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Investment Management Legal and Regulatory Update - July 2013

July 09, 2013

SEC Settles Enforcement Action with Morgan Keegan Directors Regarding Fair Valuation
In our April Update, we reported that the SEC had reached a tentative settlement agreement with former Morgan Keegan directors relating to charges that they failed to adequately oversee the fair valuation of securities in five Morgan Keegan funds that were heavily invested in securities backed by subprime mortgages. The six independent and two interested directors reached a settlement in principle with the SEC on March 27th, just days before the start of an administrative hearing on the matter. Details of the settlement were not known until the SEC announced a final settlement on June 13, 2013. The settled order finds that the directors caused the funds' violations of Rule 38a-1 under the Investment Company Act, which requires funds to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws. The directors were ordered to cease and desist from committing or causing any violations and any future violations of that rule. The directors consented to the entry of the settled order without admitting or denying any of the findings. Although no monetary penalties were imposed, an SEC enforcement action against individual directors is unusual and signals the importance that the SEC assigned to the matter.

"Our settlement sends a clear warning of our commitment to enforce the duty of mutual fund directors and trustees to closely oversee the process of valuing securities held by their funds," said George S. Canellos, Co-Director of the SEC's Division of Enforcement.

Under the securities laws, fund directors are responsible for determining the fair value of portfolio securities for which market quotations are not readily available. In addition, fund directors must determine the methodologies to be used to fair value securities and must periodically reevaluate the appropriateness of those methodologies. The SEC took the opportunity to remind directors of its position that while directors may engage others to calculate fair values, they are ultimately responsible for valuations of portfolio securities, citing Accounting Series Release No. 118 (Dec. 23, 1970).

Sources: Former Mutual Fund Directors Agree to Settle Claims That They Failed to Properly Oversee Asset Valuation, SEC Press Release 2013-111 (June 13, 2013); In the Matter of J. Kenneth Alderman, CPA; Jack R. Blair; Albert C. Johnson, CPA; James Stillman; R. McFadden; Allen B. Morgan Jr.; W. Randall Pittman, CPA; Mary S. Stone, CPA; and Archie W. Willis III; Investment Company Act Release No. 30557 (June 13, 2013).

SEC Settles Enforcement Action with Trustees Regarding Investment Advisory Contract Approvals and Renewals
The Investment Company Act requires mutual fund directors to evaluate and approve a fund's contract with its investment adviser, and the fund must report to shareholders about the material factors considered by the directors in approving the contract. The SEC Enforcement Division's Asset Management Unit has been taking a widespread look into the investment advisory contract renewal process and fee arrangements in the fund industry. "Determining the terms of the investment advisory contract, especially compensation of the adviser, is one of the most critical duties of a mutual fund board," said George S. Canellos, Co-Director of the SEC's Division of Enforcement. "We will aggressively enforce investors' rights to accurate and complete information about the board's process and decision-making."

An SEC investigation that arose from an examination of the Northern Lights Fund Trust and the Northern Lights Variable Trust found that some of the trusts' shareholder reports either misrepresented material information considered by the trustees or omitted material information about how they evaluated certain factors in reaching their decisions on behalf of the funds and their shareholders. The trusts are series trusts that included up to 71 mutual funds, most of which were managed by different unaffiliated advisers and overseen by a single board of trustees. From January 2009 to December 2010, the trustees conducted 15 board meetings and made decisions about 113 advisory and 32 sub-advisory contracts pursuant to Section 15(c) of the Investment Company Act.

In the enforcement order, the SEC alleged that: the trustees caused violations of Section 34(b) of the Investment Company Act; the chief compliance officer, Northern Lights Compliance Services (NLCS), and the trustees caused violations of Rule 38a-1 under the Investment Company Act; and the trusts' administrator, Gemini Fund Services, LLC (GFS), caused violations of Sections 30(e) and 31(a) of the Investment Company Act.

Without admitting or denying the SEC's allegations, the five trustees, including four independent trustees, consented to a cease and desist order against them. NLCS and GFS also consented to a cease and desist order and each agreed to pay a $50,000 civil money penalty. NLCS, GFS and the trustees also agreed to hire an independent compliance consultant to address the violations in the SEC's order.

