Compliance Officers Beware: Your Conversations With the NFA During Examinations Could Lead to Charges

The U.S. Commodity Futures Trading Commission (“CFTC”) sent a strong message to Chief Compliance Officers (“CCO”) this week when it held a CCO held accountable for lying to the National Futures Association (“NFA”) during an examination. Also, if you did not believe the CFTC’s message about its intention to reach across borders to pursue bad actors, it’s time to reconsider.

Earlier this year the CFTC instituted a civil enforcement action against Phy Capital Investments, LLC and its CEO, Fabio Bretas de Freitas. The firm was formed in 2016 and the CEO solicited participants to invest in a pool to trade commodity futures contracts. According to the CFTC, despite representing to pool participants that it made substantial commodity trading profits, the firm never engaged in any trading activity and instead misappropriated participant funds. The civil charges against the firm and the CEO included various forms of fraud as well as making misstatements and omissions to the National Futures Administration (“NFA”).

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The SEC Speaks . . . and Cooperation is Key

SEC Speaks, the SEC’s annual conference in Washington, D.C., often provides valuable insight into developments at the agency, as well as pronouncements about policy evolution and enforcement priorities. At this year’s conference, “cooperation” emerged as one of the themes that the SEC has been prioritizing over the past year – and is committed to prioritizing in the future. Indeed, the co-directors of the SEC’s Division of Enforcement remarked that, “cooperation is as important now as it has ever been,” and that the “full range” of remedies are available to entities that provide meaningful cooperation to the SEC. Interestingly, the staff emphasized that the SEC is making a concerted effort to use its press releases and orders to highlight the importance, components, and benefits of cooperation – all in an effort to promote earlier, more meaningful, and more widespread cooperation.

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Second Circuit Will Not Revisit Opinion Barring Testimony Compelled by Foreign Sovereigns

On Thursday, the United States Court of Appeals for the Second Circuit refused to revisit a July 2017 decision by a panel of that court in United States v. Allen, which held, among other things, that the Fifth Amendment prohibits the use of compelled testimony in U.S. criminal proceedings, even when the testimony was lawfully compelled by a foreign sovereign. Thursday’s Order is significant because it ensures that the Allen decision is the law of the Second Circuit, and the government’s only remaining option to challenge Allen is to petition the United States Supreme Court for review.

The circumstances in Allen arose in the wake of the well-publicized LIBOR rate manipulation scandal. Among many other prosecutions, the United States sought to prosecute two citizens of the United Kingdom – Anthony Allen and Anthony Conti. Allen and Conti worked in the London office of a European bank, and were responsible for the bank’s U.S. dollar LIBOR submissions. The United States indicted Allen and Conti for wire fraud, bank fraud, and related conspiracy charges for allegedly manipulating the bank’s LIBOR submissions in favor of the bank’s trading positions. Following a full trial, Allen and Conti were convicted.

Allen and Conti appealed their convictions – and for good reason. Before being indicted in the United States, both Allen and Conti gave testimony to the U.K. Financial Conduct Authority (“FCA”) in connection with a nearly identical LIBOR manipulation investigation. Allen and Conti’s testimony to the FCA was compelled under penalty of imprisonment, and there is no Fifth Amendment analogue in such proceedings that shields an individual from giving self-incriminating testimony. A separate target of the FCA’s LIBOR investigation was then allowed to review Allen and Conti’s compelled testimony. That target subsequently became a cooperating witness for the United States – giving statements to the FBI, and ultimately testifying as a government witness at Allen and Conti’s trial. In addition, the FBI agent who testified in the grand jury to secure Allen and Conti’s indictment relayed information that was provided to the government exclusively through the cooperating witness.

On appeal, the Second Circuit overturned Allen and Conti’s convictions, dismissed their indictments, and clarified the boundaries of the Fifth Amendment in the process. First, the court held that the Fifth Amendment’s prohibition on the use of compelled testimony applies even when a foreign sovereign has compelled the testimony (and even when the foreign sovereign has acted perfectly lawfully in doing so). Second, if the prosecution uses a witness who has had substantial exposure to a defendant’s compelled testimony, the prosecution must prove that the witness’s review of the compelled testimony did not shape, alter or affect the evidence used in the grand jury or at trial. Moreover, where a witness has materially altered his testimony after being substantially exposed to a defendant’s compelled testimony, the government must produce something more than a bare, generalized denial that the witness’ testimony was tainted by the compelled testimony.

