0SEC Staff Announces 2014 Broker-Dealer Examination Priorities

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced the 2014 examination priorities (the “Announcement”) for its National Examination Program (the “NEP”).  The priorities are organized according to the NEP’s four distinct program areas: (a) investment advisers and investment companies, (b) broker‑dealers, (c) exchanges and self-regulatory organizations, and (d) clearing and transfer agents.  This article presents selected highlights of the examination priorities for broker-dealers.  Selected highlights of the examination priorities for investment advisers and investment companies were covered in the January 21, 2014 Financial Services Alert.  Additionally, in a recent letter to its member firms (the “FINRA Priorities Letter”), FINRA set forth its regulatory and examination priorities for 2014, which in many cases overlap or are otherwise consistent with the NEP’s 2014 examination priorities.  The FINRA Priorities Letter was discussed in the January 21, 2014 Financial Services Alert.

NEP-Wide Initiatives

The NEP examination priorities include a number of topics that apply broadly across SEC registrant categories, including:

Corporate Governance, Conflicts of Interest and Enterprise Risk Management.  The staff will continue an ongoing effort to meet with senior management and boards of entities registered with the SEC and their affiliates to discuss “how each firm identifies and mitigates conflicts of interest and legal, compliance, financial, and operational risks.”  As described in the Announcement, “[t]his initiative is designed to: (i) evaluate firms’ control environment and ‘tone at the top,’ (ii) understand firms’ approach to conflict and risk management, and (iii) initiate a dialogue on key risks and regulatory requirements.”

General Solicitation Practices.  Designated as one of the most significant of the NEP-wide initiatives is the review of general solicitation practices and the verification of accredited investor status in conjunction with reliance on newly adopted Rule 506(c) under the Securities Act of 1933.  The staff “generally will review, monitor, and analyze the use of Rule 506(c); and will evaluate due diligence conducted by broker-dealers and investment advisers for such offerings.”   (See this article in the July 23, 2013 Financial Services Alert for a discussion of Rule 506(c) and this article in that issue for a discussion concerning a coordinated initiative on the part of various branches of the SEC, including the Division of Enforcement, to analyze the market impact of, and market practices that develop as result of, permitting general solicitation in connection with private offerings under Rule 506(c).)    

Retirement Vehicles and Rollovers.  The staff noted that during changes in employment or when entering retirement investors are faced with decisions as to how to manage retirement plan assets held in their former employer’s retirement plan, including whether to roll assets over into an IRA or into a retirement plan offered by the new employer.  The staff noted the potential conflicts of interest faced by investment advisers and broker-dealers that may have an incentive to recommend one option over another, and stated that, among other things, the staff will be examining broker-dealers and investment advisers for possible improper or misleading marketing and advertising, conflicts, suitability, churning, and the use of potentially misleading professional designations when recommending the movement of assets from a retirement plan to an IRA rollover account in connection with a customer’s or client’s change of employment.

Broker-Dealer Examination Priorities

The NEP examination priorities also include a number of topics that apply specifically to its Broker-Dealer Program.  Among the priorities identified for the Broker-Dealer Program are:

Sales Practices Fraud – Retail Investors.  The staff will conduct examinations designed to detect and to prevent fraud and other violations in connection with sales practices to retail investors, including (a) affinity fraud targeting seniors and other groups, (b) micro-cap fraud and pump and dump schemes, (c) unsuitable recommendations of higher yield and complex products (including the adequacy of due diligence with respect to such products), and (d) unregistered entities engaged in the sale or promotion of unregistered offerings or other unusual capital raising activities.

Supervision. The staff will focus on broker-dealers’ supervision of: (i) independent contractors and financial advisors in “remote” locations and large branch offices, (ii) registered representatives with significant disciplinary histories, and (iii) private securities transactions.

Trading.  The staff will focus on market access controls related to, among other things, erroneous orders; the use of technology with a focus on algorithmic and high frequency trading; information leakage and cyber security; market manipulation involving practices such as marking the close, parking, fraudulent stimulation of demand (spoofing), and excessive markups and markdowns.  Additionally, the staff will examine trading activity for abuses of the bona-fide market making exception to Regulation SHO, and will examine relationships between broker-dealers and Alternative Trading Systems (“ATSs”).

