SEC Proposes Regulation Best Interest for Brokers

On April 18, 2018, the SEC proposed “Regulation Best Interest,” which is the latest in a long and disputed line of proposed attempts by various governmental bodies to homogenize the duties owed by brokers and investment advisers to their respective clients. Professionals in the financial services industry and others should take note that they have until approximately July 23, 2018i to file a public comment on the proposed SEC rule, and investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.


For decades, customers of the financial services industry have been confused by (if not outright unaware of) the different “standards of care” that their “brokers” and “investment advisers” have owed them.

On the one hand, “[a]n investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care.”ii Investment advisers typically charge for their services via an annual fee assessed as a percentage of the “assets under management” (the so-called “AUM”) that the investment adviser “manages” for the client. The primary regulator of an investment adviser is either the SEC (usually for relatively larger investment advisers – i.e., those managing more than $100 million AUM) or a state securities commission (usually for relatively smaller investment advisers – i.e., those managing less than $100 million AUM).

On the other hand, brokers “generally must become members of FINRA” and are merely required to “deal fairly with their customers.”iii  FINRA Rule 2111 requires, in part, that a broker “must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [broker] to ascertain the customer’s investment profile” (the “suitability” standard).iv  Rather than a percentage of AUM, brokers’ compensation is typically derived from commissions they charge on each of the trades they execute for their clients. FINRA, a non-governmental organization, is the primary regulator for almost all brokers in the U.S.

At first blush, a layman retail client could easily be excused for struggling to understand the difference between the requirements of an investment adviser to “serve the best interests of its clients” and those of a broker to “deal fairly with their clients.” This confusion is exacerbated when a broker is also registered as an investment adviser, thus clouding what “hat” the advisor is wearing when dealing with a client.

Tortured Regulatory History

Regulator concern about this confusion has existed for decades.  In 2004, the SEC retained consultants to conduct focus group testing to ascertain, in part, how investors differentiate the roles, legal obligations, and  compensation between investment advisers and broker-dealers. The results were striking:

In general, [the focus] groups did not understand that the roles and legal obligations of investment advisers and broker-dealers were different. In particular, they were confused by the different titles (e.g., financial planner, financial advisor, financial consultant, broker-dealer, and investment adviser), and did not understand terms such as “fiduciary.”v

In 2006, the SEC engaged RAND to conduct a large-scale survey on household investment behavior, including whether investors understood the duties and obligations owed by investment advisers and broker-dealers to each of their clients. First, it should be noted, “RAND concluded that it was difficult for it to identify the business practices of investment advisers and broker-dealers with any certainty.”vi  Second, RAND surveyed 654 households (two-thirds of which were considered “experienced”) and conducted six focus groups, and reported that such participants –

…could not identify correctly the legal duties owed to investors with respect to the services and functions investment advisers and brokers performed. The primary view of investors was that the financial professional – regardless of whether the person was an investment adviser or a broker-dealer – was acting in the investor’s best interest.vii

In 2010, the Dodd-Frank Act mandated the SEC to conduct a study to evaluate, among other things, “Whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers relating to the standards of care for providing personalized investment advice about securities to retail customers that should be addressed by rule or statute,” and to consider ”whether retail customers understand or are confused by the differences in the standards of care that apply to broker-dealers and investment advisers.”viii A conclusion of that study was as follows:

[T]he Staff recommends the consideration of rulemakings that would apply expressly and uniformly to both broker-dealers and investment advisers, when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2).

In 2013, the SEC issued a “request for information” on the subject of a  potential “uniform fiduciary standard,”ix but never promulgated a rule after receiving more than 250 comment letters from “industry groups, individual market participants, and other interested persons[….]”x

Finally, on April 8, 2016, the U.S. Department of Labor adopted a new, expanded definition of “fiduciary” to include those who provide investment advice or recommendations for a fee or other compensation with respect to assets of an ERISA plan or IRA (in other words, certain “brokers”) (the “DOL Fiduciary Rule”). Many brokerage firms and others (such as insurance companies) made operational and licensing adjustments to prepare for the DOL Fiduciary Rule while various lawsuits were filed in attempts to invalidate the controversial rule. Most recently, the United States Court of Appeals for the Fifth Circuit vacated the DOL Fiduciary Rule on March 15, 2018.xi

