Financial Regulatory Forum Wed, 19 Oct 2016 18:19:37 +0000 en-US hourly 1 Federal marijuana ban deters insurers as U.S. states legalize Wed, 19 Oct 2016 18:19:37 +0000 By Antonita Madonna, Regulatory Intelligence

The legal use of marijuana could increase substantially by the end of the year as several U.S. states, including California, vote on its use for recreational or medical purposes. This could open new markets for insurance coverage in areas including property and casualty and health. However, insurers, principally regulated by the states, are unlikely to step in while federal regulations still criminalize use of the drug. 

More than 25 states and the District of Columbia have legalized the use of marijuana for medical or recreational purposes. It remains banned under Schedule I of the Controlled Substance Act at the federal level, “with no currently accepted medical use and a high potential for abuse.” 

Insurers have shied away from explicitly stating whether coverage benefits are applicable to the marijuana-products industry and even denied coverage to individuals and businesses, despite more supportive regulation at the state level and even state requests for industry clarity. 

“Either legalization or confirmation that state programs will be left alone at the federal level, would allow insurers to understand that they can take this on as another market,” says Manny Munson-Regala, owner and principal at Root Cause Consulting, which specializes in health policy, insurance and medical marijuana issues. “Then they can move on to issues like underwriting and rating, without having to worry about whether a particular regulator is going to look at them sideways for providing for the market,” he added. 

Munson-Regala, a former assistant commissioner in the Minnesota Department of Health, had discussed his views before industry representatives at a September meeting of the Association of Insurance Compliance Professionals.

The Republican and Democratic presidential nominees, Donald Trump and Hillary Clinton, have indicated support for legalizing medical marijuana but not provided details on when or how they plan to do so. However, Clinton has made a statement supporting reclassifying marijuana to Schedule II from Schedule I, to facilitate the use of marijuana for medical purposes and foster research. She has also welcomed a state role as “laboratories of democracy” in the future of recreational-pot legalization.

Currently, marijuana is bundled with other drugs such as heroin, LSD, ecstasy and peyote in Schedule I. 

The legal marijuana market is expected to grow at a compounded annual growth rate of 29 percent from now until 2020, according to a report by Arcview Market Research and New Frontier Data. Data shows the industry is projected to rake in revenue of as much as $20.6 billion by 2020, in an almost equal split between medical and adult use, from $5.9 billion in revenue in 2015 when adult use comprised of only $1.2 billion of the total revenue.

However, the absence of insurers in the marketplace could act as a barrier to businesses, labor and scientific researchers aiming to participate in the industry. For example, health insurances policies do not currently cover medical marijuana. Crop cultivators remain at risk of sustaining business losses from damage to the crop and workers in the marijuana industry are unsure of their insurance coverage benefits for health or workers compensation, even if they do not consume the substance. 

Marijuana businesses have experienced similar obstacles obtaining services from banks, which are subject to federal laws against the handling of proceeds from illegal activities. 

States lead

This November, nine states will hold ballot initiatives to approve the use of marijuana for medical or adult-recreational purposes. While California, Arizona, Nevada, Massachusetts and Maine will vote on recreational use, Florida, Montana, North Dakota, and Arkansas will decide on medical marijuana. 

A majority of these states are likely to vote in favor of the law, polls show, but California alone could contribute to a huge spike in growth if the substance is legalized in the state. 

The market for legal cannabis in California currently represents about 38 percent of the total U.S. market by revenue in 2016, according to the data from Arcview Market Research and New Frontier Data. In 2020, revenue in the California market is projected to grow to $6.45 billion, with adult use accounting for about $4 billion of total projected revenue.

States such as Oregon, which legalized the use of medical and recreational marijuana last year, have mandated that insurers clearly specify their stance and extent on marijuana coverage in their disclosure agreements, to avoid losses and legal disputes from misunderstandings over the terms and conditions of an insurance policy. 

More states are expected to emulate this model to encourage more transparency when they adopt marijuana regulations for their own jurisdiction in the coming years. 

More state coordination would be needed, Munson-Regala said. “The concept of interstate compacts is one that states should consider, for more consistent regulations on medical use among adjoining states,” he said. “If you allow patients to access products from multiple jurisdictions, there’ll be a better chance that they find the relevant medical formulation while having some kind of uniformity in safety, quality and labeling.”

It would also unleash the power of competition, he added. 

Regulators and researchers have urged the insurance industry to become better informed about marijuana, to overcome resistance to providing coverage. Munson-Regala also noted that medical marijuana could be cheaper for health insurers to cover than prescription opioids, and carry fewer health risks.

Antonita Madonna is a correspondent for Thomson Reuters Regulatory Intelligence, based in New York.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Oct. 13. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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IA Brief: If your program is a “wrap”, be prepared Tue, 11 Oct 2016 15:41:55 +0000 An investment adviser’s participation in a wrap fee program will not only increase its compliance and disclosure responsibilities but raise its regulatory profile with heightened focus on the programs. The focus was recently demonstrated with a Securities and Exchange Commission case in which two large firms settled complaints over wrap fee program compliance failures.
Investment advisers are often creating or implementing new programs to meet their clients’ specific needs and ultimately improving their client experience. In recent years, the use of single fee programs or a more holistic approach to the advisory relationship has been embraced; however, programs that bundle particular services can often fall into the definition of a wrap fee program.

A firm that is, or may be thinking about, participating in a wrap fee program must be conscious of the current regulatory environment and some of the increased compliance responsibilities that go along with such a program. A participating firm may have increased disclosure requirements and a need for amplified awareness of suitability for the program.SEC enforcement and focusA recent SEC case charged Raymond James & Associates and Robert W. Baird & Co. with failing to establish policies and procedures necessary to determine the amount of commissions their clients were being charged when sub-advisers traded with broker-dealers outside the wrap fee program. Both firms have subsequently settled with six-figure penalties.According to the SEC, both firms disclosed in brochures that wrap clients could incur additional costs from trades outside the program, but the firms didn’t collect information from sub-advisers about the costs of trading away, or how often they executed trades with other brokers.

Therefore, the lack of trading data left clients unaware of how much they were paying in additional trading away costs, and the clients’ advisers were unable to consider the commission costs when determining whether a particular sub-adviser or the wrap fee program was suitable for their clients, according to the orders.

Wrap fee programs have also been included in the SEC’s 2016 exam priorities. The SEC will be assessing whether advisers are fulfilling fiduciary and contractual obligations to clients and properly managing such aspects as disclosures, conflicts of interest, best execution, and trading away from the sponsor broker-dealer.

Wrap fee program

According to the SEC, a wrap fee program is one which any client is charged a specified fee or fees not based directly on transactions in a client’s account for investment advisory services (which may include portfolio management or advice concerning the selection of other advisers) and execution of client transactions.

In a traditional wrap fee program, a client pays one fee based on a percentage of the assets under management, which also covers the transactional charges that would typically be a separate expense billed to the client.

An adviser can be a sponsor of a wrap fee program, act as a manager for a wrap fee program or simply recommend wrap fee programs to their clients. A sponsor or manger will incur the most onerous disclosure requirements with all three retaining responsibility for the suitability of the program.


The Form ADV Part 1 and 2A include the disclosure of wrap fee accounts, among others. The level of disclosure depends on the level of participation.

Item 5 of the Form ADV Part 1 will question whether a firm participates in a wrap fee program and what role it holds. If a firm’s involvement in a wrap fee program is limited to recommending wrap fee programs to clients, or advising a mutual fund that is offered through a wrap fee program, no disclosure is required. A firm that is a manager/portfolio manager, or a sponsor of a program, will be required to affirm the participation and list the names of the programs and their sponsors in Section 5.I.(2) of Schedule D.

Appendix 1 of Form ADV 2A, also referred to as the wrap fee brochure, is usually prepared by the sponsor or administrator of a program, and is the main disclosure for wrap fee programs. Any registered adviser that is compensated under a wrap-fee program for sponsoring, organizing, or administering a wrap-fee program, or for providing advice to clients under the wrap-fee program, must provide clients the Appendix 1.

