By now, it should be clear, we are oft to criticize FINRA in this blog. Much of that criticism is self-inflicted by, in our view, their unfair or unreasonable decisions. But, in a departure from the norm, I want to recognize an instance when FINRA is getting something right.

Effective this Friday, there will be a new definition of who will be considered a “public” arbitrator. See Regulatory Notice 15-18. Under the current definition, folks like me who represent broker-dealers and their associated persons are considered non-public arbitrators. Essentially, because of my representation, I’m considered an industry insider. What is odd, though, is an attorney who sits on the opposite side of the arbitration table and represents investors is not considered a non-public arbitrator. The impact of this can be profound.

For those of you that don’t know, the arbitrator selection process works like this. FINRA Dispute Resolution provides each party with a list of ten chairpersons, ten public arbitrators and ten non-public arbitrators.   From each of the first two lists, the claimant and respondent can strike up to four of the potential arbitrators; from the non-public list, the parties are free to strike as many as they want. [1] The parties then must rank in order of preference the remaining arbitrators. The chairperson candidates cannot include arbitrators designated as “non-public.” From the lists of ranks and strikes provided by each party, FINRA attempts to compose a three-person panel. In some instances, though, due to conflicts and/or availability, FINRA is unable to create a panel from the names provided to the parties and it must appoint another candidate from its pool of eligible arbitrators. When this happens, the parties have no role in the selection process. But…this can result in the appointment to the panel of an attorney who represents investors for a living.

I’m not exaggerating when I say that the vast majority of lists of potential arbitrators FINRA provides include an attorney that represents claimants in FINRA arbitrations and/or a member of the Public Investors Arbitration Bar Association (PIABA). It is common for us to finish an arbitration hearing, only to find the claimant’s counsel from the previous week’s hearing appear as a potential public arbitrator on the next list we see. Of course, as a matter of routine, we strike those claimant’s attorney-arbitrators. An attorney who represents investors against broker-dealers (often arguing in favor of a fiduciary duty that doesn’t exist) isn’t likely to give a member of the industry any benefit of the doubt.

As a party can only strike four public arbitrators, this provides the customer with a distinct advantage in the ranking process, allowing them to strike other objectionable candidates and rank the biased-claimant’s attorney. The inclusion of claimant’s attorney-arbitrators is particularly troublesome when he/she is appointed by FINRA after the ranking process fails to yield three arbitrators. The representation of claimants is not deemed a conflict by FINRA and, many times, the industry is stuck with these individuals on their panel. Talk about starting with the deck stacked against you!

But on Friday, this practice will come to an end.

The new definition of a non-public arbitrator will include “professionals who regularly represent or provide services to investor parties in disputes concerning investment accounts or transactions.” This means that the industry will no longer find a claimant’s counsel sitting on an arbitration panel deciding their dispute with a customer. Again and again, FINRA seems to succumb to the pressure levied by PIABA and other investor lobbying groups. But in this instance, and despite PIABA’s cries in opposition, FINRA got it right.

[1] As a result of this ability to strike all non-public arbitrators, claimants are able to dictate that their case be heard by an “all-public” panel, i.e., a panel without anyone from the industry. Since that rule changed in September 2013, the default arbitrator selection process has been the “all-public” arbitrator panel. This means that for a non-public arbitrator to serve on a FINRA arbitration panel involving a customer dispute, the customer must affirmatively indicate that non-public arbitrators should be included on the panel. Since Claimant attorneys view non-public arbitrators as partial to the industry, non-public arbitrators rarely (i.e., never) serve on a panel to decide a customer dispute. Non-public arbitrators, however, still serve on panels involving intra-industry disputes.

 

We have complained before in this blog about some of the obvious inequities associated with the FINRA Enforcement process that disfavor respondents. But I heard of a new one this week from a colleague, so I thought I would take the opportunity to revisit the issue.

While there are several things problematic about the Code of Procedure, perhaps the most notable is the limited amount of discovery accorded to respondents. Pursuant to the Code of Procedure, the only discovery to which respondents are entitled is the right to review FINRA’s investigative file. The thing is, FINRA is free to withhold from that file whatever documents it feels are the subject of some privilege or another. In addition, under Rule 9251(b), FINRA can also choose not to produce:

  • documents that constitute “an examination or inspection report, an internal memorandum, or other note or writing prepared by a FINRA employee that shall not be offered in evidence,”
  • documents that “would disclose an examination, investigatory or enforcement technique or guideline of FINRA, a federal, state, or foreign regulatory authority, or a self-regulatory organization,”
  • documents that would disclose “the identity of a source, including a federal, state, or foreign regulatory authority or a self-regulatory organization that furnished information or was furnished information on a confidential basis regarding an investigation, an examination, an enforcement proceeding, or any other type of civil or criminal enforcement action,” and
  • documents that would disclose “an examination, an investigation, an enforcement proceeding, or any other type of civil or criminal enforcement action under consideration by, or initiated by, FINRA, a federal, state, or foreign regulatory authority, or a self-regulatory organization.”

Not only are these categories broad, but, worse than that, there is really no way of knowing if FINRA is properly withholding documents from the investigative file. Here’s why: the Code provides that “The Hearing Officer may require the Department of Enforcement or the Department of Market Regulation to submit to the Hearing Officer a list of Documents withheld pursuant to paragraph (b) or to submit to the Hearing Officer any Document withheld.” Note the use of the word “may.” Anyway, the Code continues: “Upon review, the Hearing Officer may order the Department of Enforcement or the Department of Market Regulation to make the list or any Document withheld available to the other Parties for inspection and copying unless federal law prohibits disclosure of the Document or its existence.” More uncertainty. Finally, and most troubling, the Code says, “[a] motion to require the Department of Enforcement or the Department of Market Regulation to produce a list of Documents withheld pursuant to paragraph (b) shall be based upon some reason to believe that a Document is being withheld in violation of the Code.”

How can one ever determine if Enforcement is improperly withholding a document? I had a case in which Enforcement admitted it was withholding documents under Rule 9251. I asked them to identify the documents, or at least explain the basis for their decision to withhold. They declined, and simply represented that they had complied with Rule 9251 and asked the Hearing Officer (and me) to trust the accuracy of that representation. I, for one, was unwilling to do that. So, I filed a motion under 9251.

