Remember a few weeks ago? Remember I blogged about Robert Cook, FINRA’s new CEO?  And how he was saying all the right things about FINRA perhaps being juuuuust a bit too Enforcement oriented?  I expressed hope – sincere but wary hope – that given his remarks, it was possible that the pendulum might actually start swinging back in a more reasonable direction.  Well, I just saw FINRA’s changes to the Sanction Guidelines, and suffice it to say that my wariness was justified, by and large.

By way of background first, these modifications to the Sanction Guidelines are part of an on-going process to keep them updated. As FINRA put it in the Regulatory Notice announcing these new tweaks,

FINRA initiates periodic reviews of the Sanction Guidelines through the NAC to ensure that the Sanction Guidelines reflect recent developments in the disciplinary process, comport with changes in FINRA’s rules and accurately reflect the levels of sanctions imposed in FINRA disciplinary proceedings. The revisions discussed in this Notice are the result of FINRA’s most recent review of the Sanction Guidelines. Further review is underway of changes to make the Sanction Guidelines more effective.

Two things in there jump out at me. The first is the notion that these revisions were made, in part, to “accurately reflect the levels of sanctions imposed in FINRA disciplinary proceedings.”  That seems backwards, doesn’t it?  Shouldn’t the sanctions imposed in disciplinary proceedings comport with the Sanction Guidelines, and not the other way around?  Based on this logic, hearing panels can impose whatever sanctions they want, even if not supported by the Sanction Guidelines, safe in the knowledge that it doesn’t matter because the Guidelines will subsequently be revised to accommodate the award.  It reminds me of the old joke:  what’s the secret to being successful at golf?  Not announcing your intended target until after you hit the ball, so you can see where it’s headed.  Hey, I meant to hit the drink cart!

Second, it is sobering to understand that even “further review” is underway, to make the Guidelines “more effective.” What does that mean?  What would make the Sanction Guidelines effective is if FINRA Enforcement lawyers and hearing panels actually paid some attention to them.  In reality, that is not necessarily the case.  Because the Guidelines serve merely as the starting point to the determination of the appropriate sanction, followed by the consideration of any aggravating or mitigating evidence, the actual sanctions imposed in cases are too often way, way beyond the ranges stated in the Guidelines.  In other words, the Guidelines often provide fairly little practical guidance in terms of what to expect for sanctions.  That makes them ineffective.  Tweaking the Guidelines won’t change that.  Now, actually following the Guidelines, that would make them effective.

Ok, what changes did FINRA make?

  1. They added a new principal consideration that makes it clear that exerting “undue influence” over a customer, particularly a senior or “vulnerable” investor, will be viewed as a nasty aggravating circumstance.
  2. There is a new sanction guideline for “violations related to systemic supervisory failures and firm wide supervisory problems.” According to the Reg Notice, “the current Sanction Guidelines related to supervision violations focus on limited supervisory failures, such as those involving an individual or a small number of associated persons” so a new guideline was needed. Note: the stated range for fines under the new guideline goes up to $292,000, while the upper end of the range for an “ordinary” violation for inadequate written supervisory procedures is only $37,000. Clearly, based on the size of some of the fines that FINRA has meted out recently in supervisory cases, it must have deemed them to be systemic failures.
  3. There is also a new guideline for improper borrowing from or lending to customers, which I suppose makes sense, as (1) there was no such guideline and (2) FINRA loves to bring these cases. The recommended fine ranges as high as $73,000, and, naturally, a bar is also possible when the circumstances are aggravating enough, as is the case for nearly every rule violation. There are a couple of curious things in the principal considerations for this guideline: the “purpose” of the loan, and whether the “terms” of the loan are reasonable. I am really not sure why these facts would be even slightly important to FINRA’s determination of the appropriate sanction. I mean, loans are impermissible, period. Thus, should it matter if the registered rep borrows money to go gambling in Vegas, versus paying his mortgage? Or if interest is charged or not? FINRA’s willingness to stick its nose into the tiniest of crevices never ceases to amaze.
  4. The most interesting of the changes is a new principal consideration that requires that hearing panels and Enforcement take into consideration “the potential mitigative effect of regulator or firm-imposed sanctions and corrective action.” In other words, “[a] final action by another regulator against an individual respondent for the same conduct is a potentially mitigating circumstance.” But, it is not a simple analysis. To get credit for a prior regulatory action, a respondent must show that (1) the conduct at issue before the other regulator was essentially identical, and (2) any fine has already been fully paid, any suspension has been fully served, and any other sanction has been satisfactorily completed.

It is also possible now, theoretically, to get credit for some firm-imposed sanctions, particularly fines and suspensions. The problem is that the guidance is super vague.  You tell me what this means:  “Adjudicators should consider according some mitigative weight where these firm-imposed sanctions have already been fully satisfied by a respondent.”  “Some mitigative weight??”  I have no idea what that is intended to convey, and I am sure that what FINRA Enforcement will deem to be the proper mitigative weight will be very different than me.

Finally, the new Sanction Guidelines suggest that an individual respondent may be able to avoid a harsh sanction if he was aleady fired by his BD for his misconduct. But, again, the guidance is slippery, at best:  “With regard to a firm’s prior termination of the respondent’s employment based on the same conduct at issue in a subsequent FINRA disciplinary proceeding, Adjudicators should consider whether a respondent has demonstrated that the termination qualifies for any mitigative value, keeping in mind the goals of investor protection and maintaining high standards of business conduct.”  I suppose that this would allow a respondent to demonstrate that he’s “already learned his lesson,” so further sanctions are unnecessary.  I just cannot imagine a case where this argument would get any traction.  Especially in light of the admonition in the new principal consideration that “Adjudicators may find—even considering a firm’s prior termination of the respondent’s employment for the same misconduct at issue—that there is no guarantee of changed behavior and therefore may impose the sanction of a bar.”  That just opens the door, and opens it wide, for FINRA to make the facile argument that there’s never a guarantee, in any case, that there won’t be repeat misconduct.

