Financial Regulation and Compliance E-Book

H. David Kotz

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 358

Veröffentlichungsjahr: 2015

Beschreibung

Devise an organized, proactive approach to financial compliance

Financial Regulation and Compliance provides detailed, step-by-step guidance for the compliance professional seeking to manage overlapping and new regulatory responsibilities. Written by David Kotz, former Inspector General of the SEC with additional guidance provided by leading experts, this book is a one-stop resource for navigating the numerous regulations that have been enacted in response to the financial crisis. You'll learn how best to defend your organization from SEC, CFTC, FINRA, and NFA Enforcement actions, how to prepare for SEC, FINRA, and NFA regulatory examinations, how to manage the increasing volume of whistleblower complaints, how to efficiently and effectively investigate these complaints, and more. Detailed discussion of the regulatory process explains how aggressive you should be in confronting federal agencies and self-regulatory organizations and describes how commenting on issues that affect your business area can be productive or not. The companion website includes a glossary of terms, regulations and government guidance, relevant case law, research databases, and FAQs about various topics, giving you a complete solution for keeping abreast of evolving compliance issues.

These days, compliance professionals are faced with a myriad of often overlapping regulatory challenges. Increased aggressiveness on the part of regulators has led to increased demand on financial firms, but this book provides clear insight into navigating the changes and building a more robust compliance function.

• Strengthen internal compliance and governance programs
• Manage whistleblower programs and conduct effective investigations
• Understand how to minimize exposure and liability from Enforcement actions
• Learn how to prepare for the different types of regulatory examinations
• Minimize exposure from FCPA violations
• Understand the pros and cons of commenting on regulations

The volume and pace of regulatory change is causing new and diverse pressures on compliance professionals. Navigate the choppy waters successfully with the insider guidance in Financial Regulation and Compliance.

Leseprobe

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Financial Regulation and Compliance

How to Manage Competing and Overlapping Regulatory Oversight

H. DAVID KOTZ

Copyright © 2015 H. David Kotz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

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Library of Congress Cataloging-in-Publication Data

Kotz, H. David, author.    Financial regulation and compliance : how to manage competing and overlapping regulatory oversight /H. David Kotz.       pages cm. – (The wiley finance series)    Includes index.    ISBN 978-1-118-97221-2 (hardback)  1. Financial institutions–Law and legislation–United States.   I. Title.    KF974.K68 2015    346.73′08–dc23

2015017704

ISBN 978-1-118-97221-2 (hbk)

ISBN 978-1-118-97223-6 (ebk)

ISBN 978-1-118-97222-9 (ebk)

ISBN 978-1-118-97224-3 (ebk)

Cover Design: Wiley

Cover Images: Top image ©iStock.com/scyther5; Bottom image ©iStock.com/jwohlfeil

To my wife, Debbie, and my three children, Shira, Joshua and Ruven, who inspire and support me on a daily basis, and who mean everything to me.

Contents

Foreword

Preface

NOTES

Acknowledgments

About the Author

CHAPTER 1 Jurisdiction of Regulators – Who Regulates Whom and What

1.1 FEDERAL FINANCIAL REGULATORY STRUCTURE

1.2 THE SECURITIES AND EXCHANGE COMMISSION (SEC)

1.3 THE FINANCIAL INDUSTRY REGULATORY AUTHORITY (FINRA)

1.4 THE COMMODITY FUTURES TRADING COMMISSION (CFTC)

1.5 THE NATIONAL FUTURES ASSOCIATION (NFA)

1.6 THE DEPARTMENT OF JUSTICE (DOJ)

1.7 RECENT REGULATORY FAILURES TO UNCOVER FRAUD

1.8 EXPERT ADVICE ON OVERLAPPING REGULATIONS

NOTES

CHAPTER 2 How to Strengthen Governance and Compliance in Light of New Regulations

