SEC’s National Examination Priorities

SEC’s National Examination Priorities for 2017

According to Office of Compliance Inspections and Examinations (“OCIE”)

The U.S. Securities and Exchange Commission (“SEC”) regulates more than 4,000 broker-dealers and more than 12,000 registered investment advisers (“RIAs”) with nearly 67 trillion dollars of assets under management. These are the priorities the SEC recently expressed.

  1. Elderly and Retiring Investors

The SEC will assess how firms interact with seniors, including their ability to detect the financial exploitation of seniors.  Exams will focus on supervisory programs and rules related to services and products directed at senior investors.

  1. Electronically Distributed Investment Advice a/k/a Robo Advisers

For advisers that provide electronic advice, the SEC will review disclosure of conflicts, marketing, compliance programs, data protection and the manner of how investment recommendations/algorithms are formulated.

Generally, cybersecurity refers to unauthorized internal and external access to client accounts, trading systems, wrongful asset transfers and data loss. The SEC will continue its initiative to examine controls, compliance procedures, including testing of cybersecurity plans.

  1. Bad Apple Brokers and Their Employers

The SEC says that they will use data analytics to examine individuals with a history of misconduct and examine the firms that now employ them.  For instance, if someone was banned from acting as a registered representative and now seeks to be become registered as an investment adviser representative (“IAR”) that could trigger an examination of the new RIA.

  1. Never Been Examined Advisers

This program begun in 2014 will continue, but it will be updated to add a component focusing on a risk based review. The need for this program exists because the SEC only examines approximately ten percent (10%) or so of the RIAs it regulates every year.

crowd funding

FINRA’s 2016 Examination Priorities

The Financial Industry National Regulatory Authority’s (”FINRA’s”) annual examination letter is more opaque and difficult to understand than those of prior years, but fear not; the breakdown that that you need is contained below.
Broad Themes
A) Culture, Conflicts of Interest and Ethics

According to FINRA, a firm’s culture is a “set of implicit and explicit norms, expected behaviors and practices that effect how employees and supervisors make and make decisions in conducting a firm’s business.” FINRA’s test of a culture will take five (5) factors into account:

i) Whether breaches of control or policy are tolerated;
ii) Whether the broker-dealer (“BD”) proactively seeks to identify compliance and risk events;
iii) Whether the BD values so called “control functions;”
iv) Are supervisors effective role models of the BD culture; and,
v) Does the BD allow deviations from overall culture in certain sub-cultures like a department or branch?

B) Supervision, Risk Management and Controls
FINRA will use perceived problem areas in the past to focus on the following items in the current year. They are: 1) conflict of interests; 2) outsourcing; 3) anti-money laundering (“AML”); and 4) technology. These issues are explored below.
1) Conflicts.
Among the types of conflicts that FINRA will likely examine are:
i) compensation plans for registered representatives;
ii) the sale of proprietary or affiliated products;
iii) revenue sharing where a third-party payment is made;
iv) valuation of positions by those that establish the position and are compensated thereon; and,
v) information leakage to improper areas of the firm or outside the BD.

2) Outsourcing.
FINRA reminds its members that they are ultimately responsible for compliance with the securities laws and FINRA rules whether or not they have outsourced this function. FINRA will also be looking at supervision of outsourced functions and the “due diligence” that the BDs did on various retained providers.
3) Technology.
FINRA will be examining BDs hardware, software and personnel systems. More specifically, FINRA will be examining: i) Cybersecurity. This relates to unauthorized internal and external access to client accounts or online trading systems and asset transfers and data loss. This will relate to the confidentiality of client information and the ability that electronic records are stored in a way that is fully compliant with SEC regulation.
4) Anti-Money Laundering – FINRA will be testing firms’ detection and reporting of suspicious activity in both trading activity and movement of funds. This includes testing of the same and following higher risk activity and accounts. BDs should understand the business purpose of the activity is understood and that the firm measures the actual activity from that which was originally anticipated.

Short Selling

The Dynamic & Often Controversial World of Short Sellers.

You’ve probably heard of Bill Ackman. The 49-year-old founder of Pershing Square Capital is worth a whopping $2.6 billion. He made his fortune investing in companies and buying up massive stakes. But his rise to hedge fund prominence has been anything but smooth. Ackman is an often polarizing and controversial figure in the industry. This has more to do with his short bets than his long ones.

