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FINRA Examines Fintech Including Blockchain

Posted by Securities Attorney Laura Anthony | September 11, 2018 Tags: FINRA Examines Fintech Including Blockchain

On July 30, 2018, the Financial Industry Regulatory Authority (FINRA) published a Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook. The Special Notice, and fintech in general, necessarily includes blockchain technology, a topic FINRA has been examining for a few years now. Last July, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, and earlier in January 2017 FINRA issued a report entitled “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry” on the topic (see HERE).

Also, on July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens. FINRA informs members that it is monitoring the digital asset marketplace and as part of its efforts and wants all firms to notify FINRA if it or its associated persons engage in any activities related to digital assets. FINRA has requested that it be kept updated on firms’ digital asset matters through July 31, 2019.

FINRA Special Notice on Financial Technology Innovation

Clearly financial technology innovation (“fintech”) offers benefits to investors and the financial marketplace as a whole, but also creates challenges for regulators to adapt rules and supervision that support the innovations while continuing to satisfy their goals of investor protection. In addition to blockchain, technological advances have been affecting how financial service providers conduct their business and interact with clients for years. For example, fintech applications related to digital advice including robo-advisors and algorithmic trading platforms, and the use of social media in wealth management, have been hot topics of several years now. Furthermore, the use of artificial intelligence, natural language processing and social media have impacted market research and analytical coverage on a wide scale.

FINRA’s special notice provides a succinct summary of the actions FINRA has taken to date involving fintech developments, including:

Created an external website dedicated to fintech-related matters (see HERE).
Formed Fintech Industry Committee with large and small member firms, non-member fintech service providers and SEC and NASAA representation. Topics of focus for the committee include: (i) the potential impact of innovation on FINRA’s investor protection and market integrity objectives; (ii) challenges to the adoption of fintech-based products or services; (iii) opportunities to improve interactions with FINRA; and (iv) FINRA fintech-related initiatives.
Have held 4 blockchain and/or fintech symposiums;
Fintech representation at the annual FINRA conference;
Issued reports and investor alerts related to blockchain, cryptocurrencies digital investment advice and other fintech matters;
Working with other domestic and foreign regulators to share insights and address fintech-related issues.

The special report generally seeks comments that can help identify FINRA rules or administrative processes that could be modified or improved to support fintech innovation while still protecting investors and market integrity. In addition to the general request for comments, FINRA specifically requests comments on (i) the provision of data aggregation services through compiling information from different financial accounts into a single place for investors; (ii) supervisory processes concerning the use of artificial intelligence; and (iii) the development of a taxonomy-based, machine-readable rulebook.

Data Aggregation

Many investors have started using data aggregation services that compile their financial data from different financial institutions, including broker-dealers, into one place, often using a dashboard on an Internet-based platform, in order to offer a variety of services such as financial planning, portfolio analysis, budgeting, and other types of financial analysis or advice. In order to compile the data, personal information, including passwords, must be provided to these service providers. Generally, the system is automated such that a program or computer code utilizes the passwords to access various financial institutions and obtain data that is then presented to the investor. In this case the aggregation service provider and financial institution to not have a contractual relationship.

As an alternative, some financial institutions now offer services called “application programming interface” (API) in which there is a direct transfer of data from the financial institution to the aggregator. The consumer client sets the access authorization and level. In this case there is a contract between the aggregator and the financial institution including provisions related to responsibilities and technical requirements to safeguard data and privacy.

Broker-dealers can be on both sides of these transactions. That is, the broker-dealer may be one of the financial institutions from which data is being aggregated and broker-dealers can act as the aggregation service provider as well. FINRA is exploring ways to address this increasing consumer option including through the development of standards and protocols. FINRA has provided a notice to members with some guidance on data aggregation services, including that consolidated reports are communications with the public subject to anti-fraud parameters. FINRA also provided some guidance on supervisory and internal control systems; however, with the increase use of these services, more robust rules and guidance may be necessary. Blockchain, including the use of smart contracts, could be utilized in data aggregation services.

Supervision Related to Artificial Intelligence

There is a growing interest in applying artificial intelligence, including machine learning and natural language processing, to financial markets and broker-dealer processes and services. Artificial intelligence is used in areas such as anti-money laundering/know-your-customer compliance, trading, data management and customer service.

With the growth of artificial intelligence comes concerns about how the processes fit within existing FINRA regulations, and the need for new regulations. For example, FINRA is examining how a firm can adequately supervise algorithmic trading, including suitability requirements for specific customer transactions. However, more information is needed and the Special Report indicates that FINRA needs to develop a better understanding of artificial intelligence applications in the industry. Smart contracts built on the blockchain are a form of artificial intelligence.

FINRA specifically requests comments on the following:

For what purposes are members using, or considering, artificial intelligence tools—including chat bots and robotic process automation (RPA) tools—in their brokerage businesses and what benefits will it serve?
Do firms’ governance practices for the development and ongoing operation of artificial intelligence tools differ from those used for tools or processes that use more conventional operational techniques?
What forms of quality assurance do firms use in developing artificial intelligence?
What are the greatest regulatory challenges in adapting artificial intelligence, including those related to supervision?
Are there specific regulatory issues that the use of artificial intelligence tools in the context of algorithmic trading strategies raises?

Development of Taxonomy-based, Machine-readable Rulebook

The UK Financial Conduct Authority (FCA) and the Bank of England (BoE) have launched an initiative to examine how to simplify regulatory compliance through the digitization of rulebooks, making them “machine-readable” – in other words, the creation of a rulebook that is structured in such a way as to make it more easily processed by a computer such as a rulebook built on the blockchain using smart contracts. FINRA is reviewing the possibility of machine-readable rulebooks for compliance policies, procedures and transaction databases.

According to the FCA and BoE, such efforts have the potential to “fundamentally change how the financial services industry understands, interprets, and then reports regulatory information,” through the mapping of regulatory obligations. The reduction of compliance costs and elimination of human error would benefit both firms and regulators.

Obviously, such a dramatic change in the industry will not happen overnight, but as FINRA indicates, it has to start with a first step. As such, FINRA is considering the feasibility and desirability of developing a type of machine-readable rulebook through the creation of an embedded taxonomy (i.e., a method for classification and categorization) within its rules.

FINRA specifically seeks comments on:

Who will benefit the most and who will utilize a machine-readable rulebook?
In what way will it make compliance more efficient and effective?
Is there a risk of “over-reliance”?
What are the benefits of developing machine-readable rulebooks that interact with other US-based and foreign regulators’ machine-readable rulebooks?
What role should vendors and regulated firms play in the adoption, development and ongoing taxonomy maintenance?

Regulatory Notice 18-20

The market for digital assets such as cryptocurrencies, tokens and coins continues to grow significantly and as such, fraud in their issuance and secondary trading continues to be a focus for regulators including FINRA. On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens and to continue to update FINRA on such activities through July 31, 2019. FINRA informed members that it is monitoring the digital asset marketplace and, as part of its efforts, wants all firms to advise FINRA if it or its associated persons engage in any activities related to digital assets.

Member firms are specifically requested to notify FINRA of any of the following activities:

Purchases, sales or execution of transactions in digital assets;
Purchases, sales or execution of transactions in a pooled fund investing in digital assets;
The creation of, management of, or provision of advisory services for a pooled fund investing in digital assets;
Purchases, sales or execution of transaction in derivatives tied to digital assets;
Participation in an initial or secondary offering of digital assets including ICOs and pre-ICOs;
Creation or management of a platform for the secondary trading of digital assets;
Custody or similar arrangement involving digital assets;
Acceptance of cryptocurrencies from a customer;
Mining of cryptocurrencies;
Recommending, soliciting or accepting orders in cryptocurrencies or any digital assets;
Displaying indications of interest or quotations in cryptocurrencies or any digital assets;
Providing or facilitating clearance and settlement services for cryptocurrencies or any digital assets;
Recording cryptocurrencies or any digital assets using distributed ledger technology; or
Any use of blockchain technology.

The Regulatory Notice also explicitly reminds member firms to be cognizant of all applicable federal and state laws, rules and regulations, including FINRA and SEC rules and regulations. Furthermore, any material change in the business operations of a member firm requires the submittal of a CMA. Involvement in cryptocurrencies, digital assets or blockchain would be considered a material change.

FinCEN and the SEC Weigh In

In a speech at a blockchain conference on August 9, 2018, FinCEN director Kenneth A. Blanco was less than positive on the state of compliance of money transmitter businesses such as cryptocurrency exchanges. For more information on FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE. In particular, Blanco states that the industry lacks adequate anti-money laundering (AML) controls and that most businesses do not even attempt to put better measures into place until after they are reviewed or investigated by a regulatory authority. Furthermore, the victims of improper AML procedures are not investors with money to lose, but rather families who lose loved ones to opioid addictions or terrorist acts, as both of these utilize cryptocurrencies in their operations.

Mr. Blanco’s remarks follow similar comments by SEC assistant director Amy Hartman, who also advised companies planning on an ICO to engage competent securities counsel.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty, and need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance n cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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OTC Markets Group Establishes A Stock Promotion Policy

As OTC Markets Group continues to position itself as a respected venture trading platform, it has adopted a new stock promotion policy and best practices guidelines to improve investor transparency and address concerns over fraudulent or improper stock promotion campaigns. The stock promotion policy and best practices guidelines are designed to assist companies with responsible investor relations and to address problematic issues. Recognizing that fraudulent stock promotion is a systemic problem requiring an all-fronts effort by industry participants and regulators, the new policy focuses on transparency and disclosure of current information, and the correction of false statements or materially misleading information issued by third parties.

For several years, OTC Markets Group has been delineating companies with a skull-and-crossbones sign where they have raised concerns such as improper or misleading disclosures, spam campaigns, questionable stock promotion, investigation of fraudulent or other criminal activity, regulatory suspensions or disruptive corporate actions. While labeled with a skull and crossbones, a company that does not have current information or is not on the OTCQB or OTCQX will have its quote blocked on the OTC Markets website.

The new policy addresses: (i) publicly identifying securities being promoted; (ii) identifying fraudulent promotional campaigns; (iii) responsibilities of companies with promoted securities; (iv) the impact on OTCQX or OTCQB designations; (v) caveat emptor policy and stock promotion; and (vi) regulatory referrals. This blog summarizes both the new stock promotion policy and best practices guidelines.

OTC Markets Group Policy on Stock Promotion

The basic premise behind OTC Markets Group policy on stock promotion is the timely disclosure of material information, which includes the duty to dispel unfounded rumors, misinformation or false statements. Technology has increased the ability for companies, insiders and third parties to engage in improper and manipulative activities, including through spam campaigns, and anonymous social networks and message groups.

A company that is the subject of an active campaign or has a history of stock promotion may be denied an application for trading on the OTCQB or OTCQX. A company may be removed from the OTCQB or OTCQX, upon the sole discretion of OTC Markets Group, if it is involved in an active campaign involving misleading information or manipulative promotion. Furthermore, promotional activity of a shell company will result in the immediate removal from OTCQB (shells are not permitted on OTCQX). OTC Markets Group will continue to use the caveat emptor skull-and-crossbones designations as well. Where appropriate, OTC Markets Group will refer a company to the SEC, FINRA or other regulatory agency for investigation.

Paid promotions are often associated with pump-and-dump activities where a third party is attempting to pump the stock price to liquidate at inflated prices, following which the stock will inevitably go down. Improper and misleading promotional materials, which can often be in the form of e-mails, newsletters, social media outlets (such as message boards), press releases, videos, telephone calls, or direct mail, generally share the following common characteristics.

Failure to identify the sponsor of the promotion or if the promotion is paid for an anonymous third party

Information focuses on a company’s stock rather that its business;

Speculative language, including but not limited to grandiose claims and numbers related to the company’s business, industry, financial results or business developments;

Touting of performance or profit potential from trading in a company’s stock with unsupported or exaggerated statements, including related to stock price;

Making unreasonable claims related to a company’s performance;

Directly or indirectly promising specific future performance;

Providing little or no factual information about the company;

Urging immediate action to avoid missing out;

Failing to provide disclosures related to risks of an investment.

Although not included in OTC Markets’ list of common characteristics, another red flag is when there is a comparison between the company being promoted and a well-known successful or respected company.

OTC Markets Group monitors for paid promotional activity and reviews for anonymous promotions, connections to bad actors, and impacts on trading. Beginning in first quarter 2018, stocks associated with such promotional activity will be identified with a “risk flag” next to its symbol on the OTC Markets website.