To end this post on low note, here’s another example of FINRA’s utter disregard for the impact its disciplinary cases have on people (a topic I covered earlier in a post about FINRA’s disregard for the consequences when it deems a failure to update a Form U-4 in a timely manner to be willful). The last sentence of the new principal consideration reads: “FINRA has determined that how long a respondent takes to regain employment, loss of salary, and other impacts of an employment termination are merely collateral consequences of being terminated and should not be considered as mitigating by Adjudicators.”  “Collateral consequences.”  Such language.  Did United hire FINRA to write its initial public response to the doctor being dragged off the plane?  Does FINRA serve as a consultant to famous wordsmith Sean Spicer?

As a former member of FINRA Enforcement’s Litigation Department and a current practitioner in FINRA regulatory matters, I have read my fair share of decisions from the Office of Hearing Officers (OHO). I recently read the Southeast Investments/Black decision, which was issued in March. There is some good stuff in there – from an entertainment perspective. The most entertaining cases are often those that should not have gone to hearing. Below are some of my favorites.

The Jenny Craig Dieter

The principal issue in the Springsteen-Abbott case was whether Springsteen-Abbott misused investor funds by improperly allocating expenses to investment funds. One of those expenses was a $104.23 dinner at Cody’s Roadhouse. Springsteen-Abbott initially claimed the meal was for business purposes. The receipt for the dinner, however, reflects charges for “kid’s mac & cheese” and milk. When confronted with the receipt, Springsteen-Abbott “explained that she was on a Jenny Craig diet and she was eating appetizers and drinking 2% milk.” The Panel did not buy her story:

Springsteen-Abbott’s assertion that she ate the “kid’s mac & cheese” meal as part of a Jenny Craig diet plan also was not credible.

The email that Springsteen-Abbott wrote to her sister about the family dinner at Cody’s Roadhouse also adversely impacted her credibility. The Panel found other misuses of investor funds, and it barred Springsteen-Abbott.[1]

The Auto Enthusiast

One of the issues in the Southeast Investments/Black case was whether Black conducted onsite branch audits at multiple locations across the country. FINRA presented evidence that he did not do them. One of FINRA’s most compelling pieces of evidence (aside from the reps who testified that Black did not conduct the audits) was the distance between the branches and the timing of the alleged audits. For instance, Black claimed to have: (1) driven 500 miles from his home in North Carolina to Ohio to conduct an audit on October 1; (2) driven back to North Carolina to conduct another audit on October 3; and (3) driven back to Ohio for another audit on October 4. Black testified that his back-and-forth trips to Ohio made perfect sense to him:

I love to drive cars . . . . I’ve been in a car for 22 straight hours without stopping. My day will start at 2:00 in the morning and I will drive until I can’t drive anymore, pull over, and get up and drive a little more.

It presumably did not help Black’s cause that in an unrelated proceeding, the IRS likewise took issue with his stated passion for driving:

Black claimed he drove 156,669 miles in 1991 and 181,692 miles in 1992, which averages 429 and 498 miles per day, respectively. At these rates, driving 60 miles an hour, Black would have had to drive between seven and eight hours per day, seven days a week, not including time spent stopping for gas meals, or meeting clients, the IRS reasoned.

Black, however, did concede the limits to his driving abilities. He acknowledged that he did not inspect a branch in Ohio on December 9 and another one in Texas on December 10, as his records reflect. He inspected the Ohio branch on December 19, not December 9; he said his records contain a typo. Black was barred for, among other things, providing false testimony to FINRA about his supposed branch audits, so he should have plenty of time to pursue his passion. Hopefully, he has a hybrid. [2]

The Beer Thrower

It is challenging to defeat a finding of “willfulness” in the Form U4 context, as the standard is not the dictionary definition of the word. Instead, “willfulness” means intentionally committing an act, irrespective of knowing whether or not the act violates any rules or laws. In the Harris case, Harris failed to disclose on his Form U4 felony and misdemeanor charges involving allegations of stealing a parking meter, throwing beer at a police officer, possessing someone else’s driver’s license, and stealing cough medicine at a homecoming party during his college days. The Panel found that his failure to disclose the charges on his Form U4 was not “willful” because:

The [Form U4] questions required that Harris remember details of allegations made nearly six years ago. The parking meter, beer-throwing, and driver’s license incidents would not, at first blush, appear so serious as to constitute felonies. Indeed, each ended up as a misdemeanor, and none ever went to trial. He misread the misdemeanor question’s reference to “investment-related” misconduct. Finally, the Panel credits Harris’ testimony that it would have made “no sense” for him to conceal the arrests because he knew that Dean Witter had his fingerprints and assumed that the firm would likely discover his arrest record in any event.

The Well-Dressed Man

In the Casas case, the Panel found that Casas used investor funds for personal and other improper uses. Those expenses ran the gamut from groceries to dog grooming services to client entertainment in the form of a massage at 2:00 a.m. Casas, presumably, with a straight face, attempted to justify all of the expenditures, including a $364.38 purchase of a new water heater for his home. Casas explained that the water heater was a legitimate business expense because he needed it to maintain clean clothes and good hygiene:

[I]f I wasn’t able to show up to a meeting in proper attire, in proper hygiene, MCB Capital would not have been able to move that transaction forward. So the nexus, as was common knowledge is, any out-of-pocket expense that I needed in order to meet the obligations.

Not surprisingly, the Panel did not buy Casas’ rather creative explanation, and it barred him. [3]

[1] The National Adjudicatory Council (NAC) affirmed the bar. The case is on appeal to the SEC.

[2] The deadlines for the parties to appeal the Decision and the NAC to call the case for review have yet to expire.

[3] The NAC affirmed the bar. The case does not appear to have been appealed to the SEC.

There has been a lot of discussion over the past few years, including in this blog, about the growing – and troubling – trend for Chief Compliance Officers to be named as respondents in disciplinary actions.  While regulators regularly deny that they truly have it out for CCOs, as is often the case, their actions speak louder than their words.  Today, the threat of a CCO becoming a respondent is real and undeniable.  I thought I would use a recent FINRA Enforcement action to make this point clear.

