FINRA Podcast: 2014 Regulatory and Examination Priorities – Part 2 (Recidivists, Conflicts, Cybersecurity, Rollovers and Accredited Investors)

FINRA released the second podcast in a five-part series providing an overview of FINRA’s 2014 examination priorities. This podcast focuses on recidivist brokers, conflicts of interest, cybersecurity, qualified plan rollovers, suitability and due diligence of private placements.

  • Recidivist brokers:  A small number of brokers have demonstrated a pattern of complaints or disclosures for sales practice abuses that could harm investors as well as the reputations of the securities industry and financial markets.  In 2014, FINRA will expand the high-risk broker program and create a dedicated enforcement team to prosecute cases.  When FINRA examines a firm that hires these high-risk brokers, examiners will review the firm’s due diligence conducted in the hiring process, review for the adequacy of supervision of higher risk brokers including whether the brokers have been placed under heightened supervision based on the patterns of past conduct, and will place particular focus on these brokers’ clients’ accounts in conducting reviews of sales practices.  Using sophisticated analytics known as the Broker Migration Model, FINRA identifies and monitors both brokers who move from a firm that has been expelled or otherwise has a serious disciplinary history to another FINRA-regulated firm, and the firms that hire such brokers.  FINRA uses the model’s risk scoring, among other means, to prioritize surveillance and to conduct focused or accelerated examinations and enforcement efforts.

  • Conflicts of interest:  Examiners will explore topics addressed in the report, including firms’ approaches to identifying and managing conflicts, as well as the participation of senior management in this process.  Reviews will include firms’ approaches to conducting new product reviews to identify and mitigate potential conflicts raised by those products.  FINRA will also assess whether wealth management businesses make independent decisions about the products they offer without pressure to favor proprietary products or products for which the firm has revenue-sharing agreements.

  • Cybersecurity:  Cybersecurity remains a priority for FINRA in 2014, given the ongoing cybersecurity issues reported across the financial services industry.  In recent years, many of the nation’s largest financial institutions were targeted for disruptions through a range of different types of attacks.  The frequency and sophistication of these attacks appears to be increasing.  In light of this ongoing threat, FINRA continues to be concerned about the integrity of firms’ infrastructure and the safety and security of sensitive customer data.  FINRA’s evaluation of such controls may take the form of examinations and targeted investigations.

  • Qualified plan rollovers:  FINRA is concerned that investors might be misled about the benefits of rolling over assets from a 401(k) plan to an IRA.  In Regulatory Notice 13-23, FINRA warned firms and associated persons not to make claims of “free IRAs” or “no-fee IRAs” where investors do pay costs associated with these accounts.  In 2014, reviewing firm rollover practices will be an examination priority, and staff will examine firms’ marketing materials and supervision in this area.  FINRA will also evaluate securities recommendations made in rollover scenarios to determine whether they comply with suitability standards in FINRA Rule 2111.

  • Suitability and due diligence of private placements:  FINRA stated that it will examine firms’ private placement activity to ascertain whether firms are taking reasonable steps to validate that investors meet accredited investor standards.  Also, the recent Regulation D amendments do not diminish a firm’s responsibility to conduct adequate due diligence on its offerings to ensure that any recommendations to purchase securities in a private placement are suitable.

See:  FINRA Podcast.
Related news:  FINRA Podcast: 2014 Regulatory and Examination Priorities – Part 1, Suitability (March 14, 2014).


SEC Chair White Discusses International Enforcement Cooperation in Global Markets

SEC Chair Mary Jo White delivered a speech at the Annual Forum of the Australian Securities and Investments Commission (“ASIC”) in which she discussed international cooperation and efforts in the enforcement of the regulation of global markets. 

Chair White explained that the 2002 IOSCO creation of the Multilateral Memorandum of Understanding (“MMOU”) was the first major step in recognizing that proper policing of international activity in the securities and derivatives markets required greater international cooperation among regulatory agencies.  According to Chair White, both the SEC and ASIC immediately recognized the importance of the IOSCO MMOU; they were among the first of more than a hundred signatories.  Chair White stated that, in the last fiscal year, the SEC made more than 700 requests for assistance to fellow regulators, and the SEC itself responded to more than 500 requests, most of which were made pursuant to the IOSCO MMOU.

