1. 2014 NSCP NATIONAL CONFERENCE
Session 7a
BD – Regulatory Developments Without the Regulators
Scott N. Sherman, Shareholder, Baker Donelson
Amy Rush, VP and Senior Regulatory Counsel,
Waddell & Reed, Inc. and Ivy Funds Distributors, Inc.

2. KYC and Suitability: What are the Regulators Looking At?
On July 9, 2012, FINRA Rule 2090 replaced NYSE Rule 405 as the new “Know Your Customer” (KYC) Rule
Rule 2111 supplemented NASD Rule 2310 as the new “suitability” rule.

3. Changes in Exams from a Firm Perspective – 2013 SEC and FINRA
The size of fines assessed by FINRA for suitability violations in 2013 decreased substantially over the previous year, as did the number of suitability cases.
Total fines based on suitability dropped by 74 percent (from $19.4 million in 2012 to $5.1 million in 2013.)
The number of FINRA-reported suitability cases dropped 38 percent (from 117 in 2012 to 73 in 2013) despite little decrease in the overall number of disciplinary actions filed by FINRA in 2013: overall, 1,535 disciplinary actions were filed in 2013, a decrease of less than 1% from the 1,541 cases the regulator initiated in 2012.

4. Changes in Exams from a Firm Perspective – 2013 SEC and FINRA (cont.)
FINRA’s January 2014 letter to broker/dealer members noted its concern regarding the suitability of recommendations to retail investors of complex products whose risk-return profiles, including their sensitivity to interest rate changes, underlying product or index volatility, fee structures or complexity may be challenging for investors to understand.” The 2014 focus includes:
Interest-rate-sensitive fixed income products
Concentrations in longer duration instruments, including bond funds with longer average duration
High yield securities
Concentrations in speculative equities positions in retail accounts
Training given to retail-facing brokers

5. Regulatory Actions, Sweeps, and Experiences
Municipal Bond Issuers Sweep
Beginning in April 2013, SEC Enforcement Staff conducted a sweeping review of disclosures made by financially stressed municipal bond issuers. The SEC has focused on lapses in disclosure, such as a failure to adequately disclose the level of the municipality’s financial stress.
The SEC is moving quickly with individual investigations:
March 2014: the SEC announces its Municipalities Continuing Disclosure Cooperation Initiative (MCDCI) under which the Division of Enforcement will recommend favorable settlement terms to issuers and underwriters of offerings if they self-report to possible violations involving materially inaccurate statements relating to prior compliance with continuing disclosure obligations specified in Rule 15c2-12.

6. Regulatory Actions, Sweeps, and Experiences
Municipal Bond Issuers Sweep (cont.)
July 8, 2014: SEC issues first settlement order under the MCDCI. Kings Canyon Joint Unified School District, without admitting or denying the SEC’s findings, agreed to an Order finding it in violation of Section 17(a)(2) of the Securities Act, requiring it to:
Cease and desist from violating Section 17(a)(2)
Establish written policies and procedures
Conduct periodic training regarding continuing disclosure obligations
Cooperate with the Division in any subsequent investigation and disclose the settlement in future bond offering materials
The SEC did not order any disgorgement or civil penalty.

7. AML Sweep
The SEC is engaging in a sweep of the brokerage industry to make sure brokerages are following anti-money laundering rules and looking into whether brokerages such as Merrill Lynch and Charles Schwab missed red flags that could indicate attempts to move money illicitly or to feed proceeds from drug trafficking and other crimes into the financial system by failing to know their customers well enough.
February 20, 2014: The SEC announced that its Office of Compliance Inspections and Examinations (OCIE) would target investment advisers that have never been examined, focusing on those that have been registered with the SEC for three+ years. OCIE will conduct examinations of a significant percentage of advisers that have not been examined since they registered. Exami-nations will focus on compliance programs, filings and disclosure, marketing, portfolio management, and safekeeping of client assets.

