Bridging the Week by Gary DeWaal: October 20 to 24 and 27, 2014 (Better Culture; Accountants; London Whale; Asset-Backed Securities; Collusive Activity; Cybersecurity)

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Published Date: October 26, 2014

Promoting stronger cultures at financial industry firms was the theme of a workshop held at the Federal Reserve Bank of New York this past week. Also last week, the Inspector General of the Federal Reserve System acknowledged the FRB NY’s own supervisory weaknesses that caused it not to review trading activity early on in the Chief Investment Office at JPMorgan Chase that ultimately led to losses of over US $6 billion by the end of 2012—the so-called London Whale incident.

As a result, the following matters are covered in this week’s Bridging the Week:

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Senior Fed Officials Encourage Financial Industry Firms to Improve Compliance Culture

Enhancing culture was the theme at a workshop on “Reforming Culture and Behavior in the Financial Services Industry” held at the Federal Reserve Bank in New York City last week.

In two presentations, William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York and Daniel Tarullo, Governor of the Board of Governors of the Federal Reserve System, urged financial institutions to modify compensation arrangements to help promote more desirable employee conduct.

Mr. Dudley specifically argued that more compensation should be deferred and for longer periods, and suggested that re-structuring long-term deferred compensation as debt might better align senior managers’ focus with their firms’ “long-term enterprise value.”

Likewise, Mr. Tarullo claimed that “[t]here is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees.” However, he also argued that, sometimes, poorly conceived or implemented regulations can contribute to a “mere compliance mentality” as opposed to a more meaningful culture.

In his remarks, Mr. Dudley opined that “[c]ulture relates to the implicit norms that guide behavior in the absence of regulations or compliance rules—and sometimes despite those explicit restraints.” He pointed to a number of factors that, in his view, contributed to “cultural failures” that resulted in a number of recent widely reported large sanctions against financial services institutions: the “sheer size, complexity and global scope” of some firms that may have left them “too big to manage;” the trend away from client-focused commercial and investment activities to trading; and large pay packages tied to short-term profits coupled with a “flexible and fluid job market” that has caused employees to have less firm loyalty.

Mr. Dudley argued that a respect for law must be a “core element” of firms’ mission and culture. This, he said, requires a culture of self-policing and self reporting:

If audit uncovers an instance of fraud in one unit, the firm’s leadership should ask, “Where else could this behavior occur?” If the press reports fraud at a competitor in a particular business line, the same self-assessment should apply. “Could this happen to us, could we have a similar problem here?” When fraud is detected, boards and senior leaders must ensure that they are informed promptly, and that a thorough inquiry is undertaken at once. The senior leaders of financial firms, and those who report to them, must also be proactive in reporting illegal or unethical activity. Early self-reporting sends a powerful message to employees and to regulators about a firm’s respect for law.

To better align the broader interests of a firm with employees’ interests, Mr. Dudley argued that at least some employees should have a component of their compensation deferred with vesting occurring over an additional time frame (he gave as an example a five-year deferral period with vesting then occurring over an additional five years).

Mr. Dudley suggested that, for senior managers, the vesting portion of compensation should be paid as debt and used as a “performance bond.” Whereas now, he said, shareholders typically pay for any large sanctions imposed by regulators, going forward, the aggregate total of senior managers’ performance bonds should be first used to pay such fines. According to Mr. Dudley,

[t]his would increase the financial incentive of those individuals who are best placed to identify bad activities at an early stage, or prevent them from occurring in the first place.

Without being as specific, Mr. Tarullo also argued that firms need to amend their incentive arrangements to dissuade them from adopting a culture solely of “mere compliance,” as opposed to “internalize[ing] the aims of the risk-management processes and systems that we expect of them,” which he termed “good compliance.”

Mr. Tarullo noted, however, that sometimes regulators unintentionally “can reinforce … a mere compliance mentality.” He said that this can happen when regulators impose requirements that are generally opposed, even if those inside a firm generally support the requirements’ objectives:

[I]n cases where those inside a firm would stipulate the stated objective of the regulation and still find a regulation badly conceived or implemented, there will be less possibility of internalization or integration into a broader set of firm norms and expectations. This is an outcome that regulators can avoid, and something with which the regulated firms themselves can assist by pointing out what they would regard as more sensible methods for achieving stated regulatory purposes.

Both Mr. Dudley and Mr. Tarullo also argued for more public disclosure when employees are dismissed for misconduct, with Mr. Dudley specifically calling for the creation of a central financial services industry-wide registry that would include information on the hiring and firing of all traders and other financial professionals (modeled after the BrokerCheck system of the Financial Industry Regulatory Authority for securities professionals).

Culture and Ethics: Maintaining a strong compliance culture is essential for each firm in the financial services industry, and balancing incentives to promote culture, no doubt, plays an important part. This means not only interjecting an element of deferral into compensation, but ensuring that compensation appropriately rewards those that control risks as well as those who take risks. However, as Mr. Dudley astutely points out, regulators must be careful not to overwhelm companies with requirements that are too numerous and of questionable utility. Otherwise firms will be too busy fixing these matters of questionable worth and not addressing core values—the difference between “mere compliance” and “good compliance.” In the end, however, it’s all about ensuring that every employee applies the grandmother test to every action he or she takes: do not engage in conduct that you would not be proud to defend to your grandmother when she inquires after reading about it in the morning tabloid (especially if that tabloid is the New York Post)!

CFTC Proposes More Specific Standards to Bar Accountants From Practicing Before It

The Commodity Futures Trading Commission proposes to amend one of its rules (Rule 14.8) to provide more guidance regarding the circumstances when accountants may be barred from practicing before the Commission.

