In Homer’s epic poem the Odyssey, Odysseus and the crew of his ship are faced with the impossible choice of either sailing closer to Charybdis, a whirlpool capable of sinking their entire ship, or, alternatively, to Scylla, a sea monster just as deadly.  Odysseus’ dilemma sprang to mind as I listened to a presentation last week from a panel that included a FINRA attorney meant to provide guidance on situations where FINRA will target an individual employee in addition to or instead of the offending broker-dealer.  Although this blog has covered the topic in the past, I thought it might be instructive to share what the FINRA representative had to say, especially given that FINRA has not published any official guidance on the subject.

The presentation indicated that while there has been no substantive change in FINRA’s decision-making processes, the regulator views itself as responding to a public mandate, borne out of the 2008 financial crisis, to hold individuals, and not just firms, responsible for alleged misconduct at financial firms. Implicitly then, even if the mechanics of the decisions are the same, the people making the decisions are coming at it from a different, perhaps more aggressive, perspective.  The panel discussed considerations in naming individuals and, in addition to some of the more obvious examples, like the pervasiveness of the conduct or the notice to individuals of the wrongdoing and the nature of it (e.g., failure to disclose outside business activities), they mentioned three considerations that are not quite as obvious.  They are:

1)      Adequacy of resources – if there is one compliance person working 80 hour weeks, FINRA might take a more sympathetic view of the individual and be less likely to charge him.

2)      Dissolution of the firm – the FINRA panelist indicated a slight change in that dissolution of the firm will not necessarily absolve individuals now, as it sometimes has in the past.

3)      Author of the WSPs – Obviously, poorly written or inadequate WSPs are a sure ticket to sanctions against the firm; but the FINRA panelist indicated they will look at who wrote the policies and procedure in question when considering charges against the individual.

The talk then turned to the culpability of the Chief Compliance Officer (“CCO”). A current CCO, sitting on the panel, made two astute observations on the policy of charging CCOs.  The first, and more obvious of the two, is that it serves as an attack on the person in the company who is, at least in theory, FINRA’s best ally.  The CCO is, after all, a sort of in-house regulator who should be able to work with FINRA to ensure compliance.  The second, less obvious point, is that the career of a CCO is over once he is charged, even if said charges are eventually found to be baseless.  No firm will ever hire that CCO, as it will raise red flags and bring enhanced scrutiny on the new firm.  At a time when knowledgeable CCOs are needed more than ever, FINRA’s actions might only serve to shrink the pool of qualified individuals.

Next on the agenda was discussion of a recent case where a CCO was charged with failing to adequately review firm emails. Here is the thing: the WSPs specifically delegated that responsibility to the President of the firm, and the CCO, when interviewing, was assured he would not have to review emails.  After the President failed to review the emails, however, the CCO stepped into the void and assumed that responsibility, only to be charged by FINRA.  It is in this situation that, like Odysseus, a CCO faces a choice between two unpleasant fates.  He can do nothing and hope the firm is not charged, or he can assume responsibility and open himself to individual charges.  The CCO in this case was pro-active and took the latter tack, yet FINRA still came after him.  This case was important because it encourages a CCO NOT to assume responsibility and instead to do nothing.  Another interesting wrinkle to this case is that in this particular case, the firm’s WSPs called for review of emails on a daily basis.  That standard is above and beyond anything that is required in the industry; yet FINRA charged the CCO with failing to meet it, just because it was in the WSPs.  In this matter, the CCO was fined $5,000; a mere slap on the wrist, but for reasons mentioned earlier, his career has in all likelihood been irreparably harmed.

Does this encourage firms to set their standards at the lowest possible threshold because if they hold themselves to a more stringent standard and fail to meet it, they are opening themselves to punishment? Seems like a reasonable takeaway to me.

While FINRA continues to provide no formal guidance on the subject, recent cases indicate that its enforcement standard with regard to CCOs is much harsher than the SECs. In its zeal to hold individuals responsible, FINRA seems to be acting in a counter-productive manner that incentivizes lower standards at firms and discourages CCOs from filling supervisory gaps that may arise at the firm.  None of this advances investor protection.  Until FINRA provides better guidance, CCOs will have to do their best to chart a course between the two unpleasant fates; hopefully with fewer casualties than Odysseus and his crew.

Tis the season for announcing the year’s top examination priorities. This week, the SEC released its own examination priorities. Top priorities include:

  • liquidity controls;
  • public pension advisers;
  • product promotion;
  • exchange-traded funds; and
  • variable annuities.

Thematically, the SEC’s priorities adhere to its larger objectives: protecting retail investors (especially retirement savings); assessing market-wide risks; and utilizing data analytics to look for illegal activity (AML, mircrocap fraud, excessive trading, etc).

Also, if you are an IA or Investment Company who has not yet had the pleasure of undergoing an SEC examination, they have made it a priority to give you that opportunity.

You can read the SEC’s full list here or review the summary, contained in its press release, here.

