A couple of weeks ago, the SEC released an opinion in a markup/markdown matter where a substantial penalty was imposed on the registered representative in large part because his actions were not in conformity with industry standards. At the time, I wrote:
the Commission is engaging in a bit of "having it both ways" here. Its findings are based on the fact that the respondent did not follow industry norms. However, if a respondent were to offer as a defense that his behavior was within industry norms, the Commission would likely give this little or no weight.
Eleven days later, the Commission released an opinion in another matter
in which one of the respondents' defenses was that their actions were in compliance with industry standards. The Commission here stated: "While compliance with industry standards is a consideration, it is only one factor to be weighed." You really can't win: if the respondent complied with industry standards, it's just one factor to be considered, but failure to comply with industry standards is determinative.
UPDATE: On further review of the opinion, I think I may have oversimplified. The Commission states:
We reject PCM's assertion that its conduct was not egregious because it complied with industry standards. PCM engaged in a variety of fraudulent and deceitful conduct, as well as deliberate and reckless disregard of various regulatory requirements.
Ouch -- that's strong language. I think that the message here is that the Commission is implicitly rejecting the ALJ's original finding that the behavior complied with industry standards.
Bloomberg reports a new twist in the ongoing eSpeed/BrokerTec litigation: BrokerTec is alleging that eSpeed engaged in "industrial espionage" by inducing BrokerTec customers to give it BrokerTec users guides.
eSpeed, a unit of Cantor Fitzgerald, and BrokerTec both operate electronic marketplaces for cash U.S. government securities. eSpeed originally sued BrokerTec in June, alleging patent infringement.
The CBOT has approved new membership rules that, for the first time, will permit entities with non-members or passive investors to become CBOT member firms. Access to the advantages of membership for these firms will come at a steep price, however. Such firms will be required to own 4 full memberships and 2 associate memberships. Currently, buying those 6 seats would be in the neighborhood of $2.0 million. That's less than the CME (where becoming a member firm with access to the most favorable exchange fee rates would cost about $5.0 million), but a big step up from current practice at the CBOT, where only one full membership was required for a firm to have access to the most advantageous exchange fee rates.
The SEC released an opinion in a matter involving markups/markdowns on debt securities. The ALJ that originally heard the matter dismissed the proceedings against the individual. The Commission, on appeal, imposed a substantial penalty on the individual, including both a civil fine and disgorgement.
Two thoughts arise. First, read together, the ALJ's initial decision and the Commission's opinion provide an excellent primer to issues and standards regarding markup/markdown on debt. In fact, the Commission opinion specifically states that, to the extent there was ambiguity previously regarding such standards, that ambiguity has been clarified. In other words, the Commission's opinion is now the definitive expression of permitted practices in this area.
Second, how is it that the Commission and the ALJ saw things so differently? Differing opinions make the market, of course, but how is it possible for the same behavior to cause different reviewers to reach such different conclusions? For example, the Commission states:
the evidence clearly establishes that Anderson's markups and markdowns deviated significantly from industry norms.
In contrast, the ALJ found industry norms to be only one factor to be considered and that one must determine whether "under all the circumstances of the transaction, the price charged for the security was reasonably related to the prevailing market price." Using that standard, the ALJ concluded that the respondent
is entitled to a profit and I conclude that the Division has failed to prove the prices that he charged his clients were not reasonably related to the prevailing market prices of the securities. He also attempted to cooperate with the NASD inquiry.
There were other differences in opinion as well. The Commission, in assessing penalties, states that the risk of future violations by the respondent
"is heightened by Anderson's unwillingness to accept the wrongfulness of his conduct."
One reason for such unwillingness might be the statement by the ALJ that
"Careful analysis of the ninety-six bond trades in the instant case reveals that Anderson acted fairly based on the type of security."
[A side note: the Commission is engaging in a bit of "having it both ways" here. Its findings are based on the fact that the respondent did not follow industry norms. However, if a respondent were to offer as a defense that his behavior was within industry norms, the Commission would likely give this little or no weight].
One clue to why the Commission reached such a different conclusion than the ALJ can be found in facts that the Commission cites in its opinion. One can assume that the Commission includes in its opinions those facts that it finds significant and included were the following facts and testimony:
[The respondent] testified that, at some point in time, he owned a bond yield calculator, but it broke and he never replaced it.... [He] was unable to recall "[s]pecific" details regarding particular transactions. He retained no notes regarding his trades. He explained that he "never thought [he would] need them and it's a very . . . paper intensive business and . . . [his] files [were] stuffed already."
