There have been some developments this week in a few matters on which I have previously offered my views. To help you stay on the cutting edge of financial world current events as you mingle at your upcoming Cinco de Mayo fiestas, here are three updates.  Two, not surprisingly, represent wins for the regulators.  The third, however, offers a ray of hope for all my fellow doubters.

FINRA beats back a challenge in court. A few weeks ago, I reported on what I thought was a clever and compelling legal challenge that had been raised by a broker-dealer, Scottsdale Capital Advisors, to FINRA’s ability to bring Enforcement actions based on violations of the Securities Act of 1933.  According to the argument, in none of the statutes that empowers FINRA to bring Enforcement cases is any language that expressly imbues FINRA with authority to enforce violations of the Securities Act.  As a result, FINRA should not be able to file complaints based on perceived Securities Act violations.  Simple, logical, compelling.

FINRA opposed the challenge, of course, and filed a motion to dismiss the complaint. The SEC even jumped in, too, filing an amicus brief in support of FINRA.  FINRA made a number of arguments against Scottsdale, including (1) FINRA Conduct Rule 2010 is broad enough to include Securities Act violations, regardless of what the statutes say or don’t say, (2) Scottsdale jumped the gun by filing in court, and should be required first to exhaust its administrative remedies, and (3) FINRA is immune from such lawsuits anyway.

Oral arguments were held this week, and the Federal District Court Judge who heard them granted FINRA’s motion to dismiss the complaint. Shocking news, right?  In her ruling from the bench following the arguments, the judge concluded that before Scottsdale can go to court to challenge FINRA’s jurisdiction, it first has to run the gamut of fighting it out at FINRA – which means a hearing before the hearing panel, and then an appeal to the NAC, i.e., the National Adjudicatory Council – and then the SEC before filing in court.  In other words, Scottsdale has to wage battle three separate times (over many years, at the cost of ridiculous legal fees) before it can even raise its argument to a judge that FINRA exceeded the scope of its statutorily mandated jurisdiction.  FINRA, it seems, not Elliot Ness, is the real “untouchable,” as nothing can prevent its Enforcement machine from grinding on, even in the absence of legal authority.

The Supreme Court isn’t interested – yet – in the challenge to SEC ALJs. We have also discussed, more than once, the SEC’s increased use of administrative proceedings (rather than court cases) to bring its Enforcement actions.  (Why?  Because the SEC wins almost all the time when it files there.  I mean, you can’t blame them, right?)  Well, several court cases have been filed attacking the constitutionality of the manner in which SEC Administrative Law Judges, or ALJs, who are actually employees of the SEC, are appointed to their positions.[1]  Perhaps surprisingly, or at least interestingly, some federal judges (in Georgia and New York) have entertained these arguments, and have even suggested that they may, ultimately, find the arguments to be valid.  On the other hand, federal judges in other jurisdictions (the D.C. and Seventh Circuit Courts of Appeals) have rejected these same arguments.

What happens when federal judges from around the country disagree on things? At least some of the time, the U.S. Supreme Court will deign to hear a case on the subject, thereby breaking the tie.[2]  Well, not here.  This week, for the second time, the Supreme Court – which has discretion whether or not to grant certiorari to hear an appeal – declined even to consider whether the SEC’s ALJs are constitutional or not.  At least not yet.  The Court may decide at some later date, when more Circuit Courts weigh in on the issue, to hear a case, but that remains to be seen.  In the meantime, then, there is a hodgepodge of rulings out there, some favorable to the SEC, some not.  But, unless and until the Supreme Court takes up one of these cases, it appears that the SEC will continue its use of administrative proceedings unabated, as it tries to recreate the perfect record that it achieved in such proceedings back in 2014, winning all six litigated APs.

FINRA’s Debt Research Rule Delayed. Finally, last year, I wrote about FINRA’s new Rule 2242, which extends to debt securities many of the existing rules governing research analysts who cover equities.  Rule 2242 was supposed to go into effect in February 2016, but, “[i]n response to industry questions regarding implementation of the requirements of Rule 2242,” FINRA delayed implementation of the new rule until April 22, 2016.  Just two days before the scheduled effective date, FINRA announced that it “continues to receive questions regarding implementation of the requirements of Rule 2242,” and, “to give members additional time to implement the requirements of Rule 2242,” it has extended the implementation date again, now until July 22.  Why the hubbub?  What are these burning questions that the industry is posing to FINRA? Well, that’s not clear, as FINRA has not released them.

The good news, however, is that back in March, FINRA did release on its website updated FAQs about the research analyst rules that incorporate some questions and answers about the new debt security rule.  And I am very ok with this.  I am always pleased when FINRA gives the industry additional time to deal with the implementation of new rules, especially rules that will, for certain firms, create big changes in how they do business. It also makes me happy when FINRA releases guidance on new rules before those rules become effective, thus reducing the opportunity for me (and others) to complain that FINRA would rather play “gotcha” after the fact than proactively help its members avoid problems.  I am hardly saying that FINRA is always fair, or even mostly fair; here, however, I cannot complain.

 

[1] It’s a pretty technical argument, but it boils down to whether the US Constitution requires the ALJs to be appointed by the Commissioners themselves, rather than some lesser authority at the SEC.

[2] Theoretically, anyway.  If a ninth Justice isn’t confirmed soon, the Supreme Court itself may not be able to accomplish anything, given that four-four ties are entirely likely.

Two years ago, FINRA first proposed to the SEC a rule that would require brokers to disclose to clients not only when they receive compensation (including signing bonuses and other payments) to switch from one broker-dealer to another, but, worse, the amount of that compensation. The industry was seriously not pleased with the rule.  FINRA, for a change, capitulated to the pressure, and withdrew its rule proposal a few months later, in June 2014.  But, FINRA was dogged, and rather than abandoning the notion, it continued to tinker with the rule.  In May 2015, FINRA circulated the revised rule – Conduct Rule 2272 – and, ultimately, submitted it to the SEC. A week or so ago, the SEC approved the revised rule. Here’s what you need to know to impress your friends who are tired of discussing the election or the tragic loss suffered by the Tar Heels in the Final Four or Jordan Spieth’s meltdown on the 12th hole (bearing in mind that the effective date of the new rule’s implementation has not yet been established).

