Let’s talk about commissions today.  Or, as they are sometimes referred to, transaction based compensation.  Specifically, who can receive commissions.  Actually, that’s not phrased correctly.  The correct phrasing of this issue, courtesy of FINRA Rule 2040, would be: to whom a broker-dealer may legally pay commissions?  According to that rule, BDs can only pay commissions to a registered BD or to registered persons.[1]  Seems straightforward enough, but, in reality, it causes all kinds of problems.  Indeed, in any given week, you are bound to see some action taken by FINRA, or the SEC, that centers on the improper payment of commissions to someone.

Let’s start with a common scenario that still manages to cause problems:  there is a registered person (typically a principal, but not necessarily) who owns and runs his own branch office, where a bunch of other people work, some registered, like the RRs, and some unregistered, like, say, the receptionist.  He operates the branch through some legal entity that he’s created, like an LLC.  The LLC pays everyone at the end of the month.  The sole source of the money that the LLC uses to pay everyone comes is a check from the BD for all the commissions earned at the branch that month.  The LLC then cuts checks to everyone for their share of the commissions (in the case of the RRs), or for their monthly salary (in the case of the receptionist).

Here’s the deal:  the BD cannot pay the commissions directly to the LLC.  Why?  Because the LLC is not registered.  Accordingly, the BD has to pay the commissions to the registered person who owns the LLC.  If it doesn’t, then it will find itself named as a respondent in a disciplinary action, such as this AWC from a few years ago.  I think most everyone understands this, and abides by this general principle.

The problem with this scenario is that it suggests that as long as a broker-dealer makes the initial commission payment to a registered person, it doesn’t matter to the broker-dealer what that person then does with the money.  Take the above example, where the BD properly pays commissions to the registered owner of the branch, who then uses that money to pay all the expenses of his branch office.  Including salaries to the unregistered receptionist.  Assuming that the commission payment represents the sole source of revenue for that branch, it is rather clear that the unregistered receptionist – not to mention the landlord, the utility company, the delivery guy who brings in the pizza for the monthly meeting – is, in fact, being paid money that came from commissions.  But, it seems that no one has any problem with this, given how common this arrangement is, and that’s fair.

But it’s not that easy, however.  The fact is, there is a lot of guidance from the SEC[2] that makes it clear that what happens after the initial payment of commissions to a registered person does, in fact, matter.  Like this 20-year old no-action letter (or, more accurately, denial of a no-action request).  In that case, the SEC declined to provide no-action relief to a BD that made this proposal:

  1. The BD would pay commissions directly to nine RRs (all owners of an entity they created for administrative reasons);
  2. The nine RRs would then deposit their commission checks into their respective personal accounts;
  3. The nine RRs would then write their own checks to their co-owned entity;
  4. The entity would deduct things like overhead, payroll taxes, etc., for of the nine RRs; and, finally,
  5. The entity would cut the checks, sans the deductions back to the nine RRs.

What do you mean the SEC rejected this proposal?  After all, the BD paid the commissions directly to the RRs, not their unregistered entity.  Isn’t that exactly what 2420 requires?  I concede that there was more to the SEC’s analysis than this.  I also concede that the SEC has granted no-action relief in “employee leasing” situations.  The point, however, is this, and it’s simple:  if you are a BD, you cannot blithely ignore what your RRs do with their commission payments, simply because you were clever enough to have been aware of Rule 2420 and ensured that all commission payments were made directly to registered persons.

I’ll give you one more scenario to think about, something even more baffling.  Let’s take the same owner of the branch I talked about earlier, same branch, same facts, but with one big difference: let’s presume that this guy is not the sole owner of the LLC under which he runs his branch.  Instead, let’s presume that the he is only a co-owner, and the other co-owner is not registered.  Let’s also presume that the unregistered co-owner has ZERO role in the operation of the branch; his sole function is to cash the check that he receives each month representing his share of the profits earned at the branch.  Is this ok under 2420?

Before I answer, consider this:  at the firm level, it is perfectly fine for an unregistered person to serve as a “passive” owner.  As long as you are not involved in the day-to-day management of the BD, you can own some or all of the BD – and be entitled to its profits – without having to register in any capacity.  (Granted, FINRA will push back hard to confirm that the ownership is truly “passive,” but it’s hardly impossible to make this showing.)

Given this, it would certainly seem that the answer to the question I posed two paragraphs ago must be “yes,” right?  I mean, if passive ownership is ok at the firm level, then it must also be ok at the branch level.  That’s just simple logic.

Well, shame on you for thinking logic applies when it comes to FINRA.  The fact is, I have had a FINRA examiner tell me, in this exact circumstance, that it was a 2040 violation for the registered co-owner of the branch to share profits with the unregistered, passive co-owner of the branch.  I pushed back – hard – and enough time has transpired since then with no follow-up that I can only presume that the issue has died on the vine (or the examiner quit FINRA and the exam got forgotten – not an unheard of story).

But, it goes to show you, again, the lesson of today’s post: as a BD, your job doesn’t end when you have ensured that commissions are paid directly to registered people.  No, you have to go further, you need to ask enough questions so you understand what those people are doing with that money.  If they simply deposit it into their personal checking account, and use it to pay their household expenses, no one is going to claim you’ve violated 2040 because the rep’s spouse wrote a check off of that account to pay the mortgage.  But…if the rep gives his commission check to an entity he created to run the operations of his branch office, you had better, at a minimum, be aware of that, and, even better, have a memo in your file reflecting your reasoned conclusion why this did not implicate Rule 2420.

[1] FINRA, of course, only has jurisdiction over BDs and individuals associated with a BD.  If someone is paid commissions but is not properly registered, while FINRA may properly take issue with the BD payor, FINRA has no standing to do anything to the unregistered recipient because it does not have jurisdiction over that person/entity.  But, because the receipt of transaction based compensation is deemed to be a hallmark of acting as a broker-dealer (not necessarily a dispositive fact, but pretty damn telling), this means that the unregistered recipient may find him/herself in hot water with the SEC, for acting as an unregistered BD.

[2] Again, the reason this guidance comes from the SEC, not FINRA, is that it is the SEC that dictates the circumstances under which an entity needs to be registered as a BD.

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.

Here is a very interesting piece from Chris about the fact that some customers who file arbitrations may come to learn the hard way that even when their attorney takes the case on a continency fee basis, they still have real skin the game.  I also want to be clear: while the award that serves as the centerpiece for this post reflects that I was counsel for the prevailing respondent, it was, in fact, Chris’s case, so all the kudos belong to him. – Alan


While the FINRA arbitration system certainly is not perfect – just see Alan’s troubling blog from last week regarding the Motion to Vacate that was granted by a Judge in Atlanta – we like to think that when cases go to hearing and all the facts come to bear, the system usually produces correct results (not all of the time, obviously).  But, the problem is the vast majority of cases never go to hearing, so investors and their attorneys are able to get away with saying anything they want when they file their claims.  In fact, the most frequent question I field from brokers is this: how can an investor get away with filing a Statement of Claim that contains so many false statements?