The Appendix 1 contains a cover page and table of contents along with a description of the fees charged under the program, a description of the portion of fees provided to persons providing services under the program, and the services provided, among other requirements. Conflicts of interest and other material arrangements must also be disclosed in Appendix 1.

The Appendix 1 must be provided prior to or at the time of entering into a written or oral agreement. The responsibility of providing the Appendix 1 is the sponsor, however, an adviser involved in the recommendation to the client may deliver the initial Appendix 1 as well. Keep in mind the Appendix 1 is not a substitute for an advisers Form ADV Part 2A, or brochure for accounts or services not affiliated with wrap fee programs.

The Appendix 1 must be updated each year at the time of filing the firm’s annual updating amendment, and promptly whenever any information in the wrap fee program brochure becomes materially inaccurate.


A wrap fee program allows for a less expensive option for clients whose investment objectives and risk tolerances call for active trading. However, it does present suitability considerations for any investment adviser participating in wrap fee programs.

Most of the suitability review will be concentrated around fees and the comparison of clients in wrap fee programs to firm clients not in the program. In that case, a firm’s compliance program must be equipped to capture and review the fees, determine whether a client is being overcharged, and ultimately whether the program is suitable for that particular client on an ongoing basis.

A common term in the brokerage space is “churning”, the practice involves excessive trading of a brokerage account to increase commission payments to the registered representative. Fortunately, a wrap fee program will protect a client from churning but could have the opposite effect, “reverse churning”.

Reverse churning should be addressed during the suitability review, as the practice includes little or no trading activity, in turn not justifying the usually more expensive wrap fee program. In this case, a client would be better off in an account where the brokerage commissions are paid separately.

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Oct. 3. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Jason Wallace is a senior editor for Thomson Reuters Regulatory Intelligence. Jason began his career at TD Waterhouse Securities Inc., now TD Ameritrade Inc., where he held key positions in the Trading, Risk Management and Compliance departments for both retail and institutional sides of the firm. Jason joins Thomson Reuters after serving as an associate director for National Regulatory Services, in San Diego, California. Follow Jason on Twitter @Wallace_iabrief. Email Jason
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IMPACT ANALYSIS: FINRA’s charges against ex-Morgan Stanley traders hired by UBS raise background questions Tue, 27 Sep 2016 19:11:53 +0000 By Julie DiMauro, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – The Financial Industry Regulatory Authority’s (FINRA) charges against John Batista Bocchino and his sales assistant, Rafael Barela Jacinto, over unauthorized trading of $190 million worth of Venezuelan bonds and falsifying records have cast light on the significance of disciplinary histories in employing brokers.

The complaint charges the two brokers with opening nominee accounts in the names of “well-known financial institutions” to avoid the anti-money laundering (AML) review Morgan Stanley’s AML and compliance teams would have performed on personal accounts. The two men had been hired by UBS Financial Services in New York only days after being dismissed by Morgan Stanley for carrying out improper securities transactions.

In April 2011, Morgan Stanley tightened its AML policies by requiring brokers to provide buy-side confirmations on Venezuelan bond trades at the time of sale to show that they were bought in U.S. dollars. The firm further strengthened its AML regime in January 2012 by prohibiting Venezuelan securities transactions with any financial institutions, with a few exceptions.

According to the complaint, Bocchino received gross compensation of about $2.3 million in 2011 and $2.3 million between January and March 2012, making him “one of the largest producers at Morgan Stanley’s Madison Avenue branch.”

FINRA also notes that both men moved to and were hired by UBS Financial Services in New York within 2 1/2 weeks of their termination by Morgan Stanley in March 2012. A UBS spokesperson declined to comment on this matter, citing the continuing investigation.

Bocchino states through a summary of the case on FINRA’s “BrokerCheck” system that the activities for which he was dismissed by Morgan Stanley involved trades for institutional customers through outside prime brokers that were made as per his clients’ instructions. Barela’s similarly states that he conducted trades in the nominee accounts at the instruction of institutional account holders and his employer.

The brokers’ statements specify that the investigations do not involve their activities at UBS. has reported that the two men declined to comment on the FINRA charges, and that UBS declined to comment on their employment status. Bocchino’s LinkedIn profile describes him as currently employed with UBS. Barela’s profile includes a UBS affiliation but does not specify his employment status.

Fictitious account names, suspicious transactions

At the time of Bocchino’s and Barela’s suspected violations, Venezuela was designated a state sponsor of terrorism, and was a country with close economic ties with Iran.

In addition to being on the list of sanctioned nations that Morgan Stanley could not transact business with, the two brokers’ alleged use of fictitious names for clients violated company policy and occurred without permission the banks labeled as owners of the accounts.

FINRA’s complaint notes that the agency is seeking disgorgement of the brokers’ “ill-gotten gains.” By creating fictitious account names for 13 clients — without the permission of those banks whose nominee accounts were being used — the brokers impeded Morgan Stanley’s efforts to document accurate ownership and trading records, FINRA states.

One of the 13 clients was Miami-based Global Strategic Investments LLC, which FINRA censured in June 2015 and fined $200,000 for failing to detect, investigate and report potentially suspicions transactions.

The amount and quality of background checking that UBS performed on each of these brokers could not be determined. What is known is that the Zurich-based bank expanded the number of employees subject to internal background checks to around 15 percent of its workforce in August 2015 — a move that came in the wake of an international probe into rigging of the global foreign exchange market. The probe was conducted by multiple regulators, including the Securities and Exchange Commission (SEC), and Britain’s Financial Conduct Authority.

Background checks for new hires and transfers

FINRA member securities broker-dealers are mandated to conduct background investigations of applicants for registration with a member firm, including verifying the accuracy and completeness of information reported to the Central Registration Depositary (CRD) using the form U-4, “Uniform Application for Securities Industry Registration or Transfer.”

In January 2015, the SEC approved a proposed rule by FINRA to strengthen the quality of the background checking requirements of member firms.

In July 2015, Rule 3110 went into effect. It requires member firms to have documented procedures for collecting information and conducting background checks on new hires and those who transfer from other firms.

Organizations must validate that the Form U-4 information provided by the candidate is complete and accurate within 30 days of its filing; that is, that it contains detailed information and prior disclosures regarding such things as bankruptcies, liens/judgments, criminal histories, and prior/pending civil litigation.

The new rule expands what the firm’s “investigation” should encompass before the U-4 is filed — when the firm is reviewing the candidate’s most recent Form U-5, which details the broker’s termination from a member firm.

FINRA offers guidance to firms about conducting this investigation, recommending a check of credit reports, fingerprint records, a national public records database (like Westlaw or LexisNexis), and a review of any consolidated report from a specialized provider (such as Business Information Group, Inc.) that includes financial and criminal records.

In addition to the initial background check performed by the member firm, FINRA will conduct periodic reviews to validate the information in the U-4 and other records about individual brokers that are available to investors, regulators and firms.

FINRA states that the search of “reasonably available public records” must be “national” in scope, although there may be circumstances in which a search in foreign jurisdictions is warranted.

Best practice considerations

Regulators expect broker-dealers to meet their significant responsibilities in performing background checks on those persons that will be handling customer money for them. The failure to meet these obligations can result in enforcement actions, not to mention negligent hiring claims in arbitrations.

FINRA is not advocating the use of one screening tool over another or even suggesting that using one constitutes some sort of “safe harbor.”

The agency is, however, underscoring its commitment to review how diligently and promptly member firms have demonstrated a commitment to vetting those potential employees who will be handling client accounts.

Maintaining such “evidence of compliance,” is one of the essential practices of any compliance process.

On employment issues, firms should seek to document what procedures they have used to learn as much about a prospective broker as possible and relevant to the job at hand and to note precisely the findings and any reasons for delays.

The broker-dealer should have internal policies outlining the steps required in this type of investigation, specifying exactly who carries out which steps.

Service providers exist that will create disclosure monitoring reports so broker-dealers can obtain reports on applicants, but those services should be vetted for how well they work, what troubleshooting they provide and how well they will meet your business’s needs as it evolves.