With Allen now firmly cemented as the law of the Second Circuit, there is more reason than ever to believe that its holdings will impact not only investigations and prosecutions in the Second Circuit, but throughout the entire country.

While the facts of Allen involved criminal prosecution, it is likely that Allen will impact SEC investigations. First, the Fifth Amendment provides protection to individuals under investigation by the SEC in that the SEC cannot compel individuals to testify against their own interest. That protection is limited because the SEC, as a civil litigant, is usually entitled to an adverse inference when an individual asserts the privilege. However, if the SEC receives compelled testimony from the FCA, it would appear that under Allen that the SEC would be prevented from using the substantive testimony in any subsequent prosecution. Second, given how often the SEC staff coordinates with the criminal authorities, the SEC staff will have to be very careful about sharing the substance of foreign compelled testimony with witnesses that the criminal authorities may want to use in any parallel criminal prosecution.

Ninth Circuit: You Don’t Need to Report Securities Violations to the SEC to Be Protected by the Dodd-Frank Anti-Retaliation Provision

On March 8, 2017, a divided panel of the United States Court of Appeals for the Ninth Circuit held that the anti-retaliation provision of the Dodd-Frank Act protects individuals who make purely internal disclosures of alleged securities violations. The decision, Somers v. Digital Realty Trust, Inc., No. 15-17352 (9th Cir. March 8, 2017), aligns the Ninth Circuit with the Second Circuit, which reached the same result in Berman v. Neo@ogilvy, LLC, 801 F.3d 145 (2d Cir. 2015). These opinions stand in stark contrast to the position of the Fifth Circuit, which concluded in Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013), that in order to enjoy the protection of the anti-retaliation provision an individual must report the alleged securities violation to the SEC. While the Ninth Circuit’s decision is the latest entry in this evolving circuit split, it is unlikely to be the last—the Third Circuit is considering this very issue.

The Dodd-Frank Act defines a “whistleblower” as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a matter established by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6).

As even the Ninth Circuit acknowledged, the definition above describes only those who report information to the SEC. But the Ninth Circuit did not regard this as determinative of the issue. Instead, the court analyzed both the purpose of the Dodd-Frank Act and the scope of the activities specifically covered by the anti-retaliation provision to reach its ultimate conclusion. In particular, the anti-retaliation provision protects those who engage in lawful activities “in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 . . . and any other law, rule, or regulation subject to the jurisdiction of the Commission.” 15 U.S.C. § 78u-6(h)(1)(A)(iii). The Ninth Circuit, like the Second Circuit, noted that Sarbanes-Oxley requires both accountants and lawyers to report internally before they report to the SEC. Thus, using the “whistleblower” definition from Section 78u-6(a)(6) for purposes of the anti-retaliation provision would provide almost no protection to such lawyers and accountants—they would be forced to report internally first, and could legally be subject to retaliation in the period between their mandatory internal reporting and the time they made the report to the SEC. The Ninth Circuit concluded that such an approach “would make little practical sense and undercut congressional intent.”

The Ninth Circuit also agreed with the Second Circuit that the SEC regulation promulgated to implement anti-retaliation provision is entitled to deference. That regulation, Exchange Act Rule 21F-2, 17 C.F.R. § 240.21F-2, makes clear that the anti-retaliation provision protects anyone who engages in activities protected by 15 U.S.C. § 78u-6(h)(1)(A), including those who make internal disclosures under Sarbanes-Oxley.

Continuing its trend in Court of Appeals cases on this issue, the SEC appeared and argued as amicus in favor of expansive coverage of the anti-retaliation provision.

OCIE Highlights the Top 5 Compliance Topics from Examinations of Investment Advisers

On February 7, 2017, the Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert discussing the five most frequent compliance topics identified in OCIE examinations of investment advisors. The Alert was compiled based on deficiency letters from over 1,000 investment adviser examinations completed during the past two years. The top five topics are: (1) the Compliance Rule; (2) Regulatory Filings; (3) the Custody Rule; (4) the Code of Ethics Rule; and (5) the Books and Records Rule.

The Compliance Rule

The Compliance Rule requires: (1) written and policies and procedures reasonably designed to prevent violations of the Advisers Act; (2) annual review of the policies and their implementation; and (3) a chief compliance officer who monitors the policies and procedures.  Examples of common Compliance Rule problems included:

  • Advisers did not follow their compliance policies and procedures;
  • Annual reviews were not performed or did not address the adequacy of the adviser’s policies and procedures;
  • Compliance manuals were not reasonably tailored to the adviser’s business practices; and
  • Compliance manuals were not current.