“Suitability” Standard vs. “Fiduciary” Standard

The “suitability” standard of a broker is a far cry from the “fiduciary” standard of an investment adviser.  As the SEC has stated, “Like many principal-agent relationships, the relationship between a broker-dealer and an investor has inherent conflicts of interest, which may provide an incentive to a broker-dealer to seek to maximize its compensation at the expense of the investor it is advising.”xii  Put more bluntly, “there is no specific obligation under the Exchange Act that broker-dealers make recommendations that are in their customers’ best interest.”xiii

FINRA (including under its former name, NASD) has certainly striven to close that gap via its own interpretations and disciplinary proceedings, and has succeeded to a point.  Specifically, a number of SEC administrative rulings have confirmed FINRA’s interpretation of FINRA’s suitability rule as requiring a broker-dealer to make recommendations that are “consistent with his customers’ best interests” or are not “clearly contrary to the best interest of the customer.”xiv However, the SEC has highlighted that these interpretations are “not explicit requirement[s] of FINRA’s suitability rule.”xv

This lower duty of care for brokers (as opposed to investment advisers, who have a fiduciary duty) has had and continues to have purportedly large and definitive financial consequences for retail investors:

Conflicted advice causes substantial harm to investors. Just looking at retirement savers, estimates that investors lose between $57 million and $117 million every day due to conflicted investment advice, amounting to at least $21 billion annually.xvi

A 2015 report from the White House Council of Economic Advisers (CEA) estimated that –

[…]conflicts of interests cost middle-class families who receive conflicted advice huge amounts of their hard-earned savings. It finds conflicts likely lead, on average, to:

  • 1 percentage point lower annual returns on retirement savings.
  • $17 billion of losses every year for working and middle class families.

Despite the controversy over the DOL Fiduciary Rule and its recent, apparent defeat, the SEC has been working under the guidance of Chairman Jay Clayton since 2017 to finally rectify the confusion among investors as to the different standards of care applicable to brokers versus investment advisers.xvii

The latest development in that regard has been the proposal by the SEC of “Regulation Best Interest” (“Reg. BI”) on April 18, 2018.xviii  The proposed rule is significant in its proposed breadth. Subparagraph (a)(1) of the proposed rule would provide as follows:

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.xix

This is a sea change in the duty of care owed by brokers to their retail clients, as it would effectively enhance a broker’s duty of care to approximate that of an investment adviser’s (at least in regard to retail clients).xx

To satisfy the “best interest” obligation in subparagraph (a)(1), subparagraph (a)(2) of Reg. BI would impose four component requirements: a Disclosure Obligation, a Care Obligation, and two Conflict of Interest Obligations.xxi

For the “Disclosure Obligation,” subparagraph (a)(2)(i) of Reg. BI would require the broker to –

reasonably disclose[] to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation.xxii

For the “Care Obligation,” subparagraph (a)(2)(ii) of Reg. BI would require the broker to “exercise[] reasonable diligence, care, skill, and prudence to” do the following:

(A) Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;

(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and

(C) Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.xxiii

Finally, for the two “Conflict of Interest Obligations,” subparagraph (a)(2)(iii) of Reg. BI would require the following:

(A) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations.

(B) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.xxiv

Furthermore, Reg. BI would expand the SEC’s records requirement rules (i.e., Rules 17a-3 and 17a-4) to  provide that “[f]or each retail customer to whom a recommendation of any securities transaction or investment strategy involving securities is or will be provided,” a broker obtain and maintain for six years “[a] record of all information collected from and provided to the retail customer pursuant to [Reg. BI].”xxv


The SEC’s proposed “Regulation Best Interest” is a significant proposal that could have far-reaching impact across the securities brokerage and other segments of the financial services industries. Whether this latest regulatory effort to establish a more consistent standard of care for brokers and investment advisers will succeed is unknown, but the proposed rule is certainly an aggressive step in that regard.

