Broker- Dealer Law Corner

Broker- Dealer Law Corner

SEC Gives Advisors A Break On Custody Rule

Posted in custody rule, SEC

A common complaint that I hear from broker-dealers and investment advisors is that it is nearly impossible anymore to obtain informal guidance from their regulators. Where it was once possible, even normal, to make a call and get casual advice how to comply with a particularly tricky rule, nowadays, regulators routinely decline to respond to such requests.  Moreover, even if you are lucky enough to find some examiner willing to go out on a limb and offer his or her opinion on something, the law is frighteningly clear that reliance on that advice provides absolutely zero protection from subsequent regulatory action.  In other words, one relies on informal guidance at one’s own peril.

Given this unfortunate fact, my advice to clients who are hell-bent on asking permission rather than forgiveness is to seek formal guidance. From FINRA, that would be an Interpretive Letter[1]; from the SEC, that would be a no-action letter.  The problem with this approach is obvious, however: you don’t always get the answer you were hoping for.  And, you are showing your hand to your regulator, thereby inviting their scrutiny anyway.

But, sometimes, it works the way you hope, and you get an answer, and it’s actually helpful. That happened recently when an investment advisor asked the SEC for a no-action letter regarding the custody rule, a deceptively simple rule that can get advisor into trouble, even when they think they’re doing the right thing.  When an advisor has actual custody of client funds or securities, several things have to happen.  The client assets have to be held securely, of course, it must be disclosed on Form ADV, and you have to subject the client assets to a surprise exam by a public accountant.  If you mess up any one of these elements, you’re in violation.  Intent is not required, so it’s basically a strict liability situation.

This gets further complicated by the fact that what constitutes custody is not always obvious. Specifically, in addition to actually holding funds or securities, an advisor is deemed to have custody if it “has any authority to obtain possession of [client funds or securities], in connection with advisory services [it] provide[s] to clients.”  Given that rule, the advisor in question here asked the SEC to agree that if the sole authority granted to the advisor was to instruct the third-party custodian of the client assets to transfer those assets in accordance with the client’s express direction, this would not constitute “custody” under the rule.

Interestingly, the SEC would not agree, and it concluded that this is, in fact, custody. But, at least in this instance, the SEC both tooketh and gaveth.  While it said this was custody, it also stated that if an advisor jumps through each of several specific hoops, it would not recommend that any enforcement action be taken, even absent a surprise audit.  The hoops are as follows:

  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a custodian to which the transfer should be directed.
  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3. The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

This may seem overly simplistic, but it is difficult to complain too loudly when a regulator supplies a detailed blueprint for compliance. The lesson is clear: as long as you’re willing to risk not getting the answer you want, seeking formal guidance can be the best way to steer clear of regulatory quicksand.

[1] To be clear, and remarkably enough, according to FINRA, it isn’t even safe to rely on an Interpretive Letter.  FINRA’s website states, “All interpretive positions are staff position, unless otherwise indicated. Staff-issued interpretive letters express staff views and opinions only and are not binding on FINRA and its Board; any representation to the contrary is expressly disclaimed.”  I mean, what’s the point if the supposedly “official” advice isn’t binding?

FINRA’s New Rules On Seniors: Let’s Protect Them From Their Own Bad Decisions?

Posted in FINRA, Rule 2165, Rule 4512, Senior Investors, Uncategorized

We have written before about senior investors, but I saw a couple of things in the last couple of weeks that suggests this subject needs to be revisited.

First, back in February, the SEC got around to passing FINRA’s proposed rules to protect senior investors, including both new Rule 2165 and amendments to existing Rule 4512.  The upshot is that broker-dealers will be required to make reasonable efforts to obtain from customers the name and contact information of a “Trusted Contact Person,” who, as the name suggests, may be contacted by the broker-dealer to discuss a customer’s account under circumstances that suggest there may be health issues, or if there are suspicions the customer has been the victim of financial exploitation.  In addition, if BD develops a reasonable belief that a senior investor may be the subject of financial exploitation, the BD may place a temporary hold on the disbursement of funds or securities from the senior’s account.  This becomes effective in February 2018.

I thought these were good ideas when they were initially proposed a few years ago, and I still do. Contrary to many commentators, I feel the existing suitability rule is sufficient to cover recommendations made to any customer, including a senior citizen.  Thus, I will not concede that there need to be special rules governing recommendations to seniors.  Seniors have all the protection they need already, given that to be suitable under existing Rule 2111, a recommendation necessarily must take into consideration things like the customer’s income, investment objective, risk tolerance, time horizon, liquidity needs, i.e., the very characteristics that supposedly make seniors special.  In other words, seniors aren’t special when it comes to suitability, as the analysis that must be employed is the exact same.

What I like about the new rules, however, is that while they nominally exist to protect customers, in fact, they are really designed to protect broker-dealers. Now, if a BD develops some suspicion that the lucidity of one of its aging customers is becoming questionable, it reaches out to family members at its own peril of violating a privacy policy, or worse.  Similarly, the idea that today a BD can safely ignore an order from a customer to liquidate a position and wire out the proceeds due to concerns about the customer’s mental health is dubious, at best, given the risk of triggering a complaint for not following a clear order.  The new rules address these situations, providing a safe harbor within which BDs can operate without fear of drawing regulatory attention.  (Even under the new rules, however, there is nothing to prevent a customer from lodging a complaint, or filing an arbitration, if a sell order is not timely executed, so the safety of this harbor extends only to regulator matters.)  I am all for the clear delineation of any safe harbor, no matter how shallow it may ultimately turn out to be.

The second thing I read was a study published by the AARP called “Investment Fraud Vulnerability Study.”  It was designed to try and determine “who and why investors fall prey” to investment scams, or, in other words, to “identify differences between known investment fraud victims and the general investor population.”  The results are pretty interesting.

