Here is Part II of Ken Berg’s analysis of constitutional defenses that have been raised in response to the SEC’s increased use of administrative proceedings.  In the interest of full disclosure, note that the Malouf case referenced towards the end is one that Heidi VonderHeide and I are handling.  In addition, it also worth mentioning that in another appeal of an adverse SEC decision that Heidi and I presently have before the DC Circuit, the Division of Enforcement advised us on Friday that the Commission plans to file a motion requesting that the Court hold briefing in abeyance pending resolution of the Lucia case, and asking whether we would agree to it.  Clearly, the SEC is hardly presuming a positive outcome from the rehearing of the Lucia case, scheduled for May.   – Alan

In last week’s installment, I discussed how the expansion of the SEC’s authority to obtain civil monetary penalties in Dodd-Frank emboldened the SEC to vastly increase the number of cases filed with SEC Administrative Law Judges instead of federal district court. In response, the defense bar asserted constitutional defenses to the administrative proceedings and filed collateral attacks in federal district court.  Though the Courts of Appeals have shut the door on collateral attacks for now, and the SEC has rejected all constitutionally-based affirmative defenses, respondents must continue to assert them in the administrative proceedings in order to preserve the issues for consideration on appeal of the SEC’s final order.  In this post, I will examine the objection that the manner of hiring the SEC ALJs violates the Appointments Clause of Article II of the US Constitution and update the current state of the law as to this defense.

Though the SEC has repeatedly rejected this defense on the merits, and a panel of the D.C. Circuit affirmed the SEC, support for this defense is gaining momentum.  A split panel of the Tenth Circuit held that the SEC ALJs are unconstitutionally appointed and the D.C. Circuit has granted a request for an en banc re-hearing.

The US Constitution, art. II, § 2, cl. 2, states: The President “shall nominate, and by and with the Advice and Consent of the Senate, shall appoint … Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”  The SEC concedes that when the Chairman acts together with the other four Commissioners, he or she is an Article II “Head of Department.”  Heads of Departments can and do appoint “inferior officers” to interpret policy and implement laws of the United States.  The issue is whether SEC ALJs function as “inferior officers” or just “employees” of the SEC?

To become an ALJ, an attorney must complete a four-hour written examination and submit to an oral exam before a panel made up of a member of the American Bar Association, a current federal ALJ, and a person from the federal Office of Personnel Management (“OPM”). OPM maintains a registry of qualified ALJ candidates.  At the SEC, there is a Chief ALJ and four other SEC ALJs.  The Chief ALJ heads the SEC’s Office of Administrative Law Judges (“OALJ”).  The OALJ selects a candidate on the OPM registry with input from the Chief SEC ALJ, the Department of Human Resources, and the OPM.  Section 78d-1(a) of the Exchange Act of 1934 gives the SEC authority to delegate to an ALJ or an employee any of its functions including “hearing, determining, ordering, certifying, reporting, or otherwise acting as to any work ….”

SEC ALJs are not appointed by the Chairman; they are hired by the OALJ from OPM. The SEC has ruled repeatedly that SEC ALJs are “employees” who do not have to be appointed.  As to other agencies, the Supreme Court has distinguished “employees” from “inferior officers” by whether the individual exercises “significant authority pursuant to the laws of the United States.” Buckley v. Valeo, 424 U.S. 1 (1976).  The Supreme Court has found Federal Election Commissioners and Special Trial Judges for the IRS are “inferior officers” who need to be appointed by a Head of Department.

In August 2016, the SEC’s position was affirmed by a three-judge panel of the D.C. Circuit in Raymond J. Lucia Companies, Inc., 832 F.3d 277 (D.C. Cir. 2016).  The judges reasoned that SEC ALJs are “employees” because the SEC has the right to review their decisions and no ALJ decision becomes final without the SEC issuing a finality order even if not appealed.  Unlike the IRS’ review of Special Trial Judges’ decisions, the SEC’s review is de novo.

But, in late December 2016, in a 2-1 decision, a panel of the Tenth Circuit expressly disagreed with the decision in Lucia.  In Bandimere v. SEC, 844 F.3d 1168 (10th Cir. 2016), the majority held that SEC ALJs are “inferior officers,” reasoning the SEC ALJ’s lack of final decision-making authority was relevant but not determinative.  Since the SEC ALJs “exercise a great deal of discretion and perform important functions,” the majority concluded they are “inferior officers.” Just because the SEC supervises the ALJs through review of their decisions does not mean they are “employees.”  The majority also noted that there is no statutory language or legislative history expressly making ALJs “employees” for purposes of the Appointments Clause.  The SEC has been given to March 13, 2017, to petition for an en banc re-hearing before the entire Tenth Circuit.  Such petitions are granted only when there is an issue of “exceptional importance.”

The Appointments Clause issue was been presented to the US Supreme Court in a petition for a writ of certiorari filed on January 18, 2017, in Tilton v. SEC, 824 F.3d 276 (2d Cir. 2016), cert. filed, 2017 WL 281861.

In another case pending before the Tenth Circuit, the court provisionally granted petitioner’s motion to file a supplemental brief on whether Bandimere requires that an SEC final order be set aside even though the Appointments Clause defense had not been asserted before the ALJ or SEC. Malouf v. SEC, Docket No. 16-9546 (10th Cir.).  Briefing is scheduled to be completed by March 20, 2017.

In the Lucia case, on February 16, 2017, the D.C. Circuit vacated the panel’s decision affirming the SEC and granted a petition for re-hearing en banc. Oral argument is set for May 24, 2017.