All those interested will have until approximately July 23, 2018 to file a public comment on the proposed rule. Meanwhile, investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.


i   The specific date will be established once the proposed rule is published in the Federal Register.

ii   Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (“Study”), at iii, available at

iii  Study at iv.

iv  FINRA Rule 2111(a), available at, as of April 23, 2018.

v   Study at 96.

vi  Study at 97.

vii Study at 98.

viii Study at i.

ix  See Request for Data and Other Information: Duties of Brokers, Dealers and Investment Advisers, Exchange Act Release No. 69013 (Mar. 1, 2013), available at

x   Regulation Best Interest, Exchange Act Release No. 34-83062 (April 18, 2018) (“Reg. BI Proposal”), at 20, available at

xi  Reg. BI Proposal at 27.

xii     Reg. BI Proposal at 7.

xiii Reg. BI Proposal at 8.

xiv Reg. BI Proposal at 14, fn. 15.

xv Reg. BI Proposal at 8, fn. 6.

xvi Reg. BI Proposal at 20, fn. 28, quoting Letter from Marnie C. Lambert, President, Public Investors Arbitration Bar Association (Aug. 11, 2017) (“PIABA Letter”).

xvii    Chairman Jay Clayton, Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers, Public Statement, June 1, 2017, available at

xviii   See Reg. BI Proposal.

xix Reg. BI Proposal, at 404.

xx In a related SEC proposal regarding investment advisers that was also dated April 18, 2018, the SEC stated that “[a]n investment adviser’s fiduciary duty is similar to, but not the same as, the proposed obligations of broker-dealers under Regulation Best Interest,” and that “we are not proposing a uniform standard of conduct for broker-dealers and investment advisers in light of their different relationship types and models for providing advice[….]” See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. IA-4889 (April 18, 2018), available at

xxi Reg. BI Proposal, at 404.

xxii Reg. BI, subparagraph (B), Reg. BI Proposal, at 404.

xxiii   Reg. BI Proposal, at 404-405.

Subparagraph (b)(2) of Reg. BI would define “retail customer’s investment profile” as including, but not be limited to, “the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer in connection with a recommendation.” Reg. BI Proposal, at 406.

xxiv   Reg. BI Proposal, at 405.

xxv      Reg. BI Proposal, at 406-407

FINRA Fines Member Firms for Violation of Its Recordkeeping Provisions and Issues Cybersecurity Warning

FINRA fined twelve of its largest member firms a combined $14.4 million for violation of its Rule 4511 and SEC Rule 17a-4(f) for their failure to keep hundreds of millions of electronic documents in a WORM or “write once, read many” format.  The WORM format is designed to ensure that important firm records including customer records containing Personally Identifiable Information are not altered after they are written.

The firms included Wells Fargo & Co., RBC Capital Markets, LPL Financial, RBS Securities, SunTrust Robinson Humphrey, Georgeson Securities Corp and PNC Capital Markets.  FINRA also found that these firms violated its Rule 3110, Supervision, and several other SEC recordkeeping provisions, Securities Exchange Act Section 17(a) and Rules 17a-4 (b) and (c), thereunder.

FINRA noted that such records must be maintained in order to ensure member firm compliance with investor protection rules and that over the last decade the volume of such data being stored electronically has risen exponentially.  In a cybersecurity warning, FINRA stated:

there have been increasingly aggressive attempts to hack into electronic data repositories, posing a threat to inadequately protected records, further emphasizing the need to maintain records in WORM format.

P&D is pleased to note that its newest partner, John R. “Jack” Hewitt is one of the country’s foremost cybersecurity authorities, and a major part of his practice is advising broker-dealers, RIAs and banks on their adherence to SEC, FINRA, CFTC and state cybersecurity requirements.  Among other things, he advises firms on information security programs, guides them through cyber-incidents and represents them in the event of a regulatory inquiry.  Mr. Hewitt regularly conducts cybersecurity audits for broker-dealers and investment advisers, and was the SEC appointed independent outside consultant in the first major SEC cybersecurity enforcement action.  He is the author of Cybersecurity in the Federal Securities Markets, a BloombergBNA publication, and Securities Practice & Electronic Technology, an ALM treatise. Mr. Hewitt is the Co-Chair of the American Bar Association, Business Section, White Collar Crime Subcommittee on Cybersecurity.

