Financial Services Alert - March 11, 2014 March 11, 2014
In This Issue

FINRA Proposes Separate Rules for Firms Whose Activities Are Limited to Advice on Capital Raising and Restructuring and Solicitation of Institutional Investors

In Regulatory Notice 14-09, FINRA requested public comment on a proposal to adopt a narrower set of rules (the “Proposed LCFB Rules”) for member firms that meet the definition of “limited corporate financing broker” (each, an “LCFB”).  The Proposed LCFB Rules, which are available as Attachment A to Regulatory Notice 14-09, generally define LCFBs as firms that engage in a limited range of activities, essentially advising companies and private equity funds on capital raising and corporate restructuring, and do not engage in many of the types of activities typically associated with traditional broker-dealers, such as carrying or maintaining customer accounts or handling customers’ funds or securities.  Firms that engage in such a limited range of activities often are registered as broker-dealers under the Securities Exchange Act of 1934 (the “Exchange Act”) because they may receive transaction-based compensation as part of their services and, consequently, are generally subject to the same rules and regulations as traditional broker-dealers.  The Proposed LCFB Rules would apply exclusively to LCFBs and would subject LCFBs to the FINRA By-Laws, core FINRA rules that FINRA believes should apply to all firms and FINRA rules specifically tailored to address an LCFB’s business activities.

General Standards

Proposed LCFB Rule 016 defines LCFB to mean any broker that solely engages in one or more of the following activities: (i) advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities; (ii) advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger; (iii) advising a company regarding its selection of an investment banker; (iv) assisting in the preparation of offering materials on behalf of an issuer; (v) providing fairness opinions; and (vi) qualifying, identifying or soliciting potential institutional investors.  However, the term would not include any broker or dealer that: (a) carries or maintains customer accounts; (b) holds or handles customers’ funds or securities; (c) accepts orders from customers to purchase or sell securities either as principal or as agent for the customer; (d) possesses investment discretion on behalf of any customer; or (e) engages in proprietary trading of securities or market-making activities.

Under Proposed LCFB Rule 014, any firm registered as an LCFB, and any persons associated with an LCFB, would be subject to the FINRA By-Laws, unless the context requires otherwise, and the LCFB Rules.  Proposed LCFB Rule 015 provides that the LCFB Rules do not apply to transactions in, and business activities relating to, municipal securities.

Member Application and Associated Person Registration

The Proposed LCFB Rule 100 series, which generally incorporates by reference FINRA’s membership application rules, sets forth the requirements for firms that wish to register as an LCFB.  Accordingly, an LCFB applicant would follow the same procedures for membership as any other applicant, with four modifications:

  • The applicant would have to state in its application that it intends to operate as an LCFB.
  • In reviewing an LCFB membership application, FINRA would consider whether the applicant’s proposed activities are consistent with the limitations imposed by the Proposed LCFB Rules.
  • A FINRA member firm that is already approved to engage in the activities of an LCFB and is seeking to change its status without changing its existing ownership, control or business operations, would not be required to file either a New Member Application or a Change in Membership Application (“CMA”).  Instead, such a firm would be required to file a request to amend its membership agreement or obtain a membership agreement (if none exists currently) to provide that (i) the firm’s activities will be limited to those permitted for an LCFB and (ii) the firm agrees to comply with the LCFB Rules.
  • An existing LCFB wishing to terminate its status as such and continue as a general FINRA member would be required to file a CMA, and to amend its membership agreement to provide that the firm agrees to comply with all FINRA Rules.

The Proposed LCFB Rule 100 series also would incorporate by reference NASD and FINRA rules related to registration and qualification examination requirements.  Accordingly, LCFB firm principals and representatives would be subject to the same requirements as principals and representatives of other FINRA firms.  However, LCFB firm principals, representatives and associated persons would be eligible for fewer registration categories.

Proposed LCFB Rule 125 would streamline continuing education requirements for LCFBs.  It would impose Firm Element requirements (i.e., requirements that a member firm establish a formal training program) for any person registered with an LCFB who has direct contact with customers in the conduct of the firm’s corporate financing activities, and to their immediate supervisors, but would not impose any Regulatory Element continuing education requirements (i.e., requirements that all registered individuals complete training) on an LCFB.  The Proposed LCFB Rules would require an LCFB to establish and implement, administer and maintain records related to Firm Element programs that are appropriate for the LCFB’s business.  The Proposed LCFB Rules would also require covered persons to take all appropriate and reasonable steps to participate in continuing education programs required by their firm and would authorize FINRA to require an LCFB to provide special training to its covered persons in such areas as FINRA may deem appropriate.

