I’ve previously posted about my frustration with the way the discovery guide is written, with particular attention focused on List 1 Item 10.  See my prior post here.  Item 14 causes me similar angst. Why? Because Item 14 is so poorly worded that, if read literally, almost no audit report will ever be responsive to it. Under Item 14, a Broker-Dealer involved in a customer arbitration must produce:

Those portions of internal audit reports for the branch in which the customer parties maintained accounts that: (a) concern associated persons or the accounts or transactions at issue; and (b) were generated not earlier than one year before or not later than one year after the transactions at issue, and discussed alleged improper behavior in the branch against other individuals similar to the improper conduct alleged in the Statement of Claim.

At first blush, Item 14 seems aimed at requiring production of documents that satisfy either part (a) OR part (b). In other words, the drafters probably intended that broker-dealers would produce audit reports that directly mention the associated person/accounts/transaction at issue, or audit reports that discuss other instances of misconduct similar to that alleged during in the Statement of Claim (within the one-year time frame).

But, there are two problems with this. First, the request uses the word “and” directly before part (b).  So the way the request actually reads, a broker-dealer would never need to produce an audit report that mentions the transactions at issue in the Statement of Claim unless the audit report also mentions similar transactions or behavior that occurred with other customers.

The second problem with Item 14, and one that is more troubling than the grammar issues, is that by requiring production of documents responsive to part (b), FINRA seems to endorse the idea that a person is guilty with regard to one customer if he is merely suspected of misconduct with regards to other customers.  Production of audit reports highlighting “similar conduct” “against other individuals” sets the case up to be one based on a pattern or practice, rather than evidence about what happened with regards to this particular customer. Claimant will simply argue that Respondent must have wronged him because there are allegations that Respondent also wronged all these other folks.

At a hearing, these types of arguments inevitably require the Respondent to explain – and defend – any of the suspicions raised in the audit reports related to other customers, rather than focusing on facts pertaining to this particular Claimant. The end result is a series of mini-trials within a trial in order to defend the allegations about other investors. This runs counter to the foundational maxim that arbitration is supposed to be an expedited proceeding, not to mention such other minor things like the presumption of innocence, relevance, and burdens of proof.

In conclusion, if Respondent produces any documents in response to Item 14, this opens the door for a prolonged final hearing due to the distracting nature of audit reports that discuss “similar conduct” “against other individuals.” Thankfully, the way Item 14 is currently drafted with the word “and,” there are actually very few audit reports that are responsive to this request.

 

We have previously posted on the issue of CCO liability, a very sensitive subject, to say the least, for many readers of this blog.  If this is a subject that interests you, then there was a very intriguing development this past week in this area that merits your attention.

It came in the form of a decision by SEC Administrative Law Judge Cameron Elliott.  In its complaint, the SEC named Judy Wolf, a former compliance officer at Wells Fargo Advisors.  She was not the Chief Compliance Officer; in fact, she was far from chief, something that, ultimately, was important to the result.  The principal allegation is that she altered – slightly, through the addition of two sentences – a report she had created two years earlier concerning her review of trading in a particular stock to make it appear that her review was more robust than it actually was.  The SEC also maintained that she lied during her intitial sworn investigative testimony when questioned about the alteration to the report.  The sanctions sought against her included a cease-and-desist order, a second-tier civil penalty, and a permanent industry bar.

In his decision, Judge Elliott found that Wolf was, in fact, liable as alleged by the SEC.  He made some very nasty sounding findings, including that she was not credible when she initially attempted to explain the alteration, that she acted with scienter, that her alteration of the report was “highly unreasonable and created an obvious danger of violating the books and records rule,” that she “does not recognize the wrongful nature of her misconduct,” and that she willfully caused and aided and abetted the books and records violations attributed to Wells Fargo.  What is fascinating about the decision is not those findings, however, but, rather, the Judge’s determination not to impose sanctions on Wolf notwithstanding those harsh findings.

In support of his decision that Wolf did not merit the imposition of any sanctions, the judge identified several mitigating factors.  First, he noted that her act of misconduct was isolated.  Second, Wolf was already out of the securities industry and expressed no desire to return, so the Judge concluded there was little likelihood of any recurrence of the misconduct.  Third, Wolf had no disciplinary history, despite having over 30 years of experience, nearly ten in compliance.

None of this sounds particularly unusual; in fact, many respondents are able to, and do, make these same assertions.  So, what made the Judge take the unusual step of not imposing sanctions on Wolf when, historically, such arguments fall on deaf ears?

He cited a couple of specific reasons, and, more importantly, some conceptual ones.  As for the specific reasons, Judge Elliott started by concluding that despite all the findings against Wolf, her “violation was not egregious and it caused no proven harm to investors or the marketplace.”  While he conceded that her initial testimony was “misleading,” it did not cause the SEC to expend additional resources.  Her alteration was “minimal,” and did not materially impact the SEC’s investigation.  Again, any lawyer that practices in front of the SEC can tell you that arguments like this are made all the time, but with little impact.  So, these cannot really explain the decision not to sanction Wolf.

That, in my view, came down to the conceptual reasons.  First, the Judge concluded that because Wolf was “low-ranking, relatively low-paid, supervised no one, and worked in a cubicle,” sanctioning her would create the false impression to the securities industry that she was simply “a bad apple, a low status worker who unilaterally caused Wells Fargo to violate the law, and will see no need to examine their own practices and corporate cultures.”  The Judge was of the view that “Wells Fargo clearly had deeper and more systemic problems than one bad apple.”  Thus, sanctioning her would send the wrong signal to the world.

