Articles Posted in FINRA Regulation

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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.

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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.

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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.

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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.

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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.”

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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.

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

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

Product at Issue:  Non-Traditional ETFs

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

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

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

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

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

Denial of FINRA Forum

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

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

AI Applications

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