Broker- Dealer Law Corner

Broker- Dealer Law Corner

The Real Lesson From FINRA’s 2018 Exam Findings Report

Posted in Enforcement, Examination, FINRA

On Friday last week, FINRA released a report discussing the findings from its 2018 exams, providing what it described as “selected observations” that were deemed to have “potential significance.” Even with that tepid introduction, in theory, this is still a great idea, since anyone in the industry, even so-called “good” or “clean” firms, should welcome the chance to learn lessons from all those other firms who have managed to find themselves on FINRA’s radar screen. Unfortunately, as is often the case, in reality, there’s really not much to see here, as the results are entirely predictable. I mean, would it surprise even one person to read that FINRA encountered issues in its 2018 exams with suitability, supervision, net capital and AML? Likely not, given the frequency with which these subjects are the subject of Enforcement actions, and not just this past year, but going back seemingly forever.

So, since the principal purpose of the report is pretty pointless (because it simply tells us what we already know), the question becomes whether there is anything else of value in there. On close reading, I think there is, as the report serves to highlight FINRA’s fairly black-and-white view of what’s ok and what’s not. And, once you know that, you can at least try to stay out of trouble.

First, it is interesting, but not at all shocking, to observe that most of what bothers FINRA relates to products other than bread-and-butter stocks and bonds. A large majority of FINRA’s discussion of the things that got firms into regulatory difficulty this year involve less mainstream products. The list includes products that FINRA describes only generally, like “complex” and “high-risk” products, but also more specific things, such as leveraged and inverse ETFs and ETNs, variable annuities, UITs, REITs, volatility-linked products, and private placements. This just serves to reinforce something I have long espoused, which is that the further one gets away from vanilla buy-and-hold strategies involving blue chip stocks or index mutual funds, the less comfortable FINRA becomes. Even products as mundane as municipal bonds or certain managed mutual funds become, in FINRA’s eyes, fraught with danger for unwary investors.

Second, even I was surprised to read, both explicitly as well as between the lines, that FINRA’s recommended approach to these “risky” products seems not to manage whatever risks they supposedly present, but, more simply, less elegantly, to eliminate them, by not selling them in the first place. Throughout the report, FINRA highlights – and not unfavorably – instances in which exams revealed that certain BDs have, apparently, just thrown in the towel and said they’ve decided it’s not worth it to sell or do something that FINRA has concluded, rightly or wrongly, is risky. Consider the following examples from the report:

  • In its discussion of suitability issues, FINRA complimented “firms with sound supervisory practices for suitability” not only because they “implemented controls tailored to the specific features of the products they offered and their customer base,” but because those controls “included, for example, restricting or prohibiting recommendations of products for certain investors, as well as establishing systems based controls (or “hard blocks”) for recommendations of certain products to retail investors.”
  • Regarding volatility-linked products, the report notes that “[s]everal firms prohibited or restricted representatives’ recommendations to retail clients for either all or some volatility-linked products, such as inverse or leveraged ETPs or other products.”
  • Similarly, the report begins the section relating to claimed abuses of discretionary trading authority by noting that “FINRA has observed that some firms prohibit the use of all discretionary customer accounts.” In that same part of the report, which discusses registered reps who happen to get named by customers as trustees, FINRA “also observed that certain firms prohibited registered representatives from acting in some positions of trust, such as trustees or co-trustees, Powers of Attorney, executors or beneficiaries.”

I don’t want to oversell this view by suggesting that FINRA is actually pushing BDs away from these products or strategies; indeed, the report contains plenty of examples of firms that somehow manage to implement supervisory procedures that FINRA deigns to call “reasonable” even though they pertain to products or strategies that other firms have deemed verboten. But, it is still very clear to me that FINRA would be happy if BDs simply steered completely away from the kinds of products or trading strategies that it has determined are risky, or too complex to be easily understood by the average investor, or, frankly, which result in high commissions. Knowing this about your securities regulator is valuable. Once you know where the landmines are buried, navigating the minefield becomes that much less challenging.

