Articles Posted in Broker Dealers

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Written by Michael Wu

On September 29, 2011, the SEC’s examination staff issued a Risk Alert warning of significant concerns regarding trading through sub-accounts, and offered suggestions to help securities industry firms address these risks.  In the alert, the staff identified certain risks associated with the master/sub-account trading model such as: i) money laundering, ii) insider trading, iii) market manipulation, iv) account intrusions, v) information security, vi) unregistered broker-dealer activity, and (vii) excessive leverage.  The alert is the first in a continuing series of Risk Alerts that the staff expects to issue.

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Written by Michael Wu

The SEC has adopted a new rule pursuant to Section 13(h) of the Securities Exchange Act of 1934 requiring large traders to register with the SEC and imposing reporting requirements on their broker-dealers.

In her speech on July 26, 2011, SEC Chairman Mary L. Shapiro said, “[t]his new rule…would significantly bolster our ability to oversee the U.S. securities markets by allowing the Commission to promptly and efficiently identify significant market participants on a cross-market basis, collect data on their trading activity, reconstruct market events, conduct investigations and, as appropriate, bring enforcement matters.”

Under the rule, large traders are required to register with the SEC using a new form, Form 13H.  Upon registration, each large trader is issued a unique large trader identification number (LTID).  Large traders are required to provide such LTID to their broker-dealers.  In addition, the rule imposes recordkeeping, reporting and limited monitoring requirements on certain registered broker-dealers through whom large traders execute their transactions.

A large trader is defined as a person whose transactions in exchange-listed securities equal or exceed 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month.

A full text of the final rule is available here.

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Written by Michael Wu

On January 21, 2011, the SEC released its study on the effectiveness of the standard of care required of broker-dealers and investment advisers that provide personalized investment advice regarding securities to retail customers (“Covered Broker-Dealers and Investment Advisers”).  The study also considered the existence of regulatory gaps, shortcomings or overlaps that should be addressed by rulemaking.  The study was prepared pursuant to Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The study recommends that the SEC establish a uniform fiduciary standard for Covered Broker-Dealers and Investment Advisers that is at least as stringent as the fiduciary standard under Sections 206(1) and (2) of the Investment Advisers Act of 1940, as amended.  The SEC staff stated that under this standard, Covered Broker-Dealers and Investment Advisers must “act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

To implement the uniform fiduciary standard, the study recommends that the SEC adopt rules to address the following:

  • Disclosure Requirements.  Rules should be adopted to address both the existing “umbrella” disclosures (e.g., ADV Part II) and specific disclosures provided by Covered Broker-Dealers and Investment Advisers when a transaction is executed.
  • Principal Trading.  Rules should be adopted to address how Covered Broker-Dealers can satisfy the uniform fiduciary standard when engaging in principal trading activities.
  • Customer Recommendations.  Rules should be adopted to address the duty of care obligations that Covered Broker-Dealers and Investment Advisers have in making recommendations to retail customers.

The study further recommends that the SEC harmonize other areas of broker-dealer and investment adviser regulation, such as regulations pertaining to advertising and communication, the use of finders and solicitors, supervision and regulatory reviews, licensing and registration of firms, licensing and registration of associated persons, and maintenance of books and records.

Based on the study, it appears likely that the SEC will adopt a uniform fiduciary standard in the near future.  However, at this time, it is not clear how the standard would affect the manner in which Covered Broker-Dealers and Investment Advisers conduct their businesses.

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Written by Michael Wu

On December 15, 2010, FINRA Rule 3270 became effective.  FINRA Rule 3270 requires each registered representative of a broker-dealer to provide it with prior written notice of an outside business activity.  FINRA Rule 3270, which replaced NASD Rule 3030 and NYSE Rule 346, specifically identifies the types of activities that would be subject to the rule and requires registered representatives to disclose to the broker-dealer whenever he or she intends to serve as an employee, independent contractor, sole proprietor, officer, director or partner of another entity, or will be compensated, or reasonably expects to be compensated, from another entity in connection with any business activity outside the scope of such individual’s relationship with the broker-dealer.  Passive investments and activities subject to NASD Rule 3040 (i.e., the private securities transaction rule) are exempt from the requirements under FINRA Rule 3270.

Upon receipt of notice of an outside business activity from a registered representative, a broker-dealer must determine whether the proposed activity would (i) interfere with such registered representative’s responsibilities to the broker-dealer and/or its clients or (ii) be viewed by clients or the public as part of the broker-dealer’s business.  Based on such analysis, the broker-dealer may impose specific limits or conditions on such activity or prohibit such activity.  The broker-dealer must document the review process of each written notice received and keep appropriate records.  If a registered representative was actively engaged in an outside business activity prior to December 15, 2010, the broker-dealer must review such activity in accordance with FINRA Rule 3270 by June 15, 2011.

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Hedge fund and private equity fund managers that use registered broker-dealers to raise capital on behalf of their funds should be aware of a recent report from the North American Securities Administrators Association (“NASAA”). The 2010 Broker-Dealer Coordinated Examination Report identifies the most prevalent compliance deficiencies by broker-dealers and offers a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures.

Fund managers should conduct initial and ongoing due diligence on all of their agents and service providers, and no less so with third party marketers, which must be registered as broker-dealers.  Agreements between fund managers and their third party marketers should include representations from the marketer that no information will be given to potential fund investors that is not approved by the fund manager.  The agreement should include an indemnification by the third party marketer to the fund manager in the event a fund investor relies on information produced by the marketer that is not accurate and complete in all material respects.

A fund manager that understands the nature of past violations by a broker dealer/third party marketer will be in a better position to protect the reputation of his/her firm.  When conducting due diligence of third party marketers, fund managers should view the FINRA “Broker Check” tool and information provided by the SEC, as well as request information regarding past engagements of the third party marketer.  Fund managers should inquire about pending or ongoing regulatory investigations, customer complaints, and whether the third party marketer has implemented NASAA’s “10 Best Practices” for broker-dealers.

The NASAA Report took into account a total of 290 examinations conducted between January 1, 2010 and June 30, 2010, which found 567 deficiencies in five compliance areas.  The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies).

The three most commonly found problem areas involved failure to follow written supervisory policies and procedures, advertising and sales literature, and variable product suitability. Half of the examinations involved one-person branch offices, 19 percent were home offices, 18 percent were branch offices with two to five agents, 10 percent were branch offices with more than five agents and 3 percent were non-branch offices.