The initial rule FINRA proposed had two key components when a rep received at least $100,000 as inducement to change from BD A to BD B: (1) the requirement to disclose the compensation (in dollar ranges) to former BD A retail customers who BD B recruited to follow the rep and transfer their accounts; and (2) an obligation to report the compensation to FINRA. The disclosure obligation also required that the rep disclose the basis for that compensation (e.g., asset-based or production-based), and if a former BD A customer would incur costs to transfer assets to BD B that would not be reimbursed by BD B. The initial proposal would have required disclosure for one year following the date the rep moved to BD B.

In the face of loud and widespread criticism from the industry, the revised proposal ditched a lot of the original requirements, including, most notably, the need to tell a customer how big a signing bonus a rep got to switch firms. Instead, it substituted the much more benign requirement merely to give customers an “educational communication” – drafted by FINRA – on the implications of moving from BD A to BD B. The communication would need to be provided at the time of, or shortly after, BD B reaches out to the client, vice versa, about transferring his or her assets.  Information to be communicated to the customer is intended to suggest to the customers issues they may want addressed about the requested transfer:

  • whether financial incentives received by the rep may create a conflict of interest;
  • whether there are assets that may not be directly transferrable to BD B, which, as a result, the customer may incur costs to liquidate and move those assets or inactivity fees to leave them with BD A;
  • potential costs related to transferring assets to BD B, including differences in the pricing structure and fees imposed between BD A and BD B; and
  • differences in products and services between BD A and BD B.

In addition, the duty to notify FINRA was eliminated, and the length of time BD B would need to provide this communication was cut in half, down to six months from the rep’s transfer.

This watered down version of the initial rule is what the SEC approved, with the following general comment:

The Commission believes that the proposed rule change would increase the information available to investors regarding the potential implications of transferring assets. The Commission further believes that the proposed educational communication may encourage former customers to make inquiries of their representatives, which could increase communication between customers and representatives about the potential implications of transferring assets.  The Commission believes that the increase in information and communication about the potential implications of transferring assets will benefit customers when deciding whether to transfer assets.

I can’t really argue with any these points. Sure, this “educational communication” may cause some customers to think about why their rep moved firms, and whether compensation was part of the reason.  And some of those customers may actually choose to engage in a dialogue about broker compensation, or fees and costs that the new BD may impose.  Not a bad thing, under any circumstance.

So, on balance, I am ok with this new rule, and, really, here’s why: I am in favor of any rule that largely puts the burden on the customer actually to take affirmative steps to protect him- or herself. There are tons of existing rules and regulations and statutes that are disclosure based, i.e., they require reps to make all sorts of disclosures to their firm, to FINRA, to their customers.  Indeed, the very heart of securities regulation in America is based on disclosure: if you fairly disclose the potential risks and rewards of an investment, and only sell it to people for whom it is suitable, you can, by and large, sell (or attempt to sell, anyway) any piece of crap you want.

The problem is that in reality, even when a rep (or a firm) makes all the required disclosures, the regulators regularly still find fault with the investment, or the manner in which it was sold.  You have read prospectuses and private placement memoranda: they contain pages and pages of risk disclosures.  I saw a four-page advertising slick for an investment the other day that had more verbiage in the fine print on the final page than in the other three pages combined.  Forms ADV, U-4 and BD disclose all sorts of potentially scary disciplinary history.  Customer account agreements have grown to monsters, with pages and pages of small print disclosures about risks, costs, etc.  Yet, because no customer bothers to read these things, despite their legal obligation to do so, BDs, IAs, and reps continue to pay the price.

If this rule truly shifts the burden to customers actually to read this disclosure, and then to follow up by asking questions that they may (or may not) have, as opposed simply to requiring that firms dump more, and more detailed, disclosures on them, I, for one, am a strong supporter.  It is about time that the regulators have acknowledged that customers have a duty to exercise their own due diligence when it comes to their accounts and their money.

 

I had an experience with FINRA this week that cannot go without comment, as it highlights one of the biggest issues that my clients and I have with FINRA.

One of the more obscure departments within FINRA is the Market Operations Department.[1]  I am not entirely sure of all of its functions, but, at a minimum, it is the place where non-exchange-listed issuer company actions in the over-the-counter (OTC) securities market are reviewed and processed. Specifically, according to Reg Notice 10-38, the “Operations Department” “reviews and processes documents related to announcements for company-related actions pursuant to SEA Rule 10b-17,” which includes distributions in cash or kind, stock splits or reverse stock splits, or rights or other subscription offerings, as well as “other company actions, including the issuance of or change to a trading symbol or company name, mergers, acquisition, dissolutions or other company control transactions, bankruptcy or liquidations.”

This is all governed by FINRA Rule 6490.  The way it works, when an OTC issuer wants to take a corporate action that is covered by the rule, it must file an application with FINRA’s Operations Department.  If FINRA concludes “that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets,” it will deem the application “deficient” and simply not process it.[2]

Last fall, a client of mine advised the Operations Department of its intent to effect a 1:50 reverse stock split, and filed the necessary application. In a four-page letter, the application was denied because the issuer’s CEO had a prior settlement with the SEC, which “raised concern for FINRA regarding the protection of investors and the transparency of the markets.”  Notably, however, the SEC had elected not to bar the CEO from associating with issuers, as it could have, which clearly suggests that the SEC was ok with him serving as CEO.  More importantly, the majority shareholder of the issuer, with over 60% of the shares, expressly wanted this guy to be the CEO notwithstanding his disciplinary history.  Unfortunately, this was not good enough for FINRA.

So, a couple of weeks ago, we resubmitted the application, but this time we told FINRA that the issuer was prepared to find a new CEO. Moreover, we represented that while the old CEO would remain on the board of directors, he would be just one of four directors, with no unilateral ability to dictate any board decision.  Finally, we also said that the old CEO would serve only in a consulting capacity, whose recommendations were subject to approval by the new CEO.  We did not actually implement any of those changes, however, since to do so would be expensive, involve a lot of work, and possibly impact the value of the issuer’s shares in a negative way, as in, OMG, THE CEO WAS LET GO!!  Instead, we simply told Operations that we would do these things, if they told us that if we made these changes, then the application would be approved this time.

