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SEC and CFTC Issue Identity Theft Red Flags Rules

May 8, 2013 James Hardaway Jr. Compliance, Final Regulations, Hedge Funds, Mutual Funds, Private Equity

On April 10, 2013, CFTC and the SEC issued final rules and guidelines to require certain regulated entities to establish programs to address risks of identity theft. These rules and guidelines implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which amended section 615(e) of the Fair Credit Reporting Act (FCRA) and directed the Commissions to adopt rules requiring entities that are subject to the Commissions’ respective enforcement authorities to address identity theft. The rules require financial institutions to develop and implement a written identity theft prevention program designed to detect, prevent, and mitigate identity theft in connection with certain existing accounts or the opening of new accounts. The rules included guidelines to assist entities in the formulation and maintenance of programs that would satisfy the requirements of the rules.

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The Rules Effective Date is May 19, 2013, and the Compliance Date is November 19, 2013.

The CFTC added new subpart C to part 162 of the CFTC’s regulations, and the SEC added new subpart C; Regulation S-ID: Identity Theft Red Flags to part 248 of the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

In February 2012, the Commissions jointly proposed for public notice and comment identity theft red flags rules and guidelines and card issuer rules.

The final rules are substantially similar to the proposed rules, and they do not exclude any entities registered with the Commissions from their scope. The SEC’s scope provides that the final rules apply to:

A broker, dealer or any other person that is registered or required to be registered under the Exchange Act.
An investment company that is registered or required to be registered under the Investment Company Act, that has elected to be regulated as a business development company, or that operates as an employees’ securities company under that Act.
An investment adviser that is registered or required to be registered under the Investment Advisers Act.

As in the proposed rules, the Commissions defined the term “covered account” in the final rules as: (i) an account that a financial institution or creditor offers or maintains, primarily for personal, family, or household purposes, that involves or is designed to permit multiple payments or transactions; and (ii) any other account that the financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation, or litigation risks. The CFTC’s definition includes a margin account as an example of a covered account. The SEC’s definition includes, as examples of a covered account, a brokerage account with a broker-dealer an account maintained by a mutual fund (or its agent) that permits wire transfers or other payments to third parties.

The Commissions defined an “account” as a “continuing relationship established by a person with a financial institution or creditor to obtain a product or service for personal, family, household or business purposes.” The CFTC’s definition specifically includes an extension of credit, such as the purchase of property or services involving a deferred payment. The SEC’s definition includes, as examples of accounts, “a brokerage account, a mutual fund account (i.e., an account with an open-end investment company), and an investment advisory account.”

As proposed, the final rules require each financial institution to periodically determine whether it offers or maintains covered accounts. As a part of this periodic determination, a financial institution or creditor must conduct a risk assessment that takes into consideration: (1) the methods it provides to open its accounts; (2) the methods it provides to access its accounts; and (3) its previous experiences with identity theft. A financial institution should consider whether, for example, a reasonably foreseeable risk of identity theft could exist in connection with accounts it offers or maintains that may be opened or accessed remotely or through methods that do not require face-to-face contact, such as through email or the Internet, or by telephone. In addition, if financial institutions offer or maintain accounts that have been the target of identity theft, they should factor those experiences into their determination. The Commissions anticipate that entities will be able to demonstrate that they have complied with applicable requirements, including their recurring determinations regarding covered accounts. If a financial institution initially determines that it does not need to have a Program, it is required to periodically reassess whether it must develop and implement a Program in light of changes in the accounts that it offers or maintains and the various other factors set forth in the regulations.

The rules provide that each financial institution that offers or maintains one or more covered accounts must develop and implement a written Program designed to detect, prevent, and mitigate identity theft in connection with the opening of a covered account or any existing covered account. These provisions also require that each Program be appropriate to the size and complexity of the financial institution or creditor and the nature and scope of its activities. Thus, the final rules are designed to be scalable, by permitting Programs that take into account the operations of smaller institutions.

The final rules set out the four elements that financial institutions and creditors must include in their Programs. These elements are being adopted as proposed and are identical to the elements required under the FCRA Agencies’ final identity theft red flags rules.

The elements of the Program should be as follows:

(1) Develop a Program that includes reasonable policies and procedures to identify relevant red flags for the covered accounts that the financial institution or creditor offers or maintains, and incorporate those red flags into the Program. Rather than singling out specific red flags as mandatory or requiring specific policies and procedures to identify possible red flags, this first element provides financial institutions and creditors with flexibility in determining which red flags are relevant to their businesses and the covered accounts they manage over time. The list of factors that a financial institution or creditor should consider are included in Section II of the guidelines, which appear at the end of the final rules. Given the changing nature of identity theft, the Commissions believe that this element allows financial institutions or creditors to respond and adapt to new forms of identity theft and the attendant risks as they arise.

(2) Implement reasonable policies and procedures to detect the red flags that the Program incorporates. This element does not provide a specific method of detection. Instead, Section III of the guidelines provides examples of various means to detect red flags.

(3) Implement reasonable policies and procedures to respond appropriately to any red flags that they detect. This element incorporates the requirement that a financial institution or creditor assess whether the red flags that are detected evidence a risk of identity theft and, if so, determine how to respond appropriately based on the degree of risk. Section IV of the guidelines sets out a list of aggravating factors and examples that a financial institution or creditor should consider in determining the appropriate response.

(4) Implement reasonable policies and procedures to periodically update the Program (including the red flags determined to be relevant), to reflect changes in risks to customers and to the safety and soundness of the financial institution or creditor from identity theft. As discussed above, financial institutions and creditors are required to determine which red flags are relevant to their businesses and the covered accounts they offer or maintain. The Commissions are requiring a periodic update, rather than immediate or continuous updates, to be parallel with the identity theft red flags rules of the Agencies and to avoid unnecessary regulatory burdens. Section V of the guidelines provides a set of factors that should cause a financial institution or creditor to update its Program.

The Program must be written and approved by either its board of directors, an appropriate committee of the board of directors, or if the entity does not have a board, from a designated senior management employee. However, if a financial institution has a Program in place, the board is not required to reapprove the existing Program in response to this requirement, provided the Program otherwise meets the requirements of the final rules.

In addition, financial institutions must involve the board of directors, an appropriate committee thereof, or a designated senior management employee in the oversight, development, implementation, and administration of the Program. The designated senior management employee who is responsible for the oversight of a broker-dealer’s, investment company’s or investment adviser’s Program may be the entity’s chief compliance officer. Also, they must train staff, as necessary, to effectively implement their Programs.

Finally, financial institutions must exercise appropriate and effective oversight of service provider arrangements. The Commissions believe that it is important that the rules address service provider arrangements so that financial institutions and creditors remain legally responsible for compliance with the rules, irrespective of whether such financial institutions and creditors outsource their identity theft red flags detection, prevention, and mitigation operations to a service provider. The final rules do not prescribe a specific manner in which appropriate and effective oversight of service provider arrangements must occur. Instead, the requirement provides flexibility to financial institutions and creditors in maintaining their service provider creditors are still required to fulfill their legal compliance obligations.

