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from Financial Regulatory Forum:

Client funds, net capital among hot topics for SEC 2012 exam program

By Nick Paraskeva, Thomson Reuters Accelus contributing author

NEW YORK, May 18 (Thomson Reuters Accelus) -  The SEC has new priorities in its 2012 exam program, including verifying firms’ holding of client funds and their net capital calculations.

The changes follow the collapse of MF Global, which revealed that client funds were missing despite regulations requiring that they be segregated. The revisions also reflect top findings found during the 2011 exam program, and follow major reforms to the SEC’s exam office.“Events at MF Global led to greater concerns on how firms are calculating their reserve formula, their net capital computations, and custody of customer assets,” said Carlo di Florio, director of the SEC Office of Compliance Inspections and Examinations (OCIE). Di Florio was speaking at a meeting of the Securities Industry and Financial Markets Association (SIFMA) Compliance and Legal Society in New York.

Exam program developments

The compliance inspections office has moved from a confederation of 12 autonomous regional programs to building a national exam program. This includes consistent policies and procedures and recruitment of a Chief Compliance Officer.

New management in the last year includes Julius Leiman-Carbia to lead the national broker-dealer exam program and Drew Bowden to lead the national investment adviser/Investment company exam program. The exam office has also recruited specialists with PhDs in math, quantitative analytics and models.

The office moved from a manual process to an automated exam system on an Oracle platform, which is flexible and better analyzes exam results, di Florio said. A new Office of Risk Analytics and Surveillance identifies those firms with higher-risk attributes for the SEC to review. An Office of Data Analytics can further investigate the firms so identified, where there is a lot of data to analyze.

from Financial Regulatory Forum:

Foreign bribery fines and settlements: who should get the money?

By Luke Balleny

NEW YORK, May 9 (Thomson Reuters Foundation) - ‘Share and share alike,’ some parents love to tell their offspring. But when it comes to fines or settlements from foreign bribery cases, the issue of sharing is a contentious one.

The U.S. government receives all proceeds from fines or settlements that companies pay it in connection with violations, or alleged violations, of U.S. anti-bribery laws.But would the country ever share the proceeds of such fines or settlements with governmental and non-governmental groups working in the countries where the bribery allegedly occurred?

A Nigerian accountability watchdog, the Socio-Economic Rights and Accountability Project (SERAP), wrote to the U.S. Securities and Exchange Commission (SEC) on the issue last month.

In its letter, SERAP asked for the the U.S. financial regulator’s enforcement division to establish a case-by-case policy or process that would:

“…enable foreign governmental entities that have been victims of corruptly-procured contracts to apply for, subject to appropriate anti-corruption safeguards, some or all of the civil penalty and disgorgement proceeds that would eventually be paid by companies alleged to have violated the U.S. Foreign Corrupt Practices Act.”

SERAP also suggested in the letter that: “civil society groups in the home country, or U.S. non-profit organisations serving that country, be eligible within a short time period to apply for such proceeds as well...”

from Financial Regulatory Forum:

Negligence charges gain clout in SEC enforcement arsenal

By Julie DiMauro

BOSTON/NEW YORK, May 9 (Thomson Reuters Accelus) - Financial services firms may face more negligence cases brought by the U.S. Securities and Exchange Commission, reflecting a greater willingness by the commission to base charges on negligence findings, industry professionals were told at a Thomson Reuters forum.

“What we are seeing is a willingness to actively go out and charge negligence,” Ian Roffman, a partner at Nutter, McClennen & Fish LLP, told compliance officers and others in a panel discussion on SEC enforcement hosted by the Thomson Reuters Governance, Compliance and Risk division. Negligence charges have traditionally been used as a fallback position in settlements, said Roffman, a former SEC trial attorney who now specializes in securities cases. But an SEC fraud case brought last year was founded on negligence accusations, and several other firms have received “Wells notices” of looming enforcement action or other indications that they may face possible negligence charges from the SEC, he said.

