Broker- Dealer Law Corner

Broker- Dealer Law Corner

Let The Sun Shine On FINRA’s Office Of Disciplinary Affairs

Posted in Disciplinary Process, FINRA, ODA

Back in the old days, back when it was still NASD and it bore some reasonable semblance of a true self-regulatory organization, the important decisions relating to the Enforcement process – the decision to issue a complaint, the decision to settle a case, and the decision in litigated matters that actually went to hearing – all resided with the District Business Conduct Committee, or DBCC (n/k/a the District Committee) and, for, trading cases, the Market Surveillance Committee (n/k/a the Market Regulation Committee). The DBCC and MSC were comprised exclusively of industry members who were voted into their roles by their peers.  That’s where the “self” in self-regulation came from, since it was actually brokers making decisions about other brokers.

That changed, of course, in 1996, when NASD got sanctioned by the SEC in the infamous 21(a) Report that disclosed that the relationship between NASD staff in the New York District and the members of the DBCC, as well as the relationship between the Market Surveillance staff and members of the MSC, was a bit too cozy, resulting in those committee members sometimes using the NASD to bring Enforcement actions (relating to market making activities) against their business competitors.  As a result of that Report, NASD dramatically altered it processes, carving out the DBCC and MSC from any decisions relating to filing or settling complaints, and vesting those decisions with NASD Enforcement staff.  Thus, many argue, began the elimination of “self” from self-regulation.

To prevent Enforcement from running amok, NASD also created the Office of Disciplinary Affairs, or ODA. ODA is a completely separate group, not associated with Enforcement, designed as a check to ensure that Enforcement’s decisions were reasonable.  Specifically, before Enforcement could file a complaint, it first had to apply for and obtain approval from ODA.  Additionally, ODA needed to approve all settlements, even though the actual settlement negotiations were conducted with Enforcement staff.  Clearly, in light of these critical activities, ODA was established to play a very, very powerful role in the Enforcement process.  And today, nothing has changed.

But, here’s the thing, and the point of this post: Who, exactly, is ODA?  Who is actually making its decisions?  On what basis does it makes its decisions?  And why is it that only Enforcement gets to communicate with ODA?

Look at the FINRA website, and I challenge you to figure out what exactly the ODA is, what it does, of whom it is comprised, how it functions, etc. I mean, you can easily see the old Notice to Members from 1999 that announced the formation of the ODA, and you can see the rules – 9211, 9216, and 9270 – that state that the ODA must authorize complaints and approve settlements.  There is also Reg Notice 09-17, which did not create anything new, but merely reiterates the current Enforcement process.  It provides the following completely unhelpful, unenlightening explanation about ODA:

FINRA’s Office of Disciplinary Affairs (ODA) is independent of Enforcement and is not involved in the investigation or litigation of cases. ODA is charged with reviewing each proposed settlement or complaint, including any Wells Submissions, to provide an independent review of the legal and evidentiary sufficiency of the charges proposed by the staff. ODA also 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.

Let’s take this incrementally. Let’s say Enforcement wants to file a complaint, and, in anticipation of that, it invites my client to submit a Wells letter.  I prepare the response and send it to Enforcement which, apparently, then sends it to ODA.  But, what else does Enforcement do?  Does it also submit a rebuttal to the Wells?  Does it get to converse with ODA?  Does it get to answer questions that ODA may have?  The answer to these is yes, of course.  All of those communications between Enforcement and ODA happen, yet I never get to see them, or respond, or comment, or participate.  ODA is “independent of Enforcement,” purportedly, yet it is entirely dependent on Enforcement for the information it needs to do its assigned job.  Why can’t a prospective respondent communicate directly with ODA?  Why does everything I submit have to get filtered by Enforcement first?  Why can’t I even know the name of the individual(s) who is (are) serving as the final arbiter of whether a complaint is mandated?  Indeed, I have no idea if ODA is one person, or a group (as it used to be), or if it is a group, who runs the place.  And if it is, truly, independent of Enforcement, to whom does ODA report?

Same thing with settlements. While it certainly helps to have the Enforcement lawyer agree that my offer is reasonable (because the Enforcement lawyer, in turn, will then try to sell it to ODA), ultimately it is only ODA’s opinion that matters.  The Enforcement lawyer is largely relegated to the role of ferrying offers and demands back and forth between ODA and me.  It would be way easier, and more sensible, if I could just talk directly to ODA, rather than having Enforcement serve as the conduit.

The point is, ODA is incredibly powerful in the FINRA Enforcement process, arguably more powerful than the Department of Enforcement itself, given that Enforcement can’t issue a complaint or settle a case unless ODA says so. Yet, ODA is nameless, faceless, accountable to no one, working entirely behind the scenes, away from public scrutiny, unavailable for a dialogue, able to issue decrees that both Enforcement and respondents must follow.  This sounds like the antithesis of what due process should be, but it is the norm for FINRA.  Members should demand that, as the SEC did when it issued the 21(a) Report against NASD, more sunshine be provided to remove the mysterious procedures that now shroud Enforcement actions.  Make ODA show itself, let respondents be able to communicate directly with ODA, require it to be accountable for its decisions.

