FINRA Rules - Herskovits PLLC

Violations of FINRA Rule 2010 (high standards of commercial honor and just principles of trade)
Regulation Best Interest (Reg BI) / Exchange Act Rule 15l-1(a)
Unauthorized trading / discretionary authority violations (FINRA Rule 3260,2360)
FINRA Rule 4511 (Recordkeeping / misreporting violation)
Supervisory failures and deficient compliance

Week in Review:

Between November 17 and 21, 2025, FINRA took disciplinary actions against both individual registered representatives and firms for a range of violations, including unsuitable investment recommendations, undisclosed outside business activities, falsified expense reports, unauthorized trading, excessive options trading, supervisory failures, deficient disclosure in research reports, and failure to maintain net capital or proper handling of investor funds. Sanctions imposed included suspensions ranging from one to ten months, fines from $5,000 to $2.5 million, disgorgements, censure, partial restitution, and requirements for firms to implement or certify remedial supervisory measures. These cases highlight FINRA’s continued emphasis on ethical conduct, adherence to Regulation Best Interest, compliance with supervisory and reporting obligations, and maintaining robust firm-level oversight to protect investors and ensure market integrity.

Observation:

FINRA Rule 2010 remains the most frequently cited violation, reflecting FINRA’s emphasis on ethical conduct across a wide range of misconduct. Many cases also highlight failures in disclosure, supervision, or suitability obligations, showing that regulatory oversight targets both individual behaviour and firm-level compliance systems. Recurring compliance challenges for registered representatives include high-risk and unsuitable investment recommendations, unauthorized trading, and undisclosed outside activities. Large firms, such as Deutsche Bank and Laidlaw, are held accountable for systemic deficiencies, underscoring that lapses in oversight can impact thousands of transactions and a broad base of investors.

CASE SUMMARIES

1. Case: Thomas G. Scheiman & Stephen M. Franko

INTRODUCTION:

This summary reviews the disciplinary action against Thomas G. Scheiman and Stephen M. Franko, who recommended unsuitable GWG L Bonds to retail customers in violation of Reg BI and FINRA Rule 2010. The case highlights the obligation of registered representatives to make recommendations that are in the customer’s best interest, consistent with their financial profile, risk tolerance, and investment objectives.

Date of Action: November 17, 2025
Respondent: Thomas G. Scheiman, Stephen M. Franko
Violations:

A. Exchange Act Rule 15l-1(a) of Regulation BI:

This rule states brokers to act in the best interest of retail customers when making securities recommendations. The Care Obligation requires that recommendations be based on reasonable diligence and an evaluation of the customer’s investment profile, including factors such as age, risk tolerance, financial needs, liquidity needs, and investment experience.

Violation: In 2020, Scheiman recommended a $100,000 GWG L Bond to an 83-year-old customer, resulting in over 50% concentration of her liquid net worth in speculative bonds. Franko recommended GWG L Bonds to three retail customers whose investment profiles were inconsistent with the high risks, illiquidity, and speculative nature of the product. Both failed to meet Reg BI’s Care Obligation.

B. FINRA Rule 2010:

This rule states associated persons to adhere to high standards of commercial honor and just and equitable principles of trade.

Violation: By recommending high-risk, unsuitable securities to retail customers and failing to comply with Reg BI’s best-interest standards, both Scheiman and Franko violated the ethical obligations.

SUMMARY:

Scheiman and Franko recommended GWG L Bonds, speculative and high-risk corporate bonds, to retail customers despite the investments being unsuitable given the customer’s financial profiles and liquidity needs. These recommendations violated Reg BI’s Best Interest and Care Obligations and further constituted misconduct under FINRA Rule 2010. Their failures were particularly consequential given GWG’s ongoing financial losses and eventual default and bankruptcy.

SANCTIONS:

For Thomas G. Scheiman

Two-month suspension.
A fine of $5,000.
$2,600 disgorgement + interest

For Thomas G. Scheiman

Three-month suspension
$5,000 fine
Partial restitution $5,640 + interest

AWC Document:

2022074289901 Thomas G. Scheiman CRD 1508288_Stephen M. Franko CRD 2157707 AWC ks.pdf

CONCLUSION:
This case reinforces FINRA’s mandate that registered representatives must evaluate the risk, liquidity, and suitability of investment products and ensure recommendations meet Reg BI’s best-interest standards. Recommending highly speculative securities without proper diligence or regard for a customer’s financial profile violates both regulatory obligations and fundamental ethical standards.

2. Case: Robert Galloway

INTRODUCTION:

This summary reviews a FINRA disciplinary action against Robert Galloway, who falsified six expense reports to obtain reimbursements not permitted under firm rules. His conduct violated FINRA Rule 2010, which requires adherence to high standards of commercial honor.

Date of Action: November 17, 2025
Respondent: Robert Galloway
Violations:

A. FINRA Rule 2010:

This rule states associated persons to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their business.

Violation: Between January and April 2024, Galloway falsified six marketing reports for marketing expenses by claiming he had already incurred and inflated reimbursement amounts. He improperly received approximately $5,000 in reimbursements. This created false records and misled his firm.

SUMMARY:

Galloway submitted six falsified expense reports over a four-month period, seeking reimbursements for marketing expenses that were not yet incurred and overstating the amounts. This dishonest conduct violated FINRA Rule 2010 and resulted in Country Capital terminating his registration. FINRA determined that his actions demonstrated a failure to uphold required standards of commercial honor.

SANCTIONS:

Robert Galloway:

Five-month suspension
a $5,000 fine.

AWC Document:

2025-11-05_AWC_via_DocuSign_Robert_Galloway_2024083324501.pdf

CONCLUSION:
This action underscores FINRA’s expectation that registered representatives maintain integrity and accuracy in all business-related documentation. Falsifying expense reports constitutes unethical conduct and violates the principles of fairness and honesty that Rule 2010 is designed to protect.

3. Case: Evan Von Scales

INTRODUCTION:

This summary reviews FINRA’s disciplinary action against Scales, who engaged in an undisclosed outside business activity (OBA) involving the promotion and sale of a foreign-exchange trading algorithm. By failing to provide required prior written notice to his member firm, Fidelity, Scales violated both FINRA Rule 3270 and FINRA Rule 2010.

Date of Action: November 17, 2025
Respondent: Evan Von Scales
Violations:

A. FINRA Rule 3270:

This rule states registered persons must obtain firm approval before engaging in outside compensated business.

Violation: From October to December 2023, Scales operated an LLC selling an automated trading algorithm. He advertised it on social media and sold the product to nine customers for $2,000 each. He earned $13,000 after refunds and fees. He did not notify or obtain approval from Fidelity and violated the Rule.

B. FINRA Rule 2010:

This rule states associated persons to adhere to high standards of commercial honor and just and equitable principles of trade.

Violation: Because a violation of Rule 3270 automatically constitutes a breach of ethical conduct, Scale’s undisclosed OBA violated Rule 2010.

SUMMARY:

Scales established and operated a foreign-exchange algorithm business without notifying or receiving approval from Fidelity, despite firm policies and FINRA rules requiring such disclosure. His failure to provide prior written notice, combined with earning compensation from the activity, violated FINRA Rules 3270 and 2010.

SANCTIONS:

Three-month suspension
a $5,000 fine.

AWC Document:

2024083203501 Evan Von Scales CRD 6957770 AWC ks.pdf

CONCLUSION:
Scales established and operated a foreign-exchange algorithm business without notifying or receiving approval from Fidelity, despite firm policies and FINRA rules requiring such disclosure. His failure to provide prior written notice, combined with earning compensation from the activity, violated FINRA Rules 3270 and 2010.

4. Case: Oakwood Capital Securities, Inc.

INTRODUCTION:

This summary reviews FINRA’s disciplinary action against Oakwood Capital Securities, which, under prior management, failed to establish and maintain adequate supervisory systems and written supervisory procedures for monitoring deferred variable annuity exchange rates.

Date of Action: November 18, 2025

Respondent: Oakwood Capital Securities, Inc.
Violations:

A. FINRA Rule 3110:

This rule states members must maintain systems to ensure compliance with securities laws and FINRA rules.

Violation: Oakwood failed to establish and maintain a supervisory system, as well as written supervisory procedures, reasonably designed to supervise deferred variable annuity exchange activity. Although the firm’s procedures broadly stated that surveillance would occur, Oakwood had no actual processes or systems to track exchange rates, review trends, or identify representatives with potentially problematic activity. Its supervision consisted solely of manual transaction-by-transaction reviews, which were insufficient to detect patterns or repeated unsuitable recommendations.

B. FINRA Rule 2330:

This rule states firms must implement written supervisory procedures and surveillance to detect inappropriate annuity exchanges.

Violation: Oakwood also failed to establish specific written supervisory procedures tailored to deferred variable annuities and by failing to implement the required surveillance mechanisms to identify inappropriate or excessive annuity exchanges. The firm did not monitor representative’s exchange activity at all, nor did it maintain any system for tracking exchange rates, which directly caused the firm to overlook a series of short-term and unsuitable variable annuity exchanges recommended by one of its representatives.

B. FINRA Rule 2010:

This rule states associated persons to adhere to high standards of commercial honor and just and equitable principles of trade.

Violation: Because Oakwood failed to comply with Rules 3110 and 2330(d), it also violated FINRA Rule 2010. Insufficient supervision of complex and high-risk products is considered conduct inconsistent with industry standards.

SUMMARY:

Under prior management, Oakwood Capital Securities failed for more than a year to maintain adequate supervisory systems and procedures for overseeing deferred variable annuity exchanges. The firm had no system for tracking exchange rates or patterns and conducted only basic transactional reviews. As a result, it failed to detect repeated, short-term, and unsuitable variable annuity exchanges recommended by a representative.

SANCTIONS:

a censure and
a $20,000 fine.

AWC Document:

2020065145802 Oakwood Capital Securities, Inc. fka Gardner Financial Services, Inc. CRD 21000 AWC ks.pdf

CONCLUSION:
This action underscores FINRA’s expectation that firms maintain effective supervisory systems especially when overseeing complex products such as variable annuities. A failure to monitor exchange activity exposes investors to unsuitable transactions and violates core supervisory and ethical obligations.

5. Case: Barry L. Buchholz

INTRODUCTION:

This summary reviews the disciplinary action against Barry L. Buchholz for executing unauthorized trades in four customer accounts, violating FINRA Rule 2010. The case highlights the requirement for written or oral customer authorization before placing trades in non-discretionary accounts.

Date of Action: November 18, 2025
Respondent: Barry L. Buchholz.
Violations:

A. FINRA Rule 2010:

This rule states associated persons, in the conduct of their business, to “observe high standards of commercial honor and just and equitable principles of trade.

Violation: Between September and October 2023, Buchholz executed 10 unauthorized trades totalling $590,795 in the accounts of four beneficiaries of a deceased customer. He generated $16,245.63 in commissions. Two customers suffered losses from liquidating the unauthorized positions.

SUMMARY:

Buchholz executed a series of unauthorized trades in four customer accounts shortly after the accounts were funded from their father’s estate. By placing trades without any written or oral approval and later liquidating one customer’s holdings without consent, he violated FINRA Rule 2010. His actions generated significant commissions for himself and resulted in losses for certain customers, prompting formal complaints and regulatory action.

SANCTIONS:

One-month suspension.
$7,500 fine.
$7,480 disgorgement + interest.

AWC Document:

2024081242701 Barry L. Buchholz CRD 1583582 AWC lp.pdf

CONCLUSION:
This case underscores FINRA’s strict prohibition against unauthorized trading in non-discretionary accounts. Registered representatives must obtain explicit customer authorization before executing any transactions. Failure to do so violates the ethical and professional standards embedded in FINRA Rule 2010 and exposes customers to unauthorized risk and financial harm.

6. Case: Luis S. Jean-Bart

INTRODUCTION:

This summary reviews FINRA’s action against former registered representative Jean-Bart, who failed to timely respond to multiple FINRA Rule 8210 requests for information over a prolonged period, violating FINRA’s investigative requirements and conduct standards.

Date of Action: November 19, 2025
Respondent: Luis S. Jean-Bart
Violations:

A. FINRA Rule 8210:

This rule states associated persons to provide information, documents, and records necessary to an investigation, and prohibits failing to comply with such requests.

Violation: Jean-Bart failed to provide complete and timely responses to multiple FINRA Rule 8210 requests issued between October 19, 2023, and January 24, 2025. Despite extensions and repeated follow-up requests, he did not provide all required documents by the established deadlines. Some documents were not produced until more than 15 months after the initial due date. His prolonged lack of cooperation impeded FINRA’s investigation into alleged off-platform crypto-asset activity.

B. FINRA Rule 2010:

This rule requires associated persons to adhere to high standards of commercial honor and just and equitable principles of trade.