In the 2011 case, the SEC accused former GSC Capital Corp. executive Edward Steffelin of being negligent in the selection and marketing of certain collateralized debt obligations in which investors lost their money. Violations of fraud statutes, the SEC argued, can be “established by showing negligent conduct.” Steffelin is fighting the charge.

John Dugan, associate regional director of the SEC’s Boston office, confirmed what he said was the commission’s interest in the negligence issue but played down the idea that it represented a major shift.

“I don’t know if you’re going to see a lot of these cases, but we have expressed a willingness to bring them recently,” he said, “If there is a point to be made by bringing them, we will, but it’s not going to be widespread, I don’t think.”

The financial industry may strongly resist any trend towards negligence enforcement, Roffman said. “It’s going to be some time before we see how it all plays out.”

from Financial Regulatory Forum:

U.S. compliance officers need clarity on status as ‘supervisors,’ industry professionals say

By Stuart Gittleman

NEW YORK, May 8 (Thomson Reuters Accelus) - The U.S. Securities and Exchange Commission's dismissal of failure-to-supervise proceedings against a broker-dealer's general counsel did little to ease compliance officers’ concerns over their potential for acting in a supervisory capacity, according to leading industry professionals.

In January the SEC in a one-one split dismissed charges against the lawyer, Theodore Urban, for failing to prevent, detect and stop a stock fraud conducted by a registered representative at the broker, Ferris Baker Watts, and a customer of the firm.But regulators, particularly the SEC and the Financial Industry Regulatory Authority, need to provide more clarity on when a compliance officer may be deemed to have acted in a supervisory capacity, directors of the National Society of Compliance Professionals and speakers at a society program said.

FINRA found that Cantone Research and Christine L. Cantone, its chief compliance officer, failed to reasonably supervise a registered rep at the firm to stop him from conducting a fraudulent scheme, said Michael Solomon, FINRA's New York regional director. He said Cantone, who was also vice president and financial and operations principal at the firm, which had 14 registered persons, "blindly relied" on the rep's representations and did not follow up on red flags.

Whether FINRA sanctioned Cantone as a compliance executive or in her other roles, chief compliance officers need more clarity on how to act in that capacity, said Glen Barrentine, an NSCP director and special counsel at Cadwalader Wickersham & Taft. For example, a recent SEC order that two OptionsXpress compliance officers, who agreed to cooperate in proceedings against firm and others, cease and desist from violating rule 204 of Regulation SHO, could have been more specific on the supervisory aspect.

The two officers "screwed up" but it is not clear why were they sanctioned, said David DeMuro, the session's moderator, an NSCP director and deputy general counsel at AIG.

Another area of potential CCO liability involves the self-reporting provisions of FINRA rule 4530, which took effect in July 2011. The rules have been criticized for requiring firms to have a "reasonable conclusion" that they have not committed the pettiest violation.

from Financial Regulatory Forum:

The U.S. JOBS Act and non-U.S. companies: changes to the offering process and compliance challenges

By Robert Evans, Thomson Reuters Accelus contributing author

NEW YORK, May 8 (Thomson Reuters Accelus) - In April 2012, the U.S. securities laws changed significantly with the Jumpstart Our Business Startups Act, also known as the JOBS Act. The JOBS Act is deregulatory, easing some of the rules for companies seeking to access the U.S. capital markets. The offering process for SEC-registered IPOs is changing as a result and the U.S. Securities and Exchange Commission staff is working on further rule changes. Publicity restrictions will be eased for private placements and Rule 144A offerings. Offerings of up to $50 million will be exempted from registration. These changes pose interesting compliance challenges.