First, investment scam victims “reported valuing wealth accumulation as a measure of success in life, being open to sales pitches, being willing to take risks, preferring unregulated investments and describing themselves as ideologically conservative.” So, here’s the first weird part:  these customers like risk, they like taking chances on what the Study called “emerging investment opportunities that no has heard about yet,” even knowing, based on ordinary risk/reward considerations, there’s a likelihood they will lose their money.  Indeed, 48% of investment scam victims agreed with the statement that “[t]he most profitable financial returns are often found in investments that are not regulated by the government,” versus only 30% of general investors.  The victims are not naïve grannies, they are dice-rolling, anti-Government Trump supporters, apparently, who are betting they know better.  It makes me wonder why, therefore, that regulators probably spend 75% of their time focusing on protecting these investors from these investments that are somewhat removed from the mainstream.

Second, the victims were targeted by phone calls and emails with investment pitches to a much greater degree than the general investing public. That’s no coincidence, it seems, as the victims also reported that they were three times more likely – four times when it comes to phone calls – to respond positively to such pitches.  If only legitimate BDs had access to such effective lead sheets as the fraudsters apparently have, selling stocks would be a breeze!

Finally, victims skewed toward being male, married and over 70, with a substantial percentage being veterans. Not sure what to make of this, but perhaps it falls somewhere in the same psychological category as men being willing to drive 20 miles in the wrong direction rather than admitting we are lost, or to stop for directions.  It’s also why not every victim complains – sometimes, they just know they messed up, and are willing to accept the consequences.  Of course, that is until some sweet-talking claimants’ counsel convinces them it wasn’t their fault at all!




DOL Seeks To Clarify Fiduciary Rule Timing With Temporary Enforcement Policy

Posted in Fiduciary duty, Fiduciary Rule, Fiduciary Standard

On Friday evening, March 10, 2017, the Department of Labor (DOL) issued a field assistance bulletin establishing a new temporary enforcement policy for the DOL Fiduciary Rule set to become effective on April 10, 2017. (See here) The temporary policy was designed to deal with industry uncertainty created by a new rule proposed for comment by the DOL on March 2, 2017 in response to a Presidential Memorandum to the Secretary of Labor, dated February 3, 2017 (discussed on Ulmer’s BD Law Corner blog, here). That memorandum directed the DOL to examine whether the Fiduciary Rule might adversely affect “the ability of Americans to gain access to retirement information and financial advice” among other things. The President’s directive can only be accomplished by issuing a new rule because the Fiduciary Rule has already become final.

The DOL’s newly proposed rule is subject to a 60-day comment period under applicable law, making it iffy whether the DOL will be able to digest comments and issue a final rule potentially delaying the effective date of the Fiduciary Rule before its current effective date of April 10. Needless to say, this uncertainty created market disruption, with some financial services firms proposing to communicate to investor and IRA clients that they would only become a “fiduciary” when and if the Fiduciary Rule became applicable. Based on industry comments, the DOL “determined that temporary enforcement relief is appropriate to protect against investor confusion and related marketplace disruptions” while this all plays out. To that end, the temporary enforcement policy also gives firms additional time to implement policies required by the Fiduciary Rule after the DOL finalizes the new rule.

Critically, Friday’s bulletin emphasizes that any implementation of the Fiduciary Rule by the DOL “will be marked by an emphasis on assisting (rather than citing violations and imposing penalties on)” institutions and persons who are “acting in good faith” to implement the Fiduciary Rule. For the sake of the affected financial services firms and individuals, we certainly hope this is true, although past regulator performance might suggest a different outcome.


SEC ALJs, Part 3: Separation Of Power/Removal Defense Rides On Coattails Of Reinvigorated Appointments Clause Defense

Posted in Administrative Proceedings, Defenses, Disciplinary Process, SEC

In my second post on constitutionally-based affirmative defenses to SEC administrative proceedings, I discussed the shift of momentum in favor of the defense that the process of hiring SEC ALJs violates the Appointments Clause of the U.S. Constitution. This post examines the defense that the process of removing SEC ALJs violates the separation of power doctrine in the Constitution.

The U.S. Constitution, art. II, § 1, cl. 1, provides that “[t]he executive Power shall be vested in a President of the United States of America.” Article II, § 3, states the President “shall take Care that the Laws be faithfully executed ….”  The Constitution requires that a President elected by the People oversee the execution of the laws of the United States.  The Constitution nowhere addresses the power to remove, but it is derived from the power of appointment.  The President’s power to remove Heads of Departments such as the SEC Commissioners ensures that laws are executed in accordance with the President’s policies.  Even though Heads of Departments cannot be removed except for cause, this limitation was held constitutional because the President directly decides if cause exists for removal. Humphrey’s Executor v. United States, 295 U.S. 602 (1935).

Unlike SEC Commissioners appointed by and accountable to the President, SEC ALJs are hired by the Chief SEC ALJ and the Office of Administrative Law Judges (“OALJ”) from a register maintained by the Office of Personnel Management (“OPM”). SEC ALJs receive a career appointment without an initial period of probation and their salaries are set by statute.  They cannot be removed at-will by the President or even by the SEC.  They can only be removed “for cause” after a hearing before the Merit Systems Protection Board (“MSPB”).

The separation/removal defense asserts that the ALJs’ multiple-layer protections against removal violates the separation of power doctrine by placing impermissible limitations on the President’s power to see that the securities laws are faithfully executed. These protections are an aggrandizement of the Legislature, which authorized the delegation of adjudicating violations of the securities laws to the SEC ALJs, at the expense of the President’s Executive power.  Multiple layers of tenure insulate ALJs from direct Presidential control.  An ALJ cannot be removed by the SEC except for cause and the President cannot remove a Commissioner except for inefficiency, neglect of duty, or malfeasance in office.  The Commissioners are accountable, therefore, only for their decision to determine whether good cause to remove the ALJ exists.  The President can no longer hold the Commission fully accountable.

In Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), the Supreme Court held that the creation by the Sarbanes-Oxley Act of 2002 (“SOX”) of a Board within the SEC to oversee accounting firms contravened the separation of power doctrine by conferring executive power on Board members without subjecting them to Presidential control.  Board members could be removed only for good cause by the Commission and the Commissioners could be removed by the President only for good cause.  Chief Judge Roberts wrote, this “second level of tenure protection changes the President’s review.  …  The President … cannot hold the Commission fully accountable for the Board’s conduct, to the same extent that he may hold the Commission accountable for everything else that it does.  …  That arrangement is contrary to Article II’s vesting of the executive power in the President.” Id. at 496.

