Whether intentionally or not, in drafting certain provisions of settlement and severance agreements with employees, many employers have used language that violates the anti-retaliation protections for individuals who report violations of the securities laws and Foreign Corrupt Practices Act (“FCPA”). The Securities and Exchange Committee (“SEC”) promulgated Rule 21F-17(a) making it unlawful “to impede the efforts of individuals from communicating directly with the Commission staff… including enforcing, or threatening to enforce, a confidentiality agreement…” (17 C.F.R. §240.21F-17(a)).Continue Reading...
Brian A. Carlis, Shareholder and member of Stark & Stark’s Securities Arbitration Group, was featured in the article, “Few RIAs Accept Finra Invitation,” published in the Wall Street Journal on May 29, 2013.
The article discusses the meager RIA response to Financial Industry Regulatory Authority (“Finra”) expanding its arbitration forum to include registered investment advisors. Traditionally the Finra arbitration process was used solely by broker-dealers. This attempt to take over the role of overseer from the Securities and Exchange Commission (SEC) would mean lower arbitration fees for brokerages who would otherwise turn to the American Arbitration Association (“AAA”) to resolve issues with customers or employees.
Mr. Carlis, who represents RIAs in securities arbitration proceedings, explains that the higher AAA fees deter investors with small financial claims who are seeking a quick or cheap settlement. However, Finra is better equipped to handle securities disputes and ultimately clients would save money in the long run, even if it meant having to amend pre-dispute agreements in their contracts with clients to reflect this change in plan.
Mr. Carlis believes that many RIAs are reluctant to commit to Finra’s system until they see how others fare in the program. He said that as the first few cases are handled by Finra, he expects the number of RIAs who switch over to Finra to grow. Mr. Carlis “routinely discusses the pros and cons of both forums with his RIA clients, who might have to foot a hefty bill for an AAA hearing.”
Regulation S-ID: SEC and CFTC Impose New Identify Theft Regulations Requiring Investment Advisory Firms to Consider Updates to Policies and Procedures
On April 10, 2013, the Securities and Exchange Commission (“SEC”) and Commodity Futures Trading Commission jointly adopted and announced new identity regulations, which are being imposed pursuant to their respective authority under Dodd-Frank Act and the Fair Credit Reporting Act (“FCRA”).
In this context, a “Red Flag” is a “pattern, practice, or specific activity that indicates the possible existence of identity theft.” 
Who is Affected?
Generally speaking, the SEC’s updated regulations (“Regulation S-ID”) will apply to investment advisory firms deemed to have custody of client funds or securities for the purposes of ADV Part 1, Item 9 and ADV Part 2A, Item 15, who are subject to annual surprise examinations.
More specifically, Regulation S-ID will affect broker dealers, investment companies, and investment advisory firms that are required to be registered under the Investment Advisers Act of 1940, which also meet the definition of: “financial institution” or “creditor”  under the FCRA, and which maintain or offers “covered accounts.” (each, an “Affected Entity,” and collectively, the “Affected Entities”).
While the definition of “creditor” generally does not apply to most investment advisory firms, the term “financial institution” may apply to firms that report having custody on form ADV because under the FRCA, a “financial institution” is:
a State or National bank, a State or Federal savings and loan association, a mutual savings bank, a State or Federal credit union, or any other person that, directly or indirectly, holds a transaction account belonging to a consumer. 
A “transaction account” is:
a deposit or account on which the depositor or account holder is permitted to make withdrawals by negotiable or transferable instrument, payment orders of withdrawal, telephone transfers, or other similar items for the purpose of making payments or transfers to third persons or others. Such term includes demand deposits, negotiable order of withdrawal accounts, savings deposits subject to automatic transfers, and share draft accounts. 
The term “covered account,” is intentionally flexible, which basically describes any account: designed to permit multiple payments or transactions” and “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.” 
In short, if an investment advisory firm has the capacity to withdraw funds from client accounts and transfer those funds to unrelated third parties, (commonly defined as having custody ) that firm generally has a “transaction account” and therefore meets the definition of a “financial institution” for the purposes of the updated Red Flag Requirements.
When Will Regulation S-ID Take Effect?
The final rules will become effective thirty days after publication in the Federal Register, and the compliance date will be six months after the effective date. Affected Entities should therefore anticipate the compliance deadline to take effect approximately between November and December 2013.
How Should Affected Investment Advisory Firms Comply with Regulation S-ID?
Step 1: Develop Policies and Procedures to Identify and Respond to Identity Theft Red Flags
Affected Entities are required to adopt policies and procedures designed to detect and address “reasonably foreseeable risks” from identity theft.” (the “Red Flag Policies”).
The Red Flag Policies should be tailored to an Affected Entity’s business model, the type of accounts maintained for its clients; its methods to open or access the affected accounts; and its prior experiences with identity theft.