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Municipal Industry Group Issues Paper in Response to MSRB Notice on Enhanced Disclosure of Bank Loans

May 3, 2013 James Hardaway Jr. Compliance, Hedge Funds, Mutual Funds, Private Equity

As a result of the growing concerned about the lack of disclosure on bank loans, the Municipal Securities Rulemaking Board (“MSRB”) issued a notice last year encouraging issuers to voluntarily post information about them on EMMA. The board said “the availability of timely information about bank loan financings is important for market transparency and promoting a fair and efficient market” and that bondholders and potential investors need such information to assess their muni holdings or make muni investment decisions. The public is often in the dark about the details of the borrowing, with investors and regulators sometimes having to wait for annual statements to learn loans even exist. “I think it’s great that there’s again another opportunity, another tool for state and local governments to tap, but I do think we do need to be vigilant about some of the pitfalls in that private funding market,” said MSRB Executive Director Lynnette Kelly.

Many loans are being used as substitutes for the liquidity facilities and letters of credit that banks provide to back variable-rate demand bonds, according to Thomas Jacobs, who tracks products related to municipal bonds as a vice president for Moody’s Investor Service.

In response, a municipal bond market task force issued a paper recently urging state and local issuers and conduit borrowers to consider voluntarily disclosing certain information about bank loans. The groups, which included the National Federation of Municipal Analysts and National Association of Bond Lawyers, as well as dealer, banker, issuer, financial advisor and other organizations, joined together to help issuers and other market participants decide whether to disclose information about bank loans.

“This is a significant achievement, which demonstrates the industry’s commitment to reach consensus on a framework to analyze important disclosure issues,” said Allen Robertson, a shareholder at Robinson, Bradshaw & Hinton, PA who is to become NABL’s president in October. “This paper encourages careful consideration of making voluntary disclosure about bank loans, while acknowledging that issuers and borrowers may conclude not to provide voluntary disclosure about a particular bank loan depending on the facts and circumstances.”

“Contrary to the expectations of many participants in the municipal market, however, banks have continued to make a substantial amount of bank loans on a non-bank-qualified basis since January 1, 2011,” according to the white paper. “Because the incurrence of additional debt, including Bank loans, is not one of the material events for which disclosure is required under SEC Rule 15c2-12, holders of an issuer’s outstanding bonds may not become aware of a bank loan or its impact on the issuer’s creditworthiness until the issuer’s next financial audit is released or new bonds are sold.”

Bondholders and investors may want such information as whether the bank loan increases the issuer’s outstanding debt or whether certain assets previously available to secure bonds are pledged to the bank as security for the bank loan, the groups said. And issuers could voluntarily disclose on the MSRB’s EMMA system, documents relating to a bank loan, such as the loan or financing agreement.

Also, private bank loans are riding a wave of popularity among cities, counties and other local governments, leaving the $3.7 trillion municipal bond market racing to assess and contain any risks they may pose. The climb in borrowing, either by selling bonds to banks or through direct loans, has been swift and steep. U.S. banks held a record high level of municipal bonds and loans in the final quarter of 2012, $363.1 billion, according to the Federal Reserve, one of the few sources of data on the loans. Banks have long made tax-exempt and taxable bank loans to issuers, but since 2009, they have been more willing “to make an increasing amount of tax-exempt bank loans to issuers as an alternative to publicly offered tax-exempt bond issues,” according to the white paper.

The 2009 federal stimulus plan raised the amounts of “bank-qualified obligations” that banks could hold, as part of a grander scheme to thaw a municipal credit freeze. In 2009 and 2010, issuance of the obligations doubled. Essentially, the obligations are exceptions to part of the tax code that prevents banks from deducting the carrying cost of municipal bonds from their taxes. By doing so, the tax code eliminates the appeal of most tax-exempt debt for banks. When the stimulus plan expired issuance of the qualified obligations slowed, but the public sector continued relying on banks in general, the task force found.

The NFMA and Government Finance Officers Association may follow up with drafting best practice documents that provide further guidance for issuers and other market participants, said Robertson and Lisa Washburn, a managing director at Municipal Market Advisors who is NFMA’s secretary.

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The Inevitable Bursting of the Municipal Securities Bond Market Bubble

April 19, 2013 James Hardaway Jr. Hedge Funds, Mutual Funds, Private Equity

In the next few years, the Treasury plans to completely “wind down” FNMA and FHLMC, and the impact on the pre-refunded and escrowed-to-maturity municipal securities could be devastating. According to the Municipal Market Advisors Research, in 2009 bond refunding was 35% of the $400 billion municipal bond refunding activity, new money was the remaining source activity.

Because of the government divestment, the escrowed values of FNMA and FHLMC bonds will drop significantly, and the municipal issuers of pre-refunded bonds will have the daunting task of meeting their contracts stipulating that the cash value of pre-refunded securities escrowed by FNMA and FHLMC bonds must be sufficient enough to pay the principal and interest of the issue being refunded, on the original interest and maturity dates or on an early call date. It is likely that many of these municipal bonds will default, which would cause the municipal issuers’ bond ratings to decline, and consequently negatively impact bonds prices across the entire municipal securities bond market.

Even now, there is a wide spread between the yields (interest payments divided by market value) of FNMA and FHLMC mortgage-backed bonds and Treasury bonds. In a recent article, Walt Schmidt, a mortgage strategist at FTN Financial stated that [m]ost of the reason for the wider spreads is “based on uncertainties regarding prepayments and supply, not credit-based downgrade fears.”

Why is there not more publicity and action being taken on this inevitable market price bubble bursting? Because prior to the Treasury’s plan to wind down the “reverse privatized ” FNMA and FHLMC corporations, it was, and still is, generally accepted by auditors and compliance professionals that these two corporations are in substance, implicitly government-backed. Therefore, the Generally Accepted Auditing Principal of ‘substance over form’ is why securities issued by FNMA and FHLMC have been accepted as government-backed by the industry and investors.

This fallacy has evolved into a threat to the municipal securities industry because there has been a concerted effort by the Obama Administration and the U.S. Treasury to wind down FNMA and FHLMC, which essentially means to “privatize” them and withdraw U.S. Government support. President Obama has stated several times that the U.S. Taxpayer will no longer support Wall Street corporations, and he has been recently joined by the junior senator from Massachusetts, Senate Banking Committee member, Elizabeth Warren.

The privatization of these agencies will likely follow with the new private owners securitizing their assets thru Special Purpose Entities (“SPEs”), and traunching these new securities based on the similar risks of collateralized mortgage obligations. These new owners of FNMA and FHLMC will likely pool the ex-agencies’ receivables due from FNMA and FHLMC owned or guaranteed mortgages to create new securities and issue them through their SPE’s. With the current market trend, this will eventually cause downward pricing pressure on FNMA and FHLMC issued bonds used as escrow for refunded securities.

