Over the years that I have defended broker-dealers and investment advisors, a more robust overview of outside business activity (OBA) disclosures would have gone a long way to disprove a number of claims. So where did these firms go wrong?

The biggest issue that I have seen is a firm’s willingness to take the OBA of a representative or IAR at face value and not do any more due diligence. In one instance, that due diligence could have unraveled a Ponzi scheme at its inception, instead of years after the facts and millions of dollars lost.money and calculator

In that case, the representative disclosed a beneficial interest in another business and that certain of his clients used that other business for tax preparation services. Although that other entity was not subject to the firm’s authority, the firm could have done more than nothing.

For one, the firm could have conditioned its approval of the OBA on the representative providing bank account statements for the other firm so that the FINRA-regulated firm could have assessed the scope of its clients using that other firm. By doing so, the firm could have uncovered that its clients were transferring money in not insignificant sums from their brokerage accounts to this third-party.

Conversely, if the representative refused or unable to get these statements, the firm could have denied approval of the OBA. Although this extra step may not have exonerated the firm from its representative’s use of the OBA to perpetrate a fraud, it would have provided a solid argument that it should have no liability because the representative acted outside the scope of his authority.

The moral of the story is that there is no perfect system for assessing OBAs. The important thing, however, is to take nothing at face value. Ask questions and push for information. If your employee is unwilling or unable to get that information, then the best thing is to not approve the OBA and lay the foundation for a defense if you are ever questioned about your employee’s outside business activity.

The SEC and FINRA have made it very clear that they are focused on senior customers and elder abuse. Granted, firms must be focused on the elder customers, but, at the same time, must also focus on the fact that many advisors are included in the graying generation.

What are firms to do about that? Before you do anything definitive, you should vet your ideas with an employment consultant or lawyer to make sure that any plan does not run afoul of labor and employment laws because older advisors may be within a protected class.confusion.jpg

Separate and apart from any legal analysis, you should consider doing certain things to make sure your advisors are acting properly and clients are being protected. Here are some suggestions that, in reality, apply across all age groups; these areas of inquiry could include:

  1. Having a supervisor meet with the advisor on a more regular basis just to see how they are doing; i.e., are they acting properly in the office or are they even in the office.
  2. Monitor trading activity; has it changed radically over a short period of time.
  3. Analyze the outflows of cash from customer accounts.
  4. Analyze the loss of customers over time (i.e., has the advisor lost a number of clients in short order).
  5. Randomly contact customers to vet their recent experiences with their advisor.

These oversight tools may help you uncover an elder advisor who is suffering from dementia, or, quite possibly, uncover a young advisor who is defrauding customers. Either way, the key is simple, properly monitor your advisors’ activity and protect your clients in the process.

* photo from freedigitalphotos.net

FINRA recently announced a change to the supervision rule to require hiring firms to conduct background checks on new employees.  This rule change raises the question; what have member firms been doing all along. 

In this day and age of instant information, having a new registered representative complete his/her U-4 should have only been a start of the inquiry.  A simple internet search of the new hire or transfer, including publicly available financial and criminal records can yield critical information that may impact the hiring decision.   

The need for a background check becomes even more critical where new hire comes from another member firm and his/her U-5 has an unclear reason for termination. 

The terminating firm will, to avoid liability, only confirm the former registered representative’s status as being associated with the firm.  What should the new firm do?  The upside of FINRA’s rule change is that your regulator has made the decision for you; perform a background check.   pointing.jpg

A few years ago, I had 40+ day arbitration, and it largely dealt with the issue of a representative leaving one firm and going go to another, but the hiring firm and the claimants did not think that the terminating firm did enough in the U-5 to highlight the reason why the person left the firm.  The representative is now spending a few years in federal prison because he conducted a Ponzi scheme.

By changing the supervision rule, FINRA has taken the burden off of firms to consider whether to conduct a background check.  The risk firms have is how much is enough to weed out a criminal. 

From my perspective, the issue will come down to process and the reasonableness of the background search.  Firms should document every step in their background analysis to address those situations where a hire goes bad.  It may also be worth considering the use of a service to aid in this process.  Either way, verifying the worthiness of a new hire must be a critical component in your risk avoidance program.