It is a good sign if the vendor is as selective of its customers as the firm is of its vendors.

When checking credit histories of a prospective broker, it is important to be aware of Fair Credit Reporting Act (FCRA) requirements. Under the FCRA, it is necessary to get permission from the subject of a prospective credit report. Also, if a hiring decision is made based on a candidate’s financial history, the FCRA requires notices to the applicant, both before and after the adverse hiring decision is made. Failure to do so can trigger monetary penalties.

The FCRA process enables applicants to challenge decisions made on credit histories and establish whether information in them is erroneous.

In examining information concerning a broker, any red flag should be documented and followed up promptly. Turning a blind eye to such information can lead to severe consequences.

Departments in a firm must coordinate their efforts regarding background checks and their documentation. Human resources and compliance departments, for example, should agree on allocating task responsibilities, sharing of information and record maintenance.

Finally, firms must have policies addressing current employees and their annual affirmations about the accuracy of the information on their U-4 forms. Specifically, firms must decide if they will rely on these attestations, or if they will independently verify on an annual basis the currency and accuracy of such data.

While broker-dealers cannot rely on the affirmation of a new applicant, they can rely on them at the annual certification stage. But actively verifying, if only randomly, brokers’ annual attestations can help a firm look more diligent about compliance. The exercise would also prepare the firm for the possibility of FINRA making such verification a requirement.

(Julie DiMauro is a regulatory intelligence and e-learning expert in the GRC division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at
(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 23. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)
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Wells Fargo case highlights need to monitor employees with stressful performance goals Thu, 22 Sep 2016 19:25:47 +0000 One of the more difficult tasks for compliance officers is to question employee success, even if those achievements come against almost insurmountable odds. The disclosure that Wells Fargo employees, in order to meet sales targets, signed up more than 2 million of its customers for new accounts and credit cards without their knowledge, is an example of employee performance that should be questioned even though the impulse is often to look the other way.

“The key is that few people ever question good news,” says Walt Pavlo, co-founder of Prisonology, a consulting firm that supports legal professionals and defendants. Pavlo, who has written widely on compliance issues, adds: “If the news is good it typically lowers our level of professional skepticism . . . and makes it difficult for compliance to challenge the news, even if they should.” On Tuesday (Sept. 13) Wells Fargo, the largest U.S. bank by market capitalization, said it would eliminate all product sales goals in retail banking, starting next year. The move comes days after the Consumer Financial Protection Bureau (CFPB) and two other regulators fined the bank $185 million over its abusive sales practices.One of the other regulators, the Office of the Comptroller of the Currency, said in the agency’s consent order that the bank “lacked an enterprise-wide sales practices oversight program and thus failed to provide sufficient oversight to prevent and detect the unsafe or unsound sales practices . . . and failed to mitigate the risks that resulted from such sales practices.”While such an oversight program clearly should have been in place, there are other facets to the Wells Fargo case that apply across the industry, particularly in an environment where many employees are under stress to meet performance goals that may actually be designed for failure. At root, the problem rests with behavior and accountability.”I don’t think (bank behavior) has changed enough,” said Federal Reserve governor Dan Tarullo in an interview with the CNBC network, citing the Wells Fargo case.”There is a need for a focus on individuals as well the fines on institutions. In appropriate cases, I think that fines against individuals, prohibition orders, and … Justice Department prosecutions are things that do need to be pursued,” Tarullo said.

Employees under growing pressure to perform

While Wells Fargo illustrates what may still be lacking in the cultural reform of large banks, a contributing factor to the temptation by employees to cut corners is the workplace they are operating in. Among some of the largest U.S. financial institutions there has been a growing tendency to avoid mass redundancies amid an environment of shrinking margins and need to control costs. Instead, what some industry participants point to is a more selective process, where certain employees are continually forced to achieve ever higher performance goals, whether in sales or trading. The hope is, say some, that the frustration will build to such an extent that the employee will simply leave the firm.

“Nobody wants to let go of thousands (of employees) if they can avoid it,” said one senior employment recruiter at a large New York firm. “What you tend to see more are small groups – two or three – leaving a firm, or individuals quietly giving up.” By giving up the bank or firm can avoid severance packages, which are often quite expensive if the employee has numerous years of service.

“Especially in sales, a lot of people are put under massive pressure, to the point where what they are being asked to do simply can’t be done,” said a senior fixed-income trader at a large New York investment bank.

In such a competitive environment, where one’s career is essentially on the line with few options of returning to the industry once you’re out the door, there is a risk that employees might resort to actions that are fraudulent in order to deliver their expected performance results, say experts.

“The great check on people’s ethical impulses is that you are going to be around for a while,” said Donald Langevoort, law professor at Georgetown University. “The more short-term you think your time is the more you are able to rationalize little steps towards a bad line.”

“Given the stresses, given the competition, you probably have to worry about this more than in any other industry,” he added, noting that healthcare was another sector under similar regulatory and competitive strains.

Compliance surveillance of those under stress

The Wells Fargo case has the added, and somewhat astounding, feature of the number of individuals involved. The bank said it dismissed 5,300 staff who were involved in the fraudulent cross-selling of products. Such a high number suggests that senior management were well aware of what was going on, and perhaps even encouraged the activity, say observers, albeit they might have resorted to communications with staff that was not specific, but left enough leeway for interpretation.

“It’s hard to fathom that senior people were unaware of what so many were doing,” said a legal expert at a New York law firm. “In that sense, I think (Fed governor) Tarullo has a very valid point.”

Yet from a compliance perspective, the Wells Fargo case also raises questions. What did compliance know about a business practice that was going on for years, according to regulators? Were compliance staff complicit as well, or did they lack the tools, as the OCC suggests, to effectively monitor the activities of the sales staff?

With technology surveillance capabilities now widespread across the industry, it would seem that many compliance functions need to focus on individuals who might be exhibiting stress and facing a high bar when it comes to performance objectives. Systems can also monitor all those new accounts that were established, and flag troubling patterns of low balances and inactivity.

Langevoort of Georgetown says there are two types of employees one needs to perhaps keep a close eye on: one, is someone who might have personal issues, such as health, and are looking at a year-end bonus to help pay extraordinary medical expenses, and second, is the employee who is very close to meeting their financial targets and feels entitled or justified to do something that gets them across the finish line.

“To to make up that last bit of difference people will go to almost any extremes,” he said. “But if a company has the kind of compliance resources to do desktop surveillance to keep a watch, it’s a no brainer that you can identify those who you want to devote greater human attention to.”


(Henry Engler is a North American Regulatory Intelligence Editor for Thomson Reuters Regulatory Intelligence. He is a former financial industry compliance consultant and executive, and earlier served as a financial journalist with Reuters. Email Henry at

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 14. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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INSIGHT: SEC delivering on promise to scrutinize private equity firms Thu, 15 Sep 2016 19:03:11 +0000 By Todd Ehret, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – Private equity firms in the 1980’s and 1990’s gained a notorious image as corporate raiders thriving on leveraged buyouts and hostile takeovers funded by junk bonds. The industry spawned famous tales and movies about the deals and larger-than-life personalities. Nevertheless, the number of participants and total assets of approximately $30 billion of that era were miniscule compared to today’s private equity (PE) industry, which has finally come under greater regulatory oversight.

Assets under management by PE managers grew to $700 billion in 2000 thanks to the technology and dot-com boom. They have now swelled to more than $4.2 trillion according to the 2016 Preqin Private Equity Report. This tremendous growth in assets now dwarfs total hedge fund assets of approximately $2.8 trillion.

This industry largely went unregulated until the passage of the Dodd-Frank Act in 2010 which required PE and hedge fund managers to register by 2012. Two recently settled enforcement actions involving prominent PE firms added to the growing list of PE managers tripped up by the U.S. Securities and Exchange Commission’s (SEC) probe into PE firms. This, along with a handful of other expensive SEC settlements, and prominent public warnings by regulators to the industry are noteworthy and prompted our review below. We also highlight the top areas of concern and offer some suggestions.

