Today, the Public Investors Arbitration Bar Association (PIABA) published another hit piece on the expungement process.   For those of you interested, you can find it HERE.   Again and again, PIABA issues press releases and reports contending that the expungement process is broken because expungement is granted at an “alarmingly high rate.”  Let’s start with the basic issue PIABA has with the expungement process.  Although they claim to be interested in investor protection, I don’t think that’s the main motivator.  What they really want is to be able to keep all of the frivolous arbitrations they file on the permanent record of the Financial Advisor (“FA”) so, when they sue those FAs again, they can argue that the FA is a repeat offender.

We defend arbitration after arbitration in which counsel representing a Claimant files a cookie cutter Statement of Claim alleging identical facts and causes of action no matter the actual circumstances in that investor’s account or portfolio.  Just the caption and the identity of the Claimant in the opening paragraph is changed.  These documents are nearly a word for word replications of other Statements of Claim filed on behalf of other Claimants.  Oftentimes, they even forget to change the pronouns in the filed document from “he” to “she” when the gender of the Claimant changes.  They contain references to investments never purchased by the Claimant.   It is even common to see the wrong broker-dealer referenced in the body of the Statement of Claim.  Seriously.  This is happens all the time.

The firm, now in receipt of a written complaint, has a duty to disclose this complaint on the permanent record of the FA no matter how ridiculous the complaint may seem.  For example, say the investor signed and initialed 20 separate disclosures indicating that the investor understood that the investment he was about to purchase was not guaranteed from loss.  If a Claimant’s counsel files a Statement of Claim making the conclusory allegation that the FA misrepresented that the investment was guaranteed, the firm must disclose this complaint on the FA’s U4.  There is no discretion here.[1]   The mere allegation creates the duty to disclose.  I’ve defended FA’s against Claimant’s allegation that they lost hundreds of thousands of dollars associated with an investment when, in fact, the investment recommended was very profitable.  Like every other customer complaint, this issue ended up on the FA’s U4.  Where’s the investor protection related to maintaining that complaint on the FA’s permanent  CRD record?  Got me!

There is nothing wrong with the expungement process.  In my experience, arbitrators take a very critical look at expungement requests asking pointed questions trying to determine – even in the face of a cookie-cutter Statement of Claim – whether the Statement of Claim alleges a plausible cause of action.   Arbitrators take their duty to evaluate expungement requests seriously and, in my view, have not failed the expungement process in any way.

Making sure the public is protected should be the goal of everyone associated with this industry but these self-serving reports are not advancing investor protection.  If PIABA really wanted to advocate for investor rights, they would show up to expungement hearings and defend their frivolous complaints.  Instead, they skip those proceedings and then complain about the result.  But correlation does not equal causation.  The expungement rate is not a product of a broken expungement process.   It’s a product of broken Statements of Claim.

 

[1] Under FINRA Bylaws (Article 5, Sec. 2), a firm must report customer disputes to FINRA’s Central Registration Depository (“CRD”).

At the end of last week, we received our second[1] decisive win in a FINRA Enforcement case in a matter of days. Following a two-day hearing back in July, the hearing Panel dismissed all charges against our clients Paul J. McIntyre and MSC-BD, LLC. While any victory is nice, and doing justice for a client who always viewed these allegations as meritless is rewarding, this success was even sweeter because of the completeness of the victory: the Panel found that Enforcement did not provide evidence to support any elements that formed the basis of its claims.

Enforcement alleged that McIntyre and MSC had drafted and distributed a fraudulent private placement memorandum (“PPM”) to potential investors to raise money to acquire and build a marina in Fort Myers, Florida. McIntyre had previously been involved in raising money for the same marina project when the marina owner defaulted on its mortgage, refused to repay investors, and declared bankruptcy. With the interests of those initial investors in mind, McIntyre spent thousands of hours of his time trying to purchase the marina from the bank in order to complete construction and earn a profit for investors, as well as litigating against the first mortgager on the property who had personally guaranteed the investors’ investments.

Despite McIntyre’s considerable efforts to help the investors, Enforcement tried to paint him as a fraudster, who was actually misleading investors to his own benefit. Enforcement even went so far as to allege that McIntyre acted with scienter, or fraudulent intent, when compiling and circulating the PPM to raise money for the project. The tragedy is that Enforcement never had any evidence to support such harsh allegations in the first place, and probably should have never brought them.

