Sorry for the long period of radio silence, just been busy getting ready for the continuation of the longest arbitration I have ever worked on, now in the midst of week no. 6!  But thanks to Denise for this thoughtful take on the Howey test and its application to crypto. – Alan

In any classic securities regulation textbook, you’ll be sure to find a chapter called “Definition of a Security.” Besides your typical bonds and stocks, which are easily identifiable as securities, the most infamous (and a sure-to be on a law school final exam) question is: What is an investment contract and under what circumstances is it deemed to be a security? A quintessential catchall, the term “investment contract” has been liberally construed by courts to apply to a wide range of money-raising schemes that were found to be securities (even as far-reaching as interests in whiskey warehouse receipts).

This progeny of cases comes from the landmark case of SEC v. W.J. Howey Co. in which the Supreme Court established the “Howey test” for an investment contract. For those of you not familiar with the case or need a refresher, in Howey, a hotel operator sold interests in orange groves as an investment scheme, combining both a real estate contract for the sale of tracts of land with a service contract to cultivate the orange trees. The Court, focusing on the economic reality of the transaction, held that the circumstances surrounding the sale of the orange grove interests constituted an investment contract and therefore a security. To clarify the Court’s finding, it’s important to point out the following distinction: the underlying asset (the orange grove) itself was not held to be a security, but rather it was the way in which the tracts of orange groves were sold that rendered them an investment contract. Naturally, you may be wondering, what exactly do orange groves have to do with digital assets? As it turns out, the SEC believes they have a lot more in common than you would think.

Cryptocurrencies have been all the talk lately, but despite the growth of the decentralized finance (DeFi) movement, U.S. laws and regulations have been stagnant and haven’t kept up with the crypto craze. Now, with the mainstream acceptance of cryptocurrencies, there is also mounting pressure on federal agencies like the SEC to figure out a way to regulate them under existing laws. That’s where the Howey test comes in.

Without new legislation to rely on, the SEC has determined that a digital asset (such as a cryptocurrency) may be considered an investment contract and therefore a security under the Howey framework. As SEC commissioner Hester Pierce (a.k.a. “Crypto Mom”) explained, “when we think about a cryptoasset as being a security what we’re doing is we’re saying it’s being sold as part of an investment contract. It doesn’t mean that the asset itself necessarily has to be a security. It means that it was being sold as a security.” Putting aside Pierce’s remarks, SEC Chair Gary Gensler recently admitted that cryptocurrencies are like the “Wild West,” and continues to vocalize his desire for more Congressional rulemaking on digital asset regulation.

At the same time, though, Gensler expressed his view that there is no issue on how cryptocurrencies are currently treated under the securities laws, concluding that “certain rules related to crypto assets are well settled.” Referring again to the Howey test, he also remarked that “the test to determine whether a crypto asset is a security is clear.” Yet, it is actually the lack of regulatory clarity that has kept the cryptocurrency community in limbo on how to act and at the mercy of the SEC’s scattered method of regulation-by-enforcement. As a testament to that, the SEC has now brought several digital asset cases under the Howey framework, alleging that the digital assets at issue were investment contracts and therefore securities.

In one recent case (SEC v. Ripple) being dubbed the “cryptocurrency trial of the century,” the SEC filed an action against Ripple Labs and its founders for their unregistered offering of the XRP digital token in alleged violation of the securities laws. The SEC alleged that XRP is an investment contract due to its centralized nature and the way in which it was offered, sold, and promoted. In order to preserve the sanctity of the Howey test and its application to digital asset cases, the SEC did not allege that XRP (as in the digital token) was itself a security, but, rather, it was the circumstances surrounding XRP’s offering that made it one.

Yet, the SEC felt the need to further justify its position that XRP is an investment contract by also explaining why “XRP is not a currency.” This leaves us with one remaining question: if XRP (as in the digital token itself) is not a security, but it’s also not a virtual currency, then what exactly is it? According to the SEC, the answer is simple: it’s “software code.” Respectfully, I have to disagree with the SEC here. The essence of a digital token cannot be diluted to have such a rudimentary meaning. Applying this type of logic to the Howey case would the equivalent of reducing the orange grove’s meaning to an orange seed. The XRP digital token represents something beyond software code; it represents a virtual currency. So whether the SEC would care to admit it or not, the Howey orange grove analysis does not apply as neatly to the facts and circumstances surrounding XRP and its offering.

While the Ripple case guarantees to be an interesting outcome for the DeFi movement, the SEC doesn’t plan to stop there. The SEC has put a “spotlight” on initial coin offerings (“ICOs”) and continues to bring more cases of unregistered offerings of digital assets and their promoters (celebrities not excluded), such as against “Above the Law” star Steven Seagal. While new legislation such as the Securities Clarity Act is promising, as its name aptly suggests, more clarity in this area, in the meantime, the SEC will continue regulating the nascent cryptocurrency industry under 75-year old jurisprudence. It is my hope that we will soon see formal cryptocurrency regulations in place so that the SEC can start reviewing digital asset cases using an apples-to-apples analysis rather than settling on comparing them to orange groves.

I am certain that, by now, you have read the Robinhood AWC.  Here is a fascinating take on that settlement, and what it portends for the securities industry, as well as for FINRA, by Denise. – Alan

There’s no question that FinTech firms are on the rise, and attempting to revolutionize the financial services space for the better. One such FinTech firm is none other than the notorious Robinhood. A technology company at heart, but a broker-dealer by definition, Robinhood wants its users to take trading into their own hands (or should I say smartphones?). While it’s true that more Americans are turning to the self-directed, commission-free trading model via FinTech apps, this sometimes comes at a cost, too. On June 30, 2021, FINRA announced that it reached an AWC with Robinhood, imposing a $70 million record-breaking monetary sanction against the FinTech firm. Although FINRA cited various violations of its rules, ultimately, its message to the industry goes beyond Robinhood’s underlying misconduct: FINRA is bearish on FinTech – at least for now.

FINRA acknowledges that FinTech is alive and well, even providing a loose definition of the term in a footnote (“FinTech refers to new uses of financial technology”). Yet, FINRA hasn’t quite fully accepted the FinTech brokerage model. As Jessica Hopper, FINRA’s Head of the Department of Enforcement, said, “compliance with these rules is not optional and cannot be sacrificed for the sake of innovation or a willingness to ‘break things’ and fix them later.” As a further testament to that, FINRA, through its findings in the AWC, concluded that Robinhood relied too extensively on its automation to conduct its brokerage operations, and did not conduct adequate supervision over its technology-based brokerage model. While Robinhood may want to revolutionize the financial markets, FINRA wants to continue regulating them in the way it knows how. In furtherance of this point, here are some of the key findings from the AWC.

False and Misleading Information Distributed to Customers.

FINRA found that Robinhood made various false and misleading communications to its customers, including misinformation regarding its “Free Stock” program, inaccurate cash balances and buying power, and the ability to place trades on margin, among other things. Although FINRA took issue with the misleading communications, it also brought up the corollary issue that no firm principals supervised those communications. Specifically, FINRA found that “Robinhood did not establish reasonable procedures to supervise the accuracy of the account information it displayed to customers via its website and mobile applications,” and further explained that “the firm relied on mathematical models and formulas to calculate much of the data it displayed to customers, but it did not require that a supervisory principal review the accuracy of those models and formulas.” Yet, this is only one of FINRA’s many findings that focus on the fact that Robinhood failed to employ firm personnel to supervise critical brokerage operations. Apparently, not all regulatory requirements can be outsourced to “new uses of financial technology” as FINRA sees it.