Presumably, the testimony came from the 1998 public hearing and would have dealt with transactions that occurred as early as 1992. That the respondent did not recollect specific transactions from years earlier is not surprising. What is surprising is that the respondent had so few records regarding the transactions. By having so few records, the respondent lost the opportunity to achieve the "halo effect."
The "halo effect" occurs when a firm or representative maintains well-organized records. Regulators simply do not have the personnel or resources to review all records that are required to be maintained. Thus, when records are requested and a firm promptly produces what appears to be complete and well-organized records, those records may receive only cursory review because the tidiness of the records creates the impression (deservedly or not) that the firm is in compliance with requirements.
Could better records have created a "halo effect" for the respondent and avoided this whole proceeding? There's no way of knowing. Was the lack of records determinative? Probably not, but the Commission found it significant enough to be one of the first facts noted in its opinion. Would it have been worth keeping better records? Consider that this matter was commenced by issuance of an OIP (Order Instituting Proceedings) in 1997. That means that the respondent has been paying attorneys fees and suffering the mental stress of this matter for almost six years. Even if he had won in the end, he would have paid a high cost. Anything that might have helped to avoid this situation from the beginning would have been a good investment indeed. One lesson that might be drawn here is that maintaining well-organized books and records is not just a regulatory requirement; it's also good business.
The SEC announced today that it had settled actions against SG Cowen and Lehman Brother for failure to supervise Frank Gruttadauria, a broker who misappropriated $115 million in customer funds over a fifteen year period.
The lesson for compliance officers in the press release comes from Stephen Cutler, SEC director of enfocement:
"At both SG Cowen and Lehman Brothers, the primary responsibility for overseeing Gruttadauria's daily retail brokerage activity was entrusted to Gruttadauria's own subordinates. We have grave doubts that such a structure — absent frequent and meaningful involvement by independent supervisors — could ever be effective."
Last month, a bill in Congress was tabled, in part due to complaints by Eliot Spitzer, attorney general of New York. Spitzer asserted that the bill would have undercut anti-fraud actions by state securities regulators. Actually, the bill would not have done that, but it would have made clear that, in the world of securities regulation, the SEC was the primary regulator and that state securities regulators could not, as part of settlement agreements with securities firms, impose regulatory requirements higher than the requirements set by the SEC.
All news reports about the bill focused on the SEC/state issue, but the bill also included provisions which would have allowed persons to produce privileged documents to the SEC without waiving the privilege as to other persons. Stephen Cutler, SEC director of enforcement, testified before Congress as to how beneficial he believed this provision to be, because it would cut down on the battles the SEC has to fight to get privileged documents. Currently, when a person waives a privilege to one person such as the SEC, he waives the privilege for all. Since many of the firms the SEC wants documents from may also have potential liability from private lawsuits, this creates a strong discentive for producing privileged documents. That's because producing a privileged document for the SEC means you also have to produce it for Bill Lerach.
Today's WSJ reports (subscription required) that RJR is asserting privilege and refusing to produce certain documents requested by the SEC. The article indicates that RJR is asserting that it cannot turn over the documents until a protective order is in place which would prevent the documents from being made public. Had the bill in Congress last month been enacted, RJR likely would not have a leg to stand on. The SEC could tell RJR that it didn't need the protective order because of the new law and further tell it that failure to produce the documents immediately would have consequences.
New York was an enthusiastic participant in the litigation against tobacco companies several years ago. So when Eliot Spitzer complained last month about the House bill, he probably never considered that one result of the bill not being enacted would be to help RJR's argument against producing privileged documents to the SEC.
The SEC today simultaneously instituted and settled proceedings against Steven L. Hunt. Between October 2001 and November 2002, Hunt was president and general counsel of two entities, one registered as a BD and one registered as an IA. Another individual, Wendell Belden, was chairman of both entities. Belden had been the subject of a 1993 disciplinary action for improper distribution of sales literature. Additionally, in August 2002, the NASD National Adjudicatory Council suspended, fined and imposed restitution payments upon Belden after finding that he made unsuitable recommendations to a client. The Oklahoma Securities Commissioner, in an apparent follow-on proceeding, also imposed penalties shortly thereafter.
So what did Hunt do? He failed to amend the Form BD and Form ADV of the firms to reflect any of these disciplinary events. The SEC barred Hunt, with the right to reapply in three years, from association with any BD or IA. The Commission indicated that it imposed no fine only because of Hunt's financial condition.
