FINRA recently entered into a settlement with Gar Wood Securities LLC (the “AWC”) concerning allegations that Gar Wood facilitated the sale of restricted securities in violation of the Section 5 of the 1933 Act, and the Firm failed to identify “suspicious” activity in a customer’s account that should have warranted the filing of a Form SAR-SF.

Continue reading

Pillar close-upFollowing its broad ruling in UBS Financial Services v. Carilion Clinic, 706 F.3d 319 (4th Cir. 2013), the 4th Circuit has issued two recent decisions that somewhat lessen the impact of the UBS holding. In UBS, the court held that a customer of a FINRA firm is anyone “not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities,” including “investment banking and the securities business.” But in two recent rulings, the Court refused to further extend that definition, enjoining two FINRA arbitrations in which claims were based on (1) losses resulting from bonds issued by a FINRA member where the claimants purchased those bonds in a secondary market transaction from an unaffiliated third party and (2) losses resulting from purchases of fraudulent securities that were recommended by an attorney informally associated with an advisor at a FINRA-member firm.

Morgan Keegan & Co. v. Silverman, 706 F.3d 562 (4th Cir. 2013)
The Defendants in Morgan Keegan suffered losses in bond funds that were distributed and underwritten by Morgan Keegan (“MK”). The losses were allegedly in part the result of MK’s failure to disclose certain information regarding the valuation of – and risk associated with – the bonds. In enjoining the arbitration, the 4th Circuit noted that no contractual relationship existed between the Defendants and MK – the Defendants had not purchased the funds through an IPO but in a secondary market transaction from Legg Mason, a FINRA member unaffiliated with MK. Continue reading

Depositphotos_9223427_xsLincoln Financial Securities Corp. recently settled with FINRA concerning supervisory deficiencies over a now-deceased rep (Kenneth Wayne McLeod) who purportedly ran a Ponzi scheme targeting retired government employees (Department of Enforcement v. Lincoln Financial Services Corp. – Case No. 2010025074101). A copy of the FINRA AWC can be accessed here: (FINRA AWC). FINRAs case is a follow-up to an SEC action which charged Kenneth Wayne McLeod’s estate and entities run by Kenneth Wayne McLeod with operating a Ponzi scheme promising investors with tax-free returns of 8% to 10% per year (Securities and Exchange Commission v. Estate of Kenneth Wayne McLeod, F&S Asset Management Group, Inc. and Federal Employee Benefits Group, Inc. – Case No. 10-22078, U.S. District Court, Southern District of Florida). A copy of the SEC Complaint can be accessed here: (SEC Complaint). Continue reading

Robert L. Herskovits, Herskovits PLLC, Herskovits PLLC Submits Comments to FINRA Proposed Rule on Recruitment Compensation PracticesOn January 30, 2013, we sent FINRA a comment letter concerning the controversial proposed rule which would require disclosure of all “enhanced compensation” – forgivable loans, up-front bonuses, back-end bonuses, and the like – to customers. For those opposed to the proposed rule, the comment period is open until March 5, 2013. The text of our comment letter is set forth below:

Marcia E. Asquith Office of Corporate Secretary FINRA 1735 K Street, NW Washington, DC 20006-1506
Re: Comment on Proposed FINRA Rule concerning Enhanced Compensation

Dear Ms. Asquith:

This letter comments on FINRAs proposed rule to require disclosure of purported conflicts of interest relating to recruitment compensations practices. See Regulatory Notice 13-02. We oppose the proposed rule for three reasons. First, the proposed rule is overly broad and goes far beyond the discrete concerns expressed by the Securities and Exchange Commission in August 2009. Second, Regulatory Notice 13-02 speaks of “conflicts of interest” in “enhanced compensation packages” without providing any support – special studies or otherwise – to buttress FINRAs conclusion. Third, the proposed rule runs roughshod on legitimate expectations of privacy that financial advisors should enjoy with respect to their income.

For purposes of this comment letter, only the first objection noted above requires further amplification.

Concerns Expressed by the SEC

On August 31, 2009, former SEC Chairman Mary L. Schapiro issued an open letter to certain broker-dealers expressing concern that “[c]ertain forms of potential compensation may carry with them enhanced risk to customers.” With regard to the enhanced risk, Chairman Schapiro offered but one example: “if a registered representative is aware that he or she will receive enhanced compensation for hitting increased commission targets, the registered representative could be motivated to churn customer accounts, recommend unsuitable investment products, or otherwise engage in activity that generates commission revenue but is not in investors’ interest.” Thus, the only publicly expressed concern of the SEC centered on “increased commission targets” given to new recruits.

Overreach by FINRA in Response to the SEC’s Concerns

The proposed rule contains only two carve-outs: no disclosure is required if the enhanced compensation is less than $50,000 or the customer meets the definition of an “institutional account.”

