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On September 9, 2020, FINRA issued an AWC resolving an investigation with FA Patrick J. Knox.  At first blush, the investigation seemed to resolve a rather straightforward Reg S-P violation.  FINRA accused Knox of printing his customer list in anticipation of joining a new broker-dealer and providing the list to his prospective employer.  Apparently, the list included customer names, social security numbers and birth dates.  Because the customer’s did not authorize the release of this information, FINRA deemed Knox to have violated Reg S-P and slapped his wrist with a 10-day suspension and a fine of $2,500.  However, a closer examination of the AWC raises some interesting questions about the viability of certain protections afforded by the Protocol for Broker Recruiting.

The Protocol for Broker Recruiting

The Protocol is an agreement designed to provide a framework for representatives to leave one firm and join another.  If an FA abides by the Protocol, she can join a competitor without fear of being sued for having violated a contractual non-solicitation provision.  Firms that join the Protocol do so on a voluntary basis and agree that an FA can join a competing firm and bring along a client list containing the following information:  client name, address, phone number, email address, and account title of the clients.

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Over the past year FINRA’s Office of Financial Innovation held meetings with over two dozen market participants, including broker-dealers, academics, technology vendors and service providers in order to better understand the use of Artificial Intelligence (“AI”) in the securities industry.  This past June FINRA issued a 20 page report which it described as an “initial contribution to an ongoing dialogue” about the use of AI in the securities industry.  FINRA notes early in the report that it is not intended to express any legal position and does not create any new requirements or suggest any change in any existing regulatory obligations.  So the report is merely food for thought on the topic of AI in the securities industry.

The paper is broken down into three sections; i) a description of the types of AI, ii) an overview of how firms are using AI in their business, and iii) the regulatory considerations surrounding AI.  Here are some takeaways from sections ii and iii.

AI Applications

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It has long been clear that the SEC opposes 12b-1 fees, the fees that funds use to compensate investment advisors for their sales and marketing efforts.  For the past two decades, the SEC has embarked upon various attempts to repeal Rule 12b-1 or render it meaningless.  The SEC, however, has never been able to build the political will to amend or repeal Rule 12b-1 and it remains the law.

The SEC’s latest attack on 12b-1 is a classic example of rule-making by enforcement.  On February 12, 2018, the SEC issued a press release announcing its new Share Class Selection Disclosure Initiative (SCSD Initiative).  The SCSD Initiative relies on Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) which imposes a fiduciary duty on investment advisers to act in their clients’ best interests, including an affirmative duty to disclose all conflicts of interest.  When an adviser receives 12b-1 fees from a mutual fund it presents a possible conflict of interest if a less expensive share class is available.  Prior to the SCSD Initiative, the industry standard was to disclose this conflict of interest in a straight forward manner.

The SCSD Initiative and subsequent guidance put out through FAQs has effectively amended 12b-1 by requiring disclosure of:

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On May 8, 2020, FINRA published an interesting AWC in which they suspended a quantitative research analyst for breaching internal policies relating to the treatment of confidential and proprietary information.  Although FINRA will aggressively pursue Reg S-P violations, in which nonpublic confidential information pertaining to a customer — such as a social security number or account number — is improperly disclosed, this AWC is somewhat unique because FINRA charged the individual with sending himself computer code seemingly unrelated to customers of the firm.

The matter at hand concerns Sune Gaulsh, FINRA Matter No. 2018058804301, an individual who was formerly employed by Barclays Capital.  According to his LinkedIn profile, Gaulsh was “part of a collaborating team within equities and research that researched and developed systematic trading strategies (volatility, global macro/CTA, L/S equity, event driven), constructed cross asset risk premia and factor portfolios, and evaluated data sets for alpha.”  Although Gaulsh voluntarily resigned from Barclays, the firm filed a Form U5 disclosing an internal investigation “to determine if the registered representative sent the firm’s proprietary business information to his personal email address.”

Underlying Conduct

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On April 21, 2020, California’s Court of Appeal, Fourth Appellate District created a significant carve-out to the absolute immunity standard previously applicable to Form U5 defamation claims in California.  The full opinion in Tilkey v. Allstate Insurance Co., Super. Ct. No. 37-2016-00015545-CU-OE-CTL (2020) is available here.  This case significantly changes the landscape for Form U5 defamation claim unless California’s highest court intervenes.  As a result of Allstate’s defamation, the trial court awarded Tilkey $2,663,137 in compensatory damages and $15,978,822 in punitive damages.