"These violations make clear that turnkey mutual fund arrangements can pose significant governance concerns, and trustees must be vigilant in ensuring that the funds they oversee meet their disclosure, compliance, reporting, and recordkeeping obligations," said Marshall S. Sprung, Deputy Chief of the SEC Enforcement Division's Asset Management Unit.

Board Minutes. Prior to each board meeting, the trustees requested information from the applicable advisers and sub-advisers to evaluate the proposed agreements and such information was then reviewed by the trusts' outside counsel. After each board meeting, GFS paralegals prepared a skeleton draft of the meeting minutes based on a minutes template. The draft minutes were then supplemented by the trusts' secretary, reviewed and revised by outside counsel, and then reviewed and approved by the trustees. The discussion of the trustees' approval process included in the meeting minutes was then used to draft the disclosure in the trusts' shareholder reports.

Shareholder Reports. Section 34(b) of the Investment Company Act makes it unlawful for any person to make any untrue statement of a material fact or omit a material fact in any shareholder report. The SEC found that the trustees were a cause of the Section 34(b) violation that resulted from the inclusion of untrue statements of material fact and omissions necessary to prevent statements from being materially misleading in the portion of shareholder reports that covered the discussion of the board's advisory contract approval process.

The SEC cited examples of disclosures it considered untrue or misleading. In one example, the SEC noted that a shareholder report disclosed that the trustees "discussed the comparison of management fees and total operating expense data and reviewed the Fund's advisory fees and overall expenses compared to a peer group of similarly managed funds. . . . The trustees concluded that the Fund's advisory fees and expense ratio were acceptable in light of the quality of the services the Fund currently receives from the Adviser, and the level of fees paid by a peer group of other similarly managed mutual funds of comparable size." However, the SEC found that these statements were materially misleading since they implied that the fund was paying fees that were not materially higher than the middle of its peer group range when, in fact, the adviser's approved fee was materially higher than all of the fees of the adviser's selected peer group of 74 funds and nearly double the peer group's mean fee.

Approval of Adviser's Compliance Policies. The SEC also determined that the trustees and NLCS each caused violations of Rule 38a-1 under the Investment Company Act, which requires fund boards to approve the policies and procedures of fund service providers, including the policies and procedures of the fund's adviser. The approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violations of the federal securities laws. Consistent with Rule 38a-1, the trusts' compliance policies and procedures required NLCS to provide the trustees with either the policies and procedures of each adviser or a summary of each adviser's compliance program. In practice, however, NLCS provided the trustees with a written statement that NLCS had reviewed the adviser's compliance programs and that they were "sufficient and in use" and that NLCS had reviewed the adviser's code of ethics and proxy voting policies and that they were "compliant." This written statement was accompanied by a verbal representation by an NLCS representative at the relevant board meeting that the adviser's policies and procedures were adequate. The SEC found that the written statement and oral representation by NLCS did not constitute an adequate summary that familiarized the trustees with the salient features of each adviser's compliance programs and that provided the trustees sufficient understanding of how the programs addressed particularly significant risks. As a result of this deviation from the trusts' written policies and procedures, the SEC alleged that each of the trustees and NLCS caused the trusts' violations of Rule 38a-1.

Records. In addition, the SEC's order stated that GFS, in its role as fund administrator, caused the trusts' failure to comply with requirements set forth in Section 31(a) of the Investment Company Act and Rule 31a-2 by failing to maintain all board materials considered in approving a fund's advisory contract. These materials included documents containing fee comparisons for peer groups and summaries that were prepared by the trusts' outside counsel as part of the trustees' approval process. The SEC stated that, in some instances, GFS discarded such information after the meetings or returned it to an adviser due to the adviser's concerns with confidentiality.

Sources: SEC Charges Gatekeepers of Two Mutual Fund Trusts for Inaccurate Disclosures About Decisions On Behalf of Shareholders, SEC Press Release 2013-78 (May 2, 2013); In the Matter of Northern Lights Compliance Services, LLC, Gemini Fund Services, LLC, Michael Miola, Lester M. Bryan, Anthony J. Hertl, Gary W. Lanzen and Mark H. Taylor, Investment Company Release No. 30502 (May 2, 2013).