We are still waiting for the decision on the resubmitted application, but, yesterday, we had a conference call with Operations, theoretically to discuss the proposed changes, to see what FINRA thought, i.e., to see if our proposal was enough to address the concerns that led to the application being denied the first time. Well, guess what? Operations absolutely, positively refused even to talk to us about our proposal.  We were informed that all they could do was either approve or deny the specific application before them, but not give us any insight whatsoever into what they would do if the changes we proposed were actually implemented.  We argued – respectfully – that it was their job to give advice, to help applicants get their applications approved by clearly articulating what their expectations were. I pointed out that FINRA employees from all Departments, whether Member Reg, Enforcement, Market Reg, etc., routinely give “conceptual” advice, to help members make sound business decisions.  Indeed, at literally every securities conference I attend, Rick Ketchum and Susan Axelrod implore the audience to call them with questions or concerns, as FINRA is happy – HAPPY! – to answer them.

That all fell on deaf ears. When we pointed out that their very job was, really, to protect shareholders, and that their absolute refusal even to discuss our proposal could actually work to the detriment of the issuer’s shareholders, they merely shrugged it off, claiming what we asked was “impossible.”  It turned into an utter waste of time and money.

There was a period of time, back in my NASD days, where senior NASD management implemented a “Customer Service” policy. The point of it was that we were to treat the NASD member firms as our “customers,” to help them with their compliance efforts, to answer their questions, to provide proactive advice and guidance, all to minimize the likelihood that any member would be found not to be in compliance.  After all, the “customer is always right,” right?  Well, that was short-lived.  When the SEC found out about it, they went crazy, and admonished NASD for being so stupid as to treat its members as “customers.”  And that was the end of that.

I am not saying, necessarily, that we need to return to those halcyon days of “Customer Service,” but I do firmly believe that FINRA has an obligation to its members to help them with compliance, to answer questions and to provide guidance. It is ridiculous for FINRA to refuse requests for assistance and, instead, simply to wait and watch to see if members who unsuccessfully seek help are somehow able to figure it out for themselves, and then deny applications (or bring Enforcement actions) if they cannot.

FINRA doesn’t seem to understand why its members are so frustrated and angry. It is events like yesterday’s that are part of the reason.

[1] Try searching on the FINRA website for its “Operations Department” or “Market Operations Department.”  I am not sure it actually exists.

[2] The purpose of this post is not to discuss the intricacies of Rule 6490, but, for those who may be interested, the only grounds on which FINRA may base its conclusion are (1) FINRA staff’s  reasonable belief that the forms and all documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the anticipated corporate action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the anticipated corporate action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security.

Last week, word spread about a legal challenge that has been mounted in federal court against FINRA’s ability to enforce violations of the Securities Act of 1933, and, perhaps not surprisingly, it has generated a lot of talk, not to mention enthusiasm (at least among those who chafe at FINRA’s aggressive Enforcement mentality). The specifics of the case are wonderful in their simplicity:  according to the ancient[1] statutes that enable FINRA to serve as a self-regulatory organization, it is expressly allowed to enforce its own rules, as well as violations of the Securities Exchange Act of 1934.  But, the clear and unambiguous language of the statutes do not say a word about the Securities Act.  Accordingly, the argument goes that Congress, the drafters of the statutes, deliberately withheld from FINRA the power to bring Enforcement cases for Securities Act violations; otherwise, Congress would have said something about it.

I do not interpret statutes for a living, but I do recall very well from law school that the legislature is presumed to intend what it says when it uses clear, unambiguous language in a law. Thus, if the statutes do not expressly give FINRA jurisdiction to enforce Securities Act violations, there is no reason to believe that such power was ever intended.

As I said, simple and compelling.

Equally interesting, and disturbing, is FINRA’s response to the argument: that even if it does not have the statutory mandate to bring cases for Securities Act violations, it can do so nevertheless by virtue of Conduct Rule 2010.  You know Rule 2010, FINRA’s catch-all ethical rule that requires member firms and associated persons to obey “high standards of commercial honor and just and equitable principles of trade.”  When FINRA does not have a specific rule prohibiting a particular variety of misconduct, it simply charges a 2010 violation.  So, according to FINRA, even if it is not permitted to charge Securities Act violations, it can still enforce the underlying activity simply by calling it a 2010 violation.

How convenient.

But, this is pretty bold stuff, and it is hardly clear that FINRA will prevail. FINRA exists because the U.S. Congress, following the crash of 1929, when deciding what to do to avoid a potential recurrence, elected to regulate the securities industry not directly, but, rather, indirectly, with self-regulatory organizations serving as the first line of defense (backed up by the government in the form of the SEC).  But, SROs are not given carte blanche.  They may do only what Congress permitted them to do, and what the SEC subsequently allows through rule-making.  No one would argue, for instance, that FINRA is permitted to subpoena documents from customers, or compel them to testify, because it is not statutorily empowered to do so.  It may want to be able to do so, from time-to-time, to aid it in its examination process, but that is irrelevant; FINRA can only compel BDs and individuals associated with BDs to produce documents, or to appear and testify.

Similarly, FINRA may want to be able to bring Securities Act cases, but if it lacks that power as a result of a decision that Congress made decades ago, when SROs were first authorized, its insistence that somehow Rule 2010 trumps that Congressional mandate would seem to ring rather hollow.

So, it will be fascinating to see how this plays out in court. And this is more than a mere academic exercise, or a rare opportunity to enjoy watching FINRA squirm.  FINRA has brought, and still regularly brings, lots and lots of Section 5 cases, i.e., cases alleging illegal unregistered distributions of securities.  If FINRA’s ability to bring such cases is successfully challenged, then it will be strictly up to the SEC to enforce Section 5.  And, what about all the cases that FINRA has already filed, that have already been settled, or tried?  If FINRA never had the jurisdiction to bring those cases, will all those results be magically vacated?

Keep an eye on this one!

[1] Ok, 1938, the year the Maloney Act was passed, may not be ancient.  But, still, it is a long time ago.