Failure to Exercise Due Diligence Before Approving Options Accounts.

This is one of the more interesting findings in the AWC. The issue here is that FINRA Rule 2360(b)(16) requires that either a Registered Options Principal or a General Securities Sales Supervisor (i.e., a person) approve a customer account for options trading, so Robinhood’s almost entirely automated system cannot satisfy the rule’s requirements. As a workaround to this rule, Robinhood employed some firm principals to review options account approvals. In reality, though, FINRA found that the FinTech giant was approving customer options accounts based almost entirely on its computer algorithms with very limited principal review (“Although Robinhood’s algorithms currently approve hundreds of thousands of options applications every month the firm’s team of principals previously reviewed only 20 applications per week; in May 2021 the firm increased its principals’ review to approximately 500 applications per week.”) As FINRA stated, “Robinhood used an almost entirely automated system for approving customers for the two levels of options trading offered by the firm.” It seems that by largely automating its options account opening process, Robinhood chose to ask FINRA for forgiveness rather than permission.

Failure to Supervise Technology Critical to Providing Customers with Core Broker-Dealer Services.

FINRA also drew an important distinction between brokerage operations and broker-dealer oversight when it found that Robinhood (the broker-dealer) failed to supervise the activities of its parent company, Robinhood Markets Inc. (RHM), which is responsible for operating and maintaining technology related to its brokerage operations. Specifically, FINRA found that:

From January 2018 to February 2021, Robinhood failed to reasonably supervise the operation and maintenance of its technology, which, as a FinTech firm, Robinhood relies upon to deliver core functions, including accepting and executing customer orders. Instead, Robinhood outsourced the operation and maintenance of its technology to its parent company, Robinhood Markets, Inc. (RHM)—which is not a FINRA member firm—without broker-dealer oversight. Robinhood experienced a series of outages and critical systems failures between 2018 and late 2020, which, in turn, prevented Robinhood from providing its customers with basic broker-dealer services, such as order entry and execution.

FINRA’s mandate is clear: Robinhood – as a regulated, broker-dealer entity – must adequately oversee its brokerage operations and ensure compliance with FINRA rules, even if those core brokerage activities are conducted through technology-driven processes by its parent company. While FINRA didn’t mind that Robinhood outsourced its operations to its parent company, it did take issue with the fact that Robinhood failed to oversee those operations. This distinction is important in the way that FinTech firms must learn to balance both their business and regulated sides. So, while Robinhood may have passed its brokerage operations off to its parent company so it can be the fun technology company it wants to be, ultimately FINRA reminds us that Robinhood cannot avoid its role as a boring, old, regulated broker-dealer entity.

Failure to Have a Reasonably Designed Customer Identification Program.

In another consequential finding, FINRA determined that Robinhood did not have a reasonably designed customer identification program in violation of its AML rules. FINRA’s main concern here was the fact that Robinhood delegated most of its account opening processes to algorithms “without any effort to verify that the information provided by the customers was accurate.” Here, FINRA set an expectation that FinTech firms should engage in some type of “manual review” conducted by personnel in order to ensure compliance with its AML rules. This is what FINRA had to say about it:

Robinhood failed to establish or maintain a customer identification program that was appropriate for the firm’s size and business.” The firm approved more than 5.5 million new customer accounts during that period, relying on a customer identification system that was largely automated and suffered from flaws.

FINRA also raised the fact Robinhood did not have any employees whose primary job responsibilities related to its customer identification program during the period, and that a single principal approved more than half of the more than 5.5 million new accounts that were opened. These findings reinforce the AWC’s principal theme: an automated brokerage model cannot run on its own without meaningful human oversight.

In all, these AWC findings, along with the others, formed the basis for the largest fine ever issued against a broker-dealer. FINRA’s award against Robinhood is monumental, and not just because of it is record-breaking amount, but also because it establishes a new regulatory precedent for FinTech firms to follow.

Still, it seems that the real winner here at the end of the day is: Robinhood. Just one day after the AWC was entered against it, Robinhood filed for its IPO under the catchy ticker, “HOOD,” showing its playing power in this industry. With over 31 million users and counting, Robinhood isn’t going anywhere anytime soon.

The question remains: Will it be FINRA that decides to update its rules to adapt to the rise of FinTech or will FinTech firms need to continue accommodating their operations until FINRA catches up with the trend? While it may be the latter for now, my prediction is that FINRA will eventually have no choice but to accept the rise of FinTech as more investors are choosing this financial path. In the end, it may be FINRA that needs to adapt to the FinTech model instead of the other way around – and FINRA may find itself bullish on FinTech after all.

There have been tons of cases where firms got in trouble – in AML trouble, which is one the worst kinds of trouble – for failing to be sufficiently on top of third-party wires, i.e., where a customer wires money not to himself but to someone else.  In a change of pace, last week, the SEC published a settlement it entered into with Securities America Advisors (SAA) that involved a failure to adequately supervise first-party wires, i.e., wires sent by the client to him- or herself.  It is a super-interesting case, as it tees up a few thought-worthy issues.  Like, did SAA’s supervisory requirements go too far?  That is, did the firm make the mistake of holding itself to a standard that was not only unnecessary, but practically impossible to meet?  Should first-party wires be treated the same as third-party wires?  Is it really reasonable to expect a firm to require that an existing customer who wants to take money out of his securities account and send it to his bank account disclose what his plans are for that money before it can be disbursed?

Let’s start, as always, with the facts.  SAA is an investment advisor.  Securities America, Inc. (SAI) is the BD that served as the introducing firm for SAA’s clients.  They share common ownership.  SAA “adopted SAI’s policies and procedures for safeguarding client assets from misappropriation . . . thereby delegating to SAI responsibility for surveilling SAA advisory accounts.”   Hector May was an RR with SAI and the owner of his own independent state-registered investment adviser.  His advisory clients participated in SAA advisory programs and opened SAA advisory accounts.  Hector, as it turned out, was not a good guy, and a rather poor fiduciary.

He encouraged certain of his SAA advisory clients “to buy bonds away from” their SAA accounts, “falsely claiming that he could obtain the bonds at a better price and avoid certain fees if they did so.”  To pull that off, “he instructed the clients to transfer the necessary funds from their SAA advisory accounts to their personal bank accounts and to approve the transfer in the event they were contacted for confirmation.”  Once the money hit the personal bank accounts, Hector then had his +clients transfer the money to an account owned by his RIA.  He did not then use the money to buy bonds, however.  Instead, he “diverted” it “for his own personal use,” and hid his misconduct by ginning up fake advisory account statements that, falsely, showed the bonds.  (For this, Hector later became a respondent in an SEC case and a defendant in a federal criminal case, resulting in associational and penny stock bars, a 10+ year prison sentence, and a restitution obligation of $8 million.)

But, enough about Hector, let’s get back to SAA and SAI.  Putting aside for the moment whether this was a smart thing to do, SAI had systems in place designed to surveil for potentially improper disbursements – apparently including first-party disbursements – both before and after the disbursement.

Beforehand, SAA required, quite predictably, that customers actually document their requests.  Interestingly, SAA policy allowed a customer to sign a disbursement request once, and it could then be used for the next 12 months.  At least one customer, however, was permitted to rely – six times – on a disbursement request that had already expired.

