We have frequently blogged here about the degree of attention that regulators pay to Chief Compliance Officers, and whether it is proper that they sometimes are named individually in Enforcement actions.  And we are hardly the only ones who see this issue.  The New York City Bar back in February – I know, that seems like a lifetime ago, as it was before COVID-19 really impacted us all – published a Report On Chief Compliance Officer Liability In The Financial Sector that explored the subject in great detail.  It concluded that “Compliance officers can function as effective gatekeepers only if they are given the information and tools necessary to carefully police the boundary between culpable and permissible conduct—and do so without bearing a disproportionate risk of liability for others’ misconduct.”

Interestingly, that Report noted at the time that there was some reason for hope, citing remarks made by Peter Driscoll, the Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), at a spring 2019 conference.  There, he announced that OCIE was embarking on a “pilot initiative to hold regional roundtables with CCOs in select locations” designed “to encourage productive dialogue with the compliance community and ‘search for ways to strengthen the role of the CCO, improve the culture of compliance, and deliver on the shared goal of investor protection.’”

Well, last week, Mr. Driscoll again offered remarks relating to CCOs that, once again, reveal not only that he feels their pain, but provide some solid guidance as to what the CCO job should look like and how CCOs should be treated by firm management.  And while he was discussing CCOs of RIAs, not BDs, I think both should pay heed to his words, as they apply equally to both.

He started with this summary observation:  A CCO “should be empowered with full responsibility and authority to develop, implement, and enforce appropriate policies and procedures for the firm.  And a CCO should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.”  He then went on, very helpfully, to illustrate what that general description means by detailing what the SEC does NOT like to see during an exam:

  • CCOs who are hired merely so the firm can “check the box,” but who are not supported or empowered by management;
  • CCOs who hold one or more roles in a firm and are, as a result, inattentive to their compliance responsibilities;
  • CCOs who are “too low in the organization to make meaningful change and have a substantive impact, such as a mid-level officer or placed under the CFO function”;
  • CCOs who “are expected to create policies and procedures, but are not given the resources to hire personnel or engage vendors to provide systems to implement those policies and procedures”;
  • When “a CCO is replaced because they challenge questionable activities or behavior”;
  • When “a CCO is trotted out for an examination or sits silently in the corner in compliance discussions, overshadowed by firm senior officers”;
  • When “a firm puts responsibility on the CCO for a failure of an employee or an officer to follow a firm policy or procedure.”

Then, he listed what the SEC LIKES to see in a CCO:

  • CCOs who “are routinely included in business planning and strategy discussions and brought into decision-making early-on, not for appearances, but for their meaningful input”;
  • CCOs with “access [to] and interaction with senior management, prominence in the firm, and when they are valued by senior management;”
  • Senior management who evidence “demonstrable actions, not just words, supporting the CCO and compliance.”

He concluded his remarks with some very powerful statements on what makes not just a good CCO, but a good firm, a firm that is truly interested in achieving – and demonstrating to its regulators – effective compliance.  If I was a CCO, I would print these things out and hand deliver them to firm management, and if all I got in return was a hearty laugh, I’d find somewhere else to work:

  • The CCO is not there to fill out irrelevant paperwork or serve as a scapegoat for the firm’s failings.
  • A firm’s compliance department should be fully integrated into the business of the adviser for it to be effective.
  • Compliance regarding conflicts of interest, disclosures to clients, calculation of fees and protection of client assets should not be done from the sidelines. The CCO needs a meaningful seat at the table.
  • Although the responsibilities and challenges are significant, the critical function of compliance should not all fall on the shoulders of CCOs.
  • Without the support of management, no CCO, no matter how diligent and capable, can be effective.
  • An effective CCO should have confidence that they can stand up for compliance and be supported.
  • Compensation and job security for CCOs should be commensurate with their significant responsibilities.
  • CCOs should not be made to feel that they are one “no” away from termination.
  • CCOs should not be made the target of every problem. The cause or blame for a compliance issue or failure typically does not sit only with the CCO and may not sit at all with the CCO.  In fact, we appreciate that often the CCO is the one responsible for identifying the problem and for fixing it.

So, let’s hear it for CCOs, as well as firms who rightfully value their CCOs.  Let’s not just look at them merely as a line – and a big one, at that – on the expense side of the ledger.  Let’s no longer brand them the “anti-sales department.”  And let’s agree that Ari Spyros on Billions is not a realistic portrayal.

As everyone is likely well aware, one of the principal changes that happened when FINRA retired the old suitability rule – NASD Rule 2310 – and replaced it with shiny new FINRA Rule 2111 back in 2012 was the broadening of the scope of the rule to encompass not just recommendations to buy or sell specific investments, but, as well, recommendations involving investment strategies (which could include a combination of securities and non-securities).  Despite that change, the overwhelming majority of suitability cases still focus on recommendations relating to specific investments.  Every once in a while, however, a case comes out that makes it abundantly clear that FINRA stands prepared to charge registered reps with making unsuitable strategy recommendations.  Richard Wesselt, who has been in the industry since 1992, learned this the hard way through an AWC that was published a week or so ago.

According to the facts of the case as recited in the AWC (which Mr. Wesselt accepted), Mr. Wesselt recommended an “unsuitable investment strategy to 78 customers.”  It was a three-step process, as follows:

Step 1: Mr. Wesselt recommended that the customers “liquidate their retirement savings, which they often held in qualified, tax-deferred accounts such as 401(k)s or IRAs.”  Hmm.  This already sounds troubling.

Step 2: Mr. Wesselt then recommended that the customers “purchase a variable annuity with funds liquidated from their retirement plans.”  Interestingly, Mr. Wesselt generally recommended that his customers “purchase an X, or bonus, share class variable annuity.”  According to the AWC, while such shares “add a cash bonus to the contract,” they also “typically have the longest surrender periods of any variable annuities offered in the marketplace and charge higher mortality and expense fees than other share classes.”  Mr. Wesselt also recommended that as part of the annuity purchase, the customers pay extra for “a guaranteed minimum withdrawal benefit rider, which allows lifetime withdrawals of a specified percentage once the customer reaches a specified age.”  By recommending both the X-share and the withdrawal rider, Mr. Wesselt managed to increase the customers’ fees for purchasing the variable annuity.  Getting worse, huh?