The Rick Ketchum Show. Today’s sessions opened with what was likely the highlight of the entire conference, Rick Ketchum’s swan song “conversation” with Ira Hammerman, GC of SIFMA, before he toddles off into retirement. Granted, these interviews never remotely approach Sixty Minutes intensity, but this year’s featured even more coddling than ever:

  • What would you like your legacy to be, Rick? Investor protection and market integrity. (yawn)
  • Firm culture: He acknowledged that folks “out there” have a hard job. FINRA is basically trying to find out how you create an environment where good people make fewer bad decisions (because not everyone is a bad guy, just lots of good guys making bad decisions).
  • He insisted that a good firm culture does not require overreaction to policy violations: you don’t need to shoot everyone, just take it seriously.
  • He tipped his hat to Susan Axelrod about five times. Hmmm. Is she his successor?
  • Lack of communication between regulators is “inexcusable” and one of FINRA’s “highest priorities.” If the SEC comes in and then FINRA immediately follows, firms should “push back,” and FINRA will go to the SEC and “make sure” no duplication. Every year, FINRA management encourages pushing back; yet, when you try it, the results are spotty, at best.
  • Cybersecurity: Big issue. Just not news.
  • Reg S-P: Firms usually handle privacy concerns well at home office, but compliance deteriorates in branches.
  • Big data: FINRA is increasingly using data analytics in its exam program to identify seriously at-risk reps, jump on them immediately, and get them out. Beyond that, FINRA pulls a lot of data before an exam so it can be more “sophisticated.” Firms should be reviewing their own data, too, e.g., trading emails and messages. Soon, regulation will be “fundamentally dependent” on this data.
  • Senior issues: Guess what? Rick said he is a senior now!  Ha ha. So funny.
  • Another hat tip to Axelrod.
  • DOL fiduciary duty, specifically, what are you hoping to see in final rule? (1) best interest standard across industry and a “rigorous” one; (2) discouraged by firms earning commission-based compensation on retirement accounts; (3) get better at identifying and managing conflicts; (4) would love to see compensation “flattened.” But, he cautioned that FINRA is “not in the business of policing DOL.”
  • The final question: What’s in your future?  Something about sleeping in.
  • On a lighter note, Mr. Hammerman asked Mr. Ketchum how can a person who lives in NYC, who spends most of his days in DC, be a Boston Red Sox fan? Mr. Ketchum, with a note of regret in his voice, responded that he has been fortunate to have a professional life where he could do what he really enjoyed, and being a Red Sox fan was his existential angst. Mr. Hammerman then presented him with a Red Sox jersey with “Ketchum #1” on the back as a gift from SIFMA. True to his regulator instincts, Mr. Ketchum queried, “Now how and where am I going to disclose this on the proper form?”

AML. Curiously, there was no FINRA representative on this panel. Anyway, there were a few topics raised. One had to do with potential individual liability of AMLCOs. The panel debated what one should do as AMLCO when a recommendation to management regarding a potentially suspicious circumstance is overruled by management. According to the DOJ, the AMLCO should be willing to battle and should not step back. Everyone seemed to agree that in a worst-case scenario, the AMLCO would have to resign. There was agreement that the AMLCO needs to document the crap out of everything, even if such “CYA” memos will later garner tremendous interest from regulators. Better to have the documentation than not.

There were a couple of seemingly obvious statements made, but, since I agree with them, I shall repeat them:

  • The decision to file a SAR is, relatively speaking, not controversial; whereas, the decision not to file a SAR will absolutely be second-guessed and, absent good documentation, hard to defend. Remember: the point of a SAR is simply to bring a potentially suspicious situation to the attention of the regulators; it is their job, not the BDs’, to decide whether it’s serious or real.
  • It is never too late to file a SAR. A late filing might raise an issue with regulators, but that is still better than never filing one.
  • Your AML review must be tailored to your business model. Changes, for example, in products or people (say, a problem branch) could create need to review your AML review process. The panel acknowledged this could be a problem if you utilize an outside vendor, because then you are stuck with the vendor’s parameters, etc., unless you shell out big time for customization.

More CCO Liability. To say that CCO personal liability is a hot topic at SIFMA this year would be an understatement.  In fact, as my colleagues exited one panel session, they overheard Rick Ketchum tell someone in the hallway, “One too many times talking about CCO liability.  I can’t do it anymore!”

Today’s sessions shed some more light on this topic.  I wrote yesterday about Mr. Ceresney and his comments that CCOs shouldn’t worry unless there is a “wholesale failure to carry out responsibility” on their part.  Today, Kevin Goodman, the SEC’s Associate Director for the Office of Broker-Dealer Examinations, punted when he was asked to define this standard of liability. When asked if it is a negligence standard or a gross negligence standard, he declined to commit to either.  But, he did say that the standard is high enough that “it is ok if you don’t act perfectly.” Take that for what it’s worth.

The rest of that panel quickly pointed out that if there is a “wholesale failure to carry out responsibility,” it is not always clear that the responsibility is the CCO’s.  There is no clear rule, or even really much guidance, as to what the CCO’s responsibilities are.  Accordingly, the best advice given by the panel was that a BD would be wise to clearly define the responsibilities of the CCO – and to make those responsibilities narrow.  Every time a CCO gets involved in a project, there should be some documentation as to who the sponsor of that project is – i.e., who is “responsible” for it.  By assigning “responsibility” to the legal department or business executives, the CCO may be able to avoid personal liability for projects in which she is involved.

Ask FINRA Senior Officials. This panel is always a crowd-pleaser, as you can have fun counting the number of people in the audience visibly biting their tongues to refrain from laughing. Here were our favorites:

  • Just as Rick Ketchum kept telling Senator Warren a couple of weeks ago when she was accusing FINRA of allowing too many reps with disciplinary records to work in the industry, Brad Bennett, EVP of Enforcement, noted proudly that 800 brokers are barred per year.  And it’s non-cyclical, every year.
  • The conduct that gets them in trouble is the same old, same old: outside business activities/private securities transactions; dealing with senior investors; and stealing, i.e., “the kind of stuff you should be surveilling for.”
  • In response to an observation that we are seeing more Enforcement attorneys involved in exams, and the expressed concern that it will “chill the dialogue,” Mike Ruffino, EVP of Member Reg, responded that it’s not that common, “only with high risk firms.” I bet a lot of low risk firms would quibble with this comment.
  • Susan Axelrod – heir apparent to Mr. Ketchum?? – said that FINRA’s current position on CARDs hasn’t changed.  She then joked, “we don’t even use that word.”
  • On FINRA’s obvious increase in its use of Rule 8210 requests, Susan insisted that FINRA is not simply trying to collect five years of your emails. Rather, she maintains that the staff is instructed to only get what it needs, and ask for more later, if needed.  As always, she invited the audience to escalate their concerns to her if the examiner fails to respond to requests to reduce the scope of an 8210 request. GOOD LUCK WITH THAT. Finally, Brad suggested that only “bad” firms (that is, the ones who don’t come to SIFMA) get onerous 8210 requests.  And, he said, it’s a product of those firms not trying or wanting to get it right.  What an odd lens through which to view the world!

