flags to senior compliance officers or the chief compliance officer of the firm, and if the response is perceived to be insufficient, then up through the chain of command including to senior management and/or the Board of Directors.

A fourth function of the compliance department is to conduct business unit compliance reviews.  According to the white paper, those reviews must be proactive, designed to identify potential regulatory, compliance and reputational risks, and designed to minimize such risks.  Furthermore, the reviews should be documented and should be reported to management.  One type of compliance review is the annual branch office examination.  The white paper makes several recommendations in that regard, including that the examination be carried out by personnel independent of the examined branch.  Additionally, a “surprise” branch office examination may be appropriate under certain circumstances, “especially where the firm has some indication of inappropriate behavior or inadequate controls.”  Finally, SIFMA’s white paper states, “Firms must be vigorous about reviewing branch office activity, even if offices have only a few employees or are in remote locations.”

Another important compliance function is to perform internal inquiries and investigations.  The focus normally is on whether a given activity or transaction has violated firm policies or procedures, laws, rules or regulations, or industry standards.  In conjunction with the legal department, a report normally is made to senior management and, if necessary, to the regulators.  In that regard, the white paper notes that the role of the compliance department is not to remediate wrongful conduct. Nor does the compliance department have the power to fire or discipline personnel. 

One more important compliance department function is to promote a “culture of compliance” within the firm.  Compliance must be viewed as a “crucial institutional value”, and business personnel must value the compliance department.  The “Tone from the Top” must allow for putting in place the people and systems necessary to achieve compliance.  The white paper states that, “This includes allocating sufficient resources to build effective compliance systems (including technology), creating incentive structures that reward compliant behavior (and penalizing behavior that sacrifices compliance principles), and giving compliance personnel regular and unfettered access to
senior management.”

As one can see, those compliance objectives and functions are as relevant today as they were in 2005.  Investors should be pleased that SIFMA has promoted and continues to promote a strong and effective compliance department function.

Broker Protocol Again Revisited; Still An "Industry Standard" For Employment Transitions?

In early 2009 and again in late 2010, I examined the Protocol for Broker Recruiting (the “Protocol”) and court opinions applying it to situations in which financial advisers had transitioned their employment from one financial services firm to another. The Protocol initially was conceived as a “safe passage” set of procedures which allowed signatories to the Protocol to avoid litigation (TROs,
other injunctive relief and damages) associated with the solicitation of clients and the taking of client information from one signatory firm to another signatory firm. 

Straightforward enough.  However, in early 2009 I also identified an “unintended consequence.”  That is, we began to see non-Protocol signatories, faced with litigation, arguing that the Protocol effectively had become an industry standard for transitioning financial advisers.  Those non-signatories to the Protocol therefore contended that they should not be subject to TROs, other injunctive relief and damages even though they themselves might have signed employment agreements or other contractual agreements that expressly had contemplated such relief.  I concluded in early 2009 that such a creative argument had experienced considerable (though certainly not universal) success in the courts. For example, a federal court in Ohio handed Merrill Lynch a defeat in its effort to rein in brokers departing to a non-signatory firm, stating that, “By setting up such a procedure for departing brokers to take client lists, Merrill tacitly accepts that such an occurrence does not cause irreparable harm.”  Likewise, a Massachusetts state court held the same way in a case involving Smith Barney.

By late 2010, I reached the conclusion that a “sea change” was taking place.  I wrote, “It now appears that the unintended consequence of allowing non-signatories to the Protocol to take advantage of
the existence of the Protocol to argue an industry standard and thereby defeat litigation seeking injunctive relief has taken a firm hold.”  By then, a federal court in Utah had denied injunctive relief for Merrill Lynch, stating, “If customer confidence is not undermined when a departing broker leaves for another Protocol firm, it is difficult to comprehend why customer confidence constitutes irreparable harm when a departing broker goes to a non-Protocol firm.”  Similarly, a Wisconsin federal court had relied upon the Protocol, court opinions and Wisconsin law to deny an injunction request related to the taking of client names, addresses, telephone numbers and email addresses.

As background, the principal goal of the Protocol is client choice.  The Protocol provides:

The principal goal of the following protocol is to further the clients’ interests of privacy and freedom of choice in connection with the movement of their [financial advisers] between firms.  If transitioning [financial advisers] and their firm follow this Protocol, neither the transitioning [financial adviser] nor the firm that he or she joins would have any monetary or other liability to the firm that the [financial adviser] left by reason of the [financial adviser’s] taking the information identified below or the
solicitation of the client services by the [financial adviser] at his or her prior firm.

To take advantage of the Protocol protection, though, transitioning financial advisers may take only the following client account information: client name, address, phone number, email address, and account title of the clients that they serviced while at the firm (the “Client Information”). 
They are prohibited from taking any other client documents or information (such as client account numbers, account statements or tax identification numbers).  Similarly, financial advisers may not share with their new firm any Client Information prior to resignation (except personal sales production information). Further, the Protocol requires that resignations be in writing, be delivered to local
branch management, and include a copy of the Client Information that the financial adviser is taking with him or her.  The Client Information list delivered to the branch additionally must
include the account numbers for the clients serviced by the financial adviser.  It is worth noting that nothing in the Protocol alters the common law duty of loyalty as it relates to prohibiting a financial adviser from soliciting clients (to move their accounts) and staff (to join the new firm) before the adviser resigns.