NON-U.S. COMPANIES ACCESSING U.S. CAPITAL MARKETS

Non-U.S. companies accessing the public U.S. equity capital markets for the first time after December 8, 2011 may benefit from the JOBS Act changes. To qualify, a company must have annual revenues of less than $1 billion. Issuers in this new category are called emerging growth companies (EGCs). The most significant changes to the securities offering process for EGCs include:

• Communications: A company making a public offering in the United States and its underwriters are strictly limited by the U.S. Securities Act of 1933 in their ability to communicate about the offering. No offers, written or oral, are permitted before a registration statement is filed with the SEC. Only oral offers, or offers made with a compliant prospectus, are permitted after filing but before the registration statement is declared effective. Under the JOBS Act, EGCs, directly or through representatives they authorize, may now test the waters with qualified institutional buyers (QIBs) and institutional accredited investors (IAIs). That is, without violating the pre-filing and waiting period restrictions, they may communicate with those potential investors to gauge whether they might be interested in an SEC-registered securities offering.
• EGCs and underwriters that test the waters remain subject to potential securities law liability for those communications, including for any material misstatement or omission. As a result, issuers and investment banks are likely to be cautious in testing the waters. Communications will be oral (which can include use of slides or flip books that are not left with investors). If written materials are used, they will likely be limited to information from the registration statement. Because the JOBS Act creates a limited carve-out to the Securities Act restrictions on communication, there will be compliance challenges. For example, market participants will need to ensure that testing the waters communications are limited to QIBs and IAIs and only used in offerings by EGCs. Also, investors may have to agree to treat information confidentially to avoid market abuse and selective disclosure concerns.
• Confidential submission of registration statements: In December 2011, the SEC staff severely limited access to confidential submission of registration statements, which had been available to all first time non-U.S. issuers that qualified as foreign private issuers. The JOBS Act gives that access back to issuers that qualify as EGCs prior to pricing of their first SEC-registered sale of equity securities. EGCs are required to include the initial confidential submission and all confidentially submitted amendments as exhibits to a publicly filed registration statement no later than 21 days before the road show. The December 2011 SEC staff policy still allows some non-U.S. issuers to confidentially submit draft registration statements if they meet the conditions outlined in the policy and either are not EGCs or do not take advantage of any benefit available to EGCs. Draft registration statements submitted confidentially must be substantially complete at the time of initial submission, including exhibits and a signed audit report covering the fiscal years presented in the registration statement.
• Financial statements and selected financial data: An EGC need only provide two years of audited financial statements in its initial public offering of common equity securities registered with the SEC, rather than the three years that are generally required. Instead of five years of selected financial data, an EGC need only present selected financial data for periods beginning with the earliest audited period presented in its IPO registration statement. Although the JOBS Act only refers to the disclosure rules for U.S. domestic issuers, EGC foreign private issuers may follow these reduced disclosure requirements.
• Research reports: The JOBS Act makes it easier for investment banks to write research reports about EGCs. Pre- JOBS Act and under the current rules for non-EGCs, underwriters in an IPO cannot publish research in advance of the IPO or during a 40-day quiet period after pricing and may not publish research for 15 days before and after the release or expiration of any lock-up agreement. There are also restrictions limiting contact between bankers and research analysts designed to separate investment banking from research in investment banks.

The JOBS Act:

• exempts broker-dealer research reports on EGCs before, during or after common equity offerings of an EGC (including an IPO) from being considered an offer or a prospectus under the Securities Act;
• permits broker-dealers to write research on EGCs after their IPOs (so no 40-day quiet period) and before the expiration of IPO lock-up agreements; and
• allows research analysts to communicate with management in connection with the IPO of an EGC even if investment bankers are present.

from MuniLand:

Muniland’s huge Dodd-Frank win

A huge win for muniland was finalized last week when the SEC approved new rules that will shine light on the municipal bond underwriting process. This Bloomberg headline says it all: "Bond-Disclosure Rules Backed by SEC to Protect States From Banks":

The rules were proposed by the Municipal Securities Rulemaking Board last year and are aimed at preventing Wall Street underwriters from steering public officials toward complicated debt financing without disclosing the risks. They were approved May 4 by the SEC, which will enforce them.