The momentum is clearly with the defense bar on the merits of the Appointments Clause issue, the first constitutionally-based affirmative defense to make it out of the SEC administrative morass.  This provides incentive to keep asserting the other constitutionally-based defenses in administrative proceedings.  In my next post, I will discuss constitutional objections to SEC ALJs arising from the civil service protections that insulate them from direct removal by the President and update the current state of the law as to this defense.

This is the first in a series of posts by my partner, Ken Berg, discussing the constitutional defenses to SEC administrative enforcement actions, which we are called upon regularly to defend. Each subsequent post will discuss one of the constitutional issues and report the current state of the law as to that defense.  Ken’s next post will examine the Article II Appointments Clause issue and update the current state of the law as to this defense. – Alan

As has been well reported, both in this blog and elsewhere, after Dodd-Frank expanded the SEC’s authority by giving it discretion to obtain civil monetary penalties against non-registrants in administrative proceedings, the SEC embraced its new powers by vastly increasing the number of cases filed before ALJs. For FY2015, 80% of all cases were filed before ALJs compared to less than 50% for FY2005.  (J. Eaglesham, “SEC Wins with In-House Judges,” WSJ, 5/6/15.)  For FY2015, 419/502 settled cases were filed before ALJs compared to only 216/434 for FY 2007.  (U. Velihonja, “SEC Settlements in the Shadows” 126 Yale L.J. Forum 124, 9/7/16.)  Filing before an ALJ statistically disadvantages respondents.  From October 2010 to March 2015, the SEC prevailed in over 90% of administrative cases (WSJ 5/6/15), while winning only 69% of the time in federal court.  (J. Eaglesham, “SEC Trims Use of In-House Judges,” WSJ, 10/11/15)

The defense bar reacted to this change in two ways:  First, various affirmative defenses based on constitutional rights were asserted in the administrative proceedings.  Second, collateral actions were filed in federal district court to enjoin the administrative proceedings.  The constitutional objections raised include: i) the manner in which SEC ALJs are appointed and removed violates the non-delegation doctrine in Article I and the Appointments Clause in Article II; ii) the SEC’s “unguided discretion” to prosecute before an ALJ or a district judge violates the Fifth Amendment rights to equal protection and procedural due process; and iii) the absence of a jury violates the Seventh Amendment.

Not surprisingly, at the SEC, these constitution-based affirmative defenses have not gotten any traction.  The ALJs decided they lacked authority to rule on them.  To no one’s surprise, the SEC on review has never held that any of these constitutional defenses has merit.  One might think it is futile, therefore, to continue asserting these constitutional defenses in an answer to an administrative complaint.  But, hold on ….

In contrast, the defense bar achieved some impressive initial successes in federal district courts. In Gupta v. SEC, 796 F. Supp. 503 (S.D.N.Y. 2015), District Judge Rakoff denied the SEC’s motion to dismiss a collateral attack complaint.  The facts of Gupta are somewhat unique, however, because the SEC filed an administrative action only against Gupta after having filed nearly identical complaints for insider trading against 28 other alleged violators in federal court.  Gupta argued that by treating him differently, the SEC violated his Fifth Amendment right to equal protection.

In Hill v. SEC, 114 F. Supp. 3d 1297 (N.D. Ga. 2015), rev’d 825 F.3d 1236 (11th Cir. 2016), District Judge May found that a registrant had a “substantial likelihood of success on the merits” that SEC’s hiring practices of ALJs violates the Article II Appointments Clause.  Though as explained below, the Second and Eleventh Circuits have held that District Courts lack jurisdiction to decide these issues, this does not diminish the significance of the fact that these District Judges ruled favorably on the merits of these constitutionally-based defenses in well-reasoned opinions.

The SEC seems to have taken notice of these criticisms by the courts and modified its course somewhat. Between July and September 2015, the SEC filed only four out of 36 contested cases to its ALJs. (WSJ 10/11/15)  For FY2015, it sent only 28% of its contested cases to ALJs compared to 43% for the previous 12 months.  (Id.)

Unfortunately, for now, the Courts of Appeals have shut the door to the federal courthouse. Five Circuit Courts of Appeals have held that District Courts do not have jurisdiction to enjoin SEC administrative proceedings, finding that Congress intended these constitutional issues first be decided by the ALJ and SEC.  Even though appellate review of an SEC final order comes years later after respondents have incurred substantial defense costs, the Courts of Appeals hold that this provides “meaningful judicial review.”  As one dissenting judge notes, however, by that time respondents “will already have suffered the injury they are attempting to prevent ….” Tilton v. SEC, 824 F.3d 276, 298 (2d Cir. 2016) (Droney, J., dissenting).  This issue is included in a petition for a writ of certiorari to the US Supreme Court in the Tilton case filed on January 1, 2017.  The petition argues, “an error is an error, whether it is made once or repeatedly.”  2017 WL 281861, at *20.

Despite the SEC’s certain rejection of constitutionally-based affirmative defenses, respondents must keep asserting them in their answers to administrative complaints to preserve the issue for appeal. If the constitutional affirmative defense is not asserted before the SEC, the court of appeals may refuse to hear the issue on appeal.  The one defense that has already made its way to court on direct appeal, the Appointments Clause issue, has been gaining momentum in the federal courts.  See Bandimere v. SEC.  On Feburary 16, 2017, the D.C. Circuit granted a petition for rehearing en banc to reconsider the panel’s decision affirming the SEC in Raymond J. Lucia Companies, Inc.

