Broker- Dealer Law Corner

Broker- Dealer Law Corner

Ameriprise Learns The Hard Lesson That To Be Deemed “Reasonable,” A Supervisory System Actually Has To Work

Posted in SEC, Supervision

A little over a year ago, I blogged about a FINRA Enforcement action against an Ameriprise rep – but, notably, not Ameriprise – to highlight what a great job the firm did in ensuring that its sales force was not engaging in any undisclosed outside business activities.  It had a robust supervisory procedure, with multiple levels of review, generating a significant amount of documentation.  Unfortunately, this week, that same firm entered into a $4.5 million settlement with the SEC that highlighted several problems with a different Ameriprise supervisory system, one designed to detect efforts by reps to steal money from client accounts.  The system was in place; it just didn’t function that well.  As a result, Ameriprise paid the price.

Proving that sometimes the old fashioned frauds can be just as effective as nifty new cyber frauds, from 2008 and continuing to 2013, a few Ameriprise reps perpetrated a fraud against certain Ameriprise clients, engaging in approximately 600 fraudulent transactions and misappropriating $1 million in client funds. Ameriprise was clever enough to understand the old trick of a rep changing the address of record on a customer account to his or her own addresses, thereby preventing the customer from receiving a copy of a monthly account statement revealing some unauthorized distribution, whether wire or check, to the rep.  Which is exactly what these reps did.  First they changed the customers’ address, and then they “forged client signatures on dozens of Ameriprise forms, including those to change the address of a client, to disburse funds via check, and to transfer funds by wire.”

Ameriprise had a system in place that was designed to issue an automated alert when the existing address on an account was changed to one that was “controlled” by one of its reps. But, “[f]or most of the relevant period . . . [b]ecause of a technical error,” the system “did not generate a flag in instances when there was a positive match between a changed address on an existing account and a ‘controlled address.’  As a consequence, [the system] did not compare the changed address to addresses associated with Ameriprise representatives and other personnel.”  Thus, Ameriprise was unaware of the unauthorized address changes, and, moreover, it “did not conduct any system testing that could have uncovered the error.”  That’s some technical error!

In addition to the flawed address change detector, Ameriprise also had a separate system designed to make sure that reps weren’t sending money to themselves out of their customer accounts. To prevent this, the system would review the identity and the address of the receiving party of an outgoing check to ensure that it was not an address controlled by one of its reps.  The problem is that the system didn’t flag the transaction unless the two addresses matched exactly.  As the SEC pointed out, “if the address information differed as between “Avenue” and “Ave.” – the Analysis Tool would not flag the transaction as suspicious.”  So, even though the addresses to which unauthorized disbursements from customer accounts were sent “were known to Ameriprise to be associated with and controlled by” the reps, no flag was generated and the unauthorized withdrawals were not questioned, either.  In addition, the system only reviewed disbursements by check, not by wire, a rather sizable loophole, and one the reps took advantage of.

Clearly, the SEC gave Ameriprise no partial credit for trying. So, the lesson is that it is not good enough to have some whiz-bang surveillance system with a great design but which only works in theory.  As the title of this blog post notes, supervision need only be reasonable, not perfect.  But, if the flaw in the well-intended and otherwise efficacious surveillance system is so big that it permits a blatant fraud to be conducted over a five-year period, it’s hard to argue with the SEC’s conclusion that it was not reasonable.  Especially if testing that would have revealed the existence of the flaw was not conducted.

FINRA Stats Reveal Horribly Kept Secret: Small Firms Are The Heart And Soul Of The Brokerage Industry, But Dying Off, Nevertheless

Posted in FINRA

If you are like me, and spend your idle time twiddling around the FINRA website, then you already know that FINRA publishes a variety of mathematical statistics, updated periodically, that provide, along with the sobering tally of the Enforcement actions brought and fines imposed, a good insight into the composition of the membership.  Yesterday, FINRA went one better and released what it called the 2018 FINRA Industry Snapshot, basically, an enhanced version of the data already available on the website.

There are no real surprises here, especially to those who, well, to anyone who knows anything about FINRA and its history. But, for the few readers who need some reminding, here are the central themes of the new report.

First, the membership of FINRA is predominantly made up of small firms. In 2017, there were a total of 3,726 broker-dealers.  Of that total, almost half – 48.3% – had ten or fewer registered reps.  If you look at firms with 20 or fewer RRs, then it goes up to 65.4% of the total.  Using FINRA’s own criteria for firm size, the number of small firms relative to the total is even more telling:

Small Firms (defined as 1 – 150 RRs):       90.0%

Mid-Size Firms (151- 499 RRs):                  5.2%

Large Firms (500+ RRs):                              4.8%

But, this is not news. FINRA has always looked like this.  It has always been dominated by small firms.  Unfortunately, despite their numbers, the revenues they generate for FINRA, even in the aggregate, cannot come close to matching those of the large firms.  Thus, while FINRA technically remains a one-firm/one-vote organization, don’t delude yourself into thinking it’s truly democratic.  The voices of large firms are heard way more loudly than the small firms because that’s where FINRA gets its money from.

It is no surprise, therefore, that when this report discloses the “Aggregate Financial Information” for the member firms, FINRA does not bother to break the numbers down by firm size. Instead, all we are shown is the total revenue for all firms, the total expenses, and the total pre-tax net income.  If FINRA were to publish these data points separately for small firms, mid-size firms and large firms, it would demonstrate that the top 5% or so of broker-dealers are responsible for the lion’s share of the revenues and the profits, as well as FINRA’s own revenues.  And that is not something FINRA is comfortable revealing.

Second, and more troubling, is the continuing decline in the number of FINRA member firms.[1]

The Snapshot contains data only going back to 2013, and they show a drop in the total number of firms in excess of 10%.  If you think that’s scary, how about going back ten years, to 2017.  In that ten-year period, FINRA lost 1,273 firms, or fully 25.5% of its members.  The oldest figures available are from 2003, when FINRA had 5,261 members.  By 2017, that number fell by over 29%.