The disclosures are part of the effort to reshape financial regulations to prevent a repeat of the credit-market crisis of 2008, and stem from Congress’s decision to provide added protections for state and local governments. The economic crisis hit taxpayers with billions of dollars in unexpected costs when complex bond deals, once pitched as money savers, backfired as credit markets seized up.

I spent almost a year on Capitol Hill leading an open-source financial reform project as Dodd-Frank was being written. This is about the only area of the legislation in which there was no pushback from banks. Spencer Bachus, the Republican chairman of the House Financial Services Committee, was the committee's ranking member at the time the legislation was being developed. Bachus's home district in Alabama includes Jefferson County, the bankrupt county that has been buried under a series of deals with JPMorgan on interest-rate derivatives deals. Whether the banks explicitly held off challenging tighter municipal bond rules out of deference to Representative Bachus or whether they decided other parts of the legislation were higher priority is unknown.

In any event, the new rules are sweeping. Alan Polsky, the chairman of the Municipal Securities Rulemaking Board, said as much in a statement:

These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975.

The new rules detail a number of ways that underwriters must disclose their conflicts of interest to states, cities and other entities that issue municipal bonds. But the heart of the new rules addresses the sale of interest-rate derivatives tied to municipal bond offerings. Reuters blogger Felix Salmon described the practice like this in 2010:

I can guarantee you that every time a swap was sold, the person selling it got a nice fat up-front commission, and the unsophisticated small municipality buying it wound up getting a very unattractive deal. And the more complex the swap, and the higher the up-front payment to the town, the more the municipality was likely to be ripped off.

The underlying problem here is that interest-rate swaps tend to be sold rather than bought. If municipal treasurers came up with these plans on their own, and then asked a few banks for bids on the exact swap that they wanted, many of the rip-offs would never have happened. But instead, like subprime borrowers encouraged to monetize their home equity, they got talked into bad deals by sleazy financial professionals working on commission.

from Alison Frankel:

To silence critics, SEC should use Option One MBS case as template

If you haven't already, read Jesse Eisinger's piece for ProPublica and the New York Times on the Securities and Exchange Commission's case against the upstart credit-rating agency Egan-Jones. The SEC sued Egan-Jones – which challenged the traditional business model for rating agencies by charging users, not issuers, to opine on the riskiness of securities – for exaggerating its bona fides in a 2008 filing. Eisinger questioned the wisdom of sending Egan-Jones "to the guillotine" while letting bigger players, with business models that are susceptible to corruption, off the hook for their patently ridiculous ratings of toxic mortgage-backed securities. "This is your S.E.C., folks," Eisinger wrote. "It courageously assails tiny firms, and at the pace of a three-toed sloth. And when it goes after its prey, it's because it has found a box unchecked, rather than any kind of deep, systemic rot."

Inspired by the piece, I went back to take another look at the SEC's Apr. 12 complaint against Option One, a relative small-timer in the mortgage-backed securities market. Could Eisinger's criticism of the SEC's credit-rating enforcement – that the agency is netting minnows while the sharks swim away – apply just as well to MBS issuers?

Well, yes. But I'm getting tired of asking why the SEC has been so slow to enforce accountability for banks that packaged and sold securities backed by subprime mortgages that didn't meet even the lax underwriting standards they warranted. So instead, I'm choosing to regard the Option One case as a model for the kinds of actions the already much-maligned mortgage fraud task force keeps promising to bring. From my reading, there's no reason other MBS defendants can't be held liable for the same disclosure problems that Option One agreed to settle for $28.2 million.

Granted, the case against the H&R Block subsidiary was clear-cut by the standards of financial fraud litigation. Option One was a major originator of subprime mortgages. In 2006 and 2007 it got into the securitization business. In addition to selling packages of loans to other MBS issuers, it acted as the sponsor of seven MBS trusts with a face value of $4.3 billion, all backed by Option One-issued mortgages. The MBS trust contracts included a provision promising that Option One, as the mortgage issuer, would buy back mortgages that materially failed to meet its representations and warranties. But according to the SEC, Option One knew it didn't have enough money to make good on those repurchase promises. At the time Option One issued those mortgage-backed notes, H&R Block was quietly propping up its subsidiary, a fact Option One omitted from its MBS disclosures. (For more on Option One and put-backs, here's a piece I did on the attempts of Sand Canyon, its successor, to block the company that bought the loan servicing business from turning over loan files to noteholders. Stay classy, Sand Canyon!)