So, has the sea change, with respect to the increasingly broad application of the Protocol, continued, or is it reversing?  Overall, court opinions do not provide clear guidance.  Nonetheless,
it is clear that some courts continue to refuse to extend Protocol protections
to non-signatories.  Consider a 2011 Connecticut state court case in which the court ruled that the Protocol rules were inapplicable to the parties’ dispute because neither the plaintiff nor the
defendant was a signatory to the Protocol.

Additionally, in 2012 a FINRA panel of arbitrators rendered a reasoned award in a dispute involving
Fidelity and Morgan Stanley.  In that case respondents argued that the Protocol had become an “industry standard” and a “best practice” in the securities industry.  Nonetheless, the arbitrators rejected that argument, finding, “Based on rudimentary principles of contract law, it is axiomatic that Fidelity, as a non-signatory, cannot be bound by nor have the terms of the Protocol imposed upon it by a signatory firm.”

Finally, one must be mindful of the fact that federal privacy regulations (known as Regulation
S-P) also can impact the strategy surrounding and the outcome of an employment transition.  For example, in a Securities and Exchange Commission enforcement proceeding against NEXT Financial Group, the SEC issued an order against NEXT for allowing its financial advisers to disseminate customer nonpublic personal information (albeit for thousands of customers) without notice or ability to opt-out.  The SEC disagreed that the Protocol justified that behavior.

In conclusion, it is uncertain whether the sea change has continued or is reversing.  The protections of the Protocol may or may not apply to non-signatories, depending upon the facts of the case
and the court jurisdiction.  Accordingly, lawyers and their clients are urged to research the law in their particular jurisdiction before relying upon any Protocol protections that may – or may not
-- exist.

SEC Examination Priorities Announced

Annually, the Securities and Exchange Commission (SEC) determines and communicates to investors and SEC registrants the examination priorities that best will protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.  This year’s priorities include several new
and emerging issues, as well as some ongoing risks, which I discuss below.

Preliminarily, the SEC’s examination priorities are published and effectuated through the
National Examination Program (“NEP”).  NEP covers four distinct program areas: investment advisers and investment companies; broker-dealers; clearing and transfer agents; and market
oversight.  NEP-wide initiatives, which apply to all registrants, include fraud detection and prevention and conflicts of interest.  Regarding fraud detection and prevention, NEP has adopted a risk-based approach to targeting registrants, and utilizes both quantitative and qualitative tools to identify fraudulent and unethical behavior.  The SEC, and NEP in particular, also encourages tips, complaints and referrals.  Likewise, with respect to conflicts of interest, NEP reviews all registrants to ensure that if not eliminated, conflicts are properly mitigated and managed.  NEP also reviews the sufficiency of disclosures regarding conflicts of interest made to investors.

Moving on to the examination program for investment advisers and investment companies (like mutual funds), NEP has identified five areas of ongoing risks.  They are: safety of assets; conflicts of interest related to compensation arrangements; marketing and performance advertising; conflicts of interest related to allocation of investment opportunities; and fund governance.  In terms of new and emerging issues for investment advisers and investment companies, NEP identifies several worth noting.  One is the focus upon the growing use of alternative and hedge fund strategies in open-end (mutual) funds, exchange-traded funds (ETFs) and variable annuity structures.  In particular, the SEC staff “will assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.”

Another major, new and emerging initiative relates to dually registered investment advisers and brokerage firms.  There has been a “continued convergence”, and the SEC is concerned about “multiple conflicts” that this business model presents.  The publication states, “Among other things, the staff will review how financial professionals and firms satisfy their suitability obligations when
determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.” 

Moving on to the examination program for brokerage firms, the sheer size of the broker-dealer program is noted: 4,600 registered broker-dealers, approximately 111 million customer accounts, over 160,000 branch offices, and over 630,000 registered representatives!  Examinations thus are focused upon issues and practices that present the highest risk to investors and to the integrity of the market. 
Beyond that, though, NEP identifies several ongoing risks that will be a focus for 2013 brokerage firm examinations.  They are: sales practices and fraud; trading risks; capital and other financial risks; and anti-money laundering (“AML”).  Regarding sales practices and fraud, the publication notes that an examination “frequently finds fraud” in connection with some of the following: affinity fraud or fraud targeting seniors; unsuitable recommendations of higher yield products such as municipal or corporate
bonds; outside business activities; failure to mitigate or disclose conflicts of interest; and a focus on firms identified as recidivists or high risk for potential misconduct.

There are two new and emerging issues related to broker-dealer examination priorities.  One concerns ETFs.  The examination program will continue to examine the suitability of leveraged and inverse ETFs.

