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In a decision last month, the California Court of Appeals may have opened the door for brokers to bypass the Financial Industry Regulatory Authority’s (FINRA) rigid expungement rules in order to remove matters from their CRD records. Currently, brokers must abide by Rule 2080 in order to expunge their records. The FINRA rule allows for expungement only upon meeting one of three tests: (1) the claim is factually impossible, (2) the broker was not involved in the conduct or (3) the information is false. The rule states that a broker who seeks expungement “must obtain an order from a court of competent jurisdiction directing such expungement or confirming an arbitration award containing expungement relief.”

In its recent decision, the California Court of Appeals held that a court may expunge a broker’s CRD record in the interest of fairness and equity, regardless of FINRA’s rule. Edwin Lickiss filed a petition in the court in April 2011 seeking expungement of 17 customer complaints and a regulatory action from his CRD record claiming that they were old and irrelevant and negatively affected his profession. The customer complaints against Mr. Lickiss had resulted in total payments of $831,000, and Mr. Lickiss was required to personally pay a $5,000 settlement. FINRA objected to Mr. Lickiss’s expungement request, stating that he was trying to “sanitize his record and prevent regulators, brokerage firms and investors from learning of this history for what amounts to ‘time served.'” The trial court dismissed the complaint, citing the requirements of Rule 2080. The court of appeals reversed the trial court’s decision, holding that it should have looked to equitable principles instead of FINRA rules.
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The North American Securities Administrators Association (NASAA) released preliminary numbers this month showing that the number of enforcement cases brought by state regulators doubled during 2011. During that year, states brought about 400 cases compared to 208 cases brought during 2010. This increase is due in large part to an expansion of state examinations as a result of the Dodd-Frank financial reform law. Dodd-Frank gave the states examination authority for some approximately 2,400 “mid-sized” advisers (firms with less than $100 million in assets under management) which are required to switch from SEC to state registration.

As a result of the switch, some former SEC firms that haven’t been examined in many years, if ever, by the SEC now find themselves subject to a state examination and can also look forward to being examined by the state more frequently.
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Proposed legislation designed to create a self-regulatory organization (SRO) for investment advisers may not be acted on during this Congressional session, according to its sponsor, Rep. Spencer Bachus (D-Ala.). Rep. Bachus, Chairman of the House Financial Services Committee, said earlier this week that no consensus has developed regarding any proposal relating to enhancing investment adviser oversight and that, therefore, no action is imminent.

There has been increasing interest and legislative activity over the past several months relating to investment adviser examinations. While there is almost universal agreement that examination coverage should be increased, there is a sharp division among industry members, regulators and legislators about how to accomplish that goal.

Most observers agree that Rep. Bachus’s bill, if passed, would lead to the Financial Regulatory Authority (FINRA) becoming the SRO for investment advisers. Adviser organizations have split over supporting the bill, with the Financial Services Institute (FSI) as a supporter, and the Investment Adviser Association (IAA) and the American Institute of CPAs strongly opposed. Other investment adviser organizations have also come out in opposition to the Bachus bill, as has the North American Securities Administrators Association (NASAA).
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According to an InvestmentNews poll, 58.7% of 293 advisers who responded to a recent survey support the option of the Securities and Exchange Commission (SEC) charging user fees to defray the costs of increased examinations. This is an increase from a year ago when only 27.8% of 335 responding advisers supported the user fee approach. The poll also concluded that 74.7% of advisers said they oppose permitting the Financial Regulatory Authority (FINRA) from becoming the self regulatory organization (SRO) for advisers.

The increased willingness of advisers to pay user fees suggests that there could be more support for the bill soon to be introduced by Rep. Maxine Waters (D-CA) that would authorize the SEC to charge user fees for advisers to cover or defray the costs of examinations. Rep. Waters’s bill would combat the SRO bill introduced by Rep. Spencer Bachus (R-Al) and Carolyn McCarthy (D-NY).
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The Financial Industry Regulatory Authority (FINRA) released a Regulatory Notice in May clarifying its new suitability rule, Rule 2111. The rule, which was approved by the Securities and Exchange Commission (SEC) in November 2010, will be implemented on July 9, 2012. The Notice is intended to answer industry questions and provide guidance on the new rule.

According to FINRA, the new rule imposes the same obligations as the predecessor rule and related case law. It is intended to clarify and codify three main suitability obligations.

The first obligation is reasonable-basis suitability, which has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.

