July 26, 2013

Robert Herskovits Appears on Reuters TV Side Bar Show

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May 8, 2013

FINRA Identifies "Red Flags" for AML Compliance

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.

The customer, identified as ICG, was apparently in business of issuing loans secured by low-priced stock. Over a two-year period, ICG supposedly deposited penny stocks into its Gar Wood brokerage account and immediately liquidated the positions and wire transferred the proceeds.

ICG's activity caught the attention of FINRA, which identified the following "red flags" that Gar Wood apparently failed to act upon:

• ICG opened a new account and delivered physical certificates representing a large block of thinly traded or low priced securities;

• ICG had a pattern of depositing physical share certificates, immediately
selling the shares and then wiring out the proceeds of the sale;

• ICG deposited share certificates that were recently issued or represented a
large percentage of the float for the security;

• The lack of a restrictive legend on deposited shares seemed inconsistent
with the date the customer acquired the securities or the nature of the transaction
in which the securities were acquired;

• ICG had limited assets but received an electronic transfer or journal
transaction of large amounts of low priced unlisted securities;

• Issuers' SEC filings were not current, were incomplete or nonexistent; and
" Some of the company stocks deposited and sold in the ICG account
involved shell companies that issued shares; and

• JP Morgan, the original clearing firm for the ICG account, closed the ICG
account after JP Morgan identified several red flags related to ICG's operations.

The AWC is worthwhile reading for attorneys who counsel broker-dealers on anti-money laundering compliance.

April 1, 2013

4th Circuit Further Defines A "Customer" Under FINRA Arbitration Rules

Robert L. Herskovits - 4th Circuit Gives Further Defines A "Customer" Under FINRA Arbitration Rules

Following 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.

In rejecting the idea that the Defendants were customers of MK, the opinion emphasized that courts should be guided by the common understanding of a customer (one who purchases a commodity or service) when evaluating whether a customer relationship exists. The Court held that the contact between the Legg Mason broker and MK, including his review of marketing materials, was not sufficient to transform the Defendants into a customer of MK, even if the activity related to MK's securities business: "The defendants cannot satisfy the common understanding of the term 'customer,' namely, of 'one who purchases a commodity or service,' by alleging merely a remote association with alleged misconduct falling within the general ambit of FINRA's regulatory interests."

Raymond James Fin. Servs. v. Cary, 2013 U.S. App. LEXIS 4738 (4th Cir. 2013) The Defendants in Raymond James bought securities in Inofin, Inc. (essentially a Ponzi scheme), on the recommendation of David Affeldt, who was allegedly recruited for that purpose by his broker, Kevin Keough. Keough was a registered representative with Raymond James ("RJFS") when the Defendants made their Inofin purchases, and when Inofin later declared bankruptcy, Defendants filed FINRA arbitration claims against Raymond James. Although the Defendants had no personal contact with Keough or RJFS, it is worth noting that according to the SEC, both Affeldt and Keough were soliciting investors and were in fact sharing referral fees indirectly through Keough's wife.

Explicitly recognizing that investors often rely on the reputations of the entities with which they are dealing, the 4th Circuit nevertheless enjoined the Defendants' FINRA arbitration. Noting that the Defendants did not have a single direct contact with RJFS (whether by holding RJFS accounts, speaking with RJFS representatives, or through contractual relationships), the Court held that even if some sort of agency existed between Affeldt and Keough, Affeldt had neither actual nor apparent authority to act on behalf of RJFS: "the investors made their decision to invest independently of any recommendation on the part of RJFS. To find a customer relationship in such a situation would impose responsibility on a company whose name was never so much as utilized to induce the investors to part with their funds."

Take Away Together, these cases indicate that although the 4th Circuit is willing to take a broad view of what constitutes a FINRA-member firm's "business activities" in analyzing the existence of a customer relationship, the court is NOT willing to impose arbitration by imagining a "customer" relationship out of indirect contacts that do not involve the purchase of a commodity or service directly from a FINRA member.
February 11, 2013

FINRA Hits Lincoln Financial With Failure to Supervise Concerning a Ponzi Scheme

Robert L. Herskovits - FINRA Hits Lincoln With Failure to Supervise Concerning a Ponzi SchemeLincoln 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).

The supervisory deficiencies noted by FINRA were:

  • Lincoln Financial failed to place McLeod on heightened supervision given that Lincoln Financial hired McLeod while a state securities regulator had an open investigation.

