THE SEC, FINCEN AND FINRA SANCTION BROKER

The anti-money laundering and customer identification rules are important market policing tools monitored by the SEC, the Financial Crimes Enforcement Network or FinCEN and FINRA. Pinnacle Capital Markets LLC, a broker dealer whose customers are largely outside the United States, was sanctioned by each regulator for violating these rules. The Commission’s action also named as a respondent Michael Paciorek, Pinnacle’s President and Chief Compliance Officer. In the Matter of Pinnacle Capital Markets LLC, Adm. Proc. File No. 3-14026 (Sept. 1, 2010); FinCEN Release, Sept. 1, 2010, available here. Previously, FINRA sanctioned the firm for violations of its anti-money laundering rules.

Pinnacle is a broker dealer based in Raleigh, North Carolina. Over 99% of the firms customers are outside the U.S. Many of those customers hold both corporate and individual accounts. A large number of the corporate customer accounts that are foreign entities also have omnibus accounts. In some instances, the foreign entities have sub-accounts for their own corporate or retail customers. Most of the firm’s regular and omnibus sub-account holders use direct access software to enter trades in the U.S. markets through their computers. Trades can thus be routed to the New York Stock Exchange and the NASDAQ system without an intermediary.

As of 2004 the firm had a documented anti-money laundering program which included a customer identification section. Exchange Act Rule 17a-8 requires broker dealers to comply with the Currency and Foreign Transactions Reporting Act of 1970 known as the Bank Secrecy Act. This includes adherence to the customer identification rules which essentially require that the broker dealer establish, document and maintain procedures for identifying and verifying the identity of customers.

From 2003 through November 2009 Pinnacle collected identifying information for its regular account holders. The firm failed, however, to verify information for corporate accounts in accord with its procedures. It also failed to collect or verify all identifying information for most of its omnibus sub-account holders. Mr. Paciorek, as the firm’s president and chief compliance officer, directed all of the broker’s actions with respect to its customer identification procedures and the identification and verification of its customers.

As a result of the foregoing failures Pinnacle willfully violated Section 17(a) of the Exchange Act and Rule 17a-8, according to the Order for Proceedings. Mr. Paciorek was the cause of those violations, the Order notes.

Respondents resolved the matter by consenting to the entry of a cease and desist order from committing or causing any violations and any future violations of Section 17(a) and Rule 17a-8. The firm was also censured and ordered to pay a $25,000 civil fine. Mr. Paciorek was not directed to pay a fine.

FinCEN assessed a $50,000 fine against the firm. FINRA, in February 2010 (discussed here), imposed a $300,000 fine on the firm for violating its anti-money laundering rules based in part on the facts detailed in the Commission’s Order and a finding that the firm failed to detect and report suspicious activity. FINRA also censured the firm and ordered it to comply with certain undertakings.

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THE IMPACT OF DODD-FRANK – AND A WARNING TO RATING AGENCIES

The Moody’s Investors Services, Inc. Section 21(a) report released on August 31, 2010 gives an indication of the potential impact of Dodd-Frank. It is based on an existing limitation of the enforcement program, but reflects the removal of that impediment by the legislation. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Moody’s Investors Services, Inc., Exchange Act Release No. 62802 (Aug. 31, 2010).

The Report details the cover-up of a rating error by Moody’s European operations and the Commission decision not to bring an enforcement action because of a question regarding its jurisdiction. In the summer of 2006, Moody’s Investor Services, Inc. developed a new rating methodology for constant proportion debt obligation notes or CPDOs. These are special purpose vehicles that sell unfunded CDS on corporate debt indices. The issuers use the proceeds from the notes to purchase liquid instruments which can be sold to pay CPDO issuer obligations when specific events occur.

MIS developed a new model to rate the instruments which resulted in a rating of Aaa. The instruments were marketed in Europe. Subsequently, it was determined that the metric in the rating model was inadvertently set too high. Several internal meetings were held at Moody’s Investor Services in France and the U.K. to analyze the matter. In April 2007, the rating committee voted not to downgrade the ratings for the affected notes. This decision was based in part on concerns regarding the reputation of MIS.

In May 2008 the Financial Times published an article exposing the error. Following an internal investigation, the company acknowledged it. Prior to that time however, Moody’s registered with the SEC as an NRSRO. Those papers detailed the Core Principles for the Conduct of Rating Committees. The ratings here did not adhere to those principles.

Based on these facts, the Commission declined to bring an enforcement action “[b]ecause of uncertainty regarding a jurisdictional nexus to the United States in this matter . . .” While the Release did not cite any authority on this point, clearly the Supreme Court’s decision in Morrison v. National Australia Bank Ltd., No. 08-1197 (June 24, 2010) (discussed here) delimiting the reach of Exchange Act Section 10(b) to the U.S. had an impact. Dodd-Frank however gives the Commission a predicate for warning rating agencies regarding the type of conduct detailed in the Release. The new legislation effectively overrules Morrison as to the SEC and the Department of Justice (discussed here): “The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions . . . involving ‘conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States that has a foreseeable substantial effect within the United States.’” Citing other provisions of the reform bill, the Commission also cautioned rating agencies that they are now required to maintain effective systems of controls and procedures which must be followed. For those wondering about the impact of the huge new reform bill, the Moody’s Release is a good example of its potential impact.

Note: Each year Lexis recognizes the top twenty five corporate and securities blogs. This blog has been nominated for this honor. To vote please click here.