But, that assumes that you are still willing to enter the minefield. Just because you have a map doesn’t ensure that it is 100% accurate, and messy errors can still happen. And that is the message that FINRA is espousing here. Sure, you can sell ETFs or ETNs. You can recommend an aggressive trading strategy that entails frequent in-and-out trading. You can sell private placements replete with nasty risk disclosures. Just know that if you do, FINRA will be watching you, and watching closely, ready to second-guess your supervisory efforts. That’s no way to live, at least professionally, constantly looking over your shoulder.

The Rule 8210 Karma Train Runs FINRA Over

Posted in Enforcement, FINRA, Rule 8210, Uncategorized

If you’ve read this blog for even a short while, you know my feelings on Rule 8210, or, more specifically, how FINRA uses that rule, i.e., as a cudgel to keep member firms and their associated persons in line. Endless 8210 requests for documents and information, sometimes asking multiple times for the same stuff, each one requiring the devotion of significant time, effort and money; this is what haunts broker-dealers these days. This is why compliance departments of almost any firm with more than a handful of reps have people whose sole (but horrifying) job is to respond to the barrage of regulatory inquiries. That’s also why when a decision like this comes down, a decision that finds that FINRA abused its 8210 power, it needs to be brought out into the daylight and examined closely.

The respondent, Jessica Bower Blake, worked in a non-registered capacity for UBS until January 2018. Apparently, UBS filed a disclosure with FINRA under Rule 4530 that she was terminated “for altering information on client-signed documentation and for ongoing performance issues.” (Why Rule 4530? Because, as I said, Ms. Blake was not registered, and thus had no Form U-4 or U-5, which would be the typical place a disclosure like this would reside.) Its curiosity appropriately whetted by this language, FINRA proceeded to send Ms. Blake an 8210 request, seeking her side of the story. Nothing unusual about that.

But, almost immediately, this routine inquiry went off the rails. The first problem was a simple matter of poor draftsmanship by the examiner who sent the 8210 letter. There were only four specific requests in the 8210 letter, the first of which asked for a “[s]igned statement addressed to FINRA in response to the allegations.” Unfortunately, according to the decision, “FINRA did not specify the allegations in the Rule 8210 request or elsewhere” that it wanted Ms. Blake to address in her statement, so she was unable to provide it. What Ms. Blake did was to email the examiner and say, “I am not sure what you need for this and I do not have any relevant documents because I no longer work for the firm ….” The decision continued: “She also told the examiner that she did not plan to register or work in the field again, and that she did not see an address to send any information. She concluded the email with, ‘Please advise.’”

The examiner responded to Ms. Blake’s email with his own, but he didn’t help things at all. He informed her that she had failed to provide the requested statement, specifically telling her, “What we need is a statement in response to the allegations reported by the Firm.” Repeating the same omission he made in the initial 8210 request, however, the examiner again “did not identify the allegations or attach a copy of UBS’ Form 4530 filing.” In addition, the examiner failed to inform Ms. Blake “in his email, or at any time thereafter” that he was of the view that she still owed him a response to two other requests in the 8210 letter.

I suppose Ms. Blake got frustrated by the examiner’s failure or refusal actually to spell out the allegations to which he wanted her to respond, so it seems she just decided to ignore it. Three weeks later, Enforcement issued the Notice of Suspension under Rule 9552, which informed Ms. Blake that FINRA was suspending her in all capacities “for failing to provide information to FINRA, unless she took corrective action by complying with the ‘requests.’” The Notice of Suspension did not specify which requests, documents, or information in the Rule 8210 request remained outstanding.

Here came the next set of errors by FINRA. First, the Notice of Suspension indicated that Ms. Blake’s Rule 8210 failure was predicated on a complete failure to respond when, in fact, she had responded, albeit only partially. Second, and worse, FINRA apparently failed to read Rule 9552, or maybe it just misunderstood how a 9552 suspension works, but, either way, there was a problem, as you will see.  The Notice itself correctly informed Ms. Blake that if she requested a hearing in a timely manner, that would operate to “stay the effective date of any suspension.” Despite her stated intent to leave the securities industry, Ms. Blake nevertheless timely requested a hearing, which, by rule, stayed her suspension. Moreover, Ms. Blake responded to the Notice of Suspension with an email that said, “I did reply to this matter! Please contact me so we can resolve the matter.”

