Two weeks ago, the Securities and Exchange Commission (SEC) revealed that Goldman, Sachs & Co. has agreed to pay $550 million and to reform its business practices for its part in subprime-related investment collapse. The settlement was recently approved by United States District Court Judge Barbara Jones.

In the SEC's complaint filed this past April, the firm was alleged not only to have affirmatively misstated key facts, but also to have omitted them. The problems for the firm centered on the performance of subprime residential mortgage-backed securities. Investors were not told about the role that the hedge fund Paulson & Co. Inc. played in the Collateralized Debt Obligation (CDO) portfolio selection process. Paulson's interests were not aligned with those of investors. In fact, Paulson had "taken a short position against the CDO."

In Goldman's consent, the firm did not admit or deny the allegations, but did acknowledge that its marketing materials contained incomplete information. The firm also called it "a mistake" not to have disclosed the role of Paulson in the portfolio selection process because their interests were "adverse" to Collateralized Debt Obligation (CDO) investors.

Robert Khuzami, Director of the SEC's Division of Enforcement put it this way: "[t]his settlement is a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing."

As part of the settlement, Goldman is permanently enjoined from violating the antifraud provisions of the Securities Act of 1933. The payment includes $250 million to investors harmed in these transactions. The firm will also be required to reform its review and approval process with regard to mortgage securities offerings, including written marketing materials, as well as the role of key functions in theprocess, including counsel and compliance personnel.

A Full Review
The settlement requires that SunTrust review all their UIT purchases and ensure that certain customers receive remediation since, according to FINRA, those including the elderly and disabled, suffered "significant losses" in these investments. Specifically, two former SunTrust brokers and their supervisor from its Maryland Region are alleged by FINRA to have sold UITs, closed end funds and mutual funds that were unsuitable investments to the elderly and the disabled. The pattern of unsuitability involved margin transactions in which these customers are alleged not to have received maximum sales discounts.

Unsuitable Investments
The pattern also involved the unsuitable purchases and sales of these securities on margin within short periods of time and on the brokers' recommendation. These activities resulted in either "little or no [customer] benefit." In addition, the risks and costs of these investments were not disclosed to these customers.

Red Flags Ignored
As the Securities Lawyer Blog has noted in other FINRA investigations, SunTrust's systems and procedures for monitoring these transactions were found to be inadequate and red flags for these transactions were ignored.

Broker Actions Pending
Actions are pending against one of the brokers and the supervisor involved. The other broker has been permanently barred from the securities industry for his activities at SunTrust and subsequently at Merrill Lynch. These activities included a pattern of investment recommendations that were unsuitable, failures to inform customers of costs and fees of transactions, failure to provide applicable discounts and the transfer and use of customer funds to pay personal expenses while at Merrill Lynch.

Related Web Resources

For more information on UITs and other securities visit the Securities and Exchange Commission website.

Some of the major additions include more information about customer complaints, extension of records disclosure from two years to 10 years for brokers leaving the industry, permanent information on criminal convictions and other proceedings such as arbitration awards and injunctive relief.

More specific information on what the BrokerCheck® expansion will include can be viewed here. Briefly summarized, it includes the following.

Expanded Historic Complaint Disclosure
Expect expanded disclosure of what are known as "historic" complaints that were over two years old, were not resolved through adjudication or were settled for less than the required reporting amount, now set at $15,000. Previously, these events were disclosed on the service after a broker had three or more such events. The expansion will now include all historic complaints from 1999 forward for current brokers and those brokers whose registrations terminated in the prior 10 years.

Expanded Disclosure for Former Brokers
The expansion of disclosed information will reach back 10 years for those brokers who have left the securities industry. The current period is only two years, which FINRA notes aligns with its jurisdiction over former brokers and the time-frame in which an individual can continue broker activities without requalifying.

Expanded Permanent Information on Former Brokers
The new BrokerCheck expansion will include permanent information about brokers who have been subject to final regulatory action. It will also include additional information such as criminal convictions, guilty or nolo contendere pleas, injunctive relief related to regulatory violations and arbitration or civil judgments relating to "alleged sales practice violations."