In July, an Illinois appellate court issued an opinion in litigation brought by certain members at the CBOT. There are different categories of CBOT membership and the litigation revolved around the number of shares each category would receive if the exchange converted from its current non-profit mutual ownership to stock ownership. William Blair, an investment banking firm, had assisted the CBOT in setting the planned ratio of shares between the categories. The court disagreed with the methodology used in determining the ratio and ordered that a fairness hearing (technically referred to as an "entire fairness hearing") be conducted that would determine who gets what.
This is an instance where the court, in trying to be fair, has probably cost every one involved. This litigation is one of the primary reasons that the CBOT has not yet converted to stock ownership. The delay has meant that the CBOT has continued to have to operate as a mutual membership entity, surely one of the least efficient governance structures ever invented. Complying with the court order will mean further delay at a time when the CBOT really needs to be focusing on its business and not on litigation (one estimate is that Eurex may take 25% of the CBOT's volume when it begins offering competing products next year). Furthermore, it is unclear why the fairness hearing ordered by the court will be fairer than the process undertaken by William Blair. "Fairness hearing" sounds dispassionate and equitable but it really boils down to asking if what is to be paid is in line with what is currently being paid for similar assets. Only the CME has done a similiar demutualization and the CBOT, and the relationships between its memberships, is different than the CME.
So how to conduct a fairness hearing when there is nothing comparable? I guess you do what William Blair did last time (i.e., you eyeball it and see what seems fair) but add lots of mathematical formulas and research to give it an appearance of precision. But, no matter how precise the appearance, the final determination will still only be an educated guess, just like William Blair's previous attempt to calculate the share ratios between the membership categories. The problem is that producing this educated guess will cost substantial time and the CBOT does not have much time. I think everyone involved would agree that loss of substantial market share to Eurex would have a strongly negative effect on any stock ultimately issued by CBOT. If the CBOT does loses substantial market share to Eurex, it will be due to a variety of reasons, not just this litigation. But wouldn't it be ironic if this litigation about how the pie is to be cut up contributes to the pie becoming much, much smaller?
The SEC has released a FAQ regarding the auditor independence rules released in January. Among other items, the FAQ confirms that the rules regarding compensation and partner rotation do not apply to auditors of non-issuer BDs and IAs.
Interesting WSJ article (subscription required) regarding the SEC's newly-announced policy prohibiting individuals who consent to injunctions from denying the allegations in later disciplinary proceedings. The article notes that David Becker, former SEC general counsel and now with Cleary, Gottlieb, believes the new policy is due partly to the SEC's irritation at having to spend time arguing facts in disciplinary proceedings. Becker says the SEC
"finds it galling that a litigant who has already settled would have the effrontery to litigate."
The Queen of Hearts said: "Sentence first, trial later." The SEC now appears to be saying: "Why have the trial at all?"
UPDATE: I have learned that the Queen of Hearts actually said "Sentence first--verdict afterwards." I have tried, without success, to work this into a snappy one-liner regarding the SEC's "how dare they?" attitude to those who would defend themselves in court. Any suggestions?
The WSJ reports (subscription required) that the Massachusetts securities commissioner is expected to file civil charges against Morgan Stanley alleging violations of anti-fraud provisions of the state's securities laws. At least in part, these allegations arise because Morgan Stanley brokers received incentives to sell the firm's proprietary mutual fund products; these incentives were not disclosed to customers. The WSJ reports that Morgan Stanley conducted a sales contest with cash prizes going to brokers that met or exceeded their quota for proprietary products. The WSJ notes that the regulators are expected to assert that the contest violated Morgan Stanley's procedures, which require that sales contests reward brokers for total sales of proprietary and non-proprietary products.
Among the evidence expected to be used is an email from the Morgan Stanley executive running the program which said "Please DO NOT put anything in writing via E-mail or fax" about the contest.
There was a recent entry here discussing how a email, pulled out of context by a regulator, can make a firm look bad. Here, however, there isn't any need to take the email out of context; this one just makes the firm look bad in context or out of context. Sending an email telling everyone not to discuss the contest in emails or faxes sure makes it look like the firm is trying to hide something. This is probably more damaging than if there were a number of back-and-forth emails discussing the contest. If that had happened, Morgan Stanley could argue that the contest was an inadvertent violation of its procedures (the old pure heart, empty head argument). Instead, Morgan Stanley now has to explain why it permitted a contest that appears to have been knowingly structured to violate its own procedures. That's a hard explanation to make and, in the end, that one email is likely going to be an expensive one for Morgan Stanley.