Chair White noted that, in order to continue to police the global markets effectively, the 2002 IOSCO MMOU must not remain static, and added she is glad that IOSCO is considering an enhanced MMOU to broaden the types of information that can be obtained and streamline the process.  Chair White said that the SEC and ASIC have already increased their levels of cooperation through a new bilateral agreement that goes beyond the IOSCO MMOU to allow the agencies to obtain not only bank, brokerage and beneficial ownership records, but also audit work papers, internet service provider records, travel histories and more.  Chair White stated that international cooperation should continue to be strong so that “borders do not serve as barriers that prevent us from obtaining the assistance we need for the strongest enforcement programs possible.”

Chair White concluded by mentioning recent SEC enforcement initiatives such as requiring admissions by defendants as a condition of a settlement, a renewed focus on gatekeepers and prosecuting smaller compliance-related violations (as well as larger ones). 

See:  Chair White’s Speech


SEC Issues Staff Analysis of Data and Academic Literature Related to MMF Reform

The SEC staff of the Division of Economic and Risk Analysis published analyses of data and academic literature related to money market fund (“MMF”) reform.  The analyses, which are available for review and comment, examine:

  • the spread between same-day buy-and-sell transaction prices for certain corporate bonds from January 2, 2008, to January 31, 2009;
  • the extent of government MMF exposure to nongovernment securities;
  • academic literature reviewing recent evidence on the availability of “safe assets” in the U.S. and global economies; and
  • the extent to which various types of MMFs are holding in their portfolios’ guarantees and demand features from a single institution.

Comments on this supplemental information may be submitted to the SEC under the comment file for rule amendments that the SEC proposed in June 2013 regarding MMF reform.  Comments should be received by April 23, 2014. 

See:  SEC Press Release; Analysis of Liquidity Cost During Crisis Period; Analysis of Government MMF Exposure to Non-Government Securities; Analysis of Municipal MMF Exposure to Parents of Guarantors; Analysis of Demand and Supply of Safe Assets in the Economy
Related news:  SEC Proposes Money Market Fund Reforms (June 7, 2013); SEC Proposes in the Federal Register Money Market Fund Reform and Amendments to Form PF; Comments Due September 17th (June 20, 2013); Hearing on Money Market Funds (with Summary of the Hearing by Delta Strategy Group) (September 19, 2013); SIFMA Comments on SEC MMF Proposal (September 19, 2013); Investment Company Institute Comments to SEC Regarding Money Market Funds (September 19, 2013).


SEC Announces Agenda and Panelists for Cybersecurity Roundtable

The SEC announced the agenda and panelists for its March 26, 2014, roundtable on the issues and challenges cybersecurity presents for market participants and public companies. 

The roundtable will begin at 9:30 a.m. and will be divided into four panels:

  • Panel 1 will discuss the cybersecurity landscape;
  • Panel 2 will discuss cybersecurity disclosure issues faced by public companies;
  • Panel 3 will discuss the cybersecurity issues faced by exchanges and other key market systems; and
  • Panel 4 will discuss how broker-dealers, investment advisers and transfer agents address cybersecurity issues, including those involving identity theft and data protection.  

See:  SEC Agenda and Panelists for Cybersecurity Roundtable.
See also:  Submit comments to the SEC on the Cybersecurity Roundtable.


CFTC No-Action Letter (14-34) Raises De Minimis Threshold for Swaps with Utility Special Entities

The CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) issued a letter generally liberalizing the de minimis limits that would apply to an entity that is not registered as a swap dealer, but that seeks to enter into dealing swaps with certain power utililties that are within the definition of “special entity.” 

Under the CFTC’s swap dealer registration requirement, an entity that engages in as little as $25 million in notional swaps activity with a “special entity” could be required to register as a swap dealer.  Under a prior CFTC no-action letter,(CFTC Letter No. 12-18), this limit had been raised to $800 million for utility commodity swaps, albeit subject to various conditions including that the swap dealing entity not be a “financial entity,” a term that has a very broad definition, and thus which limited the benefits of the 12-18 no-action letter.  The attached letter provides that for qualifying swaps with utilities that are special entities, unregistered swap dealers are subject only to the ordinary $8 billion notional limit before they are required to register as swap dealers.  The relief is NOT available to all swaps with utilities; only to those swaps that satisfy the conditions of this letter, includng obtaining certain representations from the utility.  However, the prohibition on the unregistered swap dealer being a financial entity is withdrawn.

Lofchie Comment:  While this letter is obviously an improvement over letter 12-18, which it replaces, it is not appropriate that the CFTC should purport to withdraw the prior letter with no notice whatsoever.  Since the requirements of this new  letter are somewhat different from the requirements of the prior letter, an entity could violate the law by reason of being unaware that the CFTC issued a letter that very day.  Certainly the CFTC does not actually intend this as a trap for the unwary, but the fact that the CFTC would operate in this manner reflects a certain institutional inattention to the reasonable concerns of the entities it regulates. 