Second, and more important, was the Judge’s view, generally, of Compliance personnel:

In my experience, firms tend to compensate compliance personnel relatively poorly, especially compared to other associated persons possessing the supervisory securities licenses compliance personnel typically have, likely because their work does not generate profits directly.   But because of their responsibilities, compliance personnel receive a great deal of attention in investigations, and every time a violation is detected there is, quite naturally, a tendency for investigators to inquire into the reasons that compliance did not detect the violation first, or prevent it from happening at all.  The temptation to look to compliance for the “low hanging fruit,” however, should be resisted.  There is a real risk that excessive focus on violations by compliance personnel will discourage competent persons from going into compliance, and thereby undermine the purpose of compliance programs in general.

In conclusion, Judge Elliott wrote:  “I do not condone Wolf’s misconduct.  Neither the Division nor the Commission as a whole should tolerate falsified records or knowingly false testimony, and the Division was quite right to at least investigate Wolf.  But now that the evidence has been fully aired, it is clear that sanctioning Wolf in any fashion would be overkill.”

The unusual nature of this decision cannot be overstated.  Arguments about mitigation that are made every day without success were found here to have import.  Deliberate acts of record falsification, lies to investigators, pish posh, no sanction.  Really rather amazing.  I am hopeful that this case marks the start of a real analysis by securities regulators of the role that Compliance plays at broker-dealers, and a recognition that not every error committed, even when intentional, merits the attention that regulators now feel compelled to pay to Compliance personnel.  Thank you, Judge Elliott, for this decision.  Anyone want to bet if the Division will appeal?

UPDATE: 9/23/15:  I hope no one took my bet!  Turns out that the Division did not appeal after all, so the Initial Decision is now final.  Imagine that!

 

I have told many people over the years that the only way to effect true change at FINRA must come from the inside. I can write blog posts every day pointing out what I perceive to be the occasional error of FINRA’s ways, but apart from the cathartic effect it provides me to vent, the likelihood of my opinions having any real impact is pretty dubious. Similarly, clients of mine who complain about the treatment they have received from FINRA examiners, or the cost of achieving compliance, or the patent unfairness of the arbitration process, or whatever, who claim to “know” some politician who is going to rein FINRA in once they hear the horror stories that we describe in this blog are, sadly, deluding themselves. No elected official, at any level of government, is going to take a public stand that FINRA is too hard on its member firms. Not after Bernie Madoff.

With that said, elected Board members at FINRA can do so; frankly, they should do so. Let’s not forget that FINRA is, after all, a self-regulatory organization. It is broker-dealers directly governing themselves, with governmental oversight (in the form of the SEC) one level removed. The treatment that BDs receive from FINRA is, at least in theory, no more than what the industry agrees to receive.  As the great Walt Kelly put it so pointedly,

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But, member firms seem to have lost sight of this, that, really they are FINRA, and that FINRA exists because 75 years ago the industry decided that the best way to keep things under control was for it to regulate itself, rather than endure direct governmental oversight.I was very happy, therefore, to read recently of the campaign presently underway for the “mid-size” firm seat on the Board between Brian Kovack, of Kovack Securities in Ft. Lauderdale, and John Muschalek, of First Southwest Securities, in Dallas. I have known them both for probably going on 20 years, and believe that either will serve very well as the voice of their constituents, many of whom are, frankly, pretty angry.

Brian and John have taken fairly diverse approaches to their respective campaigns for this election, which takes place on July 30. Brian, who got on the ballot by obtaining enough votes from member firms to force a contested election, has been rather outspoken about his views. On the other hand, John, who is a current member of the NAC, i.e., the National Adjudicatory Council, and was nominated for the mid-size seat by FINRA, has remained relatively quiet, perhaps allowing his existing record to speak for itself. Regardless of the difference in their approach, I believe that both candidates fully understand what their role would be on the Board if elected: they must represent their constituents, i.e., mid-size firms, defined to be BDs with between 151 and 499 RRs. They are not there to serve as “yes men” to FINRA initiatives raised by FINRA management. They are not there to remain silent when considering proposals with significant anticipated impact on member firms. They must serve as the voice of the members. If they do not, the concept of self regulation becomes nothing more than a quaint notion harkening back to the good old days, like “TV dinner” or “drive-in movie.”

I am heartened by the vigor with which Brian has outlined his platform, because now is not the time for pussy-footing around. If the Board is really ever going to take steps – any steps, whether aggressive or just baby steps – to begin to reduce the burden of compliance with which FINRA (and the SEC, and Congress) have saddled broker-dealers, the industry needs representatives like Brian, and John, who not only have the bona fides to establish that they know what they are talking about, but who are actually willing to speak their minds, with conviction. It is not relevant to me that Brian is a so-called “dissident” candidate, whatever that means anymore, and that John was nominated by FINRA. What matters is what they each bring to the table. Either would be a good choice.

So, the long and short of it is that if you are a mid-size firm, vote. Show an interest in your industry. Remind FINRA that it answers to you, not the other way around.

There was a decision this week from the D.C. Circuit Court of Appeals on an appeal of a decision by a respondent who – stop the presses! – lost an SEC administrative proceeding, and then lost his appeal to the SEC. Montford and Company, Inc. v. SEC, No. 14-1126 (July 10, 2015). One of the arguments that the respondent made to the Court on appeal was that the SEC had violated its own internal rule that requires the initial complaint to be issued within 180 days of the date of the Wells notice. The Court gave that argument short shrift, concluding that the rule merely created an “internal deadline,” one that carried no consequences in the event the SEC failed to meet it.