Happily, the Panel quickly figured this out: “Enforcement offered no evidence whatsoever that [McIntyre] intended to omit material information from the PPMs or mislead…investors…. On the contrary, as explained above, before making the PPM available to investors, [McIntyre] circulated drafts widely, seeking comments and proposed revisions to improve the document.” Furthermore, the Panel found that McIntyre did not even act recklessly or negligently. Rather, McIntyre “acted in good faith in promulgating the PPM” since he circulated it for comment to three attorneys, prior investors, broker-dealers, and a third-party due diligence company before he ever distributed it to potential investors.

Besides coming nowhere close to proving that McIntyre acted with scienter, Enforcement also failed to demonstrate that the PPM contained any material misrepresentations or omissions. In fact, the Panel found that there were such “extensive disclosures in the PPM” that any additional disclosures that Enforcement thought should have been included were not necessary because they “would [not] have been material to a reasonable investor.” In other words, McIntyre did such a thorough job of disclosing facts about his involvement in the first marina offering and his compensation for his involvement in the project that additional disclosures would not have “significantly altered the total mix of information available to…investors.”

Perhaps the most puzzling allegation was that the PPM failed to disclose the true purpose for which the offering proceeds would be used. Specifically, Enforcement alleged that the purpose of the offering as stated in the PPM – to purchase the marina and resume construction – was false, and that the real (but unstated) purpose was actually to raise money to fund litigation against the guarantors of the first offering.

The problem with this allegation is that it ignored some obvious – and unrebutted – facts. It ignored that the McIntyre entered into a contract with the bank to purchase the marina, and a contract with a construction company to resume construction. Neither would make sense if the true goal was to simply raise money to litigate? And why would the offering attempt to raise over $10 million if the anticipated legal expenses to fund litigation were only $300,000? While Enforcement may have ignored these obvious facts in a strained effort to paint McIntyre as a fraudster, the Panel did not.

In addition to dismissing all of the allegations that McIntyre or MSC-BD mispresented or omitted material information in the PPM, the Panel also dismissed the allegation that McIntyre violated FINRA Rule 2010 by returning funds to one investor. “The Panel conclude[d] that [McIntyre] had authority under the provisions of the PPMs and the Operating Agreement to make that decision.” Again, the Panel made this determination based on the plain language of the PPM, which was available to Enforcement when it decided to bring these allegations.

I suppose it is Enforcement’s job to be skeptical. When faced with conflicting facts or inconsistent stories among witnesses, that’s fine. But, this was a case where, when faced with unrebutted facts, Enforcement simply chose not to believe them. That may be acceptable when listening to Donald Trump on the campaign trail, but that should not be the standard for bringing regulatory actions that threaten to strip a registered rep of his license, his career, his livelihood and his reputation. Thankfully, the Panel heard the facts and reached the right decision: dismissal of all claims.

[1] Heidi VonderHeide blogged about that win here.

Fans of this blog (or, at least, readers of this blog who are fans of Jeopardy) will no doubt remember Alan’s prior post, published a few weeks ago, and discussing a recent case that FINRA’s Department of Enforcement brought against one of our clients. From the very beginning, we, as her counsel, were both bewildered and outraged by the case, given the particular circumstances.

Alan recapped the story nicely in his prior post, but the highlights are as follows: Our client was required to file an MC-400 application as a result of her decision to sign a Consent Order with the State of Washington that included among its sanctions a one-year suspension as a principal.   FINRA opposed the application, claiming she had improperly violated the terms of the Consent Order by acting in a principal capacity. The issue made its way to the NAC (the National Adjudicatory Council – FINRA’s appellate tribunal), which, following an evidentiary hearing, ruled against FINRA, granted the application, and held that she did not, in fact, violate the state order. You can read that decision here.

The NAC’s ruling was very detailed in its conclusions, finding not only that her conduct was not violative of the terms of the Consent Order, but that she acted reasonably and in good faith throughout the suspension term. Needless to say, our client was thrilled.

Oddly, despite that ruling, and its crystal clear reasoning, the DOE nevertheless decided to go forward with an Enforcement proceeding based on the exact same conduct that had already been considered by the NAC. In other words, what the NAC had already found to be proper, the DOE now alleged was “unethical” and violative of Rule 2010.

Like I said, bewildered and outraged.

After an unsuccessful attempt to convince the DOE to drop the case, we filed a Motion for Summary Disposition, arguing that the DOE’s case was barred by the doctrines of collateral estoppel and res judicata – fancy legal jargon that forbids you from suing someone twice for the same thing.