Takeaway from Morgan Keegan and Northern Lights Enforcement Actions
Taken together, the Morgan Keegan and Northern Lights settled enforcement actions suggest a broader trend of SEC inquiry into fund governance procedures, a closer look at the actions of fund boards, and a potentially increased willingness by the SEC to bring enforcement actions against fund boards and, in certain circumstances, against individual directors and trustees.

SEC Releases Money Market Fund Reform Proposals
SEC Chair Mary Jo White announced that the SEC will consider proposals that would reform the way money market funds operate in order to make them less susceptible to significant redemptions. As Chairman White explained:

Money market funds . . . have become an important provider of short-term financing to corporations, banks and governments. All told, money market funds hold nearly $3 trillion in assets.

While money market funds have thus long served as an important investment vehicle, the financial crisis of 2008 highlighted the susceptibility of these products to runs. In September of that year -- at the height of the financial crisis -- a money market fund called the Reserve Primary Fund "broke the buck" -- a term used when the value of a fund drops and investors are no longer able to get back the full dollar they put in.

Within the same week of that occurrence, investors pulled approximately $300 billion from other institutional prime money market funds. The contagion effect was rapid. The short term credit market dried up, and corporations had trouble borrowing to run their businesses. This reaction contributed to the significant disruption that already was consuming the financial system.

To stop this run, the government stepped in with unprecedented support in the form of the Treasury temporary money market fund guarantee program and Federal Reserve liquidity facilities.

In the aftermath of that experience, the Commission - in 2010 - adopted a series of reforms that increased the resiliency of money market funds. But, as the Commission stated at that time, those reforms were only a first step. Today's proposal takes the critical additional step of addressing the stable value pricing of institutional prime funds - at the heart of the 2008 run - and proposing methods to stop a money market fund run before such a run becomes a systemically destabilizing event.

The SEC's proposal contains two alternative reforms that could be adopted separately or combined into a single reform package. The reforms are designed to:

  • mitigate money market funds' susceptibility to heavy redemptions during times of stress;
  • improve money market funds' ability to manage and mitigate potential contagion from high levels of redemptions;
  • preserve as much as possible the benefits of money market funds for investors and the short-term financing markets; and
  • increase the transparency of risk in money market funds.

Alternative One: Floating NAV. Under the first alternative, prime institutional money market funds would be required to transact at a floating net asset value (NAV), not at a $1.00 stable share price. The floating NAV alternative is designed primarily to address the heightened incentive shareholders have to redeem shares in times of financial stress. It also is intended to improve the transparency of money market fund risks through more visible valuation and pricing methods.

  • Floating NAV. Prime institutional money market funds would no longer be able to use amortized cost to value their portfolio securities except to the limited extent all mutual funds are able to do so (i.e., fixed income securities maturing in less than 60 days). Daily share prices of these money market funds would fluctuate along with changes, if any, in the market-based value of their portfolio securities.
  • Showing Fluctuations in Price. Prime institutional money market funds would be required to price their shares using a more precise method so that investors are more likely to see fluctuations in value. Currently, money market funds "penny round" their share price to the nearest one percent (to the nearest penny in the case of a fund with a $1.00 share price). Under the floating NAV proposal, prime institutional money market funds instead would be required to "basis point round" their share price to the nearest 1/100th of one percent (the fourth decimal place in the case of a fund with a $1.00 share price, i.e., $1.0000).
  • Exempting Government and Retail Money Market Funds. Government and retail money market funds would be allowed to continue using the penny rounding method of pricing and maintain a stable share price. A government money market fund would be defined as any money market fund that holds at least 80% of its assets in cash, government securities, or repurchase agreements collateralized with government securities. A retail money market fund would be defined as a money market fund that limits a shareholder's redemptions to no more than $1 million per business day.

