Motion Practice – Five Day Reply Period for Responses in Arbitration – Regulatory Notice 11-23
Effective June 6, 2011, a moving party will have five days to reply to a response to a motion. FINRA amended Rules 12206 and 13206 (Time Limits), Rules 12503 and 13503 (Motions), and Rules 12504 and 13504 (Motions to Dismiss) to provide the moving party with a five-day period to reply to a response to a motion.
Promissory Note Proceedings – Regulatory Notice 11-22
Effective June 6, 2011, FINRA will appoint chair-qualified public arbitrators to panels resolving promissory disputes for disputes arising from claims that an associated person failed to pay money owed on a promissory note. No longer will the chair-qualified public arbitrators be required to be also qualified to resolve statutory discrimination claims. Per Rule 12400(c), chair-qualified arbitrators have completed chair training and are attorneys who have served through award on at least two cases, or, if not attorneys, are arbitrators who have served through award on at least three cases.
Contact Evans & Kob PC if you need experienced legal representation and advice regarding any FINRA arbitration or other regulatory or securities matter at firstname.lastname@example.org.
FINRA Rule 4360 requires each member firm that is required to join the Securities Investor Protection Corporation (SIPC) to maintain blanket fidelity bond coverage with specified amounts of coverage based on the firm’s net capital requirement, with certain exceptions. Such firms must maintain fidelity bond coverage that provides for per loss coverage without an aggregate limit of liability. The new rule is based on NASD Rule 3020, taking into account certain requirements under NYSE Rule 319 and its Interpretation.
A firm not qualifying for a fidelity bond with per loss coverage and no aggregate limit of liability must maintain substantially similar cover with compliance with all other provisions of the rule, providing that the firm is able to show through correspondence from two insurance carriers that the firm does qualify for such coverage.
A firm’s fidelity bond must provide against loss and have Insuring Agreements covering at least the following: fidelity, on premises, in transit, forgery and alteration, securities and counterfeit currency. Also, the rule replaces the specific coverage provisions in the NASD and NYSE rules that permit less than 100 percent of coverage for certain agreements, thus coverage for all Insuring Agreements must be equal to 100 percent of the firm’s minimum required bond coverage. A firm’s fidelity bond must include a cancellation rider providing that the insurer will use its best efforts to promptly notify FINRA in the event the bond is cancelled, terminated or substantially modified.
The minimum required coverage increased under the new rule for firm’s with minimum net capital requirements that are less than $250,000 to the greater of 120% of its required minimum net capital or $100,000 (presently $25,000).
Deductibles are allowed up to 25% of the fidelity bond coverage purchased by a firm, but any deductible amount greater than 10% of the coverage purchased must be deducted from its net worth in the net capital calculation for purposes of Exchange Act Rule 15c3-1.
A member firm (even for a multi-year insurance policy) must review annually the adequacy of its fidelity bond and make required adjustments to its coverage, based on its highest net capital requirement for the preceding 12-month period.
Further, Rule 4360 removes the historical exemption of NASD Rule 3020(e) for a one-person firm.
FINRA Rule 4360 takes effect on January 1, 2012.
Contact Evans & Kob PC for experienced legal representation regarding securities, broker-dealer and investment advisers, arbitration or litigation or any other regulatory related matter at email@example.com.
FINRA announced in Regulatory Notice 11-17 that a revised Discovery Guide and Document Production Lists for Customer Arbitration Proceedings was approved by the SEC and will be effective May 16, 2011 (and apply to customer cases filed on or after such date). The revised Discovery Guide changes not only the format, but also substantive changes that expand the scope and number of presumptively discoverable documents.
The original Discovery Guide was adopted in 1999, including document production lists for use in customer arbitration proceedings, and provides direction on which documents parties should exchange without arbitrator or staff intervention, and the Lists specifically identify the documents parties should exchange before the hearing, depending on the type of dispute.
Per the Notice, the Discovery guide is revised to expand and update the Lists. FINRA is replacing the current 14 Lists with just two Lists of presumptively discoverable documents: one for firms/associated persons to produce and one for customers to produce. The revisions include additional types of documents that users indicated are needed to develop a case and while each will be presumptively discoverable in every customer case, the revisions encourage arbitrators to tailor the Discovery Guide to the facts and circumstances to each case.
