Financial Services Alert - September 6, 2011

FINRA has published  Regulatory Notice 11-39 providing guidance on business communications on social media websites and on personal devices, particularly with respect to recordkeeping and supervision.  FINRA stated that the notice provides further clarification of the guidance provided in Regulatory Notice 10-06 (“Social Media Websites”) but is not intended to alter the principles stated in the earlier notice.  This article summarizes the guidance provided in Regulatory Notice 11-39, which is presented in a question-and-answer format (questions 1-14 and their responses are referred to as Q1-Q14).

Most of the guidance in Regulatory Notice 11-39 is organized around three key distinctions:  business vs. non-business communications; firm vs. third-party material; and static vs. interactive communications.  For any given communication, these distinctions have important consequences for a member firm’s liability for the communication’s content, the need for supervisory approval of the communication and recordkeeping responsibility with respect to the communication.

Business vs. Non-Business.  SEC Rule 17a-4(b)(4) under the Securities Exchange Act of 1934 requires a firm to retain records of communications that relate to its “business as such.”  The analysis of whether a communication is business-related does not depend on whether it is made on a personal device of a registered person or a firm-issued device; rather, it depends on the content of the communication.  A communication by a registered person relating to the firm’s business would be subject to the record-keeping requirement even if sent through a third party’s platform or system.  Firms must have policies and procedures to (i) train associated persons regarding the difference between business and non-business communications and (ii) ensure that any business communication made by an associated person is retained, retrievable and supervised (Q1).

Firms may permit associated persons to use personal communications devices, whether owned by the individual or the firm, for business communications, provided that the device includes programming to capture business communications.  If the device is also used for personal (non-business) communications, and the user is able to separate personal and business communications on the device, the firm is not required to supervise personal communications.  However, the firm may, if it considers it prudent, treat all communications on the device as business communications, subject to its review (Q14).

Autobiographical information that associated persons post about themselves may be business or non-business, depending on the context in which it is presented.  A resume sent to a prospective employer is not relevant to the business of the individual’s current firm.  Autobiographical information presented with information about the products and services of the member firm would be viewed as a business communication (Q2).

Firm vs. Third-Party Material.  Third-party material posted by a firm or its associated persons is generally not treated as the firm’s material for purposes of NASD Rule 2210 (Communications with the Public) unless the firm or its associated persons have adopted or become entangled with the posted material.  The recordkeeping requirements, however, require retention of the material if it relates to the business of the firm (Q4).

The concepts of adoption and entanglement were developed by the SEC in its interpretive releases on Use of Electronic Media (Rel. No. 33-7856, April 28, 2000) and Use of Company Web Sites (Rel. No. 34-58288, Aug. 1, 2008) in the context of securities registration, and adapted by FINRA for member firm communications in Regulatory Notice 10-06.  A firm is considered to be entangled in third-party material if it was involved in the preparation of the content.  A firm is considered to have adopted third-party material if it explicitly or implicitly endorses or approves the content.  A firm that co-brands any part of a third-party site, such as by placing the firm’s logo prominently on the site, is considered to have adopted the entire site, and is responsible for its contents (Q10).  A firm is not responsible for the content on a third-party site to which it links if the firm does not adopt or become entangled with the content of the third-party site and the firm does not know or have reason to know that the site contains false or misleading information (Q11).  Deleting some inappropriate third-party content (for example, screening for offensive material) does not in itself cause material that is not deleted to be deemed adopted (Q12).

Firms should have policies to cover what associated persons must do in the event that a third party posts a business-related communication on an associated person’s personal social media site.  For example, if the firm does not permit business communications on personal devices or social media sites, and a customer or prospective customer posts a question about securities on the associated person’s Facebook page, the associated person could be instructed to advise the person to address his or her question to a firm-approved communications medium.  If the firm permits associated persons to engage in business‑related communications on personal devices or in social media sites, the policy must provide for supervision of the communications (Q9).

Static vs. Interactive Communications.  FINRA considers unscripted participation in an interactive electronic forum to come within the definition of a “public appearance” under NASD Rule 2210, which does not require prior approval by a registered principal.  Firms must adopt procedures for post-use review reasonably designed to ensure that interactive electronic communications do not violate SEC or FINRA rules, including the content standards of Rule 2210.  A static posting, on the other hand, is deemed an “advertisement” under Rule 2210, requiring pre-use approval by a registered principal.  Interactive content on a social media site may become static if it is copied or forwarded and posted in a static medium.  If the static posting was created or adopted by the firm, it will be subject to pre‑use approval, i.e., approval prior to being converted to static form (Q6).

Recordkeeping requirements do not differ for static and interactive communications.  If they are business related, they must be retained (Q5).  A firm or associated person may not sponsor a social media site or use a communication device that includes technology that automatically erases or deletes the content, as that would preclude the ability of the firm to retain the communications in compliance with its obligations under SEC Rule 17a-4 (Q3).

Material changes to static content posted by a firm or its associated persons are subject to separate pre-use approval before the material changes take place (Q8).  Rule 2210 permits special treatment of material changes to statistical information provided on the firm’s website.  Statistical information that is presented in a static format is considered an “advertisement” under the rule and thus subject to approval and recordkeeping requirements.  However, a firm may establish templates for the presentation of the data, and subject the templates to the approval process.  The data used to populate the template fields would not be subject to approval each time it changes.  Firms using templates for statistical information must have procedures reasonably designed to ensure that the data can be verified as timely and accurate and that the firm can promptly correct data that is erroneous when posted or after the passage of time.