The U.S. Government’s efforts to wind down FNMA and FHLMC began over four years ago.

On November 4, 2008, the U.S. Department of the Treasury in a press release stating that “[o]ne member recommended that Treasury should consider entering into a swap agreement with FNMA and FHLMC to enable them to grow their mortgage portfolio without the need to issue new debt under their name. If the mandate for these GSE’s (Government Sponsored Enterprises) is to “grow for a short period” and then to “shrink” then it doesn’t make sense for them to issue additional paper given the ambiguity of their future mission and the wide spreads to Treasuries that their bonds trade in the marketplace.”

In 2011 the Obama Administration reported that the government “will work with FHFA to determine the best way to responsibly reduce Fannie Mae (FNMA) and Freddie Mac’s (FHLMC) role in the market and ultimately wind down both institutions, creating the conditions for private capital to play the predominant role in housing finance. These efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market.” Further “[i]mplementing a wind down of Fannie Mae and Freddie Mac’s future participation in the housing market requires recognition of both the fragile state of that market today and the private sector’s need for clarity about the speed with which that transition will take place. As the market begins to heal and private investors return, we will seek opportunities, wherever possible, to accelerate Fannie Mae and Freddie Mac’s withdrawal.”

On August 17, 2012 in a press release the U.S. Department of the Treasury announced a set of modifications to the Preferred Stock Purchase Agreements (PSPAs) between the Treasury Department and the Federal Housing Finance Agency (FHFA) as conservator of Fannie Mae and Freddie Mac (the Government Sponsored Enterprises or GSEs) that will help expedite the wind down of Fannie Mae and Freddie Mac, make sure that every dollar of earnings each firm generates is used to benefit taxpayers, and support the continued flow of mortgage credit during a responsible transition to a reformed housing finance market.

“With today’s announcement, we are taking the next step toward responsibly winding down Fannie Mae and Freddie Mac, while continuing to support the necessary process of repair and recovery in the housing market,” said Michael Stegman, Counselor to the Secretary of the Treasury for Housing Finance Policy. “As we continue to work toward bi-partisan housing finance reform, we are committed to putting in place measures right now that support continued access to mortgage credit for American families, promote a responsible transition, and protect taxpayer interests.”

The modifications to the PSPAs announced today are consistent with FHFA’s strategic plan for the conservatorship of Fannie Mae and Freddie Mac that it released in February 2012. The modifications include the following key components:, which among other thing listed “[t]he agreements require an accelerated reduction of Fannie Mae and Freddie Mac’s investment portfolios. Those portfolios will now be wound down at an annual rate of 15 percent — an increase from the 10 percent annual reduction required in the previous agreements. As a result of this change, the GSEs’ investment portfolios must be reduced to the $250 billion target set in the previous agreements four years earlier than previously scheduled.

On August 17, 2012, Rueter’s responded to this new action by publishing that “[t]he U.S. Treasury on Friday revamped the bailout of Fannie Mae and Freddie Mac to curb chances the giant mortgage finance firms could emerge from government control as the powerful, profit-driven corporations they once were. The Treasury said it would require the companies, whose massive losses threatened the financial system after the housing bubble burst in 2007, to shrink their investment portfolios more quickly and turn over any profits to taxpayers.”

It is because the Treasury is focusing on housing market and its recovery, that the nexus of FNMA and FHLMC issued bonds to the municipal securities market has not been revealed.

[This blog was published in the April 11, 2013 issue of "Bond Buyer"]

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SEC Requires Mutual Funds to Validate Information Submitted to the National Securities Clearing Corporation Through the Mutual Fund Profile Service Database

March 31, 2013 James Hardaway Jr. Compliance, Final Regulations, Mutual Funds

On March 25, 2013, the National Securities Clearing Corporation (“NSCC)” updated its previous announcement that it will be enhancing the Mutual Fund Profile Service II Profile Security Issue database with a web-based data extraction and comparison tool allowing fund members to update and compare data against their prospectuses and other source documents filed with the SEC. A new mainframe batch record called “Specific Data,” will be added to include the new fields that will become available on the web application specific to 408(b)(2) reporting needs. The scheduled Production date for implementation of the new Profile Security Comparison Tool web application and mainframe batch files is May 20, 2013. Testing will be available for fund members to begin testing effective April 15, 2013. Funds are urged to familiarize themselves with the new functionality and begin reviewing their data in the comparison tool.

In early 2009, the SEC amended SR-NSCC-2008-08 added a new agreement for fund members regarding mutual fund profile information. The rule amendment required a written agreement between the fund member and the NSCC that fund members have taken reasonable steps to validate the accuracy of their submitted data. NSCC indicated that the intent of the amendments is to expand the Fund Profile’s capacity to be a comprehensive and accurate source for distributors. The new agreement is not intended to be a basis for any independent legal rights against the fund member and third parties aren’t permitted to rely on the agreement as a representation of the accuracy of information provided in the Fund Profile. The exact language in the amendment to Rule 52 is “Each Fund Member agrees with the Corporation that the Fund Member will take reasonable steps to validate the accuracy of the MFPS data that it submits to the Corporation.” According to the NSCC, the tenet of the amendments is that the requirements are consistent with section 17A of the Securities Exchange Act of 1934 to facilitate prompt and accurate clearance and settlement of securities transactions.

The NSCC initially developed the Fund Profile as a repository of mutual fund prospectuses and operational information that is organized into three databases. The databases are organized as follows: (i) the Security Issue Database, containing information such as security identification number, security name, fee structure, investment objectives, breakpoint schedule data and blue sky eligibility; (ii) the Participant Database, containing contact information, NSCC processing capabilities and restrictions on requirements; and (iii) the Distribution Database, containing projected or actual distributions, capital gains and dividend amounts and details, and commission information. NSCC fund members input data regarding their mutual funds into the Security Issue and Participant Profile databases. The designated end users for the system are mutual fund third-party selling members.

At that time, the NSCC developed assistance to funds members in validating their data once it is input into the Fund Profile. These included database reports that note probable inconsistencies among related data fields and arranging for free access by fund members to a vendor tool that verifies Fund Profile data. Also, NSCC supported the system by providing help contacts at the NSCC and an on-line web demonstration.

Mutual funds should have developed and implemented under rule 38a-1 requirements to document the Fund Profile validating process for future CCO and regulatory review. Further, fund legal personnel should review and execute the written NSCC agreement to take reasonable steps to validate the fund profile information, and consult with the fund Board to determine if a resolution is required for the agreement.

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SEC Charges Mutual Funds Directors for Negligence in Valuing Securities

March 26, 2013 James Hardaway Jr. Compliance, Final Regulations, Mutual Funds

In December 2012, the SEC arraigned cease and desist orders to several former mutual fund directors until a hearing addressing their allegations are held in an administrative law court.