Violation: By failing to timely respond to FINRA Rule 8210 requests, Jean-Bart violated FINRA Rule 2010. An untimely or incomplete response to an 8210 request constitutes a breach of the standards of conduct required of registered persons.

SUMMARY:

Jean-Bart repeatedly failed to comply with FINRA’s Rule 8210 information requests over an extended period, delaying and hindering an active investigation. His failure to timely provide the required documents and information resulted in violations of both FINRA Rules.

SANCTIONS:

Ten-month suspension.
$5000 fine.

AWC Document:

2023080015803 Luis S. Jean-Bart CRD 5472965 AWC ks.pdf

CONCLUSION:
FINRA’s action highlights the critical importance of full and timely compliance with Rule 8210 requests. Failure to cooperate with regulatory investigations undermines FINRA’s ability to protect investors and enforce industry standards, and such conduct constitutes a serious violation of FINRA rules.

7. Case: Deutsche Bank Securities Inc.

INTRODUCTION:

This summary reviews FINRA’s action against Deutsche Bank for longstanding failures to include required conflicts-of-interest disclosures in equity and debt research reports and for failing to maintain supervisory systems designed to ensure compliance with research disclosure rules. These failures occurred over an extended period and affected approximately 110,000 research reports.

Date of Action: November 19, 2025

Respondent: Deutsche Bank Securities Inc.
Violations:

A. FINRA Rule 2241:

This rule governs equity research reports and requires member firms to ensure that such reports include complete and accurate conflicts-of-interest disclosures, such as whether the firm or its affiliates expect to receive investment banking compensation from the subject company, whether the subject company is or has been a client of the firm, and whether the research analyst or household members have a financial interest in the securities discussed..

Violation: Deutsche Bank violated FINRA Rule 2241 by publishing approximately 99,000 equity research reports that omitted required disclosures relating to expected investment banking compensation and thousands more that failed to disclose client relationships and analyst ownership interests. The missing disclosures resulted from flawed data feeds, incomplete client information, and inadequate monitoring of analyst trading. These failures spanned from January 2007 through May 2025 and reflect the firm’s inability to ensure that its equity research reports contained accurate, comprehensive, and compliant conflict-of-interest disclosures.

B. FINRA Rule 2242:

This rule governs debt research reports and requires firms to disclose expected investment banking compensation, client relationships, analyst financial interests, and other conflicts that may affect the objectivity of debt research.

Violation: Deutsche Bank violated FINRA Rule 2242 by publishing approximately 9,000 debt research reports containing incomplete or missing conflicts-of-interest disclosures, including failures to disclose expected investment banking compensation, client relationships, and analyst ownership. The firm also released 172 compendium debt research reports lacking the required hyperlink-accessible disclosures due to an incomplete online search tool. These violations, occurring from July 16, 2016, through May 2025, resulted from the firm’s long-standing failure to maintain adequate data systems and supervisory controls to ensure compliance with debt research disclosure requirements.

C. FINRA rule 3110:

This rule states member firms to establish, maintain, and enforce a supervisory system and written supervisory procedures designed to ensure compliance with applicable securities laws and FINRA rules.

Violation: From January 2007 to the present, Deutsche Bank failed to maintain a supervisory system reasonably designed to ensure that its research disclosures were accurate and complete. The firm did not verify the integrity of data feeds used for disclosure triggers and lacked adequate procedures to monitor and restrict research analyst trading in covered securities, including trades in third-party managed accounts. These deficiencies resulted in widespread disclosure omissions and violations of supervision rules.

D. FINRA Rule 2010:

This rule states member firms to observe high standards of commercial honor and just and equitable principles of trade.

Violation: Deutsche Bank’s systemic failures to comply with research disclosure obligations and supervisory requirements constitute violations of Rule 2010, as the firm failed to ensure transparency in areas critical to investor protection and market integrity.

SUMMARY:

For more than a decade, Deutsche Bank operated with defective data systems, inadequate oversight, and incomplete supervisory procedures, resulting in inaccurate or missing conflict-of-interest disclosures in approximately 110,000 research reports. These failures violated multiple research and supervision rules, undermining investor transparency and market integrity.

SANCTIONS:

a censure.
$2.5 million fine.
An undertaking requiring senior management to certify, within 180 days, that Deutsche Bank has remediated the failures and implemented a supervisory system reasonably designed to comply with FINRA Rules.

AWC Document:

2022073416601 Deutsche Bank Securities Inc. CRD 2525 AWC ks.pdf

CONCLUSION:
This action underscores FINRA’s expectation that firms maintain rigorous systems ensuring complete and accurate research disclosures. Effective supervisory controls and transparent conflict-of-interest reporting are essential for investor protection and the integrity of the research process.

8. Case: James Daniel Lang

INTRODUCTION:

This summary reviews FINRA’s action against Lang, who engaged in multiple outside business activities (OBAs) without providing the required prior written notice to his member firms. His failure to disclose compensated trustee and executor roles over several years resulted in violations of FINRA’s OBA and conduct rules.

Date of Action: November 19, 2025
Respondent: James Daniel Lang
Violations:

A. FINRA Rule 3270:

This rule prohibits registered persons from engaging in outside business activities or receiving compensation from any business outside their member firm unless they provide prior written notice to the firm.

Violation: Between October 2016 and December 2022, Lang failed to disclose multiple compensated fiduciary roles, including serving as trustee for two customer trusts and as executor of a customer’s estate. Despite being required to disclose all OBAs through LPL’s electronic system, Lang failed to report his trustee roles until after they were discovered during a branch audit, and even after being instructed to relinquish the positions, he continued acting as trustee. After joining IFG in October 2020, Lang again failed to disclose his ongoing trustee activity until December 2022. He also did not disclose his executor role to either firm. Lang repeatedly certified inaccurately on compliance questionnaires that he had no undisclosed outside activities and no fiduciary roles, rendering his conduct a clear violation of Rule 3270.

B. FINRA Rule 2010:

This rule states associated persons to adhere to high standards of commercial honor and just and equitable principles of trade.

Violation: By knowingly failing to disclose required OBAs, inaccurately completing compliance questionnaires, continuing fiduciary activities after direct firm instructions to cease, and withholding material information from both LPL and IFG, Lang violated FINRA Rule 2010, as nondisclosure of OBAs constitutes misconduct inconsistent with ethical industry standards.

SUMMARY:

Lang engaged for years in undisclosed outside business activities, including compensated trustee and executor roles for a long-time customer, despite firm requirements to report all external activities. His failure to disclose these roles and his inaccurate compliance certifications violated FINRA Rules 3270 and 2010.

SANCTIONS:

Four-month suspension.
$5000 fine.

AWC Document:

2020067065101 James Daniel Lang CRD 2959057 AWC lp.pdf

CONCLUSION:
This action reaffirms FINRA’s expectation that registered persons fully and accurately disclose all outside business activities. Failure to provide prior written notice undermines firm oversight, introduces undisclosed conflicts, and violates fundamental conduct standards.

9. Case: Mark A. Carter

INTRODUCTION:

This summary reviews FINRA’s action against Carter, who engaged in excessive and unsuitable options trading, exercised discretion without authorization, and mismarked trades in two retail customer accounts while associated with Pruco Securities. His actions resulted in violations of Regulation Best Interest (Reg BI) and multiple FINRA rules.

Date of Action: November 19, 2025
Respondent: Mark A. Carter
Violations:

A. Exchange Act Rule 15l-1(a) of Regulation BI:

This rule states brokers to act in the best interest of retail customers when making recommendations, without placing their own interests ahead of the customer’s. It requires reasonable diligence to ensure the recommendation is suitable and not excessive in light of the customer’s investment profile.

Violation: From January to December 2023, Carter recommended more than 2,200 options trades to two retail customers whose profiles reflected long-term, capital-appreciation objectives making highly active and risky options strategies deeply unsuitable. His trading caused over $600,000 in losses, representing more than 99% of the customers’ account value, while generating commissions of $6,773 for himself. Annualized cost-to-equity ratios averaged 42%, demonstrating excessive trading far outside the customer’s best interest. Carter therefore wilfully violated Reg BI’s Best Interest Obligation and FINRA Rule.

B. FINRA Rule 3260:

This rule prohibits the exercise of discretionary trading authority in a customer’s account unless the customer provides prior written authorization and the member firm approves the discretionary arrangement in writing.

Violation: Carter exercised discretion in the customer’s accounts without obtaining any written authorization. Over the course of twelve months, he placed 2,314 options trades without speaking to the customers, violating the rule and exceeding both customer and firm authority.

C. FINRA Rule 2360:

This rule prohibits discretionary trading in options accounts unless it complies with Rule 3260 and specifically authorizes options trading.

Violation: Because Carter lacked written discretionary authority for options transactions, each discretionary trade he placed in the customers’ accounts constituted a separate violation of Rule 2360(b)(18)(A)(i). His extensive pattern of unauthorized discretionary options trades violated this rule repeatedly.

D. FINRA Rule 4511:

This Rule states members and associated persons to maintain accurate books and records, including properly marking whether trades are solicited or unsolicited.

Violation: Carter mismarked all 2,314 solicited options trades as unsolicited. These false markings caused the firm to maintain inaccurate books and records and concealed the magnitude of his excessive trading activity, constituting a direct violation of Rule 4511.

D. FINRA Rule 2010:

This Rule states associated persons to observe high standards of commercial honor and just and equitable principles of trade.

Violation: Because Carter engaged in unsuitable trading, exercised unauthorized discretion, and mismarked order tickets, he failed to meet the high standards of conduct required under Rule 2010. Each underlying violation independently supports a violation of this rule.

SUMMARY:

Carter’s trading activity was excessive, unsuitable, and unauthorized. He breached Regulation Best Interest, FINRA’s suitability rules, discretionary trading rules, and books-and-records requirements. His conduct resulted in severe customer harm and violated multiple FINRA rules.

SANCTIONS:

Nine-month suspension.
$20,000 fine.
Disgorgement of $6,773 plus interest.

AWC Document:

2024081675801 Mark A. Carter CRD 6387371 AWC vr.pdf

CONCLUSION:
Carter’s misconduct demonstrates serious breaches of both suitability and supervisory standards. By recommending excessive and high-risk options trades that were not in the best interest of his retail customers, exercising discretion without proper authorization, and creating inaccurate trade records, Carter violated multiple FINRA rules and Regulation Best Interest. These actions caused significant financial harm to the customers and undermined the integrity of the brokerage process. FINRA’s sanctions including suspension, fines, and disgorgement underscore the critical importance of adhering to suitability obligations, obtaining proper authorizations, and maintaining accurate records to protect investors and uphold market integrity.

10. Case: Laidlaw & Company (UK) Ltd.

INTRODUCTION:

This summary reviews FINRA’s actions against Laidlaw, which involved failures to maintain minimum net capital, deficient supervisory procedures, and improper handling of investor funds in a contingency offering. These deficiencies violated multiple SEC and FINRA rules, posing risks to investors and the integrity of the securities market.

Date of Action: November 20, 2025
Respondent: Laidlaw & Company (UK) Ltd.
Violations:

A. Exchange Act §§ 15(c)(3), Exchange Act Rule 15c3-1:

This rule states the minimum net capital standard that must be continuously met by all registered broker-dealers.

Violation: Between September 2022 and March 2023, Laidlaw operated while undercapitalized on at least 108 days, with deficiencies ranging from $53,000 to $1.26 million, sometimes exceeding $1 million. These deficiencies occurred because the firm failed to reconcile bank statements and general ledger entries consistently. By conducting business while undercapitalized, Laidlaw violated the minimum net capital requirements set forth in Exchange Act § 15(c)(3) and Rule 15c3-1.

B. Exchange Act § 17(a) and Exchange Act Rule 17a-11:

This rule states firms to notify FINRA and the SEC immediately if net capital falls below required minimums.

Violation: Laidlaw filed two inaccurate deficiency notices in December 2022 and January 2023, misreporting the start and end dates of net capital deficiencies. Additionally, an April 2023 notice overstated compliance. By failing to provide accurate and timely net capital deficiency notices, Laidlaw violated Exchange Act § 17(a) and Rule 17a-11.

C. FINRA Rule 4110:

This rule states a member firm to suspend all business operations during any period in which it is not in compliance with applicable net capital requirements.

Violation: Laidlaw continued to conduct securities business during the periods it was undercapitalized. By failing to suspend operations during these times.

D. FINRA Rules 3110:

This rule states member firms to establish, maintain, and enforce supervisory systems and written supervisory procedures (WSPs) reasonably designed to ensure compliance with applicable laws and rules.

Violation: Between September 2022 and June 2023, Laidlaw failed to maintain WSPs for general ledger maintenance, reconciliation, intercompany transactions, and net capital calculations. Staffing shortages exacerbated these deficiencies, and no remedial steps were taken until July 2023.

