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I recently had the extremely unhappy experience of losing a FINRA arbitration following a week-long hearing. Fortunately, this tends to be a rare occurrence around here, but that’s not really a surprise, since we tend to go to hearing only in those cases with strong facts, while we work hard to settle those with difficult facts. This particular case did not have overtly troublesome facts, and was eminently defensible. Moreover, and to the point of this article, my client, a broker-dealer, had no insurance coverage for the claim (as selling away claims are often expressly excluded from any coverage). Given that, and the fact that the pre-hearing settlement demand was outrageous, there was no reason, or financial ability, to settle it.

In any event, as noted at the outset, contrary to our expectations, we lost. Sadly, the award was so big that my client was unable to afford to pay it. With no alternative, after decades in the business without incident, my client was forced to abruptly close its doors, terminate its reps, and transfer away all of its customer accounts. Its owners – both named individually as respondents and found liable by the panel along with their firm – were forced to file for personal bankruptcy and sell their home. Their personal and professional lives were forever altered.

Claimants’ counsel has publicly complained about the fact that my client had no insurance to cover the loss, and that his clients will never collect on their award. He has also argued that FINRA rules ought to be changed, to require that broker-dealers carry sufficient insurance coverage to ensure that successful claimants will always collect. Is there a business anywhere in America, in any segment of society, that is required to have enough money, or enough insurance, to guarantee that anyone who files suit against it, for anything, will absolutely, positively collect if they manage to prevail? If there is, I am unaware of it. And I am unsure why broker-dealers should be treated any differently than any other business.

As consumers, we elect to do business with companies and individuals whom we trust, whether it is a dry-cleaner, a car repair shop, a deli, an airline, or a broker-dealer. We naturally hope that things will go smoothly, but, if things go badly, that we will be treated fairly. But, “fairly” does not necessarily mean that we can blithely act with the expectation that we will be “made whole” in the event of a big problem. That is why “losses” are included among the items that may be deductible on tax returns, because sometimes we are not made whole. It is a risk we assume every day, in many aspects of our life. Even SIPC has dollar limits on what it will pay when a bank fails. I cannot understand why broker-dealers should be treated differently than everyone else, and be mandated by rule to carry outrageous amounts of insurance, for ridiculous premiums, covering every imaginable claim, just to ensure that claimants can collect arbitration awards, and that their attorneys can collect their contingency fees.

It may be the ultimate example of the heavy price that a BD pays for being subject to FINRA regulation, and it happens all the time. Broker-dealer A decides to cease operations, for whatever reason, so it files a Form BDW (which, technically speaking, is a request by the BD to withdraw its FINRA membership and SEC and state registrations). In addition, in connection with that decision, broker-dealer B contracts to buy A’s assets (read “assets” to be “customer accounts”). As a result of that asset sale by A to B, FINRA requires A to file a CMA under Rule 1017.[1] A full-blown CMA. In other words, what this means, in essence, is that A has to ask FINRA’s permission simply to go out of business (for if the CMA is denied, then the asset purchase cannot happen.)

Is there another industry anywhere with such an absurd requirement? Can you imagine an unpopular restaurant that wants to shut down, but is forced to continue serving lousy food because the health department won’t allow it to close? Or an airline compelled to keep flying unprofitable routes because it first has to ask the FAA for permission to mothball its jets? No, even though those are both regulated entities, their business exigencies trump their respective regulators’ ability to dictate to them. But not a broker-dealer.

Even a cursory review of Form CMA reveals that it was not designed to address the situation where a BD is selling its all of its assets. The vast majority of the questions posed on the form do not contemplate the scenario where the BD does not survive the asset transfer. Yet, FINRA still requires that the entire form be completed, even if answer after answer is “not applicable”; in fact, if an applicant submits a form that FINRA deems to be “substantially incomplete,” the CMA will be summarily rejected…and the firm remains the owner of the assets it is seeking to sell.

