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Form U4 and Form U5 | Information About the Uniform Registration Forms for Broker-Dealers and Investment Advisors

Purpose of the Forms and Discussion of Recently Approved Changes & Requirements

The Financial Industry Regulatory Authority (FINRA), is the largest independent regulator for all securities firms doing business in the United States, and is the entity designated as the filing depository by the U.S. Securities and Exchange Commission for purposes of the Investment Advisers Act of 1940. There are currently six different Uniform Registration Forms that are used to file information with FINRA. The Form U4 (Uniform Application for Broker-Dealer Registration) and the Form U5 (Uniform Termination Notice for Security Industry Registration) are used by broker-dealers to register, and terminate the registrations of, associated persons with self-regulatory organizations (SROs), and jurisdictions.

Representatives of broker-dealers and investment advisers use Form U4 to register with the states and with self-regulatory organizations (e.g., FINRA). Forms are filed electronically by their employing firms using the Central Registration Depository (Web CRD or IARD). Broker-dealer agents and investment adviser representatives have an obligation to update previously filed Forms U4 with any new information required to be disclosed. FINRA makes information filed on Form U4 publicly available through its BrokerCheck program.

Broker-dealers and investment advisers use Form U5 to terminate a representative’s registration in a particular jurisdiction or with a particular self-regulatory organization. Firms terminating the registration of an associated person must respond to a series of disclosure questions. Firms also have the obligation to update previously filed Forms U5 if they become aware of new disclosure information.

As discussed above, Form U4 and Form U5 filings (initial applications. termination notices, and amendments) will generally be made electronically through Web CRD or IARD. However, some individuals may need to file the form on paper, including: agents of issuers, certain persons filing with stock exchanges, and certain investment adviser representatives. In addition, NASD Rule 1013 requires the submission of certain paper Forms U4 along with an initial membership application.

The SEC recently approved amendments to Forms U4 and U5 that were proposed by FINRA that call for significant changes to disclosure questions on the Forms, including the addition of questions about certain regulatory actions. The new amendments to the Forms include:

New regulatory action questions that will enable FINRA and other regulators to identify more readily persons subject to a particular category of “statutory disqualification” under the federal securities laws and the FINRA By-Laws. Among the items that would cause a person to become subject to a statutory disqualification are “willful” violations of the federal securities laws, the Commodity Exchange Act, or the rules of the Municipal Securities Rulemaking Board. Under the proposed rule changes, both Forms U4 and U5 would be amended to add questions requiring disclosure of findings of “willful” violations.
New questions that require firms to report allegations of sales practice violations made against a registered person in an arbitration or litigation in which the registered person is not a named party. Under the new amendment, reporting would be required if the registered person was either named in or could reasonably be identified from the body of the arbitration claim or civil litigation as a registered person who was involved in one or more of the alleged sales practice violations.
An increase in the monetary threshold for reporting settlements of customer complaints, arbitrations or litigation from $10,000 to $15,000.
The clarification that the date to be provided by a firm in the “date of termination” field is the “date the firm terminated the individual’s association with the firm in a capacity for which registration is required.” Under the new amendment, a firm would be permitted to change the date of and reason for termination, but would be required to state a reason for the change.

The revised Forms were implemented in Web CRD on May 18, 2009. The effective date for most of these changes is May 18, 2009 (the “release date”). The effective date for the new regulatory action disclosure questions will be 180 days from the release date, or November 14, 2009.

Key Items Regarding the Forms Changes:

Invalidation of Pending Form Filings Upon Web CRD System Shutdown:

Implementation of the revised “form versions” will cause all pending (in-process) Form U4 and U5 filings that are not submitted to Web CRD prior to system shutdown on Friday, May 15, 2009, to become invalidated (i.e., converted to a read-only mode). Firm users that still need to submit the information on those invalidated filings will need to recreate the filings using the new forms.

Form U4 Amendments Required:

All registered persons are required to answer new regulatory action disclosure summary questions the next time they file a Form U4 amendment or no later than 180 days following the release date.

Copies of the revised Forms and instructions are available here.

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Congress and Regulators Discuss OTC Derivatives Regulation

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Increased regulation looming as SEC and CFTC jockey for position

The severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation, as well as the pressing need for a comprehensive regulatory framework. Part of President Obama’s new financial regulation plan is to regulate the over the counter (OTC) derivatives markets. On June 22nd, 2009, both the SEC and CFTC testified to congress regarding the regulation of these markets.

Chairman Mary Shapiro (SEC) and Chairman Gary Gensler (CTFC) each testified before Congress to address the existing gaps in regulatory oversight of these securities-related OTC derivatives, and propose a new framework that would provide expand regulatory authority of the CTFC and SEC to oversee the OTC markets. The primary goal of the proposed regulatory reform measures is to achieve the following four primary objectives:

preventing activities in the OTC derivatives markets from posing risk to the financial system;
promoting efficiency and transparency of those markets;
preventing market manipulation, fraud, and other market abuses; and
ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

I have reprinted the entire SEC testimony and CFTC testimony below.

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Testimony Concerning Regulation of Over-The-Counter Derivatives
by Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission
Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing and Urban Affairs
United States Senate
June 22, 2009

I. Introduction

Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee:

I am pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission concerning the regulation of over-the-counter (“OTC”) derivatives. The severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation. One of these is the gap in regulation of OTC derivatives, which under current law are largely excluded or exempted from regulation. The SEC is committed to working closely with this Committee, the Congress, the Administration, and fellow regulatory agencies to close this gap and restore a sound structure for U.S. financial regulation.

My testimony today on the regulation of OTC derivatives will reflect the SEC’s perspective as the country’s capital markets regulator. First, I will give an overview of the OTC derivatives markets, with particular focus on those derivatives products that are directly related to or based on securities or issuers of securities and therefore directly connected with the SEC’s statutory mandate. Second, I will outline an approach that would address the existing gaps in regulatory oversight of these securities-related OTC derivatives.

I must tell you right at the start that, given the current limited regulation of OTC derivatives, no regulatory authority can give you a complete picture of OTC derivatives and how they have affected the regulated securities markets. One reason that we need legislation is that our sources of information about securities-related OTC derivatives products, participants, and trading are limited, particularly when contrasted with the tools we have to monitor the markets for other securities products subject to the federal securities laws.

The good news, however, is that the U.S. regulatory authorities have reached a broad consensus on the pressing need for a comprehensive regulatory framework for OTC derivatives. As reflected in Treasury Secretary Geithner’s letter to the Congressional leadership on May 13, 2009, this consensus covers all of the basics of sound financial regulation in the 21st century, including recordkeeping and reporting requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing.

One important aspect of a new regulatory framework will be well-regulated central counterparties (“CCPs”). CCPs address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. For this reason, CCPs contribute generally to the goal of market stability. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, CCPs help protect the broader financial system. It is important to note that achieving standardization, a prerequisite for centralized clearing, may present significant challenges.

U.S. regulators agree on the objectives of a new regulatory framework for OTC derivatives that will protect the public interest, manage systemic risk, and promote capital formation and general economic welfare. Any new regulatory framework, however, should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk. My goal today is to assist the Congress as best I can in its efforts to craft legislation that empowers the respective regulatory authorities to do their jobs effectively in any new framework. I am confident that, working together, we will meet the challenge that is so important to the financial well-being of individual Americans.

II. Overview of Securities-Related OTC Derivatives

A derivative is a financial instrument whose value is based on the value of an underlying “reference” (e.g., an asset such as a commodity, bond, equity, or currency, or an index of such assets, or an event). For example, in exchange for $100 today, financial institution “A” will pay counterparty “B” $150 if “something” happens (something can be almost anything: Z company defaults on its debt payments; the S&P 500 falls 10%; the Dow rises 5%). A derivative is “OTC” when it is not traded on a regulated exchange. An OTC derivative is “securities-related” when the reference is to an entity that is an issuer of securities (such as a public company), to a security itself (or a related event such as a dividend payment), to a group or index of securities or issuers, or based on related aspects of a security or group or index of securities or issuers, such as price, yield, volatility, dividend payments, or value.

An OTC derivative is an incredibly flexible product that can, essentially, be engineered to achieve almost any financial purpose between two parties. Indeed, as I will discuss later, an OTC derivative can enable market participants to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves. Transactions occurring in the OTC derivatives markets can serve important economic purposes such as allowing market participants to hedge exposure and manage risk. When market participants engage in these types of transactions in the OTC derivatives markets, the transactions, which are substantially similar to traditional securities transactions, and the parties engaged in them, would fall outside the current reach of key provisions of the federal securities laws.

