Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

Recently, FINRA publicized penalties against three companies and associated individuals for failing to implement adequate anti-money laundering procedures.  These fines should serve as a warning to the industry as a whole that FINRA is very focused on AML policies and procedures.

In its announcement, FINRA noted that the firms failed to implement adequate procedures to detect and monitor suspicious transactions.  Key to each finding was that the firms failed to identify red flags of money laundering activities and, in doing so, failed to investigate suspicious activity or file suspicious activity reports.  The fines were in the hundreds of thousands of dollars and individuals were suspended.

So what does this mean for you?  For one, you should take this warning to heart.  FINRA is taking a very strict look at firm AML policies and procedures.

Revisit your policies and procedures now.  Ask yourself this question; do my policies and procedures have those key components designed to identify red flags to detect and prevent money-laundering activity.   If the answer is no, you have work to do, and we can help.

In a recent speech, FINRA CEO, Richard Ketchum, told broker-dealer compliance officers that, although firm compliance programs have improved, there must be heightened supervision when it comes to complex products.  In light of these comments, you must assume that the supervision over the sale of complex products will be a focus of your next examination.

Ketchum noted certain products that should be subject to heightened supervision.  Those products include: structured products, closed-end funds, private REITs, private placements and “exotic ETFs.  If you offer any of these products, now is the time to revisit your supervision over their sale.

You may ask why such heightened supervision is required.  According to FINRA, it does not believe that many in the investing public understand these products, and that there is a lack of available information about some of them.

Take Ketchum’s comments as a warning.  Revisit your supervision if you sell complex products, or face certain exceptions on your next examination.

My partner, Ernest Badway, recently blogged about the dangers of a lawyer referring a client to a rogue stockbroker.  The question for the broker-dealer/investment advisors is how do you uncover rogue brokers or prevent them from infecting your firm.

In all of the years that I have defended broker-dealers and investment advisors in cases involving rogue brokers, I have found that the answer to this question is much like the search for Bigfoot; everyone thinks it exists but cannot see to find it.  So what is a firm to do?

The most fundamental thing a firm can do to prevent/uncover rogue brokers is to foster a culture of compliance.  Firms with such a culture will go a long way to establishing itself as an entity to which rogue brokers need not apply. 

Rogue brokers tend to thrive in those environments where compliance and supervision are not up to snuff.  A firm that promotes a culture of compliance will also encourage other brokers to report up the supervisory chain when they see conduct that one can characterize as "rogue". 

Another useful tool for firms to employ is a regular review of your brokers, coupled with occasional surprise reviews.  Regular reviews are good because they emphasize that the firm is watching its brokers.

Surprise reviews are, in some ways, even better because the truly rogue broker may be able to cover their tracks before a regularly scheduled review.  The surprise inspection takes away this potential luxury.  Also, the firm should let its brokers know that they are subject to no notice surprise inspections.

Unfortunately, some rogue brokers are so good that they may fly under the radar even at firms that promote the culture of compliance; I have seen it happen.  But put the odds in your favor.  Keep tabs on your brokers through regular and surprise inspections, and maybe you will find Bigfoot.

One of the greatest philosophers of our time, Yogi Berra, must have had the debate over the uniform fiduciary duty standard when he penned this line.  Yes, believe it or not, the debate is about to resume.

The SEC is yet again working on possible recommendations regarding a uniform fiduciary duty for investments advisors and broker-dealers.  In accordance with Dodd-Frank, the SEC is expected to issue a request for information for economic data to determine the viability of such a standard.

All of the debate seems like much ado about nothing.  There is generally widespread industry support for a uniform standard, as long as it takes into account the nuanced differences between investment advisors and broker-dealers.

Although the standard will likely become reality in some form, is all of this time and money being spent on the debate really worth it.  In my years of defending broker-dealers, courts and arbitration panels already have routinely imposed a fiduciary duty standard on broker-dealers.  Indeed, it is common for a broker-dealer's WSPs to state that the associated persons owe a fiduciary duty to their customers. 

It seems to me that the only real benefit of having a uniform standard is to have courts and arbitration panels apply one standard, as opposed to multiple and inconsistent application to a floating standard.  A uniform fiduciary duty will exist, the only question is whether we will all live to see it.