OTC Markets Group may also request that a company that is subject to promotional activity issue a press release to: (i) identify promotional activity; (ii) confirm information in the promotion or identify misinformation; (iii) and/or disclose recent securities transactions by insiders and affiliates. Furthermore, OTC Markets group may request information from a company and/or its transfer agent related to transactions and request additional disclosures from the company related to share issuances, financing agreements and the identity of people or advisors associated with the transactions.

OTC Markets Group Best Practices Guidelines for Stock Promotion

As in its separate stock promotion policy, the OTC Markets Group best practices on stock promotion guidelines reiterate the core principle that the timely disclosure of material information is key, which includes the duty to dispel unfounded rumors, misinformation or false statements.

OTC Markets Group suggests that companies perform due diligence on investor relations firms and their principals prior to engaging services. This is advice I am constantly giving to my clients. Basic due diligence includes reviewing other represented clients and doing basic searches for regulatory issues or negative news. Companies should also be very clear on what services an investor relations firm will perform and what compensation will be paid for those services.

Very vague service descriptions often indicate an improper promotional campaign. OTC Markets Group also warns of red flags, including a request that payment be split among various individuals or groups.

A company that hires or sponsors investor relations is responsible for the content of communications made by that company and must ensure that all information is materially current and accurate. In addition, a company should retain editorial control and review all information before it is disseminated. Investor relations materials should not use language that makes assumptions, is speculative or misleading, or brazenly hypes the stock. Communications should not cover new material information that has not been previously disclosed, and should not extend beyond providing factual information to investors and shareholders.

The disclosures required by Section 17(b) must always be properly made, and OTC Markets Group specifically requires that any relationship between the investor relations individuals and entities and the company be fully disclosed.

Since third parties often engage in stock promotional activities without the knowledge or consent of a company, it is important for a company to know its investors, including the people behind any entities or investor groups. Investors that desire anonymity or utilize offshore entities raise a red flag. Furthermore, companies should be wary of shareholders that own significant control or investor groups that will qualify to remove restrictive legends on stock. Investor groups often change the name of their investment vehicle entity and, as such, due diligence should include prior entities.

OTC Markets Group warns against toxic or death spiral financing. Toxic or death spiral financing generally involves an investment in the form of a convertible promissory note or preferred stock that converts into common stock at a discount to market with no floor on the conversion price. As I have written about many times, there are quality investors and others that are not quality in the microcap space. The use of convertible instruments as a method to invest in public companies is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. Further examples of abusive or improper activity could include: (i) backdating of notes or failure to provide the funding associated with the note; (ii) improper undisclosed affiliations between investors and the company or its officers and directors; (iii) manipulative trading practices; (iv) improper stock promotion; or (v) trading on insider information. Again, in choosing a transaction it is incumbent upon the company to conduct due diligence on the investor, including their reputation in the industry and trading history associated with other investments and conversions.

OTC Markets Group also warns of anonymous third-party promotions, noting that these promotions are a significant source of misleading and manipulative information. Any company-sponsored stock promotion must be disclosed, whether the company is involved directly or indirectly. The identity of a company’s investor relations firm must be disclosed on the company’s profile page on otcmarkets.com.

OTC Markets Group recommends that a company make a public announcement with the following information in the event it learns it is the subject of misleading or manipulative stock promotion.

A summary of the company’s understanding of the stock promotion, including how and when the company became aware of the campaign and a description of the promotion’s effect on the company’s trading activity;

Whether the content of the promotion is accurate or contains untrue or misleading information;

Conduct an inquiry of company management, officers and directors, to ascertain whether they are involved in the stock promotion and/or of have purchased or sold securities before, during or after the promotion;

Provide an up-to-date list of service providers who perform investor relations or similar services;

Disclose the issuance of convertible securities with variable rate or discount to market conversion rates. This disclosure should include details on the convertible instruments, including date, number of shares issued or issuable, price, conversion terms, and parties involved.

OTC Markets also suggests that all companies have insider trading policies, a policy which I support and suggest to my clients.

Section 17(b) of the Securities Act of 1933

The federal securities laws also govern stock promotion activity. Section 17(b) of the Securities Act of 1933 is an antifraud provision which requires that any communications which “publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service or communication” which describes a security, must disclose any consideration received or to be received either in the past, present or future, whether directly or indirectly by the issuer of such communication. Generally the disclosure must include: (i) the amount of consideration; (ii) from whom it is received, such as the company, a third-party shareholder or an underwriter and the individual persons behind any corporate entity involved; (iii) the nature of the consideration (for example, cash or stock, and if stock, whether restricted or unrestricted); and (iv) if consideration is paid by a third party other than the company whose securities are being promoted, the relationship between the company and the third party. Moreover, I recommend that companies ensure such communications include a disclosure as to whether the issuer of such communications owns stock which may be sold in any upmarket created by the communication.

The disclosure required by Section 17(b) must be included in each and every published document, including emails, message board postings and all other communications.

Further Reading on OTC Markets Group Rules

For a review of the OTCQB listing standards, see HERE . For a review of the OTCQX listing standards, see HERE. For a review of the OTC Pink standards, see HERE.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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FINRA Issues New Guidance On Communications With The Public, Including Social Media

Posted by Securities Attorney Laura Anthony | August 22, 2017 Tags: Finra, FINRA Rule 2210, Regulatory Notice 17-18

In April 2017 FINRA issued Regulatory Notice 17-18 providing additional guidance on the use of social media and digital communications by member firms and persons associated with member firms. The guidance specifically relates to FINRA Rule 2210 – Communications with the Public, and supplements previously issued guidance in Regulatory Notices 10-06 and 11-39, published in 2011. The new guidance is in the form of FAQ’s and concentrates on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

I have previously written about the SEC’s guidance on social media use by companies, including as a method for communications with investors and the public. The most recent blog is HERE and includes hyperlinks to prior blogs, including a three-part summary of the SEC Guidance on Social Media and Websites for Company Announcements and Communications.

Brief Overview of Rule 2210

FINRA Rule 2210 governs communications by FINRA member firms and associated persons, including: (i) institutional communications – including any written or electronic communication, distributed or made available only to institutional investors such as banks, insurance companies and investment companies; (ii) retail communications – including any written or electronic communication distributed or made available to more than 25 retail investors within any 30-calendar-day period; and (iii) correspondence. The Rule also sets forth requirements related to approval, review and recordkeeping of communications; filing requirements and review procedures and content standards.

The Rule’s general content standards apply to all communications and are meant to ensure that communications are fair, balanced and not misleading. Communications to retail customers or potential customers have the highest standards. The communication rules focus on the recipient and not the type of product (IPO, private, debt, etc.) that might be being discussed.

Retail Communications

Subject to certain exemptions, an appropriately qualified registered principal of the member firm must approve each and every retail communication before the earlier of its first use, or its filing with FINRA’s Advertising Regulation Department. However, this requirement does not apply where another member firm has used the same communication and received approval from FINRA as to its content. In other words, member firms can piggyback on each other’s advertising and communication approvals.

The requirement also does not apply to: (i) certain communications excepted from the definition of a research report or debt research report unless the communication makes a financial or investment recommendation; (ii) any retail communication that is posted on an online interactive electronic forum; and (iii) retail communication that does not make any financial or investment recommendation or otherwise promote a product or service of the member firm.

Correspondence

All correspondence must be subject to general supervision and review requirements.

Institutional Communications

Members must establish written procedures that are appropriate to their business, size, structure, and customers for the review by an appropriately qualified registered principal of institutional communications used by the member and its associated persons. The procedures must be reasonably designed to ensure that institutional communications comply with applicable standards. When the procedures do not require review of all institutional communications prior to first use or distribution, they must include provisions for the education and training of associated persons as to the firm’s procedures, documentation of the education and training, and surveillance and follow-up to ensure that the procedures are implemented and adhered to.

Recordkeeping

As required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

Records must include: (i) a copy of the communication and the dates of first and last use; (ii) the name of any principal who approved the communication and the date of approval; (iii) if the communication was not approved, the name of the person who prepared or distributed it; (iv) information on the source of any statistical table, chart, graph or other illustration; (v) where the firm or representative is relying on another member’s approval, the name of the member and a copy of the review letter and approval from FINRA; and (vi) for any retail communication that includes or incorporates a performance ranking or performance comparison of a registered investment company, a copy of the ranking or performance used in the retail communication.

Filing Requirements and Review Procedures

For the first year as a licensed broker-dealer, a firm must file all retail communications with FINRA’s Advertising Regulation Department at least 10 days prior to its first use. If a communication is a free writing prospectus that has been filed with the SEC, it can be filed with FINRA within 10 days of its first use, instead of prior. FINRA can also impose a filing requirement on any firm at any time if it determines that the firm has departed from the standards in Rule 2210.

Retail communications concerning registered investment companies, which include or incorporate performance rankings or comparisons, must always be filed at least 10 business days prior to use. Likewise, retail communications recommending a specific registered investment company, concerning a direct participation program, concerning collateralized mortgages or concerning derivatives or indexes must all be filed with FINRA at least 10 business days prior to their first use.

If a member has filed a draft version or “storyboard” of a television or video retail communication pursuant to a filing requirement, then the member also must file the final filmed version within 10 business days of first use or broadcast.

Certain retail communications are excluded from the filing requirements, including: (i) communications based on a template that has previously been filed with FINRA and approved for use either without material change, or changes limited to updated statistical and other information; (ii) retail communications that do not make any financial or investment recommendation or otherwise promote a product or service of the member; (iii) retail communications that do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker; (iv) retail communications that do no more than identify the member or offer a specific security at a stated price; (v) offering documents, reports or free writing prospectus that have been filed with the SEC or a state or offering documents for exempt offerings; (vi) tombstone communications identifying a firm’s participation in an offering; (vii) press releases that are made available only to members of the media; (viii) republications of unaffiliated third-party articles or reports that the firm has neither adopted nor become entangled with; (ix) correspondence; (x) institutional communications; (xi) communications that refer to types of investments solely as part of a listing of products or services offered by the member; (xii) retail communications that are posted on an online interactive electronic forum; (xiii) press releases issued by closed-end investment companies that are listed on the New York Stock Exchange; (xiv) research reports on exchange traded securities.

FINRA may grant exemptions to the filing requirements for good cause. All filings must be approved by a registered principal within the firm prior to submitting to FINRA.

Content Standards

Rule 2210 focuses on antifraud issues. In particular, the Rule provides that “All member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” The next section continues: “No member may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication. No member may publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.”

Information may only be placed in a footnote if it is still clear. Members must ensure that statements are not misleading and that they provide balanced treatment of risks and potential benefits. FINRA requires that firms consider their audience in creating content, and such content must be audience-appropriate. Communications cannot exaggerate and may not predict or project performance.

There are specific requirements for content in communications. For example, a member firm must prominently include the name of the member firm, fictional names, and relationships between parties listed in the communication. There are specific requirements regarding communications related to tax-free or tax-exempt products and disclosures of fees and expenses for investment management companies and pooled funds.

Testimonials and Recommendations

Rule 2210 governs the use of testimonials about a member firm and the use of recommendations by a member firm. Each requires a reasonable basis and must be rendered by a person with the knowledge and experience to form a valid opinion. Retail communications involving recommendations about a product or service by a member firm have additional technical requirements.

BrokerCheck

All communications must contain a prominent reference and hyperlink to BrokerCheck.

New Guidance

FINRA Regulatory Notice 17-18 provides additional guidance on the use of social media and digital communications by member firms and associated persons through FAQ’s designed to supplement previously issued guidance on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

Recordkeeping

As noted above, and as required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

The new guidance confirms that the record retention requirements apply to communications made through text messaging or a chat service or app. Prior to allowing text or chat communications, a firm must ensure that it has the ability to retain the content of the communications.

Third-party Posts; Adoption or Entanglement

Generally speaking, posts by customers or other third parties on social media or any website established by a firm or its personnel do not constitute communications with the public by the firm or its associated persons under Rule 2210. Accordingly, these posts do not require pre-use approval by a principal in the firm, and as a practical matter, a firm could not require third parties to seek such approval. However, if the firm or associated person paid for the preparation of the content or otherwise caused it to be prepared and posted, the firm would be responsible for its content under FINRA’s “entanglement” theory. Moreover, if the firm or associated person explicitly or implicitly endorses or approves the third-party content, it would also be responsible for its content under FINRA’s theory of “adoption” of content. Where a firm or associated person is responsible for the content, it must comply with all the requirements of Rule 2210.