Step 3: Finally, after the variable annuity was issued, Mr. Wesselt recommended that his customers take early withdrawals, causing them not only to lose benefits they had paid for, but to incur surrender charges.  Many of withdrawals were large one-time withdrawals to purchase whole life insurance policies (notoriously expensive products that have super high commissions); others were used “to pay significant expenses, such as the purchase of a home or the settlement of a divorce.”  The purpose of the life insurance policy was to build cash value, part of what Mr. Wesselt dubbed “building your own bank” or, even more perplexing, “infinite banking.”

FINRA rightly takes the position that a variable annuity is a “complex” investment vehicle, with lots of moving parts.  Given that, it is essential that extra care be taken when recommending such products to ensure that customers understand how they work, how much they cost, how the RR is going to be compensated, etc.  Indeed, as you know, FINRA has a special suitability rule – Rule 2330 – just for annuities.[1]  Mr. Wesselt, sadly, seemed to go in the opposite direction, and hid vital disclosures from this customers, as he “typically had his customers sign blank or incomplete disclosure documents or had them sign those documents quickly in his presence.”  As a result of his sleight-of-hand, “his customers frequently did not understand the unique features and risks associated with these variable annuities and riders.”

No surprise, I suppose, that between the unsuitable recommendations and the paperwork trickery, FINRA had enough to permanently bar Mr. Wesselt.

But, what about Mr. Wesselt’s BD, The O.N. Equity Sales Company?  The AWC states that during the relevant period, Mr. Wesselt was one of the firm’s “top producers for variable annuity sales”; in fact, in 2016 he was the firm’s highest producer.  For the 78 customers alone who FINRA identified, Mr.  Wesselt earned $686,025 in commissions just on the sale of the variable annuities.  And that doesn’t include, I expect, the commissions he earned on the sale of the products in Step 1 of his plan, or the purchase of the whole life insurance in Step 3.  The point is, Mr. Wesselt should certainly have been the focus of a good bit of attention from the firm.  Yet, there is no indication that O.N. Equity noticed anything untoward.  (Similarly, there is no indication that the firm has been the subject of any action taken by FINRA, i.e., no Wells letter, no filed complaint and no settled case.)

And, look, I get two things.  First, I get that Mr. Wesselt made it appear that his clients actually signed all the necessary documents, but all that means is that as far as O.N. Equity knew the transactions were authorized; those signatures do not, however, establish that the transactions were suitable.  A customer cannot conclusively agree that a recommendation was suitable, as that is not something a customer is deemed capable of knowing.  That’s why Supplementary Material .02 to FINRA Rule 2111 explicitly states that “[a] member or associated person cannot disclaim any responsibilities under the suitability rule.”

Second, I get that the final step in the strategy – the purchase of the whole life insurance – did not take place at O.N. Equity, so the firm may not have known about it.  (I know this because O.N. Equity went to court to fight to keep complaints about the whole life insurance purchases out of four customer arbitrations that Mr. Wesselt’s conduct triggered.  According to the court’s decision determining that the insurance piece of the strategy was not subject to FINRA arbitration, “O.N. Equity is not in the business of selling life insurance, is not licensed to sell insurance, and does not appoint life insurance agents.”)  But, O.N. Equity certainly could have seen the early and sizable withdrawals from the recently purchased annuities across his customer accounts.

And when you look at the descriptions of what happened to the sample of Mr. Wesselt’s 78 customers described in the AWC, it makes you wonder how the firm could have missed these situations:

  • In 2014, Customer 1 was 43 years old, with “substantial daycare expenses” and a 401(k) worth $220,000. He had her liquidate the 401(k), and used the proceeds to buy an X-share variable annuity.  He then had her withdraw $225,000 from the annuity to buy whole life insurance (that amount included surrender fees of $11,998 and tax withholding of $71,564).  The early withdrawals also caused her to incur a tax penalty.  Now she can’t afford her life insurance premiums, and her annuity, which held most of her retirement savings, is worth less than $10,000.


  • Customer 3 was 59 years old in 2014 and nearing retirement. She approached Mr. Wesselt regarding the purchase of an apartment and assisting a child with student loan repayment.   Wesselt had her take $58,000 from her 401(k) and buy a variable annuity.  Six months later, he had her buy whole life insurance using her annual withdrawals from the annuity.  Each withdrawal was $16,840, which included $12,000 for the insurance premiums, $840 in surrender charges, and tax withholding of $4,000. Not surprisingly, because each withdrawal depleted the value of the annuity, this was sustainable for only three years.  By June 2017, the variable annuity had declined from its original value of $57,955 to $8,489.


  • Customer 4 was 52 years old when she met with Mr. Wesselt in 2016. She needed to pay $40,000 as part of a divorce settlement, and wanted to help a child pay off student loans.  The only money she had available was her 401(k).   Wesselt had her roll her 401(k) into an X-share VA worth $133,144. Within three days, he recommended that she withdraw $63,697, which included $40,000 for the divorce settlement.  A week later, he had her withdraw another $55,323 from the variable annuity in order to pay for a new whole life policy.  In other words, in one week, her new annuity declined by 85% to $19,764, she paid $8,180 in surrender charges, and she was assessed a tax penalty for taking the early withdrawals.

Anyway, I didn’t mean to get hung up on O.N. Equity, but it does make me wonder how the firm has stayed clean throughout this.  The reason I found the AWC worth discussing is that, unlike probably 99% of suitability cases, this one focuses solely on the notion of an unsuitable strategy.  So, if anyone tries to tell you that Rule 2111 really didn’t change anything from old, reliable Rule 2310, feel free to laugh in their face as you share Mr. Wesselt’s sad tale.

[1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a “strategy,” as Rule 2111 does.  If you read Rule 2330, it only “applies to recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations,” i.e., actual transactions, not strategies.  Nevertheless, the AWC provides that Mr. Wesselt violated both Rule 2111 and Rule 2330(b).

As should be clear to readers of this Blog, I find that Enforcement actions often provide the best guidance in terms of what regulators deem to be unacceptable conduct, which is very useful when dealing with subjective standards like “reasonableness.”  This past week, FINRA published an AWC submitted by Coastal Equities, Inc. that offers a good lesson in the sort of red flags associated with unsuitable recommendations – particularly quantitatively unsuitable recommendations – to which every BD ought to be sensitive.