Discovery Guide Introduction
The introduction was revised to provide guidance to parties and arbitrators, including:
- Flexibility – one-size may not fit all – arbitrators retain flexibility to order production not provided in the lists, to refuse to compel production of documents in the list and to alter the production schedule
- Objections based on Cost/Burden
- Requests for Additional Documents
- Party and Non-Party Production
- Consideration of Firm Business Models and Customer Claims
- Electronic Discovery – electronic files are considered “documents”
- Privilege – protection for privileged documents
- Affirmations for no responsive documents in possession
- No Obligation to Create Documents
- Admissibility – production does not create a presumption of admissibility at hearing
Expanded and Increased Production
Notable additions to documents presumed to be discoverable by claimant include:
- Telephone logs related to the claimant’s transactions;
- All advertising materials sent to customers of the firm that refer to the securities and/or account types at issue or that were used to solicit and provide services to the claimant;
- All customer complaints filed against the associated persons assigned to the accounts at issue for the three years prior to the statement of claim;
- Increased scope relating to associated person’s disciplinary history;
- Documents related to trading or investment strategies utilized/recommended in the claimant’s account;
- Associated person’s compensation for the transaction at issue;
Notable additions to documents presumed to be discoverable by the firm include:
- Research report(s) claimants received from the firm;
- All non-confidential settlements claimant(s) entered in civil actions involving securities matters and/or securities arbitration proceedings;
- All documents the claimant received related to the investments at issue;
- All materials received by claimant or obtained from any source relating to the transactions or products at issue;
- All correspondence related to the accounts at issue (not just with the firm).
Notable deletions include:
- Firms are no longer required to produce holding pages, or account statements/confirmations for the claimant’s accounts and transactions at issue.
- Claimant’s are no longer required to produce prior complaints involving securities matters and the firm’s response, or documents showing actions claimant took to limit losses in the transaction at issue.
The revised Discovery Guide becomes effective and applicable to all customer cases filed on or after May 16, 2011. Broker-dealers should take steps to ensure that their procedures for responding to newly-filed customer cases are in compliance with the changes. As always, it is essential to be proactive to implement these changes. Contact Evans & Kob PC if you need experienced legal representation and advice regarding FINRA arbitration or updating your current procedures to accommodate these changes at firstname.lastname@example.org.
On April 7, 2011, both FINRA and the SEC announced actions both broker-dealers and supervisory personnel in connection with sales of private placement offerings without adequate due diligence. The actions relate to private placement offerings of Medical Capital Holdings, Inc. (MedCap), Provident Royalties and DBSI – all entangled in various levels of litigation, SEC enforcement or arbitration.
In summary, the FINRA Acceptance, Waiver and Consent involve allegations that the firms, by or through its principals, failed to have reasonable grounds to identify and understand the inherent risks of the offering and the suitability of the offerings for any of their customers, including conducting effective due diligence to investigate potential “red flags,” and therefore could not have a reasonable basis to sell the offerings. The SEC alleges that the firm and its principal failed to perform reasonable due diligence on numerous private placements, while simultaneously receiving significant amounts in due diligence fees, that turned out to Ponzi schemes and offering fraud and thereby violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder.
As to FINRA, we have already seen previous actions in regards to due diligence and our firm expects to see more investigations and audits of member firms in regards to both private placements and other non-traded direct investments, including REITs. See FINRA’s targeted examination request regarding “Sale and Promotion of Non-Traded REITs” and the 2011 Examination Priorities Letter. Contact Evans & Kob PC for experienced assistance responding to any regulatory examination or sweep, modifying your written supervisory procedures, due diligence review of a particular product, investment, issuer or money manager or any other regulatory or arbitration related legal advice at email@example.com.
In March 2011, FINRA issued Regulatory Notice 11-14, requesting comments on proposed new rule 3190 clarifying the scope of a member firm’s obligations and supervisory responsibilities for functions or activities outsourced to a third-party service provider.
