Broker- Dealer Law Corner

Broker- Dealer Law Corner

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.

Procedural Motions In FINRA Enforcement Actions: An Exercise In Futility

Posted in Disciplinary Process, Enforcement, FINRA, Rule 9253

Defending a FINRA Enforcement action is not easy. This stems principally from the fact that FINRA simply won’t file a complaint in the first place if they believe that there’s any realistic chance they will not win the case.  Thus, they expect to win every time they do file a complaint, and perhaps not unreasonably so.

But, that difficulty is exacerbated by the near impossibility of getting a pre-hearing procedural motion granted, assuming Enforcement elects to fight it. On seemingly any topic.  I had two such motions denied this past week, so my frustration level is rather high right now, and I’m going to use this blog to get this off my chest.

The first situation involved our effort to require FINRA to produce statements from people it will be calling as witnesses at the upcoming evidentiary hearing. This is a pretty standard concept, not at all unique to FINRA Enforcement proceedings.  There are a few rules that pertain to this scenario.  First, Rule 9251(b)(3) requires FINRA to produce in discovery any document that contains “material exculpatory evidence.”  According to FINRA, that means “evidence relating to liability or sanctions that might be considered favorable to the respondent’s case, which, if suppressed, would deprive the respondent of a fair hearing.”  A great idea, and hardly groundbreaking, but, in reality, at least generally speaking, you have no choice but to take FINRA at its word when it says it has no exculpatory evidence to produce.

Second, Rule 9253(a)(1) allows a respondent to request that FINRA produce “any statement of any person called or to be called as a witness by” FINRA “that pertains, or is expected to pertain, to his or her direct testimony and which is ‘a stenographic, mechanical, electrical, or other recording, or a transcription thereof, which is a substantially verbatim recital of an oral statement made by said witness and recorded contemporaneously with the making of such oral statement.’”  In other words, if FINRA obtains an oral statement from someone and makes a “substantially verbatim” record of that statement at the time it is given, FINRA needs to produce it.

Third – and this is the one that my motion involved – Rule 9253(a)(2) permits me to request “any contemporaneously written statement made by an Interested FINRA Staff member during a routine examination or inspection about the substance of oral statements made by a non-FINRA person when (a) either the Interested FINRA Staff member or non-FINRA person is called as a witness by the Department of Enforcement or the Department of Market Regulation, and (b) that portion of the statement for which production is sought directly relates to the Interested FINRA Staff member’s testimony or the testimony of the non-FINRA witness.” In other words, if a FINRA examiner interviews someone and takes notes of that interview, and either the examiner or the witness is going to testify at the hearing about the same subject as the interview, the examiner’s notes must be produced.

We requested any 9253(a) statements, but the dispute narrowed down to 9253(a)(2) statements. We know for a fact that FINRA interviewed customers of my client, because the customers told us so.  But, when we asked for copies of their statements, Enforcement declined, making the rather facile argument that the interviews did not take place “during [the] routine exam.”  Enforcement contended that the routine exam ended when Member Reg sent the Exam disposition letter, which happened months before the complaint was filed.  Thus, any witness statements they obtained after that could not be compelled.  We figured the timing was irrelevant, right?  Well, naturally, the Hearing Officer bought Enforcement’s argument.

I am hard-pressed to understand the difference between statements obtained during the routine exam and those made after the exam, and how one needs to be produced but not the other.  The point of the rule is to provide a modicum of fairness to respondents, so they can assess the quality and credibility of witnesses FINRA introduces by comparing the testimony they provide at the hearing with what they told the examiner earlier.  Nothing in that concept changes in the slightest if the pertinent time period is extended beyond the formal close of the routine exam.  Yet, in an absolutely predictable showing of form over substance, the Hearing Officer hung his hat on a literal reading of the rule.  I wrote the other day that FINRA is overly rigid in its approach to regulation.  This is just one example, but one that plays out every single day.

The other order I got denied a motion I filed to sever two respondents out of a case involving multiple respondents. I am dealing with an eight-count complaint that FINRA says will take two weeks to try.  The two respondents at issue are named in only two of those eight counts, which means that they will largely have to sit there for two weeks, doing nothing, while FINRA puts on its case against the other respondents regarding the other six counts in the complaint.

You can guess the outcome. Here’s my favorite part of the Order denying my motion:  the pertinent rule recites that one thing you have to demonstrate to get a severance is “whether any unfair prejudice would be suffered by one or more Parties if the severance is (not) ordered.”  Notice that the rule only says “one or more Parties,” not all the parties, so, therefore, this includes the party or parties seeking severance.  Strangely, the Hearing Officer concluded that I did not satisfy that element, even though he appeared to concede that the two respondents on whose behalf I filed the motion would be prejudiced by having to sit there idly so long.  In support of his decision, he cited an SEC case that included this quote:  “While severance might conserve Respondent’s own resources, it would necessitate inconvenience and costs for other parties, the Hearing Panel, and witnesses.”