Regulatory Filings

OCIE frequently cited advisers for failing to make timely and complete regulatory filings, such as Form ADV (as required by Rule 204-1 under the Advisers Act), Form PF (as required by Rule 204(b)-1 under the Advisers Act), and Form D (as required by Rule 503 under Regulation D of the ’33 Act) on behalf of an adviser’s private fund clients. Timely, accurate, and appropriately amended regulatory filings, especially for these three forms, should be a priority for all advisers.

The Custody Rule

The Custody Rule, which applies to advisers who have custody of client cash or securities, is designed to safeguard client assets from unlawful activity or financial problems of the adviser.  OCIE identified the following common deficiencies or weaknesses with respect to the Custody Rule:

  • Advisers did not recognize they had “custody” due to: (1) having online access to client accounts, or (2) having other authority over client accounts (such as having power of attorney or serving as a trustee of client trusts); and
  • Surprise examinations by independent accountants were not actually a surprise, and advisers failed to fully disclose custody lists during surprise examinations.

The Code of Ethics Rule

The Code of Ethics Rule requires that advisers adopt and maintain a code of ethics that meets certain minimum requirements, and which is described in Form ADV and made available to clients or prospective clients. Deficiencies or weaknesses regarding the Code of Ethics Rule were often found because:

  • Advisers failed to identify all of their access persons;
  • Codes did not specify review of the holdings and transactions reports, and did not identify specific submission timeframes;
  • Submission of transactions and holdings were untimely; and
  • Advisers failed to describe their code of ethics in Form ADV.

The Books and Records Rule

The maintenance of books and records as dictated by SEC requirements is another frequent problem area according to OCIE. Some advisers had contradictory information within separate sets of records, while other advisers either maintained inaccurate records or failed to update their records in a timely fashion. Worse still, other advisers simply failed to maintain all of the records that the Books and Records Rule requires them to keep.

FINRA Releases its 2017 Annual Regulatory and Examination Priorities Letter

Earlier this month, FINRA published its Annual Regulatory and Examination Priorities Letter (the “Letter”). This is the first Letter under the tenure of new FINRA President and CEO Robert W. Cook. Notably, Mr. Cook introduced FINRA’s annual Letter with his own “cover letter” in which he shared several thoughts with the broker-dealer industry, including a common thread running through FINRA’s Letter—specifically a focus on core issues of compliance, supervision, and risk management. Mr. Cook also discussed his “listening tour” to meet with member firms, regulators, and investor groups since joining FINRA in August. In doing so, he shared two takeaways. First, starting this year, FINRA will publish summary reports that outline key findings from examinations in selected areas to serve as additional tools that firms can use to strengthen their controls. Second, in response to feedback from smaller firms, FINRA will start providing more, and perhaps different, compliance tools to assist smaller firms in complying with regulatory requirements.

Turning to the Letter, FINRA annually publishes such a letter to provide its member firms with helpful insight into the focus areas for the upcoming year’s examinations. Though we encourage all clients, blog readers, and interested parties to review the Letter in its entirety, we have highlighted certain topics and points that we believe are the most important for our clients and followers, as discussed in more detail below. At the offset, however, we should note that in its introduction FINRA advised that starting in 2017 it will conduct electronic, off-site reviews in addition to traditional on-site examinations. These new electronic reviews will involve a select group of firms that are not currently scheduled for a cycle examination in 2017. These reviews will focus on selected areas including those identified in the Letter. In another change for 2017, FINRA will release a “compliance calendar” and a directory of compliance service providers, with the goal of helping small firms better meet their regulatory requirements.

In the body of the Letter, FINRA provides several broad categories for its priorities: (1) High-risk and Recidivist Brokers; (2) Sales practices; (3) Financial Risks; (4) Operational Risks; and (5) Market Integrity. Within these broad categories, FINRA also identified sub-categories. For ease of referencing the Letter, our summary below follows the organization of the Letter.

High-risk and Recidivist Brokers

Not surprisingly, FINRA will continue to devote particular attention to the member firms that hire high-risk and recidivist brokers and apply greater scrutiny to such firms. First, FINRA recently established a dedicated examination unit whose sole mission is to rigorously review and monitor high-risk and recidivist brokers’ interactions with customers. Second, FINRA will also focus on the ways that firms hire, retain, and monitor statutorily disqualified and recidivist brokers, and will also focus on firms that have a high concentration of brokers with significant disciplinary records, complaints, or arbitrations. Third, and more generally, FINRA is committed to ensuring that firms have sufficient inspection programs and supervisory systems for their branch offices and non-branch office locations, including independent contractor branches.