Representative Gregory Meeks, D-NY, has introduced HR 2836, the euphonically-named "Deadbeat Corporations Tax Accountability Act of 2003" to amend the Internal Revenue Code of 1986 to reduce a corporation's tax refund by fines and penalties imposed by reason of improper accounting or reporting practices or misstatements of its financial position. Rep. Meeks previously had opposed the SEC's settlement with Worldcom, and had urged the federal judge reviewing the settlement to overturn the deal in favor of more stringent remedies. Meeks cautioned that the settlement would become a classic example of "how crime does pay."
The CME issued a notice this week regarding exchange fees on GLOBEX transactions. While the information in the notice regarding entitlement to preferential clearing rates had previously been published, the notice also included information regarding penalties on any amounts due to the CME from fee audits. I believe this penalty information had not been previously published. The penalty is an eye-popping 2% interest per month, compounded monthly, for audit assessments for clearing fees. The difference between customer clearing fees and the most preferential member rate is already substantial and that interest penalty means that, for example, if trading done two years ago was reclassified, in addition to paying the higher clearing rate, an additional 60% or so in interest penalties would be tacked on.
The UK's Financial Services Authority, regulator of UK banking, securities, futures and other financial products, fined a bank in Northern Ireland £1.25 million (almost $2.0 million) for record keeping failures in verifying customer identities during the account opening process. There was no indication that any money laundering actually occurred.
Customer Identification Program (CIP) rules were adopted earlier this year for U.S. financial institutions such as securities broker-dealers and futures FCMs and IBs. Firms must be in full compliance with the CIP rules by October 1st. Expect regulators to "send a message" by assessing a similarly large fine against some U.S. financial institution for violation of the CIP rules shortly thereafter.
UPDATE: The FSA's press release regarding the matter emphasizes that the bank had identified the weaknesses in its account opening procedures but failed to correct them.
The LaBranche-NYSE feud continues (I think). Reuters is reporting that Robert M. Murphy, CEO of LaBranche, has resigned as NYSE Vice Chair and Director, effective immediately. While there is no elaboration as to the reason, the fact that Murphy's resignation is effective immediately sure seems to indicate a connection with the investigation.
UPDATE: A LaBranche news release explains the resignation by stating that
Mr. Murphy believes that it is appropriate at this time to devote his full attention to his duties as CEO of LaBranche & Co. LLC, the specialist subsidiary of LaBranche & Co Inc.
ANOTHER UPDATE: The NY Post has a story on resignation titled, with typical NY Post understatement, It's War at the NYSE. (If Murphy had been Chair instead of Vice Chair, the title could have been: Headless Board at the Big Board). Thanks to Paul Mackey for finding the story.
The CBOT today released a notice regarding a floor trading issue. The notice informs readers that
The Floor Governors Committee has recently reviewed several matters involving trading practices in which a floor broker executes an order opposite a local and immediately thereafter executes a second trade of equal or lesser quantity on the opposite side of the market for his personal account with the same local. Patterns of this type of trading may be indicative of non-competitive activity and may also represent violations of the following Exchange regulations....
The notice then lists CBOT regulations prohibiting a floor broker from taking the other side of orders and prohibiting accomodation trading.
The notice explains the basis for these regs:
The type of trading described above has the potential to undermine competitive trading, even in the absence of express arrangements. A floor broker, for example, may be more inclined to direct trade allocations to an individual who trades back a portion of the trade to him and, likewise, a local may seek to gain future favorable trade allocations by trading back a portion of a favorable trade to a floor broker.
The notice concludes:
In the past several months, the Floor Governors Committee has taken disciplinary action in a number of matters involving trading patterns of the type described above. The Committee therefore reminds all members of their obligation to ensure that their bidding and offering practices are at all times conducive to the open and competitive execution of transactions.
One reason for this notice was to inform CBOT members that this type of trading can be a problem. However, the notice also demonstrates how difficult it is for OIA, the CBOT's investigation department, to bring an action in these matters. The activity described in the notice, depending on the intent of the traders involved, can be perfectly innocent or can represent non-competitive trading. OIA thus has to try to read the minds of the individuals involved, which the investigators attempt to do by locating "trading patterns." However, "trading patterns" may mean little or nothing, particularly in illiquid contract months with few participants. Remember, the exact same trading pattern can either be okay or be a violation. It all depends on the intent of the traders.