Internal Controls.  The staff will assess the standing, authority, and effectiveness of key control functions, including (1) liquidity, credit, and market risk management practices, (2) internal audit, (3) valuation practices, and (4) compliance.

Financial Responsibility.  The staff will review for compliance with the customer protection and the net capital rules with a focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory.

New and Emerging Issues and Initiatives.  The staff also identified other new and emerging issues and initiatives which it will examine, including: (1) whether firms are appropriately applying the Market Access Rule to their proprietary trading, as well as the adequacy of books and records maintained by broker-dealers that provide market access through master/subaccount arrangements; (2) whether registered representatives are recommending that customers accept buyback terms offered by insurance companies related to the repurchase certain variable products that have guaranteed income and/or death benefits and, if so, whether such recommendations are suitable and what types of disclosure are made to the customer; and (3) issues related to the structure of, and quality of execution of transactions, in the fixed income markets.

0SEC Settles with Portfolio Manager of Private Equity Fund of Funds Over Undisclosed Valuation Practice That Inflated Fund Performance in Marketing Materials and Investor Reports

The SEC settled public administrative proceedings against a portfolio manager (the “Portfolio Manager”) over misrepresentations he made or caused to be made to prospective and existing investors in the private equity fund of funds he managed (the “Fund”) regarding the manner in which the Fund’s largest asset (the “Underlying Fund”) was valued.  The SEC found that Fund marketing materials, primarily the Fund’s pitch book, and reports to existing Fund investors misrepresented the manner in which the Fund’s investment in the Underlying Fund was valued and that the Portfolio Manager’s undisclosed implementation of an alternative valuation methodology materially increased Fund performance over what it would have been had the valuation methodology disclosed in marketing materials and quarterly reports been applied.  The SEC also found the Portfolio Manager at fault for providing or directing others to provide marketing materials that presented Fund performance that did not reflect the effect of Fund-level expenses.

This article provides selected highlights of the SEC’s findings set forth in the settlement order (which the Portfolio Manager has neither admitted nor denied).  In 2013, the SEC settled public administrative proceedings against the registered investment adviser and its wholly owned subsidiary, also a registered investment adviser, (together, the “Adviser”), that employed the Portfolio Manager, relating to the same general underlying findings (as discussed in the March 19, 2013 Financial Services Alert).

Use of “Gross” Fund Performance

From September 2009 through at least mid-October 2009, the Portfolio Manager sent or directed others to send to consultants and prospective Fund investors pitch books reporting an internal rate of return (“IRR”) for the Fund for the quarter ended June 30, 2009 that did not deduct fees and expenses paid to underlying fund managers and the Adviser (“gross IRR”).  Including expenses at the Fund and Underlying Fund levels would have lowered the Fund’s IRR from the 12.4% reported in the pitch books to -6.3%.  The SEC found that the Portfolio manager had primary responsibility for the content of the pitch books.   

Improved Fund Performance Based on Undisclosed Change in Valuation Methodology

On October 15, 2009 Portfolio Manager submitted marketing materials with the June 30, 2009 gross IRR to the Adviser’s compliance staff (“Compliance”).  In response to comments from Compliance referencing the impact of expenses on the Fund’s return, the Portfolio Manager revised the pitch book to present the Fund’s IRR after the effect of the expenses of underlying funds, but without taking into account Fund-level expenses.  At the same time, the Portfolio Manager increased the valuation of the Underlying Fund from $6 million to approximately $9 million, basing this new valuation on the “par” value of the sole asset held by the Underlying Fund rather than, as disclosed in the pitch book and October 7, 2009 quarterly report, the value of the Underlying Fund as reported by the Underlying Fund’s manager. The Fund had up to this point reported the value of its investment in the Underlying Fund at cost, which was the fair value provided by the Underlying Fund’s manager.  Without updating disclosures regarding the valuation method used by the Fund, the Portfolio Manager revised the IRR shown in the pitch book to reflect the higher valuation for the Underlying Fund based on par value, resulting in an increase in reported IRR from 12.4% to 38%.  The reported IRR reflected the effect of expenses at the underlying fund level, but not at the Fund level.  The revised pitch book was not submitted to Compliance.  The Fund IRR based on par value for the Underlying Investment was also used in quarterly reports sent to Fund investors for the third quarter of 2009 and the year ended December 31, 2009.  