The relevant rule currently has imprecise standards regarding unprofessional conduct that could lead to either attorneys or accountants being prohibited from practicing before the Commission: mainly that such persons: (1) lack requisite qualifications to represent others; (2) lack character or integrity; or (3) have engaged in unethical or improper professional conduct in connection with certain enumerated formal Commission interactions “or otherwise.”

Going forward, unethical and improper professional conduct for accountants is proposed to be defined as: (1) “[i]ntentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional principles or standards;” (2) “[a] single instance of highly unreasonable conduct that results in a violation of applicable professional principles or standards” where the “accountant knows or should know heightened scrutiny is warranted;” or (3) “[r]epeated instances of unreasonable conduct, each resulting in a violation of applicable professional principles or standards, which indicates a lack of competence to practice before the Commission.”

The proposed amendment materially tracks an equivalent rule of the Securities and Exchange Commission (Rule 102(e)). (Click here for further details regarding this rule proposal in the article “CFTC Proposes New Rule Amendments Setting Standards to Bar Accountants” in the October 23 edition of Building Bridges.)

This proposal follows the CFTC filing and settling an enforcement action in August 2013 against Jeannie Veraja-Snelling, the external certified public accountant responsible for auditing Peregrine Financial Group’s year-end financial statements from 2001 through 2011. Peregrine, previously registered with the CFTC as a futures commission merchant, filed for bankruptcy in July 2012 after Russell Wasendorf, its owner and chief executive officer admitted to fraud in stealing customer funds.

As part of these audits, Ms. Veraja-Snelling each year issued (1) unqualified opinions stating that Peregrine’s financial statements were free from material misstatement, and (2) reports on Peregrine’s internal accounting controls concluding that the firm had no material inadequacies, as well as adequate practices and procedures for safeguarding customer funds.

According to the CFTC, Peregrine’s 2011 certified financial statement indicated that the firm was holding in excess of US$ 548 million in customer segregated and secured assets. However, that amount was exaggerated by more than US$ 200 million because of Mr. Wasendorf’s theft of customer funds for personal purposes for at least two decades.

(Click here for details on this CFTC litigation in the article “CFTC Sues Peregrine Financial Group External CPA: Says Her Audits Were Not Up To Professional Standards and She Missed Signs of Problems” in the August 26, 2013 edition of what is now known as Between Bridges.)

The CFTC’s litigation against Ms. Veraja-Snelling did not mark the first time the CFTC has filed an action against an accounting firm for failure to identify material inadequacies of a registrant to the Commission as a result of an audit.

In September 1986, the CFTC filed and settled an enforcement action involving Arthur Andersen & Co. related to its failure to report to the Commission certain material inadequacies in the internal controls of ContiCommodity Services, Inc., at the time one of the largest FCMs (click here for details regarding this action).

And briefly:

Compliance Weeds: As of November 14, new CFTC rules will require FCMs by 6 pm each business day to maintain in each of their customer segregated 1.22 and secured 30.7 accounts sufficient residual interest to cover the aggregate of all customer undermargined amounts for the prior trade date. An equivalent requirement already exists for  customer segregated 22.2 cleared swaps accounts. (Click here for details regarding these new rules in the article "CFTC Adopts More Stringent Customer Funds' Protection Rules" in the October 30, 2013 edition of what is now Between Bridges.) Now is a good time for FCMs to double check their policies and procedures to ensure they are fully compliant with the CFTC's new requirements and that staff is fully trained.

Compliance Weeds: Firms should have explicit policies requiring employees to notify them immediately of information requiring updates to their personal information on their registration data on file with FINRA and/or the National Futures Association. Employees should be obligated regularly to review their personal registration information and notify their employer of any errors. It should be made clear that it is the employee’s duty to update registration information, even if the employer physically processes such information on the employee’s behalf.

My View: I looked up and down in the SEC’s Investor Bulletin to find any statement that subjects of an SEC investigation are not accused of any wrongdoing until a formal legal action is commenced and, even then, may only be found to have violated a provision of law or SEC rule after a formal adjudicatory process or voluntary settlement. Since the SEC found it useful at this time to publish this bulletin, it would have been helpful to disclose these other important caveats too!

And even more briefly:

For more information, see:

Buy- and Sell-Side Industry Organizations Propose Form of Template for Broker-Dealer Minimum Disclosure of Order Routing and Execution Quality Information:

CEO of Member Firm Charged by FINRA With Failing to Update Personal Registration Information to Disclose Tax Liens:

CFTC Proposes More Specific Standards to Bar Accountants From Practicing Before It:

CFTC Staff Says It’s Ok for FCMs to Credit Margin Payments of Certain Clients When Sent, Rather Than When Received; Also Provides Guidance on Residual Interest Matters:

European Commission Settles With Multiple Banks for Collusive Activity:

Federal Reserve Inspector General Finds Deficiencies in Regulatory Oversight of London Whale Risks:

HKFE and LME Offer Reciprocal Membership Arrangement:

Merrill Lynch Sanctioned by FINRA for Not Monitoring Non-US Dollar-Denominated Customer Securities Transactions for Wash Sales:

SEC Issues Investor Bulletin Regarding Enforcement Investigations:

Senior Fed Officials Warn Financial Industry Firms to Improve Compliance Culture:

“Good Compliance, Not Mere Compliance” by Daniel Tarullo (October 20):
“Enhancing Financial Stability by Improving Culture in the Financial Services Industry” by William Dudley (October 20):

SIFMA Asks for Further Delay in Trade Execution Requirement for Package Transactions:

See also Request by MFA:

SIFMA Proposes Cybersecurity Regulatory Guidance:

Six Federal Agencies Adopt Final Rules Regarding Skin in the Game for Sponsors of Certain Asset-Backed Securities:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 25, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article.

Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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