Well, FINRA did contact her; this time, it was someone from Enforcement who emailed her. He told Ms. Blake that she had not responded to three of the four requests in the 8210 letter. Making matters worse, even though Ms. Blake’s suspension was stayed because she had timely requested a hearing, the Enforcement staffer incorrectly advised her that she was “due to be suspended today.” While Enforcement also provided Ms. Blake with an extension to provide a complete response, it again “erroneously advised Blake that if she did not provide a complete response by August 16, 2018, Blake would be suspended from associating with any FINRA member in accordance with the Notice of Suspension.”

Ms. Blake apparently decided she’d had enough dealing with examiners, and smartly said nothing else until the hearing. There, she asserted that she had responded as best she could to the 8210 letter, but “that she did not know what other information she was required to provide because the Rule 8210 request was ambiguous.” Specifically, Ms. Blake “testified that she could not provide a response to Request No. 1 of the Rule 8210 request because FINRA did not define or describe the allegations in Request No. 1.”

Remarkably, the Panel agreed with her, and dismissed the proceedings and ordered Enforcement to cancel her suspension. In her decision, the Hearing Officer recapped all of FINRA’s errors. First, she concluded that “Enforcement did not have an adequate basis to conclude, at the time it issued the Notice of Suspension, that Blake failed to comply with the Rule 8210 request given the ambiguity of both Request No. 1 and the requests that remained outstanding under the Rule 8210 request.” This is a direct result of the fact that until the hearing itself, FINRA never properly spelled out for Ms. Blake the allegations it wanted her to address in her statement.  As a result, the 8210 letter was “vague and ambiguous.” And now, my second favorite line from the decision: “A recipient of a Rule 8210 request should not have to guess what documents or information is being requested or have to connect the dots with language contained somewhere else in the Rule 8210 request to understand what information FINRA is seeking under a particular request.” I look forward to the first time that I will be able to invoke these words!

Second, the Hearing Officer concluded that the Notice of Suspension “was flawed” because it concluded that Ms. Blake had failed to comply with two specific requests, but “[n]o one at FINRA ever told Blake that those requests remained outstanding until after Enforcement issued the Notice of Suspension and after Blake requested a hearing.” Citing “fundamental fairness” — my favorite phrase in the decision — the Hearing Officer held that Ms. Blake “should not be suspended under the Notice of Suspension for failing to comply with requests she did not reasonably understand were outstanding prior to the issuance of the Notice of Suspension. She did not understand that these were outstanding because the . . . investigator represented to her (albeit mistakenly) that only Request No. 1 remained outstanding, and Request No. 1 was ambiguous with respect to the allegations to which Enforcement requested Blake to respond.”

Finally, the Hearing Office also found that FINRA “did not issue the Notice of Suspension in accordance with Rule 9552.” She noted that FINRA Rule 9552(c) requires “that FINRA’s notice must state the specific grounds and include the factual basis for the FINRA action, and that “FINRA Rule 9552(a) states that the written notice must specify the nature of the failure.” Here, FINRA not only failed to “adequately describe the specific grounds and factual basis for its action,” but it also confused things further by erroneously stating that the Notice of Suspension was triggered by Blake’s “complete failure to respond rather than a partial failure to respond.”

This is a small case, but a big win for Ms. Blake, as well as the industry. It is important because it highlights that FINRA can – and should – be required to act in a “fundamentally fair” way when wielding its 8210 powers. As the hearing officer observed, the obligation to respond to an 8210 request is “unequivocal” and “unqualified, and compliance is mandatory.” FINRA knows this, of course, and takes full advantage of this fact, but, arguably, too much so. Given the dire consequences for ignoring an 8210 request – permanent bars and expulsions – no one takes them lightly, so even requests that are questionable in their scope, in their length, in their relevance, are responded to. Ms. Blake, however, someone out of the industry with nothing to lose and with an argument based on nothing more than fairness, was able to make FINRA toe the line in a way that big firms do not dare to try.