FINRA purposefully makes it easy to initiate an arbitration – so that the average main street investor can seek to recover losses and keep industry professionals in check without having to expend much effort.  But that’s sort of the problem.  It’s almost too easy to file an arbitration.  Filing fees are modest – less than $1,000 if you allege damages under $100,000, and only $2,000 if you allege damages up to $5,000,000.  So there is relatively little stopping an investor from making an inflated claim for damages, hoping such a large number scares a broker-dealer into inflating its settlement check.  And there are plenty of attorneys out there who will gladly file a case for no cost and will only take a third, or so, of anything recovered.  Many of them have pre-drafted Statements of Claim containing standard allegations about suitability and failure to disclose risks that they spend no more than an hour tweaking before they file them.  And that’s where the real problem lies.

Unlike in court, where an attorney signing a Complaint affirms that to the best of his/her knowledge the allegations have evidentiary support and are not being made for purposes of harassment (Federal Rule of Civil Procedure 11 and the equivalent in state rules), no such rule applies to the filing of FINRA arbitrations.  As a result, attorneys can spend very little time investigating the merits of his client’s potential claims and can file a document containing blatantly untrue statements without any fear of repercussions.  Attorneys can get away with this because they know from historical statistics most arbitrations will settle, so the veracity of their statements will never be tested in front of an arbitration Panel.  According to FINRA’s numbers from 2012-2016, only 18% of arbitrations actually go to a final hearing.  That means customers and their attorneys can say whatever they want in the Statement of Claim and most of the time will never have to put their money where their mouth is.

This creates a “heads-I-win, tails-you-lose” scenario.  An investor who takes risk on an investment and makes money is happy (although sometimes you see the rare gem of a case where an investor actually makes money but complains that if they had been invested differently they would have made even more money in the bull market).  But if the investor loses money, he or she simply files an arbitration hoping to recover something from the broker-dealer in a settlement.  After all, something is better than nothing, and I believe many investors are convinced by attorneys that there’s no downside to filing the claim.  In fact, I am convinced that some attorneys actually promise investors that they will never have to go to hearing and they should just file a claim to see how much the broker-dealer is willing to pay in settlement to make the case go away (rather than spending tens of thousands of dollars to defend a 12-18 month long arbitration).

This can be immensely frustrating for broker-dealers and their registered reps, who have a hard time fathoming that some customers (not all) can get away with making demonstrably false statements in their complaint.  They feel like they have little recourse except seeking to expunge the disclosures that end up on their CRD and BrokerCheck records after the complaint is filed.

The silver lining for broker-dealers, and the harsh reality for investors who might have been talked into filing an arbitration by a zealous attorney, is that investors do, in fact, face some very real monetary risks for filing meritless arbitrations: being charged with paying all the hearing fees and the respondent’s attorneys’ fees as monetary sanctions.

Let’s start with the latter of these, which reared its head in a recent arbitration award in a case we handed for a broker-dealer we will call Infinity.[1]  An investor filed an arbitration against Infinity, even though he never had an account or any relationship with Infinity.  The Statement of Claim made blatantly incorrect statements such as: the customer bought an investment from Infinity (he actually bought it at another BD); Infinity failed to advise him to sell the investment (he never had an account with Infinity, nor was he Infinity’s customer); and Infinity earned high commissions from the customer relationship (since he was never Infinity’s customer, Infinity never made a dime from him).

The Statement of Claim also referred to the investment as a REIT, when it wasn’t.  The arbitrator denied our Rule 12504 Motion to Dismiss in order to give Claimant an opportunity to conduct discovery to ferret out any possible connection he may have had to Infinity.  After forcing us to conduct months of discovery, the facts – which were clearly not vetted prior to filing the claim – remained unchanged.  After Infinity signaled it would not settle the case and was preparing to refile its Motion to Dismiss, Claimant voluntarily dismissed his claims, and did so with prejudice.

Since Infinity had been forced to waste thousands of dollars to defend a claim brought by someone who wasn’t even its customer, Infinity filed a Motion for Attorneys’ Fees and Costs after the claims were voluntarily dismissed.  We argued that under the laws of the States of Washington and Nevada (where the customer was located), this litigation was “frivolous” and Infinity was entitled to recover its attorneys’ fees.[2]  All states have similar statutes, some of which are more generous than others.  They all essentially say the same thing: a prevailing party may recover its attorneys’ fees when the court finds that a claim was brought or maintained without reasonable grounds or to harass the prevailing party.  The Nevada Code is particularly pointed and states that “it is the intent of the Legislature that the court award attorney’s fees pursuant to this paragraph … in all appropriate situations to punish for and deter frivolous or vexatious claims and defenses because such claims and defenses overburden limited judicial resources, hinder the timely resolution of meritorious claims and increase the costs of engaging in business and providing professional services to the public.”[3]

Needless to say, we really believed our case warranted recovery of attorneys’ fees under these frivolous litigation statutes.  More importantly, the Arbitrator agreed, and instructed Claimant to pay Infinity some, but not all, of its attorneys’ fees.  To be clear, this is not an everyday occurrence.  But it is a very real risk that every investor faces when filing an arbitration – and probably one they are never warned about when they think they will just try to squeeze a quick settlement out of a broker-dealer.

A much more common occurrence is for an arbitration panel to charge an investor with paying the hearing fees incurred in an arbitration.  Every time the arbitration panel holds a hearing session, for either a pre-hearing conference or the evidentiary hearing, FINRA charges the parties a fee between $600 and $1,575 per session.  Under FINRA Rule 12902, an arbitration panel can allocate these fees to any party it chooses, and the losing party is often charged with footing the bill.  Even when a case never goes to hearing, if a respondent files a couple of motions on pre-hearing issues such as discovery, the Panel could charge all of those hearing session fees to the investors.  Sometimes these can really add up, especially when a case goes to hearing.

For instance, Wells Fargo recently defeated claims brought by customers seeking $5,000,000 in damages in an American Arbitration Association arbitration (not FINRA).  The Panel in that case (AAA No. 01-20-0015-7450, as reported by Capital Forensics in its weekly Arb Reporter) issued an award requiring the Claimants to bear responsibility for “the compensation and expenses of the arbitrators totaling $195,233.28.”  Interestingly, the award states that the Claimants voluntarily dismissed their claims against two Wells Fargo affiliates, but the Panel still required Claimants to reimburse those two affiliates for the portion of fees and expenses those affiliates incurred in the arbitration.

