Broker- Dealer Law Corner

Broker- Dealer Law Corner

Statutorily Disqualified? FINRA Says “Deal With It”

Posted in Disciplinary Process, Enforcement, FINRA, Sanctions, Statutory Disqualification

It is a nasty thing when one becomes statutorily disqualified. It means either leaving the industry, permanently, or having to file an MC-400 and trying to convince FINRA that you should be permitted to remain in the industry, albeit subject to heightened supervision and extra scrutiny from FINRA.  I have previously blogged about statutory disqualification, and the long and short of it is that it’s a minefield, very, very difficult to navigate.  I feel like I know as much about statutory disqualification as anyone in the industry, yet, I keep a copy of Reg Notice 09-19 handy on my desk because at least a couple of times each week I find a need to refer to it to ensure that my understanding of what triggers a statutory disqualification, and the consequences of being statutorily disqualified, is correct.  Even so, I still call FINRA’s Registration and Disclosures group regularly with questions, as 09-19 is hardly a model of clarity.

One thing that is quite clear, however, is that a finding of willfulness typically triggers a statutory disqualification. Many, many registered representatives have discovered this sad fact for themselves as they have dealt with the dozens, if not hundreds, of Enforcement cases FINRA has brought over the last few years involving failures to update Form U-4 in a timely manner to reflect an unpaid tax lien.  If that failure is not willful, the sanctions are pretty benign, maybe a $5,000 fine and a relatively short suspension.  On the other hand, if the failure is deemed to be willful, in addition to those sanctions, the respondent is also deemed to be statutorily disqualified, with all the nastiness that entails.  As defense counsel, when engaged to handle one of these cases, the battle line is typically drawn at the issue of willfulness (as the cases are pretty easy to settle absent willfulness).

The problem is, it is difficult to figure out exactly when FINRA will deem a failure to report a tax lien in a timely manner to be willful, and when it will not. I can personally attest that I have had a variety of clients tell essentially the same story to FINRA – I did not know about the lien, or I did not know I had to report the lien – yet come away with widely different outcomes.  On one end of the spectrum, I have had FINRA take no formal action, and choose to content itself by issuing a Cautionary Action letter.  In the middle, I have had FINRA take formal action, but agree the violation was not willful.  Finally, on the other extreme end of the spectrum, FINRA has taken formal action and deemed the violation to be willful.  It can be extremely frustrating to make the same argument over the same set of facts, but get different results.

This whole issue was teed up for me again recently when I read a blog post by Bill Singer, tireless author of Broke and Broker, a wonderful blog for anyone in the securities industry, who pointed out a recent FINRA settlement involving a failure to disclose a tax lien in which there was no finding of willfulness.  His point, and one with which I wholeheartedly agree, was why doesn’t FINRA give any real guidance on this subject?  You can read case after case and still not be able to get a firm handle on those particular set of facts that will cause FINRA to conclude that it must charge willfulness under those circumstances.  Given the crushing impact that a willfulness finding can have, due to the statutory disqualification that ensues, I think FINRA owes a duties to its members to spell this out with abundant clarity.

Finally, one more thing about statutory disqualification: FINRA could care less that a finding of willfulness renders a registered representative SD’d.  As the Department of Enforcement recently put it in a brief it filed in one of my cases,

statutory disqualification is not a FINRA sanction; it is a status that flows as a matter of course from predicates enumerated in the Exchange Act. If [Respondent] believes that statutory disqualification is an unduly harsh outcome for willfully violating U4 reporting requirements, he should address his grievances to the SEC and Congress. The SEC and the NAC surely would not want FINRA hearing panels to engage in the equivalent of jury nullification by declining to find willfulness where it has been proved.

What an outrageously callous remark for the staff to make. At least one hearing panel, over a decade ago, had the courage to state the obvious:  “A finding of willfulness, though not an element of the offense under Rule 2110, has serious collateral consequences.”  That FINRA staff consciously disregards these consequences, however, potentially career-ending consequences, just blows me away.

Clearly, the existence or non-existence of a statutorily disqualifying event is relevant.  And I know this because the Sanction Guideline for inaccurate U-4 cases includes as one of the Principal Considerations “[w]hether [the] failure resulted in a statutorily disqualified individual becoming or remaining associated with a firm.”  The fact that whether someone is SD’d or not is expressly pertinent to the determination of the appropriate sanction necessarily means it is not just a material fact, but an important one.  For FINRA simply to pretend it doesn’t care that its charging decision will dictate whether or not a respondent gets SD’d, or that such a finding isn’t a “sanction,” is both short-sighted and unfair.

Looking For A Silver Lining: Post-Election Thoughts On The SEC

Posted in Administrative Proceedings, appeal, Disciplinary Process, Enforcement, SEC

Wednesday morning marked the confluence of two events. First, like the rest of the world, I awoke to the reality of the results of the presidential race.  Then, as soon as I got to the office, I received the results of a case (on which I have previously blogged) that the SEC’s Division of Enforcement had appealed to the SEC after we beat them – against staggering statistical odds – in front of an Administrative Law Judge.  Sadly, but, perhaps, not surprisingly, the SEC reversed the ALJ, found liability – but only some, as I discuss below – and imposed penalties.

Well, to start with the good news: my clients are appealing the SEC’s decision, likely to the U.S. Circuit Court of Appeals for the Fifth Circuit.  Why is this good news?  Cynics among you will say it is because I get to bill more hours to this case, but, while you are technically correct, that is hardly what makes this decision by my clients to appeal a good one.  Rather, it is because there are problems with the SEC’s very system of administering cases, because the SEC specifically managed to get it wrong here, and because, maybe worst of all, it is a case that should never have been brought.  Let’s look at these.