That got me thinking of the concept of time, more specifically, the weird way it seems to work in the world of securities defense, and how disturbingly common it is for seemingly straightforward rules establishing deadlines to be ignored, generally to my clients’ detriment. Cue the Ramones: https://https://www.youtube.com/watch?v=Q3T3faCmE0I2015-07-20 10_53_17-▶ The Ramones - Out of time - YouTube

The most glaring and common situation of this ilk is the decision by FINRA arbitration panels routinely to ignore the impact of the “Eligibility Rule,” found in Rule 12206(a) of the Code of Arbitration Procedure. It requires, plainly enough, that arbitrations must be filed within six years of the occurrence or event giving rise to the claim. That doesn’t seem particularly difficult to get your head around. Customer buys the security in question on June 1, 2008, so he has to file the arbitration within six years, i.e., by June 1, 2014, and, if he is late, the case is dismissed, right? Sadly, it rarely is. Sometimes, sure, but most of the time, at least statistically and anecdotally speaking, panels deny motions to dismiss based on Eligibility even when the facts would seem to mandate dismissal. And, because panels are not required to explain their decisions, their reasoning seems mysterious, at best. It is frustrating, especially when reporting the result of a denied motion to a disappointed client.

The same is true of motions to dismiss based on statutes of limitation. Every claim contained in a Statement of Claim filed to initiate an arbitration, whether based on a statute or a violation of common law, has an applicable statute of limitations. Courts do not hesitate to enforce statutes of limitations, but arbitration panels often act quite to the contrary, despite their obligation to apply the law as written.[1]

What about Enforcement cases? This may be the more interesting discussion, as Enforcement cases brought by SROs, like FINRA, have no statute of limitations.[2] Moreover, there is no procedural rule that requires FINRA to file cases within any specified timeframe of the particular event or action that is the subject of its attention. As a result, I often find myself defending claims that are many years old. Just today, for instance, I got approached to assist a registered rep who has been “requested” by FINRA to appear for an OTR to answer questions about an investment made in the late 1990s. And there is a problem with that. Documents disappear. Witnesses’ recollections fade. Witnesses disappear. The reason statutes of limitations exist is to provide a modicum of fairness to defendants by requiring claims to be filed sufficiently close to the event at issue so documents and witnesses still exist and can be used as part of the defense. In FINRA world, however, that is not the case, so be prepared to answer questions about emails sent six years ago, or trades made eight years ago.

But, there is a slim ray of hope, as there exists an equitable defense based on timeliness that is theoretically available in FINRA actions; indeed, it has actually worked a couple of times. The defense stems from the SEC’s decision in Hayden, 15 years ago. In that case, the SEC overturned a NYSE Enforcement case because so much time transpired between the activity in question and the filing of the complaint that it was “unfair” to the respondent. The SEC stated that “a fundamental principle governing all SRO disciplinary proceedings is fairness,” and that an SRO has “a statutory obligation to ensure the fairness and integrity of its disciplinary proceedings.” Yikes! Did the SEC really say that?

Applying that principle to the facts before it, the SEC focused on four time periods to determine that the NYSE had waited too long to bring the case:

  1. The time between the first alleged occurrence of misconduct and the date the NYSE filed the complaint;
  2. The time between the last alleged occurrence of misconduct and the date the NYSE filed the complaint;
  3. The time between the date that the NYSE received notice of the alleged misconduct and the date the NYSE filed the complaint; and
  4. The time between the date that the NYSE commenced its investigation and the date that the NYSE filed the complaint.

That all makes sense, and arguments based on these timeframes would seem to remain valid. But, since then, alarmingly, FINRA has engrafted on to this rather mechanical construct the further requirement that a respondent also demonstrate that the delay has caused him “actual prejudice.”[3] Why is that alarming? Because shortly after Hayden was issued, the National Adjudicatory Council held that “even without a showing of prejudice, it can be inherently unfair to require respondents to face the prospect of claims for prolonged and indeterminate periods of time.” By now requiring what neither the SEC nor the NAC initially held was necessary to establish a Hayden defense, i.e., the need to demonstrate actual prejudice, successful Hayden defenses are few and far between.

This is just a taste of the temporal weirdness that I grapple with every day, Arbitration panels and regulators playing dangerous games with the space-time continuum. I don’t necessarily share Doc Brown’s fear that this could result in the destruction of the universe, but, if you are in the role of facing old, dusty, faded claims, it could certainly be disastrous for you.

[1] A common argument against motions to dismiss claims based on the statute of limitations, right out of the PIABA playbook, is that they only apply in court, but not in arbitrations. Happily, a couple of years ago a court in Florida largely put that one to bed, finding that statutes of limitations do, in fact, govern arbitration claims. Thanks to my friends George Guerra and Dominque Heller for that helpful decision!

[2] See William D. Hirsch

[3] See redacted decision, in which the Hearing Panel not only required a showing of actual prejudice, but detailed how such a showing has to be made: respondent “must identify key witnesses or evidence whose ‘absence has resulted in [respondent’s] inability to present a full and fair defense on the merits,’” and “must produce evidence that a witness’s memory ‘would have been fresh one, two, or three years ago, but is not fresh today.’”