Read FINRA’s official announcement

NYS DFS Cybersecurity Regulation Webinar 4/20/17: Presented by P&D’s Jack Hewitt and CohnReznick’s Jim Ambrosini

John R. Hewitt, Partner at Pastore & Dailey LLC, and Jim Ambrosini, Managing Director at CohnReznick Advisory, will be conducting a complimentary Webinar on Thursday, April 20, 2017 at 12:00 PM EDT.  Mr. Hewitt is recognized as a national authority in cybersecurity and Mr. Ambrosini is a leader in cybersecurity and technology assurance service offerings at CohnReznick.

Mr. Hewitt and Mr. Ambrosini will discuss the New York State’s Department of Financial Services (DFS) regulation, effective as of March 1, 2017, providing an overview of the regulation, a summary of what controls must be in place, how to implement controls using a risk-based approach, key DFS regulation issues, and how to develop a roadmap towards compliance.

Please join us for this Webinar on April 20, 2017 at 12:00 PM EDT by registering below:

P&D Sponsors YMCA of Greenwich Golf Event

Pastore & Dailey LLC was a sponsor of the Lou Ferraro Golf Classic presenting the 22nd Annual YMCA of Greenwich Golf Event.  The event took place at Tamarack Country Club in Greenwich, CT.  Attorneys William Dailey and Nathan Zezula were both in attendance.  Proceeds from this event will directly benefit programs and services for the YMCA of Greenwich including childcare, after school, summer camp, scholarships, senior and special needs programs.

High Frequency Trading Law

Recent Developments in High Frequency Trading Law

Last year the Federal Court of New York was stormed by investors alleging that exchanges, banks, and broker dealers created an unfair marketplace through high frequency trading (“HFT”). All suits were inspired by Michael Lewis allegations, author of the best-seller “Flash Boys: A Wall Street Revolt”, who argued that the stock market is rigged in favor of exchanges, big banks and high-frequency traders.

Case Dismissed

By dismissing a three class-action on April 30 – Lanier v. BATS Exchange Inc et al, Nos. 14-cv-03745, 14-cv-03865 (S.D.N.Y. 2015) – Judge Katherine Forest of the U.S. District Court for the Southern District of New York placed her imprint into the debate to know whether the Security Exchange Commission (“SEC”) is the only competent entity to receive a complaint involving exchanges.

Harold Lanier, the aggrieved investor who initiated the suit claimed that several major U.S. exchanges, including among others, NASDAQ, NYSE and BATS, scammed ordinary investors by selling faster access to market data to high-frequency traders and therefore broke their initial duty as market regulators. Furthermore, the claimant added that they violated the nondiscrimination and fairness provisions enclosed in the subscriber agreements issued by the exchange which details both parties’ commitments.

The plaintiff rightfully called into question the competence of the SEC as it formerly approved the practices of HFT. But according to the Federal Judge, the Exchange Act provides that any conflict should be brought before the SEC, as a two-tiered procedure is already in place in case of a violation of its rules by an exchange. In any case, if the aggrieved party seeks to go further, only Federal Court of Appeals can review the SEC order. The Judge contested anyway that the allegations of the agreement violation were sufficient to state a claim.

The market regulators “absolute immunity” question is nonetheless still unanswered as the case has not been followed up. Defendants argued that, as self-regulatory organizations, they should benefit an absolute immunity from civil lawsuits intended to get damages in connection with their regulatory responsibilities. Hence only the SEC should hear investors’ complaints.

Pension Funds Joined the Battle

The class action led by the City of Providence and Rhode Island – City of Providence, Rhode Island et al v. BATS Global Markets Inc et al, Nos. 14-cv-02811, 14-MD-2589 (S.D.N.Y. 2015) – is however still ongoing as the motions to dismiss laid recently were set aside by Federal Judge Jesse Furman. The State-Boston Retirement System and three other funds located in Stockholm, Alexandria and the Virgin Islands joined the battle. Here, in addition to public exchanges such as BATS, CHX, NASDAQ and NYSE, Barclays LX dark pool is also targeted by the plaintiffs.