Money Talks, And FINRA Is Listening

Posted in Disciplinary Process, Enforcement, FINRA, Sanctions

Last year I wrote about FINRA’s effort to encourage firms to self-report their problems, pausing to wonder at the suggestion attributed to Jessica Hopper, a Senior Vice President with Enforcement, that cooperating with FINRA by self-reporting “not only fulfills a firm’s regulatory responsibilities, but it can also mean the difference between a slap on the wrist and a steep fine, should the infraction elevate to an enforcement case.” Well, last week, LPL Financial got tagged for $2.75 million in an AWC that, remarkably enough, recites that FINRA “recognized LPL’s extraordinary cooperation.” I would hardly characterize this a slap on the wrist. One can only imagine the size of the fine had LPL not been so extraordinarily cooperative.

But that’s not the point of this piece. Rather, it is that this case serves to highlight, once again, the disparate treatment that FINRA doles out to big, rich firms vs. small firms. The former just write fat checks and get casually on with life, while small firms can struggle to survive a single regulatory incident. I mean, just look at LPL’s BrokerCheck report. It reflects 123 final “Regulatory Events” (admittedly, not all of which are FINRA related). The descriptions encompass an astounding 255 pages. The fines that LPL has agreed to pay are almost too high to compute, unless you have the time to slog your way through the entire tome that is LPL’s report. In addition to the most recent AWC, we can see, among other relatively recent disclosures, 12 payments of $499,000 each to a variety of states for selling unregistered securities and related supervisory failures. The fines imposed on LPL in just the first 25 reported Regulatory Events (i.e., the first 52 pages) total almost $14 million, and that doesn’t include a $10 million fine the firm paid to FINRA in 2015.

Simply put, what this shows is that money talks in the world of securities regulation. If you happen to be a firm that can afford to pay enormous fines, not only will you not get kicked out of the industry for being a recidivist, you will actually be commended for your “extraordinary cooperation.” What makes this even more amazing is that the particular rule violations that are the subject of last week’s AWC were repeat occurrences of prior misconduct. The Overview section of the AWC recites that LPL got in trouble because its AML supervisory system was flawed, and because it failed to make amendments (as well as timely amendments) to Forms U-4 and U-5. That $10 million AWC from 2015 I mentioned? Well, guess what? It concerned the very same issues, i.e., an AML system that failed to generate alerts of certain misconduct, and a failure to file amendments to Forms U-4 and U-5. Sound familiar? Imagine how a small firm would get treated if it committed the same rule violations exam after exam.

For what it’s worth, I had initially intended to focus on the substantive lessons to be gleaned from the AWC, including (1) the increasing mandate to file a SAR (since there appears to be nothing to gain from not doing so and plenty to lose), and (2) the need to construe broadly and liberally the definition of “customer complaint” for the purposes of determining whether disclosure is required. For those reasons, the AWC still makes good reading. But, admittedly, I got distracted by the detailed recitation at the end of the AWC of LPL’s efforts to cooperate with FINRA and the impact those efforts undoubtedly had on the fine, still a whopping $2.75 million but who knows how much less than it would otherwise have been.

I don’t mean to come down too hard on LPL; it can’t help it if it has the money to continue to pay these fines, or the fact that the regulators are content to keep cashing those checks and congratulating themselves for another successful exam. LPL didn’t create this system, it just lives in it, as do lots of other big firms. But, it doesn’t make it fair. That was true two years ago when I posted this blog about MetLife and it’s true now. And if FINRA ever tries to tell you that it treats all its member firms the same, regardless of their size or, more importantly, their financial wherewithal, I would beg to differ.  You don’t have to take my word for it, either.  LPL’s BrokerCheck report will tell you everything you need to know.

All’s Fair When It Comes To Arbitrator Ranking

Posted in Arbitration, FINRA, PIABA

I just read an article about a research study conducted of FINRA arbitrations by three people associated with Harvard, Stanford, and the University of Texas, respectively, and their overarching conclusion is a doozy.  Now, admittedly, I have not read the study itself (as it costs $5 to get a copy), so I only know what I read in the article about the study, which I am assuming is correct.  Let me get right to it.

Most notably, the authors complain that the arbitrator selection process is unfair to claimants because “though the selection process gives both firms and clients control,” “firms, especially experienced ones, are better at selecting industry-friendly arbitrators.”  This is truly amazing stuff.  As you are likely well aware, FINRA arbitration panels are determined by the parties themselves through the “neutral list selection process.”  FINRA supplies both sides the same list of names, and the parties then strike those individuals they don’t want, and rank the rest in order of preference.  FINRA removes anyone stricken from the lists and populates the panel with the highest ranked names that are left.