The fund directors allegedly violated Accounting Series Release No. 118, which the SEC provided specific guidance on with letters distributed in 1999 and 2001. In these letters they explained that “[i]n reviewing and approving pricing procedures, boards should determine whether those methodologies and procedures are reasonably likely to result in the valuation of securities at prices which the funds could expect to receive upon their current sale.”

The December order stated that between at least January 2007 and August 2007, significant portions of the Funds’ portfolios contained below-investment grade debt securities, some of which were backed by subprime mortgages, for which market quotations were not readily available. Under the Investment Company Act, those securities were required to be valued at fair value as determined in good faith by the Directors.

The funds’ securities valuations procedures provided that securities were initially recorded at cost. For daily pricing, the securities were recorded at cost unless there was a partial sale. At that time, the system issued exception reports for any security sold whose selling price was greater than 5% of its holding value. Otherwise the securities were continually recorded at costs or previous holding values. At month end, fund accounting randomly sampled 10% of the securities listed on the monthly exception report, except for two months out of the year for annual audits when the sample was 100%. These sampled securities were sent for broker quotes, and if the confirmation prices were greater than 5% of the holding value, the securities were sent to the fund adviser for valuation, or they were randomly selected to be valued using the internal pricing matrix. In many in instances Fund Accounting choose to ignore the price confirmations. It was noted that contrary to the statements in the Fair Valuation form provided to the Fund Board, the internal matrix was only used to price 125 of the securities held by funds at March 31, 2007. The fund adviser could also override prices provided by broker confirmations when it had “ a reasonable basis to believe that the price . . . does not accurately reflect the fair value of the portfolio security.

The SEC stated that the Respondents knew or should have known that Fund Accounting relied heavily on price confirmations when making fair valuation decisions, but that there was nothing requiring Fund Accounting to identify or explain those instances where the price confirmations differed materially from the Funds’ price. Further, while the Valuation Committee did receive the price confirmations that Fund Accounting solicited from independent broker-dealers, the Valuation Committee did not perform any additional tests to validate the fair values of portfolio securities that had not been sold or confirmed from a broker- dealer [emphasis added]. Less than 25% of the approximately 350 securities held by the Funds that were required to be fair valued were actually sold in the first six months of 2007 and price confirmations were sought for as few as 10% of the fair valued securities through broker-dealers on a monthly basis.

In its guidance, the SEC indicated that when the board has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague, we believe that the board’s involvement must be greater and more immediate. Also, a board acts in good faith when its fair value determination is the result of a sincere and honest assessment of the amount that the fund might reasonably expect to receive for a security upon its current sale, based upon all of the appropriate factors that are available to the fund. Furthermore, we believe that a board acts in good faith when it “continuously review[s] the appropriateness of the method used” in determining the fair value of the fund’s portfolio securities. Compliance with the good faith standard generally reflects the directors’ faithfulness to the duties of care and loyalty that they owe to the fund.

There are three takeaways for fund boards from this enforcement action. First, funds should utilize a pricing service to daily price all held securities. Second, it is known that fund advisers have extraordinary influence over fund pricing processes, especially with fund administrators, however any overrides they provide should be completely explained and vetted by the board of directors/trustees. Lastly, the Valuation Committee or Fund Accounting should utilize a pricing model that would effectively analyze future cash flows that a particular bond in a portfolio would generate. Also, there are pricing programs available that price derivatives. At Integral Financial, PC we are a strategic partner, and our consultants are proficient program operators, with a renowned derivatives pricing company.

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SEC Issues Risk Alert on Investment Adviser Custody Rule

March 19, 2013 James Hardaway Jr. Compliance, Final Regulations, Hedge Funds, Mutual Funds, Private Equity

On March 4, 2013, the SEC issued a Risk Alert on compliance with its custody rule for investment advisers. This alert comes from recent SEC examinations where significant deficiencies were found in custody-related issues in about one-third of the firms examined.

The following three (3) deficiencies found appears to be concerning for investment advisers:

Failure to recognize that they have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services.
Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
For advisers to audited pooled investment vehicles, the failure to meet requirements to engage an independent accountant and demonstrate that financial statements were distributed to all fund investors.

It is recommended that, in addition to review for compliance with the custody rule, advisers review account agreements for any custody situations. And immediately remove any clauses in agreements which are inactive.

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FinCen Issues Mandate to Electronically File SARs and Other Forms

March 9, 2013 James Hardaway Jr. Compliance, Mutual Funds

On March 8, 2013, the Financial Crimes Enforcement Network (FinCEN) issued a reminder requiring the electronic filing of most Bank Secrecy Act (BSA) reports. The required electronic filing forms are: the Suspicious Activity Reports (SARs), the Currency Transaction Reports (CTRs), the Registration of Money Services Business (RMSBs), and the Designation of Exempt Person Reports (DOEPs). Financial institutions were reminded that they must begin using the new FinCEN reports by April 1, 2013. These forms are available only electronically through the BSA E-Filing System.

They stated that financial institutions that continue to file mandated reports in paper format will fail to meet BSA reporting requirements and may be subject to civil money penalties. Also, after March 31, 2013, FinCEN may reject any mandated reports filed in paper format and return them to the filing institution.

In February 2012, FinCEN announced that it updated the BSA E-Filing System’s User Test System Web site to allow for testing submissions of batch and computer-to-computer filings of their new CTRs and SARs.

The updates to the User Test System enabled information technology professionals, including both vendors and the in-house IT staff of financial institutions, to begin testing their programs that will eventually be used to file batch or computer-to-computer submissions of the new reports based on the above-referenced technical specifications. The User Test System began to accept filings of these new reports in March 2012.

On December 20, 2011, FinCen announced that the mandatory use of these new reports will take effect on March 31, 2013. They will continue to accept submissions to its BSA E-Filing System that use the most current “legacy” forms (such as the CTR, CTR by Casinos, and industry-specific SARs) until the mandated use of the new reports in 2013.

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2013 SEC Broker-Dealers, Market Oversight, and Transfer Agents Examinations Scopes and Objectives

March 4, 2013 James Hardaway Jr. Compliance, Hedge Funds, Mutual Funds, Private Equity

On February 21, 2013, the SEC published its targeted operations of registrants in planning and conducting compliance examinations for 2013. The list was provided by the National Exam Program (“NEP”), which governs and manages federal examiners of broker dealers, SRO’s, and transfer agents. Following are the relevant broker dealer, market oversight, and transfer agent NEP examination focus areas.

Broker-Dealer Exam Program:

The Broker-Dealer (“B-D”) Program operates the SEC’s examination program for more than 4,600 registered broker-dealers with approximately 111 million customer accounts, over 160,000 branch offices, and over 630,000 registered representatives. The B-D Program also coordinates closely with the Financial Industry Regulatory Authority (“FINRA”) and state regulators.