The SEC’s probe of PE

In 2010 the SEC’s enforcement division created specialized units including the Asset Management Unit in anticipation of the new registrants as a result of Dodd-Frank. The units began developing the expertise necessary to understand PE fund advisers and their practices. In October 2012 the SEC’s Office of Compliance, Inspections, and Examinations (OCIE) launched a presence-exam initiative which was seen by many as a “light introductory exam” in an effort by the regulator to get to know all of the new registrants. OCIE also created its own specialized unit, the Private Funds Unit and began examining many hedge funds and PE firms for the first time.

The results of these initial exams identified a number of deficiencies which likely led the SEC to include PE firms in their annual exam priorities rosters in 2015 and 2016. The 2015 OCIE exam priorities warning said, “Given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area.”

In 2016 OCIE broadened the warning to include hedge funds in the exam priorities saying they “will examine private fund advisers, maintaining a focus on fees and expenses and evaluating, among other things, the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts.”

As a result of the SEC probe and despite public warnings, the SEC has now announced approximately a dozen actions against PE managers, including some of the largest and most prominent firms. Penalties, including disgorgement and fines now total nearly $150 million in settled cases.

PE firms are unique in their structures and problems

Alternative asset managers are a much bigger category and diverse group than one might assume. Within this broad category there are not only hedge funds and private equity funds but they can further be broken down by strategies, such as real estate, commodities, lending funds, venture capital funds, and buyout funds, to name a few.

PE fund’s lack of correlation with public markets and consistent long term returns are the most appealing aspect of these alternative strategies. The bulk of the assets invested in alternatives is largely of an institutional nature such as family offices, endowments, sovereign wealth funds and pensions.

Andrew Ceresney, Director of the Division of Enforcement of the SEC spoke on May 12, 2016 on the agency’s focus on the PE industry. In his speech, Ceresney pointed out that the industry “has certain unique characteristics, particularly in its investment structure.” He also said, “it is fair to say that the investment structure of private equity and the nature of private equity investments can lend themselves to some of the misconduct that we’ve observed.”

With such complex structures, the regulator’s task of examining and determining how fees and expenses are charged and if they are properly disclosed is not a simple one. Such exams can be lengthy and costly. The SEC’s exams have been focused in three areas; conflicts of interest, disclosures, and allocations of expenses and fees.

The trifecta of conflicts, expenses, and disclosures

In the same speech, Ceresney said that OCIE had observed that over 50 percent of the examined PE fund advisers had compliance problems. The most problematic practices identified were allocation of expenses, hidden fees, disclosures, and issues related to valuation. Ceresney added that the asset management enforcement units had opened investigations where appropriate. Ceresney cited eight enforcement actions and said there were “more to come.”

Almost all of the settled enforcement actions have involved fees, expenses, conflicts of interest, and disclosures.

Another concern surrounds fiduciary obligations under the Investment Advisers Act of 1940. It is a fundamental principle of the 1940 Act that fiduciaries must make full disclosure of all material facts relating to advisory services including conflicts, fees, and expenses and clients understand and give consent to such practices or conflicts. Ceresney signaled that the next round of proceedings against PE managers could focus on failures in this area.

Apollo, KKR, and Blackstone settlements

Four private equity funds affiliated with Apollo Global Management, the $186 billion PE manager settled charges with the SEC last month agreeing to pay $52.7 million to settle charges they misled fund investors about fees and a loan agreement. The SEC said Apollo, which settled without admitting or denying the government’s allegations, was also charged with failing to supervise a senior partner who charged personal expenses to the funds.

Between 2011 and 2015, the SEC said, Apollo failed to adequately disclose benefits they received, to the detriment of investors, by speeding up the payment of fees paid to them by companies in the funds’ portfolios when those companies were sold or became the subject of an initial public offering. Those fees, which the Apollo received in lump sum amounts, reduced the value of those companies prior to their sale or IPO. That, in turn, reduced the amounts available for distribution to investors, the SEC said. Apollo faced a “conflict of interest” it wasn’t making clear to its clients, SEC said in the settlement.

An Apollo spokesman said in a statement, “Apollo seeks to act appropriately and in the best interest of the funds it manages at all times.” Apollo had enhanced its disclosure and compliance related to the matters at issue “long before the SEC inquiry began,” the spokesman added.

One partner at a mid-sized PE firm Thomson Reuters spoke with said, “the SEC’s position that acceleration of monitoring fees should be disclosed in advance of a limited partner’s investment may present an industry-wide issue. This was a very common practice that pre-dates many managers becoming registered.”

Blackstone and Kohlberg Kravis & Roberts (KKR) also settled cases for similar fee monitoring acceleration and disclosure lapses. In the Blackstone settlement the firm agreed to a $39 million settlement of which $29 million will be distributed to investors. “Blackstone voluntarily made changes to the applicable policies well before this inquiry was begun,” a company spokesman said.

In the press release announcing the settlement, Ceresney warned PE industry participants “Full transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses, as Blackstone did here.”

The KKR settlement with the SEC also involved expenses and revolved around allocation of “broken deal” expenses over a six-year period ending in 2011. The nearly $30 million settlement occurred in June 2015 and was the first in the series of cases against the largest PE firms. The period covered in the KKR settlement dated back to 2005 should be noted by industry participants.

WL Ross and others benefit from-self reporting and cooperating

PE firm WL Ross & Co. settled last month with the SEC over its disclosures of fee allocation practices. The SEC said WL Ross voluntarily reimbursed about $11.8 million to certain WL Ross funds and agreed to pay a $2.3 million civil penalty. The firm didn’t admit or deny the SEC’s findings, according to the agency.

Transaction fees that WL Ross receives from portfolio companies result in a reduction of the management fees that the funds pay to the firm. The firm’s limited partnership agreements were “ambiguous” about fee offsets in situations where ownership was shared by multiple funds and other co-investors, the SEC alleged. The fees in question occurred over a 10-year period from 2001 to 2011.The SEC said WL Ross has voluntarily adopted new methodology on fee allocation and noted their cooperation and self-reporting of the issue.

The WL Ross order does not detail how much the penalty amount was reduced because of the self-reporting and cooperation. Essentially the voluntary reimbursement amount effectively fulfills the need for disgorgement and the penalty of $2.3 million is less than a quarter of the calculated harm to investors.

In the Blackstone settlement, the SEC also noted voluntarily and prompt provision of documents and cooperation as well as Blackstone’s willingness to meet many times with the SEC staff. Likewise, in the Apollo case, the SEC stated, “Apollo was extremely prompt and responsive in addressing staff inquiries.” The agency cited the cooperation in its decision to accept Apollo’s settlement offer.

The exact amount of cooperation or self-reporting credit is likely only known by the SEC and possibly the attorneys in negotiating the settlements; regardless, the SEC is sending a clear message encouraging others to self-report and cooperate.


  • PE managers and funds must ensure that investor interests are placed ahead of the management company and principals. They must also exercise caution when offering co-investment opportunities to only selected or preferred parties, as it could be breach of fiduciary duty.


  • Managers should be sure to integrate compliance into overall risk management by developing and implementing compliance procedures that equally empower the chief financial officer, chief compliance officer, and chief operating officer to correct potential conflicts of interest. The addition of a compliance chief to the investment committee is an excellent step to ensure all transactions and investments are monitored and thoroughly scrutinized.


  • Compliance should also be sure that a limited-partners advisory committee is in place. The committee should be informed of all potential conflicts and have a say in the matter.


  • Management of conflicts of interest is a high priority with the SEC. PE managers are more exposed to this than other asset managers because of the unique structure, where the manager holds controlling interests in portfolio companies. Potential pitfalls for a manager include: the receipt of fees, allocation of expenses between managers and portfolio companies and the process of directing portfolio companies to use service providers, buy products, or make financial reports.


  • Valuation is perhaps one of the most difficult and important areas for PE firms. Because the investments are non-public the valuation is critical as it directly relates to performance. Performance affects a manager’s ability to market and raise new capital for a new fund so valuation, performance and marketing all become dependent on each other. PE firms must be sure to establish iron-clad processes, procedures, and controls to manage their valuations and be sure to take extra care as it relates to performance and marketing.

