As the Fourth Circuit Court of Appeals made clear a week or so ago, serving as a FINRA arbitrator seems rather apropos in a world where the score is not kept in kids’ baseball games (to avoid there being any “losers”), and where adults receive medallions celebrating the fact that they are “participants” in distance races, regardless of where they happen to finish, because merely trying is good enough.

With that in mind, pity poor Interactive Brokers: at almost the same time that it simultaneously settled three AML cases with the SEC, FINRA and the CFTC, respectively – to the collective tune of over $38 million – its successful vacatur of a $1 million arbitration award against it – an award that a Federal District Judge called “perplexing” and “baffling” – was reversed on appeal by a panel of the Fourth Circuit in a 2-1 decision, based on the application of the trying-is-good-enough standard.  Not surprisingly, it wasn’t just the claimants who argued that arbitrators are free to ignore clear legal precedent, as they were joined in their appeal by several amici, consisting of the usual host of entities that complain that the entire arbitration system is somehow unfairly stacked against customers, including PIABA and the investor clinics at four law schools (some of which were funded with grants from FINRA).  Troublesome law getting in the way of your recovery, like, say, a statute of limitations?  Just ignore it!  Focus instead on, um, fairness, yeah, that’s the ticket.

But I digress.  The facts here – as taken from the Fourth Circuit opinion – were not in dispute:

  • Claimants had brokerage accounts at Interactive
  • The accounts were margin accounts
  • The investments in those accounts were selected not by Interactive, but by a third-party money manager – who, sadly but predictably, is judgment proof – with whom claimants separately contracted
  • Among other things, the third-party manager invested the claimants in an exchange-traded note, iPath S&P 500 VIX Short-Term Futures (“VXX”), which is tied to the market’s “fear index,” meaning the price fluctuates with the stability of the market
  • Specifically, the third-party manager had claimants sell naked call options for VXX. If the market remained stable, the price of VXX would remain stable, the options would not be exercised, and the strategy would make money as claimants retained the premiums they received when they sold the calls. If, however, the market became volatile, the price of VXX would increase, the options would be exercised, and the strategy would lose money
  • FINRA Rule 4210(g) prohibits trades of certain high-risk securities in portfolio margin accounts, including trades of VXX
  • For a time, claimants made significant profit in their accounts, including from the VXX naked call sale strategy
  • On August 24, 2015, however, the Dow Jones Industrial Average underwent what was then the largest one-day drop in its history, causing claimants’ accounts to drop by 80%
  • Because the value of the accounts fell below requirements for the amount needed to maintain a portfolio margin account, Interactive began auto-liquidating the accounts, pursuant to its contract with claimants
  • Although Interactive sold everything in the accounts it could not recoup the full loss. Ultimately, claimants owed Interactive $384,400 for the unpaid debit balance.

Claimants won the arbitration, and Interactive filed a motion to vacate the award with the Federal Court in Virginia, essentially arguing that the arbitration panel “manifestly disregarded” the law.  In short, Interactive argued this (almost) syllogism:

  • It is undisputed that the controlling law provides there is no private right of action for violation of FINRA rules, including Rule 4210(g)
  • The basis for the panel’s decision that claimants won was that Interactive violated FINRA Rule 4210(g) by allowing claimants to trade VXX in their margin accounts
  • Because the panel was legally precluded from basing its decision on a violation of a FINRA rule, and was aware of that fact, it was evident that the panel knowingly elected to disregard controlling law, a concept known as “manifest disregard,” which certain circuits, including the Fourth, recognize as a basis for vacating arbitration awards

The District Court wholeheartedly agreed with Interactive.  It scrutinized the award of damages, but could find no legal basis for it.  Accordingly, the Court remanded the case back to the hearing panel to explain how it conjured up the damages.

The panel then proceeded to amend the award, in an effort to address the Court’s concern.

Not surprisingly, Interactive went back to the Court, renewing its argument that the award was not permitted under controlling law.  Once again, the District Court agreed with Interactive, granting its motion to vacate the award in favor of the claimants, and remanding Interactive’s counterclaim back to a new hearing panel this time.[1]  In what has become one of my favorite lines from any court, the judge who heard the case apparently said during oral argument that he was “just astounded at the jackleg operation that I see here.  I don’t know why anybody would agree to have these people [the arbitrators] do anything,” based on his determination that because the panel based its finding that Interactive was liable to the claimants on FINRA Rule 4210, it constituted “a manifest disregard of the law because the law is clear that there is no private right of action to enforce FINRA rules.”  From there, claimants – aided by their friends at PIABA, et al. – appealed.

As the title of this post makes clear, the Fourth Circuit – in a 2-1 split decision – saw things differently.  First, it concluded that it was not necessarily true that the panel based the award solely on its conclusion that Interactive violated Rule 4210(g) (this despite the fact that the panel, in its amended award, specifically explained that it denied Interactive’s counterclaim because of a perceived Rule 4210(g) violation, noting that Interactive’s “position that the Panel should not enforce a FINRA rule amounts to saying that FINRA should provide an opportunity for investors to commit financial suicide by investing in securities that are ineligible for inclusion in a portfolio margin account. To ignore a FINRA rule by the Panel would defeat the purpose of FINRA”).

Second, after observing that the panel “simply did not state which cause of action provided the basis of its award to the” claimants, the appeals court proceeded to speculate that it was possible the award was based on a breach of contract theory.  Specifically, like probably every customer agreement ever, the claimants’ agreements recited that “All transactions are subject to rules and policies of relevant markets and clearinghouses, and applicable laws and regulations.”  The Court then noted that “[t]his, of course, includes the publicly available FINRA rules,” including Rule 4210(g).  Thus, “the clause could well be read as incorporating the FINRA rules, making a violation of the rules a breach of the parties’ contracts.”

So…even though a claim for violation of FINRA rules cannot be brought by a customer – because there is no private right of action – the Fourth Circuit found a back door for a customer to do just that, by calling it, instead, a breach of contract.

Why did the Court go through such mental contortions to find a way not to vacate the award?  No need to guess, as the Court supplied the answer at the end of its decision: “Without appropriate deference to arbitrators, the costs of vindicating rights drastically increase, threatening to foreclose yet another avenue of relief for ordinary consumers who routinely enter contracts with mandatory arbitration provisions.”

Where does this leave us?  Arbitrators are happy, since they don’t have to worry so much about applying that pesky law to the facts.  As the Court recognized, its job was “to determine only whether the arbitrator did his job – not whether he did it well, correctly, or reasonably, but simply whether he did it.”  (Ah, here’s your “participant” award!)  Claimants – their lawyers, actually – are happy, because they are newly emboldened to encourage panels to ignore clear, binding law.  The only ones who are not happy are the respondents (and their counsel, of course), who are forced to reckon with the fact that arbitrations are, basically, free-for-alls, where the law plays only a minor role in the outcome.

[1] The court wrote that a new panel was necessary due to the original panel’s “rather flagrant disregard of settled law.”

Carlos Legaspy is a respondent in a FINRA arbitration that was scheduled to go to hearing in August.  As with all other FINRA cases, it was subject to a sweeping administrative decision by FINRA to postpone all in-person hearings through the summer, due to the pandemic.  As I have noted before, that decision imbued hearing panels with the power to compel the parties to conduct the hearing by Zoom, even over the parties’ objections.  And that is exactly what the panel did in Mr. Legaspy’s case, it ordered that the final evidentiary hearing take place in August, but by Zoom.

Displeased by that ruling, Mr. Legaspy went to federal court in Illinois to challenge it.  In an Order issued last week – and summarily affirmed by the Seventh Circuit Court of Appeals two day later – the Court denied Mr. Legaspy’s request for a TRO enjoining FINRA from proceeding with the Zoom hearing.  To my knowledge, this is the first ruling by any court on the legitimacy of FINRA’s delegation to hearing panels of the authority to require that hearings take place over Zoom, rather than in-person.  Given that this decision is likely to become precedent in other cases, it is worth reviewing the Court’s logic.

Mr. Legaspy made a number of arguments, all of which were rejected.

