Legal Alert: Summary of Selected Programs from SIFMA ... · Comments from the Regulators at the...

LEGAL ALERT

April 3, 2007

© Sutherland 2007. All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient. 1 ATLANTA AUSTIN HOUSTON NEW YORK TALLAHASSEE WASHINGTON DC www.sutherland.com

Summary of Selected Programs from SIFMA Compliance & Legal Division’s 2007 Annual Seminar

Recently, the Securities Industry and Financial Markets Association (“SIFMA”) Compliance & Legal Division hosted its annual seminar. Drawing some 2,000 securities industry participants and observers, the seminar constitutes one of the leading educational seminars of its kind. The securities industry represents a substantial part of the client base we serve at Sutherland Asbill & Brennan LLP, including broker-dealers, investment advisers, investment banks, hedge funds, mutual funds, and other businesses and individuals associated with the financial services industry. Sutherland is a proud sponsor of the seminar and, as you might expect, many of our attorneys look forward to attending each year. This year 11 of our securities litigation and arbitration, enforcement, and regulatory attorneys attended and/or presented at the seminar. Understanding that not all of our clients and friends attend the seminar, and even those who do cannot take part in every program and workshop, we make it a point each year to send a summary of certain selected seminars and workshops to our clients and others. This year is no exception, and we hope you will find the summary that follows informative. As always, if you have any questions about our summary, or if we can otherwise be of service to you, please contact any of the partners listed at the end of the summary.

© Sutherland 2007. All Rights Reserved. This article is for informational purposes and is not intended to constitute legal advice. 2 ATLANTA AUSTIN HOUSTON NEW YORK TALLAHASSEE WASHINGTON DC www.sutherland.com

Table of Contents

Page

Comments from the Regulators at the General Sessions……………………………........ 3 Electronic Communications……………………………………………………………… 7

Information Barriers……………………………………………………………………… 8

Managing Conflicts………………………………………………………………………. 9

Issues of the Smaller Broker-Dealer……………………………………………………… 9

Designing an Effective Retail Surveillance Program……………………………….......... 9

Structured Products………………………………………………………………….......... 10

Mutual Funds – The Broker-Dealer (Distributor) Perspective…………………………… 11

Variable Annuities – The Distributors’ Perspective…………………………………. ….. 12

Development of New Products and Services……………………………………………... 13

Compliance Directors/Chief Compliance Officers Roundtable (Large Firm Retail).......... 14

General Counsels’ Roundtable……………………………………………………………. 15

Customer Complaints…………………………………………………………………….. 17

Arbitration (Sessions I and II)……………………………………………………………. 18

Mediation…………………………………………………………………………………. 21

Litigation Update – Major Civil Cases……………………………………………………. 22

Challenges of Electronic Discovery………………………………………………………. 23

Litigation Update – Regulatory and Criminal ……………………………………………. 25

Employment Litigation and Workplace Issues…………………………………………… 26


Comments from the Regulators at the General Sessions

High-ranking representatives from the SEC, NASD, and the NYSE were on hand to brief seminar participants on current issues and initiatives. The regulators who spoke at the General Sessions touched on common themes. Each focused on a need to move from the current rules-based regulatory approach to a more flexible principles-based approach. Other topics addressed included the consolidation of NASD and the NYSE, the evolution of regulators, and the underpinnings of effective regulation.

Annette L. Nazareth, Commissioner, U.S. Securities and Exchange Commission1

U.S. Securities and Exchange Commissioner Annette L. Nazareth inaugurated the substantive portion of the Annual Seminar on Monday, March 26, giving a keynote address in coordination with Mary Schapiro, Chairman & CEO of NASD. Addressing the debate over whether to adopt a one-size-fits-all, rules-based approach or an overarching principles-based approach to regulation, Nazareth advocated another approach: a “prudential approach.” Incorporating elements of both the rules-based and principles-based approaches, Nazareth’s “prudential approach” would articulate a “clear set of standards” while allowing “a more flexible implementation approach for meeting those standards.” This approach, she stated, would result in more efficient, but not less effective, regulation. According to Nazareth, the need for prudential regulation arose in the 1990s with the Drexel Burnham failure.2 The demise of Drexel Burnham resulted in the Market Reform Act of 1990,3 requiring larger broker-dealers to provide, among other things, information about material affiliates. Although the Market Reform Act of 1990 was the first instance of prudential regulation, Nazareth touted the Consolidated Supervised Entity (“CSE”) as the SEC’s best example of such regulation. CSE is a system of supervision of five of the largest broker-dealer holding companies. The Commission monitors for—and can respond to—financial or operational weakness in a supervised entity’s holding company or unregulated affiliates. Rather than taking a rules-driven “cookie cutter” approach to documentation, the CSE system takes into account the unique nature of the business. This approach allows documentation to be reviewed for both adequacy of controls as well as implementation. The Commission staff and senior managers interact to test the firm’s implementation of documented controls. The SEC foresees broadening this type of approach to other areas, such as portfolio margining. Nazareth cautioned, however, that although the prudential approach works in the risk management context, it might not work in the sales practices context, where investor protection concerns might necessitate a more rules-based model. Interestingly, Nazareth also cautioned that the prudential approach would require “heavy investment in internal controls and infrastructure that likely would be too burdensome for some firms.”

1 The full text of Nazareth’s speech is available at http://www.sec.gov/news/speech/2007/spch032607aln.htm. 2 Despite Drexel Burnham’s compliance with the net capital requirements, the broker-dealer failed when its associated holding company, which was the broker’s point of access to the public financial markets, lost the ability to raise capital in the public debt markets following the Michael Milken and Ivan Boesky scandals. 3 Pub. L. No. 101-432, 104 Stat. 963 (1990).


Mary L. Schapiro, Chairman & CEO, NASD4

Mary Schapiro followed up on Nazareth’s remarks by taking a seemingly different view in addressing the type of regulatory approach that should be adopted. Schapiro foresees and supports a move from the “one-size-fits-all” rules-based approach to a principles-based approach. As she recognized in her remarks, a change from a rules-based approach is necessitated by the growth in size and complexity of markets and, consequently, industry firms, along with the expanding array of financial services and products. She supports the move to a principles-based approach because broker-dealers have varying business models and a wide variety of investment products that cannot be pigeonholed into black-and-white rules requiring specific behaviors or imposing specific requirements. Moreover, although Schapiro recognized that a principles-based approach may seem troublesome for not being cut-and-dried, she supports a move to such an approach, stating it is necessary. Schapiro also acknowledged the need to tailor the regulatory scheme to fit a world that is not confined by geography, time zones, or static investment products. Regulations must mesh with the new economy, the new face of broker-dealers, and the introduction of new financial products into the marketplace. Regulators, too, must continue to evolve. For example, Schapiro suggested that they should become more proactive in identifying problems, assisting the industry in meeting its compliance and regulatory obligations, and finding ways to engage investors rather than simply responding to customer complaints. Schapiro also briefly discussed the upcoming consolidation of NASD and the NYSE. Schapiro stated that the new SRO would result in a more sensible and less complex regulatory system that will reduce regulatory costs and provide more effective protection for investors. The new SRO, to be staffed by a team of 3,000, will be the sole private-sector regulator for all 5,100 firms doing business in the United States. It will bring together NASD and NYSE Regulation’s member firm examination and related enforcement functions, as well as arbitration and risk assessment. The SRO will consist of one set of examiners and one set of enforcement staff. Crediting SIA’s 2000 white paper,5 which suggested a regulatory consolidation, Schapiro touted the new SRO as crucial to the U.S. financial regulatory structure.

Richard Ketchum, CEO, NYSE Regulation, Inc.6

Richard Ketchum gave opening remarks on Tuesday, March 27, providing comments on—among other issues—the upcoming NYSE-NASD merger, prudential-based regulation, and the underpinnings of effective regulation. Although Ketchum expressed support for a principles-based approach to regulation (as opposed to the current rules-based approach), he cautioned against viewpoints that oversimplified the regulatory issues involved or that advocated a principles-based approach “as a means to avoid regulatory compliance costs or disciplinary accountability.” Ketchum mentioned “prudential” regulation but seemed to use the term interchangeably with “principles-based” regulation.

4 The full text of Schapiro’s speech is available at http://www.nasd.com/PressRoom/SpeechesTestimony/MaryL.Schapiro/NASDW_018865. 5 Available at http://www.sia.com/market_structure/html/siawhitepaperfinal.htm. 6 The full text of Ketchum’s speech is available at http://www.nyse.com/Frameset.html?nyseref=&displayPage=/about/viewpoints.html.

http://www.sia.com/market_structure/html/siawhitepaperfinal.htm

http://www.nyse.com/Frameset.html?nyseref=&displayPage=/about/viewpoints.html


Ketchum ended his address by providing his list of the five underpinnings of effective regulation. These included (1) implementing a prudential approach to regulation, (2) giving “conscious consideration” to whether more general requirements can allow for “more industry-empowered, risk-based discretion,” (3) recommitting to providing greater levels of interpretive guidance, (4) rededicating to effective, less adversarial interaction with stakeholders in formulating and applying rules, and (5) accepting that investor education represents a core regulatory responsibility.

