Broker- Dealer Law Corner

Broker- Dealer Law Corner

INSIGHT: Protecting Broker Dealers From Cyber Threats

Posted in Cybersecurity, FINRA

Yesterday, two of my colleagues here at Ulmer, Fran Goins and Michael Hoenig, published an article in @BLaw Insight in response to a recent report by FINRA outlining the best practices for BDs to deal with cyber threats.  Since this is undoubtedly a subject of considerable interest to many of you, I wanted to share it right away.  Click here to link to their excellent article.  – Alan

Contrary To What FINRA Believes, Rule 8210 Is Not A Search Warrant

Posted in FINRA, Rule 8210

I have been waiting for a while to write about this issue, since it arose in an Enforcement case I handled for a client, and I wanted the matter to run its full course at FINRA before I started throwing stones. Sadly, there are so many things I could complain about here. The fact that the entire case derived from my client’s supposed failure to abide by interim restrictions that FINRA imposed in connection with a pending CMA, even though there was no basis for FINRA to have imposed the restrictions in the first place. The fact that, apparently, it matters not how badly a witness called by FINRA performs at the hearing: they will always be deemed credible. The fact that – pursuant to rule – FINRA invites witnesses who appear for OTRs to go in and review their testimony afterwards, but, if someone actually avails himself of the right to do so and corrects his testimony, that fact will be held against him in gauging his credibility. The fact that FINRA dishes out permanent bars like Halloween candy, almost irrespective of the allegations.

But, there was something worse than all of that. And it involves a subject on which I have written repeatedly, and that’s FINRA’s abuse of its 8210 power. This case may have included not just the worst abuse I have ever witnessed, but, even worse, a threat made not by the examiner but, rather, by the Hearing Officer that underscores the nearly limitless scope of FINRA’s ability to compel an associated person to produce documents, no matter how personal, no matter how clearly unrelated to the exam those documents may be.

Here is what happened. My client was “requested” by FINRA pursuant to Rule 8210 to appear and provide sworn testimony at an OTR. One of the subjects of interest to FINRA was a laptop my client testified was the only computer that he recalled using for BD-related business. He wouldn’t unequivocally say he never used another, but, if he did, he lacked a specific recall. In the middle of the OTR, FINRA whipped out another 8210 letter that required my client to produce the laptop immediately. FINRA had some forensic computer guy standing by, ready to image the hard drive. The only thing that FINRA said it would not copy from the hard drive was the email folder, so as not to obtain any attorney-client privileged communication. But, everything else on the hard drive was fair game. No matter how personal. Wedding photos. Documents relating to businesses other than the BD. Didn’t matter.

We expressed concern, naturally, but FINRA threatened to bring an immediate 8210 Enforcement action. So, like everyone else with an 8210 gun to their head, we produced the computer, and FINRA copied the hard drive, wedding photos and all, everything but the email folder.

At the Enforcement hearing a couple of years later, I objected to the search of the hard drive, calling it illegal, complaining that FINRA had absolutely no right to see anything on the hard drive except documents relating to the BD.

Two things happened. First, the Hearing Officer concluded that we had waived any objection because we capitulated to FINRA’s threat at the OTR that if we didn’t produce the laptop then and there my client would have been named as a respondent in an Enforcement action immediately. Not sure exactly what the HO thought we should have done, to be honest. But, I will tell you this: next time I get a request like this for a laptop, FINRA is going to have to pry it out of my hands. I mean, my client ended up getting charged with an 8210 violation anyway, so why not fight about the scope of the request upfront?

Second – and these are the words that I have been stewing about for two years – the HO said this when I pointed out that 8210 gives FINRA no right to compel my client to produce the many personal documents he maintained on the hard drive: “A firm or an associated person who nevertheless elects to commingle personal or unrelated business materials with member firm materials, whether stored electronically or in hard copy, does so at its own risk.” If you wanted clearer evidence that FINRA considers Rule 8210 to be equivalent of a search warrant, you couldn’t find it. For what is the “risk” that HO is referring to if not the risk that your personal materials are going to be grabbed by the FINRA examiner due to their mere proximity to business materials?

But, that’s NOT how 8210 works. It does not provide FINRA the right to play storm trooper and seize whatever it wants under penalty of being barred. Rule 8210 does not give FINRA the right to rifle through your desk drawers, your file cabinets, or your computer hard drive It merely gives FINRA the right to compel BDs and individuals associated with BDs to produce documents and information that are related to an exam. But, under the HO’s interpretation of Rule 8210, FINRA can literally grab whatever it wants, whether it’s on your hard drive or in your desk, if it happens to be near some business document.

