Articles Posted in FINRA Rules

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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 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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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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