Noteworthy is one new and emerging risk relating to transfer agents.  Specifically, microcap securities and private offerings are a focus of the 2013 examination program -- both for transfer agent examinations and for broker-dealer examination programs.  The reason for their inclusion in transfer
agent exams is that, “Transfer agents that service microcap securities, especially those involved in private offerings, may be used to facilitate the unregistered offering of restricted securities by allowing securities transfers that could circumvent existing rules or enable fraudulent schemes.”  To counter that, SEC staff will review for effectively implemented formal written policies and procedures, and be on guard for conflicts of interest.

As one can see, there are many important examination priorities set for 2013.  While not exhaustive, and while subject to change, investors should be pleased at the breadth and scope of the SEC’s /
NEP’s examination program for 2013.

Broker Protocol Again Revisited; Still an "Industry Standard" for Employment Transitions

In early 2009 and again in late 2010, I examined the Protocol for Broker Recruiting (the “Protocol”) and court opinions applying it to situations in which financial advisers had transitioned their employment from one financial services firm to another.  The Protocol initially was conceived as a “safe passage” set of procedures which allowed signatories to the Protocol to avoid litigation (TROs,
other injunctive relief and damages) associated with the solicitation of clients and the taking of client information from one signatory firm to another signatory firm. 

Straightforward enough.  However, in early 2009 I also identified an “unintended consequence.”  That is, we began to see non-Protocol signatories, faced with litigation, arguing that the Protocol effectively had become an industry standard for transitioning financial advisers.  Those
non-signatories to the Protocol therefore contended that they should not be subject to TROs, other injunctive relief and damages even though they themselves might have signed employment agreements or other contractual agreements that expressly had contemplated such relief.  I concluded in early 2009 that such a creative argument had experienced considerable (though certainly not universal) success in the courts. For example, a federal court in Ohio handed Merrill Lynch a defeat in its effort to rein in brokers departing to a non-signatory firm, stating that, “By setting up such a procedure for departing brokers to take client lists, Merrill tacitly accepts that such an occurrence does not cause irreparable harm.”  Likewise, a Massachusetts state court held the same way in a case involving Smith Barney.

By late 2010, I reached the conclusion that a “sea change” was taking place.  I wrote, “It now appears that the unintended consequence of allowing non-signatories to the Protocol to take advantage of
the existence of the Protocol to argue an industry standard and thereby defeat litigation seeking injunctive relief has taken a firm hold.”  By then, a federal court in Utah had denied injunctive relief for Merrill Lynch, stating, “If customer confidence is not undermined when a departing broker leaves for another Protocol firm, it is difficult to comprehend why customer confidence constitutes irreparable harm when a departing broker goes to a non-Protocol firm.”  Similarly, a Wisconsin federal court had relied upon the Protocol, court opinions and Wisconsin law to deny an injunction request related to the taking of client names, addresses, telephone numbers and email addresses.

As background, the principal goal of the Protocol is client choice.  The Protocol provides:

The principal goal of the following protocol is to further the clients’ interests of privacy and freedom of choice in connection with the movement of their [financial advisers] between
firms.  If transitioning [financial advisers] and their firm follow this Protocol, neither the transitioning
[financial adviser] nor the firm that he or she joins would have any monetary or other liability to the firm that the [financial adviser] left by reason of the [financial adviser’s] taking the information identified below or the solicitation of the client services by the [financial adviser] at his or her
prior firm.

 

            To take
advantage of the Protocol protection, though, transitioning financial advisers may
take only the following client account information: client name, address, phone
number, email address, and account title of the clients that they serviced
while at the firm (the “Client Information”). 
They are prohibited from taking any other client documents or
information (such as client account numbers, account statements or tax
identification numbers).  Similarly,
financial advisers may not share with their new firm any Client Information
prior to resignation (except personal sales production information). Further,
the Protocol requires that resignations be in writing, be delivered to local
branch management, and include a copy of the Client Information that the
financial adviser is taking with him or her. 
The Client Information list delivered to the branch additionally must
include the account numbers for the clients serviced by the financial adviser.  It is worth noting that nothing in the
Protocol alters the common law duty of loyalty as it relates to prohibiting a
financial adviser from soliciting clients (to move their accounts) and staff
(to join the new firm) before the adviser resigns.

 

            So, has the sea change, with
respect to the increasingly broad application of the Protocol, continued, or is
it reversing?  Overall, court opinions do
not provide clear guidance.  Nonetheless,
it is clear that some courts continue to refuse to extend Protocol protections
to non-signatories.  Consider a 2011
Connecticut state court case in which the court ruled that the Protocol rules
were inapplicable to the parties’ dispute because neither the plaintiff nor the
defendant was a signatory to the Protocol.

 

            Additionally,
in 2012 a FINRA panel of arbitrators rendered a reasoned award in a dispute involving
Fidelity and Morgan Stanley.  In that
case respondents argued that the Protocol had become an “industry standard” and
a “best practice” in the securities industry. 
Nonetheless, the arbitrators rejected that argument, finding, “Based on
rudimentary principles of contract law, it is axiomatic that Fidelity, as a
non-signatory, cannot be bound by nor have the terms of the Protocol imposed
upon it by a signatory firm.”