FINRA Rule 3190 clarifies that:
- Outsourced functions of a broker-dealer to a third-party service provider does not relieve the firm of its obligation to comply with applicable securities laws and regulations
- The firm cannot delegate its responsibilities for, or control over, any outsourced functions or activities
- The firm must maintain supervisory procedures, including due diligence measures, reasonably designed to ensure that third-party service provider arrangements achieve compliance with applicable securities laws and regulations
- Additional restrictions and obligations apply solely to clearing and carrying member firms and third-party service provider arrangements
Comments Requested by May 13, 2011
Member Firms’ Responsibilities for Activities Outsourced to Third-Party Service providers and Activities Requiring Registration and Qualification
FINRA Rule 3190(a)(1) – member firm’s use of a third-party service provider (including any sub-vendor) to perform functions or activities related to the firm’s business as a regulated broker-dealer does not relieve the firm of its obligation to comply with applicable securities laws and regulations.
- Third-party service provider (including any sub-vendor) – defined to include any person controlling, controlled by or under common control with a member firm, unless otherwise determined by FINRA.
- Prohibits the firm from delegating its responsibilities for, or control over, any functions or activities performed by such provider
FINRA Rule 3190(a)(3) – proper registration and qualification required to engage in activities requiring such under FINRA rules
Member Firms’ Supervision and Due Diligence Analysis of Third-Party Service Providers
FINRA Rule 3190(a)(2) – requires firms to establish and maintain a supervisory system and written procedures reasonably designed to achieve compliance with applicable securities laws and regulations for any functions or activities performed by a third-party service provider
FINRA Rule 3190(b) – requires firms include in their WSPs an ongoing due diligence analaysis to determine, at a minimum, whether:
- the provider is capable of performing the activities being outsourced; and
- as to such activities, if the firm can achieve compliance that are reasonably designed to achieve compliance with applicable securities laws and regulations
Clearing or Carrying Member Firms’ Restrictions and Obligations Regarding Outsourced Activities
The proposed rule imposes heightened requirements on a clearing or carrying firm’s outsourcing arrangements designed to address concerns regarding the potential harm that could result from its third-party service providers’ non-compliance. FINRA believes the concerns are mitigated by limiting certain activities to persons directly subject to the control and supervision of the firm, having additional supervisory procedures to oversee third-party service providers and notify FINRA of its outsourcing arrangements.
FINRA Rule 3190(c) – requires a clearing or carrying member firm to vest an associated person of the firm with the authority, responsibility and necessary registrations and qualifications for the following activities:
- the movement of customer or proprietary cash or securities;
- the preparation of net capital or reserve formula computations; and
- the adoption or execution of compliance or risk management systems.
FINRA Rule 3190(d) – requires that a clearing or carrying member firm include additional supervisory procedures to:
- enable the firm to take prompt corrective action where necessary to achieve compliance with applicable securities laws and regulations; and
- require the firm to approve any transfer of duties by a third-party service provider to a sub-vendor.
FINRA Rule 3190(e) – requires a clearing or carrying member firm to notify FINRA within 30 days after entering into any outsourcing agreement and such notification must include:
- the function(s) being performed by the third-party service provider;
- the identity and location of the third-party service provider;
- the identity of the third-party service provider’s regulator (if any); and
- a description of any affiliation between the firm and the third-party service provider.
Further, the firm would be required to maintain a copy of each notification and underlying agreement in accordance with SEA Rule 17a-4(b).
Exceptions to Proposed FINRA Rule 3190’s Requirements
FINRA Rule 3190 excepts from its requirements ministerial activities performed on behalf of a member firm, unless otherwise prohibited, and clarifies it does not restrict activities performed pursuant to carrying agreement approved under FINRA Rule 4311.
Assuming the rule is approved, there is not a substantial change from the previously issued guidance in NTM 05-48, except for heightened restrictions on certain clearing and carrying member firms’ activities. However, please contact our firm if you need experienced legal representation and advice or if you need assistance updating your written supervisory procedures, providing comments to FINRA, or any other regulatory or arbitration related legal assistance at firstname.lastname@example.org.
