10 Things to Do (Or Not Do) To Help Avoid Regulatory Problems in 2013
January 18, 2013
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Hello, and welcome to the webinar/teleconference on 10 Things to do - ?or not do ?- to help avoid regulatory problems in 2013.? My name is Joel Beck and I am attorney in private practice in Lawrenceville, GA.? Lawrenceville is a suburb of Atlanta, GA.?? With my firm, The Beck Law Firm, LLC, I devote the majority of my law practice to representing stockbrokers and investment advisors across the country.? To put it simply when asked what I do, my response is this: I help stockbrokers and investment advisers protect their #1 investment.? What?s that, you ask?? Simple, it is their careers. I?ll share a bit more about my practice later on in the program.
So since you?ve decided to be on this call today, and that tells me that you are concerned, at least a little, about staying out of regulatory trouble.? That you probably want to focus this year on operating your business, maybe growing it, rather than on dealing with internal investigations by the compliance department or outside counsel, responding to customer complaints and arbitrations, and on dealing with regulators conducting investigations or pursuing disciplinary actions.? So for those reasons, I commend you.
?Before we get to my ten things to do ? or not to do, let me just share this with you.? Can?t have a program like this without a disclaimer, so here it is: This program is provided for general educational and informational purposes only.? It is not intended to be legal advice for you or anyone else.? If you want legal advice, then you need to hire a lawyer.? It?s that simple.? ?And, also, you should understand that in addition to regulatory requirements that I?m going to discuss today, you may be required to follow the policies and procedures of your firm as well, and those can be more restrictive than FINRA or SEC or state rules.? So be aware of that, and if you are with a firm, it is always a good idea to understand the policies and procedures of your firm, and what your duties and obligations there are.
Let me also tell you that in preparing this list, I?m drawing on my close to sixteen years of experience dealing with regulatory investigations, enforcement proceedings, and ways that brokers and advisers get in trouble.? And these aren?t in any particular order, because they are all important.? So let?s get started.
?The first thing I want to impress upon you is to stay out of trouble by not providing too much client service. ?Yep, that?s right. Trying to provide too much service to a client can land you in hot water.
Over the years, I?ve seen many brokers face pretty harsh enforcement actions because they thought they were doing things to help their client, to provide a high level of client service, and to make sure that the job got taken care of.? But sometimes these efforts are simply misguided.? There are three examples of things in my ten things list that I think sometimes fall into the to much service category:
?1.? Forgery / Signing a Client?s Name.? The basic rule here is to never, ever sign a client?s name to any document.? And this would include signing the client?s initials to anything as well.?
I?ve seen this come up many times, where a broker or advisor might have the client sign three forms, but forget to get the signature on the 4th form.? There is no question the transaction is authorized, no issue that the client wanted to purchase the product or do whatever.? But when the broker signs the client?s name, it can really open up a can of worms.? First, if that document contains some key disclosures, the client can allege that he was never informed of those disclosures, and wouldn?t have gone along with the deal had he been advised of such.? This opens up the broker, and the firm, to some potential civil liability for the transaction if it goes south or the client decides he doesn?t want to proceed with it.
?In addition, signing a client?s name is a violation of industry rules.? If you are a broker, it is a violation of FINRA rules to sign a client?s name to any document, even if the client had given you authorization to do so.? And it is almost certainly against firm policy, so a violation there could lead to action by your firm.
?Finally, in addition to these reasons, if you don?t have permission to sign, the act is likely considered forgery and is a criminal offense.? I?ve also seen this play out where the broker can?t reach the client but knows that the client wants to move forward but has to have a signature, etc., or the broker completed the wrong form and had the customer sign the older version of the form, and then can?t process the business unless the newer form is completed.?
So there are lots of good reasons to avoid this.? Have the customer come back in and sign the form, do it via fax or email if allowed, etc., but don?t sign a client?s name.? That?s the first thing to do, or not do, as the case may be.