The Hearing Officer denied that motion, holding as follows:

            The motion does not state that Respondents have some reason to believe Enforcement is withholding any documents in violation of the FINRA Code of Procedure. This omission is fatal to their motion. Rule 9251(b)(1) permits a document to be withheld if it falls within certain enumerated categories, unless it contains exculpatory evidence. The Code does not require, however, that Enforcement explain the basis upon which it is withholding a document. Respondents do not contend otherwise. Instead, they seek to obtain this information through a Rule 9251(c) motion. But this Rule requires that such a motion “be based upon some reason to believe that a Document is being withheld in violation of the Code.” Respondents seek to bypass this requirement by claiming that without a withheld list and an accompanying explanation regarding “the respective basis for withholding,” they cannot determine if Enforcement is improperly withholding documents. This argument has previously been rejected, and the Rule’s requirement must be satisfied. Respondents have not done so.

I have a hard time following the circular, Catch-22-ish logic employed here. You can only – possibly – get a list of withheld documents if you have some reason to believe something has been improperly withheld. But, you can’t tell if something has been improperly withheld – even when you know some unidentified group of documents is being withheld – unless you see the list. Joseph Heller would undoubtedly be very proud of this decision by the Hearing Officer.

Enforcement, on the other hand, does not simply have to rely on representations made by a respondent, Enforcement is free to conduct continuing discovery. That is because Enforcement can, at will, issue post-complaint 8210 letters, to explore things like the basis for affirmative defenses asserted in an Answer, or the anticipated testimony of a potential witness. There are only two easy hoops through which Enforcement has to jump. First, they must “promptly inform the Hearing Officer and each other Party” when they issue 8210 letters, and, second, the 8210 request must be “issued under the same investigative file number under which the investigation leading to the institution of disciplinary proceedings was conducted.” It hardly seems fair that FINRA can conduct ongoing discovery while respondents are stuck with no equivalent tools.

Which brings me to the new thing I heard this week. When a new case is filed, the Chief Hearing Officer appoints a Hearing Officer to hear the case. Typically, that appointed Hearing Officer remains with the case through to its completion. The Code of Procedure, specifically, Rule 9231(e), outlines what happens if/when, however, the appointed Hearing Officer needs to be replaced: “In the event that a Hearing Officer withdraws, is incapacitated, or otherwise is unable to continue service after being appointed, the Chief Hearing Officer shall appoint a replacement Hearing Officer.” That doesn’t seem particularly controversial, does it? I suppose I understand what “incapacitated” means, and even “unable to continue service.” The issue surrounds the word “withdraws.” The Code doesn’t articulate why an appointed Hearing Officer might withdraw. But, as you will see below, perhaps it should.

In my friend’s case, not one but two appointed Hearing Officers withdrew. The second one gave no explanation. Hmm. But the first one, the one initially appointed, more interestingly, withdrew because she was not available on the dates when Enforcement insisted it wanted the case heard. Enforcement felt the hearing needed to held eight months from the date the complaint was filed; the Hearing Officer could not schedule the hearing, however, until ten months from the date the complaint was filed, i.e., two months after Enforcement’s desired timeframe. Enforcement refused to agree to that. Rather than simply move the hearing back, over Enforcement’s objection, instead, the Hearing Officer withdrew and a new Hearing Officer was appointed, one who apparently was able to schedule the hearing in accordance with Enforcement’s preference.

This is odd and troubling for a couple of reasons. First, the exam that led to the issuance of the complaint took years for FINRA to complete. Given that, how could a delay of only two months possibly prejudice Enforcement in the slightest, especially given respondent’s willingness to proceed? Delay in prosecuting a case is typically offered as a defense.[1] If the respondent did not mind another two-month delay, how could Enforcement? Thus, shouldn’t the Hearing Officer have simply rejected Enforcement’s proposed schedule and insisted that the hearing take place ten months after the complaint, rather than eight?

Second, how is that Enforcement got to force the issue? It is outrageous – to me – that the Office of Hearing Officers simply kowtowed to Enforcement here, replacing the Hearing Officer rather than disappointing Enforcement. If Enforcement is imbued with such power, it can literally dictate the identity of the Hearing Officers appointed to its cases simply by pushing to schedule hearings on dates that don’t suit the appointed Hearing Officer. I certainly do not have that ability as respondent’s counsel. No party to an Enforcement proceeding should have that kind of sway over decisions like this.

[1] See Jeffrey Ainley Hayden, Exchange Act Rel. No. 42772, 2000 SEC LEXIS 946 (May 11, 2000).

FINRA recently announced a multi-million dollar ad campaign to increase public awareness of BrokerCheck, in an effort to increase the number of investors who actually use it. I had a few initial thoughts.

First, as I have observed before, it is hardly a secret that BrokerCheck does not serve as the basis for the vast majority of investors’ decisions regarding who will handle their money. For the most part, those decisions are still based on word-of-mouth recommendations and referrals from existing, satisfied customers. Same as it works for insurance salesmen. Same as it works for suit salesmen. Same as it works for attorneys, for that matter. When people are pleased with a service-provider, they like to spread the word. (Of course, when people are displeased, they like to spread the word even further. Just take a look at Yelp, or TripAdvisor, if you want to see just how vocal, and colorful, consumers get when they believe they have received poor service.) Thus, while this constitutes a noble effort on FINRA’s part, it seems rather unlikely that this campaign will have much of an impact.

Second, putting to one side the issue of whether or not it makes sense for FINRA to spend any money to publicize BrokerCheck, in light of its limited utility, I also doubt that the amount of money that has been earmarked for this campaign can possibly achieve much. Last month, I couldn’t watch anything on TV, or read any newspaper or magazine, without being urged in one fashion or another to go see the new Mad Max movie. (Ultimately, I went, and it was excellent!) But ad campaigns of that magnitude don’t cost millions, they cost tens of millions. If FINRA is serious about  successfully broadcasting the potential benefits of using BrokerCheck, the relatively few ads it can place with its budget will not make any difference.