 

Let’s chalk this one up to “great minds think alike,” or maybe just “minds think alike.” You may recall that in his recent letter to member firms that accompanied FINRA’s 2017 Exam Priorities Letter, FINRA CEO Robert Cook said, “starting this year, we will publish a summary report that outlines key findings from examinations in selected areas.” Cool idea, right?  Well, last week, the SEC’s Office of Compliance Inspections and Examinations, or OCIE, beat FINRA to the punch and released a Risk Alert called “The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers.” If you’re an SEC-registered IA, or, like me, someone who represent IAs, it is a must-read.  Now, I am not necessarily saying that anything it contains is particularly eye-opening, but it does provide a tidy roadmap to those things on which your compliance efforts should be focused, even if those things are, arguably, pretty obvious.

Compliance Rule. The Compliance Rule – Rule 206(4)-7 under the Investment Advisers Act of 1940 – basically provides that adviser must (1) have written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules that the SEC has adopted under the Act; (2) review, no less frequently than annually, the adequacy of those policies and procedures; and (3) designate a CCO responsible for administering the compliance policies and procedures.[1]  What OCIE has found (over the course of over 1,000 exams of IAs over the last two years) are these common deficiencies:

  • Compliance manuals are not reasonably tailored to the adviser’s business practices. This is not just a common problem, but an old one. It can be more than just embarrassing to present an examiner with an “off-the-shelf” compliance manual that contains sections that have no relation to the firm’s actual business, or, worse, doesn’t contain sections that are pertinent.
  • Annual reviews are not performed or do not address the adequacy of the adviser’s policies and procedures. Like some BDs, it seems that some advisers simply don’t conduct annual reviews of their compliance policies and procedures, as required by the Compliance Rule. Others do the reviews, but they are insufficiently introspective, and fail to address the adequacy of the advisers’ policies and procedures and the effectiveness of their implementation. Finally, if a review reveals a problem, that cannot be ignored. Steps – demonstrable, memorialized steps – must be taken to address or correct the problem.
  • Adviser does not follow compliance policies and procedures. What good is having a robust policy if it is ignored? Indeed, arguably, it is worse than not having a policy at all.
  • Compliance manuals are not current. As noted in the first bullet point, it is sloppy to continue to maintain a compliance manual that contains outdated information or policies, such as “investment strategies that were no longer pursued or personnel no longer associated with the adviser and stale information about the firm.”

Regulatory filings. OCIE focused principally on Form ADV filings here, although it also mentioned Form PF and Form D.  Essentially, the advice boils down to this nugget of wisdom:  make sure that your filings are (1) timely, (2) accurate, and (3) complete.  Ooh, why didn’t I think of that?

Custody Rule. The Custody Rule – Advisers Act Rule 206(4)-2 – covers advisors who have custody of clients’ cash or securities.  Unfortunately, it is pretty much a strict liability situation if it is determined that an adviser had custody and failed to jump through the Rule’s hoops.  The common problems that advisers have with the Custody Rule are as follows:

  • There are situations where advisers did not recognize that they may have custody. OCIE identified a few situations where an advisor is deemed to have custody, but the advisor failed to realize it.
    • If a client provides an adviser online access to client accounts using the client’s personal usernames and passwords, including the ability to withdraw funds and securities from the client accounts;
    • If an adviser (or a related person) has powers of attorney authorizing him to withdraw client cash and securities; and
    • If an adviser (or a related person) serves as trustee of clients’ trusts or general partners of client PIVs.
  • Faulty surprise exams. A requirement under the Custody Rule is that an independent public accountant perform a surprise exam. According to OCIE, however, some of these exams have not exactly been a surprise (e.g., exams were conducted at the same time each year). Also, some advisers failed to provide the auditor with a complete list of accounts over which the adviser had custody or other information necessary for the exam to be conducted timely.

Code of Ethics Rule. Advisors are required to have a Code of Ethics.  Advisers Act Rule 204A-1.  OCIE identified these common issues regarding the Code of Ethics requirement:

  • Access persons not identified. Access persons (e.g., certain employees, partners or directors) must periodically report their personal securities transactions and holdings to the CCO, and obtain pre-approval before investing in an IPO or private placement. Some advisers did not identify all of their access persons. In addition, some access persons submitted transactions and holdings less frequently than required by the Rule.
  • Codes of ethics missing required information. Some advisers’ Codes of Ethics did not specify review of the holdings and transactions reports, or identify the specific submission timeframes.
  • Form ADV omissions. Certain advisers did not describe their Codes of Ethics in Part 2A of their Forms ADV and did not articulate that their Codes of Ethics were available to any client or prospective client upon request.

Books and Records Rule. The Books and Records Rule – Advisers Act Rule 204-2 – is the last common problem area.  And the problems are exactly what you would expect to hear:  (1) incomplete records, (2) inaccurate records, (3) records not updated in a timely manner, and (4) internally inconsistent records.

 

[1] These sound very much like a BD’s requirements under FINRA’s supervision rule, Conduct Rule 3110.

Here is a fascinating analysis by my partner, Michael Gross, of FINRA’s twisted logic when it comes to sanctions:  your very decision not to admit liability and to put FINRA to its proof can, and will, be held against you when it comes time to determine the appropriate sanctions. Or will it?  –  Alan

The FINRA Sanction Guidelines, which are designed to ensure the imposition of fair and consistent sanctions, provide, among other things, that in determining what and how much sanctions to mete out, adjudicators should consider whether a respondent has acknowledged and accepted responsibility for his or her misconduct. On its face, this appears to be the ultimate Catch-22: How can I be exonerated if I admit that my actions are improper? Needless to say, this does not seem to be fair.