Not surprisingly, when a broker-dealer files Form BDW and is trying to sell its customer accounts so it can close its doors, time is typically of the essence. The sooner the transition happens, the more accounts will transfer, and the more valuable the assets are to both the selling firm and the acquiring firm. Moreover, once Form BDW is filed, the firm’s registered reps will very quickly scatter to other broker-dealers (typically to the firm that is attempting to acquire the customer accounts, but not always), since they will be prohibited from conducting anything other than unsolicited liquidating trades activities at the firm that is closing. Until the CMA is approved, however, or, possibly, the use of a negative consent bulk transfer letter, in the absence of a written direction to transfer from the customer, the accounts must remain where they are, at BD A, orphaned and restricted.

One might think that under such circumstances, given its proclaimed interest in “investor protection,” FINRA would act swiftly to consider and approve the CMA, or at least the bulk transfer letter, to ensure that someone is watching the abandoned customer accounts. Sadly, that is not the case. It takes 60 days for the SEC to approve a Form BDW. Once that happens, a withdrawing firm loses any ability to service its clients, even on a limited, liquidating-only basis. In my experience, FINRA uses nearly all of that time period to deal with the CMA, ensuring that the firm going out of business has almost no time to deal with its customer accounts. That is in no one’s best interest, particularly the customers. Given that, FINRA would be wise to re-think the process by which customer accounts of withdrawing firms are handled.

[1] If the assets to be acquired exceed 25% of B’s existing assets, then B will also need to file its own CMA.

I used to work for NASD (before it became FINRA). First as an attorney for the Department of Enforcement, and, later, as the Director of the Atlanta District office. Given the scope of my experience, I was able to see Enforcement cases as they were developed in the examination phase, conducted by Member Regulation, through the referral to Enforcement, through the disposition of the case, whether by settlement or after a hearing. The process really hasn’t changed much since I left (except, perhaps, for the fact that increasingly Enforcement treats Member Reg as its “client,” meaning that Enforcement is much less likely today than it used to be to disagree with a recommendation by Member Reg to proceed with formal disciplinary action). But, there is one thing that has most certainly changed.

Back in the day, when Enforcement concluded that the prospective respondent’s actions were serious enough to merit formal disciplinary action, we would do as FINRA counsel do today, i.e., we would advise the respondent of this determination. While some cases got resolved without a Wells letter ever being issued, in most instances, respondent would receive a Wells letter. This provides formal notice that NASD/FINRA has reached the preliminary determination to recommend that a disciplinary complaint be issued. In most cases, the recipient of the Wells would respond by requesting a settlement guideline, i.e., a description of the sanctions that NASD would accept to resolve the matter. I would respond, and specifically tell the prospective respondent (1) who I intended to name as respondent(s), (2) the rule violation(s) I intended to charge, and (3) the sanctions (monetary and/or non-monetary) that I would recommend be accepted. The respondent then had a simple decision to make: take my offer and settle, or reject it. If rejected, I would draft a complaint naming exactly the respondents I said I would name, and including the exact rule violations I had articulated.

Sadly, it does not work that way anymore. Today, for whatever reason, FINRA has become a horse trader, routinely engaging in lengthy negotiations over settlements. Rather than simply offering their bottom line sanctions, as I had done, FINRA counsel start high, asking for way more than they are actually willing to accept. A vigorous back-and-forth inevitably ensues, as I probe the Enforcement lawyer, trying to divine FINRA’s true bottom line.

Frankly, it is a bit unseemly. FINRA has a statutory mandate to enforce the rules. If the rules are broken, then FINRA has an obligation to take appropriate action, and to mete out the appropriate sanction. The notion, however, that FINRA may, for instance, initially ask for $200,000 and a six-month suspension when, in fact, it will really accept $50,000 and only ten days off is, well, odd.

Even worse, however, is FINRA’s occasional practice, not to put too fine a point on it, of pressuring respondents into settling. FINRA accomplishes this by threatening/promising the respondent that if he will not settle on FINRA’s stated terms, thus requiring a complaint actually to be issued, the complaint will include (1) additional respondents beyond those who would have been included in the settled action, and/or (2) additional rule violations to those that would have been in the settled action.