That’s it for today.

 

Opening Session/Firm Culture/CCO Liability. If you are reading this blog, then you, like me, have been probably eagerly waiting for the start of SIFMA’s annual Compliance and Legal conference not just for the jumbo shrimp at the reception, but also to learn some insights from the regulators about their concerns and intentions. If you attended the opening session of the conference this morning, “Current Enforcement Issues Panel,” then you are probably still waiting for those insights, at least from FINRA. During the entire 65-minute opening session, FINRA’s Executive Vice President of Enforcement, Brad Bennett, uttered a grand total of six sentences. He was asked zero questions by the moderator and was given the floor for three whole minutes at the end of the session. His preparation must have been grueling.

Besides the brevity of his remarks, the substance of Mr. Bennett’s six sentences was also curious. His first comment was that the Series 7 exam needs to be more difficult. The implication, I suppose, is that a more challenging Series 7 exam will help keep less intelligent individuals from becoming registered persons, which FINRA must think is good, because, presumably, intelligent people will commit fewer sales practice violations. The problem is, while the Series 7 exam may or may not be a measure of intellect or knowledge, it is certainly not a measure of honesty. So, even if the goal is hiring more intelligent, or at least more knowledgeable, brokers, this hardly protects customers. A smart broker does not equate to an honest one; indeed, some devastating frauds have been incredibly sophisticated, perpetrated by financial geniuses.

The second thing that Mr. Bennett said was that FINRA will NOT be using its new culture survey as a feeder for eventual Enforcement actions. Laughter ensued. A breakout session later in the day on “Compliance for Small and Regional Firms” offered two theories for the culture survey. First, FINRA may be encouraging firms to cull outlier brokers or branches that don’t fit within their self-described culture. In other words, once a broker-dealer defines its culture, it can more easily identify those reps who don’t fit that culture and then either figure out how to integrate them better, or cut ties with them.

The second theory about why FINRA is focusing on culture – the one which received near universal head nods from the audience – is that FINRA is, in fact, going to bring Enforcement actions based on poor firm culture, or where it identifies registered persons who do not seem to be adhering to firm culture. In other words, nobody believed what Mr. Bennett had said 30 minutes earlier. The prevailing theory suggests that FINRA may bring an action against the firm or individual for a Rule 2010 violation (FINRA’s favorite rule, besides 8210), based on “just and equitable principles of trade.”

As for the SEC, its Director of Enforcement, Andrew Ceresney, was asked about the “targeting” of CCOs. The moderator framed the question to Mr. Ceresney by asking if the SEC was going after CCOs for “wholesale failure to carry out policy and procedure.” Mr. Ceresney interrupted the question and said the SEC wasn’t looking to enforce conduct that is considered a wholesale failure to carry out policy and procedure but, instead, conduct that is a “wholesale failure to carry out responsibility.” Hmmm. I am not certain I understand this distinction, but, one could very well make the argument that notwithstanding the repeated statements that the SEC is NOT targeting CCOs, the message is that the SEC is focused both on a CCO’s strict compliance with WSPs and its enumerated responsibilities, as well as other, unspecified responsibilities that CCOs routinely assume. If so, that’s a scary prospect.

Fiduciary Duty. One of the biggest attractions was the panel on the Fiduciary Duty Rules. As everyone likely already knows, the proposed Department of Labor rules will be released by the OMB within weeks and, unless Congress manages to kill them, they will become effective in early 2017.  What does this mean?  Owners of 401ks and IRAs will be able to hold their advisors liable as fiduciaries, assuming that some recommendation is made (and the standard of what is a recommendation may be very easily satisfied).  Even simple solicitations to rollover your 401k to an IRA could create a fiduciary duty.  Even saying “you should open an IRA with my firm” during a cold call could make the securities professional a fiduciary.  TV ads directed to the general public that say, “follow the green line” to retirement security may create a fiduciary duty.  The panel believed that among the unintended consequences of this change in the law will be that employees/investors will have less information available to them and fewer products to choose from.

Let’s take a step back.  Remember the days when many employees had a professionally managed pension as a benefit of their employment?  Employers got out of these expensive plans because Congress created 401ks and IRAs.  As a result, employees became managers of their own retirement funds.  But – and I acknowledge I am painting with a very broad brush – the average American is relatively incapable of managing his own retirement funds.  Indeed, most Americans are so inept at managing their financial affairs that they have not saved anywhere near enough to maintain the same lifestyle to which they were accustomed, and a significant number of people have not saved any money for retirement.  With this new Fiduciary Duty Rule, the DOL is shifting the cost of employers guaranteeing their workers a decent retirement and the cost of the financial incompetency of employees onto the financial securities industry, which will end up bearing the financial burden of baby-boomer retirement.

Municipal Securities: Not a subject for everyone, but, very important to those who sell munis, obviously. A few things of note were said. First, FINRA said it would be focusing on late trade reporting, concentration and new issue pricing.  Second, the panel went into some detail about the new best execution rule going into effect on March 21.  They advised that firms should look wide and document their search for bonds in different places to ensure that customers get the best price.  Interestingly, it was suggested that putting out lots of bids, looking for the best price, can have the unintended consequence of masking illiquidity. Third, with regard to “Extended Settlement,” the panel discussed FINRA Rule 4210 and said that FINRA seems to view purchases not settled by T+6 to be purchases on credit…which is problematic because it would then require margin.  Finally, the panel revealed what is already clear to those of us who work with muni firms, which is the regulators’ renewed focus on enforcing the minimum denomination rule. Cases in that area were few and far between for years, but not anymore.