OTC derivatives are largely excluded from the securities regulatory framework by the Commodity Futures Modernization Act of 2000.1 In a recent study on a type of securities-related OTC derivative known as a credit default swap, or CDS, the Government Accountability Office found that “comprehensive and consistent data on the overall market have not been readily available,” that “authoritative information about the actual size of the CDS market is generally not available,” and that regulators currently are unable “to monitor activities across the market.”

One source of information on OTC derivatives volume is the data collected by the Bank for International Settlements (“BIS”). BIS data cover the OTC derivatives exposure of major banks and dealers in the G10 countries. For all OTC derivatives in December 2008, BIS reported a notional amount outstanding of $592 trillion and a gross market value outstanding of $34 trillion. Interest rate contracts and foreign exchange contracts are the two largest sources of OTC derivatives volume. For those types of products that appear to be securities-related credit derivatives and equity derivatives in December 2008, BIS reported a notional amount outstanding of $48.4 trillion and a gross market value outstanding of $6.8 trillion. A notional amount of $70 trillion and a gross market value of $5 trillion are “unallocated” for December 2008. Clearly, this volume of largely unregulated financial activity is enormous, even when just considering the relatively small volume component that is securities-related.

Who are the major participants in the securities-related OTC derivatives markets? First, the markets are concentrated and appear to be almost exclusively “dealer-intermediated” — that is, one of a small number of major dealers is a party to almost all transactions, whether as a buyer or a seller. The customers of the dealers appear to be almost exclusively institutions. Many of these may be highly sophisticated, such as large hedge funds and other pooled short-term trading vehicles. As you know, many hedge funds have not been subject to direct regulation by the SEC and, accordingly, we have very little ability to obtain information concerning their trading activity at this point.

Other customers in the securities-related OTC derivatives markets have been institutions for which derivatives products may not be a suitable investment. In this regard, there is consensus among U.S. regulators reflected in Secretary Geithner’s letter is to ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties. The SEC and CFTC staff, together with other financial regulators, currently are considering a tiered approach to regulation, with scaling that could be based in the first instance on indicia of sophistication and financial thresholds, with requirements for additional disclosure and standards of care with respect to the marketing of derivatives to less sophisticated counterparties. Implementation of such a regulatory approach would depend on a Congressional grant of authority in this area.

Finally, what are the purposes for which securities-related OTC derivatives may be used? One example of a useful purpose for securities-related OTC derivatives is to manage the risk associated with a particular securities position. An investor with a large position in the debt of a company may seek to reduce or hedge some of the risk associated with that investment by purchasing credit protection in the CDS market. In addition, market participants also may use a securities-related OTC derivative to establish a short position with respect to the debt of a specific company. In particular, a market participant that does not own a bond or other debt instrument of a company may purchase a CDS as a way to short that company’s debt.

Market participants take positions in a wide range of exchange-traded and OTC instruments. It is a market participant’s overall (or net) economic exposure that plays a role in determining the risks to which it is exposed. Because OTC derivatives can be customized, a market participant could take a long position in an index — such as the S&P 100 index — through a securities-related OTC derivative and a short position through another OTC derivative on a subset of the securities in the S&P 100 index. The flexibility to tailor OTC derivative contracts allows a participant to create an economic exposure to as large or small a portion of the market it chooses through one or a combination of contracts. This flexibility allowed by OTC derivatives is one of these contracts’ strengths. Because of the link to regulated securities market, however, it is important that the SEC have the tools to see all related activity so that it is in the best position possible to detect and deter market abuses that can disrupt the integrity of the market.

III. Filling Regulatory Gaps in Oversight of Securities-Related OTC Derivatives

Secretary Geithner’s May 13 letter to the Congressional leadership outlined the Administration’s plan for establishing a comprehensive framework for regulating OTC derivatives. The framework is designed to achieve four broad objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

Secretary Geithner recognized that multiple federal regulatory agencies would play critical roles in implementing the proposed framework, including the SEC and the CFTC. He emphasized that the securities and commodities laws should be amended to ensure that the SEC and CFTC, consistent with their respective missions, have the necessary authority to achieve — together with the efforts of other regulators — the four policy objectives for OTC derivatives regulation.

The final part of my testimony today is intended to follow up on Secretary Geithner’s letter by recommending a straightforward and principled approach for achieving these policy objectives. Stated briefly, primary responsibility for “securities-related” OTC derivatives would be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, , would rest with the CFTC.

Under this functional and sensible approach to regulation, OTC derivatives markets that are interconnected with the regulated securities markets would be incorporated within a unified securities regulatory regime. The direct link between securities-related OTC derivatives and securities is such that SEC regulation of the former is essential to the effectiveness of the SEC’s statutory mission with respect to the securities markets. The securities regulatory regime is specifically designed to promote the Congressional objectives for capital markets, which include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. It is important that securities-related OTC derivatives be subject to the federal securities laws so that the risk of arbitrage and manipulation of interconnected markets is minimized.

Over the years, Congress has fashioned a broad and flexible regulatory regime for securities that long has accommodated a wide range of products and trading venues. The products include equities, debt, other fixed income securities, options on securities, exchange-traded funds and other investment companies, and many other types of derivative contracts on securities. Some of these securities products are among the most actively traded financial products in the world, with exchange-listed US equities currently trading approximately 11 billion shares per day. Many other securities products trade rarely, if at all. In addition, securities products trade in many different ways in a wide variety of venues, depending on the particular features of the product. These venues include 11 national securities exchanges with self-regulatory responsibilities, more than 70 alternative trading systems that execute OTC transactions, and hundreds of broker-dealers that execute OTC transactions. Finally, securities products are cleared and settled in a variety of ways depending on the particular characteristics of the product.

The current securities laws are broad and flexible enough to regulate appropriately all of these varied securities products and trading venues. The regulatory requirements are specifically tailored to reflect the particular nature of products and venues and to promote the Congressional objectives for capital markets. Accordingly, securities-related OTC derivatives could be brought under the same umbrella of oversight as the related, underlying securities markets in a relatively straightforward manner with little need to “reinvent the wheel.” Specifically, Congress could make a limited number of discrete amendments to the statutory definition of a security to cover securities-related OTC derivatives. With these definitional changes, securities-related OTC derivatives could be incorporated within an existing regulatory framework that is appropriate for these products.

The rest of my testimony will elaborate on this basic approach. I first will discuss the close relationship between the regulated securities markets and the markets for securities-related OTC derivatives and then sketch an overview of how oversight of such instruments could be integrated with the SEC’s existing oversight of the securities markets.

A. Relationship between the Securities Markets and Securities-Related OTC Derivatives

In fashioning a regulatory framework for OTC derivatives, it is crucial to recognize the close relationship between the regulated securities markets and the now mostly unregulated markets for securities-related OTC derivatives. Securities-related OTC derivatives can be used to establish either a synthetic “long” exposure to an underlying security or group of securities, or a synthetic “short” exposure to an underlying security or group of securities. In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves.

For example, an equity swap on a single equity security or on an index, such as one of the Dow stocks or the Dow itself, would give the holder of the “long” position all of the economic exposure of owning the stock or index, without actual ownership of the stock or index. This would include exposure to price movements of the stock or index, as well as any dividends or other distributions. Similarly, credit default swaps (“CDS”) can be used as synthetic substitutes for the debt securities of one or more companies. Indeed, any exchange of cash for a security can be structured as an OTC derivatives contract.

Because market participants can readily use securities-related OTC derivatives to serve as synthetic substitutes for securities, the markets for these OTC derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the federal securities laws. These objectives include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

1. Investor Protection

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and recordkeeping and reporting (including those that serve as prophylactic measures against fraud, manipulation, or insider trading) that helps to promote enforcement of the securities laws.

The exclusion of certain securities-related OTC derivatives from most of the securities regulatory regime has detracted from the SEC’s ability to uphold its investor protection mandate. For example, in investigating possible market manipulation during the financial crisis, the SEC has used its anti-fraud authority over security-based swaps to gather information about transactions in OTC derivatives as well as in the underlying securities. Yet investigations of these OTC derivative transactions have been far more difficult and time-consuming than those involving cash equities and options. Audit trail data on OTC derivative transactions is not readily available and must be reconstructed manually, in contrast to the data available in the equity markets. The SEC’s enforcement efforts have been seriously complicated by the lack of a mechanism for promptly obtaining critical information — who traded, how much, and when — that is complete and accurate.