Dispute Process Available
Brokers will have the opportunity to dispute accuracy of information included in the BrokerCheck service through a formalized process. This will include a notation of disputed information after a broker has filed a written notice to FINRA and will remain posted as such until resolved after FINRA investigation.

The Securities Lawyer Blog urges brokers to stay posted with us on the developments with regard to expanded BrokerCheck.

Resources
For any questions or concerns on the expansion of BrokerCheck® disclosures, please contact Gusrae, Kaplan, Bruno & Nusbaum, PLLC. We can provide support and guidance for brokers to ensure that their BrokerCheck® disclosures are accurate and when they are not accurate, follow the procedures for disputing their accuracy.

In a recent case, Deutsche Bank's compliance department apparently did its job and now one of its former brokers is permanently barred. A hearing panel at the Financial Industry Regulatory Authority (FINRA) issued this ruling on a complaint filed by FINRA in December 2008. The decision will be final, unless appealed.

Big Manipulations
Essentially, the broker involved was alleged to have manipulated the price of a biosciences stock seeking to create big gains for a hedge fund client, his family and himself. The panel's litany of findings are a roadmap for noncompliance and self-dealing.

Mr. Edward Brokaw was located in a Connecticut office of Deutsche Bank Securities. He is said to have executed a deliberate effort to drive the biosciences stock value down and in so doing, enhance the value of contingent value rights (CVRs) for this stock.

The hedge fund client held about 18.5 million CVR's for the bioscience stock, which amounted to about 30 percent of the total outstanding CVR's. The broker and his family owned over 200,000 of these. As the stock value dropped the CVR values increased and a big payout would result for CVR holders.

Bad Calls
The evidence against the barred-broker included recorded sell orders that were placed at the firm's trading desk. And the decision by the hearing panel included evidence that orders were taken by the trading desk to sell off large share holdings of the bioscience stock by the hedge fund resulting in a drop of value.

Further, another call "explained the pricing of the CVRs and the strategy behind the hedge fund's instructions to sell close to the market's open and close" and included a statement that this game was to be played for the next 15 days. Ultimately, it was found that this was a deliberate effort to depress the stock's price.

Compliance Works
After three days, Deutsche Bank's compliance personnel picked-up on the aggressive trading pattern and stopped sales of the biosciences stock for the hedge fund. Mr. Brokaw was suspended and terminated for these trades.

Another policy at Deutsche Bank was found to have been violated in that order tickets were not created as received, but rather were aggregated for each day "with a false notation that the order was given by the client directly to the trading desk rather than to Brokaw - thus circumventing automatic branch office compliance review of the orders"

In mid-June, the agreement was finalized and FINRA has now taken over the regulatory functions for the following markets and exchanges: NYSE Euronext's U.S. equities and options markets; New York Stock Exchange; NYSE Arca, and NYSE Amex.
This adds to FINRA's scope of responsibility as it already provides regulatory services to several other markets and exchanges including the NASDAQ Stock Market and NASDAQ Options Market, among others.

The move towards consolidation in these functions is intended to create what NYSE's Euronext COO Lawrence Leibowitz called "a consistent and completely integrated approach to regulation."

FINRA's Chairman and CEO, Richard Ketchum echoed this view noting that the consolidation is a "significant step in addressing the fragmented trading environment, which has eroded the ability of regulators to get a complete picture of market activity." He went on to call this a "more holistic, unified approach" that will benefit markets and protect investors.

According to Nasdaq.com, Mr. Ketchum had previously warned that multiple regulators created potential for loopholes, avoidance of oversight and created an "incomplete picture" of the overall market.

The oversight for these regulatory services will continue to be provided by NYSE Euronext, through its subsidiary NYSE Regulation. Costs for this function and staffing should remain at prior levels, although some staff is expected to move over to FINRA.

Earlier this week, the Securities and Exchange Commission (SEC) charged Thomas Priore, the owner and president of ICP Asset Management, LLC (ICP) and affiliated broker-dealer and holding company firms, with fraud. The action relates to the management of mortgage investment products.