As in every AWC, the salient facts recited were deemed by Coastal to be accurate.  They relate to the recommendations made by a particular RR referred to as “SA,” who, according to a footnote, was barred by FINRA (for violating Rule 8210 for not appearing at his OTR, which was investigating his “recommendations of excessive and unsuitable trading, including his recommendations involving the use of margin”[1]):

  • During the pertinent time period, i.e., from September 2015 to July 2018, Coastal supervised the recommendations of its registered reps “primarily through the review of daily trade blotters.” Ok, no problem here, as lots of firms rely on the same tool.
  • The blotters showed each trade entered by each RR, as well as the turnover rate and the amount of commissions charged to each account for the preceding 12-month period. Wow, this sounds great!  This is clearly more info than many blotters provide.
  • In addition to that, from time-to-time, supervisors would calculate the cost-to-equity ratio for certain accounts. More points for Coastal!
  • In September 2016, Coastal, through daily trade blotter review by SA’s immediate supervisor, became aware that SA had recommended frequent transactions in preferred stock that resulted in significant losses in the account of one customer. Man, this is sounding great for Coastal.  I can’t imagine how it could’ve gone wrong!
  • That led SA’s supervisor to sample other customer accounts of SA. This is exactly the response you would want to see.
  • That revealed “additional accounts showing indicia of potential excessive trading.” Ok, that’s what the sample was designed to look for.
  • When asked about this trading, SA “claimed that the customers approved of his trading strategy.” Uh oh.  Everyone knows that the issue of suitability does not turn on the question whether the customer approved; indeed, it is irrelevant. This answer was not what you would want to hear.
  • Coastal accepted that explanation at face value and as a result took no further steps at that time. Well, here we go.  Now I see the problem. 

FINRA could have ended the AWC at this point and it would have been clear that there was a supervisory problem.  As I have said countless times, when confronted with red flags, you cannot simply pretend they do not exist; you must investigate them to see whether a problem exists and, if it does, address the problem.  Here, Coastal did everything exactly right . . . up until the moment it confronted SA, at which point it (1) asked him the wrong question, and then (2) blindly relied on his irrelevant answer.  The potential issue that the blotter review revealed was SA possibly churning his accounts, i.e., making quantitatively unsuitable recommendations.  But, rather than explore that, Coastal apparently satisfied itself that there was no problem because SA assured them that his customers “approved” his trading strategy.  In no world does that constitute a defense to a suitability claim, and Coastal had to have known that.

But, as is typical, it only gets worse.

As the AWC provides, after that observant supervisor picked up on SA’s red flags, “Coastal, through supervisory review of the daily trade blotter, was on notice of additional red flags that SA was recommending unsuitable and excessive trading in the accounts of four customers, and that that he was making unsuitable recommendations to purchase securities using margin in two of those customers’ accounts.”

In other words, Coastal compounded its problem.  Not only did it fail to understand the implications of the first situation it stumbled across, it now failed to appreciate all these other red flags madly waving in its face.

Who, exactly, were these four customers?  They were, in short, the embodiment of your worst case scenario:  all were seniors, all were retired, and all had a “moderate” risk tolerance.  There is no greater sin, in FINRA’s eyes, than messing with seniors.  Hard to argue with that, at least in this case, when you consider some of these ugly details:

  • Customer 1 was 75 years old. From October 2016 to July 2018, SA recommended more than 100 trades in his accounts, resulting in commissions totaling $84,525.
  • Customer 2 was a married couple living on a fixed income. From October 2016 to April 2017, SA recommended 65 trades in their account, including recommendations to purchase securities using margin. They paid $97,587 in commissions plus another $11,845 in margin interest.
  • Customer 3 was 91 years old, also on fixed income. According to his new account paperwork, his annual income and other investments were less than $50,000.  From October 2016 to July 2018, SA recommended 31 trades in his account, resulting in $61,657 in commissions and $580 in margin interest.
  • Customer 4 was 82 years old. From October 2016 to December 2017, SA recommended 39 trades resulting in $14,126 in commissions.

To be clear, there can no reasonable argument that the flags were not red, or that Coastal somehow could not plainly see them.  From October 2016, its daily trade blotter showed not only SA’s frequent trading but the “correspondingly high turnover rates and commissions in the accounts of Customers 1 through 4.”  Each had a turnover rate well over 6 and a cost-to-equity ratio in excess of 20%.  I am not saying that these numbers conclusively establish churning, but they do require investigation, which Coastal failed to do.

Finally, on top of that, beginning in August 2017, Coastal bolstered its daily blotter review with exception reports from its clearing firm, which included a report of accounts with turnover rates over 6 and a report for accounts with high margin-to-equity ratios.  The accounts of all four customers generated multiple turnover exceptions, and Customer 3’s account generated two margin exceptions.

Yet, even with these nifty exception reports, even in the face of all these red flags, from October 2016 through December 2017, no one at Coastal:

  • reviewed the accounts of Customers 1 through 4 to determine whether SA’s recommendations were suitable,
  • questioned SA about the trading in any of his customer’s accounts,
  • contacted any of SA’s customers, or
  • took any steps to reduce the commissions that SA was charging his customers or the frequency with which SA was recommending.

The AWC does show that, finally, in December 2017, the firm suggested that SA move some actively traded accounts from commission-based to fee-based accounts, and in February 2018, Coastal began sending activity letters to some of SA’s customers.  Despite this, however, SA “continued to recommend excessive trading and/or unsuitable use of margin to certain customers.”

Coastal stepped it up in April 2018 and sent SA a “letter of admonishment,” for what that’s worth, but, even then, SA did not sign it until June 2018.  SA finally quit in July.

There are so many things here that Coastal did wrong, or did too late, or did too half-assedly, that it is impossible to argue with the outcome.  So, as I said at the outset: use this as a lesson in what NOT to do.[2]






[1] About two minutes of Google research revealed this AWC for the RR, Sam Aziz.

[2] There is more point I want to make. At the beginning of the AWC, as it does in all AWCs, FINRA outlines the rule that the respondent violated.  Here, it was FINRA Rule 3110, the supervision rule.  But, strangely, the AWC does not include a simple recitation of the rule; instead it includes what I find to be a disturbingly inaccurate summary of the rule:  “FINRA Rule 3110 requires that a member firm take reasonable steps to: ensure that the activities of each registered representative comply with applicable securities laws, regulations, and FINRA rules, and FINRA rules.”  I want to be very clear about something:  Rule 3110 does not require that a firm’s supervisory system “ensure” that its reps abide by all applicable rules.  The word “ensure” appears in the rule exactly eight times, by my count, but never in the manner that FINRA uses it here.  Through its use of “ensure” here, FINRA has inaccurately elevated the core standard of “reasonableness” that underpins Rule 3110 to something rather higher.  Thanks to my buddy Richard Brodsky for sensitizing me to this issue.

