Securities Law Prof Blog

FINRA Panel Fines Brookstone Securities $1 Million for Fraudulent Sales of CMOs

A FINRA hearing panel ruled that Brookstone Securities and the firm's Owner/CEO Antony Turbeville and one of the firm's brokers, Christopher Kline, made fraudulent sales of collateralized mortgage obligations (CMOs) to unsophisticated, elderly and retired investors. The panel fined Brookstone $1 million and ordered it to pay restitution of more than $1.6 million to customers, with $440,600 of that amount imposed jointly and severally with Turbeville, and the remaining $1,179,500 imposed jointly and severally with Kline.

The panel also barred Turbeville and Kline from the securities industry, and barred Brookstone's former Chief Compliance Officer David Locy from acting in any supervisory or principal capacity, suspended him in all capacities for two years and fined him $25,000. Unless the hearing panel's decision is appealed to FINRA's National Adjudicatory Council (NAC) or is called for review by the NAC, the hearing panel's decision becomes final after 45 days.

The panel found that from July 2005 through July 2007, Turbeville and Kline intentionally made fraudulent misrepresentations and omissions to elderly and unsophisticated customers regarding the risks associated with investing in CMOs. All of the affected customers were retired investors looking for safer alternatives to equity investments. According to the decision, Turbeville and Kline "preyed on their elderly customers' greatest fears," such as losing their assets to nursing homes and becoming destitute during their retirement and old age, in order to induce them to purchase unsuitable CMOs. By 2005, interest rates were increasing, and the negative effect on CMOs was evident to Turbeville and Kline, yet they did not explain the changing conditions to their customers. Instead, they led customers to believe that the CMOs were "government-guaranteed bonds" that preserved capital and generated 10 percent to 15 percent returns. During the two-year period, Brookstone made $492,500 in commissions on CMO bond transactions from seven customers named in the December 2009 complaint, while those same customers lost $1,620,100.

 

 

Heminway on Interrelationship between Gender and Insider Trading

A Portrait of the Insider Trader as a Woman, by Joan MacLeod Heminway, University of Tennessee College of Law, was recently posted on SSRN.  Here is the abstract:

This draft book chapter describes the interrelationship between gender and U.S insider trading law and explores (anecdotally and through extensions of existing gender studies outside the insider trading realm) the potential roles and significance of gender in that context. Although women have become more visible as participants in the securities markets and as alleged and actual transgressors of insider trading rules, the role of women in insider trading is still ill understood, except anecdotally. In sum, the portrait of the insider trader as a woman is a work in process.

Morley on Allowing Mutual Funds to Issue Debt

Let Mutual Funds Issue Debt, by John Morley, University of Virginia School of Law, was recently posted on SSRN.  Here is the abstract:

At present, the only type of security open-end mutual funds can issue is common stock. This paper contemplates a broader set of possibilities: maybe mutual funds should be allowed to issue debt securities, such as redeemable bonds, in addition to common stock. Debt securities might hold many advantages. Most obviously, they might offer superior alternatives to money market fund shares. Unlike money market fund shares, debt securities could offer fixed interest rates as well as fixed redemption values and would be insulated from risk by loss-bearing equity. There is no obvious mechanical obstacle that prevents open-end mutual funds from issuing debt: these funds already borrow from banks and derivative counterparties, and they used to issue redeemable bonds and preferred stock in the past. This draft is preliminary and suggestions are welcome.

FINRA Suspends Provident Principals for Two Years for Role in Ponzi Scheme

Are $50,000 fines and two-year suspensions from the industry meaningful sanctions for two principals of Provident Asset Management, LLLC, which marketed and sold preferred stock interests in a series of 23 private placements offered by an affiliate?  The offerings, as many will recall, were in fact a big ponzi scheme that raised over $458 million from at least 7,700 investors.  The order of settlement between FINRA and Coughlin and Harrison, which is posted on the FINRA website, is criticized by some as a "slap on the wrist."  Others point out that as a practical matter the two men are barred from the industry, as neither has worked in the industry since 2009, when the fraud was discovered.  As an SRO, moreover, FINRA is not permitted to "punish" wrongdoers, but only impose remedial sanctions, although the distinction is unclear.  For more on this story, see InvNews, Finra's settlement with ex-Provident execs 'slap on the wrist,' says lawyer

SEC Approves Plans to Address Extraordinary Stock Volatility

The SEC approved two proposals submitted by the national securities exchanges and FINRA that are designed to address extraordinary volatility in individual securities and the broader U.S. stock market.