SEC Panel Discussion

Four representatives from the SEC7 participated in a panel discussion on the morning of Tuesday, March 27. The panel discussed five hot topics before the SEC and, as usual, gave their top ten list of areas on which SEC examiners will be focusing in the coming year. The discussion of hot topics began with the ability of U.S. investors to invest in foreign securities. The concern, of course, is establishing a regulatory framework to protect those retail investors. The SEC is reviewing current rules to determine what impact they have on foreign investments and whether they provide sufficient protection. The panelists cited an article written by two SEC staff members: Ethiopis Tafara and Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 HARV. INT’L L.J. 1, 31 (Winter 2007). This article provides other possible recommendations for “cross-border” trading. The panel’s second hot topic was the regulation of mutual funds. Items addressed included the implementation of data-tagging and the decision in Chamber of Commerce v. SEC, 443 F.3d 890 (D.C. Cir. 2006). The panel observed that the implementation of data-tagging—working toward a streamlined shareholder prospectus that incorporates identifier information —has been put on the backburner while current rules are revisited. The panel moved next to a discussion of insider trading cases, noting the industry’s surprise at the continued prevalence of these cases. Several new decisions were cited, including Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 443 F.3d 987 (8th Cir. 2006), cert. granted, 2007 WL 879583 (US March 26, 2007) in which the Supreme Court recently granted certiorari (this case is addressed in the “Civil Litigation Update” below). Other insider trading cases of note were SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006), and SEC v. Talbot, 430 F. Supp. 2d 1029 (C.D. Cal. 2006). The fourth hot topic for the panel was portfolio margining. They discussed NASD’s upcoming pilot program on portfolio margining and noted the SEC’s efforts to set requirements for portfolio margining while also allowing firms to implement their own controls. The panel’s fifth topic included a discussion of how matters are decided before the Staff and how they become enforcement actions. The panel noted that the SEC is referring more exams to the SROs, such as matters involving misuse of material nonpublic information, suitability, sales to seniors, or execution practices. Finally, the panel provided their top ten list of issues to which SEC examiners are now paying special attention:

7 The SEC participants were Jennifer McHugh, Lori A. Richards, Erik R. Sirri, and Andrew N. Vollmer.


retail sales practices, including supervision and documentation of suitability; fee-based accounts;

net capital requirements and customer reserves;

trading issues, including best-execution issues and insider-trading prevention;

fixed income issues, including trade markups and execution quality;

anti-money laundering issues;

internal controls; information and account security, including identity theft issues;

business continuity; and

supervision as a catch-all.

Current Enforcement Issues

A panel including Joseph P. Borg of the Alabama Securities Commission, Susan L. Merrill of the NYSE, James S. Shorris of NASD, and Linda Chatman Thomsen of the SEC discussed current enforcement issues and best practices for broker-dealers. During a discussion on hedge funds, the panel noted that big cases, fines, and penalties had decreased as a whole, but that the years 2004 and 2005 saw an increase in smaller issues. Panelists discussed whether additional regulation of hedge funds should be imposed. It was noted that broker-dealers are concerned that they could be held liable for aiding and abetting a hedge fund’s fraudulent conduct. The panel recommended looking for “red flags,” understanding the firm’s relationship with the hedge fund in all of its complexities, recognizing the potential conflict of interest that exists, enlisting a task force, and considering an official agreement with the hedge fund. On the upcoming NASD/NYSE merger, the panel noted that the enforcement docket of the two SROs would be harmonized upon consolidation. Moreover, the panel indicated that the two rule books that now exist would be melded into one book. Many of the panelists saw the merger as an opportunity for states to increase their coordination with the new SRO. Finally, the panel presented its own top ten list of best practices that broker-dealers should adopt:

Developing, updating, and enforcing written supervisory procedures; Ensuring that the firm provides each customer, within 30 days of account opening, upon updating,

or on a rolling 36-month period, copies of the new account information, all customer agreements, and “Plain English” definitions of the broker-dealer’s investment objectives;

Providing customers with names and addresses for returning inaccurate account information, as

well as information on where to direct customer complaints and questions (to the firm rather than the registered representative);


Developing effective standards and criteria for determining suitability;

Ensuring that exception reports are generated when necessary and that “red flags” are

documented and resolved in a timely manner; Developing a branch audit program that includes an effective audit plan, unannounced visits,

communication of audit results, corrective action by the branch and an effective follow-up plan; Ensuring that registered representatives disclose—and firms adequately investigate—outside

business activities and requests to sell unapproved securities; Ensuring that advertisements and sales literature are approved prior to use and contain full and

fair disclosures; Approving seminars, guest speakers and handout materials in advance; and

Implementing a system for monitoring, capturing and maintaining correspondence, both electronic

and hard copy, sent by registered representatives from outside the firm.

Electronic Communications

A panel that included representatives from the NASD and NYSE8 tackled the thorny issues surrounding supervision and retention of electronic communications. According to at least some panelists, the supervision of electronic communications—including e-mail, instant messaging, chat rooms and websites—has become an important issue because the applicable rules are ambiguous and offer little guidance as to what regulators may require in the future. While there are no formal SEC regulations regarding supervision of these types of communications, the SEC stated in a 1996 Release that “the rules concerning the supervisory requirements for electronic communications should be based on the content and audience of the message, and not merely the electronic form of the communication.” Securities Exchange Act Release No. 7288, 1996 SEC LEXIS 1299, at *7. Panelists noted that NYSE and NASD rules governing the review of communications give members flexibility to develop policies and procedures that are appropriate for their business, size, structure and customers. Both SROs have clarified that a firm’s record retention policy should include procedures for reviewing and maintaining e-mails, instant messages, and other electronic communications. In 2005, NASD and the NYSE formed a joint task force to develop best practices for supervising and maintaining electronic communications. Panelists expect the task force, which will be publishing its findings soon, to recommend that firms adopt written supervisory procedures that would identify, among other things, specific persons responsible for review, the frequency of review, and the method of documenting the reviewer’s findings. The panel observed that, currently, firms are required to review a portion of all external communications and to devise a way of supervising non-member e-mail accounts, instant messages, and web-based message boards if employees are allowed to use such sites. While firms may use a risk-based approach

8 The regulatory representatives were Kris Daily, Managing Director of NYSE’s Regulatory Development and Services Group, and Patrice Gliniecki, Senior Vice President and Deputy General Counsel of NASD’s Office of General Counsel.


to supervise internal e-mail traffic—focusing on e-mail deemed most likely to be problematic by, for instance, reviewing e-mail traffic to or from higher risk brokers or e-mail containing certain words—they should keep records indicating who reviewed e-mail and their training and qualifications. Panelists also advised firms to keep records of when the review took place, what communications were reviewed, and what steps were taken as a result of any significant issues identified. Unfortunately, many firms, according to the panel, fail to meet these requirements, particularly when it comes to documenting the frequency of reviews or adhering to their own frequency requirements. Many firms choose to review only a random sampling of e-mail. The panel stated that the rules allow this type of review as long as (1) everyone has some of his or her e-mails reviewed at some point, (2) firms use random or lexicon methods for generating “hits,” and (3) the lexicon lists remain confidential. In certain circumstances, problematic e-mails should be re-reviewed by legal and compliance. If a firm allows employees to send encrypted e-mails, reviewers should know how to work around this so that they are actually able to review the text. Similarly, if the firm does business in a foreign language, reviewers should be available to review e-mail sent in languages in which the firm does business. The panel stated that the SEC is working to come up with more concrete regulations regarding e-mail retention and is considering whether to exclude from retention requirements any electronic communication that would not be a “record” required to be maintained under SEC books and records rules. For instance, the SEC may ultimately conclude that e-mail sent between individuals who are not required to be registered need not be retained. This would include e-mail between groups such as technology, real estate, accounting, and payroll.

Information Barriers

A panel discussed barriers to prevent the misuse of material, nonpublic information, another current hot topic. Importantly, various statutes and rules either explicitly or implicitly require information barriers. Although SROs have not mandated particular information barrier procedures, SRO rules do emphasize that supervision and record-keeping be designed to act as a checking mechanism to determine whether a firm’s policies and procedures are effective, maintained, and enforced. Panelists discussed the role of a control group at a broker-dealer and the types of information barriers that broker-dealers have; the misuse of syndicate-level information in public markets and LSTA’s current guidelines with best practices regarding loan making; use of legal and compliance as a gatekeeper to channel information; use of confidentiality agreements to restrict information flow; and the institution of additional procedures for control room employees in light of the recent SEC administrative proceeding against Morgan Stanley with respect to its policies and procedures to prevent the misuse of material, nonpublic information (Exchange Act Release No. 54047, Advisers Act Release No. 2526, Admin. Proc. File No. 3-12342). The panelists concluded their remarks with four recommendations:

Review procedures to make sure they are reasonably related to the business in which the firm is engaged;

Review procedures to ensure that they work effectively;

Provide guidance to the employees dealing with information barriers to make sure they know

what they are doing; and


Do not ignore the nuts and bolts of systems issues.