In September 2011, Southridge Investment Group, LLC, a broker-dealer, withdrew its membership from FINRA. For a two-year period leading up to that withdrawal, Thaddeus North was the firm’s CCO.  Generally speaking, when a BD files a BDW, FINRA calls off its dogs…at least as far as the firm itself is concerned.  For the defunct firm’s principals, however, it is quite another story, as FINRA will absolutely, positively continue to pursue those individuals, whether they move to another firm or whether they leave the securities industry altogether.  Mr. North learned that lesson firsthand and the hard way.

While FINRA took no action against Southridge, FINRA did file an Enforcement action against Mr. North alleging a bunch of rule violations, including a couple that, in my view, would have been more appropriately targeted against Southridge, except for the unfortunate fact that the firm was not still in business. Specifically, FINRA alleged that Mr. North – as CCO, remember, not as CEO, not as owner[1] – failed to establish a reasonable supervisory system for the review of electronic correspondence, and failed to report that one of the firm’s registered representatives had a relationship with an individual who was statutorily disqualified.  The hearing panel found Mr. North personally liable for both of these violations – shocking, yes, I know – and, on appeal, the NAC concurred.[2]

Let’s start with the supervisory violation. Generally speaking, there are two broad categories of supervisory cases:  either the procedures themselves are inadequate, or there is a failure actually to supervise.  (Sometimes, a case can involve both.)  The case against Mr. North involved the former.  We all acknowledge that under NASD Rule 3010(a), every broker-dealer must “establish and maintain” a supervisory system that is reasonably designed to achieve compliance with applicable securities laws and FINRA rules, and, under NASD Rule 3010(d), firms must also establish written supervisory procedures to effectuate the supervisory system.  Clearly, these are both responsibilities of the firm.

Given that, it is typically the broker-dealer that gets named when the problem is with the supervisory procedures. Now, I am not saying there aren’t exceptions to this, as there are such cases with individual respondents.  (Indeed, as I’ve blogged about before, FINRA does routinely threaten to name individuals as respondents as part of its efforts to exact settlements from firms, and sometimes it follows through on those threats.)  But, from a strictly logical standpoint, the broker-dealer is the appropriate respondent: it is a firm responsibility to come up with a reasonable system and set of procedures.  Here, however, the hearing panel and the NAC both hung their respective hats on the fact that in Southridge’s 2008 written supervisory procedures, the firm’s “compliance officer” was designated as the person responsible for maintaining the procedures, “and the 2010 written supervisory procedures designated Mr. North, by title and name, as the person responsible for reviewing and maintaining the procedures.  The 2010 procedures also provided that the CCO was responsible for ensuring that Southridge had appropriate policies and procedures concerning electronic communication.”

My problem is that every firm’s WSPs designate someone as the person responsible for the “maintenance” of the WSPs, whatever “maintenance” means, but most of the time, FINRA is content only to go after the firm for inadequate procedures.  Here, it seems that the driving force behind FINRA’s decision to pursue Mr. North individually was simply the fact that Southridge was dead, and safe from Enforcement action.  I simply hate it when FINRA, or any regulator, acts inconsistently (and, therefore, unpredictably).  Two sets of identical facts should yield the same result.  But, that is clearly not the case when dealing with FINRA, which is wildly inconsistent and wildly unpredictable.  And that, to put it directly, is just not fair.

Regarding the latter violation, NASD Rule 3070(a)(9), effective through June 30, 2011, required a member firm to report to FINRA whenever it, or one of its associated persons, was “associated in any business or financial activity with any person who is subject to a ‘statutory disqualification’ … and the member knows or should have known of the association.” In the pertinent written supervisory procedures, Mr. North was delegated the responsibility for Southridge’s compliance with its Rule 3070 reporting requirements.  Accordingly, FINRA concluded that Mr. North was personally responsible for the firm’s failure to have made a timely report of its registered representative’s association with an SD’d individual.  But, again, in many, if not most, instances, violations of this sort are deemed to be firm violations, not individual violations.  Here, because Southridge had already withdrawn, FINRA had no firm on which to focus its Enforcement wrath, leaving only poor Mr. North.

The lesson here is not just for CCOs, but any principal at a firm that no longer exists: you need to understand that it’s not just possible that you will be named individually, but it’s much more likely than if the firm was still around and available as a respondent.  Not saying this is right or fair; it’s just an acknowledgement of the fact that FINRA wants its pound of flesh, and if the firm cannot supply it, then it will look to individuals who can.

 

[1] In the interest of full disclosure, it appears that Mr. North was registered as a principal and sales supervisor.  But, it is noteworthy that it is his role as CCO that is highlighted by FINRA in the decision to find him personally liable.

 

[2] It is also worth noting that FINRA brought an action against the firm’s CEO, too.  He submitted an Offer of Settlement, which FINRA accepted.

A common complaint that I hear from broker-dealers and investment advisors is that it is nearly impossible anymore to obtain informal guidance from their regulators. Where it was once possible, even normal, to make a call and get casual advice how to comply with a particularly tricky rule, nowadays, regulators routinely decline to respond to such requests.  Moreover, even if you are lucky enough to find some examiner willing to go out on a limb and offer his or her opinion on something, the law is frighteningly clear that reliance on that advice provides absolutely zero protection from subsequent regulatory action.  In other words, one relies on informal guidance at one’s own peril.

Given this unfortunate fact, my advice to clients who are hell-bent on asking permission rather than forgiveness is to seek formal guidance. From FINRA, that would be an Interpretive Letter[1]; from the SEC, that would be a no-action letter.  The problem with this approach is obvious, however: you don’t always get the answer you were hoping for.  And, you are showing your hand to your regulator, thereby inviting their scrutiny anyway.

But, sometimes, it works the way you hope, and you get an answer, and it’s actually helpful. That happened recently when an investment advisor asked the SEC for a no-action letter regarding the custody rule, a deceptively simple rule that can get advisor into trouble, even when they think they’re doing the right thing.  When an advisor has actual custody of client funds or securities, several things have to happen.  The client assets have to be held securely, of course, it must be disclosed on Form ADV, and you have to subject the client assets to a surprise exam by a public accountant.  If you mess up any one of these elements, you’re in violation.  Intent is not required, so it’s basically a strict liability situation.