8. Cybersecurity Sweeps
In an April 2014 Risk Alert the SEC stated that it had issued a cybersecurity sweeps letter to 50 member firms. The SEC’s Risk Alert states that the sweep is “intended to empower compliance professionals in the industry with questions and tools they can use to access their firms’ level of preparedness, regardless of whether they are included in OCIE’s examinations…”
FINRA also sent sweep letters to member firms in early The sweep letter focused on member firms’ management of cybersecurity risks.

9. Cybersecurity Sweeps How Firms are Handling Cybersecurity Issues:
Gather staff from all business divisions to understand how well prepared the Firm was to withstand an attack.
Review the SEC sweep letter with the business divisions.
Request that IT and Disaster Recovery Teams respond to the questions in the SEC’s sweep letter as an exercise to determine if the Firm was prepared for a SEC exam and/or a cybersecurity event.
Review Firm’s E&O policy to determine if the Firm had coverage if a cybersecurity event were to occur.
Put procedures in place, but, also ensure that the Firm has systems in place to stop any type of attack. Then test the systems to ensure that they can withstand a cybersecurity event.

10. Cybersecurity Sweeps How Firms are Handling Cybersecurity Issues:
Many commentators recommend that Firms review the NIST (National Institute of Standards and Technology) Cybersecurity Framework published in February 2014.

11. WRAP Fee Program Sweep
The SEC announced in January 2014 that review of wrap fee programs would be among its 2014 priorities. Since then, the SEC has been requesting detailed information about wrap fee programs and compliance policies and procedures in its exams.
The letters request:
Detailed information about compliance policies and procedures
Any analysis conducted by the firm of wrap accounts with high cash balances and low levels of trading
Documentation of ongoing reviews of suitability with regard to trades conducted in the firm’s wrap fee programs and the supervision of advisors engaged in the sale of the firm’s wrap fee programs.

12. WRAP Fee Program Sweep
The letter also requests detailed information regarding each wrap fee program offered by the firm, including:
names of the investment managers and sub-advisers
program inception date and termination date (if any)
description of the program’s strategy and investments
number of accounts in the program
discretionary authority of the portfolio manager over the account
total value of the program’s assets
custodial arrangement for the assets in the program
total fee charged by the Sponsor
total fee charged by the Adviser

13. Conflicts of Interest
October 2013: FINRA published its Report on Conflicts of Interest. The report highlights the necessity of effective conflicts management practices.
Although there is no regulatory requirement to conduct a conflicts of interest assessment, FINRA examiners will evaluate firms’ conflicts management practices during routine cycle exams.
FINRA will be seeking to understand how firms have assessed and, if necessary, controlled and/or disclosed conflicts which may impact their clients.

14. Successful Preparation and Implementation of New/ Revised Rules to Benefit Your Regulatory Relationship
Legal and Compliance teams should review the new rules and all commentary regarding the rules. Sometimes interpretive guidance is also available and very useful.
Set a meeting with business divisions and the compliance/legal team to review the rules.
In the case of FINRA rules 2090 and 2111, firms took several different steps. Some created mandatory training for their registered representatives; other firms created FAQs based on the rules’ new requirements. These types of tools can be useful in proving to regulators that the firm has reviewed the rule and provided guidance to its registered persons.

15. Successful Preparation and Implementation of New/ Revised Rules to Benefit Your Regulatory Relationship
Firms also added to their written supervisory procedures and their client-facing forms to comply with the requirements of both rules.
Putting together a notebook of what steps the firm has taken when new rules as far-reaching as FINRA Rules 2111 (Suitability), 2030 (suitability of deferred variable annuities), 2310 (communications with the public rule) and 3110, 3120, 3150 and 3170 (the consolidated supervision rules) are issued is a good idea.
The notebook, which would contain memorandums to registered persons regarding the new rule, training, and new procedures, can be provided to regulators at the start of an on-site exam.

16. An Assessment of the Regulator and Compliance Relationship
Tips for interacting with regulators:
Firms should view regulators as any type of auditor. The regulator is on site doing a job. The better relationship you can build with your regulators, the better the exam will go.
One person (the firm delegate) should be the contact for the regulatory exam team. All interview and document requests should go through the firm delegate.
Each exam (SEC, FINRA or state) should start with an overview of the firm, which should include an org chart of key people and an org chart of the firm’s affiliated companies (if any).