Specifically, the civil action, filed in the United States District Court for the Southern District of New York, charges that Mr. Priore and affiliates fraudulently managed collateralized debt obligations (CDO's). The defendants intend to vigorously defend themselves against these charges and have issued a statement that they acted in their clients' best interests at all times.

The filing of this action is part of the SEC's ongoing investigation surrounding the financial crisis and its relationship to such products as CDO's and the major losses suffered during this period with these sorts of investments.

The impact alleged in this case is big. The SEC's allegations include "fraudulent practices and misrepresentations" that resulted in four multi-billion dollar CDO's to lose millions of dollars. Additionally, the defendants are alleged to have secured large advisory fees and undisclosed profits related to these investments at the "expense of their clients and investors," taking advantage of the distressed market for their own benefit.

The SEC also claims that the defendants allowed trades for the CDO's knowing that the prices were inflated and that clients would be exposed to overpayment and potential losses.

The SEC's New York Regional Office Director, George S. Canellos, put it this way: "The CDOs were complex but the lesson is simple: collateral managers bear the same responsibilities to their clients as every other investment adviser." He continued saying that advisers will be held accountable when clients' trust is violated.

Related Web Resources

For more background on this case and other aspects of the mortgage crisis, go to law.com.

This matter has many twists and turns and would be best presented by a visual roadmap of alleged fraud and misappropriation. But, simply stated, it boils down to supervisory violations in the handling of cemetery trust funds in Michigan and Tennessee.

Specifically, the $1.5 million sanction imposed was half for fines and half for disgorgement of commissions. The cemetery trusts will receive partial restitution from the sanction.

The Big Scheme
The problems for Citigroup are alleged to have taken place over a two-year period and involved a broker and two customers. They are alleged to have created and executed a scheme that involved more than $60 million in cemetery trust funds and included the use of trust funds to purchase cemeteries and funeral homes.

The Citigroup broker involved helped his clients open improper personal accounts. He also helped the transfer of monies from these accounts to third party accounts that were used to hide the misappropriation of funds and fake investments.

Red Flags Ignored
FINRA found that Citigroup failed to appropriately supervise these accounts and also failed to respond to red flags that could have stopped these activities. The prior employer of the broker involved in this scheme warned Citigroup of the irregularities in trust fund movement.

But Citigroup did not adequately investigate the warning. Even after a series of unusual transfers and opening of accounts in third party names, Citigroup allegedly did not pursue the matter adequately.

Whistleblower Letter
Citigroup even received a whistleblower letter that apparently was quite credible from a party whose company was involved as a trustee for the cemeteries. The letter exposed some of the broker's unusual activities, including the use of a personal email address to avoid Citigroup's monitoring systems. FINRA said that even after this, Citigroup did not respond adequately to stop the allegedly improper activity.

Related Web Resources

For more information on broker-dealer status, visit FINRA's service, BrokerCheck®.

Judge Rakoff weighed in this week on the ratings agencies role in evaluations for securities offerings. The plaintiffs' claimed that the defendants including Moody's and McGraw-Hill Companies' Standard & Poor's were actually acting as underwriters. This claim was dismissed with prejudice. The plaintiffs' argued that securities were issued based on ratings agency evaluations and that these evaluations formed the basis of allegedly false and misleading statements in offering documents.

Calling this claim an "extremely broad view of what constitutes an underwriter" the opinion points out that under Sections 7 and 11 of the Securities Act of 1933 the security rating that is assigned by a nationally recognized statistical rating organization is not considered part of the registration statement prepared or certified by a person within the meaning of these sections. The opinion also notes that the SEC does not interpret underwriters as falling under these definitions.

According to law.com, there are a few defendants left in the case after dismissal of Merrill Lynch subsidiaries Merrill Lynch Mortgage Lending and First Franklin Financial, JPMorgan, ABN Amro, and Credit-Based Asset Servicing and Securitization. The remaining claims are now those brought against individual Merrill executives, Merrill Lynch Mortgage Investors, and Merrill Lynch, Pierce, Fenner & Smith.