Managing Conflicts

The “Managing Conflicts” session emphasized the need for conflict management to change as the business of the firm changes. The panel discussed several situations in which a need for conflict management may arise. This could occur, for example, when an entity is managing fiduciary money side-by-side with proprietary capital; when products have both fiduciary and brokerage elements; when there are sales between affiliated arms of an investment bank; when investments are made by a single fund, such as investing at multiple tiers of the capital structure; and when multiple funds that are being managed have investment conflicts with each other. When these conflicts arise, the question is how to handle them. The entity may need to control information-sharing by controlling the physical proximity of the documents, ensuring they are safeguarded appropriately, and conducting conference calls in private areas. Sometimes, however, a conflict may simply be too significant to manage.

Issues of the Smaller Broker-Dealer

One session was devoted to issues faced by the smaller broker-dealer. Joy Weber, Vice President in the Division of Enforcement of NYSE Regulation, began the session by addressing concerns of smaller broker-dealers in light of the upcoming NASD-NYSE consolidation. Weber assured small firms that regulators will be making a push to ensure that firms have a voice in the new SRO. Moreover, Weber touted aspects of the consolidation that are positive for small firms, such as the elimination of duplicative exams and competing rules, a decrease in over-regulation, and cost-saving due to fewer exams and regulatory requirements. Regarding the technicalities of the new SRO and examinations of smaller broker-dealers, Weber specified that investigators that previously covered only NYSE firms will now examine smaller firms as well, that the new SRO will move to a regional approach (likely keeping the district office model), and that the SRO will be a new entity “with an NASD feel.” Electronic communications can pose many challenges for small firms. The panel counseled that broker-dealers should adopt specific guidelines and work on informing their compliance personnel about such guidelines. In addition, the panel recommended that broker-dealers implement a system to spot and report problems, target individuals/products as problems arise, and supervise representatives’ use of instant-messaging and text-messaging. The panel attempted to provide guidance on annual certification. NASD Rule 3012 requires testing and verification of the firm’s supervisory procedures, while Rule 3013 requires the firm’s CEO to certify annually that the firm has processes in place to establish, maintain, review, modify, and test policies and procedures. Specifically, the panel noted that sub-certifications are probably a good idea, different personnel can certify different controls in their respective departments, and Offices of Supervisory Jurisdiction (“OSJs”) should sign certifications.

Designing an Effective Retail Surveillance Program

A panel gathered to discuss the challenges related to their retail surveillance programs. Most firms use report-driven programs that swamp their information technology (“IT”) departments with paperwork. At


the same time, firms are finding that these reports add little value—they fail to identify many problems. Report-driven surveillance platforms, processes and underlying technology are not in line with the scale and complexity of today’s business environment, and firms are looking for alternatives. The panel suggested that behavior-based systems are a possible solution. Such systems are rules-based and exception-driven. They identify potential problems by correlating trades, accounts, brokers, and branches. They have the additional benefits of creating workflow and audit trails and increasing supervisory efficiencies. The panel suggested a multi-phase process for implementing a new surveillance program. First, the firm should develop a well-defined concept and vision of the final state. Next, the firm should perform a current-state review to understand the firm’s key technology drivers and capabilities. In addition, firms need to understand what data they have and make sure that the data are reliable. Firms should perform a gap analysis to determine what critical issues are not currently addressed. Firms should then develop a clear, concise vision around the future of surveillance and supervision, involving key compliance, risk, and field colleagues in the process. The panel noted that the new system should be as simple as possible. To better understand the options, the panel recommended that firms research vendors and consult with industry peers, involving branch management in this process, especially in vendor review. Once the compliance and IT departments have agreed on the scope and content of the system, the firm should present the plan to the business side and obtain funding. The system should have a clearly defined escalation program to deal with issues as they arise. Once the system is approved by the regulators, the final phase is to get all of the stakeholders together and launch the new system. The panel added a few final suggestions regarding surveillance programs. First, firms should not rely on their IT departments to handle the entire surveillance process. IT personnel do not know the rules. Second, the panel suggested that firms train an IT employee in compliance and move the employee to compliance to serve as an interface between the two groups.

Structured Products

The session on developments in the area of structured products focused primarily on a document issued earlier this year by banking agencies and the SEC. Published in the Federal Register on January 11, 2007, the statement on “Sound Practices Concerning Elevated Risk Complex Structured Financial Activities” (the “Final Statement”)9 was meant to assist financial institutions in two ways. First, the Final Statement helps financial institutions identify complex structured finance transactions (“CSFTs”) that may pose heightened reputation and legal risks to them. Second, the Final Statement helps them evaluate, document, manage, and address elevated-risk CSFTs. The Final Statement does not define a CSFT. Instead, it gives examples. The statement is principles-based, not rules-based. According to the Final Statement, the two characteristics of a non-complex structured finance transaction are “a well established track record and familiarity in the financial markets.” To determine whether a transaction or product constitutes an elevated-risk CSFT, and therefore warrants further risk oversight and review, the following questions should be asked:

9 The full text of the Final Statement can be found at http://a257.g.akamaitech.net/7/257/2422/01jan20071800/edocket.access.gpo.gov/2007/07-55.htm.

http://a257.g.akamaitech.net/7/257/2422/01jan20071800/edocket.access.gpo.gov/2007/07-55.htm


Is there an economic substance or business purpose for the transaction?

Is the transaction designed for questionable accounting, regulatory or tax objectives?

Does the transaction raise concerns as to how the customer is going to account for it on financial

statements and how he or she is going to disclose it to the public in public filings? Does the transaction involve circular risk transfers lacking economic substance or business

purpose between the customer and the financial institution or between the customer and other related parties?

Are there side agreements involved that would shift the economic risk or benefits of the

transaction? Are there undocumented agreements that would materially impact the regulatory, tax or

accounting treatment of the “primary” transaction or the customer’s disclosures? Are there economic terms to the transaction that are not within economic norms?

Is there disproportionate compensation provided to the financial institution working with the

customer in connection with the transaction?

The panel recommends that, if any of these risk factors is present, the financial institution should employ policies and procedures that allow the firm to understand, evaluate and manage the risks of the potential CSFT. Institutions should provide for the review and approval of potentially elevated-risk CSFTs by management and all relevant control areas, including control areas that are independent from the business units involved in the particular transaction. Finally, the panel noted that the Final Statement represents guidance by the banking agencies and a policy statement by the SEC. It does not, by itself, create any legally enforceable requirements or obligations and does not create a private right of action.

Mutual Funds – The Broker-Dealer (Distributor) Perspective

One session at this year’s conference was devoted to a discussion of mutual funds from the broker-dealer perspective. The panel began by reporting on the number of market-timing cases that have been brought recently, including the first case in which criminal charges were brought against a hedge fund based on market-timing. Panel members noted their expectation that additional market- timing cases would be forthcoming, including cases against hedge funds and cases involving variable annuities, as regulators work their way through the backlog of cases on these issues. The topic of mutual fund disclosure obligations existing at the point of sale generated substantial discussion. The panel mentioned the fact that NASD does not have any express rule requiring the disclosure of revenue-sharing arrangements at the point of sale and that a majority of the failure-to-disclose actions have been brought by the SEC, not NASD. The panel discussed the two types of disclosure cases that commonly are brought: (1) cases involving directed brokerage arrangements; and (2) the less common cases involving brokers’ affirmative representations to customers that the firm


created a preferred list of funds based on what the firm believed was best for its customers, without disclosing revenue sharing. As an example of a failure-to-disclose case, the panel discussed American Fund Distributors, Inc., NASD Discip. Proc. No. CE3050003, 2006 NASD Discip. LEXIS 32 (August 30, 2006), in which the firm was fined for directed brokerage activities, but the amount of the fine was less than the amount sought by NASD. In so ruling, the NASD hearing panel noted that the firm’s conduct was consistent with industry practice and, by the time the case went to hearing, the firm already had scaled back on the conduct at issue. Finally, the panel turned to a discussion of old issues that still exist, including B and C share cases, which the panel felt will be the basis for a lot of future activity. Recently, NASD has brought a number of cases where it believed a customer with B and C shares could have saved a significant amount of money had they invested in A shares instead. The panel also discussed the SEC proceeding, In the Matter of IFG Network Securities, Inc., Exchange Act Release No. 54127, Advisers Act Release No. 2533, Admin. Proc. File No. 3-11179 (Jul. 11, 2006), in which the Division of Enforcement lost in charging Rule 10b-5 fraud against three registered representatives and lost in charging the firm and its president with failing to supervise with respect to A share sales. (The firm and president were represented by Sutherland.) One specific issue discussed at length was the NASD reference to a simple calculator to determine whether A shares are preferable. Joseph Savage from NASD said that use of this calculator is not like a “get out of jail free card;” rather, firms are expected to have policies and procedures in place to ensure that the appropriate share class is recommended to the customer and that, obviously, a calculator is a good way to achieve that result. He noted, however, that NASD is not trying to micromanage firms by giving them a specific tool they must use.