 

            Finally,
one must be mindful of the fact that federal privacy regulations (known as Regulation
S-P) also can impact the strategy surrounding and the outcome of an employment
transition.  For example, in a Securities
and Exchange Commission enforcement proceeding against NEXT Financial Group,
the SEC issued an order against NEXT for allowing its financial advisers to
disseminate customer nonpublic personal information (albeit for thousands of
customers) without notice or ability to opt-out.  The SEC disagreed that the Protocol justified
that behavior.

 

            In
conclusion, it is uncertain whether the sea change has continued or is
reversing.  The protections of the Protocol
may or may not apply to non-signatories, depending upon the facts of the case
and the court jurisdiction.  Accordingly,
lawyers and their clients are urged to research the law in their particular
jurisdiction before relying upon any Protocol protections that may – or may not
-- exist.

Securities Regulators Focus on Complex Products to Better Protect Investors

FINRA (the Financial Industry Regulatory Authority) has issued a warning to financial services firms that they need to heighten their supervision of and compliance procedures associated with complex products.  Complex products include any security or investment strategy with “novel, complicated or intricate derivative-like features.”  The basic rationale for heightened supervision is the fact that FINRA is concerned that retail investors may not understand the characteristics of the product or appreciate its risks. 

As background, Regulatory Notice 12-03 is not the first notification that FINRA has provided to financial services firms. As early as 2003 FINRA sounded the alarm.  In Notice to Members 03-07, FINRA reminded members of their obligations with respect to selling hedge funds, and in Notice to Members 03-71, they did the same with respect to selling “non-conventional” investments.  Similarly in 2005, Notice to Members 05-26 recommended best practices with respect to reviewing new products.  Thereafter, the securities regulator issued numerous notices related to equity-indexed annuities,
structured products, leveraged and inverse exchange-traded funds, principal protected notes, reverse convertibles, commodity futures-linked securities and Regulation D offerings. 

The Securities and Exchange Commission (SEC) likewise has expressed concern about complex products, has devoted more resources to the issues presented by complex products, and, in recent years, has brought a number of enforcement cases. 

Let’s examine the key points contained in Regulatory Notice 12-03, focusing first on what constitutes
complexity, broadly speaking, and, second, what constitutes effective, heightened supervision. 

First, what constitutes complexity?  FINRA answers that question simply by stating that, “Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex.”  FINRA includes the following as some examples of complex products:

 

• Asset-backed securities.
• Unlisted REITs (real estate investment trusts).
• Products that include an embedded derivative component.
• Products with contingencies in gains or losses. 
• Structured notes.
• Exchange-traded products and especially leveraged or inverse
  exchange-traded funds (ETFs).
• Products with principal protection that is conditional or partial,
  or that can be withdrawn.

Second, what constitutes heightened supervision?  Preliminarily, firms must satisfy two levels of suitability.  As with any investment, the first obligation is to determine that the complex product is suitable for at least some investors (known as “reasonable basis suitability”); the second is to determine that the complex product is suitable for each particular investor to whom the firm recommends the investment (known as “customer specific suitability”).

To satisfy each level of suitability, firms must conduct adequate due diligence, so that the firm at least understands “the potential risks and rewards associated with the recommended security or strategy.”  Regulatory Notice 12-03 requires that a complex product be “thoroughly vetted”, through firms asking questions such as:

 

• For whom is the product intended, and to whom should the product
  not be offered?
• What is the product’s investment objective, is that objective
  reasonable in light of the product’s characteristics, and can less complex
  products achieve the objectives of the product?
• What assumptions underlie the product, and how sound are they?
• How is the product expected to perform in a wide variety of market
  or economic scenarios, and under what scenarios would principal protection,
  enhanced yield or other presumed benefits not occur?
• What are the risks for investors, and if the product was designed
  mainly to generate yield, does the yield justify the risks to the principal?
• How liquid is the product, and is there an active secondary market
  for the product?

Moreover, FINRA imposes additional requirements by way of a post-approval review.  That is, firms are required to “include a process to periodically reassess complex products a firm offers to determine
whether their performance and risk profile remain consistent with the manner in which the firm is selling them.”  Likewise, firms should develop procedures to “monitor how the products performed after the firm approved them”, recognizing that “[e]very product presents risks that may cause the product to perform differently than anticipated, particularly when market conditions have changed.”

Finally, the regulatory notice encourages firms to adopt heightened customer account approval procedures.  Specifically in recommending complex products, FINRA encourages firms to “adopt the approach mandated for options trading accounts, which requires that a registered representative havea reasonable basis for believing, at the time of making therecommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to
bear the risks of the recommended position in the complex product.”  In addition, FINRA observes that some firms have imposed specific limitations, such as investment concentration limitations, or “specialized investor qualification agreements that may explain the products features and risk in plain English” with a customerattestation.  FINRA reminds firms, however, that “the agreement cannot mitigate the responsibility of the firm and the registered representative to conduct a thorough, customer-specific suitability analysis.”

In conclusion, Regulatory Notice 12-03 is a game-changer!  Investors, who have suffered losses, due to
unsuitable recommendations and inadequate risk disclosures related to complex products, now can rejoice that FINRA has reminded firms of their sales practice obligations.