Yesterday, FINRA released its annual Examination Priorities Letter in which it set forth the top issues that would guide its examinations in the coming year. Running 13 pages in length (while complaining about having to be so “brief”), FINRA set forth some of the “many areas of potential concern” it expects to encounter this year.

None of the items is particularly shocking if you regularly follow FINRA chatter. They are, for the most part, well known FINRA favorites: conflicts of interest, cybersecurity, AML, senior investors, and supervision.

The most notable change over last year’s priority list (aside from shaving off a few pages) is the prevalent focus on “firm culture.” While the term appeared on prior lists, it is now front and center, making clear that the regulator will be looking not just at the firm’s written policies and records, but how genuinely the firm implements them.  To guide firms which are unsure how to demonstrate how highly they value compliance, FINRA has said it intends to look for the following five factors:

  • Are control functions valued?
  • Are policy breaches tolerated?
  • Is the organization proactive in identifying risk?
  • Are supervisors good role models?
  • Are non-conformist subcultures within the firm identified and “addressed”?

The idea behind the initiative is not terribly revolutionary – FINRA has never looked favorably on firms that merely go through the motions and fail to meaningfully implement their policies. Still, it will be interesting to see how FINRA analyzes these behavioral elements.  For example, how will firms deal with policy violations?  Does a violation that previously warranted a reprimand now require something more severe?  Heightened supervision, suspension, or termination? And how do you measure how highly your control functions are “valued”? (Or, more specifically, how will FINRA measure it?)

FINRA certainly has provided a lot to look forward to in 2016.   If you’d like to review each of the items on its “brief” 13-page list, you can find it HERE.

Right around Christmas, NASAA, the North American Securities Administrators Association, which is comprised of the securities regulators from each of the 50 states, released its annual list of the top five threats to investors.  To compile the list, NASAA polled each state’s securities commissioner to learn the “the five most problematic products, practices or schemes.”  The five items described below topped the list.  What is remarkable, however, is not that these items represent new issues, but, to the contrary, that these are essentially the same issues that investors and regulators have been dealing with, well, forever.  Equally interesting, the list amply demonstrates some of the biases that securities regulators have against certain “alternative” investments.

Unregistered products/unlicensed salesmen.   NASAA helpfully warns that “[t]he offer of securities by an individual without a valid securities license should be a red alert for investors.” Well, who can disagree with that?  The problem is, con artists very rarely advertise the fact that they lack a proper securities license.  Moreover, and unfortunately, there are also lots of licensed securities salesmen who commit fraud.  So, while I appreciate that this is a problem, apparently common to states across the country, apart from identifying the problem, there is no real solution. With that said, I do agree with NASAA’s admonition that investors should be wary of any investment that is accompanied by the representation that it presents the holy grail of impossible combinations:  “limited or no risk” plus high returns.  It is just impossible to get these two characteristics in any single investment.

Promissory Notes.   According to NASAA, there is a real concern over the sale of high-interest-bearing promissory notes, especially to “seniors and others living on a fixed income.”  While that may be true, it sounds like a headline from 1995.  The sale of promissory notes has long been problematic, stemming from the fact that some promissory notes with a duration of nine months or less are, by definition, not securities, and, thus, need not be sold through BDs.  Accordingly, short-term notes are often offered by individuals who are not subject to regulatory oversight or the supervisory system in place at BDs.  Not surprisingly, some of these notes are fraudulent, and the promised returns are never realized.  To avoid, or at least minimize, potential problems, it makes sense only to do business with an appropriately registered broker at a registered broker-dealer.  At least then, even though there is no guarantee of any return, at least there is a clear avenue of redress in the event of a true fraudulent scheme.  Another lesson here, of course, is, again, that when something – in this case, the promised return – sounds too good to be true, it likely is.

Oil/Gas Investments.  While NASAA (begrudgingly) concedes that “[m]any oil and gas investment opportunities, while involving varying degrees of risks to the investor, are legitimate in their marketing and responsible in their operations,” it also observes that oil and gas deals are often “fraudulent.”  The message here is a clear one, and one I am called upon frequently to point out to my clients:  the further away an investment is from a simple buy-and-hold strategy employing something totally vanilla, like blue chip stocks or no-load mutual funds, the more nervous it makes securities regulators.  Merely to incant the words “oil and gas,” or “limited partnership,” the structure through which oil and gas deals are typically sold, to a securities regulator is to incite a lather.  It is important to remember the danger of generalizing.  Deals are different, as are the individuals who offer them.  I resent it, therefore, when a regulator presumes that my client must be guilty of something merely by virtue of the product sold.