As dark pools are private exchanges without either quotations or subscribers noticeable, only large investors can deal on these platforms. Alternative trading systems are more and more coveted by investors and their part of the market doubled in the last five years. Nowadays around a third of the trades are being conducted through dark pools in the United States.

Although individual investors should not have access to these venues, mutual or pension funds might. Therefore, individuals can be harmed indirectly in dark pools which are much more vulnerable to HFT predators than public exchanges. The plaintiffs will nonetheless have to demonstrate clear and specific damages to win their case, which in this complex and obscure market, will need a very high level of expertise.

Hazy Dark Pools

In July 2014, individual investor Barbara Strougo brought her grievances to the New York District Court – Strougo v. Barclays, No. 14-cv-05797 (S.D.N.Y. 2015) – against Barclays and its executives of covering up aggressive high frequency trading operations on their Barclays LX dark pool.  In addition to that, she claimed that Barclays gave crucial non-public information to hostile traders.

In essence, Rule 10b-5 of Securities Exchange Act of 1934 deems illegal any behavior aimed to deceive people involved in securities transactions in an exchange. Would this mean that investors should be entitled to know the presence of HFT when trading in the venue?  Indeed, if the exchange owner is aware about HFT predators, not to disclose it would be breaking the law. Knowing the potential risks of his or her investment is a fundamental right to any investor.

The rules that regulate dark pools depend whether they are registered as national securities exchanges or broker dealers and also about their activities and trading volume. If recognized as broker dealers, they perform under a different set of regulations than public exchanges and the Exchange Act is not applicable in the same way. As a result, the SEC review does not apply and complainants can head straight to district court.

Barclays’ dismissal bids were turned down by the Federal Judge as questions about the integrity of its alternative trading system are still unanswered. The Judge expressed her concern about specific misstatements – i.e., touting the safety of the LX platform while, on the other hand, allowing aggressive behavior.

Barclays maintains that it would deny access to any trader who operates aggressively on its platform but the plaintiff assure that the platform was infested by high speed traders who used their technology to make profit at the expense of common investors.

David Against Goliath

While big financial companies struggle against investors to defend themselves and try to minimize the impact of HFT on the market, Goldman Sachs is determined not to let go off anything against one of its former computer programmer. Serge Aleynikov left his employer to join startup Teza Technologies, bringing with him the trading algorithm he had set up while working there. The stolen code in question was initially an open source code barely modified under the pressure of the bank to reach quick results.

Notwithstanding that Mr. Aleynikov had been cleared of all federal charges after having spent one year behind bars, Manhattan District Attorney Cyrus R. Vance Jr. took over the case and filed and a new suit against the programmer – New York v. Sergey Aleynikov, No. 004447/2012 (N.Y.C. Crim. Ct.).

Here again, on the first step of the judicial procedure, Mr. Aleynikov was found somewhat guilty of stealing the codes –i.e., the jury, confused faced of the complexity of the matter, reached a mitigate decision founding him not guilty of unlawful duplication of computer-related material, guilty of unlawful use of secret scientific material and deadlocked on another unlawful use charge. Even though the conviction stands, he is unlikely to serve any more time in prison.

Although outlandish, the Aleynikov case is not isolated in the High Frequency Trading history. Other programmers were arrested by Mr. Vance to whom intellectual property theft should be seen as physical property theft.

The District Attorney to say: “When an employee takes software to create his own company, anybody would classify that as “stealing” or “theft”; under existing state law, however, stealing valuable printer toner out of an office supply closet is a more serious offense than stealing valuable computer source code.”

Jason Vuu, Glen Cressman and Simon Lu, all in their mid-twenties, were arrested and prosecuted on similar counts – People v. Simon Lu et al., No. 03869/2013 (N.Y.C. Crim. Ct.). Vuu and Cressman were former employees of the Dutch trading house Flow Traders. All three ducked prison for pleading guilty and were fined and put under probation.

Kang Gao, former analyst for hedge fund Two Sigma Investments was however sentenced ten months in jail – New York. v. Kang Gao, No. 00640/2014 (N.Y.C. Crim. Ct.) –, a time that he had already served waiting for his judgement.

