Gary DeWaal's Bridging the Week: January 27 to 31, and February 3, 2014 (Computer Glitches, Employee Raid Aftermath, and a CCO Suspension)

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Published Date : February 03, 2014

Last week, many in the world celebrated the lunar New Year and the arrival of the "Year of the Horse." However, there were no celebrations at two large financial service firms when complex computer systems they daily relied on for compliance with regulatory obligations turned out to be Trojan horses. This was because coding issues made these computer systems produce reports that looked accurate but in fact contained incomplete or inaccurate information that caused the firms significant regulatory headaches, including large fines.

As a result, the following matters are covered on this week's Gary DeWaal's Bridging the Week:

• Computer coding errors result in fines for two US SEC registrants (includes Compliance Weeds);
• State Street UK fined GB £22.9 Million (US $37.9 Million) by UK Financial Conduct Authority for deliberately charging clients more than agreed management fees or commissions;
• FINRA fines Broker Dealer and suspends BD's former CCO and AML officer for inadequate AML program;
• UK FCA bans from the industry former BGC senior officer for employee raiding dispute with a competitor;
• IOSCO publishes recommendations regarding client asset protection and survey of client asset protection regimes of 20 jurisdictions;
• Member of European Central Bank Executive Board warns of certain risks of central clearing (includes My View);
• BNP Paribas cited by Australian regulator for potential misconduct related to the Australian Bank Bill Swap Rate;
• ICE Clear Credit proposes rule changes related to cash and collateral fees;
• SEC advises on industry measures to enhance alternative investments' selection; and more.

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Computer Coding Errors Result in Fines for Two SEC Registrants

Both Scottrade, Inc., a broker dealer, and Western Asset Management Company, an investment advisor, settled enforcement actions with the US Securities and Exchange Commission last week related to rule violations that initially derived from computer system coding errors.

Scottrade

In its enforcement action against Scottrade, the SEC charged the firm with violating its record keeping obligations. This is because the Firm failed to provide the SEC complete and accurate information in response to requests for information related to possible law violations (blue sheet requests).

In 2003, Scottrade instituted a new back office processing system to store and provide information to the SEC and self-regulatory organizations in response to blue sheet requests. In March 2006, the Firm implemented a code change to this program. However, this code change inadvertently caused Scottrade not to report to the Commission on 1,231 occasions certain types of trades from March 2006 through April 2012. The problematic trades were trades that had been transferred from Scottrade's customers' to its own error accounts because the trades resulted from trading errors or had been deemed fraudulent.

The SEC acknowledged that this error was not intentional and that Scottrade's Information Systems Department had conducted tests of the data processing system after the coding change, and that the Compliance Department annually tested samples of blue sheet responses, but both departments failed to discover the problem.

For its violations, Scottrade agreed to pay a fine of US $2.5 Million and retain an independent consultant to assess the adequacy of, and make recommendations regarding, the Firm's policies and procedures regarding blue sheet submissions.

Western Asset Management

In the other computer coding incident, Western Asset Management Company (WAM) was charged by the SEC with various violations of the Investment Advisers Act, including a prohibition against fraud and a requirement that managers maintain policies and procedures to avoid violations of law.

WAM's offense related to the initial allocation of securities from a private placement to accounts of various retirement plans subject to the Employee Retirement Security Act, contrary to offering restrictions by the issuer. WAM did not take prompt action to correct its mistake, nor notify the affected retirement plans until months after it liquidated the securities from their accounts.

After WAM purchased US $50 Million of the relevant private placement in early 2007, a WAM compliance officer made change regarding the nature of the issuer's security on the Firm's automatic compliance system. However, this change automatically changed the designation of the security to "ERISA eligible," when in fact it was not. Thereafter, WAM continued to purchase the relevant issuer's security for its customers' accounts, including more than US $90 Million worth of the private issue for 99 ERISA accounts. More than a year later, WAM recognized its error; however, it did not liquidate the security or notify the relevant accounts until almost two years after the initial incident. Moreover, it did not reimburse the ERISA accounts for losses sustained as a result of the liquidation.

In connection with its settlement, WAM agreed to pay US $10 Million to harmed clients, a US $1 Million fine to the SEC, and a US $1 Million fine to the Department of Labor in connection with a separate enforcement action brought regarding the same matter. WAM is a subsidiary of Legg Mason, Inc.

In an unrelated action, WAM also agreed to pay impacted clients US $7.4 Million, a US $1 Million fine to the SEC, and more than US $600,000 to the Department of Labor, for engaging in prohibited cross trade transactions.