Real Estate-related Investments: According to NASAA, “[n]on-traded REITS can be risky and have limited liquidity, which may make them unsuitable for certain investors.”  Like oil and gas deals, REITs, in the eyes of regulators, seem to be presumptively unsuitable due to their liquidity issue.  That, of course, flips the burden of proof on its head, as a recommendation should be presumed to be suitable unless proven otherwise.  Clearly, a customer’s need for liquidity is something that must be factored into any recommendation, but it does not mean that the sale of a product with limited liquidity is necessarily problematic; it always requires a case-by-case analysis.  A REIT’s limited liquidity is generally, if not always, explained in great detail, and in several places, in the typical set of offering documents, so it is nearly impossible to conjure up a situation where a reasonably intelligent investor considering a REIT investment is truly unaware of the liquidity concerns a REIT presents.  Despite this, regulators are very, very quick to conclude that liquidity was never adequately considered or explained when a complaint about a REIT is received.  Knowing this, anyone who deigns to sell REITs must document the heck out of the suitability analysis, in anticipation of being second-guessed by regulators.

Ponzi Schemes: Finally, NASSA includes Ponzi schemes on the list of horribles.  Well, duh.  Ponzi scheme, bad.  Unfortunately, as regulators would have to concede, a well-run Ponzi scheme doesn’t look at all like a scheme; it looks legitimate…until is discovered not to be.  So, it is of limited utility to offer counsel that “[i]nvestors should always be wary of unsolicited financial advice or investment opportunities,” because Ponzi schemes are generally only revealed after the loss has been incurred, and the fraudster has absconded.  Ask anyone who invested with Bernie Madoff or Allan Stanford.  The sad fact is, it is impossible to prevent someone from perpetrating a Ponzi scheme, especially when the fraudster looks, acts and sounds like anything but the kind of guy who would steal investors’ money.  I know that regulators hate Ponzi schemes and the devastating impact they can have on investors; I just wish there was something to do to stop them.  But, alas, there isn’t.

Happy New Year, everyone!

Back when I was a Director of NASD’s Atlanta District Office, I spent a lot of my time apologizing to the approximately 500 member firms my office regulated about the quality of the arbitration process. Almost uniformly, broker-dealers held the view that it was not just flawed but broken, that it was unfair (tilted in favor of complaining customers), and that it was neither cheap nor fast (the two principal reasons mandatory arbitration was upheld by the US Supreme Court).  Today, 15 years later, nothing much has changed.  The FINRA arbitration process is still subject to the same criticisms; interestingly enough, they come from by both claimants and respondents.

In an effort to address these criticisms, FINRA assembled a task force to take a look at the process, to see what was working and what wasn’t. Late last week, the task force issued its final report, and it is worth reading.  There are 51 separate recommendations, and I will not go through each one, but here are the ones that will undoubtedly generate the most conversation.

The number one recommendation was for FINRA to increase the amount of money that its arbitrators receive, up from $300/session to $500 (meaning $1,000/day, since a full day is comprised of two sessions). Theoretically, this will (1) increase the number of qualified people willing to serve as arbitrators, and (2) increase the likelihood that good arbitrators will be willing to volunteer to sit on cases with hearings anticipated to last more than a couple of days.  That may be true, but, sadly, it will undoubtedly also increase the likelihood that individuals who make lousy arbitrators will now want to participate, not to “give back,” but just to make some money.  And, believe me, there are plenty of arbitrators in the current pool who already approach this as a job, not a service.[1]

Second, the task force recommends that more arbitration awards be “explained,” with a disclosed rationale behind the decision, to achieve greater “transparency.” (Apparently, but unknown to me, a lot of people are concerned that arbitration is too “opaque.”)  Presently, very, very few awards are explained.  Both parties must agree for it to happen, and they almost never do.  In addition, frankly, arbitrators generally hate the idea of having to prepare an explained award.  Under the task force’s proposal, the requirement of an explained award would be presumed, unless either party opts out.  Moreover, even when an award is not explained, the award will still include at least “some summary explanation of the reasons behind any damage calculation.”  That last part sounds like a good idea to me, as we are often left guessing how a panel comes up with a damages figure, but I don’t imagine that parties will agree to an explained award any more than they do now, especially if they know it will displease the arbitrators.

The task force declined to eliminate the ability of a customer claimant unilaterally to dictate that no industry person be included on the hearing panel, which is unfortunate. But, the task force did recognize that when the all-public option is selected, meaning all ten of the industry members on the list are stricken, the resulting panel is often comprised of very low ranked panelists, i.e., individuals that neither party really wants.  To address this, the task force recommends that when all the industry member are stricken, a new list of ten additional potential panelists then be circulated.  This way, the panel is always selected from 30 possible names, not 20.  This is a very positive development.

Regarding expungement, the task force recommended that in cases when expungement is the only relief sought, a separate pool of special arbitrators be created to hear them. The feeling was that expungement is supposed to be extraordinary, so it makes sense to have panelists with particular training in that area, to be able to understand the unique arguments raised that support the award of expungement.  I am not necessarily against this idea, but it raises the question: what’s so special about expungement? If understanding expungement requires arbitrators with specialized training, how is that any different from other legal arguments heard in arbitrations, arguments that would be best understood by panelists with pertinent backgrounds and experience? Ironically, despite this recommendation, FINRA apparently has no problem with the elimination of the industry members from the panels, even though their background would clearly aid in the disposition of the case.