In addition, the SEC believes that it is important in the OTC derivatives market, as in the market for securities generally, that parties to transactions have access to financial information and other disclosures so they can evaluate the risks relating to a particular investment to make more informed investment decisions and can value and evaluate their OTC derivatives and their counterparty exposures. For example, this information assists market participants in performing adequate due diligence on their investments and in valuing their OTC derivatives and their other risks.

A basic tenet of functional regulation of securities markets is to have a regulatory regime under which similar products and activities should be subject to similar regulations and oversight. Currently, securities are subject to transparency, active enforcement, and appropriate regulation of business conduct. Whereas securities-related OTC derivatives, which are interconnected with the securities markets (and in some cases are economic substitutes for securities) are not subject to most of these investor protection requirements. The securities laws are uniquely designed to address these issues and should be extended to OTC derivatives.

2. Fair and Orderly Markets

Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities.

For example, credit default swap, or CDS trading is closely related to trading in the underlying securities that compose the capital structure of the companies on which protection is written. Trading practices in the CDS market, whether legitimate or abusive, can affect the securities markets. The CDS market, however, lacks the level of transparency and other protections that characterize the regulated securities markets. As a result, the SEC has been unable to monitor effectively for trading abuses and whether purchasers of CDS protection on an issuer’s debt have sold short the equity securities of that company as a trading strategy, effectively linking activities and changes in the CDS market with those in the cash equity market. These activities in the CDS market could adversely impact the regulated securities markets. Any regulatory reform that maintained distinct regulatory regimes for securities markets and markets for securities-related OTC derivatives would suffer from this same limitation.

The SEC is considering whether reporting under the Exchange Act should apply to security-based OTC derivatives so that the ownership of and transactions in security-based derivatives would be considered ownership of and transactions in the underlying equity security. We are further evaluating whether persons using equity derivatives, such as an equity swap, should be subject to the beneficial ownership reporting provisions of the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

3. Capital Formation

Facilitating capital formation depends on the existence of fair and efficient secondary markets for investors. Purchasers in the primary offering of a company are attracted by secondary markets that enable them to liquidate their positions readily. Less efficient markets can cause potential investors in companies either to find other uses for their funds or to demand a higher rate of return to compensate them for a less efficient secondary market. If a disparity in the regulatory requirements for securities and securities-related OTC derivatives cause securities markets to operate less efficiently, it will harm those companies that depend on the U.S. securities markets to access the capital that is essential for innovation and growth, as well as harming investors and the capital markets as a whole.

Because many securities-related OTC derivatives are allowed to trade outside of the securities regulatory regime, the SEC generally is unable to promote transparency in the trading of these products and efficiency in pricing. As noted above, companies whose securities are affected by the excluded products could suffer from the absence of transparency and efficiency. Moreover, manipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation. Nevertheless, it is important to remember that derivatives transactions, including OTC derivatives transactions, allow parties to hedge and manage risk, which itself can promote capital formation. To the extent the ability to manage risk is inappropriately limited, it can discourage market participation, including by investors.

B. Regulatory Oversight of Securities-Related OTC Derivatives

To provide a unified, consistent framework for securities regulation, Congress should subject securities-related OTC derivatives to the federal securities laws. This result can be achieved simply by clarifying the definition of “security” to expressly include securities-related OTC derivatives, and removing the current express exclusion of swaps from that definition. The SEC then would have authority to regulate securities-related OTC derivatives regardless of how the products are traded, whether on an exchange or OTC, and regardless of how the products are cleared.

1. Definition of Securities-Related OTC Derivatives

OTC derivatives can be categorized generally as securities-related or non-securities-related, based on the different types of underlying assets, events, or interests to which they are related. Securities-related OTC derivatives would include equity derivatives and credit and other fixed income derivatives. Non-securities-related derivatives would include interest rate derivatives, foreign currency derivatives, and all non-financial derivatives. By including securities-related OTC derivatives under the umbrella of the federal securities laws, the SEC would have responsibility over the portion of the OTC derivatives market that is vital to promote its mission of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

In addition, the SEC would continue to regulate those types of OTC derivatives that always have been considered securities, such as OTC security options, certain OTC notes (including equity-linked notes), and forward contracts on securities. These particular types of OTC derivatives always have been included in the definition of security and current law recognizes this fact by excluding these derivatives from the definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act.

2.Regulation of OTC Derivatives Dealers and Major OTC Participants

Under our recommended approach, major participants in the OTC derivatives markets would be subject to oversight and supervision to ensure there are no gaps. To reduce duplication, OTC derivatives dealers that are banks would be subject to prudential supervision by their federal banking regulator. All other OTC derivatives dealers in securities-related OTC derivatives would be subject to supervision and regulation by the SEC. The SEC would have authority to set appropriate capital requirements for these OTC derivatives dealers. This approach would permit existing OTC derivatives dealers that are banks to continue to engage in OTC derivatives activities without being subject to the full panoply of broker-dealer regulation, while ensuring that all currently unregulated OTC derivatives dealers in securities-related OTC derivatives are subject to appropriate supervision and regulation. Should Congress establish a new systemic risk regulator or systemic risk council, that entity also could help monitor institutions that might present systemic risk.

In addition, the SEC would have authority to establish business conduct standards and recordkeeping and reporting requirements (including an audit trail) for all securities-related OTC derivatives dealers and other firms with large counterparty exposures in securities-related OTC derivatives (“Major OTC Participants”). This “umbrella” authority would help ensure that the SEC has the tools it needs to oversee the entire market for securities-related OTC derivatives. Major OTC Participants also would be required to meet appropriate standards for the segregation of customer funds and securities.

3. Trading Markets and Clearing Agencies

Trading markets and clearing organizations for securities-related OTC derivatives would be subject to registration requirements as exchanges and clearing agencies. Importantly, however, the conditional exemption from exchange registration the SEC provided under Regulation ATS would be available to trading systems for securities-related OTC derivatives. Among other things, Regulation ATS lowers barriers to entry for trading systems in securities because the systems need not assume the full self-regulatory responsibilities associated with being a national securities exchange. Both registered exchanges and ATSs are subject to important transparency requirements. Consequently, expanding the SEC’s authority over securities-related OTC derivatives would promote improved efficiency and transparency in the markets for securities-related OTC derivatives.

Similarly, the regulatory regime for securities clearing agencies would ensure that CCPs for securities-related OTC derivatives impose appropriate margin requirements and other necessary risk controls. The SEC’s historic regulation of clearing agencies under Section 17A of the Exchange Act has resulted in the most efficient, lowest cost clearing in the world. Indeed, the solid performance of securities clearing systems during the financial crisis bears out that they have the resilience to withstand difficult economic conditions. In addition, the regulation of securities clearance and settlement would directly affect market structure and competition in the trading markets for securities-related OTC derivatives. For example, the SEC’s statutory mandate governing clearing agencies prohibits clearing agencies from engaging in anti-competitive practices, such as imposing unreasonable limitations on access to services. Clearing agencies cannot exclude participants merely for executing their trades in a cleared product in a particular venue. This fair access requirement allows for multiple, competing markets, including OTC trading systems and OTC dealers, to trade the same securities and clear through a single clearing organization. The securities clearing system would support both the goal of having the greatest number of OTC derivatives centrally cleared, while retaining flexibility to allow variation in trading venues to meet the trading needs of different instruments and participants.

The SEC already has taken a number of actions to help further the centralized clearing for OTC derivatives, including exempting three CCPs from the requirement to register as securities clearing agencies. These exemptions were issued to speed the operation of central clearing for CDS. They are temporary and subject to conditions designed to ensure that important elements of Commission oversight apply, such as recordkeeping and Commission staff access to examine clearing facilities. In addition, to further the goal of transparency, each clearing agency is required to make publicly available on fair, reasonable, and not unreasonably discriminatory terms end-of-day settlement prices and any other pricing or valuation information that it publishes or distributes.

One important issue is how to deal with those OTC derivative contracts that may be ineligible for central clearing. OTC derivatives may be ineligible for clearing for a variety of reasons, including customized terms and an inability of CCPs to effectively manage the risks. In many cases, there are legitimate economic reasons to engage in customized transactions. Participants in individual transactions, however, should not be permitted to externalize the costs of their decisions, such as by creating additional systemic risk. Regulatory requirements often have costs, but they are costs incurred to protect the public interest and the general economic welfare. One way for regulators to help ensure market participants incorporate all the risks in the terms of a transaction would be to impose appropriate margin and capital requirements on the participants in customized transactions to reflect the risks they pose to market systems generally. This is an area in which the various functional regulators for particular entities could consult closely with any systemic risk agency that Congress might establish.