Attentive readers will recall that a couple of weeks ago, I mentioned in a preface to great post from Chris about expungement becoming an endangered creature due to changes in FINRA rule that I was about to embark on a two-week FINRA Enforcement hearing, all done by Zoom, by consent.  I promised to provide some feedback, so here it is.

In short, despite the best and sincere efforts and intentions of the parties, their counsel, and the Hearing Officer, in a word, it simply failed.

It was not, however, a matter of the typical Zoom-related technical glitches, like someone inexplicably dropping off the feed, or someone’s video freezing.  We had a few of those, but, at the Hearing Officer’s instructions, everyone on the call was extremely attentive to any such occurrences, and when they happened, they were immediately brought to the Hearing Officer’s attention (unless she discovered the problem first herself), and she paused the proceeding to correct the glitch.  So, I have no complaints about that.

Sadly, my complaints are much more serious.

What happened was that at the close of the hearing on Day 2 (of what was supposed to be a 10-day hearing, remember), I posed a question to the Hearing Officer.  I told her that when a witness was testifying while a document was being displayed to the witness – which was about 90% of the time a witness was testifying – I could only see the document, and not the witness.  (For that matter, I couldn’t see anyone, that is, either the witness or the members of the hearing panel, so I also had no way of gauging the degree of attention being paid to the proceedings by the panelists.)  Maybe it was no big deal that I couldn’t see the witnesses.  But, given that it was the job of the hearing panel, perhaps its most important job, to make credibility calls about the testifying witnesses, based not only on what the witnesses said but, as well, on how they said it, i.e., their demeanor, it was a very big deal to ensure that each panelist was able to see the witnesses as they testified.  So, I asked if anyone else was having the same experience as me.

The Hearing Officer told me that, indeed, she could see both the witness and the exhibit.  Great.  The second panelist echoed that response, as he, too, could see both.  Excellent.  But…the third panelist said, nope, that, like me, he could only see the document and not the testifying witness.

Remember, this was after two full days of testimony, all from my clients, the respondents.  This meant that one-third of the hearing panel was, basically, deprived of the essential tools he needed to do his job.

Ah, but that’s not all!

After informing us that he couldn’t see the testifying witness 90% of the time, the third panelist also volunteered the fact that he had not been able to hear the second witness very well, either.

Mind you, that witness’s testimony, i.e., my client’s testimony, had occupied much of the second hearing day.  Which meant that for all intents and purposes, the hearing panelist could neither see nor hear (at least not very well) hours of testimony from one of the two respondents.  I know justice is blind, but this, well, this is not what anyone had in mind.

Perhaps not surprisingly, when we resumed the hearing on Day 3, the Hearing Officer announced that due to the problems that my inquiry had revealed at the close of Day 2, she was adjourning the hearing, and that there would be a do-over.  That is, we would pretend the first two day had not happened, i.e., no opening statements, no testimony, no nothing, and we would start all over again at some point in the future, from the beginning, when the hearing panel could both see and hear the witnesses.

From a fairness-of-the-hearing standpoint, I think that the Hearing Office had no choice but to make that decision.  There was simply no way to adequately remedy the problem.  I mean, I suppose that the third hearing panelist could be provided with a transcript of the hearing to read the testimony he was not able to hear, but there is simply no way to make up for the fact that he had been deprived of his ability to eyeball the witnesses while they testified.

From a fairness-to-my-clients perspective, however, consider the costs, both out-of-pocket as well as emotional, of having to start over again.  Consider, too, that when this hearing restarts, Enforcement will have had the benefit of hearing my opening statement, and seeing my nifty PowerPoint slide deck, and seeing how my clients performed on the witness stand.  There is nothing that FINRA can do to compensate for that.

The only positive development is that this little snafu provided an opening to settle the case on terms that heretofore FINRA refused to find agreeable.  In other words, for the first time, FINRA agreed to drop its insistence that – guess what? – both my clients be permanently barred.

The irony of this experience is that it happened despite pretty good diligence by the Hearing Officer, not because of inattentiveness.  The lesson is that you can take absolutely nothing for granted in a virtual hearing, and must constantly take steps to ensure that everything is proceeding according to plan.  While there is no good excuse for the third hearing panelist not to have complained sooner that he could not hear the witness’s testimony, there is also not much excuse for FINRA to have set up a system in the first place that apparently did not permit that panelist to see the witness while a document was being displayed, and for not checking on that before I happened to bring it up when I did.  It should not be my job to ensure that the hearing – from a straight technological, administrative angle – is fair.



On October 26, the SEC hosted a roundtable discussion during which the SEC and FINRA shared some of their observations about how firms are doing implementing Regulation Best Interest.  If you missed the live presentation, it was recorded and is available here.

The discussion covered a lot of topics and, in some instances, simply directed firms to the FAQs and guidance released to date.  But, in a few instances, there were glimpses of what the regulators liked and what troubled them as they conducted these reviews.   Here are a few of the highlights where we learned what pleased and displeased the regulators:

Reg BI training.  The regulators are seeing a lot of firms sharing documents with their reps that explain what Reg BI is, what their procedural changes and requirements are, etc.

The Regulators are pleased with firms that:

  • Added a “live” (electronic, of course, given the pandemic) training element.
  • Included in their training specific guidance for reps on how they fulfil the various obligations owed under the regulation. So, for example, instead of merely repeating the requirement reps must act in the customers’ best interest when recommending a specific account type, the regulators were pleased by firms who go on to train reps on how to perform that analysis (and how to memorialize it).
  • Conduct ongoing testing to ensure that the rep’s understanding of his or her obligations has “stuck.”
  • Write up reps who do not complete their training on time.

The Regulators are displeased with firms that:

  • Had not started training or started it long after Reg BI’s implementation date.
  • Merely distributed rule updates as training.

Care Obligation.  The care obligation requires reasonable diligence and care when making a recommendation including knowledge of risks, rewards, costs, and that the rep has a reasonable basis to believe that the recommendation is in the customers’ best interest.  This analysis specifically requires that the rep consider “reasonably available alternatives” to the product or strategy the rep intends to recommend.