The task force has suggested that to increase the number of simplified arbitrations, which are decided on the papers alone, the Code of Arbitration Procedure be amended to add a quasi-mini-hearing, where the parties can look the panel in the eye and tell their stories, at least in some summarized, non-evidentiary fashion. Supposedly, this will make parties feel more comfortable with the result, because now, according to the task force, claimants mostly lose simplified arbitrations and aren’t very happy about it, because they have no interaction with the panel.  And FINRA, of course, can’t tolerate unhappy claimants.

The existing rule on motions to dismiss – which basically eliminates the ability to file pre-hearing, dispositive motions to dismiss – is recommended to be maintained, yet another claimant-friendly decision. The task force did throw a bone to the respondents’ bar by suggesting that one additional ground for a motion to dismiss be added, and that is when the Statement of Claim has already been litigated or arbitrated and the claimant lost.  It seems like an obvious proposition, but I can’t wait to hear from the claimants’ bar that, somehow, even this is unfair to customers.

Finally, in one of the more fascinating non-decisions by the task force, it debated whether nor not arbitrators should be instructed that they were required to strictly follow the applicable law. Like a judge does.  Or a jury.  This was too controversial for the task force, unfortunately.  Instead, the task force observed that arbitration is an equitable forum, so strict adherence to the law may or may be necessary.  I find this to be extraordinarily troubling.  I concede that arbitrators should entertain equitable notions of fairness, but that does not mean that they should be able to disregard pertinent law – as claimants’ counsel often urge – and simply “do what’s right.”  The law is the law, no matter whether one is in court or in arbitration; otherwise, the arbitral process is in serious danger of becoming a true farce.

[1] Interestingly, the task force declined to specify particular qualifications for panelists, and could not reach a consensus on whether arbitrators should more accurately reflect the characteristics of a judge – who, theoretically, knows the law and how to apply it – or a juror, who is not an expert in the law, but is, simply, a “peer” to the litigants.

Based on the definition employed by Supreme Court Justice Potter Stewart in 1964, best execution is the opposite of hard-core pornography: no one seems to know it when they see it. Despite this (at best) fuzzy standard, FINRA and the SEC still require all broker-dealers to obtain best execution for their customers when they place orders for execution.  Because the historic guidance on obtaining best execution is all over the place, and therefore of limited utility, FINRA celebrated the Holiday season by releasing Regulatory Notice 15-46, about best execution, subtitled “Guidance on Best Execution Obligations in Equity, Options and Fixed Income Markets,” to try to clear things up.

There are some fairly interesting things buried in this Notice.

First, as an initial observation, it is worth noting that, like 99% of its Regulatory Notices, FINRA characterizes 15-46 as a “reminder” of guidance supposedly issued previously. Sometimes that’s true, but, other times, as discussed below, it is a much more dubious proposition.  FINRA is legally prohibited from creating new obligations or standards in Regulatory Notices (or through Enforcement actions); that can only come out of the rule-making process.  Nevertheless, it often seems that so-called “reminders” are, in fact, brand new propositions.

Second, harkening back to some earlier blog posts about FINRA’s increasingly frequent willingness to blur the lines between broker-dealers and investment advisors, and, more specifically, the suitability standard which governs the former and the fiduciary standard which governs the latter, FINRA states at the outset of 15-46 that “a broker-dealer’s obligation to obtain best execution of a customer’s order in any security is based, in part, on the common law agency duty of loyalty, which obligates an agent to act exclusively in the principal’s best interest.” This use of the phrase “best interest” – essentially a synonym for “fiduciary duty” – clearly reveals that, at least to some degree, FINRA is already holding broker-dealers to a higher standard than the law presently requires.[1]  It is bad enough when a customer’s lawyer makes that fallacious argument in the context of an arbitration, but it is downright regrettable when the principal regulator cannot get it right.

The most noteworthy takeaway from 15-46 concerns a firm’s obligation to conduct a “regular and rigorous” review of its best execution. Historically, that has meant a periodic review – perhaps monthly or quarterly – conducted on a look-back basis, to determine that the prices obtained in executions are both quantitatively and qualitatively appropriate.[2]  The reason the review is done retrospectively is that there may not be time to do it upon receipt of an order, since orders have to be executed “fully and promptly,” and searching for the “best” venue for order execution can take some time.

Notwithstanding this, FINRA has now concluded that “given developments in order routing technology, order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options.”  The Notice goes on to say: “A firm that chooses not to conduct an order-by-order review for some orders must have procedures in place to ensure that it periodically conducts a regular and rigorous review of execution quality for those orders.”  Finally, FINRA admonishes that “[f]irms choosing to conduct a regular and rigorous review must conduct the reviews, at a minimum, on a quarterly basis; however, Supplementary Material .09 to Rule 5310 notes that firms should consider, based on the firm’s business, whether more frequent reviews are needed.”

Remember I said Regulatory Notices are supposed to be “reminders?” This is anything but that.

