Broker-Dealer Regulation

 

Over the last several months, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has been conducting a “sweep examination” of over 70 broker-dealers and investment advisers to assess their cybersecurity policies and procedures.  https://www.sec.gov/files/observations-from-cybersecurity-examinations.pdf.  In particular, OCIE looked at their preparedness regarding governance and risk assessment; access rights and controls; data loss prevention; vendor management; training; and incident response.

For the most part, OCIE found policies and procedures in place, and these firms did, in fact, conduct penetration tests and vulnerability scans; used a system to prevent data loss; installed software patches; adopted response plans; and conducted vendor risk assessments.  However, all the news was not good.  OCIE believes that these firms should have better tailored policies and procedures; conduct enhanced employee training; replace outdated systems; and make sure that various vulnerabilities were addressed in a timely fashion.  OCIE also informed these firms that it will continue to be vigilant in the cybersecurity sphere in both its examinations and testing.

In sum, with the exception of tweets from the White House, no area is getting more attention from the public and the government than cybersecurity precautions and detection.  It is critical that senior management and compliance at broker-dealers and investment advisers take this threat seriously or there could be serious repercussions if their business is attacked.

The CEO of FINRA recently announced that FINRA plans to provide firms with additional resources to deal with recidivist brokers. So what does this mean?

For years, FINRA’s exam priorities have focused on, among other things, brokers who are repeat violators of FINRA rules. FINRA has made this a priority as a way to weed out brokers who do not deserve to be in the industry because they are likely causing more harm than good.

FINRA is effectively asking the firms to do their part in cleansing the industry of bad brokers. What can a firm do in this regard?

First, firms must take more care in the hiring process. Your due diligence cannot begin and end by pulling the registered representative’s CRD. You should run a Google (or similar) style search on the broker. There are also services you can use to find out if there are judgments, liens or lawsuits against the broker. This way, you can find red flags that may not appear on CRD.

Second, once you hire the broker, you have to make sure he/she is coming under a robust supervisory and compliance overview. Be proactive if you sense there is a problem. By doing do, even if there is a problem, you may be able to cut it off before it gets worse.

There is no easy solution. From FINRA’s perspective, however, you are either part of the solution or part of the problem. The choice is yours.

FINRA is currently reviewing its rules regarding outside business activities and private securities transactions. From time to time, FINRA reviews its rules and application of those rules to see if anything needs to be tweaked. Is there any significance to FINRA looking at these particular rules?

From my experience, some bad brokers have used the outside business activity disclosure process as the tool to cover their tracks while engaging in activity that the firm would otherwise want to know about. In some case, the undisclosed outside business turned out to be a Ponzi scheme.Core Values

The purpose of requiring outside business disclosures is for a firm to make sure that it and its clients know about any conflicts of interest that their brokers may have. For example, the firm would want to know if the broker had a real estate broker’s license because that business may compete with the time the broker can give to her securities investing clients.

FINRA exploring this area should be a message to firms that they need to ask critical questions about what they are doing regarding outside business disclosures.

Ask yourself:

  • Are you doing enough to make sure you receive honest and complete disclosures?
  • What, if any, ramifications are there for incomplete or untimely disclosures?
  • Are you asking enough follow-up questions to understand the proposed outside business activity?
  • What follow-up, if any, do you make with brokers who make disclosures?

If you cannot answer these questions, you need to do more homework or be exposed to the bad broker who may be in your midst.

 

One certainty in the brokerage world is that registered representatives often switch from one member firm to another. There is nothing wrong with the switch, but there is a word of caution to be shared.

Before you leave, make sure you only have in your possession, if anything, only those things that the firm you are leaving lets you keep. If you take something you are not allowed to have, you can rest assured that your former employer will come looking for you.Core Values

Similarly, you should determine whether the old or new firms are members of the broker-dealer protocol. If so, you should check the protocol for what you are allowed to take and what notice you have to give to your former employer about the information you are taking with you.