Yesterday, the SEC held its 2015 “National Compliance Outreach Program for Broker-Dealers.” The program was designed to “provide[] an open forum for regulators and industry professionals to share strong compliance practices and promote the exchange of ideas to develop an effective compliance structure.” In the spirit of this cooperation, SEC Chairwoman White opened the conference with a speech that included the following remark[1]:

To be clear, it is not our intention to use our enforcement program to target compliance professionals. We have tremendous respect for the work that you do. You have a tough job in a complex industry where the stakes are extremely high. That being said, we must, of course, take enforcement action against compliance professionals if we see significant misconduct or failures by them. Being a CCO obviously does not provide immunity from liability, but neither should our enforcement actions be seen by conscientious and diligent compliance professionals as a threat. We do not bring cases based on second guessing compliance officers’ good faith judgments, but rather when their actions or inactions cross a clear line that deserve sanction.

This comment comes on the heels of Commissioner Aguilar’s Public Statement on June 29, 2015. In that statement, he wrote:

In fact, over the years the Commission has brought relatively few cases targeting CCOs relating solely to their compliance-related activities. In general, the Commission’s enforcement actions against CCOs ebb and flow with the number of cases brought against investment advisers and investment companies. Estimates show the following number of enforcement cases brought against these CCOs, compared to the number of enforcement cases brought against investment advisers and investment companies, between 2009 and 2014:

       2009 — 8 out of 76 cases (11%)

       2010 — 7 out of 112 cases (6%)

       2011 — 14 out of 146 cases (10%)

       2012 — 16 out of 147 cases (11%)

       2013 — 27 out of 140 cases (19%)

       2014 — 8 out of 130 cases (6%)

The vast majority of these cases involved CCOs who ‘wore more than one hat,’ and many of their activities went outside the traditional work of CCOs, such as CCOs that were also founders, sole owners, chief executive officers, chief financial officers, general counsels, chief investment officers, company presidents, partners, directors, majority owners, minority owners, and portfolio managers. Many of these cases also involved compliance personnel who affirmatively participated in the misconduct, misled regulators, or failed entirely to carry out their compliance responsibilities.

Chairwoman White’s remarks and Commissioner Aguilar’s statement stem, in part, from the settlement in the Blackrock Advisors matter.   On April 20, 2015, the SEC issued an order requiring a CCO to pay $60,000 in civil penalties for, in part, “not recommend[ing] written policies and procedures to assess and monitor . . . outside business activities and to disclose conflicts of interest. . . .” The order does not indicate that the CCO wore any other hats or was directly involved in the alleged misconduct. Interestingly, the order recites that the WSPs were amended in January 2013. This decision was also unique in that Commissioner Gallagher issued a Public Statement explaining his dissent from the approval of the settlement. In his Statement (he also dissented from another similar settlement as well), he stated:

Both settlements illustrate a Commission trend toward strict liability for CCOs under Rule 206(4)-7. Actions like these are undoubtedly sending a troubling message that CCOs should not take ownership of their firm’s compliance policies and procedures, lest they be held accountable for conduct that, under Rule 206(4)-7, is the responsibility of the adviser itself. Or worse, that CCOs should opt for less comprehensive policies and procedures with fewer specified compliance duties and responsibilities to avoid liability when the government plays Monday morning quarterback.

Despite the fact that I represent folks in fights with securities regulators every day, I’m not against strong and fair regulatory enforcement. If there are bad guys out there, we should all want them off of the proverbial streets. Here, though, I think Commissioner Gallagher has it exactly right.

What I find troubling is the double-talk coming from the regulators. If you listen, they want CCOs to be their allies in working towards the goal of creating superior firm compliance. As Chairwoman White said yesterday, “You are on the front lines working to create, implement, and enforce a strong and comprehensive set of policies, procedures, and systems to govern and supervise firm employees.” They want CCOs to adopt a culture of compliance and focus on ensuring that the firm operates as it should.

If that’s the case, they must exercise discretion and only bring actions against a CCO for egregious conduct. As Commissioner Gallagher notes, regulators need CCOs to help them ensure regulatory compliance.   That means they want CCOs actively examining and involved in the firm’s operations.  But, the more a CCO digs, the more he/she risks being found to have participated in the misconduct. By bringing actions against these individuals, the regulators disincentivize the exact habits they wish to enforce.  Rather than CCOs trying to improve the firm’s supervisory system and commitment to regulatory compliance, CCOs must keep one eye on regulators to ensure they don’t get caught up in the same net.

Of course, this observation should not apply to CCOs that are directly complicit in the regulatory failings of a firm. If a CCO turns a willful blind eye to a supervisory violation or knowingly and actively participates in the alleged wrongful conduct, or worse, fraudulent conduct, it makes perfect sense to bring enforcement actions against those individuals. But absent that, it would be in the SEC’s and FINRA’s interest to be very very selective in bringing enforcement actions against CCOs. That would have the greatest investor protection benefit.

What’s the moral to this story?

Until the SEC and FINRA stop targeting CCOs in enforcement actions, CCOs should be very careful. The regulators are playing a game of “gotcha” and do not show any appreciable restraint when it comes to regulating the conduct of CCOs.  As long as regulators continue to bring enforcement actions against CCOs, the industry should assume comments like the ones coming from Chairwoman White or Commissioner Aguilar are merely hollow words offered to give individuals in an already highly regulated industry a false sense of security.

[1] The full text of her speech can be found by clicking here.

FINRA’s Discovery Guide for Customer Disputes is not perfect. I think that FINRA would be the first one to admit that – which is why the Discovery Guide adopted under the Code of Arbitration Procedure for Customer Disputes has been revised three times in the past five years, and a task force has been set up to continue making revisions. This is the first of what will likely be many posts that highlight some of the Guide’s serious “misguidance.”