In this other matter, the SEC alleged that WAM, on behalf of various clients, including ERISA clients, sold certain mortgage-backed securities and similar assets into a declining market from 2007 through 2010. However, WAM had arranged for certain broker-dealers to buy these securities and sell them back to other WAM clients with greater risk tolerance. These transactions were done as cross trades at the bid price, rather than at an average price in between the bid and ask, providing the new purchasing clients with the full benefit of the cross, while the selling clients were harmed. However, WAM owed a fiduciary duty to both its selling and buying clients.

In additions to paying restitution and a fine, WAM also must hire a compliance consultant to conduct a follow-up review of certain recommendations made by a remedial consultant related to WAM's systems and controls related to cross trades.

Compliance Weeds: Once again, changes to software and data entry have caused issues with firms' computer systems that caused inadvertent compliance issues that the firms were unable to self detect promptly. This should again remind firms that:

1. periodically, tests on computer systems to emulate regulatory requests should be conducted to ensure that the production is as anticipated.
2. output generated by new or amended software should be reviewed carefully following roll-out to ensure it is producing data as anticipated; and
3. no change to computer software should be implemented without following the procedure for rolling out new software;
4. no new computer software should be implemented without a comprehensive consideration and testing of such system prior to roll-out, in a robust test environment, to ensure (a) full compliance with all applicable regulatory requirements and (b) no impact on other systems' compliance with all applicable regulatory requirements.

All testing should be documented in writing and include the sign-off of appropriate Compliance and IT staff.

State Street UK Fined GB £22.9 Million (US $37.9 Million) by UK Financial Conduct Authority for Deliberately Charging Clients More Than Agreed Management Fees or Commissions

In connection with its transition management services, State Street Bank Europe Limited and State Street Global Markets International Limited (collectively State Street UK) were fined GB £22.9 Million (US $37.9 Million) by the UK Financial Conduct Authority for developing and executing, "a deliberate and targeted strategy to charge substantial mark-ups on certain transitions, in addition to the agreed management fee or commission, that were deliberately not agreed with clients or disclosed to them." As a result, six customers were overcharged over US $20 Million as a result of transitions undertaken on their behalf between June 2010 and September 2011.

Transition management services involve carrying out structural changes to asset portfolios on a client's behalf. TM clients at State Street UK are typically large investment management firms or asset owners (including pension fund trustees) holding pension funds or savings on behalf of retail investors.

FCA claimed that, during the relevant period, State Street UK failed to take "reasonable care" to ensure that relevant documentation, the trading process, or communications with clients were adequately monitored. The FCA attributed this to the State Street's "matrix management framework."

Apparently, after an individual client identified certain non-agreed mark-ups on certain trades, the management of the group directly overseeing this business claimed the mistaken mark-up was inadvertent and paid a substantial rebate on that basis for those trades only. However, the managers failed to disclose the existence of other improper mark-ups to the same client, State Street UK Compliance, or State Street UK senior management. Subsequently, managers outside the group raised concerns and an internal investigation was conducted, problems found, and rebates or offers of rebates provided to all impacted customers.

In agreeing to the fine with State Street UK, the FCA gave the Firm credit for implementing its own "comprehensive remediation program, at its own initiative" to resolve this matter with its clients and to enhance its control environment.

And briefly:

• FINRA Fines Broker Dealer and Suspends BD's former CCO and AML Officer for Inadequate AML Program: The Financial Industry Regulatory Authority fined Banorte-Ixe Securities International, Ltd, a broker dealer US $475,000 for not having adequate anti-money laundering procedures and not registering between 200-400 foreign finders who dealt with Mexican clients.  More significantly, FINRA also suspended the Firm's former Anti-money Laundering and Chief Compliance Officer for 30 days in a principal capacity. According to FINRA, because of its failures, the Firm, among other matters, opened an account for a corporate customer owned by an individual with reported ties to a drug cartel without investigating or reporting the rapid movement in a short period during 2010 of large amounts of US dollars in and out of the account. FINRA claimed that Banorte and Mr. Simms did not adopt AML Policies and Procedures that were particularized to the Firm's business (using off the shelf procedures, instead); did not enforce the Firm's AML program; and did not detect certain suspicious activities despite reviewing all securities transactions and wire transfers.
   