First, the SEC’s system. When this complaint was issued by the Division of Enforcement, it was first authorized by the SEC itself, i.e., the actual five individuals (or however many were actually in place at the time) who comprise the Commission.  Obviously, if those individuals did not believe that the allegations against my clients were viable, they would not have authorized the issuance of the complaint.  When the Division of Enforcement lost the case before the ALJ, under the SEC’s rules of procedure, it appealed that decision to the Commission, that’s right, the very same individuals who had authorized the complaint in the first place.  Can you see why, then, that I said the Commission’s decision to reverse the ALJ is not surprising?  I mean, if they found the facts sufficient to justify a complaint being filed, it is hardly a stretch for them later, when presented with the same facts – but this time in the context of the Division’s appeal – to find them compelling again.  Does this sound in the slightest bit fair?  How can the Commission’s review of the ALJ’s decision possibly be unbiased?

Second, putting aside the unfairness of the system that allows the same people who authorized the issuance of the complaint to decide the appeal, it remains that the SEC got it wrong. As the Division of Enforcement is wont to do, when it offered my clients the opportunity to settle the proposed charges prior to any complaint being issued, it was willing to keep out any findings of scienter-based fraud.  When my clients ultimately declined to settle, however, the Division got angry, and so it included scienter-based allegations in the complaint (along with non-scienter-based allegations).  In his Initial Decision, the ALJ dismissed both the scienter- and non-scienter-based charges, highlighted by his conclusion that after observing my clients’ “demeanor under cross-examination, it is difficult to imagine them trying to defraud anyone, let alone their investment clients.”

In its decision reversing the ALJ, the SEC nevertheless cited that specific finding, with approval, and gave it “significant weight.” But, despite concurring that my clients were incapable of defrauding anyone, the SEC proceeded to conclude that my clients were guilty of “negligence,” under Section 206(2) of the Advisors Act.  The problem is, “negligence” under 206(2) still constitutes fraud.  Thus, if my clients were well intended and incapable of defrauding anyone, it would not seem to matter if the charge was scienter-based fraud or non-scienter-based fraud; both should have been treated the same.  Somehow, however, the SEC managed to figure out a difference.

Making it worse, the SEC imposed second-tier civil penalties, even though based on its finding of mere “negligence.” Such penalties require a finding of at least recklessness, and permit the SEC to impose a penalty of up to $80,000 for an individual for each such act or omission.  A first-tier penalty, by comparison, which does not require negligence, can only be as high as $7,500.  In light of the SEC’s conclusion that the ALJ properly found that my clients were incapable of committing fraud, it is downright outrageous for it to have imposed second-tier penalties.

My last issue is with the SEC’s agenda itself. Tons of articles were written after the SEC recently closed its books for the last fiscal year about how the Commission set a new record for actions brought.  The consensus view – and one to which I adhere – is that this was a result of the SEC’s acknowledged “broken windows” approach to Enforcement, bringing formal actions for relatively minor violations in a supposed effort to avoid bigger ones.  The issue is not only that such minor violations are better off dealt with in some manner other than being made the subject of administrative proceedings, but, when such proceedings are instituted, the Division of Enforcement routinely over-charges the violations, and characterizes them as intentional, scienter-based fraud, as it did here.  Good corporate citizens are branded as fraudsters, and unnecessarily so.  Things need to change.

Which brings me back to the election. Despite people – including people I truly respect – providing reassurances that things won’t be so bad, and urging the electorate to keep an open mind as the new administration’s agenda is fleshed out, some of the media spins out worst-case scenario after worst-case scenario.  But, perhaps there is at least one ray of hope on which both parties can agree.  It seems clear that the president-elect is not a fan of regulation, or the SEC, or its present chairwoman.[1]  If this means that “broken windows” goes the way of Dodd-Frank, or the Affordable Care Act, among other things, at least as promised during the campaign, then, hopefully, people like my clients will no longer find themselves in the bizzarro world that is the present-day SEC Enforcement protocol.

[1] For what it’s worth, the SEC’s decision was made by the three current members of the Commission.  Although he agreed with the finding that my clients were liable for negligence, the one Republican Commissioner dissented from the imposition of the civil penalties!  Draw your own conclusions.

When It Comes To Churning, FINRA Knows What’s Best For Investors

Posted in Churning, Disciplinary Process, Enforcement, FINRA

Since I first started practicing law back in the 1980s, customer complaints against brokers have often involved allegations of “churning,” which is deemed to be fraud. Now, as it was 30+ years ago, to prove a churning claim, a customer needs to demonstrate that (1) the broker acted with scienter, which is defined to be either an intent to deceive or such recklessness that it essentially constitutes the equivalent of intent, (2) the broker “controlled” the account (either actually or in a “de facto” manner), and (3) the account was, quantitatively speaking, traded excessively.  When an account is excessively traded, but there is no evidence of scienter, FINRA can still charge a violation, but it is simply deemed to be a suitability violation, specifically, a quantitative suitability violation.  Because we are still routinely called upon to defend churning and excessive trading claims in both customer arbitrations and disciplinary actions, a look at a very recent FINRA Enforcement action involving these claims serves as a good refresher on what the expectations are in such matters.

Enforcement v. David M. Levy, et al., is a default decision[1] against three individuals who were accused, and found guilty, of churning and excessively trading the accounts of several customers. Let’s first look at how the issue of “control” was addressed.