We are looking forward to Day 2!

 

 

For some reason, a bunch of noteworthy events all happened around the same time this week, so please bear with me as I vent a little about them.  Individually, they are irritating; in the aggregate, they are borderline alarming.

First, the FINRA Wells process. I have blogged about this before, and how, in a couple of recent matters, FINRA refused to provide settlement proposals prior to issuing a Wells letter.  This is about something else.  As you are likely aware, FINRA issues a Wells letter when it has, theoretically, completed its examination,[1] and concluded, after a thorough and sifting review of the facts, that a formal disciplinary action is necessary.  The recipient of the Wells letter has one last chance to try and convince FINRA that it’s wrong, and that no formal action is necessary (or that the supposed charges are unprovable, or that the proposed respondent should not be included in the case, etc.)  Anyway, the point is, by the time the Wells letter is sent, FINRA should already have a thorough grasp of the facts, so its decision to proceed with a formal action is well founded.

Or so you would think. This week, I participated in a Wells call on behalf of a BD client in which FINRA advised of its intent to recommend a formal disciplinary action against the firm for AML violations, among other things, following a “short” four-year exam.  One of the specific allegations is that my client did not do enough to understand the supposedly questionable nature of the background of some of its customers.  In other words, it missed an AML red flag.  We asked FINRA to identify the customers at issue, and the Staff complied.  We were astounded to learn that one of the customers they listed was, in fact, a disclosed Schedule B indirect owner of the BD, someone that my client had known, and known well, for 20 years.  Even more astounding, however, is the fact that FINRA Staff was unaware that this customer was an owner of the firm!  When we pointed this out, and argued that it was just silly to believe that my client could possibly have been unaware of the customer’s background, given the very close and lengthy relationship between the firm and the customer, Staff acknowledged we might be right.[2]

The question is, after a four-year exam with multiple OTRs and countless 8210 requests, how could this possibly get to the point where FINRA is making a Wells call, where it is literally on the precipice of issuing a complaint, without being aware of such an obvious and important fact as the customer being an owner of the BD? Seems that FINRA should do a better job of making sure it is aware of all material facts before it launches the Wells missile, given the damage that necessarily causes.

Second, examiner misconduct. FINRA can compel a BD and an RR to jump through hoops all day long, and there’s very little they, or I, can do about it.  But, the rest of the free world is not subject to FINRA’s jurisdiction.  That includes customers.  Frequently, FINRA contacts customers as part of its examination, both in writing and over the phone.  Unfortunately, FINRA does an awful job of explaining to customers who FINRA is.  Indeed, FINRA seems perfectly content when customers it contacts labor under the misapprehension that FINRA is the government, and that they must, therefore, cooperate with FINRA.  If you have ever seen a letter that FINRA sends to customers, it does not say anywhere that the customer has the right simply to tear the letter up and ignore it.  Moreover, FINRA does not volunteer that fact when it calls customers, either, or advise them that they can just hang up.

This week, one of my clients got a call from a longstanding customer to report that she had been contacted repeatedly by a FINRA examiner to ask about trading in her account. She said that the FINRA examiner told her he was with the federal government, and that she had to respond to him.  She went on to say that he was rude, and that he kept pushing her to lodge a complaint against the broker-dealer.  Finally, she said that he ignored her instruction to stop calling her, and that he kept at it, badgering her about my client.

Obviously, I was not on the phone, and I don’t know what was actually said here. But, I have heard from enough customers over the years about similar calls received from FINRA examiners to suspect that much of what she said likely did happen.  There needs to be some meaningful way of governing the conduct of FINRA examiners when they interact with customers, to ensure that the customers are expressly made aware of what FINRA is, what its role is, and, more importantly, what it is not, i.e., that it is not the government, and therefore cannot compel any customer to cooperate with them.  Also, FINRA needs to do a much better job of making crystal clear that the subjects of their calls, the brokers and BDs, are not guilty of anything, and that customer should not infer anything to the contrary.

Finally, Rick Ketchum, FINRA’s outgoing Chairman. Last week in front of the Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Securities, Insurance and Investments, he was confronted[3] by Senator Elizabeth Warren about a couple of things, one of which was the subject of a recent blog post here:  PIABA’s whiny “report” that sometimes when customers win arbitrations, they cannot collect because the BD goes out of business.  I wrote that this is really more a complaint about the PIABA lawyers’ inability to collect their fees, and questioned why broker-dealers, among all businesses in America, should be required to keep enough money on hand to ensure that all their creditors get paid.  Anyway, one might think that Mr. Ketchum would make these same, or at least similar, pro-industry observations to the Subcommittee, right?

Wrong. To the contrary, Mr. Ketchum agreed with the Senator’s remarks that this was a real problem and said, “Something should be done about it. . . . This is an issue we want to be part of, we want to work with the SEC on, and it is a real concern.”  In light of FINRA’s long history of kowtowing to PIABA, this should come as no surprise to anyone.  It is just painful to see it play out before your own eyes.

Senator Warren also grilled Mr. Ketchum on a recent paper by the University of Chicago and the University of Minnesota highlighting the relatively large number of registered representatives working in the industry with a record the authors deemed to be “indicative of . . . misconduct.”  The Senator was upset[4] about this, and Mr. Ketchum echoed her concerns.  Strongly.  In light of Mr. Ketchum’s remarks, I just cannot believe that there is anyone out there still crazy enough to hold on to the fanciful notion that the enforcement pendulum can’t go any further in the “aggressive” direction.  Instead, it seems that what we should expect are more exams, more cases, higher fines, longer suspensions and more permanent bars.  Batten down the hatches.

[1] See Regulatory Notice 09-17 for FINRA’s own explanation of the Wells process.

[2] The Staff did not immediately agree, however, to drop all potential claims involving that customer; instead, they merely agreed to “consider it.”

[3] Start around 51:00 in the Senate webcast to see the pertinent exchange between Mr. Ketchum and Senator Warren.

[4] Start around 45:00 in the webcast to see this exchange.

