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The Friday List: 10 Examples of Brokers Behaving Badly

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

The debate about the now-vacated DoL fiduciary rule and the recently proposed Regulation Best Interest continues.  We have argued that a uniform fiduciary standard should apply to both retail brokers and advisers.  Why?  We accept the position that retail consumers should not have to hire a lawyer to determine the advice standards to which his/her financial professional adheres.   More significant, however, is that brokers behave badly and need a higher standard.  An academic study that was first published in 2016 reported that 7% of broker-advisers have misconduct records, prior offenders are 5 times more likely to engage in misconduct, and 44% of brokers fired for misconduct are re-employed within a year.  The authors concluded: “We find that financial adviser misconduct is broader than a few heavily publicized scandals.”   They also argued that a more stringent standard would help the industry by improving the low reputation of financial professionals.  Our reporting of cases also shows endemic broker misconduct.  In today’s list, we highlight examples of brokers behaving badly, which should inform the debate on a uniform fiduciary standard.


10 Examples of Broker Behaving Badly

  1. Stealing from clientsA broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
  2. Churning.   A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
  3. Misrepresenting disciplinary recordA broker’s website claimed he never had a complaint, even though several customers filed and settled complaints over the course of an 8-year period.
  4. Misusing client information. A broker shared nonpublic personal information (including holdings and cash balances) about clients with a person no longer affiliated with his firm.
  5. Revenue sharing.   A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
  6. Undisclosed markups/markdownsAn interdealer failed to disclose markups and markdowns on securities traded for clients.
  7. Commission kickbacksA trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
  8. Pump-and dumpA broker engaged in an ongoing penny stock pump-and-dump scheme.
  9. Bribing public officials.    A broker spent nearly $20,000 on hotels, meals and concert tickets to bribe a public plan official to secure brokerage business from a public plan.
  10. IPO kickbacks.   A broker and his client conspired in a kickback scheme whereby the customer would pay back 24% of his profits in exchange for preferred IPO and secondary offering allocations.

FINRA Proposal Eliminates Control/Discretion Defense to Churning

FINRA has proposed changing the suitability standard so that brokers could have liability for excessive trading even if the broker did not exert control or discretion over the client’s account.  Current FINRA rules require a showing of control before FINRA could charge a broker with churning.  FINRA questions whether this control element puts a “heavy and unnecessary burden on customers by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendation.”  FINRA says that this control element may not be appropriate in light of the recently proposed SEC’s Regulation Best Interest.  FINRA would evaluate churning based on the total facts and circumstances including turnover rate (e.g. greater than 6), cost-to-equity ratio (e.g. greater than 20%), or the use of in-and-out trading.

OUR TAKE: Brokers, and their compliance officers, have long relied on the regulatory distinction between accounts over which they exercised discretion versus directed accounts.  This proposal eliminates that ostensible compliance bright line which really has very little meaning in the real world where retail clients rely on broker recommendations.  Acting in a client’s best interest should not depend on how much control a broker exercises.


SEC Upholds FINRA Bar Based on Untruthful Form U4


The SEC has upheld a statutory disqualification imposed by FINRA for failing to file a truthful U4 and lying on compliance questionnaires.  FINRA barred the appellant from the securities industry because his Form U4 failed to disclose federal tax liens and a bankruptcy and because he provided false responses on his firm’s annual compliance questionnaires.  The appellant sought a stay of the disqualification on the grounds that he would get fired from his current job and suffer economic harm.  The SEC rejected his argument and denied the appeal because FINRA has an interest in protecting investors, and a stay of the statutory disqualification for material failures on Form U4 “could endanger investors.”

OUR TAKE: FINRA and the SEC take Form U4 (and annual compliance questionnaires) very seriously.  The regulators view the disclosure as a lynchpin to protecting investors.


SEC Chairman Commences Consideration of Uniform Fiduciary Rule

SEC Chairman Jay Clayton has solicited public comment concerning the standard of conduct applicable to retail advisers and broker-dealers.  The SEC seeks public input on such topics as the preferred standard of care, conflicts of interest, approaches to regulation, disclosure, technologies, and investor confusion.  Mr. Clayton asks, “If the Commission were to proceed with a disclosure-based approach to potential regulatory action, what should that be?  If the Commission were to proceed with a standards-of-conduct-based approach to potential regulatory action, what should that be?  Should the standards for investment advisers and broker-dealers be the same or different?  Why?”  Mr. Clayton notes that the SEC last solicited such information back in 2013 but that rapidly changing markets, participants, and regulations require updated information.  He welcomes coordination with the Department of Labor as it implements and re-considers the Fiduciary Rule.  The SEC has set up a webform and email box to receive comments.

OUR TAKE: The SEC should adopt a uniform fiduciary or best interest standard for all retail advisers and broker-dealers, and the DoL should incorporate that standard rather than create a separate regime solely for retirement products.  We hope that Mr. Clayton has begun the process to ending this internecine regulatory battle of agencies.


Brokers Can Block Disbursements to Senior Investors Under New FINRA Rule


Following recent SEC approval, FINRA’s new rule allowing firms to block disbursements to senior investors goes into effect on February 5, 2018.  The rules allow members to put a 25-day hold on suspicious disbursements of funds for any customers over the age of 65 and for any other customer that the member reasonably believes has a relevant mental or physical impairment.  The rule allows, but does not require, a member to hold funds if the member “reasonably believes that financial exploitation…has occurred, is occurring, has been attempted, or will be attempted.”  During the hold, the member must try to contact the designated “Trusted Contact Person” previously named by the account holder.  To enforce the rules, members must adopt and implement applicable written supervisory procedures and ensure retention of relevant records.


OUR TAKE: The new rules create significant compliance obligations for account opening, procedures, testing, and record retention.  They also will likely require a process to resolve potential conflicts between senior investors and the brokers that hold their assets.



SEC, Not FINRA, Brings Churning Case Against 2 Brokers

trust me


The SEC charged two brokers with churning and excessive trading in customer accounts.  The SEC accuses the brokers of engaging in excessive short-term trading that had little chance of benefiting customers after payment of fees.  Both brokers, who had significant disciplinary histories, used telemarketing and cold-calling to find clients who they pressured with pre-filled agreements and margin arrangements.  An SEC official commented, “This case marks another chapter in the SEC’s pursuit of brokers who deploy excessive trading as a strategy in customer accounts to enrich themselves at customers’ expense.”

OUR TAKE: It is very unusual for the SEC to bring suitability and churning cases against individual brokers.  These types of cases are usually FINRA’s jurisdiction.  Perhaps this is the beginning of the SEC moving to regulate retail brokers in response to the DoL fiduciary rule.