In other words, while I met the strict requirements of the rule by showing my two clients would, indeed, suffer prejudice, that was apparently less important than the “inconvenience and costs” for Enforcement and the hearing panel. This FINRA-centric analysis is startling in its one-sidedness.  But, sadly, maybe not surprising.  I am sure that FINRA with readily agree with the old Mel Brooks joke:  tragedy is when I cut my finger; comedy is when you fall into an open sewer and die.

This is not to say one should never fight FINRA. Many of my clients choose not to settle, prefering to duke it out in front of a hearing panel.  As my friend and former colleague Brian Rubin regularly reports in his helpful statistical analyses, respondents often do better, in terms of sanctions, by going to hearing, rather than settling.  But, if go that direction, you have to acknowledge that you are playing on FINRA’s field, with FINRA’s ball, under FINRA’s rules.

FINRA’s 2015 Annual Report: No Cliffhangers Here

Posted in Annual Report, FINRA

Yesterday, FINRA released its 2015 Annual Report, and it contained maybe one surprising figure: a decrease in the amount of fines it levied.  Beyond that, however, it was more of the same that we have seen over the last few years; just read my blog from a year ago about the 2014 report and you will see that nothing has really changed from trends I observed last year:

  • Continuing decrease in the number of member firms  – 3,916 in 2015 vs. 3,957 in 2014
  • Continuing decrease in the number of registered representatives – 640,111 in 2015 vs. 643,322 in 2014
  • Continuing decrease in the number of branch offices – 161,821 in 2015 vs. 162,655 in 2014
  • Continuing increase in number of FINRA employees – about 3,500 in 2015 vs. about 3,400 in 2014
  • Continuing increase in FINRA’s expenses – $1.038 billion in 2015 vs. $964.8 million in 2014 (including a $36.2 million increase in compensation and benefits)
  • Continuing increase in number of Enforcement actions brought – 1,512 in 2015 vs. 1,397 in 2014
  • And, of course, continuing increase in number of senior management personnel receiving more than $1 million in compensation packages

In short, FINRA is regulating fewer firms, fewer reps, and fewer branch offices than ever, but, remarkably, with more people than ever at a higher price than ever. It is hardly a wonder, then, that despite revenues of $992.5 million (which, with the exception of $93.8 million in fines collected, comes from YOU and your firm), FINRA experienced a loss of $39.5 million.  No worries, though.  FINRA still has assets of approximately $2.4 billion (including nearly $2 billion in cash and investments), so it can undoubtedly weather this storm.

None of this would be particularly remarkable if, in fact, FINRA was actually achieving its statutory mandate of investor protection and market integrity. But, the problem is, at least in the eyes of the industry, FINRA is not effective or nimble, as Mr. Ketchum characterized it in the Report.  To the contrary, FINRA is, generally speaking, too slow, too reactive, and too rigid in its interpretations to instill any confidence in the investing public, or its membership, that it is on the job, detecting and preventing securities fraud.  FINRA lumbers along, for the most part, bludgeoning small members and their officers into submission while big firms skate by with fines that, while admittedly sometimes sizeable, are readily affordable.  Too many firms now spend too much time on a weekly, if not daily, basis, just responding to regulatory inquiries that take time, money and effort to respond to, but go nowhere, or achieve little in terms of actual compliance.  Ultimately, FINRA’s effectiveness is like the old Woody Allen joke about the bad restaurant:  the food is terrible, and the portions are so small!

The Wendell Belden Case And Its Progeny: Fiduciary Before Fiduciary Was Cool

Posted in Fiduciary duty, Fiduciary Standard, FINRA

The entire securities world is anxiously awaiting the implementation of the fiduciary standard over retirement accounts, and, by most accounts, the eventual spread of that standard to ordinary investment accounts. I am not prepared to argue that this is not a big deal, and will cost the industry a ton of time and money to get its collective head around it.  But, I am of the view that the trip to fiduciary land from where we were, and where we are now, is shorter than many people suggest.  Over the years, FINRA has given plenty of signals that while broker-dealers operate under the transactionally oriented suitability standard, under the right set of facts, that standard already looks a lot like a fiduciary duty.

In support of this, I often cite a 2001 FINRA case out of the Dallas District office. Wendell Belden ran a small broker-dealer.  One day, a retired pilot approached him to invest his $2.1 million account.  Belden put the customer in Class B shares of certain mutual funds, knowing that this would result in him receiving more commissions than if he had used Class A shares.  In a rather startling display of candor, Belden admitted at the hearing that, basically, he felt he had to charge his bigger accounts higher commissions in order to earn enough money to be able to service his smaller accounts, which represented the lion’s share of his book.