2nd Circuit to Madoff Fraud Victims: Winners Keepers, Losers Weepers

If you invested money with Bernard Madoff, were a net investment “loser” with him in his Ponzi scheme, but had hope to claw back some of your losses from other Madoff victims who were net “winners,” you just lost again.

In a decision proving yet again that justice is indeed blind, the 2d Circuit Court of Appeals this week affirmed an earlier decision by SDNY Judge Jed Rakoff in ruling that victims of Madoff who were profitable in the balance need not hand back their profits (a.k.a., suffer a “clawback”) for the benefit of other victims who had losses in the balance.

Madoff trustee Irving Picard had sued net profitable victims for their profits, so as to return them to other victims who were net unprofitable.  The decision in In re: Bernard L. Madoff Investment Securities LLC turned on whether Madoff’s Ponzi payouts (which came after he took in investors’ money into his broker-dealer, never invested it, and then distributed some of it back out to investors on demand) amounted to “a transfer made by [a] . . . stockbroker . . . in connection with a securities contract,” which is excepted under Section 546(e) of the Bankruptcy Code from clawback. Clawback defendants successfully argued to the Court that their account opening documents (customer agreement, trading authorization and options agreement) amounted to such a “securities contract,” even though no securities were ever bought by Madoff with the funds provided him by clawback defendants.

The Court agreed with the Madoff trustee (the plaintiff in the case) that the purpose of Congress in enacting such an exception to the Bankruptcy Code was to safeguard markets from suffering a domino effect and make them unstable, should completed and cleared securities transactions in the markets suddenly be called into question.  The Court also generally agreed with the trustee that no such risk existed here since no trades were actually effected.  However, the Court emphasized the expansive reach of the wording in the above clawback exception, going to the dictionary to discuss the broad meaning of terms like “any,” “similar” and “connection” that were found in the relevant sections of the Bankruptcy Code, and thus finding that the broad language of the statutory exception applied to this fact pattern (no matter how unfair it may seem to some).

Interestingly (and perhaps with no small amount of purposeful irony on Judge Rakoff’s part, given his legal battles with the SEC), the court cited various SEC-related decisions to support its decision.  It cited a series of cases where defendants were held liable for SEC Rule 10b-5 fraud (which requires the fraud to be “in connection with the purchase or sale of any security”) in cases where securities were never actually bought with victims’ money.

It is now up to trustee Picard if he wants to seek review by the U.S. Supreme Court of this decision.  Stay tuned….

Commodity Futures Trading Commission Proposes New Conflict of Interest Rules

The Commodity Futures Trading Commission recently proposed new rules to implement statutory provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules relate to the conflicts of interest provisions set forth in section 732 of the Dodd-Frank Act, which amends section 4d of the Commodities and Exchange Act, to direct futures commission merchants and introducing brokers to implemental conflict of interest systems and procedures to establish safeguards within the firm. The proposed rules seek to ensure that any person researching or analyzing the price or market for any commodity is separated by appropriate informational partitions. The proposed rules also address other issues, such as enhanced disclosure requirements.

Section 732 of the Dodd-Frank Act requires that futures commissions merchants and introducing brokers “establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in trading or clearing activities might potentially bias the judgment or supervision of the persons.” While section 732 could be read to require informational partitions between persons involved in any research or analysis and persons involved in trading or clearing activities, the Commission believes that the Congressional intent underlying section 732 was primarily intended to prevent undue influence by persons involved in trading or clearing activities over the substance of research reports that may be publicly distributed.

The proposed rule establishes restrictions on the interaction between persons within a futures commission merchant or introducing broker involved in research or analysis of the price or market for any derivative and persons involved in trading or clearing activities. Further, the proposed rules also impose duties and constraints on persons involved in the research or analysis of the price or market for any derivative by, for example, requiring such persons to disclose during public appearances and in any reports any relevant personal interest relating to any derivative the person follows. The proposed rule also prevents futures commissions merchants and introducing brokers from retaliating against a person for producing a report that adversely impacts the current or prospective trading or clearing activities of the firm.