For those of you who don’t professionally handle money, short selling is the opposite of buying a stock. When you buy a stake in a company, you become a part-owner and hope for the best. Short selling, however, entails borrowing a stock to sell it to someone right away, and then waiting for the price to drop so you can buy it up cheaper. The difference is, of course, your profit.

Essentially betting that a company fails or its stock starts to plummet is not for everyone, and it isn’t publicly popular either. But some argue that having short sellers in a market is healthy.

Prices tend to get out of whack with reality all too often, and short sellers tell the other side of a rosy story, bringing the market back to reality. Despite this, governments rush to block short sales when markets collapse. For example, the Chinese government pressured brokerages to ban short selling temporarily during the recent turmoil in Shanghai.

Ackman is a gifted short seller. He made a $1 billion bet that supplement marketer Herbalife is a Ponzi scheme that will collapse. He’s willing to bet the SEC and FTC will investigate the company soon and the stock price may go down to 0.

So far, however, things haven’t panned out as expected. The Justice Department and the FBI have ongoing investigations to see if Ackman’s company attempted to manipulate the price of Herbalife. The SEC and FTC are investigating other investments too.

Just a few days ago, a report by Citron Research pointed out that Valeant Pharmaceuticals, one of the companies Ackman has invested in, has been practicing sales tactics that could make it the “Enron of Big Pharma.”. That’s a pretty bold claim, and there is sure to be considerable investigation into the claims of the research team and the company before we know who’s right. But the damage is already done. Valeant’s stock fell by over 55% in a single day.

Short sellers have been increasingly focusing on regulatory malpractices and suspicious activity to figure out if a company is overvalued. It seems a lot easier to make a short bet if the company in question has been engaging in something illegal or unethical, rather than make a risky bet on pure fundamentals.

Sometimes the traders get lucky, as was the case with Volkswagen. A few hedge funds had made short bets on the German car manufacturer’s stock right before the emissions scandal hit and the stock plummeted.

It’s a world filled with regulations, legal disputes and considerable profit. Just another day on Wall Street.

Journalism’s Secret Romance with Insider Trading

We drift again, as we often do, into the murky world of insider trading. It’s one of the most common forms of securities fraud and it takes little to understand just why it’s so prolific – it is very hard to pin down. The terms are vague and the enforcement is complicated.

We, as a society and an industry, have not yet figured out how to stop insider trading. It’s clear that it’s important to crack down on the violation since the implication of a rigged game spoils it for everyone. If average middle-class investors don’t buy stocks because they think rich people are getting away at their expense, even the rich won’t benefit from capital appreciation. So, in the end, it’s bad for everyone, even those at the top.

We also know that there are time when insiders, like managers and minority shareholders have to purchase stocks. And that’s actually been dealt with fairly well – we have regulations that require managers to declare every trade and certain windows where they can’t trade at all. It isn’t water-tight, by any means, but it is somewhat effective.

Another sort of potentially problematic trading is the kind that is done on knowledge of what the industry refers to as, “material nonpublic information.” That means if you know something that is likely to impact the stock price, and you trade based on that knowledge before the public knows about it, you’re guilty.

Keep that in mind it pays to look a little closer at how information relevant to trading goes public. Of course, there are requirements for companies to make official public statements, but that’s not really how most investors get their updates. Most actually get updates through the media. Journalists report on the key issues, and that’s where things can get a bit tangled.

Most veteran journalists are likely to tell you their sources have their own motives for divulging information that is newsworthy. Even a regular viewer of House of Cards can tell you that. Inside sources aren’t parting with vital information out of the goodness of their hearts.

Iraj Parvizi, from the UK, knows this well. He’s on trial in Britain right now for insider trading. In his court appearances, he’s said that it was easy to figure out what the journalists he was speaking to were likely to print the next morning. His words were likely to send the stock up or down by multiple percentage points, so why not take advantage of that?

Parvizi was so successful at manipulating stocks through the media, that he went from owning a small kebab shop to amassing a £70 million fortune over the past few decades. “The whole stock market is built on lies,” he says.

Whether or not the whole stock market is, in fact, built on false information, is up for debate. But one thing is certain; we still don’t know the true extent of the illegitimate relationship between the media and investors and the degree to which it impacts the market.

How Inversions Went from Being a Boring Accounting Term to a Hot Button Issue

For anyone who can’t tell the difference between EBITDA and NOPAT or simply isn’t bothered about accounting terms like these, corporate inversions are actually pretty boring.