In other words, in both of these cases, if the investors thought they would file an arbitration and could always just dismiss it, “no harm no foul,” they were sorely mistaken.  Perhaps it is just coincidence that two separate arbitration panels instructed two different sets of Claimants to reimburse defendants thousands of dollars in expenses even after the Claimants decided to voluntarily dismiss their claims.  But the message should be clear: filing an arbitration claim may be every investor’s right, but it also comes with real risks.  Counsel and their clients should make sure they have done their homework prior to filing a claim, and should strap together something more than a cookie cutter complaint to file.  On the flip side, if a broker-dealer is faced with a truly frivolous claim, there can be some potential silver-lining to fighting it – with the right set of facts and the right panel.

[1] Infinity gave us permission to discuss its case on this blog.

[2] Revised Code of Washington 4.84.185 and Nevada Revised Statutes 18.010(2)(b).

[3] There are other bases for awarding a respondent its attorneys’ fees even if the arbitration panel does not find the claim to be frivolous.  For example, a contract may exist that states the prevailing party is entitled to his/her attorneys’ fees, or if both the Claimant and Respondent request fees in their pleadings then the Panel may award them to either party – even if the claims are not so meritless that they are considered frivolous.

Motions to vacate an adverse arbitration award are rarely granted by courts.  Indeed, that should come as no surprise to anyone inasmuch as the awards rendered at the conclusion of the arbitral process are explicitly designed to be “final.”  As a matter of both federal and state law, there are very, very few available bases on which a court may overturn an award rendered by an arbitration panel.  (In some jurisdictions, lawyers can be – and have been – sanctioned for filing a motion to vacate without a sound basis for it.)  As everyone who participates in arbitrations understands (except, perhaps, clients on the losing end of arbitrations), even errors of law and errors of fact committed by an arbitration panel are not grounds for vacatur.  By comparison, adverse decisions issued by a court can be appealed pretty much for any reason one is capable of conjuring up, even silly ones.

Last week, however, a Superior Court Judge in Fulton County, Georgia – my old stomping grounds – actually granted a motion to vacate that a customer filed after losing a FINRA arbitration he had brought against Wells Fargo Advisors.  What makes the Order remarkable is not that it was granted, a rarity, as I said, but why it was granted.

In fact, the Judge identified five separate reasons to vacate the award.  I will not focus on all of them; you can read them for yourself, and it’s not very pretty.  Rather, I want to focus on the most troubling, and the one that should cause anyone who appears in FINRA’s arbitration forum to have questions about the fairness of the process.  Namely, the Judge found that FINRA’s administration of the arbitrator selection process was not fair, and it wasn’t fair because it wasn’t, as advertised, neutral.

Here is the pertinent part of the story in a nutshell, according to the Judge’s Order:

  • As in any customer arbitration, FINRA supplied both parties the same list of potential arbitrators, who together comprise the “pool.”
  • From that list, the parties each strike the potential arbitrators they don’t want to sit on the panel – and that can be for any reason whatsoever – and rank the remaining candidates in order of preference. That is the so-called “Neutral List Selection System” identified in Rule 12400, namely, “a computer system that generates, on a random basis, lists of arbitrators from FINRA’s rosters of arbitrators.”  Emphasis on random.
  • In the case at hand, however, an extra step was inserted: when counsel for WFA got the list, he noticed that it included a potential arbitrator who he was not expecting to see.
  • The reason the lawyer was not expecting to see this person is that, apparently, he had had the same arbitrator on the panel in a prior case (one not involving WFA), and claimed that the arbitrator “harbored personal bias” against him based on how that prior case had been conducted.  Following that, WFA’s lawyer entered into an “agreement” with FINRA that none of the three members of the arbitration panel in that prior case would ever be included in any lists in any subsequent cases in which the lawyer participated.[1] Accordingly, prior to submitting his rankings, WFA’s lawyer requested that FINRA strike this one arbitrator from the list and replaced with someone else, since it violated the terms of his agreement with FINRA.
  • Although claimant objected, FINRA did remove the arbitrator and replaced him in the pool with someone else.

The Judge did not approve of this, at all, and the words she used to express her view on the subject say it perfectly:  “Permitting one lawyer to secretly red line the neutral list makes the list anything but neutral, and calls into question the entire fairness of the arbitral forum.”

It has been reported, following the publication of this Order, that FINRA flat-out denied the existence of any supposed agreement with the lawyer to exclude certain potential arbitrators from lists he is provided.  One article I read includes this quote from a FINRA spokesperson: “There has never been any agreement between Finra Dispute Resolution Services and [the] attorney . . . regarding appointment of arbitrators.  Any assertions to that effect are false.”  The spokesperson went on to say that FINRA has “reviewed all cases involving [the attorney] . . . and none of the three arbitrators in question was excluded or removed from ranking lists prior to sending the lists to the parties.”

Frankly, I do not know how to account for the 180° difference between what the FINRA spokesperson said – i.e., what agreement? – and what the lawyer represented to Fulton County Judge in a legal brief – “It was made clear to me verbally [by FINRA] that none of the . . . arbitrators [from the prior case] would have the opportunity to serve on any one of my cases given the horrific circumstances surrounding the underlying case.”  All I know is that these cannot both be true.  I also know that I am damn careful when I make representations to a judge that what I am saying is true, and demonstrably so.  I think it’s fair to say that any competent lawyer is similarly careful.

There is nothing in the Order that suggests that WFA was aware of any of these supposed shenanigans.  And I expect that WFA will appeal (with different counsel, no doubt).  But, for now, the Order stands, and FINRA (among others), for now, looks awfully bad.

And that is a problem for everyone who participates in FINRA arbitrations.  Win or lose, but particularly when I lose, I have to be able to look my client in the eye and say, well, at least you got a fair shot.  Arbitrations are not perfect, but neither are jury trials.  But, as long as the process is fair, then the imperfections are annoyances, at best, but not grounds to throw the whole system away.  But what this case presents is not some silly annoyance that makes for a good war story; it goes to the heart of the arbitral process, that is, to its fairness.  If, in fact, FINRA played games here with the arbitrator lists pursuant to some secret agreement with one of the lawyers, then there should be hell to pay.  And Senator Elizabeth Warren would be justified in ensuring that something be done to FINRA.

[1] It should be noted that in the prior case, i.e., the one that supposedly caused the arbitrator to develop his “personal bias” against the lawyer, the lawyer filed a motion to vacate the adverse arbitration award, claiming his client had lost as a result of that supposed bias.  The motion to vacate was denied, however. which raises questions, of course, about the legitimacy of the claim of bias.

Happy New Year!  I hope you had an enjoyable holiday season.  At least happier than that of JP Morgan Securities, which, right before Christmas, got to write checks to the SEC and the CFTC totaling $200 million.  That’s a lot, even for JPMS.  How did this happen?