If the proposed rules are implemented, they would require that futures commission merchants and introducing brokers adopt written conflicts of interest policies and procedures, document certain communications between non-research personnel and provide other disclosures. They would also prevent non-research personnel from reviewing a research report prior to dissemination, except to verify the factual accuracy of the report and provide non-substantive edits. Non-research personnel may only communicate with research personnel through authorized legal or compliance personnel. The firm’s business trading unit may not influence the review or approval of a research personnel’s compensation and may not influence the research personnel. Futures commissions merchants and introducing brokers must keep a record of each public appearance by a research analyst. The proposed rule applies to third-party research reports as well, except where the reports are made available upon request or through a web site maintained by the futures commissions merchants or introducing brokers.

While the Commodity Futures Trading Commission is continuing to receive public comments on any aspect of the proposed rule, the Commission is particularly interested in comments about whether the rules should apply to futures commission merchants and introducing brokers of all sizes or whether the nature of the partitions should depend on the size of the firm.


Brokers and Advisors Beware

In the last two months, the SEC and FINRA have, for the first time each, taken Enforcement action — including against a broker-dealer’s chief compliance officer — in regard to the safeguarding of confidential customer information under a 10-year-old SEC rule called “Regulation S-P.”  These actions seem likely to cause a significant shift in how brokers, investment advisers and their firms handle customers’ confidential information, particularly when it comes to a broker or adviser taking his or her “book” of business to another firm.


Previously, when brokers or advisers left for new firms, they and their new firms usually only had to worry about their former firm suing them for breaches of non-compete, non-solicitation and non-disclosure clauses in their agreements, or suing the new firm for “raiding” the former firm’s agents (and, thus, their customers).

But recent SEC and FINRA actions put brokers, advisers and their firms on notice that each could suffer formal regulatory consequences (including fines and suspensions) from brokers or advisers casually — or clandestinely — taking confidential customer information to their new firms.


The SEC adopted Regulation S-P in 2001 pursuant to a mandate in the Gramm-Leach-Bliley Act of 1999, and amended it in 2005 pursuant to a mandate in the Fair and Accurate Credit Transactions Act of 2003 (the FACT Act).

Broadly speaking, Regulation S-P requires broker-dealers, investment advisers and other financial firms to protect confidential customer information from unauthorized release to unaffiliated third parties.  Included in Regulation S-P is the “Safeguard Rule” (Rule 30(a)), which requires broker-dealers to, among other things, adopt written policies and procedures reasonably designed to protect customer information against unauthorized access and use.

Of course, several headlines in recent years have focused on the reported thefts or losses of large caches of confidential customer information from banks and other businesses, so it comes as no surprise that the SEC and FINRA would seek to assert their Enforcement powers in this area.  Each of the recent SEC and FINRA Enforcement actions arose from departing registered representatives taking customer information to new employers without providing said customers with sufficient notice and opt-out procedures under €¨Regulation S-P.

Case Study # 1: Recent SEC Disciplinary Actions

In an administrative settlement dated April 7, 2011, the SEC fined a brokerage firm’s president, national sales manager and chief compliance officer between $15,000 and $20,000 each in regard to the transfer of 16,000 customer names and addresses, account numbers and asset values to a new firm.  It did not matter that customers approved the transfer after the fact, nor did it matter that the transfer occurred because the broker-dealer was winding down its business and thus simply transferring many of its accounts to a new broker-dealer. The SEC found the firm and its senior executives liable for Regulation S-P violations and fined each of them accordingly.

Especially noteworthy is that the SEC fined the firm’s chief compliance officer for “aiding and abetting” these Regulation S-P violations by failing to improve the firm’s “inadequate” written supervisory procedures for safeguarding customer information (the “Safeguard Rule”) after “red flags” arose from prior security breaches at the firm.  (Significantly, those security breaches did not involve other instances of intentional transfer of customer data to a new firm, but rather mostly theft by outsiders of a few RRs’ laptops and the unauthorized access by a former employee of a current employee’s firm e-mail account.)