SEC Issues Investor Alert and Underwriter Best Practices for the Issuance of Municipal Bonds

The Securities and Exchange Commission (SEC) has issued investor and underwriter guidance with respect to municipal bonds.  For investors, the SEC issued an Investor Bulletin addressing the key
concepts associated with investing in municipal bonds.  For underwriters, the SEC issued a National
Examination Risk Alert entitled, Strengthening Practices for the Underwriting of Municipal Securities.  Let’s examine the key points of eachpublication.

First, regarding the Investor Bulletin, the SEC sets forth a basic definition of municipal bonds.  The bulletin then discusses the two most common types of municipal bonds.  They are: General Obligation bonds (which are bonds backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders); and Revenue bonds (which are not backed by the government’s
taxing power buy only by the revenues generated from the underlying, specific project or source).  Another type of bond is known as a “conduit”.  In those situations, municipal borrowers sometimes issue bonds on behalf of private entities such as a non-profit colleges or hospitals, which then agree to repay the issuer, which in turn pays interest and principal on the bonds.

The Investor Bulletin also recites some basic risks associated with the ownership of bonds (municipal bonds or corporate bonds).  Those risks are: call risk (the risk that an issuer will pay a bond before its maturity date if interest rates decline); credit risk, including default risk (when the issuer may experience financial problems making it difficult to pay interest and principal in full); interest rate risk (where the price of the bond moves up or down depending upon the movement in interest rates); inflation risk; and liquidity risk (when investors cannot find an active trading market for the
bond).  Given all of the risks associated with investing in bonds, investors must do their homework before investing.

The second SEC publication has resulted from the SEC’s “concerns about the extent of written documentation by broker-dealers of due diligence efforts and supervision of municipal securities
offerings.”  This second publication is more technical and substantive than the first publication, and includes best practices for financial services firms to consider implementing to satisfy their duty of due diligence and supervisory review.  Let’s highlight some of the more important
points.

The SEC first establishes that municipal underwriters have a due diligence obligation.  By participating in an offering, the financial services firm underwriting the offering makes an implied representation “that it has a reasonable belief in the truthfulness and completeness of the key representations made in any disclosure document used in the offering.”  In particular and as an example, a municipal securities underwriter must “obtain and review” a “deemed final” official statement, prior to bidding for or purchasing those securities.  The SEC cites its own Release issued in 2010, which set forth a number of requirements.  Among them, the 2010 Release states that “sole reliance on an issuer will not suffice in meeting an underwriter’s ‘reasonable basis’ obligations.”

Regarding supervisory obligations, the SEC cites particular MSRB (Municipal Securities Rulemaking Board) rules, which require financial services firms to supervise the conduct of their employees in
connection with their municipal securities activities.  Firms must establish and enforce written
policies and procedures.  Part of enforcement includes implementing “measures to monitor compliance with those policies and procedures and an appropriate system of follow-up and review if
red flags are detected.” 

Helpfully, the SEC provides a non-exclusive list of six factors “that it believes generally would be relevant in determining the reasonableness of an underwriter’s basis for assessing the truthfulness of key representations in a final official statement.”  They are:

• The extent to which the underwriter relied on municipal officials and other persons
  whose duties have given them knowledge of particular facts;
• The role of the underwriter;
• The types of bonds being offered;
• The past familiarity of the underwriter with the issuer;
• The length of time until maturity of the securities; and
• Whether the bonds are competitively bid or are distributed in a negotiated offering.

The SEC provides additional, helpful examples of practices used by financial services firms which may help to demonstrate due diligence and supervisory reviews.  Those examples are: Commitment Committees (which are firm-wide, senior level committees that review and approve various underwritings); use of diligence checklists; due diligence memoranda (describing due diligence efforts, issues noted and how those issues were resolved); outlines for due diligence calls; on-site
examination activities; and recordkeeping checklists.

As one can see, the SEC has issued a pair of publications that will assist both municipal bond investors and municipal bond underwriters alike! 

Financial Advisers in Motion; A Primer on the Employment Issues Facing Those in Transition

We often consult financial advisers who are transitioning their employment to a new firm. 
Financial services attorneys need to be mindful of issues unique to employees in the financial services industry.  Let’s overview the key issues.

As background, a common scenario involves a large producer moving from a major, “wirehouse” firm to another wirehouse firm.  That isn’t always the case: advisers may choose to “go independent” by
moving from a wirehouse to either an “independent” firm or even start their own investment advisory firm.  Wirehouse advisers typically have developed a client base (or “book of business”) over
many years and from many sources.  They had received, and expect again to receive, a large incentive payment up-front and over time, memorialized by a “forgivable loan”.  They likely (and unwisely) chose not to negotiate their employment agreement with the current firm, which agreement has
a host of provisions that naturally are designed to impede the adviser in his or her transition to a new firm.  Those impediments include broad document confidentiality clauses, restrictive non-solicitation (and sometimes non-competition) clauses, and consent to a TRO (injunction). 

The job of a skilled financial services employment lawyer is to consult the transitioning adviser as to what he or she may do without violating the employment agreement.  Those determinations vary with state law.  Attorneys also need to be familiar with industry practices.  One very helpful industry practice is known as the Protocol for Broker Recruiting.  Originating as a mere litigation forbearance agreement between a handful of wirehouse firms, the “Protocol” has become, in many respects, an industry standard.  While courts are not uniform in interpreting it broadly to expand the rights of transitioning advisers, the clear trend in authority points in that direction.