One initiative establishes a “limit up-limit down” mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band. When implemented, this new mechanism will replace the existing single-stock circuit breakers that the Commission approved on a pilot basis after the market events of May 6, 2010.

The second initiative updates existing market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. The existing market-wide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. The changes lower the percentage-decline threshold for triggering a market-wide trading halt and shorten the amount of time that trading is halted.

The exchanges and FINRA will implement these changes by February 4, 2013, for a one-year pilot period.   Additional information, including the approval orders, are posted on the SEC website.

GAO Reports on SEC's Oversight of FINRA

GAO released a report, Opportunities Exist to Improve SEC's Oversight of the Financial Industry Regulatory Authority (GAO-12-625, May 30, 2012).  Here is its summary:

What GAO Found
Historically, the Securities and Exchange Commission’s (SEC) oversight of the Financial Industry Regulatory Authority’s (FINRA) programs and operations varied, with some programs and operations receiving regular oversight and others receiving limited or no oversight. Through its inspection process, SEC conducted routine and special inspections of various aspects of FINRA regulatory programs, including examinations, surveillance, and enforcement programs. SEC has also conducted routine inspections of FINRA’s advertising and arbitration programs but not as frequently as it had planned. SEC has also regularly reviewed FINRA proposed rule changes that are subject to SEC approval to determine consistency with the Securities Exchange Act of 1934 and related rules and regulations. However, neither SEC nor FINRA conducts retrospective reviews of FINRA’s rules. GAO and others have reported on the usefulness of retrospective reviews as they allow agencies to assess the effectiveness of their rules, and some federal financial regulators, including SEC, have begun pursuing plans to conduct retrospective reviews of their rules in light of a recent executive order that encourages independent regulatory agencies to do so. By not conducting these reviews, FINRA may be missing an opportunity to systematically assess whether its rules are achieving their intended purpose and take appropriate action, such as maintaining rules that are effective and modifying or repealing rules that are ineffective or burdensome. Further, by not reviewing what steps FINRA takes in reviewing its existing rules, SEC may not capture sufficient information to form an opinion about FINRA’s efforts to review its rules. Further, SEC has conducted limited or no oversight of other aspects of FINRA’s operations, such as governance and executive compensation. According to SEC, these operations were not historically considered due to competing priorities and resource constraints. Specifically, SEC officials said that SEC focused its resources on FINRA’s regulatory departments, which were perceived as programs that have the greatest impact on investors.

SEC is in the process of enhancing and expanding its oversight of FINRA using a more risk-based approach. To assess the risks facing FINRA, SEC has collected a substantial amount of information on FINRA’s regulatory programs and operations, including for programs and operations of FINRA for which it has not previously conducted oversight. SEC has analyzed the information it collected, and, according to SEC staff, will use this information as it implements its enhanced risk-based oversight of FINRA later this year. SEC has followed some elements GAO has previously found to be important in a risk-management framework, but officials have not articulated or documented how they will implement all of the elements, such as considering alternative oversight approaches and monitoring the effectiveness of its oversight. Incorporating these other elements will better position SEC to prioritize evolving and varying risks, evaluate alternatives, and monitor its oversight efforts. Without such elements, SEC may be missing opportunities to take a more comprehensive, risk-based approach in overseeing FINRA.

 

Eleventh Circuit Says Misrepresentations Affecting Choice of Broker are not Material

SEC v. Goble (11th Cir. May 29, 2012) addresses the issue of what constitutes "securities fraud" under rule 10b-5 in the context of a clearing firm's fudging its books and records to meet regulatory reserve requirements.  To my astonishment, the appellate court decided that the principal of a clearing firm did not commit securities fraud when he caused the firm to enter on its records a sham transaction purporting to be a $5 million money market purchase because, according to the court, "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for 10(b) securities fraud liability." ( Download SECv.Goble ) 

