Last year, I wrote a piece called “Wedbush Learns That It’s Not Enough Just To Spot Red Flags.”  As the title suggests, it analyzed an SEC decision in which Wedbush was sanctioned because it failed in several respects to follow up on certain red flags it saw that were indicative of potential misconduct.

I am now following another SEC case, this one involving a CCO of a broker-dealer, that highlights a similar, but slightly different, theme.  In this case, the lesson is that it’s not just the red flags you see (but fail to investigate properly) that can burn you, but also the red flags you miss entirely but “should have” seen.

This started out as a FINRA Enforcement case.  In December 2015, Thaddeus North, CCO for Southridge Investment Group, LLC, was found liable by a FINRA hearing panel for, among things, failing to report to FINRA (under Rule 3070) that one of the firm’s associated persons was “involved in a variety of business activities with a statutorily disqualified person.”  Here are the pertinent facts:

  • Southridge had an RR, we will call her Ms. A
  • Before joining Southridge, Ms. A had worked with another RR – Mr. B – at another firm
  • After Ms. A joined Southridge, Mr. B had a little problem reporting a tax lien on his Form U-4 in a timely manner, and because that failure was deemed to be willful, he became statutorily disqualified
  • Southridge contemplated hiring Mr. B, but when Mr. North learned that he was SD’d, that was aborted, and Mr. B left the securities industry
  • In July 2009, and without disclosing it to Southridge, Ms. A entered into a Services Agreement with Mr. B’s entity, pursuant to which she would pay him for referrals, advice and training
  • From August 2009 through September 2011, Ms. A received and paid at least 42 invoices from Mr. B’s entity totaling $605,365 for various services
  • Although Mr. North didn’t know about the Services Agreement when it was executed by Ms. A in July 2009, eight months later, in March 2010, he learned about it when FINRA, after having been provided invoices to Ms. A from Mr. B’s entity, asked for any agreements relating to it, and Ms. A gave him a copy
  • Mr. North looked at the Services Agreement
  • The Services Agreement does not disclose Mr. B’s name, only the name of his entity; indeed, while Ms. A signed it, there is not even a signature block for Mr. B or his entity
  • Mr. North was not familiar with Mr. B’s entity, and did not know that Mr. B was connected with it
  • Mr. North did not question Ms. A about the agreement, did not investigate the relationship between her and the mystery entity with which she had entered into the Services Agreement, and he made no attempt to learn the details about that entity

Based on the evidence, the panel concluded that

at a minimum, North should have known of these relationships by March 2010, after seeing the Services Agreement and the invoices issued by [Mr. B’s entity] under that agreement.  At that point, when North learned that [Ms. A] and [Mr. B’s entity] had a business relationship, he knew nothing about [Mr. B’s entity], including the identity of anyone connected with it.  As the Firm’s CCO and the person responsible for Rule 3070 reporting, North should have followed-up by seeking all relevant details of [Ms. A’s] relationship with [Mr. B’s entity], as well as inquiring about the identity of the person or persons behind it.  Significantly, the Services Agreement was only executed by [Ms. A] and not by anyone on behalf of [Mr. B’s entity]. By itself, this peculiarity — which hid the identity of persons connected with [Mr. B’s entity] – was a red flag that should have caused North to inquire further. Had he done so and asked [Ms. A] who she was dealing with at [Mr. B’s entity], North likely would have learned of [Mr. B’s] connection to [Mr. B’s entity] and his ongoing relationship with King.

In short, using a “should have known” standard, the hearing panel concluded that Mr. North missed the red flag waving in his face.

On appeal, the NAC affirmed the findings, and the hearing panel’s analysis.  It held that

North should have learned about [Ms. A’s] relationship with [Mr. B] shortly after March 2010, after seeing the . . . [S]ervice [A]greement and the invoices that Southridge produced to FINRA in March 2010. Although the [S]ervice [A]greement and invoices did not reference [Mr. B], North should have sought additional details about [Ms. A’s] business dealings with [Mr. B’s entity], in particular because of certain existing red flags.  First, the monthly invoices submitted by [Mr. B’s entity] were for considerable amounts with little description about the services being provided.  Among other things, the invoices generally referenced “consultations,” ”phone consultations,” various “trainings,” and ”introductions” to various people. From July 2009 to February 2010, the . . . invoices totaled $151,800, and included monthly invoices for significant amounts (e.g., $39,800 and $32,500).  Second, the [S]ervices [A]greement, under which the invoices were issued, was vague. It was one page, and it only was executed by [Ms. A] . . . . No one executed the agreement on behalf of [Mr. B’s entity], and it did not identify anyone associated with the company. Had North investigated and inquired further about [Mr. B’s entity], he would have discovered the connection to Mr. B and his ongoing relationship with [Ms. A].