Needless to say, we were super pleased when we received the Hearing Officer’s order this week, granting our motion and dismissing the complaint. Motions for Summary Disposition are rarely filed by respondents, probably because they are practically never granted. (Our research revealed only one or two other successful motions in the last 25 years).

We were even more pleased when we read the Hearing Officer’s reasoning. Not only did he agree with us on all points – and find that the NAC’s prior ruling precluded the Enforcement proceeding – he sent a loud and firm message to the Enforcement attorneys who filed the case, and FINRA generally. Here are his concluding thoughts:

That her good-faith efforts at compliance fell short of perfection does not inexorably lead to the conclusion that she acted unethically. And holding a person liable for even the most minor mistakes regardless of the ethical implications of the person’s actions would not serve to enhance the ethical standards of FINRA members.

To paraphrase (perhaps too generously): mistakes will happen in the intricate, ever evolving world of compliance; prosecuting members for minor mistakes, made despite a good faith effort to comply, serves NO purpose, protects no one, and is a total waste of time and effort.

You can review the Hearing Officer’s Order here.

Yesterday, NASAA released a Model Fee Disclosure Template for broker-dealers, urging firms voluntarily to adopt the model as a means of clearly disclosing to customers and prospective customers the types and amounts of various miscellaneous fees that BDs ordinarily charge their customers. Working with FINRA, SIFMA, the FSI, LPL Financial LLC, Morgan Stanley Smith Barney LLC, Prospera Financial Services, and Signator Investors, Inc., NASAA developed the disclosure template “to help investors better understand and compare various broker-dealer service and maintenance-related fees and guidelines to make fee disclosure accessible and transparent.”

This sounds great, actually. No customers should be unsure about the services they pay for, how much they pay, and how frequently the fees are assessed. This schedule takes all the mystery out of those questions, so, theoretically, no customer provided one of these schedules ought to be able to claim confusion. Indeed, that is the express goal of the schedule, to make the fees express, thereby eliminating any questions about what was disclosed, or that customers understood what was disclosed to them. Reality, however, suggests that this goal may be illusory.

As a litigator, I look at the world through the prism of evidence. Good evidence, bad evidence, no evidence, documentary evidence, testimonial evidence, etc. I have often told people that in my ideal world, when a registered rep has a conversation with a customer, it would be under oath and videotaped, since that would clearly be the best evidence of what transpired. Armed with that tape, I could likely persuade any reasonable factfinder about what was actually said in that conversation. But, in the real world, there are no such tapes. Often, disputes over what was said in a particular conversation boil down to a swearing match between the participants, as a result of which the credibility of the respective witnesses becomes the single factor which dictates the resolution of the dispute.

To avoid this, broker-dealers commonly use documents to memorialize information that they pass along to their customers. A prospectus, for example, is nothing other than a compilation of material disclosures of which any prospective investor should be made aware before investing. No one provided a prospectus can reasonably argue that he or she did not know about the 15 pages of “risk factors” carefully described by the issuer, including the risk that the investment is speculative, and that no investor should proceed if unable to bear the risk of possibly losing the entire investment.

Yet, every day in arbitration, customers who receive such disclosures – indeed, customers who sign multiple documents expressly acknowledging not only receipt of such disclosures but, as well, that they have read and understand them – are able to convince panels, for whatever reason, to disregard the disclosures. Case in point: years ago, I defended a customer arbitration in which the principal claim was that the claimant did not know the REIT he had purchased lacked liquidity. I thought the defense was easy and compelling, as the customer had signed and/or initialed at least three different disclosure documents, each describing in plain English that the product was not liquid. On cross-examination, the customer dutifully acknowledged his signatures and initials, but maintained that despite all that, he still failed to understand that the REIT lacked liquidity. In fact, a similar disclosure was in the prospectus. I recall asking the customer if he had read the prospectus, and he honestly answered, “No, it is too long.” So, I asked if he had bothered, then, to read at least the very first page, on which, in bold print, all caps, was a disclosure that the REIT was not liquid. Again, he told me “no.” I was comfortable that no panel would ever award money to a customer who so readily admitted he had not read the disclosures provided to him.

Guess what? The customer prevailed.