* photo from freedigitalphotos.net



A divided Securities and Exchange Commission adopted new rules to strengthen oversight of broker-dealers’ custody of customer assets.

The regulations amend the SEC’s broker-dealer reporting rule Securities and Exchange Act of 1934 Rule 17a-5, requiring firms to file new quarterly reports — Form Custody — containing information as to if and how they maintain custody of their customers’ cash and securities.  See http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539740621#.UfmIFmljuSo.  The amendments also require the firms — whether they have custody or not — to allow examiners from the SEC and relevant SROs to review their audit work papers, if the documents are requested in writing for purposes of a broker-dealer examination.  The firms further must allow their accountants to discuss their findings with the SEC or SRO staff.  Broker-dealers must start filing the quarterly reports with the SEC by the end of 2013.

The new rules also come with annual reporting requirements. Broker-dealers that have custody of customer assets annually must file “compliance reports” with the SEC to verify that they are complying with capital requirements, protecting customer assets, and sending periodic account statements to their customers.  Firms that do not hold customer assets annually must file “exemption reports” with the SEC.  The new reports must be examined in accordance with Public Company Accounting Oversight Board standards.  Moreover, broker-dealers that are Securities Investor Protection Corporation members must file annual reports with SIPC to allow the organization to better monitor industry trends and firms.  The first annual reports to SIPC are due by the end of the year.  The effective date for the other annual reporting requirements is June 1, 2014.

The SEC also finalized rule amendments that would strengthen its broker-dealer financial responsibility rules regarding net capital, customer protection, and books and records.  See   www.sec.gov/News/PressRelease/Detail/PressRelease/1370539739257#.UfmIe2ljuSo.  The amendments will require broker-dealers that maintain customer securities and funds to maintain a new segregated reserve account when the account holder is a broker-dealer.  The rules also restrict cash bank deposits pursuant to Exchange Act Rule 15c3-3 to maintain a reserve to protect customer cash; and establish customer disclosure, notice, and affirmative consent requirements for new customer accounts in programs where the customer’s cash in a securities account is placed in a money market or bank deposit product.  Finally, all of the rules become effective 60 days after publication in the Federal Register.

In short, broker-dealers are paying for the sins of the Ponzi scammers.

fraud.jpgThe outside business activities of registered persons have the potential for causing your firm significant liability, especially where those activities are unknown to the firm, involve firm customers and constitute a fraud.  FINRA 3270 only requires the registered person to provide notice to the firm before engaging in the activity, but should the firm do more.

The short answer is, absolutely.  First, the firm should either approve or disapprove of the proposed activity.  Standing silent is no longer an option.

Second, if approved, review that activity with the registered representative as part of the normal compliance review, as well as suprise reviews.  Part of this review process should also include an objective review of the registered person’s lifestyle; if they are living beyond their means, there may be a problem.

Third, monitor all correspondence (including electronic), as well as Internet use (including social media).  Many times bad brokers are sloppy covering their tracks.

Finally, do not be afraid to say no to a proposed activity.  Remember, your obligation is to the firm and its customers.  They should never be sacrificed to an outside business activity.

Regulators seem to believe that lawyers and their law firms act like ostriches when it comes to their clients and Ponzi schemes.  For example, a law firm paid $25 million to settle malpractice claims over legal services rendered to certain hedge funds and related entities controlled by a Ponzi Scheme artist, Arthur Nadel.  See SEC v. Nadel, M.D. Fla., 09-00087, 8/28/12, and http://en.wikipedia.org/wiki/Arthur_Nadel.

Although the law firm continues to maintain its innocence, it settled with the Court appointed receiver over allegations that it failed to detect red flags from the fraudster’s activities during their representation of him between 2002 and 2009.  See Scoop Real Estate LP v. Holland & Knight LLP, Fla. 12th Cir. Ct., 2009-CA-014877, 2009, and the settlement announcement. In his pleadings, the receiver argued that, if the firm acted sooner, things would have been different.  For its part, the law firm merely said that it wanted to end the litigation.

