Securities Law Blog

A 2007 lawsuit filed against the Financial Industry Regulation Authority (FINRA) was dismissed on March 1, 2010. The suit stemmed from a complaint that National Association of Securities Dealers (NASD) members were misled during the 2007 merger of the NASD and the regulatory arm of NYSE. The plaintiffs, Standard Investment Chartered Inc. and Benchmark Financial Services Inc., each filed class-action lawsuits in 2007 and 2008 respectively.

Judge Jed S. Rakoff, of the U.S. District Court for the Southern District of New York, held that the NASD, now known as FINRA, has immunity from “private damage suits challenging official conduct performed within the scope of their regulatory functions.”

The lawyers for the plaintiffs argued that their claim was unrelated to the organization’s regulatory function. Instead it was based on allegedly misleading statements made by the NASD and its executives regarding their finances.

The disputed issue was the adequacy of the $35,000 payout received by NASD member firms at the completion of the merger. The intent of the payout was to compensate members in exchange for giving up significant voting rights under the new FINRA corporate structure. Both plaintiffs said the NASD allegedly misled its members by telling brokerages that due to Internal Revenue Service (IRS) rules governing non-profits, the $35,000 payout was the maximum it could dish out to each member firm.

According to Jonathan Cuneo, lawyer for Benchmark Financial and Standard Investment, a March 2007 IRS letter to FINRA gave a very different range of permissible payouts. Allegedly the letter showed that the NASD could have paid brokerages between $70,000 to $111,000 each. However, the letter was sealed in 2007 by another U.S. District Judge, the late Shirley Whol Kram, with the dollar amounts of the possible payments redacted. Judge Kram’s reasoning was that disclosure of the IRS payment range would harm the NASD’s competitive advantage.

The Financial Industry Regulatory Authority (FINRA) recently released a regulatory notice to remind firms of their responsibilities when dealing with deferred variable annuities. FINRA outlines several steps that ought to be taken in order to ensure customer suitability when buying deferred variable annuities and compliance measures that can be set up by the firm.

The recommendation requirements state that:

*No recommendation of the purchase or exchange of a deferred variable annuity shall be made unless a member or person associated with a member has reasonable basis to believe that the customer has been informed of various features of deferred variable annuities, and that the customer would benefit from certain features of deferred variable annuities.

*Prior to recommending the purchase, the associated person must research the customer’s background and needs. Such fields should include but are not limited to age, income, financial situation, investment experience/objectives, assets and risk tolerance.

*After receiving necessary information, the application should be submitted to the firm’s office of supervisory jurisdiction (OSJ).

*A registered principal shall review and determine whether he/she approves the recommended purchase or exchange of the deferred variable annuities prior to submitting to the insurance company.

*Each suitability determination should be documented and signed by the person recommending, approving or rejecting the transaction.

FINRA also reminds firms that it is their responsibility to establish and maintain specific supervisory procedures reasonably designed to achieve compliance. Surveillance procedures should be implemented to prevent inappropriate exchanges and corrective measures should be in place to deal with inappropriate conduct.

Training policies or programs should be developed and documented to ensure that persons who effect and those who review transactions dealing with deferred variable annuities comply with the requirements of this Rule and understand material features of deferred variable annuities.

Since the boom of investment fraud uncovered during the financial crisis, lawmakers and state securities regulators are attempting to assume oversight of many investment advisers currently under the supervision of the Securities and Exchange Commission (SEC).

According to the testimony given by Texas Securities Commissioner and the North American Securities Administrators Association (NASAA) President Denise Voigt Crawford, “As the regulators closest to the investors, state securities regulators provide an indispensable layer of protection for Main Street investors.”

Crawford was one of many industry leaders to testify before the U.S. Financial Crisis Inquiry Commission (FCIC) during its first round of hearings in January 2010. The FCIC is a 10-member bipartisan panel established to examine the cause of the financial crisis with the intention of producing a report offering recommendations to prevent a reoccurrence.

The financial regulation proposals in Congress could bring about 4,000 advisers who manage between $25 million and $100 million in assets under the supervision of state regulators, according to NASAA. Currently the SEC says it inspects from 9% to 12% of the 11,000 advisory firms it oversees. Allowing each state to oversee anywhere up to around 600 additional advisers, as would be the case in California, would lead to more frequent examinations. State regulators are in the process of generating a mutual agreement to cooperate with one another in policing additional advisers if the proposal passes.

“Our presence did not contribute to the crisis; rather, the fact that our regulatory and enforcement roles have been eroded was a significant factor in the severity of the financial meltdown,” testified Crawford.

Since the passage of the National Securities Markets Improvement Act of 1996 (NSMIA), the responsibility of enforcement shifted from state to federal government. Now the states are fighting to get it back.

The NASAA President offered a series of recommendations to improve the ability of state regulators to pursue financial fraud. A few of these recommendations include: restoring state regulatory oversight of all Regulation D Rule 506 offerings; increasing state regulation of investment advisers; reexamining and removing the hurdles facing securities plaintiffs in private actions; and providing additional resources to uncover and prosecute securities fraud cases.

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.