There have been lots of articles written about the difficulty of running a small broker-dealer today, what with the high cost of compliance and the sheer number of man-hours required each year just to deal with FINRA and its seemingly incessant requests for documents and information. The resultant migration away from FINRA to the investment advisory world is amply demonstrated by the data in the Snapshot.  From 2008 – 2017, the number of BD-only firms, i.e., firms only registered with FINRA as broker-dealers, dropped 21.1%, from 3,969 to 3,132.  Not surprisingly, the number of dually registered BD/IA firms also fell, and by an even greater percentage, 35.9%.  During that same time period, however, the number of investment advisor-only firms, i.e., firms registered with the SEC or with the states only as investment advisors (and not registered with FINRA as BDs), increased 22.6%, from 24,147 to 29,599.

My point with this blog was not necessarily to offer an opinion about the data that FINRA published, but that’s really because the numbers, as they say, speak for themselves. And they are saying this:

  • FINRA is still mostly composed of small firms
  • But the number of those firms, and the influence they wield on FINRA’s direction, continues to diminish
  • If the trend continues, the landscape for broker-dealers will no longer look as it does today, as “mom-and-pop” shops will go the way of the paper tickertape and the handwritten order ticket

Maybe FINRA would prefer only a few hundred members, like the NYSE, who knows. But, if it’s not careful, that may be where this all ends up.

[1] A couple of years ago, in a blog regarding this same topic, I pointed out the dubious irony of the fact that despite the drastic reduction in the number of firms it regulates, FINRA’s annual expenses continue to climb dramatically.

FINRA Proposes To Require Disclosure Of Insurance Information In Arbitrations. Seriously.

Posted in Arbitration, FINRA

Once upon a time, FINRA at least pretended that it was interested in maintaining a level playing field for claimants and respondents in the arbitrations it administers. Today, all that pretense has been jettisoned.  In Regulatory Notice 18-22, which seeks comments on FINRA’s proposal to require respondents to produce information relating to their insurance policies, FINRA unabashedly concedes that “[t]he benefits of the proposed amendments accrue primarily to claimants in arbitration cases.”  And by “primarily,” FINRA really means “entirely.”  So, if you’re a BD with insurance coverage, not sure you need to read any further; instead, head directly to your computer and let FINRA know you don’t appreciate any rule explicitly designed to favor one party over another.  For those of you who want to get even angrier, read on.

First, some background. The way discovery works in FINRA arbitrations, there are lists of documents, one for claimants, another for respondents, comprised of the things that FINRA believes are “presumptively discoverable.”  In other words, even without the other side asking for these documents, a party is required to produce them (unless the party objects to doing so, which is its right).  FINRA established this practice a long time ago in the hope of reducing disputes over discovery.  Given the number of cases I am personally involved in that include one side, or both, filing a motion to compel discovery, not sure how successful this has been.  Nevertheless, “list” discovery is the norm in FINRA arbitrations.

Today, FINRA has proposed to add to the list of documents respondents are required to produce – even without being asked – “documents sufficient to provide details concerning the coverage and limits of any insurance policy under which any third party insurance carrier might be liable to satisfy in whole or in part an award issued by an arbitrator in the subject arbitration proceeding or to indemnify or reimburse a party for payments made to satisfy an award.” Why has FINRA done so?  It’s all part of a theme, apparently, that FINRA is pursuing: what can it do to increase the likelihood that customers not only collect money when they file arbitrations, but that they collect as much as possible.  If you have any doubt about this, please see recent blog posts on efforts to create a fund from which unpaid arbitration awards can be satisfied.

If you want something more concrete concerning FINRA’s intent to put its thumb on the scale for the benefit of customers, look no further than the Reg Notice itself. FINRA flat out admits that this proposal helps customers at the expense of respondents.

FINRA writes that “[i]nsurance information can provide valuable information to a claimant when determining a litigation strategy.” “To a claimant,” not to a respondent.

FINRA continues: “By receiving details of the existence and scope of any third-party insurance coverage, a customer can decide whether to amend the statement of claim to fit within the coverage.”  In other words, if I know the limits of your coverage, I can be sure to sue you for at least that much.

Now, for my favorite part:

Insurance information can be particularly important during settlement discussions when the ability of a firm or an associated person to pay an award is otherwise less certain. For example, when the insurance coverage of a firm or an associated person is not known and their ability to pay an award is less certain, then a customer may have difficulty determining whether to settle a claim and for what amount.  In this instance, a customer may be more likely to settle a claim for a lesser amount to ensure some monetary compensation for damages. The discovery of insurance information, therefore, could increase the ability of customers to determine a litigation strategy to maximize the monetary compensation they could expect to receive.

That’s what we need, a rule designed expressly to “maximize” the amount of money a claimant could receive. I can only imagine the enthusiasm the securities industry will express for this proposal.

In an odd display of candor, FINRA admits several additional problems that its proposal presents to respondents: (1) “[u]nder the proposed amendments, firms and associated persons could incur additional costs associated with arbitration”; (2) “Firms and associated persons that would otherwise not have provided the information would now have exposure to the risk that the opposing party could leak the information and prejudice the arbitrators”; and (3) because “[t]he proposed amendments could also increase the use of policies by firms and associated persons when customers receive monetary compensation for damages,” this could result in “[a]n increase in payout by insurance companies [which] could result in an increase in premiums, reducing the incentive for firms and associated persons to purchase coverage.”

Gee, what selling points!

But, no worries, FINRA has thought this through. In response to its acknowledgement that “customers could also increase their claim amount in response to knowledge of insurance coverage,” FINRA says no big deal, as it “believes that arbitrators would continue to determine monetary awards based on actual damages.”  Right, like the amount claimed by a customer is irrelevant to a panel’s consideration of a complaint.