In addressing all of these issues with respect to OTC derivatives, moreover, the U.S. must coordinate its efforts with those of regulatory authorities abroad as they seek to address similar issues. The global financial crisis is a potent reminder of the extent to which economies around the world are linked by financial practices and market participants. A sound regulatory approach for managing the systemic risk of such practices and participants benefits from the implementation of complementary measures on an international basis.

V. Conclusion

Bringing securities-related OTC derivatives under the umbrella of the federal securities laws would be based on sound principles of functional regulation, would be relatively straightforward to implement, and would promote Congressional policy objectives for the capital markets. A clear delineation of primary regulatory responsibility for OTC derivatives also would help avoid regulatory gaps from arising in the future. Finally, integrating oversight of securities-related OTC derivatives with oversight of the related, underlying securities markets would minimize the extent of dislocation with respect to existing participants and current practices in the OTC derivatives markets, while still achieving the objectives for OTC derivatives regulation set forth in Secretary Geithner’s letter to the Congressional leadership.

Thank you for the opportunity to address issues of such importance for the strength and stability of the U.S. financial system, and the integrity of the U.S. capital markets. I would be pleased to answer your questions.

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Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
202.418.5080

Testimony of Chairman Gary Gensler, Commodity Futures Trading Commission Before the Senate Banking Subcommittee on Securities, Insurance, and Investment
June 22, 2009

Good morning Chairman Reed, Ranking Member Bunning, and Members of the Committee. I am here today testifying on behalf of the Commission.

The topic of today’s hearing, how to best modernize oversight of the over-the-counter derivatives markets, is of utmost importance during this crucial time for our economy. As President Obama laid out last week, we must urgently enact broad reforms in our financial regulatory structure in order to rebuild and restore confidence in our overall financial system.

Such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade. I look forward to working with the Congress to ensure that the OTC derivatives markets are transparent and free from fraud, manipulation and other abuses.

This effort will require close coordination between the SEC and the CFTC to ensure the most appropriate regulation. I’m fortunate to have as a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable expertise in both the security and commodity futures area, which gives me great confidence that we will be able to provide the Congress with a sound recommendation for comprehensive oversight of the OTC derivatives market. We also will work collaboratively on recommendations on how to best harmonize regulatory efforts between agencies as requested by President Obama. Comprehensive Regulatory Framework A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

Lower systemic risks;
Promote the transparency and efficiency of markets;
Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and
Protect the public from improper marketing practices.

To best achieve these objectives, two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses. Only with these two complementary regimes will we ensure that federal regulators have full authority to bring transparency to the OTC derivatives world and to prevent fraud, manipulation, and other types of market abuses. These two regimes should apply no matter which type of firm, method of trading or type of derivative or swap is involved.

Regulating Derivatives Dealers:

I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms whose activities in these markets can create large exposures to counterparties. The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. The AIG subsidiary that dealt in derivatives – AIG Financial Products – for example, was not subject to any effective regulation. The derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks were not subject to mandatory regulation either. By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we can oversee and regulate the entire derivatives market. I believe that our laws should be amended to provide for the registration and regulation of all derivative dealers.

The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules, and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

Capital and Margin Requirements:

The Congress should explicitly require regulators to promulgate capital requirements for all derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin requirements, on all transactions by these dealers will help prevent the types of systemic risks that AIG created. No longer would derivatives dealers or counterparties be able to amass large or highly leveraged risks outside the oversight and prudential safeguards of regulators.

Business Conduct and Transparency Requirements:

Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions. To promote market integrity, the business conduct standards should include prohibitions on fraud, manipulation and other abusive practices. For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets.

Business conduct standards should ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. These standards for “back office” functions will help reduce risks by ensuring derivative dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks.

Derivatives dealers also should be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions. These requirements should include retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository. Trade repositories complement central clearing by providing a location where trades that are not centrally cleared can be recorded in a manner that allows the positions, transactions, and risks associated with those trades to be reported to regulators. To provide transparency of the entire OTC derivatives market, this information should be available to all relevant federal financial regulators. Additionally, there should be clear authority for regulating and setting standards for trade repositories and clearinghouses to ensure that the information recorded meets regulatory needs and that the repositories have strong business conduct practices.

The application of these business conduct standards and the transparency requirements will enable regulators to have timely and accurate knowledge of the risks and positions created by the dealers. It will provide authorities with the information and evidentiary record needed to take any appropriate action to address such risks and to protect and police market integrity. In this regard, the CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses.

Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public. No longer should the public be in the dark about the extensive positions and trading in these markets. This public information will improve the price discovery process and market efficiency.

Regulating Derivatives Markets:

In addition to the significant benefits to be gained from broad regulation of derivatives dealers, I believe that additional safety and transparency must be afforded by regulating the derivative market functions as well. All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems. Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted.

Regulating both the traders and the trades will ensure that both the actors and the actions that may create significant risks are covered. Exchange-trading and central clearing are the two key and related components of well functioning markets. Ever since President Roosevelt called for the regulation of the commodities and securities markets in the early 1930s, the CFTC (and its predecessor) and the SEC have each regulated the clearing functions for the exchanges under their respective jurisdiction. The practice of having the agency which regulates an exchange or trade execution facility also regulate the clearing houses for that market has worked well and should continue as we extend regulations to cover the OTC derivatives market.

Central Clearing:

In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction. They also require the daily posting of margin to cover the daily changes in the value of positions and collect initial margin as extra protection against potential market changes that are not covered by the daily mark-to-market.

The regulations applicable to clearing should require that clearinghouses establish and maintain robust margin standards and other necessary risk controls and measures. It is important that we incorporate the lessons from the current crisis as well as the best practices reflected in international standards. Working with Congress, we should consider possible amendments to the CEA to expand and deepen the core principles that registered derivatives clearing organizations must meet to achieve these goals to both strengthen these systems and to reduce the possibility of regulatory arbitrage. Clearinghouses should have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants.

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing. By novating contracts to a central clearinghouse coupled with effective risk management practices, the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

One of the lessons that emerged from this recent crisis was that institutions were not just “too big to fail,” but rather too interconnected as well. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

In implementing these responsibilities, it will be appropriate to consider possible additional oversight requirements that may be imposed by any systemic risk regulator that Congress may establish. Under the Administration’s approach, the systemic regulator, would be charged with ensuring consistent and robust standards for all systemically important clearing, settlement and payment systems. For clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC or SEC would remain the primary regulatory, but the systemic regulator would be able to request information from the primary regulator, participate in examinations led by the primary regulator, make recommendations on strengthening standards to the primary regulator and ultimately, after consulting with the primary regulator and the new Financial Services Oversight Council, use emergency authority to compel a clearinghouse to take actions to address financial risks. Exchange-trading. Beyond the significant transparency afforded the regulators and the public through the record keeping and reporting requirements of derivatives dealers, market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. I believe that this should be required of all standardized contracts.

Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions. The Trade Reporting and Compliance Engine (TRACE) system currently required for timely reporting in the OTC corporate bond market may provide a model.

The CFTC and SEC also should have authority to impose recordkeeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses.

In contrast to long established on-exchange futures and securities markets, there is a need to encourage the further development of exchanges and electronic trading systems for OTC derivatives. In order to promote this goal and achieve market efficiency through competition, there should be sufficient product standardization so OTC derivative trades and open positions are fungible and can be transferred between one exchange or electronic trading system to another.

Position Limits:

Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.

Standardized and Customized Derivatives:

It is important that tailored or customized swaps that are not able to be cleared or traded on an exchange be sufficiently regulated. Regulations should also ensure that customized derivatives are not used solely as a means to avoid the clearing and exchange requirements. This could be accomplished in two ways. First, regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps. Second, we must ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems.

One way to ensure this would be to establish objective criteria for regulators to determine whether, in fact, a swap is standardized. For example, there should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared. Additional potential criteria for consideration in determining whether a contract should be considered to be a standardized swap contract could include:

The volume of transactions in the contract;
The similarity of the terms in the contract to terms in standardized contracts;
Whether any differences in terms from a standardized contract are of economic significance; and
The extent to which any of the terms in the contract, including price, are disseminated to third parties.