The Discovery Guide for Customer Arbitration List 1 Item 10 requires respondents, i.e., broker-dealers and registered representatives, to produce:

All Forms RE-3, U-4, and U-5 and Disclosure Reporting Pages, including all amendments, for the associated persons assigned to the customer parties’ accounts at issue during the timer period at issue, redacted to delete associated persons’ Social Security numbers, all customer complaints identified in such forms, and all customer complaints filed against the associated persons that were generated not earlier than three years prior to the first transactions at issue through the filing of the Statement of Claim, redacted to prevent the disclosure of non-public personal information of the complaining customers.

Phew! After you catch your breath from that ridiculously long sentence, with a ridiculously large number of commas – and no subparts – go ahead and read it again. If you are like me, at first glance you may have interpreted Item 10 as requiring the production of one item (Forms RE-3/U-4/U-5) with various information redacted.

But, when you get to the end of Item 10, you realize that’s not correct. The request actually calls for production of three items: (a) Forms RE-3/U-4/U-5, redacted to delete the associated person’s Social Security numbers; (b) all customer complaints identified in such forms, redacted to prevent disclosure of non-public personal information about the complaining customers; and (c) all customer complaints filed against the associated person that were generated not earlier than three years prior to the first transactions at issue through the filing of the Statement of Claim, redacted to prevent disclosure of non-public personal information of the complaining customers.

Why the drafters choose to use commas instead of subparts like they do for other Items, such as Items 1 and 7, is a mystery. But the lack of subparts makes the request confusing at best, and misguiding at worst. Even more troubling, however, than the structure of Item 10 is its substance. Item 10 requires production of all complaints listed on the rep’s Form U-4/U-5, and all complaints filed within the three years prior to the first transaction at issue – not just complaints that are “of a similar nature” to the claims at issue.

Seasoned practitioners may remember a time – prior to May 16, 2011 – when a rep was only required to produce complaints if they involved claims or conduct “of a similar nature” to those at issue in this case. From April 16, 2007 to May 16, 2011, Item 8 (predecessor to current Item 10) required production of “All Forms RE-3, U-4, and U-5, including all amendments, all customer complaints identified in such forms, and all customer complaints of a similar nature against the Associated Person(s) handling the account(s) at issue.” FINRA rather quietly eliminated the language “of a similar nature” from that Item. Both the original list of FINRA’s presumptively discoverable items, first published in Notice to Members 99-90, as well as the first version of the modern iteration of the discovery guide in place from 2007 to 2011 required only Complaints “of a similar nature” to be produced.

So why did FINRA remove this condition? Are complaints about insider trading really relevant to claims involving churning? Of course not. Will a panel allow a claimant to present evidence of a rep’s disciplinary history, no matter how old or unrelated to the claims at issue? Probably. Apparently, FINRA now believes that if a rep is even merely accused of being a bad guy once, he must surely be bad guy now, even if the two incidents are “apples and oranges.”

Even more curious – or troubling, depending on your point of view – is the fact that throughout the revisions to the Discovery Guide, FINRA actually left intact the condition that other categories of documents only need to be produced if they involve conduct “similar to the conduct alleged in the Statement of Claim.” These categories of documents include any internal audit reports (Item 14), records of disciplinary action (Item 15), regulatory investigations (Item 16), and examination reports (Item 17). In a case involving churning, is an internal audit report related to insider trading any less relevant than a customer complaint related to insider trading? The answer is obvious to everyone except FINRA, which decided to eliminate the “similar conduct” language from the request for customer complaints, but kept it as a restriction in these requests.

So, to recap – if you have ever been accused of any wrongdoing by a disgruntled customer who lost money in a down market and found an attorney in the newspaper willing to take his case, that is relevant regardless of the subject matter. But, if you have been the subject of a disciplinary action or a regulatory investigation, this isn’t so bad that you need to produce it, unless it is “similar” to the conduct at issue. Is a disgruntled customer’s complaint more indicative of a rep’s character than a report by a regulator whose job is to detect improper behavior? Not likely. Someone please tell this to the Discovery Guide task force. And while you are at it, teach them about commas.

There are lots of FINRA rules, so many that some don’t get the attention they deserve because others, like the suitability rule or the supervision rule, generally hog the limelight. Moreover, some rules have such narrow application that you may not realize they even exist because they impact only a very few people or entities.

One such rule is FINRA Rule 8311, the amendments to which take effect on August 24, 2015. Most people, happily, never have to deal with Rule 8311, since it deals with what happens after a respondent is suspended, revoked or cancelled. In short, the present rule provides that once your registration is suspended (typically as a result of a disciplinary action), you may not receive any salary or commissions relating to securities transactions that you otherwise might have been entitled to receive during the period of suspension. That makes sense. If you are on the sidelines, you cannot earn money from transactions effected during that time period.

But, I am often asked about trail commissions, i.e., commissions paid on transactions done before the suspension, sometimes a long time before the suspension. Clients want to know if they are entitled to continue to receive trail commissions, which can be sizable, while suspended. Historically, I have said “yes,” but without any real hard data to support my opinion (other than the fact that FINRA has never questioned it). The answer, thanks to the soon-to-be-enacted amendments to Rule 8311, now is no longer subject to any doubt: you can receive trails while suspended, unless those trails relate back to the activity that resulted in the suspension itself.