This sad case underscores the need for the rule to be amended to add a process by which the recipient of an 8210 request can challenge the request without having to worry that the consequence of not prevailing is a permanent bar. As I have noted before, a subpoena recipient can go to court to argue about the scope of a subpoena. If he loses, the result is that he must obey the subpoena, and that’s it. There is no other sanction. Under FINRA’s ridiculous rule, however, the only way to challenge an 8210 request is to be named as a respondent in an Enforcement action, an action that will result in a permanent bar if FINRA wins.

FINRA examiners all too frequently misunderstand the scope of their permissible 8210 requests, making life difficult for member firms who have little choice but to knuckle under to overly broad, overly numerous requests; but, when empowered with language like this from OHO, not only it is easy to see why examiners act the way they do, it is clear that they will simply continue to treat their 8210 request as search warrants. This cannot continue. The industry members of the District Committees, of the NAC, of the Board: they must speak as one to rein FINRA in. Otherwise, there is no check, no balance on FINRA’s extraordinary power under Rule 8210.


Does FINRA Have Jurisdiction Over Me?

Posted in Arbitration, FINRA

Does FINRA have jurisdiction over me? This is a question that I regularly field at the outset of regulatory engagements. My answer differs depending on a number of factors, including the nature of a person’s role and duties at a firm, his or her registration status, when the alleged misconduct occurred, whether he or she is still associated with a firm, and when the association ended. This post outlines some of the basics on FINRA’s jurisdiction.

Who Is Subject to FINRA’s Jurisdiction?

Under FINRA Rule 8310, FINRA may impose sanctions, including a censure, fine, suspension, and bar, upon a person associated with a member firm for violations of certain federal securities laws, MSRB rules, or FINRA rules. Under FINRA Rule 8210, FINRA can require a “member, person associated with a member, or any other person subject to FINRA’s jurisdiction” to provide documents, information, or sworn testimony. The definition of an “Associated Person” under FINRA Rule 1011 is extremely broad. It includes just about anyone and everyone who has anything to do with a firm, with the exception of persons who perform only clerical and ministerial tasks:

  • Any person registered with FINRA;
  • A sole proprietor, partner, officer, director, or branch manager of a firm, or any person occupying a similar status or performing similar functions;
  • Any person who controls the firm;
  • Any employee of the firm, except any person whose functions are solely clerical or ministerial;
  • Any person engaged in investment banking or securities business controlled by the firm; and
  • Any person who will be, or is anticipated to be, a person described above.

What Time Period Is Covered by FINRA’s Jurisdiction?

With the exception of requests for documents, information, and testimony issued under Rule 8210 (discussed below), FINRA only has jurisdiction to pursue charges against an associated person for conduct that occurred while the person was associated with a firm. By way of an extreme example, if a registered rep robbed a bank before and after he was associated with a firm, FINRA would not have jurisdiction to bring an action against the rep for either robbery. If the rep was convicted of a felony for the first robbery before joining a firm (and setting aside the facts that the rep would be subject to statutory disqualification, and that no firm, hopefully, would hire him), but the rep did not disclose the robbery on his Form U4, then FINRA could bring an action against the rep for failing to disclose a reportable event on his Form U4. The failure to disclose occurred while the rep was associated with a firm.

How Long Does FINRA Have to Bring a Disciplinary Action?

Registered Persons

Under Article V, Section 4 of the FINRA By-Laws, FINRA retains jurisdiction over a registered person for purposes of filing a complaint (i.e., bringing a disciplinary action) for two years after the effective date of the person’s termination from the firm. Under the same Section, FINRA retains jurisdiction over a registered person for the purpose of requesting documents, information, and testimony under Rule 8210 for just about two years after the effective date of the person’s termination. I wrote “just about two years” because, technically, FINRA can file a complaint against a registered person for not providing documents, information, and testimony requested within the two-year post-termination period, but the complaint needs to be filed within the same two-year period.

There are a couple of important things to note about the two-year time period for registered persons. First, the effective date of termination is the date when the firm files the Form U5, not the date when the person actually stopped working for the firm, and not the date of termination listed on the Form U5. For example, if a firm terminates a registered person on January 1st, but it does not file the Form U5 until January 31st, the two-year period begins to run on the 31st.

