SECURITIES ENFORCEMENT

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1 THE CORPORATE & SECURITIES LAW ADVISOR THE CORPORATE & SECURITIES LAW ADVISOR Volume 20 Number 12, December 2006 SECURITIES ENFORCEMENT How to Succeed at Settling SEC and NASD Enforcement Actions by Katherine A. Schulze, Brian L. Rubin, and Olga Greenberg Congratulations! You ve decided to settle with the regulators. One question remains: Now what? Every year, thousands of regulated entities and individuals settle with the Securities and Exchange Commission and NASD. Indeed, the vast majority of enforcement actions result in settlements. 1 The agreement to settle often follows months, or even years, of a long, expensive, and arduous process involving inspections or examinations, document and review and Katherine A. Schulze is currently an attorney for a financial services company. Previously, she was a Senior Counsel in the SEC s Division of Enforcement and a trial attorney with the Department of Justice. Brian L. Rubin is a partner with Sutherland Asbill & Brennan LLP. Previously, he was NASD s Deputy Chief Counsel in the Department of Enforcement and was a Senior Counsel in the SEC s Enforcement Division. Olga Greenberg is an associate with Sutherland Asbill & Brennan LLP. This article is published for informational purposes only the views and conclusions expressed in the article are those of the individual authors and not of the firm, and are not intended to constitute legal advice or a recommended course of action for any individual or organization. production, and testimony. While many people think that a decision to settle an SEC administrative proceeding or an NASD disciplinary proceeding represents the end, it is often only the beginning. Certain issues that investment advisers, broker-dealers, and associated individuals (known in settlement documents as respondents), or their attorneys, should consider when negotiating an Order Instituting Proceedings (OIP) in SEC settlements or a Letter of Acceptance, Waiver and Consent (AWC) in NASD settlements are highlighted below. (The SEC can also file a civil action in Federal Court, although such proceedings are less common than administrative proceedings when a regulated entity or individual is involved.) Each settlement, of course, presents its own set of issues that should be carefully reviewed and analyzed because there will likely be implications outside the scope of this article. How to Negotiate the Settlement Prior to negotiating an OIP 2 or an AWC, the parties reach an agreement in principle regarding the terms of the settlement. These terms could include a penalty or fine, a cease and desist order, a bar or suspension, restitution and/ or disgorgement, periodic reporting to the regulator or oversight by an independent consultant. An agreement in principle on settlement terms may then be subject to an agreement on the exact words used in the settlement document and

2 any resulting order. Anecdotally, it appears that once parties have agreed to settlement terms, it is rare that negotiations break down solely over the words of the settlement document. Prior to settlement negotiations, it often makes sense for the respondent to decide what aspect or aspects of the settlement are most important. For example, is a fraud charge or the retention of an independent consultant to review the firm s policies and procedures a nonstarter? Or is keeping individuals out of the settlement a top priority? What kinds of sanctions are simply unacceptable? Negotiating the Charges Generally, the first issue negotiated is the alleged charges. The OIP or AWC will state that the regulator has made findings that the respondent has violated the securities laws, rules and/or regulations. The respondent neither admits nor denies the charges. Respondent should consider negotiating over these charges by arguing, as appropriate, that as a matter of fact or law (or both) the staff cannot establish its case. Negotiating the Sanctions After the parties have agreed to proposed charges, or often as part of the negotiation process, the staff will generally propose sanctions. At that point, respondents generally negotiate over the sanctions, arguing that they should be lower. To bolster the respondents arguments, it often makes sense to research prior settlements and litigated decisions to determine what sanctions have been applied historically in similar cases. The settlements themselves or summaries of them are generally available through the NASD and SEC Web sites and sometimes through commercial legal research services. AWCs must be obtained by contacting NASD directly. In addition, for NASD settlements, NASD has published the Sanction Guidelines (also available online 3 ), which provide ranges of fines, suspensions and other sanctions that NASD considers appropriate for various violations of its rules. If the staff proposes that a person be suspended or barred, respondent should consider statutory disqualification issues. NASD member firms and associated persons may become statutorily disqualified, i.e., ineligible from membership or association if, for example, they were barred or suspended by the SEC or an SRO, enjoined by courts of competent jurisdiction, or found to have made false statements in applications or proceedings before SROs. A person subject to statutory disqualification may not associate with a broker-dealer in any capacity unless and until approved to do so. Article III, Section 3(d) of NASD Bylaws permits a member firm to sponsor the association of a disqualified associated person by filing a membership continuance application (Form MC-400), 4 which initiates an eligibility proceeding. A comparable procedure, however, is not available for member firms or Investment Adviser Representatives (IARs). IARs facing a possible bar from the industry should therefore consider attempting to negotiate a right to re-apply for registration after an agreed upon period of time. Negotiating the Language Once the charges and sanctions have been agreed to, the staff generally provides a draft settlement document that the respondent has the opportunity to review and suggest edits. The language in the OIP or AWC can be very important to the respondent because, if the regulator issues a litigation release or press release, the language contained in the release will generally track the language contained in the settlement document. Thus, when negotiating over the settlement document, the parties are, in effect, also negotiating over the press release language. The respondent may therefore want to see that the language of the settlement document is based on facts discovered during the investigation, not conjecture or inferences drawn by the regulator from the investigative record. Different strategies exist for limiting the language of the settlement document. For example, if the alleged misconduct involved

