SEC Tells Investors to Resolve to Be Smarter

The SEC Office of Investor Education and Advocacy offered ten tips for investors. The tips are intended to help them make informed investing decisions and avoid common scams in 2016.

The SEC’s bulletin listed the following ten investment tips:

  • always check the background of an investment professional – doing so is easy and free;
  • promises of high returns with little or no risk are classic warning signs of fraud;
  • be careful when using social media as an investment tool;
  • ignoring fees associated with buying, owning and selling an investment product can be costly;
  • be alert to affinity fraud;
  • any offer or sale of securities must be registered with the SEC or exempt from registration – otherwise, it is illegal;
  • diversification can help reduce the overall risk of an investment portfolio;
  • active trading and other common investing behaviors actually undermine performance;
  • unbiased resources are available to help individuals make informed investing decisions; and
  • contact the SEC Office of Investor Education and Advocacy online for answers to any questions about investments, investment accounts or financial professionals.

MSRB Proposes Shortening Time to Close out Fails (MSRB Reg. Notice 16-02)

The MSRB solicited comments on proposed draft amendments to MSRB Rule G-12 (“Uniform Practice”). The amendments would update the close-out procedures provided under Rule G-12(h), and require specifically that municipal securities transactions be closed out no later than 30 calendar days after the settlement date.

The MSRB emphasized that the amendments would (i) reduce the number of inter-deal fails and shorten the period before they are resolved, (ii) reduce regulatory risk, (iii) reinforce investors’ confidence in the market, and (iv) provide firms that wish to resolve inter-dealer fails with the ability to do so in a timely fashion.

The MSRB said that it is soliciting comments on estimates of costs stemming from the amendments’ mandated close-outs and use of industry utilities, but also assumes that the “costs will be significantly less than the benefits that will accrue to dealers and the market as a whole.”

Comments on the proposed draft amendments must be submitted by March 6, 2016.

Lofchie Comment: This proposal and the proposal to shorten the securities settlement cycle, along with related requirements for margin to be posted on To-Be-Announced securities, reflect regulators’ ongoing drive to decrease settlement risk in the securities markets.

FINRA Announces 2016 Regulatory Priorities

This year, FINRA will focus its regulatory efforts on the broad categories of supervision, risk management and controls, and liquidity in the new year. In a 2016 Regulatory and Examination Priorities Letter, FINRA stated that it will also concentrate on “firm culture, conflicts of interest and ethics, and the significant role each of these plays in the way a firm conducts its business.” FINRA emphasized that that these priorities include (i) sales practices, (ii) financial and operational controls, and (iii) market integrity.

FINRA highlighted its approach to these priorities:

  • Culture, Conflicts of Interest and Ethics: A firm’s culture is both an input to and a product of its supervisory system. It affects the firm’s approach to identifying and managing conflicts of interest, and ensuring the ethical treatment of customers.
  • Supervision, Risk Management and Controls: FINRA will focus on four areas: (i) management of conflicts of interest, (ii) technology, (iii) outsourcing and (iv) anti-money laundering.
  • Liquidity: FINRA will review the adequacy of firms’ contingency funding plans in light of their business models (FINRA Regulatory Notice 15-33).

Regarding other areas of regulatory focus, FINRA stated:

  • Suitability and Concentration: FINRA will assess whether registered representatives that sell fixed-income, complex and alternative products are considering certain factors adequately, such as credit risk, duration and leverage.
  • Financial and Operational Controls: FINRA will monitor firms’ policies and controls concerning (i) market-maker net capital exemptions, (ii) exchange-traded funds, (iii) fixed-income prime brokerages, (iv) internal audit frameworks, (v) onboarding clients and correspondents, and (vi) the transmittal of customer funds.
  • Market Integrity: FINRA will review firms’ (i) compliance with Rule 603(c) (“Distribution, Consolidation and Display of Information with Respect to Quotations for and Transactions in NMS Stocks”) of Regulation NMS (“Regulation of National Market System”) (FINRA Regulatory Notice 15-52),(ii) compliance “report cards” derived from FINRA’s cross-market equity manipulation surveillance program, (iii) fixed-income order handling, markups and related controls, (iv) compliance with Regulation SHO (“Regulation of Short Sales”), (v) cross-market and cross-product manipulation, and (vi) audit trail integrity.

As to its overall approach to firm culture, FINRA Chair and CEO Richard Ketchum said: “Our goal is not to dictate a specific culture, but rather to understand how each firm’s culture affects compliance and risk management practices. Firms with a strong ethical culture and senior leaders who set the right tone, lead by example, and impose consequences on anyone who violates the firm’s cultural norms are essential to restoring investor confidence and trust in the securities industry.”

FINRA Fines Firm for Submitting Inaccurate Blue Sheet Data

FINRA censured and fined a financial services firm (the “Firm”) for failing to provide “complete and accurate trade data” in automated form when requested by the SEC and FINRA. Such trade data, commonly known as “blue sheets,” provide information about securities transactions, including the security, trade date, price, share quantity, customer name, and whether the transaction was a buy, sale, or short sale.

FINRA found that from January 2012 to September 2015, the Firm submitted to the SEC and FINRA inaccurate trade data as a result of problems with the Firm’s automated systems. According to FINRA, these problems were caused by technical deficiencies in the Firm’s blue sheet systems; errors in its blue sheet logic; and the fact that information was pulled from a front-end database that did not accurately reflect actions that sometimes occurred after a trade was executed.

FINRA also found that the Firm failed to have adequate audit systems in place for providing accountability of its blue sheet submissions.

In addition to the censure and fine, the Firm must also conduct a comprehensive review of its policies, systems and procedures related to blue sheet submissions, and to subsequently certify that it has established procedures reasonably designed to address and correct the violations.