Well, the story starts with a very old, and very broad, SEC rule, specifically, SEC Rule 17a-4(b)(4), which, since 1939 (as best I can determine) has required that broker-dealers preserve in an easily accessible place originals of all communications sent and received relating to the firm’s “business as such.”  It was probably never easy to divine with much precision exactly what “business as such” means, but, clearly, this somewhat odd phrase was deliberately employed to capture an extremely wide swath of documents.  So, for convenience sake, let’s say that it covers pretty much everything that anyone at a BD – but particularly the management of a BD – sends or receives that’s got anything whatsoever to do with the firm’s business.  Unsolicited emails to buy generic Viagra?  Feel free to delete those, but be careful with everything else.

Regardless, when all of a firm’s records were in paper form, it was a relatively easy proposition to keep track of and preserve the documents covered by the rule just by putting them in manila folders in a filing cabinet in the corner of the office.  But, the world moved on from paper.  Recognizing that, in 1970, the SEC permitted BDs to keep their records on microfilm. In 1993, through a no-action letter, the SEC recognized the optical disk as an acceptable means of storing communications.  Then, in 1997, the codified and expanded this concept, approving any electronic storage medium to be utilized.

While the SEC should be commended for its attempt to keep up with the times, the times always manage to stay out ahead.  Which is what caused the problem for JPMS.  Specifically, the problem is that today, people communicate – A LOT – through personal devices, using specialized apps that no one could have contemplated when the rule was promulgated decades ago.  But the SEC rule doesn’t care about that; the rule requires that ANY communication relating to the firm’s business must be captured, reviewed and preserved.  Doesn’t matter how the communication was sent, whether it was paper or electronic or carrier pigeon or semaphore.

Most firms address this problem – the difficulty of simply being aware of communications being sent from personal devices – by flat-out forbidding their registered people from conducting firm business on their personal phones, laptops and tablets.  Indeed, that’s what JPMS did.  It’s just very, very hard to enforce such a policy because it runs completely contrary to how people act in 2022.

You want proof?  Last year, in what now looks like the tip of the iceberg, the SEC settled a case with JonesTrading Institutional Services, a California BD, and tagged it with a $100,000 civil penalty because it “failed to preserve business-related text messages sent or received by several of its registered representatives on their personal devices when communicating with each other, with firm customers, and with other third parties.”   Notably, the SEC found that “JonesTrading’s senior management were among those sending and receiving business-related text messages that were not retained by the firm.”  Ouch.

It seems that the SEC must have figured, gee, if JonesTrading does this, what about everyone else?  In October 2021, Gurbir Grewal, the Director of the SEC’s Division of Enforcement, citing the JonesTrading case, gave a speech in which he issued this not-so-cryptic warning:

Recordkeeping violations may not grab the headlines, but the underlying obligations are essential to market integrity and enforcement. . . .  We continue to see in multiple investigations instances where one party or firm that used off-channel communications has preserved and produced them, while the other has not. Not only do these failures delay and obstruct investigations, they raise broader accountability, integrity and spoliation issues.

Shortly after that, the news broke that the SEC was conducting a “sweep,” looking for the same issues it had spotted at JonesTrading.  And poor JPMS got caught in the SEC’s net.  I venture to say it won’t be the last, because I believe that most firms, maybe even the vast majority of firms, are guilty of doing the same things as JonesTrading and JPMS.

This raises the question whether the problem is the way broker-dealers conduct their business, or whether the rule needs updating to reflect the reality that the ability to capture and preserve all communications that relate to a firm’s business as such is highly dubious given the ubiquity of personal communication devices.  Candidly, I am not sure how the rule ought to read; I just know that it seems a bit unfair to tag a firm for $200 million in fines for doing what everyone else is also doing.

With that said, I suppose there are some lessons to glean from JPMS’s SEC settlement.

First, it should be noted, again, that JPMS did have a policy providing that “the use of unapproved electronic communications methods, including on their personal devices, was not permitted, and they should not use personal email, chats or text applications for business purposes, or forward work-related communications to their personal devices.”  If you don’t already have such a policy, you need one.  That’s the easy part, and there’s no excuse for failing to do even that.

Second, JPMS also “had procedures for all employees, including supervisors, requiring annual self-attestation of compliance” with its prohibition on the use of personal devices for business communications.  So, again, points to JPMS, and another good practice to adopt.

Unfortunately, JPMS “failed to implement a system of follow-up and review to determine that supervisors’ responsibility to supervise was being reasonably exercised so that the supervisors could prevent and detect employees’ violations of the books and records requirements.”  The firm also “failed to implement sufficient monitoring to assure that its recordkeeping and communications policies were being followed.”  What does that mean in real terms?  It means that “[e]ven after the firm became aware of significant violations, the widespread recordkeeping failures and supervisory lapses continued with a significant number of JPMorgan employees failing to follow basic recordkeeping requirements.”

Looking at this quantitatively, you can perhaps see why the fine was so big:

  • An executive director and co-supervisor of the high grade credit trading desk launched a WhatsApp group chat entitled “Portfolio Trading/auto ex” on April 24, 2019, and invited the other 19 members of the trading desk to join. From April 24 through December 16, 2019, at least 1,100 messages were sent among the chat group, nearly all of which concerned the firm’s securities business;
  • From at least November 2019 through November 2020, an executive director who worked on the capital markets desk texted with more than a 100 colleagues, including the investment bank, and with dozens of managing directors and heads of several business lines;
  • The same executive director also texted with dozens of firm clients, third-party advisers, and market participants;
  • In all, this executive director texted more than 2,400 times in the one-year period, discussing various aspects of the high yield and leveraged loan capital markets business;
  • Between at least January 2018 and November 2019, firm employees, including desk heads, managing directors, and other senior executives sent and received more than 21,000 securities business-related text and email messages using unapproved communications methods on their personal devices.

This probably all sounds worse than it should simply by virtue of the fact that JPMC is a big firm, with lots of clients and lots of employees, so necessarily the numbers are high.  I am thoroughly convinced, however, that the phenomenon cited in the settlement – that even the respondent’s senior executives use personal devices for firm business, thereby preventing those communications from being preserved – is commonplace in the industry.

Which brings me back to the rule itself: if there exists a rule that is, basically, impossible to comply with, but which carries a crazy expensive price tag for compliance failures, then there is a problem with the rule and not with the firms that are found to have violated it.  I am sure that additional settlements will be forthcoming, and the facts will sound much like those in the JPMC settlement.  All the more reason to consider how this cranky old rule can be dragged into the 21st century.

My job frequently requires that I explain to someone – whether my client, an ALJ, an arbitration panel, even a regulator – the fundamental difference between a broker-dealer and an investment advisor.  An IA operates pursuant to a fiduciary duty; a BD, on the other hand, even with the advent of Regulation BI, largely has transactional duties.  That is, a BD’s duty to its customers largely manifests itself if and when it deigns to make a recommendation.  It could be a recommendation to buy or sell (or hold) a security, but it could also be a recommendation regarding the nature of the relationship the customer undertakes with the BD, i.e., a commission account vs. a fee-based account.  In the absence of a recommendation, however, it is difficult to pin responsibilities on a BD.