What about that problem with “prejudice [to] the arbitrators” if the fact/amount of insurance coverage gets “leaked” by a claimant? Pish posh, as “FINRA will train arbitrators to address potential prejudice by providing training materials on ODR’s webpage and publications including The Neutral Corner.”  Unless FINRA’s training materials teach arbitrators how to reverse the Earth’s rotation in order to go back in time – see the original Superman (the movie, not the TV show!) – there is just no way to successfully unring that bell.  Granted, the Reg Notice asks what sanctions ought to be imposed on a party who provides insurance information to an arbitration panel without first seeking authorization to do so, but, short of outright dismissal of the case, I don’t see how any sanction would be appropriately remedial.  And, frankly, I am rather pessimistic that FINRA would ever create a rule mandating dismissal of a claim, given how hard FINRA has worked in recent years to minimize the ability of a respondent to have a statement of claim dismissed prior to the conclusion of the claimant’s case-in-chief at the hearing.

Look, this whole proposal is driven by FINRA’s concern – and by FINRA I mean PIABA – that smaller, less capitalized firms may not have enough money to pay adverse arbitration awards. The Reg Notice is clear that if you’re a big firm, with enough capital on hand to pay an award without having to rely on a third-party insurer, FINRA doesn’t care.  It is only interested if an insurance policy is the only thing that stands between a prevailing customer and his payday.  I just don’t understand how FINRA can get away with being so transparent with its sentiments.  FINRA rules governing arbitrations should be neutral.  Even to request comment on proposed amendments so obviously tilted in favor of claimants represents a dereliction in FINRA’s obligations as the provider of this arbitral forum.

BD Learns It’s Not Enough To Have A Supervisory Procedure For OBAs, You Actually Have To Follow It

Posted in Enforcement, FINRA, Outside business activities, Rule 3270, Uncategorized

In most Enforcement cases involving outside business activities, it is the registered rep who is named as the respondent, and the allegation is that the RR failed to provide notice (or timely notice) to his or her broker-dealer about the OBA. On occasion, however, it is the BD that gets tripped up, typically for not bothering to follow up appropriately (or at all) on an RR’s disclosed OBA.  Cetera just learned this lesson the hard way, i.e., a $200,000 AWC for violating Rules 3010/3110 and 3270.

The facts of the case are pretty straightforward. The RR in question managed to get two of his elderly customers to grant him power of attorney, broad enough for him to be able to control their financial affairs (including the securities accounts for which he was the RR of record).[1]  According to Cetera’s perfectly reasonable policy, an RR could not do so (for a non-family member) without obtaining authorization from Compliance.  Turns out that the RR never got that authorization.

But, interestingly, also turns out that the RR tried to get it.  In fact, according to the AWC, on three separate occasions, the RR disclosed to Cetera that his two customers had granted him power of attorney over their financial affairs.  Cetera, however, “did not timely review, evaluate or respond to [RR’s] disclosures.”  In fact, Cetera “did not commence a review” of the RR’s trading on behalf of the two customers until questions were raised by a third party: a “mutual fund issuer detected that some of those transactions appeared questionable and alerted” Cetera.  There’s only one thing that could have been worse than that, and that would have been if FINRA examiners discovered the problem.

There are some pretty obvious lessons to learn here. First, it is not enough to have your RRs disclose their outside business activities; you actually have to review what they disclose.  (Like Jerry Seinfeld’s complaint that it’s not enough for the car rental company to “take” the reservation if it doesn’t actually “hold” the reservation.)  Cetera had the right supervisory procedure in place, which required a timely review of disclosed OBAs; it just failed to follow it.

Second, don’t ignore the supplementary material for any FINRA rule; sometimes, that’s where the juiciest language can be found. Certainly, that’s true for Rule 3270.  On its face, the rule is rather short and seems pretty simple to comply with, especially since approval of OBAs isn’t even required; rather, all that’s needed is that an RR provide “prior written notice.”  It only gets more complicated, as I said, when you drag your eyes down to the bottom of the page and read the supplementary material.  There, you will find the requirement that upon receiving notice of an OBA, a BD must “consider whether the proposed activity will: (1) interfere with or otherwise compromise the registered person’s responsibilities to the member and/or the member’s customers or (2) be viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.”

Once the firm considers those two questions, it “must evaluate the advisability of imposing specific conditions or limitations on a registered person’s outside business activity, including where circumstances warrant, prohibiting the activity.” That includes the need to “evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirements of Rule 3280.”  Finally, the firm “must keep a record of its compliance with these obligations with respect to each written notice received and must preserve this record for the period of time and accessibility specified in SEA Rule 17a-4(e)(1).”

In other words, the supplementary material changes the rule from merely a “notice” provision to one that actually requires “approval.” But, Cetera didn’t make any of the analyses required by the supplementary materials.  As a result, it had no defense to offer to FINRA when confronted with its omissions.

The third lesson is that when considering OBAs, firms should take an expansive view. That is, RRs should be made to disclose anything and everything that could possibly be considered to be an OBA, even if it’s not obvious.  Rule 3270 requires that an RR provide notice when he or she is “an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or ha[s] the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm.”  Based on this description, it is not entirely clear that simply being granted power of attorney over a client’s financial affairs, particularly when there is no compensation involved, technically requires an OBA notice.  But, it seemed that Cetera did require it to be disclosed here (even though it then dropped the ball by not reviewing the disclosures), which is smart.  The spirit of the rule is simple to divine: RRs should be required to disclose anything that they do away from the BD that could cause a conflict with what they do as an RR, or which could cause customers to be uncertain of the capacity – RR vs. non-RR – in which the RR is operating.  There should be no close calls.  Always err on the side of requiring disclosure.

The final lesson is the same one as always: if you actually do something to fulfill your supervisory obligations but fail to document the fact that you did it, as far as FINRA (or, sometimes, an arbitration panel) is concerned, you didn’t actually do it.  So, write  a memo.  Write yourself an email.  Make an entry on your calendar.  Do something to physically record the fact that you took some action.  From an evidentiary perspective, even a modest, unabashedly self-serving effort to memorialize an event is better than nothing.

