Broker-Dealer Regulation

If you cannot answer this question, you may have an issue when you have your next FINRA exam. After all, firm culture is a FINRA exam priority. Does your firm have a culture of compliance?

This question only leads to another; what is a culture of compliance. For one, this is something that has to resonate from the top down. If senior management ascribes to uphold firm compliance, that should promote the “culture of compliance.”CEO tree

For example, does senior leadership enforce the firm’s written supervisory processes and procedures? In doing so, does senior management hold everyone accountable the same way, or are exceptions made for the “big producers”. If exceptions are made, you are not promoting a culture of compliance.

Does senior management ensure that there is adequate training of all personnel? There should be a robust and mandatory training program to account for changes to the rules and to make your personnel aware of risks and how to avoid them; one of the biggest being data security.

These are only two of many considerations for assessing whether there is a culture of compliance. The key in it all is leadership from the top. After all, people cannot follow a leader who does not lead. Be a leader.

My friend and a legend in the securities regulatory field, Edwin Nordlinger, who served as Deputy Regional Director in the SEC’s New York office for years, was one of the nation’s premier experts on the SEC’s net capital and customer protection rules.  He taught hundreds of SEC staff members and others about these rules over the years.  However, when Ed would begin one of these lectures, he would always introduce himself by saying: “Hello, I am Ed Nordlinger from New York, where you do not go to jail for killing people, but you will go to jail if you violate the net capital or customer protection rules.”  Well, Ed, you continue to be right on point about these rules and their impact.

The SEC’s net capital rule, SEC Exchange Act Rule 15c3-1, requires firms to maintain certain capital so that the firms will be able to meet their financial obligations to customers and other creditors.  Similarly, SEC Exchange Act Rule 15c3-3, the customer protection rule, requires a firm that clears transactions to maintain certain reserve amounts to protect customers in the event of a firm failure.

Recently, the SEC found a firm to have violated the customer protection rule, and settled the matter with the firm whereby the firm agreed to pay a fine of $358 million and a total amount of $415 million.  https://www.sec.gov/news/pressrelease/2016-128.html.  Further, the SEC also charged the firm’s regulatory reporting officer and financial operations principal for aiding and abetting the violations by misleading regulators about the real reason behind certain transactions that caused the violations.  In particular, the SEC claimed that the firm used synthetic securities transactions solely to reduce the reserve calculation and release capital.  The firm also apparently used non-qualifying bank accounts that could be subject to bankruptcy if the firm were to fail.

The real kicker, however, is the SEC’s announcement that it plans to undertake a targeted sweep of firms to find potential violations by other firms of the customer protection rules.  Of course, the SEC also encouraged firms to self-report any potential violations of the customer protection rule.

In short, Ed, after all these years, you are still right.  Firms need to seriously undertake compliance with these rules, or there will be significant consequences.  Accordingly, although the rules may seem technical with no fraud or customer losses, the SEC plans major activity to ensure compliance.

The SEC recently announced that an equity advisory firm and its owner agreed to pay more than $3.1 million to resolve charges that they improperly engaged in brokerage activity, as well as charging fees without registering as a broker-dealer.  In other words, the firm acted like a broker-dealer but never bothered to register as one.

The SEC’s investigation demonstrated that the firm performed brokerage services in-house, instead of using investment banks or broker-dealers to handle the acquisition and sale of portfolio companies for a pair of equity funds they advised.  Interestingly, the firm disclosed to its customers that it would provide brokerage services and charge customers a fee for doing so.

The problem is that the firm provided those services itself even though it was not registered to do so.  This action should serve as warning, particularly for firms who may be engaged in Reg. D offerings.

money and calculatorIf part of the offering you find yourself engaged in the sale of securities, you better be registered as a broker-dealer to be doing so.  Alternatively, you could have retained the services of a broker-dealer to sell interests in the fund.  The law is clear; you need to do one of the two.

Another point of interest is that the SEC uncovered this improper conduct through an ordinary examination of the investment advisory firm.  In other words, there was no customer complaining that it suffered any harm.  So what lessons are to be learned?

For one, only broker-dealers can engage in brokerage services.  Second, the SEC in its exam process is looking for such activity and going after it.  Don’t make the same mistake; register as a broker-dealer or retain one to provide those services for you.

Unfortunately, a bad broker does not take on the same attributes as a fine wine. Bad brokers do rarely improve with time.

At least this was the recent message of Robert Ketchum, head of FINRA. But should all brokers who have any pings on their record be foreclosed from the industry? Certainly not, but what should you do?Core Values

The question is tougher when the broker coming to you with some knocks on his record has been a historically high producer for his prior member firm. Surely, there must be more to the story.
In my experience, there usually is more to the story. Just because someone has some marks does not mean he/she is not worthy to be with your firm. But be careful.

Anyone coming to your firm with any pings on their U-4 should be brought on under heightened supervision. This way you can personally assess this person and test the reasons why this person has been pinged in the past. Maybe the registered representative was just the victim of circumstance in the past.