There are a couple of typical scenarios. In one, FINRA will express its willingness to settle with only the firm being named; but, if the firm will not deign to settle, then FINRA will name both the firm AND a principal of the firm as respondents in complaint. Often, this threat alone is enough to compel the firm into signing an AWC, saving the individual’s U-4 from a nasty disclosure. In another common case, FINRA will agree to settle without a finding of fraud, but, if a settlement is not forthcoming, the complaint will include fraud allegations. For many firms, the potential downside to defending a fraud claim, even if unfounded, presents too much risk (even if only in terms of negative publicity) to contemplate seriously.

It is tough enough to defend a FINRA Enforcement case, given FINRA’s historic disinclination to proceed with any matter that poses what it deems to be a realistic chance of the respondent prevailing. FINRA just doesn’t bring too many “hard” cases, preferring, instead, the proverbial low-hanging-fruit cases. In light of this fact, the strong-arm tactics it employs to wrest settlements from broker-dealers unwilling to see their presidents named personally is troubling. I concede that no one puts a gun to anyone’s head to work in an industry as regulated as the securities industry, where one’s history, disciplinary and otherwise, is put on open display for the world to see and judge. But, it is not too much to expect fairness from a disciplinary process that is already heavily tilted in FINRA’s favor.

At a recent industry conference in New York, members of FINRA’s Office of Hearing Officers gathered to discuss current issues and topics relevant to FINRA disciplinary hearings. During one of the sessions, a Hearing Officer panelist lamented the format of the Answers he typically receives from the respondents in his cases. Almost without exception, respondents file Answers that merely admit or deny the various allegations contained in the Division of Enforcement’s Complaint, without providing any explanation of the facts and circumstances underlying the dispute.

If only, he mused, respondents would tell their side of the story right from the start, it would make his job as factfinder so much easier – and clearer.

As counsel for brokers and broker-dealers who find themselves the unfortunate subject of Enforcement’s attention, I have drafted and filed, many times, the sterile admit/deny answers the Hearing Officer described and, when he expressed his desire for more flavorful pleadings, I could not agree more.

In fact, that used to be my practice. Answers always began with a narrative introduction responding directly to Enforcement’s allegations, setting forth the key facts and players relevant to our defense. Were it possible, I would still be filing those Answers today.

Alas, I no longer advise my clients to do so. Experience has taught me that filing a narrative Answer has a sure-fire, immediate, and unavoidable response: a post-Complaint 8210 request. Enforcement, utilizing the full extent of its 8210 power, unleashes upon the respondent requests for documents, identifications, information relating to the narrative, and even demands further on-the-record testimony. (Of course, even a sterile admit/deny answer can invoke this response from Enforcement. In a recent case, my client stated in the Answer that, at all times, it acted “in good faith.” Enforcement immediately sent an 8210 asking the firm to explain what it meant by “good faith.”)

Now, it is certainly not my position that post-Complaint 8210s are never warranted. Indeed, I can think of numerous examples where they would be entirely justified. The problem is that, without some check or balance on its power, Enforcement is able to serve 8210s that are duplicative, harassing and frivolous.

A respondent’s only recourse in receiving such a request is to ask the Hearing Officer assigned to their case to quash the request. Hearing Officers rarely – assuming it’s happened at all – grant respondents’ motions to quash. So, instead of preparing for hearing, respondents find themselves spending time and money further explaining the meaning of “good faith.”

If the Office of Hearing Officers is firm in its desire for more detailed Answers, it should view post-Complaint 8210 requests critically, and examine whether something included in the Answer is truly new information upon which new discovery is warranted and, if not, quash it. Until then, I will continue to advise my clients to avoid narrative Answers, and save the details of their defense for hearing, even if this means disappointing the Hearing Officer.

For more information on Rule 8210, one of Alan’s pet peaves, feel free to read two prior articles he wrote on the subject, To Infinity And Beyond: Rule 8210, previously published in Law360, and I (Still) Got Them 8210 Blues, a follow-up piece published as an Ulmer & Berne client alert.

FINRA recently passed an amendment to the Code of Arbitration Procedure which provides that arbitrators no longer have to wait until the end of a case to make a disciplinary referral. Now, panelists are free to make such a referral in the middle of a hearing!