E. Exchange Act § 15(c)(2) and Rule 15c2-4(b)

This rule sates that in contingency offerings, broker-dealers either deposit investor funds into a separate account or transmit funds to an independent escrow agent when the broker is affiliated with the issuer.

Violation: Between November 2020 and January 2021, Laidlaw participated in a contingency offering for an affiliated issuer but failed to establish an independent escrow account, instructing investors to send funds directly to the issuer.

SUMMARY:

Laidlaw’s failures to maintain net capital, submit accurate deficiency notices, establish supervisory systems, and properly handle investor funds in a contingency offering violated multiple SEC and FINRA rules. These lapses created regulatory and investor risks and demonstrate significant supervisory and compliance deficiencies.

SANCTIONS:

a censure
$200,000 fine.

AWC Document:

2023077061201 Laidlaw & Company (UK) Ltd. CRD 119037 AWC ks.pdf

CONCLUSION:
Laidlaw’s conduct demonstrates significant failures in financial and supervisory controls. By operating while undercapitalized, submitting inaccurate net capital deficiency notices, failing to suspend business during periods of deficiency, neglecting to maintain adequate supervisory procedures, and mishandling investor funds in a contingency offering, the firm violated multiple SEC and FINRA rules. These violations exposed investors and the marketplace to risk and reflect a breakdown in both compliance and operational oversight. FINRA’s sanctions, including censure and a $200,000 fine, underscore the importance of maintaining adequate capital, accurate reporting, robust supervisory systems, and proper handling of investor funds to protect investors and uphold market integrity.

FINRA Charges First Trust Portfolios L.P. with $10 Million Fine for Excessive Gifts and Misleading Reporting

Herskovits, PLLC — Mon, 17 Nov 2025 15:21:03 GMT

The Financial Industry Regulatory Authority (FINRA) recently sanctioned First Trust Portfolios L.P., a Wheaton, Illinois-based securities wholesaler, imposing a $10 million fine for serious violations involving non-cash compensation and misleading reporting. This enforcement highlights underscores the importance of strict compliance with gift and entertainment rules in the securities industry.

I. Background

First Trust has operated as a wholesale distributor of securities issued mainly by affiliated investment companies since 1991. It employs approximately 700 registered representatives across four branch offices nationwide.

II. The Violations: What Went Wrong?

A. Unauthorized and Excessive Gifts

First Trust wholesalers routinely provided lavish perks that far exceeded FINRA’s annual $100 per person non-cash gift limit. These included:

Multiple instances of courtside basketball tickets valued at around $3,200 per pair, given without an accompanying First Trust employee.
Tickets to a Broadway musical costing more than $1,800, again without firm accompaniment.
Bottles of alcohol priced at $400 or higher, given repeatedly to client representatives.
Luxury suite tickets for NBA and NHL playoff and professional football games worth tens of thousands of dollars.

Additionally, one representative received over $31,000 in tickets and entertainment within 18 months, such as NBA All-Star game luxury suite access. Another was given more than $50,000 in gifts and entertainment over a four-year period, including meals, concerts, and golf outings, with seventeen events exceeding $21,000 in one year.

Furthermore, six wholesalers explicitly linked gifts to sales targets, such as promising hockey game tickets contingent on a broker selling $1 million in Unit Investment Trusts (UITs) or offering to pay for future events if sales goal of $1 million to $10 million were achieved.

These actions violate FINRA Rules 2341(l)(5) and 2010, which prohibit excessive gifts and sales-based inducements.

B. Falsification of Expense Reports and Records

More than 40 expense reports were falsified involving more than $650,000. Violations included:

Listing deceased or inactive individuals as attendees.
Omitting actual attendees from reports to lower apparent costs.
Coordinating false reports through private texts, evading firm surveillance.

Supervisors occasionally advised wholesalers on how to disguise true expenses, violating FINRA Rules 4511 and 2010, Section 17(a) of the Securities Exchange Act of 1934, and Exchange Act Rule 17a-3.

C. Failure to Accurately Report to Client Firms

First Trust submitted at least 25 quarterly reports to client firms, understating or omitting non-cash perks benefits over $500,000, including a failure to report luxury suite tickets costing $20,000 for football games in late 2019. Despite improvements after October 2021, some omissions continued, violating FINRA Rule 2010.

D. Lack of Adequate Supervision Supervisory Failures

Despite having written policies, First Trust failed to supervise the provision and reporting of non-cash compensation properly. The supervisory system relied on wholesalers’ unverified self-reporting and permitted modifying approved reports without internal checks. Notably, the firm failed to supervise Firm-paid tickets prior to October 2021, significantly compounding compliance failures.

These supervisory failures violated FINRA Rules 3110(a), 3110(b), and 2010.

III. Remedial Actions Taken by First Trust

To address these issues, First Trust implemented several corrective measures, including:

Establishing a dedicated compliance audit function reporting directly to executive management focused on non-cash compensation and sales practices.
Enhancing tracking systems for event ticket distributions.
Disciplining employees through suspensions without pay, fines, and increased supervision.

IV. Sanctions and Undertakings

First Trust agreed to:

A censure.
A $10 million fine.
An undertaking mandating the firm’s senior management, identified as a registered principal, to certify annually for three years that it complies with FINRA Rules 2010, 2341, 3110, and 4511 as well as Exchange Act 17(a) and Exchange Act Rule 17a-3.

The firm voluntarily waived any right to claim an inability to pay, now or at any time after the execution of this AWC, the monetary sanction imposed in this matter.

V. Why This Matters?

This case underscores the importance of ethical practices and cautious supervision in brokerage operations. It reflects FINRA’s dedication to protecting investors by holding firms accountable for improper gift and entertainment practices that may skew financial advice.

For firms operating in the securities industry, First Trust’s penalty is a stark reminder to maintain transparent records, enforce reasonable gift limits, and foster a culture of compliance to ensure trusted client relationships and market integrity. The statements in this blog post are allegations as set forth in the AWC.

Herskovits PLLC represents broker-dealer and registered persons in defense of FINRA investigations and disciplinary actions. Feel free to contact us for a consultation at (12) 897-5410.

FINRA’s 2024 Regulatory Oversight

Herskovits, PLLC — Tue, 03 Sep 2024 16:56:00 GMT

The 2024 FINRA Annual Regulatory Oversight Report provides a detailed overview of FINRA’s regulatory activities, priorities, and key initiatives for the year. The report covers areas such as market regulation, member supervision, enforcement actions, and rulemaking efforts. It also highlights trends in the financial industry, emerging risks, and FINRA’s response strategies. The document emphasizes the importance of protecting investors, ensuring market integrity, and maintaining fair and efficient markets.

Financial Crimes

The financial crime section of the report details FINRA’s focus on combating activities such as money laundering, fraud, and market manipulation. Key initiatives include the use of advanced surveillance technologies and data analytics to detect suspicious activities. FINRA also emphasizes the importance of firms adhering to Anti-Money Laundering (AML) regulations, including thorough customer due diligence and suspicious activity reporting. The report highlights several enforcement actions taken against firms and individuals involved in financial crimes, showcasing FINRA’s commitment to maintaining market integrity and protecting investors.

Crypto Assets Developments

FINRA addresses the growing involvement of member firms in crypto-related activities and the associated risks. The report emphasizes the need for firms to have robust compliance frameworks to manage the unique risks of crypto assets, including fraud and market manipulation. FINRA is focused on ensuring that firms adhere to existing regulations while also adapting to the evolving landscape of digital assets. This includes enhanced due diligence, investor protection measures, and the proper disclosure of risks associated with crypto products.

Firm Operations

This section highlights the importance of strong operational risk management practices, especially in the context of technological advancements and increased cyber threats. FINRA underscores the need for firms to maintain comprehensive business continuity plans, implement effective cybersecurity measures, and ensure the proper management of third-party vendors. The report also discusses the importance of ongoing training and awareness programs for staff to mitigate operational risks, particularly in a remote or hybrid work environment.

Communications and Sales

FINRA focuses on the regulation of communications between firms and their customers, particularly in the context of digital platforms and social media. The report stresses the importance of transparency and accuracy in marketing materials and customer communications. Firms are encouraged to establish strong supervisory systems to oversee sales practices, ensuring that they are fair and not misleading. The section also touches on the use of new communication technologies and the need for firms to adapt their compliance programs accordingly.

Market Integrity

The report outlines FINRA’s efforts to uphold market integrity through vigilant surveillance, examinations, and enforcement actions. Key areas of focus include detecting and preventing market manipulation, insider trading, and other illicit activities. FINRA employs advanced analytics and technology to monitor trading activity and identify suspicious behavior. The organization also works closely with other regulators to ensure coordinated responses to potential threats to market integrity.

Financial Management

FINRA emphasizes the importance of sound financial management practices within member firms, particularly in areas such as capital adequacy, liquidity management, and financial risk management. The report discusses the need for firms to comply with financial responsibility rules and to maintain sufficient capital reserves to withstand economic stress. Additionally, FINRA highlights the importance of regular financial reporting and audits to ensure transparency and accountability.

For more in-depth information, you can review the full report here.

FINRA PROVIDES GUIDANCE ON FINANCIAL ADVISOR SUCCESSION PLANS

Herskovits, PLLC — Thu, 10 Nov 2022 20:58:38 GMT

FINRA recently released Regulatory Notice 22-23 providing guidance on what firms should consider when constructing succession plans for Financial Advisors (“FAs”) who will no longer service their customers do to expected or unexpected life events.

The Need for a Plan

The Notice begins by listing the various cost/benefits of having or not having a succession plan, which would seem obvious to all. It takes no great imagination to see the benefits of a sound succession plan in the event of an FA’s sudden death or the consequent difficulties of not having such a plan. The Notice, however, provides some interesting real-life anecdotes that FINRA Staff have witnessed of the years regarding succession failures and successes.

The Notice also addresses the much trickier issue of an FA’s possible diminished capacity. FINRA noted that some firms have implemented comprehensive policies regarding possible diminished capacity among employees. These include:

training on signs of cognitive decline,
having a formalized escalation process to raise concerns,
establishing a diminished capacity committee to evaluate and decide next steps,
developing a committee to evaluate representatives’ limitations, engage their physicians, protect their privacy and implement working arrangements that comply with relevant employment laws and accommodated their disabilities; and
engaging with representatives and, depending on the circumstances, supporting the representatives with implementing a new working arrangement, developing a succession plan, providing assistance with performance issues or recommending termination.

Types of Plans

FINRA notes that there is no set way to craft a succession plan and that the complexity and details of any plan may vary greatly based on the firm but, in general, plans can broadly be divided into two categories: (1) internal programs, or (2) an external sale or other transaction.

Internal programs can come in many forms. One answer to the succession problem is for firms to encourage teams of FA’s to work together. Many large firms are actively encouraging FA’s to join teams and actively discouraging solo FA’s. The team can come in different forms. For example, it could consist of two or more FA’s of similar seniority who put a plan in place to purchase the others book of business should the need or desire arise. The team could also involve the hiring of younger FA’s with the goal of developing them to someday take over the more senior FAs book.

An FA, not with a team, might designate in advance an FA as his successor or the firm may make such designation, in each case informing customers of the new arrangement. Many, if not all, of these transition plans incorporate agreements to pay retiring representatives commissions once they leave.

External plans generally consist of a sale of the book of business to another firm or an FA at another firm or a merger of two firms. In the case of an external succession plan, the retiring FA often agrees to continue to work for a certain amount of time to help transition the clients to the new FA.

Relevant FINRA Rules

FINRA Rule 4370 (Business Continuity Plans and Emergency Contact Information) requires firms to adopt Business Continuity Plans (“BCPs”) designed to ensure that firms continue to meet customers’ needs in the event of an emergency or significant business disruption. Depending on the size of the firms and role of an individual FA, a succession plan may need to be part of the BCP.

A member firm’s succession plan may involve the Membership Application Program rules, FINRA Rules 1011 – 1019, that could include filing a Continuing Membership Application (CMA), or engaging in the materiality consultation process (MatCon). A change in ownership could trigger an obligation for member firms to file a CMA under FINRA Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations). Rule 1017(a) specifies the changes in firms’ ownership, control or business operations that require a CMA, such as a merger with another member firm; an acquisition or transfer of 25 percent or more of the member firm’s assets; or a material change in business operations as defined in FINRA Rule 1011(m). In general, the Notice encourages firms to work closely with their Risk Monitoring Analysts at FINRA and share relevant succession planning for control person.

The Notice also highlights the concern of a succession being necessitated by the lengthy suspension or bar of an FA. In these situations, FINRA sees a heighted risk that the disciplined FA may sell his book of business to another FA who will improperly act as a proxy while sharing commission with the former FA. FINRA suggests that firm’s monitor for, “an unusually high degree of engagement between the representative and former representative or an unusually low degree of engagement between the new representative and that representative’s customers . . . .” FINRA also suggests that firm’s conduct customer “check-in calls” to determine of the terminated FA is improperly engaging with former customers.