Control is easy to demonstrate when a broker has discretionary authority over the trading in a customer’s account. In that case, the broker controls the account as a matter of law.  When an account is non-discretionary, on the other hand, control is generally shown by the fact that a customer routinely acquiesces to his broker’s recommendations.  But, in fact, the analysis is somewhat more nuanced.  It is not merely that a customer follows his broker’s recommendations; rather, it is that the customer lacks “sufficient understanding to make an independent evaluation of the broker’s recommendations,” and that is why the customer acquiesces.  Thus, if the customer is an “inexperienced” and “naïve” investor, as was the case in Levy, a broker can wrest control over a non-discretionary account.  But, if the customer is perfectly capable of understanding his broker’s recommendations, but nevertheless agrees with those recommendations, control over the account will still lie with the customer.  The lesson is that the issue of control turns not on whether the customer routinely follows his broker’s recommendations, but why the customer does so.

As for the whether an account is excessively traded, it is important to bear in mind that this phrase does not connote some absolute standard (despite the 5% figure that appears in FINRA’s Mark-Up Policy); rather, the trading must be excessive relative to the customer’s stated investment objective.  Thus, a customer with a speculative investment objective and an aggressive risk tolerance should expect to see more trading than a conservative customer.  What is interesting about the Levy case is that while FINRA acknowledged this fact, it nevertheless concluded that the trading at issue was so frequent that it “would not be suitable for any customer, regardless of the customer’s financial circumstances and investment objectives.”  The decision continued:

The Hearing Officer acknowledges that active trading leading to turnover rates well above six could conceivably be suitable for certain sophisticated customers who understand the risks associated with such trading. The Hearing Officer can conceive of no customers, however, for whom turnover rates coupled with cost-to-equity percentages at the levels found in this proceeding would be suitable….  No customers, regardless of their financial circumstances and investment objectives, would make a rational decision to invest on such a basis because they would know they would be highly unlikely to profit from the trading, and that the trading would primarily benefit the RR.

It astounds me that FINRA can substitute its judgment for investors in this fashion. Clearly, if an investor is so “sophisticated,” to use FINRA’s word, that he can “understand the risks associated with” frequent trading, then just as clearly that customer – and not the customer’s broker – controls the account.  Since FINRA must prove that the broker controlled the account, however, to establish churning or excessive trading, I just don’t see how FINRA can ever prevail when the customer is truly sophisticated, no matter how excessive the trading.

FINRA attempted to address this in the decision. But, again, notice in the analysis below that the focus is not on “control” but, rather, the excessive nature of the trading and the costs associated with a frequent trading strategy:

Even if some customers invested only money that they were prepared to lose and understood that their accounts would be invested in speculative securities, the trading that actually occurred in their accounts was excessive. Those customers accepted market risk, that is, the possibility that the securities they invested in might decrease in value, costing them the funds they had invested.  But in fact the customers’ losses were not primarily attributable to market risk, but rather to the RRs’ greed in trading the customers’ accounts for their own benefit.  Indeed, in some of the customers’ accounts there was little or no net loss on the trades themselves; rather those customers lost significant amounts of money because of the extraordinary amounts, including commissions, markups and markdowns, and other costs, that they were charged for the trades.  Even if the funds they invested were insignificant to their total financial circumstances, none of the customers intended that their investments serve primarily to benefit the RR through whom they invested.

FINRA cannot have it both ways. If a customer is sophisticated enough to be deemed to be in control of his account, then he cannot simultaneously be unsophisticated when it comes to appreciating that the frequent trading strategy he has elected is expensive.  Regardless, it is odd to me how FINRA can so easily substitute its judgment for the investors’.  Just because the Hearing Officer could not conceive of any customer willing to employ an aggressive, but expensive, trading strategy hardly means they do not exist.

Putting to one side the result in Levy, which, after all, was a default decision, it is clear that there are ways to successfully defend churning cases, at least those involving sophisticated customers.


[1] Under FINRA’s rules, even when a respondent fails to appear and defend himself, the Department of Enforcement is still required to produce evidence in support of its allegations.  Not surprisingly, however, since no one is there to contest FINRA’s case, it is awfully difficult for FINRA to lose a default decision.

It’s Official: The SEC Has No Sense Of Humor

Posted in Administrative Proceedings, Disciplinary Process, Enforcement, SEC

One of my colleagues and I were busy the last two week defending an SEC administrative proceeding out-of-town, so I have not had much chance to blog. But…there was one development during our hearing that merits some immediate attention.

My client has been accused, essentially, of making a number of material misrepresentations and omissions in a series of Offering Memoranda. In support of its case, the Division of Enforcement put one of the investors on the stand to testify about his experience and whether one of the alleged misrepresentations was important to his investment decision.  (For what it’s worth, this was over our objection, given that the standard of “materiality” is objective, not subjective, so who really cares what any particular investor has to say on this subject.  The ALJ agreed with our statement of the standard; but, he felt customer testimony would help “inform” his judgment of what is reasonable under the circumstances.)

At some point, testimony was adduced from the witness that his investment has not lost any money, and has continued to pay the required return each month like clockwork. The customer was still unhappy, however, as he was, apparently, hoping to have gotten his money back sooner.  To drive home how he currently feels about his investment, he asked my colleague – unbidden and unsolicited – during cross if, perhaps, she would be interested in taking his investment off his hands.  She laughed.  I laughed.  The court reporter laughed.  Most importantly, the ALJ laughed.

The Division of Enforcement, however, did not. In fact, they lodged an objection on the record, insisting that this “was not” humorous.

To his credit, the ALJ dutifully overruled the objection, and declared the statement was, in fact, funny.

So, if anyone ever tells you that in their opinion the SEC has no sense of humor, you can tell them that it’s not only true, but that they have gone so far as to object to its very existence.