Third, I read somewhere that even if BrokerCheck is forcibly waved in front of every investor, members of the Claimants’ bar are still unhappy that BrokerCheck does not reveal everything contained in CRD. Things like exam scores, for instance, which are visible if one has access to CRD, are not contained in a BrokerCheck report. The author of the article was arguing that without access to “essential” information like exam scores, BrokerCheck was inadequate as a tool for investors. I found that to be an amazing proposition.

Registered persons live in the most transparent world of any profession. You can’t go on-line to see how I scored on the LSAT, or the various bar exams I had to take to become a practicing lawyer. You can’t look up how many times it took the driver of your child’s school bus to get his driver’s license, or the pilot of your plane to get his pilot’s license. You can’t easily learn where your doctor graduated in his or her class. Yet, somehow, life goes on, and we all manage pretty well. But, when it comes to registered representatives, attorneys who make their living suing brokers and broker-dealers continue to advocate that investors are somehow being cheated, that they are robbed of their ability to make informed decisions, because BrokerCheck doesn’t reveal the scores that brokers received on their Series 7, Series 24, etc.

It is a patently absurd argument. Nevertheless, I would not rule out the possibility that, someday, FINRA caves to the pressure. Because, historically, that is what FINRA does. Already, FINRA has proposed a rule presently before the SEC – a watered down version of an earlier proposal – that would require BDs’ webpages to have a direct link to BrokerCheck, to make it absurdly easy for someone to take the 90 seconds or so necessary to look up their broker. Is that really necessary?

I remember hearing a comedian riffing on the spiel that flight attendants give before each flight about the location of the exits, the oxygen masks, etc. He highlighted the part where they talk about how to operate the seat belt, you know, insert the flat metal tip into the buckle, etc., etc., and asked – rightly so, in my mind – whether anyone who didn’t already know how to work the seatbelt should be flying in the first place. Is it much different with investors? The relationship between a broker and customer is most definitely a two-way street. Sure, the broker has a number of statutory and regulatory duties to the customer, but, conversely, the customer has his own duties, as well: to provide complete and accurate information about finances, investment objective, risk tolerance, liquidity needs, time horizon, etc., when opening an account; to read agreements before signing them; to open mail when it comes in, such as confirms or monthly account statements, and read them for accuracy (gee, just like a bank statement!); to ask questions if something isn’t understandable. If, however, an investor can’t figure out how to navigate to BrokerCheck without being personally guided there, one can only wonder whether such an investor has the capability of fulfilling his duties as investor. If I was a registered rep, I would think long and hard about entering into a client relationship with someone who couldn’t figure out BrokerCheck on their own, or buckle their own seatbelt, for that matter.

The Illinois Appellate Court issued an opinion this week with important repercussions for financial institutions who step in and take over the assets of failed institutions.

In a case of “first impression in Illinois,” the Illinois Appellate Court held that Illinois courts lacked jurisdiction to consider a motion to vacate an arbitration award where the underlying arbitration claim was barred by the federal Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”).

Instead of filing her defamation claim with the FDIC as required by FIRREA, Plaintiff filed her complaint in 2010 in state court, alleging our client was liable as successor for Washington Mutual Bank’s (“WMB”) pre-dissolution defamation by publishing an allegedly false financial report. (Our client had assumed most of WMB’s accounts when it was closed on September 25, 2008.)

Because the WMB customer agreement had an arbitration provision, the trial court ordered the matter to arbitration before the American Arbitration Association (“AAA”). But, plaintiff argued that FIRREA says “no court” shall have jurisdiction; it does not say “no arbitrator.” Further, she argued our client waived the FIRREA protections by agreeing that the claim should be arbitrated. Nonetheless, the AAA arbitrator decided that the claim was barred by FIRREA and dismissed the claim.

Plaintiff challenged the arbitrator’s decision by filing a motion to vacate in state court, arguing the arbitrator lacked authority to dismiss the claim based on FIRREA. The trial court denied the motion to vacate and Plaintiff appealed.

Last week, the Illinois Appellate Court issued its ruling that the trial court lacked jurisdiction to hear a motion to vacate. As a result of the Court’s decision, the arbitrator’s dismissal will stand. While its holding is unquestionably a great victory for our client, its implications extend far beyond the unique facts of this case and could impact future proceedings against financial institutions that assume the accounts of failed institutions.

Specifically, the Appellate Court reaffirmed existing law in other states that it mattered not whether the claim was asserted against our client as a successor in interest or against WMB directly. Either way, the Court held the claim is barred since plaintiff had failed to file the claim with the FDIC before the FIRREA bar date. The court states, “[t]he court did not have such jurisdiction when plaintiff filed … the claim … in 2010. For the same reason, the court also lacked jurisdiction to consider plaintiff’s motion to vacate the arbitrator’s award on the claim.”

Significantly, the Illinois Appellate Court expressly declined to decide whether the arbitrator lacked jurisdiction under FIRREA to hear the barred claim, but in dicta the Court commented “arguably, he did not.”

Without the protections provided by FIRREA, financially sound institutions would be reluctant to aid customers of less secure institutions due to the fear that they will be liable for pre-failure misdeeds of the dissolved institution. For the first time in Illinois, the Illinois Appellate Court’s decision reaffirms the basic principles and protections of FIRREA.

However satisfying the result in this case, the Appellate Court’s reasoning raises multiple questions:

  • Would the state court have jurisdiction to hear a bank’s motion to vacate a legally erroneous arbitration ruling if the arbitrator had failed to dismiss the barred claim?
  • Would the state court have jurisdiction to hear a bank’s motion to confirm an order by the arbitrator awarding the bank money damages (say for attorney’s fees) if the claim was barred by FIRREA so the award could be enforced?

Questions aside, the decision reached the right result, allowing the arbitrator’s dismissal to stand. Here is a copy of the Appellate Court’s opinion.