My first observation is: was there really a need for this new rule? Was there a clamor among arbitrators who felt their hands were unduly tied by having to wait for the end of a hearing to make a disciplinary referral? I am still a bit confounded by the impetus for this new rule. After all, the overwhelming majority of hearings last a few days, a week at most. And, these hearings occur years after the conduct actually took place that is the subject of the arbitration. So, under the old rule, if a panel heard something so troubling at the hearing that it felt compelled to make a disciplinary referral, it would have to wait, at most, a few days before it could do so. How many things are so horrific that it would be an affront to justice for a panel not to make an immediate disciplinary referral, years after the actual misconduct? Are there any?

Also, remember that every Statement of Claim is reviewed by FINRA Member Regulation at the time it is filed. If there is something disclosed in the SOC that is so bad that it presents an immediate threat to investors or to the integrity of the market, FINRA already has the opportunity to open an investigation promptly; it does not have to wait for a disciplinary referral from the panel.

Thus, the protection this rule provides is a bit illusory, both in terms of the temporal aspect (given how very few matters couldn’t wait a couple more days, until the end of the hearing, to become the subject of a disciplinary referral) and the duplicative aspect (as the allegations in the SOC are already reviewed).

The most troubling issue, however, is that it makes a mockery of the supposed fairness of the arbitration process. As in court, a claimant who files a Statement of Claim has the burden of proof. The respondent is presumed innocent. To try to meet his burden, the claimant introduces evidence. At the close of the claimant’s case, the respondent is given the opportunity to put on his own evidence, in his defense. Arbitrators are trained not to deliberate, not to reach any conclusions as to possible liability, until all the evidence has been heard. This new rule, however, basically encourages arbitrators to make decisions before all the evidence has been heard. How can an arbitrator state with a straight face that even though he elected to make a disciplinary referral after hearing only the claimant’s evidence – and before hearing the respondent’s evidence – that he or she will not reach any conclusions about liability until the end of the case? It simply cannot happen.

And while respondents are expressly invited by the new rule to seek to recuse a panelist who makes a mid-case referral to Enforcement, there is hardly a guarantee that such a request will be granted. As with “ordinary” requests for recusal, the decision is made by the panelist, not by the Director of Dispute Resolution. Historically, most panelists resist recusal requests despite repeated admonitions from FINRA always to err on the side of conflict avoidance. Moreover, if the referral comes in the middle of a hearing, by the time the respondent learns about it, makes the recusal motion, and gets a decision on the request, the hearing may very well have already concluded.

It sure seems like the new rule creates many more problems than it could ever have been planned to resolve.

Anyone who’s handled FINRA arbitrations is well familiar with panelists who regularly respond to evidentiary objections by overruling them, but with the admonition that they will only give whatever weight, if any, to the evidence that they deem appropriate. While that can sometimes be frustrating, it is understandable. The Federal Arbitration Act, and the many states that have adopted the Uniform Arbitration Act, include as one of the very limited available grounds for vacatur a panel’s refusal to admit relevant and admissible evidence. What this means is simple: no award will ever be vacated as a result of a panel’s decision to admit evidence, but an award is subject to vacatur if a panel elects to exclude evidence. Arbitrators know this, and so they act accordingly.

There is one piece of evidence, however, that apparently is so explosive, so potentially upsetting to the fairness of the hearing, that FINRA doesn’t trust panelists to hear it and to give it appropriate weight. Instead, FINRA says the mere effort by a respondent (whether firm or registered person) to introduce it will subject that respondent to a disciplinary referral. What is this stunning fact that even seasoned arbitrators are apparently unable to evaluate?

It is this: it is when FINRA performs an investigation of the respondent regarding the same conduct that is at issue in the arbitration, and decides not to bring any disciplinary action against the respondent. In fact, when a firm or an individual receives a letter from closing out an examination, announcing that FINRA has determined not to bring any formal or informal action, the letter expressly recites that the letter cannot be used by the respondent at an arbitration as evidence that the respondent has no liability to the claimant.