This gets further complicated by the fact that what constitutes custody is not always obvious. Specifically, in addition to actually holding funds or securities, an advisor is deemed to have custody if it “has any authority to obtain possession of [client funds or securities], in connection with advisory services [it] provide[s] to clients.”  Given that rule, the advisor in question here asked the SEC to agree that if the sole authority granted to the advisor was to instruct the third-party custodian of the client assets to transfer those assets in accordance with the client’s express direction, this would not constitute “custody” under the rule.

Interestingly, the SEC would not agree, and it concluded that this is, in fact, custody. But, at least in this instance, the SEC both tooketh and gaveth.  While it said this was custody, it also stated that if an advisor jumps through each of several specific hoops, it would not recommend that any enforcement action be taken, even absent a surprise audit.  The hoops are as follows:

  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a custodian to which the transfer should be directed.
  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3. The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

This may seem overly simplistic, but it is difficult to complain too loudly when a regulator supplies a detailed blueprint for compliance. The lesson is clear: as long as you’re willing to risk not getting the answer you want, seeking formal guidance can be the best way to steer clear of regulatory quicksand.

[1] To be clear, and remarkably enough, according to FINRA, it isn’t even safe to rely on an Interpretive Letter.  FINRA’s website states, “All interpretive positions are staff position, unless otherwise indicated. Staff-issued interpretive letters express staff views and opinions only and are not binding on FINRA and its Board; any representation to the contrary is expressly disclaimed.”  I mean, what’s the point if the supposedly “official” advice isn’t binding?

We have written before about senior investors, but I saw a couple of things in the last couple of weeks that suggests this subject needs to be revisited.

First, back in February, the SEC got around to passing FINRA’s proposed rules to protect senior investors, including both new Rule 2165 and amendments to existing Rule 4512.  The upshot is that broker-dealers will be required to make reasonable efforts to obtain from customers the name and contact information of a “Trusted Contact Person,” who, as the name suggests, may be contacted by the broker-dealer to discuss a customer’s account under circumstances that suggest there may be health issues, or if there are suspicions the customer has been the victim of financial exploitation.  In addition, if BD develops a reasonable belief that a senior investor may be the subject of financial exploitation, the BD may place a temporary hold on the disbursement of funds or securities from the senior’s account.  This becomes effective in February 2018.

I thought these were good ideas when they were initially proposed a few years ago, and I still do. Contrary to many commentators, I feel the existing suitability rule is sufficient to cover recommendations made to any customer, including a senior citizen.  Thus, I will not concede that there need to be special rules governing recommendations to seniors.  Seniors have all the protection they need already, given that to be suitable under existing Rule 2111, a recommendation necessarily must take into consideration things like the customer’s income, investment objective, risk tolerance, time horizon, liquidity needs, i.e., the very characteristics that supposedly make seniors special.  In other words, seniors aren’t special when it comes to suitability, as the analysis that must be employed is the exact same.

What I like about the new rules, however, is that while they nominally exist to protect customers, in fact, they are really designed to protect broker-dealers. Now, if a BD develops some suspicion that the lucidity of one of its aging customers is becoming questionable, it reaches out to family members at its own peril of violating a privacy policy, or worse.  Similarly, the idea that today a BD can safely ignore an order from a customer to liquidate a position and wire out the proceeds due to concerns about the customer’s mental health is dubious, at best, given the risk of triggering a complaint for not following a clear order.  The new rules address these situations, providing a safe harbor within which BDs can operate without fear of drawing regulatory attention.  (Even under the new rules, however, there is nothing to prevent a customer from lodging a complaint, or filing an arbitration, if a sell order is not timely executed, so the safety of this harbor extends only to regulator matters.)  I am all for the clear delineation of any safe harbor, no matter how shallow it may ultimately turn out to be.

The second thing I read was a study published by the AARP called “Investment Fraud Vulnerability Study.”  It was designed to try and determine “who and why investors fall prey” to investment scams, or, in other words, to “identify differences between known investment fraud victims and the general investor population.”  The results are pretty interesting.

First, investment scam victims “reported valuing wealth accumulation as a measure of success in life, being open to sales pitches, being willing to take risks, preferring unregulated investments and describing themselves as ideologically conservative.” So, here’s the first weird part:  these customers like risk, they like taking chances on what the Study called “emerging investment opportunities that no has heard about yet,” even knowing, based on ordinary risk/reward considerations, there’s a likelihood they will lose their money.  Indeed, 48% of investment scam victims agreed with the statement that “[t]he most profitable financial returns are often found in investments that are not regulated by the government,” versus only 30% of general investors.  The victims are not naïve grannies, they are dice-rolling, anti-Government Trump supporters, apparently, who are betting they know better.  It makes me wonder why, therefore, that regulators probably spend 75% of their time focusing on protecting these investors from these investments that are somewhat removed from the mainstream.

Second, the victims were targeted by phone calls and emails with investment pitches to a much greater degree than the general investing public. That’s no coincidence, it seems, as the victims also reported that they were three times more likely – four times when it comes to phone calls – to respond positively to such pitches.  If only legitimate BDs had access to such effective lead sheets as the fraudsters apparently have, selling stocks would be a breeze!

Finally, victims skewed toward being male, married and over 70, with a substantial percentage being veterans. Not sure what to make of this, but perhaps it falls somewhere in the same psychological category as men being willing to drive 20 miles in the wrong direction rather than admitting we are lost, or to stop for directions.  It’s also why not every victim complains – sometimes, they just know they messed up, and are willing to accept the consequences.  Of course, that is until some sweet-talking claimants’ counsel convinces them it wasn’t their fault at all!

 

 

 

On Friday evening, March 10, 2017, the Department of Labor (DOL) issued a field assistance bulletin establishing a new temporary enforcement policy for the DOL Fiduciary Rule set to become effective on April 10, 2017. (See here) The temporary policy was designed to deal with industry uncertainty created by a new rule proposed for comment by the DOL on March 2, 2017 in response to a Presidential Memorandum to the Secretary of Labor, dated February 3, 2017 (discussed on Ulmer’s BD Law Corner blog, here). That memorandum directed the DOL to examine whether the Fiduciary Rule might adversely affect “the ability of Americans to gain access to retirement information and financial advice” among other things. The President’s directive can only be accomplished by issuing a new rule because the Fiduciary Rule has already become final.