In an interesting no-action letter presented by FINRA, the SEC staff granted relief in that where FINRA saw multiple class ownerships where some of these classes indicate almost a relationship between a broker dealer and a customer, the staff would permit such ownership classes without it affecting SEC Exchange Act Rule 15c3-3.

The SEC would allow such arrangements so long as there is an outside lawyer’s opinion letter indicating it was a good legal standing, that the person is actually an equity participant in the firm, the relationship between the person and the brokerage is spelled out in writing, and that their investment is not considered protected under the securities Laws or Securities Investors Protection Act, this person must reaffirm this in writing each year, and the registered person is appropriately registered.

This no-action letter will permit those who wish to invest in broker dealers who seem to be customers are in fact owners.  See Financial Industry Regulatory Authority, SEC No-Action Letter, (12/10/12), and http://sec.gov/divisions/marketreg/mr-noaction/2012/finra-121012-15c3-1.pdf.

After Hurricane Sandy caused such devastation in the Northeast, FINRA began to question firms as to their business continuity plans and if precautions were in place.

FINRA has asked these firms about their relocation, outsourcing, and alternative trading plans.  FINRA has not received responses, but it expects these firms to respond shortly.  FINRA will likely use these results in its examination program for the upcoming year. 

Although Hurricane Sandy was a tragic event, it does provide an opportunity for BDs to assess their preparedness for the next natural or man-made disaster.

Seemingly-- according to FINRA-- broker-dealers are failing in their due diligence efforts relating to knowing their clients, and, as required by FINRA Rule 2090.

Over the last year or so, the most FINRA rule has been FINRA's know-your-customer rule or Rule 2090.  As many know, FINRA Rule 2090 was modeled after the old NYSE Rule 405(1), requiring broker-dealers to use reasonable diligence in opening and maintaining customer accounts.  Broker-dealers are required to "know the essential facts concerning every customer," so that they may 

• service the customers' accounts;
• make appropriate decisions regarding special handling for the account;
• have appropriate authority from the customer; and
• follow all applicable laws, regulations, and rules.

This Rule must be followed by the broker-dealer at the beginning, during and, if necessary, the end of every customer relationship regadless of the type of account.

FINRA has also developed suitablity rules for transactions found in FINRA Rule 2111.  These rules require the broker-dealer or registered representative to have a reasonable belief when recommending a transaction or investment strategy or associated person "have a reasonable basis to believe that a recommended transaction or investment strategy.  Initially, the security or securities must be suitable for the customer, and based upon the information obtained from the process outlined abobe.  FINRA believes that there will be many factors involved depending upon, among other things, complexity and risk and broker-dealer and registered representative familiarity and knowledge.  FINRA Rule 2111 also requires that the broker-dealer and registered representative know much about a customer's investment profile, including, among other things, age; other investments; financial predicament and needs; tax status; investment objectives, experience, time horizon; liquidity requirements; tolerance for risk; as well as any other customer specific information disclosed to the broker-dealer and registered representative.  Finally, analysis of this information is critical to determine quantitative suitability if there is actual or assumed discretion over the customer's account.

Essentially, broker-dealers and their registered representatives are now on notice that they must know their customers or risk violating FINRA's rules.

In a recent award, a FINRA panel held that the use of a personal investment advisory questionnaire as a disclosure device was misleading and had the capacity to deceive.  The panel also found that the firm’s continued approval of that use constituted inadequate supervision.  Although FINRA panels rarely disclose the reasons for their decisions, this panel specifically stated that it intended to give the Respondents the benefit of its conclusion so that the Respondents may modify their conduct accordingly.

The panel’s award could have significant repercussions for the industry.  Although not every firm uses a personal investment advisory questionnaire as a means of disclosure, the practice is not uncommon.  Questionnaires are popular among firms because they can convey information in an easy to read and understand format.  The panel did not explain how or why the questionnaire was misleading but the award could be interpreted as suggesting that all questionnaires are misleading.  Firms and advisors should immediately review their policies, procedures and questionnaires to make sure they are not using the questionnaires as a means of a disclosure. 

Last week, FINRA issued FINRA RN 12-45 laying out several items members should consider in the aftermath of Hurricane Sandy.