Variable Annuities – The Distributors’ Perspective

This panel focused on a number of issues related to the distribution of variable annuities, including suitability, proposed NASD Conduct Rule 2821, equity-indexed annuities and related transactions, and anti-money laundering requirements. The panel also discussed the status of so-called “insurance networking” no-action relief for insurance agencies associated with broker-dealers distributing variable annuities. With respect to proposed Rule 2821, which addresses purchases and exchanges of deferred variable annuities, Eric Arnold, a Sutherland partner on the panel, reviewed the history of the proposed Rule, which dates back to NASD Notice to Members 04-45 issued by NASD in the Summer of 2004. So far, the NASD has made five rule-filings with the SEC, the most recent being Amendment No. 4, which was filed with the SEC in March 2007 (“Amendment No. 4”). Larry Kosciulek, a panel member from the NASD, described the most substantive of the revisions made in Amendment No. 4. Kosciulek then addressed the timing of the principal approval required for deferred variable annuity purchases and exchanges under Amendment No. 4. He explained that the proposed Rule now requires a member firm’s registered principal to review the transaction prior to submitting the application to the issuing insurance company, but in no event later than seven business days after the application was executed by the client. In addition, Kosciulek addressed the potential conflict between the seven-day rule for principal approval under proposed Rule 2821 and other NASD Rules (e.g., the prompt transmittal rule under Rule 2820), and the application of the SEC’s customer protection rule and net capital rule to many firms that are required to “promptly transmit” funds and securities.


Kosciulek noted that NASD has indicated that, if a member firm complies with the principal approval requirements under Rule 2821, it will not view other potentially conflicting NASD rules as being violated by the firm. In addition, NASD will be seeking no-action relief from the SEC staff on the net capital and customer protection rule issues where member firms hold customer funds for a period of time exceeding what would otherwise be permitted, when such funds are held while a firm’s principal is completing a suitability analysis on the variable annuity purchase or exchange. As a final point regarding proposed Rule 2821, Kosciulek suggested that it was unclear whether the SEC was going to request public comment on Amendment No. 4. He speculated that, if the SEC did request comments (as they did on the first and second amendments to the proposed rule), the Rule was not likely to be in place in 2007. Kosciulek also provided a brief update on NASD’s Notice to Member 05-50, which requires registered personnel to report to their member firms that they are engaging in the sale of EIAs. Kosciulek confirmed that a number of member firms over the last year have received inquiries from NASD focusing on their variable annuity exchanges into EIAs. John Cronin, with the Vermont Securities Division, provided some insights into what types of annuity sales practice issues his division has been addressing recently. Cronin indicated that, in addition to general sales practice issues with variable annuities, Vermont’s Securities Division had seen a number of cases where unregistered insurance agents authorized only to sell fixed life insurance or annuities were recommending that clients (or potential clients) liquidate securities holdings in order to purchase fixed annuities, including unregistered equity indexed annuities (“EIAs”). Cronin explained that the division was looking into bringing actions for failure to register as an investment adviser, and other claims, against the fixed insurance agents engaged in this practice. The panel also briefly identified the general issues raised under NASD Notice to Members 07-06 with respect to exchanges of a newly-hired registered representative’s book of business, and certain issues raised by anti-money laundering requirements. Finally, the panel discussed the revocation by the SEC of an insurance networking no-action letter issued to M Financial, and the combined industry response and effort (including a joint meeting of the staff of the SEC and SIFMA, the American Council of Life Insurers, and the Committee of Annuity Insurers, and their members and counsel) to receive industry-wide relief.

Development of New Products and Services

New products remain a hot topic at NASD, and this year’s conference included a panel discussion of this topic. Panelists focused on the challenges involved in defining a “new product” and constructing an effective approval process.

Defining “New Products”

Panelists posed the question: “What is a new product?” Although there is no single universally accepted definition of “new product,” NASD Notice to Members 05-26 provides some guidance. The primary test is whether the product or service is one that has not previously been offered by the firm or involves an activity or business in which the firm has not previously engaged. Even if a product is only “significantly different” from another product, it may be considered “new” and therefore subject to the internal review and approval process. Examples of material modifications include a proposed sale or execution in a new geographic region, a proposed restructuring of a business across different legal entities, or a proposed change in sales practice fees or compensation arrangement. As the


NASD has noted, when in doubt, “the best practice is to err on the side of caution” and to send the product through the firm’s new product approval process. NASD Notice to Members 05-26.

New Product Approval Process

The panelists emphasized that the new product approval process constitutes a key control over new business activity. They identified the following objectives for the process:

To notify all relevant functions of the intention to introduce a new product or activity; To share all information between functions so there is a thorough understanding of the product;

To identify all potential areas of concern and obtain approvals before activity commences;

To ensure due diligence by appropriate function areas; and

To have the product or activity reviewed by an independent area of the firm.

Lawyers and compliance professionals should be involved from the beginning in new product development to provide specific guidance. Further, they should design, implement and maintain the internal control structure by developing written policies and procedures, participating in internal approval committees, documenting the approval process, and monitoring compliance. One panelist emphasized the importance of providing training programs to members of the firm, including supervisors and registered representatives. The training should cover all of the characteristics and risks of the new product or activity.

Compliance Directors/Chief Compliance Officers Roundtable (Large Firm Retail)

This year, large firm compliance directors and chief compliance officers convened for a roundtable discussion of the issues they currently face and how they are addressing them. The panel initially covered the NASD and NYSE CEO/Chief Compliance Officer Certification Process. Under both NYSE Rule 342.30 and NASD Rule 3013, the CEO must certify annually that the firm has a process to establish and maintain procedures reasonably designed to achieve compliance with federal securities laws and SRO rules and test and verify the effectiveness of the procedures. Furthermore, under both rules, firms must have supervisory control procedures that establish a process to test and verify that the firm’s supervisory procedures are reasonably designed to achieve compliance with applicable laws and rules. When necessary, firms must amend or supplement their supervisory procedures. The panel suggested that firms identify all applicable new federal and state laws and SRO rules and keep track as new ones are promulgated. Firms should have a process to incorporate new laws and rules into policies and procedures and to modify systems and processes accordingly. Firms should also have written procedures for addressing updates. The panel next covered evaluating the effectiveness of compliance. Panelists talked about the importance of having management (including possibly the CEO) meet with the regulators. Regulators need to understand the business, including management’s position and role; conversely, management needs to understand the regulators’ expectations. Those expectations include maintaining sufficient documentation in the Written Supervisory Procedures (“WSPs”), ensuring that the WSPs are current, and making business people responsible.


Third, the panel focused on where the CCO fits in the organization. While there are different organizational structures and reporting relationships, the panel emphasized that substance must take precedence over form. Compliance officers need to “sit at the table” so that they understand what the business is doing and so that the business function understands compliance issues, including risks. Finally, the panel focused on “hot issues.” Among the topics discussed by the panel are the following:

Senior Customers – key issues include:

o The definition of seniors; o When to focus on age; o Concerns about “free” lunches.

Net asset value (“NAV”) Transfers – key issues include:

o Suitability; o Eligibility vs. entitlement.

Gifts and Gratuities – key issues include:

o How to track gifts and gratuities; o Current rules vs. possible future rules.

Registrations – key issues include:

o What the rules require; o Implications of recent cases; o Permitted registrations vs. required registrations vs. prohibited registrations (even if the

employee works at the broker-dealer).

General Counsels’ Roundtable

The General Counsels’ Roundtable covered a variety of topics currently confronting industry legal departments, ranging from dealing with multiple regulators to interacting with members of the firm’s board of directors.

The Challenges of Dealing with Multiple Regulators

Regulators, panelists noted, tend to dislike being surprised by a firm’s settlement with other regulators. Thus, if a firm is preparing to negotiate a settlement with one regulator, it should consider informing its primary regulator of that fact before the settlement becomes public. Moreover, occasional “competition” among regulators can result in a game of one-upmanship during the settlement process, with each regulator striving to negotiate a greater settlement amount than the previous one. To avoid this problem, the panel suggested global settlements with all regulators at one time.


Has the United States Lost Its Competitive Advantage?

The panel expressed concern that the share of equity offerings in the United States has declined relative to the offerings abroad. According to the panel, one possible cause may be the added regulations in the U.S. and the significant costs of compliance with those regulations. Essentially, foreign companies have been opting to list abroad to avoid added regulatory burdens in the U.S. The panel pondered whether the relative regulatory burdens in the U.S. would increase after the completion of the NASD-NYSE consolidation. The panel also wondered whether a principles-based approach to regulation might exacerbate the perceived regulatory burdens of doing business in the U.S. Indeed, principles-based regulation often can result in uncertainly because it can be less clear how the rules will be enforced. As a result, the panel stated that, in view of a move towards a more principles-based approach, regulators should not pursue an enforcement action unless a firm has violated both rules and principles.

Reporting-Up and Sarbanes-Oxley

Pursuant to Section 307 of the Sarbanes-Oxley Act (“SOX”), 15 U.S.C. § 7245, and the SEC rules implementing them, attorneys appearing and practicing before the SEC must report evidence of a material violation of law or breach of fiduciary duty by an issuer. The panel noted that there was considerable initial anxiety about this relatively complicated rule. As a result, many firms developed common-sense policies or codes of conduct that were broader than Section 307. Some firms encourage lawyers to come forward any time they see something they believe is not right. In adopting such a policy, firms can avoid the need to debate the key terms set forth in Section 307: “material violation of law” and “covered person.”

The Relationship Between Legal and Compliance

The panel next considered the relationship between the legal department and the compliance department and addressed whether the compliance department should report to the general counsel. Of the session attendees who are in-house counsel, a majority reported that, at their firms, the compliance departments report to the legal departments. The panel discussed the advantages of this arrangement, which include: (1) the general counsel is viewed as the person with authority; (2) the legal department and the compliance department are able to coordinate and speak with one voice; and (3) the compliance and legal departments can complement each other since lawyers typically are good at creating plans while compliance people typically are better at execution.

General Counsel Acting as a Member of Senior Management and as the Chief Lawyer for the Firm

Most general counsels have a senior management function in addition to responsibilities for addressing purely legal issues. The panel noted that this range of duties can create conflicts when corporate interests clash with the firm’s legal obligations. When that occurs, it is the general counsel’s professional credibility with senior management that carries the day and often will allow a crisis to be averted. What general counsels must do on the front-end, the panel noted, is decide when they should get involved. If the issue is a hybrid—a legal issue with potential financial consequences—the general counsel’s principal task is to make sure that the issue is addressed at the appropriate level of the


business by someone who properly can balance the relevant risks and rewards. On the other hand, if a legal issue could have a potentially significant impact on the firm’s reputation, the general counsel should elevate that issue to the CEO.

The Role of General Counsel When Dealing With the Board

The panel briefly discussed interactions between the general counsel and the board, and noted that the key for the general counsel is to build relationships with key directors and establish credibility with them before a crisis arises. To do this, the panel recommended that general counsels attend all board meetings and audit committee meetings and become involved in committee work. The panel also emphasized the need for a general counsels to inform board members of regulatory issues involved in the securities industry and to give board members an honest assessment of the range and nature of regulatory issues.

Customer Complaints

The session on customer complaints covered the early case evaluation process, including the procedures for responding to new customer complaints, the SROs’ trend and risk analysis, and immunity in connection with Form U4 and U5 reporting, among other topics. Sutherland Partner Terry R. Weiss appeared as one of the panelists for this session.

Responding to Customer Complaints

The panel discussed alternative processes that firms use in responding to customer complaints; some use compliance personnel to respond while others use legal professionals. Regardless, the panelists agreed that it is important to have a dedicated group responsible for handling the responses to customer complaints. By having dedicated personnel responsible for this function, firms will be able to respond to customers in a more consistent and efficient manner. Additionally, a dedicated group reviewing all of the complaints will be better able to spot firm-wide trends concerning particular products or brokers. From the regulatory perspective, firms are expected to have policies and procedures for responding to customer complaints available to firm personnel across all departments. Although all customer complaints must be acknowledged within 15 days of receipt, firms may have a “reasonable period of time” to provide a substantive response. See NYSE Rule 401A(a)(1)-(2). Anthony Cavallaro, Vice President in the NYSE’s Division of Enforcement, acknowledged that the definition of a “reasonable time” may depend on the specific circumstance of each complaint; there is no specific deadline for responding substantively.

Trend and Risk Analysis

Over the past several years, the NSYE has invested a considerable amount of time and resources in using the latest technology to analyze trends across firms and products. This technology is providing the regulators with enhanced means to design more comprehensive exam programs. As an example of this enhanced technology, the NYSE is currently using the STAR (Statistical Trend Analysis and Risk) Matrix to help spot risks and trends. This proprietary software application allows investigators to search all regulatory information (including filings and CRD data) by registered representative, product or firm. Using the data compiled by the STAR Matrix, the analysts can then generate a heat map, in which potential problems are identified by geographic location. In addition, the


STAR Matrix information is provided directly to the SEC via an electronic data feed. In 2006, 12 enforcement actions were brought based solely on the data collected by the STAR Matrix system. Given the sophisticated technology that regulators are using, firms must be able to identify the potentially problematic trends within their organization. Otherwise, the first time a firm will learn of these problems is when the regulators come knocking. Moreover, if firms learn of these issues at an early stage, they can focus on greater education and enhanced supervision before the problems are “out of control.”

Heightened Supervision

The panel discussed in some detail NASD Notice to Members (“NTM”) 97-19, which sets forth the applicable standards for heightened supervision. Firms should consider a history of complaints, disciplinary matters and arbitrations as a basis for developing a heightened supervision plan. Heightened supervision plans should be designed to address the historical conduct at issue. The panel suggested that an appropriately designated supervisor should document the heightened supervision plan, recording when it began, when it ended, and what it encompassed. Currently, the NASD does not have specific triggers for when heightened supervision should be imposed. In 2003, the NASD proposed that a heightened supervision plan should be used if a registered representative had three complaints or arbitrations in five years, but that proposal (NTM 03-49) was never passed. Since then, however, many firms have promulgated a similar standard in their internal policies and procedures.

Immunity in Connection with Form U5 Reporting

The day after the conference concluded, New York State’s highest court ruled that potentially defamatory statements contained in a Form U5 should enjoy an absolute privilege, meaning that brokerage firms are fully immune from defamation suits based on U5 disclosures. See Rosenberg v. MetLife, Inc., 2007 N.Y. LEXIS 504 (N.Y. March 29, 2007). New York and California currently are the only states that provide an absolute privilege for Form U5 disclosures. The other states that have addressed the privilege issue in the specific context of U5 disclosures allow only a qualified privilege, meaning that the privilege will be lost if the former broker is able to establish that the statements were made with actual malice or reckless disregard for the truth. In 11 of these states, the qualified privilege was enacted as part of the Uniform Securities Act promulgated by the National Conference of Commissioners on Uniform State Laws; in a half dozen states, the qualified privilege standard has been established by case law. Overall, more than half the states in the U.S. have not expressly decided the issue. In these states, the Rosenberg decision should be persuasive.

Arbitration

The two arbitration sessions focused primarily on the newly adopted NASD Code of Arbitration Procedure for customer cases (“the Code”), which becomes effective April 16, 2007; the pending merger between the arbitration departments at the NYSE and NASD; and the effect of this merger on arbitration practice and the rules that will govern arbitrations in the future. The comments by the regulators on these panels (Karen Kupersmith, NYSE Director of Arbitration, and Linda Feinberg, NASD Director of Arbitration), as well as comments from the audience during these sessions, were particularly illuminating. For a more in-depth review of the changes to the Code, please see our March 2, 2007 Legal Alert. Linda Feinberg discussed NASD’s key issues and undertakings for 2007. One such undertaking is an update of NASD’s discovery lists. In addition, NASD may seek to expand the discovery arbitrator pilot,

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keeping it a voluntary program but allowing parties all across the country—not just in certain regions—to voluntarily select a discovery arbitrator. NASD believes that in industry disputes, there will be more interest in using a discovery arbitrator if the discovery arbitrator comes from the industry. Although case filings with NASD are down, Feinberg indicated that there may be increased activity after the new Code becomes effective April 16, 2007, and due to the recent market volatility. Potential claims against hedge funds may add to that activity.

The Pending Merger

Karen Kupersmith began by noting that there is no set date for the NASD/NYSE merger. Cases filed with NASD prior to the merger will be arbitrated under the NASD Code, and cases filed with the NYSE prior to merger will be conducted under NYSE Rules. Cases filed post-merger will be governed by the NASD Code, which may be modified as part of the NASD/NYSE “rule harmonization” process. All 69 NASD hearing locations will be kept, and a few NYSE locations will be added. According to Linda Feinberg, once the consolidation takes place, six existing NYSE staff members familiar with NYSE Rules will process the pending NYSE cases through to their conclusion. Karen Kupersmith will oversee the existing NYSE cases. Two processes are already underway that will be the topic of further discussion: (1) rule harmonization; and (2) practices and procedures harmonization between the NYSE and NASD. Further modifications may be made to the newly adopted NASD Code in order to harmonize NASD and NYSE arbitration practices and procedures. There is a great deal of overlap with regard to the NYSE and NASD arbitration rosters, which will be subject to review. NASD will look individually at each NYSE arbitrator who has not been approved to be an NASD arbitrator to evaluate his or her training and experience, whether he or she previously applied to NASD and was rejected, and whether he or she is on NASD’s inactive list. NASD will encourage and invite all NYSE arbitrators who meet its criteria to join the NASD roster.

The New Customer Code

Although the new Code applies to every NASD case filed on or after April 16, 2007, the new subpoena rule, amended Rule 10322, will be effective April 2, 2007 in all NASD cases. There was a good deal of discussion regarding the subpoena rule, as well as the newly enacted pleading requirements for answers. For statements of claim filed under the new Code, the documents supporting the claim no longer are required to be filed with the statement of claim. Claimants will have the obligation to plead the relevant facts and remedies, but the rule does not specifically require claimants to lay out their causes of action or the legal bases for their claims. Nonetheless, new Rule 12308 requires a respondent to “include defenses or relevant facts in its answer that were known to it at the time the answer was filed.” The panelists expressed concern over how a broker-dealer is to determine the facts “known at the time the answer was filed,” especially in light of the fact that all account documents may not be available and all persons with knowledge may not have been interviewed. Questions from the panel and the audience focused in large measure on the proposed rule regarding motions to decide claims prior to a hearing on the merits (“dispositive motions”), which is not included in the Code as adopted. According to Feinberg, proposed Rule 12504, which provided that dispositive motions were to be discouraged and only granted under “extraordinary circumstances,” generated a “maelstrom” of commentary and criticism, primarily from the claimants’ bar. Ultimately, the NASD elected


to defer adopting a rule on dispositive motions so as not to delay enactment of the new Code. Nevertheless, the dispositive motions rule will remain a hot topic in the coming years, and the failure to adopt the proposed rule could lead to confusion in future arbitrations. Feinberg explained that, due to this criticism, the NASD has “gone back to the drawing board.” She commented that unnamed “highly regarded claimants’ counsel” have told NASD that dispositive motions practice is abusive because such motions are filed even when statements of claim contain precise damage calculations and attach expert reports. NASD likely will further modify proposed Rule 12504 so that it will limit the ability to grant motions to dismiss without at least some sort of an evidentiary hearing on the motion, but it is unclear whether a telephonic hearing would be allowed. In the interim, as referenced in Notice to Members 07-07, dispositive motions will be allowed, as under existing practice, and will be governed by Rules 12504 and 13504, except that the time for responding to the motion will be set by the panel. Rule 12503(a) requires that a party must attempt to resolve the issue with the other parties before filing a written motion; the motion must describe these efforts. The Code does not (presently) apply to pending NYSE cases. According to Karen Kupersmith, the NYSE allows the filing of dispositive motions, but such motions may be granted only after an evidentiary hearing, at which claimants have a fair opportunity to be heard. Although the NYSE requires a live hearing with witnesses, it remains possible to conduct a telephonic hearing. Kupersmith noted that most dispositive motions are fact intensive and thus require an evidentiary hearing, even a challenge based upon the six-year eligibility rule. The NYSE has a proposed rule that requires written motions to be filed 45 days prior to the first scheduled hearing date. The purpose is to prevent eleventh-hour motions practice that may delay the final hearing. The new subpoena rule (Rule 12512) generated considerable comment. The new rule makes clear that only arbitrators can issue subpoenas, thus eliminating the “New York practice” of subpoenas signed by counsel. On each arbitration panel, there is one arbitrator designated to decide arguments and motions made by parties regarding subpoenas. A subpoena may be issued only pursuant to motion, with the opposing party having ten days to file a response, to which the moving party then has ten days to file a reply. Whether a subpoena is necessary to obtain documents from a member firm remains an open question, as is the issue of whether such a request is subject to the same notice requirements. Requests from member firms may not be subject to the ten-day provision or to any requirement that the opponent be notified of the receipt of such documents. The regulators have indicated that sanctions should be imposed for abusive subpoena practices. Kupersmith noted that parties in NYSE arbitrations are encouraged to cooperate in discovery and, thus, to engage in voluntary document exchanges. One should first ask the claimant to sign a written authorization for third-party documents, and the subpoena process should be used only when the parties cannot otherwise come to such an agreement. Also, the NYSE has a subpoena rule awaiting SEC approval that is similar to the NASD rule.

Expungement

Feinberg stated that NASD is reviewing the expungement rules and processes, and some revisions should eventually be expected. NASD has the benefit of reviewing two years of practice since the new expungement rule became effective in April 2005. Between the effective date and December 31, 2006, NASD was named in 40 cases by parties wanting to confirm expungement, and NASD did not oppose 33 of those. In five of the seven remaining cases, the plaintiff dismissed the case after NASD filed an opposition. The court confirmed one expungement. The other case remains pending. With a waiver request, which NASD recommends be done in the first instance, there have been 315 such requests and


NASD granted 282 of the waivers. Feinberg noted that if a case is settled for a “large amount of money” and the stipulated award includes expungement, the NASD likely will appear and oppose the request in a subsequent confirmation action. There also is the possibility that a state securities commissioner could oppose an expungement request separately from the NASD.

Mediation

A five-person panel that included George H. Friedman, Executive Vice President of NASD Dispute Resolution, discussed the topic of mediation. The discussion included the advantages of mediation, when a case should be mediated, and how to prepare for mediation. The panel recognized that there are certain cases that should not be mediated, including those involving claimants who are unrealistic or irrational or who are determined to take the case to final hearing in the hopes of winning a large award. The panel agreed, however, that in suitable cases, mediation provides a less expensive alternative than an evidentiary hearing. Moreover, the panel noted that mediation provides an opportunity to request documents and to seek the dismissal of individual respondents. Even if the mediation is not successful in resolving the case, it provides an opportunity to gain useful information about the claimants, their approach to the case, and their likely effectiveness at the hearing. In agreeing to mediate, the panel counseled that conditions precedent should be avoided. The parties should agree in advance that both sides will split the cost of the mediation. The panelists disagreed on whether settlement numbers and/or ranges should be discussed before the mediation. To prepare for a mediation, the panelists agreed that the parties should provide the mediator with information in advance, such as a cover memorandum with bullet points, the profit and loss analysis, case pleadings, statements and letters received by the claimants, and other key documents. At the mediation itself, attorneys should be wary of starting out on the wrong foot by being too adversarial in an opening statement. The panel cautioned that the opening statement is not the place for “shock and awe.” The panel discussed the difficulties in attempting to settle several cases that have been consolidated into one mediation. For instance, there can be situations in which several different claimants, represented by one counsel, bring separate cases against a firm and a broker—all of which are mediated at once. These cases may be related because (1) the claimants were all employees of one company or were friends; (2) the broker allegedly used a “one-size-fits-all” approach to managing money; or (3) simply because the claimants share the same counsel. The panelists cautioned that these types of group mediations can present difficult ethical and practical problems. Many of these concerns arise from the fact that the cases may not be similar. Certain claimants have stronger cases than others. In these situations, the panel recommended conducting due diligence to determine the relative strength of the cases. Armed with this information, the parties may have an easier time dividing the claimants into various “buckets” based on the relative strengths of their cases. Using these buckets, the mediator can better ensure that the claimants’ expectations are managed in a way that allows the more deserving claims to get paid a commensurate amount. The panel also cautioned that ethical concerns arising from the claimants’ lawyer’s position may prevent the seamless resolution of group cases. Namely, the claimants’ lawyer might be forced to take a lump sum settlement for all cases and divide the amount between the numerous claimants she or he represents.


Litigation Update – Major Civil Cases

This year’s litigation update focused on class certification appeals pursuant to Rule 23(f) of the Federal Rules of Civil Procedure.

Class Certification

Defense counsel have successfully used Rule 23(f) to appeal class certifications at dramatically increasing rates as federal appellate judges aggressively check perceived or actual overreaching by district court judges. Nevertheless, the law in this area tends to vary’ and courts have adopted conflicting standards relating to issues such as the standard of proof necessary to satisfy Rule 23(f). The Second Circuit’s decision in Miles v. Merrill Lynch (In re Public Offering Securities Litigation), 471 F.3rd 24 (2d Cir. 2006), was a key topic of discussion. In Miles, the Second Circuit imposed new standards for deciding Rule 23(f) petitions:

The court rejected the “some showing” standard, which required only “some showing” that class certification was merited, whether by expert opinion, evidence, or the uncontested allegations of the complaint.

Instead, a district court may certify a class only after making factual findings that each 23(f)

requirement has been satisfied. This standard requires district courts to resolve contested factual disputes and to hear evidence if necessary.

District courts must make 23(f) factual evaluations regardless of whether there is a direct overlap

between those findings and the merits of the underlying disputes.

The Miles decision significantly expanded the scope of interlocutory jurisdiction in the Second Circuit. Its impact in other Circuits has been mixed. The Fifth Circuit, in its recent decision in Regents of University of California v. Credit Suisse First Boston (USA), Inc., 2007 WL 816518, 2 (5th Cir. 2007), took a position similar to the Second Circuit and denied class certification in a class action arising out of the collapse of Enron. The Ninth Circuit, however, took a position directly contrary to Miles in Dukes v. Wal-Mart Stores, 474 F.3d 1214 (9th Cir. 2007). In Dukes, the court held that it was inappropriate to make merit-related determinations at the class certification stage.

Loss Causation

Loss causation represented another significant area of interest this year, as cases continue to interpret the holding of Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). In Joffee v. Lehman Bros. Inc., 2006 WL 3780547 at *1 (2d Cir. 2006), the Second Circuit held that allegations that “plaintiffs paid artificially inflated prices for . . . securities and suffered damage[s]” are—without some connection between defendant’s “misstatements” and plaintiffs’ losses—insufficient to state a claim for federal securities fraud. In that case, all of the risks that the research reports allegedly “concealed” from the market had been disclosed by the company in its quarterly reports. The same Circuit held, in Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 158 (2d Cir. 2007), that plaintiffs did not sufficiently allege that any misstatement by Deloitte was the proximate cause of their loss. “[T]o state a claim, plaintiffs had to allege that Deloitte's misstatements concealed the risk of Warnaco’s bankruptcy”—the event that had directly caused plaintiffs’ losses. Id. at 157.


The panel also discussed two recent state court decisions addressing loss causation. First, the Arizona Court of Appeals, in Grand v. Nacchio, 147 P.3d 763 (Ariz. Ct. App. 2006), held that the plaintiff’s loss need not occur subsequent to the alleged wrongdoing and its disclosure. This case has been appealed to the Arizona Supreme Court and has generated considerable industry concern. In Florida, an appellate court recently reversed a $1.58 billion jury verdict in a case in which a partial default judgment had been entered against Morgan Stanley as a sanction for discovery abuses. The court held in Morgan Stanley & Co. Inc. v. Coleman (Parent) Holdings Inc., 2007 WL 837221 (Fla. 4th Dist. 2007), that the plaintiff did not offer sufficient evidence on loss causation and damages; judgment will be entered in favor of Morgan Stanley.

Aiding and Abetting Liability

Recent developments in aiding and abetting liability under Section 10(b) and Rule 10b-5 also generated discussion. On the first day of the conference, the Supreme Court granted certiorari in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 443 F.3d 987 (8th Cir. 2006), cert. granted, 2007 WL 879583 (U.S. March 26, 2007). The issue in Stoneridge is whether counterparty transactions fall within the ambit of primary liability under Section 10(b) and Rule 10b-5 under a theory of “scheme liability.” The Circuits are currently split regarding where to draw the line between primary and secondary liability in “scheme liability” cases under Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994).

Challenges of Electronic Discovery

This was a big year for electronic discovery, with the Federal Rules of Civil Procedure having been amended to incorporate new provisions that deal specifically with electronically stored information. This year’s conference included a session exploring the new electronic discovery rules and the measures that firms should be taking to ensure compliance with them. According to panelists, these new rules are causing anxiety not only because many do not understand the technology, but because many fear that these new rules will significantly increase the costs of litigation. Examples abound of e-discovery issues spawning satellite litigation and sanctions motions that can expose the client to more risk than the underlying case. According to the panel, the best way to tackle these issues is to develop a good working knowledge of the technology and to get an early understanding of the client’s capabilities and systems. The panel discussed three important changes to the Federal Rules of Civil Procedure. First, Rule 37(f) now provides a “safe harbor” that may protect against the imposition of discovery sanctions when electronic information is lost due to the routine, good-faith operation of an electronic information system. The panel noted that this rule does not protect against sanctions for lost information that should have been subject to a litigation hold. The panel also suggested that the use of outside vendors could mitigate the chance of sanctions if a vendor with a proven track record is used, as long as the attorney keeps regular reports on the vendor’s progress. Second, Rule 34(a) now expressly allows a requesting party to inspect, copy, test or sample electronically stored information (“ESI”). The rule, according to the panel, affirms the increasing trend of using sampling protocol as a means of dealing with large amounts of documents or ESI. Panelists cautioned that attorneys must consider the format in which they want ESI produced. Often, attorneys think they want the files in native format and later discover that they do not have the software required to read the native files. The panel suggested a compromise of producing documents in tif format (which is essentially a picture of the document that cannot be altered) and also providing a load file that extracts text and metadata to be loaded into a searchable database. This compromise, according to the panel, will likely not be acceptable to the requesting party if spreadsheets and excel files are being produced. Typically, requesting parties will want these produced in native format so that they can see the underlying formulas.


Third, new Rule 26(b)(5)(B) addresses the dilemma created by the potentially enormous cost of reviewing ESI for privilege. This rule, the panel noted, does not change the substantive law of privilege, waiver, or inadvertent disclosure, but it does set up a process to stop the initial spread of privileged information until the judge can rule on the issue. The panel encouraged parties to deal with inadvertent disclosure in advance by entering into a suitable agreement. Two types of agreements were discussed. A “claw-back agreement” specifies that the inadvertent production of privileged or otherwise protected materials will not result in a waiver of the privilege or other protection. A “sneak peek/quick peek” agreement allows parties to produce ESI without an initial privilege review and later get back any privileged documents that were produced. The panel cautioned that these agreements do not provide complete protection, especially as to third parties, and that opposing counsel will likely argue that the privilege has been waived after seeing privileged documents. The new rules also mandate that the parties participate in a discovery planning conference, including discussions regarding ESI. The panel suggested preparing for this conference by meeting with the client and the client’s IT staff in advance. At this meeting, the attorney and client should, according to the panel, discuss the following issues:

The client’s ESI preservation system. The attorney should know in advance what representations he/she can make regarding what is being preserved.

The disclosure of ESI and the form or forms in which it should be produced.

How much time and effort is required to produce the client’s ESI, how long it will take to process

and review ESI, and how much will it cost. Attorneys should have a reasonable understanding of the processes involved in collecting ESI. Attorneys also should be prepared to identify ESI that the client is not willing to produce due to undue cost or burden (for example, legacy data or data on backup tapes used for disaster recovery). Some judges have indicated that ESI that is not being searched and produced should be disclosed in the equivalent of a privilege log. It was noted that a client could be ordered to produce inaccessible material with certain conditions, such as having the cost of production shifted onto the requesting party.

Any privilege or work-product protection agreements that the attorney might want to negotiate.

Another topic for discussion is whether these agreements should be included in the discovery order.

Panelists cautioned attorneys to be careful not to make any promises at the discovery conference that they cannot keep. Otherwise, they might face sanctions. Preservation of ESI after a claim is threatened or brought was another topic of discussion. There are certain types of ESI that will almost always be requested: e-mail, voicemail, and Word, Excel and PowerPoint documents. Zubulake v. UBS Warburg LLC, 220 F.R.D. 212, 214 (S.D.N.Y. 2003), provides useful guidance in this area. While all ESI need not be preserved, attorneys should consider who the key players are and what the key facts are and preserve ESI that is reasonably likely to lead to the discovery of admissible evidence. The panel advocated for attorneys to work with IT to determine where the key players keep their material and to consider having someone from IT accompany them to the discovery conference. The panel further advised that, at the discovery conference, attorneys should try to agree on key players whose information should be searched and on the search terms that will be used. The panel also discussed e-discovery in the regulatory context. They pointed out that the new discovery rules do not apply in this arena and that there is no room for bilateral negotiation. As the panel noted,


there are no safe-harbors and no limitations stating that the scope of electronic discovery should be proportional to the case. The panel characterized the SEC and other regulators as aggressive in requesting all e-mail for certain individuals, including many research analysts who were the subject of investigation a few years ago. The panel suggested that opening a dialogue with regulators regarding the actual scope and cost of complying with their broad requests might cause them to revise those requests. As a possible means of narrowing the scope of e-discovery, the panel suggested proposing a list of custodians whose records would be searched, as well as the search terms that would be used. Another suggestion was to search a few custodians as a pilot program to determine how much irrelevant information the searches would produce. Such issues are important because failures to comply with requests for ESI have resulted in major settlements between large broker-dealers and regulators.

Litigation Update – Regulatory and Criminal

The litigation update session on enforcement and criminal actions explored a fact pattern that involved a multi-regulator (both criminal and civil) investigation into the conduct of several employees of a global brokerage firm. The most pertinent issues discussed are summarized below.

Sharing Information Between Regulators

Criminal and civil government agencies now commonly conduct parallel investigations. The subjects of those investigations, however, are not always aware of all the agencies involved. For example, a company may be aware that the SEC is investigating its conduct in a particular action but may not be aware that the DOJ is investigating the same conduct. When parallel investigations occur, panelists agreed that the law gives agencies broad authority to share information. Section 21(d)(1) of the Securities Exchange Act of 1934 expressly authorizes the SEC to “transmit such evidence” of violations to the Attorney General. The panel noted, however, that two recent cases, United States v. Scrushy, 366 F.Supp.2d 1134 (N.D. Ala 2005), and United States v. Stringer, 408 F. Supp.2d 1083 (D. Ore. 2006), have criticized the government for the manner in which they conducted parallel investigations.

Cooperation

Cooperation remains a significant factor in SEC investigations. Peter Bresnan, a Deputy Director in the Enforcement Division of the SEC, noted that the SEC recently chose not to impose civil penalties on companies that demonstrated cooperation with the government. Bresnan reminded the audience of the Seaboard 21(a) report, Exchange Act Release No. 44969 (October 23, 2001), in which the SEC outlined the specific factors that it deems relevant when evaluating a firm’s effort to cooperate with an investigation. These factors consist of self-policing, self-reporting, remediation, cooperation, and appropriate internal discipline.

Effect of the McNulty Memo

In December 12, 2006, the DOJ issued revised internal policies dealing with charging corporations with federal crimes (the “McNulty Memo”).10 The McNulty Memo may have ramifications in a couple of key areas with respect to responding to DOJ investigations. One affected area is a company’s decision to

10 The full text of the McNulty Memo can be viewed at http://www.abanet.org/poladv/priorities/privilegewaiver/2006dec12_privwaiv_dojmcnulty.pdf.


advance legal fees to employees subject to investigation. The McNulty Memo reflects a change from the DOJ’s previous stance on the advancement of attorneys’ fees, stating that prosecutors “should not take into account whether a corporation is advancing attorneys’ fees to employees or agents under investigation or indictment.” Id. at 11. In this respect, the McNulty memo followed the recent holding of United States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y. 2006). The panel also discussed whether the McNulty Memo has brought about any change in the DOJ’s requests for waiver of the attorney-client privilege. The McNulty Memo states that waivers may be requested only “when there is a legitimate need for the privileged information to fulfill … law enforcement obligations.” McNulty Memo at 8. Although it is not entirely clear yet, the panel noted that since the release of the DOJ’s guidelines, the government is less likely to request an immediate waiver at the beginning of an investigation. The panel recommended that defense counsel enter a dialogue with both the government and the company with regard to producing results of internal investigations. Peter Bresnan noted that the SEC’s policy is clear: waiver of the attorney-client privilege is not a prerequisite for obtaining credit for cooperation.

Employment Litigation and Workplace Issues

Two sessions at the conference focused on employment issues, providing updates primarily on developments in the areas of diversity, discrimination and retaliation. The Sarbanes-Oxley Act and wage and hour claims also were addressed.

Diversity and Discrimination

Panelists reviewed recent EEOC initiatives focusing on diversity in the financial industry. The EEOC recently published a report highlighting a lack of promotions for minorities in the finance industry11 and is now looking at industry practices to determine whether there is a systemic problem. The EEOC also is considering potential disparate impact claims aimed at firms’ hiring criteria, such as the use of credit scores and financial background investigations. The EEOC’s theory is that such practices tend to screen out disproportionate numbers of African-Americans. Class actions could result. The panel emphasized the need for firms to be objective in promotions and in making lead assignments. They suggested that firms establish factors for making lead assignments and publish these factors throughout the firm. The panel recommended increased monitoring and a higher level of transparency in assignments and suggested that firms involve outside counsel in creating a system for making assignments and giving promotions. The panel noted that most firms have diversity training. The panel recommended that firms assign at least one senior manager to mentor women and historically underrepresented groups who may need support in their careers. The panel also noted that the industry is re-focusing management training on skill-building so that supervisors will be better able to spot problems and handle situations as they arise.

11 The EEOC’s report, “Diversity in the Finance Industry,” can be found at http://www.eeoc.gov/stats/reports/finance/index.html.

http://www.eeoc.gov/stats/reports/finance/index.html


Retaliation

Retaliation complaints, the panel noted, constitute the fastest-growing employment issue. The panel cautioned that many employers wrongly assume that, once the complaint has been investigated and some corrective action has been taken, the matter is closed and nothing further needs to be done. Not so, said the panel, stressing the importance of routine follow-up with the complainant and the accused. The panel also suggested that firms discuss the matter again with outside counsel at the three-month mark, focusing on how to avoid any subsequent retaliation claims. A recent Supreme Court case dealing with retaliation generated a lengthy discussion. In Burlington Northern & Santa Fe Railway Co. v. White, 126 S. Ct. 2405 (2006), the Supreme Court held that, because the anti-retaliation and anti-discrimination provisions of Title VII differ in both language and purpose, retaliation claims are not limited to actions adversely affecting the terms and conditions of employment. Instead, the Court adopted a standard intended to deter the many forms that effective retaliation can take. That standard requires a retaliation plaintiff to show that the challenged action would have been materially adverse to a reasonable employee or applicant or, in other words, that the action might well have deterred a reasonable worker from complaining to the EEOC, the courts, and employers. This standard, while essentially objective, recognizes that the significance of a claimed act of retaliation may depend on the particular circumstances. In the panel’s view, this standard has created more confusion and will lead to more litigation.

Wage and Hour Claims

Another topic of discussion was the proliferation of wage and hour cases in the financial services industry. Brought initially in California, wage and hour cases targeting the financial services industry have now been brought in other states as well. The claims in California were based on allegations that employees who would traditionally be considered “exempt” from the state wage and hour laws were not exempt because they performed non-exempt duties. Panelists expressed concern that financial advisors might bring wage and hour cases, claiming that their activities do not qualify for exemption from the overtime provisions of state or federal laws. The U.S. Department of Labor, which administers the Fair Labor Standards Act (“FLSA”), issued an opinion letter on November 27, 2006 (FLSA 2006-43), stating that registered representatives can satisfy the exemption for administrative employees if they are paid more than $445 per week and satisfy the job duties component of the exemption. The opinion goes on to state that a registered representative’s duties, which include “collecting and analyzing a client’s financial information, advising the client about the risks and advantages and disadvantages of various investment opportunities in light of the client’s particular financial status, objectives, risk tolerance, tax exposure, and other investment needs,” would satisfy the duties requirements for the administrative exemption. Id. at 5. This opinion letter may deter claims, but its effectiveness is limited because it only addresses federal law and has no binding authority.

Sarbanes-Oxley

The panel briefly discussed provisions in the Sarbanes-Oxley Act (“SOX”) that encourage employees to raise issues with legal or compliance, noting that SOX whistleblower complaints are becoming common. The panel recommended that firms establish a written code of conduct and encourage employees to report any potential wrongdoing. There has been some confusion as to whether SOX claims belong in arbitration or in court. At least one case, Alliance Bernstein Inv. Research & Mgmt. Inc. v. Schaffran, 445 F.3d 121 (2d Cir. 2006), held that an arbitrator, rather than a court, must decide whether a whistleblower claim under SOX is an “employment discrimination claim,” which would exclude it from mandatory


arbitration under NASD rules. The panel noted that, although SOX’s impact on the industry is not yet clear, employment-related cases under SOX may proliferate.

U5 Disclosures

The panel identified defamation claims relating to Form U5 statements as another hot issue, even though the discussions took place prior to the New York Court of Appeals’ decision in Rosenberg (discussed above in “Customer Complaints”). Regulators appear concerned that firms may feel pressure to “sugar coat” what they say in a Form U5. The panel advised firms to be careful in drafting Form U5 statements and to state only that the firm “believes” the individual violated a firm policy or that the employee disagrees with the allegation and does not believe that he violated any firm policy. Employers face a dilemma because, although regulators may not be satisfied with a weak or vague statement on a Form U5, saying more could expose the firm to liability.

If you have any questions about the SIFMA’s annual seminar, or the services we provide, please feel free to contact any of the partners in our Securities Litigation and Arbitration, Securities Enforcement or Financial Services teams, including any of the following:

Peter J. Anderson 404.853.8414 [email protected] A. Arnold 202.383.0741 [email protected] Thomas A. Farnen 404.853.8480 [email protected] L. Haas-Goldstein 404.853.8521 [email protected] G. Heilizer 202.383.0858 [email protected] Kirsch 212.389.5052 [email protected] Michael B. Koffler 202.383.0106 [email protected] Susan S. Krawczyk 202.383.0197 [email protected] Neil S. Lang 202.383.0277 [email protected] A. O’Brien 404.853.8219 [email protected]. Lawrence Polk 404.853.8225 [email protected] L. Rubin 202.383.0124 [email protected] H. Smith 202.383.0245 [email protected] Stadler 404.853.8292 [email protected] Terry R. Weiss 404.853.8393 [email protected]

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Legal Alert: Summary of Selected Programs from SIFMA ... · Comments from the Regulators at the...

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