FINRA’s Annual Report: I Wish It Was Fake News

Posted in Annual Report, FINRA

This past week, FINRA very, very quietly released its Annual Report for 2016.  Too quietly, as they say in the movies.  No press release.  No press conference.  No media attention at all, hardly.  As President Trump just asked about State Election Commissioners who refused to respond to a request from his Election Fraud taskforce for a vast array of personal information about voters, “what is it hiding?”  Well, seems to me there are a couple of things in the Report that, frankly, FINRA would prefer not become the topic of too many conversations.

First, of course, is the embarrassing annual parade of FINRA millionaire employees. At first glance, you may be buoyed by the fact that only three of the top ten earners are slated actually to make $1 million or more in 2017, down from six in 2016.  But, that is deceiving, as the 2017 figures revealed in the Report do not include deferred comp, which isn’t determined until the end of year.  Once that is tallied up, undoubtedly, the number will climb.  Plus, even absent a consideration of deferred comp, no one on the list is struggling to make ends meet.  The lowest comp number is still a whopping $728,000.  And, one of the poor guys who doesn’t make $1 million (absent deferred comp) is Tom Gira, who made a cool $2.6 million last year (due to a one-time pension thing), more than anyone else at FINRA.  Tom is nice guy, and I personally like him, but there is simply no way that he brought $2.6 million of value to the table.

FINRA may be a not-for-profit company, but its management compensation sure looks a lot more like a Silicon Valley tech success than a stuffy old regulator. These insane comp numbers make Robert Cook’s boast that he is addressing FINRA’s expected “operating revenue challenges” this year by “freezing officer salaries” sound more than a bit ridiculous.  What?  You’re going to freeze my salary at a paltry $1 million??”

The second thing of note about the Report is that it makes abundantly clear just what FINRA views its job to be, and what, presumably, it feels the public deems important. And believe me, it is not to make the lives of broker-dealers easier. To the contrary, what FINRA leads its Report off with is a self-congratulatory recitation of its Enforcement work, extolling $173.8 million in fines, $27.9 million in restitution to harmed investors, 24 firms expelled, 727 brokers suspended, 517 brokers barred, 1,434 disciplinary actions, 785 cases referred for prosecution to the SEC and other federal or state law enforcement agencies, 439 potential market manipulation cases referred to the SEC, and 97 potential Reg M violations detected by cross-market patterns referred to the SEC.

In fact, FINRA notes in the Report that it collected so much money in fines last year that this single part of its revenue stream was alone more than enough to address the loss that FINRA suffered in 2015. The Report states: “We reported net income of $57.7 million in 2016 versus a loss of $39.5 million in 2015.  The change is primarily related to two areas: fines and portfolio returns.  An increase in fines revenue more than offset the decrease in operating revenues for the year….”  I suppose the good news, therefore, if you were a respondent in a FINRA Enforcement action last year and paid a fine, is that you can rest easier at night knowing that you helped FINRA turn around its financial problem.[1]

Perhaps it wouldn’t be so difficult to stomach FINRA’s Report if it was clear that it was doing a good job and that it was spending its money wisely. But, anecdotally, anyway, based on comments from the very members who pay those salaries through assessments, fees and fines, FINRA is failing to meet its statutory mandate.  It still spends way too much time and money going after firms and individuals who don’t represent a true threat to the integrity of the markets.  It refuses to settle cases for a reasonable sanction, even though such sanctions are not supposed to be punitive.  It sends out examiners who lack sufficient knowledge and understanding of how firms run their businesses, leading to miscommunications and time wasted, at a minimum.  It is way too focused on headlines, especially negative ones, that is, on the appearance of accomplishing something, than actually accomplishing it.  It is very fast to jump on problems that others have discovered, rather than proactively identifying such problems itself and nipping them in the bud.

Ultimately, it boils down to whether member firms feel like they are getting what they’re paying for with FINRA, and, at least as I see it, the consensus is a resounding “no.”


[1] To be fair, FINRA “do[es] not view fines as part of [its] operating revenues.  The use of fine monies is limited to capital expenditures and regulatory projects, such as [its] efforts to leverage technology innovations and the Cloud initiative, and other projects as appropriate, which are reported to and approved by [its Finance, Operations and Technology Committee and Board.”

The Unassailable FINRA Rule 8210

Posted in Disciplinary Process, Enforcement, FINRA, Rule 8210

My dissatisfaction with FINRA’s Rule 8210 and, more specifically, the aggressive manner with which FINRA wields that rule, has been the subject of several prior blogs.  I happy to report that my partner, Michael Gross, has drunk the Kool-Aid, and joined me in tilting at this windmill.  – Alan

The first paragraph of a paper calling for reform at FINRA notes that:

FINRA is a regulator of central importance to the functioning of U.S. capital markets. It is neither a true self-regulatory organization nor a government agency. It is largely unaccountable to the industry or to the public. Due process, transparency, and regulatory-review protections normally associated with regulators are not present . . . .[1]

One of FINRA greatest powers – FINRA Rule 8210 – epitomizes its lack of accountability and meaningful due process protections.

The Power of Rule 8210

FINRA Rule 8210 requires members and their associated persons to provide documents, information, and testimony “with respect to any matter involved in the investigation, complaint, examination, or proceeding.” 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 anything business-related. Moreover, FINRA alone determines what is relevant to its investigations.

Rule 8210 is a tremendous power. If a registered rep does not comply with a request for documents, information, or testimony, FINRA can have the rep barred from the securities industry.[2] Once barred, an individual becomes subject to statutory disqualification, which has implications beyond the ability to function as a registered rep. Simply put, FINRA’s power through Rule 8210 extends beyond the securities industry it governs.