Not true for IAs.  As fiduciaries, IAs are legally compelled to do things that BDs aren’t.  For instance, ongoing monitoring of accounts.  Once a BD makes a recommendation to a customer, in a commission-based account, the BD is pretty much off the hook for any subsequent developments that may impact the success or failure of that trade.  (There are certain notorious exceptions, like after a BD makes a recommendation to a customer to invest in a private offering of securities; there, BDs are required to conduct ongoing diligence to ensure that the issuer actually uses the proceeds in a manner that’s consistent with representations made in the offering materials.)  Not so for IAs.  IAs, in theory, have to constantly monitor the position, the account overall, the markets, to ensure that no further changes need to be made (or at least recommended to the customer).

Recently, Michigan-based IA Regal Investment Advisors LLC learned the hard way that an IA does not fulfill its fiduciary obligation by putting advisory accounts on cruise control, paying them no attention while the financial world continues to turn.  And what’s worse than ignoring advisory accounts?  Charging such accounts an advisory fee for the privilege of being ignored!

Well, that’s exactly what happened to Regal, according to this settlement with the SEC.  The case involved so-called “orphan accounts,” i.e., advisory accounts left behind when the IARR who had been responsible for the accounts leaves the firm.

For reasons that remain unexplained, until November 2019, Regal had no written policy or procedure that addressed what happened when an IARR left Regal, but his/her client accounts remained at Regal.  Instead, Regal relied on “an informal procedure” that designated those orphan accounts as “house accounts” and assigned them to the firm’s three owners, two of whom “would share responsibility for managing these accounts” and split the IARRs’ share of the advisory fees paid by the customers.

But, between July 2015 and April 2021, while Regal classified approximately 250 such accounts as house accounts, which paid both advisory fees – i.e., a fee for “account management services” – and portfolio management fees – i.e., for “selection of securities in the account,” about 81 of those accounts received no advisory services.  That is, they “continued to receive portfolio management services, but failed to receive regular account monitoring by [the two owners] to determine whether the selected portfolio remained consistent with clients’ investment objectives and goals.”  Consistent with that, Regal didn’t even bother, in many instances, to inform the customers that their IARR had left, or that someone else had been assigned to their account.  As an example, the SEC cites one customer in particular whose IARR left Regal in 2014 to work with a different firm, resulting in his account being classified as a house account.  Despite the customer paying over $7,600 in advisory fees to Regal from then until 2017 when he closed his account, “[n]o one at Regal provided [him] with advisory services during this period[,] . . . no one from Regal ever contacted [him] after the departure of [his] IAR, and there is no indication anyone at Regal monitored or conducted periodic reviews of [his] account.”

Everyone knows that BDs, too, can get in trouble for seemingly doing nothing.  There are any number of “reverse churning” cases, where a BD puts a customer in a fee-based account – an account that can be cheaper for clients who trade a lot – yet the customer doesn’t make many (or any) trades (meaning that the customer would have paid less if the account had been set up as a commission account).  Indeed, I have blogged about such cases before here and here.  But, it is a bit misleading to suggest that it was the absence of trades that triggered these cases.  In fact, these cases did not arise as a result of the fact that a BD failed to make enough trades in a fee-based account to justify charging a fee; rather, they stemmed from the BD’s threshold recommendation – the unsuitable recommendation – to the customer to open a fee-based account.  In other words, the BD did not, in fact, get in regulatory hot water for doing nothing, but, rather, for doing something – making a recommendation – wrong.

Putting aside this reverse-churning issue, I stick with what I said earlier: generally speaking, a BD doesn’t really have to do anything with an existing customer account if it doesn’t want to.  (Granted, it might not make any money – buy and hold strategies don’t generate new commissions, after all – so it’s not necessarily a great business model.)  But IAs don’t have that luxury.  Frankly, it is the constant monitoring, and the potential adjustments that monitoring mandates, that justifies the advisory fee in the first place.  Absent that monitoring, I’m not really sure what advisory clients are buying.

This case also serves as a good reminder that orphan accounts are still accounts.  A house account doesn’t mean they get moved to the attic, or the basement, or the garage.  These customers are entitled to the same attention, the same energies, as any other account.  It is not their fault their IARR left them behind.

Look, most cases don’t present the layup that Regal handed to the SEC here.  Most cases in this area don’t provide the SEC with such an easy means to establish liability, given that Regal literally had nothing to show the SEC.  But, just because an IA does something more than “nothing,” it still doesn’t necessarily mean that it is meeting its fiduciary responsibility to its customers, or that it will be enough to avoid an awkward moment with a regulator.  That’s why here, my advice to my clients sounds the same as it does in many other circumstances:  when you do something, document it!  If you do an account review, put it writing, for heaven’s sake.  If you call an advisory client to discuss his/her account, create a memo of the call.  Create a document trail.  Always act as if two years from now, you may be called upon to prove to some stranger exactly what you did and said and when you did it, and, in many instances, to do so without any assistance from your customer, who despite having sat next to you during that account review, manages not to recall that it happened.  This is true for BDs, for IAs, for RRs, and IARRs.  I hate to sound so cynical, but, after all, history teaches.

I continue to wade my way through a few months’ worth of cases, press releases, etc., looking for things that manage to catch my attention.  I found this SEC settlement from the end of July involving Integral Financial, a BD out of California, and its founder, majority owner, President, and Chairman of the Board of Directors, Weiming “Frank” Ho.  In and of itself, the case isn’t exactly ground-breaking.  It involved four RRs who spent two years making unsuitable recommendations to ten customers, and their supervisor, Mr. Ho, who failed to monitor the reps’ trading and their compliance with the firm’s WSPs.  What makes it interesting is not the trading itself; rather, it was the failed defensive strategy that Mr. Ho employed, which I will get to momentarily.

First, some background, starting with the product at issue:  variable interest rate structured products (“VRSPs”).  According to the SEC, VSRPs are “complex, illiquid, structured securities” with long maturity dates.  Traditional bonds provide periodic fixed-interest payments and are directly linked to a bond issuer’s ability to make those payments and repay principal at maturity.  By comparison, the VRSPs at issue only paid fixed amounts for an introductory or “teaser” period of one to five years. After that, the interest payments are not guaranteed, nor are they solely linked to the issuer’s ability to meet its payment obligations.  In fact, investors in VRSPs can lose some or all of their invested principal at maturity if the products’ derivative components fail to perform within certain pre-determined ranges.  Given that, the SEC concluded that “the VRSPs present higher risks than traditional municipal or corporate bonds.”

Next, let’s look at the ten investors.  According to the SEC, they “had reached or were approaching retirement age and relied on their investments for income; had conservative or moderate risk tolerances; investment objectives such as capital preservation, growth and/or income; limited investment experience; investment time horizons of less than fifteen years; higher liquidity needs; in most cases, a net worth of less than $500,000; and were unwilling to risk losing their invested principal.”