Second, under Article V, Section 4, the two-year period for registered persons can be extended by two years by the filing of an amendment to the initial Form U5 that: (1) is filed within the original two-year time period; and (2) discloses that the “person may have engaged in conduct actionable under any applicable statute, rule, or regulation.” FINRA generally has interpreted this provision to apply to the disclosure of new conduct (i.e., not an amendment disclosing that a previously reported customer complaint has settled). For example, if a firm files the initial Form U5 on January 1, 2015, and if it subsequently files an amendment to the Form U5 disclosing a new customer complaint on December 30, 2016 (which is within two years of the initial filing), then the amended filing recommences the running of the two-year period on December 30, 2016. Therefore, it is possible for FINRA to possess jurisdiction over a registered person for purposes of filing a complaint, and requesting documents, information, and testimony, for nearly four years following termination. Lastly, FINRA’s extension of jurisdiction is not limited to pursuing or investigating charges based solely on the newly-disclosed conduct in the amendment to Form U5. In other words, FINRA can use the extension of jurisdiction to bring and investigate charges based on unrelated conduct known to it prior to the filing of the amendment to Form U5 that extended jurisdiction.

Unregistered Persons

FINRA’s retention of jurisdiction over unregistered persons differs slightly. Under Article V, Section 4, FINRA retains jurisdiction over an unregistered person for purposes of requesting documents, information, and testimony, and filing a complaint, for “two years after the date upon which such person ceased to be associated with the member.” In the case of unregistered persons, the two-year period is absolute, and cannot be extended.

Arbitration Award and Settlement Exception

The one exception to the above limitations periods concerns the failure to comply with an arbitration award or written and executed settlement agreement obtained in connection with an arbitration or mediation submitted for disposition pursuant to FINRA rules. Under Article V, Section 4, if an associated person fails to comply with the terms of such an award or agreement, FINRA may suspend the person from associating with a firm so long as that proceeding is instituted within two years after the date of entry of the award or settlement.

Does FINRA’s Jurisdiction for Arbitration Proceedings Differ?

The short answer is “yes” – FINRA’s jurisdiction, to use that term loosely, differs in the arbitration context.

Current and former associated persons[1] generally are required to arbitrate a dispute with a customer in the FINRA forum if: (1) arbitration under FINRA’s Code of Arbitration for Customer Disputes is required by a written agreement, or requested by a customer; (2) the dispute is between a customer and member or current or former associated person; and (3) the dispute “arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company.” FINRA Rule 12200. This means that even if an associated person has left the industry, he or she still may be required to arbitrate a dispute in the FINRA forum. Customer disputes, however, are ineligible for arbitration “where six years have elapsed from the occurrence or event giving rise to the claim.” FINRA Rule 12206.

With a few notable exceptions, current and former associated persons generally are required to arbitrate a dispute with a FINRA member or associated persons in the FINRA forum under FINRA’s Code of Arbitration for Industry Disputes “if the dispute arises out of the business activities of a member or an associated person and is between or among” members, members and associated persons, or associated persons. FINRA Rule 13200. The exceptions include “a claim alleging employment discrimination, including sexual harassment, in violation of a statute,” and “a dispute arising under a whistleblower statute that prohibits the use of predispute arbitration agreements.” FINRA Rule 13201. Industry disputes, like customer disputes, are subject to a six-year eligibility rule. FINRA Rule 13206.

Class actions and shareholder derivative actions generally may not be arbitrated in the FINRA forum.

Arbitration is a creature of contract so unique circumstances may dictate that certain claims are not subject to arbitration.

[1] FINRA Rule 12100 oddly defines an “associated person” or “person associated with a member” to include, “[f]or purposes of the Code, a person formerly associated with a member is a person associated with a member.” The Code of Arbitration for Industry Disputes contains the same definition. FINRA Rule 13100.

The Securities Regulators All Have Senior-itis. Maybe For Good Reason.

Posted in FINRA, Rule 2165, Rule 4512, Senior Investors

The securities industry’s concern over the aging of the U.S. population, specifically, aging investors, has, apparently, reached a fever pitch. Yesterday in New York, SIFMA hosted its “Senior Investor Protection Conference – One Year Later: FINRA Rules 2165 and 4512,” and, for a securities conference, it received pretty extensive news coverage. I saw at least two articles published today that discussed what transpired, and both stressed the same underlying points: first, abuse of elders is serious and on-going, and, second, while the new FINRA rules are helpful, they are limited in their utility.

I blogged about the two FINRA rules regarding seniors two years ago. I said at the time that they were a good idea, since they primarily served to provide protections to BDs which develop concerns about the mental acumen of an aging customer, and I still feel that way. Look, I am now 60 years old. Despite (or, maybe, because of?) my continued affinity for clearly non-senior things like loud punk rock music, I am compelled to admit that, at a minimum, I may be on my way to becoming one of “those” customers. And there are lots of us. Back in 2007, in the first Regulatory Notice that FINRA published about seniors, some pretty daunting statistics were cited:

The number of Americans who are at or nearing retirement age is growing at an unprecedented pace. The United States population aged 65 years and older is expected to double in size within the next 25 years. By 2030, almost 1 out of every 5 Americans – approximately 72 million people – will be 65 years old or older. Those who are 85 years old and older are now in the fastest-growing segment of the U.S. population.