More generally, the need to issue this letter reflects one of the larger problems with Dodd-Frank.  Rather than reducing the problem of “too big to fail,” Dodd-Frank will exacerbate the problem by reducing the number of entities that are willing to act as swap dealers above the registration limits.  While the letter lessens the problem on one set of transactions, the more general problem remains.  One step that the CFTC should consider taking is making permanent the $8 billion de minimis limit before an entity is required to register with the CFTC, rather than proceeding with the planned reduction to $3 billion.

See: CFTC Letter 14-34.
See also:
Statement of Commissioner Scott D. O’MaliaCFTC Letter No. 12-18
Related news: CFTC Staff Ratifies Cross-Margining of Customer Swaps Collateral (October 22, 2012).


CFTC Commissioner O’Malia Remarks on the Impact of Dodd-Frank on Commodity Futures and Swaps Markets

In a speech at the 2014 Bank of Canada International Economic Analysis Workshop on Financialization of Commodity Markets, Commissioner O’Malia discussed the impact of the Dodd-Frank Act and CFTC regulations on commercial end-users who have historically used the commodity futures and swaps markets for risk mitigation and hedging.

In his remarks, Commissioner O’Malia’s focused on the following:

  • the importance of hedging in the commodity markets, especially given volatile commodity prices;
  • the impact that Dodd-Frank and CFTC reforms have had on hedging in the commodity markets, including the “futurization” of swaps;
  • the potential impact on hedging of upcoming CFTC rulemakings; and
  • the importance of the CFTC’s utilization of data in its oversight of the commodity markets.

To the importance of hedging in the commodity markets, Commissioner O’Malia reminded the audience that the futures markets originated as “a way for buyers and sellers to hedge price risk in the grain markets,” and encouraged the CFTC to be mindful of the impact of its rules on the cost of hedging for end-users so that they are able to engage in legitimate hedging activities. He stressed that this is especially important given the volatility in commodity prices, and given that hedging holds an important role in the commodity markets.

In his discussion on Dodd-Frank, the commissioner stated that the CFTC’s swaps rules have introduced “unnecessary complexity, vagueness, and costs into the markets, including the commodity markets,” and that these consequences have led some hedgers to seek out alternatives, such as swap futures (i.e. the “futurization of swaps.”)  Commissioner O’Malia remarked that if end-users are forced to use swap futures because the cost of using swaps is too high, these participants will have a less perfect hedge, which could result in additional risk or reduced capital investment.

Commissioner O’Malia proposed a “modest fix” that would allow end-users to exclude all cleared trades from the calculation towards the de minimis threshold, which he claims will provide end-users greater certainty and would encourage end-users to clear their trades.

In a brief survey of upcoming CFTC rulemakings, Commissioner O’Malia cited the following key changes:

  1. the Commission is considering a proposed futures block rule that will limit the availability of block trades, especially for energy futures;
  2. the OTC margin and capital rules for uncleared swaps will increase the cost of hedging;
  3. the Commission staff is working on mandatory clearing determinations for additional interest rate swap contracts and non-deliverable forward (“NDF”) contracts; and
  4. the position limits re-proposal has the potential to negatively impact end-users legitimate hedging activities.

Lastly, Commissioner O’Malia emphasized that it is crucial for the CFTC to improve and effectively utilize its data so that the Commission develops a complete picture of both the swaps and the futures markets, noting that a number of the questions regarding the impact of financialization on the commodity markets would be answerable if the CFTC had a complete picture of market participants and their trading strategies.

Lofchie Comment:  The Commissioner’s remarks make explicit a key fallacy behind Dodd-Frank: that it is somehow possible to impose burdensome regulations and costs on the financial sector without having the effect of those burdens and costs ultimately borne by the commercial sector.  Punitive regulation of Wall Street ends up being costly regulation to Main Street.

See: Commissioner O’Malia’s Speech.


Better Markets Amicus Brief Supports CFTC’s Cross-Border Guidance

Better Markets, Inc. (“Better Markets”), a nonprofit organization that promotes the “public interest” by “argu[ing] extensively for the adoption of appropriately strong rules governing the derivatives markets” and for “broad application of those rules to international or ‘cross-border’ transactions,” submitted an amicus brief in support of the CFTC’s position in the lawsuit filed by ISDA, SIFMA and the Institute of International Bankers (“IIB”) (together, the “Associations”) challenging the legality of the CFTC’s Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations (“Cross-Border Guidance”).

