SEC Commissioner Calls for New Enforcement Approach toward Compliance

SEC Commissioner Hester M. Peirce called on the SEC to consider alternative methods when addressing compliance infractions rather than resorting to enforcement proceedings.

In remarks at the National Membership Conference of the National Society of Compliance Professionals, Ms. Peirce stated that enforcement resources should not be used on relatively minor compliance infractions, but should be saved for more serious matters. Ms. Peirce advocated for a more “subtle” approach to resolving compliance infractions, such as building norms that foster compliance, as opposed to initiating “formal enforcement action[s].”

Commissioner Peirce expressed concern that actions directed against a compliance officer can have a “chilling effect” and adversely impact the compliance industry and profession. Ms. Peirce said that the SEC should not bring enforcement actions simply because it disagrees with a compliance officer’s judgment.

Commissioner Peirce also stated that a compliance examiner should help firms to pinpoint issues and, subsequently, work with them to correct those issues in an efficient as well as collaborative fashion without resorting to enforcement proceedings. Conversely, Ms. Peirce emphasized the importance of firms’ cooperation with SEC compliance staff and asserted that, too often, firms “drag their feet” or provide inaccurate information. According to Ms. Peirce, while the SEC’s Enforcement Division has a part to play in countering violations of securities laws, managers and employees at firms are the “first line of defense,” followed by compliance officers.

SEC to Examine Operations of Certain Mutual and Exchange-Traded Funds

In a Risk Alert, the SEC Office of Compliance Inspections and Examinations (“OCIE”) provided information on a series of examination initiatives being conducted on industry practices and regulatory compliance of mutual funds and exchange-traded funds (“ETFs”) (collectively, the “funds”). The OCIE is interested in how the operation of these funds may impact retail investors.

The OCIE said it is investigating the following funds and advisers:

  • index funds that track custom-built indexes;
  • smaller ETFs and/or ETFs with little secondary market trading volume;
  • mutual funds with higher allocations to certain securitized assets;
  • funds with aberrational underperformance relative to their peer groups;
  • advisers who are relatively new to managing mutual funds; and
  • advisers who provide advice both to mutual funds and to private funds that (i) have similar strategies or (ii) are managed by the same portfolio managers.

The OCIE stated that it is evaluating whether the advisers’ and funds’ policies and procedures are designed to address risk and conflicts. The OCIE said it will examine disclosures and how the funds assess portfolio management compliance, and fund governance.

Lofchie Comment: It should be expected that the SEC will look closely at any situation where a public fund underperformed a private fund or managed account with a generally similar strategy. Any adviser who is managing clients that fit that description should carefully consider the reasons for the difference in performance.

SEC Commissioner Urges SEC Enforcement to “Resist” Numerical or Financial Targets

SEC Commissioner Hester Peirce called on the agency to “resist” the distraction of focusing on achieving numerical and penalty amount targets with respect to enforcement actions.

In remarks at the Annual Securities Litigation and Regulatory Enforcement Seminar, Ms. Peirce contended that the number of initiated or settled enforcement cases and penalty amounts is a “meaningless measure of the effectiveness of the enforcement program.” She stated that analyzing the different types of cases brought by the SEC would be a better indicator of the success of the agency’s enforcement work.

Ms. Peirce further advised the SEC to consider the entirety of the case – rather than just the potential penalty amount – when deciding on whether to divert resources to a specific enforcement action. According to Ms. Peirce, a case with a smaller penalty amount may set a more meaningful precedent than one with a larger penalty amount.

“Halting a Ponzi scheme or an affinity fraud that touched the lives of retail investors might be more meaningful than halting a practice in which one large financial institution gives a bad deal to another.”

Additionally, Ms. Peirce highlighted several issues the SEC should ask for help in pursuing. In particular, she suggested that the SEC:

  • revisit SEC rules that are implementing antifraud statutes to ensure the rules are accomplishing their intended mission;
  • consider rulemaking to alter the transfer agent rules and reporting requirements; and
  • help public companies build more effective Foreign Corrupt Practices Act programs.

Ms. Peirce also expressed concern regarding recent enforcement actions targeting suspicious activity report (“SAR”) filing errors, especially when a firm has an operational SAR program in place. According to Ms. Peirce, the recent SAR enforcement actions may cause (i) an increase in quantity, rather than quality, of SAR filings or (ii) legitimate firms to exit the “microcap space,” forcing investors to rely on “unsavory firms” instead.