The obvious question is this: why is FINRA proposing disclosure of all enhanced compensation whether or not the new recruit’s compensation package includes “increased commission targets”? Given the sensitive nature of an individual’s compensation, it would seem that FINRA should satisfy the SEC’s concerns – e.g., disclosure of increased commission targets – without requiring additional disclosure. If FINRA is concerned about an industry practice, it would seem appropriate to first express that concern to the member firms and allow the industry to address the concern before seeking approval of a sweeping and controversial rule.

If FINRA has concluded that any form of enhanced compensation creates a conflict of interest, then FINRA should justify that position to permit meaningful comment on the proposed rule. Instead, FINRA has taken a discrete concern expressed by the SEC and used that as a launching pad to seek approval of an expansive rule. FINRAs proposed rule is overly broad and should be narrowed to address only legitimate regulatory concerns.

Respectfully submitted,
Robert L. Herskovits

Depositphotos_1913696_xs-thumb-300x256-57397Last week, the U.S. Court of Appeals for the 4th Circuit issued a favorable ruling on the arbitrability of suits against FINRA members. Traditionally, under FINRA Rule 12200 any “customer” may request arbitration of a dispute with a FINRA member. UBS and Citi argued that Carilion was an issuer of securities, not a customer, and thus did not have the right to arbitrate their claims against the banks, both of which are FINRA members. The 4th Circuit joins the U.S. Court of Appeals for the 2nd Circuit and several district courts that have recently defined “customer” broadly in the FINRA context. The case is UBS Financial Services v. Carilion Clinic, (3:12-cv-00424-JAG).


Carilion is a non-profit hospital administration group based in West Virginia that issued $308 million of municipal bonds through UBS/Citi to finance a series of renovations and improvements. $234 million of that debt was issued in the form of auction rate securities (“ARS”).

UBS/Citi provided various services for Carilion in relation to the ARS issuances, acting as an underwriter, lead broker-dealer and seller of interest-rate swaps, as well as in an advisory capacity. Neither of the series of governing agreements between the parties contained an arbitration clause; one of the two contained a forum selection clause requiring that any related proceedings be filed in the Southern District of New York.

Legal Holdings

When a dispute arose, Carilion initiated a FINRA arbitration and UBS/Citi responded with a suit in federal court seeking to enjoin the arbitration on two grounds: (1) that Carilion was not a “customer” and therefore not eligible to bring a FINRA arbitration and (2) that the forum selection clause constituted a waiver of the right to arbitrate.

UBS/Citi argued that Carilion was, in this instance, acting as an issuer of securities, not as a customer receiving investment or brokerage services. UBS/Citi cited to a 2001 8th Circuit case holding that a party receiving banking and investment services was not a “customer” under NASD rules (note: this 2001 case involved a party receiving purely advisory services). In rejecting this argument, the court held that for purposes of FINRA, a customer is anyone “not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities” and that those activities include “investment banking and the securities business.” The opinion cites a couple of similar holdings by federal courts in New York and California, noting that no court faced with a similar situation found a customer relationship lacking.

The court further held – as a matter of pure contractual law – that the forum selection clause was too ambiguous to constitute a waiver of the right to arbitrate. The court noted that although an unambiguous waiver clause would be honored, the language at issue here (“all actions and proceedings arising out of this transaction… shall be brought” in New York federal court) left doubt as to whether it was intended to cover all disputes, or merely non-arbitrable ones.

Take Away

UBS Financial Services v. Carilion Clinic provides two valuable lessons:

(1) FINRA members and their “customers” should choose their words carefully if they wish to avoid arbitration, and (2) member parties acting as a jack-of-all-trades for their clients are unlikely to find courts receptive to arguments that the services they provided fall outside of FINRA’s jurisdiction. Conversely, FINRA member customers should feel confident in filing arbitration claims, no matter how large or complex the dispute.

Person's hand signing documentIt is commonplace in the securities industry for reps to transition from one broker-dealer to another. If the rep is a big producer, it is typical for the hiring firm to offer the rep a “forgivable loan” as an inducement to join. Depending upon the size of the producer’s book, the forgivable loan can equal 100% to 200% of the producer’s trailing 12 month’s of production, and is typically forgiven in equal increments annually over a 7 to 9 year period.

FINRA just published Regulatory Notice 13-02, seeking comments on a proposed rule to require disclosure of “conflicts of interest” relating to recruitment compensation practices. The proposed rule, called “Enhanced Compensation”, has the following components:

  • For one year following the rep’s start date, the “recruiting” broker-dealer must disclose the “details” of the enhanced compensation “at the time of first individualized contact by the recruiting member or registered person with the former customer after the registered person has terminated his or her association with the previous firm.” That should make for an interesting first conversation with the customer.
  • If the disclosure is made orally, “the recruiting member also must provide the disclosure in writing to the former customer with the account transfer approval documentation.”
  • If the customer seeks to transfer absent contact by the new firm, disclosure must still be made in writing with the ACAT paperwork.
  • The written disclosure must be “clear and prominent.” According to Regulatory Notice 13-02, disclosure “must include information with respect to the timing, amount and nature of the enhanced compensation arrangement.”
  • The proposed rule requires no disclosure to institutional accounts that meet the definition of FINRA Rule 4512(c) (unless the rep is a registered investment adviser) or for enhanced compensation less than $50,000.