Respondents in SEC administrative proceedings recognized Free Enterprise’s potential application to the multiple-layers of an SEC ALJ’s tenure and asserted the separation/removal defense in answers to administrative complaints.  The ALJs ruled they do not have authority to decide the issue.  The SEC ruled the defense lacks merit. In re Timbervest, 2015 WL 5472520 (SEC Sept. 17, 2015).  But, history shows that ALJs may be used willingly or unwillingly by the agency to which they are assigned to further a particular political agenda or policy of enforcement—exactly the responsibility the Constitution assigns to the President.  For instance, “a former SEC ALJ stated that she was pressured to rule in favor of the SEC and that Chief Judge Murray questioned her loyalty to the SEC because the former ALJ found in favor of defendants too often.  The former ALJ also alleged that the SEC instructed her to work under the presumption that defendants were guilty until proven innocent.” Timbervest v. SEC, 2015 WL 7587428, at *4 (Aug. 4, 2015).  This is not an isolated occurrence.  A similar brouhaha was widely reported in connection with CFTC ALJs when shortly before he retired one ALJ publicly accused another ALJ of having promised that he would never find in favor of customers.  “Notice and Order” (Sept. 17, 2010)  The Wall Street Journal then published an article accusing the retiring ALJ of mental unfitness and heavy drinking.  Lynch, “Case Sheds Light on Judge” WSJ (Oct. 21, 2010)

Rejection of the separation/removal defense by the SEC was countered by the defense bar filing collateral suits in federal court to enjoin SEC administrative proceedings, alleging that the multi-level protection of ALJs violated the doctrine of separation of power. Most collateral cases were dismissed for lack of jurisdiction without reaching the merits of this defense.  Those courts that held there was jurisdiction ruled favorably on the Appointments Clause defense—not the separation/removal defense.  The petition for certiorari pending in Tilton v. SEC, 824 F.3d 276, 298 (2d Cir. 2016), pet. for cert. filed 2017 WL 281861 (Jan. 18, 2017), raises only the jurisdictional issue and the Appointment Clause defense.  Similarly, none of the cases pending before the D.C. and Tenth Circuits presents the removal/separation of powers defense.  Accordingly, it is fair to say that there is no binding decision anywhere in favor of or against the merits of the separation/removal defense and no court is expected to rule on the issue soon.

Despite the futility of receiving a real hearing on the separation/removal defense at the SEC, respondents should continue asserting the defense in administrative hearings to set up a direct challenge of an SEC final order to the Court of Appeals on this issue. Respondents should be emboldened by the upswing of support for the Appointments Clause defense because the first hurdle to overcome on the separation/removal defense is to establish that SEC ALJs are “inferior officers.”  But, respondents must then argue that Free Enterprise’s separation of power holding applies to SEC ALJs.  Arguably, Free Enterprise is distinguishable in at least two significant respects: First, the accounting oversight Board had more authority than do ALJs.  Not only were the Board’s decisions not reviewable by the SEC, but the Board could initiate investigations unlike ALJs.  Second, ALJs have been around at many federal agencies since the 1940s when the Administrative Procedures Act became law; whereas, the Board was a recent creation of SOX in 2002 whose constitutionality had never been tested.  Even Judge May, who took the lead in finding that the Appointments Clause defense was likely to succeed on the merits, Hill v. SEC, 114 F. Supp. 3d 1297 (N.D. Ga. 2015), expressed doubts whether the separation/removal defense would be successful. In re Timbervest, 2015 WL 7597428, at *11 n.10 (N.D. Ga. Aug. 4, 2015).  These differences do not really negate the serious constitutional infirmity presented by multiple layers of tenure that troubled the Supreme Court in Free Enterprise, however.  They relate more to whether SEC ALJs are “inferior officers” than to whether the ALJs are directly controlled by the President or vulnerable to improper agency interference.  Accordingly, respondents should not lose heart.  The success of the separation/removal success is still very much an open issue.

In my fourth post, I will examine the defenses of whether the SEC’s “unguided discretion” under Dodd-Frank to file a case before an ALJ rather than in federal district court violates the Fifth Amendment equal protection and due process, and/or the Seventh Amendment right to a jury trial.


FINRA OTRs: Preparation Is The Key

Posted in Disciplinary Process, Enforcement, Examination, FINRA, OTR

Last week, I published a post about the benefits of “lawyering up” when dealing with FINRA, particularly to handle the defense of an OTR.  Here, my partner Michael Gross, who, like me, is a former FINRA Enforcement attorney, offers his advice about how properly to prepare for an OTR.  While this post is helpful, it clearly underscores that the only way to prepare adequately is to engage competent counsel.  And, speaking of that, a friend sent me a comment regarding my post from last week that bears a brief discussion here:  It is not simply a matter of getting a lawyer.  In addition, it is important, especially as a registered rep who is provided counsel by his or her broker-dealer, to appreciate exactly who the lawyer is representing.  An in-house attorney for the BD, if the firm is big enough to have an in-house Legal Department, generally considers the BD to be the client, not necessarily the registered rep.  And sometimes, this distinction matters.  For instance, if a customer arbitration settles for more than $15K, that disclosure will appear on a rep’s Form U-4 forever; thus, many reps only want to settle if a deal can be pulled off for less than $15K.  But, if both the BD and the rep are named as respondents, the firm may want to settle — even if it means the firm paying the entirety of the settlement amount, even if that amount is in excess of $15K — notwithstanding the fact that the rep is dead set against that settlement (because the size of the settlement would result in a mark on Form U-4).  If, in that situation, the rep’s counsel is the BD’s counsel, as well, the rep may need to consider getting separate counsel.  Some BDs will pay for such, to avoid putting their attorney in a conflict situation, but, even if the firm isn’t so generous, the rep needs to carefully consider whether it pays to get truly independent counsel.  – Alan


A Classic Example

During a rep’s OTR, he truthfully testifies that he does not recall being aware of certain facts. (It is not uncommon for FINRA to investigate events years after they have transpired, or not to notify a rep of the subjects to be covered during the OTR.) FINRA becomes particularly perturbed by the testimony because it expected the rep to have been aware of those facts. FINRA then aggressively pursues a disciplinary action. Only after the complaint has been filed does the rep come to appreciate the magnitude of his situation. He finally conducts a thorough search for relevant records, and finds documents that show he must have known about those important facts.  Situations like this (or worse) can potentially be avoided through thorough OTR preparation.