Firms will also have to consider the payment of commissions to an unregistered person if that is part of the succession plan. FINRA Rule 2040 governs the payment of transaction-based compensation by member firms to unregistered persons. Subject to conditions, under Rule 2040(b), member firms can pay continuing commissions to their “retiring registered representatives,” after they cease to be associated with the firms, derived from accounts held for continuing customers of the retiring registered representative regardless of whether customer funds or securities are added to the accounts during the period of retirement.

Rule 2040(b) incorporates guidance from prior SEC no-action letters on the payment of commissions to retired registered representatives (referred to herein as SEC Staff Retired Representatives Guidance). Accordingly, firms and representatives who are drafting, reviewing or executing agreements for continuing commission payments to retired representatives should consider the requirements of Rule 2040 and the prior SEC Staff Retired Representatives Guidance. See SEC No-Action Letter to the Securities Industry and Financial Markets Association and SEC No-Action Letter to Amy Lee, Chief Compliance Officer, Co-CEO, Packerland Brokerage Services Questions for Consideration

The Notice concludes with a lengthy set of “Questions for Consideration” with regard to succession planning. For example, FINRA urges firms to consider such things as:

Does the firm have a plan that addresses both retirement as well as unplanned life events?
Does the plan account for both external and internal transitions?
Are there different procedures for key personnel?
Does the firm’s plan address risks of diminished capacity?
Are written succession agreements required? Can they be customized?
Does the plan address FAs’ disciplinary histories and other regulatory risks?
Does the plan address continuing commissions in a way that complies with FINRA Rule 2040?
Does the plan protect nonpublic customer information?
Does the plan address the required customer communications necessary upon transition?

These are only a small sample of the questions that FINRA poses and suggests that firms consider when constructing a succession plan. What the Notice makes abundantly clear is that, given that over 16% of all FAs are over the age of 60, the issue of succession is only going to grow in the coming years and firms would be wise to be prepared for the many pitfalls involved.

Herskovits PLLC represents financial advisors in litigation, arbitration and regulatory matters. Feel free to contact us at (212) 897-5410

FINRA RULES EX PARTE TEMPORARY RESTRAINING ORDER RESULTS IN STATUTORY DISQUALIFICATION

Herskovits, PLLC — Tue, 04 Oct 2022 20:28:40 GMT

FINRA’s Office of Hearing Officers recently rendered a decision on an issue of first impression in Dep’t of Enforcement v. NYPPEX, LLC, et al., (Disc. Proc. No. 2019064813801). Enforcement charged FINRA member firm, NYPPEX, LLC, its former CEO, Laurence Allen, and its CCO, Michael Schunk, with numerous violations of FINRA rules. The charges stemmed from Respondents’ conduct in the wake of a temporary restraining order issued by a New York state court against Allen. Among other things, the order, obtained at the behest of the Office of the Attorney General for the State of New York (“NYAG”), enjoined Allen from engaging in securities fraud and violating New York’s securities laws. Enforcement took the position that the TRO rendered Allen statutorily disqualified from continued association with a FINRA member firm. Allen could have remained associated with the Firm if it applied for, and received, FINRA’s permission pursuant to FINRA Rule 9520. Allen’s supervisor, Schunk, however, purportedly let Allen continue as an associated person at NYPPEX for over a year without seeking a waiver from FINRA.

FINRA’s disciplinary proceeding was triggered by the ex parte TRO. After a two-year investigation, in December 2018, the NYAG commenced an action under Article 23-A of New York’s General Business Law, known as the Martin Act, against Allen and certain others. The NYAG applied on an ex parte basis for preliminary injunctive relief against Allen, NYPPEX Holdings, and others under Section 354 of New York’s General Business Law. The NYAG stated that a preliminary injunction was warranted because of the allegations of fraud and fraudulent practices by Allen and his refusal to produce documents or appear for testimony. In December 2018, the Supreme Court of the State of New York granted the NYAG the relief it sought and issued the TRO without hearing from Allen or NYPPEX. Allan was served with the Order in January 2019 and Schunk learned about it that month as well.

On December 4, 2019, the NYAG filed a complaint in the New York Supreme Court against NYPPEX, Allen and others (Index No. 452378/2019). In February 2020, the New York Supreme Court concluded a five-day hearing and issued a preliminary injunction prohibiting Allen and NYPPEX from, among other things, violating the Martin Act and from “facilitating, allowing or participating in the purchase, sale or transfer of any limited partnership interest in [the fund].” At this point in time, NYPPEX filed an MC-400 Application seeking permission for NYPPEX to remain associated with a disqualified person, Allen. FINRA Enforcement, however, argued that Allen became statutorily disqualified when the TRO was issued in 2018, more than a year before NYPPEX filed the MC-400 Application.

A person is deemed disqualified from continued association with a FINRA member firm if, among other things, such person “is enjoined from any action, conduct, or practice” specified in Section 15(b)(4)(C) of the Exchange Act. That section, in turn, includes a situation in which a person “is permanently or temporarily enjoined by order, judgment, or decree of any court of competent jurisdiction from . . . engaging in or continuing any conduct or practice in connection with any such activity, or in connection with the purchase or sale of any security.”

Once a member becomes aware that one of its associated persons is subject to a disqualification, the member is obligated to report the event to FINRA. The firm must amend the individual’s Form U4 within 10 days of learning of a statutory disqualifying event. The member firm then must either file a Form U5 terminating the individual’s association or file an MC-400 Application seeking to sponsor the association of the disqualified person. If the member firm neither terminates the individual nor submits an MC-400 Application, the member is ineligible to continue in FINRA membership.

In the case of NYPPEX and Allen, the respondents argued that the TRO did not cause Allen to be statutorily disqualified and they claimed that they relied on both in house and outside counsel in coming to that conclusion. Among other things, Respondents argued that the TRO did not subject Allen to statutory disqualification because it was issued ex parte and Allen had no “notice and opportunity to be heard.” The OHO noted that “[w]hether an ex parte temporary restraining order triggers a statutory disqualification appears to be an issue of first impression.” The OHO, however, had little difficulty in finding that the TRO was indeed an injunction that triggered statutory disqualification. The decision notes that nothing in the language of the Exchange Act requires notice and opportunity to be heard before an event is disqualifying. The OHO concluded, “[i]n sum, there is no basis to conclude that Congress meant to exclude an ex parte temporary restraining order from the operative provision.”

Finally, the OHO also rejected any advice-of-counsel defense because, “[r]eliance on advice of counsel is not relevant to liability if scienter is not an element of the violation.” The decision noted, however, that even when reliance on advice of counsel is not relevant to liability it may be considered as a possible mitigation of sanctions. In the present case, however, there seems to be little mitigation of the sanctions imposed. NYPPEX was expelled from FINRA membership, Allen was barred from the securities industry, and Schunk was fined $120,000, barred from acting in any principal or supervisory capacity and suspended from the industry three and a half years.

Similar to Enforcement, the NYAG likewise prevailed at trial. The New York Supreme Court found Allen and NYPPEX liable for assorted false and misleading statements and ordered disgorgement of nearly $7 million.

Herskovits PLLC has a nationwide practice defending investigations and litigation brought by FINRA and other regulators. Feel free to call us for a consultation at (212) 897-5410.

FINRA AWC PROVIDES A PRIMER ON ACTIVITIES VIEWED AS AML RED FLAGS

Herskovits, PLLC — Thu, 01 Sep 2022 15:10:56 GMT

On August 23, 2022, FINRA published an AWC reflecting a settlement with ViewTrade Securities, Inc. The AWC alleges that ViewTrade failed to establish and implement written AML policies and procedures that could reasonably detect and cause the reporting of suspicious transactions in violation of FINRA Rule 3310. FINRA Rule 3310 requires that each member firm develop and implement a written AML program reasonably designed to achieve and monitor the member’s compliance with the requirements of the Bank Secrecy Act (31 U.S.C. 5311, et seq.) (BSA). Rule 3310(a) further requires firms to, “[e]stablish and implement policies and procedures that can be reasonably expected to detect and cause the reporting of transactions required under [the BSA] . . . . ” The regulations implementing the BSA, in turn, require every broker-dealer to file a Suspicious Activity Report (“SAR”) with the Financial Crimes Enforcement Network any time they detect, “any suspicious transactions relevant to a possible violation of law or regulation.”

FINRA’s past guidance on this issue (NTM 02-21 and Regulatory Notice 19-18) advised firms to look for red flags and provided several examples:

Customers’ mailing address is associated with multiple other accounts or business that do not appear related,
Customers that buy and sell securities for no discernable purpose,
Inflows or outflows of funds that are well beyond the known means of the customer, or
Unexplained or extensive wire activity.

FINRA described a litany of failures on the part of ViewTrade to monitor for suspicious activity. While ViewTrade produced a daily transaction report to be review by a designated principal, the firm’s WSPs failed to reflect how that principal was supposed to use that report. Apparently, ViewTrade’s WSPs contained no parameters on detecting suspicious activity, no guidance on who would review the report or the frequency of the review. ViewTrade’s procedures also failed to address how personnel should document their reviews of the report and when and how to escalate potential issues. ViewTrade failed to review instances where its surveillance reports flagged potential spoofing, layering and wash trades.

FINRA also criticized ViewTrade’s surveillance reports for not being reasonably designed to detect suspicious activity. The example provided in the AWC stated that ViewTrade’s volume report was designed to detect when a customer’s trading activity surpassed a certain percentage of average daily volume, yet was unreasonably limited to low-priced securities. Remarkably, when reviewing reports for suspicious trading activity, the reviewers apparently had no automated system to determine if a particular customer’s account had previously come up on a given exception report.

According to the AWC, the failures of ViewTrade’s AML policies and procedures resulted in multiple failures to detect and investigate suspicious activity. For example, ViewTrade did not detect or investigate when purportedly unrelated foreign-based customers opened accounts on the same day with identical or near-identical mailing addresses. Similarly, ViewTrade did not detect or investigate several instances of purportedly unrelated foreign-based customers opening accounts and then using identical email addresses to submit indications of interest in an upcoming IPO. In three separate IPOs in which ViewTrade acted as underwriter, ViewTrade failed to detect multiple foreign-based customers who, on an unsolicited basis, provided identical indications of interest in the IPOs at or near the same time. After the IPOs, ViewTrade’s customers engaged in suspicious trading activity that FINRA described as, “indicative of bid support and attempts at manipulating market prices.”

ViewTrade also allegedly failed to detect inflows and outflows of assets that were not in line with the customer’s stated net worth and income. In one example, a customer listed their net worth between $50,000 and $100,000 and then proceeded to purchase over a $1,000,000 in securities in a single year, included the large amount of the IPOs discussed above.

Separately, the AWC also alleged that ViewTrade violated various rules regarding procedures required for managing the risk surrounding market access. From July 2017 through at least February 2020, ViewTrade provided its customers access to trading on multiple exchanges through use of ViewTrade’s market participant identifier. ViewTrade established credit controls for its customers, but it did not monitor on an ongoing basis whether its customer credit controls remained appropriate, and it did not have any written supervisory procedures in place requiring that it do so.

For this laundry list of rule violations, FINRA imposed a fine of $250,000 and ViewTrade is required to work with a third-party consultant (approved by FINRA) to set its house in order. In determining sanctions, the AWC does note that ViewTrade “took proactive steps and invested substantial resourced to remediate its AML program.” ViewTrade must see a $250,000 fine as a great result, particularly in light of some of the much heavier fines that other firms have paid for AML issues, such as the $15 million fine that Interactive Brokers paid in 2020.

Herskovits PLLC has a nationwide practice defending against FINRA investigations and disciplinary proceedings. Feel free to contact us at (212) 897-5410.

FINRA RELEASES GUIDANCE ON SUPERVISION RELATING TO DIGITAL SIGNATURES

Herskovits, PLLC — Fri, 12 Aug 2022 18:49:55 GMT

FINRA recently released Regulatory Notice 22-18, reminding firms about their obligation to supervise registered representatives to prevent falsification of digital signatures. FINRA’s guidance comes on the heels of multiple investigations concerning instances when registered representatives forged or falsified client signatures on account transfer documentation or on disclosure forms, “acknowledging a products alignment with the customer’s investment objective and risk tolerance . . . .”

FINRA’s notice explains the varied methods used to forge or falsify electronic signatures and how firms can thwart such forgeries or detect them after the fact. Generally, electronic signatures have an audit trail with identifying information such as the recipient’s IP address and e-mail address. Financial advisors have been admonished for sending documents to their personal e-mail addresses or to an assistant to sign the documents themselves. Firms also found instances where documents were sent to an IP address that was the same as the registered representative or that was inconsistent with the customer address on file. Sometimes representatives sent e-mails to the e-mail address associated with an outside business activity. FINRA’s guidance recommends that firms review correspondence to look for these red flags.