3 isolated instances, the settlement document should not use general or sweeping terms. Instead of statements such as [bad] conduct occurred, the respondent should consider proposing language such as in isolated circumstances, in limited circumstances, on few occasions or specify the exact dates involved. Similarly, the respondent may desire to ensure that the settlement does not refer to parties and corporate entities that are not part of the charges. For example, a firm s corporate parent or an affiliated product provider may not have been involved with the underlying conduct, and mentioning it by name could expose that entity to bad press and/or civil litigation. In addition, if a branch manager was involved with a transaction, but is not being charged, she should probably not be mentioned in the settlement document, even by title. Respondents also should consider that the settlement document may be used against the respondent in subsequent proceedings, such as class actions, private litigation, and customer arbitrations. How to File and Amend Appropriate Forms After the settlement document is finalized and accepted, the respondent must file and amend the appropriate regulatory forms reflecting the conclusion of the regulatory action. Failure to timely file and update the necessary paperwork may result in a follow-up enforcement action. Form BD. Form BD is the Uniform Application for Broker-Dealer Registration that broker-dealers file with the SEC, self-regulatory organizations, and state jurisdictions through NASD s Central Registration Depository (CRD) system. 5 SEC and NASD evaluate the information on Form BD to determine whether a prospective broker-dealer meets the statutory requirements to engage in the securities business. 6 Item 11 of Form BD requires disclosure of regulatory and other proceedings by the broker-dealer completing the form or a control affiliate. 7 With regard to disclosure of regulatory enforcement proceedings, Form BD requires disclosure of findings made by the SEC, Commodity Futures Trading Commission, any other federal regulatory agency, state regulatory agency, foreign financial regulatory authority, self-regulatory organization or commodities exchange relating to violations of securities laws, regulations or rules, license or registration restrictions, or improper investment-related activities. 8 If the broker-dealer or control affiliate provides a Yes response to a question in Item 11 when filing Form BD or an amendment thereto, the disclosure must be supplemented with the Disclosure Reporting Page (DRP), which is attached to the Form BD. The DRP is a questionnaire that asks detailed questions relating to the disclosed event. Specifically, it asks the applicant to describe the allegations; how the matter was resolved; what, if any, sanctions were ordered; and the products at issue. If the disclosure relates to a control affiliate that is an organization or individual not registered through the CRD, the entire DRP must nonetheless be completed. If a control affiliate is registered through the CRD, the control affiliate need only complete the Regulatory Action Disclosure Reporting Page (BD) Part 1. The applicant must amend its Form BD within 30 days after the occurrence of any reportable event or if any information on Form BD becomes incomplete or inaccurate for any reason. 9 The applicant must retain a paper copy of the amendment bearing the original signature of the individual who completed the Form BD and must make it available for inspection upon a regulator s request. Forms U4 and U5. Form U4 is the Uniform Application for Securities Industry Registration or Transfer. An individual must file this form to become a registered or associated person of a broker-dealer, investment adviser or issuer of securities.