Alternative Two: Liquidity Fees and Redemption Gates. Under the second alternative, money market funds would continue to transact at a stable share price, but would be able to use liquidity fees and redemption gates in times of stress.

  • Liquidity Fees. If a money market fund's level of "weekly liquid assets" were to fall below 15% of its total assets (half the required amount), the money market fund would have to impose a 2% liquidity fee on all redemptions. However, such a fee would not be imposed if the fund's board of directors determines that such a fee is not in the best interest of the fund or that a lesser liquidity fee is in the best interest of the fund. Weekly liquid assets generally include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week.
  • Redemption Gates. Once a money market fund had crossed the 15% weekly liquid asset threshold, its board of directors also would be able to impose a temporary suspension of redemptions (or gate). A money market fund that imposes a gate would need to lift that gate within 30 days, although the board of directors could determine to lift the gate earlier. Money market funds would not be able to impose a gate for more than 30 days in any 90-day period.
  • Prompt Public Disclosure. Money market funds would be required to promptly and publicly disclose that the fund crossed the 15% weekly liquid asset threshold, the imposition and removal of any liquidity fee or gate, and a discussion of the board's analysis in determining whether or not to impose a fee or gate.
  • Exemption for Government Money Market Funds. Government money market funds would be exempt from the liquidity fees and gates requirement. However, these funds could voluntarily opt into this new requirement.

Potential Combination of Both Proposals. The SEC is considering whether to combine the floating NAV and the liquidity fees and gates proposals into a single reform package. If adopted in that form, prime institutional money market funds would be required to transact at a floating NAV and all other non-government money market funds would be able to impose liquidity fees or gates in certain circumstances. Certain of the SEC's other proposals discussed below would vary depending on whether one or the other, or both, major reform proposals are adopted.

Enhanced Disclosure Requirements. In addition to requiring certain disclosures relating to the floating NAV and liquidity fees and gates proposals, the proposal seeks to improve the transparency of money market fund operations and risks as follows:

  • Website Disclosure. Money market funds would be required to disclose on their website, on a daily basis, their levels of daily and weekly liquid assets and market-based NAV per share.
  • New Material Event Disclosure. Money market funds would be required to promptly disclose certain events on a new form (Form N-CR). These events would include the imposition or lifting of liquidity fees or gates, portfolio security defaults, sponsor support, and, for funds that would continue to maintain a stable share price under either alternative, a decline in the fund's market based NAV per share below $0.9975.
  • Disclosure of Sponsor Support. Money market funds would be required to disclose in their SAIs historic instances of sponsor support for money market funds.

Immediate Reporting of Fund Portfolio Holdings. Money market funds currently report detailed information about their portfolio holdings to the SEC each month on Form N-MFP. Under the proposal, Form N-MFP would be amended to clarify existing requirements and require reporting of additional information relevant to assessing money market fund risk. In addition, the proposal would eliminate the current 60-day delay on public availability of the information filed on the form and would make it public immediately upon filing.

Improved Private Liquidity Fund Reporting. To better monitor whether substantial assets migrate to liquidity funds in response to money market fund reforms, the proposal would amend Form PF, which private fund advisers use to report information about certain private funds they advise. The proposed changes would require a "large liquidity fund adviser" (a liquidity fund adviser managing at least $1 billion in combined money market fund and liquidity fund assets) to report substantially the same portfolio information on Form PF as registered money market funds would report on Form N-MFP. A liquidity fund is essentially an unregistered money market fund.

Stronger Diversification Requirements. The proposal includes the following proposed changes to the diversification requirements for money market funds' portfolios:

  • Aggregation of Affiliates. Money market funds would be required to aggregate affiliates for purposes of determining whether they are complying with money market funds' 5% concentration limit. Under this limitation, a fund may not invest any more than 5% of its assets in any one issuer or affiliated group of issuers (based on 50% ownership).
  • Asset-Backed Securities. Money market funds would need to aggregate all of the asset-backed securities vehicles sponsored by the same entity for purposes of the 10% guarantor diversification limit. However, this would not be necessary if a money market fund's board of directors determines the fund is not relying on the sponsor's strength or structural enhancements of the asset-backed security in determining the quality or liquidity of the asset-backed security.
  • Removal of the 25% Basket. All of a money market fund's assets would need to meet the concentration limits for guarantors and 'put' providers, thereby removing the so-called 25% basket that permitted a single guarantor to guarantee up to 25% of a money market fund's assets.