2. Unauthorized Trades.? Some times, unauthorized trading falls under the too much client service category as well.? Whether you are a broker or an investment advisor, if you don?t have written discretionary authority, you have an obligation to consult with the client before the trade is placed, and obtain authorization to effect the trade.
?I?ve seen it several times.? A broker knows a customer wants to get out of a security, or get into it.? The security, let?s say an equity, starts to move.? The broker can?t reach the client and tried every phone number the broker had for him, to no avail, so the broker goes ahead and places the trade without authorization.? That?s a violation of the rules on the regulatory side.? And on the civil side, the broker is exposed to liability as well, especially if the market later moves away from the trade, the client is likely going to be upset and seeking compensation.? UAT cases can often be made by proving the lack of contact, via emails and phone records, and the like.? So, for item 2 remember this:? only conduct trades when you have proper authorization.?
And along these lines, make sure that the authorization you get is valid.? It has to come from an owner of the account, or someone who has been granted trading authority in writing.? Remember this especially when dealing with married folks.
3. Discretion.? This is closely related to unauthorized trading, but it deserves its own separate point here in the list of ten things.? On the broker-dealer side, most all firms prohibit use of discretion unless the account has been approved as a discretionary account.? Many firms prohibit use of discretion at all.? Brokers will often have problems with the client, with the firm, and with the regulators, when they use discretion improperly.? To use discretion under the rules, the discretionary authority must be in writing, AND the account must be approved as a discretionary account by the firm and supervised as such.? Even when the client says you know what I like, or I trust you and want you to handle the account, make sure you get it in writing, and have the firm approve it.?
?On the RIA side, many accounts will be set up as discretionary accounts, so this helps avoid problems in this area.? But be sure that the paperwork is in order that you have discretionary authority for each account.
And while we?re talking about discretion, let?s quickly cover time and price discretion.? Remember that this applies only to a specific security for a definite amount, and the time and price discretion lasts only for the business day on which it is received unless it is in writing.? Be sure you are familiar with your firm?s policies on T&P before utilizing it, and remember that all use of discretion needs to be noted on the order ticket.
So those three items fall under what I call, the too much service category.? So don?t try to provide too much client service and fall into one of these traps.?
?Let me turn now to some disclosure issues.
?4.? Form ADV / Form U4 issues.
RIAs use the Form ADV, and their IARS use the Form U4, and stockbrokers complete the U4 as well. But most folks don?t understand the significance of these documents.? They form the basis for numerous disciplinary cases each year, and almost all of them are entirely preventable.?
?When a broker or advisor fills out a U4, the information on it is to be current and accurate.? And, when things change from time to time, the individual has an obligation to update the U4.? In addition to disclosing your address, date or birth, employment history and other stuff, there are some other disclosures that can be problematic:
Many types of Customer complaints, investment related arbitrations and lawsuits and settlements have to be disclosed.? You have to read the specific questions to see which ones need to be disclosed.
Certain criminal charges have to be disclosed as well.? There are certain types of misdemeanor charges and convictions that require disclosure, and all felony charges and convictions have to be disclosed.
And an area that has been tripping up a lot of folks lately is the personal financial disclosures.? Bankruptcy filings, as well as the existence of any unsatisfied liens or judgments have to be disclosed.?
Penalties for a failure to disclose information on the U4 can be disastrous.? Under the laws, the Sec Exch Act and the Inv Advisers Act, a willful failure to disclose material information on the U4 means that the violator is statutorily disqualified from being registered and working in the b/d or RIA industry.? Statutorily disqualified means that you can?t work in the business.? Period.? No real exceptions, unless you can get permission from SEC to override the disqualification, and that is generally pretty difficult.
And willfulness here, as interpreted by the SEC and the courts, does not mean specific intent, it only means the intent to complete the U4.? So, if you fail to disclose something, because you didn?t understand that disclosure was required or you simply forget to amend your U4, you can face a willful charge.? Essentially, the law would support a willfulness finding in almost every circumstance.?