But, FINRA goes well beyond merely establishing a new minimum frequency for a regular and rigorous review; it actually dictates circumstances when a real-time, order-by-order review must be undertaken, rather than a look-back review:

Although FINRA has noted that a regular and rigorous review can satisfy a firm’s best execution obligation for firms that route orders and for firms that internalize orders, a firm’s ability to rely on a regular and rigorous review applies only to the firm’s initial determination whether to route an order and those orders ultimately routed outside of the firm. Any orders a firm determines to execute by internalizing would be subject to an order-by-order analysis of execution quality. Thus, while Supplementary Material .09 to Rule 5310 allows a firm to use a regular and rigorous review of execution quality, this standard only applies to a firm’s initial determination whether to route an order and to its review of orders routed outside of the firm. Orders that a firm determines to execute internally are subject to an order-by-order best execution analysis.

Notably, but not surprisingly, no attribution is supplied for this guidance, which, of course, suggests that it is brand new.

Finally, much of the remainder of the Notice is devoted to obtaining best execution for fixed income securities. Here are the key points:

  • FINRA recognizes that the market for fixed income securities differs from the market for equity securities and options and also can vary significantly depending on the specific fixed income product.
  •  Given this significant variation in trading characteristics across fixed income securities, the best execution rule uses a “facts and circumstances” analysis by requiring that a firm use reasonable diligence to ascertain the best market for the security and to buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.
  • FINRA recognizes that orders may be handled and executed differently in the fixed income market than in the market for equity securities and options. Given such differences firms may determine that their review of execution quality for fixed income securities may be less frequent than that of equity securities or options.

I don’t find these concepts alarming, but, what is concerning is that FINRA’s conclusion that obtaining best execution in fixed income securities is a “facts and circumstances” analysis. In reality, obtaining best execution for any security is a “facts and circumstances” endeavor, that requires “reasonable diligence.”  I am just not sure why FINRA has seemingly applied these concepts only to fixed income securities.

The bottom line, I suppose, is that with best execution, as with everything else, BDs need to be prepared to be second-guessed by FINRA examiners who employ standards of conduct that FINRA conjures up to suit its whims, rather than articulating in a manner that facilitates compliance.

[1] Curiously, however, in the same paragraph, FINRA also observes that when a broker-dealer acts as agent on behalf of a customer in a transaction, the BD is merely “under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.”  There is a vast difference between a “reasonable care” standard and a “best interests” standard; it is unfortunate that FINRA is so loose with its verbiage.

[2] Interestingly, “best” execution does not necessarily mean the cheapest price, given that qualitative concerns also must be addressed.

A few months ago, I blogged about how FINRA rarely holds itself to the same standards of conduct that it expects from member firms, and I gave some examples. The other day, a good friend of mine brought to my attention yet another example, this one so blatant it can only make you laugh.

As you know if you read my posts, you are well aware that the SEC recently announced its intention to amend the Rules of Practice governing its administrative proceedings, a move that was largely heralded (well, by me, anyway) as “a good start.” Among the changes the SEC suggested was the requirement that all documents and other items be submitted electronically, and that all “sensitive personal information” be excluded or redacted from such filings.

That seems pretty reasonable, doesn’t it? I mean, if you are a broker-dealer, you are already used to taking what seem like extraordinary steps to ensure the confidentiality of customer information. Indeed, in every setting, FINRA requires that firms go to great (read “expensive”) lengths to ensure that confidential customer information is protected.

For example, responses to 8210 requests that are provided electronically must, pursuant to Rule 8210(g) and Regulatory Notice 10-59, be encrypted, with the password sent separately to “help ensure that personal information is protected from improper use by unauthorized third parties.”

Regulatory Notice 14-27 requires that any document that a party files with FINRA in connection with an arbitration that contains an individual’s Social Security number, taxpayer identification number or financial account number must be redacted to include only the last four digits of any of these numbers.

In FINRA Enforcement matters, parties are routinely made subject to what has become a standard pre-hearing order (an example can be found here) strictly limiting the use of documents containing “PCI,” personal confidential information, including social security numbers, taxpayer ID numbers, driver’s license numbers, and financial account numbers (including checking and savings accounts, and credit card numbers).

And, of course, there are tons of Enforcement cases that FINRA has brought over the years against firms for not taking sufficient steps to protect confidential customer information, meting out huge fines.

Amazingly, however, in response to the SEC’s proposed rule change, FINRA submitted a comment letter in which it sought permission from the SEC to be exempted from the requirement to redact confidential information from the documents it has to send to the SEC in connection with administrative proceedings. It’s not that FINRA doesn’t think maintaining the confidentiality of customer information is important; indeed, the comment letter starts by “applaud[ing] the Commission’s efforts.” Apparently, the problem for FINRA is that it would just be too much work! As FINRA put it, the requested exemption is necessary “[b]ecause making redactions will be an extremely time- and labor-intensive process,” or, stated somewhat differently, because “redaction will be a highly costly endeavor that intensively consumes time and labor.” Finally, “FINRA believes that the burdens of redaction receive scant recognition from the Commission’s proposed amendments and far outweigh any assumed potential benefits of public access to every page of the record in FINRA proceedings.”