Affected Entities are also required to consider inclusion of the following in the Red Flag Policies, as appropriate:
- Alerts, notifications, or other warnings received from consumer reporting agencies or service providers;
- Presentation of suspicious documents, such as documents that appear to have been altered or forged;
- Presentation of suspicious personal identifying information, such as a suspicious address change;
- Unusual use of, or other suspicious activity related to, a covered account; and
- Notice from customers, victims of identity theft, law enforcement authorities, or others persons regarding possible identity theft.
Step 2. Develop Oversight Plan
Next, Affected Entities should involve and obtain approval of the Red Flag Policies from either its board of directors, an appropriate committee of the board of directors, or from a designated senior management employee, as appropriate.
Those parties should develop and approve an oversight plan, which:
- Assigns specific responsibility for the Red Flag Policies’ implementation, to an individual or committee, who will report to the board of directors or designated senior management employee as appropriate;
- Assigns specific responsibility to issue reports prepared by staff [generally, the Chief Compliance Officer] about the Affected Entity’s compliance with Regulation S-ID;
- Provides for the approval of material changes to the Red Flag Policies as necessary to address changing identity theft risks;
- Ensures that outside service providers comply with the developed Red Flag Policies;
- Provides for periodic reviews and updates to the Red Flag Policies with respect to:
- Provides for staff training to detect and respond to identity theft red flags as they arise.
a. The experiences of the Affected Entity with identity theft;
b. Changes in methods of identity theft;
c. Changes in methods to detect, prevent, and mitigate identity theft;
d. Changes in the types of accounts that the Affected Entity offers or maintains;
e. Changes in the business arrangements of the Affected Entity, including mergers, acquisitions, alliances, joint ventures, and service provider arrangements; and
Step 3. Implement Red Flag Policies
As part of its Red Flag Policy program, the Affected Entity will be required to appropriately respond to identity theft red flags, which could but do not necessarily include the following:
- Monitoring a covered account for evidence of identity theft;
- Contacting the customer;
- Changing any passwords, security codes, or other security devices that permit access to a covered account;
- Reopening a covered account with a new account number;
- Not opening a new covered account;
- Closing an existing covered account;
- Not attempting to collect on a covered account or not selling a covered account to a debt collector;
- Notifying law enforcement; or
- Determining that no response is warranted under the particular circumstances.
Step 4. Update Red Flag Policies as Necessary
Finally, in conformity with its oversight plan, the Affected Entity is required to periodically review and update the Red Flag Policies with respect to:
- The experiences of the Affected Entity with identity theft;
- Changes in methods of identity theft;
- Changes in methods to detect, prevent, and mitigate identity theft;
- Changes in the types of accounts that the Affected Entity offers or maintains; and
- Changes in the business arrangements of the Affected Entity, including mergers, acquisitions, alliances, joint ventures, and service provider arrangements.
As the prospect of new and more effective means of identity theft develop, investment advisory firms are compelled to react appropriately. The development and implementation of Red Flag Policies is therefore critical to an Affected Entity’s ongoing compliance program.
 17 CFR § 248.201(b)(10)
 Under the FCRA, a “creditor” is: “any person who regularly extends, renews, or continues credit; any person who regularly arranges for the extension, renewal, or continuation of credit; or any assignee of an original creditor who participates in the decision to extend, renew, or continue credit.” 15 U.S.C. § 1681; 15 U.S.C. §1681A(r)(5).
 15 U.S.C. § 1681A(t)
 12 U.S.C. § 461 C
 17 CFR § 248.201(b)(3)
 Among other reasons, an investment advisory firm generally has “custody” under 17 CFR § 275.206(4)-2(d)(2) if: it or a related person has direct or indirect possession of client funds or securities; any arrangement (including a general power of attorney) under which the related person is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the related person’s instruction to the custodian; and any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives the investment advisory firm or its related person legal ownership of or access to client funds or securities.
 SEC Release Nos. 34-69359, IA-3582, IC-30456.
In July 2012 Netflix, Inc. (“Netflix”) Chief Executive Officer, Reed Hastings, posted a seemingly innocuous statement to his personal Facebook page:
Congrats to Ted Sarandos, and his amazing content licensing team. Netflix monthly viewing exceeded 1 billion hours for the first time ever in June. When House of Cards and Arrested Development debut, we’ll blow these records away. Keep going, Ted, we need even more!
Mr. Hastings did not post that information on Form 8-K, the Netflix website, the Netflix Facebook page, or in any other public medium. Critically, Netflix’s shareholders were not separately informed of the above information.
As a result of that post, the Securities and Exchange Commission (“SEC”) announced approximately six months later that it was investigating whether to bring an enforcement action against Netflix and Mr. Hastings for potential violation of Regulation FD.