In March 2011, FINRA issued Regulatory Notice 11-11 requesting comments on a concept proposal to apply objectivity safeguards and disclosure requirements to the publication and distribution of debt research reports. The proposal would provide retail debt research recipients with most of the same protections provided to recipients of equity research, while exempting research provided solely to institutional investors from many of the provisions.
Comments must be received by April 25, 2011
FINRA is concerned over firms’ management of conflicts of interest related to the publication and distribution of debt research, including certain cases where firms lacked any policies and procedures to manage debt research conflicts to ensure compliance with applicable SRO ethical and anti-fraud rules and recent allegations of misconduct in the sale of auction rate securities (ARS). Currently, FINRA’s research rules apply only to “equity securities” as defined under the Securities Exchange Act of 1934, subject to certain exemptions.
In response, FINRA developed this concept debt research rule that would recognize a bifurcated debt research regulatory approach – the proposed rule extends protections similar to equity research to retail investors, while research distributed solely to institutional investors would require a more general “health warning,” but would allow such institutional investors to choose to receive the full protections accorded to retail investors.
Standards Applicable to Retail Debt Research
The majority of NASD Rule 2711 would apply to debt research with the proposed addition addressing conflicts between debt research and sales and trading personnel. Thus, the rule would:
- Require member firms to establish, maintain and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest
- Prohibit prepublication review, clearance or approval by investment banking and sales and trading, as well as restrict (or prohibit) such by a subject company (except for fact checking)
- Prohibit input by investment banking and sales and trading into the determination of the research department budget.
- Limit the supervision and compensatory evaluation of debt analysts to persons not engaged in investment banking services or sales and trading.
- Require similar compensation rules and review as equity analysts
- Restrict or limit debt analyst account trading in the securities, derivatives and funds related to the securities covered by the debt analyst
- Prohibit promises of favorable debt research coverage.
- Prohibit retaliation against debt analysts by investment banking personnel or other employees as the result of an unfavorable research
- Restrict or limit activities by debt analysts that can reasonably be expected to compromise objectivity
- Prohibit investment banking from directing debt analysts to engage in sales or marketing efforts
Further, FINRA envisions disclosures applicable to equity research largely should apply to debt, including:
- personal and firm financial interests;
- receipt of investment banking services compensation from the subject company; and
- the meaning of each rating employed in any rating system used by the member firm in the research report.
Institutional Investor Exemption
The general exemption is based on the assumption that institutional investors are aware of the types of potential conflicts that may exist between a member’s recommendations and trading interests, and are capable of exercising independent judgment in evaluating such recommendations (and instead incorporate the research as a data point in their own analytics) and reaching pricing decisions. However, the institution-only exemption, if not opted out by the institution, requires a “health warning” disclosure on the first page, including:
- the research is intended for institutional investors only and is not subject to all of the independence and disclosure standards applicable to research provided to retail investors;
- if applicable, that the firm trades the securities covered in the research for its own account and on behalf of certain clients; such trading interests may be contrary to the recommendations offered in the research and the research may not be independent of the firm’s proprietary interests; and
- if applicable, that the research may be inconsistent with recommendations offered in the firm’s research that is disseminated to retail investors.
In addition, specific prohibitions and restrictions are placed on:
- promises of favorable research;
- debt research analyst involvement in pitches, road shows and other marketing;
- certain three-way meetings with analysts, investment banking and issuer management
- input into research coverage by investment banking personnel;
- retaliation against debt research analysts for unfavorable research;
- review of research by the subject company (beyond fact-checking) or investment banking personnel; and
- FINRA rules would continue to apply to member conduct, including Rules 2010 and 2020
Communication Firewalls Unique to Debt
While certain communications between debt analysts and sales and trading personnel are necessary to allow each to perform their primary functions, the following are expressly prohibited:
- Sales and trading personnel attempting to influence a debt analyst’s opinion
- Debt analysts identifying or recommending specific potential trading transactions to sales and trading personnel not contained in such debt analyst’s published reports; disclosing the timing of, or material investment conclusions in, a pending debt research report; or otherwise having any communication for the purpose of determining the profile of a customer
Assuming the rules are approved, broker-dealers will need to significantly alter policies and procedures regarding debt research to ensure and monitor compliance Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures, providing comments to FINRA, or any other regulatory or arbitration related legal assistance at email@example.com.