If you have been a regular reader of this Blog, or even if you just browse the Wall Street Journal on occasion, you have undoubtedly noticed the attention being given over the last few weeks to the SEC’s decision increasingly to bring its Enforcement cases before Administrative Law Judges, rather than in federal court. While the SEC has attempted, somewhat inadequately, in most people’s eyes, to explain its rationale for doing so, the generally accepted viewpoint seems to involve the application of Occam’s razor, i.e., that the simplest explanation for something is typically the best: when it goes before an ALJ, the SEC almost always wins.

Emphasis on “almost.” I am very pleased to report the receipt today of an Initial Decision by ALJ James Grimes in a case that we tried in February 2015 in which he dismissed all charges levied by the SEC against my clients:  Robare decision

The case was filed against The Robare Group, Ltd. (“TRG”), an SEC-registered investment advisory firm in Houston, Texas, and its two founders and principal owners, Mark Robare and Jack Jones.  It concerned the adequacy of certain disclosures, primarily in TRG’s Form ADV, they made regarding potential conflicts of interest arising out of compensation that they received from Fidelity, which served as the custodian for their customers’ assets, when their customers invested in certain non-Fidelity mutual funds.  In short, the SEC alleged that the disclosures were not adequate, and that, as a result, Mr. Robare and TRG willfully violated subsections (1) and (2) of Section 206 of the Advisers Act, that Mr. Jones willfully aided and abetted and caused the same violations, and that all three respondents violated Section 207 of the Advisers Act.  Respondents, of course, denied the allegations.

In his Initial Decision dated June 4, 2015, Judge Grimes, the ALJ assigned to the case, dismissed all allegations and charges that the SEC brought.  In reaching that conclusion, Judge Grimes made several pertinent findings.  First, he found that disclosures by advisors to customers and prospective customers may appear in documents other than just Form ADV.  As a result, regardless of whether respondents’ Form ADV was adequate or not, if other documents that respondents supplied their customers, which in this instance included a separate disclosure document and a Fidelity customer agreement, among others, did contain adequate disclosures, then there is no violation.

Second, he found that respondents reasonably relied on advice they received over the years from several trusted sources – including consultants as well as the broker-dealer with which they were registered – regarding their disclosures, rebutting the SEC’s insistence that they acted with scienter, recklessly, and negligently.   Specifically, and dramatically, Judge Grimes stated the following in denying the scienter charge:

[I]n listening to Mr. Robare and Mr. Jones testify and observing their demeanor under cross-examination, it is difficult to imagine them trying to defraud anyone, let alone their investment clients.  They came across as honest and committed to meeting their disclosure requirements. Indeed, their belt-and-suspenders approach to compliance, through which they relied on multiple firms, including [their BD] and [their consulting firm], to ensure the Robare Group was compliant with its disclosure obligations belies any argument that Mr. Robare or Mr. Jones acted with intent to deceive, manipulate, or defraud anyone.

Third, the Judge found that respondents established that they never made any investment decisions on behalf of their customers that were influenced, in any way, by a desire to receive compensation from Fidelity; to the contrary, they made their investment decisions not knowing whether whatever non-Fidelity mutual fund they happened to select would result in them receiving a payment.  Moreover, the Judge found persuasive the fact that respondents often deliberately included Fidelity mutual funds in their customer portfolios, even though they knew such mutual funds would not result in them receiving compensation from Fidelity.

Finally, and perhaps most interestingly, Judge Grimes expressly recognized the difficulty that investment advisors experience when trying to determine whether their disclosures are adequate, citing unrebutted testimony from two witnesses respondents produced to the effect that  “the Commission’s position as to what constitutes adequate disclosure is a ‘moving target’,” or, similarly, “investment advisors ‘struggle[] to determine what is sufficient disclosure,’” and that “the reason for this struggle is a lack of clear and consistent guidance.”

The Initial Decision is final unless a party files a petition for review, i.e., an appeal, or a motion to correct manifest error of fact, or if the SEC determines on its own initiative to review the decision.

Attentive readers may have noticed that Judge Grimes has already been the subject of earlier blog posts regarding the SEC’s increased use of Administrative Proceedings. Just days ago, an Order that Judge Grimes entered in another matter received attention from the media because he agreed to the issuance of a subpoena to the SEC to allow the respondent to explore suggestions raised in an article in the Wall Street Journal that a former SEC ALJ had resigned in the face of pressure from the SEC to rule against respondents. Clearly, given his decision in the Robare case completely blowing up the SEC’s theories, Judge Grimes either is feeling no such pressure himself, or, perhaps, he doesn’t care about it. Either way, it is extremely gratifying to know that there is at least one ALJ who is willing to call them as he sees them…which is how this process is supposed to work.

Finally, congratulations to my clients for having the bravery to take this case to a hearing, even knowing the massive statistical hurdle they faced by having the SEC bring it as an Administrative Proceeding, and also given the fact they could have settled for charges much more benign than those the SEC ultimately included in the Order Instituting Proceedings. Let them serve as role models for the industry.

I recently had two clients, both respondents in pending matters – ask me the same question in the same day: should I mediate this case? The answers I gave them differed dramatically, not just because the facts of each case were very different, but because one case was a customer arbitration, where we are defending against claims of fraud brought by a sophisticated investor, and the other was an Enforcement action, where we were defending against allegations brought by FINRA. Someone who hasn’t been through both of these situations might not realize it, but the process – and usefulness – of mediation in these two situations is very, very different. In short, it often makes sense to mediate customer arbitrations, but it can be an unproductive waste of resources to mediate FINRA Enforcement cases. Here is why.

Mediation of a customer arbitration resembles traditional civil litigation style mediation, and it often provides the parties with a healthy dose of reality about the relative strengths and weaknesses of their respective cases, leading them to settle, most of the time. In these cases, which typically involve an investor who alleges he lost money as a result of a poor investment recommendation, the claimant often has an unrealistic view of the strength of his case. In the typical mediation, it starts with an opening session with the mediator where each side puts on an “opening statement” and tears apart the other side’s case. The benefit to mediating, then, is that you have the chance to explain the problems with the claimant’s case directly to his face – instead of just making your arguments to claimant’s attorney and hoping he passes along what you said to the client (which often does not happen). In the typical claimant’s case, where the attorney has convinced the claimant that his case is a winner, this may be the first time the claimant hears about all of the problems with his case.