Age alone certainly doesn’t tell anything, of course, about a person’s intellect. There is a Supreme Court justice in her 80s who no one would reasonably suggest has lost a thing mentally. Nancy Pelosi is 78. Still sharp. Bernie Sanders is 77. Same. Joe Biden is 76. Same. The president is 72. Well, you get my point. The aging of America is undeniable.

Neither is the impact that exploitation of seniors has, and not just on the actual victims of the scams. According to SIFMA, while

no one has yet been able to estimate the precise impact of financial exploitation on the national economy, . . . a New York study estimated an annual cost around $1.5 billion in that state alone. Across the entire U.S. population, that could mean a $25 billion annual cost. Making things more difficult is the fact that the bad actor is often a family member, friend or caregiver of their victim – in fact, that same New York State found that 67% of verified cases of financial exploitation were committed by family members – and only an estimated 1 in 44 cases are ever reported to the authorities.

So, it makes sense that the regulators are paying pretty close attention when it comes to protecting seniors. The problem, however, is twofold. First, there is only so much that rules can accomplish. Second, as with, say, AML, BDs have been installed by their regulators as the first line of defense against senior exploitation, which raises the question whether this in an appropriate role for the industry. I mean, neighborhood watch programs may also a first line of defense against vandalism, but they are voluntary. If some dad is late for his “shift,” and, as a result, misses some teenager whacking a mailbox off its post with a baseball bat, the dad doesn’t find himself named as a respondent in a disciplinary action that could cost him his career. On the other hand, if a BD misses a red flag indicative of senior exploitation, well, the consequences could be dire.

According to FINRA Rule 2165, when a BD “reasonably believes that financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted,” it may impose a temporary hold on requests by the customer to disburse money from his or her account (theoretically, to prevent a scammer who has exercised some unhealthy influence over a senior citizen from quickly getting his hands on funds from the securities account). It’s not perfect, of course; no rule is. As was highlighted at the SIFMA conference, the length of the temporary hold is relatively short – no more than 15 business days initially (subject to being further extended by a state agency or a court), plus up to ten more business days if the initial review turns up something that reinforces the BD’s “reasonable belief” that there is, has been, or may be financial exploitation of the senior customer. In other words, the rule simply may not provide sufficient time within which to investigate the circumstances adequately, or to succeed in getting a state agency sufficiently motivated to intercede (which then leaves the BD no choice but to accede to the disbursement request).

Also, the rule only addresses the disbursement of funds and securities, not actual securities transactions. So, if an elderly customer gives an order to sell securities in his account – even, say, with the stated intent of having the proceeds of the sale disbursed to someone the BD may suspect to be a scammer – while the BD can put a hold on the disbursement request, it cannot legally ignore the sell order. Obviously, that could result in trades taking place that, if the industry had the same ability to step in and impose a hold as it could with a disbursement request, would never happen in the first place. Even trades that make no financial sense, even trades that result in serious tax implications for the customer, must happen if the client directs it.

There is also a practical problem with FINRA Rule 4512, which – sensibly – encourages a BD to make reasonable efforts to identify a “trusted contact” for any customer over 18 years old, i.e., someone who the BD can contact when it develops concerns about “possible financial exploitation” of the customer. The problem is that while BDs can ask their customers to name a trusted contact, they can’t require that their customers actually provide one. It seems that when BDs ask seniors for a trusted contact, many of them react like they’re being asked to give up their driver’s license. They refuse. It was reported that Vanguard’s chief compliance officer informed the attendees at the SIFMA conference that of the 300,000 trusted-contact forms Vanguard received in the last year, 78 percent of them were for investors under age 65. In other words, the investors who have the most pressing need for a trusted contact are the very ones most likely to decline to provide one.

If there’s good news, it’s that FINRA supposedly isn’t immediately interested in dinging firms regarding their compliance with Rules 2165 and 4512. Investment News wrote that Jim Wrona, an associate GC at FINRA (who has been around a long time), announced at the SIFMA conference that while FINRA will look at how firms have implemented these rules, “the exams will primarily be to check on the systems and processes firms have in place, to check that issues are properly elevated and that there’s an identified team to handle relevant decisions.” According to Mr. Wrona, FINRA just “want[s] more information. This isn’t going to be a gotcha, check the box, did you do it or not. We’re interested in learning about your situations, how you’re dealing with [the rules] and how we can assist.”