In addition, there was a separate policy that required the back office to review outgoing wire requests over $50,000 for possible misappropriation.  This entailed a four-step process.  First, the back office staff had to contact the advisor to confirm that the customer had verbally confirmed the wire request.  Next, the back office was required to speak directly to the client to confirm the request, including confirming the client’s full name, last four digits of the client’s social security number, date of birth, and the amount and destination of the wire.  Third, the back office had to administer a Verification ID test designed to confirm the client’s identity.  Last, once steps 1-3 were done, staff was required to complete the Representative Verification and Client Verification section of the brokerage disbursement verification checklist.  While this is an impressive sounding list of requirements, in practice, staff failed to do everything in every case that the policies required.  One customer had 20 outgoing wires that should have resulted in a call to him, but he only got called 11 times.  Another five disbursements were approved where the customer could not identify the amount or the destination of the wire.

As for after-the-fact supervision, SAI had an automated AML surveillance system that generated alerts “based on certain preset rules and scenarios for potentially suspicious disbursements from client accounts,” including alerts based on the size of disbursements, size of disbursements relative to total account value, frequency of disbursements, and the percentage of disbursements to deposits.  Once generated, these alerts were supposed to be reviewed “within two to ten days depending on the alert” and analyzed for suspicious activity.  The disbursements by Hector’s customers triggered multiple alerts.  Indeed, between November 2014 and March 2018, at least 55 alerts were generated for outgoing disbursements to May’s advisory clients were identified as suspicious, but they were not analyzed, and not escalated for further action.  Why were the alerts triggered?  As examples, the SEC pointed to Client A, a senior citizen, and Client B, a company pension fund.  Both had account profiles that identified growth among their investment objectives and both stated that they held no assets away from SAA, facts apparently inconsistent with multiple withdrawals. Despite these facts, and despite the fact that these multiple disbursements were emptying the accounts, the alerts were not analyzed; indeed none of the 55 alerts was analyzed as per SAA’s policies.

For this, SAA paid the SEC $1.75 million, and had to retain an Independent Consultant.  Hardly a slap on the wrist.

And for what, really?  That’s what I’m trying to figure out.  When you read the details of the actual violations, it certainly seems that what got the SEC worked up is the fact that SAA had policies in place that seemed pretty good, but, for whatever reason failed to abide by them:  “SAA failed to implement its policies requiring AML analysts to review automatically generated surveillance alerts for suspicious client disbursements. SAA also failed to implement the signature requirements delegated to Cashiering and the call-out requirements for Trade Support.”    Granted, the failure happened multiple times, and resulted in over $8 million in customer losses.  When you put it that way, the result doesn’t sound crazy, right?  The SEC hates seeing that much money misappropriated from customers, so its reaction is hardly surprising.

But…would this have been the result if SAA didn’t have policies in place to monitor first-party wire disbursements?  What if SAA didn’t bother to make customers explain why they were taking money from their advisory or brokerage accounts and transferring it to their bank accounts?  Would the SEC have written the firm up in that circumstance for not having a first-person disbursement surveillance program in place?

I don’t think the answer is clear.  I don’t represent banks, but I am unaware of any rule that says a bank – which, of course, also has to abide by the very same AML rules – is obliged to ask a customer who makes a withdrawal – even a big withdrawal – why the customer wants his or her money and how it’s going to be spent?  Assuming that I am correct, why, then, would a BD or an RIA have to pose those same questions to their customers?  I have defended hundreds of customer arbitrations, and in many of them, I am faced with facially odd spending decisions by the customer.  My response is generally the same:  a customer is free to do with her money whatever she wants.  Not my problem, or, more importantly, my clients’ problem, if a customer decides to pull money out of an account – even money that when deposited was represented to be a long-term investment – and buy a car, or re-do a kitchen, or pay an unexpected medical bill.

In 2020, FINRA entered into an AWC with Royal Alliance that suggests I am correct.  In that case, FINRA found that two Royal Alliance RRs stole more than $3.8 million from customers by having their customers send wire transfers or checks from their brokerage accounts into accounts for entities the RRs created.  The gravamen of the complaint is that “the firm’s cashiering group unreasonably treated these . . . transfers as first-party transactions and thus processed them in contravention of the firm’s prohibition against third-party wire transfers.”  In other words, Royal Alliance was ok with first-party transfers, but not third-party transfers.  Notably, however, FINRA did not write the firm up for not having a more robust policy to cover first-party transfers, but, rather, for not doing a particularly job of figuring out that the transfers at issue were, in fact, third-party transfers.  That is consistent with my experience: first-party disbursement requests are routinely made without the same scrutiny that third-party requests are supposed to require, and the regulators are cool with that.

Notwithstanding this, the SAA settlement certainly suggests that there is some real risk to any advisor or BD that is not paying the same attention to first-party wires as it is to third-party wires.  I just don’t see that this reflects reality.  I cannot imagine that customers will cotton to having to tell their advisors why they want their own money.  The answer that “well, sorry, Mr. Customer, but I am required to ask” is not going to stop customers from taking ALL their money out and moving it elsewhere, where the advisors aren’t quite so nosy.

In conclusion, I am conflicted on what advice to give here.  The conservative me says that you should use the SAA settlement as a lesson not to distinguish between how you treat first- and third-party disbursement requests.  But, given the ridiculous amount of work that advice engenders, and the lack of prior indications from regulators that this is something you HAVE to do, the reality me says that you don’t need to do this.  Well, maybe only in those situations where your advisors are using first-party transfers to steal customer money.  Once you figure out how to detect those, maybe you can share it with the rest of us.  But in my experience, it is not easy to do, no matter how robust your supervisory system.  I will say this, however, which I have said before: Be very careful about creating a supervisory policy that holds you to a standard above and beyond that which the regulators demand.  Because once you do, then it’s fair for the regulators to insist that actually do what you say you’re going to do.


Most securities regulations, by design, create a gray world where compliance is not crystal-clear, but, rather, subject to interpretation.  After all, what you think constitutes “reasonable” supervision and what FINRA or the SEC think is reasonable may very well be two extremely different things.  Indeed, it is the existence of subjective standards of conduct like this that, ultimately, put food on my table, as people and firms hire me to advocate on their behalves that they have met such standards.  (When the issue is black-and-white, alas, I am reduced to arguing what the appropriate remedial sanctions ought to be.)  Sometimes I win, sometimes not, but there is always plenty of room to accommodate the discussion.

That is not the case, however, in those relatively rarer instances where a rule is plain and simple enough that the issue of compliance vs. non-compliance cannot generate any legitimate debate.  When a rule is like that, and articulates a specific standard in clear, precise language, there is no real excuse for violating it.  Yet…somehow, perhaps inexplicably, firms can still be counted upon to get it wrong.