FINRA reports that, in some cases, administrative staff raised issues to management about pressure by representatives to manipulate the digital signature process. FINRA encourages training for such staff to encourage them to resists such pressure.

FINRA noted that some firms use an authentication process that asks the customers to answer certain questions to authenticate their signatures. The problem, however, is that representatives have been able to circumvent this process because they have enough information about the customer to answer the questions themselves. FINRA warns firms from relying solely on such authentication processes for supervision.

Of course, FINRA’s position and guidance make sense when a registered representative is trying to deceive their customer. FINRA, however, states that, “[f]orgery occurs when one person signs or affixes, or causes to be signed or affixed, another person’s name or initials on a document without the other person’s prior permission.” FINRA goes on to state that forgery is a violation of FINRA Rule 2010. FINRA’s definition of forgery does always line up with state law. For example, in New York and New Jersey, the crime of forgery requires an intent to defraud. The Model Penal Code adopted by many states also requires an intent to defraud or injure to establish forgery. So if a representative electronically signs a customer’s document solely for the customer’s convenience they have not committed forgery. For example, imagine that a customer mails a check to fund their account but forgets to endorse it. The registered representative decides to sign the customer’s name and deposit the check to avoid any delay in getting the money into the account. The registered representative is not guilty of forgery but we know that FINRA still deems this a violation of FINRA Rule 2010.

FINRA also states that it is only forgery when done “without the other person’s permission.” Is FINRA saying that a registered representative can sign a document on behalf of a customer, electronically or otherwise, if they have the customer’s permission? That seems doubtful. As a practical matter, every firm likely has a policy against letting registered representatives sign documents even with a client permission so it is not a wise thing to do. A violation of a firm policy, however, is not necessarily a violation of FINRA Rule 2010. “A FINRA Rule 2010 violation requires either bad faith or a breach of ethical norms in the industry. In the context of Rule 2010 violation, the SEC has defined bad faith as a dishonest belief or purpose, and unethical conduct as conduct inconsistent with the moral norms or standards of professional conduct.”[1] It would seem that when it comes to forgery and Rule 2010, FINRA should start differentiating between bad faith behavior designed to harm or deceive a customer and behavior that is solely to avoid inconveniencing a customer.

Herskovits PLLC has a nationwide practice defending against FINRA investigations and disciplinary proceedings. Feel free to contact us at (212) 897-5410.

[1] Dep’t of Market Reg. v. Paul C. Dotson, 2015 FINRA Discip. LEXIS 47, at *83 (OHO Aug. 7, 2015) citing Blair Alexander West, Exchange Act Release No. 74030, 2015 SEC LEXIS 102, at *20 (Jan. 9, 2015) and Edward S. Brokaw, Exchange Act Release No. 70883, 2013 SEC LEXIS 3583, at *33 (Nov. 15, 2013).

FINRA ENDS MANDATORY ARBITRATION FOR CLAIMS OF SEXUAL HARASSMENT OR SEXUAL ASSAULT

Herskovits, PLLC — Mon, 25 Jul 2022 20:00:17 GMT

On July 15, 2022, FINRA filed Regulatory Notice 22-15 and announced the amendment of its Code of Arbitration for Industry Disputes to conform to the Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act of 2021, Pub. L. No. 117-90, 136 Stat. 26 (2022). The amendments permit person with claims of sexual assault or sexual harassment to pursue those claims in court irrespective of any agreements otherwise mandating arbitration.

Background

FINRA members historically forced employees to arbitrate claims of sexual harassment or assault by use of agreements containing pre-dispute arbitration clauses. The pre-dispute arbitration clauses were typically contained within a Form U4, employment agreements or provisions within an employee manual that the employee was bound by.

Use of pre-dispute arbitration clauses for claims of sexual harassment or sexual assault was upended by the Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act of 2021. FINRA has now changed its rules to comport with the Act.

Amendments to FINRA’s Rules FINRA Rule 2263 Rule 2263 (titled: Arbitration Disclosure to Associated Persons Signing or Acknowledging Form U4) now includes a new Section 4 stating:

“A party alleging a sexual assault claim or sexual harassment claim that has agreed to arbitrate before the dispute arose may elect post dispute not to arbitrate such a claim under the Code. Such a claim may be arbitrated if the parties have agreed to arbitrate it after the dispute arose.”

FINRA Rule 13100 Rule 13100 contains definitions applicable to the Code of Arbitration Procedure for Industry Disputes. FINRA has added a definition for “sexual assault claim,” meaning:

“a claim involving a nonconsensual sexual act or sexual contact, as such terms are defined in section 2246 of title 18 of the United States Code or similar applicable Tribal or State law, including when the victim lacks capacity to consent.”

FINRA also added a definition for “sexual harassment claim,” meaning:

“a claim relating to conduct that is alleged to constitute sexual harassment under applicable Federal, Tribal, or State law.”

FINRA Rule 13201 Rule 13201, as amended, applies to arbitration of statutory discrimination claims and codifies a prohibition against the use of pre-dispute arbitration agreements for claims under a whistleblower statute, or claims sexual harassment or sexual assault. Rule 13021 now includes a new Section (c) stating:

FINRA Rule 13803 Rule 13803 is triggered when a claimant files certain claims (such as a sexual harassment claim) in court and other claims (such as a compensation claim, for example) in arbitration. In an instance like this, a member is now permitted to file a motion forcing the employee to consolidate all outstanding claim in the court proceeding.

Herskovits PLLC has a nationwide practice representing individuals in the securities industry with claims of sexual assault or sexual harassment. Feel free to call us for a consultation at (212) 897-5410.

FINRA ENFORCEMENT SEEKS BAR FOR FAILURE TO ATTEND AN OTR AND GETS DENIED BY THE OHO

Herskovits, PLLC — Fri, 15 Jul 2022 19:53:56 GMT

Practitioners are familiar with the fact that a failure to respond to a FINRA Rule 8210 request almost automatically results in an industry bar. Except when it doesn’t. The Office of Hearing Officers (the “OHO”) recently published a decision in which it discussed what the Hearing Officer referred to as a “partial but incomplete response” to FINRA’s requests for testimony.

In March, the OHO rendered a decision against Jason DiPaola who was accused by FINRA Enforcement of taking discretion in his mother’s E-trade account without written instructions and without disclosing the account to his employer Chardan Capital Markets, LLC (“Chardan”) in violation of NASD Rule 3050. Dep’t of Enforcement v. DiPaola, Discip. Proc. No. 2018057274302 (OHO Mar. 25, 2022). The OHO, however, claimed that the “most serious allegation” was DiPaola’s failure to appear and provide on-the-record (“OTR”) testimony.

DiPaola was not a trader at Chardan and had no retail customers. DiPaola worked in the firm’s equity capital markets group. DiPaola was first interviewed by FINRA Staff in January of 2018. The Staff obtained account statements for DiPaola’s E-trade accounts and his mother’s E-trade account. FINRA also obtained over a million e-mails from Chardan.

The Staff asked for a second OTR which took place in April 2019. During the second OTR, DiPaola’s counsel, who also represented Chardan, asked that the OTR be suspended because he discovered that he had a conflict upon hearing DiPaola’s testimony. A third OTR took place over two days on July 17, 2019 and July 18, 2019.

On March 11, 2021, a year and eight months since DiPaola’s two-day, 2019 OTR, the Staff asked for yet another OTR on March 26, 2021. DiPaola’s counsel informed the Staff that he was not available on March 26^th. On March 26, 2021 the Staff sent DiPaola’s counsel a Wells Notice and another Rule 8210 request for an OTR on April 5^th. Dipaola’s attorney responded in an e-mail, “[a]re you serious? You served a Wells Notice, you cannot take another OTR after serving a Wells Notice. Does your supervisor know what you are doing?” The FINRA Supervisor declined to withdraw the request and DiPaola failed to appear on April 5^th. Enforcement sent another 8210 requesting an OTR on April 15, 2021 which DiPaola also failed to attend.

DiPaola argued that FINRA lacked the authority to demand his testimony because FINRA’s investigation had concluded with the issuance of the Wells Notice. In making this argument, DiPaola relied on FINRA Regulatory Notice 09-17 (“RN 09-17”). RN 09-17 discusses the Wells process. Part of the process is that, after receiving a Wells Notice, the potential respondent is then given the opportunity to make a Wells Submission explaining why formal charges are unwarranted. RN 09-17 states that the Staff will review the Wells Submission “and may ask for additional information or obtain additional evidence in the matter.” DiPaola’’s attorney’s argued that no further investigation could take place until DiPaola had made a Wells Submission. The Hearing Officer disagreed.

Here is where the matter gets interesting. Enforcement sought to bar DiPaola from the industry for failing to attend the OTR. As many lawyers know, this is the standard sanction that FINRA seeks for failing to respond to an 8210 request and it is routinely granted by the OHO. For an individual who provides a partial but incomplete response to Rule 8210 requests, the Sanction Guidelines state that “a bar is standard unless (i) the person can demonstrate that the information provided substantially complied with all aspects of the request,” or (ii) mitigating factors are present. The OHO stated that it was also required to assess (i) the importance of the information sought from FINRA’s perspective, (ii) the number of requests made and, (iii) whether the respondent provided valid reasons for not responding.

Despite finding that DiPaola had no valid reason for not responding and that the information sought was important, the Hearing Panel declined to impose a bar and only imposed a 30 day suspension. The most significant factor seem to have been the issuance of the Wells Notice. The Hearing Panel determined that the act of issuing the Wells Notice meant that Enforcement had reached a preliminary determination to recommend formal discipline. The Hearing Panel decided, therefore, that DiPaola’s prior testimony and information responses before April 2021 were “significantly, if not substantially compliant with Enforcement’s Rule 8210 requests.” Notably the OHO imposed no suspension related to the other causes of action and drastically reduced Enforcement’s request of a bar with regard to the Rule 8210 violation. The OHO also reduced Enforcement’s requested fines of $32,500 to a mere $5,000.

Interestingly, it was probably the threat of a bar that caused DiPaola to take this matter to an administrative hearing in the first place. Unfortunately for DiPaola, Enforcement’s overreach likely cost him a great deal in legal fees and anxiety. Despite this win, he probably wishes he had gone to that OTR in the first place.

Herskovits PLLC has a nationwide practice defending FINRA investigations and disciplinary proceedings. Feel free to call us for a consultation at (212) 897-5410.

FINRA HEARING PANEL REJECTS “NO HARM, NO FOUL” DEFENSE

Herskovits, PLLC — Mon, 11 Jul 2022 15:22:07 GMT

On July 7, 2022, FINRA’s Office of Hearing Officers issued its decision in Dep’t of Enforcement v. Burford, Discip. Proc. No. 2019064656601 (OHO July 7, 2022). Here, the Hearing Panel found that Burford caused no customer harm. There was no evidence that Burford gained monetarily from his actions. Burford was “polite, respectful, and cooperative” throughout the investigation and disciplinarily proceeding. Nonetheless, the Hearing Panel refused to deem these factors “mitigating” and whacked Burford with a 6-month suspension – double the suspension sought by Enforcement – and $10,000 fine. At its core, this is a case of registered representative alleged to have improperly taken instructions from a deceased customer’s widow. This case highlights the perils of efforts by a financial adviser to assist an individual when those efforts skirt the policies of a broker-dealer.

Background Facts

Burford was registered with Hilltop Securities Independent Network, Inc. In November 2019, Hilltop discharged Burford and filed a Form U5 alleging a “failure to follow firm policy regarding the death of a client.”

FINRA alleged that Burford failed to notify Hilltop that one of his customer’s (a first cousin of Burford’s wife) passed away in October 2016. The customer had a trading authorization agreement on file permitting Burford to accept trading instructions from the customer’s wife. After the customer’s death, Burford executed 9 trades at the instruction of the decedent’s widow and facilitated 8 ACH disbursements to the widow. The post-death trading activity and money movements came to light when the decedent’s daughter (the adult child from a prior marriage) challenged the customer’s will and petitioned the probate court to restrain the widow from any further disposition of the decedent’s property. Apparently, the widow did not file the will for probate until February 2019, more than 2 years after her husband’s passing. Under Texas law, the right to inherit under a will is not effective until the will is admitted to probate.

FINRA’s Enforcement Department filed a one-count Complaint in September 2021 alleging that Burford violated FINRA Rule 2010 (requiring registered representatives “to observe high standards of commercial honor and just and equitable principles of trade”) by engaging in unauthorized trading and withdrawals. Specifically, FINRA alleged that the trading authorization terminated upon the customer’s death and, in any event, the trading authorization never permitted money movements. According to FINRA, until the probate court admitted the will for probate and issued letters testamentary, no one had authority to direct transactions in the decedent’s brokerage account.

Burford defended the Complaint by alleging that (a) the widow was the named executor and primary beneficiary of the customer’s will; (b) the widow directed and authorized the transactions and money movements; and (c) the activity in question served the widow’s best interests.