The SEC found that on numerous occasions during the period from October 26, 2009 through June 30, 2010, the Portfolio Manager also made and caused others to make the following misrepresentations in connection with marketing the Fund to existing and prospective investors and to consultants: (i) the increase in the value of the Underlying Fund was due to an increase in performance (when, in fact, the increase was attributable to Portfolio Manager’s use of par value for the Underlying Fund investment); (ii) the increase in the Fund’s IRR was attributable to increased valuations provided by third party evaluation firms (when no such valuations were provided); and (iii) the Fund’s underlying funds were audited by independent, third party auditors (when, in fact, the Underlying Fund was not audited).  

The SEC found that marketing efforts for the Fund during the period from October 2009 to June 2010 resulted in approximately $61 million in investments from new and existing investors.

Violations of Law

The SEC found that the Portfolio Manager willfully violated the anti-fraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, relating to the purchase or sale of securities.  The SEC also found that the Portfolio Manager willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder, which generally prohibit material misstatements or omissions to, and fraudulent, deceptive or manipulative practices by an investment adviser with respect to, any investor or prospective investor in a pooled investment vehicle.


In addition to a cease-and-desist order, the SEC imposed a civil money penalty of $100,000 on the Portfolio Manager and imposed an industry bar on the Portfolio Manager relating to (a) association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and (b) service in various capacities with respect to a registered investment company, subject in each case to a right to apply for reentry after two years to the appropriate self-regulatory organization, or if there is none, to the SEC.

In the Matter of Brian Williamson, SEC Release No. 33-9515 (January 22, 2014).

0FINRA Files Proposed Amendments to Rule 5110 and Rule 5121 Narrowing the Scope of Required Information and Lock-Up Restrictions in Public Offerings

On January 9, 2014, FINRA made a filing with the SEC (SR-2014-003) that proposes to amend Rule 5110 to: (1) narrow the scope of the definition of “participation or participating in a public offering;” (2) modify the lock-up restrictions to exclude certain securities acquired or converted to prevent dilution; and (3) clarify that the information requirements apply only to relationships with a “participating” member.  FINRA also proposed to amend Rule 5121 to narrow the scope of the definition of “control.”  The language in the current rules is broad and places restrictions and requirements on FINRA members in public offerings that FINRA finds are beyond the rules’ intended purpose.  The proposed changes, which are summarized below, would simplify the rules and clarify what actions and circumstances related to FINRA members are permissible in public offerings.

Participation in a Public Offering.  Rule 5110 regulates underwriting compensation and arrangements, which include items of value and other arrangements with FINRA members that are “participating” in the public offering of an issuer’s securities.  FINRA is proposing to amend the definition of “participation or participating in a public offering” to exclude any member that “provides advisory or consulting services to the issuer and is neither engaged in, nor affiliated with any entity that is engaged in, the solicitation or distribution of the offering.”  In its filing, FINRA explained that this would allow FINRA members to advise issuers on topics such as financing options, benefits and disadvantages of a public offering and offering terms being proposed by an underwriter.  However, if a FINRA member engages in any solicitation or distribution activities, then all compensation paid to that member, including for any advisory or consulting services, would be subject to the compensation limitations of Rule 5110.

Lock-Up Restrictions.  Rule 5110(g) places a 180-day lock-up restriction on underwriters barring them from selling securities acquired in the period beginning 180 days before the initial filing with FINRA, including securities that are excluded from underwriter compensation pursuant to Rule 5110(d)(5).  The proposed amendments would remove the lock-up restriction from the category of securities owned by a FINRA member due to “acquisitions and conversions to prevent dilution.”  FINRA notes that Rule 5110(d)(5) requires as a condition to the exclusion that the securities have been provided to all similarly situated security holders, and that the receipt of these additional securities did not increase the recipient’s percentage ownership of the same class.  FINRA explains that locking up such securities thus does not provide any useful protection, and that it is proposing to remove the lock-up restrictions on securities received in a transaction excluded by Rule 5110(d)(5) in order to remove unnecessary burdens on firms to track and monitor compliance with the lock-up provisions, among other reasons.