Claimants and respondents are provided the exact same universe of information about potential arbitrators, including their bios and a list of any prior awards.  In addition, both sides have the ability to do whatever further research is available, including, at a minimum, Google searches.  From this, the parties attempt to divine how a potential arbitrator will respond to the anticipated evidence.  As defense counsel, I look for people who may be dismissive of a claimant who refuses to take responsibility for his or her own trading decisions.  I look for people who are actually willing to apply the law to the facts.  I look for people who are not swayed by efforts to appeal to their sympathy, or to “do what’s right” even if not countenanced by the law.  There is nothing wrong with what I do; indeed, if I didn’t do it, I would undoubtedly be committing malpractice.

More importantly, the lawyers for the claimant are doing the exact same thing, conducting the exact same analysis, only approaching it from the reverse perspective.  They read the tea leaves as best they are able to rank potential panelists who they believe would be most inclined to reject my arguments and award their clients money, and lots of it.

Granted, it is a bit of an art rather than a science, and is something that one tends to get better at the more one does it.  But, to suggest that respondents have an unfair advantage over claimants in the arbitrator selection process is absolute nonsense.  And I don’t need study data to prove my point; I am made aware of this every day, in every case I work.  How?  Easy.  Let’s take, for instance, the ranking of the panel chairman.  FINRA supplies the parties ten names.  From those names, both claimant and I each get to strike four of them.  That leaves six for each side to rank (which, generally speaking, ensures that there will be at least one person left for FINRA to appoint, since if we each strike four entirely different people, there will still be two names left).

So, I immediately strike the potential panelists whose bios or award histories tell me that they would be claimant friendly.  I rank highest those people who I believe would be the opposite, i.e., friendly to my client.  But, remember, the claimant is doing the same thing.  So, how do I know that the claimant is doing just as good a job as me in evaluating the panelists?  Because the people that end up on the panel are not the ones that I ranked highly, because all of those names are stricken by the claimant.  In other words, by striking the very same people who I ranked highly, claimant has demonstrated that he/she has evaluated those people’s predilections the same as me, has correctly identified them as respondent friendly.

I will attest that this is the general rule, not the exception.  The exceptional case will be the one where I somehow manage to end up with a panelist who I ranked highly.  Unfortunately, what this means, that is, what happens when both claimant and respondent do their jobs well in evaluating potential arbitrators, is that the panels end up being comprised of the lowest ranked candidates (since I strike all claimant’s highly ranked names and claimant does the same to mine).  But that’s not the point here; the point is that it is absurd for anyone, particularly three researchers who don’t do arbitrator rankings every day, to conclude that I somehow have an advantage over the claimant in the arbitrator ranking process.

And lest we forget, remember that nowadays, there are almost no cases anymore that include an industry panelist.  Nearly all customer arbitrations are conducted by “all-public” panels because PIABA convinced FINRA that having someone from the industry on the panel was unfair to claimants.  FINRA, characteristically afraid of upsetting PIABA, instituted a rule giving the claimant the absolute right to dictate an all-public panel composition, no matter what I think about it.  So, if you want to talk fairness of the arbitrator selection process, how about we remember that little fact.

There are a couple of other things in the article that I cannot refrain from commenting on.  First, there is a quote from Christine Lazaro, PIABA’s president.  According to the article, she “favors making FINRA arbitrations more public” because “firms can take positions that they wouldn’t take in court. . . . The privacy and the confidentiality of the system can systematically hurt investors because the firms are able to take positions that are inconsistent with their public positions.”  I can’t tell you how ironic this is.  Just a week or so ago, I was defending an arbitration, and in response to my motion to dismiss based on the statute of limitations, claimant’s counsel repeatedly reminded the hearing panel that they were there to do “equity.”  In support of this argument, he handed the panel a printout of a speech that Linda Feinberg, the former president of FINRA Dispute Resolution, gave to NASAA back in 2004, in which she said extolled the virtues of arbitration vs. litigation because in arbitration, panels need not be wedded to the law.  The inference the lawyer urged the panel to draw from her remarks was that the panel ought not to apply the statute of limitations if that would, somehow, be “unfair” to the claimant.