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 9. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence. He has more than 20 years’ experience in the financial industry where he held key positions in trading, operations, accounting, audit, and compliance for broker-dealers, asset managers, and hedge funds.)

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COMMENTARY: How to fix a broken system that fails flood victims Tue, 13 Sep 2016 00:56:51 +0000 By Lawrence Hsieh, Practical Law for Thomson Reuters

(Thomson Reuters Regulatory Intelligence) – A homeowner’s insurance policy covers most disasters, but it won’t cover flood damage. Private insurers long ago deemed flood loss, which accounts for most disaster losses in the United States, as “too big to insure.” So people who live in a flood zone and have a federally-backed mortgage must purchase flood insurance through the National Flood Insurance Program (NFIP), which was established in 1968 to make flood insurance more affordable.

That program has significant flaws, but reform efforts are afoot and may gather steam as rising sea levels increase the potential for catastrophic flood losses.

The NFIP, which is operated by the Federal Emergency Management Agency (FEMA), has had its fair share of bad press. Frontline and NPRrecently reported on the plight of policyholders who are still fighting to have their claims paid, even as they continue to pay premiums on the empty lots where their homes once stood before Hurricane Sandy. Some blame waste and inefficiency, an instinctive reaction to government bureaucracy. Others fault private insurers who partner with the program, and assume no risk but earn fees by selling and servicing NFIP policies and making payout decisions on behalf of the program.

The real culprit is the distorted incentives created by basic structural problems with the program. These structural flaws cause homeowners to take excessive risk, artificially prop up coastal property values, and drive even more development in fragile ecosystems, which ultimately harm consumers and the taxpayers who bail everyone out.

In free-market theory, insurers compete for business and charge premiums based on the likelihood and severity of the insured event. Sound risk-pricing helps to ensure that the premiums collected are sufficient to pay policyholder claims. The NFIP, however, incorporates faulty risk-pricing. Only about 80 percent of NFIP policyholders pay premiums that actually reflect the full risk of anticipated flood losses based on the latest data on storm tides, river flow, and other measurements incorporated in flood hazard maps maintained and updated by FEMA.

The remaining 20 percent pay discounted rates. But the discounts are not pegged to income, which would at least be consistent with the NFIP’s goal of affordability. Rather, the discount is a subsidy for owners — rich or poor — of older buildings that were built before their communities received their first set of flood maps when they joined the NFIP. And grandfathering allows owners to keep paying existing lower rates even when new data shows increased flood risk in areas that were previously mapped.

People who live in flood zones already expect that when floods hit, the government will step in to repair public infrastructure and provide temporary shelter and other disaster relief. In recent years, however, they’ve also come to demand that extra tax dollars be diverted to reclaim and shore up vulnerable beachfront land where development always courted weather disruptions. Factor in the subsidies and grandfathered rates, and policyholders have even more incentive to take excessive risk and rebuild again on unsafe land.

In the meantime, the unsubsidized majority cannot shop around. Most private insurers have been priced out of the market because of the subsidies. They have little incentive to directly insure as long as they can profit with no risk by partnering with the NFIP. While the amount of profit is disputed, FEMA pays its private partners up to one-third of the premiums that FEMA collects from policyholders. In return, the partners sell and service NFIP policies, and make claim payout decisions on behalf of FEMA. If there is a dispute with a policyholder, FEMA pays the partner’s legal fees.

Since FEMA, not the private partners, are on the hook for paying out insurance claims, the private companies would seem to have little incentive to lowball those claims. But the Frontline/NPR investigation highlighted widespread lowballing by the partners on behalf of FEMA. Customer complaints led to FEMA’s decision to reopen thousands of claims for reevaluation. According to Frontline/NPR, some observers speculate that the private partners are motivated to keep NFIP expenses low on behalf of FEMA, which helps to keep the program solvent, and therefore, the partner’s service fee “gravy train” alive. It’s a pretty twisted theory, but hard to verify because one of the biggest problems with the program is the lack of transparency.

Secondary market for insurance risk

Consumers burned by the financial crisis typically look askance at secondary markets. That’s understandable. After all, the banks and their counterparties were neck-deep in the derivatives that spread the risk of bad loan originations across the entire financial system. But private insurers who maintain actuarially sound practices can harness the robust and beneficial secondary market for insurance risk, where commercial reinsurers and capital markets investors vie to reinsure insurance risk. This allows insurers to reallocate risk and manage their reserves. The resulting liquidity helps insurers maintain sound financial health so that they can pay policyholder claims. The competition also helps to lower premiums.

But reinsurers and investors won’t provide cheap liquidity unless the flood market becomes more transparent and adopts sound risk-pricing practices. Without the ability to tap the secondary market, the NFIP will continue to tap the U.S. Treasury any time claims overwhelm premiums like they did after Sandy. FEMA owed taxpayers $23 billion and counting as of November 2015.

Another unintended consequence of the government monopoly is that too many people now view flood insurance as an entitlement. Subsidized policyholders are indignant when the government tries to raise premiums. Most policyholders don’t want to hear that taxpayers absorb the shortfall when policyholders take out more in claim payments than they “pay into” the system in premiums.

The best way to view flood insurance is a cost of coastal living to be borne by the people who choose to live there. And the best solution to flood insurance reform is to follow calls to introduce risk-based pricing, such as those voiced by the head of the Association of Bermuda Insurers and Reinsurers. Risk-based pricing would encourage private insurers to enter the market and compete for our business, for example, by offering actuarially-based discounts to customers who mitigate flood risk. This will allow the government to concentrate on what it does best – provide disaster relief after an emergency.

Current regulatory initiatives

The Homeowner Flood Insurance Affordability Act of 2014 (HFIAA), which mollified constituents by softening some of the market-based reforms introduced in 2012 by the Biggert-Waters Flood Insurance Reform Act, still aims to eventually phase out most subsidies. Phasing out the subsidies will help to break the government monopoly for homeowners who must purchase flood insurance because they live in a designated flood zone and have a federally-backed mortgage.

But phasing out the subsidies will also entice private insurers to grow the market and offer policies to risk averse homeowners who want protection even though they might not have a federally-backed mortgage or might not currently live in a designated flood zone. Many of the areas severely impacted by the recent floods in Louisiana were outside of designated flood zones.

Another potential avenue for the development of a private market is the Flood Insurance Market Parity and Modernization Act (H.R. 2901), which was passed by the House of Representatives in April and awaits consideration in the Senate. The bill aims to foster the growth of the private market by leveling the playing field and allowing some private insurers to offer flood policies that meet the legal requirements for homes purchased with federally-backed mortgages.

Reform would necessarily involve trade-offs. Even if a lot of flood risk moves to the private market, substantial flood risk will remain in the NFIP or its successor as a safety net to help low-income residents in transition. This part of the market by definition will remain subsidized. But a move to actuarially sound risk pricing is the correct first step of the long journey towards flood insurance reform.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 2. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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INSIGHT: U.S. insurance regulators pressured over universal life premium increases Thu, 08 Sep 2016 22:32:43 +0000 By Lawrence Hsieh, Practical Law for Thomson Reuters
 The post-crisis regulatory environment and ultra-low interest rates that ravaged bank proprietary trading desks have also hugely affected the insurance industry. This includes universal life insurance, which offers policyholders a cash value savings component earning tax-deferred interest on top of the death benefit. State insurance regulators face increasing pressure to stop insurers from raising premiums to offset their obligation to make guaranteed interest payments on the savings component at rates that were fixed during the high-interest rate “bubble” of the 1980s and 1990s.

Regulators also must figure out how to deal with insurers who harness captive reinsurance or newly devised transaction structures to upstream dividend payments to shareholders even as they raise policyholder premiums.