First, he argued that FINRA breached two separate agreements, the Uniform Submission Agreement (“USA”) and the Code of Arbitration Procedure. Regarding the USA, Mr. Legaspy relied on language that provides “in the event a hearing is necessary, such hearing shall be held at a time and place as may be designated by the Director of FINRA” and that “the arbitration will be conducted in accordance with the FINRA Code of Arbitration Procedure.”  According to Mr. Legaspy, this language requires that the hearing happen in some physical “place,” not via Zoom.  Consistent with that argument, he also took the same view of the word “location” as used in the Code of Arbitration Procedure, specifically, Rule 12213(a):  “The Director will decide which of FINRA’s hearing locations will be the hearing location for the arbitration.” The Court had answers to these arguments:

  • First, and right out of first-year Contracts class at law school, the judge observed that FINRA is not a party to the USA, and, thus, is incapable of breaching it.
  • Second, the Court disagreed that either “place” or “location” necessarily means a physical location. According to the Court, “the parties, witnesses, and arbitrators are still ‘located’ somewhere in a remote proceeding, it is simply not all the same location.”  The Court also dismissed Mr. Legaspy’s position that “proceedings cannot be remote because parties are entitled to ‘attend all hearings’ under Rule 12602(a)” by noting that “he may still ‘attend’ the hearing remotely, just as he did for the telephonic temporary restraining order hearing in this court.”

Second, Mr. Legaspy argued that FINRA had denied him due process, but, because FINRA is not a “state actor,” it has no obligation under the Fifth Amendment to provide due process.

Next, Mr. Legaspy urged that the Zoom hearing would “be cumbersome and procedurally irregular” because:

  • the Claimants are from Argentina and will require an interpreter;
  • there are dozens of witnesses and hundreds of documents that would have to be shared remotely; and
  • by the time the hearing is over, he will have spent so much on attorneys’ fees that he will have exhausted his insurance coverage.

None of these convinced the Court.  In what is really the heart of the Order, the Court dismissed all these arguments:

Legaspy – who bears the burden of persuasion – cites no evidence that defenses cannot be presented remotely.  He thus pits his conjecture against this court’s experience holding several remote evidentiary hearings since the pandemic began (once with an interpreter), all of which permitted the parties to air their claims and defenses fully. Remote hearings are admittedly clunkier than in-person hearings but in no way prevent parties from presenting claims or defenses.  Moreover, the court sees no reason why the Claimants would fare better than the respondent in a remote hearing.  The Claimants will have the burden of proof in the arbitration; if anything, the logistical challenges of a remote hearing is more likely to harm them.  Legaspy has established, at most, that he would prefer not to arbitrate remotely, not that remote proceedings make it more likely that he will suffer any harms.

Finally, the Court concluded that the “balance of equities” tilts against Mr. Legaspy.  First, it held that “an order holding that FINRA cannot conduct hearings remotely would force it to choose between either holding in-person hearings that expose the arbitrators, Claimants, Legaspy, [the other parties], and witnesses to COVID-19, or indefinitely delaying its hearings, . . . because it is not clear when FINRA will be able to hold in-person hearings again, given the uncertainty around the pandemic.”  In light of Mr. Legaspy’s inability to articulate how a Zoom hearing would prevent him from fairly defending himself, the Court seemingly had no choice but to deny the request for the TRO.[1]

This is one decision by one federal judge, and by a judge whose own experiences with virtual hearings seem to have been positive.  Conceivably, another judge in another District with different experiences might have come to a different conclusion.  But that would be speculation, and we have what have here.  In light of the fact that no can identify a date by which time in-person hearings can be conducted safely, the need of FINRA to give claimants a chance to try and recover their losses, and the lack of any solid evidence that Zoom hearings are more than merely “clunkier” than in-person hearings, as respondents’ counsel, I am preparing my clients for what this decision suggests may be the inevitable: that we will be defending cases sitting in front of our computers, not is some smelly hotel conference room.


[1] The Court was also unhappy that Mr. Legaspy waited until what was essentially the last minute to file for the TRO, even though the hearing panel had ordered the Zoom hearing almost two full months earlier.

For the third year, FINRA has published its now-annual (apparently) statistical accounting of its membership and the registered representatives who work for those firms.  I went back and looked the blogs I posted after the 2019 report and the 2018 report, and, predictably (and somewhat sadly), the same trends continued last year as I previously observed:

  • The number of BDs continues to decline
  • The number of small BDs continues to decline even more precipitously
  • The number of IAs continues to increase

Let’s take a quick look at the numbers.

Number of BDs.  Remarkably, for what is now the 14th consecutive year, the total number of BDs dropped.  According to the chart provided in the report, from 2005 – the first year for which data is included – FINRA has lost 1,589 member firms, a drop of over 31%.  Perhaps not surprisingly, the total number of registered representatives has declined for the fourth year in a row.

Number of small firms.  While the net number of total FINRA member firms only dropped by 90 from the previous year, it is noteworthy that, in fact, the number of small firms actually dropped by 91.  (That number was offset by a slight increase in the number of mid-size firms, which is why the total is actually slightly less than the total for small firms.)  This marks the fourth consecutive year in which the number of small firms has gone down.  With that said, the overwhelming majority of FINRA members are small, almost 90% of the total (at least based on FINRA’s definition of “small.”)[1]

Number of IAs.  FINRA breaks firms down into three categories: BD-only firms, IA-only firms, and dually-registered firms.  According to the data,

  • The number of BD-only firms dropped for the ninth consecutive year
  • The number dually registered firms dropped for the ninth consecutive year
  • The number of IA-only firms increased for the ninth consecutive year

Consistent with these data, the number of BD-only registered representatives dropped again, while the number of IA-only and dually-registered registered representatives have both increased.  Again.

I am not sure what else to say anymore, after being shown essentially the same picture three years in a row.  The slow but steady reduction of BDs, the rise of IAs, and the particularly troubling demise of small BDs.  If FINRA is interested in stopping any of this from happening, it sure hasn’t provided any evidence of such.  It is tempting to draw, and frankly, pretty hard to argue with, the more obvious conclusion, which is that these figures are actually consistent with FINRA’s desires.  If that’s true, then it is yet one more sad day for the industry.

[1] Once again, while FINRA disclosed the total revenue for all member firms, it refused to break that down by firm size.  It is my opinion, again, that the reason for this is that it would show all-too-clearly that notwithstanding the fact that most firms are small, the industry’s revenues – and FINRA’s, as well – principally come from just a handful of big firms.  By keeping this data secret, FINRA can continue to act as if no one firm is more important than any other.

Right after I posted this, FINRA announced a third AML settlement, this time with Interactive Brokers.  It was no small deal: it came with a $15 million fine and an obligation to retain an independent consultant.  (In addition to the FINRA AWC, Interactive simultaneously entered into settlements with the SEC — with another $11.5 million fine — and the CFTC — with its own $11.5 million fine.)  According to FINRA’s Press Release, Interactive “did not reasonably surveil, detect, and report many instances of suspicious activity that were Ponzi schemes, market manipulation schemes, and other misconduct.”  Specifically, FINRA found that

  • Interactive Brokers did not reasonably surveil hundreds of millions of dollars of its customers’ wire transfers for money laundering concerns. Those wires included millions of dollars of third-party deposits into customers’ accounts from countries recognized as “high risk” by U.S. and international AML agencies.
  • Interactive Brokers did not reasonably investigate suspicious activity when it found it because it lacked sufficient personnel and a reasonably designed case management system. Even after a compliance manager at the firm warned his supervisor that “we are chronically understaffed” and “struggling to review reports in a timely manner,” it took Interactive Brokers years to materially increase its AML staffing or augment its AML systems.
  • Interactive Brokers failed to establish and implement policies, procedures, and internal controls reasonably designed to cause the reporting of suspicious transactions as required by the Bank Secrecy Act (BSA). In certain instances, the firm’s AML staff identified suspicious conduct, including manipulative trading and other fraudulent or criminal activity. But the firm only filed Suspicious Activity Reports (SARs) regarding that suspicious conduct after it was prompted to do so by FINRA’s investigation.