The Presumptive Purposes of an OTR

FINRA, like attorneys who take depositions, presumably takes OTRs for a few basic reasons: to find out what it does not know, to confirm what it does know, to test its factual and legal theories, and to lock the witness’s story down.[1] As FINRA tells its deponents at the outset of an OTR, it wants to obtain information to determine what, if any, violations may have occurred.

It is important to know that FINRA likely will take your OTR testimony to be something from which you cannot easily walk away. If emboldened enough by events surrounding your inaccurate testimony, such as an email that directly contradicts your testimony, FINRA may seek to bar you for not providing truthful testimony.  If you are the target of an inquiry, you would be well advised to prepare for your OTR. Even if you are not the target of an inquiry, you likewise would be well advised to prepare for your OTR so you do not say something to make you the target of that inquiry or another one (yes, this happens).

How to Prepare for an OTR

Preparation begins with understanding the “who,” “what,” “where,” “when,” “why,” and “how” of the topics to be covered during your OTR. Simply put, you need to try to figure out what questions FINRA will ask you — FINRA certainly won’t tell you in advance — and how you will answer them (within, of course, the bounds of honesty and candor). There is no shortcut to doing this. You may need to review emails, notes, calendar entries, account documents, account activity, etc. to best answer questions. You may even want to speak with others about their recollection of events, although this can be dicey at times.

You also should have a solid understanding of the FINRA rules and securities laws at issue so that you have the same appreciation for your answers that FINRA will have. This entails reviewing the relevant rules, laws, Regulatory Notices, etc. It is quite common for FINRA to ask a deponent about his understanding of what the rules and laws require. If you do not appreciate what the rules and laws require of you, FINRA likely will not appreciate your answer.

Preparation also includes understanding the written and unwritten rules of OTRs. It is nerve-racking enough to testify with a room full of people staring at you (and FINRA typically rolls at least three deep at OTRs) and a court reporter taking down your every word; it is even more nerve-racking to do that when you do not understand the rules of engagement. You should know: what to expect; what will be expected of you; which questions are fair; which questions are unfair; how to deal with unfair questions; what, if any, objections you can make; how much or how little detail to provide in response to a question; and how to create a record that will best benefit you.

It certainly may feel good, at least momentarily, to politely or otherwise tell the FINRA staffers who are half your age that they do not know what they are doing, that you have significantly more industry experience and knowledge, or that FINRA would not have missed the Madoff and Stanford scandals if it did not waste time on matters like yours. It, however, is best to bite your tongue, kiss the ring, and remember that you are trying to convince those FINRA staffers that you are an upstanding member of the industry, not incite them to burn midnight oil to prove otherwise.

Lastly, preparation includes knowing when not to sit for an OTR. As the famous Kenny Rogers song goes: “You’ve got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.” The worst thing that FINRA can do to you may not be to bar you from the securities industry; it may be to share your sworn OTR testimony with government agencies that can do a lot more than that to you. Some OTRs have been terminated when counsel realized that FINRA was the least of the client’s problems. Other OTRs have never been taken because counsel decided it was more prudent for her client to accept a bar and show the judge meting out criminal sanctions that her client has accepted responsibility for the misconduct by, in effect, surrendering his securities licenses. Other times, it may be in your best interest to try to settle a matter without subjecting yourself to the seemingly boundless scope of questions that can be asked during an OTR. You, of course, cannot make this determination if you are not properly prepared for your OTR.


[1] As noted above, unlike civil litigation where a complaint has been filed, and everyone is generally aware of the events at issue, FINRA will take an OTR without providing a full or complete picture of the topics to be covered. This, however, is the subject for another post.

Puerto Rico Customer Arbitrations: The Untold Story About Why So Many Settle

Posted in Arbitration, FINRA, Puerto Rico, Settlements

Here is a piece from Chris Seps, who has a bit of a reputation around here for being angry.  Judge for yourself.  But, for what it’s worth, I do want to say that I have had the pleasure of being involved in several cases in which the subject of this post, Dr. Craig McCann, appeared on behalf of the opposite party.  While I generally disagree with his opinions, Dr. McCann is a gentleman, and has been nothing but courteous and respectful to me.  I guess he’s just misguided.  – Alan


Craig McCann, who testifies regularly (but not exclusively) for claimants in FINRA customer arbitrations, must not be as busy as he would like. A few days ago, he published a report from the “Securities Litigation & Consulting Group” – i.e., Dr. McCann’s own company – regarding the number of Puerto Rico securities arbitrations filed and settled since the Puerto Rico bond market collapse in 2013.  His report includes some interesting statistics, but then goes off the rails with a self-serving conclusion: that more Puerto Rico arbitrations should go to hearing rather than settle.

But before we get into the erroneous assumptions baked into his conclusion, let’s look at the stats he provided. First, Dr. McCann reports that at least 1,874 Puerto Rico securities arbitrations have been filed with FINRA since the bond crash of 2013.  That’s not really big news.  Every time a particular market sector crashes, whether it is PR bonds or the ARS market or whatever, hundreds of claimants’ attorneys chum the waters with advertising and convince investors that somebody should be made to pay for their losses. That’s the American way.

In Puerto Rico, it was no different. In fact, it was even easier for claimants’ attorneys this time around because you could literally stand in San Juan and throw a rock in any direction and hit someone who was invested in Puerto Rico bonds and closed end mutual funds.  Why?  Taxes.  Puerto Rico’s unique set of tax laws allow residents of the island to invest in Puerto Rico securities with little or no income tax burden.  The result is that the yields on such bonds – which were all investment grade or close to it – were much higher for residents than taxable bonds.

Moreover, unlike Americans, for whom the 2017 federal estate tax exemption is now up to $5.49 million/person, relatively speaking, Puerto Rico’s exemption is a mere fraction of that. But, estate taxes are not payable on any Puerto Rico securities in the estate.  As a result, most investors, especially very wealthy investors looking to avoid a big estate tax hit, focus heavily on Puerto Rico securities, even while disregarding the risks of failing to diversify.