Held against Respondent

In the Anthony A. Grey case from 2015, FINRA charged Mr. Grey with, among other things, charging excessive mark-ups on municipal bonds. Mr. Grey fought the charges at the OHO, NAC, and SEC levels, arguing to each tribunal that his mark-ups were appropriate, and not excessive. He even presented expert testimony in support of his position. His arguments ultimately were rejected, and his mark-ups were found to be excessive by each tribunal. In the sanctions section of its Opinion, the SEC noted that Mr. Grey had not acknowledged that his misconduct violated the securities laws, and issued the following seemingly inconsistent statements:

We reject Grey’s argument that FINRA punished him for defending himself in a disciplinary action. The acceptance or acknowledgment of misconduct is a principal consideration in tailoring appropriate sanctions to deter future misconduct.

The SEC then cited another case where sanctions were adjusted upward for the same reason. By all appearances, Mr. Grey was punished for defending his mark-ups, and for not acknowledging that his mark-ups were improper. Of course, if Mr. Grey had admitted his mark-ups were excessive, he would not have mounted much, if any, of a defense. Hence, the Catch-22.

Not Held against Respondent

In the J.W. Korth & Company case, just decided a couple of weeks ago, FINRA similarly charged the respondent firm with charging excessive mark-ups on corporate bonds.[1] The firm, like Mr. Grey did in his case, argued its mark-ups were appropriate, and not excessive. As with Mr. Grey, the OHO Hearing Panel found the mark-ups to be excessive. The Panel, however, did not punish the firm for defending itself (despite FINRA’s argument that it should have done so), unlike Mr. Grey’s Hearing Panel:

While we agree that it is aggravating when a respondent refuses to accept responsibility for its misconduct, we do not find that J.W. Korth’s actions should be so characterized. J.W. Korth launched a vigorous defense and contested the allegations against it.

The Decision then explained how the firm presented evidence of the factors that it considered in making its pricing determinations and the supervision of its pricing practices.

Reconciliation?

While you try to wrap your head around the seemingly unfair notion that a respondent can be punished for defending himself, and the seemingly inconsistent results in these two cases, you should know that the J.W. Korth Decision contains a dozen citations to the Decisions and Opinion issued in Grey. This issue, however, may not be as unfair as it appears, and the two differing results may not be as inconsistent as they appear. Two factors may determine whether or not a tribunal will punish you for defending your actions: the nature of your misconduct and the manner in which you defend your actions.

Mr. Grey charged excessive mark-ups in connection with what was determined to be a fraudulent interpositioning scheme. J.W. Korth’s excessive mark-ups did not involve a fraudulent scheme. It is possible that the nature of the misconduct in the cases is what resulted in the differing interpretations of acceptance of responsibility. By way of a more extreme example in the context of a criminal case, it seems appropriate to punish more severely the thief caught red-handed stealing money who denies his obvious culpability than the same thief who acknowledges his guilt. In sum, there is a difference between defending actions that arguably may or may not be improper, and actions that clearly are improper.

It also is possible that the manner in which Mr. Grey and J.W. Korth defended their actions played a role in the decisions (although I cannot attest to that in either case). As the saying goes, you can catch more flies with honey than with vinegar. There is a difference between respectfully disagreeing with someone’s position, and impolitely doing so. The latter is rarely, if ever, successful in litigation – or life.

 

[1] Since the Decision was issued on January 26, 2017, the deadlines for the parties to appeal it and the NAC to call the case for review have yet to expire.

I read an article this week bemoaning the fact that “rogue brokers” – a term that is commonly used but steadfastly undefined – apparently remain rampant in the securities industry. Anyone that has read FINRA’s 2017 Exam Priorities Letter knows that this is one of the issues on which FINRA intends to focus its regulatory attention this year (although FINRA tactfully calls them “high-risk and recidivist brokers”).  Indeed, it was the very first issue described in the letter, as FINRA articulated its three-pronged attack to address it:

  • The recent creation of “a dedicated examination unit to identify and examine brokers who may pose a high risk to investors.” This unit “will rigorously review these brokers’ interactions with customers,” focusing on suitability, OBAs, PSTs, commissions and fees.
  • A promise to review firms’ “supervisory procedures for hiring or retaining statutorily disqualified and recidivist brokers.” To that end, FINRA will evaluate how well BDs are meeting the requirement in Conduct Rule 3110(e), announced in Reg Notice 15-05 (which I blogged about here), within 30 days after a U-4 is filed to “verify the accuracy and completeness of the information” in the U-4 by, “at a minimum,” conducting “a search of reasonably available public records.”
  • The continued evaluation of firms’ branch office inspection programs and supervisory systems for branch and non-branch office locations.

I don’t have an issue with any of these initiatives (although I would certainly quibble with the notion of characterizing them as “initiatives,” as that suggests they are something new; FINRA (or NASD) have supposedly focused on these same sorts of things before). They are sensible, and no one could reasonably argue that paying particular attention to reps who have already demonstrated a proclivity for misconduct is time ill spent.  But, what does bother me is this notion that somehow, all of this happened in some clandestine manner, hidden from FINRA which, like Captain Renault in Casablanca, is now shocked – shocked – to learn that there are registered reps out there with multiple disclosures on their U-4s.  The simple fact is that FINRA has always known it, but has never bothered to do anything about it.

Indulge me for a second as I travel back in time: I joined NASD in 1993 as an attorney in its Enforcement Department, after having spent ten years in private practice defending BDs.  When I first got there, I had fun looking up my former clients on CRD, and it became abundantly clear that some of them had quite the regulatory history.  Yet, there they were, still registered, still selling and earning.  Nothing changed a few years later when I became the Director of NASD’s Atlanta office.  Every examiner in my office District knew exactly the firms that had reputations for hiring reps with “dings” on their records, but there was nothing to be done about it, apart from conducting very thorough exams.