In November 2012, the SEC issued a decision in the case of a broker named Robert Tucker, who had been sanctioned by FINRA for U4 violations.? In analyzing the case, the SEC held:
?A willful violation under the federal securities laws simply means ?that the person charged with the duty knows what he is doing.?? It is not necessary to additionally find that Tucker ?was aware of the rule he violated or that he acted with a culpable state of mind.?? A failure to disclose is willful under Exchange Act ?3(a)(39)(F) if the respondent of his own volition provides false answers on the Form U4.??
That?s straight from this 2012 case decision.
So, as you can see, the U4 is a huge area.? You need to familiarize yourself with the disclosure questions asked, and make sure that you keep it current ? and current means you update it within 30 days or less.
?Let?s talk about the ADV for a moment.? RIAs use the ADV, and IARS use a portion of that as well, with the newer brochure supplements.?
Lately, we?ve seen recent enforcement actions relating to misrepresentations in services provided or assets under management.? Be sure not to inflate or hype up your dollar amount of assets under management and put that artificially high number on the ADV.? The SEC has been active in pursuing ADV misrepresentation cases.? If you happen to get examined, they will certainly look at the amount reported on the ADV and the actual assets they can verify and compare those two numbers.?
5.? Correspondence.? Correspondence is great, and correspondence is terrible.? It lets us communicate with clients and share information, but it also leaves a lasting record of that communication.? Another good way to help avoid regulatory problems is to be careful with correspondence.
Whether you are with an RIA or with a B/D, correspondence that relates to sales, including those about trading recommendations and investment strategy, are business records that have to be supervised and maintained for some period of time.
When we think about correspondence, there are a few general rules that come to mind:
??????????? 1st, make sure you are complying with your firm?s correspondence policies, including having it approved and filed appropriately.
??????????? 2nd, be careful about making contradictory statements about the features or benefits of a product that don?t jive up with what is in the official product documents such as a prospectuses, offering circular or PPM, or marketing material.? This means that you need to know what you are selling ? and that?s always a good idea.
??????????? 3rd ? don?t make guarantees about any feature of any investment.?
??????????? 4th ? be careful about your audience.? Be wary about sending out emails touting a product that is not necessarily going to be suitable for all of the recipients.? This means you need to tailor your messages for your audience.
??????????? 5th ? understand that correspondence is long lasting.? Don?t fire off an email or letter in anger, or without thought, especially in response to a customer expressing a complaint or dissatisfaction with something, or even worse ? to a regulator.
OK, we?re halfway through our ten things list.? Let me take a break and share with you a bit more about The Beck Law Firm, LLC, my firm that is the sponsor of this program.
?I started my own firm in 2007, after a ten-year career at NASD.? I worked in the member regulation and enforcement departments, and spent my last 6 years there as an enforcement lawyer.? In 2007, I left to go into private practice, and since then, the majority of my practice has focused on financial markets law.? I represent stockbrokers and investment advisers in regulatory investigations and enforcement actions, in internal investigations by their firm, in connection with investigations by other entities, such as professional societies or organizations (for example, I?m working with a client now on an investigation by the CFP Board).? I also represent smaller broker-dealer firms and small RIA firms in these types of matters as well. And, from time to time, I?m involved in representing clients in other types of government investigations and prosecutions.?
My financial markets practice also gets me involved in arbitration cases relating to the securities industry, including disputes between firms and brokers, as well as customer cases. ?I also frequently get involved in helping brokers and advisors make a career change ? whether that involves starting their own firm, moving from one firm to another, and dealing with the associated contract issues, promissory notes, and compliance matters associated with making such a change.
?And then, I also represent clients ? both individuals and firms - in day to day compliance matters, providing advice and guidance on whether something can be done, and if so, how best to do it, to avoid regulatory or other legal issues.
Finally, while the vast majority of my work involves a stockbroker, an investment adviser or a firm, in some fashion, I also handle general small business legal needs as well as basic estate planning needs for clients here in the metro Atlanta area.