FINRA’s 529 Share Class Self-Disclosure Initiative: If It’s Good Enough For The SEC, It Must Be Good Enough For FINRA

Posted in 529 Plan, FINRA

About a year ago, the SEC offered investment advisors the unique opportunity to report themselves to the SEC if they sold mutual funds to their clients that offered a lower priced share class than the class actually selected by the advisor, but failed adequately to disclose the conflict of interest that created.  For those advisors willing to self-report under the Share Class Selection Disclosure Initiative – and pay their customers whatever excess fees they paid by having been improperly sold the higher priced share class – the SEC’s Enforcement Division promised that it would “recommend standardized, favorable settlement terms to investment advisers.”  While these settlements haven’t quite gotten to the finish line yet – the first ones appear to be close to being finalized – it does seem that the SEC is going to honor that promise.

Well, I guess that FINRA saw this and said, hmmm, maybe we should do that, too.  (FINRA is unique, perhaps, for being the only entity in the world that knowingly models its operations on those of a U.S. governmental agency, given the well-earned reputation among such agencies for, um, efficiency, fairness, and ease of process.)  So, earlier this week, FINRA announced its own self-reporting initiative – the 529 Plan Share Class Initiative – this time for BDs, so they, too, can turn themselves in to their regulator for sales practice issues in exchange for the promise of (relatively) gentle treatment by Enforcement.

The concept is simple enough to describe:

·         You’re a BD that sells 529 plans.

·         Maybe you haven’t been paying particularly close attention to the share class that your reps are recommending to their customers, despite FINRA’s efforts to publicize this issue, and now realize that, oops, there were, in fact, cheaper share classes available, so your clients may have paid too much.

·         You now face a choice:  you can do nothing, and sit back and cross your fingers and hope that FINRA never stumbles on to your situation (which is theoretically possible, not because FINRA is incompetent, but because FINRA exams don’t review every single facet of your business, and, therefore, may not take a hard look at your 529 sales, especially if they represent a very small component of your revenue), or you can voluntarily report your supervisory lapse to FINRA under this Initiative and take your lumps with Enforcement (with the thought that those lumps won’t be nearly as bad as they would be if you don’t self-report and FINRA does manage to figure out on its own that you’ve been overcharging your customers).

This may or may not be an easy decision to make, for the simple reason that it may not be clear that the recommendation to use a share class with a higher fee was, in fact, not appropriate.  In other words, to determine if you have a supervisory problem that FINRA is going to care about, it’s not just a matter of identifying the share class that was recommended and then seeing if a cheaper one was available.  As FINRA itself recognizes, the choice of share class can be dictated by the anticipated period of time until the funds will be needed from the 529 plan to pay for the beneficiary’s education.  For older beneficiaries, the hold period may be shorter, which could impact the choice of share class.  The point is, the analysis is not simply an arithmetic one, but something more involved.  And, the more customers you have, the lengthier and more involved that analysis becomes.

And, don’t forget that a condition to participating in the Initiative is your commitment to providing restitution back to your customers of whatever they overpaid as a result of being placed in a higher priced share class.  That could be a lot of money, especially since FINRA is looking at 5 ½ year time period, from January 2013 through June 2018.  For some firms, it may be enough money to justify the decision not to self-report and, instead, roll the dice that you somehow remain under FINRA’s radar.

So, if you are a firm that does think you have a problem with your 529 sales, it comes down to a couple of things.  First, are you willing to risk that FINRA won’t find your problem.  Second, can you afford the restitution that will be required.  Third, if you don’t self-report and FINRA does discover your problem, would you be ok with the harsher treatment you’ll then receive.  What will that entail?  First, firms that self-report will not pay a fine; that is not necessarily going to be the case for firms that don’t self-report.  According to FINRA, for a firm that does not participate in the Initiative that FINRA later discovers has a 529 share class problem,“any resulting disciplinary action likely will result in the recommendation of sanctions beyond those described under the initiative.”

Second, firms that self-report will likely all be lumped together when the settlements are announced.  From a publicity standpoint – or, more accurately, bad publicity standpoint – it may be advantageous simply to be one of several (or many) firms that are listed in a press release than to be the sole subject of a standalone press release.

Regardless of whether a firm self-reports under the Initiative, FINRA will give no assurances that it will not also go after individuals it deems to have culpability.  (The SEC provided the very same caution for its SCSD Initiative.)  So, at least this is one thing that can be removed from the calculus in determining whether to self-report, since individual supervisors may face disciplinary action either way.