For example, FINRA suggested that member firms provide office space to those member firms affected by the Hurricane.  Further, member firms housed in temporary space would not need to make an application for a new branch location or have to update RRs' Form U-4 forms.  FINRA did specifically require these firms to contact their FINRA regulatory coordinator as soon as possible.  FINRA also extended the deadlines for completion of CE requirements and qualification examinations for those people living in federally declared disaster areas.  These deadlines now will be extended to December 10, 2012.

Additionally, at the time of this writing, FINRA's NYC offices are still closed, but that may change shortly.  As a result, member firms and RRs should check on any filed information to ensure FINRA has any materials filed by these member firms or RRs.  FINRA is also allowing member firms and individuals the opportunity to ask for more time to respond to investigations or make filings.  However, a request must be made, it will not be automatically be granted or extended.

Finally, we are all in this together, and, at Fox Rothschild, we are prepared to offer assistance where we can.

The short answer to this question is a very large, NO!

All too often in my defense of registered representative and investment advisors do I see a completed account application as the only indicia of the performance of a know your customer analysis.  From my perspective and years of experience, the account application is only the floor, not the ceiling for the know your customer analysis.

Clearly, the account application is a necessary tool in the information gathering process, but checking off boxes does not give you the whole picture.  What I have found most defendable is where the advisor had his or her own checklists to ensure that they adequately know their customer.

For example, many times account applications do not take into account situational issues that may impact an investment strategy.  Does your customer have dependents?  Does your customer have health issues that would require immediate liquidity needs? Does your customer plan to retire in their near or long-term?

Account applications can never answer all of these questions, but my know your customer guidebook may help you with this information gathering process.  It is impossible to truly “know” everything about your customer, but the question in any lawsuit will be did you do enough for that customer and that investment.  A file full of things that reflect a know your customer analysis is much easier to defend than one with only an account application, which was hopefully not completed in blank.

Take your time, and go beyond the account application.  Ask the tough questions.  Push for answers.  Know your customer, and avoid the risk of a customer complaint.

The SEC recently completed the Dodd-Frank mandated study on financial literacy for retail investors and it revealed, not shockingly, an absence of basic financial literacy.  The study also found that it was important for retail customers to have a better appreciation of the costs associated with their investments, as well as conflicts of interest related to transactions. 

All those years of hearing customers testify of not knowing the difference between a stock and a bond may not have been a lie.  Without basic financial literacy, how can you know your customer to make investment recommendations with a reasonable basis and satisfy the applicable rules.

These issues should not come as a surprise to you because they are fundamental things that both your clients must know and you need to certain that they know. The absence of financial literacy will lead to two bad results.  First, you do not know your customer as required.  Second, if you do not know your customer, you could not have had a reasonable basis for making your investment recommendations.  As such, you will have liability exposure if sued by this client.

So what do you do.  For one, make sure that you do what you can to make your clients financially literate.  Once you have level of comfort that your client possesses some basic understanding of investing, you are then able to make suitable investment recommendations.  Take your time with this analysis; it may be the best way to protect yourself from customer complaints.

It has been two months since FINRA Rule 2111 has come into effect.  This new rule requires that there must be a reasonable basis to believe that the recommended transaction or investment strategy involving a security is suitable for a customer, where a strategy can involved the recommendation to buy, sell or hold a security.  So what does it mean to make a suitable investment recommendation?

I have effectively argued in arbitrations that a 100% equity growth investment portfolio was suitable for a investor.  Although this may seem a bit out of whack, the panel did not think so; why.

The key for making suitable investment recommendations is to make sure that you first know your customer.  Equally important, you must document the rationale for making such a recommendation.

From my experience, the more documentation in your file to demonstrate your explanation to the customer of the respective risks and benefits of a proposed investment strategy, the more likely that an arbitration panel will agree that you had a reasonable basis for the investment recommendation. 

To protect yourself, never take a shortcut.  Make sure your fully  document you recommendation in your notes, with prospectus or other written materials.  If you  do, you stand a reasonable chance of prevailing if that same customer decides to bring a claim against you.

One of the more challenging things that registered representatives must do is to truly know their customers.  You cannot make suitable investment recommendations without knowing your customer.  My recent guidebook addresses things you can do to know your customer.

 Although knowing your customer seems so basic, many registered representatives take a very cursory approach to this analysis.  In one instance, we had a registered representative learn, for the first time, in the middle of a trial that his customer was a functional illiterate.  This made defending his covered call option strategy an impossible task.

