Securities Industry Commentator by Bill Singer Esq

October 29, 2020

SEC Adopts Modernized Regulatory Framework for Derivatives Use by Registered Funds and Business Development Companies (SEC Release)
What's the difference between a regulatory Bar and a regulatory Suspension? Many would answer that a Bar begins on a date certain but does not end on a date certain; whereas, a suspension begins on a date certain and ends on a date certain. With some suspensions, however, you become subject to a statutory disqualification, which, if you think about it, is a variation on the theme of a bar. Nonetheless, the general idea behind a Bar is that you're out of the business. Can you get back in? Sometimes, yes. Sometimes, no. It all sort of depends. Depends on what exactly? Ahhh . . . now there's the rub. Consider the petitions to the Securities and Exchange Commission by a barred individual.

Two Admit to Using Casinos to Facilitate Financial Crime (DOJ Release)
Fan Wang pled guilty in the United States District Court for the Southern District of California to operating an unlicensed money transmitting business; and, as part of his plea agreement, he will forfeit $225,000.  As alleged in part in the DOJ Release:

[W]ang sold hard currency in U.S. dollars that he collected from various third parties.  His customers were typically individuals with bank accounts in China who could not readily access cash in the United States due to capital controls that cap the amount of Chinese yuan that an individual can convert to foreign currency.  Often these customers needed the money to gamble at the casinos in Las Vegas and elsewhere. Upon receiving U.S. dollars, the customers would transfer from a Chinese bank account an equivalent value in yuan, over their mobile phones in the United States, to a separate bank account in China designated by Wang.  As part of a typical money exchange transaction, Wang was introduced to his customers by a casino host whose job it was to facilitate that customer's play at a particular casino.  The customer then used the U.S. currency to gamble.

This start-up promised higher interest rates on savings. Now some customers are struggling to get their money back (CNBC by Lorie Konish, Scott Cohn, and Dawn Giel)
Wow, wow, and wow!!! Just a superb bit of old-fashioned reporting by CNBC's Konish, Cohn, and Giel. A stunning into the mobile, high-interest-paying Beam Financial, which seems to be having problems when asked to refund customers' deposits. And as folks take a second look at Beam, it's becoming less clear as to just exactly what the company is and isn't. It sorta looks like a bank but it's not or it is or, well . . . and that's fueling the fires of consumer complaints. 

Feds accuse Visa consultant of stonewalling on documents as legal wrangling heats up in antitrust investigation into Visa acquisition of Plaid / Visa paid Bain & Co. for insights on competitive position and pricing. The DOJ says it has a right to documents as part of its antitrust investigation (RIABiz by Oisin Breen)
The high-profile fintech acquisition by Visa of Plaid has run into the formidable wall of a Department of Justice investigation. RIABiz's Oisin Breen does his usual wonderful job of putting the disparate pieces together. 

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, William T. Burke submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. The AWC alleges that William T. Burke entered the industry in 1984, was first registered in 1988, and by February 2003, he was registered with FTN Financial Securities Corp. ("FTN"), where he remained until October 2019. The AWC alleges that Burke "does not have any disciplinary history." In accordance with the terms of the AWC, FINRA found that Burke had violated FINRA Rules 3270 and 2010, and the self-regulatory imposed upon him a $5,000 fine and a one-month suspension with any FINRA member in any capacity. In part the AWC alleges that:

In July 2011, Burke formed Burke Development Associates Limited Liability Company (BDA), a family-run real-estate and construction business. Before forming BDA, Burke disclosed the venture to personnel at FTN, but only in a single, brief oral conversation, without submitting FTN's required outside business activity disclosure form. In his oral disclosure, Burke stated he would merely invest in BDA leading FTN personnel to believe that he would be a passive investor, when he was not. Notably, Burke did not disclose that he would be BDA's sole managing member and tax matters partner, have signatory authority over BDA's financial accounts, devote approximately five to ten hours per month to BDA business, supervise BDA's activities, and participate in strategic business decisions.

Bill Singer's Comment: I don't like this settlement because it strikes me as ticky-tacky given that Burke's cited outside business activities was initiated in 2011, nearly a decade ago. Given the ages of the alleged misconduct, it gets a tad silly trying to argue that the belated imposition of a fine and suspension will rectify the violations, and FINRA seems to gloss over the mitigating fact that Burke did, indeed, have an oral conversation about the OBA notwithstanding that it may have been a single, brief conversation. I mean, c'mon, 5 to 10 hours a month on this alleged OBA works out to something like 10 to 20 minutes a day over the span of a 30-day month. That's a little too precious for me to warrant a $5,000 fine and one-month on the sidelines.

