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.”

Carlos Legaspy is a respondent in a FINRA arbitration that was scheduled to go to hearing in August.  As with all other FINRA cases, it was subject to a sweeping administrative decision by FINRA to postpone all in-person hearings through the summer, due to the pandemic.  As I have noted before, that decision imbued hearing panels with the power to compel the parties to conduct the hearing by Zoom, even over the parties’ objections.  And that is exactly what the panel did in Mr. Legaspy’s case, it ordered that the final evidentiary hearing take place in August, but by Zoom.

Displeased by that ruling, Mr. Legaspy went to federal court in Illinois to challenge it.  In an Order issued last week – and summarily affirmed by the Seventh Circuit Court of Appeals two day later – the Court denied Mr. Legaspy’s request for a TRO enjoining FINRA from proceeding with the Zoom hearing.  To my knowledge, this is the first ruling by any court on the legitimacy of FINRA’s delegation to hearing panels of the authority to require that hearings take place over Zoom, rather than in-person.  Given that this decision is likely to become precedent in other cases, it is worth reviewing the Court’s logic.

Mr. Legaspy made a number of arguments, all of which were rejected.

First, he argued that FINRA breached two separate agreements, the Uniform Submission Agreement (“USA”) and the Code of Arbitration Procedure. Regarding the USA, Mr. Legaspy relied on language that provides “in the event a hearing is necessary, such hearing shall be held at a time and place as may be designated by the Director of FINRA” and that “the arbitration will be conducted in accordance with the FINRA Code of Arbitration Procedure.”  According to Mr. Legaspy, this language requires that the hearing happen in some physical “place,” not via Zoom.  Consistent with that argument, he also took the same view of the word “location” as used in the Code of Arbitration Procedure, specifically, Rule 12213(a):  “The Director will decide which of FINRA’s hearing locations will be the hearing location for the arbitration.” The Court had answers to these arguments:

  • First, and right out of first-year Contracts class at law school, the judge observed that FINRA is not a party to the USA, and, thus, is incapable of breaching it.
  • Second, the Court disagreed that either “place” or “location” necessarily means a physical location. According to the Court, “the parties, witnesses, and arbitrators are still ‘located’ somewhere in a remote proceeding, it is simply not all the same location.”  The Court also dismissed Mr. Legaspy’s position that “proceedings cannot be remote because parties are entitled to ‘attend all hearings’ under Rule 12602(a)” by noting that “he may still ‘attend’ the hearing remotely, just as he did for the telephonic temporary restraining order hearing in this court.”

Second, Mr. Legaspy argued that FINRA had denied him due process, but, because FINRA is not a “state actor,” it has no obligation under the Fifth Amendment to provide due process.

Next, Mr. Legaspy urged that the Zoom hearing would “be cumbersome and procedurally irregular” because:

  • the Claimants are from Argentina and will require an interpreter;
  • there are dozens of witnesses and hundreds of documents that would have to be shared remotely; and
  • by the time the hearing is over, he will have spent so much on attorneys’ fees that he will have exhausted his insurance coverage.

None of these convinced the Court.  In what is really the heart of the Order, the Court dismissed all these arguments:

Legaspy – who bears the burden of persuasion – cites no evidence that defenses cannot be presented remotely.  He thus pits his conjecture against this court’s experience holding several remote evidentiary hearings since the pandemic began (once with an interpreter), all of which permitted the parties to air their claims and defenses fully. Remote hearings are admittedly clunkier than in-person hearings but in no way prevent parties from presenting claims or defenses.  Moreover, the court sees no reason why the Claimants would fare better than the respondent in a remote hearing.  The Claimants will have the burden of proof in the arbitration; if anything, the logistical challenges of a remote hearing is more likely to harm them.  Legaspy has established, at most, that he would prefer not to arbitrate remotely, not that remote proceedings make it more likely that he will suffer any harms.