[1] Presumably, the RR exerted some degree of undue influence to obtain the POAs in order to benefit himself, given that he entered into his own AWC with FINRA, agreeing to a permanent bar for misusing at least $75,000 from the bank account of one of the two senior customers.

FINRA’s “Massive” Discovery Failure Results In…Absolutely Nothing

Posted in Disciplinary Process, Enforcement, FINRA, Sanctions, Uncategorized

You are not going to believe this one. Here are the unadulterated facts, taken directly from the Order entered by the FINRA Hearing Officer (an Order, by the way, which FINRA elected not to publish on its website):

  • Five days into an Enforcement hearing against Respondent Steven Larson, “Enforcement disclosed that it just realized it had failed to produce certain documents in discovery.”
  • Enforcement admitted that it was unable “to represent that it knew the full extent of the non-production.”
  • The Hearing Officer adjourned the hearing to give Enforcement time to figure out the scope of its discovery failure.
  • After a week, Enforcement “announced at a status conference the extent of the non-production.”
  • “It was massive,” according to the Hearing Officer.
  • “Enforcement admitted to not producing at least 30,000 emails (plus attachments).”
  • “[T]he volume of improperly non-produced documents [was] more than double the total documents [Enforcement] had produced.”
  • “Stated differently, well into the final phase of the hearing, Enforcement had only provided [respondent] with approximately half the documents he was entitled to receive.”
  • In addition, Enforcement also admitted that it had “inadvertently omitted” from its previous discovery production “an additional 160 documents and 17 emails (plus attachments).”

In response to this astonishing development, Mr. Larson filed a motion to dismiss, essentially seeking dismissal as a sanction for Enforcement’s “massive” discovery failure.  Enforcement responded to the motion, and, according to the Order, “[w]hile conceding it should have produced the documents as part of its FINRA Rule 9251-mandated discovery, Enforcement argues that sanctions should not be imposed because its document production failure was inadvertent; it has now produced the omitted documents; [respondent] has not been prejudiced; and it did not make any representations.”

In other words, according to FINRA, hey, we messed up but it wasn’t intentional, and anyway, no harm no foul, so let’s just let bygones be bygones.

The Hearing Officer considered FINRA’s argument.  He labeled FINRA’s discovery failure to be “disconcerting in a number of respects.”  First, FINRA not only failed to timely comply with its discovery obligations under Rule 9251, but it “also violated the Case Management and Scheduling Order.”  Second, “the period of non-compliance was lengthy.”  Eight months late and, indeed, five days into the actual hearing.  Third, “the volume of documents that Enforcement failed to produced is staggering.”  Fourth, “the non-production did not result from a single cause, but from a combination of miscommunication, misunderstandings, and other errors.”  Fifth, “the discovery failure resulted in a four-month delay in the completion of the hearing.”  Finally, “while it is unclear whether any of the additional documents contain material exculpatory evidence, some of these documents may at least be relevant to [respondent’s] defense.”

All of these facts seemed to dictate that dismissal was appropriate.  Against those facts, however, the Hearing Officer weighed the following:  First, the record did not show that Enforcement “engaged in willful misconduct, bad faith, or that it otherwise acted contemptuously.”  Second, “Enforcement admitted it made a mistake.”  Third, “Enforcement has made substantial remediation efforts.”  Fourth, “any prejudice resulting from Enforcement’s failure to timely produce the documents has been eliminated, or at least substantially mitigated, because” the Hearing Officer continued the hearing for four months.  Finally, and most alarming (at least to me), “dismissing this proceeding” at what the Order calls “this late stage” “would undermine the public policy favoring the disposition of cases on their merits.”

Can you guess what the Hearing Officer decided to do?  Not only did he deny the motion to dismiss, he concluded that “the imposition of lesser sanctions [was] unwarranted.”  In other words, he did nothing.

All because, basically, he determined that FINRA didn’t intentionally screw up.

Eventually, months later, the hearing continued and – shockingly!! – FINRA prevailed.  In the final Decision, all the hubbub about FINRA’s “massive” discovery failure was reduced to a single mention.  In one measly footnote.  Nothing to see here, move along, apparently.

Just imagine what FINRA would have done to a respondent who failed to produce 30,000 emails in response to an 8210 request.  Even a respondent who admitted his failure, and whose failure was inadvertent, would, in my experience, be staring at nothing less than a permanent bar as a sanction.  The double-standard that the Hearing Officer employed here is staggeringly obvious and, frankly, outrageous.  It was not enough that he gave respondent a four-month break in the middle of the hearing to deal with the giant, late production by Enforcement.  To suggest that doing so “eliminated, or at least substantially mitigated” any prejudice to the respondent is sheer fantasy, a dream that, I suppose, helps FINRA management sleep at night.

I have complained before about the fact that FINRA does not hold itself to the same standards as the individuals and firms that it regulates.  So, this sort of thing isn’t new.  But, this case may take that concept to a new height (or depth), unrivaled for the patently inequitable way respondent was treated.  I harbored some hope that under its (relatively) new stewardship, FINRA Enforcement might start to demonstrate a greater degree of fairness, but such hope was dashed by this case.

You want more proof, more reason to remain a cynic?  How about this:  it was not enough, apparently, that the respondent’s rights under the Code of Procedure were so thoroughly trampled.  On top of all that, Enforcement has now filed an appeal.  Yes, that’s right, even though Enforcement prevailed on some of the charges it brought, other charges, including, notably, the fraud charge, were dismissed (in a 2 – 1 decision, prompting a dissent from the Hearing Officer).  So, despite the fact respondent was suspended for 18 months “for submitting materially misleading Continuing Membership Applications to FINRA,” fined $37,000 and suspended for two years “for failing to provide complete and timely responses to FINRA document and information requests,” and suspended for 18 months “for falsifying firm records by backdating supervisory documents and then submitting some of them to FINRA,” I guess that’s not enough sanctions for Enforcement.  Because the two industry members of the hearing panel concluded that “Enforcement failed to prove by a preponderance of the evidence that Respondent made fraudulent misrepresentations and omissions to customers about their church bond holdings and in connection with church bond cross trades he arranged” and dismissed the charges relating to these allegations, respondent was not barred.  And, like the evil clown Pennywise from Stephen King’s It, with his insatiable appetite for the children who inhabit the town of Derry, Maine, FINRA will not be cheated of its own pound of flesh from respondents like Mr. Larson here, who had the temerity somehow to avoid a bar.