The Regulators are pleased with firms that:

  • Had developed tools to assess “alternative” recommendations.
  • Conducted up front review of certain products prior to making them available.
  • Evaluate their existing customer records and the manner in which they collect customer information to ensure they are properly collecting and preserving information about the customers’ risk, experience, etc.
  • Requiring reps to include comments around each recommendation so that supervisors can review compliance with care obligation. (The regulators acknowledged that there was no requirement to document this process, but recommended firms do so, especially if it involves an unusual product or if the recommendation seems to be a poor fit for the customer, in case the regulators come in and ask about it).

The Regulators are displeased with firms that:

  • Had procedures that failed to distinguish between the Rule 2111 suitability and the best interest standard OR had simply added Reg BI language to existing procedures without “harmonizing” Reg BI and the Suitability Rule.
  • Required reps to certify that they had performed the care analysis, but did not require the reps to explain what the analysis was.

Form CRS.  The Regulators pushed firms to review the guidance and FAQs they had published about Form CRS and its requirements.

The Regulators are pleased with firms that:

  • Avoided legalese and disclaimers. The document should be in plain English.  (I think one of the Panelists suggested that it should be written for a person who reads at an 8th grade reading level, but I’m not sure I caught that correctly and there was no rewind button!)
  • Used charts, graphics, and exciting fonts to highlight items.
  • Made sure conversation starters were visible.
  • Did not “overload” the pages in dense text and, instead, used white space to draw the reader’s attention.
  • (for dual registrants) used side by side columns or boxes to illustrate the differences between brokerage and IA accounts.
  • Clearly described how and when fees were imposed.
  • Explained whether the firm monitors customer accounts and, if so, the frequency.

The Regulators are displeased with firms that:

  • Modified the conversation starters.
  • Used Form CRS as marketing material instead of a disclosure document.
  • Used Form CRS to explain how conflicts would be mitigated or to suggest they were rare/minimal by using words like “may.” (The Commission believes this downplays the conflicts, whereas the purpose of Form CRS is to highlight them).
  • Failed to disclose disciplinary history or incorrectly said no history existed when it did.
  • Provided “extraneous” language explaining disciplinary history.
  • Failed to state “yes” or “no” in response to the disciplinary history question or otherwise provided a vague response.
  • Provided only vague cost and fee descriptions and no discussion on how they are imposed.
  • Failed to provide a WRAP fee disclosure.
  • Modified the required headings.
  • Missed required sections of Form CRS.
  • Missed required headers.
  • Missed required conversation starters.
  • Failed to deliver the Form CRS.
  • Failed to record delivery (meaning delivery could not be verified).

Towards the end of the program, FINRA suggested that it may not necessarily agree with some of the firms that had concluded they were not required to file Form CRS at all.  FINRA seemed surprised by the number of firms that reached this conclusion.

I encourage everyone to find the archived program and watch it.  A lot of the information will be repetitive for anyone who has read the Rule, Form CRS and followed the subsequent guidance.  But it is interesting to hear about what other firms are doing (good or bad) and see which areas the regulators are most focused on – at least for the moment.

I dare you. In fact, I double-dog dare you to figure out how or why FINRA decides to charge willfulness in some cases but not in others.  Bottom line is that it is nearly impossible (except if you’re a big firm, in which case you can rest easy that FINRA will manage to skip the willfulness charge in your Enforcement action).  In support of this conclusion, I submit this AWC, published a week or so ago.

Steven Gribben had a brief stint in the securities industry, about five years in all.  For one year, from 2017-2018, he was registered through Alpine Securities as an Investment Banking Representative.  While with Alpine, Mr. Gribben founded the firm’s 3(a)(10) investment-banking business.  What, exactly, does that mean?  According to the AWC,

Section 3(a)(10) of the Securities Act provides an exemption permitting a company, in certain circumstances, to extinguish debts and claims in exchange for court-approved issuances of unregistered securities that generally are freely tradeable.  More specifically, in relevant part, Section 3(a)(10) exempts from registration securities issued in exchange for “bona fide outstanding . . . claims,” if a court conducts a public hearing and finds the terms of the issuance to be fair to the company and to those receiving the shares.

Here is how Mr. Gribben worked his business, step-by-step, in 11 deals he did while he was with Alpine:

First, a third-party investor worked with a microcap company to identify “claims” (i.e., outstanding payables) that the investor could purchase from creditors of the company.

Second, the investor then recruited Alpine to serve as the microcap company’s placement agent.  As placement agent, Alpine’s nominal role included finding investors to purchase the microcap company’s debt (notwithstanding the fact that it was the third-party investor who had recruited Alpine in the first place).

Third, through its placement agent agreement – all of which Mr. Gribben signed – Alpine became a creditor of the microcap company, which typically agreed to pay Alpine 10% of the total debt that the investor purchased from the microcap company’s creditors.

Fourth, Alpine executed a claim purchase agreement – again, all signed by Mr. Gribben – in which it sold to the investor Alpine’s claim (the 10% placement agent fee) against the microcap company.  The microcap company’s other creditors also entered into claim purchase agreements with the investor, pursuant to which each creditor sold to the investor its interest in the microcap company’s payables.

Fifth, the investor then filed a lawsuit against the microcap company for the total amount of the payables, including Alpine’s claim against the microcap company for its 10% fee.

Sixth, the investor and microcap company then executed a settlement agreement, pursuant to which the investor’s newly-purchased debt was exchanged for shares of the microcap company’s common stock.

Seventh, the court where the lawsuit was filed scheduled a hearing to determine whether the terms and conditions of the settlement were fair to the microcap company and to the investor.

Eighth, after the court conducted the hearing and approved the fairness of the 3(a)(10) debt-for-shares exchange, the microcap company issued the shares to the investor.

Finally, Alpine then served as the clearing firm through which the investor deposited and liquidated the settlement shares of the microcap company.

This was not an insignificant business for Alpine.  According to the AWC, all of the requested share issuances were approved, in exchange for payables totaling $3,025,520.30 from 40 creditors.  The exchanges resulted in approximately 7.5 billion shares being issued to third-party investors, who then deposited them with Alpine.  Alpine sold the shares on the open market for over $2.7 million.  This, ultimately, is how Alpine made its money on the deals, from commissions on the liquidations.