The point is, disclosure documents are useful, but they are hardly the silver bullet that regulators seem to believe they are. Even detailed disclosures, acknowledged in writing by a customer, are routinely ignored by arbitration panels (or, worse, second-guessed by regulators who insist the disclosures did not go far enough). NASAA’s template is a fine document, and will obviously help broker-dealers communicate clearly with their customers about fees. But, it is completely unrealistic to expect that firms which elect to employ the template will be able to use it as a shield against any potential liability. If NASAA believes otherwise, then it ought to join me the next time I have to defend an arbitration brought by a customer who admits he didn’t bother to read the very disclosures that would have revealed the baseless nature of his case, and watch how the panel responds.

In what many will likely consider to be an effort to quiet the increasing chorus of criticism over the SEC’s increased use of administrative proceedings over the last few years, today, the SEC announced a proposal to amend several of the rules governing those proceedings. While the SEC did not expressly acknowledge that the amendments were intended to address the growing number of attacks on the fairness, and even the constitutionality, of administrative proceedings, certainly the timing of today’s release suggests that this had something to do with it.

In any event, here are the highlights of the proposed amendments. Comments can be made for 60 days following the publication of the amendments in the Federal Register.

  • Discovery depositions: perhaps the most dramatic change would be the availability of prehearing discovery depositions. Under current procedures, depositions are relegated only to those few situations where testimony must be perpetuated as a result of a witness’s inability to appear and testify at a hearing. The proposed amendment, however, would permit both the respondent and the Division of Enforcement each to take up to three discovery depositions, including the ability to serve accompanying document subpoenas. This includes the right to take discovery depositions of expert witnesses.

For those of you getting excited about the prospect of deposing the SEC examiners, well, not so fast. The proposed rule recites that to be deemed to be a fact witness subject to deposition, the individual must have witnessed or participated in “any event, transaction, occurrence, act, or omission that forms the basis for any claim asserted by the Division, or any defense asserted by any respondent in the proceeding.” As a result, “this excludes a proposed deponent whose only knowledge of relevant facts about claims or defenses of any party arises from the Division’s investigation or litigation.” Since SEC examiners invariably only gain their knowledge from their investigations, depositions of these witnesses would seem unlikely, if not impossible.

  • Time limits: today, litigated administrative proceedings are supposed to take 300 days from the day the Order Initiating Proceedings is served on the respondent until the ALJ issues the Initial Decision. Because the ALJ needs time after the hearing to review the record and draft the Initial Decision, a big chunk of that 300-day period is reserved for the post-hearing phase; thus, the length of the prehearing period – approximately four months – is often shorter than ideal, or necessary to prepare adequately for the hearing. Under the proposed amendment, that four-month period is doubled, up to eight months, in order to give parties “additional flexibility during the prehearing phase of a proceeding and afford parties sufficient time to conduct deposition discovery.” In addition, ALJs are expressly given the right to seek an additional 30 days within which to issue the Initial Decision.
  • Evidence: as everyone knows, unlike in court, the Federal Rules of Evidence do not apply in administrative proceedings. Rather, under the existing rule, “relevant” evidence is admissible while evidence that is “irrelevant, immaterial, or unduly repetitious” is not. To that list, the SEC proposes to add “unreliable” evidence. In addition, the proposal expressly clarifies that hearsay testimony may be admitted if it is relevant, material, and bears satisfactory indicia of reliability so that its use is fair. I don’t think this really changes anything that is already in practice before ALJs, but it is nice to see the standard expressly articulated.

What is it that people say? The first step to solving a problem is admitting that you have one. Arguably, as evidenced by today’s proposal, the SEC may be admitting that its current set of rules governing administrative proceedings is somewhat less than fair to respondents. But, SEC statistics clearly reveal that the Division of Enforcement is enamored with administrative proceedings – and who can blame them, given their ridiculous winning percentage there. Given that, there seems little chance that, at least in the short run, the SEC is suddenly going to abandon administrative proceedings and increase its court filings, notwithstanding the fact that some of the constitutional challenges to the SEC ALJs have some real legs.[1] At least if these amendments are approved, respondents can feel a little bit better during their four – no, eight – month trip to the gallows.

[1] A very interesting SEC decision was released last week. In affirming an ALJ’s Initial Decision finding that respondent investment advisors had, in fact, violated the Advisers Act, the SEC took the opportunity to address in detail for the first time these constitutional challenges. Indeed, 13 of the decision’s 52 pages are devoted to the discussion of the constitutional challenges.

A couple of events caught my attention this week and, since they are related, I thought I’d address them together.

On Monday, the SEC announced a proposed rule change to FINRA Rule 8312, the FINRA BrokerCheck Disclosure Rule. Rule 8312 permits FINRA to disclose certain information on BrokerCheck about registered individuals. As many of you are intimately aware, BrokerCheck reports information on a registered individual that is included in that person’s Forms U-4, U-5, and U-6. The information includes regulatory complaints and customer disputes, as well as the resolution of those matters.

