Weekly RoundUp
March 11, 2015

Financial Services Weekly News

SEC Spotlight on Broker-Dealer Supervision of Outside Business Activities of Registered Representatives. In this issue we report on the SEC’s settled administrative proceedings against H.D. Vest Investment Securities, Inc., a broker-dealer with a network of over 4,500 independent contractor registered representatives located throughout the United States, most of whom are tax professionals operating tax businesses as outside business activities. The SEC found that H.D. Vest had violated customer protection rules after failing to adequately supervise registered representatives who misappropriated customer funds. Similar arrangements in which individuals become registered with broker-dealers on an independent contractor basis are increasingly being used by investment fund advisers as a means of registering their marketing personnel; this trend is driven both by the SEC’s increased focus on whether marketing personnel are registered and by the substantial investment of time and money necessary to register a new broker-dealer firm, often not economically justifiable. In the announcement of the H.D. Vest settlement, the SEC acknowledged the challenges faced by broker-dealer firms with numerous small branch offices spread across the country, but the SEC did not specifically address the additional challenges that arise when registered representatives are also employees or associated persons of an entity subject to separate regulation. In the investment fund context, registered representatives of the broker-dealer may also be investment adviser personnel, subject to supervision of the investment adviser. Neither SEC nor FINRA rules provide adequate guidance concerning how responsibility for supervising dual-hatted employees should be accomplished, leaving counsel and compliance officers to negotiate procedures that will satisfy the requirements of both regulatory regimes without interfering with the ability of the registered representative of the broker-dealer to conduct the “outside business activity” of being an investment adviser.

Regulatory Developments

Financial Stability Board Issues Revised Proposal for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions Including Investment Funds, Asset Managers and Broker-Dealers

The Financial Stability Board announced that in consultation with IOSCO, it had issued a revised proposal with methodologies for identifying non-bank non-insurer (NBNI) global systemically important financial institutions (G-SIFIs). The proposed NBNI G-SIFI methodologies include a high-level framework and an operational framework for identifying G-SIFIs that would apply across NBNI financial entities, as well as a “backstop” guiding methodology for assessing the global systemic importance of NBNI financial entities that are not covered by one of the sector-specific methodologies for (i) finance companies, (ii) market intermediaries, (iii) investment funds and (iv) asset managers. The methodologies being proposed for investment funds and asset managers would operate separately, which could result in funds managed by an asset manager being identified as NBNI G‑SIFIs, without the asset manager being identified as such, or, the asset manager being identified as an NBNI G-SIFI, while the funds it manages are not. The FSB and IOSCO are considering excluding public financial institutions (e.g., multilateral development banks and national export-import banks), sovereign wealth funds and pension funds from the scope of the proposed NBNI G-SIFI methodologies. The deadline for public comment is May 29, 2015.

CFPB Holds Public Discussion of Results of Study of Mandatory Arbitration Clauses

On Tuesday, March 10, the CFPB held a public field hearing in Newark, N.J., to discuss the results of its study on the use of mandatory arbitration clauses in connection with consumer financial products and services. The study looked at arbitration clauses in at least six different consumer finance markets and found that tens of millions of consumers are covered by arbitration clauses, with large numbers in the credit card debt and checking account markets. It found consumers did not file a great amount of arbitration cases or individual federal lawsuits, and that lawsuit filings greatly outpaced arbitration filings. It also found that while nearly 32 million consumers were eligible for relief through consumer financial class action settlements each year, arbitration clauses were often invoked to block class actions. The majority of consumers did not know if they were subject to an arbitration clause, and the study found no evidence of arbitration clauses leading to lower prices for consumers. The CFPB has authority to issue regulations prohibiting or imposing conditions limiting the use of arbitration clauses in consumer financial contracts.

OCC Issues Revised Deposit-Related Credit Booklet of the Comptroller’s Handbook

On March 6, the Office of the Comptroller of the Currency (OCC) issued a revised “Deposit-Related Credit” booklet of the Comptroller’s Handbook. This booklet replaces and clarifies the version of the booklet issued on February 11, 2015. The Deposit-Related Credit booklet references relevant supervisory guidance and includes examination procedures that OCC examiners use to assess a bank’s deposit-related credit products and services.