Finally, the Court concluded that the “balance of equities” tilts against Mr. Legaspy.  First, it held that “an order holding that FINRA cannot conduct hearings remotely would force it to choose between either holding in-person hearings that expose the arbitrators, Claimants, Legaspy, [the other parties], and witnesses to COVID-19, or indefinitely delaying its hearings, . . . because it is not clear when FINRA will be able to hold in-person hearings again, given the uncertainty around the pandemic.”  In light of Mr. Legaspy’s inability to articulate how a Zoom hearing would prevent him from fairly defending himself, the Court seemingly had no choice but to deny the request for the TRO.[1]

This is one decision by one federal judge, and by a judge whose own experiences with virtual hearings seem to have been positive.  Conceivably, another judge in another District with different experiences might have come to a different conclusion.  But that would be speculation, and we have what have here.  In light of the fact that no can identify a date by which time in-person hearings can be conducted safely, the need of FINRA to give claimants a chance to try and recover their losses, and the lack of any solid evidence that Zoom hearings are more than merely “clunkier” than in-person hearings, as respondents’ counsel, I am preparing my clients for what this decision suggests may be the inevitable: that we will be defending cases sitting in front of our computers, not is some smelly hotel conference room.


[1] The Court was also unhappy that Mr. Legaspy waited until what was essentially the last minute to file for the TRO, even though the hearing panel had ordered the Zoom hearing almost two full months earlier.

For the third year, FINRA has published its now-annual (apparently) statistical accounting of its membership and the registered representatives who work for those firms.  I went back and looked the blogs I posted after the 2019 report and the 2018 report, and, predictably (and somewhat sadly), the same trends continued last year as I previously observed:

  • The number of BDs continues to decline
  • The number of small BDs continues to decline even more precipitously
  • The number of IAs continues to increase

Let’s take a quick look at the numbers.

Number of BDs.  Remarkably, for what is now the 14th consecutive year, the total number of BDs dropped.  According to the chart provided in the report, from 2005 – the first year for which data is included – FINRA has lost 1,589 member firms, a drop of over 31%.  Perhaps not surprisingly, the total number of registered representatives has declined for the fourth year in a row.

Number of small firms.  While the net number of total FINRA member firms only dropped by 90 from the previous year, it is noteworthy that, in fact, the number of small firms actually dropped by 91.  (That number was offset by a slight increase in the number of mid-size firms, which is why the total is actually slightly less than the total for small firms.)  This marks the fourth consecutive year in which the number of small firms has gone down.  With that said, the overwhelming majority of FINRA members are small, almost 90% of the total (at least based on FINRA’s definition of “small.”)[1]

Number of IAs.  FINRA breaks firms down into three categories: BD-only firms, IA-only firms, and dually-registered firms.  According to the data,

  • The number of BD-only firms dropped for the ninth consecutive year
  • The number dually registered firms dropped for the ninth consecutive year
  • The number of IA-only firms increased for the ninth consecutive year

Consistent with these data, the number of BD-only registered representatives dropped again, while the number of IA-only and dually-registered registered representatives have both increased.  Again.

I am not sure what else to say anymore, after being shown essentially the same picture three years in a row.  The slow but steady reduction of BDs, the rise of IAs, and the particularly troubling demise of small BDs.  If FINRA is interested in stopping any of this from happening, it sure hasn’t provided any evidence of such.  It is tempting to draw, and frankly, pretty hard to argue with, the more obvious conclusion, which is that these figures are actually consistent with FINRA’s desires.  If that’s true, then it is yet one more sad day for the industry.

[1] Once again, while FINRA disclosed the total revenue for all member firms, it refused to break that down by firm size.  It is my opinion, again, that the reason for this is that it would show all-too-clearly that notwithstanding the fact that most firms are small, the industry’s revenues – and FINRA’s, as well – principally come from just a handful of big firms.  By keeping this data secret, FINRA can continue to act as if no one firm is more important than any other.