However, inversions are pretty simple to understand. Say you own a media company in the United States and have been running this firm for many years. In the past, most of your profits were made in America, so you paid your taxes and moved on. But recently you’ve been using the internet a lot and now have clients from all over the world, paying you in ten different currencies.

You probably don’t want to pay American taxes on this non-American income, so you find a company in a country where the tax rate is low, buy it and convert your company into a foreign company. That’s an inversion.

Corporate inversions were not very common before the 1980s simply because the world wasn’t as connected then as it is now. Multinationals were rare and money was mostly generated within one’s own country. But this is no longer the case. Now, even small companies can set up shop abroad and avoiding taxes isn’t just a thing rich people do anymore, everyone is involved.

The Panama Papers leak goes to show that big companies and wealthy individuals can store their wealth away on a nice little island with no taxes. Payments that come to Google or Apple or Netflix from India, for example, go into a subsidiary in Ireland, Singapore or the Netherlands. It’s pretty much an open secret how the big corporation cut taxes. It’s all very clever, but completely legal.

But inversions go one step further and change the location of a corporation. These inversions are now in the spotlight, since the Allergan/Pfizer merger issue started. The fact that these were big pharma companies (which are controversial for their pricing strategies anyway) helped the issue attract even more attention. And since it’s an election year, such a major deal and large amount of money not going into the government’s pocket becomes an even bigger issue. But the new anti-inversion rules from the US treasury have some far reaching effects.

The new rules discourage US companies from inverting abroad and cutting down taxes, but they have also disrupted the Allergan Pfizer deal, which is the biggest deal in history to fall apart. Critics are arguing that this does harm to the economy and it’s easy to see why- foreign corporation may be wary of using debt to fund a US plant if they don’t think the debt will actually be treated as such. Pfizer’s chairman argued that the new rules mean foreign acquisitions of local companies will increase, which will cut local jobs.

But the US Treasury has made it’s decision, Hillary Clinton has made it firmly part of her campaign and the public’s opinion on the issue is unlikely to change any time soon. So, in short, that is how a boring merger strategy became front-page news.

The Evolution of Insider Trading

In the world of finance, one of the most malleable legal terms is “‘insider trading.” It may seem obvious to financial experts, but many don’t fully appreciate how convoluted the laws surrounding this form of securities fraud really are.

The standard definition of insider trading is, “Trading on material nonpublic information,” which seems straightforward enough. In fact, in many cases it is as straightforward as a director telling her friend or relative to buy stock in her company before they announce a major merger. That is a textbook case study of insider trading. But that doesn’t mean there aren’t questions left unanswered by the current laws.

For instance, if a banker tips off his sister to a big deal and the sister tells her husband about it, is it insider trading simply because the parties are related or does the prosecution have to prove the banker received something of value in return for the leak? It seems there isn’t a clear answer to that question just yet, but we may have one soon.

The U.S. Supreme Court is about to hear a very similar sort of case where a banker tipped off his brother and the brother told his brother-in-law about a deal. Salman v. U.S., 15-628. is ongoing and we don’t really have a clear indication of where it is heading just yet, but we do know the prosecution must show some sort of “personal benefit” for the tipster that pushed him to leak information.

Whatever the final call in this case, it could have far reaching consequences for the financial industry. Bassam Salman, the accused, got trade tips from his brother-in-law, whose brother works at Citibank as an investment banker. When the case went up to the local court in California, the court said the relationship between the brother and brother-in-law was enough to prove insider trading.

However, if the Supreme Court disagrees with that verdict, the floodgates to insider trading would be opened, according to prosecutors. Family members could leak sensitive, nonpublic information and their relatives could trade on it freely, so long as they can prove they didn’t give anything valuable in exchange for the information.

A similar case went up to a panel in New York in December 2014. That panel didn’t believe insider trading could be pinned solely on family ties and the verdict eventually led to the reversal of over a dozen convictions in the past.

This goes to show how vague and unwieldy the concept of insider trading is. It is much easier to be sure of guiltiness when there is a paper trail of money or corporate actions that were unethical. Even emails amongst colleagues can be sufficient to prove misconduct. But insider trading is a legal tangle that is yet to be fully defined. The law evolves as time goes on and more such cases continue to be heard which help establish more firmly how the crime is defined.