If one or neither firm is a member of the protocol, it still makes sense to follow the protocol. By doing so, you can demonstrate, if ever challenged, that you tried to do the right by following an objective standard that many in the industry have accepted.

Another thing you should verify is whether you are under contract with your old firm to delay your formal commencement with the new firm; otherwise known as a garden leave policy. If so, you had better follow it. If you opt not to follow it, you should expect a disgruntled former employer coming after you.

So change firms if you like. Just be certain you know what you are doing before you do it. A couple missteps here and there could get you in front of FINRA on an enforcement case.

The SEC recently announced that it charged a former broker with knowingly or recklessly trading unsuitable investment products for five customers and taking $170,000 for one of those customers. These charges follow a prior SEC Investor Alert warning about excessive trading and churning as well as another one focused on the risks associated with exchange-traded notes.

The broker must not have read those two alerts. According to the SEC, the broker enriched himself by systematically disregarding client investor profiles. He repeatedly traded in risky, unsuitable and volatile products like leveraged exchange-traded funds and exchange-traded notes.

Money and calculator
Copyright: denikin / 123RF Stock Photo

This case provides a number of lessons that firms should take away. Specifically, the SEC publishes Investor Alerts for a reason. The SEC is doing your work for you by flagging an issue for investors, as well as firms.

The second thing that this case hammers home is that firms must be more diligent in their broker supervision. As part of the firm’s ordinary surveillance, it should have flagged the unsuitable sale of highly volatile products to relatively unsophisticated clients.

A valuable thumb rule to follow is that as the sophistication of the products increases so should the sophistication of the customer buying those products. Although this rule of thumb will not completely stop all bad brokers, it will go a long way toward flagging those brokers before they cause harm to your clients and liability for your firm.

 

In Notice to Members 17-13, FINRA announced changes to its sanction guidelines. In other words, FINRA has listed its new top hits that it is pursuing. Two items bear particular attention.

First, FINRA has introduced a “new principal consideration that examines whether a respondent has exercised undue influence over a customer.” This guideline reinforces FINRA heightened focus on senior investors and those who may be otherwise vulnerable, such as those with diminished capacity.Core Values

Second, FINRA has introduced a “guideline related to borrowing and lending arrangements between representatives and customers.”   This guideline is particularly alarming in as much as it suggests that associated persons are actively engaging in such transactions even though firms uniformly ban them.

Notice to Members 17-13 is a strong guidepost for your supervision and compliance teams. The guidelines highlight growing problems in FINRA’s eyes. This is a cue that you should be ever vigilant for the same conduct. Otherwise, you may be the focus of the new sanction guideline that addresses systemic supervisory failures.

Contrary to what the title may suggest, I am not referring to students who are about to graduate from high school or college. Instead, this post is about that group of our society who all too often (based upon my years of defending broker-dealers) are claimants in FINRA arbitrations; senior investors.

As part of its ongoing effort to protect seniors, FINRA recently introduced Rule 2165 and amended Rule 4512. Both rules reflect a growing trend to provide greater protection to seniors.

Rule 2165 allows a member firm who reasonably believes that senior financial exploitation may be occurring to hold for up to 15 business days the disbursement of money or securities from a senior’s account. This rule gives a firm a safe harbor to take action when it reasonably suspects such exploitation. The firm can extend the hold an additional 10 days.

24752961 - grunge rubber stamp with text disclosure,vector illustration
24752961 – grunge rubber stamp with text disclosure,vector illustration

At the same time, FINRA amended Rule 4512 (providing for the firm to make a reasonable effort to obtain the name of a trusted contact person to place on a newly opened account) further defined the trusted person to be someone that the customer authorized the firm to contact and disclose information to in the event that there is possible financial exploitation. Importantly, the firm is only obligated to make a reasonable effort to obtain this information.

So what does all of this mean for the industry? For one, I do not think that FINRA has to paint you a picture to show you how serious it is taking financial exploitation of seniors. Considering the ongoing greying of the baby boomers, this focus will likely become even more heightened as the years pass.