Clearly, in light of this settlement, the stakes relating to the lessons that I hoped to impart with this post about two much smaller settlements are even higher than I had suggested. – AlanT


First, a couple of years ago, I wrote a piece called BD Learns It’s Not Enough To Have A Supervisory Procedure For OBAs, You Actually Have To Follow It.  Second, about four years ago, I wrote In AML World, The Need To File A SAR Can, Apparently, Be Too Obvious To Ignore, about an SEC case that stood for the proposition that sometimes, the facts are so clear that a SAR must be filed that it is impossible to make a reasonable argument to the contrary.  Perhaps these titles gave away the whole story a bit too much, but apart from that flaw, they were fairly instructive articles (at least compared to some of my more rant-y pieces).  Well, it appears that Hilltop, and perhaps (at least) one other firm (which I will get to in a minute), somehow managed to miss them, and, unfortunately, learned their lesson the hard way.

Hilltop is a firm whose roots as a NASD/FINRA member firm, pre-mergers, go back over 70 years.  It is a clearing firm, but also has its own retail operation.  At its core, the AWC involved two principal issues, which are the same I covered in the earlier blogs mentioned above: (1) the repeated failure to detect (supposed) red flags consistent with possible money laundering, despite supervisory procedures that covered that area, and (2) the failure to have filed SARs in light of such obvious red flags.  I will address them both.

Among its AML procedures, Hilltop required its associated persons to collect and complete “Deposit Review Forms” for all receipt of low-priced securities positions.  These forms required, among other things, information that could be used in an AML analysis:

  • whether the stock had undergone a reverse merger in the prior year
  • whether the stock had undergone a name or business change
  • the number of shares owned by the customer overall, including at other firms
  • revenue of the issuer
  • the exchange on which the stock was listed
  • the total outstanding shares of the stock on the market

All that’s good stuff.  But, for whatever reason, from 2015-2016 – a mere five years ago! – Hilltop routinely failed to obtain the Deposit Review Forms that its AML procedures required and, when it did collect them, many were inaccurate or incomplete.  As a result, the firm failed to identify as a possible red flag the fact that a single customer deposited millions of shares of a low-priced security – indeed, this one customer’s trades “represented 25% of Hilltop’s overall clearing of transactions in low-priced securities” during the review period – “without having sufficient information to . . . make a reasonable determination regarding the suspicious nature of the transactions and whether a SAR filing was warranted.”

But, that’s not all!  In addition, Hilltop also dropped the ball in other ways.  One of its introducing firms manifested all kinds of potential AML issues, but they were dismissed by a Hilltop AML analyst who reviewed the activity, commenting that “activity appears normal.”  What did he miss?

  • The introducing firm had four accounts that alone were responsible for over 78% of the firm’s total low-priced securities volume and traded in 930 different low-priced securities issuers
  • Many of the issuers of these securities had no material operations or revenues, and were the subject of promotional campaigns
  • One account owner was allegedly involved in a manipulative trading scheme using convertible notes, and the other, a former AMLCO, was sanctioned by FINRA for AML deficiencies involving low-priced securities.

In summary:  Hilltop had a decent procedure, i.e., the Deposit Review Form requirement, but it failed to abide by it.  That will never be ok with FINRA.

Even more damning, however, was FINRA’s conclusion that Hilltop failed “to devote adequate resources to its AML program,” which, therefore, “could not reasonably be expected to detect and cause the reporting of suspicious activity.”  FINRA’s concern centered on the firm’s use of another report – the Daily Penny Stock, or “DPS” Report – which was described as “the primary report used by the Firm’s AML analysts to review low-priced securities transactions for red flags.”  The DPS Report was created manually, “a process that took between one and one and half hours.”  Despite all the work that went into its creation, however, “neither the DPS Report nor any other report was utilized to assist analysts in identifying” AML red flags.

This seems to have been a function of several things.  First, there were not enough AML analysts and too many trades to review (even though the thresholds that the firm used for trades to appear on the report were set so high that they “excluded 80% of the total value of penny stock transactions”).  Second, “[w]hen the AML analysts selected a transaction for review, minimal analysis was performed, and the analysts’ documentation of the review frequently failed to note any red flags identified or what steps, if any, were taken to investigate the red flags.”

It is hard to imagine a worse scenario than this, having FINRA tell you that your AML program is patently undermanned and not performing.  A fantastic written procedure will not save you from an unhappy outcome.

The other aspect of the Hilltop AWC that bears noting is that FINRA took the firm to task specifically for not filing SARs, something you don’t see every day.  FINRA was helpful inasmuch as it explained for our benefit what the particular problem was:  when the firm reviewed penny stock trades, it “applied an unreasonably high threshold for the filing of SARs.”  According to the pertinent law, a BD is required  “to file a SAR for any transaction that it knows, suspects, or has reason to suspect “has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage.” Even though a SAR must be filed even when a problem is only “suspected,” Hilltop “would not file a SAR unless it had evidence proving that the low-priced security was part of a fraudulent scheme, even where activity triggered multiple red flags.”

So, there are some clear lessons to be gleaned from the Hilltop AWC.  None is particularly tricky, however, or particularly new, but given FINRA’s proclivity to bring AML cases, it is in your own best interest to take them to heart:

  • Make sure your written procedures are robust and up-to-date
  • Make sure you follow your procedures
  • Makes sure you document the hell out of the fact you have followed your procedures
  • Make sure that the volume/nature of your business hasn’t changed in a material way since you instituted your procedures and hired the people to implement them; otherwise, be prepared to revise and amplify your procedures, and hire more bodies
  • Whatever your decision is regarding the filing of a SAR, or not, memorialize your thought process, in order to be able to defend the reasonableness of your decision.

Finally, I mentioned at the outset that there were at least two firms that seem to have failed to learn these lessons.  One was Hilltop, and the other was J K R & Company, a small BD that’s been around for over 40 years, and without any disciplinary history.  It, too, signed an AWC involving AML issues.  Like Hilltop, its AWC stands for the proposition that it is not enough to have good procedures if you don’t follow them.

According to the findings in that matter, in a four-year period extending from 2012 to 2016,[1] the firm “failed to detect red flags of suspicious activity in four related accounts” despite the fact that it had “written AML procedures that required the firm to monitor for red flags of potentially suspicious activity.”  I bet now you can really get a sense of the (sadly, all-too-obvious) theme of this blog post?  When you commit in writing to doing something of a supervisory nature, you had better be sure to actually do it, because FINRA is not going to let you off the hook, or even give you partial credit, for having beautifully detailed written procedures if you fail, for whatever reason, to follow them.  Here is how FINRA tersely put it in the AWC:

The firm’s AML procedures indicated that when the firm detected any red flags of potentially suspicious activity, it would determine whether and how to investigate further and take steps that could include: gathering additional information internally or from third parties, contacting the government, freezing the account, or filing a SAR.  JKR did not, however, implement those measures.

So what red flags did FINRA claim JKR missed?  There were a bunch, frankly.  But, interestingly, the fine imposed was only $50,000, very modest by AML standards.  What does that mean?  Well, either the firm’s counsel did a great job for his client, or, perhaps more likely, the missed flags at issue here were, in fact, actually only a very pale red, at best; some of them you wouldn’t even call them pink.

First came the supposed red flags that appeared during the account opening process for four accounts.  The firm missed the fact that:

  • the four accounts had beneficial owners and control persons in common
  • one of the accounts was opened seven months after the accountholder’s corporate president and the control person were barred by the SEC from participating in any manner in any offering involving penny stocks (even though the stated purpose of the account was to trade penny stocks)
  • three accounts were controlled by a single person, who granted a Power of Attorney to someone else, giving that other person the power to trade the account
  • one of the customers was the investment advisor for another of the customers
  • the legal address for one of the accounts was not a physical address, but instead, was a personal mailbox at a retail store
  • the account-opening documents for one of the accounts indicated that one of the customers was self-employed as an investment banker for the corporate entity listed for one of the other four accounts
  • the copy of the passport provided by one customer was not properly certified
  • the corporate entities for two of the accounts had been created just one week prior to account-opening under the laws of the Republic of Seychelles, a country known for heightened money-laundering risk.

