Securities Law Blog

The Financial Industry Regulation Authority (FINRA) recently issued fines to two financial firms with inadequate anti-money laundering (AML) programs, as required by the Bank Secrecy Act and FINRA Rules. According to the industry regulator, a firm’s AML program must be made to fit their business models, nature of their clients, and take into consideration the technological environment.

Penson Financial Services, a Dallas securities clearing firm, has been fined $450,000 for failing to establish and implement adequate AML procedures. From October 1, 2003 until May 31, 2008, Penson employed two individuals to review thousands of pages of AML reports, which led to reports not being consistently reviewed. Failure to monitor such transactions involving penny stocks and liquidations left the firm at high risk for fraud and money laundering.

As early as January 2004, employees as well as internal audit identified compliance concerns. Through December 2007 customers were allegedly allowed to disburse funds out of certain accounts using check writing features without proper AML review.

According to its findings, FINRA found 129 instances of suspicious activity that had been flagged by Penson’s automated system and that the firm had failed to follow-up with a timely review. Other alleged deficiencies in Penson’s AML program include failure to assess money laundering risks presented by foreign financial institutions, failure to comply with FINRA reporting requirements and failure to keep accurate records of unsecured deficits in the accounts of its correspondent firms.

In a similar case Pinnacle Capital Markets, a Raleigh, N.C. provider of online access to capital markets, is being fined $350,000 for its failure to implement AML procedures to detect suspicious activity and to verify the identity of its customers, according to FINRA’s statement.

Pinnacle functions as an online business providing mainly foreign customers with direct access to U.S. securities markets. Customers of Pinnacle included foreign financial institutions which allegedly opened sub-accounts for foreign customers who were not required to fully disclose their identity. According to FINRA’s report, from January 2006 to September 2009, Pinnacle failed to adopt risk based procedures to verify identity.

The firm used a manual system to conduct daily review of its trade blotter. The highly insufficient system allegedly caused Pinnacle to miss suspicious trading patterns and other indications of market manipulations.

In a 2007 Securities and Exchange Commission (SEC) enforcement action that targeted a “pump-and-dump” scheme involving a Latvian Bank, Pinnacle allegedly failed to detect suspicious trading patterns. The firm however was not named as a defendant in the case.

In an effort to create more clarity for financial services firms surrounding the use of social media networks, the Financial Industry Regulatory Authority (FINRA) released a Regulatory Notice on January 25, 2010 entitled “Guidance on Blogs and Social Networking Web Sites”.

While the industry regulator does not codify any direct actions that need to be taken by financial firms, they do make several suggestions that could protect a firm’s liability when communicating over the internet. Organized in a Question and Answer format, FINRA sheds light on potential compliance issues and offers possible policies and procedures that firms could adapt in order to deal with supervisory and recordkeeping responsibilities.

The main message for firms throughout the Notice seems to be, if you plan on using it, you better be able to supervise it, we don’t care how or what you use to do it but it better be done and it better be done right.

Some key points in the Notice:

*If a firm communicates or allows its employees to communicate through social media sites, it is the firm’s responsibility to keep records of communications that relate to “business as such”. Firms need to ensure that associated personnel using social media sites for business purposes are adequately supervised, have necessary training in such activities, and do not present undue risk to investors.

*Requirements set forth by Federal securities laws and FINRA rules may be triggered when registered representative’s communications include recommending specific investment products. Additional disclosures should be made available to the customer to prevent any skepticism that a firm’s associate was misleading in anyway. FINRA suggests that firms should prohibit all interactive electronic communications that recommend a specific product unless a registered principal has previously approved the content.

*For static information, which could include profile, background or wall information, on social networking sites that are established by the firm or a registered representative, a registered principal of the firm must approve all information before it is posted. It is advised that these approvals also be documented.

*For interactive electronic communication, it is not required to have a registered principal’s approval, but it still must be supervised by the firm. FINRA suggests that firms adopt supervisory procedures similar to those used for electronic correspondence. It is up to the firm to develop policies that address communication liability and ensure that they are “reasonably designed to ensure that interactive electronic communications do not violate FINRA or SEC rules”.

*It is also the firm’s responsibility to prohibit personnel from engaging in business communication on social media sites that are not subject to firm’s supervision, and to take disciplinary action if firm policies are violated.

The overall goal of the Notice is to protect investors from misleading representations and allow firms to take part in the benefits of social media while effectively and appropriately supervising their associated persons’ involvement with these sites.

Increasing numbers of complaints from investors concerning sales of private placements has brought more cases against brokerage firms involved in selling private placement or Regulation D offerings. The representatives marketing these offerings are also being singled out by defrauded investors.

In the U.S. District Court in Boise, Idaho, a group of investors have filed a lawsuit against their adviser, Bradley Hofhines, and his firm, Summit Retirement Advisers LLC. The claimants allege that Hofhines failed to disclose that returns from investments in Provident Royalties LLC securities were not in fact profits generated by investments in oil and gas properties but instead were a Ponzi-esque mixture of investor funds and proceeds of later offerings.

The lawsuit also names affiliates of Hofhines, including Securities America Inc., the firm’s broker-dealer, as well as Ameriprise Financial Inc., which owns Securities America Inc. The broker-dealer and its parent company could be liable for failure to supervise the representative. While the degree of participation of each party has yet to be uncovered, Securities America has been named in two other lawsuits related to private placements gone askew.

In Hofhine’s statement, he claimed to have done the right thing when selling the Provident shares.