Regulation FD, which stands for “Fair Disclosure,” became effective in October 2000 and is codified at 17 CFR 243.100-243.103 (“RegFD”). According to the SEC, RegFD seeks to address:
- The selective disclosure by issuers of material nonpublic information;
- When insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information; and
- When the breach of a family or other non-business relationship may give rise to liability under the misappropriation theory of insider trading. (See: SEC Release Nos. 33-7881; and 34-43154).
At its core, RegFD requires a public company representative who discloses material nonpublic information to certain individuals, (generally, securities market professionals and shareholders who may trade on the basis of the information) to issue either a “prompt” or “simultaneous” disclosure of the same information to the public (depending upon whether the initial disclosure was intentional or accidental).
Luckily for Netflix, on April 2, 2013, the SEC issued a “Report of Investigation Pursuant to Section 21(a) of the Securities Act of 1934: Netflix and Reed Hastings” (the “2013 Report”) in which it stated it would not pursue an enforcement action. However, the SEC only refrained from an enforcement action because its investigation revealed: “there is uncertainty concerning how Regulation FD and the Commission’s 2008 Guidance apply to disclosures made through social media channels.”
Now that the SEC has ostensibly removed all uncertainty by releasing the 2013 Report, public companies and its representatives should proceed with caution when releasing company information on a personal social media site.
As stated in the 2013 Report:
Although every case must be evaluated on its own facts, disclosure of material, nonpublic information on the personal social media site of an individual corporate officer, without advance notice to investors that the site may be used for this purpose, is unlikely to qualify as a method ‘reasonably designed to provide broad, non-exclusionary distribution of the information to the public’ within the meaning of Regulation FD.
Accordingly, before posting any such information, public companies and their representatives should consider:
- Whether the potential post contains material, nonpublic information;
- Whether the company has provided appropriate notice to investors of the specific channels that it will use for the dissemination of material, nonpublic information; and
- If the information will be disseminated in such a way reasonably designed to provide broad, non-exclusionary distribution of information to the public.
As we advised you in our Fall Compliance Update, on October 3, 2011, the U.S. Securities and Exchange Commission's ("SEC") new Rule 13h-1, under Section 13(h) of the Securities Exchange Act of 1934, became effective. The purpose of the new rule is to assist the SEC in identifying and obtaining trading information on market participants that are involved in a large amount of trading activity in the U.S. securities markets.
The new rule imposes new filing requirements on "Large Traders," and new recordkeeping, reporting and monitoring requirements on broker-dealers. Rule 13h-1 defines Large Trader as: any person or entity, including investment advisers, that directly or indirectly exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any [exchange-listed] security for or on behalf of such accounts, by or through one or more registered broker-dealers, in an aggregate amount equal to or greater than either 2 million shares or $20 million in a single day or 20 million shares or $200 million in a calendar month. There are a limited number of exceptions to the definition of Large Trader including trades related to gifts, distributions of estates, court-ordered transactions, exercises or assignments of options contracts, and the creation of ETFs.
Rule 13h-1 requires a Large Trader to identify itself to the SEC and make certain disclosures on Form 13H. The information requested by Form 13H includes basic identifying information, the name of the organization and any affiliates, an organizational chart, a description of the nature of the firm's business, a list of forms the firm filed with the SEC, the names of each general partner and executive officer, director and trustee, and a list of broker-dealers where the trader has an account. The Form 13H will be kept confidential by the SEC and will be exempt from Freedom of Information Act requests.
Upon receipt of Form 13H, the SEC will assign the Large Trader an identification number known as an LTID. The Large Trader must provide its LTID to each registered broker-dealer effecting transactions on its behalf. The registered broker-dealer(s) are required to maintain records concerning the Large Trader's trades.
Organizations that are required to file Form 13H have until December 1, 2011 to do so. Please Note: Your firm is only required to file Form 13H by December 1, 2011 if your firm placed any qualifying trades from the effective date, October 3, 2011, through December 1, 2011. If your firm has not placed any trades during that time period that would require it to register as a Large Trader, the firm must file a Form 13H within ten days of qualifying as a Large Trader. After making an initial Form 13H filing, your firm must continue to file Form 13H annually. Further, if any information contained within the form becomes inaccurate or out-dated, an amended filing must be made by the end of the calendar quarter. If your firm has filed Form 13H, but during the previous calendar year did not place a trade that qualified as a large trade, it can make a filing to request "inactive" status and re-activate whenever necessary.
Please Note: The above discussion is a Summary only. Should you have any questions regarding how Rule 13h-1 and the Form 13H requirements will affect your firm, we remain available to address same. Should your firm be required to file Form 13H, Stark & Stark is prepared to make your initial filing and any subsequent annual filing.
Click here to obtain a copy of Form 13H.
Please Note: all 13H filings MUST be filed on the EDGAR system. Our staff can help you obtain the proper EDGAR system log-in if you do not currently use the EDGAR system.