• UK FCA Bans from the Industry Former BGC Senior Officer Related to Raiding Dispute with a Competitor: The FCA banned Anthony Verrier, the former Executive Managing Director and General Manager responsible for BGC's London and European Offices from any regulated activity in the financial services industry because of his role and conduct in an employee recruiting raid on an inter-dealer broker competitor, Tullet Prebon, during 2009. The FCA claimed that Mr. Verrier is not fit and proper because of concerns over his integrity. Prior to joining BGC, Mr. Verrier was Tullet's second most senior executive. Mr. Verrier joined BGC during January 2009, and then proceeded to recruit a substantial number of Tullet employees. The means he utilized, claims the FCA, were unlawful, and included (quoting the High Court that adjudicated a suit by Tullet against BGC), "…the inducement of the [employees] to breach their contracts with Tullet by leaving early without justification." According to the High Court, during the litigation, "Mr. Verrier stuck to the truth where he was able to, but departed from it with equanimity and adroitness where the truth was inconvenient."
   
• IOSCO Publishes Recommendations Regarding Client Asset Protection and Survey of Client Asset Protection Regimes of 20 Jurisdictions: The International Organization of Securities Commissions last week published recommendations regarding the protection of client assets at regulated intermediaries, as well as a survey of the client protection regimes of 20 worldwide jurisdictions. This comprehensive survey and a summary chart are the most helpful part of this publication to brokers and customers. In general, IOSCO's recommendations are mostly very high level, and in some cases reflect minimum standards that may already have been exceeded by local regulatory requirements (e.g., measures adopted by the CFTC and self regulatory organizations in the US post the failures of MF Global and Peregrine Financial Group). For a detailed article, see: http://www.garydewaalandassociates.com/?p=1908.
   
• Member of European Central Bank Executive Board Warns of Risks of Central Clearing: Last week, Benoit Coeure, a member of the Executive Board of the European Central Bank, discussed "some unintended side effects that need to be addressed" related to the reliance on central clearing counterparties after the 2008 financial crisis. He did this in a presentation before the Office of Financial Research and Financial Stability Oversight in Washington, DC. Although Mr.  Coeure acknowledged many commonly accepted benefits of clearing, he noted that the rise in central clearing is leading to a number of side effects: including risk concentration within CCPs that are causing them to become "institutions of unprecedented systemic importance." Mr.  Coeure also warned that access to CCPs may be limited to a "few large global intermediaries." According to Mr.  Coeure, "[a] factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms." Although Mr.  Coeure supports the "trend towards central clearing, "[i]t strikes me however that further efforts are needed to be able to cope with CCP default, to address risks associated with changes in market structures, and to remove cross-border differences in regulation where needed.

  My View: This is a very important speech by a very distinguished government official. Although Mr.  Coeure articulates the many well-acknowledged benefits of central clearing, he discusses certain risks of the global march towards central clearing, including the concentration of global market risk among just a few CCPs. He also comments on the possible evolution in the marketplace to there being just a few clearing members, causing problems of access for other than the most commercially attractive end clients. His concerns are well worth considering.

• BNP Paribas Cited by Australian Regulator for Potential Misconduct Related to the Australian Bank Bill Swap Rate: BNP Paribas agreed to an enforceable undertaking" with the Australian Securities & Investments Commission and made a "voluntary" Aus $1 Million contribution to fund financial literacy programs in Australia related to possible misconduct in connection with its role in settling the Australian Bank Bill Swap Rate (an Australian benchmark interest rate) at various times from 2007 to 2010. This possible misconduct was discovered by a BNP self-conducted internal audit in late 2012 initiated at the request of the Monetary Authority of Singapore. An independent expert retained by the Firm found that the potential benefit to BNP of this possible misconduct was negligible and the potential impact on the market ("and no such impact had been established") would have been very minor.
   
• ICE Clear Credit Proposes Rule Changes Related to Cash and Collateral Fees: ICE Clear Credit filed last week with the Securities and Exchange Commission a proposed rule change related to the manner it charges clearing participants for cash and collateral posted with it as margin or to satisfy guaranty fund obligations. Going forward it proposes to charge a five basis point fee (annualized, but calculated and charged monthly) on US Treasury securities balances. In addition, it proposes to retain an unspecified portion of the interest earned on cash balances. These changes are proposed to be effective today, February 3. These charges are consistent with charges implemented by ICE Clear US on January 1, 2014 (See article, "ICE Clear US Announces New Fees for Collateral and Cash Holdings at:" http://www.garydewaalandassociates.com/?p=1599).
   