Right after I posted this, FINRA announced a third AML settlement, this time with Interactive Brokers.  It was no small deal: it came with a $15 million fine and an obligation to retain an independent consultant.  (In addition to the FINRA AWC, Interactive simultaneously entered into settlements with the SEC — with another $11.5 million fine — and the CFTC — with its own $11.5 million fine.)  According to FINRA’s Press Release, Interactive “did not reasonably surveil, detect, and report many instances of suspicious activity that were Ponzi schemes, market manipulation schemes, and other misconduct.”  Specifically, FINRA found that

  • Interactive Brokers did not reasonably surveil hundreds of millions of dollars of its customers’ wire transfers for money laundering concerns. Those wires included millions of dollars of third-party deposits into customers’ accounts from countries recognized as “high risk” by U.S. and international AML agencies.
  • Interactive Brokers did not reasonably investigate suspicious activity when it found it because it lacked sufficient personnel and a reasonably designed case management system. Even after a compliance manager at the firm warned his supervisor that “we are chronically understaffed” and “struggling to review reports in a timely manner,” it took Interactive Brokers years to materially increase its AML staffing or augment its AML systems.
  • Interactive Brokers failed to establish and implement policies, procedures, and internal controls reasonably designed to cause the reporting of suspicious transactions as required by the Bank Secrecy Act (BSA). In certain instances, the firm’s AML staff identified suspicious conduct, including manipulative trading and other fraudulent or criminal activity. But the firm only filed Suspicious Activity Reports (SARs) regarding that suspicious conduct after it was prompted to do so by FINRA’s investigation.

Clearly, in light of this settlement, the stakes relating to the lessons that I hoped to impart with this post about two much smaller settlements are even higher than I had suggested. – AlanT


First, a couple of years ago, I wrote a piece called BD Learns It’s Not Enough To Have A Supervisory Procedure For OBAs, You Actually Have To Follow It.  Second, about four years ago, I wrote In AML World, The Need To File A SAR Can, Apparently, Be Too Obvious To Ignore, about an SEC case that stood for the proposition that sometimes, the facts are so clear that a SAR must be filed that it is impossible to make a reasonable argument to the contrary.  Perhaps these titles gave away the whole story a bit too much, but apart from that flaw, they were fairly instructive articles (at least compared to some of my more rant-y pieces).  Well, it appears that Hilltop, and perhaps (at least) one other firm (which I will get to in a minute), somehow managed to miss them, and, unfortunately, learned their lesson the hard way.

Hilltop is a firm whose roots as a NASD/FINRA member firm, pre-mergers, go back over 70 years.  It is a clearing firm, but also has its own retail operation.  At its core, the AWC involved two principal issues, which are the same I covered in the earlier blogs mentioned above: (1) the repeated failure to detect (supposed) red flags consistent with possible money laundering, despite supervisory procedures that covered that area, and (2) the failure to have filed SARs in light of such obvious red flags.  I will address them both.

Among its AML procedures, Hilltop required its associated persons to collect and complete “Deposit Review Forms” for all receipt of low-priced securities positions.  These forms required, among other things, information that could be used in an AML analysis:

  • whether the stock had undergone a reverse merger in the prior year
  • whether the stock had undergone a name or business change
  • the number of shares owned by the customer overall, including at other firms
  • revenue of the issuer
  • the exchange on which the stock was listed
  • the total outstanding shares of the stock on the market

All that’s good stuff.  But, for whatever reason, from 2015-2016 – a mere five years ago! – Hilltop routinely failed to obtain the Deposit Review Forms that its AML procedures required and, when it did collect them, many were inaccurate or incomplete.  As a result, the firm failed to identify as a possible red flag the fact that a single customer deposited millions of shares of a low-priced security – indeed, this one customer’s trades “represented 25% of Hilltop’s overall clearing of transactions in low-priced securities” during the review period – “without having sufficient information to . . . make a reasonable determination regarding the suspicious nature of the transactions and whether a SAR filing was warranted.”

But, that’s not all!  In addition, Hilltop also dropped the ball in other ways.  One of its introducing firms manifested all kinds of potential AML issues, but they were dismissed by a Hilltop AML analyst who reviewed the activity, commenting that “activity appears normal.”  What did he miss?

  • The introducing firm had four accounts that alone were responsible for over 78% of the firm’s total low-priced securities volume and traded in 930 different low-priced securities issuers
  • Many of the issuers of these securities had no material operations or revenues, and were the subject of promotional campaigns
  • One account owner was allegedly involved in a manipulative trading scheme using convertible notes, and the other, a former AMLCO, was sanctioned by FINRA for AML deficiencies involving low-priced securities.