By now you have probably read FINRA’s recent “Targeted Exam Letter” entitled “Establishing, Communicating and Implementing Cultural Values.”  In case you haven’t, it is clear that FINRA is following up on the promise it made in January in the 2016 Regulatory & Examination Priorities Letter to “formalize [its] assessment of firm culture while continuing [its] focus on conflicts of interest and ethics.” With this new letter, FINRA has now moved, at least for the 12 firms that received it, beyond the conceptual and theoretical and on to the actual and practical.  Unfortunately, attempting to measure objectively something as clearly subjective as “firm culture” is of limited utility, and the eight questions that FINRA has posed establish that fact.

I suppose that the problem starts with the effort even to define “firm culture.” Strangely, in the Targeted Exam Letter, FINRA identifies “one definition of ‘firm culture,’” but does not expressly adopt that definition as its own, even though the language comes almost[1] directly from FINRA’s 2016 Examination Priorities letter.  Moreover, FINRA acknowledges that each firm “may have its own definition of ‘firm culture.’”  So, as its examiners work to gauge whether the broker-dealers who received the letter have a firm culture, or, if they do, whether it is good or bad, we don’t really know the standard to which FINRA will be holding these firms.

Second, even if we assume that the definition FINRA provides is, in fact, the one that FINRA has adopted, it is so general and vague that it is largely without meaning. According to FINRA, this “one definition” of firm culture is “the set of explicit and implicit norms, practices and expected behaviors that influence how employees make and carry out decisions in the course of conducting the firm’s business.” This is like trying to describe the color blue.  You can likely conjure up some adjectives, but, really, the result may not be particularly useful.  It’s like a Dilbert cartoon, or, even better, one of those “mission statement generators”[2] you can find on the web that basically string a bunch of important-sounding words together, creating a grammatically correct but utterly nonsensical phrase.

So let’s look at the eight things that FINRA is asking these 12 firms to provide, and other than chuckle at them, see if there is any real guidance to be gleaned:

  1. “summary of the key policies and processes by which the firm establishes cultural values”
  2. “description of the processes employed by executive management, business unit leaders and control functions in establishing, communicating and implementing your firm’s cultural values”
  3. “description of how your firm assesses and measures the impact of cultural values (to the extent assessments and measures exist) and whether they have made a difference”
  4. “summary of the processes your firm uses to identify policy breaches”
  5. “description of how your firm addresses cultural value policy or process breaches once discovered”
  6. “description of your firm’s policies and processes, if any, to identify and address subcultures within the firm that may depart from or undermine the cultural values articulated by your board and senior management”
  7. “description of your firm’s compensation practices and how they reinforce your firm’s cultural values”
  8. “description of the cultural value criteria used to determine promotions, compensation or other rewards”The first thing that strikes me is, basically none of these has any application to a small broker-dealer, and, last time I checked, the vast majority of FINRA members is still comprised of small firms. FINRA has nearly always employed a one-size-fits-all approach to its rules, but I wonder here whether its concern about firm culture has any real application to most of its members. Second, as we try to understand what FINRA is really looking for, I think we can skip through a lot of this rhetoric and safely substitute “conflict of interest” for “cultural values.” While “culture” is difficult to define, identify or measure, the same is not true for conflicts of interest. Even small broker-dealers can reasonably be expected to be able to demonstrate their sensitivity to conflicts of interest in a manner that cannot be replicated for “firm culture.” FINRA has increasingly begun to signal its interest in testing how its members deal with conflicts of interest, and the questions posed in the Targeted Exam Letter reflect that same interest.

Last, pay particular attention to “compensation practices,” found in Item 7. Given FINRA’s keen interest in conflicts, and especially in light of the DOL’s anticipated rules regarding retirement accounts, firms simply cannot pay enough attention to their current compensation practices to make FINRA happy.  The industry seems inexorably sliding towards a “best interest of the client” standard, and one of the easiest ways for a regulator to demonstrate an indifference to that standard is the use of pricey fee/pay structures.  So, if even if you find FINRA’s questions to be wholly inapplicable to your business, at least this one should strike home.

Remember, FINRA has stated its goal with this Letter is merely “to better understand industry practices and determine whether firms are taking reasonable steps to properly establish and implement their own cultural values within the firm.” But, history teaches that it is a very short trip from merely “understanding” industry practices to examining them, and then to enforcing them.  So ignore this Letter, even if it seems completely off-target, at your own peril.

[1] Interestingly, the one difference between the two iterations of the definition is that the first time it was used, in the 2016 Exam Priorities Letter, FINRA referred to “firm executives, supervisors and employees.”  In the Targeted Exam Letter, however, FINRA simply used “employees,” suggesting, perhaps, that firm culture should be embraced at all levels, not just at management levels.

[2] http://www.laughing-buddha.net/toys/mission;  http://cmorse.org/missiongen/

Once again, I found myself gritting my teeth in frustration after reading yet another PIABA report complaining about some perceived inequity in the FINRA arbitration process that cuts against customers. This week, PIABA released its study demonstrating that sometimes when claimants prevail in arbitrations against broker-dealers, the BD that lost is unable to pay the award, and, as a result, the claimant collects nothing.  Since PIABA lawyers generally take their engagements on a contingency-fee basis – i.e., they get paid by taking a hefty percentage of the amount actually collected – a failure to collect anything means the lawyer, as well as the customer, gets nothing.

So, you can see why this is such a big deal to PIABA!

But, putting aside the transparent self-interest that is really underlying the PIABA study, let’s consider the situation.

I was taught in law school 35 years ago, and, believe me, it was reinforced when I actually started practicing law, that there are two issues that a lawyer must always address before taking on a plaintiff as a client: (1) do the law and the facts suggest that you will win the case, and (2) if you win, what are the chances of actually collecting on the judgment?  The point is, the second question exists in every case, in every forum, because there is never a guarantee that a defendant who loses, even deservedly so, will be able to pay whatever he has been ordered to pay.

I am not saying that is good or bad, but it is a fact. In the United States, neither companies nor individuals are required to maintain the ability to pay off any judgment that might be rendered against them.  State law mandates that drivers carry only a minimum amount of liability insurance, but, if there is an accident, and someone suffers damages in excess of the minimum, those damages may never be recovered if the insurance is not enough.  That is a fact of life.

Sometimes, when defendants just don’t have the money, or the assets, to be able to satisfy a judgment, they declare bankruptcy. When that happens, in most instances, the judgment is either discharged, or reduced.  Again, that is not necessarily good or bad, it just is a fact.