  • Lincoln Financial's registration department failed to inform McLeod's supervisor of the pending state investigation and the advertising review department failed to inform the supervisor of concerns over McLeod's advertising.

  • Incredibly, Lincoln Financial permitted McLeod to hire an individual for one of McLeod's outside businesses and designate that person as his own supervisor. Lincoln Financial then failed to contact the "supervisor" to inquire about his resignation.

  • Lincoln Financial failed to conduct an email review of an outside email account that McLeod used for outside business activities.

Lincoln Financial was censured and fined $175,000. Additionally, Lincoln Financial paid $5.63 million in restitution to certain investors.

This case is yet another example of outside business activities coming back to haunt the broker-dealer. Broker-dealers often find themselves stuck with the liabilities of the outside business activity without ever having shared in the revenue.

February 4, 2013

Herskovits PLLC Submits Comments to FINRA Proposed Rule on Recruitment Compensation Practices

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
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

January 29, 2013

Courts Lining Up in Favor of Broad Definition of Customer Under FINRA Rules

Depositphotos_1913696_xs.jpgLast 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.

January 15, 2013

FINRA Is Looking for Additional Disclosure on Up Front Loans to Reps

Depositphotos_2505951_xs.jpgIt 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 (http://www.sec.gov/news/press/2009/2009-189-
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.

November 6, 2012

Enforcement Report Issued by State Securities Regulators Emphasize RIAs

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

Thumbnail image for Thumbnail image for Robert L. Herskovits, Esq.NASAA 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."

November 1, 2012

FINRA Exec Lays Out FINRA's Enforcement Agenda

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 (http://www.finralawyerblog.com/2012/06/are-you-making-suitable-recommendations.html). 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

October 29, 2012

FINRA Arbitrators Start Getting Tough With Discovery Abuses

Thumbnail image for Thumbnail image for Depositphotos_13455751_m.jpgTwo 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.

October 23, 2012

FINRA Provides Guidance for Supervisory Review of Email

FINRA recently released an Acceptance, Waiver and Consent signed by Deutsche Bank Securities, Inc. (FINRA Matter No. 2010023096302). The AWC is instructive because it speaks to supervisory review of electronic correspondence and should be considered by broker-dealers when crafting a lexicon-based search system for electronic correspondence.

Background Facts

Depositphotos_11071264_M.jpgDeutsche Bank's Private Client Services division has 16 offices with approximately 240 registered representatives. Deutsche Bank's Boston office employed a registered representative who engaged in questionable conduct, including: borrowing $220,000 from a customer, issuing personal checks totaling $860,000 which were returned for insufficient funds, failing to repay the customer loan in full, failing to obtain Firm approval to borrow from a customer, and charging personal expenses to a corporate credit card.

Clearly, Deutsche Bank had a problem broker on its hands and FINRA asserted that Deutsche Bank was on notice of the employee's financial troubles though various "red flags", including: charging personal expenses to a corporate credit card, bouncing 2 checks to a credit card company, and bouncing a personal check to a co-worker.


FINRA treated Deutsche Bank with a heavy hand by issuing a censure, assessing a fine in the amount of $100,000, and forcing undertakings which include a revision to Deutsche Bank's system of supervision as it relates to supervisory review of electronic correspondence.

Takeaway Lesson

As is commonplace in the securities industry, Deutsche Bank employed a lexicon-based search system to flag electronic correspondence for supervisory review. The supervisory system was required to comport with NASD Rule 3010(d), which requires that: "Each member shall develop written procedures that are appropriate to its business, size, structure, and customers for the review of incoming and outgoing written (i.e., non-electronic) and electronic correspondence with the public relating to its investment banking or securities business, including procedures to review incoming, written correspondence directed to registered representatives and related to the member's investment banking or securities business to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with firm procedures."

The AWC chastised Deutsche Bank's system of supervision by stating that:

"The lexicon, however, failed to include any search terms to detect communications concerning loans, liens, personal bankruptcies, delinquent payments, bounced checks or other indications that a registered representative might be experiencing financial difficulties and/or violating certain applicable laws, regulations and rules. As a result of DBSPs failure to include such search terms in the lexicon, the Firm did not review numerous MJ e-mails that contained evidence of red flags regarding his misconduct."

