Fixed Income Conference March 12, 2013 2013 by FINRA. All Rights Reserved. The FINRA Fixed Income Conference Video is reproduced by permission of the Financial Industry Regulatory Authority, Inc. (FINRA) under a non-exclusive license and may not be rebroadcasted, reproduced, or repurposed without the express written consent of FINRA. FINRA is not responsible for any errors in or omissions from the information contained in the FINRA Fixed Income Conference Video. All such information is provided "as is" without warranty of any kind and FINRA makes no representations and disclaims all express, implied and statutory warranties of any kind to the user and/or any third party, including any warranties of accuracy, timeliness, completeness, merchantability and fitness for any particular purpose. FINRA reserves the right to amend the Fixed Income Conference Video at its discretion.
Rulemaking Developments
Markups, Commissions and Fees Proposed FINRA Rules Current NASD Rules FINRA Rule 2121 --------- Rule 2440, IM-2440-1(the parts being transferred) FINRA Rule 2122 --------- Rule IM-2440-2 FINRA Rule 2123 --------- Rule 2430 1
Markups, Commissions and Fees Government Securities / Treasury Securities Extend the proposed markup rules to transactions in government securities (except Treasury securities) (Proposed amendments to FINRA Rule 0150) Question: Should the proposal include an additional extension Extend the proposed markup rules to Treasury securities or address issues under FINRA s Rule 2010? 2
Markups, Commissions and Fees Retention of the five percent guidance Establish a rebuttable presumption that a markup, markdown or commission in excess of five percent is unfair and unreasonable. Revision of certain factors used to determine reasonableness of markups and commissions Disclosure as a factor requirements Elimination of the proposed requirement to provide equity commission schedule(s) 3
Markups, Commissions and Fees Markup Case: Department of Enforcement v. R.D. Capital Group, Inc. and Ramon Luis Dominguez, Disc. Proc. E072005002901 (Order Accepting Settlement), April 17, 2009. Product: Treasury strips Customers: Two institutions and one natural person 4
Debt Research Proposal Tiered structure Retail debt research Institutional debt research Managing conflicts between debt research and investment banking and sales and trading Prepublication review Supervision Coverage input Budget determinations Analyst compensation 5
Debt Research Proposal Content and disclosures Communications between research and sales and trading Exemptions for limited investment banking and principal trading activity 6
Debt Research Proposal Comments Definition of institutional investor QIB plus FINRA Rule 2111 suitability standard can receive institutional debt research by negative consent Other 4512(c) institutions must affirmatively opt out of full protections Firewalls between research and those involved in principal trading activities Budget Evaluation and compensation CFTC approach 7
Conference resumes at 10:30 a.m. View related resources on finra.org: Report Center Secure access to data and reports designed to support firms compliance activities MSRB G-32 Report Card Municipal Continuing Disclosure Report Municipal Primary Offering Disclosure Report TRACE Quality of Markets Report Cards www.finra.org/reportcenter
Municipal Securities
FINRA Fixed Income Conference Peg Henry - Senior Vice President and Assistant General Counsel March 12, 2013 Jefferies & Company, Inc. Member SIPC
Table of Contents SEC Report on Municipal Securities 1 Municipal Advisor Regulation 4 Jefferies & Company, Inc. / January 2013 i
SEC Report on Municipal Securities Jefferies & Company, Inc. / January 2013 1
The Commission and the MSRB could consider ways to encourage the use of ATSs or similar electronic networks that widely disseminate quotes and provide fair access Possible Proposals: Require municipal bond dealers to affirmatively offer retail customers the option of exposing their orders on one or more ATSs that widely disseminate quotes and provide fair access. Another alternative that could be considered is requiring a municipal bond dealer to expose a retail customer order on one or more of these ATSs before it executes as principal, unless the customer affirmatively opts out of this process. The MSRB should consider a rule that would require municipal bond dealers to seek best execution of customer orders for municipal securities: Incorporate a best execution obligation into MSRB rules and providing related guidance, similar to FINRA s approach to corporate fixed income securities. Jefferies & Company, Inc. / January 2013 2
Considerations Regarding SEC Report FINRA s best ex rule (5310) requires a dealer to use reasonable diligence to ascertain the best market for transactions with customers for equities and corporate debt securities. The rule is geared to larger trades in more liquid corporate securities and discourages the use of broker s brokers. Even so, relative liquidity and the size of a transaction are factors to be considered in determining whether a dealer has satisfied its reasonable diligence obligation. Seventy-five percent of municipal securities on ATSs and broker s brokers never trade. Many dealers use them solely for price discovery purposes. MSRB s Interpretive Notice on the obligations of dealers that use broker s brokers discourages the use of broker s brokers solely for price discovery purposes. Could be Rule G-17 violation. Is the SEC proposal inconsistent with this Notice? Jefferies & Company, Inc. / January 2013 3