Once the accounts were opened and started to trade, the firm then proceeded to miss these additional red flags:

  • two accounts evidenced extensive trading in a penny stock, which, based upon conversations with the customer, was contrary to the expected activity in those accounts
  • potentially suspicious wire activity that was unexplained, repetitive and showed unusual patterns with no apparent business purpose
  • two accounts engaged in very minimal securities activity.

Quantitatively speaking, that’s a lot of red flags to miss.  But, qualitatively, maybe there’s not a whole there beyond the usual knee-jerk conclusions that FINRA always touts, i.e., things that sound bad but aren’t.  I mean, the Republic of Seychelles??  How can any entity from there possibly be legit, right?  Ok, mark it down.  Or the old “no apparent business purpose” gambit.  Remember: FINRA is the arbiter of what is and isn’t a “legitimate” business purpose.  It doesn’t matter what YOU claim is the purpose of a trade or a money transfer if FINRA concludes, in its opinion, that it was not legitimate.

Or perhaps my favorite one on the list, the absence of a certification on the copy of the passport.  According to the AWC, one of the customers provided a passport “reflecting only a stamp from a Notary Public in the State of Florida, instead of an affidavit sworn to by [the] Customer . . . as the custodian of the passport, as required by the American Association of Notaries’ rules governing copy certification by a document custodian.”  Seriously, and no offense intended to Notaries, it is rather amazing that FINRA actually cited to the these rules, for maybe the first time in recorded history.  What makes this even worse, and considerably less funny for JKR, is that, as Alison Jimenez pointed out in her blog about this same AWC, the “Customer Identification Program (CIP) rules do not require notarization of identification documents, nor does the AWC state that the firm’s policies & procedures required notarized copies of customer IDs.” If neither the AML rules nor the firm’s own procedures required either a notary stamp or a custodial affidavit, then how can this possibly be a red flag?

The point is: even when the red flags are ticky-tacky, as most of these were, stack enough of them together and maybe you can cobble together enough to justify a $50K fine.  Just another example of FINRA using quantity, rather than quality, to coerce a firm into settling.



[1] Let me just stop for a minute here.  The pertinent time period goes back EIGHT YEARS!  I mean, the end of the pertinent time period was four years ago.  How can it possibly take FINRA this long to conduct exams?  And how can it possibly be fair to a firm to have defend actions it took (or, as in this case, didn’t take) almost a decade ago?  Yet, as readers of this blog will acknowledge, this is a common issue in FINRA Enforcement actions.  Someone ought to look into this, as it is a real, and continuing, problem.

I hope that you have had the chance to enjoy Jessica Hopper’s paean to Rule 8210 in her recent blog posted on FINRA’s website.  Very disturbing, and for all the old reasons.

First, once again, she starts by patting herself – well, not just herself, I guess, but Enforcement generally – on the back for having “barred more than 730 brokers and associated persons” in just the last two years!  That statistic sounded familiar, for some reason.  A little research revealed that, sure enough, FINRA had touted that very same number in another self-congratulatory blog it posted back in April (which, given pandemic-driven quarantining, admittedly feels like a lifetime ago), a post that caused me to write a piece called “FINRA Claims To Be Reasonable When It Comes To Sanctions, But It Is Clear That Permanent Bars Are What It’s All About.”    The point of my blog – that FINRA is more interested in barring people than simply doing what’s right – is borne out here, again.

Second, there is the everlasting oddity surrounding the fact that FINRA continues to refer to its 8210 letters as mere “requests,” as if the recipient of such had a choice whether to respond or not.  Jessica writes, “What is FINRA Rule 8210?  Simply put, the rule allows FINRA to request documents, information, and testimony from member firms and their associated persons in connection with an examination or investigation.”   As phrased, frankly, it doesn’t sound so bad.  But, just a couple of sentences further into her post, she concedes the ugly truth about Rule 8210, that “FINRA relies on [it] to protect investors and the market by requiring individuals under FINRA’s jurisdiction to provide information when requested.”  Truly, FINRA should start calling 8210 letters what they are: demands, even edicts, but certainly nothing as tepid as a request.

Third, I am more than a little troubled by the way that 8210 letters have morphed from a fact-finding tool, i.e., something designed to help FINRA figure out what happened, into a means of proving a suspicion of wrongdoing.  No good auditor presumes the outcome of the audit; you do the work, you ask the questions, you review the documents, and you see where you end up.  FINRA examiners, sadly, too often give the undeniable impression that they already believe you did something wrong, and it’s only a matter of time until they prove it.  That has the unfortunate consequence of coloring the entire exam, as the examiner may unknowingly (or, worse, knowingly) look for facts corroborating their preconception of the eventual outcome, i.e., a finding of wrongdoing, rather than merely following evidence trails to wherever they may lead.

Regrettably, it appears that Jessica may have fallen into this same trap.  Consider this from her blog post:  “Perhaps a bar for violating Rule 8210 – a seemingly administrative rule – may seem severe.  But in reality, the underlying wrongdoing that led to the Rule 8210 request is often quite serious; in many cases, there are suspicions of fraud, conversion of customer funds or other egregious misconduct.”  Perhaps I am parsing her language too closely, but it really, really troubles me how she phrased this, specifically, how she omitted the word “possible” before “underlying wrongdoing.”  Even if this was simply an unfortunate drafting or editing mistake, I find it rather telling that FINRA seems to base its decision to issue an 8210 letter on a conclusion that, in fact, there has been some wrongdoing.  That is wrong.  Even in the quasi-governmental world that FINRA occupies, where due process and Fifth Amendment rights don’t exist, brokers and broker-dealers are still presumed to be innocent until proven otherwise.

Fourth, and most important, there is simply a problem with the way that FINRA wields its 8210 power.  And by that I mean, in its supposed zeal “to protect investors and the markets,” FINRA tosses off 8210 requests like someone riding a float in the Mardi Gras parade tosses beads, that is, indiscriminately and with a notable degree of glee and vigor.  As my partner Michael Gross – like me, another former FINRA Enforcement lawyer – accurately observed in this blog some time ago, “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.”  He noted – with some degree of horror – that there is no limit on:

  • the number of document and information requests that FINRA can issue
  • the scope of document and information requests that FINRA can issue
  • the length of time for FINRA to complete its exam
  • how far back in time FINRA can go for its “requests”[1]

I don’t harbor any real hope of ever seeing things change, but, for what it’s worth, I will renew my regular plea for some change in the FINRA rules that provides the recipient of an 8210 letter to ability to challenge it without having to risk a permanent bar for not responding.  A document subpoena issued in a court case can be challenged, and if the challenge is unsuccessful, the result is merely that the document at issue must be produced.  If such subpoenas were handled like FINRA 8210 letters, the unsuccessful challenger would be deemed to have lost the entire case.  That makes zero sense, and it makes no better sense in the context of FINRA exams.  Yet, that’s how it works under FINRA rules.  And THAT is why, as Jessica observes, a whole lot of people who receive 8210 letters decide that they won’t bother to respond to respond, and begrudgingly sign AWCs imposing permanent bars.  It doesn’t necessarily mean, as Jessica concludes, that all these people are bad, or caused any customer harm; it simply means, in many cases, that it is easier, way cheaper, and certainly faster just to tell FINRA to buzz off, rather than fight what is, in essence, an unwinnable fight.

[1] Just this week, FINRA issued an AWC involving Citadel Securities that included findings that the firm had deficient supervisory procedures going back to 2012, over eight years ago!