If any party is guilty of making arguments in arbitration that are unconnected to the law, arguments that would not be countenanced in court, I can assure you that it is not the respondent’s counsel.

Finally, the article also noted this: “[T]he researchers also found that clients retaining an attorney who is a member of PIABA received awards four to five percentage points closer to the damages requested in their cases.  The difference stems from the experience of PIABA attorneys, and legal expertise clearly helps a case.”  Putting aside the question whether the methodology chosen to evaluate the potential benefits of using a PIABA attorney makes any sense – and I don’t think it does, given how inflated the requested damages generally are – I can’t tell if this should be construed as an endorsement of PIABA or a condemnation.  Yes, PIABA lawyers get bigger awards, but, frankly, I would have expected to see the difference between using a PIABA lawyer to handle an arbitration and someone without any significant securities experience to be much greater than four to five points.

FINRA Announces Changes To Its Exam Program. Or Does It?

Posted in Examination, FINRA

As I am (probably too) fond of reminding people, I was an English major, and pride myself, at least to some degree, on my ability to use words effectively to communicate clearly. I get easily frustrated, therefore, when I read or hear something that was purportedly designed to relate a specific message, but the message is nevertheless muddled, even if deliberately.  This happens all the time, for example, in politics.  Politicians are notorious for talking (and talking and talking) without actually saying anything.  It is also true in business.  It is an art for a corporate Marketing Department to be able to describe some product as “new-and-improved” when, in fact, it’s really neither, and any actual changes are simply cosmetic, likely in the packaging.

These were the thoughts that ran through my mind this morning when I read FINRA’s press release announcing its “Plan to Consolidate Examination and Risk Monitoring Programs!”  It sounds intriguing, right?  I mean, member firms complain tirelessly about over-regulation and redundant inquiries.  So, anything that could result in a more focused approach to regulation, with a resultant reduction in effort and expense, seems like a good idea.

But, as I read the press release, I found myself scratching my head, trying to divine just what it was that FINRA had announced. According to FINRA, its “examination responsibilities are currently divided among three different programs responsible for business conduct, financial and trading compliance.  The consolidation will bring those programs under a single framework designed to better direct and align examination resources to the risk profile and complexity of member firms.”  Hmm. I read that last sentence three times.  Is it simply saying that FINRA will spend more time, energy and money examining firms that it deems to be “risky” and “complex,” however those words are defined?  If so, isn’t that exactly what FINRA already does?

Without a doubt, FINRA already purports to utilize a risk-based examination program, one that results in “risky” firms receiving more attention than their vanilla peers. FINRA’s website, on its most basic page – “What We Do” – explains FINRA’s job like this:  “Every day, hundreds of professionally trained FINRA financial examiners are in the field taking a close look at the way brokers operate, with a focus on the greatest risks to the markets and investors.”  Given language like this, which is repeated all over the website, I hope you can understand, then, my confusion over today’s press release that seems to suggest FINRA’s determination to employ its examination resources in a more “directed” manner somehow represents something new.

My favorite example of corporate-speak on this subject was the following remarkable quote, from the EVP that FINRA apparently hired to honcho this novel, ground-breaking approach to examinations: “After careful consideration and extensive feedback from internal and external stakeholders, we are moving toward a program structure that is based on the firms we oversee.”  Seriously?  Is there a possible basis for FINRA’s “program structure” other than the firms that it oversees?  I suppose FINRA could base its exams on, say, the eye color of the CCO, or the kind of car that the FINOP drives, but that would hardly be scientific.  Yes, much better to design a firm exam program that focuses instead on the firms.

And, if a firm-based exam program is where FINRA is “moving toward[s],” as the EVP states, where is it supposedly moving from? Her quote clearly reflects that currently, FINRA’s exam program is not firm-based.  If so, then on what is it based?  And what has it been based on for the last decade or so?  Again, in light of FINRA’s insistence that the exam program is already risk-based, I am truly at a loss trying to figure this press release out.

Maybe it was just poor draftsmanship of the press release; maybe, in fact, FINRA is about to embark on something that will truly result in more streamlined exams being conducted by better trained examiners who are well versed in the business of the firms they examine, resulting in quicker and more reasonable dispositions than members presently experience. I hope that is the case, but, as with most things that FINRA announces, only time will tell.