In summary:  Hilltop had a decent procedure, i.e., the Deposit Review Form requirement, but it failed to abide by it.  That will never be ok with FINRA.

Even more damning, however, was FINRA’s conclusion that Hilltop failed “to devote adequate resources to its AML program,” which, therefore, “could not reasonably be expected to detect and cause the reporting of suspicious activity.”  FINRA’s concern centered on the firm’s use of another report – the Daily Penny Stock, or “DPS” Report – which was described as “the primary report used by the Firm’s AML analysts to review low-priced securities transactions for red flags.”  The DPS Report was created manually, “a process that took between one and one and half hours.”  Despite all the work that went into its creation, however, “neither the DPS Report nor any other report was utilized to assist analysts in identifying” AML red flags.

This seems to have been a function of several things.  First, there were not enough AML analysts and too many trades to review (even though the thresholds that the firm used for trades to appear on the report were set so high that they “excluded 80% of the total value of penny stock transactions”).  Second, “[w]hen the AML analysts selected a transaction for review, minimal analysis was performed, and the analysts’ documentation of the review frequently failed to note any red flags identified or what steps, if any, were taken to investigate the red flags.”

It is hard to imagine a worse scenario than this, having FINRA tell you that your AML program is patently undermanned and not performing.  A fantastic written procedure will not save you from an unhappy outcome.

The other aspect of the Hilltop AWC that bears noting is that FINRA took the firm to task specifically for not filing SARs, something you don’t see every day.  FINRA was helpful inasmuch as it explained for our benefit what the particular problem was:  when the firm reviewed penny stock trades, it “applied an unreasonably high threshold for the filing of SARs.”  According to the pertinent law, a BD is required  “to file a SAR for any transaction that it knows, suspects, or has reason to suspect “has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage.” Even though a SAR must be filed even when a problem is only “suspected,” Hilltop “would not file a SAR unless it had evidence proving that the low-priced security was part of a fraudulent scheme, even where activity triggered multiple red flags.”

So, there are some clear lessons to be gleaned from the Hilltop AWC.  None is particularly tricky, however, or particularly new, but given FINRA’s proclivity to bring AML cases, it is in your own best interest to take them to heart:

  • Make sure your written procedures are robust and up-to-date
  • Make sure you follow your procedures
  • Makes sure you document the hell out of the fact you have followed your procedures
  • Make sure that the volume/nature of your business hasn’t changed in a material way since you instituted your procedures and hired the people to implement them; otherwise, be prepared to revise and amplify your procedures, and hire more bodies
  • Whatever your decision is regarding the filing of a SAR, or not, memorialize your thought process, in order to be able to defend the reasonableness of your decision.

Finally, I mentioned at the outset that there were at least two firms that seem to have failed to learn these lessons.  One was Hilltop, and the other was J K R & Company, a small BD that’s been around for over 40 years, and without any disciplinary history.  It, too, signed an AWC involving AML issues.  Like Hilltop, its AWC stands for the proposition that it is not enough to have good procedures if you don’t follow them.

According to the findings in that matter, in a four-year period extending from 2012 to 2016,[1] the firm “failed to detect red flags of suspicious activity in four related accounts” despite the fact that it had “written AML procedures that required the firm to monitor for red flags of potentially suspicious activity.”  I bet now you can really get a sense of the (sadly, all-too-obvious) theme of this blog post?  When you commit in writing to doing something of a supervisory nature, you had better be sure to actually do it, because FINRA is not going to let you off the hook, or even give you partial credit, for having beautifully detailed written procedures if you fail, for whatever reason, to follow them.  Here is how FINRA tersely put it in the AWC:

The firm’s AML procedures indicated that when the firm detected any red flags of potentially suspicious activity, it would determine whether and how to investigate further and take steps that could include: gathering additional information internally or from third parties, contacting the government, freezing the account, or filing a SAR.  JKR did not, however, implement those measures.