As the opinion in the class action case was issued, and quite coincidentally, as Mr. Warren Buffet weighed in on the ratings agencies after having been subpoenaed to the Financial Crisis Inquiry Commission on the business practices of the ratings agencies. Mr. Buffett testified at the same hearing as Moody's Investor Services CEO, Raymond McDaniel.

The subpoena was issued after several attempts by the Commission to bring Buffett to the table voluntarily. Berkshire Hathaway is the largest Moody's shareholder and Mr. Buffett has been a big seller of Moody shares as well.

To view Mr. Buffett's testimony on the ratings agencies click here.

This past week the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 10-25 in which it requests comment on its proposal that would make some important additions to its regulatory scope. Comments on this new proposed rule are due prior to July 12, 2010. The rule would be subject to SEC approval.

The Notice concerns a new proposed rule that would provide greater oversight to back office operations. Specifically, the new rule would establish expanded registration requirements that would apply to those "individuals engaging in, or supervising, activities related to sales and trading support, and handling of customer assets."

This means that in addition to broker dealers, those individuals who are part of the operations staff that support broker dealer activities will now be subject to registration. The new rule would apply to certain individuals involved in activities that could impact investors and customers in a significant way. The rule would not only require their registration, but also would require testing and continuing education.

According to FINRA, "[t]hese employees perform an integral role inside the firms, and their actions can have meaningful connections to the safety of customer funds, accounts and transactions, and the overall integrity of firm books and records." Recent history seems to bear this out.

Specifically, the individuals that are intended to fall under this new rule are those involved with valuation models, and manage such activities as trade confirmations, account statements, trade settlement and margin. Additionally, those individuals who oversee such activities as stock loan/securities lending, prime brokerage, receipt and delivery of securities, and/or financial regulatory reporting would also be covered by this registration rule.

FINRA notes that the SEC has suggested that raising awareness of back-office personnel and ensuring a level of knowledge of the securities industry would be advisable. FINRA's goal appears to be the enhanced likelihood that individuals involved in these activities understand their obligations and become more aware of potential problems, as well as have a basic knowledge of the industry and its high level of regulation.

Calling the locate "an essential component of ensuring that short sales are executed properly," James S. Shorris, FINRA Executive Vice President and Acting Chief of Enforcement, stated that "[t]he failure to design, implement and supervise systems that reasonably ensure that shares of a security are available to be borrowed before a short sale is executed significantly undermines the effectiveness of Regulation SHO."

The specific problem for these firms was similar, as was the end result of their system failures with regard to ensuring compliance with Regulation SHO. Each firm did maintain systems to block short sale orders that did not have a documented "locate." But in both cases there were exceptions to that which end up being fairly costly and had the effect of failing to block short sales that did not have a locate associated with them.

What FINRA found when sampling short sale orders for each of these firms, was a failure to ensure that a locate had been secured before such trades were executed. In Deutsche Bank's case the block was disabled in "certain instances" and in NFS' case, a separate system applied to "certain customers."

Ironically, because Deutsche Bank's systems had some outages that at times precluded data involving locates to be imported, the firm disabled the system altogether during outages. This occurred over a four-year period. No system was created to ensure that during the period when the system was disabled, another review was in place. This allowed short sales to go through that otherwise were not in compliance with the locate requirement.

Similarly, NFS maintained an automated system, but also excepted some firms that circumvented automatic blocks and allowed manual locate requests and approvals with account representatives. This occurred over a similar time-frame to that of the Deutsche Bank's challenges with regard to compliance with Regulation SHO. The FINRA press release called this a "flawed system."

In both instances, FINRA also found that the review processes for these firms on this type of trading was not adequate nor were the implementation of supervisory systems. The violations of Regulation SHO apparently could have been avoided had these systems been developed and reviewed for compliance.

To learn more about on Regulation SHO and short selling practices, visit investopedia.com.

Westpark Capital, Inc., has been ordered to pay $100,000 in fines and $300,000 in restitution to those customers impacted by several alleged failures, says the Financial Industry Regulatory Association (FINRA). The problems for Westpark derive from its Long Island operations in which it is alleged that brokers churned their customers' accounts and made both unauthorized and unsuitable trades.