Duties and Conflicts

The Proposed LCFB Rule 200 series would establish a streamlined set of conduct rules that would include current FINRA and NASD conduct rules and interpretative guidance related to, among others, (i) standards of commercial honor and principles of trade, (ii) use of manipulative, deceptive or other fraudulent devices and (iii) transactions involving FINRA employees.  The Proposed LCFB Rule 200 series would also impose more streamlined know-your-customer and suitability obligations than are imposed under FINRA Rules 2090 and 2111 as well as an abbreviated version of FINRA Rule 2210, which essentially prohibits false and misleading statements in a firm’s communications with the public.

Under Proposed LCFB Rule 240, if an LCFB or associated person of an LCFB had engaged in activities that would require the LCFB to register as a broker or dealer under the Exchange Act, and that are inconsistent with the limitations imposed on an LCFB under Proposed LCFB Rule 016(g), FINRA could examine the LCFB for compliance with all FINRA rules, and enforce any of those rules against the broker or associated person.

Supervision and Responsibilities Related to Associated Persons

The Proposed LCFB Rule 300 series would establish a limited set of supervisory rules for an LCFB.  FINRA rules regarding influencing or rewarding employees of others, borrowing from or lending to customers and outside business activities of registered persons would apply to LCFBs.  More specifically, Proposed LCFB Rule 311 would subject an LCFB to some, but not all, of the requirements of FINRA’s rule regarding the supervision of and responsibilities related to associated persons and would provide flexibility to LCFBs to tailor supervisory systems to their business models.  A number of the existing FINRA requirements with respect to supervision of offices, personnel, customer complaints, correspondence and internal communications would also apply to LCFBs.  However, an LCFB would not be subject to the provisions of FINRA Rule 3110 that require annual compliance meetings, review and investigation of transactions, specific documentation and supervision procedures for supervisory personnel, and internal inspections.  Proposed LCFB Rule 313 would require an LCFB to designate and identify one or more principals to serve as the firm’s chief compliance officer.  In addition, proposed LCFB Rule 331, which is similar to FINRA Rule 3310 (AML Compliance Programs), would require each LCFB to implement a written anti-money laundering (AML) program but would permit the LCFB to conduct the required independent testing for compliance every two years.

Financial and Operational Rules

The Proposed LCFB Rule 400 series would establish a streamlined set of rules concerning firms’ financial and operational obligations.  An LCFB would be subject to existing FINRA and NASD rules related to, among other things, (i) auditing, (ii) guarantees by, or flow through benefits for, members, (iii) verification of assets), (iv) fidelity bonds, and (v) books and records, including custody and records of written customer complaints.  Proposed LCFB Rule 411 would include some, but not all, of the capital compliance requirements of FINRA Rule 4110.  An LCFB would be required to suspend business operations during any period the firm is not in compliance with the applicable net capital requirements set forth in Rule 15c3-1 under the Exchange Act, and FINRA would be authorized to direct the LCFB to suspend its operation under those circumstances.  Proposed LCFB Rule 411 would set forth requirements concerning withdrawal of capital, subordinated loans, notes collateralized by securities and capital borrowings.

Because an LCFB would not carry or maintain customer accounts, it would be subject to more limited customer information requirements than traditional broker-dealers.  An LCFB would have to maintain each customer’s name and residence, whether the customer is of legal age (if applicable), the names of any persons authorized to transact business of the customer and all records required by Rules 17a-3 and 17a-4 under the Exchange Act.  Pursuant to the Proposed LCFB Rules, an LCFB would also be subject to a limited set of requirements for the supervision and review of a firm’s general ledger accounts.

Investigations and Sanctions, Code of Procedure and Association and Mediation

LCFBs would be subject to a number of the FINRA Rule 8000 series rules governing investigations and sanctions of firms.  Proposed LCFB Rule 900(c) would provide that any LCFB may be subject to a fine under FINRA Rule 9216(b) with respect to an enumerated list of FINRA By-Laws, LCFB Rules and rules under the Exchange Act.  Proposed LCFB Rule 900(d) would authorize FINRA staff to require an LCFB to file communications with the FINRA at least ten days prior to use if the staff determined that the LCFB had departed from certain standards set forth in LCFB Rule 221.  An LCFB would be subject to FINRA’s Code of Arbitration Procedure, Code of Arbitration Procedure for Customer Disputes, Code of Arbitration Procedure for Industry Disputes and Code of Mediation Procedure.