Let me share with you a resource that you might find valuable.? Since 2007, I have authored and published BDLawBlog.com.? You can find it online.? The blog gives a great deal of information about general compliance issues in the securities industry, as well as news updates and commentary on issues in the industry.?
Also, my email newsletter can be a good source of info. for you ? it comes out about once a month.? You can sign up for it on my blog.?
This year, I hope to be doing a series of webinars like this for folks on areas of interest in my practice areas.? Upcoming will be a webinar on basic estate planning, and we?ll discuss issues with the recently passed fiscal cliff legislation, and later on I?ll do another program on small business legal issues.? And then later this year, I hope to come back and do another program for securities industry folks on hot trends in the regulatory and compliance area.? So watch the blog and the email newsletter for information on those.? And, of course, if I can ever be of assistance to you, please call on me.
OK, that?s enough about me and my practice, so let?s get back to the list.
6.? Outside business activities is an area that trips up brokers as well.? Under FINRA rules, a broker has an obligation to disclose any outside business activity in which they are engaged.? This includes activities for which the broker receives compensation ? whether working as an employee or contractor, AND it also includes other activities ? where there is a reasonable expectation of compensation even though no compensation is pad, and also other activities such as serving as a director of a corporation, etc. ?
Under the rules, the key to compliance is making disclosure to your firm. And the disclosure has to be timely.? To be timely, the notice needs to be BEFORE you do the activity, or as the rule says, ?prior written notice? is required.? The rule at issue here in FINRA Rule 3270.
Now also understand that your firm?s policies may be more restrictive.? Many firms have a policy in place that prohibits the rep. from doing the outside activity unless the firm approves it.? So here, we see that the rule requires prior written notice, but many firms would require that they approve it as well.
Let me circle back to the U4 as well.? If you look at the U4 closely, you?ll see that Box 13 requires disclosure of outside business activities.? Some firms do a good job of making sure reps. Update their U4 to disclose their OBAs, but not all firms do.? Nevertheless, you can provide prior written notice of an OBA to your firm, and get their approval to participate if needed, but then possibly have a U4 violation if you fail to amend your U4 to disclose the OBA.? So be very careful in this area.?
7. Selling Away.? When I started as an investigator with NASD in 1997, selling away was one of the most serious rules that a broker could break.? It was like a cardinal rule, and a violation of it was a quick way to getting barred from the industry.? Since then, the sanction guidelines for selling away violations and outside business activity violations were changed dramatically ? largely in part to two outside business activity cases I prosecuted as a NASD lawyer.? Now, while selling away is still serious, there is much more flexibility in the sanctions and a small violation does not necessarily equate to a bar from the industry.
While the sanction has changed, the amount of confusion with reps. doesn?t seem to have changed.? Or, if that?s not the case, then we just have a lot of reps. who like to roll the dice and take their chances on getting caught, because there are always a good number of enforcement cases for selling away violations each year.?
So let?s break down this problematic area a bit, and begin by looking at the rule.? The rule here is NASD Rule 3040, which is part of the FINRA Manual.? It says that no person associated with a member shall participate in a private securities transaction except in accordance with this rule.
First, notice the broad application.? This rule applies not only to registered reps., but also to anyone associated with the B/D.? So, this means that it includes associated and non-registered staff.
?Then, when we look at what is required it says that the individual must provide written notice to the firm describing in detail the proposed transaction and the person?s role, and whether the person will received any type of compensation.?
If the transaction is one for which the person will receive some type of compensation, then there are additional requirements.? First, the transactions and the person?s involvement in them must be approved by the firm, in writing.?
?Second, the firm has to supervise the transaction, and that includes recording them on the books and records of the firm just as if the transaction was executed by the firm.?
In my experience over the years, here?s where I see a lot of brokers have problems.? It is three things.
