FINRA Proposes Funding Portal Rules with Related Forms

FINRA proposed the adoption of Funding Portal Rules 100, 110, 200, 300, 800, 900 and 1200 (collectively, the “Funding Portal Rules”) and related forms. The new rules were promulgated pursuant to the 2012 JOBS Act which “prohibits funding portals from a variety of activities, including offering investment advice or recommendations, soliciting transactions for securities displayed on their websites, compensating employees for securities solicitations, and holding investor funds or securities.” As part of its plan, FINRA also proposed the adoption of new FINRA Rule 4518 (“Notification to FINRA in Connection with the JOBS Act“) in the FINRA rulebook.

The proposed Funding Portal Rules consist of the following set of seven rules and their related forms:

  • Funding Portal Rule 100 (“General Standards”);
  • Funding Portal Rule 110 and Forms (“Funding Portal Application”);
  • Funding Portal Rule 200 (“Conduct”);
  • Funding Portal Rule 300 (“Compliance”);
  • Funding Portal Rule 800 (“Investigations and Sanctions”);
  • Funding Portal Rule 900 (“Code of Procedure”); and
  • Funding Portal Rule 1200 (“Arbitration and Mediation”).

FINRA’s proposed Rule 4518 would apply to registered broker members and also would provide that a member of FINRA should notify it in the manner prescribed by FINRA:

  • prior to engaging, for the first time, in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6) (“Exempted Transactions”) of the Securities Act; or
  • within 30 days of directly or indirectly controlling, or being controlled by or under common control with, a funding portal as defined pursuant to Rule 300(c)(2) of the SEC’s proposed crowdfunding regulations.

In a related filing, FINRA proposed a rule change to adopt Section 15 of Schedule A to the FINRA By-Laws, which would govern fees for funding portals.

Lofchie Comment: The new rules are less burdensome than those that were proposed originally.

Law Professor Suggests an Ex Ante Formula for Nationalizing Clearinghouses

In a paper titled “Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?” Professor Stephen Lubben of Seton Hall University discusses “what should happen if the worst should happen,” with regard to Dodd-Frank’s lack of risk management provisions in the event of a clearinghouse failure.

First, Mr. Lubben suggests that while bailouts of individual institutions may end, bailouts of clearinghouses might become inevitable in a “post Dodd-Frank world.” He argued that the reason bailouts are now “foreseeable” is because Dodd-Frank makes their failure “too disruptive to be politically tolerated.”

Mr. Lubben further remarked that stakeholders in the clearinghouse would have a strong incentive to avoid failure if the government implemented ex ante procedures, or “structured bailouts.” This would involve the government stating that clearinghouses that ultimately fail would be nationalized, and that there would be specific consequences to investors as well as an expectation of member participation in the recapitalization of the clearinghouse.

However, Mr. Lubben advised that these consequences must include “clearly outlined delineated outcomes” for the stakeholders best suited to avoid problems at the clearinghouse.

Lofchie Comment: The reality that the government-created clearinghouses are the ultimate “too big to fail” is becoming more and more obvious. Having created this problem, the government is likely to find attractive the notion that its solution can be pushed on to private market participants; i.e., the clearinghouse members, as the Professor suggests. It is not obvious that this is really doable: the clearinghouses are just too big. If clearing firms really take account of the scale of the risk to which they are potentially subject, they may opt out of becoming clearing members. This would then leave an ever shrinking pool of sell-side firms willing to become clearing members, and those firms would be asked to absorb ever more risk from trades entered into by others. Further, since the clearing members don’t own the clearinghouse, or fully control it, it could be an imprudent risk to take. Bottom line, it just doesn’t sound attractive to be a clearinghouse member and bear this risk.

SEC White Paper Examines Liquidity and Flows of U.S. Mutual Funds

In a white paper titled “Liquidity and Flows of U.S. Mutual Funds,” the SEC Division of Economic and Risk Analysis examined the U.S. mutual fund industry with particular attention paid to: (i) fund flows; (ii) the liquidity of fund portfolios; and (iii) the interaction of these characteristics.

The white paper emphasized that liquidity risk management is a primary concern for mutual funds due to: (i) the possibility of so-called asset “fire sales;” (ii) the exacerbation of these sales by how a fund’s net asset value is determined for redeeming investors; and (iii) the significant growth in emerging market, fixed income and alternative strategy mutual funds.

The white paper documented the following general trends in U.S. mutual funds:

  • the amount of assets held by U.S. mutual funds (excluding money market mutual funds and exchange traded funds) is increasing rapidly;
  • potentially less liquid mutual fund categories have grown substantially over the same period, with alternative strategy funds growing faster than any other category;
  • the cash and cash equivalent holdings of mutual funds vary significantly, and the variation in cash holdings within each investment category is larger than the variation between investment categories;
  • the volatility of net asset flows exhibits considerable variation between investment categories, and alternative strategy funds face more volatile flows compared to more traditional funds;
  • portfolio liquidity levels vary significantly between funds and over time;
  • among U.S. equity funds, those that invest in large cap equities and those with greater assets hold more liquid equity portfolios; and
  • equity portfolio liquidity decreased for U.S. equity funds during the financial crisis, particularly among those funds that already had relatively low equity portfolio liquidity.