Under the current version of Rule 8312(d)(5), FINRA is not allowed to publish on BrokerCheck information disclosed in a registered person’s Form U-5 until 15 days have elapsed following the filing of the U-5. The idea behind this cooling off period is to allow registered persons sufficient time to address and comment on the information disclosed on the U-5, such as the Firm’s stated reason for termination.

Apparently, 15 days is too much time, though. The new proposal would reduce that time period from 15 days to a mere three days. FINRA says it “is concerned that the length of the current waiting period may provide, for an extended period of time, an incomplete picture of a broker’s disciplinary history if an investor reviewed a broker’s BrokerCheck report during the waiting period.” If you haven’t heard the public calling for this information to be published sooner, you aren’t alone – unless, of course, you read “public” as the Public Investors Arbitration Bar Association (PIABA). PIABA regularly issues press releases, ostensibly on behalf of the public, suggesting FINRA is not doing enough to provide information to the public. But, as we’ve written previously in this blog (Problems with Registration of Registered Reps, Part 1: Does Anyone Actually use BrokerCheck?), the idea that the public is clamoring or even using BrokerCheck doesn’t seem grounded in reality. Nonetheless, FINRA, in typical reactionary form, is attempting to address an illusory problem.

What’s the takeaway?   If this proposed rule change happens, registered persons must be prepared to move expeditiously to ensure that his/her comment is properly reflected on BrokerCheck.   And be happy it’s not worse. At least a person still has the ability to provide a comment.

Wait, never mind. Forget I said anything.   I don’t want FINRA getting that idea. Moving right along…

In other news, apparently, it’s also still much too easy to obtain expungement removing frivolous customer complaints from one’s CRD record. To address this ghastly situation, the FINRA Board of Governors voted this week to propose an amendment to the Code of Arbitration Procedure formally codifying what has been, up until now, merely “guidance” provided to arbitrators by FINRA Dispute Resolution on how they should evaluate requests for expungement. FINRA has provided extensive training to its arbitrators and told them repeatedly and emphatically to treat expungement as an “extraordinary” remedy. We’ve often wondered where this “extraordinary” standard came from, as the word itself doesn’t appear in any specific FINRA Rule or Code section concerning expungement. If it seems like FINRA merely made up a standard, it’s because, well, they pretty much did. Perhaps this proposed amendment is a way to help FINRA get back over its skis on this issue.

Regardless, it’s safe to say that the expungement process isn’t going to get any easier in the coming months and years. Arbitration panels, which have already been repeatedly admonished by FINRA not to grant expungement requests readily, are only going to be more critical of such requests once this rule is approved by the SEC. And given the fact it takes so little for a mark to be placed on a registered person’s record, that’s a shame.

Much like some people (well, me, anyway) enjoy debating what was the first “punk rock” song to go mainstream (Pump It Up, by Elvis Costello, of course), others more erudite than I prefer, instead, to argue about what it was that initially propelled FINRA down its current Enforcement oriented path. To me, the answer has always been clear: the research analyst “Global Settlement” largely brokered in 2003 by then New York Attorney General Eliot Spitzer with Wall Street’s elite firms. At a time when NASD sat blithely by, raking in money from the enormous trading volumes on Nasdaq (which NASD still owned at the time) generated during the “tech bubble,” Mr. Spitzer was aggressively investigating the overly cozy relationship between the investment banking and research departments of the big broker-dealers who were underwriting the many technology-based IPOs that were coming out. According to his investigation, issuers were promised, in essence, that no matter how sketchy their stories, no matter how non-existent their profits, they would nevertheless be provided positive research coverage in exchange for entering into an underwriting agreement. Thanks to a broadly drafted New York statute[1] that effectively gave him greater remedial powers than NASD (or the SEC), Mr. Spitzer was able to do what neither of those regulators did on their own, and shut that down.

In an obvious effort to catch up to the State of New York, NASD eventually ended up promulgating Rule 2711, the Research Analyst rule, which served to prohibit much of the misconduct detailed in Mr. Spitzer’s settlement by ensuring that research be conducted independently of whatever a firm’s bankers wanted, or didn’t want. From that point in 2002 forward, it has basically been a steady deluge of new rules and rule changes, and tougher enforcement of those rules, which continues to this day.