Oh my. How horrible. Complying with a rule takes time, effort and money. Stop the presses. Alert the media. Poor FINRA.

Perhaps even more galling, FINRA also requested a year within which to comply not with the redaction requirement, but, rather, the simple requirement of filing documents electronically! According to the comment letter, “[a]bsent a reasonable implementation period, the proposed electronic filing requirement will impose substantial costs on FlNRA in the short term.”

I must admit, I have no idea what the SEC will do with FINRA’s requests for relief.  I can, however, clearly anticipate what FINRA would do were I to make a similar argument to, say, a Member Reg examiner, or an Enforcement attorney, that my client should be exempt from some obviously burdensome rule because to comply would take a lot of effort and cost a lot of money. It will undoubtedly be very handy to have a copy of the FINRA comment letter available. Just be sure you don’t send it electronically, as it may take FINRA a year to figure out how to read it.

I posted several blogs this summer about our victory over the SEC in the Robare case (which, naturally, has been appealed by the SEC’s unhappy Division of Enforcement). One of the key elements in our ability to prevail in that matter was my client’s extensive use of outside securities consultants to assist in the preparation and ongoing review of its Form ADV. Last week, the SEC’s Office of Inspections and Examinations – OCIE – issued a National Exam Program Risk Alert that touched upon the same subject of outsourced compliance functions by investment advisors. Although it was pretty specific in scope, addressing in particular the outsourcing of the Chief Compliance Officer position, it contained some general observations about compliance that are important for every advisor to understand, whether or not they outsource any aspect of their compliance responsibilities. In fact, many of these observations about compliance are equally applicable to broker-dealers, so they, too, should study this Alert.

Here is what the SEC had to say about compliance, generally, and CCOs:

  • “Frequent” and “personal” interactions between compliance staff and advisors (as opposed to “impersonal interaction, such as electronic communication or pre-defined checklists”[1]) are preferable, and result in a better understanding by compliance of the firm’s “business, operations, and risks.” This may not be an especially illuminating observation, but given how easy it is to abide by this guidance, it would be foolish to ignore it. Of course, as with anything compliance related, it is not enough just to do it; you have to memorialize the fact that you did it. So, don’t just hold “personal” meetings, document when they happen, who is in attendance, and what is discussed. And don’t minimize the importance of the frequency of such meetings. While the SEC has not quantified what it deems to be reasonable, once or twice a year is not “frequent” by anyone’s definition.
  • Firms that fail to provide their compliance officers with “sufficient resources to perform compliance duties” do so at their own risk. This is particularly true when a CCO does not work fulltime, but is registered with several registrants, and, as a result, is given limited time within which to accomplish the designated compliance tasks. You can guarantee that if questioned by a regulator, a CCO will be asked if he or she was provided adequate time and resources to accomplish the delegated tasks, so you never want to run the risk that the answer will be “no.”
  • The failure to have policies, procedures or disclosures “necessary to address all of the conflicts of interest” SEC staff has previously identified is problematic. This covers such areas as compensation practices, portfolio valuation, brokerage and execution, and personal securities transactions. I have blogged repeatedly about the regulators’ obsession with the identification and management of conflicts. Ignore conflicts of interest at your own peril, and that’s true even for broker-dealers, who, unlike advisors, have no obligation to disclose their conflicts on Form ADV.
  • Firms that fail to follow their own existing policies and procedures just plain look stupid and sloppy. Make sure that everyone is provided up-to-date versions of the latest procedure manual, and make sure that everyone actually reads it. They need not memorize it, but you want to avoid a situation where, under oath, an advisor concedes that he hasn’t seen the manual, and has no idea about its contents. It is simply impossible to unring the bell of lousy supervision once that happens.
  • It is equally bad when there is an inconsistency between a firm’s stated policies and procedures and its actual practices. Again, in this circumstance, you are inviting the regulator to conclude that your written policies and procedures are meaningless.
  • Make sure that the written policies and procedures are specifically tailored to the business the firm actually conducts. It is dangerous, and silly, to use an unedited off-the-shelf set of procedures because they may contain sections with no relevance to a firm’s business, or, worse, because they do not include sections that are necessary. Either way, to use a procedures manual that is not specific to your particular business model is to create the impression – and not necessarily an invalid impression – that, at best, you are careless, or, at worst, that you are indifferent to your compliance responsibilities.
  • The annual review of existing policies and procedures cannot be perfunctory. Too many advisors and BDs simply rubber-stamp this “testing” requirement, figuring that the absence of a problem must mean the WSPs were effective. That is not enough. Rules change, standards are tweaked, guidance is issued, products and/or business lines are added or dropped. Firms must, at least annually, take a fresh look at their policies and procedures to ensure that they are current, in light of whatever changes manifest themselves during the course of a year. AND DOCUMENT THAT ANALYSIS!