Frequently Asked Questions About FINRA Rule 8210

Posted in Disciplinary Process, Enforcement, Examination, FINRA, Rule 2010, Rule 8210, Sanctions

As readers of this Blog know, Rule 8210 is a favorite subject of mine to complain about, particularly the frightening vigor with which FINRA constantly tests the limits of the rule.  What follows are some very helpful FAQs about Rule 8210 from Michael Gross.  –  Alan

The Scope of the Rule

Can FINRA really ask for that?

Probably. Under FINRA Rule 8210, FINRA can require firms and individuals subject to its jurisdiction to produce documents “with respect to any matter involved in [an] investigation, complaint, examination, or proceeding that is in such member’s or person’s possession, custody or control.” Because of the exceedingly broad scope of FINRA Rule 2010 (which requires firms and individuals, “in the conduct of [their] business, [to] observe high standards of commercial honor and just and equitable principles of trade”), the subject matter of an investigation can encompass nearly anything. Consequently, the scope of Rule 2010 is not limited to securities-related misconduct; it also encompasses unethical business-related misconduct. FINRA has successfully prosecuted actions for stealing funds from a political club, improperly obtaining a donation for private school tuition from an employer, and falsely inducing an employer to pay country club fees.

What if I think a request is irrelevant, overly broad, or unduly burdensome?

You should explain your rationale, in writing, to FINRA. If FINRA does not agree to withdraw or limit the request, you have two choices. First, you can provide the requested documents and information. The case law on this issue is clear: only FINRA determines what documents and information are relevant to its investigation. If you elect not to do that, your only alternative, as discussed below, is defend yourself in an Enforcement action.  If you lose, however, the consequence is not simply that you have to produce the document or information; the consequence is that you will get barred.

What should I do if I cannot comply with burdensome requests for documents or information in the limited time provided?

You should make a written request for additional time to respond to the requests. In most cases, FINRA will grant a two-week extension of time. Requests for additional time also may be granted. You should obtain written confirmation of any extension. In the Segall case, FINRA’s Office of Hearing Officer’s recently held that “it is ‘essential’ for FINRA and its examiners to be flexible, to make allowances for human error and unintentional failures to meet all deadlines.”

What if I cannot afford, and/or do not want, to travel to a FINRA office that is farther from my home than a FINRA office closer to my home in order to provide on-the-record testimony?

Rule 8210 requires you “to testify at a location specified by FINRA staff.” That being said, you should ask FINRA, in writing, to pay your travel costs or allow you to provide testimony at the FINRA office closest to your home. If those invitations are declined, you should not hesitate to elevate your request to more senior FINRA management. Sometimes, lower level FINRA staff take a hard line, only to have their boss display greater flexibility.

What if I do not have the requested documents but can get them?

You need to get the documents and produce them, if they “are in the possession of another person or entity, such as a professional service provider, but the FINRA member, associated person or person subject to FINRA’s jurisdiction controls or has a right to demand them.” Supplementary Material to Rule 8210. This means that if your bank, accountant, or lawyer has the documents, i.e., someone who must take your direction, then you need to get the documents from them for FINRA.

What if it will cost me a small fortune to get and/or copy the requested documents?

You should ask FINRA, in writing, to pay your costs of obtaining and/or copying the documents. If FINRA declines the invitation, you are no worse off; unfortunately, you still must produce the documents.

What if I do not have the requested documents and cannot get them?

You need to tell FINRA that in writing. The SEC has determined that you also have “a responsibility to provide a detailed explanation of [your] efforts to obtain the information requested and the problems [you] encountered.”

Are there any limits to the scope of Rule 8210?

Very few. FINRA, of course, is not entitled to privileged communications, such as those subject to the attorney-client, physician-patient, or spousal privileges (unless you waive the privilege). In addition, the SEC opined that “[FINRA’s] authority under the Rule might not extend to documents that may belong to a third party, or that may contain a third party’s confidential information not closely related to securities trading with a member or associated person, even if those documents were in the possession and control of a member or associated person.” The Supplementary Material to Rule 8210 likewise acknowledges that “[Rule 8210] does not ordinarily include books and records that are in the possession, custody or control of a member or associated person, but whose bona fide ownership is held by an independent third party and the records are unrelated to the business of the member.”

The Sole Avenue for Appeal

What if I think FINRA is not entitled to the requested documents or information?

Unfortunately, you need to provide the requested documents or information in order to avoid a likely bar. In the Berger case, Mr. Berger argued that “he should have the ability to challenge NASD’s jurisdiction without first appearing at an OTR, and that he should be entitled to do this without the risk that NASD will find that he refused to provide the information and bar him from association.” In a decision ultimately affirmed by a federal court, the SEC held that “subjecting oneself to NASD’s disciplinary process and relying on NASD’s procedures is the appropriate route to challenge NASD jurisdiction.” More succinctly stated by the SEC: “the only recourse against possible overreaching by [FINRA] is for the person to whom the request is directed to refuse to comply, and to appeal any consequent disciplinary action to the [SEC].” Somehow this process has been deemed to be “fair.”

If FINRA can bar someone for not providing requested documents or information, then who in their right mind would not comply with a request?

No one who desires to remain in the industry.

If there is no avenue to appeal whether FINRA is entitled to documents or information (other than risking a bar), then how will the limits of Rule 8210 be tested?