Guggenheim Securities discovered this hard truth a week or so ago, as reflected in this short-and-sweet SEC settlement.  The facts, blessedly, are awfully straightforward:

  • One of the explicit purposes of the Dodd-Frank Act was “to encourage whistleblowers to report possible securities law violations.”
  • To help fulfill this Congressional purpose, the SEC created Rule 21F-17, which provides that “[n]o person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.”
  • That rule became effective in 2011.
  • Despite the existence of that rule, from at least April 15, 2016 to July 2020, Guggenheim’s Compliance Manual included a section called “Communications with Regulators,” which stated, in relevant part: “Employees are also strictly prohibited from initiating contact with any Regulator without prior approval from the Legal or Compliance Department. This prohibition applies to any subject matter that might be discussed with a Regulator . . . .  Any employee that violates this policy may be subject to disciplinary action by the Firm.”
  • In 2018 and 2019, as part of its annual compliance training, Guggenheim reminded its employees that they were “prohibited from initiating contact with any regulator without prior approval from Legal or Compliance.”
  • While Guggenheim’s majority indirect owner, Guggenheim Capital, LLC, maintained a Code of Conduct that provided it “should not be interpreted to restrict or interfere with any employee’s rights, free speech, or any whistleblower protections under applicable laws, regulations and requirements,” Guggenheim’s Compliance Manual provided that in the event its policies were “more restrictive” than a Guggenheim Capital policy, Guggenheim “personnel should follow the more restrictive of the policies or procedures, absent explicit direction to the contrary.”

When the SEC discovered this, and apparently brought the problem to the attention of the firm, Guggenheim promptly revised the offending language to remove the impediment to any employee who might be interested in blowing the whistle.  Somehow, it seems that the SEC gave Guggenheim credit for this remedial action.  (In many, probably most, cases, to get any kind of real credit for taking remedial action, you need to do it BEFORE the SEC points out your problem.  But, who am I to argue with this?)  But, it still cost Guggenheim the (strangely specific) sum of $208,912 in a civil penalty. Small potatoes on a day when Robinhood just paid $70 million, but, still, enough to get your attention.

The lesson from this settlement seems pretty obvious to me.  And it’s not too different from Ferris Bueller’s observation that “Life moves pretty fast.  If you don’t stop and look around once in a while, you could miss it.”  The same goes for rules – especially new rules – and your WSPs and Compliance Manual: you have to pay attention when new rules are created that impose new requirements, and make sure that you are timely and appropriately updating your internal documentation to comport with those requirements.  It is inexcusable to continue to have a prohibition in your Compliance Manual that is at odds with a rule that was implemented, say, five years earlier.

I actually got to thinking about this not too long ago when I happened across Reg Notice 21-16.  That was issued in April 2021 to remind people about FINRA Rule 2268, which dictates – in very precise language – what must (and must not) be included in a pre-dispute arbitration clause in a customer agreement.  That rule first became effective in 1989, and has existed pretty much in the same format ever since.  Yet, over 20 years after the rule came out, FINRA claims it felt compelled to issue this Reg Notice because it “has become aware that customer agreements used by some member firms contain provisions that do not comply with FINRA rules.”  Apparently – and I say “apparently” because FINRA cites no actual Enforcement cases that it brought recently involving this rule – FINRA found firms using arbitration clauses that wrongfully (1) dictated the hearing location, (2) attempted to shorten an applicable statute of limitations, (3) limited a customer’s right to pursue a class action in court, (4) prohibited a customer from seeking punitive damages, and (5) included indemnity language.

Rule 2268 is super easy to comply with.  I mean, the rule actually spells out the exact verbiage that you have to use in an arbitration clause.  Compliance with the rule could not be easier.  It literally is a matter of accurately cutting-and-pasting.  And, yet, if you believe FINRA, firms still manage to blow it.  I just don’t get it.

The good news, I suppose, is that the SEC did not name anyone individually, and clearly it could have.  Someone was responsible for the care and feeding of the firm’s Compliance Manual.  FINRA Rule 3130(b) requires that annually, the CEO certify that the firm “has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable FINRA rules, MSRB rules and federal securities laws and regulations, and that the chief executive officer(s) has conducted one or more meetings with the chief compliance officer(s) in the preceding 12 months to discuss such processes.”  In light of this requirement, and Guggenheim’s five-year failure to figure out that its Compliance Manual conflicted with the SEC Rules, it is easy to see how the CEO could have been implicated here.  So, take this case as the warning it is meant to be: Pay Attention!

FINRA Enforcement has often been accused (again, admittedly, by me, and not too infrequently) of going after the “low-hanging fruit,” that is, taking the easy case when it presents itself.  Putting aside the question whether this observation is accurate or not – for what it’s worth, I think the answer is that it is often, but not always, true – a recent case triggers a better, more nuanced question: does FINRA Enforcement sometimes bring the wrong case, because it is easier?

Here is what made me think of this: a series of cases concerning a mutual fund called the LJM Preservation & Growth Fund (the “LJM Fund”).  You probably recall hearing about it.  The LJM Fund was a so-called “alternative” mutual fund.  Here is how FINRA defines that:

Alternative mutual funds are publicly-offered mutual funds that seek to accomplish the funds’ objectives through non-traditional investments and trading strategies. . . .  Alternative mutual funds are often marketed as a way for retail customers to invest in sophisticated, actively-managed hedge fund-like strategies that will perform well in a variety of market environments. Alternative mutual funds generally purport to reduce volatility, increase diversification, and produce non-correlated returns and higher yields compared to traditional long-only equity and fixed-income funds, all while offering daily liquidity.

The LJM Fund’s investment strategy involved, in part, collecting premiums from the sale of out-of-the-money options on the S&P 500 futures index.  (While the LJM Fund also bought options, overall, it was “net short.”)  Actually, this is a perfectly fine strategy, provided you are in a relatively flat trading environment.  In that setting, all you do is collect the premiums, watch the options you’ve sold expire worthless, and sit back and look like a genius.  In times of volatility, however, it carries the risk of significant losses as those out-of-the-money options suddenly become in-the-money.

On casual review, the LJM Fund apparently looked like any other of the hundreds of mutual funds that appear on the long lists of available mutual funds provided by clearing firms.  It did not readily appear to be an alternative or complex fund, and so was sold by several BDs to customers with conservative or moderately conservative investment objectives.

As you might expect in a story that starts out like this, the worst case scenario did, in fact, happen: on February 5, 2018, the S&P 500 fell 113 points, a loss of about 4.1%.  In just two days, the LJM Fund (and its companion private funds) lost 80% of their value, i.e., over $1 billion (yes, billion with a “b”).  A month later the Fund was liquidated and closed.  Customers suffered large losses.

So, what did FINRA do about this?  You can guess.  It took the easy path.  It went after BDs which had sold the LJM Fund.  In March this year, FINRA accepted AWCs from three such BDs.  The principal allegation that FINRA made was that the firms permitted the sale of the LJM Fund without having conducted reasonable due diligence, i.e., without fully understanding that it was an alternative fund, with unique risks that set it apart from all those vanilla mutual funds that also appeared on the sales platform.

In other words, as FINRA saw it, the customer losses were the fault of the selling BDs.  And that’s how FINRA always sees the world, in much the same way as PIABA lawyers do: it’s always the selling BD’s fault.

Yet, fast forward a few months from March to about a week ago, when the SEC filed a complaint against investment advisers LJM Funds Management, Ltd. and LJM Partners, Ltd. and their portfolio managers, Anthony Caine and Anish Parvataneni.[1]

These are the individuals and entities who ran the LJM Fund.  And what did the SEC allege that these defendants did wrong?  According to the SEC’s Litigation Release, they “fraudulently misled investors and the board of directors of a fund they advised” – i.e., the LJM Fund – “about LJM’s risk management practices and the level of risk in LJM’s portfolios.”  More specifically, while “LJM adopted a short volatility trading strategy that carried risks that were remote but extreme,” allegedly, some of the defendants, “in order to ease investor concerns about the potential for losses . . . made a series of misstatements to investors and the mutual fund’s board about LJM’s risk management practices, including false statements about its use of historical event stress testing and its commitment to maintaining a consistent risk profile instead of prioritizing returns.”