Over the years, FINRA has attempted every once in a while to pass some rule designed to reduce recidivism, but has never gotten very far. Remember this golden oldie from 2003, when FINRA proposed a rule that would require heightened supervision on reps with more than a specified number of customer complaints, etc.?  Well, it died on the vine.  But the point is, 14 years ago, NASD was abundantly aware of the fact that there were reps out there with “long regulatory record[s], . . . a history of customer complaints, disciplinary actions involving customer harm, or adverse arbitrations,” and that such reps presented “higher risk[s]” to investors. For FINRA now to suggest that this is a new problem, or that the industry is somehow at fault, or that FINRA itself is powerless to address it, is just wrong.

Look, I am not advocating that FINRA create a rule that makes firms unable to hire individuals with disclosures on their U-4s. Many of my clients over the years made stupid mistakes that resulted in some disciplinary action, but they learned from their errors and are now solid, productive reps providing quality advice to their investor clients, and representing no risks to anyone.  I mean, the core philosophy behind FINRA’s Enforcement process is that it is remedial, not punitive.  Barring people with “dings” from working in the industry would be senseless overkill and clearly punitive.  So, unless and until FINRA passes a rule against hiring a “recidivist” with some real teeth in it – which doesn’t look like it will ever happen – it should stop pointing fingers at its member firms, and consider that it has no one to blame for this situation but itself.

Here are some important observations from my partner, Fran Goins, on two missives President Trump issued on Friday that you should know about.  My own politics have made themselves pretty clear in recent posts, so it’s good to have someone comment on these presidential pronouncements without the snarkiness I would have undoubtedly injected, wittingly or otherwise.  – Alan

On February 3, 2017, President Trump signed a memorandum addressed to the Secretary of Labor directing that the Conflict of Interest Rule Retirement Investment Advice, 81 Fed. Reg. 20946 (April 8, 2016) (the “DOL Fiduciary Rule” or “Fiduciary Rule”) be examined “to determine whether it may adversely affect the ability of Americans to gain access to retirement information and financial advice.”  (See full text here.)  Acting Labor Secretary Ed Hugler promptly issued a statement indicating that the DOL would “consider its legal options to delay the applicability” of the Fiduciary Rule, currently set to take effect on April 10, 2017.  

Contrary to initial reports based on an earlier draft, the President’s memorandum itself did not delay implementation of the Fiduciary Rule for 180 days – or at all – possibly since such action would likely have been open to challenge as a violation of the Administrative Procedure Act, although it will likely have that impact.  The memorandum instructs that if the DOL affirmatively determines that the Fiduciary Rule in its present form “is likely to harm investors,” “has resulted in dislocations or disruptions within the retirement services industry that may adversely affect investors or retirees,” or “is likely to cause an increase in litigation” or the prices of retirement services, the Secretary is to “publish for notice and comment a proposed rule rescinding or revising the [Fiduciary] Rule.”  Interestingly, the memorandum does not explicitly instruct the DOL to seek a  delay in the applicability of the Fiduciary Rule, although White House National Economic Council Director Gary Cohn told the Wall Street Journal that, “We think it is a bad rule. It is a bad rule for consumers.” 

An open question remains as to what the DOL will determine about the issues it is instructed to examine (all of which were exhaustively reviewed in some form or other in connection with the determination leading to adoption of the Rule in its current form), although it seems likely that any examination now would arrive at affirmative findings on the issues presented in the memorandum.  Meanwhile, consumer groups have threatened legal action to preserve the Fiduciary Rule in its present form.  The message for financial institutions that were gearing up to comply with the Fiduciary Rule is far from clear, but a conservative approach would seem to dictate that such efforts continue, at least until there is more certainty with respect to the DOL’s direction.

Also on Friday, the President issued an executive order setting out his “Core Principles” on financial regulation.  (See full text here.)  The order instructs the Secretary of the Treasury to consult with the Financial Stability Oversight Council and report back within 120 days and periodically thereafter on the “extent to which existing laws, treaties, regulations, guidance, reporting and recordkeeping requirements, and other Government policies promote the Core Principles” with particular attention to such policies that “inhibit Federal regulation of the United States financial system in a manner consistent with the Core Principles.”  The Core Principles favor independence in financial investing, economic growth, prevention of taxpayer-funded bailouts, competition, preservation of American interests in international financial negotiations, and restoration of public accountability.  Ironically, many of these are the same principles the Dodd-Frank Act aimed to strengthen.

While widely touted as the first step to repealing the Dodd-Frank Act, the wording of this executive order is so ambiguous that it is difficult to fathom how it will be implemented or what effect the first report in 120 days (assuming no extensions) may have on the financial regulatory system.  While the order will likely stymie any further rule-making under the Act for the time being, financial institutions would be reckless to assume that any existing regulation would not be enforced while this plays out.

 

 

Back in December, the State of Massachusetts filed a Complaint against LPL and one of its big producers alleging that the producer, Roger Zullo, defrauded his clients and lied to his supervisors in connection with the sale of variable annuities.  What struck me when I read the Complaint, and what has still stuck with me, is the sheer number of alleged supervisory mistakes that LPL made.  Now, granted, it has been reported, and accurately so, that the State of Massachusetts has had LPL squarely in its regulatory crosshairs for several years, resulting in the payment by LPL of millions of dollars in fines relating to its sales of nontraded REITs.  But, assuming these current allegations are true, it certainly seems like LPL has not done nearly enough to get out of the regulatory doghouse.  A review of LPL’s purported failures and mistakes serves as a helpful reminder of what it takes to establish that one’s supervision is, in fact, “reasonable” enough to satisfy regulators.