 So how do you really know your customer?  Unfortunately, there is no guaranteed method to learn everything you need to know and, as important, ensure that your customer is telling the truth. 

 For one, try to gain as much objective information as possible; things like tax returns, investment statements, and bank account statements come to mind.  Next, do not be afraid to ask customers the tough questions to get the answers to make sure you really know your customer.  If you do your job on the front end, you can be reasonably assured that you will not get embarrassed in an arbitration.

On July 9, FINRA Rule 2111 took effect, but it has lead some to question whether this suitability rule is simply “fiduciary duty light”.  In other words, a placeholder until the SEC finally defines the uniform standard.  FINRA’s pre-live guidance on this rule has only fueled this debate, leaving the industry to scramble to modify its policies and procedures to address a potentially moving target.

As reported by Dan Jamieson of the Investment News, FINRA’s May guidance (Regulatory Notice 12-25) has done little to quell the debate.  In its guidance, FINRA set forth a “best interests” standard of care for the rule.  The guidance further provided that the rule would apply to potential clients and to investment products that were not securities.  FINRA claimed that it was simply interpreting the new rule consistent with prior enforcement actions. 

A number of industry people saw the guidance as just another way of stating that the rule imposes a fiduciary duty through its “best interests” standard of care because the FINRA rule makes no reference to “best interests”.  Equally disturbing, the guidance imposes obligations on the industry to supervise non-securities activities (i.e., mortgages or insurance), leaving some to question whether FINRA overreached with its jurisdiction.

FINRA’s late guidance is surely going to lead to uncertainty at broker-dealers regarding what conduct to supervise and how to supervise it under the new suitability rule.  Some broker-dealers have undoubtedly had to revisit the policies and procedures developed in anticipation of the new rule.  Unfortunately, they may have to further revisit those new policies because, in the end, suitability may actually equal fiduciary duty.  Only FINRA can resolve this confusion, but the question is when and how.

Chairman Ketchum is seeking new areas of growth for FINRA.  At FINRA's annual meeting, Ketchum stated that he wanted to see FINRA take on the role as regulator for both retail professionals and institutions.  He also wants greater market transparency through the use of audited quote and trade systems.  Ketchum stated that he wants to see investors increase their use of BrokerCheck -- the system the public can use to check the background of registered representatives and broker-dealers -- so the investing public can better protect itself.  Despite this push from FINRA to grow its reach, the number of broker-dealers has been in decline.

One reason for this decline could be the increase in user fees that FINRA charges.  Another reason for the decline is the attractiveness of the registered investment adviser model, who are currently subject to SEC or state oversight depending on their size.  The SEC only examined 8% of RIAS last year, while FINRA examined 58% of its members in the same time period.  As such, RIAs are generally opposed to FINRA become their SRO, asserting that the FINRA rules-based business model does not mesh with their fiduciary duty business model.  The apparent decreased oversight of RIAs may be the ultimate reason for the decrease in broker-dealers and the increase in RIAs, which, in turn, is the likely reason that FNRA is pushing to become the SRO for RIAs.

From Ketchum's remarks, FINRAs growth model can be seen as a transparent effort to demonstrate to Congress and the SEC that it has the capacity to take on new and greater tasks.  In other words, to support FINRA's claim that it is the best choice to become the SRO for RIAs.  This political debate will likely rage on through the summer; all the while FINRA will try to do more and more to increase the perception that it is the best choice.  In the end, the most likely choice still seems to be a better funded and more active SEC.  We shall see . . .  

Much has happened in nearly one since since the Dodd-Frank Act became effective, and much more remains.  According to the recent thoughts of one commentator, Kyle Colona of Compliance EX, Dodd-Frank may be doomed to fail as it faces it first year of existence.

Colona noted five factors working against the full implementation of the law: (1) the CFTC and SEC are far behind schedule; (2) the regulatory authority under the Act is shared by too many entities; (3) recent comments from the Federal Reserve Bank suggest that the Volcker Rule may not become law because of its impossibility to implement; (4) the financial services industry has unleashed a full-scale effort to defeat the full implementation of the Act; and (5) certain banks are trying to influence the public that implementation of the Volcker Rule would be bad.