How could the SEC extend the theory of the Option One case to other mortgage-backed securitizers? It's a matter of what MBS issuers knew about the originators of the loans underlying the notes they sold. Option One wasn't the only subprime mortgage originator that was in trouble in 2007 and 2008: IndyMac, New Century, Ameriquest, American Home Mortgages – the list goes on and on. They all sold loans that were packaged and resold via MBS trusts, which typically offered the same sort of put-back promises as the Option One MBS trusts, assuring investors that the loan originator was responsible for buying back materially deficient underlying mortgages.

In the Option One case, there was a clear link between the originator's precarious financial condition and the MBS sponsor's knowledge of the originator's problems, since the sponsor and originator were one and the same. But couldn't the same be said about Countrywide and Washington Mutual? History certainly shows those two mortgage giants didn't have the funds to back repurchase promises. Could their successors at Bank of America and Wells Fargo be liable under the Option One theory? It would be tougher for regulators to use the Option One model against issuers that didn't originate their own underlying mortgages, but the agency could use its subpoena power to find out what exactly the banks snapping up mortgage portfolios from the likes of New Century knew about originators' true ability to make good on repurchase claims. My guess is that many of the banks were well aware of their mortgage suppliers' problems.

My Reuters colleague Aruna Viswanatha has been doing a bang-up job covering the mortgage-fraud task force. Last month, for instance, she reported that the Justice Department used the obscure 1989 Financial Institutions Reform, Recovery, and Enforcement Act to issue MBS-related subpoenas to top financial institutions. FIRREA violations, which require a lower burden of proof than criminal charges, carry stiff civil penalties for misconduct like mail and wire fraud. But there's nothing wrong with an old-fashioned disclosure case, either. The SEC got almost $30 million from Option One without even explaining a damages theory. If it can do the same against some of the bigger names in mortgage-backed securitization, that would shut its critics up.

from Financial Regulatory Forum:

Time to merge risk management and compliance?

By Rachel Wolcott

LONDON/NEW YORK, April 5 (Thomson Reuters Accelus) - Regulators' rising interest in risk management combined with a long trail of big fines for compliance failures has some consultants and industry leaders wondering whether it is time for the two disciplines to come closer together if not merge completely.

More than ever there are areas of overlap between risk and compliance. Risk management is now hardwired into more rules and regulations since the beginning of the financial crisis. In the UK, for example, the Financial Services Authority (FSA) hasincreased its fines for risk management failures . The U.S.'s Securities and Exchange Commission (SEC) has also indicated that it intends to take risk management as well as other governance and compliance issues even more seriously than in the past.Rodney Nelsestuen, senior research director at the CEB TowerGroup, told Thomson Reuters: "What's changed is with Solvency II and Basel III and those types of rule changes since the crisis is we've gone from being a backward-looking regulatory environment to saying we need more capital, better liquidity. The regulators are redefining all these things. So risk has been built into the regulation at a much stronger level than it ever was."

NON-COMPLIANCE IS A RISK

Equally, non-compliance with the host of new regulations covering all aspects of financial services has become a serious risk for firms. The price of getting compliance wrong is getting larger as headline-grabbing fines in both the United States and UK recently have demonstrated. Surely firms want to avoid being hit with fines such as ones handed to the likes of Coutts, Credit Suisse, and Greenlight Capital.

One way to manage that is to treat compliance issues as a risk category just like credit or market risk, for example. Chief risk officers need to understand the risk of non-compliance and assess their firms' performance in compliance as part of the bigger risk management picture.