The McCann report then states that of those 1,874 cases filed, 742 have settled while only 30 have been tried at a final hearing (1,083 are still pending). In other words, the report says 96% of the Puerto Rico arbitrations that have been resolved have been settled rather than tried.  The report notes that this is a much higher percentage than the nationwide arbitration figures, where only 73% of cases settle.  The other half of the story is that in those 30 Puerto Rico arbitrations that went to hearing, customers were victorious a surprisingly high amount of the time – 83% of the time (in 25 cases) – whereas nationally, customers are only victorious 40% of the time.  The report concludes: “The much lower proportion of Puerto Rico cases which go to a hearing than the mainland cases and the fact that customers are winning in Puerto Rico at twice the national average strongly suggests too many cases are settling in Puerto Rico rather than going to a hearing.”

Besides being self-serving – if he convinces more customers to go to hearing rather than settling, then Dr. McCann gets to bill more fees for his expert services – these statistics and conclusion are rather misleading.

What the report fails to say is the reason why so many Puerto Rico arbitrations settle: they usually are of dubious merit and often include bloated damages claims. Claimants’ counsel often tout their high track record of success at trial, and for good reason – they only take cases all the way to trial (rather than settle them) if they are strong.  But, the strength of a case has nothing to do with whether it gets filed in the first place.  Claimants’ attorneys file cases all the time without much thought to the merits as long as they can tell a good story in the Statement of Claim.  And that part is easy in FINRA arbitrations, since the filing fees are only a few hundred dollars and there is no codified obligation only to file a case in good faith (as there is in court, i.e., Rule 11).

The result is that Statements of Claim spin the “facts” as aggressively as possible, and often include irrelevant but horrible stories, sometimes about other broker-dealers who aren’t even named as respondents. Months after the claim is filed, when claimants’ counsel get around to a serious evaluation of the facts, one of two things happens.  First, they might discover their case has great facts, that they have a high likelihood of success at hearing, and there is a big loss involved.  If the potential payoff is great, they may put in the time and effort to take it to a hearing.  It is little surprise, then, that the Puerto Rico cases that actually go to hearing achieve such success because they are the cases with the best facts for claimants and largest losses.

On the other hand, and this is the scenario that plays out more often than not with these Puerto Rico cases, claimant’s counsel realizes how bad the facts are for his client, decides that there is little chance of success at a hearing, and so settles cheaply. In other words, once claimant’s counsel realizes that his client received a 50-page presentation from the broker analyzing his portfolio and recommending diversification (which claimant rejected), and that the client signed documents stating that all he wanted was tax free income and nothing else, claimant’s counsel is usually smart enough to realize they won’t fare well at a hearing.  So, they settle.

How do we know this is true? Look at the damages numbers in the report.  Dr. McCann reports that the 742 cases settled for $162,484,574 in total, or $218,981 per case.  The 25 customers who received a favorable award at a hearing won $64,206,348 in total, or $2,568,253 per case.  Dr. McCann simply compares these two numbers and concludes that more cases should be tried because successful claimants receive so much more, on average, than claimants who settle.

The simple fact is, whether you are looking at Puerto Rico specifically, or across the board in all jurisdictions, from the claimant’s perspective, the cases that don’t go to hearing are the ones that, based on their merits, shouldn’t go to hearing (or, in some cases, even be filed in the first place). And when the case has no merit, claimants’ counsel settles it.  The side effect is that Dr. McCann doesn’t get to show up at more hearings.  And that isn’t necessarily good for Dr. McCann.

It Can Pay To “Lawyer Up” When Dealing With FINRA

Posted in Defenses, Disciplinary Process, Enforcement, Examination, FINRA, OTR, Registered Representative, Sanctions

I realize that the title of this blog post may sound self-serving, so I apologize for that up front, as it is not my intent.  Still, there is a lesson here to be learned.

I got a phone call yesterday from a reporter asking me to comment on a disciplinary action that FINRA had just announced.  According to the reporter, FINRA permanently barred Thomas James Stewart, a former registered rep, for using his firm’s parking garage validation stamp without authorization 50 times over the course of a four-month period, saving him a whopping $731 in parking fees he would otherwise have had to pay.  The question posed to me was, what was my reaction to someone getting barred for stealing, essentially, $731 from his firm, and whether I thought that was too harsh of a sanction, given the underlying misconduct.

Well, clever lawyer that I am, before answering, I asked some questions of my own. Most importantly, I learned that this was a settled case – Mr. Stewart signed an AWC – not a litigated case.  I also learned that Mr. Stewart was apparently not represented by counsel.  (AWCs are signed by the respondent and the respondent’s attorney, and this AWC had no signature block for an attorney, which suggests that Mr. Stewart was unrepresented here.)  As a result, I told the reporter that the case could not be viewed as evidence of some new “zero-tolerance” policy by FINRA, since the sanctions were the result of a negotiation, not an adjudication.

After I hung up, however, I began to think about the case, and it struck me that the real issue was not the magnitude of the sanction compared to the severity of the misconduct; rather, it was the fact that FINRA was likely only able to secure this seemingly harsh result as a consequence of the fact that Mr. Stewart was not represented by counsel. I seriously question whether any competent, experienced broker-dealer defense lawyer would have ever agreed to take a bar for such a modest amount of pilferage.  But, FINRA doesn’t care about that.  Of course FINRA will acknowledge a respondent’s right to an attorney, but, when no attorney appears, you can bet that FINRA will not hesitate in the slightest to take full advantage of that.

This attitude manifests itself in other areas. For instance, when FINRA sends out an 8210 “request” to take someone’s sworn testimony – an OTR – the boilerplate includes the recital that it is ok to bring your attorney.  But, not every witness feels the need to bring counsel, or can afford to even if they want to do so.  When that happens, FINRA’s glee is palpable.  It means that no one is going to pose those pesky objections to the oftentimes poorly phrased questions, no one is going to keep the interviewers from delving into subject matters that may have no reasonable relationship to the exam, and no one is going to ensure that privileged communications are not disclosed, among other things.  I am not kidding when I say I have seen transcripts of OTRs where FINRA has run roughshod over witnesses not accompanied by counsel.  Having an attorney present won’t necessarily change the outcome of an exam, but, having an attorney does keep FINRA honest.  As I am fond of saying, you can’t “win” an OTR, but you sure as heck can lose one, and having counsel present helps prevent that.