So what red flags did FINRA claim JKR missed?  There were a bunch, frankly.  But, interestingly, the fine imposed was only $50,000, very modest by AML standards.  What does that mean?  Well, either the firm’s counsel did a great job for his client, or, perhaps more likely, the missed flags at issue here were, in fact, actually only a very pale red, at best; some of them you wouldn’t even call them pink.

First came the supposed red flags that appeared during the account opening process for four accounts.  The firm missed the fact that:

  • the four accounts had beneficial owners and control persons in common
  • one of the accounts was opened seven months after the accountholder’s corporate president and the control person were barred by the SEC from participating in any manner in any offering involving penny stocks (even though the stated purpose of the account was to trade penny stocks)
  • three accounts were controlled by a single person, who granted a Power of Attorney to someone else, giving that other person the power to trade the account
  • one of the customers was the investment advisor for another of the customers
  • the legal address for one of the accounts was not a physical address, but instead, was a personal mailbox at a retail store
  • the account-opening documents for one of the accounts indicated that one of the customers was self-employed as an investment banker for the corporate entity listed for one of the other four accounts
  • the copy of the passport provided by one customer was not properly certified
  • the corporate entities for two of the accounts had been created just one week prior to account-opening under the laws of the Republic of Seychelles, a country known for heightened money-laundering risk.

Once the accounts were opened and started to trade, the firm then proceeded to miss these additional red flags:

  • two accounts evidenced extensive trading in a penny stock, which, based upon conversations with the customer, was contrary to the expected activity in those accounts
  • potentially suspicious wire activity that was unexplained, repetitive and showed unusual patterns with no apparent business purpose
  • two accounts engaged in very minimal securities activity.

Quantitatively speaking, that’s a lot of red flags to miss.  But, qualitatively, maybe there’s not a whole there beyond the usual knee-jerk conclusions that FINRA always touts, i.e., things that sound bad but aren’t.  I mean, the Republic of Seychelles??  How can any entity from there possibly be legit, right?  Ok, mark it down.  Or the old “no apparent business purpose” gambit.  Remember: FINRA is the arbiter of what is and isn’t a “legitimate” business purpose.  It doesn’t matter what YOU claim is the purpose of a trade or a money transfer if FINRA concludes, in its opinion, that it was not legitimate.

Or perhaps my favorite one on the list, the absence of a certification on the copy of the passport.  According to the AWC, one of the customers provided a passport “reflecting only a stamp from a Notary Public in the State of Florida, instead of an affidavit sworn to by [the] Customer . . . as the custodian of the passport, as required by the American Association of Notaries’ rules governing copy certification by a document custodian.”  Seriously, and no offense intended to Notaries, it is rather amazing that FINRA actually cited to the these rules, for maybe the first time in recorded history.  What makes this even worse, and considerably less funny for JKR, is that, as Alison Jimenez pointed out in her blog about this same AWC, the “Customer Identification Program (CIP) rules do not require notarization of identification documents, nor does the AWC state that the firm’s policies & procedures required notarized copies of customer IDs.” If neither the AML rules nor the firm’s own procedures required either a notary stamp or a custodial affidavit, then how can this possibly be a red flag?

The point is: even when the red flags are ticky-tacky, as most of these were, stack enough of them together and maybe you can cobble together enough to justify a $50K fine.  Just another example of FINRA using quantity, rather than quality, to coerce a firm into settling.



[1] Let me just stop for a minute here.  The pertinent time period goes back EIGHT YEARS!  I mean, the end of the pertinent time period was four years ago.  How can it possibly take FINRA this long to conduct exams?  And how can it possibly be fair to a firm to have defend actions it took (or, as in this case, didn’t take) almost a decade ago?  Yet, as readers of this blog will acknowledge, this is a common issue in FINRA Enforcement actions.  Someone ought to look into this, as it is a real, and continuing, problem.

I hope that you have had the chance to enjoy Jessica Hopper’s paean to Rule 8210 in her recent blog posted on FINRA’s website.  Very disturbing, and for all the old reasons.