The DOL’s newly proposed rule is subject to a 60-day comment period under applicable law, making it iffy whether the DOL will be able to digest comments and issue a final rule potentially delaying the effective date of the Fiduciary Rule before its current effective date of April 10. Needless to say, this uncertainty created market disruption, with some financial services firms proposing to communicate to investor and IRA clients that they would only become a “fiduciary” when and if the Fiduciary Rule became applicable. Based on industry comments, the DOL “determined that temporary enforcement relief is appropriate to protect against investor confusion and related marketplace disruptions” while this all plays out. To that end, the temporary enforcement policy also gives firms additional time to implement policies required by the Fiduciary Rule after the DOL finalizes the new rule.

Critically, Friday’s bulletin emphasizes that any implementation of the Fiduciary Rule by the DOL “will be marked by an emphasis on assisting (rather than citing violations and imposing penalties on)” institutions and persons who are “acting in good faith” to implement the Fiduciary Rule. For the sake of the affected financial services firms and individuals, we certainly hope this is true, although past regulator performance might suggest a different outcome.

 

In my second post on constitutionally-based affirmative defenses to SEC administrative proceedings, I discussed the shift of momentum in favor of the defense that the process of hiring SEC ALJs violates the Appointments Clause of the U.S. Constitution. This post examines the defense that the process of removing SEC ALJs violates the separation of power doctrine in the Constitution.

The U.S. Constitution, art. II, § 1, cl. 1, provides that “[t]he executive Power shall be vested in a President of the United States of America.” Article II, § 3, states the President “shall take Care that the Laws be faithfully executed ….”  The Constitution requires that a President elected by the People oversee the execution of the laws of the United States.  The Constitution nowhere addresses the power to remove, but it is derived from the power of appointment.  The President’s power to remove Heads of Departments such as the SEC Commissioners ensures that laws are executed in accordance with the President’s policies.  Even though Heads of Departments cannot be removed except for cause, this limitation was held constitutional because the President directly decides if cause exists for removal. Humphrey’s Executor v. United States, 295 U.S. 602 (1935).

Unlike SEC Commissioners appointed by and accountable to the President, SEC ALJs are hired by the Chief SEC ALJ and the Office of Administrative Law Judges (“OALJ”) from a register maintained by the Office of Personnel Management (“OPM”). SEC ALJs receive a career appointment without an initial period of probation and their salaries are set by statute.  They cannot be removed at-will by the President or even by the SEC.  They can only be removed “for cause” after a hearing before the Merit Systems Protection Board (“MSPB”).

The separation/removal defense asserts that the ALJs’ multiple-layer protections against removal violates the separation of power doctrine by placing impermissible limitations on the President’s power to see that the securities laws are faithfully executed. These protections are an aggrandizement of the Legislature, which authorized the delegation of adjudicating violations of the securities laws to the SEC ALJs, at the expense of the President’s Executive power.  Multiple layers of tenure insulate ALJs from direct Presidential control.  An ALJ cannot be removed by the SEC except for cause and the President cannot remove a Commissioner except for inefficiency, neglect of duty, or malfeasance in office.  The Commissioners are accountable, therefore, only for their decision to determine whether good cause to remove the ALJ exists.  The President can no longer hold the Commission fully accountable.

In Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), the Supreme Court held that the creation by the Sarbanes-Oxley Act of 2002 (“SOX”) of a Board within the SEC to oversee accounting firms contravened the separation of power doctrine by conferring executive power on Board members without subjecting them to Presidential control.  Board members could be removed only for good cause by the Commission and the Commissioners could be removed by the President only for good cause.  Chief Judge Roberts wrote, this “second level of tenure protection changes the President’s review.  …  The President … cannot hold the Commission fully accountable for the Board’s conduct, to the same extent that he may hold the Commission accountable for everything else that it does.  …  That arrangement is contrary to Article II’s vesting of the executive power in the President.” Id. at 496.

Respondents in SEC administrative proceedings recognized Free Enterprise’s potential application to the multiple-layers of an SEC ALJ’s tenure and asserted the separation/removal defense in answers to administrative complaints.  The ALJs ruled they do not have authority to decide the issue.  The SEC ruled the defense lacks merit. In re Timbervest, 2015 WL 5472520 (SEC Sept. 17, 2015).  But, history shows that ALJs may be used willingly or unwillingly by the agency to which they are assigned to further a particular political agenda or policy of enforcement—exactly the responsibility the Constitution assigns to the President.  For instance, “a former SEC ALJ stated that she was pressured to rule in favor of the SEC and that Chief Judge Murray questioned her loyalty to the SEC because the former ALJ found in favor of defendants too often.  The former ALJ also alleged that the SEC instructed her to work under the presumption that defendants were guilty until proven innocent.” Timbervest v. SEC, 2015 WL 7587428, at *4 (Aug. 4, 2015).  This is not an isolated occurrence.  A similar brouhaha was widely reported in connection with CFTC ALJs when shortly before he retired one ALJ publicly accused another ALJ of having promised that he would never find in favor of customers.  “Notice and Order” (Sept. 17, 2010)  The Wall Street Journal then published an article accusing the retiring ALJ of mental unfitness and heavy drinking.  Lynch, “Case Sheds Light on Judge” WSJ (Oct. 21, 2010)

Rejection of the separation/removal defense by the SEC was countered by the defense bar filing collateral suits in federal court to enjoin SEC administrative proceedings, alleging that the multi-level protection of ALJs violated the doctrine of separation of power. Most collateral cases were dismissed for lack of jurisdiction without reaching the merits of this defense.  Those courts that held there was jurisdiction ruled favorably on the Appointments Clause defense—not the separation/removal defense.  The petition for certiorari pending in Tilton v. SEC, 824 F.3d 276, 298 (2d Cir. 2016), pet. for cert. filed 2017 WL 281861 (Jan. 18, 2017), raises only the jurisdictional issue and the Appointment Clause defense.  Similarly, none of the cases pending before the D.C. and Tenth Circuits presents the removal/separation of powers defense.  Accordingly, it is fair to say that there is no binding decision anywhere in favor of or against the merits of the separation/removal defense and no court is expected to rule on the issue soon.