The SEC complaint further alleges “that, beginning in late 2017, during a period of historically low volatility,[some defendants] increased the level of risk in the portfolios in order to chase return targets, while falsely assuring investors that the portfolios’ risk profiles remained stable.”

In other words, at least according to the SEC complaint, these Defendants, who were well aware that “the funds’ investors and their financial advisors were primarily concerned about the risk of loss – including estimated worst-case loss scenarios – and how the risk of investment loss was managed,” intentionally and craftily created a false narrative about the LJM Fund’s risk management practices designed to mask the true risks associated with the fund.  And mask these risks not just from investors, but, as well, from the investors’ financial advisors.  That is, from the same BDs that FINRA decided to sanction because somehow, they failed – LIKE EVERYONE ELSE – to figure out that the folks running the LJM Fund were – allegedly – fraudulently hiding its real risks.

So, now we get to the point: for FINRA, it seems that when customer losses occur, especially after spectacular blow-ups like the sudden explosion of the LJM Fund, it goes after any BD that managed to have its fingerprints on things.  Rather than taking a more deliberative approach, one that takes into full consideration the fact that we are strictly dealing with a “reasonableness” standard of supervision, and one that is open to the possibility that the BD itself may have been a victim of someone else’s fraud, FINRA takes the “easy” route, as it did here with the three firms from which it exacted the AWCs, and just blames the BD.

Attentive readers may recall that not too long ago I wrote a blog generally complaining of claimants’ counsel who troll for clients by posting notices on their websites of supposed “investigations” that they are conducting of some alleged fraud, and specifically pointing out the intensive campaign they’ve waged to induce investors in GPB to file arbitrations against the BDs that sold GPB.  All that despite the fact that, according to the SEC, the selling BDs were not the bad guys, but were themselves the victims of the alleged fraud that was perpetrated by GPB.

Yet, notwithstanding this conclusion by the SEC, who among us would be surprised in the slightest if FINRA starts filing Enforcement actions against the selling BDs, alleging some supposed failure to have conducted adequate due diligence on GPB?  Sadly, the answer is none of us.  Because we know from its historic practice of playing the role of claimants’ counsel, that FINRA will, inevitably, blame the BDs.  Because it’s easy.


[1] Rather remarkably, mere minutes after I initially posted this blog, I received an email from the “strategic communications and media relations firm” that represents LJM Funds Management.  According to the firm’s website, among the services it offers to its clients is “reputation management,” which is described as follows: “We actively monitor and advise our clients on market and public sentiment around their businesses in the media and online.”  To that end, I was asked to share with you a statement from Mr. Caine in which he (1) denies the allegations, (2) insists that he has “summarily rejected” the SEC’s settlement offer, and (3) states his intent to “vigorously defend these false claims while continuing to aggressively pursue actions to seek financial recourse for LJM investors,” among other things.

The controller has been passed to a new team of players in Washington. New players prefer to hit the reset button and start a new game, not pick up where the prior player left off. We know how our new players like to play the game. They want to control every aspect of the game through regulation, occasionally, using the cheat code to attempt to regulate by enforcement. Securities regulators’ recent interest in gamification exemplifies just that.

According to Merriam-Webster, “gamification” is “the process of adding games or gamelike elements to something (such as a task) so as to encourage participation.” Google’s dictionary provides a similar definition: “[T]he application of typical elements of game playing (e.g. point scoring, competition with others, rules of play) to other areas of activity, typically as an online marketing technique to encourage engagement with a product or service.” Some broker-dealers have employed this marketing concept to their trading platforms in an effort to encourage investors traders to trade more, and thus to generate more revenue for the broker-dealers. In other words, for-profit entities have enhanced their services to differentiate themselves from their competitors by making their services more attractive to consumers in an effort to generate more revenue.

I fail to see the problem with the use of gamification in the broker-dealer industry. It does not directly or proximately cause losses to the consenting adults who choose to trade securities. The performance of the securities that grown men and women choose to buy and sell is dictated by the performance of the securities, not whether confetti pours down, or firework light up, the screen after profitably closing a position. There also is nothing misleading about gamification. I highly doubt that there are any traders, even neophyte traders, who actually believe they cannot lose money buying and selling securities. Broker-dealers disclose those risks in spades. Even gamers know they are not going to win every game they play. Trading securities is no different. You make money on some trades and you lose money on others.

So what exactly is the problem with broker-dealers adding game-like features to their trading platforms? One SVP at FINRA was quoted in a recent article as describing the problem to be: “The real danger here is that investors may be making decisions that are contrary to their own financial goals.” (Emphasis added.) In other words, it is possible that gamification might cause some investors traders to make poor decisions. The reality of the situation is that people who indiscriminately trade securities just for the confetti and fireworks screens, instead of the bottom line, are apt to make poor decisions, with or without the special effects and irrespective of where they fall on the platform’s leaderboard. While there apparently is uncertainty regarding the causal connection between gamification and poor trading decisions, there is no uncertainty that inexperienced and unsophisticated investors are more likely than experienced and sophisticated investors to make poor investment decisions.

FINRA now has a working group dedicated to gamification. Both the SEC and FINRA will be seeking public feedback on gamification. The regulators apparently need testimonials and data to tell them that the more user friendly and exciting a product is, the more likely a consumer is to use and enjoy it. Gamification is widely used to make the mundane more enjoyable. It even makes some human resources and other training and educational endeavors bearable. I have no doubt it has the same intended effect on trading platforms.

Setting aside the new regime’s need to regulate anything and everything, another problem with regulating gamification is assessing where to draw the line. Sure, there are easy things to address, such as leaderboards, but there is also a lot of grey area. Drawing lines will be challenging, if not impossible. If a customer profitably closes a position, what is the limit on how a broker-dealer can convey that generally good news and what is the basis for the limit? Is confetti okay? Money bag emoji? Smiley face emoji? Cha-ching sound effect? A flashing “Congratulations!”? A simple “Congratulations!” Or is that all too much? On some platforms, daily and overall unrealized losses on each position are in red font and daily and overall unrealized gains on each position are in green font. Is this too far? Does this cause some people to sell all of their reds to accumulate greens? What about the “buy” button? What can that permissibly look like?

We all know how this game will end. The SEC and FINRA are not going to pass the controller. Their efforts likely will result in guidance and/or rules on gamification. They believe gamification adversely affects some traders, albeit ignorant ones, so they will act, and likely will overreact, in their efforts to be the perceived champions of main street. Hopefully, they act through guidance and rulemaking, not enforcement. Because the posterchild for gamification appears to be surrounded by Inky, Blinky, Pinky, and Clyde without a Power Pellet in sight, it would not surprise me if they go the enforcement route.

The truth of the matter is every dollar and ounce of energy spent by regulators on gamification in an effort to protect the ignorant would be much better spent on investor education. As Benjamin Franklin observed: “An investment in knowledge pays the best interest.”