FINRA also takes advantage of counsel’s absence when it interviews customers. Now, remember, FINRA has no power to compel a customer to answer any questions, and must rely on customers agreeing voluntarily to participate in an interview.  But, as I believe I’ve lamented before, FINRA doesn’t do a particularly good job of letting customers know that they are free to ignore requests for an interview.  More to the point of this post, however, FINRA certainly says or does nothing to let a customer witness know that not only can they blow off the interviewer, but, if they deign to cooperate, they may elect to bring their counsel into the conversation.  What this means is that in probably 99% of customer interviews, including interviews that culminate in the preparation of a Declaration or an Affidavit from the customer that FINRA will utilize in connection with the prosecution of an Enforcement action, no lawyer for the customer is involved.  The result is that FINRA can basically bake into these documents whatever language it wants, language that, had it been reviewed by counsel, may very well have been phrased rather differently.

Look, I don’t know why Mr. Stewart agreed to take a bar for improperly using $731 worth of parking garage validations.  According to the AWC, he is already out of the securities industry.  Maybe he was simply happy being out,[1] and had no intent of ever returning.  If that was the case, then it was easy enough for him to take the bar; it got FINRA off his back and cost him nothing in terms of a monetary sanction.  But, it is also possible that he just didn’t know that a bar for this offense was out of line.  We will never know his true motivation, but his case serves as a lesson for every registered rep (and some customers, as well): when FINRA comes calling and “requests” something from you, you would be well served to consider enlisting the assistance of a lawyer immediately.  Like they (almost) used to say on TV, you can pay me now, or pay FINRA later.

[1] Isn’t it funny how we use that phrase, “out of the industry” like it’s being “out of jail?”  Clearly, there are lots of registered reps and broker-dealers still subject to FINRA’s jurisdiction who would argue that it’s a very apt comparison.  I have known former registered reps who literally count down the days until they finally reach two years from the date of their resignation, just waiting to celebrate the moment when FINRA can no longer assert jurisdiction over them.

Article II Appointments Clause Defense To SEC Administrative Actions Gains Momentum In The Courts

Posted in Administrative Proceedings, appeal, Dodd Frank, SEC

Here is Part II of Ken Berg’s analysis of constitutional defenses that have been raised in response to the SEC’s increased use of administrative proceedings.  In the interest of full disclosure, note that the Malouf case referenced towards the end is one that Heidi VonderHeide and I are handling.  In addition, it also worth mentioning that in another appeal of an adverse SEC decision that Heidi and I presently have before the DC Circuit, the Division of Enforcement advised us on Friday that the Commission plans to file a motion requesting that the Court hold briefing in abeyance pending resolution of the Lucia case, and asking whether we would agree to it.  Clearly, the SEC is hardly presuming a positive outcome from the rehearing of the Lucia case, scheduled for May.   – Alan

In last week’s installment, I discussed how the expansion of the SEC’s authority to obtain civil monetary penalties in Dodd-Frank emboldened the SEC to vastly increase the number of cases filed with SEC Administrative Law Judges instead of federal district court. In response, the defense bar asserted constitutional defenses to the administrative proceedings and filed collateral attacks in federal district court.  Though the Courts of Appeals have shut the door on collateral attacks for now, and the SEC has rejected all constitutionally-based affirmative defenses, respondents must continue to assert them in the administrative proceedings in order to preserve the issues for consideration on appeal of the SEC’s final order.  In this post, I will examine the objection that the manner of hiring the SEC ALJs violates the Appointments Clause of Article II of the US Constitution and update the current state of the law as to this defense.

Though the SEC has repeatedly rejected this defense on the merits, and a panel of the D.C. Circuit affirmed the SEC, support for this defense is gaining momentum.  A split panel of the Tenth Circuit held that the SEC ALJs are unconstitutionally appointed and the D.C. Circuit has granted a request for an en banc re-hearing.

The US Constitution, art. II, § 2, cl. 2, states: The President “shall nominate, and by and with the Advice and Consent of the Senate, shall appoint … Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”  The SEC concedes that when the Chairman acts together with the other four Commissioners, he or she is an Article II “Head of Department.”  Heads of Departments can and do appoint “inferior officers” to interpret policy and implement laws of the United States.  The issue is whether SEC ALJs function as “inferior officers” or just “employees” of the SEC?

To become an ALJ, an attorney must complete a four-hour written examination and submit to an oral exam before a panel made up of a member of the American Bar Association, a current federal ALJ, and a person from the federal Office of Personnel Management (“OPM”). OPM maintains a registry of qualified ALJ candidates.  At the SEC, there is a Chief ALJ and four other SEC ALJs.  The Chief ALJ heads the SEC’s Office of Administrative Law Judges (“OALJ”).  The OALJ selects a candidate on the OPM registry with input from the Chief SEC ALJ, the Department of Human Resources, and the OPM.  Section 78d-1(a) of the Exchange Act of 1934 gives the SEC authority to delegate to an ALJ or an employee any of its functions including “hearing, determining, ordering, certifying, reporting, or otherwise acting as to any work ….”

SEC ALJs are not appointed by the Chairman; they are hired by the OALJ from OPM. The SEC has ruled repeatedly that SEC ALJs are “employees” who do not have to be appointed.  As to other agencies, the Supreme Court has distinguished “employees” from “inferior officers” by whether the individual exercises “significant authority pursuant to the laws of the United States.” Buckley v. Valeo, 424 U.S. 1 (1976).  The Supreme Court has found Federal Election Commissioners and Special Trial Judges for the IRS are “inferior officers” who need to be appointed by a Head of Department.

In August 2016, the SEC’s position was affirmed by a three-judge panel of the D.C. Circuit in Raymond J. Lucia Companies, Inc., 832 F.3d 277 (D.C. Cir. 2016).  The judges reasoned that SEC ALJs are “employees” because the SEC has the right to review their decisions and no ALJ decision becomes final without the SEC issuing a finality order even if not appealed.  Unlike the IRS’ review of Special Trial Judges’ decisions, the SEC’s review is de novo.