I think that there is now a sixth factor that may work against the full implementation of the Dodd-Frank Act; namely, a presidential election this fall.  With the politicalclimate becoming more and more focused on the election, it is only natural that there would be less attention devoted to a law that the financial services industry is committed to pealing back or doing away with altogether.  If the President loses the election, there are some who believe that Dodd-Frank may be in trouble.  Even if the President prevails, it is unlikely that there will be full implementation because attention will surely be focused elsewhere.

Although it is unlikely that there may ever be full implementation of the Act, we need to still anticipate that many provisions of the Act will come to pass.  For example, at some point, the SEC will finally commit to the adoption of the uniform fiduciary duty rule and there will be a decision on who will serve as the SRO for investment advisors.  Dodd-Frank is not dead; it just may limp along for the next year.

The new SEC Rule 13h-1, the large trader reporting rule, became effective. 

Starting on April 30, 2012, broker dealers will be required to maintain records of large trader trading, similar to records maintained relating to the electronic blue sheet system.  Further, supplemental information will also be required.

This new large trader rule could implicate investment advisers, banks, broker dealers, insurance companies and foreign entities.  All may be required to self-identify by filing a Form 13H with the SEC, and provide unique information to the SEC.  Broker dealers will also be required to maintain information relating to these trading records supplemented with the time of order, execution and the trader’s ID number if the SEC so requests.  Broker dealers will also be required to file a Form 13H if they are large traders.

Although the definition of a large trader is enunciated in the rule, there is some factual assessment that goes into it.  That is, it relates to any person, who directly or indirectly, exercises investment discretion over one or more accounts through NMS securities and registered broker dealers in a certain activity level.  The large trader must file an initial Form 13H promptly after it crosses the trading thresholds, and it has been considered that promptly means within ten days.  There are also annual filings that must be done within 45 days after each calendar year.  Confidentiality was also critical in assessing this information, and the SEC expects firms to realize that it will maintain the confidentiality of said information.  However, it may have an obligation to disclose it to Congress, other federal agencies and pursuant to a federal court order. 

Accordingly, firms should be aware that these issues may arise, and should be ready to file and maintain the appropriate records.

FINRA recently announced that, in the first quarter, it will issue a risk control assessment survey to all member firms.  Although this is a voluntary program, member firms should strongly consider their participation.  Your efforts on the front-end may alleviate the work you would otherwise perform during an examination.

The purpose of the survey is for FINRA to better understand member firm business models, the risks attendant with those models and the controls intended to manage those risks.  According to FINRA, responses to this survey will afford it the ability to conduct more focused examinations.  In other words, the program will give examiners a better understanding of your firm before arriving on site and allow the examiners to streamline the examination.

According to FINRA, firms who do not participate will not suffer negative consequences.  However, those non-participating firms should expect FINRA to spend more time during an examination.  FINRA plans to conduct this survey on an annual basis; the content will change as new risks emerge and as priorities evolve.

Even though answering the survey will take time to complete, streamlining the examination process is a laudable goal.  If the time spent on completing the survey results in a more focused and shorter examination, it seems to me that the decision to participate in the survey should be a forgone conclusion.

BrokerCheck is a publicly available tool that FINRA offers for the public to learn about member-firms and their registered representatives.  Over the years, the information available to the public has expanded.  The fallout from the financial crisis has resulted in more and more information being made available to the public, with additional categories of information being made available by July 2012.  Now, FINRA is seeking public comment for the release of reasons for termination and scores from industry qualifying examinations, but there is a potential unappreciated downside to the release of this information.

 Making information available to the public about a registered representative’s reason for termination can be seen as another way to smoke out those individuals who should not be in the industry in the first place.  This disclosure will provide the public greater protection against rogue brokers fleeing one firm for another.

 One commentator has noted that there is a downside from the dissemination of all this information; namely, identity theft.  The more and more personal information that becomes available, the more likely for there to be identity theft.  In light of the SEC’s recent alert on investment scams through social media, FINRA may be inadvertently helping the promulgation of such scams.

 In the end, I suspect that the reasons for termination and test scores will become available through BrokerCheck.  As such, member-firms and registered representatives will have to be even more diligent to ensure that they are not subject to the improper use of this information.  One potential tool is the frequents internet searching of the names of registered representatives to test for improper use, but this will come at a cost in time and resources.  Similarly, FINRA will have to critically review instances of purported financial fraud to ensure that the perpetrator is who the public thinks she or he is.  Otherwise, BrokerCheck will become a tool for fraudsters as opposed to protecting the public.