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Andrew J. LeBlanc II submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. The AWC alleges that Andrew J. LeBlanc II was first registered in 1995 with Merrill Lynch, Pierce, Fenner & Smith, where he remained until April 2017. The AWC alleges that LeBlanc "does not have any disciplinary history with the Securities and Exchange Commission, any state securities regulators, FINRA, or any other self-regulatory organization." In accordance with the terms of the AWC, FINRA found that LeBlanc had violated NASD Rule 2040 and FINRA Rule 2010, and the self-regulatory imposed upon him a $20,000 fine and a six-month suspension with any FINRA member in all capacities. In part the AWC alleges that:

Between January 2012 and August 2013, LeBlanc participated in two private securities transactions involving $1.75 million in securities. First, LeBlanc participated in the purchase by a customer of a $500,000 membership interest in a closely held film company organized as an LLC. Second, LeBlanc participated in the sale of $1.25 million in preferred stock in a closely held men's apparel company to an investor group consisting of the first customer and two other customers. He used the firm's email system to participate in these transactions. 

LeBlanc neither originated the customers' investments nor did he recommend that the customers purchase the securities. However, he participated in the purchases by arranging for and attending a meeting between the first customer and the president of the closely held LLC, and by attending a meeting between the two other customers and a major shareholder of the second company. He received legal documentation from the customers' attorney and forwarded that documentation to his clients. He was instructed by two of his clients to pay for the investments from their firm accounts. He also discussed the investments with executives of both companies; the customers; and the customers' attorney. Although the companies are still operating, the three customers are unlikely to receive any return on these investments. 

All three customers were pre-existing customers of the firm at the time of the sales; were experienced investors, had a high net worth, and, in connection with these investments, were represented by counsel. LeBlanc received no compensation for his participation in the transactions. LeBlanc did not provide written notice to the firm prior to his participation in the private securities transactions, as required by NASD Rule 3040 and the firm's written supervisory procedures. During June 2013 and May 2014, LeBlanc also failed to list his involvement with these private investments on Firm annual certifications calling for him to disclose his involvement with securities transactions away from the firm.

Bill Singer's Comment: I don't like this settlement because it strikes me as ticky-tacky given that LeBlanc's cited private securities transactions took place in 2012 and 2013, over seven to eight years ago. Given the ages of the alleged misconduct, it gets a tad silly trying to argue that the belated imposition of a fine and suspension will rectify the violations. On the other hand, not wanting to be a hypocrite, I will give FINRA full credit and a doff of my cap for adding this commentary in the AWC:

In determining the appropriate sanction in this matter, FINRA considered, among other factors, that (1) the customers were each experienced investors, had a high net worth, and were represented by counsel in these transactions; (2) LeBlanc did not recommend the investments, but rather facilitated transactions that the customers themselves wanted to make; and (3) LeBlanc was not compensated for his role in the transactions.

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, National Securities Corporation submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. The AWC alleges that National Securities Corporation has been a FINRA member firm since 1947 with about 660 registered representatives at 130 branches.. The AWC alleges the following "Relevant Disciplinary History":

  • On December 4, 2014, FINRA accepted an AWC in which National Securities was censured and fined $35,000 for failing to timely file amendments to Uniform Applications for Securities Industry Registration or Transfer (Forms U4) and Uniform Termination Notices for Securities Industry Registration (Forms U5), failing to comply with filing requirements for reporting statistical and summary information regarding complaints and settlements, and failing to enforce its written supervisory procedures for compliance with these obligations. 

  • On February 1, 2011, FINRA accepted an Offer of Settlement in which National Securities was censured and fined $22,500 for failing to file amendments to Forms U4, failing to timely file and filing inaccurate amendments to Forms U4 and U5, and failing to comply with filing requirements for reporting statistical and summary information regarding complaints. 

  • On December 17, 2002, FINRA's predecessor NASD accepted an AWC in which National Securities was censured and fined $32,500 for, among other things, failing to file amendments to Forms U4 and U5 and failing to supervise its timely reporting of customer complaints and settlements on Forms U4 and U5.
In accordance with the terms of the AWC, FINRA found that National Securities had violated Article V, Sections 2 and 3 of FINRA's By-Laws and FINRA Rules 1122, 3110, 4530 and 2010.; and the self regulator imposed upon the firm a Censure and $125,000 fine. As alleged in part in the AWC: 