Sales Practices

  • Senior Investors – FINRA will continue to closely evaluate recommendations that senior investors purchase speculative or complex products, particularly in light of the investor’s profile and risk tolerance. Last year, fraud schemes involving microcap (or “penny”) stocks were on the rise, and often targeted senior investors. FINRA encourages firms to take steps to protect elderly customers from such fraud by contacting these customers to verify those types of transactions.
  • Product Suitability and Concentration – FINRA will continue to assess how firms conduct reasonable-basis and customer-specific suitability reviews, and will increase its focus on the controls firms have in place for recommending new products and for recommendations that result in excess concentration in customers’ accounts. FINRA makes specific reference to ETPs, non-traded REITS and BDCs. Furthermore, firms should be prepared to discuss how changes in the interest rate environment impact their recommendations to clients.
  • Excessive and Short-term Trading of Long-term Products – FINRA is clearly concerned about excessive and short-term trading of long-term products, as such activity is detrimental to clients but can bolster sales credits for registered representatives. FINRA makes specific reference to UITs. In addition to FINRA’s examination of this activity, FINRA urges firms to determine whether their control systems are sophisticated enough to detect deliberate attempts to avoid automatic surveillance for excessive switching activity.
  • Outside Business Activities and Private Securities Transactions – FINRA will continue to focus on firms’ controls, documentation, and evaluation of written notifications of proposed outside business activities by registered representatives and associated persons. In addition, FINRA will focus on associated persons’ notification of private securities transactions and firms’ ongoing supervision of approved private securities transactions.
  • Social Media and Electronic Communications Retention and Supervision – FINRA makes clear that both SEC and FINRA record-retention requirements extend to all business-related communications, regardless of the devices or networks used. FINRA will ensure that firms are complying with these retention requirements, as they are essential to a firm’s ability to detect inappropriate business conduct.

Financial Risks

  • Liquidity Risk – FINRA’s 2016 assessment of liquidity management practices at firms identified a variety of issues. As a result, in 2017 FINRA intends to focus on firms’ funding and liquidity plans to determine whether firms adequately evaluate their liquidity needs, develop contingency plans to handle market stresses, and effectively test those contingency plans.
  • Financial Risk Management – Furthering its attempts to understand how larger firms manage risk across their organizations, FINRA will ask a select group of firms to explain how they would react to specific stress scenarios, considering the areas of readiness, communication plans, risk metrics, and contingencies.
  • Credit Risk Policies, Procedures and Risk Limit Determinations Under FINRA Rule 4210 – On December 15, 2016, the first phase of the new amendments to FINRA Rule 4210 became effective. In 2017, FINRA will evaluate firms’ compliance with the first phase of the rule amendments and the corresponding supervision, policies, procedures and processes.

Operational Risks

  • Cybersecurity – According to FINRA, cybersecurity threats are one of the most significant risks for many firms. FINRA will focus on reviewing firms’ data systems, the controls designed to protect those data systems (including from insider threats), the strength of controls and practices at branch offices and independent contractor branch offices (which tend to be weaker), and firms’ compliance with Securities Exchange Act of 1934 (SEA) Rule 17a-4(f), which requires the use of write once read many (aka “WORM”) format.
  • Supervisory Controls Testing – FINRA reminds all firms of their obligations with respect to supervisory controls testing and chief executive officer certifications with specific reference to FINRA Rules 3120 and 3130.
  • Customer Protection/Segregation of Client Assets – Compliance with SEA Rule 15c3-3 is also a priority. FINRA will assess the sufficiency of firms’ documentation of the absence of liens and encumbrances on securities. In addition, FINRA will be examining whether firms are engaging in transactions that are designed, in whole or in part, to reduce a firm’s reserve or segregation requirements.
  • Regulation SHO – Close Out and Easy to Borrow – Due to recent SEC enforcement actions regarding SEC Regulation SHO, FINRA will focus on the locate processes employed by firms in connection with short sales, and emphasized that firms should closely monitor their close-out process to ensure they are complying with Rule 204 of Regulation SHO.
  • Anti-Money Laundering and Suspicious Activity Monitoring – Anti-money laundering programs will continue to be a FINRA focus in the upcoming year. Firms must incorporate anti-money laundering red flags into their trading surveillance systems, and should evaluate their controls around accounts held by nominee companies.
  • Municipal Advisor Registration – Firms that advise state and local governments on municipal securities should ensure that they are registering correctly with the SEC and the Municipal Securities Rulemaking Board and that individuals engaging in municipal advisory activities pass the Series 50 Examination made available on September 12, 2016. Firms that do not register but still provide services to municipal customers should ensure that they meet the appropriate statutory exclusions and regulatory exceptions.