Had Deutsche Bank's lexicon-based system included the search terms noted by FINRA, it is claimed that Deutsche Bank would have become aware of various emails which underscored the registered representative's financial pressures.

The upshot of this AWC is clear: If you employ a registered representative under financial duress, your supervisory system for communications must be tailored to ensure supervisory review of potentially problematic emails. Given the inherent costs associated with additional layers of supervisory review, it begs the question of whether the cost is justified by the producer's revenue. Odds are it isn't because financial pressures often flow from a lack of production. As FINRA noted in the AWC, the broker "was generating little revenue of the Firm."

The AWC also suggests that FINRA will take issue with any lexicon-based system which does not adequately root out emails concerning matters which may lead to a disclosure item on a Form U4.

October 16, 2012

Fidelity Wins Against Morgan Stanley in a Non-Protocol Solicitation Case

In Fidelity Brokerage Services LLC v. Morgan Stanley Smith Barney LLC and Brian Wilder (FINRA Arbitration No. 11-03937), a FINRA arbitration panel found against respondents and annexed a 25 page Arbitrators' Report to the Award which excoriated respondents for misappropriation of trade secrets (Fidelity's customer list) among other violations. The Award stands out for various reasons, including the punitive damages awarded against Morgan Stanley and the sizable attorneys' fees awarded to Fidelity. Most interesting, however, is the Arbitrators' Report itself, which carefully applied the facts to the law and is a must-read for any broker who may be considering jumping ship from a firm which is not a signatory to the Protocol for Broker Recruiting.

Facts of the Case

The underlying facts are straightforward. The rep had an employment agreement with Fidelity which contained non-solicitation and confidentiality clauses. The confidentiality clause stated that customer lists and contact information were deemed to be trade secrets by Fidelity. Prior to leaving Fidelity, the rep met with counsel and created a list of customer contact information purportedly in conformity with the Protocol for Broker Recruiting even though Fidelity is not a signatory to the Protocol. Upon leaving Fidelity, the rep began calling his former customers to inform them of his new employment and sent ACAT forms to a sub-set of his former customers.

Fidelity promptly ran off to court and received a Temporary Restraining Order protecting against further solicitation by the rep. Despite the fact that only 7 brokerage accounts transferred from Fidelity to Morgan Stanley, a contentious arbitration ensued which included 34 hearing sessions before the arbitration panel.

The Award is instructive because it clearly addresses (a) the legal protections which brokerage firms may waive by joining the Protocol for Broker Recruiting; (b) whether a customer list is in fact a trade secret; and (c) ways in which reps can notify their former customers of new employment without running afoul of the law.

Recap of the Protocol for Broker Recruiting

The Protocol for Broker Recruiting is an agreement among broker-dealers to refrain from enforcing non-compete agreements against brokers who move between signatory firms. The caveat, however, is that the transitioning rep must strictly follow the procedures set forth in the Protocol to enjoy its protections. The procedures are the following: (1) Prior to resigning, the rep should prepare two lists: the first containing his customers' names, addresses, telephone numbers, email addresses and account types; the second containing all the information in the first, plus client account numbers. (2) The rep must submit a written resignation letter to someone in management. (3) Along with the resignation letter, the rep must provide the customer list containing the account numbers to someone in management. Assuming the three-steps are followed, the rep can take the list without account numbers to their new firm and use it to solicit customers to transfer their accounts.

Protections Waived by Joining the Protocol

The arbitrators noted that Fidelity's customer list qualified as a "trade secret" under Massachusetts law. However, had Fidelity joined the Protocol it would not enjoy "trade secret" protections for its customer list because it would willingly release same to the departing rep. The arbitrators went on to explain why some firms, like Morgan Stanley, opt to join the Protocol, while other firms, like Fidelity, choose not to. Fidelity, on the hand, spends substantial sums of money on direct client acquisition through advertising and then provides its brokers with a book of business to service. Thus, the "good will" inures to the benefit of Fidelity, not the broker. By contrast, wire-houses like Morgan Stanley expect its brokers to develop a book of business on their own and sometimes at the broker's own expense. Thus, the "good will" inures to the benefit of the broker, not the firm. The arbitrators went on to note that Massachusetts courts have long held that "goodwill" is a legitimate business interest which may be enforced by non-solicitation clauses like the one within the reps employment agreement.