Has The SEC Taken All The Mystery Out Of Filing SARs?

Posted in AML, SAR, SEC

This week, Charles Schwab consented to pay the SEC a $2.8 million civil penalty for failing to file SARs on certain transactions – suspicious transactions, namely – by a number of independent investment advisors that Schwab had terminated from its platform. This matter is noteworthy not just for the size of the civil penalty, but because it reflects the continuation of a concerning trend by the SEC to focus less on a firm’s AML processes and procedures and more on the firm’s ultimate decision whether or not to file a suspicious activity report, or SAR.

Section 356 of the USA PATRIOT Act amended the Bank Secrecy Act to require broker-dealers to monitor for and report suspicious activities when circumstances warrant. The rule requires broker-dealers to file a SAR when they know, suspect, or have reason to suspect that a transaction of at least $5,000 involves money from illegal activity, or was conducted to disguise such funds or evade the requirements of the BSA, or has no business or apparent lawful purpose, or involved the use of the broker-dealer to facilitate criminal activities.  Based on this somewhat fuzzy language, figuring out whether some set of facts requires the filing of a SAR can become the subject of intense debate.

But, here is why I find the Schwab case to be interesting. Historically, perhaps because of the fuzzy language used in the statute, the focus of regulators in their enforcement actions involving AML cases has not been on whether or not a firm actually filed a SAR; instead, the focus has been on whether the firm had proper AML procedures in place that allowed it to spot the apparently suspicious activity in a timely manner, to investigate the suspicious activity promptly and thoroughly, and to document that entire process.  The case that most people, including me, cite for this proposition is the Sterne Agee decision, a FINRA OHO decision.  The hearing panel in that case looked to guidance from bank examiners to determine what the proper focus ought to be.  It noted with approval that

[t]he Federal Financial Institutions Examination Council (“FFIEC”) has emphasized the importance of focusing on the process, rather than on whether a particular SAR was filed. In its examination manual for banks, FFIEC states, “The decision to file a SAR is an inherently subjective judgment.  Examiners should focus on whether the bank has an effective SAR decision-making process, not individual SAR decisions.”  This is not to say that the failure to file a SAR cannot be questioned, and FINRA has settled matters involving the failure to file SARs.

Schwab is now the latest in a recent line of SEC cases that turns the Sterne Agee reasoning on its head, by caring more – or at least as much – about whether a SAR was filed than whether the firm had a reasonable supervisory system in place that allowed the firm to spot the suspicious circumstances in the first place.

In November 2017, Wells Fargo Advisors, LLC agreed to pay $3.5 million to the SEC for its “failure to file or timely file”  “at least 50 SARs, a majority of which related to continuing suspicious activity occurring in accounts held at Wells Fargo Advisors’ U.S. branch offices that focused on international customers.”  In March 2018, Aegis Capital Corp. entered into a settlement with the SEC, resulting in a $750,000 civil penalty, because it

failed to file Suspicious Activity Reports (“SARs”) on hundreds of transactions when it knew, suspected, or had reason to suspect that the transactions involved the use of the broker-dealer to facilitate fraudulent activity or had no business or apparent lawful purpose. Many of the transactions involved red flags of potential market manipulation, including high trading volume in companies with little or no business activity during a time of simultaneous promotional activity.  Aegis did not file SARs on these transactions even when it specifically identified AML red flags implicated by these transactions in its written supervisory procedures.

I am hardly saying that it is not necessary to worry about your AML supervisory procedures; indeed, that remains a legitimate concern. But, what seems to be a new development is the need to worry a lot about the actual decision to file a SAR or not.  I am wondering now if my historic advice to clients not to be concerned about that as long as they make a reasoned, documented decision not to file a SAR remains valid in light of these recent cases.  Now, the lesson of these cases seems to be: if you identify something suspicious, even potentially suspicious, then file a SAR, since that will avoid the nasty call from the SEC asking for the explanation for the absence of a SAR.

But that would be a lousy development and a bad lesson. While the whole process of filings SARs often seems to be an exercise in box-checking and doing it because the rules say that I have to do it, in fact, SARs fulfill an important function in helping detect and prevent real criminal activity.  I would 100% agree, of course, that very, very few SARs reveal actual criminal activity, but that’s for FinCEN to suss out.  If BDs simply file a SAR every time they spot something even potentially suspicious, without bothering really to analyze the activity to figure out if it is truly suspicious – something that I have seen characterized as filing a “defensive” SAR, i.e., a SAR designed simply to avoid regulatory scrutiny, rather than to report of suspicious activity – then it could very well compromise FinCEN’s ability to meaningfully review and follow up on those SARs that reveal truly suspicious conduct.

I don’t advocate, therefore, that firms simply abdicate their responsibility to determine whether activity is suspicious or not and just file SARs anyway. But, I do think it’s clear that there is no point whatsoever in sweating over the decision to file a SAR.  There is no reason only to file SARs in those instances in which you are 100% convinced a filing is necessary.  If it is arguable that a SAR should be filed, then stop the internal debate and make the filing.  The SEC is not going to make an example of you if you do, but, as these cases reveal, you run a legitimate risk of being second-guessed if you don’t.

PIABA’s Efforts To Get A Law Passed To Ensure Payment Of Legal Fees Off To Rough Start

Posted in Arbitration, FINRA, PIABA

About a month ago, I posted a blog about the apparent success that PIABA had achieved in getting two US senators — a Democrat and a Republican — to sponsor a bill to require FINRA to create a fund from which unpaid arbitration awards — and, of course, unpaid claimants’ counsel fees — would be paid.  I complained about the proposed bill, and argued that it was flawed in a number of obvious ways.  But, who listens to me.