Sorry for the flurry of posts this week, but the development Chris writes about here was not expected, and it is important enough that I decided to push it out today, on the eve of a three-day weekend. – Alan

Today FINRA announced in a press release here that it has withdrawn from SEC consideration its proposed rule changes regarding the expungement process.  The proposed rule changes were dramatic and included the creation of a special roster of arbitrators to decide expungement cases, and the appointment of arbitrators to expungement cases (rather than allowing the parties to choose them through the ranking process), as mentioned in these prior posts.

FINRA also pushed out a new webpage today devoted solely to expungement.  It includes key statistic about the numbers of expungements granted, as well as the proposed rules that have now been tabled.  The website indicates that the SEC clearly took issue with the proposed changes, as it required FINRA to respond to comments on three separate occasions (according to the timeline on this new website).

This development is significant, to say the least.  FINRA has been working on these rule changes since 2017, when it published Regulatory Notice 17-42.  Now, four years later, it is not clear where FINRA goes from here.  FINRA describes the withdrawal as “temporary” and vows to keep working to improve the expungement process.  It is too early to declare victory on either side, although PIABA has already done so  and seems to think FINRA will revise the proposed changes to make them even more harsh on brokers.  That may be true, but it may not.

For now, let’s all just enjoy the holiday weekend.

So I spent last week – the whole week – doing an arbitration with JAMS.  It involved some of the typical elements of a FINRA claim, e.g., allegations of the sale of an unregistered security, of an “investment” gone bad, of misrepresentations and omissions in connection with the “sale” of that “investment,” but for reasons not pertinent here, the case did not have to be heard in the FINRA arbitral forum.  Anyway – and I acknowledge that I am painting with an awfully broad brush here – it was a remarkably different, and by different of course I mean better – experience than most any FINRA arbitration.  Let me count the ways.

First, and most important, was the quality of the arbitrator.  My case was heard by a retired Federal District Court judge.  Someone who had sat on the bench for over 27 years.  He has seen and heard it all during that time.  So, even handicapped by having to conduct the hearing through the sometimes glitchy auspices of Zoom, I was always confident that he understood the issues, was listening to hear what he knew would ultimately be relevant to his eventual decision, and could easily filter out the BS (whether from witnesses or counsel).  I would not be able to say the same, unfortunately, about some FINRA hearing panels I have appeared before.  What clearly seemed to matter to the judge were the facts and the law, period.  Well, and, maybe, an effort to be “fair” to both sides.

He was unimpressed by anything that served to waste his time as factfinder.  Both sides were given ample, but hardly unfettered, latitude to put on their cases.  If a line of questioning seemed to be of dubious relevance, he didn’t wait for an objection; rather, he would ask counsel, proactively, what was the point.  If a lawyer had already made his point, he would tell us, with a gentle admonition to move on.  He did not need witnesses or lawyers simply to read (sometimes dramatically) from exhibits when the documents were in the record and he could read them himself.  Closing arguments?  Bah, waste of time.

He was not hesitant to make rulings, or to enforce them after the fact.  I find that too often, FINRA chairpersons can be decision-averse, hesitating before ruling, perhaps hoping that the parties will simply figure it out for themselves and move on.  As a former judge, he was quick to decide any issue that arose, whether substantive or evidentiary.  Indeed, regarding the latter, when’s the last time you had an in-depth discussion with a FINRA arbitrator about the interplay between Rules 404 and 608 of the Federal Rules of Evidence?  I am going to venture to guess that the answer is “never.”  And while the rules of evidence don’t “strictly apply” in JAMS any more than they do in FINRA, that doesn’t mean such rules should be ignored, either, so it was really helpful to have an arbitrator who knew the lingo.

It was also heartening as counsel for the respondent not to have be concerned about the typical arguments that claimants make about arbitration being an equitable forum, so the arbitration panel should feel free simply “to do what’s right” and, well, law shmaw.  This former judge seemed singularly unimpressed by repeated efforts by claimant to evoke sympathy for his claimed plight, or to paint — using a very colorful verbal palette — my clients as greedy bad guys who took advantage of claimant’s feigned naivete.  I mean, he sat there and listened closely to all the testimony, but what he was listening for were facts, not emotional diatribes.

Second was the nature of the discovery we were permitted to conduct.  Specifically, the ability to take select depositions.  Having done arbitrations for the past four decades, I am, by now, pretty good at conducting “blind” cross-examinations, i.e., cross-exams of witnesses who I have not previously deposed.  (Indeed, that’s my standard retort to “litigators” who occasionally insist that doing an arbitration is somehow not as difficult as conducting a court trial: hey, man, when’s the last time you cross-examined an expert witness without having first deposed him/her, or at least had the chance to pore over a written report?  Well, I do that every day.)  With that said, if you offered me the chance to depose a claimant, or a claimant’s expert witness, in advance of the hearing, I cannot imagine the case where I would decline such an opportunity (even at the price of having to produce my own client for opposing counsel to depose).

Here, we got to depose not only the claimant, but his expert, as well as a couple of people who we knew would be called as witnesses.  It made the cross-exams at the hearing quicker, cleaner, and damning, frankly, every time the previously deposed witness attempted to pivot from prior sworn testimony. (Just as it’s supposed to be in court.)  With no surprise answers to deal with, it really was a fairer hearing for all involved, including the judge, than one where impeachment can be difficult in the absence of some document that contradicts the testimony.

I know what you’re going to say: arbitration is designed to be quicker and cheaper than going to court, and adding depositions to the list of permissible discovery tools would run counter to both of those goals.  Well, I suppose I would have to agree with you.  But, I would still vote in favor.  The ultimate goal, after all, is to have everyone who participates in the process agree that they have been treated fairly, and got an equal chance to develop and then present their case.  Allowing the parties some deposition discovery – not unlimited, but some key witnesses – would, in my assessment, greatly increase the likelihood of achieving that end.  Too many times after an arbitration I am forced to look my client in the eye and vainly attempt to argue that what we both just endured was not, in fact, a free-for-all or, worse, a total s***show.  Allowing depositions could at least help avoid these difficult conversations.

Finally, it’s worth noting that JAMS tries really, really hard to provide a smooth experience for all parties.  They are accommodating and attentive.  (And when you do JAMS hearings in person, they have all kinds of snacks!  Including fresh baked cookies, yum.)  I am not necessarily saying this in any relative sense, that is, I am not necessarily saying that JAMS is more accommodating and more attentive than FINRA; I will let you reach your own conclusions about that.  Many FINRA Case Administrators are super at their jobs, and take very seriously their obligation to ensure that the cases run their course without a hitch.  But, with that said, I can’t tell you how many hearings I have participated in that didn’t start on time because the tape recorder failed to show up, and we were dealing with a Case Administrator who was hundreds of miles away, trying to figure out over the phone what hotel employee had supposedly signed for the FedEx package.

JAMS is pricey, no doubt about it.  That alone will be enough to dissuade a lot of people from considering it.  And there are no free rides: you will not get your final Decision unless/until all fees have been paid.  But, you simply have to agree that some of the fundamental things about FINRA arbitrations that are the most troubling – the qualifications of the arbitrators, the ability to prepare the case properly for hearing, and then a fast-paced, smoothly run hearing – are most assuredly not issues in JAMS.  Of course, let me remind you that a few blog posts ago, I told you that I’d be perfectly content if we just ditched arbitrations altogether in customer cases, since I know that many claimants’ counsel simply could not survive in that environment.  Maybe JAMS represents a decent compromise.