First, they don?t recognize that the product they want to sell is a security, and is therefore covered under Rule 3040.? It doesn?t matter what the broker believes, it matters what the product is.? If it IS a security, then the selling away rule applies.?
?This means that brokers can?t rely on the statements of others about the product, especially the folks promoting the product.? I?ve seen numerous cases where a promoter provides marketing material to the rep. stating that the product is not a security.? Sometimes they come up with a name for what the product is ? one I recall was labeled as a chattel mortgage and the broker swore to me that there was no way this promissory note could be a security because it was called a chattel mortgage. ? ? ? ? ? ? ? ? ??
I?ve also seen marketing materials aimed at brokers where a letter from a lawyer is included, and where that letter purportedly analyzes the product and determines it is not a security.? Well, generally speaking, if you didn?t hire that lawyer yourself, you?re not going to be able to easily argue advise of counsel, and besides, that doesn?t really go anywhere anyway in terms of a selling away defense, especially if you also failed to disclose your activity as an outside business activity.
?The second item here has to do with participation.? Over the years I heard brokers say something like this:? ?But I didn?t sell it.? I only referred the client to Joe Schmoe to do the deal?
The rule discusses participation in the transaction, specifically, it prohibits ?participation in any manner? unless the provisions of the rule are followed.? Participation is broadly construed, and a referral can be enough to qualify as participation.? So, even if a broker doesn?t actually sell the deal, they can have problems.? Cases have been made against brokers who made referrals, against those who shuttled papers back and forth, and the like.
Finally, The third problem area here has to do with compensation, and what compensation means.? Compensation is also broadly construed, and it goes beyond just a commission on the deal.? Any type of compensation counts.? A finder?s fee or a referral fee, getting securities or rights to acquire securities, rights of participation in profits or tax benefits or other proceeds and expense reimbursements all qualify as compensation under the rule.
So, to wrap up this point, don?t participate in private securities transactions in violation of the Rule.
8. Other Disclosures.? Disclosure of stuff is a way of life in the securities industry.? Whether you are with a B/D or RIA, you have certain disclosure obligations, and we touched on a big one with respect to the Form U4 and ADV issues earlier today.? For point 8, let me briefly talk about other disclosure items.?
Many of you don?t just limit your work to being an IAR or a RR.? You perhaps are also a licensed insurance agent, and some of you also have professional designations that you worked hard to achieve, such as a CFP.? Some of you may be a CPA. It is important to remember that disclosure requirements might exist for these other areas as well.?
Many state insurance departments have disclosure requirements that obligate you to disclose certain criminal charges, regulatory investigations and proceedings, and the like.? The same is true for certain professional societies and designations.? So, whenever you think about disclosure items, think beyond just the U4 and ADV.? Think about your other obligations as well. ??
9.? Privacy Issues.? The safeguarding and privacy of non-public customer information continues to be a hot area for the regulators at both the state and federal levels.? We see issues arise in this area in several different ways.?
Here in Atlanta, several years ago, there was a case that got local media attention when, if I recall correctly, several boxes full of customer information and documents were discarded on the side of the road.? Someone stopped to look at what was in the boxes, and then called the police ? I think ? and the media ? when they saw what was in the boxes.? Of course, the regulators got involved and pursued an enforcement action against the folks involved.? So, improperly discarding of documents and data can be problematic.
Another area where we see problems both with respect to civil litigation and arbitration, as well as in regulatory action, is the improper use of customer data and confidential information when a broker moves from one firm to another and takes client information to the new firm ? or even worse ? sends it over to the new firm before leaving the old firm.? Brokers and advisors need to understand here that Regulation SP that deals with privacy of information does not have an exclusion for firms that participate in the protocol for broker recruiting.? There?s a lot more to this, and today?s call doesn?t lend itself to getting into that much detail, so I?ll leave it at this: know what you can and can?t do here with respect to client information, and consult with your counsel and compliance folks before making a move.
?10. Follow Your Advisory Agreement.