So, that’s all background.  What, exactly, did Mr. Gribben do wrong that got him in trouble?  He made two material misrepresentations in the claim purchase agreements.  In ten of the 11 3(a)(10) transactions, he falsely represented in the claim purchase agreements that Alpine “did not enter into the transaction giving rise to [Alpine’s] Claim [against the microcap] in contemplation of any sale or distribution of [the microcap’s] common stock or other securities.”  This was blatantly false, as the principal reason Alpine entered into the placement agent agreements was to facilitate the distribution of common stock pursuant to Section 3(a)(10).  In addition, in two of those ten claim purchase agreements, Mr. Gribben also falsely misrepresented that Alpine was “not a broker or dealer in securities.”  Hmm, sounds bad.

Exacerbating his misconduct, Mr. Gribben knew that investors would be filing the claim purchase agreements in court, where they were a necessary part of the mechanism that ultimately resulted in the issuance, and subsequent sale by Alpine, of the shares for which the debt was exchanged.  The AWC recites that Mr. Gribben’s “misrepresentations may have impacted the courts’ understanding of the proposed settlements, and may have influenced the courts’ decisions to approve the exchanges of unregistered securities for Alpine’s claims.”

Got all that?  Multiple material misrepresentations that may have directly influenced the court’s rulings.  Sounds very bad.

Well, not so much.  Mr. Gribben got suspended for a piddling three months and a $7,500 fine.  But, even crazier, get this:  FINRA found that Mr. Gribben did not act willfully.  As the AWC put it, “Gribben’s conduct . . . was negligent—he did not read the claim purchase agreements carefully before signing them, despite knowing that they would be submitted to a court.”

I simply cannot wait to use the “Gribben defense” next time one of my clients is accused of signing something that FINRA claims contains a false statement, especially a document that could result in a statutory disqualification if there is a finding of “willfulness.”  Perhaps a U-4, where a tax lien is not timely disclosed.  Perhaps an annual OBA certification.  Perhaps, even, an 8210 response.  “I didn’t read it carefully before signing it.”  I love it!  So simple, so easy.  Of course, I would point out that I have made that very argument before, as, I am sure, have countless other defense lawyers, but I have never achieved the success that Mr. Gribben did here.  Kudos to Mark David Hunter, Mr. Gribben’s attorney, for pulling off this coup, and for providing this settlement as precedent.  FINRA, as you may know, does not consider prior settlements to be binding precedent, but, still, at a minimum, this case will clearly preclude FINRA from claiming that it never accepts the “I didn’t read it” defense.

Having completed my Enforcement hearing conducted by Zoom – more about that in an upcoming post – I can finally turn my attention back to some matters that arose while I was busy.

One that stood out for the sheer (and frightening) universality of its lesson is an SEC settlement entered into by Jonestrading Institutional Services, LLC.  According to the Order, the firm was fined $100,000 for failing to preserve “business-related text messages sent or received by several of its registered representatives, including senior management.”

What are the details?

  • Like lots of firms, Jonestrading’s WSPs flatly forbid its personnel from using text messages for business-related communications. (I mean, that’s the easiest way to avoid the problem with texts, right?  Apparently not, as you will see.)
  • Late last year, the firm received certain requests for documents from the SEC as part on an enforcement investigation being conducted not about Jonestrading, but, rather, a third party.
  • One of the responsive documents referenced the existence of texts between a JonesTrading RR and a firm customer.
  • Unfortunately, the firm did not retain those text messages, and so could not produce them to the SEC.

It gets worse.

  • Upon further investigation, the SEC determined that it wasn’t just one RR, but “several” RRs.
  • These RRs sent each other “business-related text messages.”
  • They also exchanged such texts with firm customers and “other third parties.”

Here is my favorite part.

  • JonesTrading’s senior management knew that its employees were texting each other and the firm’s customers in text messages.
  • In fact, “JonesTrading’s senior management, including compliance personnel, themselves sent and received business-related text messages with others at JonesTrading.”

Ok, hard to argue with the fact that the SEC felt compelled to bring a formal action here.  But, you see why I said this case has a frighteningly broad application?  Putting aside communications with customers, what firm out there does not, at a minimum, have texts messages among senior management relating to the firm’s “business as such,” a deliberately undefined term (found in SEC Rule 17a-4(b)(4)) designed to cast as wide a net as possible.  It is fast, it is easy, it convenient.  Texts work.  That’s why people use them.

But, that’s not the point.  FINRA has been rather clear for years that business-related texts have to be preserved, whether they are internal or whether they are with customers.  In Reg Notice 17-18, FINRA stated that

[a]s with social media, every firm that intends to communicate, or permit its associated persons to communicate, with regard to its business through a text messaging app or chat service must first ensure that it can retain records of those communications as required by SEA Rules 17a-3 and 17a-4 and FINRA Rule 4511.

Exactly one year ago, FINRA issued its 2019 Report on Examination Findings and Observations on “Digital Communications.”  In that Report, FINRA noted that “some firms encountered challenges complying with supervision and recordkeeping requirements for various digital communications tools, technologies and services” that were specific to text messages:  “In some instances, firms prohibited the use of texting, messaging, social media or collaboration applications (e.g., WhatsApp, WeChat, Facebook, Slack or HipChat) for business-related communication with customers, but did not maintain a process to reasonably identify and respond to red flags that registered representatives were using impermissible personal digital channel communications in connection with firm business.”  In light of that Report, it was hardly a surprise that shortly after it was released, FINRA included the supervision of text messages as one of its exam priorities in 2020.

The point is, it IS a challenge to keep a handle on text messages, given how ubiquitous they are, how customers increasingly expect to be able to communicate using all sorts of electronic media, not just emails (which are easily captured and preserved), and how people who work together rely on them to conduct day-to-day business.  But, just because it’s hard doesn’t mean you get a pass.  To the contrary, there are no points allotted for trying, no partial credit.  With that said, there is simply no excuse for senior management doing precisely what they undoubtedly train their own RRs not to do.  If you are silly enough to be guilty of that, then you better have your checkbook handy to pay the fine.


Here is the second part of Chris’s blog on FINRA’s effort to make expungement harder and more expensive to obtain.  It is remarkable to me just how blatant FINRA has been here in admitting the reasons for the rule amendments.  Anyone who thinks that FINRA is a membership organization that actually cares for its members is sadly mistaken. – Alan

The second dramatic change to the expungement process under the proposed rules relates to who will be deciding the expungement request.  Thankfully, FINRA will still have arbitrators decide expungement requests, not the Director, but FINRA is now requiring a three-arbitrator panel to decide all expungement requests, instead of just a single arbitrator (unless it is a simplified case).  In and of itself, this is not hugely detrimental to brokers, since the decision must be only by majority, instead of unanimous.