In its amicus brief, Better Markets states that the Associations challenging the Cross-Border Guidance do not acknowledge the financial crisis in 2008, which necessitated the passage of financial reform law such as Dodd-Frank Title VII (“Title VII Rules”), nor do the Associations “acknowledge the role of their own members in causing the crisis.” According to Better Markets, if the Associations’ “assault” on the Cross-Border Guidance and the international application of the Title VII Rules is successful, the result will be “a perpetuation of the deregulatory environment that incubated the financial crisis of 2008.” 

Additionally, Better Markets states that, while the Associations alleged that cross-border application of the rules will impose heavy compliance costs and cause damaging disruptions, “they offer little concrete support for such predictions.” Better Markets argues that past claims of such predictions about the impact of regulation have proved to be groundless.

Better Markets also states that, although the Associations assert that CEA Section 15(a) requires the CFTC to employ a cost-benefit analysis of its actions, it only requires that the CFTC consider “the costs and benefits of the action of the Commission.” Because the decision to extend the protections set forth in the Title VII Rules to international derivatives activities was made by Congress and not the CFTC, Better Markets claims that the CFTC was under no obligation to apply Section 15(a) to the cross-border applications of the rules.

Lofchie Comment:  During the Dodd-Frank rulemaking process, the tango between the CFTC (under former Chairman Gensler) and Better Markets has been interesting to watch.  Regardless of the burden of regulation the CFTC would propose, Better Markets would write a comment letter asserting that the CFTC should impose a greater burden.  Then, in its review of comment letters, the CFTC would quote from Better Markets’ letters extensively.  In reaching its conclusions, the CFTC would then summarize with language suggesting that some people say we should impose less regulation, but Better Markets said we should impose more regulation, so we did something in the middle.  In effect, under former Chairman Gensler, Better Markets served as a device to provide the CFTC with cover for virtually any position.

See: Better Markets Amicus Brief
Related news: CFTC Legal Memorandum to Dismiss Challenge to Its Cross-Border Guidance (March 18, 2014); Market Participants File Lawsuit Challenging CFTC Cross-Border Guidance for Being a Rule Adopted in Violation of the APA (December 4, 2013); Market Participants File Amended Complaint Challenging CFTC Cross-Border Guidance (January 8, 2014); Chamber of Commerce Submits Amicus Brief Regarding Lawsuit against CFTC Cross-Border Rule (February 5, 2014).


CFTC Announces It Is Requesting Public Comment on Swap Data Reporting Rules (Pre-Fed. Reg.)

The CFTC requested public comment on the swap data recordkeeping and reporting requirements under CFTC Rules Part 45 and related provisions.  Part 45 requires reporting counterparties and entities to submit swap transaction data to swap data repositories via electronic reporting to enable the CFTC to perform a range of market integrity, risk monitoring and other supervisory functions. 

The request for comment, which was developed by the newly created CFTC Interdivisional Working Group, seeks public input on approximately 70 questions addressing topics such as:

  • the reporting of primary economic terms, confirmation and continuation data;
  • the manner in which the reporting rules address different transaction types, business models and data flows present in swaps markets;
  • the reporting of cleared swaps; and
  • data harmonization.

Regarding the request for comment, Commissioner Scott O’Malia urged market participants “to carefully review the Commission’s requests, submit their comments, and alert the Commission to other data reporting issues that have not been included,” stating that the comment period is a critical step in the CFTC’s effort to improve data utilization.

The comment period will be open for 60 days from the date of publication of the request for comment in the Federal Register. 

Lofchie Comment:  This request for comment, which will undoubtedly be followed by changes to the Part 45 Rules, is only one step in what will likely be a decade-long process of cleaning up the rules.  It is a credit to acting Chairman Wetjen for undertaking this long term effort and to Commissioner O’Malia, who persisted on the revisitation of the Part 45 Rules.

It is to be hoped that the process of revisiting the Rules begins with questions not for the market, but rather for the CFTC:  (i) What information does the CFTC hope to obtain; (ii) what does the CFTC believe it will be able to accomplish with that information; and most importantly, (iii) does the CFTC actually have the technology to receive, retain and analyze whatever information it requires?

See:  CFTC Press Release; Commissioner O’Malia’s Statement.
Related news:  CFTC Announces Formation of Interdivisional Working Group to Review Regulatory Reporting (January 22, 2014).