Despite the futility of receiving a real hearing on the separation/removal defense at the SEC, respondents should continue asserting the defense in administrative hearings to set up a direct challenge of an SEC final order to the Court of Appeals on this issue. Respondents should be emboldened by the upswing of support for the Appointments Clause defense because the first hurdle to overcome on the separation/removal defense is to establish that SEC ALJs are “inferior officers.”  But, respondents must then argue that Free Enterprise’s separation of power holding applies to SEC ALJs.  Arguably, Free Enterprise is distinguishable in at least two significant respects: First, the accounting oversight Board had more authority than do ALJs.  Not only were the Board’s decisions not reviewable by the SEC, but the Board could initiate investigations unlike ALJs.  Second, ALJs have been around at many federal agencies since the 1940s when the Administrative Procedures Act became law; whereas, the Board was a recent creation of SOX in 2002 whose constitutionality had never been tested.  Even Judge May, who took the lead in finding that the Appointments Clause defense was likely to succeed on the merits, Hill v. SEC, 114 F. Supp. 3d 1297 (N.D. Ga. 2015), expressed doubts whether the separation/removal defense would be successful. In re Timbervest, 2015 WL 7597428, at *11 n.10 (N.D. Ga. Aug. 4, 2015).  These differences do not really negate the serious constitutional infirmity presented by multiple layers of tenure that troubled the Supreme Court in Free Enterprise, however.  They relate more to whether SEC ALJs are “inferior officers” than to whether the ALJs are directly controlled by the President or vulnerable to improper agency interference.  Accordingly, respondents should not lose heart.  The success of the separation/removal success is still very much an open issue.

In my fourth post, I will examine the defenses of whether the SEC’s “unguided discretion” under Dodd-Frank to file a case before an ALJ rather than in federal district court violates the Fifth Amendment equal protection and due process, and/or the Seventh Amendment right to a jury trial.

 

Last week, I published a post about the benefits of “lawyering up” when dealing with FINRA, particularly to handle the defense of an OTR.  Here, my partner Michael Gross, who, like me, is a former FINRA Enforcement attorney, offers his advice about how properly to prepare for an OTR.  While this post is helpful, it clearly underscores that the only way to prepare adequately is to engage competent counsel.  And, speaking of that, a friend sent me a comment regarding my post from last week that bears a brief discussion here:  It is not simply a matter of getting a lawyer.  In addition, it is important, especially as a registered rep who is provided counsel by his or her broker-dealer, to appreciate exactly who the lawyer is representing.  An in-house attorney for the BD, if the firm is big enough to have an in-house Legal Department, generally considers the BD to be the client, not necessarily the registered rep.  And sometimes, this distinction matters.  For instance, if a customer arbitration settles for more than $15K, that disclosure will appear on a rep’s Form U-4 forever; thus, many reps only want to settle if a deal can be pulled off for less than $15K.  But, if both the BD and the rep are named as respondents, the firm may want to settle — even if it means the firm paying the entirety of the settlement amount, even if that amount is in excess of $15K — notwithstanding the fact that the rep is dead set against that settlement (because the size of the settlement would result in a mark on Form U-4).  If, in that situation, the rep’s counsel is the BD’s counsel, as well, the rep may need to consider getting separate counsel.  Some BDs will pay for such, to avoid putting their attorney in a conflict situation, but, even if the firm isn’t so generous, the rep needs to carefully consider whether it pays to get truly independent counsel.  – Alan

 

A Classic Example

During a rep’s OTR, he truthfully testifies that he does not recall being aware of certain facts. (It is not uncommon for FINRA to investigate events years after they have transpired, or not to notify a rep of the subjects to be covered during the OTR.) FINRA becomes particularly perturbed by the testimony because it expected the rep to have been aware of those facts. FINRA then aggressively pursues a disciplinary action. Only after the complaint has been filed does the rep come to appreciate the magnitude of his situation. He finally conducts a thorough search for relevant records, and finds documents that show he must have known about those important facts.  Situations like this (or worse) can potentially be avoided through thorough OTR preparation.

The Presumptive Purposes of an OTR

FINRA, like attorneys who take depositions, presumably takes OTRs for a few basic reasons: to find out what it does not know, to confirm what it does know, to test its factual and legal theories, and to lock the witness’s story down.[1] As FINRA tells its deponents at the outset of an OTR, it wants to obtain information to determine what, if any, violations may have occurred.

It is important to know that FINRA likely will take your OTR testimony to be something from which you cannot easily walk away. If emboldened enough by events surrounding your inaccurate testimony, such as an email that directly contradicts your testimony, FINRA may seek to bar you for not providing truthful testimony.  If you are the target of an inquiry, you would be well advised to prepare for your OTR. Even if you are not the target of an inquiry, you likewise would be well advised to prepare for your OTR so you do not say something to make you the target of that inquiry or another one (yes, this happens).

How to Prepare for an OTR

Preparation begins with understanding the “who,” “what,” “where,” “when,” “why,” and “how” of the topics to be covered during your OTR. Simply put, you need to try to figure out what questions FINRA will ask you — FINRA certainly won’t tell you in advance — and how you will answer them (within, of course, the bounds of honesty and candor). There is no shortcut to doing this. You may need to review emails, notes, calendar entries, account documents, account activity, etc. to best answer questions. You may even want to speak with others about their recollection of events, although this can be dicey at times.

You also should have a solid understanding of the FINRA rules and securities laws at issue so that you have the same appreciation for your answers that FINRA will have. This entails reviewing the relevant rules, laws, Regulatory Notices, etc. It is quite common for FINRA to ask a deponent about his understanding of what the rules and laws require. If you do not appreciate what the rules and laws require of you, FINRA likely will not appreciate your answer.