The SEC's delay in adopting an uniform fiduciary duty will only be prolonged but yet another analysis that the SEC will commission.  Chairman Schapiro recently announced plans to issue a public request for information regarding "retail financial advice and the regulatory alternatives".  With respect to the adoption of the uniform fiduciary duty standard, the SEC suggested that it was still in the information gathering stage of rule-making.  Interpretation; the SEC is no closer to adopting a uniform fiduciary duty standard.  Although the SEC has not ruled rule-making for 2012, it is not likely.

The SEC has advised the House Financial Services CapitalMarkets subcommittee that it has three economists working on the initiative.  Among other things, the economists have reviewed available market information for the retail financial advice market, including the differences between broker-dealers and registered investments advisers.  Notwithstanding the work of the economists to date, the SEC noted that the rule-making associated with the uniform fiduciary duty will require an analysis of information that may not be publicly available such that it will be particularly important for the SEC to solicit the public to provide information and/or empirical data.

Of the information that the SEC will seek in its public request for information, broker-dealers should expect that some of the data sought will cover a cost-benefit analysis of whether the adoption of a uniform standard will outweigh the cost of doing so.  Although delayed, the SEC is, it appears, trying to have a full and complete analysis to ultimately justify a uniform fiduciary duty.  In light of the manner in which many courts and arbitration panels treat broker-dealers, this whole exercise could be seen as making something "official" that has already been in place for many years.  The question that remains is whether the cost to make the standard an "official" one is worth it considering the prevailing view of many that it may already exist.

For anyone reading this post, you appreciate the value of social media.  It looks as though FINRA is finally prepared to do so as well.

FINRA recently proposed changes to its rules governing communications with investors.  In doing so, FINRA has proposed easing its requirements of pre-approval for a broker-dealer's use of social media.  Chief among the proposed changes would be the authorization of registered representatives communicating with clients via social media without a supervisor's prior approval.  Without pre-approval, a registered representative could engage in interactive , real-time communications with customers via a social media site.

Assuming this proposal is adopted, this is a positive step for FINFRA.  Nevertheless, I think that broker-dealers and registered representatives still must be wary of using social media to communicate in real-time with their clients.  First, the member firm will surely still be required to maintain copies of these communications consistent with its record retention obligations.  Keeping track of the potential volume of such communications creates a record-keeping nightmare.  Second, broker-dealers should consider restricting their registered representatives from making investment recommendations through interactive social media because of suitability concerns.  The risk of an investment recommendation being disseminated via social media is that anyone accessing that source could argue that it was an investment recommendation made by the firm and pursue a claim against the firm in the event of a loss. 

In my experience defening member firms and registered representatives, the types of claims asserted are only limited by the creativity of the lawyers.   Do not be a victim.  If FINRA specifically endorses inter-active communciations via social media without pre-approval, be certain that you have meaningful policies, procedures and protocols to maintain proper records and avoid open-ended recommendations to the public.

Although the use of social media has been embraced by many industries, it is of particular concern for investment advisors and broker-dealers.

In many situations, the use of these outlets touch upon several areas.  For investment advisors and broker-dealers, the advertising requirements under the Investment Advisors Act of 1940 and certain Securities Exchange Act of 1934 provisions may be implicated when one uses social media, including various features on Linked In or Facebook.  Additionally, recordkeeping is a critical function required by both acts since this information must be maintained.  Further, it is likely that those who work for either and use social media sites, may require supervision.  Additionally, when one uses these types of communications, there are various regulations that require the firms to monitor these third party communications to ensure that, among other things, non-public information is not disclosed.  Firms would also be required to apply their audit function to these media policies and procedures internally, to determine if the procedures are effective.  Moreover, the SEC, FINRA and the states may begin to regulate these types of social media in amore forceful manner. 

As such, although social media venues may present certain benefits, the risk is palpable.

FINRA, recently, announced that it was developing a cross market surveillance system that will allow it to detect and stop improper conduct.  This was reported by FINRA Chief Executive Officer, Richard Ketchum. 