First, the facts: Richard Goble controlled North America Clearing, Inc., a clearing broker for about forty small brokerage firms.  In 2007-2008 the firm had financial difficulties and struggled to maintain at the appropriate level the cash reserve account required by SEC regulations.  Finally, in May 2008, Goble directed the CFO  to record a sham transaction -- $5 million money market purchase -- to make it appear that firm could withdraw $3.4 million from the reserve account.  FINRA examiners, who were on site, quickly discovered the sham transaction; within a few days, it was clear that the firm could not meet the reserve requirements, and the firm was wound down.  An SEC enforcement action followed, charging that the firm violated the customer protection rule and books and records requirements.  It also charged Goble with violating Rule 10b-5 (in addition to aiding and abetting the firm's violations).  The district found against Goble on both counts, enjoined him from future violatons of the securities laws and permanently restrained him from seeking a securities license or engaging in the securities business.  The appeals court reversed the district court's judgment on the 10(b) count, upheld the judgment on the aiding and abetting count and remanded for reconsideration of the injunctive relief and the bar.

Second, the appellate court's analysis of the 10(b) claim:  The SEC based its 10(b) claim on Goble's causing the CFO to record the fake money market fund purchase in the firm's books.  The appellate court first rejected the district court's finding that this was a material misrepresentation.  It "easily dispatch[ed] the ... theory that the sham transaction would have been material to an investor's choice of broker-dealers," because the materiality test focuses on the importance of the fact on an investment decision -- which the court believes does not include an investor's choice of broker-dealer.  The court categorically states that "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for a 10(b) securities fraud liability."  The appellate court also found that the misrepresentation was not made "in connection with the purchase or sale of securities," even though it assumed, without deciding, that the money market fund was a security.  (The district court had found that a money market fund was not a security, another curious assertion.)  Since the only "purchase" was a sham transaction, it was neither a "purchase" nor the type of behavior that 10(b) forbids.  Indeed, another categorical assertion by the court:  "Section 10(b) was not intended to protect investors from a broker-dealer's inaccurate records or an inadequate reserve fund."

As noted, the count against Goble for aiding and abetting the customer protection rule and books and records regulations was upheld, although the district court was directed to reconsider the remedy and determine if a bar is an appropriate remedy.  Nonetheless, it is discouraging to read that information that would affect an investor's choice of broker-dealer is not material because it does not relate to an investment decision.  I just hope that the reach of this opinion is confined to its particular facts and the sweeping assertions do not come back to bite investors who rely to their detriment on brokers' assertions of their competence, expertise and probity.

 

Second Circuit Interprets Disclosure Obligations under Item 303 of Reg S-K

The Second Circuit has issued several opinions interpreting the disclosure obligations created by Item 303 of Regulation S-K, which requires registrants to "describe any known trends or uncertainties ... that the registrant reasonably expects will have a material ... unfavorable impact on ... revenues or income from continuing operations."  Panther Partners Inc. v. Ikanos Communications, Inc. (decided May 25, 2012)(Download PantherPartners.052512[2]) is the latest in this line of cases.  Plaintiff appealed a federal district court order that dismissed its third complaint alleging violations of Securities Act 11, 12(a)(2) and 15 in connection with a March 2006 secondary offering of Ikanos Communications stock.  In contrast to the district court, the appeals courts held that the complaint stated a claim because it plausibly alleged that defects in the company's semiconductor chips constituted a known trend or uncertainty that the company reasonably expected would have a material unfavorable impact on revenues.

As alleged in the complaint, in 2005 Ikanos sold chips to Sumitomo and NEC, its two largest customers and the source of 72% of its 2005 revenues.  They in turn incorporated the chips into products that were sold to NTT and installed in its network.  In early 2006 Ikanos learned that the chips were defective and were causing the network to fail, with the complaints increasing in the weeks preceding the March 2006 offering.  Indeed the board of directors met and discussed the problem, and company representatives regularly traveled to Japan to meet with Sumitomo and NEC to discuss the problem.  Ultimately, the company had to replace at its expense all of the units sold, resulting in substantial losses.  

