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An AWC issued on July 1, 2021, reflects that FINRA suspended an FA formerly registered with David A. Noyes & Company (now known as Sanctuary Securities) for three-months and imposed a deferred fine of $5,000.  This AWC demonstrates FINRAs ongoing concerns around the sale of leveraged and inverse exchange traded funds to retail customers.  This week’s AWC is the book-end to an AWC issued in May 2021 against Sanctuary for a variety of violations, including the failure to establish, maintain and enforce a supervisory system designed to meet FINRAs suitability standards for non-traditional ETFs.  Sanctuary was fined $160,000 and ordered to pay customer restitution of $370,161.

By way of background, the broker-dealer permitted FA Stuart Pearl to resign in March 2019.  According to statements on BrokerCheck, Mr. Pearl resigned while on heightened supervision and the firm alleged that Mr. Pearl had not followed the heightened supervision plan.

Product at Issue:  Non-Traditional ETFs

In September of 2018, Merrill Lynch terminated the Claimant in this arbitration for allegedly opening up a Bank of America bank account for a customer without authorization.  In 2020, the Claimant brought an arbitration against Merrill Lynch seeking expungement of the alleged defamatory reason for termination  and also sought $50,000 in compensatory damages.  The FINRA arbitration award is viewable here.

The arbitration was conducted under FINRA’s simplified rules before a single public arbitrator and the Claimant represented herself without an attorney.  Merrill Lynch was represented by the law firm Seyfarth Shaw LLP.

In her findings, the single arbitrator seemed particularly concerned that Merrill Lynch failed to even speak with the customer about the allegations in dispute.  Merrill Lynch also failed to have the customer sign an affidavit supporting the allegations.  The client in question was known to be suffering from memory problems so significant that Merrill Lynch terminated her as a brokerage client despite an account balance in excess of $500,000.  The client had previously complained about unauthorized trading in her account by her primary advisor.

On January 14, 2021, the SEC issued an Order Determining Whistleblower Award Claims (the “Order”).   The Order grants “Claimant 1” a $600,000 award while completely denying any award to “Claimant 2.” The heavily-redacted Order makes it impossible to determine what Covered Action and monetary sanction triggered the claims for a Whistleblower Award.  You can quickly tell when reading the Order, however, that things are not going to go well for Claimant 2 when the commission notes early on in the Order that:

“Enforcement staff responsible for the Covered Action confirmed that they did not receive any information from Claimant 2, nor did they have any communications with Claimant 2, before or during the investigation.”

Claimant 2’s theory, we learn, is that his tip did not have to be communicated directly to the Enforcement Staff responsible for the Covered Action.  It turns out that Claimant 2 provided information about a company to Enforcement Staff in an entirely different regional office.  An investigation was commenced and Enforcement Staff was unable to substantiate Claimant 2’s claims.  The investigation was closed without commencement of an enforcement action.  The Commission pointedly defines the redacted company as the (“Unrelated Company”) and the investigation as the (“Unrelated Investigation”).

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On November 19, 2020, FINRA published a noteworthy arbitration award for a Herskovits PLLC client in FINRA Arbitration No. 20-01054.  This case has garnered significant attention in the press due to the fact that Wells Fargo was ordered to pay our client’s attorneys’ fees.  Stories about the case have been reported in AdvisorHub, InvestmentNews and ThinkAdvisor.

On February 18, 2020, Wells Fargo terminated the FA and inserted the following allegation on the Form U5:

“WF Bank, N.A., registered banker was discharged by the bank after a bank investigation reviewed complaints received by AMIG from two bank customers alleging the customers were enrolled in renter’s insurance policies for which the banker received referral sales credit without the customers’ authorization.  The registered banker denied the customers’ allegations.  The activity was not related to the securities business of WFCS.”

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On September 22, 2020, FINRA submitted a proposed rule change to the SEC.   The proposed rule furthers FINRAs assault on the expungement process by imposing stringent requirements on expungement requests filed during a customer arbitration by or on behalf of the associated person (“on-behalf-of request”) or filed by a registered representative separate from a customer arbitration (“straight-in request”).  The proposed rule also (a) establishes a roster of arbitrators with enhanced training and experience, from which a panel of 3 arbitrators would decide straight-in requests; and (b) codifies and updates the Notice to Arbitrators and Parties on Expanded Expungement Guidance.

Here are some of the key takeaways from the proposed rule change:

Denial of FINRA Forum

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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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