I find this baffling. I recognize that there may be several reasons why FINRA does not pursue any disciplinary action following an examination, and not all of those reasons have to do with the absence of misconduct by the subject of the exam. But, most of the time, that is exactly why FINRA takes no disciplinary action. I do not understand why respondents are forbidden from introducing this fact into the record, and allowing the panel to give it the weight – if any – it deserves. Why are panelists able to divine the appropriate weight to every other fact, but not this? Especially when claimants are free to introduce every item contained in a respondent’s Form U-4, no matter old, no matter how irrelevant, in an effort to prove that the respondent is somehow a recidivist. There is no rule against that; instead, FINRA lets the panel decide the weight such evidence deserves.

If an arbitrator is trusted enough to know how to deal with anything else that might come up during the course of an arbitration, I simply cannot figure out why FINRA draws the line at its own decisions not to pursue disciplinary action. Can it be that FINRA is embarrassed by some of the decisions it makes? That it doesn’t want its decisions not to file Enforcement actions subject to second-guessing? I don’t know the answer, but, in FINRA’s continuing effort to “level the playing field” on which arbitrations occur, it seems that this one exception has no place, and should be reconsidered.

SEC Chairwoman Mary Jo White recently announced her support of a uniform fiduciary standard for broker-dealers and investment advisers, ending any remaining speculation as to her views on the subject. The announcement kicked of a whirlwind of speculation in the industry – What would the new standard look like? When would we see it? Will the initiative thrive or die when we get a new president in 2017?

We will have to wait months, perhaps years, for the answers to these questions. FINRA, apparently, has no interest in waiting. In its annual Regulatory and Examination Priorities Letter, FINRA clearly stated its priorities for 2015, and the very first challenge it finds itself facing in 2015: getting broker-dealers to put customer interests first.

This sentence, at first blush, seems somewhat benign. Of course, a registered person should honor her clients’ interests. So, what makes this priority so concerning? The answer, not surprisingly, lies in the details.

First, a bit of background on the differing obligations imposed on investment advisers and brokers. Under the current law, investment advisers are already fiduciaries. This means they are legally required, in making investment decisions, to put their clients’ interests first – elevating them above the advisers’ own interests (and the interests of their firm). Brokers, on the other hand, owe a different duty, namely, to make sure that when they make recommendations to buy, sell or hold a security, those recommendations are “suitable.” This standard requires that the investment recommendation comply with the client’s stated financial profile and investment objectives, but does not require the broker to put aside her own interests in the process.

With this background in mind, and understanding the difference between the obligations placed on investment advisers and brokers, respectively, consider the following 2015 FINRA Initiative:

Putting customer interests first: A central failing FINRA has observed is firms not putting customers’ interests first… FINRA believes that firms best serve their customers – and reduce their regulatory risk – by putting customers’ interests first.

(FINRA’s full letter can be found here).

So, despite the fact that the government is miles away from enacting a uniform fiduciary standard, FINRA has made imposing and enforcing that standard its number one priority for 2015. Firms should expect exams and examiners to pay special attention to the areas where this is most likely to arise, which is anywhere there could be a conflict of interest between the broker and her client, for example, product choices, fees and compensation (where the product may be suitable for the customer, but carry some monetary incentive for the adviser).

I have discussed in prior blogs some issues with the process of registering individuals, and ensuring that information on U-4 is complete and accurate. To some degree, the debate is a bit silly, if the question is whether there is enough information provided on BrokerCheck.

There is a real problem, however, one that is much less academic, and with potentially devastating consequences. It stems from the definition of “statutory disqualification,” or “SD,” a subject that routinely confounds both practitioners and industry members. (Sadly, I have been retained on numerous occasions to help someone who, on the advice of some other lawyer, signed a Consent Order with the SEC or a state securities Commissioner that resulted in them being deemed “SD’d,” much to the surprise of the rep and prior counsel. By that point, unfortunately, the tools available to me are extremely limited.) In short, if a registered representative does one of a long list of things that have been identified by the SEC (and adopted by FINRA), e.g., a felony conviction, a supervisory failure, the rep is forbidden from ever associating with any BD in any capacity (unless the rep can induce a BD to file an MC-400 application on his behalf, and convince FINRA and the SEC that he or she should be permitted to remain in the securities industry, subject to heightened supervision). Becoming “SD’d” is the equivalent of the death penalty for a broker.