The Potential for Abuse

With this much power, Rule 8210 has the potential for abuse. FINRA can seek to expel those whom it deems to be undesirable by making compliance with the nature, volume, or scope of Rule 8210 requests so undesirable or burdensome that providing the requested documents or information is not a real option.

There is no limit on the number of document and information requests that FINRA can issue. It is not uncommon for FINRA to issue pages upon pages of document and information requests, and to follow up one set of overly broad and unduly burdensome set of requests with another set of the same. There likewise is no limit on the number of hours or days for which FINRA can take a rep’s testimony.[3] Multiple-day on-the-record interviews are not uncommon. Under Rule 8210, FINRA can even compel a rep, who lives within walking distance of its New York office, to travel across the country at his own expense to provide testimony in its Los Angeles office.

In addition, there generally is no limit on the scope of document and information requests that FINRA can issue.[4] For example, a rep may possess confidential medical records regarding a client to whom he sold an annuity (which is not a security). FINRA can demand those records, even if the rep did not conduct any securities business with the client. By further example, it may be a violation of state, federal, or international law or a breach of contract to provide certain confidential documents that a rep possesses by virtue of his non-securities-related business, but FINRA still can requests that those documents be produced.

Further, there is no time limitation on the length of a FINRA inquiry.[5] It is not uncommon for FINRA to investigate matters long after the fact, or to conduct inquiries that can be measured in years, not months. It likewise is not uncommon from FINRA to receive a response to a Rule 8210 request, not communicate with the rep for months or longer, and then continue to pursue the inquiry. Lengthy inquiries can be quite stressful to those under scrutiny, as well as their families.

The potential for abuse is there. And there are plenty of firms and reps that will testify that they have been harassed by FINRA through its seemingly limitless Rule 8210 power.

The Unassailability of Rule 8210

If a rep believes that FINRA is abusing its Rule 8210 powers, he has limited options –none of which provide appropriate due process.

The first option is to complain to FINRA. This can be done through complaints at the district and national levels or to its Office of the Ombudsman. This route leaves a rep at the mercy of FINRA – the very same people who issued the requests (and who feel compelled to defend the actions of their organization). This is not due process.

The second option is to not provide the requested documents and information. This is a very risky route. It requires a rep to put his license on the line to assert that FINRA has overstepped the bounds of Rule 8210. If FINRA determines that it is entitled to the requested documents and information (which presumably will be the case), then it likely will initiate a disciplinary proceeding in its forum, the Office of Hearing Officers (OHO), which can be appealed to another one of its forums, the National Adjudicatory Council (NAC). If those tribunals, and any tribunals to which subsequent appeals are lodged, determine that any of the requested materials should have been provided, the likely result is a bar from the securities industry. Needless to say, this method of “due process” discourages challenges to Rule 8210 requests, gives FINRA a tremendous amount of leverage in any attempt to negotiate a limit to the scope of Rule 8210 requests, and emboldens FINRA to push the boundaries of the Rule.

There is no body, independent or otherwise, from which a rep can seek interlocutory relief from overly broad, unduly burdensome, harassing, or otherwise abusive Rule 8210 requests, without running the risk of being barred from the securities industry. Given the power that FINRA wields through Rule 8210, there should be.

[1] A copy of the paper, entitled “Reforming FINRA,” by David R. Burton, is available here.

[2] I used the term “request” throughout this post, because that is the term that FINRA uses. As one of my colleagues has observed, “demand” is probably the more appropriate nomenclature given the consequence of non-compliance.

[3] The Federal Rules of Civil Procedure limit the number of interrogatories to 25 and the length of a deposition to one day of seven hours, without leave of the court. The Federal Rules of Civil Procedure limit the number and scope of document requests, as well as discovery in general, through relevancy, proportionality, and other requirements.

[4] FINRA usually recognizes common law and statutory privileges, such as the attorney-client privilege.

[5] The period for discovery in a civil proceeding is typically limited by court order. SEC enforcement actions seeking civil penalties are subject to a five-year statute of limitations.


What Else Is New? FINRA Skates Despite “Massive” Failure To Produce Documents

Posted in Discovery, Enforcement, FINRA, Rule 8210, Rule 9251, Uncategorized

Let’s play pretend.  Can you imagine what FINRA would do to a respondent broker-dealer in an Enforcement action that announced on Day Five of the hearing – i.e., during the “final phase” of the hearing – that – whoops! – it had forgotten to produce certain documents that it should have produced eight months before the hearing even started? Documents that would potentially prove FINRA’s case?  And then, after being given a week to determine exactly how many documents it forgot to produce, the respondent announced that, in fact, it was, um, 30,000 emails?  That the failure was the result of an “apparent miscommunication?”  And that in addition to those emails there were another few hundred more that also hadn’t been produced because they were “inadvertently omitted” from an earlier production?

I am speculating, if course, but it’s not difficult to imagine that there would be a permanent bar involved.  Rule 8210, which gives FINRA the power to compel the production of documents and information, is powerful.  The failure to abide by the rule routinely results in permanent bars.  FINRA takes very seriously its right to require member firms and their associated persons to produce whatever documents it feels are necessary to conduct an exam.  Apparently, however, when the shoe is on the other foot, when it is FINRA that fails to produce required documents, a simple apology is good enough to resolve the problem.