Lofchie Comment: Commissioner Pierce makes a number of important points.

The SEC has treated its imposition of financial penalties as if the agency were a corporation that was under pressure to announce greater profits each year. The SEC’s mission is larger than that; it is, or at least should be, to create a capital market system that functions well and serves the economy. Catching and punishing bad actors is part of that, but a limited part. Rather than boast of fine amounts, the SEC would do better to consider the decrease in the number of initial public offerings.

Commissioner Pierce is absolutely right to point out that sanctioning firms for operational issues in filing SARs, or in other anti-money laundering procedures, is driving legitimate firms out of a variety of lawful activities.

SEC Amends Regulation NMS to Require Additional Order-Handling Disclosures

The SEC will amend Regulation NMS Rules 600(b) and 606 to increase the transparency of broker-dealers’ “handling and routing of orders in NMS stock.” The amendments (i) will require a broker-dealer, upon request by a customer, to provide such customer with certain standardized disclosures related to the broker-dealer’s routing and execution of the customer’s “not held” orders for the previous six months, and (ii) revise the current quarterly public order-routing report to include additional disclosures regarding the terms of any payment for order flow and any profit-sharing arrangements that may influence a broker-dealer’s order-routing decision.

The amendments will become effective 60 days after their publication in the Federal Register. The compliance date will be 180 days following the date of publication of the amendments in the Federal Register.

Lofchie Comment: This requirement is in line with the SEC’s historical policy of requiring disclosure and then allowing investors to make their own investment and trading decisions based on that disclosure. Questions remain as to whether the disclosures are sufficient for customers to make informed decisions and whether the requirement of making the added disclosures may motivate broker-dealers to improve their execution practices.

Trade Associations Request Extension of Comment Period for Security-Based Swap Rules

Several trade associations requested that the SEC extend the comment period for its proposed rules on capital, margin and segregation requirements for security-based swaps. The requests seek an additional 30 days to comment (comments are currently due on November 19, 2018).

As previously covered, the SEC reopened the comment period, and requested additional comments, on proposed new rules and amendments to (i) establish capital, margin and segregation requirements for security-based swap dealers and (ii) revise broker-dealer capital requirements relating to the use of security-based swaps. The extension requests came in two letters: one from SIFMA and the Institute of International Bankers, and the other from ISDA, the Investment Company Institute, the MFA and the Chamber of Commerce Center for Capital Markets Competitiveness. In requesting an extension, the trade associations cited, among other things, the long period between the initial comment period and the reopening, as well as the significance of the proposal for market participants.

Lofchie Comment: It is really difficult to see any justification for not extending the comment period by another month. The rule proposals have been sitting at the SEC for years. Not only are the proposals extremely complicated in their implementation, but much has changed since they were first proposed.

FRB to Implement New Supervisory Rating System

The Federal Reserve Board (“FRB”) will implement a new supervisory rating system for large financial institutions.

Effective February 1, 2019, the FRB will enforce a new rating system for large financial institutions (“LFI”). The new system is intended to (i) better reflect current FRB supervisory programs and practices, (ii) enhance the supervisory assessments and communications of supervisory findings and implications and (iii) improve “transparency related to the supervisory consequences of a given rating.” The new LFI rating system will apply to (i) all domestic bank holding companies and non-insurance, non-commercial savings and loan holding companies (“SLHCs”) with $100 billion or more in total consolidated assets and (ii) U.S. intermediate holding companies of foreign banking organizations with $50 billion or more in total consolidated assets.

The existing RFI/C(D) rating system will continue to be applied to community and regional bank holding companies with less than $100 billion in consolidated assets. In addition, the RFI/C(D) rating system will be expanded to apply to certain SLHCs with less than $100 billion in total consolidated assets on February 1, 2019.

Banking Agencies Propose Updating Calculation of Derivative Contract Exposure Amounts

The Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation proposed allowing “advanced-approaches” banking organizations (i.e., those with $250 billion or more in total consolidated assets, or $10 billion or more in on-balance sheet foreign exposure) to use an alternative approach for calculating derivative exposures under regulatory capital rules.