One of the acts that triggers an SD is a finding that the broker willfully failed to make a required disclosure in an application for registration, i.e., a Form U-4. That includes a willful failure to update a Form U-4 in a timely manner to disclose something that requires disclosure. A common example of such a failure is a pending tax lien. For some reason, registered representatives cannot seem to remember that Form U-4 requires them to disclose when they become the subject of a tax lien. (It hardly matters if the lien is being contested; it still has to be disclosed.) FINRA, on the other hand, does remember. It routinely runs the equivalent of a credit check on registered persons, and, if the check turns up a pending tax lien, FINRA will then review CRD to ensure that the U-4 was properly amended to reflect it. (In fact, in its recent Examination Priorities letter for 2015, FINRA expressly acknowledges that it “is expanding its use of data mining [and] analytics” to look for issues precisely like this.) If it was not, then it presents FINRA with an easy Enforcement case (and we all know how much FINRA likes to bring the “low-hanging-fruit” cases). FINRA has brought dozens of these “U-4” cases in recent months.

Interestingly, the potential sanctions for filing a false U-4, as described in FINRA’s Sanction Guidelines, seems to indicate that this is not a serious problem in FINRA’s eyes, given that the range of appropriate fines starts at only $2,500. If you want further evidence that FINRA appears to view an untimely U-4 amendment to be a relatively modest problem, consider that it is included among the long list of Minor Rule Violations, which, by definition, call for fines of no more than $2,500.

But…these benign outcomes are only available when the failure to file the U-4 amendment, or the failure to file it timely, is not “willful.” And, unfortunately, the definition of “willful” is ridiculously easy to satisfy. It does not mean that someone intended to violate the rule. It does not mean that someone knowingly failed to file the update. It merely means, “an intent to do the act which constitutes a violation.” Thus, generally speaking, there are only two facts that FINRA needs in order to demonstrate willfulness: (1) respondent knew about the pending tax lien, and (2) respondent failed to amend his U-4 to disclose it. It has no bearing whether or not respondent knew of his obligation to disclose it.

The upshot of this is that what FINRA has expressly acknowledged to be a relatively minor rule violation can, when deemed to be willful, become a career ending catastrophe, due to the fact that it will result in a Statutory Disqualification. There is nothing cheap or easy about dealing with an SD. Assuming the SD’d rep is fortunate enough to have, or to find, a broker-dealer willing to file an MC-400, there is absolutely no guarantee that the application will be granted. It could mean an evidentiary hearing in front of a subcommittee of the National Adjudicatory Council, a hearing at which the applicant has the burden of proving his or her right to remain in the industry. As the reported SD decisions readily reveal, MC-400 applications are routinely denied.

Given the hubbub about BrokerCheck and registered reps’ failures to keep their Forms U-4 updated, coupled with FINRA’s historic reaction to “bad press,” it is easy to anticipate that FINRA will become even more aggressive in pursuing these failures as Enforcement cases, and will characterize the failures as “willful.” The result may very well be a host of brokers who, through nothing other than inadvertence or mistake, find themselves SD’d, facing the possibility of being permanently excluded from the securities industry.

The lesson here? Every rep has the duty to ensure that his or her own Form U-4 is accurate, complete and up-to-date. That cannot be left up to the broker-dealer, even though a rep cannot file his own U-4 amendments. Every rep should take the time to review Form U-4 and study the questions, to serve as a reminder the universe of information must be disclosed. Then, they should have their broker-dealer provide a copy of the CRD record itself, and confirm that everything requiring disclosure is, in fact, disclosed. (It is not enough simply to review BrokerCheck inasmuch as some things in CRD are not published via BrokerCheck, as noted at the outset of this entry.) If there are omissions, or disclosures that need updating, reps should request or, more accurately, demand that the U-4 be corrected immediately. And, of course, that that communication with the BD needs to be documented. One of the few ways that a failure to timely amend a Form U-4 charge can easily be proven not to be willful is by demonstrating that the BD was timely notified of the need for the U-4 update but somehow failed to do it. With documentation of the request/demand in hand, that is an easy demonstration to make.