Municipal Advisor Regulation Jefferies & Company, Inc. / January 2013 4
MSRB Rule G-23 Considerations Prohibits dealers from switching from issuer s financial advisor to the underwriter on same issue of municipal securities. Does not apply when dealer is financial advisor to a conduit borrower. Does not apply to loans. Important to distinguish between loans and securities. Required G-23 disclosure on role of the underwriter must be made at earliest stages of relationship with issuer. Cannot wait until the G-17 letter is sent. Jefferies & Company, Inc. / January 2013 5
Fiduciary Duty Federal fiduciary duty of municipal advisors took effect October 1, 2010. State law fiduciary duty already applied. Applies to municipal advisory relationships with issuers, not conduit borrowers. However, MSRB Rule G-17 (on fair dealing) and, possibly, state fiduciary duty laws apply to advisors of conduit borrowers. Principles of fiduciary duty described in proposed MSRB interpretive notice almost all based on case law involving breach of fiduciary duty by dealer FAs. Exception is restriction on acting as a principal. Duty of loyalty and duty of care are basic components of fiduciary duty. Under duty of loyalty, must disclose conflicts and be able to manage them. Under duty of care, must not take on assignments for which not qualified. Jefferies & Company, Inc. / January 2013 6
Conference resumes at 1:00 p.m. View related resources on finra.org: FINRA Annual Conference May 20 22, 2013 Washington, DC Features over 30 sessions on regulatory and compliance topics, including fixed-income related topics: Municipal Securities Update Research Rule Developments Fixed Income www.finra.org/annualconference
TRACE Update
Conference resumes at 2:30 p.m. View related resources on finra.org: TRACE Fact Book An historical perspective on the OTC U.S. corporate and agency bond markets Fact Book features: Market performance indicators Ranking of the most actively traded issues Transaction and par value data www.finra.org/trace/factbook
Examination and Enforcement
Market Regulation
TRACE Corporate and Agency Transaction Reporting Sweeps Late reporting Excessive commissions Dealer mismatch / under or misreporting Negative yields Contra execution times Large (blocks) and late FINRA Rule 6760. Underwriter Late Notice 2
ABS, MBS, CMO and TBA Transaction Reporting Sweeps Late reporting Excessive commissions Dealer mismatch / under or misreporting Contra execution times FINRA Rule 6760. Underwriter Late Notice 3
Municipal Transaction Reporting Sweeps Late reporting Negative yield Excessive commissions Time of trade Large (blocks) and late Contra execution times Mismatched destination codes Late submissions to SHORT 4
Fixed Income Investigations Fair pricing Best execution Daisy chains Wash sales Parking Trading ahead 5
Market Regulation Legal Section
Legal Section Who We Are Lawyers located in Maryland, New York, Illinois and Pennsylvania 21 staff attorneys in Rockville 15 staff attorneys in New York One staff attorney in Chicago One staff attorney in Philadelphia Staff attorneys report to one of six chief counsels located in Rockville (3) and New York (3) Head of Legal is Robert Marchman and Deputy is David Rosenstein 7
Legal Section What We Do Bring enforcement cases on behalf of Quality of Markets Department (includes Fixed Income) Enforcement cases relate to customer protection, sales practice and market integrity issues 8
Legal Section What We Do Snapshot of 2012 Resolved over 350 matters Fines for TRACE reporting violations were more than $2 million Fines for fair pricing and best execution violations for TRACEeligible products were more than $2.5 million Fines for MSRB reporting and pricing violations were over $1.2 million Restitution paid to customers was almost $900,000 9
Overview of Disciplinary Process Disciplinary process milestones Initial notification to firm that matter referred to legal Staff attorneys review alleged violations and entire file gathered to date including 8210 correspondence with the firm Firm offered opportunity to make Wells submission Staff attorneys recommend outcomes in accordance with FINRA s published Sanctions Guidelines Scope and duration of violations Whether firm had reasonable supervisory controls in place Whether misconduct was due to intentional, reckless or negligent acts Other considerations published in FINRA s Sanction Guidelines Recommendations are reviewed by management for reasonableness and consistency 10
Overview of Disciplinary Process Disciplinary process factors considered Staff attorneys consider all factors put forth by the firm, including: the firm s disciplinary history, the firm s subsequent performance in connection with rule violations being considered, the firm s non-compliance rate, and performance as compared to peer group. 11
Investigations Conduct investigations in more egregious matters Many investigations focus on fair pricing and best execution rule compliance. May involve on the record testimony of traders, representatives and supervisors. Staff attorneys may also examine the firm s supervisory policies, procedures and systems. 12
Factors Considered in Fixed Income Matters Fair pricing matters Factors outlined in NASD Rule 2440 and MSRB Rule G-30 Firm s pricing compared to industry outliers identified Magnitude of difference between firm s markup / markdown and those charged by other market participants Best execution matters Reasonableness standard Steps taken by firm to arrive at price to customer Documentation to support such steps are relevant Extent of violations isolated versus systemic violations Effect and extent of market factors such as market volatility and liquidity 13