On March 2, 2011, the Securities and Exchange Commission proposed rules to require certain financial institutions, broker-dealers and investment advisers with $1 billion or more in assets, to disclose their incentive-based compensation practices and prohibit such institutions from having compensation arrangements that encourage inappropriate risks.
1) Disclosures about Incentive-Based Compensation Arrangements
Annual Filing with appropriate federal regulator information including:
Narrative description of the components of the firm’s incentive-based compensation
Description of the firm’s policies and procedures governing such arrangements
A statement of why the firm believes the structure will help prevent it from suffering a material financial loss and/or why it does not provide covered persons with excessive compensation
2) Prohibition on Encouraging Inappropriate Risk
General prohibition against establishing or maintaining an incentive-based compensation arrangement that encourages inappropriate risks by providing excessive compensation, or that could lead to material financial loss – deemed assumption unless arrangements meet certain standards
“Covered persons” include executive officers, employees, directors, or principal shareholders
Prohibitions for larger financial institutions – specific requirements for executive officers and certain other designated individuals at financial institutions with $50 billion or more in total consolidated assets – 3 year deferral at least 50% of incentive-based compensation and must be adjusted for losses incurred
3) Establishing Policies and Procedures
A covered financial institution would be barred from establishing such arrangement unless the arrangement has been adopted under policies and procedures developed and maintained by the institution and approved by its board of directors.
Comments: should be received within 45 days after it is published in the Federal Register.
Assuming the rules are approved, financial institutions will need to significantly alter policies and procedures regarding incentive-compensation arrangements to ensure and monitor compliance with the requirements. Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures, providing comments to the SEC, or any other regulatory or arbitration related legal assistance at firstname.lastname@example.org.
On February 18, 2011, the Securities and Exchange Commission issued Release No. 34-63933, approving FINRA Rule 1113 (Restrictions Pertaining to New Member Applications) and amendments to the FINRA Rule 9520 Series (Eligibility Proceedings) to restrict new applicants’ and certain members’ association with disqualified persons based on the belief that “new member applicant[s] should enter FINRA membership free of the supervisory and operating concerns raised by association with a statutorily disqualified person or being itself subject to a statutory disqualification.”
FINRA Rule 1113 (Restrictions Pertaining to New Member Applications)
FINRA shall reject any application for membership in which either the applicant or an associated person is subject to a statutory disqualification. Further, any approval in error shall be subject to cancellation.
FINRA Rule 9520 Series (Eligibility Proceedings)
The amendments to Rule 9520, which sets forth the eligibility proceedings for membership, would:
- remove the ability of new members to sponsor the association of a disqualified person;
- clarify that a new member applicant is not eligible to submit an application for relief if the new member itself is subject to disqualification; and
- preclude any member from sponsoring the association the association or continued association of a disqualified person, who is directly or indirectly a beneficial owner or more than 5% of the sponsoring member, to be admitted, readmitted or permitted to continue in association.
Statutory Disqualification – Securities Exchange Act Section 3(a)(39)
A person is subject to a “statutory disqualification” with respect to a membership or participation in, or association with a member of, a self-regulatory organization if such person, among others: (1) has been convicted of certain misdemeanors or any felony criminal convictions within the ten years preceding the date of the filing of an application for membership or participation in, or to become associated with a member of, such SRO; (2) is subject to a temporary or permanent injunction (regardless of its age) issued by a court of competent jurisdiction involving at least one of a broad range of unlawful investment activities; (3) has been expelled or suspended from membership or participation in an SRO; or, (4) is subject to an SEC order denying, suspending, or revoking broker-dealer registration.
Experienced counsel is important in the new membership application phase with FINRA. Our attorneys have not only advised broker-dealers, but also formed and operated national and wholesale broker-dealers. If you have a question regarding about a potential or ongoing membership application, contact Evans & Kob PC for expert legal representation and counsel at email@example.com.
New FINRA Rule 4530, representing a consolidation of NASD Rule 3070 and NYSE Rule 351, takes effect on July 1, 2011. The rule increases the level of self-reporting by firms by requiring firms to not only report when a court or self-regulatory body determines a securities violation, but also when the firm concludes or “reasonably should have concluded” that the firm or an associated person violated securities laws.