Well, not surprisingly, the NASD frowned on that, observing that “a registered representative has an obligation to avoid increasing the costs that his or her customers pay.” What is interesting about this statement is that the focus was not on the quality of the underlying security – the mutual funds – but, rather, on the cost to the customer.  Essentially, NASD concluded that when faced with two essentially equally alternatives, a registered rep must pick the one that is cheaper for the customer.  In other words, he must pick the one that is in the customer’s best interest, not his own.  Remember, that was 2001 (affirmed by the National Adjudicatory Council in 2002, and the SEC[1] in 2003).

And, really, that concept is not altogether different from that displayed in the rash of “reverse churning” cases that FINRA has brought over the years (and which one of my former colleagues at a prior law firm believes are about to resume). Reverse churning occurs, of course, when a customer is put into a fee-based account but there is little or no trading in the customer’s account. In that circumstance, according to FINRA, the customer ought to be in a commission account, since if no trades are made, the customer will pay no commissions, and, therefore, less, perhaps way less, than the annual fee he will pay in a fee-based account, regardless of the fact there is no trading activity.  Again, the issue is not on the quality of the securities themselves, or the suitability of each recommendation made which resulted in the securities being purchased, but, rather, on achieving the lowest cost to the customer, as in the Belden case.  In other words, the cases are about doing what is in the customer’s best interest, here, the customer’s financial interest.[2]

What these cases tell me is that regardless of what the rules actually say, or what they used to say, in FINRA’s mind, brokers were always subject to an unstated, informal standard that required them to put their customers’ interests ahead of their own. FINRA never called it a fiduciary standard, however; it just called it suitability, and then found a way to cram the facts of any given case into the language of its existing rules.  If and when a fiduciary standard is implemented over all brokerage activities, of course, FINRA won’t have to be so creative anymore.

Until then, however, brokers and broker-dealers who think that they are going to have to learn to act in some dramatically different way when they become fiduciaries, ought to wake up and smell the coffee, and acknowledge that FINRA’s expectations in a pre-fiduciary vs. post-fiduciary world are really not that different at all.

[1] The SEC stated: “The NASD properly considered in determining its sanctions that Belden placed the paying of his firm’s expenses above the interests of his customer.”

[2] In addition, these cases also presaged the introduction in FINRA Rule 2111, the “new” suitability rule, of the notion that a recommendation for a “strategy” must be suitable. Whether a customer’s account should be fee-based or commission-based sure seems like a strategy call to me.

In AML World, The Need To File A SAR Can, Apparently, Be Too Obvious To Ignore

Posted in AML, Compliance, Disciplinary Process, Enforcement, FINRA, SEC, Supervision

If you’re reading this, then you undoubtedly already know that FINRA and SEC are, simply, AML crazy. Rightly or wrongly, they are both focusing more than ever on broker-dealers’ fulfillment of their supervisory obligation to be sensitive to the laundry list of red flags first articulated in a Notice to Members back in 2002 that are, theoretically anyway, indicative of potential money laundering.  The good news, to the extent there is good news, is that based on a FINRA hearing panel decision from 2010 involving Sterne Agee & Leach, as long as you have a good set of AML procedures, see the red flags, investigate the red flags, and memorialize your investigation, it is not really important whether or not you actually file a SAR. Well, based on an SEC settlement from a week ago, that may no longer be the case, at least when the red flags are numerous, obvious, and dangerous.

In the settlement, Alfred Fried & Co., LLC agreed to pay a $300,000 civil penalty to the SEC – a sum that would have been even higher absent the firm’s explicit cooperation with the SEC[1] – based on its failure to have filed SARs in light of what the settlement characterized as such obvious and numerous red flags.  The question is whether the Alfred Fried case marks a turning point in how regulators view SARs filings.

Back in 2010, the FINRA hearing panel in the SAL case “emphasized the importance of focusing on the process, rather than on whether a particular SAR was filed,” which makes perfect sense to me, and the industry. It stated: “The decision to file a SAR is an inherently subjective judgment. Examiners should focus on whether the [firm] has an effective SAR decision-making process, not individual SAR decisions.”  While it acknowledged the existence of two prior settlements that included among the noted violations the failure by the respective respondents to have filed SARs, the panel noted that it was more important to the analysis of an AML charge to determine whether the firm’s “procedures in monitoring” the accounts “were sound,” and whether, having spotted the red flags as a result of that monitoring, the determination not to file a SAR “was reasonable.”  Thus, if that decision not to file was appropriately analyzed, reflecting a legitimate deliberative process, then not filing a SAR was ok.