The new guidance clarifies that a firm or registered representative can contact a third party to correct factual information, such as the spelling of a name, an incorrect address or website, where the firm was completely unaffiliated with the publisher and not involved in the publications content, without such correction resulting in entanglement or endorsement.

Hyperlinks to Third-party Sites

A firm is responsible for links to a third-party site if that firm has adopted or become entangled with the content. A firm would be deemed to have adopted content that it explicitly or implicitly endorses or approved and would be deemed to be entangled in content where it has participated in the development of such content. A member firm may not establish a link to any third-party site that the firm knows or has reason to know contains false or misleading content and may not include a link on its website if there are any red flags that indicate the linked site contains false or misleading content.

The new guidance clarifies that by sharing or linking to third-party content, the member firm has adopted that content and is responsible for its content to the same extent it is for firm-generated communications. Where the shared or linked content itself has additional links to other content, the firm must do a facts-and-circumstances analysis to determine if it would also be responsible for that additional content. The firm would not be deemed to have adopted the content in the links in the shared content, solely by sharing or linking.

In general, if a firm shares or links to content that in turn links to other content over which the firm has no influence or control, the firm would not have adopted the other content. On the other hand, if a firm shares or links to content that in turn links to other content over which the firm has influence or control, the firm would then have adopted that other content. In addition, if the firm shares or links to content that itself serves primarily as a vehicle for links, the firm would be responsible for the content in the links.

The new guidance also clarifies that whether a firm has adopted the content of an independent third-party website or any section of the website through the use of a link is fact dependent. Two factors are critical to the analysis: (i) whether the link is “ongoing” and (ii) whether the firm has influence or control over the content of the third-party site.

Where the link is “ongoing” the firm would not have adopted the content. “Ongoing” means that: (i) the link is continuously available to investors who visit the firm’s site; (ii) investors have access to the linked site whether or not it contains favorable material about the firm; and (iii) the linked site could be updated or changed by the independent third party and investors would still be able to use the link. As an example, some firms link to regulatory agencies such as FINRA or the SEC.

However, if the firm has influence or control over the third-party site, the firm would be entangled with its content and thus responsible under Rule 2210.

Personal Communications

Personal communications are not subject to Rule 2210. Moreover, if an associated person shares or links to content that the member firm made available, which is not related to its products or services, the communication is likewise not subject to Rule 2210. Examples given in the FINRA notice include information about the firm’s sponsorship of a charitable event, a human interest article, or an employment opportunity.

Native Advertising

Native advertising is defined as content that bears a similarity to the news feature articles, product reviews, entertainment and other material that surrounds it online. Native advertising can appear to be a genuine news article or product review at first glance. FINRA clarifies that native advertising is not inherently misleading and can be used as long as it complies with Rule 2210, including that the firm ensures that the communication is fair, balanced and not misleading. Native advertising must prominently disclose the firm’s name, accurately reflect any relationship with the firm and any other entity or individual named in the advertisement, and state whether mentioned products or services are offered by the firm.

Where a member firm arranges for or pays for third-party native advertising, such as content in a blog or posts by an influencer, the firm would be responsible for its content under the entanglement theory. As provided in an earlier Regulatory Notice, if a firm or representative has paid for the publication, production or distribution of any communication that appears to be a magazine, article or interview, then the communication must be clearly identified as an advertisement. Firms should clearly identify as advertisements any communications that take the form of comments or posts by influencers and include the broker-dealer’s name as well as any other information required for compliance with Rule 2210.

Testimonials and Endorsements

Many social networking sites, such as LinkedIn, allow individuals to post opinions or provide comments regarding a person’s professional capabilities. FINRA allows registered representatives and associated persons to utilize social networking platforms for business-related purposes as long as the account is supervised and retained by the member firm. FINRA does not include unsolicited third-party opinions or comments posted on a social network to be communications of the firm or representative for purposes of Rule 2210. However, if the firm or representative likes or shares content, they have adopted the content and become subject to the communication rules, including prohibitions on misleading or incomplete statements or claims, the testimonial requirements, and the supervision and recordkeeping rules.

Testimonials are governed by Rule 2210 and in particular:

(A) If any testimonial in a communication concerns a technical aspect of investing, the person making the testimonial must have the knowledge and experience to form a valid opinion.

(B) Retail communications or correspondence providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose the following: (i) the fact that the testimonial may not be representative of the experience of other customers; (ii) the fact that the testimonial is no guarantee of future performance or success; and (iii) if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial.

Testimonials are subject to the general Rule 2210 standards as well, including that they not be false, misleading, exaggerated or promissory. The disclosures that must be required can be included via a clearly marked and labeled hyperlink. Also, investment advisors are prohibited from directly or indirectly publishing, circulating or distributing testimonials.

BrokerCheck

Effective June 6, 2016, Rule 2210 requires each of a firm’s websites to include a readily apparent reference and hyperlink to BrokerCheck on (i) the initial web page that the firm intends to be viewed by retail investors, and (ii) any other web page that includes a professional profile of one or more registered persons who conduct business with retail investors. The reference and hyperlink are not required to be included in communications appearing on a third-party website, including social media sites, or in email or text messages.

The new guidance clarifies that the reference and hyperlink to BrokerCheck would not need to be included in an app created by a firm. However, if the app accesses and displays the firm’s website, the link must be readily apparent when the page is displayed through the app.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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An Introduction To Distributed Ledger Technology (Blockchain Technology)

Posted by Securities Attorney Laura Anthony | August 8, 2017 Tags: An Introduction To Distributed Ledger Technology (Blockchain Technology), Blockchain Technology, Distributed Ledger Technology, FINRA Report on Distributed Ledger Technology, FINRA Report on Distributed Ledger Technology and Implications of Blockchain for the Securities Industry

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, including the maintenance of shareholder and corporate records. DLT is commonly referred to as blockchain. The symposium included participation by the Office of the Comptroller of Currency, the US Commodity Futures Trading Commission (CFTC), the Federal Reserve Board and the SEC.

FINRA also published a report earlier in the year discussing the implications of DLT for the securities industry. Delaware, Nevada and Arizona have already passed statutes allowing for the use of DLT for corporate and shareholder records. This is the first in many blogs that will discuss DLT as this exciting new era of technology continues to unfold and impact the securities markets. In this blog I will discuss FINRA’s report published in January 2017 and in the next in the series, I will summarize the recent SEC investigative report on initial coin offerings and conclusion that cryptocurrencies and tokens are securities. In a follow-on blog, I will summarize the state blockchain legislation to date, including Delaware’s groundbreaking statute.

Blockchain is an openly distributed database which is used to continuously maintain a list of records, called blocks. Each new block is linked to prior blocks in such a way that data cannot be retroactively changed in a prior block without changing all blocks, which is virtually impossible. A DLT ledger is shared among a network of participants, instead of relying on a single central ledger.

Ultimately the blockchain technology could be used to maintain shareholder records in a secure immediate form as well as to process capital markets trades instantaneously. It is thought that stock ledgers and any transfers would be updated instantaneously, effectively allowing for T+0 settlement of trades without the need for intermediaries. A change of this magnitude is many years away as effective regulation and consideration on market impacts will take time. For more on trade settlements, see HERE.

The technology is already being utilized, most notably by the cryptocurrency industry. At least one industry leader, Overstock CEO Patrick Byrne’s t0 Technologies, has created a system that could form the basis for widely used blockchain technology which disrupts the capital market trading systems. I don’t expect quick changes to trading systems and settlement. Blockchain remains widely unregulated and without consensus from top financial regulators, any change to capital market structures will face roadblocks. However, I expect that the ability for public companies to maintain stock ledgers using DLT technology will be forthcoming very soon.

FINRA Report on Distributed Ledger Technology and Implications of Blockchain for the Securities Industry

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry. The symposium followed FINRA’s January 2017 report on DLT and its implications for the securities industry. In recent years, over $1 billion has been invested by various market participants to explore the use of DLT in the financial services industry. Although the level and speed of disruption to current systems remains debated, it is universally agreed that DLT will be utilized in the securities industry. DLT has the potential to completely change business models and practices and as such, regulators realize the necessity to be actively engaged to prepare for the new regime. On a positive note, FINRA views DLT as having the potential to provide investors with greater access to services and transparency and to provide firms with increased operational efficiencies and enhanced risk management.

Many aspects of FINRA’s rules and areas of responsibilities can be impacted by DLT, including, for example, clearing arrangements (it is thought that DLT can eliminate middle-market participants involved in the clearing process), recordkeeping requirements, and trade and order reporting and processing. In addition, FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT is already being used in the securities markets in the form of initial cryptocurrency offerings (ICO’s) and in states that have passed corporate statutes allowing for the use of the technology to maintain corporate and shareholder records. On July 25, 2017, the SEC issued a report on an investigation related to an ICO by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report. Although I will write an in-depth blog on the report and statements in the coming weeks, the SEC concluded that the fundamental tenets related to the definition of a security apply and that cryptocurrencies and tokens that fall within that definition are securities, subject to SEC regulations, regardless of the title or form they may take. For more on decoding what is a security, see HERE.

FINRA’s report on DLT is broken down into three sections including: (i) overview of distributed ledger technology; (ii) DLT securities industry applications and potential impact; and (iii) factors to consider when implementing DLT. FINRA also discussed regulatory requirements and potential changes related to DLT. I will summarize each section with my usual commentary and input.

Overview of Distributed Ledger Technology

DLT involves a distributed database maintained over a network of computers where information can be added by the network participants. Each added layer of information or data is referred to as a block. The network participants can share and retain identical cryptographically secured information and records.

DLT uses either a public or private network. A public network is open and accessible to anyone that joins, without restrictions. All data stored on a public network is visible to anyone on the network, although it is encrypted. A public network has no central authority and relies solely on the network participants to verify transactions and record data on the network. Algorithm and computational technology is used to protect the integrity of the data.

A private network is limited to individuals and entities that are granted access by a network operator. Access can be tiered with different entities being allowed differing levels of authority to transact and view data. In the financial services industry, it is likely that networks will be private.

The transactions and data on the network usually represent an underlying asset that may be digital assets, such as cryptosecurities and cryptocurrencies, or a representation of a hard asset stored offline (a token representing an interest in a gold bar, for example). Assets on a DLT network are cryptographically secured using public and private key combinations. The public key combination allows access to the network itself, and the private key is for access to the asset itself and is held by the asset holder or its agent.

A transaction may be initiated by any party on the network that holds assets on that network. When a transaction is initiated, it is verified using a predetermined process that can be either consensus-based or proof-of-work based, although new verification processes are being explored. In layman’s terms, the verification process is based on computer computations. The settlement of the transaction is occurs when verification is completed. Currently this can occur immediately or take a few hours.

Once verified, a transaction is “cryptographically hashed” and forms a permanent record on the DLT network. Records are time-stamped and displayed sequentially to all parties with network access. Currently, historical records cannot be edited or changed, though technology is being developed to change that.

DLT Securities Industry Applications and Potential Impact

Currently, market participants are experimenting with several uses of DLT within the market infrastructure and ecosystem. DLT can be used in specific markets, such as debt, equity and derivatives, and in specific market functions, such as clearing. Many discrete applications exist for the use of DLT, including, for example, clearing arrangements, recordkeeping requirements, and trade and order reporting and processing. In addition, DLT can impact financial condition recordkeeping and reporting, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans.

The most common current use of DLT is related to private company equities. DLT can be used to track transfers, maintain shareholder records and for capitalization tables. Nasdaq has utilized DLT technology to complete and record a private securities transaction using its Nasdaq Linq blockchain ledger technology. The Nasdaq platform allows private companies to use DLT to record and track trading of private securities.

DLT will eventually be used for public company equities, but the regulatory aspects are behind the technology. However, Overstock’s Patrick Byrne has created and launched a private platform to allow for public trading of securities using blockchain, called t0 Technologies. The platform only currently trades Overstock’s digital shares, but as an SEC licensed alternative trading system (ATS), the foundation is in place for utilizing the platform to launch and trade public offerings of third-party securities.

The debt market also sees the benefit of DLT. The current average settlement time for the secondary trading of syndicated loans is approximately a month. The repurchase agreement marketplace is filled with inefficiencies, as is the trading market for corporate bonds. DLT could be used in all aspects of these markets. It is thought that DLT can also be used to automate the derivative marketplace and create greater transparency.

DLT technology is being worked on to create operational processes with the securities industry itself as well, including by creating central repositories of standardized reference data for various securities products, creating efficiencies for all participants. DLT can also centralize identity management functions, on a global scale.