Even if the claimant is already aware of his case’s weaknesses, an effective opening can really open these wounds. We recently had a highly regarded mediator tell us that our opening presentation was so well packaged that it really made the claimant – a highly sophisticated entity – re-think the claims it was bringing. After the openings, the mediator meets separately with each side to further emphasize the problems with their case, until both sides feel beat up enough that they settle on a certain dollar amount. The process alone can last all day, and if done right, will be grueling – which only aids in getting the parties to settle.

As a side note, one question inevitably comes up – couldn’t you just engage in settlement negotiations the old-fashioned way, by calling up the other side and making an offer? The answer is yes, but the typical claimant’s attorney will water down your arguments when he conveys them to his client, if he conveys them at all, so even your best arguments will do little to counteract the propaganda the claimant’s attorney has been feeding his client.

In the FINRA Enforcement context, you aren’t trying to beat up the other side at all – because there is nobody on the other side to beat up. Instead of a joint opening session, you simply engage in an individual session (usually telephonically) with a FINRA appointed mediator. You spend an hour or two telling him your sob story, and he tells you how bad your punishment is going to be if you take the case to a hearing. The entire goal of an Enforcement mediation is for the mediator to convince you, the respondent, that you are going to lose – and lose badly – if you go to a hearing, so you should take whatever deal he can convince Enforcement to offer.

It is possible, in theory at least, that you could persuade the mediator that you did nothing wrong, leading him to tell Enforcement they should cut you a sweetheart deal because their claims are weak. In reality, however, this rarely, if ever, happens. The reasons are simple: FINRA rarely brings cases that it does not think it will win. By the time a case makes it through the investigation process and culminates in a formal Complaint, FINRA has fully vetted the claims that it plans to bring on several levels. The Member Reg investigators find enough cause to make a referral to Enforcement, Enforcement finds enough evidence to draft a Complaint, the Litigation Group consultants agree that there is sufficient evidence to support the proposed charges, and finally the Office of Disciplinary Affairs (which must review and approve every Complaint before it is issued) believes the Complaint has such a strong chance of success that it authorizes the case to go forward. (See Regulatory Notice 09-17). FINRA has already evaluated any potential weaknesses with its case and accepted them as not consequential enough to impair its chances of success before a hearing panel.

So, while you can sob as much as you want in this mediation, unless you have some hidden facts that you have not already revealed to FINRA (which is a whole separate issue), you simply can’t beat up Enforcement’s case because they’ve already beaten it up themselves. The mediators, who are, or were, FINRA hearing officers, know this. They have years of experience in the securities industry and, on your best day, will tell you there are issues of fact that must be sorted out at a hearing in order to determine the strength of your defenses. They won’t tell you that your defenses are so strong that Enforcement will lose.

In the Enforcement context, then, mediation is often not worth the time and resources, unless you are opposed to taking the case to a hearing and simply want to use the mediation as a way of initiating settlement discussions. But, if that is your position, then you could probably fare just as well by skipping the mediation completely and making an old fashion inquiry to Enforcement about settlement. Conversely, in the customer arbitration context, mediation can be very useful in providing a harsh dose of reality to claimant about the weaknesses of his case.

I wish I was able to report some fireworks, or something semi-controversial, but FINRA and its hand-picked panelists managed to avoid saying anything particularly remarkable in any way. If you have never attended one of these conferences, and think that people come to learn cutting edge strategies, forget it. It is all very basic, very vanilla. The panelists, who are generally from member firms, can be counted on to offer views on how their particular firms handle issues, which I suppose some people find instructive.[1] As for me, I come to hear what FINRA has to say, since, chances are, I already know the strategies that the firms are employing. But, you have to pay really, really close attention to hear anything from FINRA that can be characterized as even slightly newsworthy…apart, arguably, from Rick’s opening statement yesterday endorsing a fiduciary standard.

With that sobering preface, here is what I heard today:

I started with a session on “suitability.” Remember: the “new” suitability rule became effective in July 2012 – nearly three years ago. By now, therefore, one would think that everyone already “gets” it. Given the tone of this session, however, it seems FINRA doesn’t think so, which is why I suppose we started with a long description of the differences between Rule 2111 and “old” rule 2310. Yawn.

There were, however, a couple of interesting things. The first concerned explicit recommendations to hold. As you know, such recommendations are now subject to the suitability requirement under 2111, just like a recommendation to buy or sell a security. But, unlike the latter, which have always been captured on order tickets, which are then reviewed and approved by a principal in a demonstration of supervision, recommendations to hold generate no paper record. Accordingly, firms have had to come up with some mechanism to memorialize these recommendations.

This has been done in different ways. Some BDs created an order ticket. Some required their RRs to record the recommendation in their electronic broker notes. Some have required that an email be sent, outlining the recommendation. When my clients ask me, I consistently advise them that I don’t care about the particular method they choose, provided that the recommendation gets reviewed right away by a principal…just like a recommendation to buy or sell. Anyway, today, to my surprise, FINRA seemed to say that it was ok if the hold recommendation is not immediately reviewed and approved by a principal. Imagine my surprise!

Here’s how that played out. One of the panelists stated that at her firm, the RR creates a note, a memo, I guess, of a hold recommendation and then sticks it in a file, a file that then gets reviewed during the next branch audit. Really?? Who knows how much time will transpire between the day the recommendation is made and the day someone comes in to do the branch audit and reviews that file? It could be months, or even years (if the RR is not in an OSJ, which are subject to annual reviews). And what if the recommendation is deemed to be problematic? How does the firm address something that took place months ago? I figured FINRA would immediately jump in and say, no, you cannot do that. But, that didn’t happen. Just crickets. Weird, if you ask me.

Here is my wish: if FINRA is really ok with that approach to capturing and reviewing hold recommendations – and I don’t see why this wouldn’t also apply to strategy recommendations, which also don’t show up on “regular” order tickets – can’t they put that guidance out in a Regulatory Notice, so everyone can see it in print and, therefore, rely on it? Somehow, I don’t see that happening.

