SEC and FINRA Look at the Back Office

By Lisa Valentine

It used to be that employees in the back office of a broker/dealer or advisory firm—those folks performing tasks such as account and custody maintenance functions, trade settlement and internal audit—largely fell beneath the radar of the SEC and the Financial Industry Regulatory Authority (FINRA). These folks could toil away without being licensed or, heck, even well-trained.

The Bernie Madoff scandal is changing that, as back office staff will increasingly come under the regulatory microscope.

In the Madoff scheme, Madoff hired employees with little securities training and apparently asked them to interface with (or lie to) clients and create false documentation. Just recently the SEC charged two computer programmers who worked for Madoff with providing “the technical support necessary to produce false documents and trading records.”

In a speech to the Practicing Law Institute, Daniel Gallagher, Co-Acting Director of SEC’s Division of Trading and Markets, said that both the SEC and FINRA will be taking a closer look at these types of back office employees. Although Gallagher did not state that these employees should be registered, he did say that they should be indentified to the appropriate regulatory agency.

He stated, “[The SEC has] asked FINRA to look hard at the universe of back office personnel and to cast the regulatory net as broadly as necessary to achieve the right level of back office oversight for today’s firms.”

One option, noted Gallagher, is to require back office employees to take an examination or to take continuing education courses. He also called for firms to create a culture of ethics and “standards of commercial honor and just and equitable principles of trade.”

Education is never a bad thing. Perhaps FINRA could offer courses titled “How to Tell if Your Boss is Ripping off Clients” and “Why Filing Fraudulent Paperwork is Never a Good Idea.”  Does the SEC and FINRA really believe that back office employees perform illegal activities because they weren’t trained?
 

SEC to Crack Down on Executive Comp Disclosures

By Lisa Valentine

It’s not enough just to report executive compensation; SEC Division of Corporation Finance Deputy Director Shelley Parratt is calling for companies to embark on “enhanced disclosure” that will describe how and why a compensation decision was made and what role performance targets played in the decision.

She also told companies that they should be proactive in their disclosures rather than waiting for the SEC to pressure them into it. Companies, reasoned Parratt, should want  to provide more information. She said, “…after all, it is your disclosure.”

Specifically, Parratt is calling for an analysis of why companies made the compensation decisions they did. She’s less interested in the “framework” of the decision and more interesting in hearing the reasons behind it. In other words, forget all the technical mumbo-jumbo about process and get to the meat. And if the decision was totally subjective, the company should come clean and say it has no basis for the compensation decision it made other than it perhaps felt good.

“When a company explains its compensation decision-making processes but does not explain why it made the compensation decisions it made, we will ask for enhanced disclosure of the analysis,” warned Parratt.

Another focus area for Parratt is pay for performance, something that investors are keen to understand. When performance targets are not met at some companies, the company ditches the target and awards the bonus anyway.

Since some performance targets may contain competitive or trade secrets, the SEC does make allowances for companies to omit some targets. However, it does appear that the SEC is ready to crack down on omissions and ask companies to explain exactly why the target should be kept a secret. And companies better have a good excuse.

And, if the company tries to explain their executive compensation by saying that it benchmarked compensation against peer companies, the SEC will ask for a list of those peer companies.

She stated, “When it comes to performance targets and disclosure, a company must first determine whether corporate or individual performance targets are material to its compensation policies and decisions. Making this determination often involved difficult judgment calls and, depending on the circumstances, we may question your conclusions.”

It’s pretty unlikely that companies will disclose more than they are required to, especially about such a touchy and high-profile subject as executive compensation. If Parratt wants companies to disclose their analysis about compensation, she should be prepared to force the issue. And it looks like the SEC is ready to do just that. She warned, “Now is the time to undertake an earnest attempt to prepare the best possible executive compensation disclosure consistent with the principles set forth in the rules.”

 

Harmony in the Eye of the Beholder

By Lisa Valentine

So how do you get two government regulatory agencies – with differing priorities – to work together for the greater good?

It’s a trick question. You can’t get them to work together, no matter how much you want them to. You simply fold both into a single agency.

Unfortunately it looks like both the SEC and the CFTC will exist as separate entities for the foreseeable future. As part of his plan for financial reform, President Obama has asked the agencies to work together in harmony. The SEC and CFTC have given this task considerable thought (and resources) in the tome “A Joint Report of the SEC and the CFTC on Harmonization of Regulation.”

The SEC, which governs securities, and the CFTC, which governs futures, were created in the 1930s as a result of the Great Depression. At the time, having two separate agencies worked relatively well. Due to financial market innovations, what made sense in the 1930s simply doesn’t make sense in 2009.

The report, at 94 pages in length, doesn’t address important issues such as closing the gap on derivatives legislation between the two agencies. It does, however, focus on the following points. The differences noted between the two agencies is just a small sampling of inherent conflict between the SEC and CFTC. Harmony is a huge task – sort of like spitting in the ocean.

•    Product listing and approval: The SEC relies on high quality disclosure about securities whereas the CFTC does not review products before introduction. This becomes a problem for those products that don’t neatly fall under either jurisdiction (or fall under both).

•    Exchange/clearinghouse rule changes. The CFTC is more limited in its ability to regulate exchange and clearinghouse rules.

•    Risk-based portfolio margining and bankruptcy/insolvency regimens. Both the SEC and CFTC can segregate assets, but how they do so differs. Also, the SEC can regulate customer margins but the CFTC cannot.