In addition to the centralization of data, DLT can be used to process transactions by using overlaid software. For example, “smart contracts” can be created that would automatically execute agreed-upon terms in a contract based on certain triggering events. Smart contracts can be used for escrow arrangements, collateral management and corporate actions such as dividends and splits.

In addition to discrete areas, DLT can have market-wide impacts as well. One area that is gaining traction is the clearing process. Overstock’s platform is called t0 as a play on the widely used T+2 (formerly T+3) time for settlement. t0 references the immediate clearing and settlement of trades using DLT technology. However, despite the technological abilities, FINRA notes that it is unclear what the ideal settlement time would be for various segments of the securities market. Some market participants advocate for a netting and end-of-day settlement rather than a real-time contemporaneous process.

Real-time settlements would also impact short trading and other hedging transactions, including by market makers. On the positive side, it is thought that real-time settlement will reduce market risk, free up collateral and create overall efficiencies. As FINRA notes, it is likely that considerations related to settlement times will differ based on asset type, volume of transactions, liquidity requirements, impact on market makers and current market efficiencies.

Clearly DLT will increase market transparency. The basis of the technology is a series of blocks with a complete history available for view by network participants. Market participants and the investing public could be provided with access to relevant information on the network without the need to create a new reporting infrastructure. FINRA notes that regulators need to consider the benefits of such total transparency and the counter need to protect privacy, personally identifiable information and trading strategies. Also, consideration must be given to the need to ensure that material information available to a private network does not disadvantage the rest of the public.

DLT has the ability to alter or even eliminate the roles of intermediaries in the securities industry. The process of executing a trade as well as the subsequent settlement and clearing of such trade could be done directly between the issuing company and purchaser or third-party buyers and sellers. In addition, the need for market participants that effectuate transaction netting and maintenance of margin requirements could be reduced or eliminated.

The operational risks associated with the securities markets can be changed including sharing information over a network of multiple entities, the use of private and public keys to obtain access to assets, the use of smart contracts and other automated operations. The very nature of DLT as a shared network creates cybersecurity risks and the need for robust countermeasures.

Factors to Consider When Implementing DLT

As discussed, DLT applications have already impacted the securities industry. Many financial institutions have already established in-house or third-party research teams to build and test DLT networks and applications. FINRA’s report provides a good high-level summary of the obvious factors to consider with implementing DLT technology in capital markets, including governance, operational structure and network security.

Governance

A basis of DLT technology is that it is an open network with no centralized governing power or operator. FINRA notes that although there are benefits to this system, there are also issues, such as how to handle a large volume of transactions effectively. As a result, closed networks have started where participants are pre-vetted trusted parties. In the capital markets, questions will need to be answered related to the operation of the network and who has responsibility for what aspects—for example, who would decide governance and internal controls and procedures, who would enforce these governance rules, who would be responsible for day-to-day operations including addressing system failures or technical issues, how errors would be rectified and conflicts of interests addressed.

Operational Structure

Any DLT Network will need to consider its operational structure including a framework for: (i) network participant access and related onboarding and offboarding procedures; (ii) transaction validation; (iii) asset representation (such as shares of stock); and (iv) data and transparency requirements.

A network will need to establish criteria and procedures for establishing and maintaining participating members and determining their level of access. Controls and procedures will need to address: (i) criteria for participants to gain access to the network; (ii) a vetting and onboarding process including identity verification and user agreements; (iii) an offboarding process for both involuntary offboarding as a result of noncompliance and voluntary offboarding; (iv) monitoring and enforcement procedures for compliance with rules of conduct; (v) establishing various levels of access; and (vi) access for regulators.

Networks will need to determine a method for transaction validation. In the short history of blockchain, there have already been different methodologies. Validation could be consensus-based, single-node verifier or multiple-node verifier. Each method has pros and cons, and the specific algorithms and processes would need to be ferreted out.

On the topic of asset representation, networks will need to determine if the actual asset will be directly issued digitally (which only works for certain assets such as intangibles, stock or agreements representing ownership interests) or issued traditionally and be tokenized on the network. If tokenized, further thought must be given to security, handling loss or theft of the underlying asset, fractionalization issues, handling changes such as reverse or forward stock splits or conversions, and new issuances as some examples.

Likewise, thought must be given to the handling of cash on the network, including the settlement of transactions. In that regard, could tokens become a form of cash and if so, how would they ultimately be converted into established government currencies? Ownership in almost any asset could also be tokenized (such as diamonds, gold, precious metals, art, etc.), creating issues of custodianship and security for the underlying asset. Intangible assets would be relatively easy to tokenize. Fungible assets would be easier than non-fungible assets, with unique assets being the most difficult.

A network will need controls and processes related to data transparency including public or shared information versus private information.

Network Security

In addition to the security of the underlying asset, there are security concerns with the network itself. The issue is more complex due to the decentralized nature of, and global access and participants to, the network. A DLT Network must have security for external and internal risks while maintaining the privacy of personal information for network participants.

Network participants will need to consider: (i) how DLT fits within their current recordkeeping framework including maintenance and backup systems; (ii) cybersecurity issues, including hacking, phishing, malware and other forms of threats and program and testing requirements; (iii) updating written supervisory procedures and policy procedures; and (iv) business controls for identity and transaction verification and fraud prevention.

Regulatory Considerations

Broker-dealers are currently exploring issuing and trading securities, facilitating automated actions such as dividend payments and maintaining transaction records on a DLT network. These areas are regulated by both the SEC and FINRA. The FINRA report points out the potential for a “paradigm shift for several traditional processes in the securities industry through the development of new business models and new practices incorporating DLT” that requires regulatory attention.

I personally believe this shift will occur in a shorter period of time than some others predict. I can see a time in the not-too-distant future where the role of transfer agents is minimalized or completely changed to a reviewer of opinion letters for legend removals; the DTC will be drastically changed and much less powerful; there will no longer be a separation between clearing firms and introducing brokers and all trades will clear instantaneously (t+0).

The FINRA report specifically discusses some major areas of consideration including: (i) customer funds and securities; (ii)

Customer Funds and Securities

DLT will create new ways to hold customer funds and securities and thus custodial changes. Broker-dealers that hold funds and securities must generally comply with Exchange Act Rule 15c3-3, which generally requires the broker to maintain physical possession or control over the customer’s fully paid and excess margin securities. Where funds and securities are purely digital, such as cryptosecurities, consideration will need to be made over how they are accounted for and who has the obligation. In addition, certain activities and access levels could amount to “receiving, delivering, holding or controlling customer assets” such as having access to a private key code for a customer.

Also potentially implicated in this area are Exchange Act Rule 15c3-1 related to net capital requirements, FINRA Rule 4160 on verification of assets and Exchange Act Rule 17a-13 related to quarterly security accounts.

Broker-Dealer Net Capital

Exchange Act Rule 15c3-1 requires a firm to maintain a minimum level of net capital at all times. The FINRA Rule 4100 series sets forth the rules and requirements for complying with net capital requirements including calculations and which assets are allowable or non-allowable within those calculations. Regulations need to address how cryptosecurities, digital currency, and tokens in general will be accounted for, for purposes of net capital calculations.

Books and Records Requirements

Exchange Act Rule 17a-3 and 17a-4 and FINRA Rule 4511 regulate book and record requirements for broker-dealers. DLT allows books and records to be maintained on the network itself, though consideration must be made as to how this will comply with regulations, and what changes need to be made with the regulations to update for the new technology.

Clearance and Settlement

It is my view that DLT could have the biggest impact on clearance and settlement from a pure industry disruption viewpoint. FINRA notes, “Depending on how trade execution and settlement is ultimately structured, broker-dealers and other market participants may wish to consider whether any of their activities in the DLT environment meet the definition of a clearing agency and whether corresponding clearing agency registration requirements under Section 17A of the Exchange Act would be applicable.”

In addition, as mentioned, DLT could eliminate the distinction between introducing and clearing brokers and the corresponding carrying agreement rules.

Anti-Money Laundering and Customer Identification Programs

DLT allows for global and anonymous participation, and accordingly practices and regulations will need to address anti-money laundering (AML) and customer identification obligations (CIP). The Bank Secrecy Act of 1970 requires controls and procedures to detect and prevent money laundering. FINRA Rule 3310 addresses AML obligations. For more on this topic, see HERE.

In addition, FINRA Rule 2090, the Know Your Customer (KYC) rule, requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” Technology is already being explored to centralize identity management functions such that once a customer identity is verified, the information can be shared with all network participants. Obviously this would greatly streamline processes for broker-dealers and customers alike.

It is likely that DLT technology will surpass regulatory changes in the AML/CIP/KYC sectors. The FINRA report notes that the current rules allow a firm to outsource functions to third parties, but not overall responsibility. Accordingly, a firm could utilize DLT technology for these functions now if they can fashion internal controls and procedures that comply with the ultimate rule responsibilities.

Customer Data Privacy

Broker-dealers have an obligation to protect personal customer information (Regulation S-P). The rules also require that a firm provide an annual notice to customers related to the protection, and sharing, of their personal information. DLT by nature will include customer information and transaction histories that will be available to network participants. Regulations, as well as internal controls and procedures, will need to adapt for DLT technology.

Trade and Order Reporting Requirements

FINRA regulates the trading and order reporting requirements for the over-the-counter (OTC Markets) and requires certain reports to a centralized Securities Information Processor for listed securities. DLT may be soon be used for the facilitation of OTC Markets equity transactions. This may involve tokenizing existing securities and trading on a different network. FINRA Rule 6100 Series (Quoting and Trading in NMS Stock), Rule 6400 Series (Quoting and Trading on OTC Equity Securities), Rule 4550 Series (Alternative Trading Systems) and Rule 5000 Series governing offering and trading standards and practices would all be implicated. I note that t0 Technologies has registered as an ATS.

Supervision and Surveillance

DLT networks will present new and unique challenges related to maintaining supervisory rules and procedures as well as surveillance systems themselves. This area includes the ability to review customer accounts and correct order errors. Like other areas of DLT technology, centralized systems available to all network participants are being developed that can perform some of these functions.

Fees and Commissions

Certain additional fees may be necessary for a DLT network, such as wallet management, key management and on-boarding, whereby other areas may reduce fees as centralization brings economies. In addition, consideration must be given to the payment of fees to third parties that are not registered broker-dealers but that provide DLT outsource functions.

Customer Confirmations and Account Statements

Exchange Act Rule 10b-10 requires firms to provide customers with certain records including trade confirmations and account statements. DLT technology will change the flow and availability of information.

Material Impact on Business Operations

NASD Rule 1017(a)(5) requires broker-dealers that undergo a material change in business operations to file a Continuing Membership Application (CMA) prior to implementing the material change. Many of the aspects of DLT technology may result in a material change and broker-dealers need to consider the need to file 1017 applications.

Business Continuity Plans

FINRA Rule 4370 requires broker-dealers to maintain business continuity plans. Firms must consider the impact of DLT technology on their plans and update accordingly.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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SEC Chair Jay Clayton Discusses Direction Of SEC

Posted by Securities Attorney Laura Anthony | August 1, 2017 Tags: Chair Jay Clayton, Finra, SEC, SEC Chair Jay Clayton, SEC Chair Jay Clayton Discusses Direction Of SEC

In a much talked about speech to the Economic Club of New York on July 12, 2017, SEC Chairman Jay Clayton set forth his thoughts on SEC policy, including a list of guiding principles for his tenure. Chair Clayton’s underlying theme is the furtherance of opportunities and protection of Main Street investors, a welcome viewpoint from the securities markets’ top regulator. This was Chair Clayton’s first public speech in his new role and follows Commissioner Michael Piwowar’s recent remarks to the SEC-NYU Dialogue on Securities Market Regulation largely related to the U.S. IPO market. For a summary of Commissioner Piwowar’s speech, read HERE.

Guiding Principles

Chair Clayton outlined a list of eight guiding principles for the SEC.

#1: The SEC’s Mission is its touchstone

As described by Chair Clayton, the SEC has a three part mission: (i) to protect investors; (ii) to maintain fair, orderly and efficient markets, and (iii) to facilitate capital formation. Chair Clayton stresses that it is important to give each part of the three-part mission equal priority. For more information on the role and purpose of the SEC, see HERE.

#2: SEC Analysis Starts and ends with the long-term interests of the Main Street investor

According to Clayton, an assessment of whether the SEC is being true to its three-part mission requires an analysis of the long-term interests of the Main Street investors, including individual retirement accounts. This involves reviewing actions in light of the impact on investment opportunities, benefits and disclosure information for “Mr. and Mrs. 401(k).”