Announcement vs. Solicitation

Notwithstanding the non-solicitation agreement, the arbitrators noted that some states (like Massachusetts and California) permit a departing rep to "announce" their new employment to their former customers. The arbitrators found a permissible "announcement" to be sending a written "wedding style" announcement card and nothing more. In contradistinction, the arbitrators found the reps conduct to be a "solicitation" because (a) the rep failed to "announce" in writing, instead doing so by telephone; (b) the rep made repeated telephone calls to his former customers; (c) the rep asked certain customers to hide his solicitation from Fidelity; and (d) sending ACAT forms to certain clients constituted solicitation in and of itself.

Kudos to the arbitrators for drafting such a thoughtful and well-reasoned Award.

June 19, 2012


FINRA issued its summary of disciplinary actions reported for June 2012. Certain actions are noteworthy and are indicative of regulatory trends money-and-gavel-150x150.jpgeffecting broker-dealers and registered representatives.

Herskovits PLLC comments on the following regulatory actions:

Net Cap Violations

Freedom Investors Corp. (CRD #23714, Brookfield, Wisconsin), Joel Reid Blumenschein (CRD #1372334, Registered Principal, Pewaukee, Washington) and Gary Lee Gossett (CRD #1939514, Registered Principal, Spokane, Washington) - FINRA Case # 2010025132201


Among other findings, FINRA found that the firm entered into a settlement with a customer that exceeded $15,000, and through its CCO, failed to timely disclose the receipt of the written complaint and the settlement to FINRA within 10 days. Furthermore, FINRA found that because the firm failed to accrue the liability resulting from the loss guarantee it made to the customer, its net capital was reduced. This resulted in it conducting a securities business
without the required net capital for four months so that the firm's books and records and Financial and Operational Combined Single (FOCUS) filings were inaccurate. The firm then failed to provide timely notice of its net capital deficiency to the Securities Exchange Commission (SEC) and FINRA.


Resolved by Offer of Settlement with a censure, fine and suspension for certain employees.


This matter highlights the importance of timely complaint reporting via Forms U4, U5 and in accordance with FINRA Rule 4530 (Reporting Requirements). Furthermore, this matter highlights FINRA's ongoing effort to discipline members concerning net cap violations; here, resulting from the member's "loss guarantee" to its customer. The "loss guarantee" arose from a peculiar circumstance in which a registered representative settled with a customer pursuant to an agreement which if, after a period of 18 months, the prior losses sustained in the account were not recovered, the firm would pay customer the difference plus 5% interest.

Anti-Money Laundering Violations

First Kentucky Securities Corporation (CRD #7524, Frankfort, Kentucky) and Frederick Jennings Kramer (CRD #2299599, Registered Principal, Owensboro, Kentucky) - FINRA Case # 2010021314101


The Member's 2009 independent AML test was inadequate because it was limited to the review of deposit slips for one branch office, rather than sampling different transactions at all branch locations. The findings stated that the test did not include a review of the firm's AML procedures, nor did it include a review of the overall adequacy of the firm's AML compliance program. Moreover, the test did not include a sample of all of the firm's business lines, review of the firm's AML training program and its customer identification program (CIP), and whether its representatives were complying with the CIP.


Resolved by Acceptance, Waiver and Consent with a censure and fine of $15,000.


AML continues to be an area of focus for FINRA. Here, FINRA fined the firm and the FINOP for the violations referenced in the AWC. This matter highlights that FINRA will enforce its AML Compliance Program Rule (FINRA Rule 3310) even as against small broker-dealers. Therefore, small broker-dealers would be well served to ensure that a procedure exists for independent testing (e.g., testing by a professional not employed by the firm) along with the annual certification by the CEO (Rule 3130).

Please contact Robert Herskovits, Esq. with any questions. (212) 897-5410. robert@herskovitslaw.com.

June 13, 2012

Are You Making "Suitable" Recommendations?

The Financial Industry Regulatory Authority (FINRA) views its mandate as investor protection and as such, they have given notice that a new suitability rule, Rule 2111, will go into effect on July 9, 2012.

As long as there have been investors and brokers, there have been people who finra-rule-2111-150x150.jpgtake advantage and people who are taken advantage of. This rule codifies a standard that FINRA thinks is best for the investing public by imposing more stringent regulations on securities that a broker recommends to buy/sell, including those within a client's existing portfolio. Rule 2111 has significant implications for broker-dealers who maintain retail brokerage accounts. The rule by its own terms, carves out institutional accounts: So if you are a broker-dealer that sells to hedge funds, this is not a game changer. But if you are selling to Main Street as opposed to Wall Street, then this is a very significant rule.