SEC Advisory Committee on Small and Emerging Companies Makes Recommendations Regarding Accredited Investor Definition

At its March 4, 2015 meeting, the SEC Advisory Committee on Small and Emerging Companies approved proposed written recommendations on the “accredited investor” definition (subject to subsequent amendment discussed at the meeting to reflect the concept that the tax treatment of assets, e.g., their status as “retirement assets,” should be disregarded when determining net worth for accredited investor status). The Committee’s principal recommendations are that (i) any modifications to the definition should expand the pool of accredited investors, e.g., by adding a category of investors who meet a sophistication test, regardless of income or net worth, (ii) to address the effect of inflation, accredited investor thresholds should be adjusted according to the CPI, (iii) the SEC should seek to protect investors through enhanced enforcement efforts and increased investor education rather than by raising accredited investor thresholds or excluding certain asset classes from the accredited investor determination, and (iv) the SEC should continue to gather data in this area for ongoing analysis.

Acting Director of SEC’s Division of Investment Management Discusses Regulatory Initiatives for Registered Advisers

In remarks at the 2015 IAA Compliance Conference, Dave Grim, Acting Director of the SEC’s Division of Investment Management, discussed the Division’s work on recommendations for registered advisers in the three principal areas referred to in SEC Chair Mary Jo White’s December 11, 2014 speech regarding regulatory initiatives for the asset management industry. The first area of recommendations involves enhanced data reporting by registered advisers on Form ADV and Form PF and otherwise, and collection of additional data on separately managed accounts. The second area of recommendations involves a proposal to require investment advisers to create transition plans to prepare for major disruptions in their business, such as the departure of key personnel or an adviser’s dissolution or sale. Finally, building on what the SEC has learned about stress testing through money market reform, the Division is evaluating what protocols may be appropriate for investment advisers and investment companies to implement the requirements for annual stress testing by certain large investment advisers, funds and broker‑dealers required by Section 165(i)(2) of the Dodd-Frank Act.

Acting Director Grim Also Discusses Regulatory Initiatives for Registered Funds

In remarks at the PLI Investment Management Institute 2015, Acting Director Dave Grim discussed the work of the Division of Investment Management on recommendations for registered funds in three principal areas referred to in SEC Chair Mary Jo White’s December 11, 2014 speech regarding regulatory initiatives for the asset management industry. The first area of recommendations involves enhanced data reporting by registered funds and advisers, including updates to the collection of basic census information in Form N-SAR and quarterly portfolio holdings information on Forms N-CSR and N-Q , and standardization of the information reported regarding certain investments, such as derivatives. The second area of recommendations relates to derivatives, including the current approach of segregating assets and the limitations on the use of leverage by funds. In this context, the Division is also considering whether funds should be required to establish broad risk management programs to address risks related to their derivatives use. Finally, the Division is considering recommending a new comprehensive approach to the management of the liquidity risks associated with fund portfolio composition.

Enforcement & Litigation

SEC Settles With Broker and its CEO Over Participation in CDO Liquidation Auctions

The SEC announced that it had settled administrative proceedings against VCAP Securities, LLC, a broker-dealer engaged to conduct auctions liquidating certain collateralized debt obligations (CDOs), and Brett Thomas Graham, VCAP’s CEO, over SEC findings that the respondents had improperly arranged for a third-party broker-dealer to bid in these liquidation auctions on behalf of Vertical Capital, LLC, VCAP’s affiliated investment adviser, for which the CEO acted as a portfolio manager. The third-party broker-dealer successfully bid for bonds in the liquidation auctions at prices designated by VCAP based on its knowledge of other bids and subsequently sold the bonds at a slight mark-up to funds and separate accounts managed by the affiliated adviser. Under the engagement agreements with the CDOs’ trustees, VCAP and its affiliates were prohibited from bidding in the liquidation auctions and from misusing confidential information or bidding information VCAP received as the liquidation agent. The SEC also found that the CEO used confidential bidding information to enable a third-party bidder to reduce its bid on certain bonds to a winning price only slightly higher than those submitted by other bidders. The SEC found that this conduct violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. VCAP agreed to pay disgorgement and prejudgment interest of $1,149,599. The CEO agreed to pay disgorgement and prejudgment interest of $127,733, and a civil money penalty of $200,000. The CEO also agreed to a securities industry bar for at least three years, subject to a narrow one-year exception during which the CEO may continue to be employed by the affiliated adviser solely for the purpose of assisting it in the sale, or transfer to independent managers, of securities and positions held by any funds or accounts the adviser manages. In re VCAP Securities, LLC, and Brett Thomas Graham, SEC Release No. 34-74305 (Feb. 19, 2015).