Cadwalader Cabinet: SEC Updates, FINRA AML Violations and More

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Cadwalader Cabinet: Garbage In, More Garbage In

by: Cadwalader, Wickersham & Taft LLP of Cadwalader, Wickersham & Taft LLP - Cadwalader Cabinet

Thursday, January 27, 2022

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SEC Proposes Changes to Private Fund Reporting Requirements

The SEC proposed amendments to Form PF, which is used for reporting by certain SEC-registered investment advisers to private funds. The proposed amendments are meant to enhance the ability of the Financial Stability Oversight Council ("FSOC") to assess systemic risk in light of the growing private fund industry.

Proposed Amendments

The SEC's proposed amendments would do the following:

Add new reporting requirements. The proposed amendments would require current reporting by (i) large hedge fund advisers and (ii) private equity fund advisers. Such reporting might indicate stress at a fund that could harm investors or signal risk in the broader financial system.
Reduce AUM threshold reporting for private equity advisers. The proposed amendments would reduce the reporting threshold for large private equity advisers from $2 billion to $1.5 billion in private equity fund assets under management ("AUM").
Amend Section 4 of Form PF. The proposed amendments would require more detailed information from large private equity advisers with regard to (i) fund strategies, (ii) the use of leverage and portfolio company financings, (iii) controlled portfolio companies and their borrowing practices, (iv) fund investments in different levels of a single portfolio company's capital structure and (v) portfolio company restructurings or recapitalization.
Make reporting consistent with Form N-MFP. The proposed amendments would require large liquidity fund advisers to report substantially the same information that money market funds would report on Form N-MFP to provide a complete picture of the short-term financing markets in which money market funds and liquidity funds both invest.

Comments on the proposal are due within 30 days after its publication in the Federal Register.

Commissioner Statements

SEC Chair Gary Gensler supported the proposed amendments, stating that they "would require certain advisers to hedge funds and private equity funds to provide current reporting of events that could be relevant to financial stability and investor protection." He also noted that the private fund industry has expanded to $11 trillion since the adoption of Form PF in 2011.

SEC Commissioner Allison Herren Lee supported the proposed amendments and gave examples of the types of events the proposed amendments are meant to address, including "deep losses, counterparty defaults, or the inability to meet margin calls." She further noted that "[t]hese kinds of events raise not only investor protection concerns, but in some cases may also implicate systemic risks of the type that the FSOC was designed to address."

SEC Commissioner Hester M. Pierce opposed the proposed amendments and stated that "[a] regulator's desire for data is insatiable, but more data is not always better. Before we seek additional information through Form PF, we must show what we have done with the information we already require and show that it is insufficient to allow FSOC to monitor for systemic risk. I do not think we have done that. Merely citing gaps in data is not enough."

SEC Commissioner Caroline A. Crenshaw supported the proposed amendments, noting that "[t]his proposal is an important step that seeks to put the Commission and FSOC in a better position to understand, assess, and take action regarding significant developments at private funds, potential stresses to the broader financial markets, and practices that raise potentially significant investor protection concerns."

"Form PF is worthless. (See, e.g., comments in 2012; comments in 2013; more comments in 2013; comments in 2014; more comments in 2014; comments in 2015; more comments in 2015; comments in 2016; comments in 2018; more comments in 2018; and so on.)

In the decade since Form PF was required, there has not been a single public report analyzing the data and demonstrating its value. That is not because the data must be kept a secret. Any lawyer knowledgeable about the issues as to which Form PF is intended to elicit information can tell, without seeing the responses, that the questions asked by the report are completely ambiguous and badly stated. There is no way that the responses to the Form PF questions could yield significant results across the industry.

Responses to badly drafted and ambiguous questions do not provide useful information. Rather than insisting upon the collection of more useless information, the SEC should take some time and really revisit the Form, and either get it right or throw it away." said Steven Loftchie

SEC Proposes to Expand Scope of Regulation ATS

The SEC proposed to (i) expand the definition of "exchange" under SEA Rule 3b-16 to include systems that only display "trading interest" (as opposed to "orders"), including by use of "communication protocols"; and (ii) remove the exemption that Regulation ATS currently provides to systems that trade only government securities. Both of these changes will materially expand the number of institutions that must comply with Reg ATS by (i) lowering the bar as to what constitutes an Alternative Trading System and (ii) removing the exemption from Reg ATS registration for systems that trade government securities. In addition, systems that become an automated trading system may not also become subject to Regulation SCI ("Systems and Compliance Integrity").