Criteria such as these could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them “customized. Regardless of whether an instrument is standardized or customized, or traded on an exchange or on a transparent electronic trade execution system, regulators should have clear, unimpeded authority to impose recordkeeping and reporting requirements, impose margin requirements, and prevent and punish fraud, manipulation and other market abuses. No matter how the instrument is traded, the CFTC and SEC as appropriate also should have clear, unimpeded authority to impose position limits, including aggregate limits, to prevent excessive speculation. A full audit trail should be available to the CFTC, SEC and other Federal regulators.

Authority:

To achieve these goals, the Commodity Exchange Act and security laws should be amended to provide the CFTC and SEC with clear authority to regulate OTC derivatives. The term “OTC derivative” should be defined, and clear authority should be given over all such instruments regardless of the regulatory agency. To the extent that specific types of OTC derivatives might overlap agencies’ existing jurisdiction, care must be taken to avoid unnecessary duplication.

As we enact new laws and regulations, we should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under pre-existing, valid agreements or to nullify pre-existing contractual obligations.

Achieving the Four Key Objectives:

Overall, I believe the complimentary regimes of dealer and market regulation would best achieve the four objectives outlined earlier. As a summary, let me review how this would accomplish the measures applied to both the derivative dealers and the derivative markets.

Lower Systemic Risk:

This dual regime would lower systemic risk through the following four measures:

Setting capital requirements for derivative dealers;
Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
Requiring centralized clearing of standardized swaps; and
Requiring business conduct standards for dealers.

Promote Market Transparency and Efficiency:

This complementary regime would promote market transparency and efficiency by:

Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;
Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;
Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to regulators;
Requiring centralized clearing of standardized swaps;
Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
Requiring the timely reporting of trades and prompt dissemination of prices and other trade information;

Promote Market Integrity:

It would promote market integrity by:

Providing regulators with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;
Providing regulators with authority to set position limits, including aggregate position limits;
Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
Requiring business conduct standards for dealers.

Protect Against Improper Marketing Practices:

It would ensure protection of the public from improper marketing practices by:

Business conduct standards applied to derivatives dealers regardless of the type of instrument involved; and
Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities.

Conclusion:

The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress swiftly responded to the clear need for reform by enacting the Securities Exchange Act of 1934. Two years later it passed the Commodity Exchange Act of 1936.

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide regulators with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Today’s complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage.

These policies are consistent with what I laid out to this committee in February and the Administration’s objectives. I look forward to working with this Committee, and others in Congress, to accomplish these goals.

Mr. Chairman, thank you for the opportunity to appear before the Committee today. I look forward to answering any questions.

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NASAA Applauds Obama’s Recent Directive on State Agency Preemption

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President of the NASAA Sends Letter to President Obama in Support of Limiting Preemption of State Regulation

In a letter dated June 9th, 2009, Fred Joseph, President of the North American Securities Administration (NASAA), applauded President Obama for his efforts to control preemption of state law in the area of securities regulation.

On May 20th, President Obama issued a directive setting limits on regulatory preemption of state regulation, largely in an effort to expand the authority of state regulatory officials to regulate many aspects of the securities markets and detect potential misconduct.

In his letter, Joseph writes that despite the proven century-long track record of investor protection by state securities regulators, Congress has still passed legislation over the years that has preempted state regulation and curtailed the authority of state officials in protecting both investors and consumers.

Joseph writes,

” Federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law.”

To further address what many regard as the most urgently needed reform, the NASAA endorses the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limited the accumulation of risk in the financial markets.

The entire text of letter by the NASAA to President Obama is included below, and can also be found here.

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NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.
750 First Street, NE, Suite 1140
Washington, D.C. 20002
202/737-0900
Fax: 202/783-3571
www.nasaa.org

June 9, 2009

President Barack Obama
The White House
1600 Pennsylvania Avenue NW
Washington, DC 20500

Dear Mr. President:

On behalf of our nation’s state securities regulators, the North American Securities Administrators Association1 applauds your effort to reverse the anti-investor preemption policies of previous administrations.

Your May 20 directive setting limits on regulatory preemption impressively affirms the vital role that state regulators play in protecting the health, safety, and financial security of citizens throughout the United States. You have sent a strong signal that our nation’s citizens are served best when the state-federal partnership works harmoniously and with mutual respect to “provide independent safeguards for the public.” Furthermore, we sincerely appreciate your recognition that states have frequently been more aggressive than the national government in protecting the public’s interest.

In the area of securities regulation, the states have a century-long track record of investor protection. One of the hallmarks of state securities regulation is its proven ability to detect misconduct, both large and small, in the early stages. Our members enjoy a unique proximity to investors and to the industry participants within their state borders. As a result, state securities regulators are often the first to investigate and uncover our nation’s latest and most damaging frauds. Examples include investigating the role of investment banks in the Enron fraud, exposing profound conflicts of interest among Wall Street stock analysts, addressing late trading and market timing in mutual funds, and recently helping to ensure that investors receive over $50 billion in redemptions for frozen auction rate securities that had been marketed as safe and liquid investments.

And yet, over a number of years, there has been a concerted effort to preempt state regulation. In the securities field, much of that effort has originated in Congress. For example, in 1996, Congress passed the National Securities Markets Improvement Act (NSMIA), which dramatically curtailed the authority of our members to regulate many aspects of the securities markets, ranging from private offerings under Regulation D to investment advisers with over $25 million in assets under management.

As your recent order recognizes, federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law. Two striking examples are found in the banking area.

The Office of the Comptroller of the Currency (OCC) has repeatedly adopted regulations that aggressively preempt the states’ authority to protect consumers through licensing requirements or enforcement actions. The impact has been felt largely in the mortgage lending field—where illegal underwriting practices helped trigger the current financial crisis. In a case now pending before the U.S.

1 NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.

Supreme Court, the Second Circuit aptly characterized the OCC as an agency that “accretes a great deal of regulatory authority to itself at the expense of the states through rulemaking lacking any real intellectual rigor or depth.” Clearing House Ass’n, L.L.C. v. Cuomo, 510 F.3d 105,119 (2d Cir. 2007) (although upholding the OCC’s limits on state visitorial powers under binding precedent). In the Cuomo case, the OCC actually sought an injunction to prevent the New York Attorney General’s Office from investigating discriminatory lending practices by various national banks and their operating subsidiaries.

The Office of Thrift Supervision (OTS) has also issued broadly preemptive regulations. Relying on those rules, the OTS has taken the position that even independent agents used by thrift institutions to market mortgages or certificates of deposit are immune from all substantive state regulations aimed a protecting consumers. The OTS’s opinion was articulated in an October 25, 2004 opinion letter. The OTS position has a direct impact on our members, to the extent it authorizes thrifts to market securities products, such as jumbo CDs, without complying with the licensing requirements applicable under state securities laws.

These examples and others affirm the need not only to rein in, but also to reverse, instances of state law preemption. An important corollary is making sure that the states are adequately represented in any regulatory reforms that your administration and Congress may fashion to address our current economic crisis. Plainly, our system of financial services regulation must be more effective. The enormous challenge of regulating our financial markets can only be met through the combined efforts of state and federal regulators, working together to protect both investors and the integrity of the marketplace. Any regulatory reforms should incorporate this guiding principle.

For that reason, to address what many regard as the most urgently needed reform, we endorse the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limiting the accumulation of risk in our financial markets. With our unique position on the frontlines of investor protection, state regulators are essential to the success of any remedy aimed at controlling systemic risk. We provide ground-level detection by gathering a huge volume of information through examinations of industry participants and complaints from investors. When that information reveals risks and abuses, we take appropriate action. The Council approach, with full state representation, takes advantage of these strengths. We would ask that you carefully evaluate the benefits of this model as you weigh alternative solutions to the difficult problem of systemic risk.

NASAA is committed to working with your Administration and the 111th Congress to ensure that the nation’s financial services regulatory structure undergoes the important changes that are necessary to enhance protections for Main Street investors. Your recent directive on agency preemption is a very important step, and as you move forward with other regulatory reforms, we hope you will continue to recognize the enormous value of state regulation in our system of federalism.