Plaintiff alleged that the company did not adequately disclose in its Registration Statement the magnitude of the problem and instead provided a generic cautionary warning that "highly complex products ... frequently contain defects and bugs..."  The district court had previously dismissed the complaint twice and denied plaintiff's motion to file another amended complaint because it failed to allege "additional facts that Ikanos knew the defect rate was above average before filing the registration statement."  In vacating the district court's judgment, the appeals court held that it construed the proposed complaint too narrowly:

We believe that, viewed in the context of Item 303's disclosure obligations, the defect rate, in a vacuum, is not what is at issue.  Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.

The appeals court emphasized two allegations in the amended complaint that it considered critical: (1) Sumitomo andNEC accounted for 72% of revenues and (2) Ikanos knew when it was receiving the complaints that it would be unable to determine which chip sets contained defective chips. From these facts, two reasonable and plausible inference could be drawn: Ikanos would have to replace and write off a large volume of chip sets and it had jeopardized its relationship with the two customers that accounted for the vast majority of its revenues.

In light of these allegations, the Registration Statement's generic cautionary language did not fulfill the company's duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks before the offering.  The court had "little difficulty concluding that Panther has adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303."

 

Moberly on Whistleblower Protection

Sarbanes-Oxley's Whistleblower Provisions - Ten Years Later, by Richard Moberly, University of Nebraska College of Law, was recently posted on SSRN.  Here is the abstract:

Whistleblower advocates and academics greeted the enactment of the Sarbanes-Oxley Act’s whistleblower provisions in 2002 with great acclaim. The Act appeared to provide the strongest encouragement and broadest protections then available for private-sector whistleblowers. It influenced whistleblower law by unleashing a decade of expansive legal protection and formal encouragement for whistleblowers, perhaps indicating societal acceptance of whistleblowers as part of its law enforcement strategy. Despite these successes, however, Sarbanes-Oxley’s greatest lesson derives from its two most prominent failings. First, over the last the decade, the Act simply did not protect whistleblowers who suffered retaliation. Second, despite the massive increase in legal protection available to them, whistleblowers did not play a significant role in uncovering the financial crisis that led to the Great Recession at the end of the decade. These related failures indicate that although whistleblowers had stronger and more prevalent protection than ever before, they had less reason to believe such protection works. This Article examines the developments in whistleblower law during the last decade and concludes that Sarbanes-Oxley’s most important lesson is that the usual approach to whistleblowing may not be sufficient. Encouragingly, the Article also evaluates recent developments in light of Sarbanes-Oxley’s successes and failures to demonstrate that policy makers may have learned from the Sarbanes-Oxley experience. During the last two years, regulators and legislators implemented new strategies that may encourage employees to blow the whistle more effectively.

Block on Systemic Risk

Letting Go of Binary Thinking and Too-Big-To-Fail: Preserving a Continuum Approach to Systemic Risk, by Cheryl D. Block, Washington University in Saint Louis - School of Law, was recently posted on SSRN.  Here is the abstract:

This Article highlights differences between principle and practical implementation of prudential regulation and resolution rules pertaining to financial institutions. In principle, even though general prudential regulatory rules reflect a gradual risk-based continuum approach, their implementation with respect to large systemically important institutions has often been through regulatory forbearance. Particularly when confronted with lobbying pressure from very large banks, regulators have opted for inaction. In ironic contrast, statutory and regulatory resolution rules over time have increasingly restricted regulators’ options, often apparently leaving regulators to make a binary choice between letting the entity fail and providing a major government rescue or “bailout.” In reality, however, regulators have adopted a range of government strategic responses to imminent or actual large private business failures. Resolution authority is binary in principle, but actually implemented along a private-public continuum. Despite Dodd-Frank’s attempt to limit this “reality,” regulators are likely to continue to exercise their resolution authority in a more flexible manner along this continuum than might otherwise appear from formal and statutory rules.

Such a continuum-based approach is important for both regulation and resolution. On the regulation side, this approach suggests better implementation of the risk-based principles already in place and assurance that new enhanced prudential regulatory rules will be properly implemented. On the resolution side, it means understanding that resolution authority reflects government policy with respect to allocating large financial entity failure risks. Rather than pretend to rid the system of bailouts, regulators should acknowledge the range of existing and potential government responses to risk allocation, and work toward developing an equitable and transparent process and substantive criteria for making allocative choices in the case of systemically important financial institution failures.

