Financial Services Alert - June 4, 2013

The SEC posted a notice that the Commissioners are scheduled to meet June 5, 2013 at 10 a.m. (Washington, D.C. time) at which the Commission will “consider a recommendation to propose amendments to certain rules under the Investment Company Act that govern the operation of money market funds and related amendments to Form PF under the Investment Advisers Act.”  A live webcast of the meeting should be available here on the day of the meeting.

The SEC filed a civil injunctive action with a federal district court charging the primary equity trader (the “Trader”) employed by an SEC-registered investment adviser (the “Adviser”) with (1) trading ahead of client trades (“front-running”), (2) insider trading, and (3) failing to report trades and brokerage accounts to the Adviser.  The SEC also filed a claim to recover proceeds of the alleged trading activity from the Trader’s wife (the “Relief Defendant”) in whose account the improper trades were alleged to have been made.  The federal district court granted the SEC’s request to issue an emergency court order freezing the assets of the Trader and the Relief Defendant.  This article summarizes the SEC’s allegations against the Trader and the Relief Defendant, as to which no final determinations have been made.

Background.  The Adviser provides advisory and portfolio management services to a variety of clients, including registered investment companies (“Funds”).  The SEC noted that the Adviser specializes in, and is considered by many investors to be an authority on, master limited partnership (“MLP”) issuers, MLP-related securities, and other energy-income securities (collectively referred to as “MLP/Energy securities”) and publishes four MLP Indices that are the basis for products offered by Credit Suisse and Morgan Stanley has a similar product based on one of the Adviser’s Indices.

The Adviser’s Code of Ethics.  The Adviser has a Code of Ethics and Personal Trading Policy (“Code of Ethics”) that prohibited the Trader from using material, nonpublic or “inside” information for personal profit, and included in its definition of inside information “knowledge of pending orders or research recommendations, . . . and other material non-public information that could affect the price of a security.”  The Code of Ethics also prohibited the Trader from: (1) buying or selling, for his own direct or indirect benefit, any “covered security” (as defined in the Code of Ethics and the federal securities laws) which he knew at the time the Adviser was buying or selling, or “actively considered” buying or selling, on behalf of a client; (2) using knowledge of portfolio transactions made or contemplated by the Adviser for personal profit, or otherwise engage in fraudulent conduct in connection with the Adviser’s trading; or (3) abusing his position of trust.

Under the Code of Ethics, the Trader was required to electronically execute questionnaires each quarter regarding his personal trading activity, which included disclosing his covered securities transactions for the quarter.  The Adviser’s Code of Ethics also required the Trader to disclose all personal brokerage accounts in which he has a direct or indirect interest, and to report and pre-clear certain personal securities transactions and holdings.

Alleged Selective Disclosure of Trading Accounts.  The SEC alleged that the Trader failed to report to the Adviser a trading account with Broker A in his own name, 3 accounts with Broker A in the Relief Defendant’s name, and 3 accounts with Broker B in the Relief Defendant’s name, although required to do so, in quarterly questionnaires submitted to the Adviser.  In November 2011, Broker A, whose affiliate was the clearing firm for one of the Adviser’s executing brokers, terminated the Trader’s and the Relief Defendant’s accounts after surveillance personnel reviewed the trading activity in the Relief Defendant’s accounts and the corresponding trades made on behalf of the Adviser’s clients.  In February 2013, when SEC inspection staff interviewed the Trader during an on-site examination of the Adviser, he failed to disclose the Relief Defendant’s accounts when asked to disclose all personal accounts.

Alleged Unlawful Trading Activity. The SEC alleged that the Trader used the Adviser’s confidential trading information to trade on and ahead of hundreds of the Adviser’s client trades.  The Trader accessed the Relief Defendant’s accounts from his office computer during the work day at least 1,123 times.  On over 400 occasions, without seeking pre-clearance, the Trader executed same day trades in the same securities that the Adviser traded in on behalf of its clients, realizing at least $1.7 million in profits.   The Trader made at least 132 of those trades, representing over $520,000 of the $1.7 million total profits alleged, ahead of the Adviser’s client trades in MLP/Energy securities.