Consequently, lawyers need to be aware of its provisions.  In simple terms, and notwithstanding an employment agreement to the contrary, transitioning financial advisers can take with them certain client information (client name, address, phone number, email address and account titles of clients serviced), and can solicit clients to join their new firm.  While no court would refuse to
grant those rights to an adviser moving from one Protocol signatory firm to another Protocol signatory firm, the good news for advisers (and their clients wishing to keep doing business with them) is that the courts have extended Protocol rights in cases not involving Protocol signatory firms. 

 Another major area of focus is counseling with respect to a transitioning adviser’s
current promissory note obligation and negotiating the promissory note that he or she will agree to with the new firm.  Here is how the typical promissory note agreement works.  The adviser acknowledges receipt of a large amount of money paid to him or her upon arrival to the new firm, and that he owes that money to the firm.  Subsequent payments are common, which again are acknowledged in a subsequent promissory note agreement.  However, in the promissory note agreement the firm and the adviser agree that his employment service to the firm, over some number of years, will serve to forgive the note balance pro rata on an annualized basis.  The typical promissory note agreement has, over time, carried a longer term; today, we see larger deals carry as much as a 12-year term “of servitude”. 

Consequently, lawyers need to be aware of the provisions of the forgivable loan, and know
what can or should be negotiated.  For example, one may be able to negotiate monthly, not annual, forgiveness of the debt, include scenarios (like death and disability) which operate to void the note
obligation, and reduce the number of years of servitude.  More sophisticated counsel can identify
certain, unfavorable trends in the language of promissory notes (such as waiving the right to bring a counterclaim within a promissory note collection action), and attempt to negotiate to remove that language.

Another major area of focus is counseling advisers in the mechanics and strategies of their actual transition (such as, when can I ask my sales assistant to join me at the new firm, how should my relocation announcements read, and so forth), and in negotiating the new firm’s employment agreement.  We have negotiated deals involving anywhere from single adviser $100 million asset deals to multiple member team $12 billion asset deals, and everything in between.  There is one common truth: every proposed employment agreement is negotiable, and every proposed employment agreement needs to be negotiated!

We have witnessed some disturbing trends that counsel needs to be aware of in negotiating the proposed employment agreements.  For example, we have seen expanded restrictions in non-solicitation provisions.  We also have seen the often disfavored “non-competition” provision come in the “back-door” through various means, including non-contact provisions.  We have seen restrictions broadly cover prospects.  We have seen an expanded use of what advisers cannot do to solicit clients.  Some bank-owned financial services firms have attempted to implement “Garden Leave”
provisions, which effectively are a death spiral to an adviser’s career.  Also, we have seen an increasing use of “clawback” provisions when advisers do not bring over sufficient assets to
justify their up-front incentive payments.  Finally, we have seen firms attempt to restrictively define what are “qualifying assets” for purposes of subsequent incentive payments.

 As one can see, financial services employment lawyers have their work cut out for them
in doing the ever more important job of negotiating for advisers in transition!

Clarifications in New Suitability and Know Your Customer Rules Underscore their Importance

1. Overview:  On July 9, 2012 new FINRA Rule 2090 and FINRA Rule 2111 will take effect.  The goal of FINRA (the Financial Industry Regulatory Authority) is to “strengthen, streamline and clarify” those very important investor protection rules.  Indeed, that goal is apparent in reviewing FINRA Regulatory Notices 11-25 and 12-25, which elaborate on those new rules. 
2. Regulatory Notice 12-25 contains an informative answer to the question of what constitutes “reasonable diligence” in attempting to obtain the customer-specific information required by new Rule 2090, the “Know Your Customer” rule.  The rule requires financial services firms (and their advisers) to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the
   authority of each person acting on behalf of such customer.”  And an important aspect of new Rule 2090 is its emphasis on requiring Know Your Customer information not just at the time
   that the account was opened, but also throughout the life of the account relationship with the customer, so that the account may be effectively serviced and supervised. 
3. What is reasonable due diligence?  FINRA answers that what is reasonable depends upon the facts and circumstances, and that absent any “red flags” indicating that the customer information is inaccurate or that the customer is unclear about the information, an adviser generally will be able to rely on that information, for example, in making investment
   recommendations. 

 However, FINRA states that an adviser “may not be able to rely exclusively on a customer’s responses” in situations such as the following:

• The adviser “poses questions that are confusing or misleading to a degree that the
  information-gathering process is tainted”;
• The customer “exhibits clear signs of diminished capacity”; or
• Other “red flags” exist indicating that the customer information may be inaccurate.