Building a case in these instances is labor-intensive. Plus, OIA has the burden of the proof. This notice is probably an attempt, in least in part, to ease that burden. The notice will now be Exhibit 1 in any action brought by OIA in this situation and, in any hearing, I'm sure counsel for OIA will say something to the effect that "You admit that you continued to engage in this trading even after the notice was published?" OIA's job at a disciplinary hearing is to convince the panel that where there's smoke, there's fire and the notice will help them to do that.
The problem with giving OIA extra leverage with the notice is that it puts the trader even more on the defensive. Any trader charged in a matter like this suffers. The perceived damage to his reputation and the distraction of the investigation almost always causes the trader's trading to significantly worsen. Thus, in addition to any suspensions or penalties that are ultimately assessed by the hearing panel (or to which the trader agrees in a settlement), the trader suffers the economic losses of six or eight months of lousy trading.
Non-competitive trading cannot be tolerated if open outcry trading is to survive. However, this notice seems to subtly shift the burden to the trader when the requisite "trading patterns' appear on his trading cards. And while non-competitive trading is wrong, I'm not sure that "guilty until proven innocent" is any better.
The SEC has finalized amendments to Rule 17a-5(c), granting relief to BDs from having to provide customers with balance sheets twice annually. The amended rule permits a BD to instead provide a "financial disclosure statement" to customers twice annually that includes information on the BD's net capital and informs customers that its balance sheet is available at no cost by (i) calling a toll-free number; or (ii) accessing the firm's website.
Thanks to Paul Mackey for the pointer.
The CFTC announced that it has finalized amendments to its rules for commodity pool operators and commodity trading advisors. We had heard some time ago that the CFTC's target date for finalizing these rules was in early June; it will be interesting to see if there are any significant changes from the March 17th proposed rules.
UPDATE: The final rules can be found here. I haven't had an opportuntity to carefully review the release yet, but a quick read shows at least one fairly significant change: the trading limits under the new de minimis exemption have been expanded, so that the proposed "2 percent/50 percent" limits (i.e., futures trading was limited to the greater of (i) initial margin committed for futures could not exceed 2% of the liquidation value of the pool's portfolio; or (ii) the notional value of the pool's futures positions could not exceed 50% of the liquidation value of the pool's portfolio) are now "5 percent/100 percent" limits.
"When I use a word," Humpty Dumpty said in rather a scornful tone, "it means just what I choose it to mean -- neither more nor less."
-- Lewis Carroll, Through the Looking Glass
The SEC has adopted Humpty's views on the meaning of words. The Commission used a recent opinion, In the Matter of Marshall E. Melton and Asset & Research, Inc., to announce a new policy with regard to administrative actions following consent injunctions.
The Commission notes that, following the issuance of the Melton opinion on July 25th:
For purposes of consent injunctions that are agreed to and entered by a court after issuance of this opinion, we will construe the "neither admit nor deny" language as precluding a person who has consented to an injunction in a Commission enforcement action from denying the factual allegations of the injunctive complaint in a follow-on proceeding before this agency.
In other words, "neither admit nor deny" now means "admit."
The Corp Law Blog has an insightful discussion of the implications of the new SEC attorney conduct rules. Great work by Mike O'Sullivan.
UPDATE: The WSJ reports (subscription required) that the Washington State Bar Association, having received the letter of Giovanni Prezioso, general counsel of the SEC, is sticking to its guns. According to the story, the WSBA rejected Prezioso's opinion and issued an interim opinion that Washington State attorneys may not reveal client confidences except as permitted under the state's rules.
The CFTC announced settlements with three energy trading firms this week. The CFTC asserted the three firms engaged in false price reporting and attempted manipulation in the natural gas market. What was particularly interesting was the difference in the settlement amount among the three firms: Encana settled for $20 million, Williams settled for $20 million, but Enserco settled for $3 million. Why the difference? Richard Wagner, deputy director of enforcement for the CFTC, said Enserco "stepped forward and provided exceptional cooperation.”
It's always encouraging to see regulators reward cooperation. It now seems eons ago, but when Harvey Pitt first became chair at the SEC in 2001, he tried to create a "kinder and gentler" SEC. The SEC even released a report indicating that it would be willing to mitigate sanctions depending upon the cooperation received. That spirit of generosity didn't last too long -- within three months of the release of this report, I attended a conference where Stephen Cutler, head of SEC enforcement, made clear that SEC staff hadn't bought into "mitigation for cooperation." Of course, Pitt didn't last much longer. He was extensively criticized for being too soft on the industry and, over time, "kinder and gentler" overtures like the cooperation report fell by the wayside. Hopefully, the CFTC's willingness to mitigate for cooperation won't turn out to be a one-off like the SEC's.