One of the unique aspects of Rule 2711 is that it only applied to equity securities, but not debt instruments. As of February 22, 2016, however, and 14 years after the rule initially went into effect, that will no longer be the case. On that date, new Rule 2242 becomes effective, extending to debt securities much of the firewall that presently exists between equity research analysts and bankers.[2]

Frankly, this is not particularly surprising. In fact, in retrospect, it seems pretty clear that it would happen. This is a result of the confluence of two things, first, the fact that the research analyst rule is largely predicated on the identification and avoidance of the obvious conflict of interest between bankers (who want to bring in underwriting business, perhaps by promising favorable coverage) and analysts (who are supposed to be independent), and, second, the fact (as we have blogged about before) that FINRA is increasingly focused on the efforts by its members to – you guessed it – identify and avoid obvious conflicts of interest. Indeed, Regulatory Notice 11-11, which first announced FINRA’s interest in extending Rule 2711 to debt securities, is expressly subtitled, “FINRA Requests Comment on Concept Proposal to Identify and Manage Conflicts Involving the Preparation and Distribution of Debt Research Reports.” Regulatory Notice 15-31 bears a similar name. It is no mystery, then, that conflicts of interest lie at the heart of this rule.

Back in May, in a post I wrote after the first day of FINRA’s national conference, I made the following statement about conflicts of interest: “There is no specific rule that dictates that BDs address conflicts of interest, but FINRA expects that firms do it anyway. As with cybersecurity issues, Susan Axelrod said that while FINRA examines for conflict management, the goal is for FINRA to ‘understand’ how firms are managing that part of their business. The cynic in me can only wonder whether, and when, that goal will change, and encompass Enforcement actions.” With the passage of new Rule 2242, I feel rather prescient. Clearly, with its research analyst rule, FINRA has taken conflict avoidance from a mere concept to an enforceable reality.

The problem, however, is that, as with many rules, while FINRA theoretically leaves it to BDs in Rule 2242 to create their own policies and procedures “reasonably designed” to address the requirement to manage conflicts of interest, historically, FINRA has demonstrated very little actual willingness to accept viewpoints contrary to its own on what constitutes “reasonableness.” In other words, FINRA freely substitutes its own business judgment for that of its member firms, insisting that only its interpretation of “reasonableness” matters. That has not worked with other rules which incorporate a “reasonableness” standard, so I have no reason to believe it will work any better here. The sad fact is that, once again, firms need to be prepared to be second-guessed by FINRA examiners who, starting next year, will begin gauging compliance with Rule 2242.

[1] The Martin Act is an antifraud statute that empowers the New York Attorney General to bring cases against allegedly fraudulent conduct without having to prove either intent or even negligence, as is the case under Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934.

[2] FINRA has also created new Rule 2241, which replaces Rule 2711. While Rule 2241 maintains most of the content of Rule 2711, there are some aspects that have been modified. Perhaps I will discuss them some other time, in another post.

I am currently in the midst of a FINRA examination that is largely focused on the adequacy of the due diligence that my broker-dealer client conducted of a private placement. What is puzzling about the exam is that FINRA is not just interested in the due diligence that was conducted prior to effecting any sales to customers, but, as well, the due diligence that my client did after the sale, i.e., “ongoing due diligence,” specifically, to determine whether or not the issuer, in fact, utilized the proceeds of the sales in a manner consistent with the description in the private placement memorandum, or PPM. And that got me wondering about so-called “ongoing due diligence,” where that supposed duty arises from, and how it appears to be utterly inconsistent with the notion that broker-dealers’ obligations to their customers are transaction based, essentially ending once a recommendation to buy (or sell, hold or exchange) is made.

Certain things about suitability are easy, and well accepted. As FINRA Rule 2111 makes clear, before an RR can recommend a security to anyone, he first must conduct due diligence, i.e., reasonable basis suitability, to ensure that the product is suitable for some investor, somewhere. If that test is passed, then the RR moves on to customer specific suitability, to determine whether the security is appropriate for a particular customer, based on the customer’s investment objective, risk tolerance, financial wherewithal, time horizon, liquidity needs, etc. Assuming that the security is suitable, and a recommendation is made, that is where the RR’s responsibility to his customer ends. There is no duty to continue to monitor the investment, or the account, or the market. This, in a nutshell, is what distinguishes the role that a BD plays from that of an investment advisor. Because an IA has a fiduciary duty, not a suitability duty, its obligations to its customers continue after the sale, and include the ongoing need to monitor the investment, the account, the market.