This new system will expand FINRA’s surveillance and enforcement of the New York Stock Exchange, as well as its own order audit trail system to include New York Stock Exchange data.  FINRA believes that, with the combination of both, it will be able to effectively monitor equity trades and data to allow it to see patterns ahead of or in conjunction with the market, as opposed to reviewing it after the fact.  Ketchum suggested that this new surveillance system would possibly assist FINRA in achieving the SEC’s goal for a consolidated audit trail system. 

This new system may significantly reduce FINRA’s expenditures on examinations, and bring to light unscrupulous activity in the market in time to protect those effected.

My colleague, Josh Horn, has written an amazing article that should be on every compliance officer’s desk.  It details methods for investigating and responding to ponzi schemes. 

In this day and age, we are met with another Ponzi scheme occurring or being uncovered almost every day.  Josh’s article is an exceptional primer since it details the steps for a proper investigation, as well as, disseminating the investigation results to the appropriate authorities.  Further, Josh lays out an approach to avoid litigation, and, if litigation does strike, responding to it.  This article appeared in the September – October 2011 Special Edition for the National Society of Compliance Professionals, in its publication, N.S.C.P. Currents, and may be viewed at www.foxrothschild.com/newspub/newspubArticle. aspx?id=4294970030.

I hope everyone considers it.

The Second Circuit Court of Appeals has ruled that the Financial Industry Regulatory Authority (“FINRA”) cannot seek to enforce a monetary fine through a judgment with the court.  What does this mean for broker-dealers?

In 1998, NASD, FINRA’s predecessor, brought an enforcement proceedings against a broker-dealer.  After a hearing, a panel concluded that the firm engaged in illegal short selling and market manipulation.  It expelled the broker-dealer and imposed a fine.  After the firm refused to pay the fine, FINRA pursued the fine through the federal court, which upheld FINRA’s right to collect its fines through a judgment against the broker-dealer.

On appeal, the Second Circuit determined that Congress did not intend to authorize FINRA to enforce its fines through judicial proceedings.  If FINRA wanted the ability to do so, FINRA would have to have pursued proper rule-making, which it failed to do.  FINRA has stated that it is weighing its options, which would include an appeal to the Supreme Court.

This decision is significant in as much as FINRA is without judicial process to enforce a fine against a broker-dealer who refuses to pay, but this does not mean that FINRA is without recourse.  First, FINRA will, in all likelihood, will attempt to pursue rule-making to enable it to seek judicial relief.  Second, FINRA has the threat of additional sanctions against member firms for failing to pay a fine, such as the ultimate sanction of expulsion; a sanction that the panel already imposed in this case.  As such, the  absence of judicial recourse should not provide broker-dealers with a rationale for not paying a fine.  If you do, you may wind up being much worse off.

In January 2001, the Securities and Exchange Commission (“SEC”) recommended the implementation of a uniform fiduciary duty standard for broker-dealers and registered investment advisors. Significant debate has followed regarding the potential parameters and scope of such a duty. Recently, the Securities Industry and Financial Markets Association (“SIFMA”), a lobbying group for large broker-dealers, proposed a framework for a uniform fiduciary duty.

Although SIFMA reiterated its support for such a standard, it also recommended against applying the fiduciary duty found in the Investment Adviser Act of 1940 to broker-dealers, stating that it would adversely impact “choice, product access and affordability of customer services”. Among other things, SIFMA proposed a new fiduciary duty for broker-dealers to accommodate broker-dealer conduct that would otherwise be in violation of the 40 Act.

In doing so, SIFMA recommended that, in its rulemaking, the SEC “provide the necessary rule-based guidance regarding when the fiduciary duty begins and ends and what disclosures and consents, if any, are necessary to satisfy the duty where a broker-dealer gives “advice involving principal trading, structured products, hybrid accounts, complex investment strategies, concentrated positions, and receipt of commissions and differential loads for different products.” To implement this standard, SIFMA proposed that it be articulated in the initial customer agreement. SIFMA also recommended that the fiduciary duty apply on an account-by-account basis.

By implementing a new fiduciary duty standard unique to broker-dealers, SIFMA believes that the SEC will properly take into account the distinctions in the law between registered investment advisers and broker-dealers while taking customer service into account. It remains to be seen if SEC heeds this call to action, or if the SEC simply rubbers stamps the 40 Act fiduciary duty standard to broker dealers.