Articles Posted in FINRA rulings

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.

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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.

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.

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

Broker examining stock dropDeutsche 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.

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.