The allegations include failures between 2006-2007 to: (1) establish and maintain an adequate system for supervising its brokers, including failures to monitor customer account activities despite former disciplinary records and customer complaints on suitability and authorization; (2) monitor excessive trading; and, (3) supervise managers with either little experience or prior disciplinary histories.

The firm will not only pay monetary fines, but is also dealing with suspensions of a former Chief Compliance Officer who is suspended for four months and is set to pay a $5,000 fine as well as its current Chief Operations Officer who is suspended for three months as a principal and set to pay a $20,000 fine.

Apparently, Westpark hired brokers that already had disciplinary histories themselves or had worked for broker-dealers that had such records. Some of these broker-dealers had even been expelled by the securities industry.

FINRA's Executive Vice President and Executive Director of Enforcement, James S. Shorris had some harsh words for the firm's hiring and operational practices saying that they failed to "recognize and respond adequately to both broker and customer account-related issues" which "resulted in significant customer harm."

Specific complaints and actions involving individual brokers in these cases are available for review on FINRA's website.

Related Web Resources

For more information on broker status, visit the BrokerCheck® service on the FINRA website.

Arbitration Lists

In the area of arbitration, FINRA had previously filed a proposed rule change with the Securities and Exchange Commission to amend Rules 12403 and 12404 of the Customer Code of Arbitration Procedure and Rules 13403 and 13404 of the Industry Code of Arbitration Procedure.

This rule change is intended to increase the number of arbitrators on the Neutral List Selection System. Specifically, parties picking an arbitration panel will select from a list of 10, rather than eight for every category of arbitrator on three-member panels, including public chair-qualified, public and non-public.

In cases involving less than $100,000, heard by a single, chair-qualified public arbitrator the list will also be increased to 10 names from the current eight.

The stated goal and expected outcome, is to make it more likely that the parties will have their cases heard by arbitrators they have selected. According to Linda Fienberg, President of FINRA Dispute Resolution, the larger pool will enable parties "to present cases before arbitrators they helped choose" instead of those generated by computer selection.

This proposed change does not alter the number of strikes allowed per party, which is currently set at four. This means that if approved by the SEC, it will be more likely that the parties end up with arbitration panelists they have selected and ranked as opposed to those generated by extended list appointments when the parties cannot agree.

NYSE Regulation

The other announcement from FINRA noted above, is that it will take over market surveillance and enforcement functions that are currently conducted by NYSE Regulation. This Securities and Exchange Commission will review this proposal.

The general agreement provides that FINRA would assume regulatory functions for NYSE Euronext's U.S. equities and options markets - including the New York Stock Exchange, NYSE Arca and NYSE Amex. The anticipated effective date is late June.

The goal in this move is to consolidate surveillance and enforcement responsibilities and aggregate these functions "with those already performed by FINRA for other markets" for a "consistent and completely integrated approach to regulation," according to NYSE Euronext COO, Lawrence Leibowitz.

And in the words of FINRA Chairman and Chief Executive Officer, Richard Ketchum, "...[t]his unified view will better enable regulators to detect problematic activity across multiple markets and financial products, and ensures that audit trail data needed for effective regulation is complete, consistently presented and transparent."

The Securities Lawyer Blog has previously posted on the many issues with ARS and related auction failures. Now ARS have resurfaced as the Financial Industry Regulatory Authority (FINRA) announced two more settlements with major firms.

FINRA says it has completed ARS settlements amounting to fines of almost $5 million with 14 firms and that those firms have returned over $2 billion to impacted investors. The two recent settlements are with HSBC Securities (USA), fined $1.5 million and US Bancorp Investments, Inc. fined $275,000.

In the HSBC matter, FINRA revealed that the firm had returned over 90 percent to ARS investors. However, there were additional investors who had for various reasons not received the repurchase of their ARS holdings. The settlement includes a repurchase offer to those customers who did not previously receive a repurchase of their holdings.

In the US Bancorp Investments matter, the firm had previously repurchased customer ARS holdings.