#3: The SEC’s historic approach to regulation is sound

As I’ve written about many times, disclosure and materiality have been at the center of the SEC’s historic regulatory approach. Chair Clayton reiterates that point. The SEC does not conduct merit reviews of filings and registration statements but rather focuses on whether the disclosures provided by a company provide potential investors and the marketplace with the information necessary to make an informed investment decision. For more information on disclosure requirements and recent initiatives, see HERE and HERE.

In addition to disclosure rules, the SEC places heightened responsibility on the individuals and people that actively participate in the securities markets. The SEC has made it a priority to review and pursue enforcement actions, where appropriate, against securities exchanges, clearing agencies, broker-dealers and investment advisors. In that regard, the SEC has historically and will continue to enforce antifraud provisions. Clayton states that “wholesale changes to the Commissions’ fundamental regulatory approach would not make sense.”

#4: Regulatory actions drive change, and change can have lasting effects

Under the fourth principle, Clayton continues to speak of the benefits of the disclosure-based system for public company capital markets. However, he does note that over time, new disclosure rules have been added on to the old, based on determinations beyond materiality, and that the SEC now needs to conduct a cumulative and not just incremental view of the disclosure rules and regulations.

Clayton specifically points to the much talked about decline in the number of IPO’s over the last two decades. He also points out that the median word count for SEC filings has more than doubled in over the same period, and that reports lack readability. Clayton points out, and I agree, that fewer small and medium-sized public companies affects the liquidity and trading for all public companies in that size range. A reduction of U.S. listed public companies is a serious issue for the U.S. economy and an improvement in this regard is a clear priority to the SEC.

For more on the SEC’s ongoing Disclosure Effectiveness program, see the further reading section at the end of this blog.

#5: As markets evolve, so must the SEC

Technology and innovation are constantly disrupting the way in which markets work and investors transact. Chair Clayton is well aware that the SEC must keep up with these changes and “strive to ensure that our rules and operations reflect the realities of our capital markets.” Clayton sees this as an opportunity to make improvements and efficiencies.

The SEC itself has utilized technology to improve its own systems, including through the use of algorithms and analytics to detect companies and individuals engaged in suspicious behavior. The SEC is adapting machine learning and artificial intelligence to new functions, including analyzing regulatory filings. On the other side, the SEC has to be aware of the costs involved with implementing these changes, versus the benefits derived.

#6: Effective rulemaking does not end with rule adoption

The SEC has developed robust processes for obtaining public input (comments) and performing economic analysis related to its rulemaking. Clayton is committed to ensuring that the SEC perform rigorous economic analysis in both the proposed and adoption stages of new rules. Clayton is aware of the principle of unintended consequences in rulemaking and is committed to ensuring that rules be reviewed retrospectively as well. Clayton states, “[W]e should listen to investors and others about where rules are, or are not, functioning as intended.”

Although Clayton does not get into specifics, certainly changes are necessary in the disclosure requirements, fiduciary rule, Dodd-Frank rollbacks (see HERE on the Financial Choice Act 2.0); finders’ fees (see HERE for more), eligibility for Regulation A+ (see HERE for more), and small business-venture capital marketplace.

#7: The costs of a rule now often include the cost of demonstrating compliance

Clayton states, “[R]ules are meant to be followed, and the public depends on regulators to make sure that happens. It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.” Vaguely worded rules end up with subpar compliance and enforcement. Clayton refers to the officer and director certifications required by the Sarbanes-Oxley Act and the need to create a system of internal controls to support the ultimate words on the paper – which system can be hugely expensive.

I note that understanding rules and their application is one of the biggest hurdles in the small-cap industry, including where responsibility lies vis-à-vis different participants in the marketplace. For example, the responsibility of a company, transfer agent, introducing broker, and clearing broker in the chain of the issuance and ultimate trading of a security, continues to provide challenges for all participants. Often participants are left with an education and interpretation by enforcement process, rather than what would be a much more efficient system providing participants with the knowledge and tools to create compliance systems that prevent fraud and related issues and reduce the need for retrospective enforcement.

#8: Coordination is key

Clayton notes that “the SEC shares the financial services space with many other regulatory players charged with overseeing related or overlapping industries and market participants.” There are more than 15 U.S. federal regulatory bodies and over 50 state and territory regulators, plus the Department of Justice, state attorneys general, self-regulatory organizations (SRO – such as FINRA) and non-SRO standard-setting entities (for example, DTC) in the financial services sector. In addition, the SEC works with international regulators and markets cooperating with over 115 foreign jurisdictions.

Clayton specifically points to the regulations of over-the-counter derivatives – including security-based swaps for which the SEC shares regulatory functions with the CFTC (for more on this, see HERE). Clayton is committed to working with the CFTC to improve this particular area of financial regulation and reduce unnecessary complexity and costs.

In addition, cybersecurity is an important area requiring regulatory coordination. Information sharing is essential to address potential and respond to actual cyber threats.

Putting Principles into Practice

After laying out his eight principles for the SEC, Chair Clayton addressed some specific areas of SEC policy.

Enforcement and Examinations

Clayton is committed to deploying significant resources to enforcement against fraud and shady practices in areas where Main Street investors are most exposed, including affinity and micro-cap fraud. He indicates that the SEC is taking further steps to find and eliminate pump-and-dump scammers, those that victimize retirees, and cyber criminals. As a practitioner in the small- and micro-cap market space, I welcome and look forward to initiatives that work to reduce fraud, while still supporting the honest participants and the necessary small-business ecosystem.

Clayton also recognizes that the markets also have more sophisticated issues requiring enforcement attention related to market participants. The SEC is “committed to making our markets s fair, orderly, and efficient – and as liquid – as possible.” Although prior Commissioners and Chairs have made similar statements, the addition of “and as liquid” by this regime continues to illustrate a commitment to supporting business growth and not just enforcement.

Finally on this topic, Clayton stresses the importance of cybersecurity in today’s marketplace. Public companies have an obligation to disclose material information about cyber risks and cyber events (see HERE for more on this topic). However, cyber criminals, including entire nations, can have resources far beyond a single company, and companies should not be punished for being a victim where they are being responsible in face of cyber threats. To bring proportionality to the topic, Clayton points out that cyber threats go beyond capital markets but affect national security as well.

Capital Formation

Consistent with his pro-business attitude, Jay Clayton advocates enhancing the ability of “every American to participate in investment opportunities, including through public markets.” Of course, the flip side is the ability for businesses to raise money to grow and create jobs. Clayton is also consistent with the message that he and other Commissioners have been relaying that the U.S. public markets need to grow and become more attractive to businesses (without damaging the private marketplace).

As a first step, the SEC recently expanded the ability to file confidential registration statements for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting, to all companies. Previously only emerging growth companies (EGC’s) were allowed to file registration statements confidentially. For more on this, see my blog HERE. Clayton believes that allowing companies to submit sensitive information on a non-public basis for initial staff review, will make the going public process more attractive to earlier-stage entities.

As a last point on capital formation, Chair Clayton encourages companies to request waivers or modifications to the financial reporting requirements under Regulation S-X, where the particular disclosure or reporting is overly burdensome and not material to the total mix of information presented to investors.

Market Structure

Clayton suggests shifting the focus of the conversation on market structure to actions. He recommends proceeding with a pilot program to test how adjustments to the access fee cap under Rule 610 of the Securities Exchange Act of 1934 would affect equities trading. The pilot would provide the SEC with more data to assess the effects of access fees and rebates on market makers, pricing and liquidity. Clayton is open to that and further suggestions from the SEC’s Equity Market Structure Advisory Committee.

Clayton believes the SEC should broaden its review of market structure to also include the fixed-income markets, to provide stable investment options for retirees. In that regard the SEC is creating a Fixed Income Market Structure Advisory Committee.

Investment Advice and Disclosure to Investors

Chair Clayton addresses both the fiduciary rule and improving disclosures to investors. Related to the fiduciary rule, Clayton states that it is important for the SEC to bring clarity and consistency to the area. In that regard, in June the SEC issued a statement seeking public input and comment on standards of conduct for investment advisers and broker-dealers.

Related to disclosures, as with all other areas of disclosure, investment advisors must provide potential investors with easily accessible and meaningful information. Clayton refers to the SEC’s ongoing Disclosure Effectiveness initiative, the progress in which is summarized at the end of this blog.

Resources to Educate Investors

A priority for the SEC is to provide more information to investors through technology and other means.

Further Reading on Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC’s ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I note that we have not seen any regulatory changes since the election and new regime at the SEC, but certainly significant changes are expected in light of Chair Clayton’s, and the Commissioners’, publicly disclosed priorities.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

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The Payment Of Finders’ Fees- An Ongoing Discussion

Posted by Securities Attorney Laura Anthony | July 5, 2017 Tags: Broker-Dealer Activity, broker-dealer registration requirements, Finders fees, Form 1-A, Private Placement Finders, SEC rules, The Payment Of Finders' Fees, The Payment Of Finders' Fees- An Ongoing Discussion

Introduction

As a recurring topic, I discuss exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services. I have previously discussed the no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act and the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer. I have also previously published a blog on the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders. I’ve included links to each of these prior articles in the conclusion to this blog.

A related topic with a parallel analysis is the use of finders for investors and investor groups, an activity which has become prevalent in today’s marketplace. In that case the investor group utilizes the services of a finder to solicit issuers to sell securities (generally convertible notes) to the investment group. These finders may also solicit current shareholders or convertible note holders to sell such holdings to a new investor or investor group.

Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.

As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black market industry has developed, and it is a large industry. Neither the SEC, FINRA or state regulators have the resources to police this prevalent industry of finders. The fact is that there are thousands of unlicensed finders that operate openly, and even advertise their services, making it impossible for practitioners to convince small issuers that they should not utilize the services of these groups. As the saying goes, if everyone is doing it and doing it openly, it must be okay – but it is not okay.

As discussed further in this blog, I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.

SEC Advisory Committee on Small and Emerging Companies’ Recommendations

The SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) has once again made recommendations to the SEC regarding the regulation of finders and other intermediaries in small business capital formation transactions. The Advisory Committee previously submitted recommendations to the SEC on September 23, 2015.

By way of reminder, the Advisory Committee was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

The newest recommendations of the Advisory Committee are almost in the form of a plea to the SEC to recognize this very important issue and take some action, any action. The entire recommendation of the Advisory Committee is that the SEC do as follows:

“The Commission take action in the near future to provide certainty in the context of finders and platforms involved in primary and secondary securities transactions. The range of potential options includes compliance or enforcement efforts, rulemaking, or coordination with the states. Even staff guidance such as Q&A’s as to what constitutes broker-dealer activity would be tremendously helpful.”

In support of its recommendations, the Advisory Committee noted that:

Identifying potential investors is one of the most difficult challenges for small businesses trying to raise capital;
There is significant uncertainty in the marketplace about what activities require broker-dealer registration. Companies that want to play by the rules struggle to know in what circumstances they can engage a “finder” or platform that is not registered as a broker-dealer.
For years, many interested parties have urged the SEC and its staff to take steps to address this ambiguity. As one recent example, in 2015, this Committee recommended that the Commission “take immediate intermediary steps to begin to address issues regarding the regulation of intermediaries in small business capital formation transactions….”; and
The Committee is disappointed that the SEC has not taken actions to help to address these concerns despite repeated and long-standing requests.

Previously, on September 23, 2015, the Advisory Committee made the following four recommendations:

The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act;
The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level;
The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and
The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

At the time of its recommendations in 2015, the Advisory Committee noted that:

Small businesses account for the creation of two-thirds of all new jobs, and are the incubators of innovation, generating the majority of net new jobs in the last five years and continuing to add more jobs;

Early-stage capital for these small businesses is raised principally through private offerings that are exempt from registration under the Securities Act of 1933 and state blue-sky laws;

More than 95% of private offerings rely on Rule 506 of Regulation D; however, less than 15% of those use a financial intermediary such as a broker-dealer. This is due in part to a lack of interest from registered broker-dealers given the legal costs and risk involved in undertaking a small transaction, ambiguities in the definition of “broker” and the danger of using unregistered finders. (For more on the topic of incentives for broker-dealers to work with smaller offerings, see my blog HERE)

As documented in the findings of an American Bar Association Business Law Section Task Force in 2005 and endorsed by the SEC Government Business Forum on Small Business Capital Formation: (i) failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies; (ii) the current broker-dealer registration system and FINRA membership process is a deterrent to meaningful oversight; (iii) appropriate regulation would enhance economic growth and job creation; and (iv) solutions are achievable through SEC leadership and coordination with FINRA and the states. For more on the ABA Task Force study, see my blog HERE.