Sincerely,

Fred Joseph
President North American Securities Administrators Association
Colorado Securities Commissioner

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CFTC Addresses 2010 Budget

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CFTC Reports to US Senate Subcommittee on Financial Services – Testimony Provided by Chairman Gary Gensler

On June 2nd, 2009 Gary Gensler of the Commodity Futures Trading Commission (CFTC) addressed the US Senate Subcommittee on Financial Services with a discussion of the issues related to the CFTC’s 2010 Budget. Gensler stated that the current priorities of the CFTC are to enhance transparency in the marketplace and ensure enforcement of laws governing the financial markets, and that increased funding will be necessary to accomplish these objectives. Specifically, the CFTC plans to grow its professional staff and adopt new technology in order to better monitor the financial markets. With these goals in mind, the Commission’s FY 2010 budget proposes an increase of $14.6 million, half of which will be used to maintain FY 2009 level of operations into FY 2010. In his closing remarks, Gensler stated:

“President Obama has called for action by the end of this year to strengthen market integrity, lower risks, and protect investors. The future of the economy and the welfare of the American people depend on a vibrant Commission to assist in leading the regulatory reform ahead. Additional funding will be necessary to properly implement these reforms.”

The entire text of the testimony is included below and can be found here.

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Testimony by Gary Gensler, Chairman on behalf of the Commodity Futures Trading Commission

Before the United States Senate Subcommittee on Financial Services and General Government, Committee on Appropriations

June 2, 2009

Thank you, Chairman Durbin, Ranking Member Collins, and other members of the Subcommittee. I am pleased to be here to testify on behalf of the Commodity Futures Trading Commission, and I appreciate the opportunity to discuss issues related to the Commission’s 2010 Budget. I am also grateful to have had each of your individual support for my recent confirmation. It is a great honor to serve my country in this capacity.

I come before you today having only served as CFTC Chairman for six calendar days, but with the full knowledge of the failures of our financial regulatory system; failures that affected all Americans and failures that we must ensure never occur again.

The last decade, and particularly the last 21 months, has taught us much about the new realities of our financial markets. We have learned the limits of foresight and the need for candor about the risks we face. We have learned that transparency and accountability are essential and that only through strong, intelligent regulation can we fully protect the American people and keep our economy strong.

As Chairman of the CFTC, I will use every tool and authority available to protect the American people from fraud, manipulation and excessive speculation. I also look forward to working with Congress to establish new authorities to close the gaps in our laws and bring much-needed transparency and regulation to the over-the-counter derivatives market. I firmly believe that doing so will strengthen market integrity, lower risks, protect investors, promote transparency and begin to repair shattered confidence in our financial markets.

I would like to thank the Committee for the $146 million recently appropriated for the CFTC for the 2009 Fiscal Year and special thanks to Chairman Durbin for visiting our Chicago office last year. As a result of this much needed boost in funding, the

Commission has begun to address our alarming staffing levels; levels that recently reached historic lows.

At present, the Commission employs about 500 career staff — roughly equivalent to when the Commission was created in 1975. Three decades later, the futures market has changed in every way: with respect to volume, complexity, risk and locality. What was once a group of regional domestic markets trading a few hours five days a week is now a global market trading 24/7, and what was once just a $500 billion dollar business has exploded to a $22 trillion dollar annual industry.

Ten years ago, the CFTC was near its peak staffing level at 567 employees, but shrunk by 20% over the subsequent eight years before hitting a historic low of 437.

With the increase in FY 2009 funding the CFTC can reach 572 employees.

While this is a start, I believe that merely raising our staffing levels to the same as a decade ago will not be enough to adequately fulfill all of the agency’s missions. In the last ten years, trading volume went up over five fold. The number of actively traded futures and options contracts went up over six fold, and many of these are considerably more complex in nature. We also moved from an environment with open-outcry pit trading to highly sophisticated electronic markets.

In addition to the dramatic evolution of the futures industry, we have experienced the worst financial crisis in 80 years. We also experienced, in my view, an asset bubble in commodity prices. The staff of the CFTC is a talented and dedicated group of public servants, but the significant increase in trade volume and market complexity, as well as rapid globalization, commands additional resources to effectively protect American taxpayers.

For all of these reasons, I feel it is appropriate for our staffing levels and our technology to be further bolstered to more closely match the new financial realities of the day.

In short, despite the recent increase in funding, the Commission remains an underfunded agency. The President’s Budget recommendation of $160.6 million dollars is recognition of this need. Specifically, the Commission needs more resources to hire and retain professional staff and develop and maintain technological capabilities as sophisticated as the markets we regulate.

I’d like to identify some of my priorities and provide some illustrations of how resource limitations have constrained the Commission. Among my priorities will be to:

Ensure robust enforcement of our laws. Currently, the Commission’s enforcement program consists of 122 employees — the lowest level since 1984. Though FY 2009 funding will get us back to 141 enforcement employees, this is still below the agency’s peak of 167 and well below what we need given the current financial turmoil. Any financial downturn reveals schemes that could only stay afloat during periods of rising asset values. Our current, and much larger, downturn is exposing more leads than the Commission can thoroughly and effectively investigate. This is true both as it relates to fraud and Ponzi schemes as well as staff intensive manipulation investigations. The regulations we enact to protect the American people are meaningless if we do not have the resources to enforce them;
Ensure greater transparency of the marketplace. Also, I believe that commodity index funds and other financial investors participated in the commodity asset bubble. Notably, though, no reliable data about the size or effect of these influential investor groups has been readily accessible to market participants. The CFTC could promote greater transparency and market integrity by providing further breakdowns of non-commercial open interests on weekly “Commitments of Traders” reports. The American public deserves a better depiction of the marketplace. The temporary relief from higher prices does not negate this need, especially given that a rebounding of the overall economy could lead to higher commodity prices;
Ensure position limits are consistently applied. The CFTC has begun a review of all outstanding hedge exemptions to position limits. This review will consider the appropriateness of these exemptions and look for ways to institute regular review and increased reporting by exemption-holders. The Commission also has begun a review of the process and standards through which no-action letters are issued. As part of these reviews, CFTC staff will consider the extent to which swap dealers should continue to be granted exemptions from position limits;
Ensure the Commission has the tools to fully monitor the markets. We must upgrade the Commission’s mission critical IT systems for the surveillance of positions and trading practices. Neither is robust enough nor have they been upgraded to reflect the vast increase in volume and complexity. Our systems must begin to produce the surveillance reports needed to meet the analytical needs of our professional staff and the transparency needs of the public; and finally,
Ensure timely reviews of the many new products and rule change filings of the futures markets. These have lagged due to the growth and complexity of markets and the added responsibilities extended to the Commission in the 2008 Farm Bill. The Farm Bill requires staff to review all contracts listed on Exempt Commercial Markets (ECMs) to determine if they are significant price discovery contracts — if they are, then any ECM that lists such a contract must also be reviewed to determine compliance with a stringent set of core principles under the Commodity Exchange Act.

Other examples that I believe are illustrative of the difficult tradeoffs caused by resource constraints are:

The Commission does not conduct annual compliance audits of every Designated Contract Market (DCM)– rather only periodic reviews on average, every three years;
The Commission does not conduct annual compliance audits of every Derivatives Clearing Organization (DCO) — rather periodic reviews are conducted of selected core principles that are rotated and completed every three years; and,
The Commission does not conduct routine examinations of Commodity Pool Operators, Commodity Trade Advisors, and Futures Commission Merchants – a function currently performed by Self Regulatory Organizations. If the Commission were to perform direct periodic audits our staff would better understand the operations of brokers and managed funds and could better assess compliance with the law and regulations.

These are only a few of our important funding priorities and the workload challenges imposed by resource limitations. There are, of course, others. I hope that this helps the Committee to understand, in a tangible way, the challenges the Commission faces in regulating the futures markets the way the Nation requires.

Although the work of the Commission can be highly technical in nature, the mission of the agency is quite straightforward. The CFTC is charged with:

Protecting the public and market users from manipulation, fraud, and abusive practices and
Promoting open, competitive and financially sound futures markets.

With that context, I would like to address the specifics of the FY 2010 Budget request. The FY 2010 Budget proposes an increase of $14.6 million. Approximately half of the increase is needed to maintain our FY 2009 level of operations into FY 2010. The balance would fund an additional 38 positions.

Twenty-six of the 38 staff would be allocated to principal program areas. Specifically, we would allocate eleven positions to Enforcement, eight to Market Oversight, six to Clearing and Intermediary Oversight, and one to the Chief Economist’s office. The remaining twelve positions will provide critical mission support in the areas of legal analysis and counsel, technology support, international coordination, legislative and public outreach, and human capital and management support.