2.1 DODD-FRANK ACT'S IMPACT ON GOVERNANCE AND COMPLIANCE

2.2 MANAGING EXECUTIVE COMPENSATION

2.3 CREATING EFFECTIVE POLICIES AND PROCEDURES

2.4 ENSURING ACCOUNTABILITY WITHIN AN ORGANIZATION

2.5 RED FLAGS OF AN UNETHICAL CULTURE

2.6 ETHICAL DECISION-MAKING

NOTES

CHAPTER 3 How to Manage Whistleblowers' Complaints

3.1 OVERSIGHT AND FAILURES OF THE SEC'S WHISTLEBLOWER PROGRAM

3.2 THE DODD-FRANK ACT'S RESTRUCTURING OF THE SEC'S WHISTLEBLOWER PROGRAM

3.3 WHISTLEBLOWER COMPLAINTS TO THE SEC SINCE THE RESTRUCTURING OF ITS PROGRAM

3.4 THE CFTC'S NEW WHISTLEBLOWER PROGRAM

3.5 SIGNIFICANT U.S. SUPREME COURT DECISION ON WHISTLEBLOWER COMPLAINTS

3.6 MANAGING COMPLAINTS BROUGHT TO INTERNAL COMPLIANCE OFFICIALS

3.7 PUTTING APPROPRIATE WHISTLEBLOWER POLICIES AND PROCEDURES IN PLACE

3.8 EFFECT OF THE SEC AND CFTC'S NEW WHISTLEBLOWER PROGRAMS

NOTES

CHAPTER 4 How to Defend SEC Examinations

4.1 SEC AUTHORITY TO CONDUCT EXAMINATIONS

4.2 SEC'S OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS (OCIE)

4.3 TYPES OF SEC OCIE EXAMS

4.4 PREPARATION FOR THE EXAMS

4.5 PROCESS OF EXAMINATIONS

4.6 HOW THE SEC EXAM CONCLUDES

4.7 SEC OCIE EXAMINATION TRENDS

4.8 NOT UNDERESTIMATING THE SEC EXAMINERS

NOTES

CHAPTER 5 How to Defend FINRA Examinations

5.1 FINRA QUALIFICATION STANDARDS AND RULES AND REGULATIONS

5.2 FINRA'S RISK-BASED APPROACH

5.3 FINRA'S REGULATORY AND EXAMINATION PRIORITIES

5.4 DIFFERENCES BETWEEN FINRA AND SEC EXAMS

5.5 TYPES OF FINRA EXAMS

5.6 CONDUCT OF FINRA EXAMS

5.7 HOW THE FINRA EXAM CONCLUDES

5.8 EDUCATING THE FINRA EXAMINERS

NOTES

CHAPTER 6 How to Defend an NFA Examination

6.1 TYPES OF ENTITIES UNDER THE JURISDICTION OF THE NFA

6.2 IMPACT OF THE DODD-FRANK ACT

6.3 NFA EXAMINATION PROCESS

6.4 PREPARING FOR AN NFA EXAM

6.5 LENGTH AND CONDUCT OF THE NFA EXAM

6.6 HOW THE NFA EXAM CONCLUDES

6.7 CFTC EXAMINATIONS

6.8 FOCUSING ON STRICT COMPLIANCE WITH THE REGULATIONS

NOTES

CHAPTER 7 How to Defend SEC Enforcement Actions

7.1 SEC'S LAW ENFORCEMENT FUNCTION

7.2 HOW SEC ENFORCEMENT ACTIONS ARE TRIGGERED

7.3 COMMENCEMENT OF AN SEC ENFORCEMENT ACTION

7.4 CONVERTING THE INQUIRY TO A FORMAL INVESTIGATION

7.5 DISCOVERY CONDUCTED BY THE SEC

7.6 THE SEC ENFORCEMENT'S “WELLS” PROCESS

7.7 USE OF EXPERTS IN SEC ENFORCEMENT PROCEEDINGS

7.8 SETTLEMENT DISCUSSIONS

7.9 TRENDS IN SEC ENFORCEMENT

7.10 MINIMIZING EXPOSURE IN AN SEC ENFORCEMENT CASE

NOTES

CHAPTER 8 How to Defend FINRA Enforcement Actions

8.1 FINRA DISCIPLINARY ACTIONS

8.2 FINRA ENFORCEMENT PROCESS

8.3 FINRA'S FORMAL PROCEEDING

8.4 CHALLENGES OF FINRA ENFORCEMENT PROCESS

8.5 CONDUCT OF THE FINRA HEARING

8.6 SETTLEMENT POSSIBILITIES

8.7 DISCIPLINARY SANCTIONS AVAILABLE TO FINRA

8.8 RIGHT TO APPEAL DECISION OF HEARING PANEL

8.9 RECENT TRENDS IN FINRA ENFORCEMENT

8.10 MOUNTING AN AGGRESSIVE DEFENSE

NOTES

CHAPTER 9 How to Defend CFTC Enforcement Actions

9.1 INCREASED AGGRESSIVENESS ON THE PART OF CFTC ENFORCEMENT

9.2 TYPES OF ENFORCEMENT ACTIONS BROUGHT BY THE CFTC

9.3 TRIGGERS FOR CFTC ENFORCEMENT ACTIONS

9.4 CFTC ENFORCEMENT PROCESS

9.5 DIFFERENCES BETWEEN CFTC AND SEC ENFORCEMENT PROCEEDINGS

9.6 THE CFTC “WELLS” PROCESS

9.7 CFTC ENFORCEMENT'S USE OF EXPERTS

9.8 SETTLEMENT DISCUSSIONS

9.9 CFTC ENFORCEMENT'S USE OF ADMINISTRATIVE PROCEEDINGS

9.10 TRENDS IN CFTC ENFORCEMENT

9.11 FLAWED ASSUMPTIONS ABOUT CFTC ENFORCEMENT PROCESS

9.12 STRATEGIES FOR CFTC ENFORCEMENT CASES

NOTES