How do I know?  Yesterday, FINRA issued an Order in an Enforcement case denying a motion to dismiss that Respondent Stephen Larson filed stemming from FINRA’s “massive” – to quote the Hearing Officer – failure to produce required documents.  These were documents that FINRA should have produced eight months before the hearing.  And there were, as my hypothetical suggests, 30,000 emails, including potentially exculpatory documents.  According to the Hearing Officer, however, this was no big deal.

He started his analysis of whether to sanction FINRA – which could, theoretically, have included a dismissal of the Complaint – by considering FINRA Rule 9251, which “requires Enforcement to make available to a respondent for inspection and copying all documents (subject to various exemptions) prepared or obtained by FINRA staff in connection with the investigation that led to the disciplinary proceeding.”  This sounds an awful lot like the flip-side of Rule 8210, which requires a respondent to produce the equivalent documents to FINRA.  It, too, is a serious, powerful rule.  As the Hearing Officer stated, “[i]t is essential that Enforcement exercise diligence in complying with this obligation, as rule-compliant document production by Enforcement is fundamental to a fair disciplinary proceeding.” He also observed that “under the Code of Procedure’s regulatory scheme, a respondent typically relies substantially on Enforcement’s good faith and diligence in producing documents; in most cases, a respondent will never know what documents Enforcement has withheld.”[1]


Given this, is not surprising that the Hearing Officer called FINRA’s document debacle “disconcerting,” explaining that

  • FINRA utterly blew its Rule 9251 obligations;
  • It violated the terms of the Case Management and Scheduling Order;
  • It missed the production deadline by a whopping eight months;
  • It didn’t acknowledge the production failure until the hearing was nearly over;
  • The volume of missing documents was “staggering”;
  • The production failure “did not result from a single cause, but from a combination of miscommunications, misunderstandings, and other errors”; and
  • The missing documents were potentially exculpatory, but, at a minimum, were relevant to Mr. Larson’s defense.

Despite all this, the Hearing Officer took no action against FINRA.  Nothing.  No dismissal.  No sanction.  Why?  Because he basically concluded that FINRA didn’t intend to screw up, and that it was all an innocent mistake:  “Enforcement [did not] engage in willful misconduct, bad faith, or . . . otherwise act contemptuously.”  Guess what?  When respondents make this same argument in the defense of an 8210 claim, they are laughed off by FINRA.

The Hearing Officer also noted that “Enforcement admitted it made a mistake in not producing the omitted documents,” and deemed this admission to be important to his ruling.  I can assure you, as a respondents’ counsel, FINRA could care less if my client is willing to admit that a “massive,” eight-month-late production was a “mistake.”  The sanction would undoubtedly be harsh; after all, intent is not an element that FINRA needs to prove in an 8210 case.  It would be unheard of to suggest that there would be no ramifications for a respondent who mistakenly failed to produce 30,000 emails, as was the case here for FINRA.

The Hearing Officer also put a lot of stock in the fact that he granted a four-month continuance in the hearing to allow Mr. Larson to review the late-produced documents, asserting that somehow this “eliminated, or at least substantially mitigated” any prejudice to Mr. Larson.  At best, this is an arguable point, not nearly the dispositive issue it is made out to be.  Prejudice is in the eyes of the beholder, and I doubt Mr. Larson would concur that he was not prejudiced by this delay in the hearing.

If anyone ever has any doubt that the deck is stacked against you in a FINRA Enforcement case, or that FINRA rules only work to the detriment of the members, just read this Order.  FINRA completely blew its deadlines by months, omitted tens of thousands of documents that should have been produced, and yet, because it was a mistake and not intentional, and because it admitted its mistake, the Hearing Officer essentially concluded “no harm, no foul.”  Respectfully, I humbly suggest that if the roles had been reversed, Mr. Larson would never have received the same treatment.  And there are dozens and dozens of former reps who have been barred for 8210 violations involving way fewer documents, way less delay, with an equal lack of intent, who will attest to this.

[1] I blogged – here – about the unfairness of Rule 9251 – that a respondent is essentially forced to rely on representations by FINRA that it has produced all the required documents – a couple of years ago.

Don’t Let The Revolving Door Hit You In The Butt

Posted in FINRA, Rule 9141, SEC

There has been a lot of talk, especially given the relatively recent change in the Executive Branch in Washington, about the problem with the “revolving door,” a concept so wide in scope that it actually has its own Wikipedia page.  It is defined to be the “movement of personnel between roles as legislators and regulators and the industries affected by the legislation and regulation.” It happens all the time in broker-dealer world, especially with FINRA and the SEC, where lawyers move back and forth between private practice and the regulator.

The examples are rampant.  Look no further than the current and former Chairmen of the SEC, Jay Clayton and Mary Jo White.  Both came from law firms before taking the reins at the SEC, and Ms. White is now back in the defense business again.  Mary Schapiro, former head of FINRA and then the SEC, is now a consultant to the industry.  Heck, look at me, I started in private practice, worked at NASD for a decade or so, and then returned to my current defense work 13 years ago.  Of course, unlike those others, I was never an officer of NASD, so my career path back to private practice is a bit less interesting, and my thoughts on things of much less import.