There was also a lot of talk about concentration issues. Possibly in reaction to the huge number of customer arbitrations filed in Puerto Rico over the past year, which, generally speaking, involve claims that the customers were the victims of unsuitable recommendations because they ended up with portfolios concentrated in Puerto Rican securities, FINRA is now examining to see how firms review concentration as part of their supervisory processes. That’s not so bad, in and of itself. But, what is potentially bad is that the FINRA representative on the panel stated that when firms review recommendations for concentration, they need to do so in light of all of a customer’s accounts and holdings. Including, presumably, accounts and holdings elsewhere. Does any BD capture that information? Apart from net worth information, which is collected on new account forms, a BD does not necessarily know, or need to know, the nature (or extent) of the assets its customers own away from the BD. If FINRA is serious, however, that a firm needs to know that information in order to be able to gauge whether a particular recommendation will result in an undue concentration, then there needs to be a rule passed that requires BDs to capture this information, because neither Rule 2090 nor Rule 2111 addresses this. Until then, this is just rhetoric.

After that, I went to a panel on Outside Business Activities. Again, it was all pretty basic information. The most encouraging thing I heard was that FINRA seems to understand perfectly well that (1) outside business activities do not need to be supervised, which means that (2) BDs are not responsible for what RRs do as part of their OBAs. Unfortunately, the panel also recognized that arbitration panels do not necessarily share that understanding, so the challenge remains to devise a system pursuant to which a customer who deals with RRs away from the BD somehow acknowledge, in writing, his awareness that he is not working with the BD, creating a document the BD can use when the customer sues the BD when, inevitably, the deal transacted away from the BD goes south.

FINRA did say that the most common exam finding relating to OBAs is a failure by firms to abide by their own WSPs. That seems straightforward enough: if you say you are going to do something, then you should expect to be held accountable if you don’t do it.

Last, but not in terms of humor, was a statement by the FINRA representative that they are not there “to second-guess” firms’ supervisory procedures and policies. Based on the fact that I have personally defended any number of Enforcement cases involving allegations of inadequate supervisory procedures, I, for one, found this remark to be rather silly.

I next attended a panel on Compliance and Legal Trends. It was largely repetitive of other sessions, however, as the speakers, essentially, identified issues discussed in detail elsewhere, e.g., the growing challenge of dealing with senior investors; addressing conflicts of interest; overlapping regulatory schemes causing increased work and expensesfor BDs; and the increased need for, and reliance on, technology solutions for compliance issues.

The last session I attended before bolting to the airport – only to sit on the tarmac, in bright sunshine, waiting for some supposed nearby lightning strikes to abate – dealt with “lessons learned” from examinations for medium and large firms. The take-aways:

  • When you get the call from FINRA 60 days before the on-site exam starts to schedule another call to discuss the firm’s business, feel free to inquire what topics FINRA is interested in;
  • When FINRA tells you that it wants to examine some of your branches, feel free to inquire why it has chosen those particular branches (and you can expect to get the answer “9 1/2 out of ten times!”); and
  • If you don’t like the answers you get from the examiner, feel free to escalate the matter to supervisors in the District Office, they don’t mind at all.

Did you detect the pattern? Easy-going, that’s the first word that comes to mind when you think of FINRA examiners, right?

Sadly, I could not stay through the conclusion of the conference tomorrow, especially since the last panel is the best: “Ask FINRA Senior Staff.” I feel like I could fill the entire hour-and-15-minute session all by myself!

[1] I don’t want to call out anyone in particular, but I found it odd, and a bit disappointing, that some of the firms that FINRA picked to sit on its panels have less-than-stellar regulatory histories. Why would anyone want to take advice from the CCO of a firm that just signed an AWC for supervisory issues? Moreover, FINRA likes to use speakers from very big BDs, with thousands of RRs. Most BDs are much smaller, with a fraction of the number of RRs and branch offices (and, of course, a fraction of the big firms’ compliance budgets). Hearing tips from big firms is often pointless as they cannot be duplicated, even partially, by small BDs, which lack the resources, in terms of staffing, software, systems, etc., that the big BDs take for granted.

Here are my thoughts after Day One.

At a minimum, you would have to admit that FINRA has a sense of humor: the song they played when Rick Ketchum, FINRA’s Chairman, was introduced to give his keynote speech was “Why Can’t We Be Friends,” the 1975 song by War. Predictably, there were few laughs after that.

Rather than give his usual pep talk to members, Rick opened the conference by taking the opportunity to announce FINRA’s strong support for the adoption of a universal standard governing the conduct of brokers, broker-dealers and investment advisors, namely, the “best-interest-of-the-customer” standard. Interestingly, he denied that this new standard was mandated by any failure on the part of FINRA or its existing regulatory program, which, as everyone knows, is based on suitability of recommendations. Instead, he insisted that it was simply an effort to align the needs of investors with the goals of securities firms. Hmmm. Not sure if all BDs would concur with that conclusion, but it does seem somewhat inevitable that BDs will, sooner or later, become fiduciaries to their customers. When that happens, be prepared to make what Rick described as “Form ADV-like disclosures” to customers, both on an annual basis as well as at point of sale, to ensure that customers are made well aware of the characteristics of the products they are buying, especially the risks attendant to those products. That would be a drastic change from how BDs presently operate, so it is difficult to imagine such a requirement being imposed without a long period of time to prepare for it.