SEC Chair Gary Gensler supported the proposed amendments, saying that "they would help promote resiliency and greater access in the Treasury market." He noted the importance of revising the SEC rules to reflect exchanges that are "increasingly electronified." He also stated that this proposal would bring Treasury trading platforms with significant volume under Reg SCI, and would also "require these platforms to comply with the Fair Access Rule."

SEC Commissioner Caroline A. Crenshaw also supported the proposal, saying that it would advance "fair competition" among similar markets. She noted that, by bringing CPS under the regulatory framework, it would (i) "help ensure that there is a level playing field for entities performing similar functions," (ii) provide "investor protections" and (iii) "comply with fair and orderly market provisions under the Fair Access Rule." She emphasized that the extension of "transparency requirements to ATSs that trade government securities" will provide more clarity as to their operations, which should allow "investors to compare different venues" and choose one that aligns with their "trading objectives."

SEC Commissioner Hester M. Peirce disapproved of the amendments. She noted that the "unrealistic time constraint" of a 30-day comment period will undermine careful deliberation about the proposal's "possible effects." She also stressed that the amendment regarding the definition of "exchange" expands too far, to the extent that it "would apply to any trading venue," and "could deter innovation and dissuade" new market participants.

"Proposing major rule changes and allowing only a 30-day comment period is simply inappropriate. This is an entirely separate question from whether the rule is good or bad. Market participants should be entitled to a reasonable amount of time to review a major rule change, consider its implications, gather together as a group, exchange ideas and reactions, and comment. There is no emergency here, just as there is no emergency in the stock lending market. Part of the regulatory process is having real respect for public comment and giving adequate time for that comment. The fact that the SEC provides for the minimum comment period permitted under the relevant statute does not mean that the SEC is providing a sufficient time for comment," said Steven Loftchie

U.S. Government Issues Advisory on Burma Risk

Six U.S. federal executive departments collectively issued an Advisory on the risks associated with doing business in Burma. In the Advisory, the executive departments recommended that businesses and individuals conduct appropriate due diligence to ensure they are not engaging with Burma in ways that that may expose them to various reputational, financial and legal risks, including violations of U.S. AML and sanctions.

The Advisory highlighted four primary industries in Burma that have been of particular concern since the Burma military overthrew the country's democratically elected government in 2021: (1) state-owned enterprises, (2) gems and precious metals, (3) real-estate and construction projects, and (4) arms, military equipment, and related activity. According to the Advisory, these industries not only provide economic resources to Burma's military regime, which has committed egregious human rights violations, but also are associated with child and forced labor, corruption, money laundering, and illegal arms trade and trafficking.

The executive departments called on those who work within the abovementioned sectors to undertake appropriate investigations to ensure that their conduct is in compliance with U.S. sanctions and money laundering controls.

Firm Settles FINRA Charges for AML Program Violations

A firm settled FINRA charges for failure to establish and implement AML policies and procedures.

In a Letter of Acceptance, Waiver and Consent ("AWC"), FINRA stated that "following a change in majority ownership, the firm’s business model shifted, and it began to service high-net worth international customers, many of whom were citizens or residents of jurisdictions that posed a heightened risk of money laundering or were considered bank secrecy havens." FINRA found that, from May 2018 to December 2019, the firm failed to (i) establish and implement a written AML program reasonably designed to detect and report suspicious activity tailored to the firm's new higher-risk business model, (ii) conduct a reasonable and independent AML test for the firm's retail securities business and (iii) obtain the signature of a principal at the firm evidencing supervisory review and approval of the opening of customer accounts.

FINRA charged the firm with violations of FINRA Rules 3110 ("Supervision"), 2010 ("Standards of Commercial Honor and Principles of Trade") and 4512 ("Customer Account Information").

To settle the charges, the firm agreed to (i) a censure, (ii) a $20,000 fine, and (iii) within 120 days of the AWC being accepted, certifying to FINRA in writing that the firm has developed and implemented a written AML program reasonably designed to achieve and monitor its compliance with the requirements of the Bank Secrecy Act and its implementing regulations.