Nelsestuen said: "The bottom line for me is it is time to start bringing risk and compliance closer together. What I've seen is non-compliance is in itself a risk. Risk managers are trying to understand compliance issues not because they want to run compliance, but they want to understand what risks they're taking. If you look at Credit Suisse which had a $500 million fine for AML infractions and HSBC ... non-compliance is a huge risk."

from Financial Regulatory Forum:

SEC examiners enter U.S. boardrooms to gauge compliance

By Nick Paraskeva

NEW YORK, April 4 (Thomson Reuters Accelus) - The U.S. Securities and Exchange Commission plans to reach into the boardroom to assess a financial firm’s culture of compliance, a senior commission official told a conference in New York.

The agency, departing from traditional practice to take a page from bank regulators, intends to have direct discussions with the firm’s board about the regulatory issues board members and senior management team are paying attention to, and how they are navigating them.“The SEC will expect to look at a firm’s budgets, hiring and firing”, said Carlo di Florio, director of the SEC Office of Compliance Examinations (OCIE). Di Florio was speaking at Fordham Law School’s Corporate Compliance Conference on April 2 in New York.

The commission already has held meetings about risk management with directors at Goldman Sachs and several other financial groups, the Financial Times reported on Tuesday.

The article named Goldman, Morgan Stanley, Barclays, Wells Fargo, Wedbush Securities and credit rating and clearing firms as among those whose directors have met SEC examiners since last summer. It cited sources familiar with the issue, but said di Florio in an interview did not comment on which banks the commission had met.

Di Florio also told Thomson Reuters on the sidelines that the SEC will continue to issue guidelines on best practices, to reflect issues that regularly arise in their exam visits.

COMPLIANCE INSPECTIONS AND EXAM OFFICE

from MuniLand:

The SEC’s startling refresher on due diligence

The SEC's Office of Compliance Inspections and Examinations, muniland's uber-regulator, issued a "Risk Alert" yesterday directed at underwriters of municipal bond offerings. The alert basically said: If you offer new bonds for sale, you must perform due diligence on the issuer. And you better document what you did.

I have to wonder about all the sudden fuss. The SEC's "Risk Alert" was just restating a fundamental law in securities markets that requires securities dealers to investigate and verify what they are offering to investors. In other words, dealers must know their product, because there is no immunity for selling bad stuff. It's a little shocking that the SEC has to remind securities dealers that they are required to do due diligence, but they went further and detailed some specifics on what had to be done (Page 3, emphasis mine):

the Commission also stated that sole reliance on an issuer will not suffice in meeting an underwriter’s “reasonable basis” obligations.

What the SEC insists on, and what is stated in the law, is that securities firms go beyond the surface facts presented by issuers and verify the underlying facts. And here they point their finger at unnamed broker-dealers who are not performing to standard and scold them for not maintaining records of their due diligence (Page 4):

[The staff] has observed instances where municipal underwriters have not maintained, nor did they require the creation and maintenance of, adequate written evidence that they complied with their due diligence obligations, including those under Rule 15c2-12 and applicable Commission interpretive guidance. Indeed, some firms have asserted that it is their specific policy not to maintain any due diligence records and have stated that “it is not industry practice” or that they are following advice from outside counsel ... This approach might lead to lax due diligence practices at a time when there are growing concerns over the fiscal well-being of some municipalities.

How crazy is that? You get the sense of some cocky broker-dealer telling the sheriff of Wall Street to buzz off because some attorney they hired told them that they didn't have to keep records. Sorry unnamed broker-dealer, that is not how it works. And you should never diss the sheriff.

Of the municipal bond defaults I have written about in the last year, several jumped to mind after seeing the alert because I had wondered at the time if the underwriters had done their due diligence. The first and craziest deal was $38 million in revenue bonds issued in Missouri for Project Sugar, a substitute sugar manufacturing plant. Basically the whole deal was misrepresented (read: fraudulent), and no one -- from state and local officials to the underwriter, Morgan Keegan -- seemed to do any due diligence.