CHAPTER 10 How to Defend NFA Enforcement Actions

10.1 NFA DISCIPLINARY ACTIONS

10.2 HOW COMPLAINTS ARE TRIGGERED

10.3 INVESTIGATIVE PROCESS

10.4 SETTLEMENT

10.5 THE HEARING PANEL AND HEARING COMMITTEE

10.6 CONDUCT OF THE HEARING

10.7 WRITTEN DECISION AFTER THE HEARING

10.8 APPEAL OF AN ADVERSE DECISION

10.9 THE MRA PROCEDURE

10.10 TYPES OF PENALTIES ASSESSED BY THE NFA

10.11 NUMBER AND TYPES OF DISCIPLINARY ACTIONS

10.12 TRENDS IN NFA ENFORCEMENT

10.13 PREPARING A DEFENSE

NOTES

CHAPTER 11 How to Participate in the Regulatory Comment Process

11.1 DODD-FRANK RULEMAKING

11.2 SEC RULEMAKING PROCESS

11.3 CANDIDATES FOR COMMENTS

11.4 ROLE OF TRADE ASSOCIATION IN COMMENT PROCESS

11.5 CONTENT OF THE COMMENT LETTER

11.6 APPROACHES TO AN EFFECTIVE COMMENT LETTER

11.7 SIGNIFICANCE OF THE ECONOMIC IMPACT OF PROPOSED REGULATIONS

11.8 REQUESTING MEETINGS WITH AGENCY OFFICIALS

11.9 SUBMITTING COMMENTS AFTER THE DEADLINE

11.10 LEARNING ABOUT RULEMAKINGS

11.11 ASSISTANCE FROM OUTSIDE COUNSEL

NOTES

CHAPTER 12 How to Defend FCPA Claims

12.1 FCPA PROVISIONS

12.2 FCPA ENFORCEMENT AUTHORITY

12.3 VIOLATIONS OF THE FCPA

12.4 PENALTIES FOR VIOLATING THE FCPA

12.5 FCPA EXEMPTIONS

12.6 DOJ/SEC GUIDANCE

12.7 THE U.K. BRIBERY ACT

12.8 DEVISING EFFECTIVE COMPLIANCE PROGRAMS

12.9 TRAINING ON COMPLIANCE STANDARDS

12.10 ACHIEVING A CULTURE OF COMPLIANCE

12.11 RISK-BASED DUE DILIGENCE AND MONITORING

12.12 CONDUCTING FCPA COMPLIANCE ASSESSMENTS

12.13 IMPORTANCE OF RISK ASSESSMENT

12.14 MANAGEMENT OF THIRD PARTIES

12.15 CONDUCTING DUE DILIGENCE ON ACQUISITION TARGETS

12.16 THE TRIGGERS FOR AN FCPA ENFORCEMENT ACTION

12.17 SELF-DISCLOSING VIOLATIONS

12.18 REDUCING EXPOSURE

NOTES

CHAPTER 13 How to Conduct Internal Investigations

13.1 LIMITING EXPOSURE THROUGH EFFECTIVE INTERNAL INVESTIGATIONS

13.2 LESSONS LEARNED FROM HIGH-PROFILE INVESTIGATIONS

13.3 COMMENCING THE INTERNAL INVESTIGATION

13.4 RETAINING AN OUTSIDE INVESTIGATOR

13.5 INITIAL STEPS OF INVESTIGATION PROCESS

13.6 METHODS OF OBTAINING INFORMATION

13.7 COLLECTING DOCUMENTS

13.8 STRATEGIES FOR CONDUCTING INTERVIEWS

13.9 BRIEFING MANAGEMENT DURING AN INVESTIGATION

13.10 DRAFTING THE INVESTIGATIVE REPORT

13.11 INCORPORATING RECOMMENDATIONS FOR IMPROVEMENT

13.12 PROTECTING FILES ASSOCIATED WITH INTERNAL INVESTIGATION

13.13 RETAINING THE INVESTIGATIVE REPORT

NOTES

CHAPTER 14 Conclusion

14.1 OVERLAPPING JURISDICTIONS AFTER THE DODD-FRANK ACT

14.2 REGULATORY FAILURES POST-FINANCIAL CRISIS

14.3 IMPROVING OF COORDINATION BETWEEN REGULATORY AGENCIES

14.4 UNDERSTANDING THE REGULATORY CLIMATE

NOTES

About the Website

Index

EULA

Guide

Cover

Table of Contents

Preface

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Foreword

Few topics in finance are more confusing to outsiders than regulation. There are many among us who understand financial valuation and even the technical intricacies of the esoteric contingent claims analysis, copula functions, and risk mapping algorithms. But the supervision and regulation of banks, much less securities firms, tend to make the eyes of most financial analysts glaze over.

Yet the compliance function is one of the most important, and valuable, functions in any financial institution. Compliance is more than just records retention. As recent crisis-era litigation has shown, managing compliance properly can help reduce vast legal costs later. While we may not want to admit it, compliance creates value.