The new rule contains three guiding principles. Each recommendation must have:

  • Reasonable-basis suitability (meaning the broker must understand the product).

  • Customer-specific suitability (meaning the security or strategy must be in-line with the customer's risk profile).

  • Quantitative suitability (meaning the broker cannot "churn" the account or otherwise charge excessive fees).

The rule imposes new responsibilities upon a broker when recommending an investment to a customer. It used to be that the investment needed to be suitable upon execution - meaning that if you were going to recommend something, at the time of the recommendation you needed to be comfortable that the investment recommendation was suitable. This new suitability rule could now apply to not just a decision to buy or sell a security, but the decision to hold a security within a portfolio, which completely changes the whole dynamic. In fact, the broker's "hold" recommendation must be suitable even if the securities were purchased at another broker-dealer.

Page two of the notice, which is lengthy and covers a lot, says the new rule imposes broader obligations on firms regarding recommendations of investment strategies. This means the new suitability rule not only applies to an individual recommendation of a security, but to the entire account from a strategy perspective. The notice also states that the term "investment strategy" is interpreted broadly and includes recommendations to hold a security or securities.

The way this suitability rule is framed changes the whole landscape. So when you are assessing someone's portfolio, you better have a good faith basis for saying you want to hold something. Otherwise, the decision, not whether to buy or sell, but merely to hold, can, in light of this new rule, be questioned as being an unsuitable recommendation.

How will regulators be made aware of possible infractions of the Rule? Issues like this often come to light either because a customer files an arbitration or through a written customer complaint to the employer. Once a complaint is filed, the securities administrator is obligated to report the complaint to regulators, who may decide that it is worth looking into.

Another way an issue could be discovered is through a cycle examination of a broker-dealer. The FINRA examiners may want to analyze the investment recommendation or the activity in 50 or 100 randomly selected accounts, whatever the case may be, and through their audit, they may stumble upon what they deem to be a rule violation.

There is a sort of preemptive action that broker/dealers can take. FINRA has published a new form for a new account document. Their position is that broker-dealers need to be making recommendations based on information disclosed on a customer's account form. To facilitate that, they have provided a new model account form (http://www.finra.org/industry/tools/p117268) for brokers to look at. Further, FINRA suggested that firms consider revising order tickets to account for hold recommendations.

Firms would be wise to amend their new account forms as they go forward so that it captures the information that FINRA says they need to know. They should also begin training their brokers to capture the appropriate information and take heed of it when recommending a client buy, sell, or hold a particular investment.

Remember, when recommending a client to buy, sell, or hold a particular investment, make sure you have done your homework and that the recommendation is suitable to your client's circumstances. Moreover, be careful when giving investment advice to non-account holders because FINRA makes clear that the term "customer" may apply to any person with whom you have even an "informal" relationship.

Prior to this rule, did your firm check the suitability of every hold recommendation as well? How will the new FINRA rule affect your internal processes? Please share your public comments below.

If you have any questions about the new suitability rule, Rule 2111, please feel free to give me a call at 212-897-5410 or email me at robert@herskovitslaw.com.

June 4, 2012

Regulators probe bank's role in Facebook IPO

Regulators are examining whether Morgan Stanley, the investment bank that shepherded Facebook through its highly publicized stock offering last week, selectively informed clients of an analyst's negative report about the company before the stock started trading.

Rick Ketchum, the head of the Financial Industry Regulatory Authority, the self-policing body for the securities industry, said Tuesday that the question is "a matter of regulatory concern" for his organization and the Securities and Exchange Commission.

The top securities regulator for Massachusetts, William Galvin, said he had subpoenaed Morgan Stanley. Galvin said his office is investigating whether Morgan Stanley divulged to only some clients that one of its analysts had cut his revenue estimates for Facebook before the stock hit the market on Friday.

The bank said late Tuesday that it "followed the same procedures for the Facebook offering that it follows for all IPOs," referring to initial public offerings of stock. It said that its procedures complied with regulations.

The questions about the role played by Morgan Stanley, the lead underwriter for the deal, add to the confusion surrounding Facebook's IPO. In the most hotly anticipated stock debut in years, the offering raised $16 billion for the social networking company, valuing it at $104 billion.