1. The significance of securing and updating accurate customer profile information cannot be understated.  For example, in Regulatory Notice11-25, FINRA discusses a customer’s liquidity needs, time horizon and risk tolerance for investments as being important considerations for the suitability requirements contained in new Rule 2111, the “Suitability” rule.
2. Second, both Regulatory Notices 11-25 and 12-25 contain a host of helpful guidance with respect to new Rule 2111.  One thought-provoking commentary in Regulatory Notice 11-25 relates to the juxtaposition of risk tolerance, on the one hand, with time horizon, on the other hand.  For example, while one may assume that an investor with a long term time
   horizon is suitable for riskier investments, FINRA states that such an
   assumption may be wrong.  As FINRA states, “Some customers with long time horizons may not desire to take on such risk and others, because of considerations outside their time horizons, are
   unable to do so.”
3. Another important aspect relates to the fact that the new suitability rule explicitly applies to recommended investment strategies involving a security or securities.  FINRA states in Regulatory Notice 11-02 that the term “strategy” is to be interpreted broadly, and that the rule is triggered when a firm or adviser recommends a security or a strategy regardless
   of whether the recommendation results in a transaction. 
4. Most critical, FINRA states that “the term ‘strategy’ would capture a broker’s explicit recommendation to hold a security or securities.”  FINRA explains that it is reasonable to hold firms and their advisers responsible for “hold recommendations” because customers may rely on them for their expertise.  Such hold recommendations, of course, frequently were made preceding and during the market downturn in 2008, causing investors to lose substantial sums, for which securities arbitration may be an option for recovery.
5. As part of its commentary as to what constitutes an “investment strategy”, FINRA states in Regulatory Notice 12-25 that a mere recommendation broadly to invest in equities, or in fixed income securities, would not qualify.  On the other hand, the new suitability rule would apply to investment strategies such as:

• Investing in dividend paying equities;
• Investing in particular market sectors;
• Day trading;
• Using home equity to purchase investments; and
• Using margin loans to purchase investments.

10.  Indeed, those latter two investment strategies should be weighed against FINRA’s new section to the suitability rule entitled Customer’s Financial Ability.  The rule reads: “Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a security or securities or the continuing purchase of a security or securities or use of an
investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment” (emphasis added).  The new rule thus envisions situations in which an investment
recommendation is unsuitable for an investor because he or she cannot afford to
lose his or her principal.  Thus, the use of home equity, as well as margin, may be a “red flag” that the customer does not have the financial ability to engage in a particular investment transaction
or investment strategy.

11.  In conclusion, new FINRA Rule 2090 related to knowing your customer and new FINRA Rule 2111 related to suitability will provide additional protections to investors. 
That’s good news investors!

SEC's Complaint Against Life Partners Underscores Senior Protection Issues with Life Settlements

The Securities Exchange Commission (SEC) began 2012 by charging Life Partners Holdings Inc. and three of its senior executives for their “involvement in a fraudulent disclosure and accounting scheme.”  One SEC official commented that, “The senior-most executives at Life Partners concealed significant risks to the business, manipulated financial statements with improper accounting, and
knowingly profited from their misconduct by executing insider trades based on information that was not available to the public.”

For quite some time, the life settlement (sometimes referred to as the senior settlement) industry has been under scrutiny.  FINRA (the Financial Industry Regulatory Authority) has issued an investor alert entitled, “Seniors Beware: What You Should Know About LifeSettlements.”  One recent report
estimates that existing policies with a collective face value of $11.8 billion were sold by policyholders to investors in 2008.  In light of the size of the marketplace, and the SEC’s complaint against Life Partners, let’s examine the guidance contained in FINRA’s investor alert.

First, what is a life settlement?  According to FINRA, a life settlement involves selling an existing life insurance policy to a third party—a person or an entity other than the company that issued the policy—for more than the policy's cash surrender value, but less than the net death benefit.  The purchasers then continue to maintain the policy in force, by paying its premiums, until the seller’s death, at which time the purchasers receive the death benefit.

Second, what factors should one consider in determining whether to sell his or her life insurance policy?  As a preliminary matter, an insured should sell his or her life insurance policy only if he or she no longer wants it or needs it, or cannot afford the premiums.  Beyond that, FINRA details ten factors to consider.

 

• Ongoing Life Insurance Needs—If you are considering buying a new policy with the proceeds of
  the life settlement, you will need to determine whether you will be able to get a new policy with equivalent coverage—and at what cost. Your old policy will still be in force and may affect your ability to get additional coverage. Even if you can get a new policy, you may have to pay higher premiums because of your age or changes in your health status.

 

• Less Costly Alternatives—If one of the factors driving your decision is a need for cash, be aware that surrendering your life insurance policy for its cash value or pursuing a life
  settlement are not your only options - especially if you would ideally like to retain your coverage. For example, you might want to see whether you can borrow against your policy. You might also be eligible for accelerated death benefits, which allow an individual with a long-term, catastrophic, or terminal illness to receive benefits on his or her policy prior to dying.

 

• Difficulty Determining Fair Prices—One of the hardest things to know when you are selling a life
  insurance policy is whether you are getting a fair price for your policy. There is no transparent secondary market for life insurance policies. The best way to make sure you are getting a fair price is to shop around.

 

• Impact on Your Finances—A cash payment from a life settlement can have unintended financial consequences, especially if your financial circumstances have changed from when you first
  bought the policy. For example, if you currently receive state or federal public assistance, such as Medicaid, a life settlement can negatively impact your ability to participate in that program. Before you proceed with a life settlement, be sure you fully understand the financial implications for you and your family.