The problem is that not many people – whether they be financial practitioners, policymakers, or sometimes even compliance professionals – really understand compliance. Part of the problem is the unique path dependence that has created a fractured supervisory structure with some delineations by institution and some by function, creating considerable regulatory overlap. Even understanding who is responsible for what, in any real sense, after accounting for “primary” supervisory responsibility, can be massively confusing.

This became apparent to me when I began to advise staff at the European Union (EU) Parliament on their own reforms to financial regulation. At the time the U.S. was (and is still) urging them to just adopt U.S. institutional features, which EU staff did not understand. Thereupon, we embarked on an almost two-year project to educate the staff in this massively tangled and – to the uninitiated – thoroughly confusing framework for U.S. financial supervision.

The problem became even worse when we ran into the subject of administrative law – that is, regulation – and also its enforcement, venues for defense, and appeal. While I was able to treat the subjects in just a few areas (primarily banking) with a wide variety of existing resources, the present manuscript pulls together far more material in a single volume than ever before published on the subject.

Moreover, this book's treatment of securities regulation pushes into a much newer area of financial supervision, covering the securities sector. Historically, only banks were supervised – that is, subjected to examinations that required producing confidential records to supervisory personnel with the threat of sanctions. But in recent years, the SEC's examination function has grown significantly, and if some policymakers have their way, it will continue to grow.

In conjunction with such growth, some of the more troubling aspects of bank regulation seem to be spilling over into securities regulation. In the 2015 examination priorities of the Office of Compliance Inspections and Examinations (OCIE), the SEC is putting more emphasis on “using data analytics to identify signals of potential illegal activity.” The idea is that trading or payment patterns can indicate firms or brokers that are “potentially engaged in fraudulent and/or other potential illegal activity.” Thus, analytical exercises are used to determine who might run afoul of anti-money laundering or other related restrictions.

The idea is generally good, but the implementation in the banking world has been fraught with controversy. The U.S. Treasury has pushed bank regulators to undertake similar programs related to Operation Choke Point in recent years. In addition, recently, the FDIC has sought to disassociate itself from the approach after some banks and companies were tremendously hurt by investigations that turned out to be for naught. The point is that while certain patterns of business behavior might be associated with criminal activity (like high chargeback rates on credit cards in the retail sector), there is little to distinguish those from legitimate activity in business that merely operates on almost identical principles. That is why fraud works.

The author of this book is the former Inspector General of the SEC and has been fortunate to see firsthand how regulations are supposed to work, and how they are often perceived by the regulated community. I have been an admirer of his work at the SEC for quite some time, as he was able to conduct meaningful oversight of a very important financial regulator during a very significant time period in our nation's financial history. In this book, he draws on his own vast experience to provide cogent hands-on advice to compliance professionals in a myriad of important areas. He also brings together a very unique collection of expertise from many individuals, including several former senior-level governmental officials which only add to the comprehensiveness and value of this book. It is a must-read for compliance professionals in the financial arena, and, as supervisory principles are applied in financial market regulation, the present manuscript will be all the more important to manage the new regulatory and administrative law burdens that will be imposed on the industry.

Joseph R. Mason, the Hermann Moyse, Jr./ Louisiana Bankers Association Endowed Chair of Banking and Professor of Finance at Louisiana State University and Senior Fellow at the Wharton School.

Preface

During the week of March 10, 2008, I was in the first few months of my new position as Inspector General of the Securities and Exchange Commission (“SEC”). I had come over to the SEC after serving as Inspector General of the Peace Corps. At the Peace Corps, I dealt with many very significant issues, some involving life and death, as I tried to put into place procedures for ensuring Peace Corps Volunteer safety and security. Much of my time was spent working with foreign governments to assist in the prosecution of individuals who committed heinous crimes against Peace Corps Volunteers, such as assault, rape, and even murder. I found my job very rewarding and many of the protections we put into place for Volunteers remain in existence today. The Peace Corps position was, however, generally low profile, and while I testified before Congress on one or two occasions during my tenure as Inspector General of the Peace Corps, for the most part, we were able to operate out of the public eye. I recall when I interviewed for the SEC position that former Chairman Christopher Cox told me, at the end of my interview, words to the effect of “one thing you will realize if you work here, this is not going to be like working at the Peace Corps.” Chairman Cox certainly turned out to be right about that statement.

I was the second ever Inspector General in the SEC's history. The previous Inspector General had been in his position for approximately 18 years, and had recently retired among some rumblings from Capitol Hill that his office could have been more aggressive in certain investigations. Shortly after I arrived at the SEC at the very end of 2007, I received a letter from Senator Charles E. Grassley (R-Iowa), who was then the Ranking Member of the United States Senate Committee on Finance, referencing the previous Inspector General's tenure and pointing out that he expected my office to engage in aggressive oversight. I understood that I was being watched carefully and expectations were high regarding my tenure as Inspector General.