The limits of Rule 8210 will be tested or determined only by the few people willing to risk a bar by not providing requested documents or information. See also above answer. Given the stakes of challenging FINRA on Rule 8210, there are unanswered questions about the scope of the Rule, which firms and individuals, not surprisingly, may choose to answer by providing FINRA with what it wants. These unresolved questions include:

  • Can FINRA require me to sign a release, such as IRS Form 4506, so that it can obtain documents or information directly from a third party?
  • Can FINRA require me to create a document for it using information that I have?
  • What if providing requested documents or information would cause me to violate a duty of confidentiality owed to persons to whom the documents or information relate?
  • What if producing requested documents or information would cause me to violate the law of another country?

 The Consequences of Non-Compliance

What likely will happen to me if I do not timely provide all of the requested documents or information?

FINRA regularly brings disciplinary actions for not timely providing requested documents or information. The typical sanction is an all capacities suspension, often for a considerable period of time.

What likely will happen to me if I do not provide any of the requested documents or information?

Under FINRA’s Sanction Guidelines, a bar is the “standard” sanction.

What likely will happen to me if I provide most, but not all, of the requested documents or information?

FINRA regularly pursues disciplinary actions for providing partial but incomplete responses. Under the Sanction Guidelines, “a bar is standard unless the person can demonstrate that the information provided substantially complied with all aspects of the request.”

What likely will happen to me if I do not provide any of the requested documents or information and I am out of the securities industry and have no desire to return?

FINRA will not go away. If you are subject to FINRA’s retained jurisdiction (which typically extends for a period of two years after you have left the industry), FINRA likely will bring a disciplinary action against you and have you barred.


A Settlement Agreement With FINRA (Or So You Thought)

Posted in Disciplinary Process, Enforcement, FINRA, Settlements

In OHO Order 16-26, a Hearing Officer confirmed what those uninitiated to FINRA’s disciplinary process likely would not even suspect: an agreement to settle a FINRA regulatory matter on terms proposed by FINRA’s Department of Enforcement is not necessarily an enforceable agreement.

In this case, the respondent argued that FINRA should be estopped from seeking fines and sanctions higher than those previously agreed to by Enforcement in a settlement agreement that fell through. In striking the respondent’s estoppel defense, the Hearing Officer ruled that there was no settlement agreement because “[t]he argument that an Enforcement attorney may agree to settle a case on FINRA’s behalf acting under actual or apparent authority is ‘wrong.’”

To the uninitiated, this may seem, well, wrong. Settlements with FINRA, however, need to be approved by FINRA’s Department of Enforcement or FINRA’s Department of Market Regulation (depending on which Department is pursuing the matter) and FINRA’s Office of Disciplinary Affairs (“ODA”).[1] “ODA [] reviews settlements for consistency with the Sanction Guidelines as well as applicable precedent. ODA approval is required before the issuance of a settlement or complaint.” Regulatory Notice 09-17.

The lesson to be learned here is to ensure that any settlement demand or proposal from FINRA has been approved both by Enforcement or Market Regulation management and ODA. If not, the settlement proposal is not really a proposal at all, and you may just be bidding against yourself.

[1] ODA was created in the late 1990s, when, as a result of an adverse report from the SEC, the NASD made wholesale changes to the Code of Procedure and the disciplinary process.  Among those changes, the decisions to file complaints and to accept settlements was away taken from the District Business Conduct Committees and given, instead, to the lawyers in the Department of Enforcement.  But, as a safeguard, to keep Enforcement from acting too crazy, the NASD created the ODA, which must approve Enforcement’s recommendations to file complaints and to accept settlements.

The Math of Mark-Ups/Downs

Posted in Disciplinary Process, Enforcement, FINRA, Mark-ups, Rule 2121

I am pleased to welcome a new author to Broker-Dealer Law Corner, my partner in Ulmer’s Boca Raton office, Michael Gross.  Like myself, Michael returned to private practice after a stint at FINRA, specifically, with the Department of Enforcement, where he handled big, litigated cases all over the US.  There is no substitute for the perspective one gains from having worked on that side of the table.  I look forward to sharing with you many more posts with Michael’s unique slant on things. – Alan, editor


  It is well settled – indeed, it is a FINRA rule – that broker-dealers need to charge “fair” prices when they buy securities from, and sell securities to, their retail customers.  This, of course, begs the question of what is a “fair” price.  The lawyer answer to the question is: “It depends.”  Unfortunately, that is the same guidance that regulators and courts have provided to the securities industry for nearly 75 years. FINRA examined this issue in 1943 and has since revisited it several times, only to conclude in the Supplementary Material to Rule 2121 that: “No definitive answer can be given and no interpretation can be all-inclusive for the obvious reason that what might be considered fair in one transaction could be unfair in another transaction because of different circumstances.” Notwithstanding this murky guidance, FINRA reaffirmed its “5% Policy” based on its finding that the large majority of transactions with customers are effected at mark-ups under that threshold.  Consonant with that guidance, FINRA has historically taken a mathematical approach to mark-ups/downs.

Securities Fraud Requires More than Math

A recent Decision by FINRA’s Office of Hearing Officers (“OHO”) rejected the pure mathematical approach to mark-ups/downs in the securities fraud context.[1] In the Singh case, FINRA’s Department of Market Regulation alleged that Bharminder Singh committed securities fraud and violated FINRA’s fair pricing rule by charging unfair and excessive mark-downs of 10% or more in 384 transactions involving distressed debt instruments.  Market Regulation calculated the mark-down percentage by comparing Mr. Singh’s prices to the lowest inter-dealer price for the same security on the same day.  In support of its fraud charge, Market Regulation argued, among other things, that mark-downs in excess of 10% are fraudulent as a matter of law. OHO squarely rejected the argument:

To the extent that Market Regulation is arguing that the size of the markdowns alone is sufficient to establish fraud, we reject that proposition. A case concerning alleged fraudulent markups or markdowns is no different with regard to scienter from any other securities fraud case.[2]

In finding that Mr. Singh did not act with scienter (i.e., intent to deceive or recklessness), and thus did not commit securities fraud, OHO noted numerous factors, including Mr. Singh’s lack of appropriate training and guidance, the highly volatile nature of the distressed securities, and the lack of any significant benefit from the mark-downs to him.  OHO, however, did find that Mr. Singh violated FINRA’s fair pricing rule by charging prices substantially in excess of the “5% Policy” memorialized in IM-2440-1 (n/k/a FINRA Rule 2121.01).