  1. To conduct its suitability review of an annuity purchase, LPL relied solely on its advisors voluntarily to supply information about other annuities that the customer already owned. Zullo, apparently, declined to provide such information, thus hindering LPL’s ability to determine suitability. Clearly, LPL could have avoided this if it required the customer to disclose the existence of other annuities.
  2. Zullo fabricated certain suitability information, particularly customers’ ages and net worth, on annuity applications. One might ask, how LPL was to have known this? I mean, ordinarily, when a customer completes a new account form, the broker-dealer is not required to verify the accuracy of any of that information, including relatively easily verified things like net worth and income. So, given that, how did this become LPL’s problem? The answer is that LPL possessed prior account applications that also disclosed the customers’ birth dates and net worth data, and a simple comparison of the information on the new application with the existing customer profile information would have readily revealed the discrepancies. In short, it does not seem to be much of a stretch to insist that a broker-dealer actually pay attention to information it possesses about its customers.
  3. Even when LPL did notice a big jump in one customer’s net worth – from $1 million to $4 million – as disclosed in the annuity application vs. prior account documentation, it failed to push Zullo for a reasoned explanation. Indeed, all Zullo did in response to the inquiry was claim the existence of some supposed Vanguard account worth $2.4 million, but he was not asked to supply any documentation or explain why that account was not reflected on the prior documents.
  4. When the customer filed a complaint with Zullo, Zullo failed to report it immediately to LPL, in contravention of LPL policy. LPL learned of the complaint only when FINRA – which got a call to its Senior Hotline! – informed LPL. But, after learning of the complaint, LPL (1) did not contact the complaining customer, (2) did not look at its records for the complaining customer (which would have revealed the discrepancy in the age and net worth on the annuity application), (3) did not request any documentation from Zullo, and (4) did not review Zullo’s emails with the customer, or his client notes. Instead, all LPL did was ask Zullo to justify the recommendation he had made to the customer (which LPL allegedly then adopted “wholesale” and denied the complaint). I don’t think it’s necessary for me even to say anything about what LPL could have done differently.
  5. LPL failed to notice serial purchases by Zullo’s customers of the same annuity in relatively short timeframes. On questioning, the supervisors acknowledged that had they seen this, or recalled it, it would have constituted a red flag. Unfortunately, LPL’s system did not permit the supervisors to see the prior purchases. That is not a helpful system.
  6. Putting aside the questionable documentation and explanations that Zullo provided to justify his recommendations on a customer-by-customer basis, it was fairly obvious, on a macro level, that Zullo basically sold the same product to practically all of his annuity customers. Given the many potential differences between any two customers’ particular suitability profiles, that a single product was somehow appropriate for 98% of Zullo’s customers seems rather dubious.
  7. Finally, and perhaps most potentially damning, LPL failed to take seriously concerns raised by Zullo’s direct supervisor about Zullo’s annuity sales. The supervisor noted Zullo’s “cookie cutter” approach, that most customers were incurring a surrender charge, and recommended that the issue be “escalated.” Instead, the supervisor’s concerns were largely swept under the rug.

Remember, these are just unproven allegations, and I presume that LPL is innocent. But, whatever the ultimate outcome, this Complaint amply demonstrates how certain facts, especially when viewed in the aggregate, make it easy for regulators to conclude that a firm is putting its desire for revenue before its need for compliance.  It doesn’t matter who is President, who he appoints to the SEC, or that the FINRA CEO is saying the right things: such behavior will never be countenanced.

Since the presidential election, heck, since the campaign, my friends and family will readily attest that my new favorite word is “gaslighting.” According to Wikipedia, it is “is a form of manipulation that seeks to sow seeds of doubt in a targeted individual or group, hoping to make the target question their own memory, perception, and sanity.”[1]  Google it, and you will see just how frequently it is being discussed these days.  How else to account for situations where facts that are plain and obvious – for instance, the difference in the number of people standing on the National Mall in front of the Capital Building watching two presidential inaugurations as revealed in two different pictures taken from the same vantage point at the same time of day – are not just denied, but staunchly denied, to the point where you start to question your own five senses.

Bruce Kelly of the Investment News – someone I know and trust – reported this week on remarks that Robert Cook, FINRA’s CEO, gave at a conference hosted by the Financial Services Institute, a trade group comprised of independent financial services firms and financial advisors. According to the article:

  • Mr. Cook said, “What I’m hearing though is also a sense that some feel that FINRA has been a little bit of a tin-ear over the years, not listening very well, and that’s something I hope to change.”
  • When asked whether FINRA has engaged in “rulemaking by enforcement,” Mr. Cook apparently said “that he had heard that comment speaking to firms and he found that to be ‘troubling,’” adding, “I just philosophically think that we shouldn’t be rulemaking by enforcement. One of the areas of interest to me is to think about FINRA’s enforcement program. I want to take a fresh look at it, and to ask ourselves what is the process by which we create an enforcement action. What kind of steps we go through and how do we think about that.”
  • “Mr. Cook struck an accommodating tone, stressing that FINRA was both a membership organization and regulator.”

Admittedly, I was not present at the conference, and neither FINRA nor the FSI has published anything regarding the dialogue on which Investment News reported. But, as I said, I know the author of the article, and am confident that he reported it accurately.  So, the question is, do I believe my eyes when I read these things, things which, based on my 35+ years of experience, sound more like science fiction than words being attributed to the head of FINRA?