Bradford on Crowdfunding

The New Federal Crowdfunding Exemption: Promise Unfulfilled, by C. Steven Bradford, University of Nebraska College of Law, was recently posted on SSRN.  Here is the abstract:

On April 5, 2012, President Barack Obama signed into law a new federal securities law exemption for crowdfunded securities offerings. Crowdfunding — the use of the Internet to raise small amounts of money from a large number of contributors — has become incredibly popular outside the securities context. But the use of crowdfunding to sell securities has been stymied by federal securities regulation. Securities Act registration is simply too expensive for small, crowdfunded offerings, and, until now, none of the registration exemptions fit crowdfunding well. Moreover, the web sites that facilitate crowdfunding could be considered brokers if they hosted securities offerings, imposing additional regulatory costs.

The new crowdfunding exemption attempts to resolve both of those regulatory problems — by exempting crowdfunded offerings from the registration requirement of the Securities Act and by providing that crowdfunding sites that meet certain requirements will not be treated as brokers. However, the new exemption imposes substantial regulatory costs of its own and, therefore, will not be the panacea crowdfunding supporters hoped for. The regulatory cost of selling securities through crowdfunding may still be too high.

This article analyzes the requirements of the new crowdfunding exemption and discusses its flaws.

Cohn on Crowdfunding

The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, by Stuart R. Cohn, University of Florida - Fredric G. Levin College of Law, was recently posted on SSRN.  Here is the abstract:

Title III of the JOBS Act, signed by President Obama on April 5, 2012, sets forth a new exemption from federal and state securities registration for so-called "crowdfunding" promotions. Crowdfunding is an increasingly popular form of raising capital through broad-based internet solicitation of donors. Many promotions simply seek charitable or other donations. But the lure of raising funds through the internet has also led to promotions for potentially profitable ventures that offer an economic return to donors. These efforts invoke the federal and state securities laws, as there are no de minimis standards protecting even the smallest of offferings. Registration exemptions under the 1933 Securities Act and those created by the Securities & Exchange Comission have not been useful for such small offerings and certainly cannot be used for internet-based offerings. In the face of SEC inaction with regard to such small-scale promotions, Congress took it upon itself to create a new exemption. Unfortunately, as described in the article, despite good intentions, the newly-created exemption is fraught with regulatory requirements that go beyond even existing exemptions and raise transaction costs and liability concerns that may substantially reduce the exemption's utility for small capital-raising efforts,

Rose & LeBlanc on State Securities Regulators

Policing Public Companies: An Empirical Examination of the Enforcement Landscape and the Role Played by State Securities Regulators, by Amanda M. Rose, Vanderbilt Law School, and Larry J. LeBlanc, Vanderbilt University - Owen Graduate School of Management, was recently posted on SSRN.  Here is the abstract:

U.S. public companies can be pursued by multiple different securities law enforcers for the same misconduct. These enforcers include a variety of federal agencies, class action attorneys, derivative litigation attorneys, as well as 50 separate state regulators. Scholars and policymakers have increasingly questioned whether the benefits of this multi-enforcer approach are worth the costs, or whether a more coordinated and streamlined enforcement regime might lead to efficiency gains. How serious are these concerns? And what role do state regulators play in the enforcement mix? Whereas SEC and class action enforcement of the securities laws has been well studied, almost no empirical research has been done on state enforcement.

This Article provides an empirical foundation for considering these questions. We reviewed the Item 3 “material litigation” disclosures in the FY2004-FY2006 Form 10-Ks filed by every domestic public company that listed common stock on the NYSE from 2000-2010 — a total of 5441 Form 10-Ks filed by 1977 distinct companies. Seventy-two percent of the companies in our unique dataset disclosed some form of material litigation over the span of the three-year period examined, and 27% disclosed some form of securities litigation. Remarkably, well over half of the companies disclosing securities litigation reported facing two or more different forms of securities litigation, and nearly 30% reported facing three or more.

