Broker- Dealer Law Corner

Broker- Dealer Law Corner

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

Posted in Administrative Proceedings, Disciplinary Process, Enforcement, SEC

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

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

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

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

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

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


Frequently Asked Questions About FINRA Rule 8210

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

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

The Scope of the Rule

Can FINRA really ask for that?

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

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

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

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

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

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

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

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

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

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

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

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

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

Are there any limits to the scope of Rule 8210?

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

The Sole Avenue for Appeal

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

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

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

No one who desires to remain in the industry.

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

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

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

 The Consequences of Non-Compliance

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

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

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

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

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

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

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

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


A Settlement Agreement With FINRA (Or So You Thought)

Posted in Disciplinary Process, Enforcement, FINRA, Settlements

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

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

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

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

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

The Math of Mark-Ups/Downs

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

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


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

Securities Fraud Requires More than Math

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

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

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

Real World Mathematical Guidance

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

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

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

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

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

Posted in Arbitration, FINRA

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Trouble With Your Clearing Firm? FINRA To The Rescue

Posted in Clearing firms, FINRA, Rule 4311

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

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

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

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

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

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

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

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

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

If only every story had this happy ending.

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

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.