FINRA passed a rule about it a few years, even if it is rather a bit tepid in its scope, prompting immediate criticism. Conduct Rule 9141(c), subtitled the “One Year Revolving Door Restriction,” provides that “[n]o former officer of FINRA shall, within a period of one year immediately after termination of employment with FINRA, make an appearance before an adjudicator on behalf of any other person under the Rule 9000 Series.”

The problem with the concept of the revolving door is that it is, basically, unseemly. It is just amazing to listen to some former senior ranking officer of a securities regulator stake out a position that, prior to going through the revolving door, would never have been uttered aloud.  Judge for yourself.  The latest issue of Investment Advisor contains a column featuring comments from Brad Bennett, who recently rejoined Baker Botts after departing from his former job as head of FINRA’s Enforcement Department, a position proudly featured (and rightly so) in his firm bio.  According to the article, when asked about the regulatory burdens that broker-dealers face, Mr. Bennett said these burdens “have not been reduced. It is difficult to comply with the broad array of compliance responsibilities if a broker-dealer does not have scale. . . .  There is no doubt that the regulatory burden is more manageable from a business perspective if you are an investment advisor.”

I am unfamiliar with any remarks that Mr. Bennett – or any other FINRA officer – ever made (at least while still employed by FINRA) (a) admitting that it is hard for broker-dealers to comply with regulations, and (b) suggesting that small firms might be better off leaving FINRA and becoming investment advisors (thus, removing themselves from FINRA’s jurisdiction). The funny part about this is that Mr. Bennett is telling the truth.  I imagine that my clients and I are in practically universal agreement with his new (at least newly voiced0 viewpoint on regulation and compliance.  The problem is, as I suggested, where was this sentiment while he ran Enforcement?  Where was the concession that compliance these days is hard, hard, hard?  Where was the sympathetic ear to pleas of mercy when there was no evidence of intent, no customer harm?  Where was anything other than the heavy hand of Enforcement?  It simply wasn’t there.

I have no doubt that Mr. Bennett, and Ms. White, and Ms. Schapiro, and all the other former officers of FINRA and the SEC are doing just great in their new gigs, and that clients will continue to flock to them to provide the sort of access to their former colleagues at the highest levels of FINRA and the SEC that can often work wonders in resolving thorny problems. And, truly, I wish them all the best.  But, that does not change the fact that the revolving door problem exists as much as it ever has, and that whatever rules or policies have been implemented to address the problem have been ineffective.

Open The Pod Bay Doors: Computers Are Here To Take Your Job

Posted in Compliance, FINRA, Fintech

I read recently that in the not-too-distant future, the practice of law by actual human beings will become a rarity, as computers will take over those jobs, because they will be able to do the work better, cheaper and faster.  Speaking as a lawyer, I find that to be a somewhat troubling prospect.  I mean, this is what puts food on my table and all.  So, given a choice, I would clearly vote “no” on this.

Well, yesterday, I read that all of you compliance personnel will eventually be joining me on the unemployment line. IBM announced that Watson, its super-amazing Super Computer, is now providing Watson Financial Services.  Now you, too, can be replaced by a machine that does your job better and faster.  (I don’t know about cheaper!)  According to IBM, Watson can “[t]ransform your regulatory compliance and surveillance programs by deploying cognitive capabilities that drive the identification and understanding of regulatory requirements, improve your efficiency at addressing compliance requirements, while reducing the risk of misconduct.”

Holy cats, that sounds good. It is all too common in my experience that one of my clients get into difficulty with a regulator (and sometimes with a customer, as well) not because the firm had a lousy supervisory system or deficient written supervisory procedures, but due to good old human error.  Someone appropriately delegated some supervisory function forgets to do it.  Or does it but fails to document it.  Then you get, essentially, what HAL 9000 said in 2001: A Space Odyssey:  “I know I’ve made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal.  I’ve still got the greatest enthusiasm and confidence in the mission.”  No matter how well intended, and even in the absence of any demonstrable customer harm, human errors like this routinely result is regulatory scrutiny, and possible disciplinary action.

If there is a computer out there that can reduce, or, better, eliminate the possibility of errors like this, I am all in favor it.

The harder question concerns the other kind of thing that gets broker and broker-dealers in trouble: the exercise of subjective judgment. Most FINRA rules (but hardly all) have a reasonableness standard, including most notably the supervision rules.  To be in compliance, all one needs to be able to demonstrate is that he or she acted reasonably.  That means, necessarily, that while errors may not be encouraged, or welcomed, they can be tolerated, at least to a degree.

There are tons of events that occur every single day that call for the exercise of some subjective determination. For example, does this penny stock trade constitute a “red flag” for AML purposes?  Is this structured product suitable for that particular customer?  Would the addition of this business line constitute a material change requiring the filing of a 1017?  Is this letter from the customer a “complaint” that requires disclosure on the RR’s Form U-4.  You get the picture.  Some clients do a very good job of making good, reasoned judgments, based on all pertinent facts and circumstances.  But, sadly, some don’t.  And even if they think they do, they do a poor job of memorializing the analysis and the reasons on which the ultimate conclusion was based.

What I don’t know is whether a computer, no matter how Super it may be, can really be relied upon to make, or even help make, the sort of subjective decisions that compliance and supervisory personnel face every day. But, I feel like as a lawyer, I make a million judgment calls a day, and if a computer is eventually going to take my job away because it can make those calls better than me, then I suppose it is possible that the same is true of anyone who works in the area of securities regulation and compliance.