You have a little bit of time to mull this one over.  The deadline for simply advising FINRA of your intent to self-report is April 1.  After that, firms will have until May 3 to do the heavy lifting, i.e., to provide FINRA with all the crunched numbers and data relating to their 529 sales.  That will likely represent a considerable amount of work, certainly not for the faint of heart.

On balance, I like this notion that FINRA copied/borrowed from the SEC.  Particularly for firms that already know they face a 529 problem.  Better to have the certainty of no fine, and of being just one firm in a crowd of other firms, than facing the uncertainty that accompanies the ordinary Enforcement action.  I tend to be conservative, so I would not advise my clients to bet that FINRA won’t discover any existing 529 problems on its own.  FINRA may not be good at all things, but (putting aside Allen Stanford) its examiners are fairly good at following the money, i.e., focusing their exams on the principal source(s) of a BD’s revenues.  If the sale of 529s represents a material portion of a firm’s sales, then undoubtedly FINRA will pay attention to those sales, including the share class utilized.  Given that likelihood, the risks of not participating in the Initiative are outweighed by the benefits of, gulp, turning oneself into FINRA.

FINRA’s 2019 Examination Priorities Letter: Beware, More Of The Same Is Coming

Posted in Compliance, Examination, FINRA, Rogue rep

In what has become an annual, but hardly exciting – I mean, it’s not like anxiously awaiting the day that pitchers and catchers report to Spring Training – tradition, with the turning of the calendar to the new year, FINRA has once again released a letter announcing what it deems to be its priorities for the upcoming examination season. FINRA claims to have tried something new this year, “by focusing primarily on those topics that will be materially new areas of emphasis for our risk monitoring and examination programs in the coming year,” rather than rehashing the same old, tired topics. I say “claims to have tried” because even though FINRA says it does “not repeat topics that have been mainstays of FINRA’s attention over the years,” in fact, a good part of the letter is devoted to those mainstays. Indeed, FINRA was very clear to state at the very outset of the letter that member firms “should expect that FINRA will review for compliance regarding these ongoing areas of focus”:

  • obligations related to suitability determinations, including with respect to recommendations relating to:
    • complex products
    • mutual fund and variable annuities share classes
    • the use of margin or the execution of trades in a margin account
  • outside business activities and private securities transactions
  • private placements
  • communications with the public
  • AML
  • best execution
  • fraud (including microcap fraud), insider trading and market manipulation
  • net capital and customer protection
  • trade and order reporting
  • data quality and governance
  • recordkeeping
  • risk management
  • supervision related to these and other areas

In other words, in large part, BDs can, by and large, expect the same-old, same-old when it comes to their 2019 exams. But, there are a couple of interesting new wrinkles worth our attention.

The first would be the three “Highlighted Items” FINRA identified, i.e., the three things that FINRA characterizes as “materially new” areas of emphasis:

  • Online distribution platforms. Specifically, FINRA is focusing on such platforms that “are operated by unregistered entities, which may use member firms as selling agents or brokers of record, or to perform activities such as custodial, escrow, back-office and financial technology (FinTech)-related functions.” The reason for the focus is that some firms which use such third-party platforms are, apparently, taking the position that “they are not selling or recommending securities,” a position with which FINRA takes some issue. As a result, even when using a third-party platform, FINRA will still be evaluating whether ordinary BD obligations have been triggered, including the obligation to conduct both reasonable basis and customer specific suitability analyses, to supervise communications with the public, and to conduct AML reviews. You can clearly see that again, even here, in this “materially new” area, it still devolves to an examination of the same-old, same-old – sales practice issues.
  • Fixed income mark-up disclosure. You can’t argue with this one, since the rule that FINRA is enforcing only became effective in May 2018, so, by definition, it is new.
  • Regulatory technology. I found this item to be particularly interesting, and it’s because of the language that FINRA employed. There was no expression of any particular concern on FINRA’s part, no overt threat of enforcement actions; rather, it was phrased more in terms of FINRA getting its head around the subject: “FINRA will engage with firms to understand” how they are using regulatory technology. I am unsure what it means for FINRA to “engage with firms,” but, regardless, history teaches that is never good for firms. It is a short walk from FINRA simply educating itself about what firms are doing to FINRA deciding that it doesn’t like what firms are doing.