But, the bigger change, and, frankly, the most consequential change to the expungement process, probably ever, is that parties in expungement cases will no longer have any input into who their arbitrators will be.  All expungement-only cases filed with FINRA (“straight-in requests”) will have three arbitrators appointed by FINRA from a special roster of highly qualified arbitrators who have received “enhanced expungement training.”  In other words, you get who whomever FINRA picks.  This differs dramatically from the current system where, as in all FINRA arbitrations, the parties receive a list (or lists) of at least ten potential arbitrators who they can strike or rank according to preference, with the highest ranked arbitrators from both parties’ lists selected to serve on the Panel.  Under the current method, a broker can review the prior awards of potential arbitrators and strike anyone who might display a history of denying expungement requests, or rank highly anyone whose award history suggests they might respond more favorably to the expungement request.  Expungement requests are often unopposed, so under the current system, the arbitrator whom the broker ranks number one is usually the one appointed, which can greatly increase the chances of the expungement request being granted.

Under the new proposed rules, FINRA will simply appoint three arbitrators from the special roster, without any input from the parties.  If you are appointed one or more arbitrators with a history of denying expungement requests, you will be stuck with them.  And don’t even think about just withdrawing your expungement claim and re-filing it, because the new rules will expressly forbid that practice.  Don’t try to stipulate with the other parties for the removal of one of the arbitrators, either, because that will be expressly forbidden, too.  Besides, all of these arbitrators will have had it instilled in them through FINRA’s “enhanced expungement training” that they should rarely grant expungement requests.

Under the new proposed rules, the only way for a broker to have any influence on the arbitrator selection process is to request expungement in the course of the customer’s arbitration that is the source of the disclosure that is sought to be removed.  In other words, going forward under the proposed rules, if a customer files an arbitration against either a broker or a broker-dealer, the broker or broker-dealer may request that the arbitration panel in that customer arbitration not only deny the customer’s claim but also grant the broker expungement.[1]  In that instance, since the expungement request is being made inside a customer arbitration, the normal ranking/striking process occurs for that panel selection, so the parties have some input into who is selected as an arbitrator.

But, none of that matters if that customer arbitration settles, as most of them tend to do.  Currently, when a customer arbitration settles, a broker can ask the current panel to be retained to hear the broker’s expungement request.  Under the new rules, that will not be allowed.  Under the new rules, once a customer arbitration settles, that’s it.  The Panel will be released and the case closed.  The broker will then have two years to file a whole new arbitration seeking expungement (“straight-in request”), assuming he/she requested expungement in the customer arbitration – and that expungement case will be appointed three arbitrators from the special roster.  “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 being to bear any special insights in determining whether to recommend the expungement.” (p.31).  That reasoning makes no sense.  A brand new arbitration panel will certainly know less about the customer’s case than the customer arbitration panel, and the customer arbitration panel may actually know a lot about the customer’s case, depending on whether substantial motions were heard.

It is painfully clear that FINRA does not want the parties to have any input whatsoever into who will hear their expungement claims.  FINRA admits this.  They state that the purpose for this rule change is to “decrease[] the extent to which an associated person and member firm with which the associated person was associated at the time the customer dispute arose may together select arbitrators who are more likely to recommend expungement.” (p.89).  FINRA fully intends for this rule change to “decrease the likelihood that associated persons are able to obtain an award recommending expungement.” (p.90).

FINRA also intends for this rule change to cause fewer customer arbitrations to settle.  They have stated that the additional costs of forcing a broker to file a “straight-in” arbitration seeking expungement after the customer case settles “may reduce the likelihood that the parties settle a customer arbitration.”  FINRA also probably hopes that by making it harder to obtain expungement after a case settles (because random arbitrators are appointed rather than ones selected by the parties), fewer customer cases will settle (if the customer case has a decent arbitration panel, the broker may just stick it out and try his luck taking the case to a hearing on liability and expungement).  In fact, I would not be surprised if in another 20 years, FINRA completely disallows expungement of any claims that settle.  Rest assured, this is not the last time when we will say “I remember the good old days” with regards to expungement rules.


[1] Under the new rules, if the broker is named as a respondent in the customer arbitration, the broker will be required to seek expungement in the course of that arbitration, or risk forfeiting the opportunity to request it.  In a case where only the broker-dealer is named, the broker-dealer may seek expungement on behalf of the broker, if the broker agrees.

I apologize for the long break between blog posts, but I have been preparing for a two-week FINRA Enforcement hearing…to be conducted by Zoom!  As is typical of most Enforcement cases that go to hearing, the Staff has insisted that — surprise! — my clients be permanently barred.  So, while the method of communication will be different, the rest will, it seems, sound rather familiar.  I will let you know how it goes.  The good news, however, is that Chris has stepped up big time with this post about FINRA’s efforts to render expungement not just “extraordinary,” but stupidly difficult to obtain even on a procedural basis.  Just ask yourselves: who is behind this?  Not brokers.  Not BDs.  Not complaining customers, because they could care less about expungement.  The answer, of course, is PIABA, which once again has FINRA doing its bidding. Ugh. – Alan 

The year 2020 has given us yet another reason to utter the phrase, “I remember the good old days.”   About two weeks ago, FINRA finally submitted sweeping and significant proposed rule changes to the SEC that, once approved in the next few months, will make it much, much harder to expunge customer dispute disclosures.  [If you want to jump straight to the bad news, and ignore the background and the mildly good news, skip the next two paragraphs.]

As regular readers of this blog already know, FINRA’s Code of Arbitration Procedure has long provided a method for registered representatives to seek to expunge, or remove, disclosures related to customer complaints from their permanent CRD records (and their publicly available profiles on BrokerCheck.com).  Over the past several years, various groups who purportedly advocate to protect investors from bad brokers have regularly complained to FINRA that it is too easy for brokers to obtain expungement.

Back in December 2017, FINRA issued Regulatory Notice 17-42, which proposed sweeping changes to the expungement process, nearly all of which were aimed at making it more difficult for brokers to obtain expungement.  Those proposed changes were so dramatic, and met with so much commentary from industry members, that it took FINRA three years to iron out the kinks, and thankfully, walk back some of its initial proposed changes (like requiring expungement awards to be unanimous from three-person arbitration panels, rather than just by a majority decision).