But, in late December 2016, in a 2-1 decision, a panel of the Tenth Circuit expressly disagreed with the decision in Lucia.  In Bandimere v. SEC, 844 F.3d 1168 (10th Cir. 2016), the majority held that SEC ALJs are “inferior officers,” reasoning the SEC ALJ’s lack of final decision-making authority was relevant but not determinative.  Since the SEC ALJs “exercise a great deal of discretion and perform important functions,” the majority concluded they are “inferior officers.” Just because the SEC supervises the ALJs through review of their decisions does not mean they are “employees.”  The majority also noted that there is no statutory language or legislative history expressly making ALJs “employees” for purposes of the Appointments Clause.  The SEC has been given to March 13, 2017, to petition for an en banc re-hearing before the entire Tenth Circuit.  Such petitions are granted only when there is an issue of “exceptional importance.”

The Appointments Clause issue was been presented to the US Supreme Court in a petition for a writ of certiorari filed on January 18, 2017, in Tilton v. SEC, 824 F.3d 276 (2d Cir. 2016), cert. filed, 2017 WL 281861.

In another case pending before the Tenth Circuit, the court provisionally granted petitioner’s motion to file a supplemental brief on whether Bandimere requires that an SEC final order be set aside even though the Appointments Clause defense had not been asserted before the ALJ or SEC. Malouf v. SEC, Docket No. 16-9546 (10th Cir.).  Briefing is scheduled to be completed by March 20, 2017.

In the Lucia case, on February 16, 2017, the D.C. Circuit vacated the panel’s decision affirming the SEC and granted a petition for re-hearing en banc. Oral argument is set for May 24, 2017.

The momentum is clearly with the defense bar on the merits of the Appointments Clause issue, the first constitutionally-based affirmative defense to make it out of the SEC administrative morass.  This provides incentive to keep asserting the other constitutionally-based defenses in administrative proceedings.  In my next post, I will discuss constitutional objections to SEC ALJs arising from the civil service protections that insulate them from direct removal by the President and update the current state of the law as to this defense.

No Surprise Here: Courts Take Constitutional Complaints About SEC Administrative Prosecutions More Seriously Than The SEC

Posted in Administrative Proceedings, Defenses, SEC

This is the first in a series of posts by my partner, Ken Berg, discussing the constitutional defenses to SEC administrative enforcement actions, which we are called upon regularly to defend. Each subsequent post will discuss one of the constitutional issues and report the current state of the law as to that defense.  Ken’s next post will examine the Article II Appointments Clause issue and update the current state of the law as to this defense. – Alan

As has been well reported, both in this blog and elsewhere, after Dodd-Frank expanded the SEC’s authority by giving it discretion to obtain civil monetary penalties against non-registrants in administrative proceedings, the SEC embraced its new powers by vastly increasing the number of cases filed before ALJs. For FY2015, 80% of all cases were filed before ALJs compared to less than 50% for FY2005.  (J. Eaglesham, “SEC Wins with In-House Judges,” WSJ, 5/6/15.)  For FY2015, 419/502 settled cases were filed before ALJs compared to only 216/434 for FY 2007.  (U. Velihonja, “SEC Settlements in the Shadows” 126 Yale L.J. Forum 124, 9/7/16.)  Filing before an ALJ statistically disadvantages respondents.  From October 2010 to March 2015, the SEC prevailed in over 90% of administrative cases (WSJ 5/6/15), while winning only 69% of the time in federal court.  (J. Eaglesham, “SEC Trims Use of In-House Judges,” WSJ, 10/11/15)

The defense bar reacted to this change in two ways:  First, various affirmative defenses based on constitutional rights were asserted in the administrative proceedings.  Second, collateral actions were filed in federal district court to enjoin the administrative proceedings.  The constitutional objections raised include: i) the manner in which SEC ALJs are appointed and removed violates the non-delegation doctrine in Article I and the Appointments Clause in Article II; ii) the SEC’s “unguided discretion” to prosecute before an ALJ or a district judge violates the Fifth Amendment rights to equal protection and procedural due process; and iii) the absence of a jury violates the Seventh Amendment.

Not surprisingly, at the SEC, these constitution-based affirmative defenses have not gotten any traction.  The ALJs decided they lacked authority to rule on them.  To no one’s surprise, the SEC on review has never held that any of these constitutional defenses has merit.  One might think it is futile, therefore, to continue asserting these constitutional defenses in an answer to an administrative complaint.  But, hold on ….

In contrast, the defense bar achieved some impressive initial successes in federal district courts. In Gupta v. SEC, 796 F. Supp. 503 (S.D.N.Y. 2015), District Judge Rakoff denied the SEC’s motion to dismiss a collateral attack complaint.  The facts of Gupta are somewhat unique, however, because the SEC filed an administrative action only against Gupta after having filed nearly identical complaints for insider trading against 28 other alleged violators in federal court.  Gupta argued that by treating him differently, the SEC violated his Fifth Amendment right to equal protection.

In Hill v. SEC, 114 F. Supp. 3d 1297 (N.D. Ga. 2015), rev’d 825 F.3d 1236 (11th Cir. 2016), District Judge May found that a registrant had a “substantial likelihood of success on the merits” that SEC’s hiring practices of ALJs violates the Article II Appointments Clause.  Though as explained below, the Second and Eleventh Circuits have held that District Courts lack jurisdiction to decide these issues, this does not diminish the significance of the fact that these District Judges ruled favorably on the merits of these constitutionally-based defenses in well-reasoned opinions.

The SEC seems to have taken notice of these criticisms by the courts and modified its course somewhat. Between July and September 2015, the SEC filed only four out of 36 contested cases to its ALJs. (WSJ 10/11/15)  For FY2015, it sent only 28% of its contested cases to ALJs compared to 43% for the previous 12 months.  (Id.)