This conclusion stems from the Supplementary Material that accompanies new Rule 8311:

Remuneration Accrued Prior to Effective Date of Sanction or Disqualification.  Notwithstanding this Rule, a member may pay or credit to a person that is subject of a sanction or disqualification salary, commission, profit or any other remuneration that the member can evidence accrued to the person prior to the effective date of such sanction or disqualification; provided, however, the member may not pay any salary, commission, profit or any other remuneration that accrued to the person that relates to or results from the activity giving rise to the sanction or disqualification, and any such payment or credit must comply with applicable federal securities laws.

This Rule makes perfect sense, and I applaud FINRA for erasing any confusion, and for doing something so reasonable. Remember, there are certain circumstances under which FINRA expressly permits commissions to be paid to unregistered persons, most notably when a registered person retires (and meets the requirements of the “Continuing Commissions Policy”[1]). Given the philosophy underlying that Policy, it makes equal sense to permit a suspended representative to continue to receive commissions earned, i.e., “accrued,” to use the language of the new Rule, prior to the effective date of the suspension. For details, refer to Regulatory Notice 15-07, released back in March.

There is one more interesting point about new FINRA Rule 2040(b), and it, too, resides in the Supplementary Material. Among other things, the new Rule continues the existing prohibition against paying commissions to unregistered persons. Nothing remarkable about that. But, here is what FINRA says about situations where it is unclear whether an unregistered person should be registered:

Members that are uncertain as to whether an unregistered person may be required to be registered under Section 15(a) of the Exchange Act by reason of receiving payments from the member can derive support for their determination by, among other things, (1) reasonably relying on previously published releases, no-action letters or interpretations from the Commission or Commission staff that apply to their facts and circumstances; (2) seeking a no-action letter from the Commission staff; or (3) obtaining a legal opinion from independent, reputable U.S. licensed counsel knowledgeable in the area. The member’s determination must be reasonable under the circumstances and should be reviewed periodically if payments to the unregistered person are ongoing in nature. In addition, a member must maintain books and records that reflect the member’s determination.

I love this language, particularly subsection (3), principally because I believe it can be employed in many other circumstances. There are several FINRA rules, the most noteworthy of which is the supervision rule, governed by a “reasonableness” standard. Here, in connection with Rule 2040, FINRA expressly concedes that an important element of establishing reasonableness is obtaining a legitimate legal opinion. If that is true for the purposes of Rule 2040, then, theoretically, it must also be true for the purposes of other rules. This new rule appropriately rewards member firms who take their compliance efforts seriously by spending money on counsel, to get opinions on which they can rely (even when those opinions are at odds with FINRA’s own opinion). One of my pet peeves has always been FINRA’s refusal to acknowledge that reasonableness can be defined by two different people in two different ways, with neither one being wrong. Perhaps I am reading too much into this language, but, seems to me, anyway, that FINRA has opened the door – a crack, at least – to entertaining contrary views on what is reasonable.

Again – twice in one post – I find myself complimenting FINRA.

[1] The Continuing Commissions Policy is presently found in IM-2420-1, but, as of August 24, will be moved to new FINRA Rule 2040(b). According to that Policy, a registered representative who retires from the securities industry can continue to receive trails after his retirement if: (1) there is a “bona fide contract” between the retiring rep and his broker-dealer, (2) that was entered into “in good faith,” (3) while the rep was still registered, and (4) expressly prohibits the retired rep from soliciting new business, opening new accounts, or continuing to service his old accounts. The designated beneficiary of a rep who dies with such a contract in place is also entitled to receive continuing commissions.

I’m not sure that I’m as excited as Navin Johnson was when the new phone books were delivered — https://www.youtube.com/watch?v=-7aIf1YnbbU – but I was pretty happy when FINRA published its 2014 Year in Review and Financial Report. That’s because, at a minimum, I get to enjoy the part where it reveals the compensation paid to its senior management. Here’s what this year’s Report states the “Top Ten” at FINRA will earn in 2015:

  • Rick Ketchum – Chairman and CEO: $1,000,000 salary plus $1,500,000 in incentive comp for a total of $2,500,000
  •  Todd Diganci – EVP and CFO: $550,000 salary plus $700,000 in incentive comp for a total of $1,250,000
  •  Steven Randich – EVP and CIO: $500,000 salary plus $565,000 in incentive comp for a total of $1,065,000
  •  Robert Colby – EVP and Chief Legal Officer: $500,000 salary plus $525,000 in incentive comp for a total of $1,025,000
  •  Susan Axelrod – EVP, Regulatory Operations: $450,000 salary plus $500,000 in incentive comp for a total of $950,000
  •  Brad Bennett – EVP, Enforcement: $435,000 salary plus $490,000 in incentive comp for a total of $925,000
  •  Tom Gira – EVP, Market Regulation: $425,000 salary plus $500,000 in incentive comp for a total of $925,000
  •  Steven Joachim – EVP, Transparency Services: $400,000 salary plus $475,000 in incentive comp for a total of $875,000
  •  Gregory Ahern – EVP, Corporate Communications and Government Relations: $400,000 salary plus $410,000 in incentive comp for a total of $810,000
  •  Cam Funkhouser – EVP, Office of Fraud Detection and Market Intelligence: $375,000 in salary plus $420,000 in incentive comp for a total of $795,000

These figures are determined by the Management Compensation Committee, comprised of four public members of FINRA’s Board of Governors. To justify their compensation determinations, the Committee states that it abides by the following “philosophy”:

FINRA’s compensation philosophy is a pay-for-performance model that seeks to achieve pay levels in line with the competitive market while meeting the objectives of attracting, developing and retaining high-performing individuals who are capable of achieving our mission, and to provide rewards commensurate with individual contributions and FINRA’s overall performance.