The Hearing Panel’s Findings

The Hearing Panel found numerous “aggravating factors:”

Burford effected the transactions over a lengthy period of time (3 years).
The value of the transactions was “high” (more than $200,000).
Burford “concealed” his actions from Hilltop by failing to timely submit the certificate of death and failing to inform Hilltop of the transactions effected after the customer’s death.

Importantly, the Hearing Panel rejected the “no harm, no foul” defense by finding that the harm was the “potential legal risk” to himself and Hilltop caused by the activity in question. Even though a “misguided attempt” to act in a customer’s best interest may be mitigating (Dep’t of Enforcement v. Noard, No. 2012034936101, 2017 FINRA Discip. LEXIS 15, at *29-30 (NAC May 12, 2017) (A respondent’s misguided attempt to act in a customer’s best interest may be mitigating)), the Hearing Panel found that the widow was not Burford’s customer and refused to treat any of Burford’s actions as mitigating. See Dep’t of Enforcement v. Correro, No. E102004083702, 2008 FINRA Discip. LEXIS 29, at *16 (NAC Aug. 12, 2008) (finding that a goal to benefit a customer is not a defense to a violation of NASD Rule 2110, the predecessor to FINRA Rule 2010); Dep’t of Enforcement v. Sears, No. C07050042, 2009 FINRA Discip. LEXIS 4, at *3-6, 11 (NAC July 23, 2009) (Rule 2010 violation found for unauthorized trading even though there was no evidence that respondent “acted in bad faith …. gained any commissions on the [ ] unauthorized trades, or was otherwise motivated by selfish interests.”).

This case serves as a stark reminder that efforts to appease a customer (or, here, a non-customer) may nonetheless be viewed by FINRA as a serious rule violation.

Herskovits PLLC has a nationwide practice representing individuals and broker-dealers in FINRA investigations and disciplinary proceedings. Feel free to call us for a consultation. (212) 897-5410.

FINRA HITS AN FA FOR RUNNING A SUBSCRIPTION-BASED INVESTOR WEBSITE

Herskovits, PLLC — Fri, 20 May 2022 12:48:55 GMT

On May 16, 2022, FINRA published an Acceptance, Waiver and Consent (“AWC”) in which FA, Robert Bennett Zamani, accepted a 14-month suspension and a $27,500 fine for violations of FINRA Rule 3270 (Outside Business Activities), Rule 2210 (Communications with the Public), Rule 4511 (Books and Records) and, as always, Rule 2010 (Standards of Commercial Honor). The investigation of Zamani was triggered by a Form U5 filed by his former firm, Morgan Stanley.

The Rule 4511 violation was based on Zamani’s alleged use of business-related text messages that were not retained by Morgan Stanley, effectively causing Morgan Stanley to violate its obligation to maintain such communications under Rule 4511. This is an easily avoidable rule violation that many FAs fall prey to.

More interesting, however, are Zamani’s alleged violations of 3270 and 2210. Zamani formed a company in 2015 before becoming associated with Morgan Stanley. Without ever disclosing the company to Morgan Stanley, between January 2017 and April 2020, Zamani, through this company, offered subscription-based investment content. On its website, which was established and operated by Zamani, the company touted itself as a subscription-based platform providing investment content for aspiring day traders to “learn from professionally licensed stock traders the skills needed to become a profitable trader.” The company maintained a blog on its website, containing investment-related content, and maintained a publicly-available YouTube channel, with investment-related videos and distributed periodic newsletters to subscribers. Remarkably, during that 3-year stretch, Zamani earned $360,000 from his subscriber-based investment advice company.

FINRA Rule 2210 requires “an appropriately qualified registered principal of the member to approve each retail communication . . . .” Retail communication is defined broadly as “any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.” A retail investor is anyone other than an institutional investor “regardless of whether the person as an account with a member.”

An important exception to this review process is that it does not apply to a communication “that does not make a financial or investment recommendation or otherwise promote a product or service of the member.” Interestingly, the AWC accuses Zamani of “disseminating investment-related communications” which is significantly different from the language in the rule, which requires the recommendation of an investment or promotion of a product.

FINRA Rule 2210 not only calls for a review of communications with the public but also sets forth Content Standards and Zamani was accused of violating several of these standards. The AWC accused Zamani of disseminating communications that (a) were not fair and balanced because, among other things, he failed to explain any risk associated with investing, (b) made “promissory statements” regarding returns, (c) made projections of investment performance, (d) contained testimonials without the required disclosures, (e) contained securities recommendations without the required disclosures, (f) contained performance data without the required disclosures, and (g) failed to disclose Zamani’s association with Morgan Stanley. Each of these Content Standards are specifically addressed under Rule 2210.

As you might imagine, Zamani apparently never disclosed this activity to Morgan Stanley or asked Morgan Stanley to review and approve any of the communications he released through YouTube, his website or his newsletters. Undoubtedly, Morgan Stanley would not have permitted any of it and a profit of $360,000 over three years is likely more money than Zamani was making at Morgan Stanley.

Zamani’s alleged conduct violated FINRA Rules 3270 and 2210. This was not a close case but FA’s should be knowledgeable about the constraints of Rule 2210. It is one of FINRA’s more complicated and detailed rules and FA’s would be well advised to seek legal or compliance advice before sending any investment-related communication to more than 25 people.

Herskovits PLLC has a nationwide practice defending investigations by FINRA, the SEC and state securities regulators. Call us for a consultation at (212) 897-5410.

FINRA RULE 3280: WHAT DOES IT MEAN TO “PARTICIPATE” IN A PRIVATE SECURITIES TRANSACTION?

Herskovits, PLLC — Mon, 25 Apr 2022 16:36:12 GMT

Most financial industry professionals are familiar with the prohibition on “selling away,” the somewhat ambiguous term contemplated by FINRA Rule 3280. FINRA Rule 3280 states that, “[n]o person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule.” Among other things, the Rule requires a financial advisor to provide written notice prior to participating in a private securities transaction even when the financial adviser receives no compensation.

While it is generally understood that FAs cannot sell securities to customers that are not offered by their broker-dealer without first receiving permission from the broker-dealer, much of the guidance around this rule focuses on what qualifies as a private securities transaction (a term that is arguably poorly defined in the Rule). Many financial advisers, however, are unaware of how broadly FINRA interprets what it means to “participate” in a private securities transaction.

FINRA recently made a determination (not yet publicly released) that a registered representative “participated” in a private securities transaction because he; a) set up a zoom conference call between the outside fund manager and the investor, b) forwarded the original offering materials to the investor, and c) forwarded amended offering materials approximately a year after the original investment.

To support the determination that this level of involvement constituted participation, FINRA’s Staff cited a footnote in a 21-year-old notice to members which states the following:

Associated persons are reminded that “participation” in a securities transaction includes not only making the sale, but referring customers, introducing customers to the issuer, arranging and/or participating in meetings between customers and the issuer, or receiving a referral or finder’s fee from the issuer.

NTM 01-79 n. 7.

FINRA’s Staff also cited In the Matter of the Application of Mark H. Love, Exchange Act Release No. 49248 (Feb 13, 2004). In Love, the financial adviser introduced several customers to the manager of a fund but the SEC found he did much more than just pass along a telephone number. “He effectively vouched” for the fund manager. Love told at least one client that he was personally interested in investing in the fund. Love also facilitated transfers of funds from his client’s brokerage accounts to the fund and when the fund became illiquid, Love interceded on his clients’ behalf.

The SEC in Love emphasized that the word “participate” should be read broadly. To support this, however, the Commission cited to two SEC actions involving reps who received compensation for referring customers to an outside investment. Thus, the question of their participation was never really in question at all.

Most interestingly, the SEC said the following:

we wish to emphasize that a broker who does nothing more than refer a customer to another investment opportunity should not ordinarily run afoul of Rule 3040 [now Rule 3280], where, as here, the broker becomes involved in a customer’s investment choice through a specific recommendation and by facilitating the mechanics of transactions, we believe that such participation fits within the broad range of behavior prohibited by Rule 3040.

(Emphasis added). This seems to directly contradict the footnote cited by FINRA in NTM 01-79 which states that merely “introducing customers to the issuer” could be deemed “participation.”

While the current guidance from regulators is far from clear, there are some common elements in instances in which regulators found that financial advisors violated FINRA Rule 3280 even when the financial advisors did not receive compensation or invest in the securities themselves. Here are some examples of actions that lead to a finding of “participation:” a) facilitating the investment by moving funds from the clients’ brokerage accounts or by delivering checks, b) delivering offering documents to or from the outside issuer, c) indicating that the adviser is interested in the investment, or d) acting as an intermediary between the issuer and the clients.

Ultimately, as in most compliance related matters, it always wise not to leave yourself at the mercy of how the regulators interpret a word such as “participate.” It is also wise not to take the SEC statement at face value that, “a broker who does nothing more than refer a customer to another investment opportunity should not ordinarily run afoul of Rule 3040.” Financial advisers should trust that FINRA will always find “something more” than a mere introduction and require disclosure of such introductions, in writing, to their firm.

Herskovits PLLC has a nationwide practice defending FINRA investigations and disciplinary proceedings. Feel free to contact us at (212)897-5410.

GAG ORDERS USED BY FINRA UNDER REVIEW BY SCOTUS

Herskovits, PLLC — Tue, 19 Apr 2022 19:56:51 GMT

When settling a FINRA investigation, the Staff drafts a letter of Acceptance, Waiver and Consent (AWC) setting forth the terms of the settlement. In the AWC, FINRA routinely demands the settling party consent to the following restraint on speech:

“Respondent may not take any action or permit to be made any public statement, including in regulatory filings or otherwise, denying directly or indirectly, any finding in this AWC or create the impression that the AWC is without factual basis.”

A matter before the U.S. Supreme Court may upend FINRA’s use of a gag order.

Case In Point

On March 21, 2022, Barry Romeril filed a petition for writ of certiorari (Romeril v. Securities and Exchange Commission). Romeril asks the Court to consider whether First Amendment and due process rights are violated when the SEC forces a settling party to agree to a lifelong prior restraint barring any statement, however truthful, that even suggests that any allegation of the SEC is insupportable.

In 2003, Romeril settled an action initiated by the SEC. As part of the settlement and judgment, the SEC demanded a non-negotiable “consent” clause stating:

“Defendant agrees not take any action or permit to be made any public statement denying directly or indirectly, any allegation in the complaint or create the impression that the complaint is without factual basis.”

It is noteworthy that the SEC and CFTC systematically demand broad restraints on speech as a condition of settlement. See generally James Valvo, The CFTC and SEC Are Demanding Unconstitutional Speech Bans in their Settlement Agreements, Yale J. on Reg.: Notice & Comment Blog (Dec. 4, 2017). In so doing, settling parties are without defense in the court of public opinion.

Would FINRA Abide by an Adverse Ruling in Romeril?

If the Supreme Court accepts Romeril’s petition, the Court would determine the legality of the SEC’s gag order. Although the SEC’s gag order is identical in substance to FINRA’s gag order, FINRA is not a party to Romeril and it is unclear whether FINRA would abide by a ruling striking down the gag order.

FINRA goes to great lengths to proclaim that it is a “private entity” and not a “governmental body” bound by the U.S. Constitution. See e.g., D.L. Cromwell Inv., Inc. v. NASD Regulation, Inc. 279 F.3d 155, 162 (2d Cir. 2002). For example, in reliance upon this distinction, FINRA chooses not to recognize an individual’s right to invoke the Fifth Amendment privilege against self-incrimination in connection with on-the-record interviews. Nonetheless, FINRA does recognize certain Constitution-based rights. For example, in disciplinary proceedings, FINRA’s staff must turn over “Brady material” to the respondent (documents containing exculpatory material). See Dep’t of Enforcement v. Southeast Inv., N.C., Inc., 2019 FINRA Discip. LEXIS 23 *14 (NAC May 23, 2019) (interpreting FINRA Rule 9253).

Given that the gag order contained in an AWC mirrors the language within the SEC’s standard gag order, it would seem appropriate for FINRA to follow any guidance from the Supreme Court in Romeril.

Herskovits PLLC has a nationwide practice defending individuals and entities in FINRA investigations and disciplinary proceedings. Contact us at 212-897-5410.

FINRA Enforcement Puts Chief Compliance Officers on Notice

Herskovits, PLLC — Tue, 22 Mar 2022 16:10:59 GMT

On March 17, 2022, FINRA released Regulatory Notice 22-10.

The regulatory guidance discusses the application of FINRA Rule 3110 – Supervision — as it relates to Chief Compliance Officers (“CCOs”). The notice begins by making it clear that, as a general matter, supervision is the responsibility of the senior business management and compliance personnel serve in an advisory role rather than supervisory. FINRA notes however, that it will bring enforcement actions against CCOs in circumstances when a firm has expressly or impliedly designated its CCO as having supervisory responsibility.