After having proudly served for decades, and surviving a dramatic face-lift in 2012 (when old NASD Rule 2310 was replaced by shiny new FINRA Rule 2111), it seems that the “suitability rule,” as we’ve come to know it, has, at long last, been quietly sent out to pasture by FINRA.  Although the title of Reg Notice 20-18 – “FINRA Amends Its Suitability . . . Rule . . .  in Response to Regulation Best Interest” – suggests that the suitability rule has only been amended, not replaced, that would not be a fair reading of what happened.  In fact, with the exception of a few specific circumstances,[1] suitability has been relegated to the clearance rack of regulatory rules.  Here is how FINRA phrased its epitaph:

Reg BI’s Care Obligation addresses the same conduct with respect to retail customers that is addressed by Rule 2111, but employs a best interest, rather than a suitability, standard, in addition to other key enhancements.  Absent action by FINRA, a broker-dealer would be required to comply with both Reg BI and Rule 2111 regarding recommendations to retail customers. In such circumstances, compliance with Reg BI would result in compliance with Rule 2111 because a broker-dealer that meets the best interest standard would necessarily meet the suitability standard.  To provide clarity on which standard applies and to avoid unnecessary duplication, FINRA has amended Rule 2111 to state that it will not apply to recommendations subject to Reg BI.

The problem I have, having read dozens of articles and attended a bunch of pandemic friendly webinars on Reg BI, is figuring out the practical impact of complying with Reg BI.  I mean, if you are a registered rep with retail customers, what, if anything, do you need to do differently to demonstrate compliance with Reg BI vs. Rule 2111?  Upon closer look, I am beginning to think that it may not amount to much.

Consider, as a starting point, this language from the SEC’s Reg BI Release:

We emphasize that what is in the “best interest” of a retail customer depends on the facts and circumstances of a recommendation at the time it is made, including matching the recommended security or investment strategy to the retail customer’s investment profile at the time of the recommendation, and the process for coming to that conclusion. Whether a broker-dealer has complied with the Care Obligation will be evaluated based on the facts and circumstances at the time of the recommendation (and not in hindsight) and will focus on whether the broker-dealer had a reasonable basis to believe that the recommendation is in best interest of the retail customer.

Later in the same release, the SEC used this “matching” concept in the very same way:

In circumstances where the “match” between the retail customer profile and the recommendation appears less reasonable on its face (for example, where a retail customer’s account objective is preservation of income and the recommendation involves higher risk, or where there are more significant conflicts of interest present), the more important the process will likely be for a broker-dealer to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer and did not place the broker-dealer’s interest ahead of the retail customer.

Read these excerpts and see if you agree with me that this concept of “matching” is, basically, exactly what RRs and BDs do today under Rule 2111 when making suitability determinations.  The same two-step process that has always existed.   First, under FINRA Rule 2090, you “use reasonable diligence . . . to know (and retain) the essential facts concerning every customer.”  Those “essential facts” are outlined in Rule 2310(a):  “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”  Then, armed with those facts, you “match” the customer to a recommendation.  If the recommendation is a mismatch, e.g., because it is too risky for a customer with a conservative risk tolerance, or provides no liquidity for a customer with liquidity needs, or has a lengthy pay-off for a customer with a much shorter time horizon, then the recommendation may not be suitable.

Seems like the same conclusion will be true under Reg BI, but instead of calling the recommendation “unsuitable,” the regulators will simply say it was not in the customer’s best interest.  Maybe this isn’t quite the sea change that people maintain.

Granted, however, not everything will be the same.  Importantly, while Reg BI, like Rule 2111, requires that a recommendation “must be based on information reasonably known to the associated person (based on her reasonable diligence, care, and skill) at the time the recommendation is made,” it goes beyond that.  Because Reg BI requires that a recommendation be in the retail customer’s best interest, in addition to “matching” the recommendation to the customer’s suitability profile, an RR must also “exercise reasonable diligence, care, and skill to consider reasonably available alternatives offered by the broker-dealer. This exercise would require the associated person to conduct a review of such reasonably available alternatives that is reasonable under the circumstances.”

Now this is something totally new.  You not only have to know what you’re recommending, you also have to know what you’re NOT recommending, just in case something else would have been, um, more suitable.  Happily (or unhappily, perhaps), the SEC has provided pretty loosy-goosy guidance regarding what this review of “available alternatives” must look like.  Indeed, they had the temerity to break out – again, ugh – that old standby, the dreaded “facts and circumstances” standard:  “What will be a reasonable determination of the scope of alternatives considered will depend on the facts and circumstances, at the time of the recommendation, including both the nature of the retail customer and the retail customer’s investment profile, and the particular associated persons or groups of associated persons that are providing the recommendations.”

I don’t want to get too deep in the weeds here, so I will cut this off by providing this nugget of good news from the SEC: “A reasonable process would not need to consider every alternative that may exist (either outside the broker-dealer or on the broker-dealer’s platform) or to consider a greater number of alternatives than is necessary in order for the associated person to exercise reasonable diligence, care, and skill in providing a recommendation that complies with the Care Obligation.”  So, take heart that you don’t necessarily need to know every stinkin’ product that your BD offers, or that any BD offers.

One last point about this Reg Notice, concerning quantitative suitability, a/k/a churning or excessive trading.  This is an age-old problem.  The legal framework of a churning case has been the same forever, consisting of three elements: (1) intent to defraud, (2) control of the account by the RR, and (3) excessive trading.  FINRA Rule 2111, not surprisingly, comported with that definition. Supplementary Material .05(c) requires that an RR have “actual or de facto control” over an account to be capable of churning it.  Well, not anymore.

According to the Reg Notice, “FINRA has also removed the element of control from the quantitative suitability obligation, a change that is consistent with Reg BI.”  What?

Sure enough.  Reg BI does not require control, either actual or de facto:

[T]he third component of the Care Obligation would require a broker-dealer to exercise reasonable diligence, care, skill, and prudence to have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. The Proposing Release noted that this requirement is intended to incorporate and enhance a broker-dealer’s existing “quantitative suitability” obligation by applying the requirement irrespective of whether a broker-dealer exercises actual or de facto control over a customer’s account, thereby making the obligation consistent with the current requirements for “reasonable basis suitability” and “customer specific suitability.

So now there is a major difference between, on the one hand, what courts and arbitration panels require to establish churning and, on the other hand, what FINRA and the SEC say is necessary.  I look forward to seeing how this plays out, as the “control” element often turns out to be the one on which Respondents hang their hats in defending churning cases.  If a Claimant no longer has to prove that element, these cases have just become much, much harder to defend.  But, since there is no private right of action for breach of a FINRA Rule, or Reg BI, it remains to be seen what standard will, in fact, be applied in churning cases after Reg BI becomes effective next week.

[1] Because Reg BI applies only to recommendations to “retail customers,” who are defined to be “a natural person, or the legal representative of such natural person, who receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer and uses the recommendation primarily for personal, family, or household purposes,” Rule 2111 still applies, therefore to: (1) recommendations to institutional customers under specified circumstances, (2) entities and institutions (e.g., pension funds), and (3) natural persons who will not use recommendations primarily for personal, family, or household purposes (e.g., small business owners and charitable trusts).  FINRA also notes that some of its other rules “have a suitability or suitability-like component (e.g., FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities) and FINRA Rule 2360 (Options))” which are not impacted by the rule changes and will still be viable.

This will be a quick one, but I just had to get something off my chest before the weekend.  As you probably know, there is an election upcoming.  No, not that one, the one to elect certain members of FINRA’s Board of Governors.  That Board consists of 24 members, as follows:

  • Robert Cook, who is the Chief Executive Officer of FINRA;
  • 13 Public Governors;
  • one Floor Member Governor;
  • one Independent Dealer/Insurance Affiliate Governor;
  • one Investment Company Affiliate Governor;
  • three Small Firm Governors;
  • one Mid-Size Firm Governor; and
  • three Large Firm Governors.

Some of these seats are appointed, but others are subject to elections.  On August 7, one Large Firm Governor and one Small Firm Governor are up for election.  To make things easy on the membership when it comes to elections, FINRA has a Nominating Committee, whose job, according to FINRA’s website, is “nominating persons for appointment or election to the FINRA Board.”  In fact, they get to nominate seven of the Board members (the three Small Firm Governors, the one Mid-Size Firm Governor, and the three Large Firm Governor).  This makes sense.  You get a bunch of qualified and experienced people together, and they use their collective skills to identify the best person for the job.