Enhanced Stress Testing. Under the proposal, the stress testing requirements adopted by the SEC in 2010 would be further enhanced. In particular, a money market fund would be required to stress test against the fund's level of weekly liquid assets falling below 15% of total assets. In addition, the SEC is proposing to strengthen how money market funds stress test their portfolios and report the result of their stress tests to their boards of directors. The SEC was critical of the industry's compliance with the 2010 stress testing requirements. It stated explicitly that the additional requirements being proposed were "minimum" requirements and not an exhaustive list.

Comments on the money market fund proposals are due September 17, 2013.

Sources: SEC Proposes Money Market Fund Reforms, SEC Press Release 2013-101 (June 5, 2013); Money Market Fund Reform; Amendments to Form PF, SEC Release No. IC-30551 (June 5, 2013).

SEC Issues Guidance Regarding Compliance with Exemptive Orders
The SEC issued an Investment Management Guidance Update warning investment advisers and mutual funds that receive and rely upon exemptive orders that they are at risk of violating the federal securities laws if they fail to comply with the representations and conditions of their orders. The SEC noted that the consequences of non-compliance may be severe. The SEC suggested that investment advisers and mutual funds adopt and implement policies and procedures that are reasonably designed to ensure ongoing compliance with each representation and condition of an SEC exemptive order. For example, a fund may have received an order that includes conditions relating to board review. The fund could consider adopting a specific policy or procedure to address the required board review. Alternatively, the fund could consider whether an existing policy or procedure relating to board review of other matters would incorporate the specific board review required by the order.

The guidance follows a June 2011 report from the Office of Inspector General that detailed certain examples of firms that failed to comply with the representations and conditions of exemptive orders and made recommendations intended to enhance the SEC's oversight of compliance with representations and conditions in exemptive orders.

Source: IM Guidance Update No. 2013-02 (May 2013).

FINRA Imposes $9 Million Penalty for Email Failures
FINRA announced that it fined brokerage firm LPL Financial LLC (LPL) $7.5 million for significant email system failures, which allegedly prevented LPL from "accessing hundreds of millions of emails and reviewing tens of millions of emails," and for making misstatements to FINRA. FINRA also ordered LPL to establish a $1.5 million fund to compensate brokerage customer claimants potentially affected by LPL's failure to produce email. LPL neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Brad Bennett, Executive Vice President and Chief of Enforcement at FINRA, said, "As LPL grew, it did not expand its compliance and technology infrastructure; and as a result, LPL failed in its responsibility to provide complete responses to regulatory and other requests for emails. This case sends a strong message to firms to make sure your business does not outgrow your compliance systems."

FINRA found that from 2007 to 2013, LPL's email review and retention systems failed at least 35 times, leaving the firm unable to meet its obligations to capture email, supervise its representatives and respond to regulatory requests. Because of LPL's deficiencies in retaining and monitoring emails, FINRA determined that LPL failed to produce all requested email to certain federal and state regulators and FINRA, and also likely failed to produce all emails to certain private litigants and customers in arbitration proceedings.

LPL's registered representatives are independent contractors and many operate under one or more "doing business as" (DBA) names and use DBA email addresses in addition to an email address for their business. FINRA found that LPL did not review 28 million DBA emails sent and received from thousands of representatives over a three-year period.

In addition, FINRA alleged that LPL made material misstatements to FINRA concerning its failure to supervise the DBA emails. According to FINRA, LPL inaccurately stated that the issue had been discovered in June 2011 even though certain LPL personnel had information that would have uncovered the issue as early as 2008. Moreover, LPL claimed that there were not any "red flags" suggesting any issues with DBA email accounts when, in fact, there were numerous red flags related to the supervision of DBA emails that were known to many LPL employees.

