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”):
- 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.
 About two minutes of Google research revealed this AWC for the RR, Sam Aziz.
 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.