After a hiatus of many years, the SIFMA Compliance and Legal Society resurrected its western regional conference, held on August 1, 2013 at the offices of Charles Schwab in San Francisco.  The day-long conference was well-attended, with spirited panels on a host of topics, including recent regulatory developments, trends in securities, compliance, arbitration and litigation, and lessons following implementation of the new suitability rules in July 2012.  Regulators from FINRA, the SEC, and the newly renamed California Department of Business Oversight (“DBO,” formerly the Department of Corporations and the Department of Financial Institutions) provided useful insights into current regulatory priorities.

Panels on anti-money laundering (AML) policies and on compliance and supervisory issues noted a recent trend of regulators charging supervisory personnel, not just firms, with wrongdoing.  The AML panel, moderated by Robert Neitz of Wells Fargo, covered recent enforcement actions in which AML Risk Officers were charged.  The compliance panel, moderated by Charles Schwab’s Scott Cook, noted an increasing number of cases against supervisory personnel wearing “multiple hats.”  The panels highlighted activities that could increase the risk of supervisory liability, including voting on policy and supervisory committees, responsibility for developing and carrying out supervisory procedures and systems, and reviewing exception reports, accounts, and correspondence.  One panelist suggested these risks could be mitigated by defining, in writing, job roles and responsibilities, although maintaining such clear distinctions is often easier in theory than in practice.      

Regulatory Priorities

The DBO Commissioner, Jan Lynn Owen, indicated that the combined regulator would save money and streamline communications, including through a new data system that will allow the DBO to reshuffle exam priorities in real-time, as data from examinations and enforcement actions are collected.  DBO exam priorities include high-risk licensees (information gleaned from complaints, tips and referrals), private placements, suitability, sales practice and marketing (particularly to seniors and affinity groups), and outside business activities.  Owen also noted issues with investment advisors and hedge funds who had failed to fully disclose to customers the extent of investment losses, and she and her staff expressed concern that crowdfunding will attract fraudulent activity as it becomes more widespread.

FINRA’s Daniel Sibears highlighted the agency’s efforts to narrow its annual exam priorities letter to focus only on the most important areas.  Current areas of emphasis include high-frequency trading, IRA rollovers, interest-rate sensitive products/complex products, private placements, and conflicts of interest.   FINRA expects to issue a white paper, during the summer, focusing on conflicts, including private wealth, new product review and vetting, and compensation practices.  A June social media sweep obtained information from firms with an eye toward issuing guidance, or, although less likely, new rules.  Sibears noted that so far, FINRA was surprised by the heightened restrictions firms were placing on social media.  Stating that FINRA’s top priority was “fraud, fraud, fraud,” Sibears noted that fraudulent private placements, oil and gas security sales, and pump-and-dump and penny stock schemes were recurring themes.  Another major focus is senior investor issues, and FINRA expects to hold a roundtable and ultimately have additional guidance in this area as well.  Finally, he noted that an Investor Alert would soon be coming out regarding a recent rash of identity theft schemes in which imposters contact clients posing as representatives of their respective investment firm and offer them fraudulent investments.   

Stephanie Wilson of the SEC reiterated the exam priorities announced in January, which focus on new Dodd-Frank registrants, valuation, conflicts of interest, and marketing.  A sweep is currently focusing on the failure of investment advisors and broker-dealers to fully disclose fees, with the expectation of issuing a report in two-three years.  Wilson indicated that in the broker-dealer arena, the agency was trying to do risk-based exams, focusing on fraud.  The SEC has also been hiring experts who build models and examine results to better focus examinations and escalate issues.  Wilson also noted, but did not comment on, the recent changes to the agency’s settlement policy, in that in some cases, a defendant may no longer “neither admit nor deny” allegations of wrongdoing.  Wilson mentioned that the agency hopes to have a new head of the San Francisco Regional Office in place by October 1st.

KYC & Suitability:  Post-Implementation Experiences

Another panel addressed the implementation of the new suitability rule, one year in.  Daniel Sibears of FINRA noted that suitability was now a “cornerstone” of routine examinations and indicated that FINRA was focusing on what firms are doing to educate personnel on what a “strategy” is, as well as on how firms are treating the rule about suitability of explicit “hold” recommendations.  Specifically, FINRA is asking, “are advisors collecting the new required profile information; or, if they do not get it, how are they making suitability determinations?”

Sibears noted that no enforcement cases have been brought solely on the suitability rule amendments to date.  FINRA has been looking for firms’ “good faith effort” to comply.  He noted, however, that by now FINRA expects firms to be well into developing their policies, and the period of “patience” was coming to a close.  Sibears noted that FINRA was not seeing the development of good systems for documenting explicit hold recommendations, and that this was an area where firms should focus their attention.  He also noted that some firms had been adopting heightened suitability requirements in relation to certain products, and that FINRA would soon be issuing guidance on this topic. 

The panel had a spirited debate on the rule regarding investment strategies, in particular when a recommended strategy intersects with an outside business activity.  Sibears emphasized that FINRA did not view the new rules as a “game-changer” on outside business activities and that they did not impose any new supervisory responsibility on firms relating to outside activity.

The firm representatives on the panel noted the challenge of modifying their systems to respond to the “hold” recommendation amendment.  They had adopted risk-based systems because a hold recommendation by definition is not a transaction.  The risk focus was on hold recommendations on concentrated accounts, complex products, seniors, and clients with limited experience or financial resources.  One firm was instructing managers to talk with reps regarding hold recommendations and to follow up with a call to the client.  Another firm developed a form for reps to fill out to document the basis for a hold recommendation.  Sibears of FINRA emphasized that the hold rule was not a monitoring rule. 

Arbitration and Litigation Update

The panel moderated by Morgan Stanley’s Jonathan Robbins focused on trends in securities arbitration and litigation and addressed the decline in customer case filings as well as proposed FINRA rule changes.  A proposal to amend the Discovery Guide to mandate production of electronic files in a “reasonably usable format,” preferably as native files, could further complicate firms’ e-discovery efforts.  The definition of “usable format” likely includes not only “searchable” but “modifiable,” meaning, for example, that spreadsheets will need to be produced in a format that allows for sorting of columns, rows and data.  Another proposal addresses “product cases,” not adding new documents to the lists but providing guidance about the types of documents that should be produced under the existing lists in “product cases.”  Because of the potentially expansive number of documents that might be required in these “product cases,” the issue of what constitutes a “product” will be hotly contested.  In an effort to anticipate this issue, the amendments may require arbitrators to determine what constitutes a product case.  Finally, FINRA is proposing to make the existing all-public arbitration panel option the default, rather than the opt-in procedure currently in use – making the industry panelist even more of an “endangered species.”