Information Requirements.  FINRA is proposing to amend Rule 5110(b)(6)(A)(iii) to require disclosure of affiliations or associations that officers, directors or certain owners of the issuer have with only “participating members” and not “members” in general.  FINRA recognizes that affiliations with non-participating members does not present the concerns that Rule 5110 is meant to address, including whether members are in a position to extract unreasonable underwriting terms.

Definition of “Control.”  FINRA is proposing to revise the definition of “control” in Rule 5121(f)(6) to exclude from it beneficial ownership of 10 percent or more of the outstanding subordinated debt of an entity.  FINRA explains that ownership of 10 percent or more of the outstanding subordinated debt of an issuer is not a meaningful measure of control or affiliation, and the proposed amendment would reduce the scope of information required to be reported by members.

Public Comment.  Comments are due 21 days after publication of the proposal in the Federal Register.

0House Passes Bill to Increase Shareholder Count Thresholds Triggering Securities Exchange Act Registration/Deregistration Obligations for Savings and Loan Holding Companies

On January 14, 2014, the House of Representatives passed H.R. 801, the Holding Company Registration Threshold Equalization Act of 2013 (the “Act”), which would increase the number of shareholders that trigger registration and deregistration obligations for savings and loan holding companies under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  The Act is designed to correct what is viewed as a technical error in the JOBS Act, which raised the registration threshold from 500 to 2,000 shareholders of record and the deregistration threshold from 300 to 1,200 shareholders of record for banks and bank holding companies, but did not explicitly extend these changes to savings and loan holding companies.  Since the passage of the JOBS Act, over 100 banks and bank holding companies have deregistered their common stock under the Exchange Act while similarly situated savings and loan holding companies have continued to be subject to SEC periodic reporting requirements.  If the Act is passed by the Senate and signed by the President, savings and loan holding companies will be eligible to take advantage of the higher shareholder of record registration and deregistration thresholds set forth in the JOBS Act.

For information on the advantages and disadvantages of deregistering under the Exchange Act, please contact Samantha M. Kirby or Matthew Dyckman in Goodwin Procter’s Banking Practice.

0OCC Requests Comments on Proposed Guidelines Setting Minimum Standards for Risk Governance Framework and Board Oversight of Banks with $50 Billion or More in Consolidated Assets

The OCC issued proposed guidelines (the “Proposed Guidelines”) that would establish minimum standards for the design and implementation of a risk governance framework (the “Risk Framework”) by national banks, federal savings associations and federal branches of foreign banks with total consolidated assets of $50 billion or more (“Large Banks”).  The Proposed Guidelines also would establish minimum standards for a board of directors in overseeing the Framework’s design and implementation for Large Banks.  The Proposed Guidelines would be issued as a new Appendix D to the OCC’s safety and soundness regulations that appear at 12 C.F.R. Part 30 promulgated under the authority of section 39 of the Federal Deposit Insurance Act.  In addition to Large Banks, the OCC said that the Proposed Guidelines could also be applied to banks smaller than Large Banks that are deemed to be highly complex or to present a heightened risk.  The  OCC stated that it decided to issue these minimum standards as “guidelines” rather than as “regulations” so that the OCC can retain its discretion to determine whether, in a particular case, it will require a Large Bank to submit a written remediation plan.

The Risk Framework

Under the Proposed Guidelines, a Large Bank is expected to establish and implement a Risk Framework “that manages and controls” the Large Bank’s risk taking.  The Risk Framework is to be designed by an independent risk management unit and be approved annually by the Large Bank’s board of directors or risk committee.  The Risk Framework is expected to be formal and in writing and cover the following categories of risk, if applicable to the Large Bank: (1) credit risk; (2) interest rate risk; (3) liquidity risk; (4) price risk; (5) operational risk; (6) compliance risk; (7) strategic risk; and (8) reputation risk.

In the Proposed Guidelines, the OCC also describes the roles and responsibilities of what the OCC characterizes as the three lines of defense to control risk taking: (i) the front-line units; (ii) independent risk management; and (iii) internal audit.  The OCC stresses that risk management and internal audit must have “unfettered access to the Board, or a committee thereof” concerning their risk assessments, findings and recommendations.  For the Risk Framework to be effective, it is also crucial that the risk management and internal audit functions have a sufficiently high stature within the Large Bank to allow the risk management and internal audit units to carry out their respective responsibilities effectively. 