First, once again, she starts by patting herself – well, not just herself, I guess, but Enforcement generally – on the back for having “barred more than 730 brokers and associated persons” in just the last two years!  That statistic sounded familiar, for some reason.  A little research revealed that, sure enough, FINRA had touted that very same number in another self-congratulatory blog it posted back in April (which, given pandemic-driven quarantining, admittedly feels like a lifetime ago), a post that caused me to write a piece called “FINRA Claims To Be Reasonable When It Comes To Sanctions, But It Is Clear That Permanent Bars Are What It’s All About.”    The point of my blog – that FINRA is more interested in barring people than simply doing what’s right – is borne out here, again.

Second, there is the everlasting oddity surrounding the fact that FINRA continues to refer to its 8210 letters as mere “requests,” as if the recipient of such had a choice whether to respond or not.  Jessica writes, “What is FINRA Rule 8210?  Simply put, the rule allows FINRA to request documents, information, and testimony from member firms and their associated persons in connection with an examination or investigation.”   As phrased, frankly, it doesn’t sound so bad.  But, just a couple of sentences further into her post, she concedes the ugly truth about Rule 8210, that “FINRA relies on [it] to protect investors and the market by requiring individuals under FINRA’s jurisdiction to provide information when requested.”  Truly, FINRA should start calling 8210 letters what they are: demands, even edicts, but certainly nothing as tepid as a request.

Third, I am more than a little troubled by the way that 8210 letters have morphed from a fact-finding tool, i.e., something designed to help FINRA figure out what happened, into a means of proving a suspicion of wrongdoing.  No good auditor presumes the outcome of the audit; you do the work, you ask the questions, you review the documents, and you see where you end up.  FINRA examiners, sadly, too often give the undeniable impression that they already believe you did something wrong, and it’s only a matter of time until they prove it.  That has the unfortunate consequence of coloring the entire exam, as the examiner may unknowingly (or, worse, knowingly) look for facts corroborating their preconception of the eventual outcome, i.e., a finding of wrongdoing, rather than merely following evidence trails to wherever they may lead.

Regrettably, it appears that Jessica may have fallen into this same trap.  Consider this from her blog post:  “Perhaps a bar for violating Rule 8210 – a seemingly administrative rule – may seem severe.  But in reality, the underlying wrongdoing that led to the Rule 8210 request is often quite serious; in many cases, there are suspicions of fraud, conversion of customer funds or other egregious misconduct.”  Perhaps I am parsing her language too closely, but it really, really troubles me how she phrased this, specifically, how she omitted the word “possible” before “underlying wrongdoing.”  Even if this was simply an unfortunate drafting or editing mistake, I find it rather telling that FINRA seems to base its decision to issue an 8210 letter on a conclusion that, in fact, there has been some wrongdoing.  That is wrong.  Even in the quasi-governmental world that FINRA occupies, where due process and Fifth Amendment rights don’t exist, brokers and broker-dealers are still presumed to be innocent until proven otherwise.

Fourth, and most important, there is simply a problem with the way that FINRA wields its 8210 power.  And by that I mean, in its supposed zeal “to protect investors and the markets,” FINRA tosses off 8210 requests like someone riding a float in the Mardi Gras parade tosses beads, that is, indiscriminately and with a notable degree of glee and vigor.  As my partner Michael Gross – like me, another former FINRA Enforcement lawyer – accurately observed in this blog some time ago, “FINRA can seek to expel those whom it deems to be undesirable by making compliance with the nature, volume, or scope of Rule 8210 requests so undesirable or burdensome that providing the requested documents or information is not a real option.”  He noted – with some degree of horror – that there is no limit on:

  • the number of document and information requests that FINRA can issue
  • the scope of document and information requests that FINRA can issue
  • the length of time for FINRA to complete its exam
  • how far back in time FINRA can go for its “requests”[1]

I don’t harbor any real hope of ever seeing things change, but, for what it’s worth, I will renew my regular plea for some change in the FINRA rules that provides the recipient of an 8210 letter to ability to challenge it without having to risk a permanent bar for not responding.  A document subpoena issued in a court case can be challenged, and if the challenge is unsuccessful, the result is merely that the document at issue must be produced.  If such subpoenas were handled like FINRA 8210 letters, the unsuccessful challenger would be deemed to have lost the entire case.  That makes zero sense, and it makes no better sense in the context of FINRA exams.  Yet, that’s how it works under FINRA rules.  And THAT is why, as Jessica observes, a whole lot of people who receive 8210 letters decide that they won’t bother to respond to respond, and begrudgingly sign AWCs imposing permanent bars.  It doesn’t necessarily mean, as Jessica concludes, that all these people are bad, or caused any customer harm; it simply means, in many cases, that it is easier, way cheaper, and certainly faster just to tell FINRA to buzz off, rather than fight what is, in essence, an unwinnable fight.