Alfred Fried, it seems, did not meet that standard. Viewed objectively, you can see why the Commission was upset that for a period of five years the firm did not file a single SAR.  First, what was supposed to happen:

  • The firm had a policy to rely on employee reporting, detection through ongoing review, transaction information, operations personnel education, and clearing firm reports to spot potentially suspicious activities.
  • Once suspicious activity was identified, it was to be reviewed and investigated by the AML officer to determine whether the obligation to file a SAR had been triggered.
  • Compliance staff was required to retain notes and other documented reviews created while investigating suspicious activities and other red flags.
  • The policies required Albert Fried to file SARs “for transactions that may be indicative of money laundering activity.”
  • Suspicious activities were defined as “a wide range of questionable activities,” including “trading that constitutes a substantial portion of all trading for the day in a particular security,” “heavy trading in low-priced securities,” and “unusually large deposits of funds or securities.”
  • The firm’s policies also stated that if it received a grand jury subpoena concerning one of its customers, the AML officer had to “conduct a risk assessment of the customer subject to the subpoena as well as review the customer’s account activity.” If the customer’s trading was determined to be suspicious in light of the risk assessment and review, the policies required the firm to file a SAR. (The mere receipt of a grand jury subpoena concerning a customer did not require the firm to file a SAR.)
  • Under the policies, a SAR should have been filed within 30 days of Albert Fried’s staff becoming aware of a suspicious transaction.

Next, what actually happened:

  • The firm allowed its customers to deposit hundreds of millions of shares of low-priced securities obtained from convertible debentures, and then immediately go about selling them.
  • These sales were often in large volumes and constituted a substantial percentage of the daily market volume in the security. On more than one occasion, a single customer’s trading in a security on a given day exceeded 80% of the overall market volume. In another instance, on three of the four days in which one customer sold a particular security, the customer’s trading accounted for more than 59% of the daily market volume – ranging from 59.07% to 77.65%.
  • Customers were trading in certain issuers that were delinquent in their SEC filings or that had ongoing penny stock promotional campaigns, executive employees with histories of securities fraud, or significant accumulated deficits.
  • The firm received regulatory inquiries and grand jury subpoenas concerning its customers’ trading.
  • Other broker-dealers rejected the firm’s attempts to transfer its customers’ securities.
  • Immediately following the liquidation of an issuer’s securities, a customer transferred the entirety of its cash proceeds out of its Albert Fried account.
  • The firm became aware of a customer’s executive being charged with criminal securities fraud charges.
  • The Commission suspended trading in a security that was recently liquidated by its customer.

Despite all of this, no SAR was ever filed. More importantly, however, the firm never even investigated the activity to determine whether it was, in fact, suspicious.  Thus, there is no way that the firm could meet the standard articulated in the 2010 FINRA case against SAL, regardless of whether or not a SAR was filed.  Given that, perhaps the lesson from Alfred Fried is not that the regulators are suddenly anxious to begin bringing cases based on a failure to file SARs, even though that represented the SEC’s specific finding here; rather, maybe it is the same lesson from the SAL case, namely, that having robust policies in place, and then actually following those policies (and documenting that you followed them), is the still the best way to defend an AML charge.  If Alfred Fried had, in fact, done what its AML policies required, perhaps its failure to have filed a SAR could have been successfully defended.  Because it ignored its policies, however, its fate was sealed.

The take-away:

  • Review your AML policies to be sure they are robust and up-to-date
  • Be sensitive to red flags of potentially suspicious activities as they manifest themselves
  • Respond to red flags promptly and in accordance with your policies
  • Document the dickens out of the response
  • And then, if you reasonably conclude the red flags do present activity consistent with money laundering, file a SAR
  • If you reach the opposite conclusion, however, and don’t file a SAR, document that decision and the basis for it even better.

[1] According the SEC, Albert Fried entered into two tolling agreements, prepared a 57-page summary of its conduct explaining its AML policies, providing background for each transaction, and took “a number of remedial measures,” including retaining a third-party AML compliance firm to improve compliance with the BSA’s SAR filing requirement and the execution of its written policies and procedures,” revising its policies to reflect updated regulatory guidance and input, and adding a low-priced security checklist to its process of accepting the deposit of securities and a customer AML risk assessment component to its account opening procedures.

Whatever Happened To The “Self” In Self-Regulation?

Posted in Board of Governors, FINRA

Buried among the usual hodgepodge of stuff in a recent weekly FINRA blast email was a notice that the SEC was accepting comments on FINRA’s request to change the composition of the NAC, the National Adjudicatory Council, so that it mirrors the FINRA Board of Governors, and instead of having an equal number of industry and non-industry members, the latter will constitute a majority. According to FINRA’s letter to the SEC proposing the rule, this move to a non-securities industry majority is necessary for the following reason:

[t]he condition that the number of Public Governors exceed the number of Industry Governors permits the FINRA Board to consider the needs of the entire securities industry, including issuers, large and small investors and securities firms and their professionals, while at the same time broadly assuring the independence of FINRA’s regulatory function…. Requiring that the number of Non-Industry Members exceed the number of Industry Members [on the NAC] will enhance overall the independence of the NAC and reinforce the integrity of the NAC as an impartial and fair adjudicatory body.

Frankly, this confuses me. How does having non-industry people on the Board and the NAC somehow ensure that FINRA is “independent?”  Independent of whom?  And, more to the point, what exactly does FINRA mean by independent?