The Advisory Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protections and safeguards on private placement intermediaries with limited activities that do not hold customer funds or securities and deal only with accredited investors, would enhance capital formation and promote job creation.

The Broker-Dealer Placement Agent Dilemma

Broker-dealers lack an incentive to engage in small private capital-raising transactions. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged.

From a regulatory perspective, when acting as placement agent in a private offering, broker-dealers must consider FINRA filing rules, general know-your-customer and suitability requirements as well as statutory liability under Dodd-Frank and the SEC antifraud provisions. For more information on these rules, see HERE.

Even when a broker agrees to act as placement agent, it can often be difficult to locate investors for small companies. It would be helpful if unlicensed individuals could refer investors to such a broker-dealer, who would then ensure that proper disclosure has been made to the investor, and that the investment is suitable for such investor. However, FINRA Rule 2040 prohibits the payment of transaction-based compensation by member firms to unregistered persons. FINRA Rule 2040 expressly correlates with Section 15(a) of the Exchange Act (discussed below) and prohibits the payment of transaction-related compensation unless a person is licensed or properly exempt from such licensing.

Rule 2040 prohibits member firms from directly or indirectly paying any compensation, fees, concessions, discounts or commissions to:

any person that is not registered as a broker-dealer under SEA Section 15(a) but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or

any appropriately registered associated person, unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.

FINRA guidance on the Rule states that a member firm can (i) rely on published releases, no-action letters or interpretations from the SEC staff; (ii) seek SEC no-action relief; or (iii) obtain a legal opinion from an independent, reputable U.S. licensed attorney knowledgeable in the area. This list is not exclusive and FINRA specifically indicates that member firms can take any other reasonable inquiry or action in determining whether a transaction fee can be paid to an unlicensed person.

FINRA Rule 2040 specifically allows the payments of finders’ fees to unregistered foreign finders where the finder’s sole involvement is the initial referral to the member firm of non-U.S. customers and certain conditions are met, including but not limited to that (i) the person is not otherwise required to be registered as a broker-dealer in the U.S.; (ii) the compensation does not violate foreign law; (iii) the finder is a foreign national domiciled abroad; (iv) the customers are foreign nationals domiciled abroad; (v) the payment of the finder’s fee is disclosed to the customer; (vi) the customers provide written acknowledgment of receipt of the notice related to the payment of the fee; (vii) proper records regarding the payments are maintained; and (viii) each transaction confirm indicates that the finder’s fee is being paid.

Current Rules on Finders’ Fees

The SEC generally prohibits the payments of commissions or other transaction-based compensation to individuals or entities that assist in effecting transactions in securities, including a capital raise, unless that entity is a licensed broker-dealer. The SEC considers the registration of broker-dealers as vital to protecting prospective purchasers of securities and the marketplace as a whole and actively pursues and prosecutes unlicensed activity. The registration process is arduous, including, for example, background checks, fingerprinting of personnel, minimum financial requirements, membership to SRO’s and ongoing regulatory and compliance requirements. However, despite the SEC’s efforts, as mentioned in the introduction, a whole cottage industry of unlicensed finders has developed, simply overshadowing efforts by regulators.

Over the years, a “finder’s” exemption has been fleshed out, mainly through SEC no-action letters and some court opinions. Bottom line: an individual or entity can collect compensation for acting as a finder as long as the finder’s role is limited to making an introduction. The mere providing of names or an introduction without more has consistently been upheld as falling outside of the registration requirements. The less contact with the potential investor, the more likely the finder is not required to be licensed.

The finder may not participate in negotiations, structuring, document preparation or execution. Moreover, if such finder is “engaged in the business of effecting transactions in securities,” they must be licensed. In most instances, a person that acts as a finder on multiple occasions will be deemed to be engaged in the business of effecting securities transactions, and needs to be licensed.

The SEC will also consider the compensation arrangement with transaction or success-based compensation weighing in favor of requiring registration. The compensation arrangement is often argued as the gating or deciding factor, with many commentators expressing that any success-based compensation requires registration. The reasoning is that transaction-based compensation encourages high-pressure sales tactics and other problematic behavior. However, the SEC itself has issued no-action letters supporting a finder where the fee was based on a percentage of the amount invested by the referred people (see Moana/Kauai Corp., SEC No-Action Letter, 1974).

More recently, the U.S. District court for the Middle District of Florida in SEC vs. Kramer found that compensation is just one of the many factual considerations and should not be given any “particular heavy emphasis” nor in itself result in a “significant indication of a person being engaged in the business of a broker.”

Where a person acts as a “consultant” providing such services as advising on offering structure, market and financial analysis, holding meetings with broker-dealers, preparing or supervising the preparation of business plans or offering documents, the SEC has consistently taken the position that registration is required if such consultant’s compensation is commission-, success- or transaction-based.

As pertains to finders that act on behalf of investors and investor groups, there is a lack of meaningful guidance. On a few occasions, the SEC has either denied no-action relief or concluded that registration was required. However, the same basic principles apply.

The federal laws related to broker-dealer registration do not pre-empt state law. Accordingly, a broker-dealer must be licensed by both the SEC and each state in which they conduct business. Likewise, an unlicensed individual relying on an exemption from broker-dealer registration, such as a finder, must assure themselves of the availability of both a federal and state exemption for their activities.

The Exchange Act – Broker-Dealer Registration Requirement

Section 15(a)(1) of the Exchange Act requires any “broker” that makes use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security) to register with the SEC.

The text of Section 15(a)(1) – Registration of all persons utilizing exchange facilities to effect transactions is as follows:

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.

Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flesh out, with inconsistent and uncertain results. As a securities attorney, I always advise to err on the conservative side where the activity is at all questionable.

The SEC’s Guide to Broker-Dealer Registration

Periodically, and most recently in April 2008, the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. On a daily basis, thousands of individuals and entities offer to raise money for companies as “finders” in return for a “finder’s fee.” Other than as narrowly set forth above, such agreements and transactions are prohibited and carry regulatory penalties for both the company utilizing the finders’ services, and the finders.

Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):

“finders,” “business brokers,” and other individuals or entities that engage in the following activities:

Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;

Finding investment banking clients for registered broker-dealers;

Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;

Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;

Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);

investment advisers and financial consultants;

persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;

persons that act as “placement agents” for private placements of securities;

persons that effect securities transactions for the accounts of others for a fee, even when those other people are friends or family members;

persons that provide support services to registered broker-dealers; and

persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer (for information on “associated persons,” see below).

Consequences for Violation

The SEC is authorized to seek civil penalties and injunctions for violations of the broker-dealer registration requirements. Egregious violations can be referred to the attorney general or Department of Justice for criminal prosecution.

In addition to potential regulatory problems, using an unregistered person who does not qualify for either the statutory or another exemption to assist with the sale of securities may create a right of rescission in favor of the purchasers of those securities. That is a fancy way of saying they may ask for and receive their money back.

Section 29(b) of the Exchange Act, provides in pertinent part:

Every contract made in violation of any provision of this title or of any rule or regulation thereunder… the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract…

In addition to providing a defense by the issuing company to paying the unlicensed person, the language can be interpreted as voiding the contract for the sale of the securities to investors introduced by the finder. The SEC interprets its rules and regulations very broadly, and so do the courts and state regulators. Under federal law the rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation. Accordingly, for a period of at least three years, an issuer that has utilized an unlicensed finder could have a contingent liability on their books and as a disclosure item. The existence of this liability can deter potential investors and underwriters and create issues in any going public transaction.

In addition, SEC laws specifically require the disclosure of compensation and fees paid in connection with a capital raise. A failure to make such disclosure and to make it clearly and concisely is considered fraud under Section 10b-5 of the Securities Act of 1933 (see, for example, SEC vs. W.P. Carey & Co., SEC Litigation Release No. 20501). Fraud claims are generally brought against the issuing company and its participating officers and directors.

Moreover, most underwriters and serious investors require legal opinion letters at closing, in which the attorney for the company opines that all previously issued securities were issued legally and in accordance with state and federal securities laws and regulations. Obviously an attorney will not be able to issue such an opinion following the use of an unlicensed or non-exempted person. In addition to the legal ramifications themselves and even with full disclosure and the time for liability having passed, broker-dealers and underwriters may shy away from engaging in business transactions with an issuer with a history of overlooking or circumventing securities laws.

Historically, it was the person who had acted in an unlicensed capacity who faced the greatest regulatory liability; however, in the past ten years that has changed. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective and a better deterrent to prosecute the issuing company than an unlicensed person who is here today and gone tomorrow.

Conclusion

The payment of finders’ fees is a complex topic requiring careful legal analysis on a case-by-case and state-by-state basis. No agreements for the payment or receipt of such fees should be entered into or performed without seeking the advice of competent legal counsel.

I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.

I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the new FINRA Securities Industry Essentials Exam (see HERE) for finders that are otherwise exempt from the full broker-dealer registration requirements.

For reference, prior blogs on the topic of the broker-dealer registration requirements include (i) the no-action-letter-based exemption for M&A brokers (ii) the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act; (iii) the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer; and (iv) the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders.

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FINRA Proposes Amendments To The Corporate Financing Rules

Posted by Securities Attorney Laura Anthony | June 6, 2017 Tags: FINRA Corporate Financing Rules, FINRA Proposes Amendments To The Corporate Financing Rules

On April 11, 2017, the Financial Industry Regulatory Authority (FINRA) released three regulatory notices requesting comment on rules related to corporate financing and capital formation. In particular, the regulatory notices propose changes to Rule 5110, which regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities; Rules 2241 and 2242, which regulate equity and debt research analysts and research reports; and Rule 2310, which relates to public offerings of direct participation programs and unlisted REIT’s.

The proposed changes come as part of the FINRA360 initiative announced several months ago. Under the 360 initiative, FINRA has committed to a complete self-evaluation and improvement. As part of FINRA360, the regulator has requested public comment on the effectiveness and efficiency of its rules, operations and administrative processes governing broker-dealer activities related to the capital-raising process and their impact on capital formation.

Regulatory Notice 17-14 – Request for Comment on Rules Impacting Capital Formation

Regulatory Notice 17-14 is a request for comment on FINRA rules impacting capital formation. In its opening FINRA notes that the ability of small and large businesses to raise capital efficiently is critical to job creation and economic growth and that broker-dealers play a vital role in assisting in that process. FINRA members act as underwriters for public offerings, advisors on capital raising and corporate restructuring, placement agents for private offerings, funding portals and research analysts. Furthermore, there have been significant changes in the capital-raising processes, such as securities-based crowdfunding and Regulation A+ both initiated from the JOBS Act.

FINRA itself has made changes to modernize its regulations such as through the creation of the new Capital Acquisition Broker (CAB) and funding portal rules for brokers engaged in a limited range of fundraising activities. For more information on the CAB rules, see HERE. FINRA also seeks comments on changes that may be helpful in both the CAB and funding portal rules.

Below is a brief summary of some, but not all, the rules highlighted in FINRA Regulatory Notice 17-14.

Rules 2241 and 2242

The Regulatory Notice seeks comment on any FINRA rules that may impact capital formation, but highlights and summarizes certain rules that have significant impact on the process. For example, FINRA highlights Rule 2241 (Research Analysts and Research Reports) and Rule 2242 (Debt Research Analysts and Debt Research Reports), both of which are subject to a separate Regulatory Notice discussed in this blog.

Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. In Regulatory Notice 17-16, FINRA proposes a safe harbor from Rule 2241 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report.

Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

Rule 2310

Rule 2310 addresses underwriting terms and arrangements in public offerings of direct participation programs (DPP’s) and unlisted real estate investment trusts (REIT’s). These investments tend to be complex and as such, the Rule regulates underwriter and placement agent compensation, requires due diligence and contains suitability guidelines.

The 5100 Series of Rules

The 5100 series of rules govern underwriting compensation and terms, underwriter conduct, conflicts of interest and related matters. Although there are nine rules in the 5100 Series, a few in particular most often affect the capital formation process.

Rule 5110 – Corporate Financing Rule – Underwriting Terms and Arrangements; Rule 5121 – Public Offerings of Securities with Conflicts of Interest

Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities. The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA. The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest. In addition, the Rule limits certain compensation such as termination or tail fees and rights of first refusal and imposes lock-up restrictions related to the sale or transfer of securities received as compensation. The lock-up restrictions apply to a period beginning six months prior to the initial filing of a registration statement with the SEC and end 90 days following the effectiveness of the registration statement.