Real World Mathematical Guidance

Needless to say, broker-dealers do not want to find themselves in the same boat as Mr. Singh. They also should know that the “5% Policy” is not a safe harbor, as tribunals have found mark-ups/downs below that threshold to be excessive.  While FINRA Rule 2121.01 identifies a number of factors to consider in determining the fairness of mark-ups/downs, it offers no mathematical guidance on how to apply or account for the subjective factors.[3]  One veteran trader with whom I recently spoke believes that the industry standard is well below the “5% Policy.”  He said that the norm is 2% to 3% on fixed income securities, 1% percent on equities, and 3% to 4% on low-priced and/or illiquid securities.  Broker-dealers, of course, may charge more than those percentages and still provide “fair” prices (and/or prices that do not draw regulatory scrutiny).  It, however, is clear that the 5% bar has been lowered considerably.

[1] The Decision may still be appealed by either party or called for review by FINRA’s National Adjudicatory Council.  In the interest of full disclosure, before returning to private practice, the author of this article represented Market Regulation in the case.

[2] OHO also observed that: “The case cited by Market Regulation for the proposition that a 10% markup on an equity security is fraudulent per se states the proposition but does not actually stand for it.”

[3] The factors include: the type of security involved; the availability of the security in the market; the price of the security; the amount of the transaction; the disclosures provided; the pattern of mark-ups; and the nature of the firm’s business. FINRA Rule 2121.01.

Pick Your Poison: Given What A Jury Can Do, Is Arbitration Really That Bad?

Posted in Arbitration, FINRA

Some of my clients simply cannot enough bad things about the arbitration process. It is expensive.  It is unfair.  There’s no industry panelist anymore.  Claimants can get away with anything.  Panels are sometimes comprised of people who care more about how many sessions they can get paid for than the merits of the case.  Or who can’t stay awake to hear the evidence.  It has come to the point where some broker-dealers have simply removed the arbitration clause from their customer agreements[1] in an effort to induce customers to duke it out in court.  Moreover, given a relatively recent decision from the Second Circuit that reduces the number of people who actually constitute “customers” capable, under FINRA rules, of compelling a BD to arbitrate, there is an increase in cases going to court that, historically, could have been arbitrated.

All I can say is, be careful what you wish for. Yesterday, following a seven-week trial – yes, seven weeks – a California state court jury returned a verdict against MetLife for a total of $15 million in punitive damages.[2]  Notably, the plaintiff had only invested $279,769 in the product she was complaining about.  Which, by the way, was not sold by MetLife.  Or approved by MetLife.  Indeed, the plaintiff was never even a MetLife customer, which is why the case went to court and not arbitration.  Apparently, the jury didn’t much care about those facts.

So, here’s the thing: arbitration is hardly perfect, and many of the complaints I hear are totally valid.  But, before we all rush headlong into litigation, it is necessary to take a deep breath and consider these facts:

  • Yes, there is discovery available in litigation that is not available in arbitration. But…that is one reason that litigation is so expensive. I have no idea how many depositions were taken by the parties in the MetLife case, but there had to have been at least a dozen. Every one of them has to be prepared for and attended (perhaps involving travel), and transcripts have to be purchased and digested. The amount of legal fees incurred on this alone must have been staggering.
  • Yes, the case is run by a judge, who knows how to do it. But…judges make funny rulings as often as chairmen of arbitration panels. And judges are completely in control, whereas in arbitration, as long as the parties agree, they can usually compel the panel to do what the parties jointly want. For instance, the judge here, as I understand it, only held sessions Mondays – Thursdays, from 10 – noon, and then from 2 – 4, or thereabouts. No wonder it took seven weeks to try the case.
  • Yes, there is a jury of one’s peers, which suggests enhanced fairness. But, as this case amply demonstrates, juries can be swayed by emphathy as easily as arbitration panels.
  • Yes, there are pretrial dispositive motions available that are not available in arbitration. But, (1) that does not guarantee they will be granted, and (2) it can be very expensive to prepare and argue such a motion.
  • Yes, a jury verdict can be appealed as a matter of right, while there are only limited grounds, both statutory and non-statutory, on which to base an appeal of an adverse arbitration award. This one I must concede is a real plus for litigation. (In this case, it is my understanding that the verdict is going to be appealed.)

Arbitration was designed to be faster and cheaper than litigation. And, for the most part, it is.  So, in light of the nasty fact that juries are capable of doing things just as crazy as arbitrators, as MetLife just experienced, I would counsel against condemning the arbitral process as being too flawed to survive.  Sometimes, better the devil you know.  You know?

[1] This doesn’t mean that no customer disputes will ever be arbitrated.  Under Rule 12200 of FINRA’s Code of Arbitration Procedure, even in the absence of an arbitration agreement, a customer can still compel arbitration of disputes with a BD and/or the BD’s reps merely by asking for it.  And, as FINRA noted just last month in Reg Notice 16-25, any such arbitration must be before FINRA.