The securities-related state matters disclosed in our dataset share some interesting characteristics. For example, they tended to target out-of-state firms (68%) and to involve scandals that beset the financial industry (85%). Overwhelmingly, they were accompanied by a related federal action or investigation (91%) and very often were accompanied by related private litigation (67%). Whereas only 34% of states have an elected (as opposed to appointed) securities regulator, these states were responsible for 80% of the state matters disclosed. We ran regressions controlling for other variables that might be expected to influence a state’s level of enforcement activity. Our statistically significant results indicate that states with elected enforcers brought matters at more than four times the rate of other states, and states with an elected Democrat serving as the securities regulator brought matters at nearly seven times the rate of other states.

Our findings bring into focus several important public policy questions concerning the use of multiple securities law enforcers in general, and the social value of state enforcement in particular, that are worthy of further exploration.

SEC Bars Former SEC Attorney from Practicing before SEC

The SEC barred Spencer Barasch, a former enforcement official in the Commission’s Fort Worth office, from appearing and practicing before the Commission for one year for violating federal conflict of interest rules.  The bar resolves allegations involving Barasch’s representation of Stanford Group Company after Barasch went into private practice. Barasch consented to the Commission’s action without admitting or denying the Commission’s allegations.

Earlier this year, Barasch agreed to pay a $50,000 civil fine to the U.S. Justice Department for the same conduct.

Barasch was the Associate District Director for the Division of Enforcement in the Commission’s Fort Worth office from June 1998 to April 2005. According to the Commission’s order, while at the Commission, Barasch took part “personally and substantially” in decisions involving allegations of securities law violations by entities associated with Robert Allen Stanford, including Stanford Group Company.

According to the Commission’s order, when Barasch joined a private law firm in 2005, he contacted the Commission’s Ethics Office about whether he could represent Stanford Group Company before the Commission and was told that he was permanently barred from doing so with respect to any matters on which he had participated while at the Commission. The order finds that Barasch declined to represent Stanford Group Company then, but that in the fall of 2006, he accepted an engagement from the Stanford entity and billed it for 12 hours of legal work related to Stanford matters Barasch had participated in while at the Commission.

During this representation, Barasch tried to obtain information about the Commission’s Stanford investigation from Commission staff in Fort Worth, but a staff attorney questioned whether Barasch could represent the firm. The staff attorney declined to have any substantive discussions with Barasch and suggested that Barasch contact the Commission’s Ethics Office on the matter. The order finds that Barasch did so and was again told that he was permanently barred from representing Stanford Group Company in the matter, prompting him to end his representation.

U.S. laws prohibit former federal officers and employees from knowingly seeking to influence or appear before any agency on a matter in which they had “participated personally and substantially” during their federal employment. The Commission’s order finds that Barasch violated this conflict of interest rule, which constitutes “improper professional conduct” under Rule 102(e) of the Commission’s rules of practice.

SEC Settles Insider Trading Charges with Former Yahoo! Executive and Mutual Fund Manager

The SEC today charged a former executive at Yahoo! Inc. and a former mutual fund manager at a subsidiary of Ameriprise Financial Inc. with insider trading on confidential information about a search engine partnership between Yahoo and Microsoft Corporation.  The SEC alleges that Robert W. Kwok, who was Yahoo's senior director of business management, told Reema D. Shah in July 2009 that a deal between Yahoo and Microsoft would be announced soon. Shah had reached out to Kwok amid market rumors of an impending partnership between the two companies, and Kwok told her the information was kept quiet at Yahoo and only a few people knew of the coming announcement. Based on Kwok's illegal tip, Shah prompted the mutual funds she managed to buy more than 700,000 shares of Yahoo stock that were later sold for profits of approximately $389,000.

The SEC further alleges that a year earlier, the roles were reversed. Shah tipped Kwok with material nonpublic information about an impending acquisition announcement between two other companies. Kwok traded in a personal account based on the confidential information for profits of $4,754.

Kwok and Shah, who each live in California, have agreed to settle the SEC's charges. Financial penalties and disgorgement will be determined by the court at a later date. Under the settlements, Shah will be permanently barred from the securities industry and Kwok will be permanently barred from serving as an officer or director of a public company.

In a parallel criminal case announced today by the U.S. Attorney's Office for the Southern District of New York, Kwok has pled guilty to conspiracy to commit securities fraud, and Shah has pled guilty to both a primary and conspiracy charge. Both are awaiting sentencing.