4 Similar to Form BD, Form U4 requires disclosure of regulatory and other actions. If a registered person was specifically named in an OIP or AWC, she must amend Item 14 of her Form U4 to reflect that fact by electronically filing a U4 amendment within 30 days of acceptance of the settlement document. 10 In addition, the disclosure must include details of the regulatory action, such as the nature of the allegation and the action and disposition dates, on the corresponding DRP. If an individual respondent holds more than one position at a company and its affiliates (also known as wearing different hats ), and is subject to a regulatory action for one position, that regulatory action may trigger a disclosure obligation for another position or role. Thus, for example, if someone is an officer for an investment adviser and is also a registered representative of an affiliated broker-dealer, and becomes a subject of a regulatory action while acting as an officer of the investment adviser, she will likely have to report the regulatory action on her Form U4. If the associated person is also an officer of the broker-dealer, the broker-dealer s disclosure obligations on Form BD may also be implicated. Form U5 is the Uniform Termination Notice for Securities Industry Termination. As a result of a regulatory or disciplinary action, a registered person may be terminated from associating with a broker-dealer by the firm because of the person s conduct or pursuant to a bar order. If the individual is a registered person, the firm must file a Form U5 and disclose the reasons and circumstances surrounding the termination. 11 The individual at the member firm responsible for Form U5 filings must complete the appropriate Yes responses in Item 7 to indicate whether the registered person s termination resulted from an regulatory investigation, the firm s internal review, or a criminal or regulatory action. Item 7 also requires disclosure of voluntary resignations of individuals accused of violating investment-related statutes, regulations, rules, industry standards of conduct, fraud, or failure to supervise. NASD Rule 3070 Reporting Requirements. NASD Rule 3070(a) requires that member firms report violations of securities laws, regulations and rules or standards of governmental, self-regulatory, financial or professional organizations within 10 business days of the acceptance of an OIP or AWC. 12 This report should be filed with NASD through its Regulation Filing Application system (Web CRD). Form ADV. Investment Advisers must file the Uniform Application for Investment Adviser Registration (Form ADV) to register with the SEC. Form ADV is filed electronically through the Investment Adviser Registration Depository (IARD). Part 1A of Form ADV asks a number of questions about the investment adviser, its business practices, the persons who control the investment adviser, and the persons who provide investment advice on the behalf of the investment adviser. Item 11 of Form ADV requires disclosure of the criminal, regulatory, or disciplinary history and civil actions against the investment adviser or its advisory affiliates in the past 10 years. 13 The information in Item 11 is used to determine whether to grant the application for registration, or, in the case of amendments, to revoke or place limitations on the investment adviser s activities. A Yes response to any of the items requires a filing of the appropriate DRP which, as explained previously, requires a detailed explanation of the reported event. Finally, Form ADV must be updated promptly after the happening of the reportable event. 14 How to Communicate with Employees or Agents Regulatory actions may directly or indirectly impact employees or agents. Some employees or agents may have been personally involved in the investigation by providing either documents or testimony. After the settlement is finalized, the firm s management should consider communicating

5 to these employees or agents before they read about the action in the newspaper or online, or hear about it from their clients. The firm also should consider drafting and distributing Questions & Answers as a reference tool for all of its employees and agents to describe the alleged conduct, the settlement and what the firm will do going forward. This Q&A can also be used by employees and agents as a tool to use when responding to clients and prospects. In addition, it may be advisable to inform employees and agents that press inquiries should be referred to one specific individual (e.g., the company s Public Relations Manager). How to Communicate with Clients At the conclusion of the regulatory action, the firm should consider whether it is necessary to contact clients about the settlement. If the settlement requires payments to clients, such communication will be necessary. Distributions of checks or credits to accounts should be accompanied by a brief description of the regulatory matter and the reason why the customer is receiving payment. Regardless of whether the firm needs to pay clients, the firm may want to establish a call-in telephone number for customers who have questions about the regulatory action as a result of hearing about it from the media. The firm may want to furnish a Question & Answer guide to employees answering the calls so that they provide consistent responses to customer inquiries. The firm also should consider communicating with its field force about the availability of this resource so that the field representatives can tell clients to contact the information line. How to Communicate with the Press Once a settlement document is approved, NASD or the SEC may issue a press release or litigation release explaining the case, the alleged violations, the sanctions and possibly a statement describing the importance of the action. As mentioned, such releases usually track the language of the OIP or AWC. In NASD actions, the respondent may request to review and comment on the press release prior to its distribution. The firm should decide whether it will publish its own press release. Such statements may be governed by the settlement document that often sets forth limits on the firm s ability to issue press releases or make other public statements denying the underlying allegations. For example, AWCs provide that [t]he firm may not take any action or make or permit to be made any public statement, including in regulatory filings or otherwise, denying, directly or indirectly, any allegation in this AWC or create the impression that the AWC is without factual basis. Similarly, Offers of Settlement state: Respondent agrees: (i) not to take any action or to make or permit to be made any public statement denying, directly or indirectly, any finding in the [OIP] or creating the impression that the [OIP] is without factual basis; and (ii) that upon the filing of this Offer of Settlement, Respondent hereby withdraws any papers previously filed in this proceeding to the extent that they deny, directly or indirectly, any finding in the [OIP]. When settling with NASD, the respondent may submit (together with the AWC) a Corrective Action Statement that outlines the corrective steps the respondent took to prevent future misconduct. As in the case of other public statements, the Corrective Action Statement may not deny the charges or make any statement that is inconsistent with the AWC. Without challenging the underlying allegations or charges, the firm s press release may state, for example, that the firm is pleased to have this action behind it and outline remedial steps the firm has taken or will take to prevent future misconduct. In deciding whether to issue a press release, firms should consider whether such a statement may attract additional unnecessary attention to the settlement. If the respondent decides to issue a press release, the INSIGHTS, Volume 20, Number 5, May 2006