Background

Before jumping in to the facts of the case, some background on Form U5 defamation claims might be helpful.  Broker-dealers are required to file a Form U5 whenever an employee’s registration is terminated.  The Form U5 requires the firm to provide a narrative explanation of the termination if the employee was discharged or permitted to resign.  When it comes to the narrative explanation, professionals in the financial services industry frequently complain that employers “play games” by providing extraneous and gratuitous remarks or, worse yet, offering an entirely false explanation for the termination.  The consequences flowing from negative Form U5 disclosure information are severe.  In addition to reputational harm, FINRA will start a costly investigation and potential employers will shy away from a prospective employee with negative information on CRD.

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This week’s FINRA settlements report AWC’s in which FINRA hit two FAs for some misguided efforts toward good customer service.

In the Matter of Sandra Gose Stevens, FINRA Matter No. 2018058123701

Stevens was formerly registered with MML Investors Services, LLC, which terminated her in April 2018 concerning an alleged “signature irregularity.”  FINRA thereafter initiated an investigation and made the following findings in the AWC:

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Maybe it’s just me, but it feels like FINRA has ramped up its caseload for undisclosed outside business activities and unapproved private securities transactions.  This week alone, FINRA resolved two such cases in FINRA Matter No. 2018058026701, Alexander Jon James and FINRA Matter No. 2019061490801, Barry Robert Bode.  Before analyzing the cases, it’s worth re-visiting the scope of these rules:

FINRA Rule 3270 (Outside Business Activities)

The rule is designed to prevent FAs from engaging in outside business activities absent written approval from the member firm.  Generally speaking, the rule does not apply to the registered person’s personal passive investments (e.g., buying away) and activities conducted on behalf of a member firm’s affiliate (e.g., work for an affiliated investment advisory firm or insurance arm).  Examples of reportable outside business activities could include providing accounting or consulting services, working for a start-up or sitting on a board of directors, acting as a real estate broker, and serving on the board of a religious or civic organization, among other things.

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On March 18, 2020, FINRA barred FA James Daughtry for his refusal to appear for an on-the-record interview, which is akin to a deposition.  Daughtry consented to the bar from the securities industry by executing the Letter of Acceptance, Waiver and Consent (AWC) in Department of Enforcement v. James Blake Daughtry, Matter No. 2020065293201.

Background

According to BrokerCheck, Daughtry entered the securities industry in 1999.  He registered with Kestra Investment Services, LLC in February 2015 and remained with Kestra until his termination in March 2020.  James Daughtry worked from a branch located in Dothan, Alabama.

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Receiving a subpoena from the U.S. Commodity Futures Trading Commission often causes panic by the recipient given the civil and criminal penalties associated with Commodities Exchange Act violations.  The recipient may have no advance notice of the subpoena and may be unaware if they are a target of the CFTC’s investigation or merely an individual or company that possesses records of interest to the government.  This blog post outlines appropriate steps to take upon receipt of a CFTC subpoena.

CFTC’s Information Gathering Process

The Staff of the CFTC is empowered to initiate investigations of persons and companies suspected of having violated the Commodity Exchange Act.  The Staff generally receives documents from voluntary productions and use of compulsory process (meaning, the issuance of subpoenas).  Any request for a voluntary interview or the voluntary production of documents requires serious consideration and consultation with counsel.  The Staff’s reach can extend internationally.  The CFTC has Memoranda of Understandings with various foreign authorities, which enables the CFTC’s staff to obtain documents without resort to use of subpoena power.

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In Next Financial Group, Inc. v. GMS Mine Repair and Maintenance, Inc., Case No. 3:19-cv-168 (USDC W.D. Pa.), the federal court was asked to define the term “customer” as it relates to FINRA’s Code of Arbitration Procedure.  The definition of that term carries significance because “customers” can compel a member firm to participate in FINRA arbitration whereas non-customers cannot.  In the case at hand, GMS Mine Repair had no account with Next Financial and received no goods or services from Next Financial itself.  This case bears some significance because the court compelled arbitration even though GMS Mine Repair was nothing more than an investor in the FAs outside business activity.

Background

The case arose from a supposedly fraudulent investment scheme perpetrated by Douglas P. Simanski, a former registered representative of Next Financial Group.  According to BrokerCheck, Next Financial terminated Douglas Simanski in May 2016 because “RR sold fictitious investment and converted funds for his own personal use and benefit.”  Mr. Simanksi currently has 30 disclosures on his BrokerCheck report, reflecting numerous settled customer claims.  On November 2, 2018, the SEC filed a complaint against Mr. Simanski alleging that Simanksi “raised over $3.9 million from approximately 27 investors by falsely representing he would invest their money in one of three ventures:  (1) a ‘tax free investment’ providing a fixed return for a specific number of years; (2) one of two coal mining companies in which Simanski claimed to have an ownership interest; or (3) a rental car company.”  According to BrokerCheck, the SEC ultimately barred Simanski and Simanski plead guilty to criminal charges filed by the U.S. Department of Justice.

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