Author: Morrie Simkin

Nearly every person in the securities business has to be registered with the Financial Industry Regulatory Authority. And as a result, they are subject to FINRA’s disciplinary authority for violating the rules of FINRA and the SEC. If they are disciplined, sanctions can include being barred from association with any member firm. A sanctioned person can go through the FINRA appeal process and from there to the SEC.

In reviewing a FINRA sanction the SEC must determine whether the sanction is oppressive or excessive. But what is the standard against which to make such a determination?

The SEC recently affirmed a FINRA bar order against John Saad that raised just this question. Saad was barred because he converted firm assets for his own use and then tried to cover it up when questioned about it by the firm. Saad appealed the SEC’s affirmance up to the D. C. Circuit Court of Appeals in two (2) separate appeals. The first appeal argued that the SEC failed to consider mitigating factors in affirming the bar. The court sent the case back to the SEC, which determined that despite Saad’s arguments the bar was merited. His last appeal argued that the bar was excessive and punitive. The court again sent the matter back to the SEC to determine if a bar in this case was punitive in light of a recent Supreme Court order holding that SEC fines were by their nature punitive.

In its last order, the SEC concluded the FINRA bar was not a punitive action based on three (3) arguments: First, bars are statutorily authorized and the SEC has authority to review them to ensure they are not impermissibly punitive; Secondly, the fact that a bar is a deterrent does not make it punitive; and Lastly, FINRA bar orders are not punitive under the test applied in that Supreme Court opinion.

But this begs the question: when is a FINRA bar impermissibly punitive. In its last order the SEC said that whether a bar is punitive and thus excessive or punitive must be evaluated under the facts of the case and must be set forth in the SEC order affirming or reversing the bar. The SEC concluded that Saad’s bar was not punitive in light of the threat his return to the industry would pose to investors and other industry participants. Assuming courts accept this standard, it still leaves a window to show why a bar order is excessive based on the facts of the case—e.g. its impact on licensing in other professions and that a similar effect can be achieved otherwise- a suspension with or without the right to reapply.

Please feel free to contact me (phone: 212 455 0476; email:  msimkin@securitiesregslawyer.com) if you would like to discuss this further.

 

SEC Rule 15c2-11 provides that before a broker-dealer can quote a security in the market it has to have reasonably current publicly available information about the subject company. The broker-dealer has to have specified information if the company is not traded on a securities exchange.

Rule 15c2-11(f)(3) is an exception to this requirement—the piggyback exception. It allows quotations if the security was quoted in an inter-dealer quotation system during the last 30 days, with no more than four business days without a quotation. The exception has swallowed the rule. It allows quotations for companies which are no longer doing business. The SEC’s answer to this has been to bring hundreds of administrative proceedings to revoke the registration of these companies. According to the enforcement staff this was to protect public investors from trading in securities of non-existent companies.

My December 2011 article, The SEC: Killing Dead Flies with a SledgeHammer (New York Law Journal, December 7, 2011), pointed out this was a waste of time and money by the SEC. It could easily solve the problem by changing the piggy back rule to prevent quotations for dead companies’ securities. I outlined three different ways to do so.

Former SEC Commissioner Luis A. Aguilar spoke to this same point in three different speeches while on the SEC.

Finally, the SEC listened. On September 25, 2019 it proposed amending the piggy back rule to prohibit its availability for companies in which the SEC suspended trading within the prior 60 days. This proposal fails to deal fully with the problem. But it is a start, and hopefully the SEC will act on this.

Please feel free to contact me(phone 212 455 0476; cell 914 646 8035; email msimkin@securitiesregslawyer.com) if you have any questions, comments or would like to discuss this further.

Heads-up to anyone holding restricted securities:

Better act now because

Congress’s Fixing America’s Surface Transportation Act

could fix you pretty good!

Woe to the person holding securities of a company that is not freely traded. People who are affiliates/controlling persons of the company or people who have bought in a private placement or hold restricted securities are in a bind if they want to liquidate any of their holdings.

Until recently there were very few ways to sell their non-freely traded securities. They could try to sell under SEC Rule 144, but this is subject to holding period and, in the case of affiliates (controlling persons), limits on amounts sold. They could try to sell under SEC Rule 144A, but then only to Qualified Institutional Buyers. That is a buyer who generally has $100 million in securities owned or under their management.

Congress changed this with the Fixing America’s Surface Transportation Act. It added section 4(a) (7) to the Securities Act of 1993. This exempts from the Securities Act’s registration requirements sales by other than the issuer or a subsidiary, subject to the following additional seven (7) conditions:

1. The purchaser(s) must be an “accredited investor” as defined in SEC Regulation D;
2. There can be no general solicitation or advertising;
3. If the company is not an SEC reporting company, specified information must be furnished to a requesting prospective purchaser;
4. The seller and anyone participating in the offering for compensation can’t be a “bad actor” as defined in SEC Rule 506(d)(1);
5. The issuer must be engaged in business, can’t be in the organizational stage or in bankruptcy, and is not a blank check, blind pool or shell company;
6. The transaction is not part of an unsold underwriting allotment; and
7. The security being sold must be of a class that has been outstanding for at least 90 days.