Strategic Plan and Risk Appetite Statement

Moreover, under the Proposed Guidelines, a Large Bank is expected to develop a three-year strategic plan that reflects the current and expected risks facing the depository institution.  Further, the Large Bank should have a comprehensive written risk appetite statement that describes its risk appetite and ties its risk appetite to the Large Bank’s strategic objectives and business plan.  Furthermore, the objectives and business plan as well as the risk appetite statement must be consistent with capital, liquidity and other regulatory requirements.

Standards for Board of Directors

The Proposed Guidelines also provide minimum standards that the Large Bank’s board of directors must meet in overseeing the Risk Framework design and implementation.  The standards set for boards of directors by the Proposed Guidelines are high.  For example, they speak of a board of directors’ duty to “enforce” an effective Risk Framework and require the board of directors to provide “active oversight,” which requires directors to “question, challenge, and when necessary, oppose recommendations and decisions made by management that could cause the bank’s risk profile to exceed its risk appetite or jeopardize the safety and soundness of the bank.”

The Proposed Guidelines provide that at least two members of the board of directors should not be members of the Large Bank’s (or its parent company’s) management.  Moreover, the Proposed Guidelines call for a formal, ongoing training program for independent directors that includes training concerning complex bank products, services, lines of business and “risks that have a significant impact on the bank,” laws, regulations and supervisory requirements, and other topics identified by the board of directors.  Furthermore, the Proposed Guidelines require a Large Bank’s board of directors to conduct an annual self-assessment regarding its risk governance effectiveness.

Comment Deadline

Comments on the Proposed Guidelines are due within 60 days of the date they are published in the Federal Register.

0Goodwin Procter Alert: FTC Adjusts HSR and Clayton Act Reporting Thresholds

Goodwin Procter published a client alert that discusses the FTC’s adjustments for 2014 to the Hart-Scott-Rodino Act reporting thresholds and the interlocking directorate thresholds under Section 8 of the Clayton Act.

0NFA Seeks Comment on Possible Capital Requirements for CPOs and CTAs and Additional Customer Protection Measures

The National Futures Association (“NFA”) issued Notice to Members I-14-03 seeking comment from its Member CPOs and CTAs as it considers (a) possible means of ensuring that each CPO or CTA has sufficient assets to operate as a going concern and (b) ways to strengthen the regulatory structure governing CPO operations to provide greater protection for customer funds.  This article provides summary highlights of the Notice.

CPO/CTA Capital Requirement

NFA is seeking input from its CPO and CTA Members on the concept of imposing capital requirements on CPOs and CTAs.  The Notice lists specific topics for comment in the following areas: (a) whether or not to impose a capital requirement, the appropriate amount of such a requirement, and the need for any related financial reporting and (b) alternative means of ensuring sufficient funds for ongoing CPO/CTA operation.

Additional Customer Protection Measures

The Notice requests comment on the following additional customer protection measures that are currently under consideration as a means of addressing improper use of pool funds by CPOs:

  • Independent third party authorization for disbursement of pool funds
  • NAV valuation and monthly or quarterly reporting
  • Independent preparation/verification of performance results
  • Verification of pool assets through periodic reporting to NFA by entities holding pool assets

The Notice also seeks comment on the appropriateness of maintaining memberships for CPOs and CTAs that do not engage in any commodity interest trading.

Comment Deadline

Comments in response to the Notice are due no later than April 15, 2014.

0Goodwin Procter DC Office Adds Expertise in Securities, and M&A for Middle Market and Community Banks

Matthew Dyckman recently joined the firm as counsel in the Banking Practice of the firm’s Financial Institutions Group, extending the firm’s expertise in corporate finance, securities, and M&A for middle market and community banks.  Matt also has extensive experience with federal banking laws and regulations and in dealing with federal and state bank regulatory agencies.  Matt routinely advises banks and other financial institutions on a host of regulatory matters, including compliance with the Bank Holding Company Act and the Home Owners’ Loan Act, regulatory capital requirements, anti-money laundering and Bank Secrecy Act, and de novo bank chartering.