Several universal life insurers, including Transamerica, AXA Equitable, and VOYA Financial, who guaranteed a fixed rate of return of at least 4 percent on the savings component during the 1980s and 1990s now face the wrath of policyholders who had hoped to rely on the income in retirement. Policyholders claim in recently filed class action litigation that the insurers breached their contracts by raising premiums upwards of 40 percent to subsidize the increased cost of the guarantees and to recoup past losses. Policyholders argue that the rate increases have essentially rendered their policies underwater – where the cost of the policy exceeds the cash value, thus inducing them to abandon their policies.

Insurers traditionally invest their premiums in corporate or government bonds. The interest earned on the bonds is the return on investment that insurers use to fund the policies that they write. The earnings also help insurers pay claims and overhead, including executive compensation. The profits support share prices and justify dividend payments to shareholders.

Policyholders’ dilemma

Life insurers who promise a high fixed rate of return, however, face a shortfall if there are no high-yield, low-risk bonds available to reinvest in when the old bonds expire. They must fund the shortfall from other sources. One way is to invest in higher yield, higher risk investments such as hedge- and private-equity funds, real estate investments and even aircraft financing. Under the Dodd-Frank regulatory reforms, the “Volcker rule” prohibits depository institutions, but not state-regulated insurers, from making such investments for their own account. The other way is to increase premiums under the policy.

This puts baby boomers locked into these policies since the 1980s and 1990s in a tough spot. The policies continue only as long as cash value is sufficient to cover the monthly deductions that insurers make to pay themselves. But raising monthly deductions threatens to quickly drain the cash value and leave policyholders high and dry. For some policyholders, the least unpalatable decision is to cut their losses by surrendering their policies and giving up their death benefits. They can salvage the remaining cash value, even if they can’t afford to replace the policy with a modern product that is less sensitive to interest-rate risk, such as an indexed universal life insurance policy. Indexed policies link growth to an equity index like the S&P 500, but include a floor that protects against negative returns when the indexes underperform.

Cost of insurance (COI)

The outcome of the litigation ultimately hinges on interpretation of the policy’s contract language related to cost-of-insurance (COI) increases. Insurers will likely argue for an expansive interpretation that gives them the flexibility to increase rates for a variety of reasons. They have argued that the new rates do not exceed the rate capped in the policy.

Policyholders and consumer groups such as the Consumer Federation of America (CFA) generally favor a strict interpretation that allows insurers to raise rates only for the reasons explicitly set out in the contract. For the plaintiffs, rate increases are justified mainly by a clearly demonstrated and unexpected increase in projected policyholder deaths based on current mortality tables. Some policyholders have even argued that insurers inappropriately failed to lower premium rates in response to improved mortality data.

The CFA sent a letter earlier in the year to all state insurance regulators urging them to intervene and stop insurers from raising premium rates to avoid making guaranteed interest payments.

According to J. Robert Hunter, CFA’s Director of Insurance and former Texas Insurance Commissioner, “We haven’t heard from the state regulators on what they plan to do, but I’m not surprised that there hasn’t been a response so far. They have a lot on their plates, but my experience is that regulators typically respond more quickly to industry than to consumer advocacy.”

It will be interesting to see whether state insurance regulators respond with formal regulation before the courts decide the cases. It will also be interesting to see how insurers respond to any regulation or court decisions by changing the way that they draft their COI provisions, and whether consumers will actually pay attention to how any language changes impact the way that they view policy illustrations.

Illustrations are presentations akin to bank stress tests that agents use to show prospective policyholders how the policies will perform under a variety of hypothetical interest rates and other scenarios. As we’ve seen time and again with complicated financial products like adjustable rate mortgages and payday loans, reform won’t make any difference if consumers either don’t understand how the products work or hear only what they want to hear.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own.)

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INSIGHT: In a regulatory era, small U.S. banks are getting some relief Thu, 08 Sep 2016 22:00:23 +0000 (Thomson Reuters Regulatory Intelligence) – While the regulatory pendulum has swung toward the “more” side since since the advent of Dodd-Frank Act in 2010, a relatively new – and less noticeable — counter-trend has emerged toward addressing complaints by smaller banks of disproportionately heavy regulation.


The Independent Community Bankers of America (ICBA), an organization representing locally owned and operated banks in the United States, including many small banks, has argued that regulatory and paperwork requirements impose a disproportionate burden on its members. The burdens reduce their ability to attract capital, support their customers’ credit needs, and ultimately make a profit.

Small bankers have complained about two regulatory areas in particular — “qualified mortgages” that meet abilty-to-pay standards and capital standards.

“The rules on the qualified mortgage, and regulations on risk weight component of Basel III capital standards applicable for commercial real estate loans are considered to be the two most challenging regulatory areas by community bankers,” said Christopher Cole, executive vice president and senior regulatory counsel at ICBA in an interview with Thomson Reuters.

On the qualified mortgage, or QM, rule, banks must face rigorous standards of proof to demonstrate that the loan is not risky. These include documentation of the borrowers’ ability to repay and of the mortgages’ contract structures (such as balloon payments) confirming that there no nonstandard clauses. In other words, regulators have put the onus on the banks from the onset to prove that the loans conform with the QM rule.

The upshot is that the information required to document for each CRE loan’s conformity with the QM may come out to be more costly than the information that the banks routinely collect as part of their own traditional due diligence and monitoring efforts.

Regulatory cost studies have found that the QM rule affects a significant share of mortgage lending by small banks. Such lending represents about 22 percent of total loan portfolio for banks with less than $100 million in assets.

As for the Basel risk-weights, the 50 percent increase from previous Basel risk-weight levels to the current 150 percent risk weight for the particular class of commercial real estate loans known as ‘high-volatility CRE’ have the potential to hit the small banks hard, as most small banks invest relatively heavily in commercial real estate. Indeed, the CRE loans comprise about 50 percent of small bank loan portfolios.


Despite these concerns, however, there is little evidence – with the notable exception of the high-risk mortgage products– of banks discontinuing any of their services or products as a direct consequence of increased regulatory costs.

This is partly because regulators generally craft the rules while keeping in mind that small banks have different business models.

Indeed, a report by the Congressional Research Service noted that regulators are careful in not pursing a “one-size-fits-all” approach. The report noted that the regulators carefully consider the effect of rules on small banks during the rulemaking process.

Regulators have exempted about 90 percent of commercial banks with assets of less than $1 billion from higher capital requirements for example, and excluded multifamily housing mortgages, and construction loans from the definition of high volatility loans.

Overall, the report noted that 13 out of the 14 major rules issued pursuant to the Dodd-Frank Act include an exemption for small banks, or are tailored so as to reduce the compliance cost for them.

Measuring the cost of the regulatory burden

The anecdotal evidence about regulatory cost for small banks is unscientific, and quantifying the cost is difficult, primarily because these banks do not normally separate regulatory costs from other costs in their call reports. Various interviews conducted by regulators indicate that small institutions do not track regulatory costs because it is too time-consuming, costly, and too interwoven into their operations.

In the last few years, however, regulators have devised relatively simple models in an attempt to estimate these costs.

Most notably, a study by the Federal Reserve Bank of Minneapolis created a flexible model in which the only inputs were (i) the number of additional staff hired, and (ii) their compensation. As incomplete as this may be –because it fails to capture the additional “hidden” costs such as compliance-related training expenses, the opportunity costs (time allocation for non-revenue generation activities) and additional costs related to potentially more risk-taking behavior by banks, it nonetheless provides a “bottom line” figure.

The study found a direct increase in marginal cost (hence lower profit margins) as the size of the bank gets smaller. For example, banks with assets below $50 million would experience a drop in their return-on-assets of nearly 23 basis points (and 18 percent of them would become unprofitable as a result), as opposed to larger size ones that would have an 11 basis point or less. No surprise there.

Even under an alternative scenario, where larger firms hire a disproportionally higher number of employees than smaller firms, the smallest group still has a significant share of the newly unprofitable firms, according to the study. This shows, again, that the highest regulatory burden is felt by the smallest banks.