Clearly, being independent, whatever it means, is something that FINRA constantly touts about itself. I picked up a piece of FINRA BrokerCheck propaganda yesterday while in the Dallas District Office for an OTR, and in the section called “More About FINRA,” it states in the very first sentence that “FINRA is an independent, non-government regulator.”  Similarly, on its website, FINRA writes that it “is not part of the government. We’re an independent, not-for-profit organization authorized by Congress to protect America’s investors by making sure the securities industry operates fairly and honestly.” These pronouncements comport with my personal understanding that FINRA was independent in the sense that it is not part of the government.  It has often been referred to as a quasi-governmental agency in that it answers to the government, specifically, the SEC, but it is not the government itself.  The industry creates rule proposals, and the SEC has to approve or disapprove them.  Thus, FINRA is, inarguably, independent of the government.  So, what kind of independence is this new proposal referring to?

More importantly, assuming that having non-industry people in positions of management somehow creates independence for FINRA, what is the big deal about that sort of independence anyway? FINRA is a self-regulatory organization, formed as a result of a 1940 Act of Congress designed to permit broker-dealers to create their own entities to regulate their own conduct, a/k/a self-regulation.  To govern broker-dealers effectively, it would seem to be necessary to be able to understand what broker-dealers do, how they operate, the challenges they face, and what it takes to deal with those challenges in the real world, not the theoretical world of rule-makers.  Given that, how do non-industry members possibly help in this effort?  I would gladly sacrifice the independence that non-industry members on the Board and the NAC supposedly provide in exchange for people actually knowledgeable about what my clients do for a living and the rules that FINRA is enforcing.

For instance, last week, I argued an appeal of a FINRA disciplinary decision to a two-person NAC subcommittee, only one of whom was associated with a broker-dealer; the other – a smart man, no doubt, and certainly respectful of me and my arguments – was a college professor who had never been registered. The case was principally about AML issues, whether my client had been sensitive enough to certain alleged red flags, and whether it responded appropriately. My appeal focused on many details of everyday life at a broker-dealer, such as the account opening process, the review of customer background information, the approval of trading activity in customer accounts, interactions with a clearing firm, etc.  Making that argument to someone who had never, even once, done any of those things, struck me as the antithesis of self-regulation.  How could he possibly understand what would be reasonable, and what would be unreasonable?

The whole point of FINRA being a self-regulatory organization is that broker-dealers are judged by their peers, who (theoretically, anyway) understand what really goes on, i.e, the difficult balancing act BD’s attempt every day to achieve compliance, at such high costs in terms of time and money, in a for-profit world. Seems to me that FINRA ought to be less concerned about its supposed independence, stop denying its provenance as a self-regulatory organization created by broker-dealers (and the people who work for broker-dealers, which, as I understand it, does not include college professors), and strive harder to fulfill its original statutory mandate.

The Long Arm Of The Law Has Nothing On FINRA’s Reach

Posted in Disciplinary Process, Enforcement, Examination, FINRA, Registered Representative, Rule 2010

So, you’re a registered rep, working for a broker-dealer. Necessarily, you are registered with and subject to the oversight of FINRA, not a particularly happy proposition.  But at least you can take comfort in the fact that while FINRA may have the right to stick its nose into your securities business, what you do away from the broker-dealer is none of its concern, right?  Well, not so fast.

As one Miguel Hernandez learned the hard way, FINRA is very interested in what you do on your own time, away from the BD, at least if that involves swindling a senior citizen.

According to the AWC that Mr. Hernandez agreed to, he convinced an elderly woman who he met at church to give him $25,000 to “cover business expenses associated with his purported tax business.”  In return, she was to receive an interest in the tax business and some number quarterly payments of roughly $1,000 each.  Sadly, but predictably, Mr. Hernandez, in fact, had no tax business, and simply kept the poor woman’s money.  FINRA appropriately characterized this misconduct as conversion, and barred permanently barred Mr. Hernandez.

The disposition of the matter is not especially newsworthy. FINRA will always bar you if you steal money from a client.  What is interesting, at least to me, however, is that nothing Mr. Hernandez did here related in any way to him being a registered rep at a FINRA member firm.  While the victim of his scam is described as a “customer” – presumably of his broker-dealer – the scam does not seem to have had anything to do with that fact.  Also, the entity that she thought she was investing in was a “purported tax business,” which means it was not a securities firm, and what she got for her money was not itself a security.  Basically, Mr. Hernandez scammed a woman he met in church out of $25,000, a woman who seems to have also been a customer of the broker-dealer, but it was irrelevant to the case that he was a registered rep.

This raises thought-provoking questions about the scope of FINRA’s authority. Essentially, FINRA’s jurisdiction, if you will, has two components:  jurisdiction over individuals, and jurisdiction over those individuals’ activities.  The first is pretty easy to understand:  if you are registered, or even just associated, with a broker-dealer, FINRA has jurisdiction over you.  Thus, very obviously, if Mr. Hernandez had not been a registered rep, FINRA could not have taken any action against him.  But, what about the second component?  Does FINRA have jurisdiction over everything that Mr. Hernandez ever did while he was registered?  Or, did FINRA have jurisdiction, somehow, because he cheated the old woman out of $25,000?  Was there something special about the fact he converted her money?