The proposed approach – the standardized approach for counterparty credit risk (“SA-CCR”) – would replace the current exposure methodology (“CEM”). If adopted, the proposal would (i) require advanced-approaches banking organizations to use SA-CCR to calculate their standardized total risk-weighted assets by July 1, 2020 and (ii) allow non-advanced-approaches banking organizations to use either CEM or SA-CCR when calculating standardized total risk-weighted assets.

In addition, the proposal would require advanced-approaches banking organizations to use SA-CCR to determine the exposure amount of derivative contracts for calculating total leverage exposure and would amend the cleared transactions framework to include SA-CCR.

Comments on the proposal must be submitted within 60 days from the date of publication in the Federal Register.

SEC Commissioner Offers Recommendations on Implementing G20 Swaps Reforms

SEC Commissioner Hester M. Peirce offered recommendations to regulators on implementing G20 swaps reforms. Ms. Peirce said that the G20 reforms were not foolproof and encouraged regulators to exercise “healthy skepticism” when implementing them.

In remarks before the International Regulators Conference, Ms. Peirce said that “poorly designed regulations” played a role in the 2007-2009 financial crisis. She cited the “favorable regulatory treatment given to highly rated securitization tranches.” She stated that, among other things:

  • “central clearing is not a panacea” and brings its own risks;
  • regulators should attend to market feedback and market professionals’ knowledge when considering rulemaking; and
  • regulators must consider more flexible regulation rather than a one-size-fits-all approach.

In implementing the regulatory framework for security-based swaps, Ms. Peirce advised, the SEC should:

  • reexamine proposed and final regulations to ensure that the regulatory framework serves its intended purpose;
  • devise clear rules and provide guidance instead of relying on staff no-action letters;
  • streamline regulatory processes so that the agency can promptly respond when implementation issues arise;
  • ensure that the compliance periods for rules provide the market with sufficient time to prepare for and then comply with requirements; and
  • provide that multiple rule sets do not overly burden market participants.

In addition, Ms. Peirce advocated for regulatory cross-border deference as international regulators develop their framework for security-based swaps. According to Ms. Peirce, regulatory cross-border deference will ensure that the global over-the-counter derivatives market can serve the risk management needs of companies throughout economies.

Lofchie Comment: Commissioner Peirce’s call for the regulators to be self-critical is welcome. Likewise are her suggestions that both the causes of the financial crisis and the regulatory responses to it be critically re-examined.

There are, however, important challenges to her stated goals. Is it possible to have multiple regulators both be open to ongoing regulatory review and revision and, at the same time, to conform their own rules? It is certainly good news that the CFTC and the SEC are cooperating now; but will the agencies be able to sustain such cooperation over the long term?

Treasury Proposes Regulations on Opportunity Zones

The U.S. Treasury Department (“Treasury”) proposed regulations relating to the new Opportunity Zone tax incentive. The tax incentive is intended to encourage investments in economically distressed communities by allowing taxpayers to defer capital gains tax if they reinvest within 180 days in “qualified opportunity funds” (“QOFs”), which are generally required to maintain at least 90 percent of their assets in “qualifying opportunity zone property.” In addition, an investor who holds a QOF investment for at least 10 years may qualify to increase its basis to the fair market value of the investment on the date it is sold.

The proposed regulations address, among other things, (i) the type of gains that may be deferred by investors (capital gains), (ii) investments in QOFs by pass-through entities, such as partnerships, (iii) guidance as to what constitutes opportunity zone property and what entities are eligible to be QOFs, and (iv) timing and election mechanics. In addition to the proposed regulations, the Treasury and the IRS issued Rev. Rul. 2018-29, which provides guidance for taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones. The Treasury and IRS also released Form 8996, which investment vehicles will use to self-certify as QOFs.

Senate Banking Committee Member Introduces “Pro-Growth” Legislation

Senate Committee on Banking, Housing and Urban Affairs member Mike Rounds (R-SD) introduced six bills intended to reduce regulatory burdens for investors and small businesses attempting to raise capital.

Lofchie Comment: As to the proposed Improving Investment Research for Small and Emerging Issuers Act, the SEC must find a way to allow broker-dealers to make money by publishing research. If the SEC ever thought that broker-dealers will continue to publish research on small companies even though there is no financial benefit in doing so, experience should have taught otherwise.