The second obligation is customer-specific suitability, in which the broker must have a reasonable basis to believe that a recommendation of a security or investment strategy is suitable for the particular customer based on the customer’s investment profile.
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The Securities and Exchange Commission (SEC) approved the Financial Industry Regulatory Authority’s (FINRA) Rule 5123 on June 7, 2012. The text of the final rule can be found here. The rule is creates some obligations for broker-dealers when they are engaged in selling private placements of securities. Due to a number of concerns, the SEC did not approve the rule until FINRA made a number of changes to the originally proposed rule. The final rule, which includes three amendments, was approved on an accelerated basis. The rule does not apply to all private placements. Sales to institutional accounts, qualified purchasers, investment companies, and other classes of purchasers are excluded.

The original proposal would have required broker-dealers involved in a private placement transaction to disclose to each of the investors prior to the sale the anticipated use of the proceeds from the offerings and the amount and type of offering expenses and offering compensation. If the disclosure documents did not include this information, the broker-dealer would have had to create a document for the investor containing the information. The proposal also required each broker-dealer to file the document with FINRA within fifteen days of the date of the first sale. If there were any amendments to the documents, then the amendments would also have to be filed with FINRA within fifteen days.
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Rhode Island has substantially adopted its proposed private fund adviser exemption, which we previously discussed in a posting dated April 10, 2012. The new rule became effective on May 17, 2012. To qualify for the exemption, the adviser must advise only private funds as defined under SEC Rule 203(m)-1. Furthermore, if it advises non venture capital 3(c)(1) funds, for each such fund:

  • The fund’s beneficial owners must meet the definition of a “qualified client” as defined in SEC Rule 205-3 after deducting the value of the primary residence;
  • The private fund adviser has to disclose the following information in writing to each beneficial owner: (1) all service, if any, to be provided to beneficial owners, (2) all duties owed to beneficial owners, and (3) any other material information affecting the rights or responsibilities of the beneficial owners; and
  • The adviser, on an annual basis, must obtain audited financial statements of each fund and provide a copy to the beneficial owner.

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The Financial Services Institute (FSI) Chair, Joe Russo, recently released a letter stating that the FSI supports the Financial Industry Regulatory Authority (FINRA) as the new self-regulatory organization (SRO) for investment advisers. Russo stated that the FSI has conducted two polls of its financial adviser members to determine whether they support FINRA as the SRO and 75% agreed that FINRA should become the SRO.

FSI has been asked by a number of critics why it has not advocated repealing the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response, FSI says that the act will likely not be repealed as a practical matter. Therefore, FSI has decided to focus its legislative efforts on securing for its members the least intrusive of the three options for investment adviser regulation posed by the Securities and Exchange Commission (SEC). Those options are (1) the SEC charging user fees to fund more examiners, (2) FINRA becoming the dual SRO for broker-dealers and investment advisers, or (3) creating a new SRO.
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As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Government Accountability Office (GAO), a non-partisan investigative agency of Congress, conducted a study which criticized the Securities and Exchange Commission’s (SEC) oversight of the Financial Industry Regulatory Authority (FINRA). The purpose of the study was to determine how the SEC has conducted its oversight of FINRA, including the effectiveness of FINRA rules, and how the SEC plans to enhance its oversight.

The GAO found that both the SEC and FINRA do not conduct retrospective reviews of the impact of FINRA’s rules. As a result, the GAO believes that “FINRA may be missing an opportunity to systematically assess whether its rules are achieving their intended purpose and take appropriate action, such as maintaining rules that are effective and modifying or repealing rules that are ineffective or burdensome.” The GAO also noted that the SEC does not conduct sufficient oversight over FINRA’s governance and executive compensation. The SEC has responded to the survey by saying that it is focused primarily on oversight of FINRA’s regulatory departments, which the SEC claims has the biggest impact on investors.
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Commissioner Luis A. Aguilar of the Securities and Exchange Commission (SEC) spoke at the recent NASAA/SEC Rule 19(d) Conference in Washington D.C. He addressed the importance of cooperation and collaboration between federal and state securities regulatory agencies in order to improve investor protection. Commissioner Aguilar also expressed a desire to have a continuing collaborative relationship between the SEC and the North American Securities Administrators Association (NASAA). “I continue to be interested in exploring more opportunities and avenues for the SEC and NASAA to partner and leverage our collective resources to protect investors,” Commissioner Aguilar said, “At a time when regulators are under greater constraints than ever, it makes sense for us to come closer together to further our common goals.”

Commissioner Aguilar discussed four areas in which the SEC and NASAA have worked together to improve investor protection. These areas include the transition of advisers to state regulation, crowdfunding, financial exploitation of the elderly and the creation of the Investor Advisory Committee.
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