FINRA explains that a CCO may have supervisory responsibility in a number of ways. For example, the CCO may have dual roles as both CCO and business management. The CCO as management would have a responsibility to supervise or delegate such supervision under Rule 3110. A firm may also designate its CCO as a supervisor as part of its written supervisory procedures. A firm’s president or CEO could also “expressly or impliedly” designate the CCO as a supervisor over a particular issue on an ad hoc basis or for exigent circumstances.

FINRA is silent on what would constitute a CCO being “impliedly” designated as a supervisor. This seems to leave CCO’s in a precarious position whereby firm management, who has the primary responsibility to supervise, could sacrifice the CCO to regulators by pointing to an “implied designation” that was not perceived as such by the CCO at the time.

Once designated, a CCO is held to the same standard as any other supervisor and will be subject to regulatory scrutiny if he or she fails to discharge their supervisory responsibilities in a “reasonable manner.” FINRA provided the following list of factors that weigh in favor or charging or not charging a CCO with a regulatory violation:

Factors that Favor Charging the CCO for Supervisory Lapses

(1) the CCO was aware of multiple red flags or actual misconduct and failed to take steps to address them;

(2) the CCO failed to establish, maintain, or enforce a firm’s written procedures as they related to the firm’s line of business;

(3) the CCO’s supervisory failure resulted in violative conduct (e.g., a CCO who was designated with responsibility for conducting due diligence failed to do so reasonably on a private offering, resulting in the firm lacking a reasonable basis to recommend the offering to its customers); and

(4) whether that violative conduct caused or created a high likelihood of customer harm.

Factors that Weigh Against Charging the CCO for Supervisory Lapses

(1) the CCO was given insufficient support in terms of staffing, budget, training, or otherwise to reasonably fulfill his or her designated supervisory responsibilities;

(2) the CCO was unduly burdened in light of competing functions and responsibilities;

(3) the CCO’s supervisory responsibilities, once designated, were poorly defined, or shared by others in a confusing or overlapping way;

(4) the firm joined with a new company, adopted a new business line, or made new hires, such that it would be appropriate to allow the CCO a reasonable time to update the firm’s systems and procedures;

(5) the CCO attempted in good faith to reasonably discharge his or her designated supervisory responsibilities by, among other things, escalating to firm leadership when any of (1)–(4) were occurring.

The ultimate take away from this notice is that CCOs and compliance personnel do not automatically have any responsibility to supervise under FINRA Rule 3110. If they are designated as supervisors, however, they have the same responsibilities as any other supervisor under the rule. As noted above, FINRA’s guidance that a CCO can be implicitly designated as a supervisor should give CCOs some pause. If there is any doubt or confusion about whether a CCO has been designated as a supervisor by implication, it is certainly wise for the CCO to confirm that designation explicitly and in writing.

Herskovits PLLC has a nationwide practice defending individuals and broker-dealers faced with a FINRA investigation or disciplinary proceeding. Feel free to contact us for a consultation at (212) 897-5410.

Will We See a Spike in Margin Liquidations Due to SEC Guidance?

Herskovits, PLLC — Tue, 15 Mar 2022 20:04:14 GMT

We are all painfully aware of the recent volatility in the markets, which has not gone unnoticed by the SEC. On March 14, 2022, the Staff of the Division of Trading and Markets stated that “broker-dealers should collect margin from counterparties to the fullest extent possible in accordance with any applicable regulatory and contractual requirements.” We shall see whether Wall Street acts upon the SEC’s guidance, and whether investors are caught flat-footed by stepped-up maintenance margin requirements.

Regulatory and Contractual Requirements

The regulatory requirements for margin are set forth in FINRA Rule 4210. Although the rule is lengthy, and incorporates other rules including Federal Reserve Board Regulation T, the essence of the rule allows a broker-dealer to lend a customer up to 50% of the total purchase price of an eligible stock. A margin call may be issued if the margin account falls beneath the maintenance margin requirements (generally 25% of the current market value of the securities in the account) or if the margin account falls below the firm’s “house” maintenance margin requirements (which can be substantially higher than 25%). Brokerage firms can, and often do, upwardly adjust “house” maintenance margin requirements if the firm has risk concerns relating to outstanding margin loans. Most margin account agreements specifically permit broker-dealers to increase maintenance margin requirements at the sole discretion of the firm. In light of the SEC’s recent guidance, it seems likely that broker-dealers will act upon its contractual rights and demand enlarged collateral from customers to protect its margin loans.

More Volatility Expected

A primary gauge of stock market volatility is the CBOE Volatility Index (VIX). The VIX volatility index measures how much volatility professional investors think the S&P 500 will experience over the coming month. The VIX index tracks volatility by analyzing trading in S&P 500 options. As a general proposition, a VIX index of 12 or lower is a period of low volatility and a VIX index of 20 or higher is abnormally high volatility. Currently, the VIX index currently sits at 31.04, which is approximately double where it sat in early January 2022.

Increase in FINRA Arbitration Claims?

Undoubtedly, any sizable increase maintenance margin requirements will trigger margin calls. That, coupled with abnormal market volatility, is a recipe for increased FINRA arbitration claims. Investors will point fingers at brokerage firms over suitability and brokerage firms will point fingers at investors for any unsecured debit balances.

Herskovits PLLC has a nationwide practice defending and prosecuting claims in FINRA arbitration. Feel free to call us for a consultation at (212) 897-5410.

Summary of FINRAs Examination and Risk Monitoring Program Findings for 2022

Herskovits, PLLC — Mon, 07 Mar 2022 20:34:52 GMT

FINRA recently published its 2022 Report on FINRA’s Examination and Risk Monitoring Program to provide member firms with guidance and insights gathered by FINRA’s Examinations and Risk Monitoring programs over the course of the year. The report also serves to inform firms what FINRA sees as “emerging” compliance risks that FINRA’s Examinations and Risk Monitoring programs intend to focus on for 2022.

Among the various areas covered by the report is a section addressing outside business activities (“OBAs”) (FINRA Rule 3270) and private securities transactions (“PSTs”) (FINRA Rule 3280). FINRA noted in its “Exam Findings” section a number of common mistakes being made by firms.

FINRA Rule 3270 requires registered representatives to notify their firms in writing of any proposed outside business activity. Member firms are then required to “evaluate the advisability of imposing specific conditions or limitations on a registered person’s outside business activity, including where circumstances warrant, prohibiting the activity.”

FINRA Rule 3280 requires registered representatives to notify their firms in writing of any proposed PST and get firm approval for any PST for which the registered representative will receive compensation. A firm approving a PST where the associated person has or may receive selling compensation must record and supervise the transaction as if it were executed on behalf of the firm.

Exam Findings

The first finding concerned the failure to properly interpret the rules. FINRA found that firms were interpreting “compensation” too narrowly and not taking into account such things as the registered representatives’ receipt of membership interests, preferred stock or even tax benefits. FINRA found instances where no notice of an OBA or a PST was provided which is an obvious rule violation. FINRA also found that firms were not retaining the necessary documents to demonstrate compliance with the rule, such as documentation of the review, approval or disapproval of OBA and PST notices.

Where firms’ approvals contained limitations, such as not soliciting firm clients, FINRA found that firms failed to monitor if these limitations were being followed. FINRA also found that firms were incorrectly assuming that all digital assets were not securities and therefore not categorizing certain transaction as PSTs.

FINRA Recommended “Effective Practices”

Not surprisingly, FINRA suggests that registered representative be required to complete periodic questionnaires regarding their involvement or potential involvement in any PST or OBA. This would seem to be a fairly universal practice among firms. As a side note, “potential involvement” is an area that gets many financial advisors in trouble. Approval must be sought before any action is taken by the registered representative. It is not uncommon for a registered representative to set up a company for some future, sometimes even unknown, purpose. Even if the company is inactive, it must be disclosed before it is formed.

Some of FINRAs other suggested practices are a bit more extreme. For example, Firms may be surprised to find that FINRA expects them to not only review the PST or OBA at the time of disclosure but continue to monitor it through periodic reviews of social media, internet websites, e-mails and interviews of registered representatives.

FINRA also suggests monitoring the other “red flags” such as the changes in a registered representatives’ “performance, production levels or lifestyle . . . .” FINRA recommends regular, periodic background check and reviews of such things as bank statements and tax returns.

Key Takeaways

It seems likely that few firms have procedures in place for monitoring OBAs and PSTs that include “regular, periodic background checks” or regular reviews of registered representatives’ tax returns and bank statements or “lifestyle.” Similarly, it is hard to envision a firm that regularly reviews registered representatives’ social media accounts. Indeed, at larger firms, such monitoring and supervision would likely be a full time job for several employees. That being said, FINRA’s report makes it clear that firms must do more than simply having registered representatives fill out an annual questionnaire. FINRA also makes it clear that, even if a firm conducts a thorough review at the time of approval an OBA or PST, a firm must also having procedures in place to continue to monitor and supervise that OBA or PST after that initial approval.

Herskovits PLLC has a nationwide practice defending against FINRA investigations and disciplinary proceedings. Feel free to contact us at (212) 897-5410 for a consultation.

FORM U4 CRIMINAL HISTORY DISCLOSURES

Herskovits, PLLC — Fri, 21 Jan 2022 21:49:09 GMT

Maybe you were caught using a fake ID when you were in college or maybe you got into a heated exchange after a fender bender. Each of these could lead to a variety of criminal charges that vary by state and by prosecutorial discretion. Criminal charges have obvious negative consequences. Many people however – even criminal defense attorneys – ignore the more subtle issue of whether or not a registered representative will have to disclose these indiscretions on FINRA’s Form U4 and publicly display them on BrokerCheck.

What Needs to be Disclosed on Form U4?

The Form U4 requires registered representatives to disclose if they have ever been “convicted of or pled guilty or nolo contendere (“no contest”) in a domestic, foreign, or military court to any felony” or if they have been “charged with any felony.” The Form U4 also requires the disclosure of any conviction, guilty plea or nolo contendere plea for any “misdemeanor involving: investments or an investment-related business or any fraud, false statements or omissions, wrongful taking of property, bribery, perjury, forgery, counterfeiting, extortion, or a conspiracy to commit any of these offenses” or if the registered representative has ever been charged with such a misdemeanor.

What at first blush seems straightforward is actually quite complicated. What if the state, such as New Jersey, does not have felonies or misdemeanors? FINRA defines these terms to help with these questions. For example FINRA explains that, “[f]or jurisdictions that do not differentiate between a felony or misdemeanor, is an offense punishable by a sentence of at least one year imprisonment and/or a fine of at least $1,000.” FINRA’s other definitions and guidance, however, can be less helpful.

What does it mean to be charged?

Here again FINRA provides a definition for the word “charged”. According to FINRA: “Charged: Means being accused of a crime in a formal complaint, information, or indictment (or equivalent formal charge).” The problem with this definition is that many states and municipalities use the term “charged” very differently. For example, a police officer may fill out an arrest report that may ask him or her to designate what crime you have been “charged” with. On more than one occasion, we have seen instances where the arresting police officer indicated that the registered representative was being “charged” with a felony only to have the prosecutor immediately change that “charge” to a misdemeanor. FINRA’s staff agrees that the police officer’s “charge” is not a “formal complaint, information or indictment.” Only a prosecutor can bring formal charges. However, the court paperwork will rarely, if ever, make a clear distinction between the police report charges and the prosecutors’ formal charges. In most cases, it will appear in the records as if the prosecutor decided to merely reducing the initial charge, which would make the initial felony charge still reportable. This can only be resolved (to FINRA’s satisfaction) by obtaining a letter from the court or the prosecutor’s office attesting that the prosecutor never formerly charged the registered representative with a felony. Obviously, this is not an easy task to accomplish.

Which Misdemeanors Involve “False Statement or Omissions” or “Forgery”?

What about the fake ID we mentioned before? This is a particularly tricky issue because different states have various criminal statutes that might apply to the possession of a fake ID. In New York, for example, the prosecutor might charge a person with misdemeanor level, “Criminal Possession of Forged Instrument.” So that would seem to clearly fall under a disclosable forgery. A “forged instrument” however, is defined under New York’s Penal Code as a “written instrument which has been falsely made, completed or altered.” So what if your fake ID was not an altered instrument but just someone else’s license who looked like you? You may still be guilty of violating New York Vehicle and Traffic Law § 509(6) which prohibits “any person at any time possess or use any forged, fictitious or illegally obtained license, or use any license belonging to another person.” Is the charge now not disclosable because you did not alter the ID? In addition, is a New York Vehicle and Traffic law a misdemeanor? What if you lied to arresting officer about your age when you were found with the fake ID.? In some states, that is a separate crime. Are you now back in the world of a disclosable “false statement” misdemeanor? The answer, of course, is that every arrest and criminal charge has its own peculiarities that require an in-depth and individualized analysis.