The answer, unfortunately, is that FINRA gets to make it up as it goes along. Historically, under similar circumstances, FINRA has taken disciplinary action against registered people for stealing money, even when the theft occurs away from the broker-dealer.  But, candidly, it is not at all clear why FINRA can do that.  It has nothing to do with either the sale of securities or the investment banking business, the two things that require registration with (or as) a broker-dealer.  Why, then, can FINRA get away with branding that particular sort of bad conduct – stealing money – as the basis for a Rule 2010 violation, when other equally bad conduct unrelated to the securities business – say, lying about  whether one’s house that’s for sale ever had termite damage – goes unexamined and unpunished?  In a related fashion, how can FINRA – admittedly on rare occasion – take disciplinary action against a registered rep for problematic advertisements used to sell straight insurance products, not securities?

I cannot explain this adequately. But, it would seem that FINRA either does or does not have the legal ability to enforce bad conduct committed by registered persons away from and unrelated to their securities business.  That is, either all such bad conduct should be subject to FINRA scrutiny, or none of it.  The notion that FINRA gets to pick the circumstances that it chooses to enforce through its disciplinary process is troublesome to me.  FINRA is already viewed by most BDs and registered reps as an aggressive “big brother,” constantly watching and waiting to swoop in to examine even the slightest perceived rule violation, followed up swift enforcement action.  I suppose that is bearable, or at least understandable, when it comes to securities-related activities.  The idea, however, that FINRA is prepared to bar people for actions that are completely unrelated to their securities business, well, that is another story; that is not necessarily what registered reps agreed to when they elected to work in this regulated industry.

Altering Documents In A FINRA Arbitration Can Have Consequences That Go Well Beyond The Arbitration Itself…At Least For Respondents

Posted in annuities, Arbitration, Disciplinary Process, Discovery, Enforcement, FINRA

The FINRA investigative process and the arbitration process exist side-by-side; at times, the misconduct that is alleged by a claimant in a Statement of Claim may simultaneously be the subject of an examination by Member Regulation, or even an Enforcement Complaint. Ordinarily, Enforcement doesn’t pay much attention to what happens in a parallel arbitration, except in those relatively rare situations where the hearing panel makes a disciplinary referral.  A very recent Enforcement case highlights the potentially grave danger of not taking seriously one’s discovery obligations in a FINRA arbitration, and how that can morph into an Enforcement case.

David Tysk is a registered rep with Ameriprise. In 2006-2007, Mr. Tysk sold his customer “GR” $2 million in variable annuities.  At least a year later, the customer sent a letter to Ameriprise, complaining of the suitability of the annuity purchases, and demanding his money back.  Shortly after the complaint letter was received, Mr. Tysk went about making “substantial alterations”[1] to his client contact notes about his meetings/conversations with GR, seemingly in an effort to lend better documentary support for the defense of his recommendations to GR to purchase the variable annuities.  This was contrary to Ameriprise’s Code of Conduct.

In 2008, after Ameriprise denied his complaint, GR initiated a FINRA arbitration against Mr. Tysk, and Ameriprise. As any practitioner knows, in customer arbitrations, FINRA has created a list of presumptively discoverable documents for respondents to produce, including “[a]ll notes by the firm/Associated Person(s) or on his/her behalf, including entries in any diary or calendar, relating to the custom[]er’s account(s) at issue.”  In response to this item, Mr. Tysk produced the revised version of his client notes; more importantly, he did not tell GR’s counsel that he had altered them.  GR’s counsel was sharp, however, and he noticed that the notes reflected that they had been “edited” by Mr. Tysk after the date of the initial complaint letter to Ameriprise.  So, he followed up and asked to see the edits Mr. Tysk had made.

Mr. Tysk’s lawyer then dutifully asked Mr. Tysk about the edits. Mr. Tysk told his lawyer that there were no documents reflecting any edits.  Based on that response, Mr. Tysk’s counsel told GR’s counsel that there were, in fact, no responsive documents.

Unfortunately, that turned out to be false. GR convinced the arbitration panel to order a “forensic search” of Mr. Tysk’s computer and server, and that search uncovered all of Mr. Tysk’s previously undisclosed edits.  Perhaps not surprisingly, the arbitration panel found Mr. Tysk and Ameriprise jointly and severally liable “for obstructing the discovery process,” and slapped a $20,000 sanction on Mr. Tysk.  More importantly, it made a disciplinary referral to FINRA, to review the conduct of Mr. Tysk and Ameriprise in connection with their discovery obligations in the arbitration.

