BD Law Blog - by Georgia Securities Lawyer Joel Beck

Is There a New Standard for Supervision? SEC Sanctions Independent Broker-Dealer

The SEC recently sanctioned independent broker-dealer 1st Discount Brokerage, Inc. for supervisory violations.  In addition to the firm, a principal was also named and charged.  In a nutshell, a broker at the firm defrauded investors by operating a ponzi scheme in which he allegedly took more than $8.6 million from 28 investors during the period from 2001 to 2008.  The SEC staff alleged that 1DB failed reasonably to supervise that broker (Michael Park) with a view towards preventing his violations.  According to the SEC action, Park pled guilty to wire and mail fraud charges and was sentenced to 96 months in prison.  

The SEC identified several issues in which the firm's policies and procedures were lacking; deficiencies that the SEC alleged could have led to the discovery of Park's misconduct.  The SEC alleged that the firm failed to have reasonable policies and procedures in place to review the DBA (doing business as) accounts of Park.  Had they done so, the Commission argues, they would have seen an influx of money into his business account through which he conducted his ponzi, and would have seen entries in such account marks as "initial stock purchase" or "liquidation of account" that would have raised red flags. Another alleged deficiency related to failing to have reasonable policies or procedures in place requiring compliance auditors to review compliance audit reports from previous years, and failures to conduct unannounced compliance audits as required by the firm's compliance and sales management manual.  In addition, the SEC found that had a reasonable review of Park's activities been conducted, inquiry into his dramatically declining commissions could have revealed that Park's customers were "closing and/or liquidating their accounts in order to invest with Park's other business, a Ponzi scheme."  

1DB is an independent contractor model broker-dealer, as opposed to a traditional centralized branch office wirehouse model firm.  In this action, it seems that the SEC is either seeking to pronounce a new supervision standard for such firms, or perhaps it merely mistakenly referred to the SEC's earlier supervision statements in the Royal Alliance case.  I didn't catch this at first blush, and can't take credit for it.  But I do want to share the comments on this case I received from my friend and former colleague at NASD, Alan Wolper (Alan is a partner with Locke Lord in Chicago).  With his permission to share this with my readers, here's Alan's comments to me on this matter:

On page 4, in paragraph 6, you will find the SEC’s seemingly throw-away observation that the respondent firm, 1st Discount, employed an independent contractor broker model, “which requires greater supervision than that of a traditional wire house brokerage firm.“   (My emphasis.)  Interestingly, the SEC cites as support for this statement the Royal Alliance case from 1997, which I’m sure you remember because it was one of the first cases that discussed the SEC’s preference for “unannounced” branch audits.  But, nowhere in Royal Alliance did the SEC go so far as it did here.  In Royal Alliance, the SEC merely stated that a model consisting of offices of one or two RRs, spread out geographically across the country, “necessarily entail[s] greater supervisory challenges.”  The SEC did NOT state that the independent contractor model required greater supervision than other models.  Indeed, to the contrary, the Royal Alliance order expressly recites that the SEC “requires firms organized in such a fashion [i.e., independent contractor RRs, in small offices around the country], and individual supervisors at those firms, to meet the same high standards of supervision as at more traditionally organized firms.”   Perhaps the English major in me is coming out, and I am splitting hairs by seeing a distinction between the phrase “greater supervision” in the 1st Discount settlement and the phrase “greater supervisory challenges” in Royal Alliance, but, seems to me that this may, in fact, represent a major change in the how supervision is viewed by the SEC:  instead of requiring you to meet the SAME supervisory standards as traditional firms, now, by virtue of your business model, the SEC will be holding you to a higher standard. 

If so, that is simply wrong.  The standard – for all BDs – is still merely reasonable supervision.  Granted, HOW firms meet that standard will vary from firm to firm, based on their particular circumstances.  But…to state that independent contractor firms require “greater supervision” than traditional wire houses, well, that is more than troubling. 

I think Alan is right.  There should be but one standard of supervision for all broker-dealers, and that standard is, or should be, reasonable supervision.  And that standard should not change based on the model of business through which a broker-dealer operates  If it is changing, that it troubling.  Should the SEC be of the view that an independent model firm be required to adhere to a higher degree of care in its supervision, then it would be more appropriate to set forth such standard through the rule-making process, rather than to legislate through enforcement action. 

All independent model firms should be well aware of both FINRA and the SEC's interest in branch audits and that there have been many disciplinary cases related to inadequate inspections of offices.  I'll conclude this post with Alan's final comments to me, the advice he'd share with his clients:

The lesson here is clear:  more than ever, as an independent contractor model BD, you may be called upon to defend the efficacy of your supervisory system, particularly your branch audit program, in the context of a FINRA or SEC exam.  So don’t wait for the examiners to show up to take a look at your WSPs, your branch audit schedule, the content of your audit questionnaires/modules, etc.  We all know how tough the regulators are these days.  Don’t make their jobs easy by disregarding the warnings they have plainly given.

Wise words, indeed.