Please contact Janet Canela (email@example.com), Cathy Pike (firstname.lastname@example.org) or Ann Cirillo (email@example.com) for additional information.
Effective September 19, 2011, the Securities and Exchange Commission amended Rule 205-3 of the Investment Advisers Act of 1940 (“Advisers Act”) which generally prohibits an investment adviser from entering into, extending, renewing or performing any investment advisory services for compensation based on a share of capital gains or capital appreciation of, the funds of a client (“performance fees”). Rule 205-3 of the Advisers Act exempts an investment adviser from the prohibition against charging performance fees in certain circumstances, including when the client is a “qualified client”.
The amended Rule 205-3 allows an investment advisor to charge performance fees if the client has at least $1 million (raised from $750,000) in assets under the management with the investment advisor immediately after engagement for advisory services or if the investment advisor believes, immediately prior to being engaged, that the client has a net worth of more than $2 million (raised from $1.5 million) (together, in the case of a natural person, with assets held jointly with a spouse).
Investment advisors should review and amend (if necessary) their disclosure documents and offering materials to comply with the amended Rule 205-3.
Recently the SEC approved a new rule to define the term “family Office.” Pursuant to the SEC’s new definition, a “Family Office” is a firm: 1) whose only clients are family clients; 2) and is wholly owned by family clients and controlled by family members and/or family entities; and 3) does not hold itself out to the public as an investment adviser.
Under the rule, family members include all lineal descendants of a common ancestor (who may be living or deceased) as well as current and former spouses or spouse equivalents of those descendants, provided that the common ancestor is not more than ten (10) generations removed from the youngest generation of family members. Furthermore, the rule accepts all children by adoption and current and former stepchildren as family members.
Included in the definition of family clients are family members (as defined above) and all of the following individuals and/or entities: 1) key employees of the family office (including executive officers, directors, trustees and general partners for the family office or its affiliated family office); 2) any other employee of the family office or any affiliated family office (other than an employee performing solely clerical, secretarial, or administrative functions) who has participated in the investment activities of the family office or any affiliated family office for at least 12 months; 3) any estate of a family member, former family member, key employee (and in some instances, a former key employee); 4) nonprofit and charitable organizations funded exclusively by family clients; 5) certain family trusts; 6) and companies wholly owned and operated for the benefit of family clients.
Family Offices are excluded from registration with the SEC. While not required to register with the SEC, those firms fitting the definition of Family Office must respond to certain questions found on Form ADV Part IA and periodically update same.
Please Note: Advisers who are currently relying upon the Family Office exemption but will no longer qualify under the new definition, must register with the SEC by March 30, 2012 (a later compliance deadline of December 31, 2013 has been established for Family Offices that manage assets of nonprofit or other charitable organizations funded by, in part, non-family assets). If you would like to discuss this blog post in more detail, please feel free to contact me in my firm's Lawrenceville, New Jersey with any questions you may have.
Stark & Stark Shareholder Comments on AllianceBernstein's Decision Not to Sign Protocol for Broker Recruiting
The article discusses the continuing legal battle AllianceBernstein is engaged in with financial advisors who recently left their firm and took clients with them. The firm filed suit against eight former brokers, claiming that they violated their non-solicitation agreements after they left without giving sufficient notice and taking their client lists and other confidential information with them.
Recently, Ashton Kutcher’s comments regarding several internet based social media companies has come under scrutiny after Kutcher authored an article for Details magazine in which he praises Tinychat, Fourquare, Arbnb and several other companies, while failing to disclose the fact that he is an investor in the companies. Now the Federal Trade Commission and the Securities Exchange Commission are questioning if this move warrants a federal investigation.
In the article, Mr. Lieberman states, “He's getting close to the line, if not crossing it, in terms of SEC regulations on insider trading."
For those who participate in the offering/sale of variable annuities and who may be subject to FINRA examinations, I have summarized some of the key points from Mr. Ketchum’s recent speech before the Insured Retirement Institute Government, Legal and Regulatory Conference.
- Verify customer assets exist and held at secure locations
- Risk analysis > examiners ask right questions when enter
- Profiles of firm’s business model and underlying risks
- Test for compliance with customer protection rules
- Examiners understand risks/management; looking for control breakdowns
- Point of Sale exams – focus on branches, rather than headquarters
- Pilot program – collect data from underwriters and manufacturers via standard request; templates being used: a) 1st round of requests sent April, 2011; and b) 2nd round of requests to VA manufacturers sent July – August 2011
FINRA is requesting broader data collection with increased analysis to spot trends and create risk-base exams.
Recent Exam findings
- Failure to document basic customer information
- Inadequate policy and procedures
- Inadequate supervisory reviews > suitability
- Training programs inadequate
- Abusive switches and costly surrender charges
- Over concentration of annuity products