Ah, but what market is “competitive” with FINRA? That is a very thorny question, one that the Committee itself acknowledges:

Defining the relevant employment market for competitive compensation benchmarking purposes is a significant challenge for FINRA due to the scarcity of natural comparisons, the uniqueness of functions performed, the need for specialized expertise in financial services and securities law and a constantly changing environment under heightened scrutiny.

Given that challenge, the Committee explains that “[a] number of external sources are leveraged to compile market data to establish these structures. FINRA uses specific position survey data to evaluate skill sets and benchmarks the compensation paid to internal talent to determine whether compensation is comparable to the price that those skills would command on the open market.” They do not explain what those “external sources” are, but, helpfully, they do acknowledge that “FINRA has determined that its competitive compensation positioning for all employees should be considered against a broad section of financial services and capital market companies, as this sector is the most likely from which FINRA will recruit talent, and that would recruit talent away from the Company.” Moreover, “FINRA also benchmarks against general industry positions and law departments for jobs that are not unique to the financial services industry.”

This all sounds amazing. Thoughtful. Logical. Sensible. The problem is, when you tell the average FINRA member firm just how much the senior managers of FINRA – a not-for-profit entity, mind you – earn, with money derived from the assessments the members pay, they go nuts. I am not saying that FINRA employees, at any level, don’t earn their money; but, I am saying that when the Management Compensation Committee is looking for benchmarks against which to measure the fairness and reasonableness of the compensation packages it is offering to senior management, it is abundantly clear that the Committee is not using the “typical” FINRA member firm as the comparator.

These days, many small firms are simply struggling to survive. The hugely increased cost of compliance, necessitated by an onslaught of new rules, and dealing with enforcement-oriented teams of examiners and their serial requests for documents and information, is just too much for many firms to bear. It is a shock to absolutely no one that the number of FINRA member firms continues to contract. According to FINRA statistics, as of May 2015, there were 4,038 members. That is down from 4,578 in 2010, and from 5,111 in 2005. Over ten years, that represents a drop of over 20%.[1] Anecdotally, at least, this plunge in members is due to the difficulty of eeking out a profit, given the financial commitment it takes to pacify the regulators. To see FINRA pay its managers as much as it does, in an environment that has caused firm after firm to close its doors because they couldn’t make enough money to survive, is downright offensive to many members.

[1] In a curious coincidence, in 2005, NASD’s total expenses were $652.5 million (of which $352.5 million, or about 54%, represented compensation and benefits), while in 2015, that same exact figure — $652.5 million – represented only the compensation and benefits portion of the total expenses. The total expenses in 2015 comes to $968.4 million, so the amounts FINRA paid, and is paying, in compensation and benefits has climbed to about 67% of FINRA’s overall expenses. Slicing this data a little differently: in a ten-year period, FINRA’s expenses climbed 48%, while the number of member firms it regulates dropped over 20%. Hmmm.

As everyone who studies FINRA’s Regulatory Notices is already well aware, two days from now, FINRA’s rule requiring background checks on prospective registered representatives goes into effect. A lot of what the new rule mandates is not new, but, as there are some things that clearly were not required before, it is worth taking a few minutes to understand what FINRA has always required (but hasn’t necessarily enforced), and what new things the rule now makes mandatory.

I have blogged before a bit about existing hiring requirements. First, according to the boilerplate currently on Form U-4, before a broker-dealer registered a prospective representative, the broker-dealer had to certify that it had spoken with the applicant’s former employer(s) for the past three years. The new rule does not change this. Thus, even though most former employers will not share any of the sort of information in which a potential new employer would really be interested – in order to avoid any potential defamation actions – it is still necessary to reach out to those former employers at least to try and learn something about an applicant. Naturally, as with all things, if you don’t document these efforts, in FINRA’s eyes, you never made those calls.

Second, old Rule 3010(e) required firms to “ascertain by investigation the good character, business repute, qualifications, and experience” of any applicant. Although FINRA never defined what it meant by “investigation,” the rule did expressly require that an applicant’s most recent Form U-5 be reviewed. Other than changing “repute” to “reputation,” the new rule maintains all this language.

So, these two requirements remain the same. What, then, is new? There are two principal changes. First, in addition simply to reviewing the Form U-5 and speaking with former employers, FINRA seems to have[1] expanded what it believes the “investigation” should encompass. According to Reg Notice 15-05, “[f]irms also may wish to consider private background checks, credit reports and reference letters.” Like the two existing requirements, this is a pre-registration requirement, i.e., it must before undertaken before the U-4 is filed.

The second change is the big one. Under new Rule 3110(e), within 30 days after a U-4 is filed, a firm must “verify the accuracy and completeness of the information” in the U-4. Moreover, “at a minimum,” that verification process “shall . . . provide for a search of reasonably available public records.” There is a lot going on here, so let’s explore it.

First, some good news. In a refreshing (albeit rare) demonstration of logic, FINRA expressly acknowledges that if the U-4 information is verified as part of the pre-registration process, then it need not be duplicated after the U-4 is filed. Moreover, if, for some reason, the information cannot be verified within 30 days, FINRA appears to be ok with that, as long as the firm procedures “provide that the verification must be completed as soon as practical, and the firm should document the basis for the delay.”

The bigger issue is the need for the search of “reasonably available public records.” What does this mean? First, the search must be “national” in scope, although FINRA notes there may be circumstances that will require public records searches in foreign jurisdictions. Second, “public records,” according to FINRA, “include, but are not limited to general information, such as name and address of individuals, criminal records, bankruptcy records, civil litigations and judgments, liens, and business records.” But, because the Rule only requires a search of “reasonably available public records,” FINRA acknowledges that looking at all of these things may be unreasonable. At a minimum, therefore, FINRA will apparently only require a search of criminal records, bankruptcy records, judgments and liens.