A hearing panel ultimately concluded that both Ameriprise and Mr. Tysk were liable, but only Mr. Tysk appealed to the National Adjudicatory Council.[2]  On appeal, the NAC affirmed the $50,000 fine the hearing panel had imposed on Mr. Tysk, but increased his suspension to one year.

Now, finally, to the lesson of the case: the hearing panel, as well as the NAC on appeal, concluded that Mr. Tysk violated IM-12000 of the Code of Arbitration Procedure – and, therefore, FINRA Rule 2010 – by deliberately submitting in discovery a document that was “misleading.”  It is at this precise point where the arbitration process and the Enforcement process intersect.  Failing to produce relevant evidence in an arbitration, or producing altered evidence, can cause a dramatic impact not just in the arbitration, but, as Mr. Tysk learned the hard way, in a subsequent Enforcement case.

And, it was not simply the production of the altered notes by Mr. Tysk that got him in trouble; it was also the fact that he (and Ameriprise) concealed the fact that he had changed his notes. According to the NAC, Mr. Tysk “subverted the arbitration process” in two ways, by producing an altered document and then by not “providing full information during the discovery process” about that document.  Specifically, the NAC found that Mr. Tysk’s argument that “providing explanations about discovered documents . . . is contrary to arbitration practices . . . constricts too narrowly his obligations under the Arbitration Code, and FINRA’s conduct rules.”

The NAC was also unimpressed with Mr. Tysk’s argument that, in the end, his alterations all came to light before the arbitration hearing itself, so no one was harmed: “If Tysk’s misconduct had not been discovered by a forensic investigation, the ability of the arbitrators to find the truth would have been undermined.  The fact that Tysk’s concealment was revealed does not lessen its potential to harm the arbitration process.”  See, even in the absence of any “actual” harm to the arbitration process, the “potential to harm” was enough to get Mr. Tysk in hot water.

At times, the arbitration process can seem like a bit of circus. Because not every chairperson is sufficiently experienced to identify misconduct when they see it, or, equally bad, strong enough to do anything about it when they do, over the years I have witnessed countless examples of parties ignoring their responsibilities under the Code of Arbitration Procedure, seemingly with no consequences.  Claimants, who are not subject to FINRA’s Conduct Rules, are, generally, safe no matter what they do, or don’t do – and maybe that’s a subject for another blog post.  But respondents, like Mr. Tysk and Ameriprise, present a very different picture.  For them, the threat of a disciplinary referral exists in every case.  Accordingly, their discovery obligations in arbitration must be taken seriously.  In FINRA’s transparent world, one’s disciplinary history, like those Mr. Tysk and Ameriprise now have as a result of their actions here, cannot be concealed quite so easily as Mr. Tysk’s after-the-fact revisions to his client notes.

[1] Mr. Tysk added 54 new entries and supplemented 13 pre-existing entries to provide additional details.  Interestingly, FINRA did not charge that Mr. Tysk’s altered notes were “false or untrue statements,” even though they were backdated.

[2] The hearing panel fined Ameriprise $100,000 for failing to inform GR’s counsel immediately that Mr. Tysk’s notes were altered once it learned that fact (and for not producing a relevant exception report until the eve of the hearing).

According To FINRA, “Culture Of Compliance” Is Not Only Definable, It’s Enforceable

Posted in Compliance, Culture, Disciplinary Process, Enforcement, FINRA, Supervision

Earlier this year, as part of its 2016 Examination Priorities, FINRA spent a lot time discussing the “culture of compliance” at broker-dealers, the notion that firms need to create an atmosphere where compliance with rules and regulations is more than just lip service, but, rather, where it is a priority established by firm management – the so-called “tone at the top” – and regularly nourished. FINRA even went so far as to suggest ways in which such an amorphous concept could be exhibited and, theoretically, tested.  At the time, like many, I questioned just how long it would take FINRA actually to bring an Enforcement case based on a firm’s lack of a culture of compliance.  Well, the wait didn’t turn out to be particularly long.

This month, FINRA released its decision in Meyers Associates, and there is some fascinating and scary language in there that you need to know about, especially if you are the “head” of a small broker-dealer.

According to the summary, in an eight-count complaint, Bruce Meyers, the firm’s owner and principal, and his firm were charged with sending misleading and unbalanced advertising materials, failing to enforce adequate supervisory procedures, and failing to maintain accurate books and records. The hearing panel concluded that Enforcement had proven most of its case,[1] fined the firm $700,000, fined Mr. Meyers $75,000, and barred him from acting in a supervisory or principal capacity.  So, not a small or minor case.  But, that’s not the point.

The point is what the panel said about Mr. Meyers, and the vocabulary it utilized:

  • “Meyers is the head of Meyers Associates; no one stands above him”
  • “As the head of Meyers Associates, Meyers sets the tone for his Firm”
  • “Despite his own and the Firm’s disciplinary history, . . . Meyers has little interest in ensuring that Meyers Associates has a strong culture of compliance”
  • “Meyers testified that he is not involved with the compliance of the Firm, has ‘no compliance experience’ and ‘no knowledge of compliance per se,’ and does not intend to acquire such knowledge”
  • “Meyers, as CEO and self-described ‘boss of the Firm,’ should have ensured that the CFO had created and maintained adequate WSPs. . . .  Instead, he ignored the CFO’s shortcomings because he did not value compliance at the Firm.”