Where Rule 5110 requires the disclosure of affiliations, Rule 5121 goes further and prevents member firms from participating in offerings where certain conflicts of interest exist. Member firms are prohibited from participating in a public offering where certain conflicts exist, including where the issuer is controlled by or under common control with the FINRA member firm or its associated persons.

For more information on Rules 5110 and 5121, see HERE.

Rule 5122 – Private Placement of Securities Issued by Members; Rule 5123 – Private Placement of Securities

Subject to certain exceptions, such as where an offering is limited to accredited investors, Rule 5123 requires member firms to file a copy of the private placement memorandum, term sheet or other disclosure document with FINRA, for all offerings in which they sell securities, within 15 calendar days of the first sale. FINRA enacted the rule in an effort to further police the private placement market and to ensure that members participating in these private offerings conduct sufficient due diligence on the securities and their issuers.

Rule 5122 requires members that offer or sell their own securities to file the private placement memorandum, term sheet or other offering document at or prior to the first time the documents are provided to any prospective investor. Rule 5122 also establishes standards on disclosure and the use of private placement proceeds.

Rule 6432 – Compliance with Rule 15c2-11

Rule 6432 generally requires that, prior to initiating or resuming quotations in a non-exchange-listed security in a quotation medium, such as OTC Markets, a member firm must demonstrate compliance with Rule 6432 which, in turn, requires that the member firm has the information set forth in Securities Act Rule 15c2-11. Under Rule 6432, a member complies by filing a FINRA Form 211 at least three business days before the member’s quotation is published or displayed in the quotation medium. In reality the processing of the Form 211 application takes much longer than three days, and often several months. Moreover, the information and review conducted by FINRA in this process can be arduous.

Regulatory 17-15 – Request for Comment on Amendments to the Corporate Financing Rule

As discussed above, Rule 5110 is the corporate financing rule regulating underwriting compensation and prohibiting unfair arrangements in connection with the public offerings of securities. Under Rule 5110, a member firm is required to submit its underwriting or other arrangements associated with a public offering and obtain a no-objection letter from FINRA before they can proceed. FINRA proposes substantial changes to modernize, simplify and clarify its provisions.

The proposed amendments will clarify what is included in determining underwriter compensation. The Rule will eliminate a limit that prevents a member and its affiliates from acquiring more than 25% of a company’s stock and increase the fraction of shares sold in a private placement that a syndicate of investors can buy from 20 percent to 40 percent. Currently, underwriting compensation is defined to include a laundry list of items. The proposed amendment would define “underwriting compensation” to mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would also include “finder fees and underwriter’s counsel fees, including expense reimbursements and securities.” The proposal would continue to provide two non-exhaustive lists of examples of payments or benefits that would be and would not be considered underwriting compensation.

The Rule would also allow members to use formulas other than those dictated by FINRA to calculate their underwriting compensation, extend certain filing deadlines, and clarify circumstances in which stock sale restrictions don’t apply.

The proposed Rule increases the filing deadline from one business day to three business days after the filing of the offering with the SEC. The Rule also reduces the number of documents that must be filed. Furthermore, if a member participating in the offering files with FINRA, other participating members will be not be required to do so.

The Rule governs all public offerings subject to exceptions. Moreover, certain offerings are not subject to the Rule, such as offerings exempt under Section 4(a)(1), 4(a)(2) or 4(a)(6) of the Securities Act.

Regulatory Notice 17-16 – Request for Comment on Proposed Safe Harbor from FINRA Equity and Debt Research Rules

As discussed above, Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

FINRA proposes a safe harbor from Rule 2241 and 2242 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report. In particular, the safe harbor would cover specified brief, written analysis distributed to eligible institutional investors that comes from sales and trading or principal trading personnel but that may rise to the level of a research report (i.e., desk commentary).

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FINRA Proposes New Registration And Examination Rules

Posted by Securities Attorney Laura Anthony | May 30, 2017 Tags: Finra, FINRA Exam Registration, FINRA Examination Rules, FINRA New Registration, FINRA Proposes New Registration And Examination Rules, SIE Exam

On March 8, 2017, the Financial Industry Regulatory Authority (FINRA) filed a proposed rule change with the SEC to adopt amended registration rules and restructure the entry-level qualification examination for registered representatives. The new rules would also eliminate certain examination categories. FINRA is planning to implement the changes in two phases, with full implementation completed during the first half of 2017.

Securities Industry Essentials Exam

As part of the proposed amendments, FINRA introduced a new beginning-level examination called the Security Industry Essentials (SIE), which can be taken by individuals without sponsorship by a broker-dealer. The SIE would be a general-knowledge examination including fundamentals such as basic product knowledge, structure and functioning of the securities industry markets, regulatory agencies and their functions, and regulated and prohibited practices.

Under the proposed new rules, anyone desiring to work in the securities industry for a member firm would need to take the SIE. The SIE would also be open to anyone who desires to take it. When becoming employed by a member firm, a person would then need to take an additional exam associated with their particular job function (for example, series 7, 79 or 24). The new SIE exam would not change the requirement to pass tests associated with those additional licenses, or that such licenses expire if a person is not associated with a member firm for a two-year period. However, as discussed below, the proposed new rules add the ability to extend this two-year period in certain instances.

Currently, in order to qualify to take a registered representative examination to become licensed in the securities industry, a person must be employed and sponsored by a FINRA member broker-dealer. The intent of the SIE is to prequalify potential job applicants, saving member firms time and expense on vetting registered representatives and putting them through the examination process. A member firm will be able to view the SIE passing status and score on FINRA’s CRD system.

The proposed SIE is broken down into four categories: (i) “Knowledge of Capital Markets,” which focuses on topics such as types of markets and offerings, broker-dealers and depositories, and economic cycles; (ii) “Understanding Products and Their Risks,” which covers securities products at a high level as well as associated investment risks; (iii) “Understanding Trading, Customer Accounts and Prohibited Activities,” which focuses on accounts, orders, settlement and prohibited activities; and (iv) “Overview of the Regulatory Framework,” which encompasses topics such as SRO’s, registration requirements and specified conduct rules.

Individuals that have passed the SIE but not yet taken a specialized knowledge examination, would not be subject to continuing education requirements.

Individuals that are already licensed as of the effective date of the new SIE, will not need to take the exam and will be deemed to have passed such exam. The SIE qualification will remain valid for four years without the person being registered with a firm. However, other licenses, such as a Series 7, may lapse if a person is not associated with a member firm for a two-year period.

Although not discussed by FINRA, I see an opportunity to use the SIE for multiple purposes going forward as the securities laws and regulations continue to evolve. In particular, the SIE could be a factor in considering whether a person is accredited. The SIE could also be a factor in considering exemptions from the registration requirements for finders, a topic that continues to be at the forefront for regulators and practitioners alike. I will be writing about the subject of finders again very soon. In my view this is a topic that needs immediate attention. The fact is that regulators do not have the resources to police the finders industry, which has indeed become a full industry. Thousands of people operate as unlicensed finders, and their use has become accepted and commonplace in the small- and micro-cap industries. Clearly, the simple “it is not allowed” approach of regulators is not working. Unfortunately, without some parameters and workable regulation around this function, bad actors, inexperienced and completely unknowledgeable individuals hold themselves out as finders together with those that can abide by basic disclosure and antifraud provisions in the offer and sale of securities. Perhaps the SIE or a variation thereof could be used as part of a workable regulatory regime related to finders.

Extension of Time Prior to License Termination

Currently, if a registered person is not employed with a member firm for a period of two years, their securities license will lapse (except for the SIE) and they will need to retake a particular examination if they become re-employed by a member firm. The new rules allow this two-year period to be extended for up to seven years where a person is working for a non-FINRA member financial services affiliate.

That is, a person can maintain licensing for up to seven years while working for a non-FINRA member financial services affiliate of the member firm (such as a parent company) if the following conditions are met: (i) the person has been registered with a FINRA member for a total of five out of the past ten years, the most recent of which must be their current employer; (ii) when the person transitions to the affiliate, a Form U-5 must be filed notifying FINRA of the transition; (iii) the person must continue to satisfy continuing education requirements and have no pending or adverse regulatory matters; and (iv) the person must continuously work for the financial services affiliate.

If each of these qualifications is met, the person can re-register with a member firm for up to seven years without retaking a licensing examination.

Consolidated Examination Structure; Elimination of Exam Levels

Over time, the number of exams and licensing levels has expanded such that as of today, there are 16 exams with a considerable amount of content overlap and requirements for individuals to pass multiple exams to work in a given job function. There are 11 FINRA exams alone for a registered representative engaging in sales activities with investors, most of which focus on specific products, such as options or private securities.

The proposed consolidation and simplification of the examination process is the result of an effort to reduce redundancies and simplify the process, resulting in cost savings for all parties including FINRA, the member firm and representatives, and eliminating outdated examinations and materials.

A part of the consolidation and simplification is the introduction of the SIE discussed above, which will test on general securities knowledge, eliminating that portion of testing for specific specialized functions and duties of the registered representative. Under the proposed rules, a person would need to take the SIE as a precondition to taking a specialized knowledge examination. The SIE remains valid for a four-year period. Moreover, although a person is not required to be associated with a member firm to take the SIE, they will be required to be associated with and sponsored by a member firm to take the specialized knowledge exam.

The new specialized knowledge exams would eliminate questions on basic industry knowledge covered in the SIE. In addition, FINRA is proposing to reduce the current 16 exams to new exams covering: (i) investment company and variable contracts products representative (current Series 6); (ii) general securities representative (current Series 7); (iii) direct participation programs representative (current Series 22); (iv) equity trader (current Series 55); (v) investment banking representative (current Series 79); (vi) private securities offerings representative (current Series 82); (vii) research analyst (current Series 86 and 87); and (viii) operations professional (current Series 99).

In addition to consolidating certain exam levels, FINRA is proposing to eliminate the following exams: (i) option representative (Series 42); (ii) corporate securities representative and government securities representative and associated exams (Series 62 and 72); and (iii) order processing assistant (Series 11). FINRA is also considering eliminating the Series 17, 37 and 38, which deal with representatives who conduct cross-border foreign business with the U.K. and Canada.

Registration Amendments

Under current rules, FINRA limits individuals that can obtain a securities license, to those working in certain functions. Currently a person must be actively engaged in the securities or investment banking business of a firm in order to be licensed, subject to certain exceptions. Those exceptions include, for example, persons performing legal, compliance, internal-audit, back-office or similar functions and persons performing administrative functions for registered persons.

The new rules would eliminate the restrictions on these permissive registrations, and allow any employee of a member firm to take examinations and be licensed in any capacity which that firm’s membership with FINRA encompasses. For example, a person not actively engaged in investment banking could nevertheless take the Series 79, or a person not actively engaged in retail client management could take the Series 7. The new rules add supervisory responsibilities for the member firm related to persons holding licenses in areas for which they are not actively engaged.

Among other benefits, the intent of the new rules is to simplify the registration requirements and encourage individuals to cross-train within a member firm’s organization.

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SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | November 22, 2016 Tags: Application; Associated Person Registration; Supervision, CAB, CABs, Conduct Rules for CABs, Description of Capital Acquisition Broker (“CAB”), Financial and Operational Rules for CABs, FINRA Rule 2121, FINRA Rule 3110, FINRA rules, M&A deals

On August 18, 2016, the SEC approved FINRA’s rules implementing a new category of broker-dealer called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. FINRA first published proposed rules on CABs in December 2015. My blog on the proposed rules can be read HERE. In March and again in June 2016, FINRA published amendments to the proposed rules. The final rules enact the December proposed rules as modified by the subsequent amendments.

A CAB will generally be a broker-dealer that engages in M&A transactions, raising funds through private placements and evaluating strategic alternatives and that collects transaction-based compensation for such activities. A CAB will not handle customer funds or securities, manage customer accounts or engage in market making or proprietary trading.

Description of Capital Acquisition Broker (“CAB”)

There are currently FINRA-registered firms which limit their activities to advising on mergers and acquisitions, advising on raising debt and equity capital in private placements or advising on strategic and financial alternatives. Generally these firms register as a broker because they may receive transaction-based compensation as part of their services. However, they do not engage in typical broker-dealer activities, including carrying or acting as an introducing broker for customer accounts, accepting orders to purchase or sell securities either as principal or agent, exercising investment discretion over customer accounts or engaging in proprietary trading or market-making activities.

