Articles Posted in Securities Industry Regulatory Defense

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

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 ( 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

French investors urged New York’s top court on Wednesday to reinstate their lawsuit over losing $43 million out of $50 million they put into two structured investment vehicles.

The investors claim Barclays Bank, Standard & Poor’s and two management companies were complicit in leaving investors with plummeting securities shortly before the Wall Street collapse. Oddo Asset Management claimed collateral managers Avendis Financial Services Ltd. and Solent Capital Ltd. conspired with Barclays in early 2007 to transfer subprime mortgage-backed securities from Barclays to the two vehicles.

The investors also claimed S&P was complicit by confirming inflated note ratings for Golden Key Ltd. and Mainsail II Ltd.

A judge dismissed the suit, concluding the collateral managers had no fiduciary duty to Oddo, so Barclays and S&P could not be liable for abetting any breach.

“What Barclays knew was these assets were largely impaired,” Oddo’s attorney Geoffrey Jarvis argued. He said the bank solicited Oddo’s investment in what was then a new type of vehicle and selected everyone else involved in it.