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Large BD Mistakenly Relied on Bank Affiliate to Conduct Background Checks

 

FINRA fined a large broker-dealer $1.25 Million for failing to conduct adequate background checks on over 10,000 non-registered associated persons over a 7-year period.  For these non-registered persons, the BD relied on less comprehensive background checks conducted by its bank affiliate, which was required by the banking laws.  The required Exchange Act background checks include a review of regulatory actions in addition to criminal activity.  A FINRA official warned that “member firms must live up to their responsibility as a gatekeeper protecting investors from bad actors.”

This case is similar to an action against another bank-affiliated broker-dealer back in 2017.  Large firms with multiple regulated affiliates must ensure compliance with each regulatory regime.  Compliance with one financial services statute does not necessarily mean compliance with another.  Firms should hire compliance specialists with substantive backgrounds in the applicable laws and regulations.

SEC Inspections Staff Chides Advisers for Weak Supervision and Compliance

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies.  Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories.  The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies.  OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation.  The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.

 

How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program?  An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation. 

FINRA Proposes More Segregated Capital for Firms that Hire Bad Brokers

FINRA has proposed a new rule that would require broker-dealers with a large number of disciplinary events to set aside segregated funds to pay future penalties or arbitration awards. Proposed Rule 4111 (Restricted Firm Obligations) would score each firm against its peers based on registered person and member firm adjudicated events and expulsions. Based on FINRA’s grid, the firm would be required to deposit funds in a segregated account until the firm takes action to remedy the situation, thereby allowing a reduction in the amount deposited. FINRA seeks to address the small number of firms that attract brokers with significant disciplinary records but have not appropriately responded to FINRA’s previous efforts to require heightened supervision or enhance sanctions.

On the positive side, requiring what amounts to a net capital penalty should get the attention of senior leaders at these problem firms. On the other hand, FINRA needs to be careful that such a firm doesn’t make a cold calculation to hire a bad broker if the broker’s production offsets the additional financial obligation.

Firm’s Procedures Did Not Guide Management on How to Respond to Red Flags

A large broker-dealer was fined and censured for failing to act against a longtime broker charged with participating in pump-and-dump transactions.  The SEC faults the firm for ignoring red flags including emails outlining the illegal activity, FINRA arbitrations, and customer complaints.  One supervisor explained that he did not act more aggressively because the broker worked at the firm for 30 years and her business partner was a partial owner of the firm. The SEC asserts that the firm’s supervisory system “lacked any reasonable coherent structure to provide guidance to supervisors and other staff for investigating possible facilitation of market manipulation.”  The SEC also maintains that the firm “lacked reasonable procedures regarding the investigation and handling of red flags.”

Reasonable policies and procedures must do more than simply restate the law and the firm’s commitment to comply with the law.  The compliance manual or WSPs must specifically describe HOW a firm will prevent and address regulatory misconduct. 

BD Fined $2.75 Million for Omitting Customer Complaints from Forms U4 and U5

 

FINRA fined a large broker-dealer $2.75 Million for failing to include customer complaints on Forms U4 and U5 and for neglecting to file Suspicious Activity Reports for cyber-related events.  FINRA examined a small sample of customer complaints and found that the firm should have reported more than 22% of its customer complaints on Forms U4 and U5.  Extrapolating the small sample that FINRA reviewed, the firm should have reported nearly 300 customer complaints over the 2013-2016 period.    The firm erroneously construed the filing requirement by declining to report customer complaints unless the customer expressly requested more than $5000 in compensation.  FINRA also faults the firm for providing inaccurate guidance to supervisory personnel and thereby failing to file more than 400 SARs to report cyber intrusions or attempts.

 FINRA requires firms to heighten supervision over bad brokers.  To ensure compliance, FINRA needs to make sure that Forms U4 and U5 include all customer complaints and other reportable activity.  Compli-pros should err on the side of reporting notwithstanding the objections of producers and their supervisors.   

BD Sued for Broker’s Inaccurate Website

 The Massachusetts Securities Division has filed a complaint against a broker and his firm for allowing the continued website publication of misleading disciplinary information.   The broker’s website claimed that he “NEVER” (sic) had a complaint made against him.  Although this statement may have been accurate when the website went live in 2008, several customers filed and settled complaints between 2011 and 2018.  The MSD faults the firm for failing to flag the misleading website language even though it conducted 4 branch audits during the period and had actual knowledge of the complaints.  The MSD criticized policies and procedures that failed to require the firm to “regularly review content after publication.”