[1] Just this week, FINRA issued an AWC involving Citadel Securities that included findings that the firm had deficient supervisory procedures going back to 2012, over eight years ago!

After having proudly served for decades, and surviving a dramatic face-lift in 2012 (when old NASD Rule 2310 was replaced by shiny new FINRA Rule 2111), it seems that the “suitability rule,” as we’ve come to know it, has, at long last, been quietly sent out to pasture by FINRA.  Although the title of Reg Notice 20-18 – “FINRA Amends Its Suitability . . . Rule . . .  in Response to Regulation Best Interest” – suggests that the suitability rule has only been amended, not replaced, that would not be a fair reading of what happened.  In fact, with the exception of a few specific circumstances,[1] suitability has been relegated to the clearance rack of regulatory rules.  Here is how FINRA phrased its epitaph:

Reg BI’s Care Obligation addresses the same conduct with respect to retail customers that is addressed by Rule 2111, but employs a best interest, rather than a suitability, standard, in addition to other key enhancements.  Absent action by FINRA, a broker-dealer would be required to comply with both Reg BI and Rule 2111 regarding recommendations to retail customers. In such circumstances, compliance with Reg BI would result in compliance with Rule 2111 because a broker-dealer that meets the best interest standard would necessarily meet the suitability standard.  To provide clarity on which standard applies and to avoid unnecessary duplication, FINRA has amended Rule 2111 to state that it will not apply to recommendations subject to Reg BI.

The problem I have, having read dozens of articles and attended a bunch of pandemic friendly webinars on Reg BI, is figuring out the practical impact of complying with Reg BI.  I mean, if you are a registered rep with retail customers, what, if anything, do you need to do differently to demonstrate compliance with Reg BI vs. Rule 2111?  Upon closer look, I am beginning to think that it may not amount to much.

Consider, as a starting point, this language from the SEC’s Reg BI Release:

We emphasize that what is in the “best interest” of a retail customer depends on the facts and circumstances of a recommendation at the time it is made, including matching the recommended security or investment strategy to the retail customer’s investment profile at the time of the recommendation, and the process for coming to that conclusion. Whether a broker-dealer has complied with the Care Obligation will be evaluated based on the facts and circumstances at the time of the recommendation (and not in hindsight) and will focus on whether the broker-dealer had a reasonable basis to believe that the recommendation is in best interest of the retail customer.

Later in the same release, the SEC used this “matching” concept in the very same way:

In circumstances where the “match” between the retail customer profile and the recommendation appears less reasonable on its face (for example, where a retail customer’s account objective is preservation of income and the recommendation involves higher risk, or where there are more significant conflicts of interest present), the more important the process will likely be for a broker-dealer to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer and did not place the broker-dealer’s interest ahead of the retail customer.

Read these excerpts and see if you agree with me that this concept of “matching” is, basically, exactly what RRs and BDs do today under Rule 2111 when making suitability determinations.  The same two-step process that has always existed.   First, under FINRA Rule 2090, you “use reasonable diligence . . . to know (and retain) the essential facts concerning every customer.”  Those “essential facts” are outlined in Rule 2310(a):  “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”  Then, armed with those facts, you “match” the customer to a recommendation.  If the recommendation is a mismatch, e.g., because it is too risky for a customer with a conservative risk tolerance, or provides no liquidity for a customer with liquidity needs, or has a lengthy pay-off for a customer with a much shorter time horizon, then the recommendation may not be suitable.