After the general session, I attended “Top Ten Regulatory Concerns,” a roundtable discussion with Susan Axelrod and Chip Jones from FINRA, as well as three industry members. (Notably, the panel only got through the first seven before time expired!) Here they are:

  • Firm culture: creating a culture of compliance, i.e., a “tone at the top.” FINRA wants to see clear evidence that firm management, regardless of the size of the firm, has bought into the concept that compliance is a paramount consideration.
  • DOL Fiduciary proposal: as noted above, FINRA is backing a universal fiduciary standard, although that standard is somewhat different than the DOL proposal (principally because the DOL standard is restricted to IRAs and 401(k) accounts). One of my favorite moments of the day occurred here, when the panel acknowledged that one of the challenges of implementing a new standard will be achieving “regulatory consistency,” as the new standard is interpreted and parsed by regulators, hearing panels, courts, etc. What made that comment so remarkable is that today, when we deal with the “reasonableness” standard that governs so many existing FINRA rules, there is already fairly little consistency. Why would FINRA expect that to change with a new fiduciary standard?
  • Cybersecurity: if you’re looking for one take-away from today’s session, it is that it is a matter of when, not if, you will find yourself the subject of some cybersecurity issue. Given that, it is best to take precautions now, while the barn door is still closed. Another good moment here: Susan Axelrod said FINRA’s goal is merely to “have a dialogue” with its member firms about cybersecurity. Assuming that’s true, I wonder how long it will be before Enforcement cases ensue?
  • Hiring practices: this topic led to a discussion of FINRA’s review of all the data in CRD. Ms. Axelrod said FINRA’s intent was to ensure the accuracy of the data. That may be true, but I found it curious that she didn’t bother to mention or even allude to the dozens and dozens of Enforcement cases FINRA is bringing and has brought against RRs who have failed to disclose pending tax liens on their Form U-4. Clearly, FINRA’s goal is not simply to get the data right, but also to sanction anyone who fails to do that. One more interesting point here: going forward, it will not be enough for a BD to blindly rely on annual attestations from RRs about their outside business activities, their financial disclosures, etc. Instead, BDs are going to need to take independent steps to verify the accuracy of RRs’ attestations to satisfy FINRA.
  • AML: it was news to absolutely no one that FINRA is excited about AML.
  • Senior investors: same here. FINRA seemed quite pleased with its efforts to protect senior investors, including its new hotline.
  • 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.
  • Fixed income matters: the panel never got to discuss this.
  • Regulatory exam process: or this.
  • New product due diligence: or this.

The next session I attended was an Enforcement roundtable, with FINRA representatives, members of the industry, and a lawyer who represents BDs. (I was not invited to participate on this, or any, panel!) Here were the highlights:

  • Enforcement says they approach the question of what cases to bring using a risk-based analysis. Despite that, or perhaps because of that, the number of cases Enforcement has brought is up 30%.
  • There was a discussion about the value of cooperating with FINRA. No consensus was reached. In fact, the FINRA members of the panel seemed surprised to learn that, sometimes at least, lawyers counsel their clients NOT to cooperate with FINRA, given that there is nothing to be gained from doing so. The one thing that the panelists agreed on was that if you are going to self-report, you need to wait long enough so you can conduct an internal review to figure out what happened, but not so long that FINRA figures out for itself what transpired.
  • If you receive an 8210 request that appears to be overly broad in scope, you should immediately call FINRA to try to reduce it. Don’t be shy about going over the head of the person who sent the letter, either, if necessary.
  • Don’t respond to 8210 requests without consulting an attorney, if possible. Members that handle these requests themselves often give away too much.

I then attended two other sessions, one on Fraud, and one on Alternative Investments/Complex Products. Neither was remarkable.

Finally, and maybe not surprisingly, the best things I heard all day came at lunch, from members, not during any panel presentation. These stories will curl your hair.

First: The owners of BD A are in the process of purchasing BD B, because they want to get in the business of selling private placements, but BD A’s Membership Agreement doesn’t include that line of business, while BD B’s does. Specifically, the owners of BD A want to sell oil and gas deals. BD B’s Membership Agreement has no restrictions whatsoever on its ability to sell ANY private placement, include oil and gas deals. Despite that, FINRA has indicated that even if BD B is acquired, along with all of its approved lines of business, FINRA may not permit BD B to sell oil and gas deals. How can that be? How can FINRA prevent a firm from conducting business that it is approved to conduct? The answer is, of course, that it cannot. But, that does not stop FINRA from attempting to intimidate the owners of BD A.

Second: The owner of a BD passed away, suddenly. Pursuant to his will, his ownership interest in the BD passed to a trust. In light of the change in ownership, the BD proceeded to file a CMA under Rule 1017. In response, believe it or not, FINRA questioned why the firm had changed its ownership without first giving 30-days’ notice. The BD responded by pointing out that the owner, rather inconveniently, it seems, failed to give any notice, let alone 30-days’ notice, of his impending demise. So far, apparently, FINRA is satisfied with that answer.

You can’t make this stuff up.

I am in DC, to attend the annual FINRA conference that starts tomorrow morning. I have been to many of these over the years, formerly as the Director of NASD’s Atlanta District Office, but, over the last ten years, as a lawyer who defends brokers and broker-dealers against, among other things, FINRA allegations of misconduct. Sadly, these things are pretty predictable. Senior management will tell the attendees how reasonable FINRA is, how they don’t go out of their way to bring Enforcement cases, how they are not looking for “foot faults,” and how they are always willing to entertain contrary views from members as to how to achieve reasonable compliances. The problem is, this message seemingly never makes it to the examiners who are actually conducting the exams, or to the Enforcement attorneys who are presented with recommendations from Member Reg to proceed with formal action. Contrary to senior management’s message, examiners regularly demonstrate not just a willingness but a desire to write firms up for the slightest violation, no matter how benign. And Enforcement lawyers routinely proceed with formal disciplinary action when, historically, a Letter of Caution would have sufficed.

I will try not to pre-judge and to keep an open mind as I sit through the sessions over the next three days. I will dutifully report the messages that FINRA delivers, and try to avoid too much editorializing. But, I have to be honest, just as we all know that Lucy will always pull that football away before Charlie Brown can actually kick it, no matter what she tells Charlie Brown to the contrary, regardless of how thoughtful and reasonable FINRA management will undoubtedly claim they are, when all is said and done, I don’t imagine that anything will change. Exams will remain burdensome. Minor violations will still appear in Exam Reports and Exam Disposition letters. Settlements will continue to be expensive. But, a guy can hope, right?