The additional 38 positions are essential to addressing some of the limitations I mentioned earlier. This increase, however, will not provide the Commission with the critical mass of professional and technical expertise needed to ensure that the growing markets remain free of manipulation and fraud.

For example, our enforcement staff needs to be significantly expanded to:

Ensure that crimes are punished to the fullest extent of the law;
Develop strategies aimed at quickly identifying and eradicating fraudulent schemes, such as Ponzi and foreign exchange “boiler rooms”; and
Importantly, pursue resource-intensive investigations and litigations involving manipulation, including energy-related market abuses, so wrongdoers will not believe they are immune from enforcement simply due to the complexity of an enforcement action.

Insufficient resources in the enforcement division force it to be too selective in the matters it investigates.

Our market oversight operation needs additional highly-skilled economists, investigators, attorneys and statisticians to:

Analyze trading reports quickly and thoroughly, indentify potential market problems or trader violations promptly, and avoid market disruptions and pricing anomalies;
Conduct timely and complete reviews of regulated entities to ensure compliance with all core principles;
Examine exchange self-regulatory programs on an on-going and routine basis with regard to trade practice and market surveillance; and
Ensure their compliance with disciplinary, audit trail, record-keeping and governance obligations.

Our clearing and intermediary oversight program needs additional auditors, analysts, and attorneys. This would allow us to:

Ensure clearing systems protect against a single market becoming a systemic crisis;
Protect investors’ funds from being misused or exposed to inappropriate risks of loss; and
Guard against abusive sales practices that harm customers and undermine market integrity.

Our economic research program needs more economists to review and analyze new market structures and off-exchange derivative instruments, especially in light of novel and complex products and practices that call for state-of-the-art economic analysis. Further, additional resources would enhance our economic and statistical analysis, improving transparency of markets and better supporting the Commission’s enforcement and surveillance programs.

We also need to transform the current legacy information technology systems into robust systems capable of efficiently receiving and managing massive amounts of raw data as well as transforming them in to useful analytical and research tools.

The Commission has made a substantial investment in technology over the past two years – focusing first on upgrading obsolete computer hardware to industry standards. We need technology, however, that is as modern and dynamic as the technology-driven markets we are charged with overseeing. Our investment in technology must be more than just periodic equipment upgrades and maintenance. The Commission must leverage resources by employing 21st century technology to protect the American people.

As the Commission informed this Committee in February of this year, the agency believes it needs $177.7 million for FY 2010 to perform its present duties. I look forward to working with this Committee to secure the funding necessary to meet our current regulatory responsibilities.

Before I close, I would like to briefly highlight funding needs that might go along with much needed regulatory reform. The CFTC along with the Administration and other financial regulators is committed to working with Congress on broad regulatory reform. This is particularly true for the markets that the CFTC currently regulates and the markets that may soon come under our regulation.

Specifically, we must urgently move to regulate the over-the-counter derivatives market and address excessive speculation through aggregated position limits.

President Obama has called for action by the end of this year to strengthen market integrity, lower risks, and protect investors. The future of the economy and the welfare of the American people depend on a vibrant Commission to assist in leading the regulatory reform ahead. Additional funding will be necessary to properly implement these reforms.

I look forward to working with the Members here today and others in Congress to accomplish this goal.

Thank you very much. I would be happy answer any questions you may have.

****

Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund articles include:

CFTC Proposes Reforms to Over-The-Counter Derivates Trading Regulation

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Statement of Gary Gensler Chairman, Commodity Futures Trading Commission

On June 4th, 2009, Gary Gensler, Chairman of the Commodity Futures Trading Commission, held a hearing before the Senate Committee on Agriculture, Nutrition and Forestry to address the importance of enacting broad reforms to regulate over-the-counter (OTC) derivates. Gensler emphasized that such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade in order to build and restore confidence in our financial regulatory system. Below is a summary of the reforms proposed in CFTC hearing:

I. Comprehensive Regulatory Framework

A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

1. Lower systemic risks

Setting capital requirements for derivative dealers;

Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);

Requiring centralized clearing of standardized swaps; and

Requiring business conduct standards for dealers.

2. Promote the transparency and efficiency of markets

Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;

Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;

Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to the CFTC and other regulators;

Requiring centralized clearing of standardized swaps;

Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;

Requiring the timely reporting of trades and prompt dissemination of prices and other trade information

3. Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits

Providing CFTC with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;

Providing CFTC with authority to set position limits, including aggregate position limits;

Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;

Requiring business conduct standards for dealers.

4. Protect the public from improper marketing practices.

Business conduct standards applied to derivatives dealers regardless of the type of instrument involved;

Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities

To best achieve these objectives, Gensler recommends implementing two complementary regulatory regimes: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses.

II. Regulating Derivatives Dealers

The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

II (a). Capital and Margin Requirements

II (b). Business conduct and Transparency Requirements

Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions.

To promote market integrity, the business conduct standards should:

Include prohibitions on fraud, manipulation and other abusive practices

Require adherence to position limits established by the CFTC on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets

Ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions.

Require derivatives dealers to be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions, including retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository

Provide transparency of the entire OTC derivates market by making this information available to all relevant federal regulators and making aggregated information on positions and trades available to the public

Provide clear authority for regulating and setting standards for trade repositories to ensure that the information recorded meets regulatory needs and the repositories have strong business conduct practices

III. Regulating Derivates Markets

All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems. Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted – Regulating both the traders and the trades will ensure that we cover both the actors and the actions that may create significant risks. To regulate both derivates and the market itself, the following areas need to be regulated:

a) Central clearing
b) Exchange-trading
c) Position limits
d) Standardized and customized derivates
e) Authority

III (a). Central Clearing

Central clearing should help reduce systemic risks in addition to the benefits derived from comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in the OTC derivatives market are not cleared, and remain as bilateral contracts between individual buyers and sellers. In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller.

Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction.

The regulations applicable to clearing should require central clearinghouses to:

Establish and maintain robust margin standards and other necessary risk controls and measures

Have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants

Have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a firm

Implement rules that allow indirect participation in central clearing

III (b). Exchange-Trading

Market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions.

III (c). Position Limits

Position limits must be applied consistently all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market. Gensler anticipates that this new authority will better enable the CFTC to protect the integrity of the price discovery process in the futures markets and protect the public against fraud, manipulation and other abuses.

III (d). Standardized and Customized Derivatives

Regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps.

Ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems

Additional criteria for consideration in determining whether a contract should be considered to be a standardized swap contract should include:

The volume of transactions in the contract

The similarity of the terms in the contract to terms in standardized contracts

Whether any differences in terms from a standardized contract are of economic significance

The extent to which any of the terms in the contract, including price, are disseminated to third parties

III (e). Authority

Lastly, to achieve the goals described above, the Commodity Exchange Act should be amended to provide the CFTC with positive new authority to regulate OTC derivatives. The term “OTC derivative” should be defined, and the CFTC should be given clear authority over all such instruments. To the extent that specific types of OTC derivatives might best be regulated by other regulatory agencies, care must be taken to avoid unnecessary duplication and overlap.
As new laws and regulations are enacted, the CFTC should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under pre-existing, valid agreements or to nullify pre-existing contractual obligations.

IV. Conclusion

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide the CFTC and other federal agencies with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Advisors Tell SEC to Rethink Proposed Custody Rule

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Overwhelming Majority of Investment Advisors Disagree with Proposed Changes to Custody Rule

In an effort to deter fraudulent activity, the SEC has proposed to amend Rule 206(4)-2, also known as the ‘custody rule’, to require that all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets. According to this proposal, there would be no exception to the annual surprise inspection requirement for advisors who possess custody of client funds solely because they withdraw funds from client accounts for payment of a client’s fees. Of the 20 responses submitted to the SEC by investment advisors and related industry professionals, 2 respondents supported the proposal and 18 respondents were opposed. Several of the respondents on both sides of the issue concede that, for those cases where a registered investment advisor does not use a qualified independent custodian, the proposed legislation offers a necessary higher level of scrutiny and oversight.

Respondent Rosamond R. Dewart, retired federal employee, states:

” I would support the proposed rule if […] it could accomplish the intent of the rule. Investment advisers certainly need more scrutiny. I have lost confidence in the entire financial sector.”

However, the majority of respondents argue that the surprise examination requirement will grossly and negatively impact small-to-medium advisers who fall who only possess ‘custody’ of client accounts as described above.