 

• Impact on Your Survivors—Consider carefully your need for current income against the future financial needs of your survivors. Even if you have determined that they do not need the proceeds from your insurance policy at this time, ask whether there could be a chance
  that this situation could change. If so, ask yourself whether you can obtain the liquidity you seek from other sources or by trying alternative ways to tap into the insurance proceeds as suggested above.

 Third, FINRA details questions to ask the life settlement broker or provider.  Those questions include whether the broker or provider is licensed in the state with either the state insurance commissioner
or with FINRA.  Additional questions that FINRA suggests are:

 

• What information will I have to provide? To whom? For how long? When you sell your life insurance policy, you will have to sign a release authorizing the release of medical and other
  personal information so that the buyer can determine how much to offer for your policy.

 

• What's the best price I can get for my policy? If you are using a life settlement broker, ask
  what bids were received, and what steps the broker used to make sure you are being offered the most competitive price available.

 

• What are the transaction costs? Life settlements can have high transaction costs. The commissions paid by life settlement companies to life settlement brokers and other
  financial professionals involved in the transaction can be as high as 30%.

 

• What if I change my mind? Always remember that you do not have to accept an offer to purchase your life insurance policy, even if you shopped around for the best price.
  
  
  
  
• Am I being pressured to make a fast decision? If you feel that you are being subjected to
  high-pressure sales tactics, and other aggressive advertising, marketing and sales efforts, beware. A legitimate investment professional will provide clear answers to your questions and will give you the time you need to make an informed decision.

 

In conclusion, seniors and others must be cautious in determining whether life settlements are appropriate for them.  FINRA’s investor alert is a helpful template to help insureds protect themselves.

SEC Whistleblower Program Reported To Be a Success in 2012

The SEC recently submitted its Annual Report to on the Dodd-Frank Whistleblower Program for 2012.  The report details several features of the program, including the activities of the Office of the Whistleblower, the kind of whistleblower tips received and the whistleblower incentive awards that
the SEC made in 2012.  The report also provides a helpful chart dividing whistleblower tips by type of allegation as well as by geographic location.  Let’s examine the highlights of the report.

As background, Fiscal Year 2012 was the first year of the SEC’s whistleblower program.  Chairman Mary Schapiro commented that, “In just the first year, the whistleblower program already has proven to be a valuable tool in helping us ferret out financial fraud”, because when “insiders provide us with high-quality road maps of fraudulent wrongdoing, it reduces the length of time we spend investigating and saves the agency substantial resources.”  Indeed, law firms such as ours which represent whistleblowers can take advantage of the program’s provision that whistleblowers with legal counsel can file whistleblower claims with anonymity.  That anonymity encourages the kind of insider reporting that the SEC has praised. 

As further background, by statute the SEC is directed to make monetary awards to eligible individuals who voluntarily provide original information that leads to a successful SEC enforcement action resulting in the imposition of monetary sanctions over $1,000,000, and certain successful related actions.  Awards are required to be made in the amount of 10% to 30% of the monetary sanctions collected.  Awards are paid from the SEC’s Investor Protection Fund.

Turning to the activities of the office of the whistleblower, critical functions to be aware
of include:

• Communicating with whistleblowers, including meeting with whistleblowers and their legal
  counsel, consulting with SEC staff and providing guidance as to expectations
  and follow-up;
• Reviewing and processing applications for awards; and
• Working with SEC staff to identify and track all enforcement cases potentially involving a whistleblower, and to assist in the documentation of the whistleblower’s information and cooperation in anticipation of an eventual claim for an award.

The report next details the kind of whistleblower tips received during Fiscal Year 2012.  Specifically, the SEC received 3,001 whistleblower tips, known as Forms TCR (Tips, Complaints and Referrals).  The most common complaint categories reported by whistleblowers were Corporate Disclosures and Financials (18.2%), Offering Fraud ((15.5%), and Manipulation (15.2%).  Other major categories included Insider Trading, Trading and Pricing, as well as Unregistered Offerings. 
Geographically, the SEC received tips from all 50 states, the District of Columbia, Puerto Rico and 49 countries outside of the United States.  Residents of California, New York, Florida and Texas submitted the largest number of whistleblower tips.

In terms of awards, the SEC reports that there were 143 enforcement judgments and orders issued during Fiscal Year 2012 which potentially qualify as eligible for a whistleblower
award.  The Office of the Whistleblower provided the public with notice of those actions because they involved sanctions exceeding the statutory threshold of more than $1 million.  As an example, in August a whistleblower who helped the SEC stop an ongoing multi-million dollar fraud received an award of 30 percent of the amount that the SEC had collected.  The whistleblower had helped the SEC by submitting a tip and by providing documents and other significant information
to the SEC.

Finally, the SEC reports on its Investor Protection Fund.  The fund fully is funded, and carried as of September 30, 2012 a balance of more than $450 million.  Undoubtedly, the SEC means business when it says that it wants to hear from whistleblowers!  That is good news for the securities industry and for the investors that it serves.