In addition to the specific risks unique to each registrant, the SEC will consider the following focus areas when scoping and conducting examinations in 2013.

Ongoing Risks

Sales Practices/Fraud. The B-D Program frequently finds fraud in connection with sales practices regarding retail investors, including:

Ponzi or pyramid schemes that target members of identifiable groups, such as religious or ethnic communities, the elderly, or professional groups (affinity frauds).
Unsuitable recommendations of higher yield products (e.g., municipal or corporate bonds), as well as improper supervision and due diligence regarding recommendations or products;
Activities and products on the periphery of certain registered entities, such as outside business activities or an affiliated entity that the registrant claims is beyond the SEC’s jurisdiction;
Conflicts of interest that are not appropriately mitigated, and are not clearly disclosed in an understandable and timely manner;
Certain firms identified as recidivist (repeat violators), or high-risk.

Trading. The SEC will focus on trading risk areas with high frequency trading, algorithmic trading, proper controls around the use of technology, alternative trading systems and order routing practices.

Capital. Examine clearing firms with multiple correspondents engaging in high frequency/high volume trading. Areas reviewed will be internal controls for managing intraday liquidity risk, as well as assessing intraday net capital and other financial risks.

AML. Examine identified clearing and introducing firms with weak anti-money laundering (“AML”) programs. Especially customer identification programs (CIP), suspicious activity identification and reporting deficiencies, and weak due diligence procedures regarding certain accounts. Focus areas will be the firm’s risk assessment of its business practices and implementation of the AML program related to those risks, including risks associated with taking on the accounts of failed or expelled firms.

New and Emerging Issues

Exchange Act Rule 15c3-5, (the Market Access Rule). Review and evaluate firms’ compliance with this rule in the following operations:

Master / Sub-Accounts: The SEC stated that the structure of this model lends itself to potential issues related to money laundering activity, market manipulation, unregistered broker-dealers, excessive margin, and inadequate minimum equity for pattern day traders. They will also evaluate the adequacy of books and records maintained by broker-dealers that provide market access;
Proprietary Trading: Some firms are unaware that the Rule applies to, and requires capital thresholds on, proprietary trading, including error accounts. These thresholds must also encompass a methodology for accounting for open quotes, taking into account quotes associated with market making activities;
Supervision of Registrants’ Technology System Controls and Governance: The SEC found that a series of technology system problems caused firms’ “significant losses and eroded customer confidence in the markets.” These technology system errors have occurred at both the exchange level as well as at multiple broker-dealers. Therefore they will review and evaluate: effectiveness of controls and oversight over technology systems; supervision of personnel; adequacy of firms’ protocols to address systems that are acting counter to expectations; and the robustness of firms’ risk management procedures.
Dual Registrants/ Regulatory Coordination: As a result of the insufficient risk mitigation found in 2012 by certain broker-dealers dually registered as futures commission merchants, the SEC will maintain its focus in this area, in coordination with the Commodity Futures Trading Commission. Moreover, the SEC is emphasizing stronger coordination among “Designated Examination Authorities.”

Exchange-Traded Funds. Recent identified operations risk with ETFs, such as fails to deliver and compliance with Regulation SHO. In addition, they will continue to review the suitability of recommendations of leveraged or inverse ETFs to retail investors.

Policy Topics

JOBS Act. In 2013 the approval of the final rule relating to the JOBS Act, which creates a new exemption from registration under the Securities Act for qualified “crowd funding” transactions, is expected. They will review firms participating in the crowd funding business.

Other Regulatory Requirements. The SEC intends to assess compliance with the new registration and related rules applicable to municipal advisors and incentive compensation, pending adoption of final rules. Also, examine firms for compliance with Security-Based Swap Dealers rules pending the final adoption or compliance effective date for such rules.

Market Oversight Exam Program:

The report noted that OCIE’s Office of Market Oversight is responsible for examining certain SROs and other entities to evaluate their compliance with applicable Federal securities laws and rules and the SRO’s own rules. The SROs subject to Market Oversight’s review include the national securities exchanges (both equity and options market centers), FINRA, and the Municipal Securities Rulemaking Board. Market Oversight also oversees the Public Company Accounting Oversight Board and the Securities Investor Protection Corporation. The 2013 risk-based exam focus will include the following priorities:

Risk Assessment Examinations of Exchanges. Market Oversight will conduct targeted, risk focused SRO examinations. Through recent assessment examinations of each SRO, Market Oversight has established a baseline for comparing the effectiveness of compliance programs across the SROs. The identified risk areas include: examinations of equity exchanges to review the internal controls and governance around each exchange’s rule making process and the supervision of regulatory service agreements by exchanges.

FINRA Oversight. Market Oversight will continue its efforts to enhance oversight of FINRA. They will evaluate and prioritize evolving and varying risks at FINRA to identify areas for review. Including those program areas specifically outlined in Dodd-Frank Section 964, as well as areas not articulated in Section 964 for possible oversight.

Examinations of New Registrants. Inspect recently registered exchanges and will continue to meet with entities intending to register as an exchange. Also review of security-based swap execution facilities if the SEC adopts final rules requiring their registration.

Regulatory Responsibility Examinations. Market Oversight plans to continue its review of the SROs’ obligations to enforce member compliance with financial responsibility requirements.

SRO Monitoring. Coordination of examination efforts with the Division of Trading and Markets (“TM”) through joint regulatory conferences, evaluation of oversight issues identified through broker-dealer examinations, and collaboration with TM on review of SRO activities and with the Division of Enforcement on related investigations. It was noted that Market Oversight also reviews significant market events with the assistance of the SROs, and conducts these activities, in part, to identify emerging risks and to work with the SROs on effective, real time mitigation strategies.

Systems Compliance. Continue to review and evaluate systems outages, systems errors, and system integrity through SRO self-reporting. Coordinate with the interdisciplinary Market Event Response Team, which examines market events in real time.

Order Type Assessments. Conduct inspections of equities exchanges to determine the types of orders available and the internal governance process around how order types are proposed, implemented, and monitored post-implementation.

Transfer Agent Exam Program:

The Transfer Agent Program examines approximately 460 transfer agents consisting of both SEC-registered (approximately 75% of the transfer agent population) and bank-registered transfer agents. In addition to core transfer agent services (defined below), certain transfer agents may provide paying agent services, which reported at the end of 2011 distributing over $1.8 trillion in shareholder dividends and interest payments.

Ongoing Risks.

The staff anticipates the ongoing risks that will be the focus for transfer agents in 2013 include:

Transfer Agent Core Activities. Transfer agents mainly engage in three core activities: the timely turnaround (elapsed time it takes to process) of items and transfers (Exchange Act Rule 17Ad-2); accurate recordkeeping and associated retention (Exchange Act Rules 17Ad-6 and 17Ad-7); and safeguarding funds and securities (Exchange Act Rule 17Ad-12). The SEC will focus on compliance with these core transfer agents’ regulations, and controls in these critical core activities.