FINRA Fines Citigroup $3.5 Million for Inaccurate Mortgage Performance Information

FINRA announced today that it fined Citigroup Global Markets, Inc. $3.5 million for providing inaccurate mortgage performance information, supervisory failures and other violations in connection with subprime residential mortgage-backed securitizations (RMBS). 

Issuers of RMBS are required to disclose historical performance information for past securitizations that contain mortgage loans similar to those in the RMBS being offered to investors. FINRA found that from January 2006 to October 2007, Citigroup posted inaccurate mortgage performance data on its website, where it remained until early May 2012, even though the firm lacked a reasonable basis to believe that this data was accurate. On multiple occasions, Citigroup was informed that the information posted was inaccurate yet failed to correct the data until May 2012. For three subprime or Alt-A securitizations, the firm provided inaccurate mortgage performance data that may have affected investors' assessment of subsequent RMBS. 

In addition, Citigroup failed to supervise mortgage-backed securities pricing because it lacked procedures to verify the pricing of these securities and did not sufficiently document the steps taken to assess the reasonableness of traders' prices. Also, Citigroup failed to maintain required books and records. In certain instances, when it re-priced mortgage-backed securities following a margin call, Citigroup failed to maintain a record of the original margin call, document the supervisory approval or demonstrate that the revised price was applied to the same position throughout the firm.

In settling this matter, Citigroup neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

 

Ketchum Addresses Conflicts of Interest at FINRA Conference

Richard G. Ketchum, FINRA's Chairman and Chief Executive Officer, emphasized identifying conflicts of interest and placing the customer's interest before the firm's in his speech before the FINRA Annual Conference on May 21:

First, I call on you to do a better job of assessing—and disclosing—your conflicts. We've heard a lot in the last couple months about the culture at large firms through various media reports and the conflicts that are part of the day-to-day operations. However, I don't think the conversation should just be about the culture at one firm or another. We understand that conflicts exist in the financial services industry. We need to take a step back, acknowledge that there are risks and look at how we handle those conflicts.

Nine years ago Stephen Cutler, who was then director of the SEC's Division of Enforcement, asked firms to undertake a top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. I would like to see such a concept review become a standard part of operating procedure. You should be assessing whether your business practices place your firm's—or your employees'—interests ahead of your customers. What I can promise you is that, particularly with respect to the large integrated firms, we will look to have a focused conversation with you about the conflicts you have identified and the steps you have taken to eliminate, mitigate or disclose each of them.

 Second, I call on you to ensure that the products you sell are appropriate for each investor. We have often reminded firms of their obligation to assess the potential risks associated with products that raise specific investor protection concerns. One of our concerns is the sale of complex products, and in January we published guidance in the form of a Regulatory Notice.

We've brought a number of enforcement actions involving complex products where we found firms didn't adequately supervise the sale of the products, the recommended products were unsuitable for the investors, or the sales material were misleading. We recognize the challenge you face when managing compliance oversight at a time when more customers are searching for yield and financial advisors are looking for products to meet these requests. Nevertheless, the suitability rule remains in effect, and it is the obligation of every firm to take steps reasonably designed to ensure that the suitability issues related to complex and other products are adequately addressed.

Before recommending a complex product to a retail customer, your financial advisers should be discussing the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. This means describing the circumstances under which the customer could lose money, not just those under which the customer would earn money. It also means explaining carefully the direct and imputed costs your client will incur and, where applicable, the fact that your firm or an affiliate is on the other side of the transaction. For this disclosure to work effectively, it will be equally important that you increase the training provided to your financial advisers to ensure that they fully understand the assumptions underlying the product and what can go wrong as well as right. 

Finally, before any complex product is offered to a retail client, your financial adviser should be able to write down on a single page why this investment is in the best interests of your client. This does not have to wait until you find out the details of any fiduciary rulemaking the SEC may make. Being able to articulate why an investment is in the best interests of your client is fundamental to what the securities industry must be about if it is to deserve the trust of investors.

SEC Historical Society Upcoming Events

Here are some upcoming events at the SEC Historical Society that may be of interest to readers.  They are webcast at the Society's website.