Putting the product and the investors together: the SEC concluded that the recommendations by the reps to purchase the VRSPs were not suitable for the customers.  This was only exacerbated by the fact that the reps sold too much of that product, managing to exceed the firm’s internal concentration limit on structured products.  Perhaps not surprisingly, none of the reps in question had reviewed the firm’s WSPs in the last five years, and one had never reviewed them.

But, on to Mr. Ho, the supervisor.  He, of course, was supposed to review the trades, to ensure that they were, in fact, appropriate for the customers based on their respective investment objective, risk tolerance, financial wherewithal, etc.  Unfortunately, he didn’t exactly do that.  Instead, he “directed the Integral RRs to have the Customers sign the firm’s standard risk disclosure form to confirm that a trade was suitable.”  And this is the point of today’s post, as I hear this all the time from reps involved in an arbitration or a regulatory inquiry revolving around suitability:  the customer wanted the product.  The problem is: this is not, as Mr. Ho learned, a defense (at least not a valid defense) to a suitability case.  As the SEC put it in the Integral settlement, “[o]btaining a customer’s written consent for a trade does not relieve a broker-dealer or its registered representative from the obligation to conduct a proper suitability determination based on all of the relevant circumstances relating to the customer.”

I know that this may seem like Suitability 101, but given how frequently I find myself instructing my clients on this issue, it seems that a reminder is appropriate.  The simple fact is, the duty to make a suitable recommendation exists, period.  It does not matter what a customer wants.  It does not matter whether a customer personally deems the product to be suitable, and is willing to sign an attestation or certification or whatever to that effect.  The duty is the BD’s.  As FINRA put it succinctly in item .02 in the Supplementary Material to Rule 2111, “[a] member or associated person cannot disclaim any responsibilities under the suitability rule.”  In other words, you can’t slough that responsibility off on to the customer.

Not to get too legal on you, but there is more than ample case law supporting this straightforward proposition.  For instance, recommendations are “not suitable merely because the customer acquiesces in [them].” Dane S. Faber, Securities Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23–24 (February 10, 2004).  Or, “a broker’s recommendations must serve his client’s best interests and the test for whether a broker’s recommendations are suitable is not whether the client acquiesced in them, but whether the broker’s recommendations were consistent with the client’s financial situation and needs.”  Dep’t of Enforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC August 9, 2004).  I could go on, but you get the point.  As I put this a few years ago in a post with a similar subject matter, “[a] customer cannot conclusively agree that a recommendation was suitable, as that is not something a customer is deemed capable of knowing.”

So, given this, what’s the purpose in getting a customer to sign a piece of paper that not only provides no legal defense, but could actually get you in hot water with FINRA (or, as was the case with Mr. Ho, the SEC)?  The answer, of course, is that there is no point in doing this.  If you are looking for a document that will actually help you defend a suitability case, it is, simply enough, an accurate and up-to-date new account form, one that captures a client’s true investment objective, etc.  Armed with THAT, there’s a LOT that I can do to defend a suitability claim.  Armed with that, it is relatively easy to defend the invariable insistence by the complaining customer that he/she was a conservative investor, someone unwilling to expose themselves to the slightest degree of risk of loss of principal.  While a good NAF is hardly a silver bullet – given customers’ predictable willingness to swear that it was signed in blank, or that the signature was forged, or that the NAF was altered after it was signed, etc., etc. – it is as good and effective a piece of documentary evidence that you will encounter.

The lesson, then?  Don’t waste your time getting your customers to confirm that they view your recommendations to be suitable.  Spend your time, instead, insuring that you can prove, if need be, at some possibly distant point in the future, that at the moment you made a recommendation, you were working with solid information about your customer.  And the best way to accomplish that is a good new account form.

I am still catching up on things that happened over the last couple of months, as I dig myself out of the hole created by (finally) completing a 39-day FINRA arbitration (SOC filed in 2014, hearing started in 2019). Truthfully, it seems there’s been a lot of the usual.  You know, FINRA taking formal disciplinary action against some poor unregistered back-office guy for not disclosing an outside brokerage account, or against some rep who had the temerity to get named as a beneficiary under the will of a longstanding client.  You get the drift.  Big, important stuff.

But, in addition to reviewing the various Enforcement actions that FINRA has taken, I have also gone back to see what FINRA has published on its website, as there are often gems buried there.  Well, I was not disappointed, as I found this, a podcast from a month ago called “Single Points of Accountability: Navigating Firms’ Experiences with FINRA.”  Happily, as I’ve pointed out before, if you are interested in a FINRA podcast, you don’t actually have to listen to it, as FINRA is kind enough to provide the transcript, so you can quickly skim it, looking only for the good stuff.  Like, for instance, this wonderfully candid admission by FINRA made in a different podcast back in June: “[I]ntelligence is a new concept for FINRA.”[1]

Anyway, the title of this particular podcast intrigued me, as I had no idea what was meant by “Single Points of Accountability.”  I mean, I am well aware that for some reason, FINRA decided about two years ago, basically, to abandon any kind of geographic-oriented approach to its relationships with its member firms.  As a result of that decision, instead of being regulated by the District Office most proximate to your particular location, you could be regulated by someone who may be on the other side of the country. That’s because FINRA determined that being located near its members didn’t really matter; what mattered more was having a person handle the relationship with your firm who, theoretically, anyway, knows something about the kind of business you conduct.

So now, rather than being assigned to its local District Office, each BD is assigned to one of five groups:  retail, capital markets, carrying and clearing, and diversified, and trading and execution.  And within its particular group, each BD is assigned a specific human being – the Single Point of Accountability.  Sounds easy enough.

Sadly, the infrastructure FINRA erected is more complex than that.  According to this podcast, each BD also has to deal with both a risk monitoring director and a risk monitoring analyst.  So, now we’re up to three people.  How do their respective roles differ?  Well, I will let the podcast speak for itself there:

The risk monitoring director’s primarily responsible for managing the day-to-day operations of the analysts, so the underlying firms that they’re each assigned, making sure that the assessments, the risk monitoring work itself, is being done timely and it’s being done accurately. The SPoA role is more so focusing on strategic goals and consistency across the larger group.  So, by way of example, I oversee the retail private placements and the retail pooled investments and variable annuities groups. Those groups encompass almost 500 firms, so I’m looking at, across those firms, peer to peer analysis, how we’re handling the firms consistently, having discussions with firms, not treating all firms the same, we’re looking at them independently as well as against their peer group. So, the RMDs are focused on the day to day. The SPoA is focused on the macro level of the group.