This stuff is not necessarily ground-breaking. For instance, I can remember offering counsel to BD clients 30 years ago about the importance of keeping WSPs current. But, given that OCIE felt compelled to issue this Alert now, it is readily evident that these basic lessons have not been universally learned. Don’t wait for an SEC or FINRA examiner to point out your deficiencies; at that point, even if you fix them, it’s too late to avoid the regulatory implications.

[1] The Alert was clearly against the use of such standardized checklists. OCIE cited a recent Enforcement action in which an outsourced CCO was alleged to have contributed to a false filing because he “did not personally review [the adviser’s] records” to validate them, but, instead, relied “exclusively on information provided to him by” advisers. The best practice is to provide CCOs, outsourced or otherwise, the power “to independently obtain the records they deemed necessary for conducting” reviews, rather than allowing the subjects of such reviews “to selectively provide records” to the CCO.

It should be abundantly clear to everyone that BDs are required to arbitrate disputes with their registered reps. There are several reasons I can assert this with such a great deal of certainty.  First, and most obvious, there is a rule about it.  Rule 13200(a) of the Code of Arbitration Procedure provides that

[e]xcept as otherwise provided in the Code, a dispute must be arbitrated under the Code if the dispute arises out of the business activities of a member or an associated person and is between or among:

  • Members;
  • Members and Associated Persons; or
  • Associated Persons.

The importance of the word “must” in that rule is made readily evident in IM-13000, which is titled “Failure to Act Under Provisions of Code of Arbitration Procedure for Industry Disputes”:  “It may be deemed conduct inconsistent with just and equitable principles of trade and a violation of Rule 2010 for a member or a person associated with a member to . . . (a) fail to submit a dispute for arbitration under the Code as required by the Code.” Plainly, since not arbitrating an industry dispute can result in disciplinary action, this is something FINRA takes seriously.

Second, in addition to the rule, there is the arbitration agreement embedded in every registered person’s Form U-4, which reads as follows:

I agree to arbitrate any dispute, claim or controversy that may arise between me and my firm, or a customer, or any other person, that is required to be arbitrated under the rules, constitutions, or by-laws of the SROs indicated in Section 4 . . . as may be amended from time to time and that any arbitration award rendered against me may be entered as a judgment in any court of competent jurisdiction.

Between the rule and the U-4 language, it seems pretty straightforward that industry disputes must be arbitrated, right? Well, curiously enough, that is not always the case.

There was a court decision in New Jersey this week that teaches that the rule and the U-4 may not, by themselves, constitute adequate evidence of the parties’ intent to arbitrate.

In Barr v. Bishop Rosen & Co., Inc., the Superior Court of New Jersey upheld a lower court’s decision to deny a motion by a broker-dealer to compel arbitration of a complaint filed in court by one of its former registered reps.  The Court took notice of the fact that the rep had signed the Form U-4 – more than once.  But, that was not enough, at least under New Jersey law.  In addition to agreeing to arbitrate disputes, the law also requires that the parties expressly waive their ability to pursue their rights in court.  While that waiver may seem implicit in light of the agreement to arbitrate, the law does not permit it to be implied; it must be explicit, i.e., “clearly and unmistakably established.”  Because the U-4 agreement to arbitrate does not include a recitation that the registered rep is affirmatively waiving his or her right to litigate in court, the Court concluded that the arbitration provision in the U-4 was not enforceable.[1]

Interestingly, FINRA has recognized this deficiency in Form U-4. That is why FINRA Rule 2263 exists.  Rule 2263 is one of the Conduct Rules that never gets any attention, but has been around for a long time, since 2000.  According to Rule 2263, “A member shall provide an associated person with the following written statement whenever the associated person is asked, pursuant to FINRA Rule 1010, to manually sign an initial or amended Form U4, or otherwise provide written (which may be electronic) acknowledgment of an amendment to the Form U4.”  It then goes on to recite, verbatim, specific language that “must” be provided to a registered rep every time a Form U-4 is signed, whether initially or as an amendment.[2]

Among the required verbiage is an explicit waiver of the right to sue in court: “You are agreeing to arbitrate any dispute, claim or controversy that may arise between you and your firm, or a customer, or any other person that is required to be arbitrated under the rules of the self-regulatory organizations with which you are registering. This means you are giving up the right to sue a member, customer, or another associated person in court, including the right to a trial by jury, except as provided by the rules of the arbitration forum in which a claim is filed.”

The lesson here is very obvious. If a broker-dealer wants to be 100% confident of its ability to enforce an arbitration provision in industry disputes, it cannot rely simply on the language in Form U-4; rather, it must also provide the separate written statement required by Rule 2263.  In my experience, unfortunately, I cannot say that all broker-dealers uniformly follow this practice, particularly with U-4 amendments.

It is perhaps even more important to understand that this legal principle, at least in New Jersey, does not apply only to industry arbitrations; it applies to all arbitrations, including customer claims. Thus, failure to include language in a customer arbitration agreement that includes a sufficiently “clear” waiver of the right to sue in court could be fatal to the ability to compel arbitration of a customer claim.  Happily, FINRA anticipated this, too.  Rule 2268 thus requires that predispute customer arbitration agreements include this:  “All parties to this agreement are giving up the right to sue each other in court, including the right to a trial by jury, except as provided by the rules of the arbitration forum in which a claim is filed.”