I very clearly recall the extreme concern at the SEC during the week of March 10, 2008, when word spread about liquidity problems at Bear Stearns. There was also, of course, a flurry of activity surrounding the March 16, 2008 Bear Stearns' sale to JP Morgan with financing support from the Federal Reserve Bank of New York (“FRBNY”). Little did I realize at that time how significant these events would be not only in my own life, but with respect to its role in the eventual global financial crisis.

On April 2, 2008, my office received another letter from Ranking Member Grassley, requesting that my office analyze the SEC's oversight of firms under its Consolidated Supervised Entity (“CSE”) program and broker-dealers subject to the SEC's Risk Assessment Program. The letter requested a review of the SEC's oversight of the investment banks that it supervised, with a special emphasis on Bear Stearns. The letter requested that we analyze the adequacy of the SEC's monitoring of Bear Stearns, and that we make recommendations to improve the SEC programs.

The CSE program was a voluntary program created by the SEC in 2004, to allow the SEC to supervise certain broker-dealer holding companies on a consolidated basis. These entities included Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup Inc., and JP Morgan. The CSE program was designed to allow the SEC to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated broker-dealers and other regulated entities at risk. The CSE program's mission was, in pertinent part as follows:

The regime is intended to allow the Commission to monitor for, and act quickly in response to, financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated entities, including US and foreign-registered banks and . . . broker-dealers, or the broader financial system at risk. (emphasis added.)1

I understood at that point in time how important it was for there to be a thorough and comprehensive assessment of the circumstances that led to Bear Stearns' collapse and the effectiveness of the CSE program, and I was very aware that my office was being given an opportunity to demonstrate that we could engage in aggressive oversight of the SEC and its programs. Accordingly, I decided that I would not “pull any punches” with respect to this assessment and audit, and determined that one of my initial conclusions in my assessment would be that “it is undisputable that the CSE program failed to carry out its mission in its oversight of Bear Stearns because under the Commission and the CSE program's watch, Bear Stearns suffered significant financial weaknesses and the FRBNY needed to intervene during the week of March 10, 2008, to prevent significant harm to the broader financial system.”2

In the audit, we also found numerous specific concerns with the SEC's oversight of the CSE program, including the fact that, although the SEC was aware, prior to Bear Stearns becoming a CSE firm, that Bear Stearns' concentration of mortgage securities had been increasing for several years and was beyond its internal limits, and that a portion of Bear Stearns' mortgage securities (e.g., adjustable rate mortgages) represented a significant concentration of market risk, the SEC did not make any efforts to limit Bear Stearns' mortgage securities concentration. We also did not “pull any punches” with respect to Bear Stearns, as we concluded that there was evidence of significant shortcomings in the area of risk management at Bear Stearns, including a proximity of Bear Stearns' risk managers to traders suggesting a lack of independence.

There was a strong reaction within the SEC as a result of our findings, and concerns were expressed about the impact of the report on the SEC's reputation and credibility, which could negatively affect its ability to engage in regulatory oversight. There were even comments made that a weakened SEC as a result of my office's report would make it more difficult for the government to manage what was increasingly being viewed as the beginning of a serious financial crisis, and suggestions about whether the entire report should be publicly disclosed. Notwithstanding these concerns, I decided that it was more important for Congress and the public to understand what had occurred with respect to Bear Stearns' collapse and the SEC's oversight, and I declined to substantially edit the report and released it with minimal redactions.

Congressional officials appreciated my willingness to accurately report what I had found in my assessment even during this difficult time. Eventually, my report was utilized extensively by the Financial Crisis Inquiry Commission (“FCIC”) in their work in attempting to understand the causes of the financial crisis. I met with FCIC officials on numerous occasions over a period of months, and eventually testified before the FCIC with regard to my findings in 2008.

Chairman Cox was prescient in telling me that life as Inspector General of the SEC was going to very different than at the Peace Corps. My tenure as Inspector General at the SEC later included several other high-profile investigations, including my investigation of the SEC's failure to uncover Bernie Madoff's $50 billion Ponzi scheme. Operating in the glare of the public eye, while attempting to conduct oversight of the very people with which I was working side-by-side on a daily basis, was tremendously challenging.

Yet, my four-plus years as Inspector General at the SEC were also incredibly rewarding. Moreover, my experiences being in the center of the regulatory storm during the global financial crisis and being in a position to see Congress' reaction firsthand, led me to decide to write this book. As Congress began deliberating what eventually became the Dodd-Frank Wall Street Reform and Consumer Protection Act, I was often asked by congressional officials to provide input and guidance on the legislation. When submitting feedback, I tried to consider how actual companies and compliance officials would be impacted by these regulatory initiatives. I have seen too many occasions when legislation is thought to work well when discussing the proscriptions in theory; but the practical impact was very different.

Now that the Dodd-Frank Act has been enacted and many of the underlying regulations promulgated, I feel it is the responsibility of former government officials like myself to assist companies in responding to the many overlapping regulations that have been put into place. In this book, with the assistance of many very distinguished experts, I have tried to provide detailed, step-by-step guidance for the compliance professional seeking to manage these regulatory responsibilities. The hope is that the information in this book will lead compliance officials and companies to be in a better position to comply fully with their regulatory responsibilities while also achieving both their business and ethical goals and objectives.