I have been in a JAMS arbitration the last week or so, so thanks to Chris — Mr. Expungement — for his thoughts about PIABA’s study. –  Alan

In a move that surprised nobody, PIABA[1] recently released an updated study on expungement awards from 2019/2020, and, in the most predictable fashion, they continue to complain that the expungement process is rigged and that brokers who seek expungement continue to “game” the system.  We’ve blogged about this before, and about the numerous changes FINRA has made to the expungement process recently, and the slew of additional rule changes that are still pending but are expected to be approved by the SEC any day now.  Even though FINRA has taken substantial steps to make expungement harder for brokers to obtain, and easier for customers to oppose, PIABA is still not satisfied.  Dare I say it – you can’t help but feel a little badly for FINRA here, as it seems none of their expungement rule changes can satisfy the PIABA attorneys.  Let’s dive into the study’s findings and PIABA’s erroneous conclusions.

First, the study found that 90% of expungements from August 2019 to October 2020 were granted.  According to the study, that number is basically the same as it was in 2015, before FINRA started making significant rule changes to the expungement process.[2]  PIABA concludes that this means arbitrators are rubber-stamping the expungement requests, arbitrator training is not working, and the recent rule changes are not working to stop useful disclosures from being removed from CRD.

I suggest that there’s a different explanation for why the number of expungements granted has not changed: there was nothing broken with the expungement process in the first place.  For as long as I can remember, FINRA arbitrators have always been warned that expungement is supposed to be an “extraordinary remedy.”  But the standard for granting expungement under FINRA Rule 2080 is that the arbitrators must find that the customer’s allegations were false or clearly erroneous.  The arbitrators are simply seeing the facts laid before them and calling it how they see it.  They either believe the evidence demonstrates that allegations are false, or not.  Unlike a true research study which proffers multiple possible explanations to explain data, PIABA’s “study” doesn’t even contemplate the notion that so many expungement requests are granted is because the claims were frivolous in the first place.  Speaking from personal experience, I take multiple expungement cases to hearing every year and end up winning (knock on wood), but I receive just as many inquiries about expungement that I never file because I will advise the client if their likelihood of success is low.  It is not a secret that attorneys only take cases to trial that they feel strongly about.  If it’s a bad case, it will likely never get to a hearing, and may never get filed in the first place.  That is why the expungement success rate is so high – not because the system is broken.

Second, the study found that customers only participate in expungement hearings 15% of the time, which has not changed much from 2019 when they only participated 13% of the time.  PIABA continues its false narrative that “the current expungement process … does not have safeguards to ensure that customers can participate in a meaningful way.”  That is just not true.  Since at least as far back as 2017 when FINRA issued its Notice to Arbitrators and Parties on Expanded Expungement Guidance, FINRA has expressly told arbitrators that “it is important to allow customers and their counsel to participate in the expungement hearing in settled cases if they wish to.”  The Guidance also contains a laundry list of ways customers are permitted to participate in expungement hearings, including by testifying, introducing documents and evidence, cross examining the broker and other witnesses, presenting opening and closing arguments, and presenting an opposition in writing.  And FINRA’s proposed rules – that will likely be approved by the SEC this week – provide for even more safeguards to give customers notice of the expungement hearings and opportunities to participate both in the pre-hearing conferences and the hearings themselves.  So, to say that there are no safeguards that allow customers to meaningfully participate is total nonsense. The real issue is that customers do not want to participate in the expungement hearings because there is no incentive for them to do so after their cases settle.

The study concludes that customers’ lack of participation in expungement cases is what causes so many expungement requests to be granted.  According to the study, “the data strongly indicates that arbitrators are granting expungement requests 90% of the time because they are being provided with one-sided presentations about the merits of the customer complaints….”   However, the study’s own data completely undercuts that conclusion. The study found that arbitrators are more likely to deny expungement requests when a customer opposes the request – not that much more likely.

According to the study, arbitrators denied expungement requests only 9% of the time when the customer did not participate, but they denied 36% of expungement requests when customers did participate.[3]  In other words, even when customers oppose an expungement request, the arbitrators still decide their allegations are false almost 7 out of 10 times.  The customer participation changes the arbitrators’ minds in only 2.7 out of 10 expungement cases.  That tells you two things: 1) customer participation in expungement cases is highly overrated and inconsequential, likely because arbitrators are smart enough to weigh facts and credibility without hearing the customer’s predictable testimony that he/she was wronged, and 2) the quality of customer claims are not very good.

And therein lies the real issue.  Any investor can file any complaint at any time, regardless of the merit, and it will live in CRD forever unless expunged.  One recent article about the study cited a Stanford Law Professor who acknowledged that FINRA should “impose a higher level of scrutiny” on what’s put on BrokerCheck in the first place. Bingo.

Finally, the study found that the number of “straight-in” expungements filings have “skyrocketed” in recent years. As the study explains, “a straight-in expungement case is an arbitration initiated by a broker against their current or former brokerage firm solely for the purpose of seeking expungement. The customer who made the complaint is not a party.”  This differs from the other scenario where a broker involved in a customer arbitration asks for expungement to be granted in the course of that customer arbitration.  The study found that in 2015 only 59 straight-in expungements were filed, but that number has increased year after year (2016 – 135; 2017 – 339; 2018 – 545; 2019/2020 – 700).  PIABA calls this a “tactic” and suggests that brokers utilize it to limit customers’ ability to participate in the expungement hearing since they will be treated simply as a “fact witness” rather than a party.  (p.21)  This is simply not true.  Even in expungement cases where the customer is not a named party, FINRA requires the broker to provide notice to the customer, and the customer is permitted to participate in many more ways than a fact witness, as described above (opening statement, closing argument, testimony, present exhibits, cross-examine other witnesses).

Furthermore, the study’s authors blatantly disregard the fact that in cases that settle, FINRA is actually in favor of requiring brokers to file a separate “straight-in” arbitration that deals only with the issue of expungement, rather than keeping the arbitration panel from the underlying arbitration in place and having them hear the expungement request.  In FINRA’s Sept. 30, 2020 filing with the SEC regarding their proposed rules (which the SEC may approve any day now), FINRA states:

The proposed rule change would provide that if, during a customer arbitration, a named associated person requests expungement or a party files an on-behalf-of request and the customer arbitration closes other than by award or by award without a hearing, the panel from the customer arbitration would not be permitted to decide the expungement request.  Instead, the associated person would be required to seek expungement by filing a request to expunge the same customer dispute information as a straight-in request under proposed Rule 13805. … FINRA believes this is the right approach because the panel selected by the parties in the customer arbitration has not heard the full merits of the case and, therefore, may not bring to bear any special insights in determining whether to recommend expungement.

So, while PIABA may not like it, there are going to be many more “straight-in” expungement requests filed.  And many more expungement requests granted.  And mark my words – when that happens, PIABA will publish another “study” claiming that the system is still broken.

[1] PIABA is a group of plaintiffs’ attorneys who market themselves as protecting investors, while at the same time lining their own pockets.

[2] The number dropped to 81% in 2015, 2016, and 2017.

[3] This is actually the data from the 2019 study. The updated study strangely does not give the exact percentages, but just states that the arbitrators are 4.3 times more likely to deny the request when a customer opposes it – which is about the same figure they cited in the 2019 study.

I am writing this while flying home from my first business trip in over 15 months.  I have to tell you, it is more than a bit of a strange feeling to be out and among people again.  While my face is sore from wearing this N95 mask nearly non-stop for three days, my hands are dry and rough from all the washing, and I basically hid in my hotel room if I didn’t have to be somewhere, I think this still marked the start of something that I recognize as sort-of normal. Cheers to that!