Tips For Staying Off The SEC’s Naughty List In 2019

Posted in CFTC, Compliance, Crypto, Cybersecurity, FINRA, SEC

I recently had to the opportunity to sit in on a talk from high ranking CFTC and SEC enforcement officials at a local bar association meeting. The purpose of the get together was, in part, to let industry folks and their lawyers know what the regulators will be focusing on in the near future in a non-adversarial forum.  In other words, it was a chance to let industry players know what to avoid doing BEFORE they end up opposite an enforcement official during an OTR, or worse.

So, without further ado, here is what the regulators had to say, with a special focus on the SEC portions of the talk and an acknowledgment that regulators tend to be pretty guarded with their comments; meaning the reader should not expect anything too exciting.

During exams, regulators will focus (not surprisingly) on protecting retail customers, especially elderly investors.   Of particular interest are conflicts of interest and hidden fees and costs.  Other areas of focus will be the ubiquitous AML and cyber-security.  Speaking of which, cyber-security continues to be a blip on the SEC’s radar that has grown and will continue to grow.  Of interest to compliance workers (and frankly, lawyers and law firms) were comments directed at companies that use third-party vendors to handle customer personal information (which is many, if not most, these days).  The gist of the comments were that when a security breach happens, and it will happen, pointing the finger at your third-party vendor is not going to absolve a party of guilt.  The SEC speaker was adamant that an industry member will have to be able to demonstrate, tangibly, that they asked the right kind of questions from their vendors and got satisfactory answers.  In other words, the supervisory responsibilities that go along with protecting a customer’s Regulation SP information do not flow to the vendors but stay with the registered party.  Needless to say, since vendors are unlikely to be registered, the corresponding consequences of a breach will also rest on the industry member.

Still, the SEC realizes cybersecurity is a tough business and that mistakes will happen, so in February it published guidance to public companies relating to when they need to disclose a data breach and what needs to be disclosed.[1]  Recognition that cybersecurity is a tough business does not mean, however, that the SEC will let things slide.  In fact, just a few days ago, the SEC announced that an Iowa-based RIA/BD agreed to pay a $1 million dollar fine as a result of a cybersecurity intrusion .[2]  Readers should expect to hear about similar penalties for firms as cyber threats will only increase in future years.

The speakers next turned to another hot topic related to technology, namely, cryptocurrency or ICOs. The regulators seemed to agree on two things: 1) this is an area that is changing quickly, and 2) the public should be very careful about investing in these products.  As for jurisdiction, while the speakers agreed that it depends on the characterization of the product as either a security or a commodity, both of them seemed to lay claim, in the most polite way possible, for their respective organizations.  In other words, everyone agrees that the determinative factor is whether the product is a commodity or a security, but it is not yet clear what test will be used to make that determination.  So it looks like, at least for the immediate future, crypto will be of interest both to the SEC and CFTC (and their respective SROs).

Issuers have been a traditional target for the SEC when dealing with crypto, but the speaker stressed that the SEC can and will bring actions against broker-dealers, as well as companies promoting crypto. The regulators made clear they think this area in one that is ripe for abuse of public investors, so any business considering getting involved in crypto or ICOs should be aware that dealing with them could put your business in the crosshairs of one or both of these regulators.

Finally, the SEC speaker stressed that with an already stretched thin budget, the Commission will continue to rely on technology in order to spot wrongdoers and will focus on recidivism and customer harm. The essence of the meeting seemed to be that as technology evolves, so will the regulators, and with that comes the responsibility for industry members to keep up with changes that could help or harm their business and its customers.





FINRA Plays Guessing Game With Expungement Waiver Request

Posted in Arbitration, Expungement, FINRA, Rule 2080

When a registered rep contacts us about seeking expungement of customer complaints from his or her CRD record, we always respond that expungement is not a sure thing.  It turns out that is more true than ever before because of the way FINRA is treating its “waiver” process.

You see, we recently participated in an expungement hearing on behalf of our client, let’s call him AJ.  After the obligatory hearing took place, which was uncontested, the panel recommended expungement of the customer disputes on AJ’s CRD record.  We always warn our clients that this is only the first step, and that they still have to go to court to get the award confirmed before CRD will expunge the records.  That is usually not a particularly arduous process, unless FINRA decides to make it one, which is what happened in this case.