In short, the lesson that lawyers and law firms must learn is that they have to implement systems to detect such potential frauds, or these law suits will undoubtedly become a terrible “cost of doing business.”

The receiver for a convicted fraudster and his entities will not be able to recover a $2 million donation the fraudster made to a small Minnesota college.  See Kelley v. College of St. Benedict, D. Minn., Civ.;’ No. 12-822 (RHK/LIB), 10/26/12, and http://docs.justia.com/cases/federal/district-courts/minnesota/mndce/0:2012cv00822/125281/34/.

The federal district court found that the receiver lacked the ability to bring this action, and that only the United States could bring such claim under the Federal Debt Collection Procedures Act.  The receiver had sued under this statute, and the college opposed.  The tortured history of this case– like most Ponzi schemes– left the court to remark that there were no winners or losers in Ponzi schemes only losers.  Nonetheless, in rejecting the receiver’s attempt to collect, the court stated that, given the interplay of the receivership, bankruptcy, and parallel criminal forfeiture order, there was reason to believe the receiver was not the appropriate party to maintain this action.

We have likely not seen the last of this case, and wonder if this result would be upheld on appeal.

Okay, no one is suggesting that you start a Ponzi scheme!!!  However, now, that we have your attention, you should be aware of the United States Court of Appeals for the Second Circuit’s decision affirming a 25-year prison sentence for Ponzi scheme operator, Nicholas Cosmo.  See United States v. Cosmo, 2d Cir., No. 11-4506, 9/20/12, and http://federal-circuits.vlex.com/vid/united-states-v-cosmo-399026010.

This action was the result of Cosmo’s role as the former head of Agape World Inc. and Agape Merchant Advance LLC.  It was alleged that he mislead clients to invest more than $400 million over five years in certain short-term loans with high rates of return promises.  However, in typical Ponzi scheme fashion, Cosmo allegedly merely paid earlier customers with new customer money.  Cosmo was also apparently a bad trader as well, losing more than $100 million though unauthorized futures and commodities trades, and not making any loans he claimed he would to investors.  Although the government claimed, investors lost over $195 million, Cosmo’s restitution order, however, was approximately $180 million along with a 25 year prison sentence.

Cosmo had, in fact, plead guilty, but he was upset that the district court sentenced him to consecutive sentences.  The Second Circuit found no problem with this sentence, indicating that Cosmo had been a bad guy and committed a major fraud.  Essentially, the Second Circuit was not buying Cosmo’s “mercy” argument.

A lesson hopefully others will learn.

The SEC has decided to appeal a district court decision denying the SEC’s application to force SIPC to pay Staford investors.  See SEC v. SIPC, D.D.C., No. 1:11-mc-00678-RLW, 8/31/12, and http://www.scribd.com/doc/81297680/Judge-Wilkins-Opinion-re-SEC-SIPC-Case.

The SEC believes that these investors should be protected by SIPC insurance.  However, the court’s decision held that the investors did not invest through the broker-dealer, but the bank portion of Standford’s operation.  SIPC does not intend on giving into the SEC’s machinations, claiming the SEC’s theory is unprecedented. 

This is the first time the SEC has ever initiated such a suit.  The result should be very interesting.

The United States Supreme Court refused to review a federal appeals court ruling approving a $62 million award against a former hedge fund manager, who defrauded hedge fund investors over several years.  See Lauer v. SEC., U.S., No. 12-260, 10/29/12, and http://www.supremecourt.gov/orders/courtorders/102912zor_3f14.pdf.

This was an appeal from the United States Court of Appeals for the Eleventh Circuit that agreed with a federal district court’s granting of the SEC’s motion for summary judgment on liability and remedies.  The SEC had alleged that the hedge fund manager had misrepresented the true value of the hedge funds, artificially inflating the value of holdings.  Further, the SEC claimed he made false statements in various written and oral communications.  Previously, the district court had frozen the hedge fund managers assets.  The big judgment followed thereafter.

In short, both the United States Supreme Court and the Court of Appeals found there was sufficient evidence to support this judgment.