There are certain topics that broker-dealers have been encountering for decades, yet continue unnecessarily to wrestle with due to the absence of clear guidance from the regulators. I have written about one such topic before, and that’s the fuzzy line between most outside business activities, which RRs are obliged (at a minimum) by rule to disclose – but which BDs are not obligated to supervise – and outside business activities that are comprised of investment advisor activity done away from the firm – which BDs may, or may not, have to supervise. Unfortunately, I am compelled to revisit this unpleasant territory.
In my last blog about this, dating back almost exactly a year ago, I highlighted an AWC that Cetera entered into with FINRA because for a seven-year period it “failed to establish, maintain and enforce a supervisory system and written supervisory procedures reasonably designed to supervise certain private securities transactions conducted by their dually-registered representatives (DRRs) at unaffiliated or ‘outside’ registered investments advisors (RIAs).” The problem, I wrote, was principally due to FINRA’s 25-year refusal to provide clear guidance to its members on when, exactly, those transactions cross the line from being OBAs – not requiring supervision by the BD – to private securities transactions – which do.
Well, sadly, nothing has changed. FINRA’s guidance on the subject – which still dates back to Notice to Members 94-44 and 96-33 – is as murky and unhelpful as ever. And the rule that FINRA proposed back in 2018 to clear this whole thing up, proposed Rule 3290, remains in rulemaking purgatory on life support. This has real-life consequences to FINRA member firms. Cetera is living proof of that. But, now, here’s another one.
Last week, the State of Massachusetts (one of my favorite tunes by the Dropkick Murphys, by the way; indeed, it’s the ringtone on my phone) filed a complaint against Purshe Kaplan Sterling Investments, a broker-dealer, alleging that the firm failed to supervise certain transactions that some of its people – who were dually registered as RRs with PKS and as IARs with Harvest Wealth Management, an unaffiliated Registered Investment advisor – effected through Harvest for their advisory customers. The complaint identifies thousands of trades involving leveraged ETFs. As avid readers are undoubtedly already aware, FINRA has provided guidance that such securities “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.” Unfortunately, according to the complaint, “[a]s a result of [PKS’s] neglect, Massachusetts investors – often holding leveraged ETF positions for periods in excess of one-year – experienced significant losses.”
But I am not here to talk about leveraged ETFs. All I will say about them is that to me, the key is FINRA’s use of the word “typically,” meaning not universally, meaning that in some instances, perhaps many instances, it would not be unsuitable to hold a leveraged ETF for longer than one trading session. What I am here to talk about, again, is the fact that FINRA’s continuing refusal to provide clear, concrete guidance to its member firms regarding exactly when they have a duty and when there is no duty to supervise transactions by dually registered RR/IARs effected away from the BDs is still resulting in such firms finding themselves the subject of enforcement actions.
What did PKS do wrong? Allegedly, it failed to supervise trades that is dually registered salespeople were making at Harvest. Specifically,
- From 2017 through 2019 PKS did not review any of these transactions at Harvest
- PKS failed to have in place “any policies and procedures requiring it to conduct risk-based account reviews regarding its DRAs investment advisory clients in 2017 and 2018.
- Although PKS amended its policies and procedures in April 2019 to conduct risk-based reviews of DRA transactions at third-party investment advisory firms, it failed to conduct any review of transactions executed at Harvest in 2019.
- In 2020, PKS only conducted one review of transactions executed by Harvest DRAs.
These are precisely the sort of trades that, had FINRA actually adopted proposed Rule 3290, would NOT have been subject to supervision by PKS. And would that have mattered? Would that have presented any real threat to investors residing in Massachusetts? Theoretically not, because Harvest, an RIA, with a fiduciary duty to its customers – a duty that is higher and greater (somehow) than either the suitability standard governing recommendations or the “best interest” standard baked into Reg BI – already had its own obligation to supervise those trades. The SEC and the State of Massachusetts have the necessary jurisdiction to bring an Enforcement action against Harvest if it fails to meets its supervisory obligations; what is gained, therefore, by requiring PKS also to supervise the same trades that Harvest is already supervising?
But, because of FINRA’s lack of action, the massive gray area at the OBA/PST border continues to exist. In its complaint, the State alleges that “PKS was on notice of its regulatory requirements to supervise private securities transactions of its DRAs . . . .” Respectfully, I have to disagree. Or at least argue that the allegation should be qualified to recite that PKS was “on very weak and confusing notice” of its regulatory obligations here. And that is utterly FINRA’s fault. There is no reason for this complete overlap in supervisory obligations by both the RIA and the BD; yet, FINRA allows it to exist, knowing that its members are paying the price.