Ignites reports that more than half the participants in a recent survey said they had increased the resources -- both time and money -- allocated to e-mail compliance over the past year. In addition, half the survey participants expect to increase those resources in the next year. "E-mail challenges still face a lot of companies," says Stephen Marsh, CEO of Smarsh, the e-mail and social media archiving firm that conducted the survey. Smarsh surveyed 284 compliance professionals who have direct compliance supervision responsibilities at an array of financial services firms. The survey was conducted between January and March of 2013.

Sources: LPL to Pay $9 Million for Systemic Email Failures and for Making Misstatements to FINRA; LPL Fined $7.5 Million and Ordered to Establish $1.5 Million Fund to Compensate Affected Customers; FINRA News Release (May 21, 2013); Financial Industry Regulatory Authority Letter of Acceptance, Waiver and Consent No. 2012032218001 (May 21, 2013); Paula Vasan, Former SEC Official Joins LPL Financial, (June 20, 2013); Beagan Wilcox Volz, Firms Boost Spending on E-Mail Compliance: Survey: Ignites (May 29, 2013).

Pay-to-Play: SEC Settles Enforcement Action
The SEC settled a pay-to-play enforcement proceeding with Neil M.M. Morrison, a former vice president in the investment banking division of Goldman, Sachs & Co., a broker-dealer and registered municipal securities dealer. The SEC alleged that Mr. Morrison's actions resulted in violations of the Municipal Securities Rulemaking Board's (MSRB) rules by both Morrison and Goldman Sachs. Starting in July 2008, Morrison was employed by Goldman Sachs to solicit municipal underwriting business from, among others, the Massachusetts Treasurer's Office. During the period November 2008 to October 2010, however, Morrison allegedly was also substantially engaged in the political campaigns of Timothy P. Cahill, the then-Treasurer of Massachusetts, including Cahill's November 2010 Massachusetts gubernatorial campaign. According to the SEC, Morrison participated extensively in Cahill's gubernatorial campaign and did so at times from his Goldman Sachs office, during his Goldman Sachs work hours and using Goldman Sachs resources, such as phones, e-mail and office space. The SEC found that Morrison's campaign work gave him complete access to Cahill and his staff, who often provided him with information about the office's internal deliberations involving underwriter selection.

The SEC determined that Morrison's campaign activities during his Goldman Sachs work hours and use of Goldman Sachs resources constituted valuable undisclosed "in-kind" campaign contributions to Cahill attributable to Goldman Sachs. In addition, the SEC found that Morrison circumvented the pay-to-play rules by making an indirect contribution to the Cahill campaign through another person in violation of MSRB Rule G-37. Moreover, Morrison allegedly solicited campaign contributions for Cahill when Goldman Sachs was engaged in or seeking to engage in municipal underwriting business with the Treasurer's Office in willful violation of MSRB Rule G-37.

Two-Year Ban on Municipal Securities Business Violated. Under Rule G-37, Morrison's indirect contribution and each "in-kind" contribution attributable to Goldman Sachs triggered a two-year ban on municipal securities business with issuers associated with Cahill as Treasurer of Massachusetts and as a candidate for Governor of Massachusetts. Despite the prohibitions contained in Rule G-37, within two years after the campaign contributions, Goldman Sachs, with Morrison's knowledge, participated as senior manager, co-senior manager, or co-manager for a total of 30 negotiated underwritings totaling approximately $9 billion. For its roles in the underwritings, Goldman Sachs received $7,558,942 in fees. The SEC found that Goldman Sachs' engagement in municipal securities business with these issuers violated MSRB Rule G-37(b).

Disclosures. Morrison's contributions were not disclosed on MSRB Forms G-37, and no records of the contributions were made and kept in violation of MSRB Rules G-37(e), G-8 and G-9. The SEC found that Morrison caused Goldman Sachs to violate MSRB Rules G-37(b) and (e), G-8 and G-9. In addition, the SEC found that Morrison did not disclose the contributions or campaign work or the conflicts of interest raised by this conduct in the bond offering documents. By failing to disclose the campaign work, cash and in-kind contributions and the resulting conflict of interest to the purchasers of municipal securities, Morrison willfully violated MSRB Rule G-17, which requires broker-dealers to deal fairly and not engage in any deceptive, dishonest, or unfair practice.