The premise of the proposed rule is that a “conflict of interest” exists when a broker receives a recruitment package from a new employer. I, for one, reject that premise and FINRA should publish its studies – if such studies even exist – which support its premise. Why should a broker be required to disclose his or her total compensation to a customer? Brokers are not held to a fiduciary standard, and have no obligation under the law to disclose their compensation beyond the fees charged to any given customer.

The proposed rule is a follow-on to former SEC Chairman Mary Schapiro’s “open letter” to broker-dealers dated August 31, 2009 (
letter.pdf). In the letter, Schapiro warned broker-dealers not to incentivize churning by giving an incoming rep increased compensation for hitting a commission target.

However, what if a broker’s book is entirely fee-based, surely that would eliminate the Commission’s concern about “churning?” Nevertheless, FINRA’s proposed rule gives no carve-
out for fee-based brokers. And what if the hiring broker-dealer offers no increased commission targets in its compensation package? Nevertheless, FINRA offers no carve-out for that either.

The bottom line is that FINRA’s rule is ill-conceived and unsupported. FINRA should articulate these “conflicts” and then give carve-outs for all “conflict free” compensation packages.

The North American Securities Administrators Association (NASAA) recently released its Enforcement Report for 2012. A copy can be found here.

Pen finance chartNASAA is an association primarily comprised of state securities regulators. Through the association, its members engage in multi-state enforcement actions and other collaborative activities. NASAA’s Enforcement Section tracks trends in securities fraud and oversees the activities of various Project Groups, including: Internet fraud investigations, oil/gas ventures, Reg D investigations, securities investigation database and enforcement zones.

The Enforcement Report contains a multitude of interesting statistics. According to NASAA:

  • The majority of fraud cases involved unregistered persons and/or selling unregistered securities.
  • The most reported securities fraud violations (in order of frequency reported by states) concerned Rule 506 or Reg D offerings, real estate investment schemes, Ponzi schemes, oil & gas investments, and structured products.
  • Interestingly, the NASAA noticed a spike in actions against investment advisor firms, with a total of 399 actions reported, almost twice that reported one year earlier. The number of actions filed investment advisor exceeded the number of actions filed against broker-dealers (359 actions).
  • State securities regulators opened 6,121 investigations, filed 2,602 enforcement actions, and ordered investor restitution of $2.2 billion.
  • Enforcement “trends and developments” reported by the states included the securities fraud violations noted above, as well as bogus promissory notes and affinity fraud.
  • “New threats” include crowdfunding and internet offers, “inappropriate advice” from RIAs, “scam artists” using self-directed IRAs, and EB-5 investment-for-visa schemes.

Regulatory Headaches Coming for Mid-Sized RIAs

The Enforcement Report is interesting because it suggests that mid-sized RIAs will be subject to heightened scrutiny by the states. According to the Report: “The 2010 Dodd-Frank Act laid the groundwork for a major regulatory shift, transferring thousands of mid-sized investment advisors to primary supervision by state regulators, rather than the SEC.” It went on to conclude: “As the states implement regular examination schedules and analyze investment advisors that have not been audited in many years, more problems are likely to be discovered.”

On October 24, 2012, Susan Axelrod (FINRA’s executive vice president, member regulation sales practice) spoke at PLI’s seminar for broker-dealer regulation and Robert L. Herskovits, Esq.enforcement. Broker-dealers and registered representatives should take note because FINRA’s enforcement agenda was made clear. Issues of concern for FINRA include:

Cyber Security

FINRA has seen an uptick in instances where a customer’s email account has been hacked and the perpetrator sends a phony email to a brokerage firm requesting an outbound wire transfer. Given that NASD Rule 3012 requires diligent supervision concerning the outbound transmittal of funds, FINRA requested that “broker-dealers reassess their policies and procedures for accepting instructions to withdraw or transfer funds via electronic means to ensure that they are adequately designed to protect customer accounts from the risk that customers’ email accounts may be compromised and used to send fraudulent transmittal or withdrawal instructions.” (FINRA Regulatory Notice 12-05). In that Notice, FINRA recommended that firms verify that the email was sent by the customer and adopt policies to identify “red flags” such as transfer requests that are out of the ordinary or to an unfamiliar third-party account.