 

 

 

Felonies and Florida Registration

Last month I had a good conversation with my friend Marc Dobin, who is also a securities lawyer.  Marc practices down in South Florida, and also publishes a blog on his website.  Anyway, Marc told me about some recent changes to Florida laws regarding registration of brokers and the state's ability to deny registration based on past offenses, even when the broker (or potential broker) would not be otherwise disqualified under FINRA or SEC rules.  I told Marc he ought to do a blog post about it.  Well, he did, and today I finally got around to checking that out.  Find Marc's post about that here and give it a quick read for more information and details.   

Are you a broker thinking of changing firms?

Looking at industry news today, I see many stories of brokers, or teams of brokers, changing firms.  This team left this wirehouse to move to that wirehouse, or this individual registered rep. moved from here to there,from one broker-dealer to another broker-dealer, or from a broker-dealer to a registered investment advisor firm, etc.  Changes like this happen often, whether they are newsworthy or not.  For various reasons, brokers want to check and see if the grass really is greener on the other side.  

Before you make the move, be sure that you've fully considered everything, including forgivable loans or promissory notes, covenants not to compete, non-solicitation issues, product mix and availability, commissions and other compensation payouts, registered rep. agreements and contracts, etc.  Odds are good that you'll likely need a lawyer to help you navigate the change, understand your responsibilities, and help make the transition go as smoothly as possible, and the earlier you get counsel involved in that process, the better.  For more info. on things to consider, take a look at these earlier posts:

* A Primer for Brokers Considering  Changing Firms

* Broker Go-Round.  Be Careful When You Get Off.

* Promises, Promises.  

 

 

FINRA Fines Collection Efforts Hampered: What It Means to You.

This past week, there has been some musings and grumblings about a recent court decision that rebuffed FINRA's efforts to collect disciplinary fines imposed against folks through lawsuits and collections efforts.  The court decision involving John Fiero, formerly of Fiero Brothers, Inc., may now bring to a close a long saga of FINRA's (formerly NASD Regulation and NASD) efforts to collect a $1 Million fine that was imposed against Fiero after a disciplinary case brought by NASD.  In a nutshell, the Second Circuit Court of Appeals ruled that FINRA did not have the power to bring suit against folks to collect fines.  Finding that no rules or federal laws provided this avenue for collection of fines, the Court found in Fiero's favor.  You can read more about the story in this Investment News article.  

So what does this mean for the average registered rep.?  Not much.  If you are working in the industry and are fined through the disciplinary process, you will either pay the fine or likely lose your ability to work in the industry.  Nothing has changed there.  If you remain registered, and don't pay the fine, FINRA will seek to revoke your registration and if they do, you'll wind up out of the industry for failing to pay.  If you are out of the industry at the time a fine is handed down, the odds are that the fine would not be due and payable unless and until you seek to re-enter the industry.  If that's the case, then you don't have to pay and FINRA doesn't come after you seeking payment, until you attempt to be associated or registered with a broker-dealer.  

This court decision does not address the issue of FINRA orders to pay restitution to customers.  It seems that much of the analysis for this issue is the same as the fine issue, but the court did not address this. Should FINRA pursue collection of restitution orders via a lawsuit, we'll find out the answer to that question.  

FINRA Sanctions Broker-Dealers for Improper "Handling" Fees

FINRA announced yesterday that is fined five broker-dealers for improper handling fees that were charged to customers.  According to the press release, the firms mischaracterized a portion of the commission it earned as handling charges for customer trades. The sanctioned firms allegedly charged handling fees on trades as high as $69 to $99 on an individual trade, with these amounts apparently being in addition to commissions that the firm charged.  FINRA stated that, "In some cases, firms charged a handling fee of almost $100 per transaction and earned a substantial percentage of their revenue from these fees."  FINRA's Enforcement chief explained, in effect, that firms must disclose trade commissions on the confirmations and that firms cannot improperly describe commissions as charges for ancillary services.   

According to FINRA's release, the fnes imposed against the firms ranged from $60,000 to $300,000.  Many of the firms involved in these cases were also charged with additional rule violations.  

I wrote about the prospect of firms facing charges like this back in July, when I highlighted a brief remark about these matters by Rick Ketchum in a speech to attendees at the FINRA annual conference.  Check out that earlier post for more background info.  

Promises, Promises.

A recent article apearing over at RegisteredRep.com concerns recruiting issues, and reports that one of their recent polls found that brokers are often recruited to other firms based on promises that go unfulfilled.  The gist of the story is that recruiters might sometimes make promises to brokers that they can't keep, to influence the broker to change firms.  If you've been in the industry for a while, you've certainly heard of issues like this, whether from a wirehouse broker or an independent rep.

So what can a broker do to ensure that the important promises are kept?  How about this: put it in writing.  If a key element of your moving to a new firm is a promise that the recruiter makes, put it in the agreement with the new firm in the first place.  If the firm won't agree to put the promise in writing, find out why (if you can), and consider whether that promise really matters before you drop that new U4.  

And remember that upfront money and promises by recruiters are not the only things to consider when contemplating changing firms.  For more on that, see earlier posts on the subject here and here.