So where, then, does FINRA come up with idea that BDs have some duty to conduct “onging due diligence” after a sale is effected? My client has been subjected to intense scrutiny regarding the steps it took, on an ongoing basis, to ensure that the issuer of the private placement applied the proceeds of the offering exactly how the offering materials described they would be applied. What I cannot figure out is why my client supposedly had a duty to undertake this inquiry, once the sales to the customers were made? How is a private placement any different than an ordinary stock, bond, or mutual fund? Once those products are sold, no one, even FINRA, would argue that there is some duty for an RR to track the investment and, in response to what ensues, make further recommendations. Yet, when dealing with private placements, FINRA has apparently created some entirely new duty – one not based on any rule – to conduct ongoing, as opposed to initial, due diligence of the issuer and the security sold. That makes no sense.

Regulatory Notice 10-22 is the gospel when it comes to outlining what reasonable due diligence consists of, at least in FINRA’s eyes, when selling Reg D private placements (although FINRA states in that notice that “many of the [reasonable investigation] practices” described there “are appropriate for other types of offerings”). Interestingly, nowhere in that notice does FINRA discuss, or even mention, ongoing due diligence. The entirety of the notice is devoted to the nature and scope of the due diligence that must be conducted before a recommendation to purchase is made. There is not even a suggestion that, post-sale, a BD should have any concern, or need to have any concern, about what the issuer does with the proceeds. Perhaps it is an issue if a BD promises to conduct ongoing due diligence, but then fails to do so. In a 2011 AWC, Credit Suisse agreed to pay a $350,000 fine for, among other things, acting inconsistently with “marketing materials that stated that the firm had performed or was continuing to perform continuous and ongoing due diligence.” Similarly, in a 2013 Offer of Settlement, Daryl Holzberg, a registered principal responsible for his firm’s compliance pertaining to the sale of private placements, was sanctioned for inadequately implementing the written supervisory procedure that required he “undertake ongoing due diligence and ‘reassess’ the suitability issues concerning the product.”

Those sanctions make some sense, I suppose. But, what if the firm has no WSP requiring that it undertake post-sale, ongoing due diligence, as is likely the case with most BDs? In that circumstance, I simply cannot understand FINRA’s interest in and concern over whether or not my client conducted ongoing due diligence. It is the height of unfairness to subject a firm to some standard that exists nowhere except, perhaps, in FINRA’s imagination.

I have spent six days in OTRs already, with another two scheduled, in large part so FINRA can ask questions about something my client had no obligation to do.

How can this happen?

I feel like Yul Brynner (without the cool costume, or the abs).

Continue Reading The Ongoing Puzzle Of Ongoing Due Diligence

As an attorney that prosecutes non-payment of forgivable loan claims on behalf of BDs, I find these cases typically go one of two ways. In one case, the departed RR raises a series of frivolous counterclaims to try to get out from paying what is, on its face, usually a clear cut breach of contract and then the RR loses. In other cases, the departed-RR raises a series of frivolous counterclaims to try to get out from paying what is, on its face, usually a clear cut breach of contract claim, loses, AND then declares bankruptcy to try to get the debt owed to the BD discharged.

Bankruptcy is always a risk to any litigation and most firms appreciate that risk when filing a note claim.  Sometimes the principle is worth enforcing even if the firm thinks the RR won’t have sufficient funds to satisfy the judgment.

What if, though, the RR tries to make himself eligible for bankruptcy protection by spending at a rate that far exceeds his income and savings levels after an arbitration panel decides against him. Then, when the money is gone, he can declare bankruptcy thumbing his nose at the firm, right?   Is the firm left with no recourse?

Saturday morning college football ESPN GameDay host Lee Corso has a famous catch-phrase that applies to this situation.

Not so fast, my friend!

https://youtu.be/ZdoOaDmFuO0

Well, I’m not sure Barclays Capital Inc. would call its ex-RR, Michael Schwartz, a friend, but I think the concept is right.

This week, the 7th Circuit issued a decision affirming the dismissal of Mr. Schawartz’s bankruptcy petition filed after Mr. Schwartz and his wife tried to spend their way into bankruptcy following an adverse arbitration award.  The ruling sends a clear signal that manufacturing a bankruptcy to walk away from a forgivable loan won’t work.

We here are particularly happy about the result because the case was handled by Ulmer & Berne partner, Pat King.

Well done Pat!