[2] In the interest of full disclosure, the jury also awarded a much, much smaller amount – less than 3% of MetLife’s number – of punitive damages against MetLife’s agent, on whose behalf I was retained as an expert witness.

Advertising Case Loss Reveals Limits To FINRA’s Jurisdiction Over Outside Business Activities

Posted in Advertising, Disciplinary Process, Enforcement, FINRA, Rule 2210, Sanctions

It is a simple fact that a broker-dealer has no obligation to supervise a disclosed outside business activity. How do I know?  FINRA has said so.  This, for instance, comes straight from Reg Notice 05-50:  “Rule 3030 does not require that the firm supervise or even approve an outside business activity, although a firm may choose to deny or limit the ability of associated persons to engage in the activity.  Rule 3030 simply requires that an associated person promptly notify the firm in writing that he is engaging in a business activity outside the scope of his relationship with the firm.”[1]

Despite the clarity of this concept, FINRA is, nevertheless, always very interested in the OBAs of registered reps, and, perhaps more importantly, how firms deal with OBAs. This tension between, on the one hand, FINRA’s lack of jurisdiction over OBAs and, on the other, its continuing interest in OBAs is felt particularly strongly in the context of the Communications with the Public rule, NASD Rule 2210.  And that’s because in the definition section of the rule, where FINRA describes the communications that the rule governs, those communications are not limited only to communications dealing with securities.  Indeed, any communication – whether “correspondence” under 2210(a)(2), “retail communication” under 2210(a)(5), or “institutional communication” under 2210(a)(3) – is subject to Rule 2210 whether it relates to a security or an OBA.

Recently, the NAC issued a decision in which it reversed a hearing panel’s determination that a BD was responsible for ads that were run by a few of its registered reps for non-securities products being sold as an OBA.  The NAC’s analysis highlights the important, and often ignored, fact that FINRA’s jurisdiction does, in fact, have finite limits.

In short, the registered reps disclosed to their BD – KCD Financial, Inc. – that they were operating a “CD locator service,” where they would help customers find CDs that paid the highest rates.  In addition, the registered reps would sometimes kick in some of their own money towards the CD purchase so the customers would realize a higher effective rate of return than the CD itself was actually paying.  They did this with the hope that the CD buyers would be pleased, and might, therefore, also be interested in buying a few securities, thus generating commissions.  KCD approved the OBA.

The reps then ran ads touting the CD locator service. Because this was an OBA, KCD neither reviewed nor approved those ads.

Later, FINRA came in and concluded that the ads for the CD locator service violated Rule 2210(d) because they were misleading, promising higher returns than the CDs actually yielded, and KCD was responsible because it knew the reps were running the ads.

The case went to hearing, and FINRA won. The hearing panel censured and fined KCD $40,000.[2]  KCD then appealed to the NAC.

As I said earlier, the NAC reversed the hearing panel and dismissed the charges and the sanctions. There is no question that KCD was aware of the ads, or that they contained exaggerated statements.  But, the NAC pointed out that “the content standards in NASD Rule 2210(d) apply to ‘member’ communications.  Although NASD Rule 2210 contains several definitions, it does not define or discuss whether communications made by a member firm’s registered persons regarding outside business activities are ‘member communications.’”  So, the NAC went about figuring out whether the CD locator service was truly an OBA – and thus not something KCD needed to supervise – or whether it was a firm activity.

Supporting the conclusion that it was an OBA, the NAC noted the following:

  • There was no evidence that KCD directed or encouraged the reps to offer the CD locator services;
  • There was no evidence that KCD was involved with providing the CD locator services;
  • KCD had dozens of registered reps, but only three who provided CD locator services; and
  • KCD did not oversee or supervise the CD locator services.

There were other facts, however, that suggested the CD locator services were, as the NAC put it, “within the scope of the representatives’ relationship with KCD”:

  • The CD ads were clearly designed to solicit securities purchases, which the reps were effecting through KCD;
  • Indeed, the reps made no money on the CD purchases, and only made money if they were able to convince the CD buyers also to invest in securities;
  • There were “significant similarities” between how the reps sold the CD locator service and how they sold securities, employing the same d/b/a names, addresses and phone numbers as they used for their securities business;
  • The reps discussed securities with the CD buyers who responded to the ads; and
  • All securities purchased were done through KCD.

On balance, the NAC concluded that the firm was not involved in the CD locator service, so the ads for it were not the firm’s concern, using this language: “To rely heavily on the securities sales that resulted would blur the line between outside business activities and member firm activities: securities sales can often result from activities that are widely understood to constitute outside business activities.”

This is pretty remarkable stuff. As I have noted, repeatedly, in my posts, FINRA is always looking for angles to push its jurisdictional limits further and further, daring firms to complain, for instance, that 8210 is not as broad as FINRA maintains.  Or bringing claims against unregistered individuals, insisting that, somehow, their conduct has rendered them to be associated persons.  For the NAC to remind FINRA that it cannot require a broker-dealer to supervise ads relating to OBAs, even when the BD knows about the ads and knows that those ads are misleading, is a real slap in the face.  And for it to have come from the NAC itself is even more surprising.

[1] NASD Rule 3030 was superceded by FINRA Rule 3270 effective as of 2010.  Like the old rule, however, the new rule still does not require that an OBA be approved.

[2] There was a second charge leveled against KCD, but it is not pertinent here.