Transfer Agent Safeguarding. Examine transfer agent services which heighten the risk of investor loss, such as paying agent activities located in non-bank registered transfer agents, and direct securities transactions where a transfer agent accepts shareholder orders (e.g., employee stock plans). Also, purchase and sale services which cause risk of engaging in unregistered broker-dealer or investment adviser activity if they offer investment advice. The SEC will focus on whether transfer agents provide appropriate customer service without offering investment advice that would require the transfer agent to register as either a broker-dealer or an investment adviser.

Transfer Agent Recordkeeping and Retention. Review and evaluate whether transfer agents have policies and procedures that include: business continuity procedures related to facility or other business impediments; electronic storage, appropriate redundancy, and timely retrieval for the required regulatory periods; and third-party vendor access and security.

Transfer Agent Size, Volume, and Experience. The size of, volumes processed by, and experience of, a transfer agent may also indicate heightened risks. For example, a transfer agent with a staff of only one or two may have an enhanced risk profile caused by key person risk. Additionally, the risk potential may increase as transfer agents service more issuers or handle increased numbers of transfers. Newly-registered transfer agents generally pose an increased risk, as they may not fully understand the requirements of applicable regulations.

New and Emerging Issues.

Microcap Securities and Private Offerings. Examine transfer agents that service microcap securities, especially those involved in private offerings. They may facilitate the unregistered offering of restricted securities by allowing securities transfers that could circumvent existing rules or enable fraudulent schemes. Review and evaluate whether transfer agents have effectively implemented formal written policies and procedures for the appropriate removal of restrictions on microcap securities. Specifically, if the transfer’s policies and procedures include, for example, an understanding of roles of the other parties involved with the transactions (e.g., attorneys, brokers, control persons, etc.), the identification of potential conflicts associated with those parties, as well as appropriate actions to be taken where conflicts may be identified.

Conflicts of Interest. Examine transfer agents where conflicts of interest may arise if principals are owners of or affiliated with issuers, vendors, or others involved in the transfer agents’ activities (e.g., attorneys, brokers, etc.). Review and evaluate if implemented formal written policies and procedures: identify, disclose, and mitigate conflicts where those conflicts could lead to unlawful activities.

Hybrid Securities. Hybrid securities increase the risks that transfer agents’ existing procedures and operations do not appropriately reflect the characteristics of these new securities. Some hybrid securities combine characteristics of equity and debt securities include, for example, preferred shareholder classes, convertible securities, and equity warrants or options. The SEC will review and evaluate whether transfer agents have implemented effective formal written policies and procedures that reflect all types of securities serviced by the transfer agent (including those that are new or complex) and can demonstrate an in-depth understanding of the instructions required for transfers and/or conversions of those security types.

Outsourcing. Examine those transfer agents who outsource certain activities to other registered transfer agents or, depending on the activity, other types of financial intermediaries. In addition, examine those larger transfer agents who establish “off-site” processing centers in out-of-state or non-US locations. Determine whether transfer agents that outsource services have implemented effective formal written policies and procedures and appropriate contractual clauses (or service level agreements) that, for example, help monitor, ensure, and maintain the appropriate processing environment for meeting their regulatory obligations and allow for timely and accurate production of books and records.

Third Party Administration. Examine transfer agents who provide “third party” administration services, which include transfer agent recordkeeping functions performed for parties other than the issuer of a Section 12 security, (e.g., a retirement plan). These recordkeeping activities are generally related to either a specific plan or performing services in conjunction with a mutual fund company and keeping plan members’ records at the omnibus level with the mutual funds’ transfer agents. Review and evaluate acceptance and routing of plan-member orders, and whether these registrants have effectively implemented policies and procedures that evaluate their activities to help identify when the activities may require either broker-dealer or investment adviser registration. In connection with IA-IC examinations, the SEC will request information on third-party administrators, and may use this information to consider whether entities that provide these services are appropriately registered or exempt from registration.

Policy Topics.

The report noted that the Transfer Agent Program may review areas in order to understand better the practices of transfer agents, which will help examination staff in informing the drafting of new rules (e.g., potential rule writing by the SEC regarding the JOBS Act), or review the effects of any new regulation for transfer agents, if adopted, and associated compliance. Additionally, the policy divisions may request the examination staff to review practices related to pending or implemented industry initiatives (for example, dematerialization, proxy reform, and escheatment practices).

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The 2013 SEC Investment Advisers and Investment Companies Examination Scopes and Objectives

February 23, 2013 James Hardaway Jr. Compliance, Hedge Funds, Mutual Funds, Private Equity

The SEC recently published its targeted operations of registrants in planning and conducting compliance examinations for 2013. The list was provided by the National Exam Program (“NEP”), which governs and manages federal examiners of broker dealers, investment advisers, and investment companies with a more intense focus on national risk management issues. Following are the relevant investment advisers and investment companies NEP examination focus areas.

National Level:

Corporate Governance and Enterprise Risk Management. The NEP will continue to discuss with registrants’ senior management and boards of entities how they govern and manage financial, legal, compliance, operational, and reputational risks. This initiative is designed to: (i) understand firms’ approach to enterprise risk management; (ii) evaluate firms’ tone at the top; and (iii) initiate a dialogue on key risks and regulatory requirements. The purpose of these “discovery” reviews is to inform both examination policy and rulemaking efforts and joint monitoring efforts with other regulators. For example, the Commission has joined the Federal Reserve in monitoring reform of tri-party repurchase agreements and practices. In addition, Hurricane Sandy brought to light certain gaps in some registrants’ business continuity plans. They will identify the overall impact of the hurricane on certain entities’ operations, including the obstacles they confronted when implementing their business continuity plans.

Conflicts of Interest. This is the top national risk management issue for the NEP’s risk-based strategy. They indicated that conflicts of interest are a particularly important challenge for large and complex financial institutions. Due to these firms’ extensive affiliations, and the dynamic nature of their businesses, conflicts are constantly arising and changing. They will focus on the steps registrants have taken to mitigate conflicts, and the sufficiency of disclosures made to investors. The staff will also look at the overall risk governance framework that firms have in place to manage conflicts on an ongoing basis.

IA-IC Examination Target Areas

The NEP’s registered investment advisers and investment companies target areas, grouped by ongoing risks, new and emerging issues, and policy topics are as follows.

Ongoing Risks

Safety of Assets. They will continue to utilize a risk-based asset verification process to confirm the safety of client assets and compliance with custody requirements. This will include, a review of the measures taken by registrants to protect client assets from loss or theft, and the adequacy of audits of private funds, and the effectiveness of policies and procedures in this area. It was noted, that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under Advisers Act Rule 206(4)-2 (the “Custody Rule”). Therefore the new focus will be whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.