This is clearly a very interesting development, and merits our attention going forward to see if, indeed, IBM has created a better mousetrap. I suppose that it is only fitting that the press release came the same week that Robert Cook announced FINRA’s Innovation Outreach Initiative, a program that, according to the press release, will “foster an ongoing dialogue with the securities industry that will help FINRA better understand financial technology (fintech) innovations and their impact on the industry.”  The impact that technological innovations will have on the securities industry is obvious; it is just a matter of how much and when, not if.

As long as this doesn’t turn into HAL 9000, or Skynet, or Nomad.  If that happens, please beam me up.

Rogue Brokers: The Numbers Do Not Tell The Whole Story

Posted in FINRA, Registered Representative, Rogue rep

Not too long ago, I blogged a couple of times about the amount of attention that is suddenly being paid to the number of registered representatives with disciplinary histories working for FINRA member firms, i.e., the so-called recidivists (who used to be called “rogue reps”).  Among the complaints I voiced was the fact that while FINRA is, and has always been, well aware of this fact, it is seemingly acting as if this is somehow a newsflash, something just discovered that needs to be dealt with right away!

Well, today I ran across a fascinating article in Reuters that not only backs up my argument, but does so based on its own analysis of empirical data drawn directly from BrokerCheck.

What Reuters did was identify particular 12 disclosure events (of the 23 they say potentially appear in Brokercheck) – supposedly the 12 “most serious” disclosures – and then see how many RRs at each FINRA member firm have such disclosures on their CRD records. I cannot imagine the amount of work that this endeavor took, since, as the article points out, it is not possible to run a “bulk” search in BrokerCheck, but I am thankful for the coders that managed to pull it off.

According to their results, and assuming that they are correct, there are a lot of broker-dealers out there with a lot of RRs with disclosures, all still merrily working in the industry. Indeed, based on its study of BDs with 20 or more RRs with disclosures made between 2000 and 2015, Reuters found a total of 48 firms that had 30% or more of their RRs with at least one of the 12 disclosures; at 14 of those firms over 50% of the RRs had disclosures.

Now, I am not saying that each of those 48 firms should be branded a “bad” firm; indeed, several are my clients, and I will be the first one to attest that they are not at all bad, and that hiring an RR with a mark on his record is not something should, in isolation, invite regulatory scrutiny. The current law permits individuals with disclosure histories to continue to work in the industry, and broker-dealers are free to hire them.

That underscores the point I made in my earlier blog posts: FINRA knows who these firms are. Not surprisingly, because FINRA owns the database that Reuters examined, FINRA is already well aware of its contents, including those firms that hire a high percentage of RRs with disclosures.  Interestingly, FINRA admitted as much to Reuters.  The article quotes Susan Axelrod, FINRA’s executive vice president of regulatory operations, as having said, “Let’s just say those are not new names to us,” when confronted with a list of the firms identified by Reuters.

But, armed with that knowledge, FINRA still, largely, has does nothing that changes the fact that having a disclosure event, even multiple disclosures, simply does not prevent someone from working for a broker-dealer. At a speech he gave this very week, Robert Cook, FINRA’s CEO, addressed this subject:

We are also asked why firms or individuals with a regulatory history are allowed to remain in the industry in the first place. On the one hand, I share the desire to be aggressive in this space and to address recidivist misconduct promptly—and we need to make sure we are doing all we can.  On the other hand, like other regulators, FINRA does not—and should not—have unfettered discretion. Formal action to bar or suspend a broker requires satisfying procedural safeguards established by federal law and FINRA rules to prevent enforcement overreach by regulators (including FINRA) and to protect the rights of brokers to engage in business unless proven guilty of serious misconduct. Those safeguards include the right to defend oneself before a hearing panel and the right to appeal to FINRA’s National Adjudicatory Council, the SEC, and ultimately the federal courts.

In addition, federal law and regulations define the types of misconduct that presumptively disqualify a broker from associating with a firm, and also govern the standards and procedures FINRA must follow when a broker who was found to have engaged in such misconduct applies to re-enter the industry. These requirements, which are complex and beyond what I can address today, impose significant constraints on FINRA.   I do not mean to profess that we are perfect—we must continually work to improve our programs within these constraints to protect investors, while doing so in a manner that is transparent and fair to those involved.  A critical factor in ensuring that we are meeting this objective is the comprehensive SEC oversight that occurs with respect to our regulatory programs, including the standards and processes governing our examination, enforcement, sanctions, and adjudication activities.

The bottom line comes down to this. First, data simply do not tell the whole story.  Just because a firm has a number of RRs with “dings” on their record is not a reason in and of itself to conclude, or even suggest, that the firm represents a particular threat to the investing public.  FINRA correctly recognizes this.  Second, FINRA’s hands are tied when it comes to its ability to address quickly those firms that it does determine to be bad.  In FINRA world, as elsewhere, people (and firms) are presumed to be innocent.  FINRA has the burden to prove misconduct, and that is not always easy, or quick, to accomplish.