Preparation also includes understanding the written and unwritten rules of OTRs. It is nerve-racking enough to testify with a room full of people staring at you (and FINRA typically rolls at least three deep at OTRs) and a court reporter taking down your every word; it is even more nerve-racking to do that when you do not understand the rules of engagement. You should know: what to expect; what will be expected of you; which questions are fair; which questions are unfair; how to deal with unfair questions; what, if any, objections you can make; how much or how little detail to provide in response to a question; and how to create a record that will best benefit you.

It certainly may feel good, at least momentarily, to politely or otherwise tell the FINRA staffers who are half your age that they do not know what they are doing, that you have significantly more industry experience and knowledge, or that FINRA would not have missed the Madoff and Stanford scandals if it did not waste time on matters like yours. It, however, is best to bite your tongue, kiss the ring, and remember that you are trying to convince those FINRA staffers that you are an upstanding member of the industry, not incite them to burn midnight oil to prove otherwise.

Lastly, preparation includes knowing when not to sit for an OTR. As the famous Kenny Rogers song goes: “You’ve got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.” The worst thing that FINRA can do to you may not be to bar you from the securities industry; it may be to share your sworn OTR testimony with government agencies that can do a lot more than that to you. Some OTRs have been terminated when counsel realized that FINRA was the least of the client’s problems. Other OTRs have never been taken because counsel decided it was more prudent for her client to accept a bar and show the judge meting out criminal sanctions that her client has accepted responsibility for the misconduct by, in effect, surrendering his securities licenses. Other times, it may be in your best interest to try to settle a matter without subjecting yourself to the seemingly boundless scope of questions that can be asked during an OTR. You, of course, cannot make this determination if you are not properly prepared for your OTR.

 

[1] As noted above, unlike civil litigation where a complaint has been filed, and everyone is generally aware of the events at issue, FINRA will take an OTR without providing a full or complete picture of the topics to be covered. This, however, is the subject for another post.

Here is a piece from Chris Seps, who has a bit of a reputation around here for being angry.  Judge for yourself.  But, for what it’s worth, I do want to say that I have had the pleasure of being involved in several cases in which the subject of this post, Dr. Craig McCann, appeared on behalf of the opposite party.  While I generally disagree with his opinions, Dr. McCann is a gentleman, and has been nothing but courteous and respectful to me.  I guess he’s just misguided.  – Alan

 

Craig McCann, who testifies regularly (but not exclusively) for claimants in FINRA customer arbitrations, must not be as busy as he would like. A few days ago, he published a report from the “Securities Litigation & Consulting Group” – i.e., Dr. McCann’s own company – regarding the number of Puerto Rico securities arbitrations filed and settled since the Puerto Rico bond market collapse in 2013.  His report includes some interesting statistics, but then goes off the rails with a self-serving conclusion: that more Puerto Rico arbitrations should go to hearing rather than settle.

But before we get into the erroneous assumptions baked into his conclusion, let’s look at the stats he provided. First, Dr. McCann reports that at least 1,874 Puerto Rico securities arbitrations have been filed with FINRA since the bond crash of 2013.  That’s not really big news.  Every time a particular market sector crashes, whether it is PR bonds or the ARS market or whatever, hundreds of claimants’ attorneys chum the waters with advertising and convince investors that somebody should be made to pay for their losses. That’s the American way.

In Puerto Rico, it was no different. In fact, it was even easier for claimants’ attorneys this time around because you could literally stand in San Juan and throw a rock in any direction and hit someone who was invested in Puerto Rico bonds and closed end mutual funds.  Why?  Taxes.  Puerto Rico’s unique set of tax laws allow residents of the island to invest in Puerto Rico securities with little or no income tax burden.  The result is that the yields on such bonds – which were all investment grade or close to it – were much higher for residents than taxable bonds.

Moreover, unlike Americans, for whom the 2017 federal estate tax exemption is now up to $5.49 million/person, relatively speaking, Puerto Rico’s exemption is a mere fraction of that. But, estate taxes are not payable on any Puerto Rico securities in the estate.  As a result, most investors, especially very wealthy investors looking to avoid a big estate tax hit, focus heavily on Puerto Rico securities, even while disregarding the risks of failing to diversify.

The McCann report then states that of those 1,874 cases filed, 742 have settled while only 30 have been tried at a final hearing (1,083 are still pending). In other words, the report says 96% of the Puerto Rico arbitrations that have been resolved have been settled rather than tried.  The report notes that this is a much higher percentage than the nationwide arbitration figures, where only 73% of cases settle.  The other half of the story is that in those 30 Puerto Rico arbitrations that went to hearing, customers were victorious a surprisingly high amount of the time – 83% of the time (in 25 cases) – whereas nationally, customers are only victorious 40% of the time.  The report concludes: “The much lower proportion of Puerto Rico cases which go to a hearing than the mainland cases and the fact that customers are winning in Puerto Rico at twice the national average strongly suggests too many cases are settling in Puerto Rico rather than going to a hearing.”

Besides being self-serving – if he convinces more customers to go to hearing rather than settling, then Dr. McCann gets to bill more fees for his expert services – these statistics and conclusion are rather misleading.

What the report fails to say is the reason why so many Puerto Rico arbitrations settle: they usually are of dubious merit and often include bloated damages claims. Claimants’ counsel often tout their high track record of success at trial, and for good reason – they only take cases all the way to trial (rather than settle them) if they are strong.  But, the strength of a case has nothing to do with whether it gets filed in the first place.  Claimants’ attorneys file cases all the time without much thought to the merits as long as they can tell a good story in the Statement of Claim.  And that part is easy in FINRA arbitrations, since the filing fees are only a few hundred dollars and there is no codified obligation only to file a case in good faith (as there is in court, i.e., Rule 11).

The result is that Statements of Claim spin the “facts” as aggressively as possible, and often include irrelevant but horrible stories, sometimes about other broker-dealers who aren’t even named as respondents. Months after the claim is filed, when claimants’ counsel get around to a serious evaluation of the facts, one of two things happens.  First, they might discover their case has great facts, that they have a high likelihood of success at hearing, and there is a big loss involved.  If the potential payoff is great, they may put in the time and effort to take it to a hearing.  It is little surprise, then, that the Puerto Rico cases that actually go to hearing achieve such success because they are the cases with the best facts for claimants and largest losses.