Trouble With Your Clearing Firm? FINRA To The Rescue

Posted in Clearing firms, FINRA, Rule 4311

For the most part, my broker-dealer clients are introducing firms that clear through any number of generally recognized clearing firms. Increasingly, for whatever reason, I have been asked to get involved in disputes with clearing firms surrounding terms contained in the clearing agreement.  Unfortunately, this typically turns into a big problem, as these agreements are some of the most one-sided contracts you would ever hope to see.  And there’s the rub:  my clients need their clearing relationships, so they have little choice but to knuckle under and sign agreements that are weighted heavily in favor of the clearing firm.

What are some examples? How about the clearing deposit, for starters.  Introducing firms are required to place a substantial amount of money with their clearing firms just to be able to do any business.  But, the amount of these deposits is largely up to the clearing firm to decide.  While there may be some rudimentary give-and-take on the amount during negotiations, ultimately the clearing firm simply dictates how much it needs.  Even after the agreement is signed, the clearing firm has the right to ask for more…or else.  You may recall a few years ago, shortly after Apex Clearing was formed, it asked its correspondents to increase their deposits by significant amounts.  Indeed, as reported in the Wall Street Journal, TradeKing had to obtain an injunction against Apex to delay a demanded increase in its clearing deposit from $100,000 to $13 million, claiming it would put the firm out of business.[1]  I am not picking on Apex, or suggesting it is the only clearing firm to have done this; but this dispute was made into a public matter, so I can highlight it.

And try getting that deposit back. While clearing firms are contractually obligated to return the deposit at the conclusion of the clearing relationship, some still hold on to the deposits like grim death, as they say, even when the introducing firm has moved on. To justify this, the clearing firms will point to a couple of stray customer accounts that still linger (even if they don’t trade), meaning that, as they see it, the clearing relationship is not truly over.  Or, they may insist that there is some wildly fantastic potential claim brewing, giving them the right, in their own complete discretion, to hold the deposit until they unilaterally conclude the threat is gone.  If ever.  And, moreover, this discussion hasn’t even touched on the insane termination fees that clearing firms require if an introducing firm wants out of the relationship prior to the end of the term of the agreement.

The indemnification provisions baked into clearing agreements are hideously tilted in favor of the clearing firm, even though they purport to be reciprocal. The introducing firm basically has to indemnify the clearing firm for anything that happens, intentional or otherwise, while the clearing firm is only required to indemnify the introducing firm when the clearing firm acts intentionally, or sometimes only when it is actually found, by a court or a regulatory body, to have acted improperly.  More than once, I have had the down-the-rabbit-hole experience of making a demand against a clearing firm for a loss incurred by my client, a loss plainly attributable to the clearing firm’s error, only to have the clearing firm respond by demanding indemnification from my client for whatever amount the clearing firm may have to pay my client.  Logic doesn’t get much more circular than that.

This past week, an issue arose when one of my clients attempted to assign its clearing agreement to another broker-dealer that was going to acquire my client’s customer accounts. Like most, if not all, clearing agreements, this one recited that the clearing firm had to approve the assignment.  There’s nothing necessarily wrong with that.  In fact, here, the clearing firm consented to the assignment.  The problem arose, however, because the clearing firm deemed the assignment to be effective before the customer accounts actually transferred.  As a result of that interpretation, the clearing firm concluded that my client needed a new clearing agreement, to cover the time period until the customer accounts all transferred.  And it wanted a new clearing deposit.  And new monthly minimum payments.  And a new two-year term, with no early termination provision.

In response, we argued that the assignment was not effective, because FINRA had not approved it and, therefore, the existing clearing agreement still governed, but the clearing firm remained adamant. Indeed, the clearing firm was so adamant that it restricted my client’s customers to liquidating trades only for two complete trading days while we hashed this out.

I think the rules are pretty clear. FINRA Rule 4311(b)(1) requires that a clearing firm “submit to FINRA for prior approval any agreement for the carrying of accounts, whether on an omnibus or fully disclosed basis, before such agreement may become effective. The carrying firm also shall submit to FINRA for prior approval any material changes to an approved carrying agreement before such changes may become effective.”  It seemed clear to my client and me (and the assignee broker-dealer, as well) that an assignment of the clearing agreement was, indeed, a “material change,” especially considering that the Supplemental Material to Rule 4311 defines “material changes” to include “changes to: (a) the allocation of responsibilities required by this Rule; (b) termination clauses applicable to the introducing firm; (c) any terms or provisions affecting the liability of the parties; and (d) the parties to the agreement.”  How can an assignment from one broker-dealer to another not be reasonably viewed as a change to “the parties to the agreement?”

But, here’s where the story gets even goofier.  How did we end up fixing it?  By notifying FINRA.  In conversations to which I was not privy, FINRA – and, later, the SEC – apparently said something to the clearing firm that made it recant its position, and reinstate all trading privileges to my client’s customers.  I am not sure what was conveyed, but I presume that the clearing firm was advised that absent regulatory approval of the assignment, it was not effective, so my client remained the introducing firm under its clearing agreement.

I readily acknowledge that I routinely take shots at FINRA in this blog, and have been quick to point out those circumstances where its purported devotion to “investor protection” seems particularly illusory. But, here, I have nothing but praise for FINRA.  When advised of the facts, most importantly the fact that my client’s customers were being denied access to the markets except to effect liquidating trades, FINRA acted immediately and dramatically, and caused the clearing firm to rethink its formerly intractable position.  Nothing I was saying was going to change the clearing firm’s mind about the assignment.  But, when confronted by FINRA and the SEC, well, that was another story. That is investor protection, ladies and gentlemen, and I will be the first to admit it.

If only every story had this happy ending.

[1] Zecco Trading also got an injunction against Apex, for the same reason.  Both cases were subsequently settled, so it is likely that Apex backed down on its demands, at least somewhat.