FINRA provides little guidance on this issue but in one example, a registered representative was accused by FINRA’s Enforcement Department of violating FINRA Rule 2110 by failing to report that he had been charged with a misdemeanor for possessing a “false and fraudulent written, printed and phototoxic evidence of age and identity.” The registered rep reported the misdemeanor at a prior firm, but when he joined a new firm, the compliance officer advised him it was not reportable. Enforcement did not contest this. A FINRA Hearing Panel found that “the applicability of those terms [false statements and omissions] to a fake ID charge is not so clear that it was unreasonable for Smith to rely on the compliance officer’s advice that he was not required to disclose the charge.” See Department of Enforcement vs. Smith. What About Criminal Records That are Sealed or Expunged?

FINRA’s guidance provides that if, “the purpose of an order to set aside a conviction is to restore the individual to the position he would have been in if the conviction had never been entered; in such case, the conviction is not reportable.” Each state has a different statute for sealing, expunging or setting aside criminal records. FINRA states that any such order should be submitted to the Registrations and Disclosures Department (“RAD”) for review to determine if a conviction is disclosable.

In theory, the guidance above would imply that if a matter has been sealed but not fully expunged then it is still needs to be disclosed. In practice however, RAD staff have verbally advised that fully sealed criminal records, i.e. ones that do not appear on any fingerprint background check, do not need to be disclosed. As such, if a rep has a criminal record that has been sealed it is important to confirm that the court personnel notified all of the necessary agencies to ensure that the records are not reflected in the FBI’s database.

Ultimately, whether a criminal charge requires disclosure is often a complicated analysis. Many criminal defense attorneys are completely unaware of FINRA’s reporting rules and might bargain for a particular charge or adjudication that looks great from the criminal law perspective but could potentially cost their client their career.

Feel free to contact Herskovits PLLC for securities industry regulatory and litigation advice. We can be reached at 212-897-5410, www.herskovitslaw.com

FINRA HITS AN FA FOR REASONABLE-BASIS SUITABILITY VIOLATION WITH NON-TRADITIONAL ETFs

Herskovits, PLLC — Wed, 07 Jul 2021 20:39:22 GMT

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

NT-ETFs are designed to return a multiple of an underlying index or benchmark, the inverse of that benchmark, or both, over only the course of one trading session — usually a single day. NT-ETFs typically rebalance their portfolios on a daily basis (also known as the “daily reset”). Due to the effects of compounding of daily returns during the holding period, the performance of NT-ETFs over periods longer than a single trading session “can differ significantly from the performance … of their underlying index or benchmark during the same period of time.” FINRA Regulatory Notice 09-31, FINRA Reminds Firm of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009). Because of that feature, FINRA has stated that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” FINRA Regulatory Notice 09-31 at 1. Rule at Issue: FINRA Rule 2111

To make a suitable recommendation, FINRA requires that FAs first understand the risks and rewards of a proposed investment. FINRA deems this a “reasonable-basis suitability obligation.” Thus, an FA can run afoul of Rule 2111 if the FA lacks an understanding of the product even if the product was otherwise appropriate given the investor’s wealth, willingness to bear risk, age, or other individual characteristics.

Facts at Issue

With the Pearl AWC, FINRA found that the FA failed to perform a reasonable basis suitability analysis for two reasons: (a) the customers held the NT-ETFs for periods ranging from 100 to 600 days; and (b) Pearl did not understand that losses in NT-ETFs compounded because of how valuations reset each day.

Herskovits PLLC maintains a nationwide practice defending FINRA and SEC investigations and enforcement proceedings. Please feel free to contact Robert Herskovits for a consultation at 212-897-5410.

FINRA SEEKS TO LIMIT EXPUNGEMENT REQUESTS WITH PROPOSED RULE

Herskovits, PLLC — Mon, 28 Sep 2020 00:58:22 GMT

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

FINRA proposes to change Rule 12203 (Customer Code) and Rule 13303 (Industry Code) to require the Director of Arbitration “to decline the use of the FINRA arbitration forum if the Director determines the expungement request is ineligible for arbitration under Rule 12805.”

Proposed Rule 12805 will provide substantial limitations on expungement requests as noted below:

Requesting Expungement When FA is Named as a Respondent in an Arbitration

The associated person must seek expungement in the arbitration or shall be prohibited from seeking expungement at a later date. The associated person must include the expungement request in the answer or other pleading. The expungement request must include the applicable fee, CRD number of the party requesting expungement, CRD occurrence number that is the subject of the request, the case name and docket number that gave rise to the customer dispute information if applicable, and an explanation of whether expungement was previously sought and, if so, how it was decided.
The associated person shall be prohibited from seeking expungement if (a) an arbitrator previously considered a request for expungement of the same customer dispute information; or (b) a court previously denied a request to expunge the same customer dispute information.
If the arbitration settles, the panel cannot consider the expungement request and the associated must initiate a new arbitration against the member firm to obtain expungement.

Requesting Expungement on Behalf of an Unnamed Person

A broker-dealer shall be prohibited from seeking expungement on behalf of an unnamed person if (a) an arbitrator previously considered a request for expungement of the same customer dispute information; or (b) a court previously denied a request to expunge the same customer dispute information
The unnamed associated person must sign a form permitting the broker-dealer to seek expungement on her behalf.
The unnamed is prohibited from intervening in the arbitration if the broker-dealer elects not to seek expungement on behalf of the unnamed person.
If the arbitration settles, the panel cannot consider the expungement request and the associated must initiate a new arbitration against the member firm to obtain expungement.

Straight-in Expungement Requests

An associated person is prohibited from filing an expungement claim if (a) an arbitrator or court previously denied a request to expunge the same customer dispute information; (b) the customer complaint or arbitration that gave rise to the customer dispute information is not closed; (c) more than 2 years have passed since the arbitration or litigation that gave rise to the customer dispute information has closed, or more than 6 years have passed since the customer complaint was reported to CRD.
The customer must be notified of any expungement hearing.
A panel of 3 public arbitrators with certain qualifications will hear the expungement request.

Expungement Hearing

The panel must hold a recorded hearing.
The associated person must appear at the hearing. A party requesting expungement on behalf of an unnamed person must also appear at the hearing.
The customer has a right to appear at the hearing or otherwise state his position in writing. The customer has the right to testify at the hearing and offer opening and closing arguments.
The panel must review any settlement agreement and consider the amount of payments and other terms of the settlement agreement. The panel must inquire whether a party conditioned a settlement on the customer’s non-opposition of the expungement request.

Herskovits PLLC has a nationwide practice prosecuting and defending FINRA arbitration claims, including expungement requests. Feel free to call us for a consultation. 212-897-5410.

FINRA ISSUES REPORT ON ARTIFICIAL INTELLIGENCE IN THE SECURITIES INDUSTRY

Herskovits, PLLC — Tue, 21 Jul 2020 16:48:38 GMT

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

FINRA notes that firms are using AI in many different ways including, among other things, bolstering compliance and surveillance functions, assisting in making suitability determinations, automating operations, algorithmic trading, portfolio management and communicating with customers.

Customer Communication

Remarkably, FINRA noted that at a few firms, virtual assistants are accepting and processing trade orders within certain thresholds although FINRA did not elaborate on what those thresholds are. Some firms noted that they are experimenting with the development of virtual assistant applications available to customers through third-party platforms, such as Amazon’s Alexa, Google’s Home Assistant, and Apple’s Siri. FINRA warned, however, that these applications may also pose certain challenges and potential risks, surrounding customer authentication, data privacy, cybersecurity, and recordkeeping.

Marketing and Suitability

Some firms are creating “holistic customer profiles,” using data from a variety of sources such as a customer’s phone and e-mail interactions, social media updates, web browsing on the firm’s website, spending patterns and customer assets (held both at the firm and outside the firm). All of this information is analyzed using AI tools that can help a registered representative better tailor their suggestions for new products and have a better understanding of what is suitable for an investor. FINRA noted that the firms it spoke with were all cautious about employing AI tools that may offer investment advice and recommendations directly to retail customers, citing several legal, regulatory, and reputational concerns.

Customized research

FINRA’s report noted a growing use of AI tools to provide curated market research directly to customers to share relevant information on various investment opportunities. For example, as noted in the earlier section, AI-based tools may offer customers social media data and related sentiment analysis on investment products and asset classes.

While these AI tools offer the potential to customize investment suggestions for customers, FINRA warned of potential concerns and challenges related to data privacy, use of corrupt or misleading data. FINRA also warned that firms using AI still need to “adapt[] to each customer’s unique circumstances” which seems to indicate that reliance on AI alone will not suffice to meet a firm’s suitability obligations.

Portfolio management and trading

Algorithmic trading and portfolio management is probably the most well-known use of AI in the securities industry. The significant take away from this portion of the paper was FINRA’s warning that some AI might not be sophisticated enough to produce reliable predictions in the face of natural disasters unusual market volatility.

Compliance and Risk Management

According to one survey of 100 firms 70% were using AI in their compliance and risk management tools. Firms are using AI for surveillance and are able to aggregate communications across various channels, such as emails, social media, and text messaging. Firms noted that these tools gave them the ability to move beyond a traditional lexicon-based review to a more risk-based review, such that they could decipher tone, slang, or code words, which may be indicative of potentially risky or non-compliant behavior. Firms are using AI surveillance to detect potential money laundering, terrorist financing, bribery, tax evasion, insider trading, market manipulation, and other fraudulent or illegal activities.

FINRA noted that firms using AI to assess credit risk management and particularly the credit worthiness of counterparties have unique concerns regarding what FINRA termed “discriminatory credit scoring based on biases present in the underlying historical data.” This is likely a reference to certain credit risk management AI applications that have proven controversial because of the resulting decisions to not extend credit to minorities to a degree that is well out of proportion to the population.

Regulatory Concerns

FINRA devoted the third section of its report to various regulatory concerns surrounding AI.

Supervision

The report notes that FINRA Rule 3110 regarding supervision still applies despite the use of technology. Firms are required to supervise their AI applications and will be held responsible for any failures that arise from lack of supervision. In this regard FINRA suggests, among other things, building a layer of human review of AI inputs to ensure accuracy and completeness and testing to ensure that outputs are in line with business goals, internal policies, procedures, and risk appetite. FINRA warns that “explainability,” i.e. understanding why a machine has made a particular determination, may be particularly important in AI applications that have autonomous decision-making features (e.g., deep learning-based AI applications that trigger automated investment decision approvals). The vast majority of firms that FINRA spoke with stated that their machine learning applications do not involve autonomous action but are instead used to aid human decision-making.

Data Bias

Machine Learning AI relies on large amounts of data to inform decision making. FINRA warns that underlying data must be “complete current and accurate.” FINRA noted that inaccurate data may lead to “inappropriate decision making” which could be a violation of FINRA Rule 2010 which requires firms in the conduct of their business, to observe high standards of commercial honor and just and equitable principles of trade. It is unclear what “inappropriate decision making” FINRA is referring to here but perhaps this is a veiled reference to the reports of AI models rejecting large numbers of minority loan applicants noted above.

Customer Privacy

As noted above, most AI applications rely on the collection of large amounts of data including information regarding customers. While mining this data can help firms provide better service to customers and suggest more suitable investment strategies, the collection and storage of this information poses distinct risks regarding the maintenance of customer privacy. FINRA advises firms to update customer consent forms to reflect any new information that is being gathered such as biometric or social media activity. FINRA also advises that firms review and update all of their policies and procedures with regard to customer privacy in light of new technology being implemented.

Trading Applications

With regard to AI applications in the in the trading sphere FINRA list various Rules that firms have been contending with for years and reminds firms that any AI application for trading is going to have to comply with these rules. FINRA cited Regulatory Notice 15-09, which stated, “[i]n addition to specific requirements imposed on trading activity, firms have a fundamental obligation generally to supervise their trading activity to ensure that the activity does not violate any applicable FINRA rule, provision of the federal securities laws or any rule thereunder.” As firms adopt AI algorithms and strategies in their trading functions, they benefit from reviewing and testing their supervisory controls to ensure that there is continued compliance with applicable rules and regulations, including but not limited to FINRA Rules 5210 (Publication of Transactions and Quotations), 6140 (Other Trading Practices) and 2010 (Standards of Commercial Honor and Principles of Trade), SEC Market Access Rule, and SEC Regulation NMS, Regulation SHO and Regulation ATS.

Conclusion

In sum it seem as if FINRA sees great promise in firms using AI to operate more efficiently and to provide better service to clients. On the other hand, it is clear that FINRA has a host of regulatory concerns that firms may be exposing themselves to through the use of AI.

Herskovits PLLC has a nationwide practice representing individual and entities in FINRA disciplinary investigations and proceedings and FINRA arbitration. Feel free to call us for a consultation at 212-897-5410.