Corporations exist specifically as a means of limiting the potential personal liability of its shareholders. If a corporation goes belly up, its judgment creditors may be out of luck, despite the fact its shareholders own ample personal assets to satisfy the judgments.  Just a fact.

Brokers and broker-dealers are no different than anyone else in America. If they lose a case, well, sometimes they can pay it, but sometimes they cannot.  For PIABA to suggest that broker-dealers should be required to maintain enough insurance so that every claimant – and his attorney, of course – will get paid in the event of a successful arbitration is just absurd.  And, it is equally absurd to argue that some fund should be created so successful claimants – and their attorneys, of course – can collect if a broker-dealer simply goes out of business.  Why not create such a fund for dry cleaners?  Or gas stations?  Or candy stores?  Why are broker-dealers so special?  The answer is that they are not, unless you are a PIABA lawyer, who makes a living suing broker-dealers.

Finally, it is worth pointing out that brokers and broker-dealers already have greater pressure to satisfy arbitration awards than other members of society, and this is a result of existing FINRA rules. The Code of Arbitration Procedure requires that awards be paid in 30 days.  If they are not, then, unless the respondent can demonstrate that (1) the award was paid, (2) the award was settled, (3) he filed for bankruptcy, or (4) he filed a timely motion to modify or vacate the award, his FINRA registrations will be summarily revoked.[1]  In addition, under IM-12000, it is a violation of FINRA Conduct Rule 2010 not to honor an arbitration award.  Ordinary businesses, i.e., dry cleaners, gas stations, candy stores, have no such gun to their head.  Only broker-dealers. Yet, it is pretty easy to anticipate that FINRA will react in its usual fashion, and pass another new rule to appease PIABA, at the expense of its already burdened member firms.

[1] Up until 2010, FINRA recognized another defense – a bona fide inability to pay.  But, under pressure from PIABA, FINRA eliminated that. See Reg Notice 10-31.

Years ago, I handled the defense of a FINRA Enforcement case that still galls me.  The client sent a series of emails, over many months, about a particular security to customers who already owned the stock.  The point of the emails was largely to provide updates, and, from time-to-time, to suggest that the customers consider adding to their existing positions.  FINRA maintained that the emails violated the Advertising Rule, because each and every email had to contain a detailed description of the potential risks associated with the security.  In response, I argued that that would be pointless, as the customers already knew those risks, having been explained in prior communications, both oral and written, so to judge the adequacy of the disclosures in any one particular email, it was necessary to view that email in the context of the entire stream of emails.

I lost.  FINRA concluded that context was irrelevant, that every email had to contain the full-blown risk disclosure, no matter how many times that same disclosure had already been made.  This is just a nonsensical result, and, to prove that, FINRA, to my knowledge, has never, ever applied that standard again.

That was a long time ago.  But, in December,[1] the First Circuit issued a decision overturning an SEC matter that, at long last, justifies my old argument that context is, in fact, important.

In Flannery v. SEC, the First Circuit vacated an Order that the SEC had issued against John Flannery and James Hopkins, two former employees of State Street Global Advisors, finding that they had made certain material misrepresentations and omissions about a State Street bond fund.  Notably, the SEC’s Order – a 3-2 decision – happened because the Division of Enforcement managed to lose its case against Messrs. Flannery and Hopkins in front of the ALJ.  And we all know how much the SEC hates to lose, so the Division of Enforcement appealed its loss to the Commission.

Anyway, contrary to the ALJ, who actually heard the evidence,[2] the SEC concluded that Mr. Hopkins was liable because a single slide in a PowerPoint presentation that he made to investors was misleading.  Specifically, the SEC was unhappy that the slide used the word “typical” to describe the fund’s portfolio, rather than its actual portfolio at the time.  The First Circuit disagreed with this narrow approach, and concluded that the SEC’s evidence of materiality was “marginal,” and that it could not support a finding of scienter, even based on recklessness.

Why?  Because “[c]ontext makes a difference.”  The single slide in question was only one “of at least twenty.”  Also, the Court was impressed by Mr. Hopkins’ expert witness, who testified that a “pre-prepared document,” such as the PowerPoint presentation, is “not intended to present a complete picture of” the investment, but, rather, to “serve as a starting point’” for investors.  After seeing the presentation, “a typical investor” would then perform his or her own due diligence.  Here, the investors were all made aware that additional, more specific, information was available upon request, and that information about the fund’s actual (not merely “typical”) portfolio was available through fact sheets and annual audited financial statements.

The Court was careful to point out in a footnote that it was not “suggest[ing] that the mere availability of accurate information negates an inaccurate statement.”  But, “when a slide is labeled ‘typical,’ and where a reasonable investor would not rely on one slide but instead would conduct due diligence when making an investment decision, the availability of actual and accurate information is relevant.”

As for Mr. Flannery, the SEC found that he made misrepresentations in two letters.  In reversing that finding, the Court concluded that one of the two letters was not misleading.  Because of that finding, the Court never even bothered to consider whether the second letter was misleading.  Even if it was, according to the SEC’s own finding in an earlier case that the Court cited with approval, a single misleading letter could not support a finding of a violation of Section 17(a)(3) of the Securities Act:  “an isolated misstatement unaccompanied by other conduct does not give rise to liability under” 17(a)(3).

There are several important takeaways from Flannery, but, to me, the most important is that when your client is accused of having violated Section 17(a) as a result of a making a single, allegedly misleading statement, the context in which that statement was made, i.e., the “total mix” of available information to the investors, can dictate whether the SEC has a case or not.

[1] Please forgive the long gap between posts, as I have been a bit busy with my new son, Jailen, born in December!
[2] The standard of review here is very interesting, in and of itself.  It is well accepted that the SEC’s findings “control if supported by substantial evidence,” and its orders and conclusions are not “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”  Cody v SEC, 693 F.3d 251, 257 (1st Cir. 2012).  But, when the Commission and the ALJ “reach different conclusions,” a different standard applies.  In that circumstance, as was the case in Flannery, the court’s review is “less deferential” to the Commission, as it will put more weight on the findings made by the ALJ, “who . . . observed the witnesses and lived with the case.”