According to FINRA’s By-Laws, the Nominating Committee has no choice NOT to do its job.  Note the use of the word “shall” here:  “The Nominating Committee shall nominate and . . . support: Large Firm, Mid-Size Firm, Small Firm, Public, Floor Member, Independent Dealer/Insurance Affiliate and Investment Company Affiliate Governors for each such vacant or new Governor position on the Board.”

Given this clear language, don’t you find it surprising, perhaps even disturbing, that the Nominating Committee has declined to nominate anyone for the Small Firm Governor seat?  As provided in this Election Notice,

With respect to the Small Firm Governor seat, the Nominating Committee determined it would not nominate a candidate for election in 2020.  Instead, any eligible candidates who obtain the requisite number of petitions will be included on the ballot.

There is no explanation provided why the Nominating Committee bailed on its responsibility.  I acknowledge that the Nominating Committee’s obligation actually to nominate someone is qualified by the phrase “[e]xcept as otherwise provided in these By-Laws,” but I looked and could not find anything in the By-Laws that provides the Nominating Committee can blithely abdicate from its sole responsibility.  Maybe it’s lurking in there somewhere, and someone from FINRA can educate us all.  But, if I am correct, and there is nothing that allows the Nominating Committee to do what it has done here, i.e., punt, then we should all collectively wonder what the point is of having that committee in the first place.  And what is it about the Small Firm seat in particular that causes the Nominating Committee such problems?  I ask that because this is not the first time the Nominating Committee chose to sit on its hands regarding the Small Firm seat. It did the same thing in 2018, also, as reflected in this Election Notice.  I don’t have answers here, only questions.

Finally, this also goes to prove a point I have made before: if FINRA was held to the same standards to which it holds its members, things would be pretty messy.  If a broker-dealer includes some mandatory supervisory obligations in its WSPs, but doesn’t bother to follow them, you know exactly how well that is going to be received by the examining staff.  I don’t know that this is an entirely apt comparison (as the duty to supervise is a legal duty while the Nominating Committee’s duty to nominate someone is self-imposed), but I think you get my point.  Let me tell you, it is a very difficult conversation to have with a client who is already angry at what they perceive to be FINRA’s incompetence or indifference when they read something like this, knowing that if the roles were reversed, and they were the one who simply decided not to perform some obligatory task, that they would be scrutinized to death over it.

A couple of years ago, I complained about PIABA’s effort to make expungement even more difficult to obtain.  Well, fast forward to June 1, and, as Chris Seps explains here, the SEC has approved the first proposed expungement rule change from FINRA, one that appears to serve no purpose other than to generate money for poor FINRA. – Alan


As many of you know, FINRA has recently proposed many rule changes for the expungement process that are still pending.  FINRA proposed those rules changes back in 2017 in order to try to make the process of removing erroneous customer complaints from a broker’s CRD record more difficult.  Many of the proposed rule changes will indeed make it more difficult to obtain expungement: there will be stricter rules about when and how a broker can request expungement, including new time limitations; they will have to convince three arbitrators of their case instead of one; and they will be required to testify in person or via videoconference rather than by telephone.  But the only rule change that has made it to the SEC – and which the SEC recently approved in an order published in the Federal Register on June 1 – is a change that simply makes it more expensive for the broker to obtain expungement.  The rule change literally serves no other purpose than to put more money in FINRA’s pocket.  We will talk about that in a minute, but first, let’s talk about the old rule and how it changed.

FINRA charges certain fees to anyone who is seeking expungement – an initial filing fee, a fee for each pre-hearing session, and a hearing fee.  Certain fees are charged to the broker-dealer named as the respondent as well.  Historically, these fees fall on a graduated scale. The higher the damages sought, the higher the fees.  In cases where non-monetary relief is sought – such as expungement cases – the fees and surcharges are in the thousands of dollars, in total.  However, experienced counsel usually add a nominal request for $1 in damages, which means the fee charged falls on the smallest end of the graduated scale.  The filing fee would be only $50, the hearing session fees would be $50 per session, and the member surcharge charged to the broker-dealer named as the respondent would be $150.  This was frequently known as the “$1 trick.”  It wasn’t illegal; it wasn’t immoral; it was just a loophole that saved dozens of brokers thousands of dollars each as they attempted to remove erroneous complaints from their permanent records.

FINRA’s new rule eliminates the “$1 trick.” Under the new rule, which was just approved by the SEC and will probably take effect later this summer, all requests for expungement will fall into the non-monetary relief category of the graduate scales, regardless of any damages that are sought.  So, the filing fee will be $1,575.  The hearing session fees would also be charged at the non-monetary relief level for a hearing with three arbitrators: $1,125 per session.  The broker-dealer named as the respondent in the expungement case will be charged the member surcharge for non-monetary relief: $1,900.  And the broker-dealer that is named as the respondent would be charged a processing fee for non-monetary relief claims: $3,750.  If the broker decides to name the customer as the respondent instead of the broker-dealer, it doesn’t matter; FINRA will still charge the $1,900 member surcharge and $3,750 processing fee to the broker-dealer where the broker was registered at the time the customer made the complaint at issue.  So, in other words, the expungement fees will go from $300 to $9,475, most of which will be charged to the broker-dealer.

Unlike the other expungement rule changes that have not been approved yet, this one is purely about money, not customer protection.  But you have to give FINRA credit – they admit it is all about money.  After FINRA proposed this rule, they made it known that from 2017 to 2019 approximately 75% of expungement-only arbitrations used this $1 trick, costing FINRA approximately $7.3 million.  FINRA was not happy about that, even though it had an operating budget of $1.053 billion in 2019 – the highest in the past three years, despite having the lowest number of broker-dealers and the second lowest number of registered reps in the past 16 years.  As a result, representatives of both sides of the aisle – the plaintiff’s bar PIABA, which files complaints on behalf of customers, and the defense bar which defends brokers and broker-dealers – are unhappy with the rule change.  In fact, as reported by Investment News, a co-author of a recent PIABA expungement  study called the rule change out for what it is: “a money grab” by FINRA.  That is quite an admission from PIABA, which routinely pushes FINRA to enact rules that make expungement more difficult to get.

Now, let’s be clear for a minute: closing a loophole and clarifying the rules regarding fees so that they are implemented the way that FINRA probably initially intended is fine.  Close the loophole and charge everyone the same for expungement requests.  And that’s what the SEC’s order routinely falls back on to justify the rule change – it claims that it is just making things fair by charging everyone the same fees in expungement cases, regardless of whether you slyly tack on a request for some nominal monetary damages.  But the real problem – and the one commentators take issue with – is the excessive fees charged not to the broker who is making the expungement request, but to the broker-dealer who has no dog in the fight whatsoever. Just so we are all clear, a broker making an expungement request has to name someone as a respondent – either a broker-dealer or the customer who complained.  In either instance, under FINRA’s rule change, the broker-dealer is going to get socked with thousands of dollars in fees for having done absolutely nothing and having no role in the expungement request.  In fact, many broker-dealers do not even participate in expungement hearings because they have nothing to gain or lose if brokers gets their records cleaned up.  But the broker-dealer has no choice but to pay the fees to FINRA, even if it has no interest in participating and does not object to the expungement request.

FINRA knows its members are being stuck with huge fees, and in fact that was its goal.  On the one hand, according to the SEC Order, “FINRA believes the Proposal will help ensure that the fees for expungement requests are assessed, and that the costs borne by the forum to administer expungement requests are allocated, as intended, to those requesting expungement under the Codes.”  If that were true, then the brokers requesting expungement of these erroneous customer complaints their records would be charged with the majority of the fees, not the broker-dealer who has no involvement in the request.  In fact, the SEC Order also states, “FINRA also noted that … it believes that member firms, rather than associated persons or customers, should continue to bear the larger share of the costs of expungement.” Not only are those two statements completely inconsistent, but FINRA really provides no reason for charging the bulk of the fees to the broker-dealer, except that someone has to pay the administrative costs of these hearings.