OUR TAKE: Earlier this year, FINRA admonished member firms to heighten supervision of brokers with a disciplinary history.  The states – including Massachusetts – can jump into the enforcement fray to ensure that the home office properly monitors the branch offices.

 

Bad Broker Costs Large RIA/BD $3.6 Million for Compliance and Supervisory Failures

The SEC fined a large broker-dealer/investment adviser $3.6 Million because its inadequate compliance and supervisory program failed to stop a broker from stealing from clients.  The broker, currently facing criminal charges, exploited a weakness in the firm’s control systems that allowed third party disbursements up to $100,000 per day based on representations that the broker received oral instructions.  According to the SEC, the broker misappropriated $7 Million from four advisory accounts.  Although the firm did have policies and procedures that included ad hoc manual supervisory reviews, the firm did not require authorization letters, call back clients to verify instructions, or record calls.

OUR TAKE: A motivated miscreant will find the weaknesses in your compliance and supervisory system.  To avoid this type of theft, a firm should prohibit any third party money movement without the review of a supervisor or compli-pro.

 

FINRA Requires Heightened Supervision over Bad Brokers

FINRA has outlined recommended heightened supervisory procedures for brokers with a history of past misconduct. FINRA suggests that firms should (i) designate a principal with supervision responsibility; (ii) provide specific training to the bad broker; (iii) require written acknowledgements; and (iv) conduct periodic reviews of the plan’s effectiveness.  FINRA also describes certain characteristics of an effective heightened supervisory plan: physical proximity of the supervisor to the broker, ongoing contacts and reviews, frequent monitoring, and expediting customer complaints.   FINRA has also proposed rules that would subject member firms that hire bad brokers to additional FINRA monitoring and reporting.

OUR TAKE: FINRA wants to make it difficult on firms that hire brokers with a disciplinary record by imposing additional regulatory, monitoring and reporting requirements.

http://www.finra.org/industry/notices/18-15

http://www.finra.org/sites/default/files/Regulatory-Notice-18-16.pdf

Weak WSPs Result in Failure to Supervise Charges

The SEC charged a broker-dealer with failing to supervise because its Written Supervisory Procedures failed to adequately detail how firm employees should respond to regulatory red flags.  The SEC asserts that the firm failed to supervise a broker that charged with participating in a penny stock pump-and-dump scheme.  The SEC maintains that the firm uncovered multiple red flags including a supervisor’s report, customer emails, arbitrations, and FINRA examinations.  However, the SEC alleges, the firm’s WSP’s did not specify who should investigate or how such investigations should proceed.  The firm did conduct two “flawed investigations” that failed to document its findings or detail a remedy.  The Director of the SEC’s New York Regional Office advised broker-dealers that this case “sends a clear message that we will not tolerate broker-dealers that fail to exercise appropriate supervision over employees.”

OUR TAKE: We predicted that the regulators would hold brokers accountable for the bad actions of their registered reps.  WSPs should follow the 5 Ws Rule: Who is responsible?  What is to be done?  Why are you doing it?  When is it due?  Where should it be presented?

http://www.sec.gov/litigation/admin/2018/34-82954.pdf

Bank-Affiliated BD Fined $1.25 Million for Inadequate Employee Screening

FINRA fined a large bank-affiliated broker-dealer $1.25 Million for failing to conduct adequate background checks on over 8,000 associated persons over an 8-year period.  The broker-dealer relied on its bank affiliate to conduct screening of its non-registered associated persons but the bank only screened for bank disqualifying criteria, not the broader categories of disqualification pursuant to Section 3(a)(39) of the Exchange Act and FINRA rules.  Also, the firm completely failed to fingerprint over 2000 employees prior to employment.  Four employees were retained despite statutory disqualifications.  FINRA’s EVP of Enforcement warned, “Firms have a clear responsibility to appropriately screen all employees for past criminal or regulatory events that can disqualify individuals from associating with member firms, even in a non-registered capacity.”

OUR TAKE: FINRA has previously warned that it would review how firms screen for brokers with disciplinary records.  The regulator wants to put pressure on the industry to drive out the bad brokers.