Request for Comments

FINRA requested comment on all aspects of the Proposed LCFB Rules, including any impact on institutional customers and issuers, potential economic costs and burdens that the proposal could impose on an LCFB, and any cost savings and reduced burdens that the proposal would create for an LCFB.  FINRA also requested comment on whether an LCFB should be subject to any FINRA Rules that are not included in the Proposed LCFB Rules.  In addition, FINRA requested comment concerning particular issues, including whether the Proposed LCFB Rules provide sufficient protections to customers of an LCFB and whether the Proposed LCFB Rules appropriately accommodate the scope of LCFB business models.

FINRA also asked commenters to address the SEC’s M&A Brokers No-Action Letter (pub. avail. Jan. 31, 2014, revised Feb. 4, 2014), which was discussed in February 18, 2014 Financial Services Alert. In that letter, the SEC staff provided relief from broker-dealer registration for firms engaged in activities related to the purchase or sale of a privately held company.  FINRA requested comment regarding the impact of the M&A Brokers letter on the analysis of whether a firm would become an LCFB.  FINRA also requested comment regarding whether some persons that would qualify as LCFBs will instead not register at all on the basis of the fact pattern set forth in the M&A Brokers letter. 

Comments are due on or before April 28, 2014.

OCC, FRB and FDIC Issue Joint Stress Test Guidance for Medium-Sized Banking Firms

The OCC, FRB and FDIC (collectively, the “Agencies”) issued joint final guidance (the “Final Guidance”) concerning the Agencies’ key supervisory expectations regarding how medium-sized banking organizations--those with more than $10 billion but less than $50 billion in total consolidated assets (“Medium-Sized Banking Firms”)--will implement the stress tests (the “Stress Tests”) required under section 165(i)(2) of the Dodd-Frank Act.  In performing their Stress Tests, Medium-Sized Banking Firms are required to assess the potential impact of at least three macroeconomic scenarios—baseline, adverse and severely adverse—on the Medium-Sized Banking Firm’s consolidated losses, revenues, balance sheet and capital (including risk-weighted assets).  The Agencies emphasize that the Stress Test requirements discussed in the Final Guidance (and which provide detail regarding the requirements of the final Stress Test rules adopted in October 2012 by the Agencies for Medium-Sized Banking Firms) are flexible and are intended to accommodate differences in risk profile, size, business mix, market footprint and complexity.

The Final Guidance discusses the principles behind Stress Test requirements and practices and provides information concerning the Stress Test methodologies that should be used by Medium-Sized Banking Firms.  The Final Guidance is similar to the proposed version of the guidance that was issued in July 2013 and discussed in the August 13, 2013 Financial Services Alert.  Medium-Sized Banking firms are required to complete their first Stress Tests by March 31, 2014.

In the Final Guidance, the Agencies state that Medium-Sized Banking Firms “are expected to have appropriate management information systems and data processes that enable them to collect, sort, aggregate, and update data and other information efficiently and reliably within business lines and across the company” [and the data used in the Stress Tests] should be generally consistent across time.  In addition, the Final Guidance provides detail regarding the requirement that a Medium-Sized Banking Firm publicly disclose a summary of the results of its Stress Tests.  Moreover, the Agencies note, the public disclosure should make it clear that the Stress Tests results are conditioned on the assumptions made in the scenarios provided by the Agencies to the Medium-Sized Banking Firms.  Furthermore, the Final Guidance requires that a Mid-Sized Banking Firm’s Board of Directors “should ensure it remains informed about critical review of elements of the [Stress Tests] conducted by senior management or others (such as internal audit), especially regarding key assumptions, uncertainties, and limitations.”

In the Final Guidance, the Agencies confirmed that Medium-Sized Banking Firms (unlike banking firms with $50 billion or more in total consolidated assets) are not subject to the FRB’s annual Comprehensive Capital Analysis and Review, the FRB’s capital plan rule, Dodd-Frank Act supervisory stress tests for capital adequacy and various related data collection requirements.  The OCC’s expectations for stress testing by community banks (those with less than $10 billion in total consolidated assets) were discussed in the October 23, 2012 Financial Services Alert.