On September 14, 2020, FINRA’s first round of changes took effect, as set forth in Regulatory Notice 20-25.  That change solely impacted the costs associated with making an expungement request.  As I explained in my prior blog post, those changes caused the FINRA fees for expungement requests to jump from approximately $300 to $9,475 as a result of FINRA closing a loophole in its rules.  Almost immediately after that change took effect, on September 22, 2020 FINRA filed a 557-page document with the SEC containing its much broader and much more comprehensive proposed changes to its expungement rules.

To be clear, FINRA’s decision to draft additional expungement rules was long overdue and a welcome sight for many people, like myself, who spend a lot of time helping brokers clean up their records from false and erroneous claims made against them.  For many years, FINRA only had two paltry rules regarding expungement (Rules 2080 and 12805 / 13805); but, FINRA also maintained dozens of uncodified “rules” governing the expungement process that were only discernable to anyone willing to wade through a patchwork of FINRA arbitrator training materials and arbitrator “guidance,” none of which were actual rules.[1] So, the decision to actually put all of these “rules” in one place is a helpful and welcome change.

The problem with the proposed rules, however, is that they make significant changes to the expungement process that will make it much harder to obtain expungement.[2]  There are two major changes that FINRA unabashedly admits will significantly limit the number of successful expungement requests made.  First, the new rules apply a much stricter time limitation on expungement requests.  Currently, the only limitation regarding when a broker can make an expungement request is FINRA’s eligibility rule (12206/13206), which states that no claim shall be eligible for arbitration if the occurrence or event that gave rise to the claim occurred more than six years ago.

Basically, if the disclosure at issue was made more than six years ago, this rule might bar your expungement request.  I say “might” because up until recently, this rule was treated like any other defense – if the other side didn’t raise it, which they usually didn’t because expungement requests are often unopposed, then it would never rear its head.  In fact, I have successfully expunged several disclosures that were over a decade old because they were unopposed and there was nobody on the other side of the table to argue that the expungement requests were filed too late.  But recently, FINRA began instructing arbitrators that they can and should raise the eligibility rule on their own, sua sponte, and deny requests based on the application of that rule.  This stems from a court ruling in Nevada that FINRA likes to cite which said arbitrators could do this: Horst v. FINRA A-18-777960-C (Dist. Ct. Nevada Oct 25, 2018).  Importantly, however, the question of whether a claim ran afoul of the eligibility rule was always one for the Panel to decide, as the Supreme Court famously held in Howsam v Dean Witter, 537 US 79, 85-86 (2002).  The upshot is that some arbitrators might apply the eligibility rule, and some might not.

FINRA’s proposed rule not only significantly shortens the time period available for filing expungement requests after a disclosure is made on a broker’s CRD record, but it also changes who decides that too much time has passed before the request was made.  Under the proposed rules, a broker will have only two years from the time a customer arbitration/lawsuit ends to file an arbitration seeking expungement (or six years from the date of the disclosure, if the disclosure relates to a customer complaint that never materialized into an arbitration or lawsuit).  Now, the proposed rule is a little more nuanced than that because brokers who are named as defendants in an arbitration / lawsuit will actually be required to request expungement in that customer’s case, and will only be permitted to file a separate arbitration to address the expungement issue (called a “straight-in” request by FINRA) if that customer’s case settles.  But that is a much more detailed discussion for another day.  The upshot of the proposed change, from a practical standpoint, is that brokers will have to request expungement of a customer complaint without waiting very long, or they will be forbidden from ever asking to have it expunged.  And, once these changes are approved and take effect, there will be a short grace period, but after that, any old disclosures won’t be eligible for expungement.

More troubling than the shortened window for seeking expungement relief is the fact that the Director – not the arbitrators – will be deciding if the expungement request has been filed too late.   According to FINRA’s proposal (p. 48), “The Director would also deny the forum with prejudice if an expungement request is ineligible under the proposed time limitation.”  FINRA must have realized that arbitrators were not always following FINRA’s guidance to apply the eligibility rule, so FINRA took matters into its own hands and declared that it would take away the arbitrator’s authority to apply the timing rules and give itself the ultimate decision-making power to reject untimely filed expungement requests.

It is not at all clear why FINRA thinks it can grant itself this power, when the United States Supreme Court expressly stated “we find that the applicability of the NASD [nka FINRA] time limit rule is a matter presumptively for the arbitrator.” Howsam, 537 US at 85.  Indeed, FINRA arbitrators – not the FINRA Director of Dispute Resolution – have always decided whether claims, including expungement claims, are timely filed.  The proposed rule marks a huge shift in policy that takes this important decision away from arbitrators – who are neutral – and puts it in the hands of FINRA staff who are clearly predisposed against expungement.

FINRA flat out admits that it goal for these new time limitations is to dramatically decrease the number of expungement requests filed.  According to FINRA’s proposal, approximately 75% of expungements filed between 2016 and 2019 would not have been permitted under the new proposed rules because they were filed either more than two years after the customer arbitration ended or more than six years after the customer complained without filing arbitration.  While I understand that eligibility rules, statutes of limitation, and other rules imposing time limits on claims exist for a reason (i.e., because memories fade and documents get lost as years pass), in the case of expungement, this represents backwards thinking.  Rather than disallowing expungement of old claims, wouldn’t it make more sense to allow expungement of really old customer complaints because they happened so long ago that they are not necessarily representative of a broker’s current character (particularly if the broker had a clean record for the past several years)?  Under FINRA’s proposed rule, a broker with one complaint from 30 years ago would not be eligible to seek expungement of that complaint, while a broker with five complaints within the past two years would be permitted to seek to have them expunged.  That makes no sense.

[1] For instance, did you know that customers who are not named parties in expungement arbitrations can actually show up at the arbitration, bring an attorney, make an opening statement, and present evidence opposing the expungement request, even though they are not a party?  If you looked at the current FINRA rules 2080, 12805, and 13805, you would never know that.  But, if you wade through dozens of pages of arbitrator training materials, you would learn that is exactly what FINRA allows.  Now, the new proposed rules actually spell this, and many other nuances of the expungement process, in fairly well-written fashion.

[2] As a disclaimer, the goal here is not to explain all of the changes contained in FINRA’s 557-page submission to the SEC.  I’ll save that post for when the SEC actually approves the changes and FINRA releases another Regulatory Notice.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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