The SEC’s allegations note (a) the movement from July 2013 through February 2013 of approximately $1.85 million from the Relief Defendant’s account with Broker B to a bank account, (b) the movement of approximately $1.1 million from his account at the same bank to one of the Trader’s brokerage accounts, and (c) a number of instances in which large deposits to the Trader’s brokerage account were made on the same day or within a few days of transfers between the Relief Defendant’s Broker B and bank accounts.  The SEC’s complaint also includes allegations that the Trader and the Relief Trader had significant personal expenditures, including monthly credit card bills that exceeded $10,000 and the purchase of a $94,000 automobile.

Alleged Violations. The SEC alleged that the Trader violated and unless enjoined, would continue to violate (1) the anti-fraud prohibitions of (A) Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) thereunder and (B) Section 17(j) of the Investment Company Act of 1940 (“Investment Company Act”) and Rules 17j-1(b)(1), (3) and (4) thereunder and (2) the requirements of Section 17(j) of the Investment Company Act and Rule 17j-1(d) thereunder with respect to reporting by specified personnel of a Fund adviser regarding certain securities transactions and brokerage accounts in which those personnel have a direct or indirect beneficial ownership interest.

The SEC also claimed that having received, directly or indirectly, from the Trader the proceeds of alleged unlawful activities, the Relief Defendant has been unjustly enriched, and under such circumstances, it is not equitable for her to retain those amounts.

Relief Sought.  The SEC has asked the Court to (a) grant permanent injunctions with respect to the above-referenced securities law violations, (b) order disgorgement  by the Trader plus prejudgment interest, (c) levy civil penalties against the Trader, and (d) order disgorgement by the Relief Defendant plus prejudgment interest.

SEC v. Bergin, No. 3:13-cv-1940 (N.D. Texas filed May 23, 2013).

LPL Financial LLC, a registered broker-dealer (the “Broker-Dealer”), executed a Letter of Acceptance, Waiver and Consent (“AWC”) with FINRA regarding alleged violations of record retention and monitoring rules applicable to emails.  The AWC details failures of the Broker-Dealer’s email review and retention system which resulted in the Broker-Dealer being unable to meet its obligations to review and retain emails and supervise its registered representatives.  In settling this matter, the Broker-Dealer neither admitted nor denied FINRA’s charges, but consented to the entry of FINRA’s findings, which are summarized in this article.

Applicable Rules.  NASD Rule 3010(a) requires Broker-Dealers to develop and maintain systems to supervise their employees that are reasonably designed to achieve compliance with applicable federal securities laws and FINRA Rules (including NASD Rules incorporated into the FINRA Rulebook).  Additionally, NASD Rule 3010(d)(2) requires Broker-Dealers to develop procedures for monitoring both written and electronic correspondence with the public relating to its investment banking or securities business.

Background.  According to the AWC, during the period between 2007-2013 the Broker-Dealer’s email review and retention system failed at least 35 times, preventing the Broker-Dealer from being able to access hundreds of millions of emails and to review tens of millions of emails.

FINRA found that many of the Broker-Dealer’s registered representatives operated using multiple “doing business as” (“DBA”) email addresses, however, the Broker-Dealer’s email review and retention system was designed to review only one DBA email address for each representative.  As a result of this technical limitation, FINRA found that from 2008 to 2011 the Broker-Dealer failed to review and supervise 28 million DBA email messages sent and received from its registered representatives.  FINRA also found that the Broker-Dealer was aware of the deficiencies in its email review and retention processes and procedures but failed to take adequate steps to address such failures.   FINRA found that in May 2010 the Broker-Dealer initiated an internal audit of its email review and retention system; however, in September 2010 after the internal auditor reported that there were a number of inconsistencies between the email addresses subject to review and those being used by the registered representatives the audit was stopped by a senior audit executive without any written explanation and without consulting with the audit committee of the Broker-Dealer’s board.  At the time the audit was stopped, the Broker-Dealer’s procedures did not include a requirement that the audit management seek approval of the audit committee to stop an audit. Additionally, FINRA found that the Broker-Dealer initiated, but never completed, a project in September 2010 to improve the Broker-Dealer’s email review and retention system, citing as key drivers of the project the “failure to properly surveil email…” and a contemporaneous enforcement action referral against the Broker-Dealer regarding DBA emails.