Although FINRA expressly disclaims any “requirement” to obtain credit reports on applicants, FINRA does include the review of credit reports among the ways the rule can be satisfied, along with (1) fingerprint checks, (2) searching a reputable national public records database, such as LexisNexis, and (3) reviewing a consolidated report from a specialized provided, such as Business Information Group, Inc. that includes criminal and financial public records. Indeed, FINRA has contracted with BIG to allow broker-dealers to obtain reports on applicants for a very fair price of $10 – $13 per individual.[2]  UPDATE:  An old friend of mine, after reading this post, wrote to tell me that he has accepted FINRA’s invitation to use BIG on behalf of his broker-dealer.  He reports that there is a difference between BIG’s “Disclosure Monitoring Report” (which he describes as “not really live monitoring, but something that you might run annually”), on the one hand, which goes for $11.75 for the credit and criminal check, and, on the other hand, BIG’s “New Hire” packages, which run around $53 with no criminal check (perhaps useful for somebody not being fingerprinted) and $108 with the criminal check, plus the availability of several add-on services.  He also advises that getting set up with BIG is quite a process that can involve multiple contracts, depending on which services you are using, plus an onsite visit to verify that you are a real business.  Thanks, Kevin, for the insight!)

There are a couple of nuances to bear in mind. First, if you are going to run credit checks, it is important that you are aware of the requirements of the Fair Credit Reporting Act. Under the FCRA, it is necessary to get permission from someone before you run their credit report. Second, if you make a hiring decision based on someone’s financial history, the FCRA also erects hoops – generally in the form of notices that must be provided to the applicant, both before and after the adverse hiring decision is made – that must be jumped through to avoid possible penalties. For example, if an otherwise qualified individual is not hired because he or she has a bankruptcy disclosure, notification of that decision must be delivered to the applicant, who can then, theoretically, challenge it.  (FYI, a similar notice is required if the adverse hiring decision is based on the applicant’s criminal record.)

Finally, it is a very fair question to ask: what do firms do about the annual affirmations obtained from existing registered representatives about the currency and accuracy of the information on their Forms U-4? Will it be sufficient simply to rely on those affirmations, as most firms presently do, or will it be necessary (to be deemed reasonable by FINRA) to independently verify on an annual basis that the information on the registered representatives’ Forms U-4 remains accurate? Remember, applicants certify to the accuracy of the information on Form U-4 when they first apply, but, as the requirements of the new Rule demonstrate, broker-dealers are not permitted simply to rely on that certification, they must independently verify everything. If that is true at the front end of the relationship between a rep and his firm, why would it be any different after that relationship already exists? Unfortunately, I believe that blind reliance on reps’ affirmations, sooner or later, will be expressly deemed by FINRA to be inadequate.

On its face, these rule changes seem simple enough, and largely a continuation of existing requirements. On closer examination, however, the new rule imposes serious and significant new responsibilities on broker-dealers, and the failure to meet these responsibilities could very well result in Enforcement actions, not to mention negligent hiring claims in arbitrations.

[1] I say “seems to have” given FINRA’s use of the phrase “may wish to consider.” Clearly, FINRA isn’t requiring that broker-dealers use these tools, or even suggesting that the use of such tools constitutes some sort of safe harbor. But, it would be a very foolish broker-dealer that doesn’t follow the “advice” that FINRA provides here.

[2] Using BIG, however, is not deemed by FINRA to be a “safe harbor.”

I reported a few weeks ago on the victory that my clients, Mark Robare and Jack Jones, achieved in the administrative proceeding that the SEC initiated against them last year. Against all odds, they convinced Judge Grimes that not only had they not committed the fraud claimed by the SEC, but, in Judge Grimes’ words, it was “difficult to imagine them trying to defraud anyone, let alone their investment clients.”

The only problem is that Judge Grimes’ decision was not final, and would not become final for 21 days, three long weeks in which we waited to see whether or not the Division of Enforcement would file a petition to review the decision, or whether the Commission itself would call the decision for review.

Today was Day 21, the last possible day for either of these things to happen. At 4:50 pm EDT, I received an email from Enforcement. Guess what? They were appealing. Shocking. This was not the appeal brief, mind you, just the notice of appeal. Sometimes such things are all of two pages long, including caption and signature block. Here, it took Enforcement 27 pages – 27! – to describe all the findings that they claim Judge Grimes managed to get wrong.

So, now, under the rules, the five Commissioners who comprise the SEC, i.e., the same five people who authorized the issuance of the complaint against Mark and Jack in the first place, now get to decide whether they can live with the fact that Judge Grimes disagreed with their view of the facts. There are lots of statistics available to show what happens when respondents who lose administrative proceedings appeal to the SEC. (Not surprisingly, they don’t do very well; in fact, often the SEC will ratchet up the sanctions imposed by the ALJ.) There are very few statistics, however, to shed light on what happens when Enforcement loses and then appeals to the Commissioners. This is for the simple reason that Enforcement, basically, never loses, and thus never has to appeal.

I will keep you apprised of further developments. Mark and Jack will keep fighting the good fight, and, as before, will aggressively defend any and all accusations that they committed fraud on their clients. I am confident that the Commissioners, once they see the evidence in the record, will agree with Judge Grimes, and dismiss these charges, once and for all.