Reiterating the failure of these firms "to adequately disclose the risks associated with auction rate securities," James S. Shorris, FINRA Executive Vice President and Executive Director of Enforcement stated that ... "FINRA's first priority has been to ensure investor access to the money frozen in their ARS investments. We are pleased that these firms have completed or agreed to complete offers to buy back frozen ARS from their customers."

FINRA found that each of these firms had engaged in the sale of ARS with representations to their customers that these were safe and liquid. In HSBC's case, FINRA found that marketing materials were not fair and balanced.

These securities were recommended as safe and liquid even after the credit crisis began and failure of the auctions became a possibility. FINRA found that one broker suggested that the firm email a warning to customers that the auctions could fail. The suggested email to customers was not permitted by management and retail brokers continued to recommend ARS.

The situation with US Bancorp also involved marketing materials (provided by other securities firms) that did not adequately disclose ARS risks, were not balanced and did not disclose material differences between money market securities and ARS while comparing the yields of the two types of securities. Additional problems included failure of due diligence prior to including ARS on the firm's approved products list.

As part of the settlement, both firms have agreed to participate in the FINRA-administered arbitration program that allows resolution of claims of consequential damages for those customers that suffered such damages when their ARS funds were not available to them.

Apparently, there are more investigations on ARS ongoing and future FINRA settlements are likely.

Related Web Resources

For more information on the special arbitration program for ARS, go to FINRA.

FINRA has taken steps to help broker-dealers understand their obligations with regard to these offerings and has recently provided some guidance on avoiding problems with them.

According to FINRA's Regulatory Notice 10-22 and related news release, there is a "significant lack of regulatory compliance" which is evidenced by investigations and enforcements. Regulatory Notice 10-22 is intended to help firms comply with requirements and ensure proper investigation before recommending and selling private placements.

The Regulation D offerings are significant. Recently, the Securities and Exchange Commission estimated that these offerings were about $609 billion in 2008. FINRA says that's a large source of capital for small businesses in particular.

Specifically, Notice 10-22 seeks to ensure that when offering and recommending private placements under Regulation D of the Securities Act of 1933, broker-dealers perform a reasonable investigation of issuers and securities offered. It also emphasizes supervisory requirements for these offerings as well as suitability and risk for the investor and accuracy in sales materials for investors to make investment decisions.

As noted by FINRA's Chairman and CEO Rick Ketchum, " '[a]n increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests. That initiative has uncovered misconduct, including fraud and sales practice abuses ... FINRA is taking this opportunity to remind firms of their substantial duties when engaging in the sale of private placement offerings.' "

Related Web Resources

The SEC has a website devoted to educating investors on how to avoid fraudulent investments and such things as Ponzi schemes which can be found at investor.gov.

Citigroup was fined $650,000 for what FINRA alleged were issues with both disclosure and supervisory violations in its Direct Borrow Program or DBP. According to the investigation, which covered nearly a three-year period from early 2003 through late 2005, the Citigroup DBP borrowed securities that were then placed in a pool of securities. This was used to support the firm's client's short-selling strategies. The loans averaged $301 million a year and were borrowed from over 2,000 customers.

FINRA alleged that Citigroup did not supervise its DBP staff or establish procedures to do so. Moreover, brokers did not adequately monitor the accounts of customer involved in the DBP.

The allegations, which were neither admitted nor denied by the firm, center around what FINRA claimed to be failures to disclose or to adequately disclose material information to customers in the DBP. FINRA found that Citigroup did not inform customers of many critical facts that could impact this activity including such things as the fact that the firm could reduce interest rates, that the loans could be sold by customers, that brokers received commissions throughout the loan period, and that higher tax rates could apply to these dividends.

Other issues FINRA found in this case involved the branches and what they knew and did not know. For example, many branch managers and supervisors were not aware that Citigroup had a DBP or that brokers they were supervising had customers involved in it. Further, customer accounts that had securities in the DBP could not be monitored with tools generally used internally. These accounts could not be monitored to accurately reflect customer's positions or to monitor the ongoing appropriateness of the activity for specific customers.

As has been determined in other cases, the marketing materials regarding the DPB were found to be misleading regarding risk and other issues.

At the time of settlement all loaned shares had been returned to Citigroup customers who were involved in the DBP.