If FINRA really wants to be fair about the fees associated with expungement requests, here is what it should do: charge the expungement fees to the broker and broker-dealer if the panel rejects that expungement request, but charge them to the customer who made the complaint that is being expunged if the panel grants the expungement request.  This will help further the goals of both the plaintiff and defense bars.  On the defense side, brokers would be happy because their fees would be covered if they prevail in the expungement.  But more importantly, this might prevent completely bogus claims from being filed in the first place.  Right now, there is nothing preventing an investor who lost money to take 30 minutes, throw together a few sentences about how they were never told of the risks of their investments, and sit around waiting for a settlement check. If a threat existed, however small, that their claim might be outed by an expungement panel as not just lacking merit, but as clearly erroneous, and they would be charged with the $9,475 in FINRA fees, then maybe customers would reconsider filing a claims that they completely fabricated.  I know what you are thinking, and no, this will not have a “chilling effect” on customers who may want to file a complaint.  Is a customer with a claim for a million dollars, or even $100,000, going to be scared away from trying to recover all that money by the prospect of having to pay a $9,000 expungement fee? Probably not.  But customers who make up a story in order to recover some losses might be dissuaded from filing – which is a good thing.

The other upside to making the expungement fees contingent on the outcome of the expungement request is that it will encourage customers to actually participate in the expungement hearings.  PIABA and FINRA have lamented for years that once customers settle cases, the vast majority of the time they don’t participate in the expungement hearing because they have nothing to gain at that point.  As a result, according to FINRA, panels only hear one side of the story and frequently grant expungement in instances that they might not have if they had heard from the customer.  Accordingly, if customers face the prospect of being charged the $9,475 in fees if their claims are found to be erroneous in the expungement hearing, I would bet that many of them would actually show up and testify in the expungement hearing.  FINRA would be happy about that, and about a potential secondary effect – brokers might think twice about filing questionable expungement requests if they know a customer will show up to contest their side of the story. This simple change to the expungement fee allocation might finally bring balance to the expungement process.  Then again, that’s probably why it will never happen.



I have blogged before about hold recommendations.  Surprisingly – at least to me – the statistics I get from the publisher of this blog reveal that more people have read that particular post than anything else I have written since I started this thing a few years ago.  That has to mean something, right?  So, when I saw a recent SEC settlement that involved hold recommendations, I figured it was worth looking into and giving my thoughts.

I wrote last time that the only occasion when hold recommendations have had any potential relevance was in the context of customer arbitrations, where clever attorneys have tried to avoid having their clients’ old – sometimes really, really old – claims dismissed under FINRA’s six-year eligibility rule by baking some vague allegations about more recent hold recommendations into the Statement of Claim.  That hasn’t changed.  I still see these all time.  For the most part, arbitrators remain unimpressed by such claims, absent some clear documentation demonstrating that there was, in fact, some explicit recommendation to hold.

But, admittedly, Reg BI potentially changes the landscape for recommendations to hold, making them something of interest both to regulators and claimants’ lawyers.  The SEC has stated that for broker-dealers, Reg BI applies both to explicit recommendations to hold and, as well, “implicit hold recommendations that are the result of agreed-upon account monitoring between the broker-dealer and retail customer.”  Indeed, that was the principal point of my prior post, i.e., the need for BDs, in light of this guidance, to disclaim, very, very clearly, any obligation to monitor customer accounts, since once a BD does that, it can avoid any potential claim – whether from a regulator or in an arbitration – that it has violated Reg BI through an alleged implicit hold recommendation.  That advice has not changed at all.  The SEC has gone to the trouble of describing a clear path to a safe harbor, and any BD that fails to follow that path does so at its own peril.

But what about dually registered RR/IARs?  This hybrid model is increasingly common, and because such individuals straddle the regulatory regimes for both BDs and IAs, it can be confusing and complicated to understand exactly what standards to which they will be held.

Let me start with some good news.  The SEC has made it very clear what it thinks:

If you are a financial professional who is dually registered (i.e., an associated person of a broker-dealer and a supervised person of an investment adviser (regardless of whether you work for a dual-registrant, affiliated firm, or unaffiliated firm)) making an account recommendation to a retail customer, whether Regulation Best Interest or the Advisers Act applies will depend on the capacity in which you are acting when making the recommendation.

Ok, good start.  But it gets even better, even clearer:

Regulation Best Interest does not apply to investment advice provided to a retail customer by a dual-registrant when acting in the capacity of an investment adviser, even if the retail customer has a brokerage relationship with the dual-registrant or the dual-registrant executes the transaction in a brokerage capacity.

Well, now we have some guidance to work with!  If you’re a BD, once you adequately disclaim your duty to monitor accounts, implicit recommendations to hold are not actionable under Reg BI.  (And, of course, we already know that they’re not actionable under FINRA’s suitability rule either, inasmuch as that rule only covers explicit hold recommendations, as FINRA has expressed many times.  See, for example, Reg Notices 12-25 and 12-55.)  If you’re a dual registrant, and you give investment advice wearing your IAR hat, rather than your RR hat – including advice that involves hold recommendations – then you are not acting under Reg BI.  This is real progress!

The problem, or at least potential problem for both dual registrants and any IAR not associated with a BD is that you’re still not out of the woods, by any means, when it comes to hold recommendations.  And that’s because while Reg BI may not present any problems, the SEC is vigorously enforcing – too vigorously, in the view of many – liability that stems from the Advisers Act.  And while the touchpoint for that liability is the inadequate disclosure of conflicts of interest, rather than the efficacy of the recommendation itself, it remains that the transaction underlying the claim is the same: a hold recommendation.

Which brings me to the SEC settlement I mentioned at the outset.  Here is the SEC’s summary of the case:

At times during the period from January 2014 through March 2019 (the “Relevant Period”), Oxbow held for advisory clients mutual fund share classes that charged fees pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”) instead of lower-cost share classes of the same funds that were available to the clients. Oxbow’s investment adviser representatives (“IARs”), as registered representatives of an affiliated broker-dealer, received 12b-1 fees in connection with these investments, but Oxbow did not adequately disclose this conflict of interest in its Form ADV brochures or otherwise.

Note the use of the word “held” here.  The case wasn’t about recommendations by Oxbow IARs to purchase the wrong share class, it was about hold recommendations.  The SEC said this very plainly later in the document: “During the Relevant Period, Oxbow advised clients to hold mutual fund share classes that charged 12b-1 fees when lower-cost share classes of those same funds were available to those clients.”  Indeed, in a footnote, the SEC explained that “[w]ith the exception of three purchases of shares of one fund in a class that charged 12b-1 fees when a lower-cost share class of the same fund was available, Oxbow did not purchase shares charging a 12b-1 fee when a lower-cost share class of the same fund was available during the Relevant Period.”  Obviously, if the problem wasn’t with purchases by Oxbow, then it had to be with the fact that Oxbow advisory customers were advised to continue to hold higher-cost share classes.

What the SEC does not illuminate in the settlement, however, is whether these hold recommendations were explicit or implicit.  But, that may be because, frankly, it doesn’t matter.  We know from the guidance that the SEC published in connection with the promulgation of Reg BI that if you “[i]f you have agreed to perform account monitoring services, then Regulation Best Interest applies even where you remain silent (i.e., an implicit hold recommendation).”  It makes logical sense that if you have a statutory (rather than a contractual) obligation to perform these same account monitoring services, i.e., because you are an IA or an IAR, the conclusion would be the same: you are potentially liable for implicit hold recommendations.  Of course, IAs and IARs do have that statutory obligation, given that they have a fiduciary duty to their clients.

So there’s the point.  Three people make an implicit recommendation to hold (i.e., they remain silent about an existing investment); one is an RR associated solely with a BD, one is a dually registered RR/IAR, and one is just an IAR.  Only the first guy is safe, under any standard.  The second guy may be safe, depending on which of his two hats he was wearing.  The third guy, on the other hand, will have to defend his recommendation under Reg BI, and faces potential liability if it is determined not to have been appropriate.

Confusing?  Yes.