Case Study # 2: Recent FINRA Disciplinary Action

This past December, FINRA’s National Adjudicatory Council affirmed a $10,000 fine and 10-day suspension ordered by a FINRA hearing panel in a contested hearing against a broker for his downloading confidential customer information from his firm’s computer system onto a flash drive on his last day of employment and then sharing that information with a new firm.  FINRA found the broker’s actions prevented his former firm from giving its customers a reasonable opportunity to opt out of the disclosures, as required by Regulation S-P.  FINRA also found the broker’s misconduct caused his new firm to improperly receive non-public personal information about his former firm’s customers.


These Enforcement actions will change the legal and practical landscape concerning the portability of a broker’s “book” of customers.  From a contractual point of view, brokers and advisers would be well-advised to build Regulation S-P-compliant language into their agreements with their current and new firms if they anticipate ever switching firms again, as these Enforcement actions effectively sound the alarm that the SEC and FINRA will sanction a broker or adviser for furtively taking customer information to a new firm. Likewise, investment adviser and brokerage firms would be well-advised to understand the relevance of Regulation S-P when it comes to brokers or advisers moving to other firms and taking firm customer information with them.

€¨Finally, from a regulatory point of view, a broker’s or adviser’s “former” firm should implement reasonable policies and procedures to ensure compliance with Regulation S-P by all firm personnel, including brokers or advisers looking to leave the firm, and a broker’s or adviser’s “new” firm should take similar care and caution when a broker or adviser brings in confidential information regarding new customers (lest the new firm also be found liable for a Regulation S-P violation, which would have happened in the above FINRA case had the new firm done anything with the customer information it got from the subject broker).

November 2010 – SEC Adopts New Rule

On November 3, 2010, the Securities and Exchange Commission (SEC) voted unanimously to adopt a new rule requiring broker-dealers to implement risk controls before they provide customers with electronic access to the equities markets. The new rule will effectively end so-called “naked” (or “unfiltered”) access by customers to the markets, and is part of a larger effort by the SEC “to help ensure the markets are fair, transparent and efficient.”

Specifically, the rule prohibits broker-dealers from providing customers with unfiltered access to an applicable exchange or alternative trading system (ATS). It requires brokers who directly access an exchange or an alternative trading system — including those who “sponsor” customers’ access to same — to put in place financial and regulatory risk management controls and supervisory procedures that are “reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous.” Among other things, these controls must include the programming and implementation of pre-order-entry filters by brokers in their own systems for orders directed either by them or their customers to the equities markets.

This issue of unfiltered access has been the subject of much debate, especially involving the high-frequency trading firms that use algorithms and high-speed and high-capacity computers to capture minimal and fleeting arbitrage (and other quantitative) opportunities in the markets. Some observers have estimated that such activity constitutes upwards of 70 percent of the volume traded in U.S. equity markets today.

Broker-dealers have eight months — which includes 60 days from publication of the rule in the Federal Register plus an additional six months — to comply with this new rule.

September 2010 – Advisors Beware of the “Switch” from SEC Oversight to State Regulation

By July 21, 2011 — the one-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act — investment advisors with less than $100 million in assets under management will be required to register with the states. This impacts all advisors, whether currently registered with the Securities and Exchange Commission. The “switch” to state regulation is likely to raise a number of issues — and confusion — for advisors.

  • Advisors with more than $25 million in assets under management previously were able to opt out of federal registration — and state registration as a result — if they had fewer than 15 direct clients. With the passage of Dodd-Frank, that 15-client threshold has been removed outright from the Investment Company Act of 1940. Thus, absent another exemption, many advisors will face federal or state registration for the first time.
  • Advisors with clients in multiple states may have to register in multiple states, potentially creating burdensome requirements for advisors. (One exception: an advisor that must register in 15 or more states may choose to remain SEC-registered.)
  • States differ on their registration, custody, books and records and other requirements. Just to cite one arcane but significant difference, Connecticut does not require its state-registered investment advisor representatives to have a 65 (or 7 and 66); it instead only requires them to have sufficient “experience.” New York, meanwhile, not only requires the 65 (or 7 and 66), but also mandates that representatives have taken the exams within two years prior to registering with New York. (That means that a neophyte advisor in New York can sail through the state registration process with flying colors, while a more veteran advisor in New York has to file for a waiver on the state’s exams-in-the last-two-years requirement to become registered (if such representative got his or her 65 (or 7 and 66) more than two years ago).)