Ongoing Monitoring of Compliance.  FINRA expects firms to conduct appropriate training and education concerning its policies relating to the use of social media.  Firms are required to look for and follow up on “red flags” that may indicate an associated person is not complying with the firm’s social media and communications policies (Q7).  Steps firms can take to ensure better compliance include (1) requiring each associated person to certify on an annual or more frequent basis that he or she is acting in a manner consistent with the applicable social media policies and (2) when feasible, conducting random spot checks of the websites and other social media sites of associated persons to monitor compliance with firm policies.

The FDIC filed a complaint (the “Complaint”) against the former directors (the “Directors”) and certain former officers of Silverton Bank, N.A. (“Silverton”), a national bank with its main office in Georgia.  The suit was filed in the U.S. District Court for the Northern District of Georgia (docket number 1:11-cv-02790-JEC).  Silverton was originally organized as a “bankers’ bank” to serve the needs of community financial institutions, and the Directors of Silverton were all chief executive officers or presidents of other community banks, which was a requirement to serve on the Silverton Board of Directors.  The FDIC alleges that the Directors’ extensive experience and knowledge of the banking industry should have meant that they were more skilled and knowledgeable about banking matters than an average corporate director and, accordingly, the FDIC states, the Directors should have been aware that their actions violated their fiduciary obligations to Silverton.  On May 1, 2009, the OCC declared Silverton to be insolvent and appointed the FDIC as receiver of Silverton.

In the Complaint, the FDIC seeks to recover damages in excess of $71 million for losses incurred by Silverton in connection with transactions that were allegedly caused by the negligence, gross negligence, breaches of fiduciary duties and/or waste committed by the Silverton Directors and/or the named officers of Silverton.  The FDIC alleges that at the time when Silverton’s financial condition was seriously impaired and when the Directors should have been aware of the downturn in economic conditions, the Directors wrongfully approved certain transactions specified by the FDIC (including the purchase of two corporate airplanes, the building of a massive airplane hangar, the hiring by Silverton of eight private jet pilots to transport the Directors and prospective clients to lavish corporate retreats, the holding of lavish annual shareholder meetings and conferences, and the construction of a palatial new bank office building).  Moreover, during the period when Silverton was under financial stress, the FDIC alleges that the Directors allowed Silverton to pursue a rapid growth strategy that relied on a high level of brokered deposits and expanded Silverton’s commercial real estate acquisition and construction loans both in Georgia and outside of Georgia, where Silverton had little experience and an inadequate understanding of the local market, and also broadened Silverton’s commercial real estate lending activities, which, the FDIC alleged, were conducted without proper underwriting standards and without adequate credit administration.

The FDIC alleged in the Complaint that the Directors and the other defendants “failed to exercise any business judgment [with respect to the criticized transactions] or even exercise a slight degree of care.  There was a complete disregard for the interests of the bank.” 

The FDIC stated that the Silverton Directors were “asleep at the wheel” and “robotically voted” to approve transactions without using their business judgment.

The SEC issued a concept release requesting public comment on issues related to the use of derivatives by registered management investment companies and companies that have elected to be treated as business development companies (“BDCs”) under the Investment Company Act of 1940 (collectively, “funds”).  The release is part of a review being conducted by the SEC and its staff to determine whether the regulatory framework, as it applies to funds’ use of derivatives, continues to “fulfill the purposes and policies underlying the Act and is consistent with investor protection.”  The review may ultimately result in regulatory initiatives.  The concept release focuses on the following topics: 

• Leverage - the Act’s senior securities limitations as applied to derivatives (and related SEC and staff guidance), industry practice with respect to coverage and asset segregation, criticisms of the Act’s requirements in this area and other approaches to limiting the use of derivatives, including those taken by non-U.S. regulators;
• Diversification - valuation practices and issuer determinations for derivatives when classifying funds as diversified or non‑diversified under Section 5(b)(3) of the Act;
• Exposure to Securities-Related Issuers - potential exposure to securities industry‑related issuers subject to Section 12(d)(3) of the Act because of the business activities of a derivatives counterparty or the issuer of reference assets, and methods of valuing derivatives when a fund relies on the conditional exemption for investment in securities industry-related issuers provided by Rule 12d3-1 under the Act;
• Fund Industry Concentration Policies - industry exposure through derivatives counterparties and issuers of reference assets, and valuation methods for derivatives when determining industry concentration; and
• Valuation of Derivatives in Determining Fund Net Asset Values. 

The concept release notes that the SEC may consider other significant derivatives-related issues under the Act, such as those related to disclosure, at a later date.  Comments on the concept release may be submitted no later than 60 days after its publication in the Federal Register.

The FRB issued a Notice of Information Collection, seeking comment on its proposal (the “FRB Proposal”) that would allow savings and loan holding companies (“SLHCs”) a two‑year phase‑in period to file FRB regulatory reports on the same forms as those filed by bank holding companies (e.g., Annual Reports on Form FR Y-6, Financial Reports on Form FR Y-9C) and to exempt a limited number of SLHCs from initially filing FRB regulatory reports.  The FRB uses the FRB regulatory reports to monitor holding company operations, determine compliance with the Bank Holding Company Act and Regulation Y and perform other supervisory functions.

As of July 21, 2011, pursuant to the Dodd-Frank Act, the OTS, the agency previously responsible for the supervision of SLHCs, was merged into the OCC, and the OTS’ former duties are now divided among the FRB, the OCC, the FDIC and the CFPB.  The FRB initially proposed that SLHCs be subject to the same type of regulatory reporting as bank holding companies.  Prior to receiving reports from SLHCs on FRB regulatory reports, the FRB, under the FRB Proposal, would rely on organizational and financial information contained in the Thrift Financial Reports and other OTS reports that thrifts and their holding companies had been filing with the OTS, and the FRB would gradually phase in FRB regulatory reports.  The FRB Proposal would also give a small number of insurance companies an exemption from the reporting requirements.

The FRB will accept comments on the FRB Proposal through November 1, 2011.