On the other hand, and this is the scenario that plays out more often than not with these Puerto Rico cases, claimant’s counsel realizes how bad the facts are for his client, decides that there is little chance of success at a hearing, and so settles cheaply. In other words, once claimant’s counsel realizes that his client received a 50-page presentation from the broker analyzing his portfolio and recommending diversification (which claimant rejected), and that the client signed documents stating that all he wanted was tax free income and nothing else, claimant’s counsel is usually smart enough to realize they won’t fare well at a hearing.  So, they settle.

How do we know this is true? Look at the damages numbers in the report.  Dr. McCann reports that the 742 cases settled for $162,484,574 in total, or $218,981 per case.  The 25 customers who received a favorable award at a hearing won $64,206,348 in total, or $2,568,253 per case.  Dr. McCann simply compares these two numbers and concludes that more cases should be tried because successful claimants receive so much more, on average, than claimants who settle.

The simple fact is, whether you are looking at Puerto Rico specifically, or across the board in all jurisdictions, from the claimant’s perspective, the cases that don’t go to hearing are the ones that, based on their merits, shouldn’t go to hearing (or, in some cases, even be filed in the first place). And when the case has no merit, claimants’ counsel settles it.  The side effect is that Dr. McCann doesn’t get to show up at more hearings.  And that isn’t necessarily good for Dr. McCann.

I realize that the title of this blog post may sound self-serving, so I apologize for that up front, as it is not my intent.  Still, there is a lesson here to be learned.

I got a phone call yesterday from a reporter asking me to comment on a disciplinary action that FINRA had just announced.  According to the reporter, FINRA permanently barred Thomas James Stewart, a former registered rep, for using his firm’s parking garage validation stamp without authorization 50 times over the course of a four-month period, saving him a whopping $731 in parking fees he would otherwise have had to pay.  The question posed to me was, what was my reaction to someone getting barred for stealing, essentially, $731 from his firm, and whether I thought that was too harsh of a sanction, given the underlying misconduct.

Well, clever lawyer that I am, before answering, I asked some questions of my own. Most importantly, I learned that this was a settled case – Mr. Stewart signed an AWC – not a litigated case.  I also learned that Mr. Stewart was apparently not represented by counsel.  (AWCs are signed by the respondent and the respondent’s attorney, and this AWC had no signature block for an attorney, which suggests that Mr. Stewart was unrepresented here.)  As a result, I told the reporter that the case could not be viewed as evidence of some new “zero-tolerance” policy by FINRA, since the sanctions were the result of a negotiation, not an adjudication.

After I hung up, however, I began to think about the case, and it struck me that the real issue was not the magnitude of the sanction compared to the severity of the misconduct; rather, it was the fact that FINRA was likely only able to secure this seemingly harsh result as a consequence of the fact that Mr. Stewart was not represented by counsel. I seriously question whether any competent, experienced broker-dealer defense lawyer would have ever agreed to take a bar for such a modest amount of pilferage.  But, FINRA doesn’t care about that.  Of course FINRA will acknowledge a respondent’s right to an attorney, but, when no attorney appears, you can bet that FINRA will not hesitate in the slightest to take full advantage of that.

This attitude manifests itself in other areas. For instance, when FINRA sends out an 8210 “request” to take someone’s sworn testimony – an OTR – the boilerplate includes the recital that it is ok to bring your attorney.  But, not every witness feels the need to bring counsel, or can afford to even if they want to do so.  When that happens, FINRA’s glee is palpable.  It means that no one is going to pose those pesky objections to the oftentimes poorly phrased questions, no one is going to keep the interviewers from delving into subject matters that may have no reasonable relationship to the exam, and no one is going to ensure that privileged communications are not disclosed, among other things.  I am not kidding when I say I have seen transcripts of OTRs where FINRA has run roughshod over witnesses not accompanied by counsel.  Having an attorney present won’t necessarily change the outcome of an exam, but, having an attorney does keep FINRA honest.  As I am fond of saying, you can’t “win” an OTR, but you sure as heck can lose one, and having counsel present helps prevent that.

FINRA also takes advantage of counsel’s absence when it interviews customers. Now, remember, FINRA has no power to compel a customer to answer any questions, and must rely on customers agreeing voluntarily to participate in an interview.  But, as I believe I’ve lamented before, FINRA doesn’t do a particularly good job of letting customers know that they are free to ignore requests for an interview.  More to the point of this post, however, FINRA certainly says or does nothing to let a customer witness know that not only can they blow off the interviewer, but, if they deign to cooperate, they may elect to bring their counsel into the conversation.  What this means is that in probably 99% of customer interviews, including interviews that culminate in the preparation of a Declaration or an Affidavit from the customer that FINRA will utilize in connection with the prosecution of an Enforcement action, no lawyer for the customer is involved.  The result is that FINRA can basically bake into these documents whatever language it wants, language that, had it been reviewed by counsel, may very well have been phrased rather differently.

Look, I don’t know why Mr. Stewart agreed to take a bar for improperly using $731 worth of parking garage validations.  According to the AWC, he is already out of the securities industry.  Maybe he was simply happy being out,[1] and had no intent of ever returning.  If that was the case, then it was easy enough for him to take the bar; it got FINRA off his back and cost him nothing in terms of a monetary sanction.  But, it is also possible that he just didn’t know that a bar for this offense was out of line.  We will never know his true motivation, but his case serves as a lesson for every registered rep (and some customers, as well): when FINRA comes calling and “requests” something from you, you would be well served to consider enlisting the assistance of a lawyer immediately.  Like they (almost) used to say on TV, you can pay me now, or pay FINRA later.

[1] Isn’t it funny how we use that phrase, “out of the industry” like it’s being “out of jail?”  Clearly, there are lots of registered reps and broker-dealers still subject to FINRA’s jurisdiction who would argue that it’s a very apt comparison.  I have known former registered reps who literally count down the days until they finally reach two years from the date of their resignation, just waiting to celebrate the moment when FINRA can no longer assert jurisdiction over them.