Factors Considered in Fixed Income Matters Transaction reporting Number of violations absolute numbers Non-compliance percentage rates Non-compliance rates compared to peer firms Systemic non-compliance evidenced by poor disciplinary history and subsequent performance Sufficiency of firm s written supervisory procedures (WPSs) Evidence of firm s enforcement of WSPs 14
2012 Significant Matters Citi International Financial Services LLC Firm cited for violations of fair pricing and best execution rules. Firm also cited for supervisory failures of pricing and best execution policies. Conduct occurred from July 1, 2007 through September 30, 2010. Firm conducted internal investigation on its own accord and agreed to pay restitution in the amount of more than $640,000 for more than 3,600 fixed income transactions. Firm fined $350,000 for combined pricing and best execution violations and $250,000 for supervision violations. Firm required to revise its WSPs. 15
2012 Significant Matters Citigroup Global Markets, Inc. TRACE reporting violations including late reporting, overreporting, failure to report and inaccurate reporting. Staff attorney factored the breadth of firm s recidivism and length of conduct (various periods from July 1, 2007 through December 31, 2010). Also factored were steps taken by firm to enhance its supervisory procedures for fixed income reporting and hiring of independent consultant to review firm s TRACE reporting. Firm fined $900,000. 16
2012 Significant Matters David Lerner Associates, Inc. (DLA) DLA targeted unsophisticated customers to sell illiquid real estate investment trusts (REITs). Joint investigation conducted by Department of Enforcement and Department of Market Regulation. Firm ordered to pay approximately $12 million in restitution. Firm fined $2.3 million for charging unfair prices on certain fixed income instruments in violation of MSRB Rule G-30 and NASD Rule 2440. Market Regulation obtained close to $600,000 in restitution payments. Firm required to hire independent consultant to review the firm s markup and best execution policies. 17
Member Regulation
FINRA MSRB Collaboration Dodd-Frank amendments to Securities Exchange Act Section 15B state that the MSRB may provide FINRA guidance and assistance in the enforcement of, and examination for, compliance with MSRB rules. FINRA, SEC and MSRB are also required to meet twice per year to describe their work involving the regulation of municipal securities and to share information about rule interpretations and the examination and enforcement of MSRB rules. In reality, we meet formally and informally on a much more frequent basis. 19
FINRA MSRB Collaboration Staff meet on a bi-monthly basis to discuss regulatory and technology issues, such as rulemaking and information sharing. Ad hoc meetings occur on a much more frequent basis to discuss novel examination findings and to ensure proper application of MSRB rules. FINRA and MSRB work in close consultation to develop annual exam priorities and to develop the risk-based exam model. 20
Overview of Risk-Based Municipal Exam Initiative MSRB Rule G-16 amendments effective December 16, 2011, permitted FINRA to extend its risk-based exam approach to municipal securities firms. Quantitative and qualitative analysis of each firm s activities results in assignment of a 1, 2, 3 or 4-year municipal exam cycle. In 2012, 595 municipal exams were conducted versus 846 in 2011. Fifty-nine firms were on an annual exam cycle in 2012. Sixty-two firms are on an annual exam cycle in 2013. 21
2013 Municipal Exam Program Exam priorities adjusted as necessary to address new market risks and/or implementation of new rules. Current priorities include: Unfair pricing, including by broker s brokers Disclosure of material facts in secondary market transactions Gifts, gratuities and political contributions Retail order periods and other issuer instructions Supervision and supervisory controls Electronic trading and brokerage Suitability Disclosure to issuers of risks and conflicts of interest Dedicated municipal exam team in New York District 22
2012 Exam Findings The most frequently cited MSRB rules included: G-27 Supervision G-14 Transaction Reporting G-8 Recordkeeping G-41 Anti-Money Laundering G-32 Submission of Primary Offering Documents to EMMA and Delivery of Official Statements to Customers G-17 Fair Dealing G-30 Fair Prices and Commissions G-15 Customer Confirmations 23
2012 Exam Findings General fixed income exam findings included: TRACE reporting exceptions Excessive markups / markdowns in TRACE-reportable securities Fixed income research exceptions Unsuitable recommendations of complex and structured products 24
Enforcement
Enforcement Priorities Municipal underwriting Unfair practices Ratings trips and entertainment Solicitation of municipal underwriting Markups on fixed income securities transactions Structured products Sales practice issues, especially suitability and disclosures Training and supervision of staff 26
ROOR
ROOR Update 2013 examination priorities Examination issues Reporting and interpretative issues 28
Conference resumes at 4:15 p.m. View related resources on finra.org: FINRA Annual Regulatory and Examination Priorities Letter View letters from 2006 to 2012 www.finra.org/exampriorities
Retail Sales Suitability and Disclosure