• SEC Advises on Industry Measures to Enhance Alternative Investments' Selection: The SEC published a Risk Alert related to the due diligence processes used by investment advisers to select alternative investments. In this Risk Alert the SEC set forth "observations" of specific measures investment advisers have implemented to help them determine whether such investments (1) meet their clients' investment objectives; and (2) are consistent with principles and strategies disclosed to the manager. Among the SEC's observations are that investment advisers are (1) seeking more and broader information and data directly form alternative investments' managers; (2) using third parties to help in their analyses and validate information; (3) performing additional quantitative analyses and risk measures on alternative investments and their managers; and (4) augmenting and expanding their due diligence processes and focus areas. By conducting this due diligence, investment advisers are seeking to find possible indications of problems earlier. Although the SEC's observations seem to articulate minimum standards, in fact the SEC categorically makes its clear "it does not take a position regarding the effectiveness or ineffectiveness of the industry practices" it describes in the Risk Alert. Alternative investments include hedge funds, private equity, venture capital, real estate and funds of private funds.

And even more briefly:

• The US Commodity Futures Trading Commission's Division of Market Oversight announced that more credit default swap contracts had been deemed self-certified as available to trade. These contracts were proposed by MarketAxess SEF, and must be executed on or subject to the rules of a Designated Contract Market or Swap Execution Facility as beginning February 26, 2014.
• The CFTC has rescheduled the recently cancelled Technology Advisory Committee for February 10. Its agenda includes discussions of swap data reporting; the CFTC's concept release on Automated Trading Environments and the impact of Made Available to Trade Determinations on so-called "packaged transactions." These packaged transactions will also be the subject of a public roundtable hosted by the Division of Market Oversight on February 12. The Global Markets Advisory Committee will meet too on February 12 to discuss the applicability of transaction-level requirements in certain cross-border situations.
• The European Securities and Markets Authority recommended to the European Commission a conditional equivalence determination for Japan for Central Counterparty Clearinghouses that clear transactions involving securities, currencies, interest rates, weather and other indices. If followed by the EC, this would permit such CCPs to be recognized within the EU by following certain Japan rules governing CCPs, not European rules (i.e., EMIR).
• The US National Futures Association has clarified that any type of NFA member as well as the public, are welcome to submit comments in response to its Request for Comments related to CPO/CTA Capital Requirements and Customer Protection Measures, initially published on January 23, 2014. Comments are due by April 15. For background, see: http://www.garydewaalandassociates.com/?p=1879).

Fore more details, see:

ASIC Enforceable Undertaking with BNP Paribas:
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/028399392.pdf/$file/028399392.pdf.

CFTC MAT Confirmation for MarketAxess SEF:
http://www.cftc.gov/PressRoom/PressReleases/pr6843-14.
ESMA Proposes Conditional Equivalent Determination for Japan CCPs:
http://www.esma.europa.eu/system/files/2014-esma-123_-_esma_technical_advice_on_equivalence_of_japan_for_ccp_ii__-_commodities_ccps.pdf.
CFTC Scheduled Hearings:

DMO (Packaged Transactions):
http://www.cftc.gov/PressRoom/PressReleases/pr6845-14.
Global Markets' Advisory Committee:
http://www.cftc.gov/PressRoom/PressReleases/pr6842-14.
Technology Advisory Committee:
http://www.cftc.gov/PressRoom/PressReleases/pr6840-14.

FCA: Final Notice re: Anthony Verrier:
http://www.fca.org.uk/static/documents/final-notices/anthony-verrier.pdf.
FCA: Final Notice re: State Street UK:
http://www.fca.org.uk/static/documents/final-notices/state-street.pdf
FINRA: Banorte-Ixe Securities International, Ltd:
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p440109.pdf.
ICE Clear Credit Cash and Collateral Fees Proposal:
https://www.theice.com/publicdocs/regulatory_filings/ICC_SEC_013114.pdf.
NFA Clarifies Who May Submit Comments for NFA's CTA/CPO Capital Requirements and Customer Protection Measures Request for Comments:
http://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4381.
SEC Alternative Investments Due Diligence Processes:
http://www.sec.gov/about/offices/ocie/adviser-due-diligence-alternative-investments.pdf.
SEC Computer Coding Enforcement Actions:

Scottrade:
http://www.sec.gov/litigation/admin/2014/34-71435.pdf.
Western Asset Management:
http://www.sec.gov/litigation/admin/2014/ia-3763.pdf.
http://www.sec.gov/litigation/admin/2014/ia-3762.pdf.

See Department of Labor Press Release Regarding These Matters:
http://www.dol.gov/opa/media/press/ebsa/EBSA20140113.htm.

Speech by Benoit Coeure Risks in Central Clearing Counterparties:
http://www.bis.org/review/r140127c.htm.

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of February 1, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.

Recent Commentaries

• Bridging the Week has moved.
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