Well, I was pleased to learn today that when the bill was presented to Senate Banking Committee, it hardly received a warm reception.  To the contrary, it seems that the Committee members were less than excited about the prospect of FINRA creating this fund, even though the proposal calls for the fund to be sourced by fine revenue that FINRA collects from unfortunate respondents in Enforcement actions.  The clever Committee members recognized a couple of very troublesome things about this proposal.  First, there is no cap on the size of the fund.  So, theoretically, FINRA will have to keep adding money to it in the event that the claims made against it exceed the initial contributions.  Second, in that event, i.e., FINRA needs to put more money in than anticipated, that money will have to come from sources beyond the fine money, which means from member firms who are not respondents in Enforcement actions.  Even US senators seem capable of recognizing that it is pretty poor form to require the rule-abiding members of FINRA to pony up money to pay the debts of other, less compliant, firms and individuals.

SIFMA weighed in, too, arguing against the proposed law.  In addition to making the points outlined above, SIFMA also observed that requiring FINRA to use fines collected as the source of the fund creates “a perverse incentive for FINRA to increase both the number of enforcement actions that it brings, and the dollar amount of penalties that it imposes, in order to ensure that the recovery pool is adequately stocked.”  I like the way that SIFMA thinks.  While FINRA always denies that its decisions to bring Enforcement actions are in any way motivated by the fine dollars it might collect at the end of the case, it is undeniable that a need for additional fine money to deposit into the fund would create an actual conflict of interest.  Much like at the end of my tenure with NASD in 2004, when senior management created objective measures by which the performance of the District Offices could be determined, one of which was the number of formal disciplinary actions we filed (it needed to be at least 10% of the number of exams we conducted to “pass”).  Clearly, that criterion added incentive for NASD to file complaints, even if not merited by the evidence.  The current FINRA proposal shares the same “ick” factor.

At the end of the day, the mere fact that PIABA has thrown its weight behind this bill should be enough to make the Committee think very hard about whose interests are at issue here.  Is it really the investors, or is it their counsel?  Every lawyer who files a complaint or a statement of claim in arbitration in an effort to collect money owes it to his or her client to explain not only the likelihood of prevailing, but, as well, the prospects of collecting on the award in the event they do, in fact, prevail.  Collecting is never guaranteed.  When collection is uncertain, it may not be in the client’s best interest to file suit.  The proposed statute turns this principle on its head, essentially ensuring that claimant will collect, and that claimant’s lawyer, who has the case on a contingency fee basis, will get paid regardless of the success of collection efforts against the respondent.  Given that, it is easy to see how arbitrations will undoubtedly increase in frequency should this bill gain traction.  Let’s hope that the chilly reception it received at the Committee level is enough to put the kibosh on this proposal.



Beyond Lucia: The Supreme Court’s Decision Is Just the Beginning

Posted in Administrative Proceedings, appeal, Defenses, SEC

Here is an important post by my partner, Ken Berg, regarding SEC administrative proceedings, and what we can expect following the Supreme Court’s recent decision in Lucia. – Alan

By now everyone knows the US Supreme Court declared the SEC’s administrative proceedings unconstitutional because the ALJs were improperly hired by the SEC staff instead of being appointed by the Commissioners. All respondents who raised this constitutional issue before the SEC, who have not settled, and whose cases are not yet final, are entitled to a new evidentiary hearing before a different ALJ.  But, here are a couple of questions the Supreme Court did not address in Lucia v. SEC and that decision may be just the beginning of the SEC’s troubles.

First. What about respondents who did not raise the issue before the SEC?  If they did not settle and their cases are not final, are they entitled to a new hearing before a different ALJ?  Looks good.  This issue is currently pending before the Tenth Circuit in a case argued by Ulmer and awaiting decision, Malouf v. SEC.  Ulmer argued even though Malouf’s former attorney did not raise the Appointment Clause issue before the SEC, the Court of Appeals can reverse because there were “reasonable grounds” for not doing so.  At oral argument, at least two of the three judges were openly skeptical of the SEC’s position that the Court of Appeals could not reverse.  Judge Hartz said to the lawyer representing the SEC, “Help me get comfortable with your position.”  The Judge was troubled because even if the constitutional issue had been raised before the SEC, the agency “almost certainly would have ignored it.”  Judge Bacharach challenged the SEC’s attorney, saying “I can’t think of a new argument that could be more futile to make than that everything [the SEC has] before [it] is invalid ….”  This bodes well for respondents getting a new hearing before a different ALJ even if they did not assert the Appointments Clause defense at the SEC.

Second. Did the SEC fix the constitutional problems when it appointed the sitting ALJs in November 2017?  Probably not.  In addition to being appointed incorrectly, there are other constitutional problems with the way SEC ALJs can be removed.  The Supreme Court did not address this issue.  (See Judge Breyer’s separate opinion.)  The Appointments Clause not only requires ALJs to be appointed by the President or the Commissioners, it also requires that the President be able to remove ALJs.  However, ALJs can only be removed “for cause” (meaning they are not doing their job) and ALJs are entitled to a hearing at the Merit Systems Protection Board before they can be removed.  These multiple levels of protection from removal violate the Appointments Clause.  Unlike the defect in appointing ALJs, the fix for the removal problem may not be within the SEC’s power and may require an act of Congress amending the Administrative Procedure Act.  Until that happens, all administrative proceedings at the SEC go forward at the risk of having to be redone.  Accordingly, all respondents should assert an appointments clause defense as early in the proceedings as possible even after Lucia.