Between May 2015 and November 2018, National Securities filed four late amendments to Forms U4 and eight late amendments to Forms U5 relating to reportable customer complaints and an unsatisfied judgment. The firm knew about each of these events but was between one month and two years late in disclosing them, with an average delay of more than 13 months, and often did not disclose them until after FINRA inquiry. The firm also failed to file five Form U4 amendments relating to reportable customer complaints during this period.
. . .
Between May 2015 and November 2018, National Securities failed to comply with its reporting obligations under FINRA Rule 4530. The firm reported a $30,000 settlement of a customer's claim for damages against one of its associated persons for sales practice violations a year late. The firm also failed to report, or failed to report timely, statistical and summary information to FINRA regarding 19 written customer complaints. In addition, the firm submitted 34 inaccurate or incomplete filings required by FINRA Rule 4530(d).
. . . 
Between May 2015 and November 2018, National Securities had written procedures in place regarding the firm's obligations to collect and report information to FINRA on Forms U4 and U5 and as required by FINRA Rule 4530. However, National Securities failed to enforce these procedures to ensure the timely and accurate filing of required information. The failure to enforce the firm's procedures occurred for various reasons. In some instances, firm personnel failed to identify the communication at issue as a complaint or incorrectly determined that a customer complaint was not a reportable event. In other instances, firm personnel failed to timely review and process customer complaints in accordance with firm procedures. On certain other occasions, the firm's registration group entered the wrong problem code or failed to identify the subject security in a FINRA Rule 4530 filing.
. . .
From July 2015 through March 2017, National Securities derived nearly 25 percent of its revenue from underwriting activity and participated in at least 20 contingency offerings. Although the firm maintained written supervisory procedures addressing contingency offerings under Exchange Act Section 10(b) and Rule 10b-9, these written procedures were limited in that they only covered escrow requirements and the return of funds where a contingency was not met by the closing date. The firm's written procedures failed to address circumstances involving material changes to an offering such as the extension of an offering, a change in the contingency amount, or a change in the structure. The written procedures also were silent on non bona-fide sales, which are prohibited by the Rule absent required disclosures. National Securities revised its written procedures in March 2017.

Rule 18f-4 provides certain exemptions from the Act subject to conditions. The conditions and other elements of the rule include the following:

  • Derivatives Risk Management Program. The new rule generally requires a fund to implement a written derivatives risk management program. The program will institute a standardized risk management framework for funds, while also permitting principles-based tailoring by each fund to the fund's particular risks. The program must include risk guidelines as well as stress testing, backtesting, internal reporting and escalation, and program review elements. A derivatives risk manager approved by the fund's board of directors will administer the program. The fund's derivatives risk manager will have to report to the fund's board on the derivatives risk management program's implementation and effectiveness to facilitate the board's oversight of the fund's derivatives risk management. 
  • Limit on Fund Leverage Risk. A fund relying on the rule generally must comply with an outer limit on fund leverage risk based on value-at-risk, or "VaR." This outer limit is based on a relative VaR test that compares the fund's VaR to the VaR of a "designated reference portfolio" for that fund. A fund generally can use either an index that meets certain requirements or the fund's own securities portfolio (excluding derivatives transactions) as its designated reference portfolio. If the fund's derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test. The fund's VaR generally is not permitted to exceed 200% of the VaR of the fund's designated reference portfolio under the relative VaR test or 20% of the fund's net assets under the absolute VaR test. 
  • Exception for Limited Users of Derivatives. The rule provides an exception from the program and VaR test requirements provided that the fund adopts and implements written policies and procedures reasonably designed to manage its derivatives risks. A fund may rely on this exception if the fund's derivatives exposure is limited to 10% of its net assets, excluding certain currency and interest rate hedging transactions. 
  • Alternative Requirements for Certain Leveraged /Inverse Funds. Leveraged/inverse funds will generally be subject to rule 18f-4 like other funds, including the requirement to comply with the VaR-based limit on fund leverage risk. This will effectively limit leveraged or inverse funds' targeted daily return to 200% of the return (or inverse of the return) of the fund's underlying index. The final rule provides an exception from the VaR requirement for leveraged or inverse funds currently in operation that seek an investment return above 200% of the return (or inverse of the return) of the fund's underlying index and satisfy certain conditions. 
  • Reverse Repurchase Agreements and Unfunded Commitment Agreements. The rule permits a fund to enter into reverse repurchase agreements and similar financing transactions, as well as "unfunded commitments" to make certain loans or investments, subject to conditions tailored to these transactions. 
  • When-Issued, Forward-Settling, and Non-Standard Settlement Cycle Securities. The rule permits funds, as well as money market funds, to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to conditions. 
  • Recordkeeping. The rule requires that the fund comply with certain recordkeeping requirements.
Modernizing the Regulatory Framework for Funds' Use of Derivatives (Statement by SEC Chair Jay Clayton)
SEC Chair Clayton states in part that:

[D]erivatives have proven useful to funds in the face of wider market developments, and in certain cases can strengthen funds' ability to compete.  The resulting return enhancements and cost savings should inure to the benefit of investors, particularly where there is transparent competition among funds.  However, we cannot lose sight of the fact that, regardless of their principal purpose, derivatives can and often do create the type of exposure, including the risk of significant losses to fund investors, that the section 18 restriction on "senior securities" was intended to limit. 

