The Commodity Exchange Act (‘‘CEA’’), as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd-Frank Act’’), authorizes the Secretary of the Treasury (‘‘Secretary’’) to issue a written determination that foreign exchange swaps, foreign exchange forwards, or both, should not be regulated as swaps under the CEA. On November 20th, the Secretary decided to do just that, and used its power to exclude foreign exchange swaps and foreign exchange forwards from the definition of a swap. Thus, this decision removes these securities from the new swap regulatory regime set up by Dodd-Frank (as discussed in the previous blog entitled “Will You Need to Register as a “CTA” in the New Year?”).
In response to their request for comments on the subject, the Treasury received 26 comment letters with 15 expressing support for the proposed exclusion, while 11 were generally opposed. Those who support issuing an exemption generally argue that foreign exchange swaps and forwards are functionally different from other over-the-counter (‘‘OTC’’) derivatives and already “trade in a highly transparentand liquid market” where the banking regulators have substantial visibility and exercise strong regulatory oversight. Furthermore, because foreign exchange swaps and forwards involve an actual exchange of principal and are predominantly very short in duration and have high turnover rates, the additional costs and operational difficulty associated with clearing foreign exchange swaps and forwards would adversely affect their business activities and discourage hedging activity.
Opponents argued that any exclusion would create an “enormous” loophole that could undermine “financial stability by preserving an opaque, unregulated and undercapitalized market.” Additionally, this loophole could be used to mask complex transactions in an effort to avoid subjecting them to clearing and trading requirements.
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The California Department of Corporations (“DOC”) recently proposed amendments to the California investment adviser custody rule, Section 260.237 of Title 10 of the California Code of Regulations. The October 18, 2012 announcement follows an initial invitation for comments on the proposed changes issued by the DOC on July 8, 2011. The proposed changes are in response to, and incorporates provisions from, the recently adopted amendments to the Securities and Exchange Commission’s (“SEC”) Custody Rule, and the North American Securities Administrators Association’s (“NASAA”) Model Custody Rule.
The proposed amendments to the California rule strike the existing language in favor of the NASAA model rule, subject to certain California-specific provisions. Like the existing rule, the proposal requires that advisers with custody maintain those assets with a qualified custodian, subject to certain limited exceptions. Of note, the proposed changes provide a specific definition of “custody”; require advisers with custody to undergo an annual surprise examination by an independent public accountant; and specify that certain audits and independent verifications must be performed by Certified Public Accountants that are registered with, and subject to regular inspection, by the Public Company Accounting Oversight Board. Unlike the model rule, the California proposal relaxes account statement requirements for advisers to private funds in an effort to maintain the confidentiality of any proprietary trading models developed by the adviser.
According to the DOC, the “proposed regulatory action seeks to increase uniformity with investment adviser regulation in other states” and the SEC. The former NASAA model rule (which California’s existing custody rule is modeled after) was drafted based on the previous custody rule employed by the SEC. Changes to the federal rule in 2009 prompted changes to the Model Rule by NASAA, leading to the present DOC proposal. Thus, the idea is that regardless of whether an investment adviser registers with the state, or the SEC, there will exist the same responsibilities for advisers, and investors will have the same protections. The DOC is accepting comments on the proposed amendments until December 31, 2012.
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Last week the SEC settled an enforcement action against Chicago Registered Investment Adviser Tilden Loucks & Woodnorth LLC, its affiliated registered broker-dealer, LaSalle St. Securities, LLC, and Tilden’s retired founder, 87 year-old Ralph B. Loucks. The action was instituted as a result of Tilden’s failure to seek best execution for its clients and its failure to disclose the nature of the commissions charged to clients by the affiliated broker-dealer. The SEC’s order instituting the settlement states that during the time period in question most trades for Tilden’s clients were executed by LaSalle, with commission charges to clients averaging more than $143 per trade despite the fact that the majority of consisted of purchases and sales of large cap equities.
Tilden’s ADV falsely stated that “clients obtained a significant ‘discount’ to LaSalle’s scheduled retail brokerage charges.” LaSalle, however, did not have any scheduled retail brokerage charges or commission schedules. Instead, “Tilden set LaSalle’s commission charges at rates exceeding LaSalle’s charge to Tilden to execute a trade and the ‘discount’ was in reality only a price lower than those reflected on a commission schedule used by Tilden that dated to at least 1988.” Tilden, in fact, paid LaSalle an average of just $37.47 to execute clients’ trades. The difference netted Tilden $186,608 in higher commissions paid by the firm’s advisory clients, over $16,000 of which was paid to Loucks.
In addition to focusing on the inaccuracy of Tilden’s ADV disclosures concerning the firm’s commissions from LaSalle, the SEC’s order also emphasizes Tilden’s failure to adhere to its own representations about its best execution policies. The firm’s ADV stated that it would undertake an annual best execution survey to “ensure that transactions executed through [LaSalle] are producing reasonable commission rates and ‘best execution’ of trades as that term is commonly understood.” To the contrary, Tilden conducted no best execution survey until 2009, and thereafter the survey it allegedly conducted was incomplete and failed to analyze the various best execution criteria specifically set forth in the firm’s ADV.
Under the terms of the settlement Tilden is required to revise its ADV pay disgorgement to clients and prejudgment interest of over $200,000.
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Last week the Enforcement Section of the North American Securities Administrators Association (NASAA) issued its annual enforcement survey, providing an overview of state enforcement efforts in 2011. The survey concludes that 6,121 investigations were conducted by the 48 responding regulators last year, resulting in 2,602 enforcement actions, more than $2.2 billion in investor restitution orders, and criminal jail sentences of 1,662 years. State regulators also reported the withdrawal of nearly 2,800 licenses and the denial, revocation or suspension of another 774 licenses. Of note, of the 2,602 enforcement actions 399 were brought against investment advisory firms, nearly double the prior year.
Regulators characterized more than 1,400 enforcement cases as fraud, with over 1,000 of those involving unregistered securities and over 900 unregistered firm or individuals. State regulators reported the most common products at the center of enforcement were Regulation D offerings, with real estate investments a close second. The survey also asked respondents to identify top enforcement trends, and regulators reported the following as consistently sited new threats to investors:
- Crowdfunding & Internet Offers – The report notes that many states report a recent increase in active investigations involving Internet fraud and that the JOBS Act provisions concerning crowdfunding may “elongate this trend.”
- Inappropriate Advice from Investment Advisers – The survey’s authors state that the “Bernie Madoff case opened a number of eyes and ears to the problems that could exist undetected in an investment advisory firm.” The report also notes the shift of oversight from the SEC to the states for mid-size advisers has resulted in the implementation of regular exam schedules by states, which the authors predict will lead to discovery of more problems.
- Scam Artists Using Self-Directed IRAs to Mask Fraud – The report explains that state regulators have investigated numerous cases where self-directed IRAs were used to lend credibility to bogus ventures.
- EB-5 Investment-for-Visa Schemes – Finally, the report warns that investors should be on alert for false claims that investments in a particular venture are safe or guaranteed due to an influx in foreign cash from the Immigrant Investor Program (known as EB-5).
For further information about the NASAA survey or any other securities related concern, please contact the author at firstname.lastname@example.org or (619)298-2880.