Finally, regardless of whatever significance you ascribe to the data the Reuters analyzed, FINRA should quit acting like the sky is falling. This is, as I have said, old news.  Perhaps it is new to Senator Elizabeth Warren, but rather than scrambling to do something – anything – to appease her and others in Congress critical of the job FINRA is doing, FINRA ought instead to educate them about the rules, the regulations, the laws that govern broker-dealers, none of which permit the sort of mass, summary revocations that the politicians seem to be contemplating.  It is time for FINRA to stand up for its members – the overwhelming majority of whom are, in fact, good – and defend them for a change, instead of rushing to jump on the recidivist bandwagon.

The Financial Choice Act — Much Ado About Nothing

Posted in Dodd Frank

While most of DC was watching the Comey hearing, the House of Representatives passed the Financial CHOICE Act, which would significantly alter the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank created the Consumer Financial Protection Bureau (CFPB).

The Financial CHOICE Act passed the House with a vote of 233 to 186; a vote straight down party lines with the exception of one Republican who voted against the bill. However, there is little chance of the bill surviving a Democratic filibuster in the Senate. To survive a filibuster, it takes 60 votes to proceed to a vote on a bill. Currently, the GOP has 52 seats in the Senate, which would require 8 Democratic Senators to vote with the GOP. Rather than face these numbers, the Senate will likely draft a companion bill, with the same intent to reform Dodd-Frank.

As passed in the House, the CHOICE Act seeks to reform the Dodd-Frank Act, but does not completely change the consumer protection landscape. Instead, the Financial Choice Act seeks to limit regulations aimed at supervising financial institutions. Specifically the CHOICE Act looks to provide an alternative to banks who maintain higher levels of capital, thus avoiding additional regulations. The Dodd-Frank Act supervised financial institutions, with particular focus on banks deemed “Too Big to Fail” and non-bank financial institutions who were deemed as “systematically important.” Further, it would ease some of the regulations that currently apply to smaller financial institutions, such as credit unions and community banks. The CHOICE Act would also repeal the Volcker Rule and the Fiduciary Rule, which would require retirement advisors to put their clients’ interests before their own.

As passed by the House, the CHOICE Act also restructures the CFPB from a bureau to a consumer law enforcement agency, subject to the congressional appropriations process. This change would also permit the President to fire the head of the CFPB at any time and without reason. The constitutionality of a bureau with a director who can only be removed for cause was one of the key issues in the PHH Case, which was argued to the U.S. Court of Appeals for the D.C. Circuit on May 24th. If the director of the CFPB or a consumer law enforcement agency can be removed without cause, the director would follow the policies and priorities of the President, which could change every election cycle.

Until the Senate drafts and votes on a companion bill or votes on the CHOICE Act, Dodd-Frank and all its regulations remain. With the current makeup of the Senate, it remains risky to attempt to predict the outcome of reform efforts.

FINRA Provides The Blueprint For Monitoring Outside Business Activities

Posted in Disciplinary Process, Disclosure, Enforcement, FINRA, Outside business activities

Outside business activities are in the news. In Reg Notice 17-20, FINRA announced that it was seeking comments in an effort to learn whether or not the existing rules governing OBAs are effective.  (The comment period is open until late June, so if you have strong feelings on the subject, now is the time to speak up!)  It’s an interesting question, but, in my long experience, the effectiveness of the rules will always be dubious for the simple reason that it is impossible to prevent undisclosed outside business activities, or, worse, undisclosed private securities transactions.  It doesn’t matter how many times a firm asks its reps to make those disclosures, how dire the potential consequences for not making those disclosures, how many Enforcement cases FINRA brings, or how simple the rule is to understand, the fact is, reps have been failing to disclose OBAs since, well, forever.

I can understand why, however. In some (rare) instances, it is because somehow, despite being peppered with constant requests to disclose, beginning with the initial hiring process, a rep may fail to appreciate that something he is doing away from the firm actually constitutes an OBA.  In most cases, however, a failure to disclose is as result of the fact that the rep simply doesn’t want his firm to know what he’s doing.

Given that OBAs are impossible to prevent, it is especially frustrating when FINRA concludes – and it happens often enough – that not only did a rep violate the OBA rule, but the broker-dealer with which the rep is associated is also guilty, specifically for not having done enough to detect the undisclosed OBA. The operative question is, what is enough?

Today, in a FINRA Enforcement decision issued by a hearing panel against Jim Seol,[1] FINRA was kind enough to answer that question. While Mr. Seol was permanently barred for not disclosing his extensive outside business activities, his broker-dealer – Ameriprise Financial Services, Inc. – was not only not named as a co-respondent, but was essentially commended for the scope of the efforts it took to try to get Mr. Seol to disclose his OBAs.  The hearing panel concluded that because Mr. Seol failed to disclose his OBAs after being subjected to everything Ameriprise did, his failure had to be intentional, thus meriting the bar.

What did Ameriprise did here serves as excellent guidance to understanding just how far a broker-dealer needs to go to satisfy FINRA that its efforts to monitor OBAs are effective. Let’s look at them.