NOTES

1

See

SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program

, SEC Office of Inspector General, Report No. 446-A, September 25, 2008, at

http://www.sec.gov/about/oig/audit/2008/446-a.pdf

.

2

Ibid. at p. viii.

Acknowledgments

I want to thank my colleagues at Berkeley Research Group for their helpful comments and edits to the first draft of the book. I wish to mention particularly the contributions of Alexandra Martin and Matthew Caselli. Alex assisted greatly in compiling the information from the interviews that I conducted with the leading experts, and in providing comments and suggestions with respect to all aspects of the book. Matt, as he has done for me on many previous occasions, expertly edited the manuscript and gave me invaluable guidance and direction.

In addition, much, if not most, of the valuable information in the book comes not from me, but from the contributions of the many experts who took the time from their very busy schedules to speak to me and furnish me their insights about the many diverse topics described in the book. These individuals – Amy Lynch, Matt Dwyer, Debbie Monson, Brad Bondi, Richard Roth, Ken McCracken, Jay Knight, and Tom Fox – could not have been more informative or more of a pleasure to work with. It was truly a joy and an honor for me to be able to speak to them about their areas of regulatory expertise, and to be able to incorporate their extremely valuable guidance in this book.

Finally, I am very grateful for the team at John Wiley & Sons, and specifically Thomas Hyrkiel, Tessa Allen and Jeremy Chia. This was a very personal project for me as I was tremendously honored to be able to publish a book for the same publishers for whom my late father, Dr Samuel Kotz, published so many of his books. It was a pleasure to work with Thomas, Tess and Jeremy and I very much appreciated the excitement and dedication that they brought to the project.

About the Author

H. David Kotz (Washington, DC) presently serves as a Managing Director at Berkeley Research Group (BRG), a leading global expert services and consulting firm that provides independent expert testimony, litigation and regulatory support, authoritative studies, strategic advice, and document and data analytics to major law firms, Fortune 500 corporations, government agencies, and regulatory bodies around the world. He is a member of BRG's Capital Markets Practice, where he specializes in the regulation of, and securities trading by, broker-dealers, investment advisers, hedge funds, insurance companies, and banks. He consults with and provides expert testimony on behalf of clients in a wide variety of areas relating to securities fraud, Ponzi schemes, securities market regulation, internal control risk policies, regulations of Futures Commission Merchants, and commodities trading regulation. He also conducts internal investigations and serves as a compliance monitor for firms that have entered into deferred prosecution agreements and similar arrangements with government agencies. Prior to BRG, Kotz served for over four years as the Inspector General of the Securities and Exchange Commission (SEC).

CHAPTER 1Jurisdiction of Regulators – Who Regulates Whom and What

Compliance professionals face a myriad of overlapping and confusing regulations and regulators. In the aftermath of the financial crisis, new regulations and increased aggressiveness on the part of regulators have led to growing demands placed on financial firms. The volume and pace of regulatory change has created new and diverse pressures on compliance functions. A primary reason for the overlapping nature of the regulations is that traditionally, financial regulation has evolved through a series of responses to developments and crises in the financial markets. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank” Act), enacted on July 21, 2010, offered some of the most sweeping and comprehensive changes to the financial industry since the Great Depression. The chief impetus for the enactment of the Dodd-Frank Act was the perception that deregulation allowed and encouraged Wall Street to indulge in excesses, resulting in the financial crisis.

Over the years, the financial regulatory system has been modified to address various sources of potential financial instability and attempt to provide regulation and a structure for areas with purported regulatory gaps. With each new crisis, efforts are made to address perceived weaknesses in the regulatory system. The result is a complex regulatory system in which federal Agencies have overlapping jurisdictions. Furthermore, Congress has adopted self-regulation by self-regulatory organizations (“SROs”) to prevent excessive government involvement in market operations, and as a more efficient and less expensive way to conduct oversight. However, SRO oversight is, often, in addition to, not instead of, federal regulatory oversight. These structures have resulted in tremendous confusion on the part of compliance professionals whose responsibility it is to make decisions regarding the allocation of often scarce resources to compliance efforts necessitated by the overlapping regulatory schemes.