“Culture of compliance” and “tone at the top” are, clearly, more than catch-phrases; they are standards of conduct that FINRA is expecting to be met.  While Mr. Meyers and his firm both had a fairly lengthy disciplinary history — the firm had ten prior events, and Mr. Meyers six — thereby simplifying FINRA’s ability to demonstrate that he didn’t seem to care particularly about compliance, the concepts bandied about in the decision are applicable to the “head” of any firm, and especially small firms, where the distance between the “top” and the registered representatives is short.  Anyone who chooses to ignore FINRA’s increased attention here to these concepts is living in the past, and is in peril of receiving treatment similar to that which Meyers got.


[1] The Section 5 claim was dismissed before the hearing.  For what it’s worth, the case was prosecuted by my new partner, Michael Gross, who has just returned from “the dark side” to private practice, and specifically to Ulmer & Berne, where he worked as an associate before spending over eight years with FINRA in its Enforcement Department.

Good Grief! MetLife Agrees To $20 Million Fine, And Another $5 Million In Restitution! For Negligence!

Posted in annuities, Disciplinary Process, Enforcement, FINRA, Suitability, Supervision

FINRA announced today that it entered into a settlement with MetLife Securities, Inc. in which MetLife agreed to pay FINRA a $20 million fine and its customers up to $5 million in compensation for, basically, making misrepresentations over a five-year period to customers who replaced one variable annuity with another regarding the costs of making the switch and the supposed guarantees offered by the replacement product.  Even for someone as jaded as me when it comes to FINRA Enforcement actions, this one took my breath away, for its sheer magnitude.  Twenty-million dollars!  Yikes, there goes FINRA’s operating budget deficit in one fell swoop!

As I read the AWC, however, there were a couple of other things besides the ridiculous size of the monetary sanction that stood out, and are worthy of mention.

First, note that no individual was named as a respondent. FINRA has taken considerable heat over the years for its seeming disparate treatment between officers and principals of small broker-dealers, on the one hand, versus officers and principals of large firms, on the other.  Anecdotally, at least, it sure seems that FINRA is much, much more apt to name individuals for supervisory failures when the respondent is a small broker-dealer.  And, given that most FINRA member firms are “small,” this happens a lot.

Here, however, despite the magnitude of the underlying supervisory problems that led to this whopping settlement, not a single person was named by FINRA. Yet, the supervisory failures identified in the AWC are undeniably serious, pervasive, and systemic, “affecting almost three quarters of the tens of thousands of [variable annuity] replacements” MetLife recommended, and for which the firm earned $152 million in gross dealer commissions.  For instance,

  • MetLife “failed to implement an adequate supervisory structure to ensure that its registered representatives obtained an assessed accurate information concerning the recommended VA Replacements”;
  • The firm “did not provide sufficient training or guidance to its registered representatives on how to complete” the form by which the costs of the replacement were disclosed;
  • The firm “did not identify or describe a process by which registered representatives could obtain” the comparative cost and benefit information to be able to fill out that form accurately;
  • The firm “did not implement an adequate review of the replacement applications to ensure the information included was accurate.” As a result, 72% of its customers got inaccurate information;
  • The firm “did not implement reasonable supervisory systems, procedures, or training regarding its principal review of the suitability of the proposed replacement”; while registered reps had to provide a written justification for the replacement, firm principals were not required actually to review that answer. Not surprisingly, 99.79% of all proposed replacements were approved; and
  • The firm failed to properly supervise the sale of a rider that provided a guaranteed minimum income benefit. FINRA found, and MetLife agreed, that it failed provide either its reps or principals with “reasonable guidance or training on the costs and benefits of the” rider.

This is an astounding list of dramatic supervisory lapses that ensued over a five-year period, resulting in massive customer losses. And, yet, no one was responsible.  I simply do not believe that a small firm would have received similar treatment.

Second, as the title of this post suggests, it is remarkable to me that FINRA was willing to characterize these seemingly endless failures as the result of “negligence.” Having been on the other side of countless negotiations with FINRA, I would bet my mortgage that when settlement discussions first began, FINRA was looking at charging these as intentional misrepresentations and omissions.  A tip of the hat to MetLife’s counsel, then, for convincing FINRA that a finding of negligence would still achieve its goal of arriving at an appropriate “remedial measure.”  Of course, that would help explain the size of the fine imposed.  I am not saying that MetLife was able to get FINRA to agree to call its misconduct “negligent” simply by paying $20 million, as opposed to, say, $5 million; but, as they say about chicken soup, “it couldn’t hurt.”  In FINRA’s world, as elsewhere, money talks.