Unfortunately, for now, the Courts of Appeals have shut the door to the federal courthouse. Five Circuit Courts of Appeals have held that District Courts do not have jurisdiction to enjoin SEC administrative proceedings, finding that Congress intended these constitutional issues first be decided by the ALJ and SEC.  Even though appellate review of an SEC final order comes years later after respondents have incurred substantial defense costs, the Courts of Appeals hold that this provides “meaningful judicial review.”  As one dissenting judge notes, however, by that time respondents “will already have suffered the injury they are attempting to prevent ….” Tilton v. SEC, 824 F.3d 276, 298 (2d Cir. 2016) (Droney, J., dissenting).  This issue is included in a petition for a writ of certiorari to the US Supreme Court in the Tilton case filed on January 1, 2017.  The petition argues, “an error is an error, whether it is made once or repeatedly.”  2017 WL 281861, at *20.

Despite the SEC’s certain rejection of constitutionally-based affirmative defenses, respondents must keep asserting them in their answers to administrative complaints to preserve the issue for appeal. If the constitutional affirmative defense is not asserted before the SEC, the court of appeals may refuse to hear the issue on appeal.  The one defense that has already made its way to court on direct appeal, the Appointments Clause issue, has been gaining momentum in the federal courts.  See Bandimere v. SEC.  On Feburary 16, 2017, the D.C. Circuit granted a petition for rehearing en banc to reconsider the panel’s decision affirming the SEC in Raymond J. Lucia Companies, Inc.


Tell Me Something I Don’t Know: OCIE’s Tips To Surviving An SEC IA Exam

Posted in Examination, RIA, SEC

Let’s chalk this one up to “great minds think alike,” or maybe just “minds think alike.” You may recall that in his recent letter to member firms that accompanied FINRA’s 2017 Exam Priorities Letter, FINRA CEO Robert Cook said, “starting this year, we will publish a summary report that outlines key findings from examinations in selected areas.” Cool idea, right?  Well, last week, the SEC’s Office of Compliance Inspections and Examinations, or OCIE, beat FINRA to the punch and released a Risk Alert called “The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers.” If you’re an SEC-registered IA, or, like me, someone who represent IAs, it is a must-read.  Now, I am not necessarily saying that anything it contains is particularly eye-opening, but it does provide a tidy roadmap to those things on which your compliance efforts should be focused, even if those things are, arguably, pretty obvious.

Compliance Rule. The Compliance Rule – Rule 206(4)-7 under the Investment Advisers Act of 1940 – basically provides that adviser must (1) have written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules that the SEC has adopted under the Act; (2) review, no less frequently than annually, the adequacy of those policies and procedures; and (3) designate a CCO responsible for administering the compliance policies and procedures.[1]  What OCIE has found (over the course of over 1,000 exams of IAs over the last two years) are these common deficiencies:

  • Compliance manuals are not reasonably tailored to the adviser’s business practices. This is not just a common problem, but an old one. It can be more than just embarrassing to present an examiner with an “off-the-shelf” compliance manual that contains sections that have no relation to the firm’s actual business, or, worse, doesn’t contain sections that are pertinent.
  • Annual reviews are not performed or do not address the adequacy of the adviser’s policies and procedures. Like some BDs, it seems that some advisers simply don’t conduct annual reviews of their compliance policies and procedures, as required by the Compliance Rule. Others do the reviews, but they are insufficiently introspective, and fail to address the adequacy of the advisers’ policies and procedures and the effectiveness of their implementation. Finally, if a review reveals a problem, that cannot be ignored. Steps – demonstrable, memorialized steps – must be taken to address or correct the problem.
  • Adviser does not follow compliance policies and procedures. What good is having a robust policy if it is ignored? Indeed, arguably, it is worse than not having a policy at all.
  • Compliance manuals are not current. As noted in the first bullet point, it is sloppy to continue to maintain a compliance manual that contains outdated information or policies, such as “investment strategies that were no longer pursued or personnel no longer associated with the adviser and stale information about the firm.”

Regulatory filings. OCIE focused principally on Form ADV filings here, although it also mentioned Form PF and Form D.  Essentially, the advice boils down to this nugget of wisdom:  make sure that your filings are (1) timely, (2) accurate, and (3) complete.  Ooh, why didn’t I think of that?

Custody Rule. The Custody Rule – Advisers Act Rule 206(4)-2 – covers advisors who have custody of clients’ cash or securities.  Unfortunately, it is pretty much a strict liability situation if it is determined that an adviser had custody and failed to jump through the Rule’s hoops.  The common problems that advisers have with the Custody Rule are as follows:

  • There are situations where advisers did not recognize that they may have custody. OCIE identified a few situations where an advisor is deemed to have custody, but the advisor failed to realize it.
    • If a client provides an adviser online access to client accounts using the client’s personal usernames and passwords, including the ability to withdraw funds and securities from the client accounts;
    • If an adviser (or a related person) has powers of attorney authorizing him to withdraw client cash and securities; and
    • If an adviser (or a related person) serves as trustee of clients’ trusts or general partners of client PIVs.
  • Faulty surprise exams. A requirement under the Custody Rule is that an independent public accountant perform a surprise exam. According to OCIE, however, some of these exams have not exactly been a surprise (e.g., exams were conducted at the same time each year). Also, some advisers failed to provide the auditor with a complete list of accounts over which the adviser had custody or other information necessary for the exam to be conducted timely.

Code of Ethics Rule. Advisors are required to have a Code of Ethics.  Advisers Act Rule 204A-1.  OCIE identified these common issues regarding the Code of Ethics requirement:

  • Access persons not identified. Access persons (e.g., certain employees, partners or directors) must periodically report their personal securities transactions and holdings to the CCO, and obtain pre-approval before investing in an IPO or private placement. Some advisers did not identify all of their access persons. In addition, some access persons submitted transactions and holdings less frequently than required by the Rule.
  • Codes of ethics missing required information. Some advisers’ Codes of Ethics did not specify review of the holdings and transactions reports, or identify the specific submission timeframes.
  • Form ADV omissions. Certain advisers did not describe their Codes of Ethics in Part 2A of their Forms ADV and did not articulate that their Codes of Ethics were available to any client or prospective client upon request.

Books and Records Rule. The Books and Records Rule – Advisers Act Rule 204-2 – is the last common problem area.  And the problems are exactly what you would expect to hear:  (1) incomplete records, (2) inaccurate records, (3) records not updated in a timely manner, and (4) internally inconsistent records.


[1] These sound very much like a BD’s requirements under FINRA’s supervision rule, Conduct Rule 3110.