The SEC has faced mounting criticism recently for its increasing use of administrative proceedings in enforcement matters. Numerous lawsuits have been filed against the agency, challenging its forum selection. Judge Jed Rakoff of the U.S. District for the Southern District of New York has made it very clear he has serious fairness and constitutionality concerns and, just recently, SEC Chairperson Mary Jo White testified before a Senate Subcommittee, responding to questions on the agency’s forum-selection procedures.

The SEC has long justified its use of administrative proceedings as quicker, more efficient, and less costly for respondents. Following Ms. White’s testimony, the SEC issued a memo titled: “Division of Enforcement Approach to Forum Selection in Contested Actions” which listed the factors considered assigning enforcement actions.

The memo contains a list of “not exhaustive,” “potentially relevant considerations.” Which include:

  • “[A]vailability of desired claims”
    • Basically, whether the claims or relief sought can be prosecuted in only one, or in either, forum;
  •  “[E]efficient use of the Commission’s limited resources”
    • Time and cost considerations (for the SEC, not the respondents);
  •  “[F]air, consistent and effective resolution of securities law issues”;
    • Theorizing that the ALJs have specialized knowledge of securities and securities law, making them better equipped to determine complex issues involving securities.

This guidance is not terribly insightful, especially since the SEC has long defended administrative proceedings as generally being more efficient and cost effective than federal litigation. Further, while the memo states that the SEC is committed to “fair enforcement of the securities laws,” it fails to address “fairness” concerns at all.

And whether the administrative proceedings are fair is, perhaps, a far greater concern than how a particular respondent ends up in that proceeding. And fairness questions are mounting.

Consider a recent article published by the Wall Street Journal analyzing the SEC’s historic use of (and success in) administrative proceedings in enforcement matters. The Journal conducted a study of SEC proceedings over the last five years, tracking their chosen forum and the SEC’s ultimate success. It found that, since 2010 (when the Dodd-Frank Act expanded the scope of administrative proceedings), the SEC has won 90% of the cases brought before ALJs, compared to 67% of those brought before a federal court. In 2014, the SEC won every single case it filed with an ALJ – a 100% win rate.

And where respondents sought to appeal a loss, success rates were even worse, with the SEC winning 95% of all appeals. (Keep in mind that the appeal of an ALJ decision is made to the Commission itself; whereas the appeal of a federal court decision is made to a federal appellate court). As if those statistics weren’t daunting enough, the Journal further found that not only was the SEC statistically sure to win on appeal, but chances were the Commission would increase the sanctions awarded by the ALJ. (That, again, was compared to an average appellate win rate in federal court of 84%).

Assuming these statistics are accurate, it is hardly surprising that the SEC has increased the percentage of cases it sends to ALJs – a trend that appears likely to continue. Back in June, the SEC announced it had hired two new Judges and three new attorneys, essentially doubling the size of its office (which, by the way, is located within the SEC Headquarters in Washington, D.C.).

But while the statistics were concerning, perhaps the most troubling part of the Journal’s article was its interview with a former SEC judge, the Honorable Lillian McEwen. Judge McEwen told the Journal that during her twelve years with the SEC, she was criticized by the Chief Administrative Law Judge for “finding too often in favor of defendants.” She further reported that she had been instructed to approach her cases with the assumption that the Department of Enforcement’s charges were accurate, and that she simply needed to determine whether the respondent offered any evidence to disprove the charges. This instruction, of course, flips the law on its head and reverses the true burden of proof imposed by law. (The SEC, as the prosecuting entity, carries the burden of proving its charges, while the respondent, on the other hand, carries no burden at all).

Judge McEwen says that she ultimately resigned as a result of this pressure.

So, while the SEC’s quick release of the guidance memo answered some questions as to its process, it leaves many more questions unanswered and unaddressed. Perhaps those questions will be answered in another memo, at some future date.

 

UPDATE: 5/26/15

While the SEC has remained  mum in response to the allegations of bias raised by Judge McEwen in the Wall Street Journal article, one of its Judges has made clear that, in his courtroom, allegations of bias will not be taken lightly, or swept under the proverbial rug.

In a pending SEC case, In the Matter of Charles L. Hill, Jr., (AP No. 3-16383), the respondent, Mr. Hill, issued a subpoena to the SEC requesting the production of  all documents that “support, reflect, or are related to” the allegations made by Judge McEwen “as reported by the Wall Street Journal” (i.e.,  that she was criticized for finding in favor of defendants too frequently and the reversal of legal burdens of proof, discussed above).   The SEC’s Office of General Counsel objected to the request, arguing that the information was not relevant and that other judges in other proceedings routinely denied document requests like this.

Judge James E. Grimes, an in-house ALJ with the Commission, summarily disagreed with the SEC’s objections and issued an order directing the SEC to produce the documents.

The documents will likely not be made public.  Simply by ordering their production, however, Judge Grimes (who was just  appointed by the SEC last June) has seemingly sent a message to the Commission, its attorneys, and the public: in his courtroom, at least, allegations of bias will be addressed.

 

UPDATE:  6/3/15

This one just keeps getting more interesting.  As reported above, in the 5/26 update, Judge Grimes issued an Order granting Mr. Hill’s request to issue a subpoena to the SEC — over the SEC’s objection that the documents sought were irrelevent — directed to allegations that a former SEC ALJ left after being criticized by the SEC for being too “respondent friendly.”  In response to the Order granting the subpoena, the SEC requested that Judge Grimes certify his decision so it could be immediately reviewed.  In support of that request, the SEC raised certain concerns about the subpoena, however, that it had not raised in its initial objection.  That is not permitted, so Judge Grimes issued a new Order denying the request to certify his initial order.  He did, however, give the SEC’s General Counsel three days, i.e., until 5 pm today, either to respond to the subpoena, or to seek interlocutory review despite the absence of certification.  According to Judge Grimes, “On one hand, Mr. Hill has a due process right to an unbiased adjudicator and the media article to which he refers raises concerns about that right.  On the other hand, the Office of General Counsel is correct that administrative law judges are presumed to be unbiased. Additionally, the conversation that is alleged in the media article must have occurred at least ten years ago — if it ever occurred at all. Mr. Hill has done little to tie that alleged conversation to his proceeding.”  I can’t wait to see what happens next.