Conflicts of Interest Related to Compensation Arrangements. Review of financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present. Focus activities include: undisclosed fee or solicitation arrangements; referral arrangements (particularly to affiliated entities); and receipt of payment for services allegedly provided to third parties. For example, advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms because such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.

Marketing/Performance. An inherent high-risk area, they will focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements. Where feasible, the staff will also review changes in advertising practices related to the JOBS Act, which requires modification of the rules restricting general solicitations.

Conflicts of Interest Related to Allocation of Investment Opportunities. They will target advisers managing accounts that do not pay performance fees (e.g., most mutual funds) side-by-side with accounts that pay performance-based fees (e.g., most hedge funds). Focus will be on confirmations that registrants have controls in place to monitor the side-by-side management of its performance-based fee accounts, such as certain private investment vehicles, and registered investment companies, or other non-incentive fee-based accounts, with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.

Fund Governance. Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination. Focus will be on confirmations that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.

New and Emerging Issues

New Registrants. The NEP stated that since the effective date in early 2012 of Section 402 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, approximately 2,000 investment advisers have registered with the SEC for the first time. The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC. Therefore a coordinated national examination initiative designed to establish a meaningful presence with these newly registered advisers will begin this year. The initiative is expected to run for approximately two years and consists of four phases: (i) engage with the new registrants; (ii) examine a substantial percentage of the new registrants; (iii) analyze our examination findings; and (iv) report to the industry on our observations. Also they will prioritize examinations of private fund advisers where the staff’s analytics indicate higher risks to investors relative to the rest of the registrant population, or there are indicia of fraud or other serious wrongdoing.

Dually Registered IA/BD. It was noted that due to the continued convergence in the investment adviser and broker-dealer industry, the IA-IC Program will continue to expand coordinated and joint examinations with the B-D Program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals. Prime targets will be financial professionals who conduct brokerage business through a registered broker-dealer, but does not own or control it. However, they conduct investment advisory business through a registered investment adviser who they own and control, but that is not overseen by the broker-dealer. Reviews will include how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed. And dually registered firms’ policies and procedures to understand if such policies and procedures provide guidelines for when a financial professional makes a securities recommendation to a customer with a broker-dealer account versus an investment adviser account.

“Alternative” Investment Companies. This new target area is due the recent proliferation of alternative and hedge fund investment strategies in open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures. Focus areas will be assessment of: (i) leverage, liquidity and valuation policies and practices compliance with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.

Payments for Distribution in Guise. Focus will be the wide variety of payments made by advisers and funds to distributors and intermediaries; the adequacy of disclosure made to fund boards about these payments; and boards’ oversight of the same. Payments such as revenue sharing, sub-TA, shareholder servicing, and conference support will be assessed on whether they are made in compliance with regulations, including Investment Company Act Rule 12b-1, or whether they are instead payments for distribution and preferential treatment.

Policy Topics

Money Market Funds. The focus will be on the recent amendments to Investment Company Act Rule 2a-7 that require money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, including changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks. The reviews will include whether firms are conducting stress testing, what factors they are considering in the stress testing, and the results of the stress testing.

Compliance with Exemptive Orders. The focus will be on compliance with previously granted exemptive orders, such as those related to closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.

Compliance with the Pay to Play Rule. The intent of the recently adopted Pay to Play Rule is to prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices).

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IOSCO Issues Final Report on Suitability Requirements for Distribution of Complex Financial Instruments

February 16, 2013 James Hardaway Jr. Compliance, Final Regulations, Hedge Funds, Mutual Funds, Private Equity

In January 2013, the IOSCO issued its final report, after comments from FINRA and others, entitled Suitability Requirements with Respect to the Distribution of Complex Financial Products (the “Consultation Report”). The purpose of the Consultation Report was to recommend principles focusing on customer protections, including suitability and disclosure requirements, relating to the distribution by intermediaries of complex financial products to retail and non-retail customers based on a review of its members’ existing regulatory frameworks, as well as the lessons learned from the 2008 financial crisis and relevant actions taken in response.

The IOSCO issued the following nine “principals” and implementation frameworks for utilization by its members:

Principle 1: Intermediaries, e.g. broker dealers, should be required to adopt and apply appropriate policies and procedures to distinguish between retail and non-retail customers when distributing complex financial products. The classification of customers (many types of complex financial products often have a “counterparty.” Accordingly, where the term customer is used in this report, the term is also deemed to refer to counterparties) should be based on a reasonable assessment of the customer concerned, taking into account the complexity and riskiness of different products. The regulator should consider providing guidance to intermediaries in relation to customer classification.

Regulators in implementing this principal should provide guidance on the process for intermediaries to independently and periodically distinguish between retail and non-retail customers. The suggested criteria included: nature of the customer (e.g. regulated or unregulated, and business or consumer); financial position; expertise in complex financial instruments, including the ability to assess independently the value, features, and risks of these products.

Principle 2: Irrespective of the classification of a customer as retail or non-retail, intermediaries should be required to act honestly, fairly and professionally and take reasonable steps to manage or mitigate conflicts of interest through implementing appropriate procedures in the distribution of complex financial products, and where there exists a potential risk of damage to the customer’s interest, the intermediaries should, where appropriate, be required to clearly disclose the risk.

Intermediaries should disclose to all of its customers any conflict of interest related to these instruments. Further, they should also have policies and procedures to assess whether the customer has sufficient knowledge and expertise to evaluate the transaction, and to evaluate any conflicts of interest that are inherent to the transaction.

Principle 3: Customers should receive or have access to material information to evaluate the features, costs and risks of the complex financial product. Any information communicated by intermediaries to their customers regarding a complex financial product should be communicated in a fair, comprehensible and balanced manner.

Intermediaries should exercise “reasonable care” in giving potential customers information about these instruments. This information includes: the specific risk-return profile; scenario presentations based on reasonable assumptions about the risks and benefits; a description of the different components of the products and how these components interact and affect the risks. Such disclosures should be tailored to the type of customer and their level of skill or knowledge of complex financial instruments.

Further, “customers should have reasonable access to information that allows them to identify costs and charges relating to the purchase of a complex financial product including, ideally, if practical and feasible, on an unbundled basis (i.e. a breakdown of the components of the total price). When a liquid secondary market for a complex financial product does not exist, the only prices available may be from the intermediary that sold the customer the product. The intermediary should know and disclose ahead of time how these prices will be computed (using models, other markets for similar products, etc.) and what the price represents (mid-market theoretical value, re-purchase prices, etc.). The customer should have access to enough information to know that the product is illiquid, including information about the means and range of timing for disinvestment (for instance, the customer should be informed if the intermediary or another entity belonging to the same group is the only source of liquidity for the instrument). Where practical and feasible, intermediaries should seek to provide customers with comparative information concerning appropriate alternative investment products, to the extent that such products are available.”