FINRA Rule 2080 requires a rep to name FINRA as a party in the court proceeding that the rep must file to confirm the expungement award, ostensibly so that FINRA has a chance to challenge the hearing panel’s decision and block the rep from obtaining that confirmation.  Putting the unfairness (not to mention the just plain weirdness) of that aside, FINRA allows a rep to seek a waiver from this requirement.  FINRA may grant the waiver if the expungement award contains findings that “(A) the claim, allegation or information is factually impossible or clearly erroneous; (B) the registered person was not involved in the alleged [misconduct]; or (C) the claim, allegation or information is false.” (Rule 2080(b)(1)).

If FINRA grants your waiver request, you don’t need to waste time and money naming FINRA as a defendant, serving it via process server, and waiting to see if it is going to challenge the award.  The good news is that FINRA almost always grants the waiver so long as the panel uses the “magic words” in its order (i.e., that the claims are “factually impossible” or “clearly erroneous” or “false”). In fact, FINRA explicitly says that in its FAQs regarding Rule 2080: “Provided that the award reflects compliance with the Arbitration Code, and contains an affirmative finding that the expungement meets one or more of the standards in Rule 2080, FINRA staff will generally grant the waiver.”  Note the use of “generally.”

In our case, we were in good shape: the expungement award contained the magic words, so there appeared to be no basis for FINRA to deny our request for a waiver.  But guess what happened?  FINRA denied our request for a waiver.  The ostensible reason? AJ owned his own broker-dealer, and he had named that broker-dealer as the respondent in the expungement arbitration. FINRA apparently did not like the fact that AJ was essentially on both sides of his expungement case.  But, FINRA said, the fact that it did not grant a waiver did not necessarily mean that it would actually proceed to challenge the confirmation of the award.  Indeed, FINRA advised us that that determination, i.e., whether actually to challenge, would, in fact, be made by a different division within FINRA.

That explanation was completely unsatisfactory for several reasons.  First, there’s no requirement about who a rep must name as the respondent when filing a Statement of Claim seeking expungement. The rep could name the complaining customer, the broker-dealer that made the initial disclosure of the customer complaint on the rep’s U4, or the rep’s current broker-dealer.  Second, naming your own broker-dealer may make it look like a one-sided arbitration on its face, but it really isn’t.  Regardless of who is actually named as the respondent in the expungement hearing, the rep must still submit evidence that he provided notice to the customer and provided the customer the chance to come testify in opposition to the expungement request.  So, there is always an opportunity for the customer to contest the expungement request regardless of who is named as the respondent.  Third, FINRA’s decision to deny the waiver was completely arbitrary.  It was not based on any rule or problem with the award, but rather, simply because FINRA didn’t like the way it looked.

As a result, we filed our petition to confirm the expungement award in court and named FINRA as a defendant, fully expecting FINRA to oppose the confirmation.  We hired local counsel in anticipation of a fight, and we hired a process server to serve FINRA.  Then, we waited.  And guess what? Just before the deadline for FINRA to file its Answer in court, we received a letter from FINRA’s Office of General Counsel stating that they decided NOT to oppose confirmation of the expungement award after all.  Gee, thanks.

Thankfully, that was the right decision because there was no basis under the state or federal arbitration act for FINRA to oppose confirmation of the award.  But the entire way that FINRA went about it was unnecessary.  If it would have just granted the waiver, we would not have had to waste a great deal of time and money naming FINRA as a defendant in the court action to confirm the award.  And, our client would not have had to wait around nervously wondering what reason FINRA was going to conjure up to oppose the award.  And, our client could have gotten the disclosure removed from his record faster, and a clean CRD is always helpful when trying to bring in new clients.

There are two lessons here.  First, despite what FINRA says, even if your expungement award complies with all the requirements of the rules, it is not a sure thing that FINRA will grant your waiver request. It might deny it for an arbitrary reason that is not grounded in any rule or law. And second, even if FINRA denies your waiver request, that alone is not a reason to panic. In the end, you might still get the expungement award confirmed, but you may need to spend more time and money doing so.  But, as with many things, that’s your problem, not FINRA’s.




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.