17. An Assessment of the Regulator and Compliance Relationship
Tips for interacting with regulators:
Next, the Firm delegate may want to explain the firm’s supervisory structure, compliance program, types of clients it services, and the products and services it offers for sale. This is best done through a PowerPoint presentation (note that the regulator may request a hard copy).
After the presentation, review the pre-production list with the regulatory exam team to ensure that you are on the same page with what has and has not been produced at that time. Take this time, if you have not previously done so, to check the parameters of any document/information production – i.e. numbering of documents, logging of document requests, uniform numbering of requests.

18. An Assessment of the Regulator and Compliance Relationship
Tips for interacting with regulators:
Most SEC and FINRA examiners will request an interview with the CCO and other key personnel based on the org chart. The firm delegate, if not a member of the legal team, should be present during each interview and should take detailed notes. Document and/or additional information requests are often made during these interviews.
Consider offering the regulatory exam team a facility tour. This provides them with comfort that the firm is not hiding anything and is willing to show them their facility, people and systems.
Keep the tone light – remember they are on site doing a job, it is not a witch hunt. However, if a regulatory examiner is out of line, ask to speak to the lead examiner alone about the behavior.

19. A Good Hard Look at the Impact of CCO Enforcement Actions
Since 2011, the SEC’s Compliance Program Initiative has targeted firms that have previously warned by SEC examiners about compliance deficiencies but failed to effectively act upon the warnings. The SEC Enforcement Division’s Asset Management Unit has coordinated with examiners to bring several cases to action.
Typically, these cases have resulted in settlements in which the firms pay financial penalties and hire compliance consultants.
Between 2011 and May 20, 2014, the Enforcement Division brought ten actions as part of this initiative, including charges against compliance personnel when they were allegedly responsible for the failure.

20. A Good Hard Look at the Impact of CCO Enforcement Actions
The Commission has stated that ultimately the responsibility for a broker-dealer’s compliance resides with its chief executive officer and senior management. The Commission further states on its website that “[w]hen the Commission staff seeks to bring legal actions for failure to supervise, its focus is on the roles and responsibilities of the respective parties. As a general matter, the staff does not single out compliance or legal personnel. Rather it encourages compliance officers and other compliance and legal personnel to take strong and vigorous action regarding indications of misconduct.”

21. A Good Hard Look at the Impact of CCO Enforcement Actions
Examples of settlements announced in October 2013:
Modern Portfolio Management Inc.: failed to complete annual compliance reviews in 2006 and 2009 and made misleading statements on its website and investor brochure. For instance, one location on the website misleadingly represented that the firm had more than $600 million in assets. However, on its Form ADV filing to the SEC during that same time period, it reported that the firm’s assets under management were $359 million or less.
MPM and its owners agreed to be censured and pay a total of $175,000 in penalties and were required to complete 30 hours of compliance training, and MPM agreed to designate someone other than the owners as chief compliance officer. MPM was also required to retain a compliance consultant for three years.

22. A Good Hard Look at the Impact of CCO Enforcement Actions
Examples of settlements announced in October 2013:
Equitas Capital Advisers LLC: made false and misleading disclosures about historical performance, compensation, and conflicts of interest. Also inadvertently yet repeatedly overbilled and underbilled their clients. Many violations occurred despite warnings by SEC examiners during exams of the Equitas firms in 2005, 2008, and The firms, their owner, and their COO failed to disclose deficiencies to potential clients in response to questions in due diligence questionnaires or requests for proposals.
Equitas had to reimburse all overcharged clients. Equitas, its owner, and the CCO agreed to pay $225,000 in additional penalties. The CCO agreed to pay a $90,000 fine. Equitas agreed to censures, to hire independent compliance consultants, and to give clients notice of the SEC enforcement actions.

23. Questions?

24. Scott Sherman
Amy Rush