The second observation I would make is that for the first time, FINRA doesn’t just call the letter the Examination Priorities letter, but the “Risk Monitoring and Examination Priorities” letter. Maybe this is what FINRA meant when it said it would “engage with firms to understand” their use of regulatory technology. Here is how FINRA described what “Risk Monitoring” means:

[T]he ongoing process through which FINRA monitors developments at firms and across the securities industry to identify risks and assess their prevalence and impact. We use this analysis to evaluate whether a regulatory response is appropriate, determine what that response should be and then allocate the required resources to implement the response. The risk monitoring process involves numerous inputs, including firms’ reporting to FINRA, data from our market and member surveillance programs, findings from our examinations, FINRA surveys and questionnaires, and ongoing dialogue between FINRA and the industry as well as other stakeholders.

Look, I would certainly prefer that before FINRA launches a new Enforcement initiative that it first take the necessary time to figure out that there is, in fact, a real problem that needs to be addressed. I guess, to some degree, however, I remain troubled by how even this seemingly righteous endeavor is phrased, i.e., FINRA’s decision to characterize it as a “risk” assessment. Not everything is about risk. By calling something a risk, however, or even a potential risk, suggests to me that FINRA may have already reached the conclusion, even if only preliminarily, that whatever FINRA is looking at does, indeed, present a risk. That is not proper auditing. No good auditor, regardless of subject, should presuppose the outcome of the audit. By labeling the subject of its inquiry a “risk,” it seems that FINRA may have done just that.

Finally, FINRA has made clear, once again, that it is interested in doing something about a perceived mess, one of FINRA’s own creation, namely, “associated persons with a problematic regulatory history.” Yes, the old rogue rep thing. As I have written about repeatedly,[1] FINRA has once again succumb to its historic inclination to bend to media attention that it considers to be unfavorable, and so it wants to do something, apparently, about BDs that hire RRs who have done nothing bad enough for FINRA to have barred them. What FINRA is doing here is passing the buck to the member firms, by focusing on their “hiring practices and supervision programs,” instead of taking responsibility for its own failures to have kept out of the industry those truly bad RRs who ought to have been barred. Again, I am certainly not advocating that FINRA start barring everyone; as things stand, FINRA already seeks to bar more respondents than actually deserve that draconian sanction – and let’s make it very clear, a permanent bar is a punitive sanction in the purest sense, with nothing “remedial” about it. Rather, I just want FINRA to acknowledge its complicity in the alleged problem, and to stand up to the media for a change. That will be high on my personal list of 2019 FINRA priorities.


Yes, You Can Form A Broker-Dealer Without Running Afoul Of FINRA’s Outside Business Activities Rule

Posted in FINRA, Outside business activities, Rule 3270

It is not a wise career move for a registered rep to leave his broker-dealer – thereby abandoning his customers, and affording competitors the opportunity to make his customers their own – and then to begin the long, expensive, and uncertain process of forming a FINRA-registered broker-dealer. Common sense, principles of fundamental fairness, and good old-fashioned capitalism warrant that a rep, while registered with another broker-dealer, be able to form his own broker-dealer (or RIA firm) without running afoul of any FINRA rules. But, as Lee Corso likes to say, “Not so fast, my friends.” FINRA’s Outside Business Activities (“OBA”) Rule, FINRA Rule 3270, provides, in pertinent part, that:

No registered person may be an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member, in such form as specified by the member.

A simple reading of the OBA rule leads to the conclusion that a rep would need to provide prior written notice to her broker-dealer of her intention to form a competing broker-dealer. Providing the notice would be comical: “I just want to give you a heads-up that I’ll be forming my own competing company where I’ll be attempting to move my customers in the next six months or so. You good with that, bro?” Needless to say, no one with a head on their shoulders would expect to receive anything but a pink slip after providing that notice.

In recognition of this quandary, FINRA’s Office of General Counsel (“OGC”) issued sound and sensible guidance in a 2001 Interpretive Letter.[1] In the Letter, the OGC wrote that the notice requirements of the OBA Rule are not triggered when a rep takes certain steps to form a new broker-dealer, including forming a company, and filing an application on behalf of the company to become a FINRA member, and a Form U4 designating himself as a principal of the company, so long as he does not: accept compensation from the company or other person; engage in securities or investment banking business for the company; raise capital for the company; solicit customers for the company; or generally engage in business activity for the company. In sum, with a few limitations, a rep generally can sow the seeds of forming his own broker-dealer without providing notice to his current broker-dealer of his intention and efforts to do so. This makes perfect sense. And it is welcome guidance from FINRA on a potentially thorny issue.

Earlier this month, FINRA accepted AWC No. 2018057258602 from Charles Gonzalez, wherein FINRA found that Mr. Gonzalez engaged in outside business activities, in contravention of the OBA Rule, by not disclosing to his broker-dealer that he had “formed a new business entity, retained and paid for services of a consultant, bought office equipment, rented and paid for his new company’s office space, and that he solicited and raised capital from a customer at [his broker-dealer] to fund his new business.” While, on its face, this finding may seem, in part, inconsistent with the Interpretive Letter, it is not. The safe harbor detailed in the Letter does not apply if a rep, among other things, raises capital for his new company, which FINRA apparently found that Mr. Gonzalez had done.