A Creative Irritant: Upcoming Broadcast on June 7th at noon

"A Creative Irritant: The Relationship between the SEC and Accounting Standard Setters." 
Moderated by George Fritz, curator of The Adkerson Gallery, the presenters will include:
• Dennis Beresford, Terry College of Business, University of Georgia and former Chairman, Financial Accounting Standards Board;
• Edmund Jenkins, former Chairman, Financial Accounting Standards Board, and retired partner, Arthur Andersen & Co.; and
• Clarence Sampson, former SEC Chief Accountant.
 
The program will be preceded by a State of the SEC Historical Society address by Robert J. Kueppers, 2012-13 President; and remarks on the tenth anniversary of the virtual museum and archive of the history of financial regulation by Carla Rosati, Society Executive Director and founder of the museum.
 
The live video broadcast will be free and accessible worldwide without prior registration.
  
Looking Back: 30th Anniversary of Regulation D

The thirtieth anniversary of the enactment of Regulation D comes simultaneously with the passage of the Jumpstart our Business Startups (Jobs) Act, which has been criticized for potentially exposing investors to fraud.
 
The enactment of Regulation D in 1982 addressed the issue of the cost of capital formation by setting out safe harbors from '33 Act registration for private and limited offerings. For a look back at Regulation D, listen to:
• Oral histories interviews with Mary "Mickey" Beach, Edward Greene, William Morley, Richard Rowe and Carl Schneider.
• Programs on Safe Harbors (March 30, 2004), Cross-Border Regulation (September 20, 2005), and the SEC Division of Corporation Finance (February 24, 2009).
 
 

NYSE Panel Recommends Changes to Proxy Distribution Fees

On May 16 the Proxy Fee Advisory Committee (PFAC), formed by the New York Stock Exchange, published its recommendations for changes to the fees paid by public companies to banks and brokers for the distribution of proxy materials to shareholders who hold their stock in "street name."  Composed of issuers, broker dealers and investors, the PFAC was formed in September 2010 to review the existing proxy distribution fee structure and make recommendations for change. Any changes to these fees are subject to SEC approval. (Download NYSE.ProxyAdvisoryPanelReport)
 
Overall, the Committee's recommendations would streamline proxy fees and make them more transparent to issuers as well as result in a modest decrease in total fees paid of approximately 4%  

The goals of the Committee have been to support the current proxy distribution system, including continued support for the elimination of mailings; to encourage and facilitate active voting participation by retail beneficial owners; improve transparency of the fee structure and ensure that fees are as fair as possible and aligned with the work involved.
 
Principal Recommendations:

Streamline the proxy fee categories into three basic fee categories - a nominee fee, a basic processing fee and a preference management fee - to increase transparency.
Provide a more gradual tiering of the basic processing fee to smooth the "cliff effect" that occurs between large/small issuers.
Reduce preference management fees for managed accounts to half the normal rate, and eliminate all processing fees for managed account positions of five shares or less.
Increase modestly the processing fees for special meetings and contests.
Reduce by half the fee for annual meeting reminder notices, to support improved shareholder communication.
Subject the Notice & Access fees to the proxy fee rules.
Allow issuers to stratify their NOBO lists, rather than require issuers to pay for complete lists as is currently industry practice (see below). 
 

The PFAC also recommended that the NYSE:
Explore the impact of allowing issuers to request stratified NOBO lists, including an extra fee for stratification. 
Discuss the proposal to create an investor mailbox as a possible means to increase voting participation by retail shareholders with additional industry representatives so it can be determined whether the proposed "success fee" is at an appropriate level. 
Create an ongoing process to review proxy fees and services more frequently going forward.

Ricks on Short-Term Funding Markets

Reforming the Short-Term Funding Markets, by Morgan Ricks, Harvard University Law School, was recently posted on SSRN.  Here is the abstract:

Traditionally, governments have established licensing requirements for the issuance of important classes of monetary instruments — namely, deposit obligations and bank notes. Their issuance has been a legal privilege. This article proposes a similar legal regime for other short-term IOUs, which present similar problems. The approach would be functional rather than formalistic. The article sketches a prototype of such a regulatory system. In addition, the article offers a critical analysis of current reform initiatives pertaining to the short-term funding markets. It finds reasons to doubt that they will be effective. It proposes an alternative, coordinated regulatory approach that could be implemented under current U.S. law.