FINRA found that in March 2009, when the Broker-Dealer changed its email archiving provider, it experienced a number of significant issues with the new system, including losing access to 280 million emails for five months.  FINRA found that the issues with the archiving system ultimately resulted in the Broker-Dealer providing incomplete responses to requests for emails from certain regulatory authorities and potentially to private parties in civil litigations and arbitrations.  FINRA found that, in addition to failing to retain and monitor emails,  the Broker-Dealer did not review or archive Bloomberg messages for the seven-year period prior to 2011 and had other email supervision failures.

According to the AWC, the Broker-Dealer reported the issues with the DBA emails to FINRA in September 2011 and in response to a request for additional information issued a letter to FINRA in January 2012 that included a chronology of the events regarding the discovery of the issue with the DBA emails.  FINRA found that the Broker-Dealer made two misstatements in the January 2012 letter regarding its knowledge of its email retention and review issues.  Specifically, the Broker-Dealer stated that it was not aware of the issues with the DBA emails until June 2011 and that it had conducted regular reviews of the DBA emails and had not identified any red flags.  FINRA found, however, that the Broker-Dealer was aware of the issues with the DBA emails as early as 2008. While FINRA did not specifically find that there were red flags associated with the use of DBA accounts, it did find that there were numerous red flags relating to the adequacy of supervision of DBA accounts.

In making its findings, FINRA noted that the Broker-Dealer was in a period of rapid expansion during the relevant period and failed to devote sufficient resources to update its email systems, which became increasingly complex and unwieldy for the Broker-Dealer to manage and monitor effectively.  FINRA also noted that in January of 2011 the Broker-Dealer entered into a separate Letter of Acceptance, Waiver and Consent with FINRA related to its failure to enforce its supervisory system and procedures that required the review of emails.

Violations.  FINRA charged the Broker-Dealer with: (i) violating NASD Rules 3010(a) and (d)(2) and FINRA Rule 2010 (formerly NASD Rule 2110) by failing to maintain an adequate system and procedures to retain and review emails; (ii) violating the books and records requirements under Securities Exchange Act Rule 17a-4 and NASD Rule 3110(a) by failing to retain emails; (iii) violating NASD Rule 3010(a) and FINRA Rule 2010 by failing to adequately supervise its internal department; and (iv) violating FINRA Rule 2010 by making material misstatements to FINRA in its responses to the investigation.

Corrective Actions.  In connection with the AWC, the Broker-Dealer submitted a statement of the corrective actions it has taken to address the issues raised in the AWC.  According to the corrective action statement, the Broker-Dealer retained a third party email consultant to assist the Broker-Dealer in enhancing its email review system, initiated a plan to transition to a Microsoft Exchange environment to simplify the operational control and surveillance of emails and, working with a different third party consultant, developed a plan for enhancing the Broker-Dealer’s overall information technology organization to meet the needs of the growing company.  Additionally, according to the corrective action statement, the Broker-Dealer has implemented changes to its internal audit department policies, requiring that, among other things,  (i) audit plans be presented to the audit committee of the Broker-Dealer’s parent company for review  and approval, and (ii) any decision to stop an audit be approved by the audit committee.  The corrective action statement submitted by the Broker-Dealer does not constitute factual or legal findings by FINRA, nor does it reflect the views of FINRA, or its staff.

Sanctions.  In addition to agreeing to a censure and a fine in the amount of $7.5 million, the Broker-Dealer agreed to establish a $1.5 million fund to compensate claimants potentially affected by the failure to produce emails, and to notify claimants of their right to receive compensation payments and to obtain emails relevant to their cases that were not previously produced.  The AWC also requires the Broker-Dealer to provide FINRA with a list of all regulatory agencies that potentially received incomplete productions of emails in response to requests or subpoenas and to notify such regulatory agencies of the potentially incomplete productions of emails.

LPL Financial LLC, FINRA Letter of Acceptance, Waiver and Consent No. 2012032218001 (May 21, 2013).

The Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Department of the Treasury issued a notice of proposed rulemaking (the “NPR”) to propose the imposition of a special measure under Section 311 of the USA PATRIOT Act against Liberty Reserve, S.A., an entity organized in Costa Rica, (“Liberty Reserve”).  Liberty Reserve is a web-based “virtual currency” operator that provided users with the capability to transmit funds anonymously throughout the world.

In a separately issued finding, the Director of FinCEN determined that Liberty Reserve is a financial institution operating outside of the U.S. that is of primary money laundering concern.