Carolyn Santo, a CFP from Hawaii, asserts in her response:

“The proposed changes to the SEC rules involving making investment advisors pay for surprise audits on themselves is a classic example of an unwieldy and clumsy attempt to protect the investing public from a super micro-minority in the world of white collar crime.”

Those opposed to the proposed changes argue that, due to a number of recent enforcement actions against investment advisors alleging fraudulent conduct , many regulators and politicians assume that the ability to withdraw fees from a client account gives investment advisors complete control of the cash inside the account. Many assert that this assumption is simply not true, and additionally point out that the costs assumed for the surprise audit may be unrealistic and unfair to small-to-medium advisors, forcing some advisors to pass these costs along to client investors.

Peter J. Chepucavage, General Counsel of Plexus Consluting LLC, states:

” We think the added cost is disproportionate to the added compensation, a fact often present in one size fits all regulation.”

Another respondent, John M. Smartt, Jr., CPA, adds:

” The additional proposed regulation, annual audit, is a significantly higher cost without significant benefits. An estimated $8,100 audit charge would cost me more than 10% of my current gross income (as a Tennessee RIA)”.

Some opposed to the new regulation have offered some constructive suggestions as to compliance alternatives that the SEC ought to consider:

Changing the definition of “custody” for accounts held at regulated third party custodians such as brokerage firms and/or trust companies
Increasing public knowledge by disseminating information about the entire industry
Increasing investigation of Red Flag situations (i.e. large withdrawals and lavish spending)
Establishing a substantial reward for information leading to the discovery of a financial scam
Requiring a higher level of disclosure of the independent custodian to the client when cumulative withdrawals are greater than an established percent of the account’s value for the prior quarter.

With regards to the suggestion for greater disclosure, Warren Mackensen, founder of Mackensen & Company, Inc., strongly encourages the SEC to implement the following additional four (4) client protection controls for advisers who debit fees from client accounts to avoid unnecessary an costly annual surprise examinations by a CPA firm:

Requiring custodians to limit fee deductions to, say, 2%, which would provide sufficient investor protection that the adviser is not absconding with client assets
Requiring at least quarterly statements directly from the qualified custodian (our clients receive monthly statements)
Requiring the custodians to send statements in any month in which a client fee was deducted (more immediate notice to the clients if statements are otherwise quarterly); and
Requiring the investment adviser to send an invoice showing the fee calculation directly to the client so that the client may compare the fee computation with his/her monthly statement showing the debited fee.

Others opposed to the proposed changes have noted the following additional points with regards to client protections already in place when an adviser uses a qualified custodian:

The third party custodian already acts as a gatekeeper to the advisors ability to pull funds from client accounts, making it virtually impossible for a an advisor using a major third party custodian, such as Charles Schwab, TD Ameritrade, Fidelity, etc.) to ‘drain the account’ through fees, as they will not process withdrawals that exceed a certain percentage per year.
Any advisor who is able to deduct fees from client accounts needs written authorization to make payments to anyone other than the client, adding an extra layer of protection for the client.

Overall, it appears that the overwhelming response to the proposed legislation indicates that the majority of investment advisors would prefer that the SEC adopt less costly and less time-consuming compliance alternatives to maximize investor protection. With regards to the anticipated effectiveness of the proposed legislation, Carolyn Santo writes,

” The wrongful taking of client assets is a criminal act, and increasing the regulatory burden on the entire industry is not going to lessen the fact that a small number of people are dishonest and will steal from clients.”

To view all comments submitted to the SEC regarding the proposed amendments to Rule 206(4)-2, including discussions from the above-cited respondents, please visit:
http://www.sec.gov/comments/s7-09-09/s70909.shtml

New Initiative to Assist in the Sale of Devalued Loans and Securities: Public Private Investment Program

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Public Private Investment Program and its Regulatory Measures

In a statement set forth on May 20th, 2009 before the Senate Banking Committee, Timothy F. Geithner, U.S. Secretary of the Treasury, discusses the rehabilitative financial programs and regulatory measures proposed by Congress in response to the nation’s financial upheaval and economic uncertainty. These initiatives are introduced as a follow-up to the Emergency Economic Stabilization Act (EESA), passed by Congress in October of 2008 with the specific goal of stabilizing the nation’s financial system and preventing catastrophic collapse. One such initiative designed to assist in the sale of devalued loans and securities is the Public Private Investment Program (PPIP).

The PPIP is designed as part of an overall strategy to resolve the crisis as quickly as possible with the least cost to the taxpayer. As asset prices have been pushed to extremely low levels, obtaining private financing on reasonable terms to purchase these assets has become increasingly difficult, further reducing the ability of financial institutions to provide new credit. The resulting uncertainty about the value of these assets has also constrained the ability of financial institutions to raise private capital. The PPIP is intended to restart the market for those assets lost in the course of deleveraging, while restoring bank balance sheets as these devalued loans and securities are sold. Using $75 to $100 billion in capital from EESA and capital from private investors – as well as funding enabled by the Federal Reserve and FDIC – PPIP will generate $500 billion in purchasing power to buy legacy assets, with the potential to expand to $1 trillion over time. By providing a market for these assets, PPIP will help improve asset values, increase lending capacity for banks, and reduce uncertainty about the scale of losses on bank balance sheets – making it easier for banks to raise private capital and replace the capital investments made by Treasury.

PPIP will follow three basic principles in its strategy:

Making the most of taxpayer dollars: Maximize utility of taxpayer resources under the Emergency Economic Stabilization Act (EESA) by partnering with the FDIC, the Federal Reserve, and private sector investors
Sharking risk with the private sector: Ensure that private sector participants invest alongside the government, with the private sector investors standing to lose money in a downside scenario and the taxpayer sharing in profitable returns
Taking advantage of private sector competition to set prices for currently illiquid assets: Use competing private sector investors to engage in price discovery, reducing the likelihood that the government will overpay for these assets

The PPIP will have two major components – securities and loans. The Legacy Securities program will target commercial mortgage-backed securities and residential mortgage-backed securities, and the Legacy Loans Program is designed to attract private capital to purchase eligible legacy loans and other assets from participating banks through the availability of FDIC debt guarantees and Treasury equity co-investments. The terms of funding provided for both parts of the PPIP, including fees, will be set in a way that is designed to limit the risks faced by U.C. taxpayers while still meeting the objective of generating new demand for legacy assets. In addition, those participating in the program will be subject to a significant degree of oversight to ensure that their actions are consistent with the objectives of the program. The U.S. Secretary of the Treasury expects the PPIP to begin operating over the next six weeks.

In response to the heightened systemic risk experienced by the securities markets due to rapid growth of the largest financial institutions, a more conservative regulatory regime is also being proposed to govern the sale of loans and securities. In addition to addressing the potential insolvency of individual financial institutions, the new regulatory measures are designed to ensure the stability and consistency of the system itself. The new comprehensive reforms will offer the following improvements:

Meaningful & simply stated disclosures that actual consumers and investors can understand
Clear , reasonable, and appropriate financial choices offered to consumer
Clear accountability, authority, and resources for protecting consumers and investors
Global consistency with U.S. standards for financial regulation
Material improvements to prudential supervision, tax compliance, and restrictions on money laundering in weakly-regulated jurisdictions
Resolution authority that would grant additional tools to avoid the disorderly liquidation of the largest (systemically significant) financial institutions

Geithner concludes his discussion by stating that the central obligation of the U.S. Treasury is to ensure that the economy is able to recover as quickly as possible. To achieve this recovery, the Treasury commits to restore 1) a stable financial system that is able to provide the credit necessary for economic recovery, 2) the strict observance of comprehensive regulatory reforms that deter fraud and abuse while rewarding innovation and performance.

Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback

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The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:

Rule 206(4)-2: All registered investment advisers:

must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
must undergo an annual surprise audit examination by an independent accountant
is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
must inform the SEC within one business day of finding any material discrepancies during an audit examination

Rule 204-2: All registered investment advisers:

must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized

Form ADV: All registered investment advisers:

must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
must report the dollar amount of client assets and the number of clients of which he/she has custody
must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports

Form ADV-E: All PCAOB-registered accountants:

must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation

All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund. Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.

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For further information regarding the proposed amendments, please refer to the more detailed abstract below. The full text of the proposed rules can be found here.

SEC Proposed Custody Amendments Abstract

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets. Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.

The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination. The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.

Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person. The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.

Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers. The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified. These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.

Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.

The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to [email protected], or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.

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Author Archives: CFM Admin

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Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback