Foreign Broker-Dealer Subject to Enforcement Action for Failing to Register with the SEC

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1 February 2009 / Issue 2 A legal update from Dechert s Financial Services Group Foreign Broker-Dealer Subject to Enforcement Action for Failing to Register with the SEC The U.S. Securities and Exchange Commission ( SEC ) announced on December 8, 2008 that it was instituting enforcement proceedings against a broker-dealer located in Moscow that executed transactions in Russian securities on behalf of U.S. institutional investors. 1 According to the SEC s order, the Russian firm violated U.S. securities laws by failing to register with the SEC. The Russian firm s U.S. registered broker-dealer affiliate and several of its employees, including its Chief Compliance Officer, also were charged with aiding and abetting the Russian broker s registration violation. With the increase in globalization, the SEC recently has proposed rulemaking and policy initiatives aimed at providing foreign securities firms greater access to U.S. institutional investors, including amendments to Rule 15a-6 under the Securities Exchange Act of 1934 ( Exchange Act ). However, this action may signal that despite these initiatives, the SEC is serious about enforcing its existing laws. Two senior SEC enforcement attorneys stated in the press release announcing the action that: Today s action demonstrates that the Commission will closely scrutinize the activities of foreign broker-dealers soliciting investors in our domestic markets, and that [i]t is incumbent upon foreign brokerdealers and domestic broker-dealers working with them to familiarize themselves 1 In the Matter of CentreInvest, Inc. et al., Ad. Proc (December 8, 2008). with, and take all necessary steps to comply with, the appropriate registration requirements required by U.S. law before soliciting business from American investors and [t]oday s action is a significant step in ensuring that these provisions are properly followed. 2 In Re: CentreInvest, Inc. The SEC s order charged 000 CentreInvest Group, a securities firm located in Moscow ( Russian Broker ), with failing to comply with the broker registration requirements under the Exchange Act. At the same time, the SEC also brought action against the registered U.S. broker affiliate of the Russian Broker, CentreInvest Inc. ( U.S. Broker ), along with its Managing Director, Sales Manager, and Chief Compliance Officer for, among other things, aiding and abetting the violations of the Russian Broker, failing to keep appropriate records, and not disclosing the control relationship between the two firms. The U.S. Broker is located in City and was established in 1998 as a wholly owned subsidiary of a Cyprus entity. The Russian Broker represents on its English language website 3 that it is one of the oldest and largest 2 SEC Charges Moscow-Based Broker Dealer for Violating Registration Requirements (December 8, 2008). 3 d

2 brokerage firms in Russia, with over 300 industry professionals. The firm also states that, among other things, it is engaged in trading in Russia (specializing in less liquid securities), provides asset management and investment banking services, and is licensed by Russian securities regulators. According to the SEC s order, it appears that the significant facts from the SEC s perspective are as follows: the U.S. Broker was organized to distribute research to institutional investors and promote the Russian Broker s expertise in the Russian markets; once an investor indicated an interest in Russian securities, which often included thinly traded Russian securities, they were referred to Moscow to complete the transaction; both the U.S. Broker and the Russian Broker were aware that employees from Moscow who were not licensed in the U.S. solicited U.S. institutional investors directly, and should have been registered in the U.S.; the U.S. Broker s Managing Director (and FINOP) was advised in 2003 by a compliance consultant that in order for the Russian Broker to qualify for the exemption in Rule 15a-6, the U.S. Broker needed to maintain books and records relating to the transactions with U.S. investors, including those required by Rules 17a-3 and 17a-4 under the Exchange Act, but it did not do so; the Russian Broker and its employees supervised and directed the staff of the U.S. Broker by controlling its budget and finances, and the SEC notes that the U.S. Broker s employees sometimes referred to an employee of the Russian Broker as their boss and to the Russian Broker as their parent broker-dealer ; the U.S. Broker failed to maintain copies of e- mails, presumably including those relating to its relationship and communication with the Russian Broker; and the U.S. Broker failed to disclose the control relationship of the Russian Broker on its Form BD, or that another control affiliate had been sanctioned by the Cyprus Securities and Exchange Commission. Based upon these facts, and perhaps others that were not disclosed, the SEC determined to institute cease and desist proceedings against the Russian Broker and one of its managers for failing to register as a brokerdealer in the U.S. Three of the U.S. Broker s employees also have been charged with aiding and abetting the Russian Broker s registration violations, as well as the books and records violations of the U.S. Broker. As explained below, the primary basis for the SEC s action is that in the absence of an exemption, a foreign broker that solicits U.S. investors, including institutional investors, to effect securities transactions must be registered in the United States. Foreign Securities Firms and U.S. Broker- Dealer Registration The SEC generally has taken a territorial approach in enforcing its securities laws internationally. Foreign securities firms may provide brokerage services to U.S. investors without registering in the United States if the relationship and contacts are initiated by the U.S. investor, even while located in the U.S. However, foreign securities firms must register with the SEC if they solicit U.S. investors to engage in securities transactions. The definition of solicitation employed by the SEC is broad, and includes any affirmative action designed to generate securities transactions. This includes meeting with or contacting investors directly within the U.S., or providing research to U.S. investors that is designed to generate securities transactions. There is no general exclusion for foreign securities brokers that limit their contacts within the U.S. to institutional investors. The registration requirements also extend to firms engaged in private placements, as well as those facilitating mergers and acquisitions. Rule 15a-6 and Proposed Amendments Since it was adopted in 1989, Rule 15a-6 under the Exchange Act has provided a conditional exemption from broker-dealer registration for foreign brokers that simply provide research reports to U.S. institutional investors. If the foreign broker wishes to engage in active sales efforts in the U.S., however, it generally must either register in the U.S. as a broker-dealer or comply with the other provisions of Rule 15a-6. The rule permits contact only with certain institutional investors, and the principal conditions of the rule require representatives of the U.S. broker-dealer to participate in and monitor any direct communications with investors. In the case of trading, the institutional investor and foreign firm may communicate directly, but the U.S. broker-dealer must have licensed personnel February 2009 / Issue 2 2

3 participating in the communications. Additionally, the U.S. broker must provide for the issuance of confirmations and account statements; maintain records of the transactions; and, importantly, generally must observe the U.S. requirements for safeguarding customer funds and securities (which require that fully paid assets be segregated from the assets of the brokerdealer and held in a good control location). 4 Because the rule requires a U.S. registered brokerdealer to participate in the transactions, it is known as the chaperone rule. Notably, there are third-party U.S. brokers that specialize in providing access to U.S. investors in compliance with the rule. However, many foreign securities firms comply with the terms of the rule by relying on U.S. registered affiliates. Despite strong statements about its jurisdictional authority, to date, there has been little enforcement by the SEC in this area, notwithstanding the growing interaction between foreign securities firms and U.S. institutional investors. The historic lack of enforcement risk has resulted in challenges for compliance officers, among others, who have attempted to conform their operations to the SEC s stated position. Moreover, with the increasing globalization, the SEC s Chairman and senior staff members recently have advocated the possibility of mutual recognition of broker-dealer regulatory schemes in other countries, and sought to remove barriers to access for foreign firms contacting U.S. institutional investors. As we explained in an earlier client communication, 5 the SEC proposed amendments to Rule 15a-6 last July that would substantially relax some of the rule s requirements and make it easier for foreign firms to gain access to U.S. investors. The proposed amendments would potentially expand the types of U.S. investors who could be contacted by foreign brokers under the exemption, allow the foreign firm to accept greater compliance responsibility, and eliminate the chaperone requirement, which the SEC noted is widely regarded by the industry as impractical and viewed as imposing unnecessary operational and compliance burdens. 4 Letter to Cleary, Gottlieb, Steen & Hamilton, SEC No- Action Letter (April 9, 1997). 5 Opening the Door a Little Wider: SEC Proposes to Ease Requirements on Foreign Broker-Dealers Selling to US Investors Issue 16 (August 2008), discussing Release No (June 27, 2008) ( Exemption of Certain Foreign Broker-Dealers; Proposed Rule ). d Does the CentreInvest Order Signal a Change in SEC Policy? Despite the recent movement towards mutual recognition, in the wake of the recent financial crises, it appears likely that SEC recognition of comparable broker-dealer regulatory schemes in other countries will at least be delayed. New concerns about custody and settlement also may cause the SEC to reexamine portions of its proposed amendments to Rule 15a-6. At the same time, the CentreInvest Order sends the message that practices which either have been ignored or tolerated by the SEC may come under increased scrutiny. The CentreInvest Order also is a reminder that no matter what changes have been proposed by the SEC in the context of mutual recognition or proposed amendments to Rule 15a-6, the status quo not only remains in effect, but the SEC may be increasing its enforcement focus with respect to both activities of foreign securities firms in the United States, and compliance with the current requirements of the Rule 15a-6 exemption. Also, while the CentreInvest Order relates to U.S. broker-dealer registration, it may suggest that the SEC is now willing to enforce U.S. registration requirements in other contexts, as well. 6 While enforcement in this area has been very rare, the potential consequences can be severe. Enforcement actions by the SEC may result in disgorgement of revenues generated by the securities transactions, bars, and fines. 7 We particularly note that while the exemption under Rule 15a-6 is designed for foreign brokers, in the CentreInvest Order both the U.S. Broker and its employees, including the Chief Compliance Officer, have been charged by the SEC with aiding and abetting the Russian Broker s registration violations. 6 In addition to traditional brokerage services, U.S. brokerdealer registration may be required of foreign firms engaged in providing merger and acquisition services and soliciting investments in private placements in the U.S. The use of finders in the U.S. to locate potential investors also may raise registration issues. 7 Other consequences potentially may include litigation with investors and actions by U.S. state securities regulators. U.S. brokers that engage in transactions that do not comply with the Rule 15a-6 exemption also may violate FINRA rules that prohibit sharing commissions with non-member broker-dealers. February 2009 / Issue 2 3

4 In light of the unusual nature of the CentreInvest Order, U.S. and foreign brokers should consider the following actions: foreign brokers must understand the implications of soliciting U.S. institutional investors, if they do not plan on registering in the United States; U.S. brokers and their foreign affiliates relying on Rule 15a-6 should closely examine their compliance procedures, particularly with respect to direct communication by the foreign affiliate with U.S. institutional investors, including solicitations and trade executions, and maintenance of records relating to transactions effected between the foreign broker and U.S. institutional investors; U.S. brokers should be sure that they retain e- mails with foreign brokers or affiliates in accordance with current policies of the Financial Industry Regulatory Authority ( FINRA ) U.S. brokers that are affiliates or subsidiaries of foreign brokers should examine their current practices with respect to the management and supervision of the U.S. firm and its employees, including compensation practices, to assure that they comply with FINRA licensing requirements and disclosure of control relationships on Form BD; and U.S. brokers should assure that they maintain a current Form BD that reflects any regulatory actions by foreign securities authorities against their affiliates. Finally, we want to emphasize that any warnings from the SEC or a foreign regulatory authority should be taken seriously. In the context of potential registration violations, prompt action to address the concerns of the regulator including, if necessary, registering in that country, can significantly reduce the likelihood of enforcement proceedings. Conclusion At this point, it may be too early to determine whether the CentreInvest Order reflects a broader effort by the SEC to police its borders, or will remain an isolated action. However, it is a strong reminder that no matter what policy measures have been proposed by the SEC, both foreign and U.S. firms should focus on compliance with existing regulations. Also, while registered U.S. brokers may have viewed Rule 15a-6 as an exemption for foreign firms, the SEC has made clear in the CentreInvest Order that they also may be held accountable if the terms of the exemption are not followed. This update was authored by Edward L. Pittman ( ; edward.pittman@dechert.com) and Elliott R. Curzon ( ; elliott.curzon@dechert.com). Practice group contacts For more information, please contact the authors, one of the attorneys listed, or any Dechert attorney with whom you regularly work. Visit us at Karen L. Anderberg London karen.anderberg@dechert.com Stephen H. Bier stephen.bier@dechert.com Elliott R. Curzon elliott.curzon@dechert.com Margaret A. Bancroft margaret.bancroft@dechert.com Daphne T. Chisolm Charlotte daphne.chisolm@dechert.com Douglas P. Dick douglas.dick@dechert.com Sander M. Bieber sander.bieber@dechert.com Christopher D. Christian christopher.christian@dechert.com Jennifer O. Epstein London jennifer.epstein@dechert.com February 2009 / Issue 2 4

5 Ruth S. Epstein Paul Huey-Burns Robert A. Robertson Newport Beach Susan C. Ervin Jane A. Kanter Keith T. Robinson Hong Kong Joseph R. Fleming Geoffrey R.T. Kenyon Alan Rosenblat Brendan C. Fox Angelyn Lim Hong Kong Kevin P. Scanlan Wendy Robbins Fox George J. Mazin Frederick H. Sherley Charlotte Thomas J. Friedmann Jack W. Murphy Patrick W. D. Turley David M. Geffen John V. O Hanlon john.ohanlon@dechert.com Brian S. Vargo Philadelphia brian.vargo@dechert.com David J. Harris david.harris@dechert.com Jeffrey S. Puretz jeffrey.puretz@dechert.com David A. Vaughan / / david.vaughan@dechert.com Robert W. Helm robert.helm@dechert.com Jon S. Rand jon.rand@dechert.com Anthony H. Zacharski Hartford anthony.zacharski@dechert.com D Dechert LLP. All rights reserved. Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel. This publication, provided by Dechert LLP as a general informational service, may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome. U.S. Austin Charlotte Hartford Newport Beach Philadelphia Princeton San Francisco Silicon Valley EUROPE Brussels London Luxembourg Munich Paris ASIA Beijing Hong Kong February 2009 / Issue 2 5