[1] The Court did not discuss Rule 13200, so I have to presume that did not enter into its analysis.

[2] Some of the other recitations that must be included in the written statement include: (1) whistleblower disputes need not be arbitrated; (2) the limited ability to appeal an arbitration award; and (3) the limited discovery available in arbitration.

 

With any luck, you can go your entire career in the securities industry without ever participating in the dreaded “Wells process.” And that’s a good thing, as the Wells process occurs only after FINRA has completed an examination and has concluded that whatever it has encountered is so serious that a formal disciplinary action is appropriate to address the perceived wrongdoing.  So, if you have never received a Wells letter, it means that you have managed to stay off of FINRA’s vast radar screen.

FINRA was kind enough to outline the Wells process in Regulatory Notice 09-17, so I need not re-create that wheel:

If a preliminary determination to proceed with a recommendation of formal discipline is made, the staff will call the potential respondent or counsel and inform the individual or firm that FINRA intends to recommend formal disciplinary action.  This is generally referred to as a Wells Call.  During the Wells Call the staff informs the potential respondent of the proposed charges and the primary evidence supporting the charges.  The purpose of a Wells Call is to give the potential respondent an opportunity to submit a writing, called a Wells Submission, which discusses the facts and applicable law and explains why formal charges are not appropriate.

Making a Wells Submission is never obligatory; it is always up to the prospective respondent to decide whether or not a Wells Submission would be helpful. There are several reasons, however, why you may not want to make a Wells Submission:

  •  It likely will have no impact on FINRA’s decision to proceed with formal disciplinary action. While most lawyers who, like me, defend BDs, can tell you a war story or two about how some Wells Submission they made somehow convinced FINRA to drop the notion of filing a complaint, or resulted in charges much less serious than those FINRA initially proposed, in the vast majority of cases, it hardly matters what you say in your Wells Submission, as FINRA’s view of the merits of the case is already galvanized.
  • Wells Submissions can be expensive to prepare. FINRA permits a Wells Submission to run as long as 35 pages. Not everyone uses all those words, of course, but even a 10- or 15-page Wells Submission can easily exceed $10,000 in attorneys’ fees. (Of course, you don’t have to use an attorney to prepare a Wells Submission, but, frankly, since the next step after the Wells process is the filing of the disciplinary complaint, it makes sense to do so.) When you couple this fact with the first bullet point, i.e., the slim chance of success, you can see why not everyone chooses to make a Wells Submission.
  • Wells Submissions are not privileged. Because they are not privileged, whatever you say in a Wells Submission is subject to further examination by FINRA. So, say, for instance, that you make some assertion in your Wells Submission that is based on some fact of which FINRA was somehow unaware, you can bet that not only will FINRA respond with a follow-up 8210 request, but, if the complaint issues and the matter goes to hearing, you will be thoroughly cross-examined about the assertion.

Because of these issues surrounding Wells Submissions, many, perhaps most, recipients of Wells letters don’t bother with them. In fact, what generally happens is that when a Wells letter is received, rather than automatically begin to prepare a response, I will, instead, ask FINRA for a settlement proposal (except, of course, in those matters where my client absolutely, positively refuses to settle under any circumstances, and is ready and willing to go to hearing). If the initial settlement proposed is reasonable, I can, typically, through the give-and-take of negotiations, get that proposal down even further, hopefully to the point where my client is willing to accept it.

This is absolutely a standard process. FINRA expressly acknowledged as much in 09-17: “In many cases, after reviewing the charges that the staff is considering, the potential respondent initiates settlement discussions instead of making a Wells Submission.”

But, here is where it gets weird. In two cases this past week, two different clients who received a Wells letter and asked FINRA for a settlement guideline, so they could decide whether or not to make a Wells Submission, were told that no settlement proposal would be provided until after they made their respective Wells Submissions. Oddly, in one of those situations, the FINRA Enforcement attorneys even argued with me when I told them their stance was hardly usual.

I cannot say that two cases constitutes a trend, but I am very troubled that FINRA, for whatever reason, is making the decision to condition a settlement proposal on the receipt of a Wells Submission. If FINRA feels strongly enough about its case to send the Wells letter – which triggers a U-4 disclosure for the recipient – then it should already be willing and able to engage in a dialogue about potential settlement. I concede, readily, that sometimes that dialogue is unsuccessful in achieving a settlement, and sometimes it barely gets started (as in those cases where FINRA demands a settlement term too onerous to be given serious consideration). But, for FINRA simply to decree that the dialogue will not take place at all unless and until a Wells Submission is made skews the process entirely, and takes away from a prospective respondent the option of making a Wells Submission or not.

Clearly, FINRA needs to go back and re-read its own Regulatory Notices, to remind itself of its own policies.