SEC Chief Economist Craig Lewis Delivers Remarks on Economic Analysis at the SEC

In a speech before the Investment Company Institute 2014 Mutual Funds and Investment Management Conference, Craig Lewis, SEC Chief Economist and Director of the Division of Economic and Risk Analysis (“DERA”), discussed the economic analysis conducted by the SEC in rule proposals and analyses.

Director Lewis explained that the 2012 Memorandum Current Guidance on Economic Analysis in SEC Rulemaking (“Memo”) outlines the SEC’s approach to “robust” economic analysis.  Additionally, Director Lewis said that the Memo “states the fundamental precept that economists are part of the rulemaking process from the very start, and thus involved in those crucial policy discussions that occur before words are ever committed to paper.”

Director Lewis laid out the four basic elements of a “robust” economic analysis:

  1. identify the need for the regulatory action;
  2. articulate the “baseline” against which any potential economic effects can be measured;
  3. explain alternative approaches to reaching the regulatory goal; and
  4. lay out the economic impact, including the costs and benefits, of the regulatory action and its principal regulatory alternatives.

Director Lewis further addressed the scope of the guidance, which he stated is not limited to development and drafting rule releases, pointing out that DERA oversees various policy initiatives at the SEC that do not directly relate to drafting rules.  Director Lewis explained that DERA has worked very hard to describe in quantitative terms the current market conditions, perform sophisticated analyses of the credit default swap market and, as a general matter, describe the economic trade-offs in an “even-handed manner” when analyzing the potential effect of the SEC’s rules.

Lofchie Comment:  It would be helpful to have the views of the CFTC, as well as of FINRA and the NFA, on their approach to economic analysis.  Ideally, it makes sense for all of the principal securities/commodities regulators to adopt a common approach to rulemaking.

See:  Craig M. Lewis’s Speech.


Attorney General Calls for New Efforts to Eliminate Special Services Provided by Trading Venues to HFTs

In a speech at an Insider Trading symposium hosted by the New York Law School, Attorney General Eric. T. Schneiderman (“A.G. Schneiderman”) called for tougher regulations and market reforms to address the “unfair advantages commonly provided to high-frequency trading firms at the expense of other investors.”  

In his remarks, A.G. Schneiderman detailed a number of services that trading venues offer to high-frequency traders (“HFTs”), including, but not limited to:

  • allowing traders to locate their computer servers within the trading venues themselves;
  • providing extra network bandwidth to HFTs; and
  • attaching ultra-fast connection cables and special high-speed switches to their servers. 

According to A.G. Schneiderman, each of these services offers clients a timing advantage – often in milliseconds – that allows HFTs to make rapid and often risk-free trades before the rest of the market can react.

A.G. Schneiderman stated that he is “committed to cracking down on fundamentally unfair – and potentially illegal – arrangements that give elite groups of traders early access to market-moving information at the expense of the rest of the market.”  Labeling it “Insider Trading 2.0,” A.G. Schneiderman stated that special services for HFTs are “one of the greatest threats to public confidence in the markets.”  A.G. Schneiderman further noted that these special services have forced large institutional investors to develop complicated and expensive defensive strategies in order to “conceal their legitimate orders from parasitic traders,” including the routing of orders into alternative trading venues, such as dark pools.

To address these issues, A.G. Schneiderman called on exchanges and other regulators to review market structure reforms.  One proposal that he highlighted would seek to process orders in batches in frequent intervals rather than continuously.  This, he suggested, would ensure that price, and not speed, is the deciding factor in who obtains a trade.

According to A.G. Schneiderman’s press release, his speech is part of a broader initiative.  In February, he announced interim agreements with a number of financial firms to stop their practice of cooperating with analyst surveys administered by certain elite and technologically sophisticated clients.

Lofchie Comment:  Issues concerning how the National Market System should operate would seem to be within the purview of the federal government generally and the SEC in particular rather than New York State.   In this regard, certain of A.G. Schneiderman’s suggestions – e.g., as to the batch execution of orders seem entirely impractical, given that there are over a dozen national securities exchanges.   This raises the question of how governmental resources should be allocated in an environment where there are limited tax dollars available, a point raised often with respect to rulemaking initiatives by the CFTC as well.  In short, is the best use of New York’s resources the redesign of the National Market System (on which Congress is already holding hearings and which is a matter of federal law) or to pursue violations of New York law?

See:  A.G. Schneiderman’s Speech; Attorney General Press Release