Next, Mr. North appealed to the SEC.  Perhaps not surprisingly, the SEC sustained the NAC’s findings:  “We agree with the NAC that these facts should have led North to inquire about that relationship [between Ms. A and Mr. B’s entity].  Accordingly, North violated NASD Rule 3070 and FINRA Rule 2010 because he did not report [Ms. A’s] and [Mr. B’s] relationship to FINRA although he should have known about it.”

Now Mr. North has appealed the SEC decision to the D.C. Circuit Court of Appeals, where it is pending.  That particular court may not be so quick to rubber-stamp the SEC’s views.  And I say this from personal experience, as counsel – along with my partner, Heidi VonderHeide – in the noteworthy Robare case.  There, the D.C. Circuit agreed with us that because my clients only acted negligently, they could not have also acted willfully.  It is certainly possible that the D.C. Circuit will look very hard at the SEC’s position here, as stated in its appellate brief, which is that the mere failure to satisfy one’s duty to “inquire” when presented with red flags somehow equates to “should have known.”  As my friend and former colleague Brian Rubin so accurately put it in his own thoughtful take on Mr. North’s travails, “FINRA presented no evidence showing that if North had followed up, he would have (or even ‘likely’ would have) learned about the relationship [between Ms. A and Mr B].  The most FINRA established is that North ‘could possibly have’ learned about the relationship, and that does not appear to be sufficient grounds to charge anyone.”

That’s the thing about those pesky red flags.  They can get you into hot water any which way.  You can see them, and fail to respond, for whatever reason.  You can see them, and choose not to respond (because you don’t think they are, in fact, red flags[1]).  You can see them, but not respond vigorously, or quickly, enough.  And you can simply not see them at all.  Mr. North was sort of all over the place.  He sort of saw the red flag, but didn’t recognize it to be a red flag, and so didn’t respond particularly well (by failing to ask enough questions).  The regulators have concluded – rightly or wrongly – that had he done so, he would have learned of the problematic relationship and reported it.

I can’t say that is true or not.  But, what I can say – and this, at last, is the takeaway from this blog post – is that this is something that no one should ever leave up to the regulators to decide.  FINRA sees the failure to ask questions as the failure to act.  If Mr. North had just asked a few questions – if he had asked Ms. A to explain about the Services Agreement (and memorialized his efforts, of course) – he likely would not have gotten into trouble, even if Ms. A ducked his questions and he never actually learned that she had entered into an agreement with the SD’d Mr. B.

In other words, Mr. North’s problem wasn’t that he didn’t know something, it’s that he didn’t try hard enough to know it.  Even when confronted with a host of facts suggesting there was an issue.

As a defense counsel, I would always prefer to defend someone who saw the red flags, and followed up on them, regardless of the conclusion he or she reached.  It wouldn’t matter to me if my client concluded that, following a robust investigation, there may have been smoke, but ultimately no fire.  Provided the investigation was, in fact, robust, that case can be defended all day, every day.  But Mr. North, alas, didn’t follow up.  And notwithstanding the result Heidi and I got in the Robare case, I have my doubts that the D.C. Circuit will see this any differently than FINRA or the SEC.  Don’t let yourself suffer the consequences as Mr. North has.  Be prepared to demonstrate not only that you didn’t know something, but, despite your best faith efforts, no one could reasonably argue that you should have known it.


[1] Let me share one anecdote here, from a FINRA Enforcement case that Heidi handled.  The FINRA examiner was on the witness stand, and he testified about something he admitted probably wasn’t a red flag, but felt it was at least a “yellow flag,” and that those also needed attention.  That certainly suggests that it is never safe simply to conclude that something isn’t a red flag, given FINRA’s demonstrated willingness to characterize anything as such.