In particular, FINRA Rule 4530(b) requires the firm to report to FINRA within 30 calendar days after the firm has concluded, “or reasonably should have concluded” that the firm or an associated person of the firm violated any securities-, insurance-, commodities-, financial- or investment-related laws, rules, regulations or standards of conduct of any domestic or foreign regulatory body or self-regulatory organization. As Regulatory Notice 11-06 spells out, the reporting is limited to only “conduct that has widespread or potential widespread impact to the firm, its customers or the markets, or conduct that arises from a material failure of the firm’s systems, policies or practices, involving numerous customers, multiple errors or significant dollar amounts.” The standard of “reasonably should have concluded” is defined as “[i]f a reasonable person would have concluded that a violation occurred, then the matter is reportable[.]” The determination is to be made by the person designated as such in the firm’s written supervisory or operating procedures.
Obviously, a reasonable conclusion as to a potential violation may differ among firms as well as with FINRA due to its subjective interpretation leaving the door open for confusion and potential liability by member firms. Further, 4530(b) is only one parameter of the new rule with Regulatory Notice 11-06 discussing several other amendments to the self-reporting framework for member firms.
One thing is certain; firms will need to update their written supervisory procedures to account for additional self-reporting. Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures as a result of FINRA Rule 4530(b) or any other regulatory or arbitration related legal assistance at firstname.lastname@example.org.
As reported in Investment News on February 15, 2011, the SEC began a sweep of registered investment advisers and investment advisory firms to gather information about their use of social media such as Facebook, Twitter, LinkedIn, blogs and others. The sweep also focuses on gathering more information about policies and procedures that govern the use of social media, retention of records of employees’ use of social media, including non-business use and networking sites, and training provided to employees on the use of social media.
The SEC letter issued to advisers requests the following documents or information within an adviser’s possession or custody or subject to an adviser’s control:
- All documents sufficient to identify the adviser’s involvement with or usage of social media websites, including, without limitation:
- Twitter, including, without limitation, AdvisorTweets.com;
- Reddit; RSS; and
- Blogs and micro-blogs.
- All documents concerning any communications made by or received by the adviser on any social media website, including, without limitation, snapshots of documents responsive to Item 1, above.
- All documents concerning adviser’s policies and procedures related to the use of social media web sites, without limitation:
- All policies and procedures concerning any communication posted on any social media website;
- All policies and procedures concerning any prospective communications to be posted on any social media website; and
- All policies and procedures concerning any ongoing monitoring or review process related to communications posted on any social media website.
- All documents concerning policies and procedures concerning a third party’s use of any social media website maintained by adviser, including, without limitation:
- All policies and procedures concerning any communication posted by a third party, including, without limitation, actual or prospective clients of adviser, on any social media website maintained by adviser;
- All policies and procedures concerning any approval processes for prospective communications to be posted by a third party, including, without limitation, actual or prospective clients of adviser, on any social media website maintained by adviser; and
- All policies and procedures concerning any ongoing monitoring or review processes related to communications posted by a third party, including, without limitation, actual or prospective clients of adviser, on any social media website maintained by adviser;
- All documents concerning policies and procedures related to the use of social media websites by adviser’s personnel for personal, non-business related matters.
- All documents concerning personnel training and education related to the use of social media websites, whether for personal, non-business related, or business related matters.
- All documents concerning any informal or formal disciplinary action of personnel related to the use of social media for personal, non-business related, or business-related reasons.
- All documents concerning record retention policies and procedures concerning the involvement with or usage of, whether for personal, non-business related, or business-related matters, any social media website maintained by adviser by:
- The adviser;
- Adviser’s personnel; and
- Any third party.
At the same time, FINRA’s Social Networking Task Force is meeting next month to discuss updating its guidance on how advisers should use social-networking sites. The previous guidance was issued in Regulatory Notice 10-06.
Please contact our firm if you need assistance responding to any letter from the SEC or FINRA, modifying your policies and procedures, assessing your compliance risks, responding to any regulatory examination, or any other regulatory or arbitration related legal advice at email@example.com.