The proposed new rules will create a new category of broker-dealer called a Capital Acquisition Broker (“CAB”). A CAB will have its own set of FINRA rules but will be subject to the current FINRA bylaws and will be required to be a FINRA member. FINRA estimates that there are approximately 750 current member firms that would qualify as a CAB and that could immediately take advantage of the new rules.

FINRA is also hopeful that current firms that engage in the type of business that a CAB would, but that are not registered as they do not accept transaction-based compensation, would reconsider and register as a CAB with the new rules. In that regard, FINRA’s goal would be to increase its regulatory oversight in the industry as a whole. I think that on the one hand, many in the industry are looking for more precision in their allowable business activities and compensation structures, but on the other hand, the costs, regulatory burden, and a distrust of regulatory organizations will be a deterrent to registration. It is likely that businesses that firmly act within the purview of a CAB but for the transactional compensation and that intend to continue or expand in such business, will consider registration if they believe they are “leaving money on the table” as a result of not being registered. Of course, such a determination would include a cost-benefit analysis, including the application fees and ongoing legal and compliance costs of registration. In that regard, the industry, like all industries, is very small at its core. If firms register as a CAB and find the process and ongoing compliance reasonable, not overly burdensome and ultimately profitable, word will get out and others will follow suit. The contrary will happen as well if the program does not meet these business objectives.

A CAB will be defined as a broker that solely engages in one or more of the following activities:

Advising an issuer on its securities offerings or other capital-raising activities;

Advising a company regarding its purchase or sale of a business or assets or regarding a corporation restructuring, including going private transactions, divestitures and mergers;

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;

Qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in respect to the purchase or sale of newly issued unregistered securities (see below for the FINRA definition of institutional investor, which is much different and has a much higher standard than an accredited investor);

Qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer or control person in connection with a change of control of a privately held company. For purposes of this section, a control person is defined as a person that has the power to direct the management or policies of a company through security ownership or otherwise. A person that has the power to direct the voting or sale of 24% or more of a class of securities is deemed to be a control person; and/or

Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters. For more information on this, see my blog HERE regarding the SEC no-action letter granting a broker registration exemption for certain M&A transactions.

Since placing securities in private offerings is limited to institutional investors, that definition is also very important. Moreover, FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. Under the proposed CAB rules, an institutional investor is defined to include any:

Bank, savings and loan association, insurance company or registered investment company;

Government entity or subdivision thereof;

Employee benefit plan that meets the requirements of Sections 403(b) or 457 of the Internal Revenue Code and that has a minimum of 100 participants;

Qualified employee plans as defined in Section 3(a)(12)(C) of the Exchange Act and that have a minimum of 100 participants;

Any person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million;

Persons acting solely on behalf of any such institutional investor; or

Any person meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (i.e., any natural person that owns at least $5 million in investments; family offices with at least $5 million in investments; trusts with at least $5 million in investments; or any person acting on their own or as a representative with discretionary authority, that owns at least $25 million in investments).

A CAB will not include any broker that does any of the following:

Carries or acts as an introducing broker with respect to customer accounts;

Holds or handles customers’ funds or securities;

Accepts orders from customers to purchase or sell securities either as principal or agent for the customer;

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making; or

Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act (interesting that FINRA would include Regulation A in this, as currently no license is required at all to maintain such a platform – only platforms for Regulation Crowdfunding require such a license).

Application; Associated Person Registration; Supervision

A CAB firm will generally be subject to the current member application rules and will follow the same procedures for membership as any other FINRA applicant, with four main differences. In particular: (i) the application has to state that the applicant will solely operate as a CAB; (ii) the FINRA review will consider whether the proposed activities are limited to CAB activities; (iii) FINRA has set out procedures for an existing member to change to a CAB; and (iv) FINRA has set out procedures for a CAB to change its status to regular full-service FINRA member firm.

The CAB rules also set out registration and qualification of principals and representatives, which incorporate by reference to existing NASD rules, including the registration and examination requirements for principals and registered representatives. CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs will also be subject to current rules regarding Operations Professional registration.

CABs would have a limited set of supervisory rules, although they will need to certify a chief compliance officer and have a written anti-money laundering (AML) program. In particular, the CAB rules model some, but not all, of current FINRA Rule 3110 related to supervision. CABs will be able to create their own supervisory procedures tailored to their business model. CABs will not be required to hold annual compliance meetings with their staff. CABs are also not subject to the Rule 3110 requirements for principals to review all investment banking transactions or prohibiting supervisors from supervising their own activities.

CABs would be subject to FINRA Rule 3220 – Influencing or Rewarding Employees of Others, Rule 3240 – Borrowing form or Lending to Customers, and Rule 3270 – Outside Activities of Registered Persons.

Conduct Rules for CABs

The proposed CAB rules include a streamlined set of conduct rules. This is a brief summary of some of the conduct rules related to CABs. CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Rules 2080 and 2081 regarding expungement of customer disputes; and the FINRA arbitration requirements in Rules 2263 and 2268. CABs will also be subject to know-your-customer and suitability obligations similar to current FINRA rules for full-service member firms, and likewise will be subject to the FINRA exception to that rule for institutional investors. CABs will be subject to abbreviated rules governing communications with the public and, of course, prohibitions against false and misleading statements.

CABs are specifically not subject to FINRA rules related to transactions not within the purview of allowable CAB activities. For example, CABs are not subject to FINRA Rule 2121 related to fair prices and commissions. Rule 2121 requires a fair price for buy or sell transactions where a member firm acts as principal and a fair commission or service charge where a firm acts as an agent in a transaction. Although a CAB could act as an agent in a buy or sell transaction where a counter-party is an institutional investor or where it arranges securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters on such M&A deals, FINRA believes these transactions are outside the standard securities transactions that typically raise issues under Rule 2121.

Financial and Operational Rules for CABs

CABs would be subject to a streamlined set of financial and operational obligations. CABs would be subject to certain existing FINRA rules including, for example, audit requirement, maintenance of books and records, preparation of FOCUS reports and similar matters.

CABs would also have net capital requirements and be subject to suspension for noncompliance. CABs will be subject to the current net capital requirements set out by Exchange Act Rule 15c3-1.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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FinCEN Updates Due Diligence Rules

Posted by Securities Attorney Laura Anthony | September 6, 2016 Tags: AML Procedures, AML Programs, AML Rules, CIP Rule, CIP Rules, Due Diligence Rules, FinCEN, Finra, FINRA Rule 3310, The Bank Secrecy Act, The USA Patriot Act

On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued new final rules under the Bank Secrecy Act requiring financing institutions, including brokerage firms, to adopt additional anti-money laundering (AML) procedures that include specific due diligence and ongoing monitoring requirements related to customer risk profiles and customer information. In addition, the new rules require financial institutions to collect and verify information about beneficial owners and control person of legal entity customers.

The Securities Exchange Act of 1934 (“Exchange Act”) specifically requires brokerage firms to comply with the Bank Secrecy Act. FinCEN provides minimum rules. Brokerage firms are also required to comply with AML rules established by FINRA, including FINRA Rule 3310. The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. FINRA also provides a template to assist small firms in establishing and complying with AML procedures. As of the date of this blog, FINRA has not updated Rule 3310 or its form template.

The new rules will make the difficult process of opening brokerage accounts even more difficult, especially for foreign individuals and entities and U.S. individuals and entities operating through offshore entities. The new rules could impact the ongoing process of depositing and trading in penny stocks, even for existing brokerage firm clients. FinCEN initially issued advance notice of proposed rulemaking in March 2012 and issued proposed rules in August 2014. A push to issue final rules gained momentum following the release of the Panama Papers. The new rules become effective for new customer accounts opened on or after May 11, 2018; however, as discussed below, where appropriate it may have retroactive application.

FinCEN requires that financial institutions address the following four key elements in all of their AML programs: (i) customer identification and verification; (ii) beneficial ownership identification and verification; (iii) understanding the nature and purpose of customer relationships to develop risk profiles; and (iv) ongoing monitoring for reporting suspicious transactions and maintaining and updating customer information.

Obligation to identify and verify beneficial ownership

The USA Patriot Act grants authority to FinCEN to establish rules for financial institutions to identify and verify customer information and establish AML procedures in general. All financial institutions are required to have minimum AML procedures, and the application of these procedures has been the subject of many enforcement proceedings. The initial customer identification program rule (CIP Rule) was enacted in 2003 and required financial institutions to identify any individual or entity that opened an account but did not require identification of beneficial ownership.

A “legal entity” is defined as a corporation, limited liability company, partnership or other entity that is created by the filing of a public document with a U.S. state or foreign governmental body. Under the new rules, the financial institution will need to identify beneficial owners of a legal entity that own (i) 25% or more of the equity of the legal entity; and (ii) any control persons over the legal entity, including officers, directors and senior management. Certain entities are excluded from the definition of an “entity” for purposes of the CIP rules, including financial institutions, banks, bank holding companies, certain pooled investment funds, state regulated insurance companies and foreign financial institutions.

Subject to certain exclusions, the new rule requires financial institutions to identify and verify the beneficial owners of their legal entity customers. The rulemaking process included numerous comments on this requirement. As a concession, the final rule generally does not contain a requirement that the financial institution verify that a listed beneficial owner in fact holds the disclosed ownership interest or exerts actual control over the entity.

As with most such rules, the financial institution can establish written processes and procedures tailored to that institution and its operations. Such processes and procedures must include a consideration of both the ownership test and control test of beneficial ownership. A financial institution must collect information on all individuals who either directly or indirectly own 25% or more of the equity of an entity. Where a financial institution has questions or determines there are risk factors, they may collect identifying information on owners with a lower percentage as well. In addition, the financial institution must collect information on all individuals that have the ability to control, manage or direct the entity, including officers, directors and key management.

The terms “direct and indirect” and “control” remain undefined and are to be broadly construed based on facts and circumstances to encompass all forms of potential ownership and control. Likewise, when making risk and knowledge assessments, the financial institution must consider all facts and circumstances and is held to a “reasonableness” standard.

Financial institutions must verify the collected information. The original CIP Rule established verification requirements based on risk. The same risk-based verification processes remain in place, with some modifications. In essence, the financial institution must gather due diligence, including corporate records, ownership records and the like, and continue such process until it is satisfied it has enough information on the beneficial owners of that particular entity, considering the risk imposed by that entity.

There are two significant modifications from the CIP Rule. In particular, a financial institution may rely on photocopies of documents rather than originals, and the institution may rely on disclosures of ownership from the entity itself except where it has knowledge of facts that would call into question the reliability or veracity of such information.

The risk assessment in the CIP Rule includes a consideration of all relevant facts and circumstances, including, but not limited to: (i) type of account; (ii) method of opening account; (iii) size of account and trading activity; (iv) type of identifying customer information; (v) relationship with the customer, including other accounts with the same beneficial owners, length of relationship, personal knowledge, and account activity; (vi) whether the customer has a physical address or physical business location; (vii) whether the customer has a U.S. tax identification number; and (viii) historical activity, including a suspicious activity.

Although the rule sets a firm requirement that financial institutions complete written procedures and apply them to all accounts opened on or after May 11, 2018, FinCEN is clear that a financial institution has a broad requirement to monitor and know its customers. Where risks are identified, additional procedures as outlined in the new rules should be applied to accounts, effective immediately. In addition, financial institutions should have ongoing monitoring procedures and may, where appropriate, go back and ask for information on existing accounts, as well as require updated information for accounts on a continuing basis. For instance, if an account has suspicious activity or contradictory ownership or control information is brought to the financial institution’s attention, there would be an obligation to conduct further due diligence and update and verify ownership and control information.

Basic AML Procedure Requirements

The USA Patriot Act sets out the basic requirements for effective AML policies and procedures. In particular, an effective AML program requires: (i) written policies and procedures; (ii) a designated compliance officer; (iii) an ongoing training program; (iv) an independent audit; and (v) customer due diligence. The new rules are focused on the fifth element: customer due diligence.

An effective customer due diligence process must have procedures for effectively understanding a customer relationship and establishing a customer risk profile, and for ongoing monitoring and compliance procedures, including those related to detecting and reporting suspicious activities and updated customer beneficial ownership and control information.

The Bank Secrecy Act imposes an obligation on broker-dealers to file a SAR with FinCEN to report any transaction (or a pattern of transactions) involving $5,000 or more, in which it “knows, suspects, or has reason to suspect” that it “(1) involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade any requirements of the Bank Secrecy Act; (3) has no business or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts; or (4) involves use of the broker-dealer to facilitate criminal activity.”

SEC guidance points out red flags that should cause a broker to conduct further investigation as to whether a SAR needs to be filed, including:

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The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host ofLawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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