New Discovery Guide and Document Production Lists for FINRA Customer Arbitrations Effective May 16, 2011

FINRA has announced, via Regulatory Notice 11-17, a newly revised Discovery Guide and Document Production Lists for customer arbitration cases.  The revised guide and lists becomes effective on May 16, 2011, and will apply to all customer cases filed on that date and after.  

This new version replaces the old guide, commonly referred to as 99-90, that was announced as NASD Notice to Members 99-90, that debuted in 1999.  99-90 contained 14 document production lists, some of which applied only to certain types of cases.  The revised guide provides for two lists of presumptively discoverable documents to be applied to all cases.  

FINRA Sanctions UBS for Issues with Sales of PPNs

FINRA announced today that it has sanctioned UBS Financial Services for sales practice issues relating to sales of Lehman-issued PPNS (principal protection notes).  According to its press release, FINRA explained that it fined UBS $2.5 Million and ordered it to pay $8.25 million in restitution for "omissions and statements made that effectively misled some investors regarding the "principal protection" feature of 100% Principal-Protection Notes Lehman Brothers Holdings, nc. issued prior to its September 2008 bankruptcy filing."  As with all FINRA settlements, UBS did not admit or deny the charges.

FINRA made findings that the firm failed to adequately emphasize (thats FINRA's word) that the protection feature was subject to credit risk, and that the firm did not adequately analyze suitability of the notes to certain customers, and failed to establish an adequate supervisory system for sale of these notes, among other findings.  The press release also explained, "FINRA found that some of UBS' financial advisors did not understand the product, including the limitations of the "protection" feature.  Consequently, certain financial advisors communicated incorrect information to their customers."  

Joel's thoughts:  This case is another example of product-based enforcement cases, somewhat similar to the very recent FINRA and SEC cases brought against firms for inadequate due diligence in private offerings. When selling non-traditional products (such as publicly traded stocks, bonds and mutual funds) firms must ensure that they have completed sufficient due diligence to understand the product and its features, that they effectively communicate information about the product to its sales reps., and that they put in place appropriate mechanisms to supervise the sale of the products.  Recent disciplinary actions show that the failure to do so can be costly.   

 

FINRA Revises the Sanction Guidelines

FINRA recently announced, via Regulatory Notice 11-13, that it has revised the Sanction Guidelines.  According to FINRA's release, the new guidelines, which are now effective, made four main changes:

    * clarify the causation standard for when restitution can be ordered as a sanction;

    * recognize the a panel can order a respondent's ill-gotten gains to be paid to those injured by misconduct;

    * recognize that not every factor in the principal considerations has the potential to be both an aggravating factor and a mitigating factor; and

    * directs adjudicators to consider the sanctions imposed by other regulators for the same misconduct,when assessing sanctions in a FINRA matter.

The majority of these changes deal with FINRA's restitution policy.  Based on the Sanction Guidelines published in 2007,adjudicators were informed, "Adjudicators may order restitution when an identifiable person, member firm or other party has suffered a quantifiable loss as a result of respondent's misconduct, particularly where a respondent has benefited from the misconduct."  (See General Principles Applicable to All Sanction Determinations #5, March 2007).  Now, in the March 2011 revision, adjudicators are advised," Adjudicators may order restitution when an identifiable person, member firm or other party has suffered a quantifiable loss proximately caused by a respondent’s misconduct." (Id., March 2011 Ed.).  

In addition to this change, the revisions to the guidelines provide adjudicators with authority to have disgorgement of ill-gotten gains to be used to redress harms to customers rather than to be paid as a fine to FINRA.

 

The Limits to FINRA Rule 8210?

Earlier this month, my friend and former colleague at NASD, Alan Wolper, published a short article on the limitations of FINRA Rule 8210 (formerly NASD Rule 8210), together with his partner Martin Jaszczuk.  The article, To Infinity and Beyond, FINRA's Efforts to Expand the Scope of Rule 8210, is worth a read by all legal and compliance folks who deal with FINRA Rule 8210 request letters, notwithstanding the fact that the article title conjures images of Buzz Lightyear in my mind.  

Alan discusses a proposed change to Rule 8210 that might seek to broaden the scope of the rule, as well as FINRA staff's apparent pushing of the boundaries of the rule to attempt to obtain documents and information that he believes are not subject to the rule itself.  He also focuses on an area in which Rule 8210 seems to be increasingly used: FINRA's efforts to obtain documents and information from non-member entities, such as broker-dealer affiliates or other entities or organizations.  Alan articulates what most of us regulatory law practitioners well understand: that firms and reps. often comply with overly invasive and over broad requests for documents and information because of the big stick swung by the regulators, and the risk of a firm or rep. being barred of expelled for failing to cooperate, even when solid arguments can be made that FINRA is simply not entitled to the information or documents it seeks.  He is also correct in noting that at some point, firms and reps. will stand their ground and roll the dice with the enforcement process.  We'll have to wait and see what happens with the proposed rule change, and find out if the SEC will impose some limits on this rule.