Seems like the same conclusion will be true under Reg BI, but instead of calling the recommendation “unsuitable,” the regulators will simply say it was not in the customer’s best interest.  Maybe this isn’t quite the sea change that people maintain.

Granted, however, not everything will be the same.  Importantly, while Reg BI, like Rule 2111, requires that a recommendation “must be based on information reasonably known to the associated person (based on her reasonable diligence, care, and skill) at the time the recommendation is made,” it goes beyond that.  Because Reg BI requires that a recommendation be in the retail customer’s best interest, in addition to “matching” the recommendation to the customer’s suitability profile, an RR must also “exercise reasonable diligence, care, and skill to consider reasonably available alternatives offered by the broker-dealer. This exercise would require the associated person to conduct a review of such reasonably available alternatives that is reasonable under the circumstances.”

Now this is something totally new.  You not only have to know what you’re recommending, you also have to know what you’re NOT recommending, just in case something else would have been, um, more suitable.  Happily (or unhappily, perhaps), the SEC has provided pretty loosy-goosy guidance regarding what this review of “available alternatives” must look like.  Indeed, they had the temerity to break out – again, ugh – that old standby, the dreaded “facts and circumstances” standard:  “What will be a reasonable determination of the scope of alternatives considered will depend on the facts and circumstances, at the time of the recommendation, including both the nature of the retail customer and the retail customer’s investment profile, and the particular associated persons or groups of associated persons that are providing the recommendations.”

I don’t want to get too deep in the weeds here, so I will cut this off by providing this nugget of good news from the SEC: “A reasonable process would not need to consider every alternative that may exist (either outside the broker-dealer or on the broker-dealer’s platform) or to consider a greater number of alternatives than is necessary in order for the associated person to exercise reasonable diligence, care, and skill in providing a recommendation that complies with the Care Obligation.”  So, take heart that you don’t necessarily need to know every stinkin’ product that your BD offers, or that any BD offers.

One last point about this Reg Notice, concerning quantitative suitability, a/k/a churning or excessive trading.  This is an age-old problem.  The legal framework of a churning case has been the same forever, consisting of three elements: (1) intent to defraud, (2) control of the account by the RR, and (3) excessive trading.  FINRA Rule 2111, not surprisingly, comported with that definition. Supplementary Material .05(c) requires that an RR have “actual or de facto control” over an account to be capable of churning it.  Well, not anymore.

According to the Reg Notice, “FINRA has also removed the element of control from the quantitative suitability obligation, a change that is consistent with Reg BI.”  What?

Sure enough.  Reg BI does not require control, either actual or de facto:

[T]he third component of the Care Obligation would require a broker-dealer to exercise reasonable diligence, care, skill, and prudence to have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. The Proposing Release noted that this requirement is intended to incorporate and enhance a broker-dealer’s existing “quantitative suitability” obligation by applying the requirement irrespective of whether a broker-dealer exercises actual or de facto control over a customer’s account, thereby making the obligation consistent with the current requirements for “reasonable basis suitability” and “customer specific suitability.

So now there is a major difference between, on the one hand, what courts and arbitration panels require to establish churning and, on the other hand, what FINRA and the SEC say is necessary.  I look forward to seeing how this plays out, as the “control” element often turns out to be the one on which Respondents hang their hats in defending churning cases.  If a Claimant no longer has to prove that element, these cases have just become much, much harder to defend.  But, since there is no private right of action for breach of a FINRA Rule, or Reg BI, it remains to be seen what standard will, in fact, be applied in churning cases after Reg BI becomes effective next week.

[1] Because Reg BI applies only to recommendations to “retail customers,” who are defined to be “a natural person, or the legal representative of such natural person, who receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer and uses the recommendation primarily for personal, family, or household purposes,” Rule 2111 still applies, therefore to: (1) recommendations to institutional customers under specified circumstances, (2) entities and institutions (e.g., pension funds), and (3) natural persons who will not use recommendations primarily for personal, family, or household purposes (e.g., small business owners and charitable trusts).  FINRA also notes that some of its other rules “have a suitability or suitability-like component (e.g., FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities) and FINRA Rule 2360 (Options))” which are not impacted by the rule changes and will still be viable.