Complex Products

FINRA examiners are focused on principal-protected notes, non-traded REITs, reverse-convertible notes, structured notes, and leveraged and inverse ETFs. Over the years, FINRA has issued various regulatory notices concerning these products and others, including Notice to Members 05-50 (equity-indexed annuities), Notice to Members 05-59 (structured products), Regulatory Notice 09-31 (leveraged and inverse ETFs), Regulatory Notice 09-73 (principal protected notes), Regulatory Notice 10-09 (reverse convertibles), and Regulatory Notice 10-51 (commodities futures linked securities).

According to Axelrod, these products require “more scrutiny and supervision” by a broker-dealer including enhanced due diligence prior to approving the product for sale to customers. Due diligence guidance for new products is found within Notice to Members 05-26, which recommends documenting a “new product” review by considering to whom the product can be sold, what kind of training must be required of the sales force, and what kind of market conditions must exist for the approval to remain effective. FINRA also recommends documenting a “post-approval review” to reassess the suitability of the product and enforce any conditions which may have been placed on the sale of the product.

New Suitability Rule and Know Your Customer Rule

FINRAs new suitability rule (Rule 2111) went into effect in July 2012 and we blogged about the rule in advance of the effective date ( The new rule requires reasonable basis suitability (the broker must understand the product), customer-specific suitability (the security or strategy must comport with the customer’s risk profile), and quantitative suitability (no churning or excessive fees). Further, the rule covers any recommendation to “hold” a security, not just “buy” or “sell.”

Axelrod noted that “although not a specific requirement of the rule”, some broker-dealers have implemented a “hold” ticket to memorialize an explicit hold recommendation. Further, FINRA examiners are looking for updated policies and procedures to account for Rule 2111 as well as Rule 2090 (know your customer).

Robert L. Herskovits, Esq.
1065 Avenue of the Americas 27th Floor New York, NY 10018 Tel: (212) 897-5410 Fax: (646) 558-0239

tug of warTwo recent FINRA arbitration awards highlight increased focus by FINRA arbitrators concerning discovery abuses by litigants. FINRA’s rules require cooperation of the parties in discovery (Rule 12505) and specifically empower the arbitrators to issue sanctions for lack of cooperation, failing to comply with the discovery rules, or frivolously objecting to the production of documents or information (Rule 12511). Rule 12511 also permits the panel to dismiss a claim, defense or proceeding if prior warnings or sanctions have proven ineffectual.

Miriam Dean v. Wells Fargo Advisors, LLC (FINRA Arbitration No. 11-03911)

Although the power to dismiss a claim is in the rule book, until recently, you would be hard pressed to find an award which exercised that power. That changed with Miriam Dean v. Wells Fargo Advisors, LLC (FINRA Arbitration No. 11-03911), wherein the customer asserted claims in connection with an investment in a reverse convertible note. Apparently, the customer ignored the first discovery order. Somewhat miffed by the customer’s non-compliance, the arbitrator issued a second order giving the claimant the following 3 options:

  1. Proceed with the hearings on the scheduled dates of October 16-18, 2012, but pursuant to Rule 12511(a) of the Code, Claimant will be sanctioned by being precluded from presenting evidence in the pursuit of her case;
  2. Claimant may request a postponement of the hearings, so that Claimant can agree to adhere to the discovery requirements by a mutually agreeable date. All postponement fees incurred will be borne by Claimant;
  3. Claimant voluntarily requests withdrawal of claim. All forum fees will be assessed equally against Claimant and Respondent.

Apparently, the customer chose to disregard the second order as well. Oh well, said the arbitrator, who followed by issuing an award dismissing the customer’s claims with prejudice and assessing motion fees and hearing session fees against the customer. Even though the customer was pro se, the award strikes me as a reasonable outcome for a litigant who chose to ignore prior warnings from the arbitrator.

Robert E. McCarthy, et al. v. AllianceBernstein L.P., et al. (FINRA Arbitration No. 10-05687)

Here, the claimants sought damages resulting from investments in real estate investment trusts. Although the arbitrators awarded no compensatory damages to the claimants, they did assess sanctions in the amount of $30,000 against respondents for apparent discovery abuses. In fact, virtually the entire award is dedicated to describing the “unconscionable discovery practices” advanced by the respondents. Here are the highlights:

  1. Respondents responded to Claimants’ discovery requests by making “voluminous” production without identifying the requests to which the documents responded.
  2. Respondents refused to identify the categories of requests to which respondents had no responsive documents.
  3. Worst yet, one of respondents’ witnesses testified that “much of the research that was relevant to Claimants’ accounts with Respondents was not made available to them.”

Notwithstanding the fact that the respondents’ conduct during discovery “obstructed, prejudiced, and sidetracked the conscientious efforts of Claimants’ counsel to develop their case”, the arbitrators still zeroed the claimants because the “discovery efforts described herein would not have changed the outcome of the case.” This is an interesting award to read.