The moral of the story is that if you are going to rely on a safe harbor or exemption, be sure to satisfy all of the criteria, or you may be found to have satisfied none of them.

[1] Interpretive Letter to Sheryl Anne Zuckerman, Esq., Singer Frumento LLP (Dec. 6, 2001).

The Disturbingly Cozy Relationship Between FINRA And PIABA

Posted in Arbitration, FINRA, PIABA

What exists at the point where PIABA’s transparent self-interest in getting paid and FINRA’s historical lack of transparency about who is actually driving its agenda regarding arbitrations? This: a late December decision by FINRA to propose a rule that prohibits non-lawyers from representing – for a fee – customers in arbitrations, and an even more recent Investor Alert from FINRA that poses the question whether such customers should hire an attorney to represent them. Read together, it is quite clear that PIABA has FINRA’s ear to a degree that most member firms could only dream of.

Under current rules, customers in a FINRA arbitration have three choices when it comes to their representation: they can represent themselves, they can hire a lawyer, or (depending on the law of the state in which they live) they can hire a non-lawyer. In 2017, at the direction of the Dispute Resolution Task Force (whose members included PIABA members), FINRA solicited comments about its rule that permits NARs, or Non-Attorney Representatives, to handle arbitrations for customers. By my count, 59 comments were received. Not surprisingly, PIABA responded. Not surprisingly, PIABA hates option three, as the scary title to its whitepaper on the subject so plainly reveals: A Menace to Investors: Non-Attorney Representatives in FINRA Arbitration. The question is whether the real menace is to investors, or to PIABA, and for an obvious reason: if the customer hires a non-lawyer, then no PIABA member – comprised only of lawyers, of course – gets the potential paycheck.

I am not saying that PIABA’s comment was the only one that argued against the use of NARs; in fact, it is quite possible that the only comments FINRA received that were in favor of NARs came from the NARs themselves. See this one, for example. Anyway, FINRA has apparently heard enough, and in December determined to float a rule proposal to the SEC prohibiting NARs.

What is troubling to me is not the proposed rule itself, but more the historic degree of success that PIABA experiences whenever it brings an issue to FINRA. Unfair to customers to have an industry member sit on the hearing panel? Well, let’s eliminate them. Unfair to customers to have to defend a pre-hearing motion to dismiss? Well, let’s curtail them to nearly nothing. Unfair to customers that some respondents are unable to pay an arbitration award? Well, let’s convene a committee to explore solutions, including solutions paid for by the industry, and let’s get Congress involved.

You want solid evidence that when PIABA talks FINRA listens? Go back and look at the Investor Alert I mentioned in the opening paragraph. I was more than a bit shocked to discover that it is co-authored by “by FINRA staff and The PIABA Foundation.” In fact, there is a hyperlink right there that takes you directly to PIABA’s webpage. Well, not the PIABA webpage, but the webpage for the PIABA Foundation, which, apparently, is something devoted to “investor education” (unlike PIABA, I guess, which is devoted to suing brokers and broker-dealers). I went back through four years of FINRA articles that were written as alerts for investors, and the only other association that FINRA permitted to co-author a piece was the BBB Institute, which I presume is an arm of the Better Business Bureau. Apparently, in FINRA’s eyes, PIABA and the BBB perform the same watchdog function on behalf of investors, and both, therefore, are equally deserving of sharing FINRA’s own bully pulpit.

It is bad enough that FINRA routinely kowtows to PIABA and then disingenuously characterizes its decisions, which uniformly hurt member firms, as efforts to “level the playing field.” But, for FINRA now actually to share a byline with PIABA, or its foundation, to be precise, takes this complicity even further, to the point that one must openly question FINRA’s ability to administer this arbitral forum fairly. I don’t mind having to duke it out with opposing counsel, that’s what I do for a living. But, I, as well as my clients, expect the rules of the game to be fair, and for the entity that runs the game also to be disinterested and fair. Recent events make me wonder if my expectations in that regard are truly being met.

The Real Lesson From FINRA’s 2018 Exam Findings Report

Posted in Enforcement, Examination, FINRA

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

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

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

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

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

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

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

The Rule 8210 Karma Train Runs FINRA Over

Posted in Enforcement, FINRA, Rule 8210, Uncategorized

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

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

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

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

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

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

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

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

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

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

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

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