•    Linked national market and common clearing versus separate markets and exchange-directed clearing. Securities are traded on multiple markets, part of the national market system in the U.S. (NMS). The SEC uses a common clearing model that serves competing exchanges while futures exchanges select a clearinghouse. The clearinghouse could be in the U.S. or it could be elsewhere in the world.

•    Price manipulation and insider trading. This is an area that has historically been less of a concern for the CFTC (and an area where the SEC could use a bit of a boost).

•    Customer protection standards applicable to financial advisors. Since futures are considered inherently “risky,” the CFTC assumes buyer beware. The SEC imposes many more limits on financial advisors.

•    Regulatory compliance by dual registrants. For instance, the SEC and CFTC have different retention and reporting requirements.

•    Cross-border regulatory matters. The CFTC allows for much greater cross-border access by intermediaries.

Harmony is a tall order, to be sure. In follow up posts, we’ll dive into some of the specific recommendations from the report. But the bottom line remains that the agencies are wasting a lot of time and resources trying to make a pig fly.

 

Commissioners Discuss Dark Pools

By Lisa Valentine

How much truth is there to the criticism levied at dark pools that “every share that is crossed in the dark is a share that doesn’t assist the market in determine an accurate price?”

SEC Commissioners debated the benefits and disadvantages of dark pools last week, batting around the pros and cons of legislation such as including actionable Indications of Interest (IOI) in the consolidated public quote stream and how to apply floor-based trading principles to automated electronic markets.

According to the SEC, the number of active dark pools has increased from 10 in 2002 to approximately 29 today. In the second quarter of 2009, dark pool trading accounted for 7.2% of the volume of these stocks.

At first glance, it would appear that dark pools are sucking market share away from quoting venues and making the entire market less transparent. However, this is not necessarily the case. While trading volumes at NYSE are down, volumes at other quoting venues such as Nasdaq, NYSE Arca, BATS and Direct Edge are increasing, according to SEC Commissioner Kathleen Casey. She says, “It appears that an obsessive focus on the rise of dark ATSs is misplaced.

In the end, the SEC voted to propose amendments to dark pool legislation, but the commissioners were not all in agreement about the viability of these amendments.

The SEC proposal contains the following three recommendations:

1.    Require actionable IOIs to display quotes and be subject to the same disclosure rules that currently govern non-dark pools.
2.    Lower the trading volume threshold of NMS stocks from 5% to .25%. Today, an alternative trading system (ATS) must display its best-priced orders to the public only when its trading volume for a stock is 5% or more.
3.    Require real-time disclosure of the identity of the dark pool executing a trade on the consolidated tape.

To avoid information leakage that could move markets, the SEC is exempting trades worth more than $200,000 from these recommendations.

Several commissioners, notably Casey and Troy Paredes, expressed concern that the SEC is moving too fast to regulate dark pools. (The name could have something to do with the urgency as the term “dark pools” sounds so negative. Dark pools are an easy target in much the same way executive compensation has become a political rallying cry.) Casey summed up her concern well by admitting that the SEC may not really understand dark pools enough to enact sweeping reform. Said Casey, “Sometimes we don’t know what we don’t know, and if we rush to regulate without a complete understanding of the extent to which complex and dynamic activities may be interrelated, the specter of unintended consequences looms large.” Casey called for decision-making to be “driven by data, not politics or unfounded assumptions.”

Paredes said, “I am concerned that considering particular features of dark pools in isolation increases the risk of unintended adverse consequences and will not yield the best results for our markets.” For example, he warns that dark pools may actually become darker as participants choose not to send actionable IOIs at all.

Or, an even more ominous darkness may descend on trading. “The demand for non-displayed liquidity presumably will continue despite any regulatory changes that may be adopted,” Paredes correctly stated. Where will non-displayed liquidity go? Perhaps to foreign markets.

By trying to shed light on dark pools, the SEC may indeed create something worse. Be careful what you wish for.

The SEC is gathering public comment.

 

SEC Sets Date for SOX Compliance

By Lisa Valentine

Early this month, the Securities and Exchange Commission announced that it had finally and definitively set a date for smaller public companies to comply with Section 404 of Sarbanes-Oxley (SOX), which sets the rules for reporting of internal controls.

SOX was enacted in 2002 but did not cover companies with a public float below $75 million in order to give these smaller firms extra time to gear up their governance efforts and figure out a way to pay for the added expense. The SEC has extended the compliance date for smaller firms several times over the past 7 years. It’s no surprise that the SEC has finally set an end-date for these smaller firms and the delay has certainly worked in favor of small firms as they learn from larger firms the most efficient ways to carry out this corporate governance.

The time extension for smaller firms expires beginning with annual reports of companies with fiscal years ending on or after June 15, 2010.

SEC Chairman Mary Schapiro closed the door on any further stays of execution, saying, “Since there will be no further Commission extensions, it is important for all public companies and their auditors to act with deliberate speed to move toward full Section 404 compliance.”
 

ASF Weighs in on Money Market Liquidity Requirements

The American Securitization Forum (ASF) (an independent organization operating as part of the Securities Industry and Financial Markets Association (SIFMA)) has weighed on the Securities and Exchange Commission’s proposed changes to Rule 2a-7 that, among other restrictions, eliminate the ability of money market funds to invest in Tier II securities to make these funds less risky. The ASF “strongly opposes” the elimination of Tier II securities, stating that this proposal could increase market volatility and put banks under undue liquidity pressures. The SEC had asked for public comment by September 8 for the proposed changes.

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