Lofchie Comment: This is yet another very significant penalty for a firm providing the regulators with bad data. Accordingly, it behooves firms to devise methods of self-auditing the financial information that they provide, recognizing that this may not always be easy because there is no inherent feedback system to tell a firm when it has made a mistake for which it may be censured.

SIFMA Provides Notice to Banking Regulators on Treatment of CCPs’ Variation Margin

SIFMA provided notice to banking regulators (the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) of a forthcoming change in the treatment of variation margin payments for over-the-counter derivatives by central clearing counterparties (“CCPs”). Historically, variation margin payments have been treated as collateral for outstanding exposure, a treatment that a SIFMA comment letter refers to as the “collateralized to market” (“CTM”) model. Going forward, the CCPs will adopt a model by which variation margin payments are treated as settlement of the exposure under the contract, a treatment that the SIFMA comment refers to as the “settled to market” (“STM”) model.

According to SIFMA, it is expected that in addition to the CCPs, other market participants will amend or clarify their terms, rules and procedures to determine circumstances under which the payment of variation margin for cleared derivatives will be deemed to constitute settlement of any exposure under the agreement, as opposed to collateralization of the outstanding exposure.

The SIFMA comment letter states that while “both models achieve the same expose-mitigating objective, they differ in their implications for the rights and obligations of the counterparties.” The STM model is “recognized as preferable to the CTM model within the regulatory capital framework” and results in “clearing member firms having higher capital and supplementary leverage ratios” SIFMA stated. The following steps are “typically pursued by clearing member firms” prior to considering a cleared OTC derivative contract to be executed under the STM model:

  • verifying that the CCP terms, rules, and procedures, as approved by the CCP’s primary regulator, and the terms of their client clearing agreements, are consistent with the STM model;
  • working with in-house and outside counsel to review such terms, rules, and procedures, and obtain legal analysis that the relevant derivative contracts are STM;
  • working with internal and independent accountants to determine the appropriate accounting treatment for relevant exposures and payments; and
  • coordinating with impacted internal functions (e.g., tax, operations, financial reporting, risk, etc.) to reflect derivative contracts as STM rather than CTM, as appropriate.

Lofchie Comment: The need for this change in the documentation of contracts is driven by the fact that the banking regulators previously took a fundamentally punitive and economically unsound position with respect to the regulatory capital treatment of collateral for cleared derivatives. As the banking regulators stretch their regulatory authority into new types of transactions (e.g., cleared derivatives), the limits of their pre-existing regulatory expertise become clear.

Recently, the banking regulators acknowledged that central clearing creates a number of systemic risks that they failed to anticipate (although they should have done so). Conversely, the banking regulators’ treatment of collateral for cleared derivatives (effectively treating posted collateral as if it were a loan of assets to the secured party) has been likewise faulty, in effect, treating a risk-reducing transfer, as if it were risk-increasing.

GAO Report Cites Increased Compliance Burden from Dodd-Frank Act

The Government Accountability Office (“GAO”) reported that community banks, credit unions and industry associations cited an increase in the compliance burden from the Dodd-Frank Act. The GAO report stated that the full impact of the Dodd-Frank Act “remains uncertain because many of its rules have yet to be implemented and insufficient time has passed to evaluate others.”

The GAO report examined: (i) regulatory analyses by federal agencies and interagency coordination, and (ii) the impact of selected Dodd-Frank provisions and related implementing rules on financial stability.

From interviews with community banks, credit unions and industry associations, the GAO drew the following conclusions:

  • Compliance Burden: Financial institutions reported increases in staff, training and time allocation for regulatory compliance and updates to compliance systems. Some industry officials reported a decline in specific business activities, such as loans that are not qualified mortgages, due to litigation concerns or not being able to sell those loans to secondary markets.
  • Availability of Credit: There have been moderate to minimal initial reductions in the availability of credit. Regulatory data has not confirmed a negative impact on mortgage lending. However, these results do not necessarily rule out significant effects or the possibility that effects may arise in the future.
  • Funding Costs: A GAO regression analysis suggests that the Dodd-Frank Act has had little effect on funding costs and may be associated with improvements in some measures of safety and soundness.
  • Swaps: Indicators of the swap reforms suggest that holding companies have been requiring their counterparties to post a greater amount of collateral against derivatives contracts.

The GAO developed indicators to monitor key risk characteristics of nonbank financial companies designated for supervision by the Board of Governors of the Federal Reserve System. Because few rules for these companies have been finalized or implemented, these indicators are intended to provide a baseline against which to monitor future trends.

Lofchie Comment: If ever a finding came under the heading of “as surely as the sun rises in the east,” it is that Dodd-Frank has increased regulatory costs. That said, based on the structure of this report, for reasons that were not the intentions of the GAO, the costs of Dodd-Frank are significantly understated. As a starting matter, the report deals with the costs imposed only on a very small subset of financial institutions. Secondly, the report covers only those rules whose costs to the economy are estimated to be at least $100 million; according to the GAO study, that applies to only 26 individual rules under Dodd-Frank (notwithstanding the fact that there have been certainly many hundreds of rules, perhaps thousands, adopted by the government under Dodd-Frank). Thirdly, only a limited percentage of the rules adopted by Dodd-Frank have even come into effect. And fourth, as some of the regulators indicated, it is not necessarily feasible to isolate the burdens of the Dodd-Frank rules from the burdens of all the other new rules not mandated by Dodd-Frank.

Ultimately, Dodd-Frank is such a gargantuan mess of a statute, it will probably take a full decade to implement all of the rules required by it. One would certainly hope that it will be possible for the government regulators to do some more big picture thinking about what is working, what is not, and at what cost, before this decade has run.