P.S.  Since I published this earlier this week, a good friend of mine, Gregg Breitbart, had an excellent article picked up by Investment News on the same subject, i.e., the serious problems that ensue when a failure to update a Form U-4 is deemed to be “willful.”  Gregg focused on what is seemingly FINRA’s favorite case to bring, the failure to disclose an unpaid tax lien in a timely fashion.  In my experience defending these cases, there are really only two ways to establish that the failure was not willful.  First, have documentary evidence that establishes the registered representative advised his or her broker-dealer about the tax lien, but, for whatever reason, the BD failed to amend the Form U-4.  Second, have documentary evidence that proves, somehow, the registered represenative was simply unaware that the lien was filed.  While that argument will never fly when a registered representative fails to disclose a bankruptcy filing (since it would be awfully hard to convince anyone you didn’t know about something that you had filed something in court and which bears your signature), it can prevail in connection with tax liens, which are simply mailed by the IRS (or the state) to the taxpayer, and, thus, can be lost in the mail.

Here is the link to Gregg’s article.

 

All the numbers are up!

I read with great interest the recent flurry of articles in the financial news, including one appearing on the front page of the Wall Street Journal, about the supposed flaws with FINRA’s BrokerCheck due to the fact that it omits from public view some items, e.g., certain misdemeanor convictions and financial issues (unsatisfied liens or judgments or bankruptcy filings), that are disclosed in registered reps’ Form U-4. According to my friends at PIABA (not to mention the author of that WSJ article), this is potentially disastrous, as it prevents members of the investing public from making informed decisions about those to whom they would trust their capital.

In typical fashion, rather than argue that the existing scope of BrokerCheck is adequate (although such an argument would be eminently reasonable, given the abundance of information about brokers already available to the public), FINRA has, instead, reacted, putting additional burdens on already strapped member firms. Although FINRA characterizes its new steps to ensure greater disclosure by registered representatives – enacting new Rule 3110 and including an item in its 2015 Examination Priorities Letter – as evidence that it is being proactive, it seems clear that, once again, FINRA has simply reacted to pressure from interests outside its ranks of member firms.

I will address new Rule 3110 and the Examination Priorities letter in another post. But, as an initial issue, let me address the elephant in the corner: Does anyone really use BrokerCheck? As anyone in the securities industry can attest, very, very few customers actually seem to use BrokerCheck. Indeed, FINRA itself has expressly acknowledged this. Regulatory Notice 12-10 was largely devoted to the subject of figuring out ways to increase the investing public’s use of BrokerCheck. The big joke among attorneys who handle customer arbitrations, on both sides of the table, is that we lawyers are the only ones who actually use BrokerCheck. We both scour the record of the broker involved (claimant’s counsel to argue it, me to defend it), looking for some blot from a decade ago that might be highlighted to the arbitration panel as supposed evidence of the broker’s predilection for misconduct.

But, does someone who is really trying to determine whether to give her hard-earned retirement dollars to Mr. X vs. Ms. Y use BrokerCheck? No, my 30-year experience suggests those decisions are generally made as a result of word-of-mouth referrals from friends or family, not by reviewing the information on BrokerCheck. Given this, the notion that the existing universe of data available about registered persons, which is already rather broad, is somehow inadequate for an investor to make an informed decision seems a bit preposterous.

FINRA Rule 3110 is the new supervision rule, of course, replacing old NASD Rule 3010. Most of it became effective on December 1, 2014, but, certain parts will only become effective on July 1, 2015. One of the latter sections is 3110(e), which addresses a firm’s obligation to investigate anyone being considered for registration, and anyone actually hired. It is important that BDs understand these obligations. Interestingly, the requirements outlined in Rule 3110(e) aren’t exactly new, as you will see. It’s just that FINRA has now incorporated the requirements in the rule itself.