Third. Does the five-year statute of limitations applicable to SEC enforcement proceedings bar retrying a case before a different ALJ?  Worth arguing.  SEC proceedings are commenced by the Commissioners issuing an Order Instituting Proceedings (“OIP”).  The OIP must be issued within five years of the allegedly unlawful conduct and it determines whether the case will proceed administratively or in district court.  The Appointments Clause “invalidates actions taken pursuant to defective title.” Ryder v. US, 515 US 177, 185 (1995).  An OIP issued before November 2017, when there were no constitutionally appointed ALJs, is void and did not commence an action.  Retrying a respondent before a different ALJ requires issuance of a new OIP.  But if the new OIP is issued more than five years after the allegedly unlawful conduct, then the proceedings are barred by the statute of limitations.  Accordingly, an unintended consequence of the Supreme Court’s decision in Lucia is that he and others similarly situated may be completely off-the-hook.


PIABA Lawyers Convince Congress Of The Importance Of Them Collecting Their Attorneys’ Fees

Posted in Arbitration, FINRA, PIABA

I have written before of the ferocious effort by PIABA lawyers to fight for their ability to collect attorneys’ fees on contingency matters – FINRA arbitrations – that they manage to win but which never get satisfied because the respondent broker-dealer has the temerity to go out of business rather than paying the award. PIABA members are clever enough not to make themselves the focus of the campaign, however; rather, they highlight the claimants, whom they characterize as being victimized twice, once by the bad broker and then a second time when the award is not satisfied.  As I have said before, I am not sure why people who choose to sue broker-dealers should be put into a special category of plaintiffs who are assured of collecting if they prevail, whereas anyone else in America runs the risk that judgments they obtain may go unsatisfied.

Well, apparently, at least two US Senators have been convinced by PIABA that this is a scourge that must be addressed. Forget immigration.  Forget tariffs.  Forget Russia.  It was reported this week that Elizabeth Warren (D-Mass) has been joined by John Kennedy (R-La) in a rare bipartisan agreement to co-sponsor a bill that would make PIABA’s dream come true, a law requiring FINRA to create a fund that could be tapped when respondents fail to pay adverse arbitration awards.

I won’t bother to comment on why Congress is dealing with this, given the host of other issues that it ought to be addressing. So, let’s look at the real problem.  According to the proposed bill, the fund would be created using money that FINRA collects in fines from respondents in Enforcement actions.  PIABA says that’s a winning formula, since the money will be coming not from taxpayers but from “bad guys” who violate FINRA rules.

But that’s just half the story. The money that FINRA metes out in fines is not just sitting around Robert Cook’s office in an envelope used to pay for the cakes and ice cream for his office’s monthly birthday celebration.  It is millions of dollars.  Last year, it was $73 million; in 2016, it was $176 million.  Granted, not all of that is collected, but that which is received is used by FINRA to accomplish very real and (hopefully) very important things.  According to FINRA’s Fines Policy, fine monies are used for “capital expenditures and specified regulatory projects that promote compliance and improve markets.”

In its 2018 Budget Summary, FINRA identified some of those projects that it paid for with collected fines, including “a successful multi-year effort to migrate FINRA’s technology environment from a data center structure to a cloudbased architecture, reducing expenses and increasing surveillance speeds,” moving its “continuing education program online in order to provide representatives with more flexibility to satisfy their requirements,” and the launching of “TRACE for Treasuries initiative to provide increased understanding and enhanced surveillance of the Treasury market through the reporting of secondary-market transactions in Treasury securities.”  In addition, fine monies were also earmarked “to transform the technological infrastructure of the registration systems for member firms and individuals, providing a significant upgrade to a core tool that is used by FINRA, the SEC, state regulators, the industry and – through BrokerCheck – the investing public.  The enhancements will transform the legacy registration systems to modern systems using open-source architecture and cloud-based infrastructure to deliver increased usefulness and efficiency.”

If fine monies are diverted from those intended uses and, instead, used to pay unsatisfied arbitration awards, then FINRA is going to have to come up with the money for its “capital expenditures” and “regulatory projects” from another source. And what source will that be?  According to the 2018 Budget Summary, “[i]f fine monies are not collected in amounts sufficient to fully fund these projects, the Board authorized the use of reserves.”  Well, how does FINRA replenish its reserves?  Unfortunately, there is no significant source other than the member firms.

Members represent the principal source of nearly all the revenues that FINRA generates. The 2018 Budget Summary includes statistics that reveal that fully 88% of FINRA’s “operating revenues” come from the members in the form of “Regulatory Fees” – defined to “primarily include the Gross Income Assessment, Personnel Assessment and Trading Activity Fee,” all of which come from member firms – and “User Fees” – defined to “primarily include Registration Fees, Transparency Services Fees, Dispute Resolution Fees, Qualification Fees, Continuing Education Fees, Corporate Financing Fees and Advertising Fees,” again, all derived from members.  Ultimately, if FINRA runs out of money to accomplish its goals, then necessarily it will be the members who pay through increased fees.  But, I guess that’s not PIABA’s problem.

And, to close, let’s play a little “what if” game, to demonstrate that this proposed Congressionally mandated FINRA fund may dry up rather quickly. Say you are a PIABA member, and say you are aware of a BD that’s been hit with so many arbitrations that it’s teetering on the verge of bankruptcy, and is unable even to pay to defend itself.  In the real world, an ethical attorney may have to dissuade a client from bringing such a case against that BD, notwithstanding the merits of the claim, and even though the BD might not even mount a defense, out of realization that any award obtained could not be satisfied.  But, what if you knew that unpaid arbitration awards are simply resolved by dipping into FINRA’s shiny new fund?  Why, then you would undoubtedly file your arbitration and ask for the most money imaginable.  Even if the BD defaulted, you could rest easy that FINRA would step in to satisfy the award.  Easy peasy money.  And there would be an onslaught of new cases being filed to get some of it before it’s all gone.

This proposal, apparently in danger of actually becoming a law, needs to be tossed out.

The Demise Of FINRA’s District Committees…And Self Regulation, Too?