Market Integrity

  • Manipulation – Manipulation is a perennial top priority for FINRA and FINRA is taking several steps to detect and deter such manipulation, including: (1) enhancing its layering pattern detection capabilities to look for larger groups of market participants engaging in this manipulative activity; (2) enforcing the recent amendments to the Order Audit Trail System (OATS) rules; (3) monitoring potentially manipulative trades surrounding market open and close; and (4) expanding cross-product manipulation surveillance to include exchange-traded products. Lastly, in 2016, FINRA introduced the Cross Market Equity Supervision Report Cards for layering and spoofing activity as a compliance tool to complement firms’ supervisory systems and procedures to detect and deter manipulative conduct by a firm or its customers.
  • Best Execution – FINRA emphasizes the importance of Regulatory Notice 15-46 and the importance of providing accurate payment for order flow disclosures. FINRA further advises that firms need to consider how the continuing automation of the markets for equity securities, standardized options and advances in fixed income markets affect order handling decisions, and factor these changes into their review of execution quality.
  • Audit Trail Reporting Early Remediation Initiative and Expansion – FINRA expects firms to address potential equity audit trail issues identified through the Audit Trail Reporting Early Remediation Initiative. If firms take quick corrective measures in response to these alerts and the problem is limited in scope, it is possible that a formal investigation can be avoided.
  • Tick Size Pilot – The Tick Size Pilot will continue in 2017, and FINRA notes that it is “critical” that firms submit accurate OATS and market maker data. FINRA intends to monitor compliance with these data requirements, and restrictions on quoting and trading.
  • Market Access Rule – Firms should focus on improving their compliance with the Market Access Rule. In this subsection, FINRA provides a list of best practices, including: implementing, memorializing, and monitoring pre-trade and post-trade controls; implementing procedures for the supervision, development, testing and employment of algorithmic trading, including code development or changes; and maintaining reasonable processes to monitor whether trading algorithms operate as intended, and processes to disable algorithms or systems that malfunction. FINRA directs firms to Regulatory Notice 15-09 for further discussion of effective electronic trading practices.
  • Trading Examinations – Conflicts of interest, the adequacy of alternative trading systems’ disclosures, and the handling of manual option orders by floor brokers and upstairs firms under their best execution obligations will be examination priorities this year. Also, FINRA intends to begin a pilot trading examination program to determine whether targeted examinations of smaller firms are worthwhile.
  • Fixed Income Securities Surveillance Program – FINRA will continue to focus on surveilling wash sales and interposing activity, and will review written supervisory procedures and systems designed to detect non-bona fide trading to create an artificial price level in a bond, in order to hide an excessive mark-up to a customer trade or reset the aging of positions held by the firm. FINRA will also continue its focus on securitized products. Also, in light of the TRACE reporting requirements, which are scheduled to become effective in July 2017, FINRA will develop ways to monitor compliance with rules applicable to U.S. Treasury securities.

Drinker Biddle Conclusion

Mr. Cook’s cover letter is revealing in terms of his initial views as FINRA’s new leader. Mr. Cook appears to aspire for increased and better communication with FINRA’s members. He also stated that one of his areas of focus will be the role that member firms “…play in facilitating capital formation by small and emerging growth companies, which are vital engines of our economy and job creation.” Turning to FINRA’s Letter, consistent with its mandate as the main self-regulatory organization for broker-dealers, the Letter and priorities ambitiously seek to cover all corners of the broker-dealer industry. That said, many of the plans discussed are continuations of long-standing efforts, though others are new priorities that demonstrate the ways in which FINRA’s oversight is evolving, expanding, and improving, such as the increased discussion of electronic and algorithmic trading. For our clients and readers, we will continue to monitor the way that FINRA’s priorities unfold over the course of 2017. In the meantime, if you have any questions about any of the topics covered in the Letter, please contact Sandy Grannum or Jim Lundy.