I am a big proponent of using written agreements with clients.? In my view, Investment advisors should always, always, always use a written advisory agreement with every client.? The agreement should specify the scope of the advisory work.? Importantly, if any assets are to be excluded from management, it is a good idea to specify that.? And, the agreement should detail how the advisory services fees shall be calculated, whether it is on an hourly basis or a percentage of assets under management.? Bottom line here is that all the details on how the fee is calculated, when it is calculated, and how it is to be paid should be in writing.
But then, the agreement needs to be followed, and not deviated from unless you do a written amendment signed by the customer and the firm.? The SEC and the states will look at how fees are calculated, and whether they are done so in accordance with the written advisory agreements.? Failures to abide by the agreement can lead to enforcement action.? And further, it can lead to civil litigation and complaints when the customer realizes what has happened.?
?11.? Conversion / Misuse.? I?ll close out the ten things list by adding an 11th item, with something that I ought never have to address, but I do.? It?s simple.? Don?t steal, use or abuse other people?s money.? If you look at the monthly notices of disciplinary action each month, you?ll find at least one ? but most likely more, brokers who are sanctioned for misuse or conversion of client funds.? And when you look at SEC releases on investment advisers, you see a lot of the same problems as well.? The end result is typically the same ? a bar from the industry.? Further, many of them have criminal charges that come about as well.?
??????????? I think in many instances these brokers or advisors start out thinking that what they are doing is OK, or that they are in a tight pinch but will be able to fix everything in a day or two.? But what we find are instances like this:
- a broker takes money intended for an investment, and uses the money himself.
- A broker or advisor causes funds to be wired out or a check written to the broker or advisor for illegitimate purposes ? such as fees that aren?t really due
- Someone gets in a tight spot and tries to borrow ? without any one knowing ? a little bit of money from a client?s account, or a deposit, etc.
- Obtains a power of attorney or trading/checkwriting authorization for a client, and then bilks the client for some money
- And, I think, there are a few cases each year where the broker or advisor just flat out decides to steal the money with evil intent from the start.
?And let?s not just limit this point to client funds.? Brokers and advisors also have regulatory problems when they abuse or misuse money that belongs to their firm.? Here, we see issues with respect to falsified expense reports, improper journals or checks that result in funds getting in the hands of the broker or advisor without authorization, misuse of business credit cards and the like.?
In all of these cases, using funds that you are not entitled to is going to be a violation of the industry rules and regulations and will be devastating to your career.? And many times it results in criminal prosecutions as well.
12.? Exam priorities:? Now, I?m past the ten things of things to do- or not do ? and I even already shared 11 things.? But let me point you to one more thing.? FINRA has recently released their annual examination priorities letter that highlights areas of significance in their exam program.
This letter, which you should read through, helps you understand some of the areas that the regulators have concerns about, which means they will be looking more closely at these items in regulatory exams in 2013.? Now please understand this:? they will still investigate and take action on other issues ? this is just a list of things that they are somewhat particularly focused on.? So, if your business contains some of these focused areas, be sure to take a look at how you are conducting that business, and that you are operating within the boundaries of the rules, and that you are following good supervisory procedures for those areas.?
The letter, just like the letters for earlier years, is on FINRA?s webpage.? You can get to it by selecting Regulation, then Guidance, and then Annual regulatory and Examination Priorities letter.? Or, just go to my blog, bdlawblog.com and you?ll find an article about it and a link to the letter.
Well, that?s our walk through ten things to do, or not do, to help avoid regulatory troubles in 2013, with two extras to make it a cool dozen.? Of course this has not been an exhaustive list and believe me, brokers and advisors can always find new and improved ways to violate the rules and get in trouble.? But, this was a pretty good starting point, a good list of recurring problems we see year after year along with giving you a sense of what?s on the regulatory radar this year.
?I hope that you enjoyed this presentation, or perhaps at least found it informative.? If I can be of help to you at some point in the future, I hope you?ll call on me.
This will conclude our program for the day.? Thanks much for participating.?
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