Under existing FINRA rules, specifically, NASD Rule 3010(e) (which is still in effect until 3110(e) takes effect), before hiring anyone, and before filing a Form U-4, a broker-dealer is required to “ascertain by investigation the good character, business repute, qualifications, and experience of” the potential applicant. FINRA has specifically articulated only two things that a firm must do to meet that requirement. First, under 3010(e) itself, for any applicant who was previously registered in the securities industry, the firm must review the applicant’s most recent Form U-5. No big deal there, everyone does that, and they should be expected to.

Second, according the boilerplate language buried in Form U-4, when the firm’s registered principal signs the form on behalf of a new applicant, he is attesting that the BD “has communicated with all of the applicant’s previous employers for the past three years and has documentation on file with the names of the persons contacted and the date of contact.” The attestation then continues: “In addition, I have taken appropriate steps to verify the accuracy and completeness of the information contained in and with this application.”

The supposed protection provided by the requirement to “communicate with” prior employers has always struck me as a bit illusory, for a couple of reasons. First, in my experience, many firms are not even aware of this language in the form, and don’t actually contact former employers. Second, and more important, today, and for at least several years, most former employers will provide very little, if any, information about a former employee beyond that included on Form U-5, for fear of encountering claims of defamation or violation of privacy laws.)

Regardless, new FINRA Rule 3110(e) keeps the requirements of Rule 3010, but goes well beyond. While it parrots the language from NASD Rule 3010(e) that firms must still “ascertain by investigation the good character, qualifications and experience of an applicant” before registering the applicant, it now requires that within 30 days after Form U-4 is filed, that firms “verify the accuracy and completeness of the information contained in an applicant’s” Form U-4. Attentive readers will undoubtedly note that this is precisely the same language that currently appears in Form U-4. The issue for FINRA, the one that drove it to create Rule 3110(e), is that very few firms actually did the verification.

Next, and more important, Rule 3110(e) goes on to require – “at a minimum” – that firms must “search . . . reasonably available public records” to achieve that verification. Thus, in essence, with its Rule 3110(e), FINRA has tried to take the mystery out of the phrase “appropriate steps to verify” in Form U-4 by defining that to mean a public record search.

This development is troubling for several reasons. First, it is evident that FINRA will now require two separate investigations, one pre-filing of Form U-4 and one post-filing. It is difficult to understand why FINRA has taken this approach. I mean, why not roll the two requirements up together into a single, pre-hire policy? And what, really, is the difference between the two anyway?

Second, who knows what “reasonably available” means, or what, more importantly, it will be interpreted by FINRA to mean? Who will determine how far back in time a search must go? Question 12 on Form U-4, for instance, requires an applicant to list his previous employers for ten years, and Question 11 asks for prior residential addresses for five years. How is a firm supposed to “verify” the accuracy and completeness of such information? Will it be enough to hire a competent third-party vendor? Or will FINRA scrutinize the vendor’s search protocols?

Third, it flips on its head the ability of a firm to rely on representations made to it by an applicant. When someone signs a U-4 to apply for registration, he already “swear[s] or affirm[s] that . . . [his] answers (including attachments) are true and complete to the best of [his] knowledge.” The applicant’s signature also acknowledges that he “understand[s] that [he is] subject to administrative, civil or criminal penalties if [he] give[s] false or misleading answers.” If the information is not complete and accurate, the applicant has opened himself up to disciplinary action. (And, as discussed in another entry in this Blog, if the failure to disclose is deemed to be willful, he also renders himself statutorily disqualified.)

There are many instances in the course of a typical day or year in which a BD has to rely on its registered persons to make complete and accurate representations, and historically that has been deemed to satisfy the requirement that supervisory systems only be “reasonable.” Yet, here, reliance by a BD on an applicant’s representations on Form U-4 is somehow not reasonable, despite the significant pressure on the applicant to ensure that those representations are correct. And this is a troubling direction for FINRA to be going. Will BDs soon have to verify the accuracy and completeness of the information that customers provide about their financial circumstances?