Principle 4: When an intermediary sells a complex financial product on an unsolicited basis (no management, advice or recommendation), the regulatory system should provide for adequate means to protect customers from associated risks.

It is recommended that regulators establish baseline disclosure and distribution requirements for these instruments. For example, supervisory approval before opening accounts; prohibiting trade execution-only services for complex financial products; and prohibiting these products for sale to retail customers.

Principle 5: Whenever an intermediary recommends the purchase of a particular complex financial product, including where the intermediary advises or otherwise exercises investment management discretion, the intermediary should be required to take reasonable steps to ensure that recommendations, advice or decisions to trade on behalf of such customer are based upon a reasonable assessment that the structure and risk-reward profile of the financial product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.

The IOSCO stated that intermediaries should have a robust process to assess the profile of a customer and document how suitability determinations would apply on the basis of, among other things, the following factors relating to the customer: investment objectives, including the length of time for which they wish to hold the investment; age of the customer may be relevant for this factor; risk tolerance and relevant risk preferences, taking into account the purpose of the investment and the need for portfolio diversification; financial situation (e.g., the customer’s other assets, income and tax liabilities) and general capacity to withstand losses of trading complex financial products; investment experience and knowledge in relation to complex financial products, including the nature, volume and frequency of previous transactions and level of familiarity with relevant complex financial products and services. The customer’s profession, former professional experience, and level of financial education may also be relevant; liquidity needs; any other relevant information the customer may disclose to the intermediary in connection with the recommendation.

Further, before recommending complex financial products to customers, intermediaries should themselves develop a thorough understanding of the features of the relevant product and its complexity and associated risks taking into account, when providing individual portfolio management or advice, the composition of the customer’s portfolio. Which includes; how the complex financial products are structured and priced; the nature and complexity of a product’s pay-off and underlying components, if any; the relevant level of risk (with, if appropriate, a separate assessment of counterparty, liquidity and market risks); the experience and reputation of the issuers and product providers/manufacturers; – any fees, charges or any other costs associated with the product; the level of liquidity; the lock-in periods and relevant termination conditions exit options and associated costs; how the product performs under abnormal or extreme conditions; and, the nature of any guarantees.

Care should be given to the different components of a complex financial product in order to foster customer understanding of the risks associated with them. The complex financial products selected by intermediaries for distribution to their customers should in general meet the needs of the customer group at which the intermediary aims its services.

Finally, intermediaries should keep written evidence of the information required by the regulator to be gathered from customers as part of the suitability determination. In addition, regulators should require intermediaries to retain documentation to the extent that such written documentation is created, to evidence any inquiries and analysis they made when carrying out the product and customer due diligence.

Principle 6: An intermediary should have sufficient information in order to have a reasonable basis for any recommendation, advice or exercise of investment discretion made to a customer in connection with the distribution of a complex financial product.

The intermediary should not sell the product to the customer if they do not have sufficient information to determine suitability, or should immediately inform customer that their recommendation to purchase the product is based on limited suitability information.

Principle 7: Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability requirements, including when developing or selecting new complex financial products for customers.

Principle 8: Intermediaries should be required to develop and apply appropriate incentive policies designed to ensure that only suitable complex financial products are recommended to customers.

The IOSCO recommended that senior management should be responsible for regularly reviewing incentive schemes and distribution practices by sales staff. And remuneration structures and related sales staff incentive programs should not conflict with the duty to act honestly, fairly and professionally, and consistent with the best interests of the customer. Regulators should consider taking steps to require disclosure of remuneration structures and policies (e.g., commissions received by the distributors from the product issuers) as a means to reduce the risks of financial incentives that could lead to unsuitable advice or recommendations.

Principle 9: Regulators should supervise and examine intermediaries on a regular and ongoing basis to help ensure firm compliance with suitability and other customer protection requirements relating to the distribution of complex financial products. The competent authority should take enforcement actions, as appropriate. Regulators should consider the value of making enforcement actions public in order to protect customers and enhance market integrity.

The IOSCO defined “complex financial products” as financial products, whose terms, features and risks are not reasonably likely to be understood by a retail customer (as that term is defined in individual jurisdictions) because of their complex structure (as opposed to more traditional or plain vanilla investment instruments), and which are also difficult to value (i.e., their valuations require specific skills and/or systems, particularly when there is a very limited or no secondary market). The term generally includes, but is not necessarily limited to, structured instruments, credit linked notes, hybrid instruments, equity-linked instruments and instruments whose potential pay-off is linked to market parameters, asset-backed securities (“ABSs”), mortgage-backed securities (“MBSs”), collateralized debt securities, and other financial derivative instruments (including credit default swaps and covered warrants). The term does not include conventional equities, conventional bonds, plain vanilla unit trusts and mutual funds and exchange-traded standardized derivatives contracts. The list is intended to be illustrative and non-exhaustive. The above criteria should be taken into account when determining the level of complexity of a financial product.

Further, they listed the following issues which may be considered by intermediaries when carrying out product due diligence in assessing suitability of a complex financial product

For whom is the product intended, e.g., limited or general retail distribution? If limited, how will the firm prevent distribution beyond the targeted customer group?
What is the product’s investment objective and how does the product improve upon the firm’s current offerings? Are less complex, less costly, and/or less risky products available to accomplish the same investment objective(s)? Are the product’s costs transparent to investors to allow independent cost comparison with other products?
What key assumptions underlie the product’s performance over time, e.g., market behavior, interest rate changes, market volatility and market liquidity? What are the qualifications of the persons making the assumptions that underlie projections of the product’s performance?
How a complex financial product is structured and priced, its underlying components, its functions, and how it is described to the customer. In other words, does the complexity of the product impair understanding and transparency of the product? If so, what are the implications for the training requirements for the sales staff? Will the product require development or refinement of in-house training programs for sales personnel and their supervisors? In what respects?
What promotional or sales materials will be used to market the product? What risks must be disclosed and how will those disclosures be made? What sorts of disclosures are needed to achieve a balanced promotion of the product to the targeted customer group?
The relevant level of risk (with, if appropriate, a separate assessment of counterparty, liquidity and market risks). For example, what are the product’s principal risk factors? Do they include any currency, legal, tax, market, or credit risks?
The experience and reputation of the issuers;
Any fees, charges or any other costs associated with the product;
How liquid is the product? Will there be an active secondary market for the product, e.g., with liquidity providers? How will the fact that a particular product is illiquid impact its valuation during its life span? Will the product be marginable?
The lock-in periods, exit options and associated costs; and
The nature of any guarantees.

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2013 SEC Broker-Dealers, Market Oversight, and Transfer Agents Examinations Scopes and Objectives

The 2013 SEC Investment Advisers and Investment Companies Examination Scopes and Objectives

IOSCO Issues Final Report on Suitability Requirements for Distribution of Complex Financial Instruments

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