A full news story of detailing the case and decision can be found here: Chicago Daily Law Bulletin – High living dooms bankruptcy petition

I have written before about some of FINRA’s procedural processes that seem strange and unfair. For instance, the constitutionally guaranteed Fifth Amendment right against self-incrimination? Doesn’t exist in FINRA world. Try invoking the Fifth at a FINRA OTR rather than answering a question and you will be facing a permanent bar for violating Rule 8210. Tell an arbitration panel that FINRA not only examined you for the very same conduct that the claimant is alleging to have been violative but concluded that you did nothing wrong? Forget it, as that is deemed to be a violation of Rule 2010, even though claimant is free to delve into each and every disclosure on your Form U-4, no matter how old or unrelated to the case at hand.

As incredible as these samples sound, I recently encountered a situation on behalf of one of my clients – admittedly, a very unusual situation, perhaps the first of its kind – that is even worse. It involves the same fairness principle behind the criminal concept of “double jeopardy,” i.e., the protection against being prosecuted twice for the same crime. Apparently, FINRA has concluded that this doesn’t apply to its proceedings, either.

It started with a settlement with a State Securities Commissioner that included as one of the sanctions a one-year suspension as a principal. Even though my client was still free to serve as a registered representative, because the suspension rendered her statutorily disqualified, she still had to file an MC-400 in order to continue to work for her broker-dealer. If you have ever been involved in an MC-400 proceeding, you know that they move rather glacially. Thus, by the time Member Reg got around to dealing with the application, the suspension had already expired. In any event, Member Reg (which has the authority to approve MC-400s but not deny them) recommended denial, based on supposed “intervening acts of misconduct” by my client. What acts? They claimed she had violated the terms of the suspension by acting as a principal in a number of different ways. In addition, Member Reg advised us that they were also making a disciplinary referral to Enforcement as a result of the claimed violations.

We requested our hearing before the NAC subcommittee, and, as you would imagine, FINRA presented evidence in its effort to prove that my client had improperly acted as a principal while suspended, and thus did not deserve to be able to work in the securities industry, period, in any capacity. We put on contrary evidence and we made our arguments and left it in the hands of the NAC.

Well, the NAC doesn’t act that quickly, either. Thus, while we awaited our decision on the MC-400, Enforcement went ahead and filed a formal complaint against my client, alleging the exact same thing that Member Reg had argued in its effort to have the MC-400 denied, i.e., that she had violated the terms of her one-year principal suspension. Cleverly (at least I thought it was clever), rather than answer immediately, I asked for an extension of time, hoping that by the time the Answer was actually due, the NAC would have released its decision on the MC-400. I figured (optimistically) that the NAC would approve the MC-400, and that Enforcement would then simply drop the complaint (since the NAC’s decision would necessarily have to be based on the conclusion that my client did not improperly act as a principal while suspended).

Turns out I was only half right. The NAC did approve the MC-400. And it did conclude that my client did not improperly act as a principal while suspended in that capacity. So, I got that part correct. Unfortunately, perhaps even bizarrely, although Member Reg lost, Enforcement is steadfast in its resolve to push its case forward. Even though the NAC has already published its findings of fact in my client’s favor on the very issues that Enforcement has alleged in its Complaint. (And even though the NAC also serves as the appellate body for Enforcement cases.) This, I cannot understand.

Enforcement has vast prosecutorial discretion. And FINRA has lots of administrative remedies available to it. Why not just drop this case, given the NAC’s ruling on the MC-400? If FINRA wants its pound of flesh, I suggested that they withdraw the complaint and, instead, issue a Cautionary Action Letter. But, Enforcement will have nothing to do with that. As a result, I am forced to continue to defend allegations that have already been decided in my client’s favor by FINRA. This cannot happen in the real world. Whether you call it double jeopardy, res judicata, collateral estoppel, it doesn’t matter. The complaint would have been dismissed, since the MC-400 findings would serve to bar the second attempt to litigate what has already been determined with finality.[1]

I recognize that I am not in court, and that FINRA is a private, quasi-governmental entity that gets to make up its own rules (apparently, sometimes, as it goes). Nevertheless, it would seem that when FINRA has discretion to exercise, as it does here, it should do so in a way that displays at least some respect for fairness and due process. Here, FINRA has elected to sacrifice those principles at the altar of aggressive Enforcement. This is not how the system was designed. Something is clearly broken.

[1] No MC-400 decision by FINRA is final until “acknowledged” by the SEC (which has the right to disagree with FINRA’s decision). Here, the SEC has already done that, so the NAC decision is truly final.