One last observation, an important one.  As I noted above, the gist of the Oxbow case is not that it violated its fiduciary duty by making inappropriate hold recommendations, but, rather, by not disclosing to its clients “all material facts,” including “full and fair disclosure that is sufficiently specific so that they could understand the conflicts of interest concerning Oxbow’s advice about investing in different classes of mutual funds and could have an informed basis on which they could consent to or reject the conflicts.”  That violation, putting aside whether or not you agree with the SEC’s take-no-prisoners approach to 12b-1 fee disclosures, would have existed whether or not Oxbow made hold recommendations, or, if it did, whether or not they were appropriate.

Disclosure cases do not require the SEC to prove that any client ever actually relied on the disclosures and proceeded to make a trade; hell, it doesn’t matter whether anyone ever even read the disclosures! They are either sufficient, or they’re not.  The challenge is simply figuring out how to disclose these conflicts of interest with sufficient detail to satisfy the SEC.  And that is really hard.  Some guidance exists,[1] but, for the most part, it has not only come after the fact, but comes in the form of disciplinary actions that the SEC has taken, which is hardly the best way to go about helping industry members.  No surprise that one of FSI’s 2020 Advocacy Priorities is “Regulation by Enforcement.”  Its website says: “Last year, we spoke out about the increasing trend of regulation by enforcement, particularly by the SEC. We continue to oppose enforcement activity that is based on staff guidance or creates new requirements without going through the formal rulemaking process.”  Hear hear!


[1] See, for example, this 2019 FAQ from the SEC, which suggests that at least the following must be disclosed about share class conflicts:

  • The existence and effect of different incentives and resulting conflicts.
    • The fact that different share classes are available and that different share classes of the same fund represent the same underlying investments.
    • How differences in sales charges, transaction fees and ongoing fees would affect a client’s investment returns over time.
    • The fact that the adviser has financial interests in the choice of share classes that conflict with the interests of its clients.
  • The nature of the conflict.
    • For example, whether the conflict arises: (a) as a result of differences in the compensation the adviser and its affiliates receive; or (b) from the existence of any incentives shared between the adviser and the clearing broker or custodian (such as offsets, credits, or waivers of fees and expenses).
    • Whether there are any limitations on the availability of share classes to clients that result from the business of the adviser or the service providers that the adviser uses. These may include, for example:
      • Limitations that a fund or the adviser’s clearing broker or custodian imposes (for instance, where a custodian’s platform only makes certain share classes available or a fund or platform has minimum investment requirements); and
      • Limitations that the adviser imposes (for instance, by type or class of clients, advice, or transactions).
    • Whether an adviser’s practices with regard to recommending share classes differs when it makes an initial recommendation to invest in a fund as compared to: (a) when it makes recommendations regarding whether to convert to another share class; or (b) when it makes recommendations to buy additional shares of the fund. For example, the adviser could consider disclosing its practices for reviewing, in conjunction with its periodic account monitoring, whether to convert mutual fund investments in existing or acquired accounts to another share class.
  • How the adviser addresses the conflict.
    • The circumstances under which the adviser recommends share classes with different fee structures and the factors that the adviser considers in making recommendations to clients.
      • For example, where the adviser would bear the cost of a transaction fee, how the adviser evaluates the differences between, on the one hand, a share class with a 12b-1 fee but no transaction fee and, on the other, a share class of the same fund with a transaction fee and, on the other, a share class of the same fund with a transaction fee but no 12b-1 fee.
    • Whether the adviser has a practice of offsetting or rebating some or all of the additional costs to which a client is subject (such as 12b-1 fees and/or sales charges), the impact of such offsets or rebates, and whether that practice differs depending on the class of client, advice, or transaction (e.g., with regard to clients whose accounts are subject to the Employee Retirement Income Security Act of 1974 or clients with individual retirement accounts).

Seems like just days ago I blogged about Jessica Hopper and her commitment to providing restitution to customers.  Since I posted that blog, there were two other settlements (which I added to that blog as updates) in which FINRA again seemed to prioritize restitution over the imposition of a fine.  Yesterday, however, FINRA announced a blockbuster settlement with Merrill Lynch that should serve to eliminate any doubt that anyone may still have about Ms. Hopper’s priorities.

In an AWC, Merrill agreed that for a six-year period commencing in April 2011,[1] the firm “failed to provide over 13,000 accounts with mutual fund sales charge waivers and fee rebates to which the customers were through rights of reinstatement offered by mutual fund companies.”[2]  Turns out that instead of having a written supervisory procedure that ensured investors got the benefit of their rights of reinstatement, Merrill “relied on its registered representatives to manually to identify and apply such waivers and rebates.”  That didn’t work out too well, it seems, as those Merrill RRs missed 13,328 accounts that were entitled to a right of reinstatement, causing those accounts to pay about $6 million in excess sales charges and fees.  As a result, Merrill was found to have violated the supervisory rule.

As a sanction for this rule violation, Merrill was censured, required to pay restitution to the affected customers, plus interest, totaling over $7.2 million.  But…there was no fine imposed.  Zero.  Nada.  Bupkis.  Why?  It appears that there were a couple of reasons, but principally it was because of what FINRA characterized as Merrill’s “credit for extraordinary cooperation.”  More on that in a second.

But, first, let’s acknowledge, for, like, the fourth time in a week, that FINRA placed the emphasis of the sanctions on the restitution component.  Again, all you’ve got to do is read the press release announcing the AWC.  Jessica Hopper is once again quoted, this time saying, “We are pleased that Merrill has reimbursed the customers affected by its failure to provide these waivers. Ensuring that harmed customers receive restitution is our highest priority and we will take a firm’s determination to proactively provide restitution into account when assessing sanctions.”  As I said recently, the evidence is indisputable that Jessica means what she says about her priorities.

Ok, let’s circle back to the cooperation credit, and start with the snarky observations.  Sure, Merrill got that credit, but the AWC recites that “[t]his matter arose from a routine cycle exam by FINRA’s Department of Member Supervision, and the firm subsequently investigated the matter further.”  Hmmm.  I read Reg Notice 19-23, and it plainly states that the first type of extraordinary cooperation is “self-reporting before regulators are aware of the issue.”  It also states that “FINRA also will consider whether the firm proactively detected the misconduct through compliance, audits or other surveillance, as opposed to identifying the misconduct only after receiving notice from customers, counterparties or regulators.”  Based on the scant recitation of the facts in the AWC, it sure seems that it was FINRA brought this matter to Merrill’s attention during a routine exam.

This would seem pretty odd, except for the fact that, hey, THIS IS MERRILL LYNCH!  You think Merrill gets treated the same as everyone else?  Consider the “Relevant Disciplinary History” portion of the AWC: it recites all of one prior regulatory matter.  But, BrokerCheck reveals that Merrill has 1,447 disclosures, 589 of which are regulatory events.  I haven’t bothered reviewing them all, but the simple fact is that Merrill has lots of prior supervisory violations.  For FINRA to agree to recite in this AWC that only one prior matter is “relevant” here is galling, given that small firms are never according similar deference.  Bill Singer, who authors an incredible blog, wrote about this very subject just last month, and I agree with his outrage.  If you don’t already subscribe to his blog, you must.

With that off my chest, let’s just take a quick look at what Merrill did to get the credit:

  • It engaged a consultant “to conduct a complex analysis” to identify the affected customers and compute the amount of money they overpaid;
  • It “promptly” came up with a plan of remediation, which included notifying the customers and, more importantly, paying them restitution (plus interest)[3];
  • It fixed the deficiency in the supervisory procedures; and
  • It provided “substantial assistance” to the FINRA examiners.

Well, there you go, there is the current blueprint to avoid the payment of fines, and, perhaps, also to qualify for credit for extraordinary cooperation.  You know the plan; now go execute it.  But, as I said in the title to this post: the key is the restitution.  Pay that, pay it voluntarily, pay it promptly, and it will clearly impact the disposition of your exam.

[1] 2011!!  By my math, that was nine years ago!  Is there no limit to how far back FINRA will deign to examine?

[2] According to the AWC, a “right of reinstatement” “allows investors to purchase shares of a fund after previously selling shares of that fund or another fund in the same fund family, without incurring a front-end sales charge . . .  or to recoup all or part of a contingent deferred sales charge fee.”

[3] Indeed, the AWC provides that Merrill had paid the restitution before the AWC was even approved.