Ok, that’s all fine, I guess.  And I even understand FINRA’s thinking behind the move to a business-based rather than geography-based approach to selecting a firm’s primary points of contact.  But, here’s the thing: as I kept reading this transcript, and these two SPoAs started telling about their supposed actual experiences with the member firms for which they had responsibility, it sounded more and more like I was reading some fiction story, or a story about some other regulator, because it sure as heck doesn’t sound like what my clients share with me about their relationship with FINRA.

To their credit, these guys did admit that BDs simply do not trust FINRA, and that their biggest challenge is earning that trust.  As one of them put it – and accurately so, in my view:  “I was on the exam side for 12 or 13 years, and what we often heard was, I’m afraid to say something to FINRA because they’re [sic] going to be retribution. You guys are going to do an exam.”  That is 100% true.  Given this skeptical view of FINRA, firms choose to avoid FINRA.  Knowing this, these SPoAs maintain that they’ve had great success turning that view around.  The problem is: what they say they’re doing to earn members’ trust just does not comport with reality.

They claimed this: “We’re happy to field any and every question that you guys may have. And if it’s not an answer that is readily available for us, we will get you the right person within FINRA. Allow us to kind of do the work for you a little bit versus you trying to figure out who the heck do I call at FINRA.”

Stated somewhat differently, but to the same effect, they also said: “But we’re that person that you can reach out to instead of pulling three names and reaching out to three different people to say, Hey, can we just have a quick call to talk? Because I have some concerns. And it’s a 15-minute conversation. We get it resolved and we move on.”

And this:  “We are truly here to be that Single Point of Accountability. The buck stops with us. If you reach out to us, we will be back in touch with you. We will get you the guidance or get you in touch with the right people within FINRA.”

No offense to these guys, but it is well known that apart from some notoriously helpful groups – CRED and MAP come to mind – it can be nearly impossible to get an answer from FINRA.  The notion that FINRA will “get it resolved,” or even provide guidance, as the result of a 15-minute call is fanciful, at best.  Examiners are loath to give black-and-white answers, as they don’t want to be held accountable.[2]  As a result, firms tend not to bother even to try and obtain advice from FINRA.  What would be the point?  As these guys acknowledged, no firm wants to bring an issue to FINRA’s attention if not only will no straight answer be provided, but it creates the risk that FINRA will then open an exam or, at a minimum, hold it against you.

With that said, I suppose we should at least give FINRA some small degree of credit for at least acknowledging the image problem it has with its members, and for hoping to do something to remedy it.  As these two guys put it, perhaps aspirationally,

we can be a very valuable partner. Our interests are aligned with firms in ensuring that FINRA understands the firm’s business and its risks, and that our risk monitoring and examination programs are tailored accordingly. So, we also, at the end of the day, want to ensure that firms get things right in the interest of investor protection and market integrity. So, no issue is too small, come to us, partner with us. We’re happy to work through things.

I like the sound of this, but, sadly, I will believe it when I see it.  It is going to take a lot of work to turn this battleship around.  Firms today simply do not view FINRA as a “partner,” someone that’s going to offer help and advice.  No, FINRA is largely seen as the enemy, happy to bring Enforcement actions for the slightest rule violations.  If FINRA can start even with baby steps, like having two SPoAs actually do what they promised here to do, then, perhaps, it can one day rehabilitate its tattered image.

[1] Ok, maybe that’s not a fair shot.  I should note that the podcast where I found that remark was called “FINRA’s Financial Intelligence Unit: Connecting the Dots,” so the use of the word “intelligence” in this quote had particular meaning.  Also, the speaker was Blake Snyder, a good guy, and someone I actually hired 20 years ago when I was the District Director of the Atlanta District Office.  Still, it’s pretty funny when taken out of context!

[2] Even worse, even when an examiner offers an opinion, you still can’t safely rely on it.  FINRA is perfectly free, come the next exam, to give a contrary opinion and hold against you the fact that you relied on the “wrong” advice provided earlier.  Why? Because the duty to comply resides solely with the firm, and cannot be delegated to anyone, not even to FINRA.

Not too long ago, a single, small BD experienced a bizarre combination of regulatory overzealousness and regulatory indifference, by the SEC and FINRA, respectively.  These things, sadly, happen all the time, but what happened to this unfortunate firm presents an excellent case study in regulators who simply do not wield their considerable prosecutorial discretion in any sort of fair, or predictable, fashion.

Let’s start with FINRA.  Spartan Securities Group was – notice the portentous use of the past tense here – a very small BD in Florida with a modest retail business, but also with a niche business in filing Forms 211, i.e., the application necessary for any BD to begin offering quotes on an issuer’s securities.  Unless and until some BD files a Form 211, no one can serve as a market maker for the issuer’s shares.  While perhaps a bit out of the realm of what “typical” BDs do, filing Forms 211 is not a particularly difficult thing, as the information contained in the form is pretty much supplied by the issuer itself.  A BD is not required under the applicable rule, i.e., FINRA Rule 6432, to independently corroborate the information supplied by the issuer.  It is worth noting that BDs may not receive any compensation in exchange for filing a Form 211, so issuers hoping to see their shares covered by market makers may not simply pay a BD to accomplish this.  Despite its small size, Spartan filed a significant percentage of all Forms 211 filed by all BDs.  Finally, but importantly, in addition to this business, Spartan also maintained a modest proprietary account in which it traded its own capital.

Unfortunately, two things happened in close succession for Spartan, neither one of which was good.

First, according to court filings, in early March 2019, Spartan’s head trader made a series of unauthorized short trades in Bio-Path Holdings Inc. in the firm’s prop account.  These trades were big enough that they exceeded the trading limits imposed on the head trader by Spartan.  Sadly, the share price kept climbing.  By the time the short positions were all covered, at great expense, it eventually resulted in a loss to Spartan, as well as Axos Clearing, Spartan’s clearing firm, in excess of $16 million.  Obviously, this caused a big hit to Spartan’s net capital, a hit from which the firm never recovered.

Second, the SEC took an interest in Spartan’s 211 business, and eventually filed a complaint in federal court against the firm and three of its principals alleging a variety of things, but principally that in filing the Forms 211 for 19 companies – out of approximately 1,500 such forms that Spartan filed overall – they failed to discover that these companies were shams, and that the individuals behind these 19 issuers were perpetrating a fraud on the investing public.  In their defense, the defendants argued that they had done nothing wrong, that they were unaware of anything untoward by the issuers, that they had done everything that FINRA and the SEC required of a BD that files a Form 211, and that the SEC was attempting to hold them to a standard of conduct in filing the Forms 211 that was not articulated in the applicable rules or any of the guidance that had been previously issued.[1]  By the time the case made its way to trial, Spartan was already out of business as a result of the unauthorized short sales described above.  The SEC persisted, however.

This is a sad tale, to be sure.  But, that’s not the point of this post.  The point is to ask you to consider the roles that FINRA and the SEC played, and just how oddly they did their jobs.