So, our task is to continue to permit funds to use derivatives in a manner that best serves the investment objectives of the fund (including its liquidity and risk management polices) while addressing the concerns underlying section 18; and to do so in a manner that provides clarity and consistency.  . .
SEC Commissioner Peirce states in part that:

[W]e should have taken other opportunities to recognize the diversity of knowledge and differences across fund strategies by further empowering funds and advisers to tailor how they manage and monitor derivatives-related risk.

Despite my concerns, there is much to commend this rule, both in its general approach and in its specifics. I appreciate, for instance, the commonsense exception from the rule's coverage for funds that limit their derivative exposures to 10 percent of their net assets. In addition, in response to some commenters who, using the volatile markets of last spring as a highly informative analytical canvas, urged us to rethink the proposed relative and absolute VaR limits, the rule increases them from 150 percent and 15 percent to 200 percent and 20 percent, respectively. Also welcome is the revision to the proposed reporting obligations for a fund that exceeds its VaR limit. Relatedly, I am glad to see the extension of the remediation period, the removal of the proposed prohibition on derivatives transactions for funds that go above their VaR limit, and the elimination of the proposed restrictions on a fund's ability to enter into derivatives transactions while out of compliance. The final rule appropriately provides funds flexibility to manage through stressed markets without an arbitrary regulatory hammer hanging over them threatening harm to funds, fund shareholders, and the broader markets.

Statement on Regulation of Funds' Use of Derivatives (SEC Commissioner Elad L. Roisman)
SEC Commissioner Roisman states in part that [Ed: footnotes omitted]:

I am pleased to see that this final recommendation does not include the proposed sales practice rules that would have applied only to leveraged and inverse, or "geared," ETFs. I believe that, to the greatest extent possible, the Commission should maintain a consistent regulatory approach to the products we oversee. Instead, these proposed rules would have introduced a new layer of regulation applicable to only a narrow subset of securities products.

Statement on the Final Rule on Fund's Use of Derivatives (SEC Commissioner Allison Herren Lee)
SEC Commissioner Lee states in part that [Ed: footnotes omitted]:

As the proposal explained, the effects of portfolio rebalancing and compounding in these products can cause a fund's returns to vary substantially from the performance of the underlying index, especially over periods of time that exceed the fund's investment time horizon, which is typically one day. Investors holding shares of these funds over a longer period of time may suffer large and unexpected losses or returns that otherwise substantially deviate from what they reasonably anticipated.

The Commission's concern about leveraged and inverse ETFs is not academic or theoretical. Numerous enforcement cases, both at the Commission and FINRA, have shown that even investment professionals often lack a basic understanding of these complex products. The problem is even more pronounced in self-directed brokerages, where investors do not currently have the benefit of an intermediary to help them understand and evaluate the risks.

Today, the Commission pulls this important protection out of the final rule, pointing to what it describes as "unique challenges" and attempting to justify inaction, at least in part, by suggesting that the proposed sales practice rules might have been under-inclusive. Indeed, other types of complex products not addressed by the proposed rules are known to cause similar harm to unsophisticated retail investors. That view is confirmed in the statement that the Chairman and Division directors issued this morning, but that does not justify or explain why we decline to act now to protect retail investors in leveraged and inverse ETFs, given that the Commission had already preliminarily concluded in its proposal that these protections are needed. The fact that other products present similar dangers should not deter us from addressing the harm to retirees, middle class savers, and other retail investors that is presently and squarely before us.

Statement on Funds' Use of Derivatives (SEC Commissioner Caroline A. Crenshaw)
SEC Commissioner Crenshaw states in part that [Ed: footnotes omitted]:

The use of derivatives, the focus of today's rule, can present an inordinate amount of risk to funds and the investors who hold them,[3] particularly in the face of market volatility. Yet during this global pandemic, as we have seen increased trading in some of these products, we have failed to address the significant risk that derivatives can pose to funds and investors.  One of our core mandates is to protect investors - including retail investors who often use mutual funds and ETFs to save for retirement, their child's education, or a down payment on a house. We had an opportunity today to ensure that some of the greatest risks to funds-derivatives and leverage risk-are appropriately constrained, but, unfortunately, the majority of the Commission is telling investors they are on their own. The world has been turned upside down. We should stop to reassess our views, but instead we have made things markedly worse than our original proposal.