While these findings show that the smallest banks are the most affected by increased regulation, they ignore the contribution that the use of third parties brings to the bottom line. Since most small banks use consultants and vendors in handling work related to some of their regulatory compliance, the real cost may indeed be lower because these contractors can spread out their fixed cost using economies of scale, just like the compliance departments of larger banks.

An emerging counter-trend

In the last few years, regulators have been heeding small bankers’ complaints about their increasing regulatory burden, and sought ways to provide some form of regulatory relief.

Burden recognized

Federal Reserve Chair Janet Yellen has acknowledged on many occasions the different nature of small banks by emphasizing their lack of systemic risk from a macro-prudential perspective, and their disproportionate regulatory load. “We recognize how high the burdens are on community banks, and for our own part we are heavily focused on trying to tailor our regulations,” she said at a Joint Economic Committee hearing last year.

Federal Deposit Insurance Corporation (FDIC) Chairman Martin Gruenberg – as head of the primary federal regulator of community banks — has stated that the FDIC does not support a “push down” of practices from larger to smaller institutions. Indeed, the FDIC has, through constant dialogue via its advisory committee of community bankers, clarifications provided by financial institution letters (“FIL”), tailored its supervisory approach and rulemaking process to the size, complexity, and risk profile of each institution.

Relief provided

In line with these concerns, Fed Governor Daniel Tarullo has called for a tiered approach, where the smaller banks would not be bound by same constraints as their larger counterparts.

Most notable of these initiatives of the tiered approach are the following:

  • the revised capital guidelines for community banks raising the small bank holding company asset threshold from $500 million to $1 billion, thus exempting banks under that level from certain capital rules;
  • an examination program linking examination intensity to the individual community bank’s risk profile (rather than the traditional risk-focused approach) adopted in 2014; and
  • an increase in off-site supervisory oversight while leveraging off of community banks’ electronic records to assess loan quality and underwriting practices.

This last initiative, through its use of electronic pre-examination information exchange, and automation on various parts of the community bank examination process is to reduce the regulatory burden, not only for the community banks but also for their supervisors.

FDIC Vice Chairman Thomas Hoenig also proposed similar regulatory relief for banks without a trading book, non-basic derivatives positions, and a ratio higher than 10 percent of equity-to-assets ratio.

The Consumer Financial Protection Bureau (CFPB) has also eased the regulatory burden when it finalized its QM rule last year, in which it modified the critical definitions of “rural area”, and “small creditor.” These changes allowed a significant regulatory relief for banks with less than $2 billion in assets and that make fewer than 2,000 mortgage loans per year.

There is also a lesser known policy initiative called the economic growth and regulatory paperwork reduction act that stipulates a review of regulation and eliminate those that are outdated, or unnecessary. Tarullo encouraged community bankers to provide suggestions on how to tailor specific regulations to fit their regulatory needs better for the review due to be completed by year-end 2016. Separately, there is a recent congressional initiative underway (supported by the ICBA) aiming to reduce the review’s frequency from 10 to 5 years, and include the CFPB’s rules as well.

Regulatory relief may not be up to their expectations, but in an environment where regulatory burden is ever increasing for their larger counterparts, small banks seem set to benefit from the treatment regulators are carefully according them.

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter@Bora_Yagiz. Email Bora at

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug. 30. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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SEC scrutinizing more sellers of F-Squared portfolios based on bad performance Wed, 31 Aug 2016 19:12:27 +0000 By Richard Satran, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – After charging 13 firms for using discredited marketing claims from the now-defunct investment adviser F-Squared, the Securities and Exchange Commission said it is looking more broadly at other companies that used a portfolio strategy for exchange-traded funds (ETFs) whose claims of market-beating results were based on false data.

The case is the latest action by the SEC in the fastest-growing enforcement category of faulty or incomplete disclosures, signalling the need for compliance to make certain performance data is verified and documented.The agency has made fund disclosures a top examination priority this year.
“The Asset Management Unit continues to investigate and pursue similar enforcement actions against other advisers that potentially misled investors and others with advertisements containing F-Squared’s false historical performance data,” said Anthony S. Kelly, co-chief of the SEC Enforcement Division’s Asset Management Unit.

While the SEC named 13 firms that marketed the discredited F-Squared “AlphaSector” system, many others could face questions. The SEC said in an earlier enforcement action against F-Squared that more than 70 investment firms used the tool at its peak.

The use of portfolio-selection tools has gained popularity as large and small firms have pushed financial advisers to concentrate on client relationships and asset acquisition instead of spending time on stock and fund picking, and to rely more on investment specialists and portfolio managers’ allocation models.

Portfolio selection tools widely used

The F-Squared AlphaSector selection tool initially was launched in the aftermath of the 2008 crash with features aimed at giving sell signals when sectors appeared vulnerable. It became one of the first companies to create a business model by licensing its selection tools. Its performance disclosures showed an enviable record at beating the market with AlphaSector.

But the SEC investigation found the company relied on back-testing and “mock audits” that appeared designed more to bolster marketing efforts than to assess its reliability. Despite claims its performance measures were generated in “live” situations, the company had not derived its results by from independently-verified results.

In addition to performance claims, some of the tools were marketed with special features suited to market trends. F-Squared became one of the hottest investment advisories and the largest licenser of “tactical” ETF allocation tools. It pitched its tool as having safeguards against market downturns, an attractive feature in the aftermath of the crash.

It became highly profitable as investors poured $30 billion into F-Squared assets. But investment firms swiftly began pulling clients’ funds out of the F-Squared funds in 2014 when word spread of an SEC probe into F-Squared. It declared bankruptcy last year and its assets have been auctioned off by receivers.

Algorithm based on college intern’s work

The SEC last week singled out 13 firms that licensed AlphaSector, which the firm admitted used the same misleading data without independent verification. SEC investigators subsequently found that the original “algorithm” used to allocate billions of dollars in assets was based on a simple list of moving averages and other features created by an unnamed college intern at the firm.

“In reality, the algorithm was not even in existence during the seven years of purported performance success,” the SEC reported two years ago when it settled the case with a $35 million fine and an admission of wrongdoing from the firm.

Other firms licensed the AlphaSector and used all or part of the portfolio features and highlighted them in sales efforts over a six-year period.

“These advisers negligently passed many of F-Squared’s claims onto their own clients, who were consequently relying upon false and misleading information when making investment decisions,” said Andrew J. Ceresney, director of the SEC Enforcement Division.

Takeaway: Firms must show documentation of performance claims

The SEC case shows that firms can face enforcement actions over misleading advertising, even when they did not originate the content. In the F-Squared case, many top firms were selling the product and it was frequently cited in press reports as a hot investment tool. The SEC requires that each firm have its own documentation of performance claims on hand to back up marketing claims regardless of how widely the tools have been adopted by the industry.

The SEC F-Squared case also points to a red flag for firms whose brokers go off-script and omit the disclaimers on performance verification in one-on-one meetings and emails. A number of the firms cited last week were cited for this lapse.

“When an investment adviser echoes another firm’s performance claims in its own advertisements, it must verify the information first rather than merely accept it as fact,” said Ceresney.

The agency said in its examination priorities for 2016 that it will look for compliance measures that go beyond printed performance claims for ETF “sales strategies, trading practices, and disclosures involving ETFs.”

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug. 29. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Richard Satran is a financial journalist covering daily and emerging issues for Thomson Reuters Regulatory Intelligence.)

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Whistleblowing practices and severance agreements — what works Tue, 30 Aug 2016 16:25:04 +0000 By Julie DiMauro, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – Through their enforcement actions, policy initiatives and press releases, United States regulators are showing what effective whistleblowing practices look like, and why their importance is growing.

Although many firms probably already have a whistleblowing policy in place, maybe even a confidential whistleblowing hotline, such steps may not be enough to satisfy critical regulatory imperatives.

Employers continue to be penalized for including language in its severance agreements requiring outgoing employees to agree to waive their right to file a whistleblower complaint with the Securities and Exchange Commission, an impermissible impediment to employees exercising their right to communicate directly with the SEC about a possible law violation.