Posted in District Committees, FINRA

Many people, myself included, are of the view that FINRA today remains a self-regulatory organization in name only. For years now, FINRA has taken a series of actions decried by its member firms – new rules, new interpretations of old rules, zealous enforcement of rules, the imposition of punitive sanctions – who correctly complain that FINRA has lost sight of the fact that it is, at its roots, a membership organization run by and for its constituents, i.e., broker-dealers.  Instead, FINRA principally acts as an enforcer, aggressively pursuing even the most modest of rule violations (despite what its senior management has said to the contrary in recent public pronouncements).

Even with that said, there has remained one last bastion of self-regulation: the District Committees. FINRA is comprised of 12 Districts, and each District has its own District Committee, elected by the membership.  Unlike the NAC, i.e., the National Adjudicatory Council, and the Board of Governors – the two levels of governance directly above the District Committees – all members of the District Committees are people currently registered with broker-dealers.  The NAC and the Board, by comparison, are comprised of a majority of non-industry members.  This was done at the SEC’s specific direction, to dilute the ability of the member firms to dictate FINRA’s ideological direction, I suppose to try to ensure that the inmates don’t somehow take over the asylum.  I mean, how can actual members of the securities industry possibly know what’s best for the industry, right?  Better bring in some CEOs and college professors.

But not at the District Committee level. There, all you see are branch office managers, chief compliance officers, firm presidents, and the like.  Everyone is registered, and everyone has skin in the game.  These are people who, almost universally, know what’s going on, how difficult it can be to run a clean shop, and how hard, at times, it can be to deal with FINRA.

The District Committee used to be a pretty powerful group of people. As I presume all readers of this blog understand, the role of District Committees changed in the late 1990s, as part of the SEC’s 21(a) Report on NASD, and not necessarily for the better.  As a result of the concerns that the SEC noted in that Report, the power of District Committees to authorize the issuance of Enforcement complaints and to review and approve settlement offers was removed and given, instead, to Enforcement itself  (subject to oversight by the Office of Disciplinary Affairs).  The only roles left to members of the District Committees following that power shift were to (1) sit on the occasional Enforcement hearing panel, and (2) attend quarterly meetings, where members of FINRA’s senior management flew in to describe all the new, cool initiatives that they’d conjured up in Rockville, DC and New York.

While those meetings were designed to be a give-and-take between the membership and management, it was clear from the outset that the collective voice of the District Committee members was faint, at best. Indeed, their job was never to approve of new proposed initiatives, since, in fact, senior management didn’t need their imprimatur to pass new rules, so their views on the subject were, ultimately, meaningless.  Simply put, the District Committee members were there to provide a degree of window dressing, to make it appear that FINRA management actually cared what the members thought.

This charade has, sadly, become obvious. What was once considered to be a position of note, a feather in the cap of anyone fortunate enough to be selected to sit on a District Committee, in short, an honor, has become something decidedly less worthy of celebration.  It has gotten to the point where instead of contested elections between multiple qualified candidates vying to win a seat on a District Committee, now, there aren’t enough people with sufficient interest in the job to bother with the process.  How do I know this?  FINRA itself told me.

Just a couple of days ago, FINRA filed a rule proposal with the SEC designed essentially to do away with the District Committees and replace them with Regional Committees.  Included in that proposal is this telling sentence: “FINRA has noted the membership’s general lack of interest in District Committee service.”  On what does it base that observation?  According to FINRA,

[t]he number of District Committee seat vacancies is the primary indicator of the membership’s declining interest in District Committee service. For the past six years, there has been an average of 29 vacant District Committee seats per year.  Of this 29-seat average, 13 (approximately 45%) have been contested seats (two or more candidates), eight (approximately 28%) have been seats with only one candidate, and eight (approximately 28%) have been seats without any candidates, thus requiring FINRA to find an eligible person to appoint to the seat.

The idea that over half the open District Committee seats attract either only one candidate or, worse, no candidates at all, speaks volumes about the superficial role that the District Committee plays in today’s FINRA, not to mention the fact that the membership correctly understands this sad truth.

To address this, FINRA has proposed several changes. First, it will eliminate the District Committees and replace them with Regional Committees.  Perhaps that’s not a big deal, inasmuch as the District Committees have already been meeting on a regional basis for years and years.  Second, it will alter the current composition of the District Committees, which is derived by a specific formula.  Now, each District Committee reflects “a configuration of three small, one mid-size and three large firm representatives.”  According to FINRA, this “three-one-three composition is intended to align District Committee representation more closely with the industry representation on the FINRA Board.”  But, FINRA maintains that this “configuration does not necessarily reflect the industry composition within the regions as each region differs regarding firm number, size and business lines.”  As a result, it wants to throw away the formula, which would make all seats on the District Committee at-large seats.  In addition, the requirement that only small firms could vote for the small firm seat, only mid-size firms could vote for the mid-size seat, etc., would be eliminated, and any member firm could vote for any vacant seat.  There are some other small tweaks, but these are the big changes.[1]


I have no idea if these changes will actually work to increase interest in District Committee membership. I hope that they do, because it is sad and disturbing that FINRA has watered down the role of the District Committees to the point that firms apparently no longer care about getting their best and brightest people to sit on them, as firms once did.  But I understand why they don’t.  I understand why people don’t want to waste their time simply being props in FINRA’s stage-managed productions where senior management pretends to be interested in what the District Committees have to say and then does what it wants anyway.

If the securities industry is ever going to get serious about fixing things, about taking back control of how FINRA acts towards its members, it must embrace that fact that changes need to start locally – at the District Committee level (or Regional Committee level, if this rule proposal is passed). Qualified individuals who feel strongly about what’s wrong with FINRA should actively participate in the FINRA committee system and make sure that their voices are heard.  If not, if the industry continues to abdicate its responsibility to ensure that self regulation survives, then it loses its right to complain about things, and, ultimately, member firms will get what they deserve.

[1] There is a very interesting throw-away line in the rule proposal regarding the role of District Committee members to comprise Enforcement hearing panels.  It states that “FINRA also is exploring options to enlarge the pool of panelists.”  I wonder what that could possibly mean?  It is incredible to consider that FINRA can’t attract enough people interested enough in the Enforcement process to volunteer to sit on hearing panels.