1.1 FEDERAL FINANCIAL REGULATORY STRUCTURE

The following describes the current federal financial regulatory structure, including the Agencies and the financial institutions they regulate. Federal Agencies regulate banking institutions, securities and futures exchanges, brokers, dealers, mutual funds, and investment advisers. Banking institutions are regulated by several Agencies, led by the Federal Reserve System (commonly referred to as “the Federal Reserve”), which regulates Federal Reserve Bank holding companies, financial holding companies, state banks that are members of the Federal Reserve System, U.S. branches of foreign banks, and foreign branches of U.S. banks.1 The Office of the Comptroller of the Currency (“OCC”) regulates national banks and U.S. federal branches of foreign banks. The Federal Deposit Insurance Corporation (“FDIC”) regulates federally-insured depository institutions, including state banks that are not members of the Federal Reserve System.2 The Office of Thrift Supervision (“OTS”) regulates federally chartered and insured thrift institutions and savings and loan holding companies.3 The National Credit Union Administration (“NCUA”) regulates federally-chartered or insured credit unions.4

Beyond the banking regulators, the Securities and Exchange Commission (“SEC”) regulates securities exchanges and brokers.5 Lastly, the Commodity Futures Trading Commission (“CFTC”) regulates futures exchanges and brokers.6

1.2 THE SECURITIES AND EXCHANGE COMMISSION (SEC)

Congress established the SEC in 1934 to enforce the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “Exchange Act”).7 The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.8 The SEC oversees the key components of the securities world, including securities exchanges, securities brokers and dealers, investment advisers, and mutual funds. The SEC's primary focus is to promote the disclosure of market-related information, maintain fair dealing, and protect against fraud.9

Although the SEC is the principal overseer and regulator of the U.S. securities markets, it works closely with the other federal departments and Agencies, self-regulatory organizations, state securities regulators, and various private sector organizations. For example, the Chairman of the SEC works with the Chairman of the Federal Reserve, the Secretary of the Treasury, and the Chairman of the CFTC, and serves as a member of the President's Working Group on Financial Markets.

The SEC is composed of five presidentially-appointed Commissioners, who have staggered five-year terms. By law, no more than three of the Commissioners may belong to the same political party. The Agency's functional responsibilities are organized into five divisions (Corporation Finance, Trading and Markets, Investment Management, Enforcement, and Economic and Risk Analysis) and 23 offices, headquartered in Washington, D.C.10

The SEC's Division of Corporation Finance oversees corporate disclosure of information to the investing public. Corporations are required to comply with regulations pertaining to disclosure that must be made when stock is initially sold and then on a continuing and periodic basis. Corporation Finance (known as “CorpFin”) reviews the disclosure documents filed by companies. CorpFin also provides companies with assistance interpreting the Commission's regulations and recommends to the Commission new rules for adoption.11

The SEC's Division of Trading and Markets is responsible for maintaining fair, orderly, and efficient markets. Trading and Markets provides day-to-day oversight of the major securities market participants: the securities exchanges; securities firms; self-regulatory organizations; clearing Agencies that help facilitate trade settlement; transfer agents, parties that maintain records of securities owners; securities information processors; and credit rating Agencies. This Division also oversees the Securities Investor Protection Corporation (“SIPC”), which is a private, non-profit corporation that insures the securities and cash in customer accounts of member brokerage firms against the failure of those firms.12

The SEC's Division of Investment Management is involved in investor protection and promoting capital formation through oversight and regulation of America's $26 trillion investment management industry. This industry includes mutual funds and the professional fund managers who advise them; analysts who research individual assets and asset classes; and investment advisers to individual customers. Investment Management focuses on ensuring that disclosures about these investments are useful to retail customers, and that the regulatory costs which consumers must bear are not excessive.13

The Division of Enforcement is the law enforcement component of the SEC. It recommends the commencement of investigations of securities law violations, whether as civil actions in federal court or as administrative proceedings before an administrative law judge, and prosecutes these cases on behalf of the Commission. Enforcement also works closely with law enforcement Agencies such as the Department of Justice to bring criminal cases. Enforcement obtains evidence of possible violations of the securities laws from many sources, including market surveillance activities, investor tips and complaints, other divisions and offices of the SEC, and the self-regulatory organizations and other securities industry sources.14

The SEC's Division of Economic and Risk Analysis (known as “RiskFin”) is involved with integrating economic analysis and data analytics into the work of the SEC. RiskFin helps to inform the SEC's policymaking, rulemaking, enforcement, and examinations.15

The offices within the SEC include, among others, the Office of the General Counsel, Office of the Chief Accountant, Office of Credit Ratings, Office of International Affairs, Office of Investor Education and Advocacy, and Office of Compliance Inspections and Examinations (“OCIE”). OCIE administers the SEC's examination and inspection program for registered broker-dealers, transfer agents, clearing Agencies, investment companies, and investment advisers. OCIE conducts inspections to foster compliance of the securities laws and to detect violations of the law. When OCIE finds deficiencies, it issues a “deficiency letter” identifying the problems that need to be rectified and monitors the situation until compliance standards are achieved. Violations that are considered serious are referred to the Division of Enforcement. OCIE also examines SROs including national stock exchanges (such as the New York Stock Exchange, NASDAQ, and Chicago Options Board Exchange), registered clearing Agencies, the Municipal Securities Rulemaking Board and the Financial Industry Regulatory Authority (“FINRA”).16

OCIE oversees FINRA and the other SROs to ensure that they and their members comply with applicable federal securities laws and SRO rules. Consistent with its oversight responsibilities for other SROs, the SEC is responsible for ensuring that FINRA carries out its regulatory responsibilities related to oversight of broker-dealers. The SEC also oversees the adoption of rules and the administration of discipline by SROs such as FINRA. These requirements include that an SRO file a proposed rule change with SEC and publish it on a publicly available website. The SEC then sends a notice of the proposed rule change to the Federal Register and allows interested persons the opportunity to submit written comments concerning the proposed rule change. Concurrently, the SEC reviews the proposed rule change and, if applicable, considers public comments and the SRO's response. The SEC then determines whether the proposed rule change is consistent with the requirements of the applicable statutes and regulations and if appropriate, approves the rule change.