It might seem clear that a process for the proper escalation of concerns helps a company and industry as a whole, but people are only going to act if they feel comfortable doing so. The idea of whistleblowing is not always seen positively; it’s ratting on your colleagues or career suicide, many believe.

With this in mind, regulators are increasingly telling firms, particularly in light of a couple recent enforcement actions: Ensure one’s employees can easily and comfortably speak up.

U.S. events, surveys and cases

The 2010 Dodd-Frank Act established whistleblower programs for both the SEC and the Commodity Futures Trading Commission. Whistleblowers who provide unique and useful information to the SEC can collect 10 percent to 30 percent of a penalty when it exceeds $1 million.

Under the SEC program, the commission has broad international reach. It offers eligible whistleblowers the ability to report anonymously and earn substantial monetary awards, regardless of nationality.

The SEC said last year that tipsters who report their whistleblower information to the company first are protected from retaliation claims, but an appeals court ruled in 2014 that that particular protection does not apply to employees in other countries.

To ensure that adequate funds are available to pay awards, Congress has established a replenishing Investor Protection Fund.

In February of this year, the Securities and Exchange Commission (SEC) reviewed the its 2015 whistleblower awards and the status of its whistleblower cooperation program.

Attempting to address skepticism surrounding the benefits of cooperation, the SEC indicated that it would keep using cooperation incentives such as non-prosecution agreements (NPAs), deferred prosecution agreements (DPAs) and penalty reductions for self-reporting.

The SEC’s Office of the Whistleblower received nearly 4,000 tips in 2015, up 30 percent since 2012, and it awarded more than $37 million to whistleblowers. The single largest award that year was $30 million, a record which still stands.

The SEC’s cooperation program extends the most credit to early self-reporters of corporate misconduct; companies that decide against self-reporting run the risk of a whistleblower informing the SEC about the misconduct.

The benefits of cooperation can include flexibility on charging decisions, lower monetary penalties, reduced suspensions, or a public reference to the cooperation in litigation or a settlement press release.

Evaluating cooperation and determining how to reward it, remains largely with the SEC’s staff. Awards can be sizable and attract significant attention, even though the identities of those reporting are concealed.

Big awards

The SEC announced in May that it would award between $5 million and $6 million to a whistleblower whose detailed information led the agency to uncover securities violations that would have been “nearly impossible to detect” without the company insider’s help.

The award is the third highest under the SEC whistleblower program since it began in 2011, and closely followed another whistleblower award of over $3.5 million granted a week earlier.

Severance agreements

Earlier this month, the SEC charged Atlanta-based building products company, BlueLinx Holdings Inc., for using severance agreements that violated U.S. securities law by requiring outgoing employees to waive their rights to a monetary recovery if they filed a complaint with the SEC or other agencies. Under the monetary-recovery provision, employees leaving the company were forced to waive possible whistleblower awards or risk losing their severance payments and other benefits, the SEC said.

BlueLinx added the provision nearly two years after the SEC adopted Rule 21F-17, which prohibits any action to impede someone from communicating with the SEC about possible securities-law violations, the SEC said.

The company, without admitting or denying the SEC’s findings, agreed to pay a $265,000 penalty, amend its severance agreements, and contact former employees who signed the restrictive provisions.

The use of illegal confidentiality agreements showcases an effort to prevent employees from speaking out against misconduct.

Less than a week following that case, the SEC filed civil charges against Health Net Inc. for inserting language into its severance agreements preventing outgoing employees from reaping the benefits of government whistleblower awards.

The Commission said Health Net must pay $340,000 to settle the charges without admitting or denying wrongdoing.

In a case entitled In the Matter of KBR, Inc., the SEC charged KBR for using overly restrictive language in confidentiality agreements to hinder whistleblowers. The agreements, which the company required witnesses in internal investigations to sign, threatened disciplinary action or termination if the employees discussed the matters with outside parties without first gaining approval from KBR’s legal department.

In another case against Merrill Lynch in June 2016, the commission again outlawed employer-imposed agreements that placed restrictions on employees’ ability to disclose information to government agencies, such as those only allowing disclosure if required by law, in response to a subpoena, or with the company’s permission.

In a 2015 survey of U.S. and UK financial services professionals conducted by Labaton Sucharow LLP and the University of Notre Dame, one in every five respondents believed their company’s confidentiality policies and procedures barred the reporting of potential illegal or unethical activities directly to law enforcement or regulatory authorities.

Critical part of compliance program

Individuals whose principal duties involve compliance or internal audit responsibilities generally are excluded from award eligibility unless an exception applies.

But in April 2015, the commission awarded more than $1 million to a compliance professional who provided information that helped the SEC in an enforcement action against the whistleblower’s company

Here, the SEC determined the whistleblower’s information was still “original information” under the whistleblower rules. The grounds were that the whistleblower had a reasonable basis to believe that telling the SEC was necessary to prevent the firm from engaging in conduct likely to substantially harm the firm or investors.

Although the Commission previously rewarded individual with compliance or internal audit functions, this was the first time it had used the “substantial injury” exception.

The SEC notes that its whistleblower program was designed to complement, rather than replace, existing corporate compliance programs.

While it provides incentives for insiders and others with information about unlawful conduct to come forward, it also encourages them to work within their company’s own compliance structure, if possible.

When submitting a tip to the SEC, whistleblowers are asked to identify the nature of their complaint allegations. For 2015, the most common complaint categories reported by whistleblowers included corporate disclosures and financials (17.5 percent), offering fraud (15.6 percent), and manipulation (12.3 percent).

As the SEC’s whistleblower office advises, the more specific, credible, and timely a whistleblower tip is, the more likely it will be forwarded to SEC enforcement staff for further follow-up or investigation.

As federal agencies and Congress have made clear, and the recent BlueLink case holds, corporate entities cannot obstruct an individual’s fundamental right to freely engage with his or her government.

Best practices for regulated companies

Passed by Congress in Rule 21F-17(a) provides: “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement … with respect to such communications.”

Unlike general anti-retaliation provisions, this rule comes into play when a company attempts to block or deter an individual from providing information to the SEC and cooperating in the agency’s investigation of that information. The rule is often violated well before an individual experiences any actionable retaliation.

Whistleblower advocates express concern that that some of those who enter into separation agreements with their employers to obtain severance or other benefits are whistleblowers or could become ones. Such agreements are routinely presented to employees.

They require that the employee release any legal claims against the company in exchange for whatever benefits the company provides. Countless employees sign such agreements in the United States every year, and often without the advice of counsel.

In the BlueLinx case, the SEC has made clearer what will constitute an unlawful impediment that employers cannot use to discourage employees from reporting securities violations and participating in the whistleblower Program.

To avoid any such attention from the SEC, companies should review their employee agreements with an eye toward:

  • Using restrictive covenants only to protect actual trade secrets;
  • Agreeing to include certain provisions in all severance agreements. As per the SEC’s order, BlueLinx agreed to include a certain provision in all of its severance agreements, and it is illustrative of the Congress’ and the Commission’s intentions behind Rule 21F-17(a) and instructive to other companies.Specifically, the provision states that the employee understands that nothing the agreement does not limit the employee’s ability to file a charge or complaint with the Equal Employment Opportunity Commission, the National Labor Relations Board, the Occupational Safety and Health Administration, the Securities and Exchange Commission or any other federal, state or local governmental agency or commission.
  • Making an exception for an employee’s right to communicate directly with federal and state agencies about possible legal violations committed by the employer or its agents in any confidentiality clause of a severance agreement.If the company mentions going to the the general counsel of the business about such possible violations, the commission will look at whether it has informed employees of their right to report to such outside entities.
  • Keeping out of any severance agreements any statement or implication that a departing employee cannot recover any bounty award from the SEC that is separate and distinct from any severance pay the employer has agreed to provide to the individual.Having one’s signature on such an agreement serve as a waiver of any right to other money from the employer — as opposed to recovering an award paid by the SEC — remains unaffected by Rule 21F-17(a).


(Julie DiMauro is a regulatory intelligence and e-learning expert in the GRC division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug. 16 (UPDATED Aug. 25). Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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