6 respondent may possibly cite to the Corrective Action Statement and outline the steps it took to prevent future misconduct. How to Meet Net Capital Requirements Settlements also may have implications for the broker-dealer s net capital. The SEC s net capital rule requires broker-dealers to maintain a prescribed level of net liquid assets over liabilities. 15 The minimum net capital requirements range from $5,000 for introducing firms not receiving funds or securities to $250,000 for firms carrying customer accounts. At some point prior to or during the settlement discussions, the firm must ensure that it has accrued at least the amount of the fine or penalty to remain compliant with net capital requirements. The firm should consider whether the reserves comply with Statement of Financial Accounting Standards No. 5, which outlines the rules for accounting for contingencies. If the payment of the fine or penalty will be handled through a capital infusion from a parent company, the firm should consider executing an expense sharing agreement between the firm and the parent company. 16 If the firm is out of compliance with net capital obligations after making the payment, it must suspend all business operations and raise more capital to satisfy the net capital rule. Pursuant to Exchange Act Rule 15c3-1, NASD and SEC may pursue actions against member firms for violations of the Net Capital Rule, even if the violation is the result of a delay in a capital infusion from a parent company. How to Try to Prevent a Future Violation During investigations, it is often appropriate for firms to review their policies and procedures to determine whether the staff has a basis to bring a case and whether the firm should institute changes to prevent future recurrences. This analysis may play an important role during settlement negotiations. As mentioned, one of the proposed settlement terms could be that the firm retain an independent consultant. If the firm has already implemented changes, the firm may argue that an independent consultant is not necessary. If the firm has not yet implemented the changes, the firm should consider putting in place a corrective action plan that identifies deadlines and deliverables. The corrective plan s oversight should probably be assigned to a specific individual who may submit a progress report to management either at different stages of action or on completion. Regardless of whether the parties are negotiating over the retention of an independent consultant or whether the firm implements a corrective action plan, firms should timely implement the necessary changes because future sanctions will likely be greater if regulators find similar violations during subsequent investigations. * * * Congratulations! You ve successfully settled a regulatory action. One thought remains: I hope I never have to go through this again. NOTES 1. See NASD 2005: Year in Review (Dec. 27, 2005), available at ; NASD 2004: Year in Review (Dec. 29, 2004), available at NASDW_012858; cf. SEC 2005 Annual Report, available at sec.gov/about/secpar/secpar2005.pdf, (citing 2004 and 2005 statistics of cases successfully resolved, which includes settled and litigated cases won by the SEC). 2. Prior to the issuance of the final OIP, a respondent who intends to settle with the SEC generally submits to the SEC an Offer of Settlement which, without admitting or denying the violations, consents to the penalties and the misconduct alleged in the proposed OIP. 3. NASD Sanction Guidelines, available at Enforcement/NASDEnforcementMarketRegulation/NASDSanction Guidelines/index.htm pdf#search=%22form%20mc-400% See generally, NASD Rule Control affiliate is defined in the Explanation of Terms section of Form BD. With respect to Item 11, a broker-dealer must disclose regulatory actions brought against its parent and subsidiary companies (i.e., entities with which it has a vertical relationship ) and its sister broker-dealers and

7 investment advisers (i.e., those entities with which it has a horizontal or under common control relationship). 8. See Item 11 on Form BD for an exhaustive list of reportable events. 9. NASD Bylaws, Article IV, Sec. 1(c). 10. NASD Bylaws, Article V, Sec. 2(c). 11. Form U-5 is the Uniform Termination Notice for Securities Industry Registrations used by broker-dealers, investment advisers and issuers of securities to terminate the registration of an individual with state jurisdictions and SROs. 12. NASD Rule 3070 (a)(1). 13. Advisory affiliates are all of the investment adviser s (1) current employees (other than employees performing only clerical, administrative, support or similar functions) and investment adviser representatives; (2) officers, partners, or directors (or any person performing similar functions); and (3) all persons directly or indirectly controlling the investment adviser or are being controlled by the investment adviser. This definition only includes parent or subsidiary entities with which the investment adviser has a vertical or parent-child relationship. 14. Form ADV does not define promptly. One SEC settlement on point states that filing an amendment more than 11 months after a reportable event occurred is not prompt within the meaning of Form ADV. See In re Deprince, Invest t Advisers Act Rel. No. 2035, 2002 SEC Lexis 1517, at *2 3 (June 12, 2002). Another SEC settlement states that the respondent firm s failure to amend Form BD for 25 days to reflect that the firm was no longer clearing its transactions through its clearing agent was not prompt within the meaning of Form BD. See In re R.E. Bolton, Exchange Act Rel. No , 1983 SEC Lexis 354, at *5 (Nov. 14, 1983) C.F.R c See NASD Notice to Members (2003), available at pdf. Reprinted from Insights December 2006, Volume 20, Number 12, pages 11 to 16, with permission from Aspen Publishers, Inc., a Wolters Kluwer business, New York, NY, ,