CFTC Staff Issues Best Practices for Customer Information Safeguards

The CFTC’s Division of Swap Dealer and Intermediary Oversight issued a Staff Advisory outlining recommended best practices for covered financial institutions to comply with Title V of the Gramm-Leach-Bliley Act of 1999 (“Title V”), which requires financial institutions to respect the privacy of their customers and protect the security and confidentiality of nonpublic personal information, and Part 160 of the CFTC’s regulations, which help implement Title V.  The best practices in the Staff Advisory are designed to be consistent with those adopted by the federal banking agencies and the FTC and those proposed by the SEC.  The recommendations apply to futures commission merchants, retail foreign exchange dealers, commodity trading advisors, commodity pool operators, introducing brokers, major swap participants and swap dealers that are subject to the Part 160 regulations (“covered entities”).

The Staff Advisory recommends that each covered entity adopt a written information security and privacy program tailored to its specific business that, at a minimum, includes the following basic elements, which are discussed in greater detail in the Staff Advisory:  (1) designation of a specific employee with privacy and security management oversight responsibilities and of employee(s) to implement and assess the program; (2) identification of all reasonably foreseeable internal and external risks to the confidentiality of customer personal information; (3) implementation of safeguards to control the identified risks; (4) staff training to implement the program; (5) regularly testing of the program with independent testing every two years; (6) oversight of third party service providers with access to customer records and information; (7) regular evaluation and adjustment of the program in light of specified factors; (8) response procedures for incidents of unauthorized access; and (9) an annual assessment of the program provided to the covered entity’s board of directors.  The Staff Advisory concludes with a statement that the best practices are issued “with the expectation that the Division [of Swap Dealer and Intermediary Oversight] will enhance its audit and review standards as it continues to focus more resources on [Gramm-Leach-Bliley Act] Title V compliance” and a citation to a 2009 settlement in which a foreign currency broker was sanctioned for placing confidential personal consumer information of approximately 13,000 customers and prospective customers on a personal website that was accessible on the Internet for at least a year.

SEC Staff Provides Guidance on Aggregate Advisory Fee Condition for Multi-Manager Relief

The staff of the SEC’s Division of Investment Management issued an IM Guidance Update concerning the aggregate advisory fee condition in the SEC’s “multi-manager” exemptive relief.  (Under the terms of this relief, a subadviser may be engaged without a vote of fund shareholders.)  The Guidance Update refers to two different types of multi-manager structure:  the “traditional” multi-manager model, in which the fund pays an advisory fee only to the primary adviser, and the “direct pay” multi-manager model in which the fund separately contracts with, and pays, the primary adviser and each subadviser.  Regardless of the model, the exemptive relief is subject to the aggregate advisory fee condition which provides that an increase in the aggregate advisory fee paid by the fund must be approved by fund shareholders.

The Guidance Update instructs new applicants for multi-manager orders to “include the aggregate fee condition, regardless of the multi-manager model that they plan to use.  [footnote omitted] The condition should specify that any new subadvisory contract or any amendment to any existing primary advisory contract or subadvisory contract that directly or indirectly results in an increase in the aggregate advisory rate charged to the fund will be submitted to the fund shareholders for their approval.”  The Guidance Update notes that this approach is consistent with the SEC’s outstanding 2003 rule proposal designed to codify its multi-manager relief (which was discussed in the October 28, 2003 Financial Services Alert).

The Guidance Update also provides the following staff guidance on whether the aggregate advisory fee condition would be triggered under various circumstances for the direct pay multi-manager model:

  • “A fund’s hiring of its first subadviser generally would require shareholder approval under the aggregate fee condition, unless the rate that the fund pays under its primary advisory contract will be reduced by the rate the fund will pay to the subadviser so that there is no increase in the aggregate advisory rate.
  • Shareholder approval under  the aggregate fee condition generally would not be required when a fund with one or more  existing subadvisers hires an additional subadviser whose rate is no higher than: (i) in the case of the new subadviser replacing an existing subadviser, the rate of the subadviser being replaced; or (ii) the rate of another existing subadviser to which the adviser could have allocated the fund’s assets that are being allocated to the new subadviser (e.g., assets in the same asset class).
  • Shareholder approval under the aggregate fee condition also generally would not  be required if any increase  in the rate payable by a fund  to an existing subadviser is accompanied by a corresponding decrease in the primary advisory contract of the rate payable by the fund to the primary adviser.”