Bar From Securities Industry. Without admitting or denying any of the findings, Morrison agreed to cease and desist from violations of the MSRB rules and to pay a $100,000 fine. The SEC also barred Morrison from associating with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.

Source: In the Matter of Neil M.M. Morrison, Investment Company Act Release No. 30540 (May 23, 2013).

Identity Theft Red Flags Rules
In 2003, Congress amended the Fair Credit Reporting Act (FCRA) to require the Federal Trade Commission (FTC) and banking regulators to jointly adopt identity theft red flags rules and guidelines. At that time, the FCRA did not require or authorize the SEC or CFTC to adopt identity theft rules. Instead, the FTC had authority to adopt and enforce these rules with respect to SEC- and CFTC regulated entities. The Dodd-Frank Act of 2010 amended the FCRA to transfer identity theft rulemaking responsibility and enforcement authority from the FTC to the SEC and CFTC for entities they regulate.

The SEC and CFTC jointly adopted rules and guidelines that require certain regulated entities that are subject to the SEC's or CFTC's enforcement authority to develop and implement a written program designed to detect, prevent, and mitigate identity theft in connection with certain accounts.

The SEC's rules are substantially similar to the FTC's identity theft rules, which applied to SEC-regulated entities when they were adopted. Therefore, entities subject to the SEC's rules should already be in compliance with the rules' requirements. However, the rules and the rules' adopting release do contain examples and minor language changes designed to help guide entities in complying with the rules, which according to the SEC may lead some entities that had not previously complied with the FTC's rules to determine that they fall within the scope of the SEC's rules. All SEC-regulated entities that fall within the rules' scope must comply with the rules by November 20, 2013.

Entities Subject to the Identity Theft Red Flags Rules. The SEC's identity theft red flags rules apply to SEC-regulated entities that qualify as financial institutions or creditors under the FCRA and require those financial institutions and creditors that maintain covered accounts to adopt identity theft programs. SEC regulated entities that are likely to qualify as financial institutions or creditors and maintain covered accounts include most registered brokers, dealers, and investment companies, and some registered investment advisers.

Financial Institutions. An SEC-regulated entity will generally qualify as a financial institution if it holds a transaction account belonging to an individual. An account may be a transaction account if the individual account owner can personally make payments or transfers of money from his or her account to third parties, or can direct the SEC-regulated entity to make such payments or transfers to third parties.

Creditors. An SEC-regulated entity will generally qualify as a creditor if it advances or loans money to consumers. However, an entity will not qualify as a creditor if it advances money for expenses incidental to a service provided by the entity.

Covered Accounts. A covered account is generally: (1) an account that a financial institution or creditor offers or maintains, primarily for personal, family, or household purposes, that involves or is designed to permit multiple payments or transactions; or (2) any other account that poses a reasonably foreseeable risk to customers of identity theft.

Identity Theft Red Flags Rules. The SEC's identity theft red flags rules require regulated entities to adopt a written identity theft program that includes policies and procedures designed to:

  • identify relevant types of identity theft red flags;
  • detect the occurrence of those red flags;
  • respond appropriately to the detected red flags; and
  • periodically update the identity theft program.

Entities that are required to adopt identity theft programs also must provide for the administration of the program, including staff training and oversight of service providers. The rules do not single out specific red flags as mandatory, require specific policies and procedures to identify possible red flags or provide a specific method of detecting red flags. The rules do, however, include guidelines and examples of red flags to help firms administer their programs. An identity theft program should be appropriate to the size and complexity of the entity and the nature and scope of its activities.

Sources: Identity Theft Red Flags Rules: A Small Entity Compliance Guide (; Identity Theft Red Flags Rule, SEC Release No. IA-3582, IC-30456 (April 10, 2013).