To be honest, the jury is still out on that, as only time will tell. But, I do know that, at a minimum, Mr. Cook is consistent: he made some fairly similar remarks at the SIFMA Compliance conference in January, which are published on the FINRA website.  While speaking of FINRA’s transparency, he mentioned FINRA’s “unique regulatory model,” and noted that “FINRA operates under a variety of rules and limitations created by Congress, the SEC and our own organizational documents that are designed to make us both a membership organization and a credible regulator.”  For years, I have been espousing the same concept, i.e., that FINRA is not just an Enforcement entity, but, more importantly, a membership organization, designed to represent the interests of those member firms.

Sadly, in recent years, FINRA has lost sight of that fact, and has been working contrary to the interests of its members, or at least with seeming disinterest in what its members say they want and need from their primary regulator. Instead, it has been driven by other concerns, perhaps principal among which is simply avoiding looking like it is doing an ineffective job at fulfilling its statutory mandate of protecting investors and the integrity of the markets.

Anyway, the problem with the fact that Mr. Cook has been consistent is that it still doesn’t necessarily mean that he truly intends to change a thing. One of the hallmarks of gaslighting is the repetition – the more you state a lie, the more legit it starts to sound.  Eventually, the lie begins to sound true even if merely for the fact that after a while, it loses any sense of audacity.

I found an article on gaslighting by Psychology Today on the internet.  According to that author, “when dealing with a person or entity that gaslights, look at what they are doing rather than what they are saying.  What they are saying means nothing.  It is just talk.  What they are doing is the issue.”  That is the approach I intend to take with FINRA (as well as the president).  I sincerely hope that Mr. Cook means what he has been saying.  Historically, however, as I have pointed out over the years, there has been a large disconnect between, on the one hand, the warm-and-fuzzy comments that FINRA management make at industry meetings and, on the other hand, the attitudes demonstrated by the FINRA examiners and attorneys who continue to pound my clients with incessant 8210 requests and threatened and actual Enforcement actions.  I hope that FINRA’s actions will demonstrate that Mr. Cook isn’t “just talk.”

[1] The term comes from an old movie called “Gaslight,” in which the husband tries to convince his wife that she is crazy by, among other things, flatly denying that the gaslights in their apartment were flickering, even though it was very clear that they were.

In the blog I posted yesterday, I discussed a late Xmas present that the 10th Circuit gave everyone who is subject to the SEC’s jurisdiction.  Today, let’s talk about FINRA’s New Year’s gift to its member firms: the annual Regulatory and Examination Priorities Letter, which was released this week.  As is typically the case with these letters, there is nothing particularly surprising about the topics that FINRA says it intends to focus its exams on; indeed, many are repeats, not just from last year, but from the last century (e.g., adequate supervision of branch offices, review of outside business activities, suitability).  In his cover letter to the first Exam Priorities Letter to be issued under his stewardship, new(ish) FINRA President Robert Cook flatly admits that “[m]ost of the topics addressed in this year’s letter have been highlighted in prior years.”  So, with that said, let’s review, briefly, what FINRA says is on its mind, and its exam radar screen.

But, first, let me comment on something that’s not in the Letter, and that’s any mention – whatsoever – about the so-called “culture of compliance” that was the star of last year’s letter.  I don’t know about you, but I was more than a bit troubled by FINRA’s stated intent to measure something that I, for one, don’t believe is particularly susceptible to objective measurement.  FINRA could not even define what it meant by culture of compliance; rather, it simply provided a list of things it expected to see at broker-dealers that maintain a good culture of compliance.

During the course of 2016, FINRA started mentioning “culture” in some Enforcement actions it brought (and which I blogged about), but, even then, the standard to which the respondent firms were being held was never really articulated.  It was more like Justice Potter Stewart’s famous quote regarding obscene material – “I know it when I see it” – or, more accurately, from an Enforcement perspective, “I know when I don’t see it.”  The problem for firms, of course, became how does one comply with a standard that isn’t really capable of being defined.

Perhaps Mr. Cook has recognized that, and perhaps that is the reason that the 2017 Letter omits any references to culture of compliance. I am hardly suggesting that FINRA no longer cares about culture of compliance; to the contrary, I believe that FINRA still expects firms to demonstrate the sorts of controls and procedures and attitudes previously identified by FINRA as the indicia of a culture of compliance.  But, sensibly, maybe FINRA will be focusing more on examining the various parts that, when viewed in the aggregate, comprise a culture of compliance, rather than the unmeasurable sum of those parts.

Now, what was in the Letter worth mentioning:

