Articles Posted in FINRA Rules

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

Background

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

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

FINRA Rule 3270 (Outside Business Activities)

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

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

Background

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

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On March 11, 2020, FINRA charged an FA with structuring cash transactions in his personal bank account so as to evade reporting requirements.  This case is worth a read because it highlights FINRAs commitment to pursue AML and AML-like cases.

Case in Point

In Department of Enforcement v. David R. Oakes, Disciplinary Proceeding No. 2018057755201, FINRA charged the FA with violating Rule 2010 (FINRAs catchall rule) for allegedly structuring three $9,000 deposits (total of $27,000) of currency to his personal bank account between December 27 and December 29, 2017; (2) structuring two $6,500 (total of $13,000) withdrawals of currency from his personal bank account on August 23, 2017; and (3) structuring four withdrawals (total of $21,500) of currency from his personal bank account between August 1 and August 4, 2016.  According to FINRA, each of these series of transactions was for the purpose of avoiding the filing of a Currency Transaction Report.

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This is a classic case of buyer’s remorse.  In the case at hand, FA Jeffrey Mohlman settled with FINRA by executing a letter of Acceptance, Waiver and Consent (called an AWC) and, in so doing, agreed to a bar from the securities industry.  Apparently displeased with his decision, he filed an action in court seeking almost $900,000 in damages by claiming that FINRA “committed fraud by inducing Plaintiff to fail to testify at a second disciplinary interview, thus allegedly fraudulently avoiding an alleged requirement that Defendants consider mitigating factors in the Plaintiff’s disciplinary case…”   Mohlman’s claims received a chilly reception by the U.S. District Court for the Southern District of Ohio (Mohlman v. FINRA, et al., Case No. 19-cv-154), which granted FINRA’s motion to dismiss on February 24, 2020.

Background

Mohlman entered the securities industry in 2001.  In March 2015, Mohlman’s then-employer, Questar Capital Corporation, terminated his registration and filed a Form U5 claiming that Mohlman “resigned while under internal review for failure to follow firm policies and procedures regarding his participation in private securities transactions.”  FINRA then launched an investigation and requested his appearance at an on-the-record interview (OTR) on September 11, 2015.  On September 9, 2015, Mohlman’s lawyer informed FINRA that Mohlman received the OTR request but would be declining to appear.  On September 17, 2015, Mohlman signed an AWC in which he agreed to a bar from the securities industry and waived various procedural rights.

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Courts call a lifetime bar “the securities industry equivalent of capital punishment.”  PAZ Sec. Inc. v. SEC, 494 F.3d 1059, 1065 (D.C. Cir. 2007).  It is a draconian measure which not only permanently removes you from the securities industry but also subjects you to “statutory disqualification” under Section 3(a)(39)(A) of the Securities Exchange Act of 1934 and all the collateral consequences that come with it.

Given the seriousness of a lifetime bar, a recently released AWC presents an alarming fact pattern in which a supervisor was barred due to the transgressions of an FA he failed to properly supervise.  Let’s consider the case of Michael Leahy, FINRA Case No. 2019063631802.  The question is, why did FINRA go after the supervisor with guns blazing?

The Applicable Rule:  FINRA Rule 3110

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On January 3, 2020, FINRA released an AWC for Robert James D’Andria, Case No. 2017056579502.  At first blush the AWC seems rather plain vanilla.  The FA recommended high-risk products, in this case leveraged and inverse exchange-traded notes and funds, to retail investors and FINRA deemed those recommendations to be unsuitable.  FINRA suspended the FA for 2 months and fined him $5,000.

In a typical suitability case, FINRA would claim that the account was over-concentrated in a given sector, or the position was too large relative to the portfolio as a whole, or the account was over-traded, or the investment was inconsistent with the investor’s stated investment objectives.  And, in a typical case, FINRA would claim that the customer suffered meaningful losses.

In this AWC, however, FINRA does not claim that the investments were inconsistent with the customers’ investment objectives.  Nor does FINRA claim that the investors were unsophisticated or otherwise lacked the ability to assess the merits of these investments.  So, this begs the question:  where’s the violation?

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FINRA published an interesting arbitration award on December 27, 2019.  In Raymond James & Associates, Inc. v. Gregory D. Clark (FINRA Case Number 18-04011), Raymond James claimed that Mr. Clark breached a settlement agreement related to the repayment of a promissory note.  Raymond James requested, and was awarded, compensatory damages of $206,000 plus interest pursuant to Florida Statutes § 55.03.  You can access the Award by clicking here.

Things get interesting when analyzing the procedural rulings of this case.

Motion to Bar Presentation of Defenses and Facts

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On December 16, 2019, FINRA released the AWC in Matter No. 2018060843801 (In re Molteni) [click here to read the AWC].  At first blush, the AWC seems to concern a garden variety violation in which the FA failed to amend his Form U4 to disclose two federal tax liens.  This doesn’t seem to be the violation of the century, right?  Even FINRA’s Sanction Guidelines suggest a regulatory slap on the wrist of a modest fine and 10 day suspension.

So here is where things get interesting.  FINRA more or less sanctioned Molteni in accordance with the Sanction Guidelines.  They hit him with a $5,000 fine and a 3 month suspension.  However, FINRA also found that he “willfully” failed to disclose the federal tax liens.  In the world of FINRA regulation, the word “willful” carries an awful lot of weight.

What does it mean to act “willfully”?

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