Either way, if you are going to bring someone on with a checkered past, you better be willing to take the time to watch over this person. After all, by bringing them to your firm, you have assumed responsibility for them. Take caution on the front end or be ready to pay the price later.

It was great speaking at the May 17 New York NSCP regional conference on risk issues facing firms where Ernie Badway and I discussed cyber-security, risk issues, regulatory matters, issues involving elder clients and ways compliance personnel can protect themselves.  For those of you who could not make the conference, these topics are frequently discussed in our various publications.  Feel free to access them here and use them as you see fit.  Core Values

On Tuesday, May 17, Ernie Badway and I are the keynote speakers at the NSCP Spring Conference in New York, entitled “Juggling Compliance Risks — Maintaining the Balance“. BoardAmong other things, Ernie and I will be speaking about cybersecurity, risk avoidance techniques, government regulations, elder client issues and compliance.  We hope to see you at the conference.

Believe it or not, the old fashioned telephone may be one of your best defenses to a data breach and corresponding fraud. How so, you may ask.

19196909_sOne of the greatest data security risks that firms have is not necessarily a hack into your IT systems. Instead, the hacking into your client’s email account may pose an even greater risk.

For example, an email account can be hacked and the hacker pose as your client and then makes an email request for a wire transfer of a significant amount of money. The easiest way to ensure that the email is legitimate is to pick up that thing that sits on the corner of your desk and call your client to confirm that he/she is requesting the wire.

This phone call takes no more than five minutes and will avoid you having to file a SAR and being out of pocket to your client. You should have a written policy that all wires should be confirmed over the phone where the failure to do so will be termination.

Hackers are getting more and more creative. Yet, the oldest technology in your office may be the difference between a data breach and a satisfied customer. Don’t forget to use it.

In this day and age of instant information and overstretched supervisory personnel, you have to be careful to avoid forgoing a very useful supervisory tool. Meeting face to face with those associated persons under your supervision on a regular basis could mean the difference between routing out rogue advisors and being subject to regulatory and civil actions.Core Values

Face to face meetings are even more important where the people you supervise are in regional offices. In other words, those advisors you do not see on a regular basis. With these people in particular, you must go to their offices for regular visits.

You may ask why it is so important to have face to face contact with the people you supervise. After all, you monitor email and correspondence on a daily basis. The advisor submits her outside business and AML forms on at least an annual basis. So who cares about a face to face?

Believe it or not, people lie on forms. It is easier to lie on paper (real or electronic) than it is in person. Also, seeing someone in their natural environment may make it easier to solicit information from them because they are relaxed.

Face to face meetings also help to show whether a person is living beyond his or her means. For example ,what would it mean if a mediocre producer is now driving a Ferrari? Maybe nothing, but maybe a lot more.

People living beyond their means can be a sign that they have another source of income, legitimate or not. You would never know if there is a potential issue if you did not bother to go to this person’s office for a face to face. That person could be the next Madoff, but you would never know if you only sat in your office and stared at a computer screen all day.

If you are going to supervise, then do it. Never forget the value of face to face meetings with those under your supervision.

The SEC recently charged four investment advisors who allegedly used free dinners to entice older clients to their firm. At these dinners, these individuals allegedly provided fraudulent marketing materials to the attendees and ultimately did not invest all of the money that they were given.whistleblower

Granted these four advisors may just be bad apples and not an indictment of the use of free lunches or dinners to attract new clients and money. However, if you do engage in these types of “seminars”, this enforcement action should be a wake-up call.

The SEC and FINRA have made it very clearly how they intend to approach marketing efforts directly at seniors. Both regulators will be taking a hard look at these types of seminars used to attract elder investors.

So, if you are going to offer a free meal, make sure that you are giving something of value to your prospects. Do everything on the up and up when offering these types of opportunities because your regulator is watching.

Unlike lawyers, especially litigators, the business model of a financial advisor is not dependent upon clients being stupid. Instead, financial advisors depend on their clients making smart decisions after full disclosure and consideration after speaking with their financial advisor. So what do you do when clients make stupid decisions?whistle

In defending brokers over the years, I have seen multiple instances where clients made stupid decisions. From a legal standpoint, there is generally no duty to prevent a client from making a stupid investment decision. It is what the advisor does in response that is the most important lesson to learn.

The mistake is when the advisor ignores his client’s stupid decision in light of an advisor having provided proper advice in the first place. The key thing is to document any instance where your client ignores your advice and does something stupid. A brief story solidifies this point.

A number of years ago, an advisor told his client not to sell his life insurance policy to take the cash out until the client cleared underwriting on a new policy. Of course, the client ignored the advice, went over the advisor’s head and cashed out the policy without clearing underwriting on the new policy. Turns out the client was “deathly” allergic of bee stings.

We were able to successfully defend because of something that the advisor did. He documented his recommendation not to cash out the old policy without underwriting being completed on the new policy.

But for the smart actions of the advisor, this situation would have turned out much differently. It is just as if not more important to document when a client ignores your advice as it is when you give advice to your clients. Doing nothing is never an option.