  • Starting this year, FINRA will initiate “electronic, off-site reviews to supplement [its] traditional on-site cycle examinations.” A “select group” of firms not scheduled for a cycle exam in 2017 will receive “targeted and limited information requests,” the responses to which will be analyzed off-site. FINRA supplied no clue who the lucky recipients of these reviews might be, or the anticipated subjects of the reviews.
  • “Rogue Reps” are back in style (although FINRA doesn’t use that phrase, it calls them “high-risk and recidivist brokers”). First, FINRA will work to “identify” and “rigorously review these brokers’ interactions with customers.” Second, FINRA will reviews firms’ “supervisory procedures for hiring and retaining” recidivist brokers. Third, FINRA will look at firms’ branch inspection programs and supervisory systems for branch and non-branch locations. This, of course, has been on the regulators’ radar screen since the 1990s.[1]
  • FINRA has senioritis. That is, FINRA is extremely interested in anything having to do with sales to seniors, particularly when those sales involve “speculative or complex products in search of yield.” (As an aside, FINRA just loves touting how many calls its Helpline for seniors gets! Indeed, it has even trademarked the acronym: HELPSTM.)
  • Suitability. Nothing new here, except, perhaps, a special shout-out for “excess concentration in customers’ accounts.” Undoubtedly, that has to be a result of the hundreds of arbitrations filed in Puerto Rico based on allegations of accounts being overly concentrated in Puerto Rico securities.)
  • FINRA is concerned about short-term trading in products that it considers to be long-term, e.g., mutual funds, variable annuities and UITs. To that end, FINRA is already engaged in a sweep, of sorts, regarding UIT rollovers, and those exams will continue.
  • The Supplementary Material to FINRA Rule 3270, the Outside Business Activity rule, requires that firms undertake a review of proposed outside business activities to consider whether the OBA will “(1) interfere with or otherwise compromise the registered person’s responsibilities to the member and/or the member’s customers or (2) be viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.” The Letter states that FINRA will be evaluating firm procedures governing this undertaking, so be sure that you are actually conducting these OBA reviews and, equally important, documenting them.
  • Various specific “risks” will be evaluated, namely “liquidity risk” – to ensure that firms have sufficient funding; “financial risk management” – interestingly, FINRA says it wants to “assess these practices to understand whether the approach appears reasonable in light of the risks to the firm’s business, not with an expectation of a ‘right way’ or ‘wrong way’ to deal with the scenario”; cybersecurity risks – FINRA wants to assess firms’ “programs to mitigate those risks,” particularly in branch offices; and AML risks – particular areas being scrutinized include automated trading and money movement surveillance, foreign currency transactions, and accounts held by nominee companies.
  • After “reminding” firms of their best execution obligations in Reg Notice 15-46, FINRA is now going to examine just how well they are fulfilling those obligations.
  • Finally, Robert Cook showed some love for “small firms,” whose role in “facilitating capital formation by small and emerging growth companies” he characterized as “vital.” He stated that he already asked his staff to develop more compliance tools and resources specifically designed to assist small firms, and that such efforts would continue.

[1] There are two comments embedded in this section of the Letter that are concerning.  First, FINRA suggests that it will increasingly scrutinize New and Continuing Member Applications when the applicants include “registered representatives with problematic regulatory histories.”  My own experience has already demonstrated this to be all too true. Second, FINRA also suggests that MC-400 applications, i.e., applications by firms to be allowed to associate with a statutorily disqualified individual, will be subject to vigorous opposition by FINRA if the SD’d person is a recidivist.

Many industry authors – including me[1] – have devoted a lot of attention lately to the SEC’s increased use of Administrative Proceedings (rather than Federal court cases) in recent years, and questioned the fairness of such proceedings, given their relative lack of discovery tools, the short timeframe provided within which to prepare a case for hearing, the fact that the Rules of Evidence don’t apply, and the knowledge that even if you win, the Division of Enforcement gets to appeal its loss to…the SEC, i.e., the very same people who authorized the issuance of the complaint in the first place.  There is another argument that has become fashionable to raise, however, and that is whether or not the ALJs who hear SEC Administrative Proceedings were appointed to their roles in a manner that comports with the requirements of the U.S. Constitution.  Until late December, that was largely an academic argument, as it wasn’t getting traction in courts, at least courts of appeals.  While some District Courts appreciated the argument, when the D.C. Circuit had the opportunity to entertain it, the notion was rejected.

But, on December 28, perhaps representing a late Xmas present to the securities defense bar, not to mention everyone regulated by the SEC, the U.S. Court of Appeals for the 10th Circuit issued its decision in Bandimere v. SEC.  In that case, Mr. Bandimere lost the Administrative Proceeding the SEC had filed against him and heard by an ALJ. Mr. Bandimere then appealed that decision to the SEC, which (naturally) upheld the ALJ’s Initial Decision.  Mr. Bandimere then appealed the SEC’s ruling against him to the 10th Circuit.

In its decision, a divided panel of the 10th Circuit determined that the SEC ALJ who heard Mr. Bandimere’s case was, in fact, unconstitutional. Why?  Because the Court concluded that the ALJs are not mere “employees” of the SEC, but, rather, “officers,” at least as that word is used in the Appointments Clause of the Constitution.  As a result, the ALJs need to be appointed by the SEC Chairman for their appointments to be valid.  In fact, however, the ALJs are selected through a different administrative procedure, one in which the SEC Chairman does not participate.  Thus, the ALJ that heard Bandimere was not Constitutionally apppointed, so the Court set aside the SEC’s decision!

Holy Cats! You don’t have to be a Constitutional scholar to appreciate the magnitude of this development.  Or at least the potential magnitude.  Does it mean that every decision in every SEC Administrative Proceeding ever held needs to be set aside?  Does it mean that only such decisions in the 10th Circuit need to be set aside?  Either way, can the problem be easily fixed,  by having the current SEC Chair now sign off on the appointments of the five SEC ALJs and making that appointment effective retroactively?  No one knows yet.

The 10th Circuit declined to address any of these issues, and seemed content to let the chips fall where they may.  Given the clear split between the D.C. and 10th Circuits that Bandimere created, it may mean the U.S. Supreme Court will step in and resolve the split, a typical result in such situations.  Perhaps it means some curtailment by the SEC of its use of Administrative Proceedings, while the issue gets sorted out.  Bottom line is for people like me, who defend individuals and firms in SEC Enforcement actions, it is not a bad development, not bad at all.  In a best case scenario, cases we thought we lost may now have to be vacated.  As I said, a late Xmas present, for sure.

When you combine this decision with the nomination of Jay Clayton as the new SEC Chairman, an individual who is reputed not to be particularly interested in the “broken windows” approach to Enforcement espoused by outgoing Chairman MaryJo White – an approach that resulted in the SEC bringing a record number of cases last year – 2017 is looking downright positive for defense counsel.

[1] You might be interested in this article on the subject, co-authored by Heidi VonderHeide, a frequent contributor to this blog.