IMN Beneficial Owners NYC Securities Lending Summit FINRA Enforcement

1. IMN Beneficial Owners NYC Securities Lending Summit FINRA Enforcement

2. FINRA ENFORCEMENT • Created in July 2007 when portions of NYSE Regulation merged with the NASD. • FINRA has about 3,000 employees in 15 offices around the country. • Enforcement – about 300 attorneys & investigators. We regulate 5,000+ brokerage & clearing firms 1

3. Enforcement Reg. SHO Actions • Several NYSE decisions brought shortly after Reg. SHO became effective (HPDs 06-111, 06-112, 06-113, 06-128, 06-139) • Fines imposed total $1.65 million and ranged from $250,000 - $400,000. • Deficient written supervisory procedures • Appropriate marking of order tickets long/ short • Locate requirements • Track fails on long and short sales • FTD closeout • Failure to perform or document locate information on short sales. 2

4. Failed to track customer assurances for “reasonable” grounds to accept customer’s locates. Used independent trading unit aggregation without meeting the specific conditions in the rule. Books and records violations Effected sales marked long without ensuring accuracy or deliverability Effected short sales without documenting/ borrowing / arranging to borrow / or having reasonable grounds to believe securities could be delivered Failed to accurately account for fails to deliver in threshold securities Prior Reg. SHO Enforcement Actions 3

5. Applicable Rules • Rule 203(b)(1): “A broker or dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account unless the broker or dealer has . . . (ii) Reasonable grounds to believe that the security can be borrowed . . . and (iii) documented compliance with this paragraph (b)(1). 4

6. Applicable Rules (con’t) Footnote 58 of the SEC’s Adopting Release, dated July 28, 2004 AND in a FAQ released by the SEC on January 3, 2005: • “where a broker-dealer knows or has reason to know that a customer’s prior assurances resulted in failures to deliver, assurances from such customer would not provide the “reasonable grounds” required.” • “It would not be reasonable for an executing broker to assert that it did not know or have reason to know whether a customer’s prior short sale trade resulted in delivery failures if the executing broker made no reasonable effort to obtain such information.” 5

7. Current Regulation SHO Concerns • Executing short sales without getting locates because of inaccurate Easy To Borrow lists. • Long sales executed without a reasonable basis to believe the shares will be delivered. The long sale fails were open for extended periods of time but firm continued to accept orders in the same stocks. • Mismarking of short sales as long sales. • Patterns of customers entering long sale orders after being denied a locate. • Firm continued use of flawed systems (If it doesn’t work, fix it or use something else). 6

8. Additional Regulation SHO Concerns • Missing, Late or Insufficient Locates • Firms’ proprietary desks were not required to obtain locates prior to execution of short sales • Firms’ systems, especially DMA systems, allowed for entry of short sale without a locate or with nonsense locate (ex: Xxxx) • Firms permitted certain customers to execute short sales on the basis of standing locate instructions • “Locates” entered after short sale is released for execution • Misuse of market maker exception and block-positioner exception 7

9. Stock Loan Violations SCAM: • Finders that are placed in the middle of transactions between stock borrowers & lenders for no purpose, with the effect of charging inflated rates. • Actions have been brought by Dept of Justice, SEC, NYSE & FINRA • For example: FINRA found that one firm’s stock loan department paid 12 finders $4.39+ million in stock loan transactions; many where the finder provided NO service at all 8

10. Stock Loan Fraud • Criminal action: In the Matter of Michael McCormack (Admin. Proc. File No. 3-13041 May 9, 2008) brought by the U.S. Attorney’s Office, McCormack, a former securities lending representative, pled guilty to conspiracy to commit wire fraud. McCormack was charged with engaging in inappropriate stock loans through a finder firm that collected fees from other stock loan representatives but did not offer legitimate finder services. Through the broker/dealer, McCormack entered into stock loan transactions with firms where the rebates paid were less favorable than those available in the marketplace. In the criminal action, McCormack was ordered to pay $900,000 in restitution and sentenced to three years imprisonment. Criminal charges against a second representative are still pending. At about the same time, the SEC filed separate actions against McCormack, the firm and the another individual still pending. The SEC barred McCormack from association with any broker or dealer. 9

11. Stock Lending Concerns • Lack of Disclosure to Customers – Does the firm disclose that interest rates could change on the loan? that value of loan could fluctuate? that brokers were paid commissions to solicit the customers to loan transaction and throughout the life of the loan? Are disclosures adequate re SIPC limitations, loss of voting rights, and dividend tax issues? • Advertising – do marketing materials suggest “very little risk” or that direct borrow customers do not suffer losses as a result of lending their shares? • Supervisory Failures – are supervisory procedures in place re: the identification and solicitation of customers to lend securities to the firm; the information disclosed to customers; and operation of the direct borrow desk? 10

12. Tax Dividend Payments, Swaps & Repos Concerns: • Firms that have failed to reasonably supervise with respect to certain derivative transactions essentially involving trades designed to • (a) enable certain foreign investor clients to avoid having taxes withheld on certain dividend payments, and • (b) enable the firm to obtain certain substantial tax benefits for the proprietary account of a firm affiliate. • The transactions did not result in a change in beneficial ownership and/or inaccurately gave the appearance of being independent transactions in the market 11

13. Tax Dividend Payments (Cont) • In the Fall of 2008, a firm consented to a $600,000 fine, split between FINRA Market Regulation and NYSE Regulation, for similar improper trades. NYSE HBD 08-45 (October 2008). The firm stipulated that it failed to reasonably supervise with regard to certain improper trades between affiliates.  Thetrades were designed to enhance a firm affiliate's yields on securities of certain non-U.S. issuers without incurring market price exposure, and to provide the affiliate with tax benefits not available to the firm. • These concerns were the topic of a US Senate Subcommittee Hearing and Staff Report. • Message: Firms must have in place adequate procedures designed to detect and prevent the kinds of improper transactions described above, and those procedures must be enforced. 12

14. IMN Beneficial Owners NYC Securities Lending Summit FINRA Department of Enforcement Susan LightSenior Vice President & Chief CounselJune 15, 2009