As regulators, SROs, like FINRA, have responsibility for much of the day-to-day oversight of the securities markets and broker-dealers under their jurisdiction. Specifically, SROs are primarily responsible for establishing the standards under which their members conduct business; monitoring the way that business is conducted; and bringing disciplinary actions against their members for violating applicable federal statutes, SEC rules, and their own rules.

1.3 THE FINANCIAL INDUSTRY REGULATORY AUTHORITY (FINRA)

FINRA is the only registered national securities association and has regulatory oversight of all securities broker-dealers doing business with the public in the United States. FINRA's mission is to safeguard the investing public against fraud and bad practices. All brokers must be licensed and registered by FINRA, pass qualification exams, and satisfy continuing education requirements. FINRA conducts routine examinations, as well as inquiries based on investor complaints and suspicious activity. It also reviews all broker advertisements, websites, sales brochures, and other communications to make sure brokers present information in a fair and balanced manner. FINRA also monitors trading in the U.S. stock markets.17

FINRA has an enforcement program that brings discipline where it believes that investors have been harmed. FINRA investigations are non-public and confidential, and firms and individuals are entitled to be represented by counsel. To conduct its investigations, FINRA requests documents and takes sworn testimony from firms and associated persons. FINRA may also contact customers and other individuals who are not within FINRA's jurisdiction to learn about the member firms' activities and who may provide information voluntarily to FINRA. FINRA then analyzes the evidence it obtained, reviews the applicable law, and makes a preliminary determination of whether or not a violation appears to have occurred. If FINRA determines that rules have been violated, it will resolve whether the conduct merits a recommendation of formal disciplinary action. If the violation is of a minor nature where there is an absence of customer harm or detrimental market impact, the matter may be settled with an informal disciplinary action. Otherwise, FINRA will proceed through a more formal route by commencing a full-blown Enforcement proceeding. In 2014, FINRA brought 1,397 disciplinary actions against registered individuals and firms, levied fines totaling more than $134 million, and ordered restitution of more than $32.3 million to harmed investors.18

FINRA also provides investor education through the implementation of programs like BrokerCheck, which gives investors a quick way to check a broker's disciplinary and professional background. In FINRA's Market Data Center, investors can find information and data on equities, options, bonds, and mutual funds.19 FINRA's Trade Reporting and Compliance Engine (“TRACE”) system helps investors monitor their bond investments by providing them with timely and accurate pricing information for corporate and Agency bonds.20 FINRA also has a dispute resolution forum, which is the largest in the country for the securities industry, handling nearly 100 percent of securities-related arbitrations and mediations from more than 70 hearing locations – including at least one in all 50 states, London, and Puerto Rico.21

1.4 THE COMMODITY FUTURES TRADING COMMISSION (CFTC)

The SEC's counterpart for futures exchanges and brokers is the CFTC. The CFTC is an independent Agency of the United States government that regulates futures and options markets. The stated mission of the CFTC is “to protect market participants and the public from fraud, manipulation, abusive practices, and systemic risk related to derivatives – both futures and swaps – and to foster transparent, open, competitive and financially sound markets.”22 The CFTC states that it carries out this mission by “polic[ing] the derivatives markets for various abuses and works to ensure the protection of customer funds.”23

In carrying out this mission, the CFTC polices the derivatives markets for various abuses and works to ensure the protection of customer funds. The CFTC also oversees designated contract markets, swap execution facilities, derivatives clearing organizations, swap data repositories, swap dealers, futures commission merchants, commodity pool operators, and other intermediaries.

The CFTC is composed of three major divisions: Market Oversight, Clearing and Intermediary Oversight, and Enforcement. The CFTC's Division of Market Oversight ensures that the futures markets are operating efficiently without manipulation and fraud. These tasks are executed first by reviewing and analyzing the very diverse group of instruments and products to ensure that they are not susceptible to manipulation. Market Oversight also conducts active market and trade practice surveillance of trading activity on designated contract markets (known as “DCMs”), like the New York Mercantile Exchange. Traders establishing positions on DCMs are subject to reporting requirements so the CFTC can evaluate position sizes to detect and deter manipulation. Market Oversight monitors the activities of large traders, key price relationships, and relevant supply and demand factors for the estimated 1,400 active futures and option contracts in the country to ensure market integrity. In addition, CFTC surveillance economists prepare weekly summary reports for futures and option contracts approaching their expiration periods.