FINRA Orders Wells Fargo and Banc of America to Reimburse Customers More Than $3 Million and Pay $2.15 Million in Fines for Unsuitable Sales of Bank Loan Mutual Funds
FINRA announced that it had fined two firms a total of $2.15 million and ordered the firms to pay more than $3 million in restitution to customers for losses incurred from unsuitable sales of floating-rate bank loan funds. FINRA ordered Wells Fargo Advisors, LLC (Wells Fargo) to pay a fine of $1.25 million and to reimburse approximately $2 million in losses to 239 customers. FINRA ordered Merrill Lynch, Pierce, Fenner & Smith Incorporated, as successor for Banc of America Investment Services, Inc. (Banc of America), to pay a fine of $900,000 and to reimburse approximately $1.1 million in losses to 214 customers.

Floating-rate bank loan funds are mutual funds that generally invest in a portfolio of secured senior loans made to entities whose credit quality is rated below investment-grade. The funds are subject to significant credit risks and can also be illiquid.

FINRA found that Wells Fargo and Banc of America brokers recommended concentrated purchases of floating-rate bank loan funds to customers whose risk tolerance, investment objectives, and financial conditions were inconsistent with the risks and features of floating-rate bank loan funds. The customers were seeking to preserve principal, or had conservative risk tolerances, and brokers made recommendations to purchase floating-rate bank loan funds without having reasonable grounds to believe that the purchases were suitable for the customers. FINRA also found that the firms failed to train their sales forces regarding the unique risks and characteristics of the funds, and failed to reasonably supervise the sales of floating-rate bank loan funds.

Wells Fargo and Banc of America neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Brad Bennett, FINRA's Executive Vice President and Chief of Enforcement, said, "As investors continue to look for yield in a low-interest-rate environment, these actions should serve as a reminder that brokers and their firms need to ensure that investment recommendations are consistent with customers' investment objectives and risk tolerances."

Sources: FINRA Orders Wells Fargo and Banc of America to Reimburse Customers More Than $3 Million for Unsuitable Sales of Floating-Rate Bank Loan Funds; FINRA Also Fines Wells Fargo $1.25 Million and Banc of America $900,000, FINRA News Release (June 4, 2013); Financial Industry Regulatory Authority Letter of Acceptance, Waiver and Consent 2008014763601 (June 4, 2013).

CFTC Rule 4.5 Withstands Litigation Challenges
In our April Update, we reported that the Investment Company Institute and the U.S. Chamber of Commerce (collectively, the plaintiffs) appealed the district court ruling dismissing their lawsuit regarding the Commodity Futures Trading Commission (CFTC) amendments to Rule 4.5 under the Commodity Exchange Act that narrow the available exclusions from the definition of a commodity pool operator (CPO).

On December 13, 2012, the D.C. District Court dismissed the plaintiffs' suit and held that the CFTC adequately conducted a cost-benefit analysis in amending Rule 4.5 and that the CFTC's reasoning was not arbitrary and capricious. The court further explained that it was not the court's role to second-guess the CFTC's analysis. In refuting the plaintiffs' argument that the rule subjects certain entities to dual regulation by the SEC and the CFTC, the court explained that the SEC itself actually admitted that it has not efficiently regulated entities that invest in derivatives.

On June 25, 2013, the U.S. Court of Appeals for the District of Columbia Circuit affirmed the district court's ruling. The court noted that the CFTC outlined in its final rule why it decided to make the amendments, including increased use of derivatives by mutual funds and a perceived lack of market transparency in this area.

Source: Beagan Wilcox Vloz, Appeals Court Deals Defeat to ICI in CFTC Challenge, Ignites (June 25, 2013).

New SEC Commissioners Nominated
President Obama nominated Kara M. Stein and Michael S. Piwowar to serve as commissioners of the SEC. Stein currently is a legal counsel and senior policy adviser for Senator Jack Reed (D-RI) and, if confirmed, will replace Elisse B. Walter. Piwowar currently is a chief economist on the Senate Banking Committee, and previously served as an economist and visiting scholar at the SEC. Piwowar, if confirmed, will replace Troy A. Paredes.

Source: President Obama Announces More Key Administration Posts, The White House Press Release (May 23, 2013).

The information contained herein is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation.

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