In a related action, the U.S. District Attorney for the Southern District of New York filed an indictment (the “Indictment”) against Liberty Reserve and seven individuals associated with Liberty Reserve in the U.S. District Court for the Southern District of New York.  The Indictment charges that Liberty Reserve and the individual defendants ran a $6 billion money laundering scheme and operated an unlicensed money transmitting business that facilitated a broad range of online criminal activity including credit card fraud, identity theft, investment fraud, computer hacking, child pornography and narcotics trafficking.

The special measure proposed by the NPR, if adopted as a final rule, would prohibit covered financial institutions (including, among others, FDIC-insured banks, trust companies and savings associations, federally-insured credit unions, brokers or dealers in securities and mutual funds) “from operating or maintaining correspondent or payable-through accounts for or on behalf of a foreign bank if such correspondent account is being used to process transactions involving Liberty Reserve.…”  In addition, covered financial institutions would be required to take reasonable steps to apply special due diligence to all of their correspondent accounts to help ensure that the account is not being used to provide services to Liberty Reserve.  As part of its due diligence process, a covered financial institution would be expected to implement risk-based procedures to identify disguised use of its correspondent accounts “including through methods used to hide the beneficial owner of a transaction.”  FinCEN said that if the NPR is adopted as a final rule, it would “effectively cut off Liberty Reserve from the U.S. financial system.”

FinCEN seeks comments on the NPR, and the comments are due on or before the 60^th day after publication of the NPR in the Federal Register.

On May 23, 2013 the U.S. District Court for the Southern District of New York (the “Court”) denied the OCC’s motion to reconsider the Court’s April 9, 2013 order (the “Order”) allowing disclosure of the Bank of China’s (“BOC”) correspondence with the OCC and other bank regulators concerning apparent weaknesses in BOC’s anti-money laundering and counter-terrorism (“AML/CTF”) program.  The OCC had argued in its brief, filed on May 10, 2013, seeking reconsideration of the Order that the OCC, as holder of the Bank examination privilege, must be provided an opportunity to review the OCC-BOC correspondence proposed to be disclosed and to assert the bank examination privilege and object to production of those documents prior to their production in civil litigation.  The arguments asserted in the OCC’s May 10, 2013 brief were described in the May 21, 2013 Financial Services Alert.  In the Court’s May 23, 2013 Opinion and Order, the Court stated that the standard for reconsideration is that to prevail, the moving party must point to controlling decisions or data that the Court overlooked and that might reasonably be expected to change the Court’s decision.

Even though some of the documents for which disclosure was sought included the OCC’s bank examination reports, OCC evaluations of BOC policies and practices, OCC recommendations to BOC and other communications concerning apparent deficiencies in BOC’s AML/CTF compliance program, the Court denied the OCC’s motion to reconsider and concluded that the OCC failed to establish the applicability of the bank examination privilege to disclosure of the documents in dispute.

The Department of Labor (the “DOL”) has proposed an amendment to Prohibited Transaction Exemption 80-26 (“PTE 80-26”) under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  PTE 80-26 is a class exemption that permits parties-in-interest with respect to employee benefit plans to make interest-free loans to such plans if certain conditions are met.  The proposed amendment was requested by SIFMA out of concern that the position taken by the DOL in a 2011 advisory opinion indicated that individual retirement accounts (“IRAs”) engage in prohibited transactions (which could disqualify the IRA) when the IRA owner’s agreements with the financial services company sponsoring the IRA provide for indemnification or cross-collateralization (or any other type of credit support) from the IRA owner’s personal account for the benefit of the IRA.  If finalized, the proposed amendment would give retroactive relief to certain covered extensions of credit to or from an employee benefit plan and to or from a related account, such as pursuant to an indemnification agreement, cross-collateralization agreement or other grant of a security interest to a financial institution as set forth in an account opening agreement.  The proposed amendment would be effective from January 1, 1975 until the date that is six months after the date the final exemption is published in the Federal Register.  Because the relief provided by the proposed amendment will expire six months after it is finalized, financial services companies that sponsor IRAs should review their relevant agreements with IRA owners to determine whether they include provisions that will not be permissible after the expiration of the proposed amendment’s relief, and consider the appropriate steps to be taken in response to that anticipated development.  Comments are due to the DOL no later than July 23, 2013.