Lofchie Comment: It seems inevitable that the final recommendation of the SEC’s study is that mutual funds should hold a greater share of their assets in “liquid” investments. In response, a quotation and a question.

The quotation is from John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 12: “Of the maxims of orthodox finance liquidity, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” The second sentence of this quotation is the one that poses a particular challenge to the regulators. It is clear that the regulators disfavor regulated banks, broker-dealers and insurance companies taking speculative or illiquid positions. Perhaps this makes sense if one views those institutions as primarily serving a custodial function as holders of the assets of others. However, the regulators also clearly disfavor either private funds or public funds holding illiquid positions. (See, e.g., FSOC Seeks Comment on Notice about Risk to U.S. Financial Stability Caused by Asset Management Products and Activities (with Lofchie Comment) Dec. 18, 2014)).

So who will hold such positions? It’s not going to be individuals in their personal accounts, as individual holdings are a very small share of national assets. Pension plans? Foreign sovereign wealth funds? The bottom line is, society as a whole cannot be liquid: someone has to be willing to bear risk for the long term. It is all very well, but a little too easy, for the regulators to assert that a person or type of entity should not bear liquidity risk. But tell us who should bear it? That is the hard question. Unless it is addressed, it is a bit of a fool’s errand to demand the impossible: that everyone become liquid.

NY Department of Financial Services Grants Charter to Bitcoin Exchange

The New York Department of Financial Services (“NYDFS”) granted a charter under New York banking law (“Banking Law”) to Gemini Trust Company, LLC (“Gemini”), a Bitcoin exchange based in New York City. The NYDFS stated that it conducted a rigorous review of Gemini’s July 2015 application to operate as a trust for virtual currency exchanges in which it examined the company’s anti-money laundering, capitalization, consumer protection and cybersecurity standards. The NYDFS stipulated that as a chartered limited purpose trust company with fiduciary powers under the Banking Law, Gemini can begin operating immediately and is subject to ongoing supervision by the NYDFS.

Lofchie Comment: Gemini made an interesting legal/strategic decision to be regulated under “banking” law rather than under the new bitcoin regulatory framework.

SEC Commissioner Gallagher Delivers Final Statement

Daniel M. Gallagher delivered his final statement as SEC Commissioner on his “bittersweet” departure from the SEC. Mr. Gallagher expressed that he “look[s] forward to remaining involved in the important policy debates facing the U.S. capital markets in the years to come,” including through his lecture series with the Securities Law Program at Catholic University Columbus School of Law.

Lofchie Comment: I believe that Commissioner Gallagher was a thoughtful and serious regulator at the SEC, who took very seriously his responsibility to implement financial regulations that would both protect investors and serve the economy. In this regard, he was a constant but reasoned critic of the regulatory philosophy that simply argues for “more” (the more regulations, the better). Perhaps the most powerful argument that he made against this self-defeating approach was the visual demonstration represented in a mind-boggling chart of the number of rules that have been adopted in light of Dodd-Frank (and of course there are many more still to come). There is a link to this graphic (which I always like to think of as the “Gallagher Egg”) in this previous Cabinet article.

See: SEC Commissioner Gallagher’s Departing Statement.
Related news: Commissioner Gallagher Announces His Departure Date from SEC (with Lofchie Comment) (September 4, 2015).

MFA Makes Recommendations for Strengthening Equity Market Structure

The MFA updated its equity market structure recommendations. It made the following new recommendations to the SEC for enhancing the resilience of critical infrastructure and the robustness of the market framework:

  • improve the reliability and oversight of consolidated market data;
  • require electronic trading venues to provide trade order and execution information in milliseconds;
  • develop contingency plans and interim processes to address unexpected trading halts, particularly those that are caused by technology failures;
  • at least every two years, reexamine the parameters used to set circuit breakers and price collars for addressing market volatility, and amend such parameters where appropriate; and
  • conduct well-designed studies to test the efficacy of alternative rules that govern market structure.

Lofchie Comment: Because the MFA’s comments about the benefits of market study tests are intentionally unspecific, they might go unnoticed, and that would be a shame. The SEC should be conducting ongoing tests of market structure rules to see what works and what does not instead of relying on accepted wisdom. Obviously, such testing is expensive and imposes costs on the industry. Accordingly, it is important that any such test be well designed and, ideally, part of an overall testing strategy. In the best case, the SEC might propose tests that it is considering and then ask market participants and academics to propose tests of their own and the means by which such tests would be conducted.