First, FINRA.  I want you to take the minute it will cost you to read this excerpt from the findings contained in the explained Award that resolved the arbitration that Spartan filed against its former trader (and which came to involve Axos, as well):

Responsibility has been defined as “the state of being held as the cause of something that needs to be set right” (Merriam-Webster Thesaurus). The Panel finds that [head trader] Respondent Scott Richard Reynolds (“Reynolds”) is solely responsible for the losses suffered by Third Party Respondent Axos Clearing LLC (“Axos”) and Claimant Spartan Securities Group, Ltd. (“Spartan”).

The witnesses called by Spartan and Axos were credible and Reynolds’ testimony was not. Moreover, the evidence of unambiguous text messages, created contemporaneously with the occurrence of operative events were highly probative, especially when compared to contradictory testimony proffered by Reynolds.

Reynolds, a licensed securities professional, initiated the short sale position in BPTH on or about March 6, 2019, creating an open-ended risk of loss to Spartan/Axos. Primarily using Axos’ money and being aware of Axos’ lending limits and its right to reject trades and close trading positions, he was caught in a short squeeze, causing Spartan to violate its net capital requirement, which as a member of FINRA, it self-reported.

As a licensed individual, trading through a FINRA member firm’s proprietary account, Reynolds had no discretion to disregard the explicit directives of Spartan’s compliance officer to cover the BPTH short on March 6, 2019 and in fact, exacerbated the highly risky short position by adding to it, in contravention of his supervisor’s instructions and his own trading limits.

The Panel finds that Reynolds’ unlawful actions were not merely negligent or reckless, but intentional. This is evidenced by numerous acts such as fictitious trade entries made by Reynolds into Spartan’s control/Brass system in order to make it appear as if the BPTH short position was materially smaller than the true amount. Reynolds’ explanation for these “wooden” tickets defied common sense. His further assurances that there was a “block-order” or big seller coming in late on March 6 was likewise false. These actions/representations, among others, caused both Spartan and Axos to reasonably rely to their detriment. Reynolds did not want to close out the short position on March 6 despite orders to do so by his employer. He lied to keep it open and concealed his intent from Spartan/Axos. Those two entities reasonably relied, suffering large losses, including the destruction of Spartan’s on-going business.

This is pretty strong language from the panel.  “Intentional.”  “Lied.”  “Concealed.”  And look – I am not saying the hearing panel was right or wrong; indeed, Mr. Reynolds is, to my understanding, pursuing a Motion to Vacate the Award that could eventually result in a different outcome.  But, what I AM saying is: what do you think FINRA did about this?  What action did FINRA take against the guy whom the panel concluded was “solely responsible” for the $16 million in losses that put Spartan out of business?

Nothing.  Not. A. Thing.

Well, let me be clearer, actually.  FINRA actually did take action.  But not against Mr. Reynolds.  No, rather remarkably, even though it never charged Mr. Reynolds with anything,[2] FINRA chose instead to go after his supervisor, i.e., the guy, according to the hearing panel, whose “explicit directives” to close out the short positions were ignored by Mr. Reynolds, the guy to whom Mr. Reynolds supposedly lied.  According to the AWC that FINRA exacted from the supervisor, although Mr. Reynolds had “executed a series of transactions in Spartan’s proprietary account that resulted in short positions in a biotechnology stock that exceeded the trading limits set forth in the firm’s WSPs,” his supervisor “became aware of the short positions in the biotechnology stock in the morning on March 6, 2019, but failed to modify or restrict the trader’s market access until close to the end of the trading day.”

So, according to FINRA – not me – Mr. Reynolds did, in fact, exceed his written trading limits, resulting in uncovered short sales that caused Spartan to incur a $16.6M loss, but instead of charging him for that, they charged his supervisor for not stopping it sooner.[3]


Chew on that while I shift our attention to the SEC.

In its complaint, the SEC leveled 14 separate charges against Spartan – defunct already – and three principals (one of whom, coincidentally, was – you guessed it – Mr. Reynolds’ supervisor).  The case went to trial earlier this year before a jury.  A three-week trial, at that.  And what do you think the jury did?  Well, it dismissed 13 of the 14 claims, leaving only a single finding of liability – a finding that is being challenged.  And, notably, all charges against Mr. Reynolds’ supervisor were dismissed.

So, what do you call a case where 13 of 14 claims you made are rejected by the jury?  I suppose it’s a matter of perspective.  If you’re the SEC, i.e., the plaintiff, you call it a big win!  It’s like a guy batting .125 who manages to eke out a broken-bat single and then celebrates his resounding hitting prowess.

There are lots of details here that I’ve deliberately omitted in an effort to keep this at a readable length.  But, truly, they’re not important, as they don’t change anything about the overarching observations I am making.  (For an excellent discussion of the SEC trial, please see this article by the attorney who defended it.)  FINRA, as everyone knows, will bring an Enforcement case at the drop of a hat, no matter what its senior management likes to say about how reasonable and understanding and non-adversarial they are.  Yet, here, when presented with evidence at least suggesting that Spartan’s head trader had allegedly committed a variety of acts that not only resulted in the demise of Spartan’s business but which constituted a number of heady rule violations, FINRA simply ignored the trader.

This is simply inexplicable.  Given the ticky-tack nature of many of the Enforcement actions I am called upon to defend, it is maddening that FINRA elected to take a pass here.  And again, I am not saying this because I have anything against Mr. Reynolds; I mean, kudos to him for managing to avoid FINRA’s wrath.  It’s just that I cannot fathom the decision-making process that must have taken place resulting in no action being brought against him.  I can only hope that when the SEC performs its oversight exam of FINRA that it manages to find this case and ask some hard questions to Enforcement management regarding its charging decisions.

As for the SEC, they are guilty of the exact opposite crime: they were so anxious to bring a case against Spartan and its principals that they pretty much invented a new standard by which to gauge the respondents’ conduct in order to justify their zeal.  Happily, the jury saw through this bit of trickiness, as reflected by the denial of 93% of the charges, and rejected the SEC’s argument that somehow the views of the staff, even published views, carry the same weight as actual law.

No one is perfect.  But the sort of imperfection displayed here by FINRA and the SEC is more than just annoying; it demonstrates a sense of haughtiness, of being able to do whatever the heck they want, that suggests the system is not working.  Broker-dealers, as well as the investing public, deserve a degree of consistency from the regulators in their charging decisions.  That does not exist right now, and poor Spartan understands this better than anyone.



[1] According to the guidance available at the time, all Spartan needed to file a Form 211 was a “reasonable basis” for doing so.

[2] It is notable that in support of his Motion to Vacate, Mr. Reynolds extolls the fact that FINRA took no action against him.

[3] In the interest of fairness, it should be noted that by the time this Award was issued, FINRA had already lost its jurisdiction over Mr. Reynolds.  But, it is also true that FINRA was well aware of these facts while it still had jurisdiction over Mr. Reynolds; it just decided not to bother to do anything.