  • As one might expect, under Ameriprise policy, Mr. Seol was required to disclose and obtain prior approval from the firm before commencing any outside business activities, including any business ownership or business appointment, regardless of whether compensation was being received.
  • To that end, like most firms, Ameriprise had Mr. Seol execute an Annual Compliance Questionnaire asking about his OBA. Here, Mr. Seol failed to disclose his OBA in February 2012, February 2013, and February 2014.
  • Beginning in at least 2011, Mr. Seol’s supervisor at Ameriprise conducted annual site inspections of Mr. Seol’s office. These in-person site inspections included a detailed review of the operation, function, and management of Mr. Seol’s office.
  • During each site inspection, the supervisor conducted an extended interview with Mr. Seol to understand his business and any issues that may have impacted the operation of the branch.
  • During the interviews, the supervisor reviewed with Mr. Seol the annual attestations he
  • submitted to Ameriprise.
  • Among the attestations reviewed was Mr. Seol’s representation that he had no outside business activities.
  • The supervisor made sure Mr. Seol had “a good understanding” of what the question called for, and confirmed that the representation was accurate.
  • The supervisor “educate[d]” Mr. Seol, ensuring that he was “familiar with what needs to be disclosed – if you have any businesses, if you have any outside activities like being on a board.”
  • During the interview, the supervisor “would not only ask if he was involved in any kind of outside [activities],” he would also inquire as to “how [he] was making his money, what’s he doing, is he focusing in on his practice, has he been out of the office.
  • In addition to these annual visits by Mr. Seol’s supervisor, the firm’s compliance department also routinely inspected Mr. Seol’s branch office. In 2012, 2013, and again in 2014, a compliance inspector traveled to Mr. Seol’s office for an in-person review.
  • Importantly, some of these were unannounced, and included a detailed and careful review of all aspects of the operation and function of Mr. Seol’s office.
  • In her interviews with Mr. Seol, the compliance inspector confirmed that he had access to the firm’s compliance manual and was familiar with the firm’s policies.
  • The inspector confirmed that Mr. Seol understood that an outside business activity was required to be disclosed whether or not he was being compensated for that activity.
  • She explained that both Ameriprise policy and FINRA rules required him to disclose and obtain prior approval for all OBAs.
  • She also reminded Mr. Seol about his obligation to update his Form U4 to include any outside business activities.

Despite all that, Mr. Seol nevertheless falsely represented to Ameriprise that he had no outside business activities, over and over again.

Ameriprise deserves commendation for the amount of effort it expended in reminding Mr. Seol of his obligations regarding OBAs, and working to ensure that it gave him every opportunity to meet them. That effort was neither cheap, quick, nor easy.  But, that is the kind of supervision that FINRA expects to see from member firms.  I’d say that Ameriprise has provided a blueprint for everyone to follow to avoid being ensnared in an Enforcement action when an RR conceals an OBA. Ignore this lesson at your own peril.


[1] The decision is subject to being appealed by Mr. Seol.

How The Fiduciary Rule May Impact Outside Business Activities

Posted in annuities, Fiduciary duty, Fiduciary Rule, Fiduciary Standard

Because fixed annuities and fixed life insurance are not securities, many broker-dealers treat the sales of these products by their registered reps as outside business activities. In that event, there is no obligation by the BD to supervise those sales, and they can be run directly with the issuing company and not through the broker-dealer.  While this may mean the firm loses out on some[1] or all of the commissions the RRs earn on those sales, that fact is tempered by the elimination of a whole host of oversight obligations by the BD which would be time-consuming and expensive.  Perhaps even more important, by not having any supervisory obligations — obligations which could, at least theoretically, subject the firm to potential liability in the event a customer claimed he or she was damaged as a result of a firm’s failure to meet them — the firm minimizes its risks on fixed annuity sales.

Well, this approach may not be viable much longer. Among the requirements of the DOL’s new fiduciary rule – effective on January 1, 2018, not this Friday, happily (and assuming that the President doesn’t do something to delay, or simply eliminate, the institution of the rule) – if a firm wants to charge commissions on the sale of these products is the execution of a contract between the customers and a “financial institution.”  In that agreement, the financial institution must represent that it is a fiduciary, and that it is acting in the customer’s best interest, among other things.

Going forward, then, broker-dealers which up to now have allowed sales of these fixed products to be handled as OBAs may be forced to sign off as the “financial institution” if they want to continue to offer these products. The bad news?  They won’t be able to treat them as OBAs anymore, and will have to take on the many supervisory obligations relating to these sales that they formerly disclaimed.  The good news?  The BDs will be able to get paid for that supervisory work through a split of the commissions paid to the selling rep.

So, the question for broker-dealers is whether this additional revenue will be worth (1) the costs associated with these new supervisory efforts, and (2) the risk (of potential liability for not supervising adequately) these sales present. Frankly, there may not be any choice involved, if BDs want to continue selling these popular products and charging commissions for doing so.

An additional concern, although it is difficult to gauge how big of a deal it might be, is how the sales force may react if, going forward, they will now have to split commissions with the BD, commissions that, in most cases, they presently keep entirely for themselves. I imagine that most reps will have no problem sharing commissions if it means that they can rely on their BD to backstop their sales efforts, but I cannot say for sure that this will be the universal reaction.

As the clock ticks down to the effective date of the fiduciary rule, firms large and small are going to have to take a very close look at their existing business model, including products that, like fixed annuities, aren’t even run through the firm. Regulators, historically, have been less than forgiving regarding compliance with new rules, no matter how significant a change they represent, when such rules have been the subject of intense public comment, as has clearly been the case with the fiduciary rule.  “I didn’t realize” simply won’t cut it as an excuse for failure to meet the new requirements.

[1] Even when these non-securities are sold as OBAs, BDs can still get paid for the efforts they make, even though those efforts are not, technically speaking, supervisory in nature.  But, the lion’s share of the sales commissions go to the selling reps.