FINRA, of course, has lots, and lots, of rules.  Heck, it has rules about making rules.  The things that RRs can and cannot do per those rules are strictly proscribed, mostly in great detail.  Things that ordinary people can do without a second thought are frequently off-limits for RRs.  Yet, notwithstanding the sizable breadth of the gamut of restrictions that FINRA has erected, sometimes, remarkably, BDs feel that FINRA hasn’t gone far enough, and so create their own rules that go above and beyond anything that FINRA ever contemplated.  In other words, BDs are free to create policies that are more restrictive than FINRA rules.  Like this common scenario:  FINRA Rule 3240 prohibits RRs from borrowing money from or lending money to their brokerage customers, subject to certain exceptions, like if the deal involves a family member.  Many BDs, however, prefer simply to disallow any loans, period, since that’s much easier to police.

The issues that this situation tees up are these:  Does FINRA care if an RR violates a firm policy through conduct that does not violate any specific FINRA rule?  And, if it does, should it?

The answer to the first question seems to be “it depends on the policy.”  Take an obvious example, like, I don’t know, dress code.  FINRA undoubtedly would not and does not care if an RR wore flip-flops to the office, contrary to firm policy.  But, if the policy touches the relationship with customers, then FINRA does seem to care.  I am just not sure why, or if it is appropriate.

I started thinking about this a few months ago, when I blogged about the SEC’s decision in Tysk.  Among the rulings the SEC made there in its review of the FINRA decision was a finding that FINRA failed to carry its burden of proof that Mr. Tysk violated Rule 2010 strictly by virtue of the fact that he had violated his firm’s policy regarding note-taking.  According to the SEC, “[a] violation of a firm policy does not necessarily mean that a registered representative has also violated” any FINRA rules.  Rather, FINRA must independently establish that the underlying conduct somehow violated FINRA Rule 2010 because it was unethical.  I characterized that ruling as “huge,” and I stick by that.

So, with that background in mind, I was really intrigued when I read this recent AWC regarding a guy named Gary Wells.  According to the AWC and BrokerCheck, Mr. Wells entered the securities industry in 1983 – the same year I started practicing law! – and stayed for 37 years.  The AWC says he had no relevant disciplinary history; indeed, it appears to me that the only disclosures he has are all related to the same events that led both to the AWC and his dismissal from his last job (which I will get to in a second).  Not a single customer complaint in almost four decades.  That’s pretty dang good (even though FINRA accords no “credit” for it, because FINRA says you don’t get credit simply for doing what you’re supposed to do).

So what happened?  Well, Mr. Wells did not violate any specific FINRA rule.[1]  Rather, like Mr. Tysk, he violated one of his firm’s policies.  In his case, Mr. Wells had the temerity to provide such good service to one of his customers that the customer decided to leave something to Mr. Wells in her will.  The AWC recites that this “long-term customer” – FINRA’s words, not mine – followed Mr. Wells to Wells Fargo Advisors in 2008 from a prior firm.  At some point prior to 2012, the customer named Mr. Wells as a beneficiary and fiduciary in her will. In 2012, as is so often the case in situations like this, not the customer but, rather, someone from the customer’s family, her brother, specifically – perhaps someone who himself stood to inherit from the customer? – filed a complaint with WFA that his sister had named Wells in a fiduciary capacity and as a beneficiary.[2]  The basis for the complaint was not indicated.  Importantly, however, there is zero indication that Mr. Wells had exerted any undue influence over his elderly customer.  Indeed, if he had done that, you could bet the farm that FINRA would’ve included that in the AWC (and that the customer’s brother would’ve mentioned it).

So, what we have is a “long-term” customer who decided, on her own, to leave a legacy to Mr. Wells, but, in so doing, managed to piss off her brother.  Perhaps the story would have just ended there, but WFA had a policy – a policy that went beyond any FINRA rule – that “prohibited acceptance of a bequest or a fiduciary appointment from a nonfamily member in the customer’s will.”  In light of that policy, FA instructed Mr. Wells to have himself removed from the fiduciary and beneficiary designations and, if his long-term customer refused, he should decline the appointments.

On December 4, 2014, following the death of the customer at age 92, Mr. Wells received a bequest in the form of a wire transfer from the customer’s estate to his WFA brokerage account. WFA reversed the transfer and told Mr. Wells the firm would not permit him to receive the funds because they represented a bequest from a non-family member.  After WFA informed him that he could not accept such funds, Mr. Wells then proceeded to accept three separate bequests from the customer’s estate, in accordance with her will.  Finally, after receiving the money, Mr. Wells “concealed the fact that he was the beneficiary and had received bequests from the customer’s estate by making false statements on [a] . . . compliance questionnaire.”

That’s the entire case.  No violation of any specific FINRA rule, but, because Mr. Wells violated a firm policy that FINRA says in the AWC was “designed to protect customers,” FINRA deemed this to be a violation of Rule 2010, the catchall rule prohibiting unethical conduct.

I am not sure why FINRA bothered with this one.  In Reg Notice 20-38, in which FINRA announced its new Rule 3241, it explicitly gave BDs the right to approve bequests from customers, particularly “long-term” customers and those customers whose bequests were not accompanied by “any red flags of improper conduct by the registered person,” such as when “the customer has a mental or physical impairment that renders the customer unable to protect his or her own interests,” or “any indicia of improper activity or conduct with respect to the customer or the customer’s account (e.g., excessive trading),” or “any indicia of customer vulnerability or undue influence of the registered person over the customer.”   Exactly NONE of those issues existed here.  To the contrary, there is no evidence of any red flags at all.  So, even though Rule 3241 was nothing more than a fantasy that FINRA harbored at the time of Mr. Wells’ conduct, and even though under that rule the facts suggest that Mr. Wells would have been permitted to inherit from his long-term customer had he asked, for the simple fact that WFA had an absolute prohibition on inheriting from customers, FINRA brought this case.

I simply do not see why, in circumstances like this, FINRA takes it upon itself to enforce BD policies.  You can make a decent argument that WFA’s policy does exist to protect customers; but that does not mean that FINRA should otherwise ignore the pertinent facts, which, as FINRA laid them out in the AWC, fail to tee up any customer protection/sales practice issues.  As it has done hundreds of times before, all FINRA did in the Wells case was prove that he violated a firm policy, not that he acted unethically.  The Tysk case states that this is not enough for FINRA to carry its burden of proof on a 2010 violation, and I agree.  FINRA needs to do more, and if it can’t, then cases like this either should no longer be brought, or hearing panels should start dismissing them.


[1] While FINRA currently has a rule – Rule 3241 – that prohibits an RR from inheriting from a non-immediate-family customer absent approval by the BD, at the time of the conduct in question, that rule was still years away from being effective.

[2] As I mentioned earlier, there are NO customer complaints reflected in Mr. Wells’ BrokerCheck report, so I don’t really know what to make of this supposed complaint from the brother.  Was it not reported because it’s not from a customer?  Was it not reported because it does not relate to sales practices?  I don’t know, but it is a bit puzzling that the AWC not only calls this a “complaint,” given that there is no record that WFA bothered to report it on Mr. Wells’ U-4, but that this “complaint” was enough to trigger an exam, and an eventual Enforcement case.