“I will say that I sold the product properly, given the information I had and the due diligence that was performed on this company,” Hofhine stated. “I certainly had no way of predicting or uncovering the alleged intentional fraud at Provident, nor how the economic collapse has magnified the problems.”

Another major bump in the road for Hofhine and Securities America is that they allegedly sold Provident securities to more than 35 non-accredited investors. Typically most investors who buy private placements or ‘Reg D’ offerings must be considered ‘accredited’; individuals with more than $1 million in assets.

Securities America’s executive vice president and chief marketing officer, Janine Wertheim, commented by saying “Each private-placement transaction of this type is reviewed on an individual basis to determine accredited investor status and requires evidence of eligibility to purchase the product.”

Now less than two months later, Securities America finds itself in more hot water, this time with the Massachusetts Securities Division.

The complaint charges that the broker-dealer misled investors when it sold them private-placement securities. It alleges that when it sold promissory notes issued by Medical Capital Holdings Inc. as private placement securities totaling $697 million, Securities America made “material omissions and misleading statements”. The broker-dealer is also said to have disregarded due-diligence recommendations to share financial information with investors.

Securities America sold 37% of the estimated $1.7 billion in notes from 2003 to 2009 issued by Med Cap. More than 60 Massachusetts investors bought approximately $7.2 million of the notes sold by Securities America, according to the Securities Division.

The Massachusetts Securities Division is seeking a cease and desist order and an administrative fine against Securities America, as well as restitution for all Massachusetts investors who bought the notes.

This case comes at a time when the Financial Industry Regulatory Authority (FINRA) is stepping up its efforts to investigate more and more allegations of misconduct arising from the sale of ‘Reg D’ private placements.

James Shorris, executive vice president and executive director of enforcement at FINRA, stated that the industry regulator will be continuing to focus their attentions on whether the brokers made any misrepresentations during a sale, whether they performed due diligence with the products sold, and whether firms adequately supervised sales of the products. FINRA will also be taking into consideration the suitability of the sales made to customers.

The collapse of Bernard Madoff’s estimated $65 billion dollar Ponzi scheme in 2008, was the precursor to the “Year of the Ponzi” in 2009. Defrauded investors saw an estimated $16.5 billion dollars disappear as more than 150 pyramid schemes unraveled, according to the Associated Press analysis of scams in all fifty states. Madoff’s very public decline brought a heightened public awareness and increased scrutiny to Ponzi schemes. But he wasn’t the only securities fraudster who made headlines.

Following the breakdown of Ponzi schemes nationwide, there was a drastic increase in federal securities fraud investigations opened in 2009. The FBI alone increased its securities fraud investigations by 1,750 from 2008. The Securities and Exchange Commission (SEC)’s Ponzi scheme investigations now make up 21 percent of the SEC’s enforcement workload. The Commodity Futures Trading Commission more than doubled its amount of civil actions in Ponzi cases this past year.

In its continuing effort to avoid being burned by another major Ponzi scheme, the SEC is developing new investigative units to improve its enforcement. A major focus will be to encourage companies and individuals to cooperate more closely in providing information, and to better analyze tips and complaints the SEC receives. The cooperation efforts will include similar incentives that have been used by the Justice Department in its criminal investigations. Included in these incentives will be written cooperation agreements under which SEC attorneys recommend leniency for parties providing information in their proposals to the SEC commissioners.

With the surge of federal fraud investigations in 2009 and those that date back to the credit crisis in 2007, an increase in federal prosecutions of financial crimes is expected to follow in 2010.

The Securities and Exchange Commission today charged Frank Bluestein with fraud for allegedly being the single largest salesperson in a $250 million Ponzi scheme that collapsed in August 2007. According to the SEC's Complaint, from 2002 to 2007 Mr. Bluestein was responsible for soliciting about 800 investors who invested $74 million into the scheme, which allegedly was operated by Edward May and his company, E-M Management Co. LLC.

In November 2007, the SEC charged Mr. May and his firm in connection with the scheme, which allegedly centered on phony Las Vegas casino and resort telecommunications deals.

Mr. Bluestein was affiliated with Questar Capital Corp. from 2000 to 2005, and then moved to GunnAllen, where he was an affiliated rep until October 2007, a few months after the Ponzi scheme collapsed, triggering a number of investors' arbitration complaints against GunnAllen and Questar.

The SEC Complaint, however, mentions neither firm, saying that Mr. Bluestein “did not sell the E-M securities” through a broker-dealer, and that the offerings did not appear on client statements. However, the firms through which he worked “provided the E-M Offerings with an aura of legitimacy and engendered trust from potential investors.”

Mr. Bluestein “lured elderly investors into refinancing the mortgages on their homes,” the SEC alleged, and he conducted numerous seminars to find new investors. At the seminars, Mr. Bluestein would often ask attendees who already invested in the E-M offering if they had “received their Ed May checks?” or “How do you like those Ed Mays?”

The seminars were often held in California and Michigan, the SEC said. Mr. Bluestein was based near Detroit. Mr. Bluestein allegedly told investors that the investments were low-risk, and Mr. May coordinated contracts with hotels for the installation of equipment such as televisions and gaming consoles. Mr. Bluestein's due diligence for the deals was shoddy and incomplete, according to the SEC Complaint.

Mr. Bluestein also misled investors about the compensation he received from the offerings, the SEC charged. On top of the $1.4 million in disclosed compensation, he allegedly received $2.4 million in hidden commissions from Mr. May and E-M Management.