There is even more good news. Sales under Section 4(a)(7) are exempt from the requirements to register or qualify the security under state Blue Sky Laws.

The only bad news is that buyers of these securities are deemed to have purchased restricted securities, and can’t resell them other than pursuant to an exemption from the Securities Act registration requirements, e.g. Section 4(a)(7).

If you have any questions, comments or would like to discuss this further please feel free to contact me (phone 212 455 0476; cell 914 646 8035; email msimkin@securitiesregslawyer.com).

Background
Many people know about Jordan Belfort, the Wolf of Wall Street. Possibly from seeing the movie of that name. He made his fortune by aggressively marketing penny stocks, many of them fraudulently, to retail customers.

Many are also aware of the SEC’s recently adopted Regulation Best Interest. That rule requires a brokerage firm or its personnel making a recommendation to a retail customer to act in the best interest of the customer as well as mitigate or disclose various conflicts of interest.

Could Belfort have survived, and even prosper, under Regulation Best Interest? Possibly “Yes.”

The Flaw
Regulation Best Interest applies to “recommendations” but does not define that term. The SEC says recommendation means what it means under the rules of the self-regulatory organizations. The applicable rule is FINRA Rule 2111 (Suitability). But that rule does not define what a recommendation is.

Instead, FINRA has issued a number of Regulatory Notices setting forth the tests it would apply in determining whether a communication or series of communications constitutes a recommendation. They are all facts and circumstances driven, i.e. there is no definitive answer. These are:
a) Given the content, context and manner of presentation, could the communication be viewed as a call to action; would it reasonably influence an investor to trade a specific security or group of securities ;
b) The more individually tailored the communication is to a particular customer or targeted group of customers about a specific security or group of securities, the more likely it is a recommendation; and
c) While an individual communication may not be a recommendation, a series of communications may be a recommendation when considered in the aggregate.

The Test
Would the following conversation be a recommendation?

Belfort: Hello. My name is Jordan Belfort. I am with Dowe Cheatem and How, a broker-dealer registered with the SEC. Our business is acting as a market-maker or dealer, buying and selling low priced speculative stocks. We trade for our account in these stocks because you can make more money with a low priced stock than with a high priced blue chip. We trade stocks based on price movements- i.e. the likelihood they will go up or down and not based on the merits, value or worth of the company. We make no recommendations.

Your name was given to me as an astute investor. So i wanted to tell you about “Flying Widget”, a stock we are actively trading. Some of our customers have bought and sold this stock at a great profit. Others have bought and are holding in light of the rapid price rise. We just bought a block of “Flying Widget” from a customer who bought it a few weeks ago at $3.00 and sold it to us at $5.00.

How many shares can I put you down for?

Customer: Can you tell me something about this company, its trading history, etc.

Jordan: No. As I said we don’t follow the company; we trade based on price movement of the stock, and we make no recommendations. So how many shares would you like?

Question
Is this conversation a “recommendation” under the FINRA standards? Is it a recommendation as defined in the dictionary? How would a judge rule?

Contact
Please feel free to call or email me (Office 212 455 0476; Cell 914 646 8035; email msimkin@securitiesregslawyer.com) with any comments or questions.

September 2019

WHAT?
You wouldn’t think that the SEC’s Regulation Best Interest (Regulation BI) and Customer Relationship Summary (Form CRS) rules would apply to the investment banker/finder who helps small companies and their owners sell, merge or raise capital. But they do.

Regulation BI and Form CRS
Regulation BI requires a broker making a securities transaction recommendation to a retail customer to act in the best interest of the customer. Form CRS requires the firm to give a retail customer a summary of the firm’s services, costs, fees and conflicts of interest. These rules are generally effective June 30, 2020.

Retail Customer
So who is a retail customer? A retail customer is an individual who receives a recommendation or establishes a customer relationship with a broker for personal, family or household purposes. In adopting Reg BI the SEC said this does not include an employee seeking services for a small business.

The Investment Banker for a Small Company
All enterprises operate through individual employees, owners, etc. In a small company where the owner is acting for the company only, the company is not a retail investor. But it is not unusual for the ultimate transactions arranged by the investment banker in the case of a sale involves selling the owner’s stock; in the case of a capital raise requires that the owner put up some of his/her own money as part of the deal. These people are not only acting for the company. In adopting Form CRS the SEC said that where the sole proprietor or small business owner might be seeking a mix of personal and commercial services the firm must deliver a Form CRS. It said in that case the broker may treat the person as a retail customer. In a footnote it added that it assumes the broker obtains sufficient information in meeting its duty under Regulation BI that it has sufficient facts to determine if this is a for a personal or commercial purpose.
In other words, prudence suggests that the broker act as if Regulation BI and Form CRS apply.

___

Please feel free to contact me if you have any questions or comments (phone 212 455 0476; cell 914 646 8035; email msimkin@securitiesregslawyer.com).

September 2019

SEC Chairman Jay Clayton for the first time laid out the bases for settling an enforcement action. They are interesting, but to a large extent reflect the bases for terminating an investigation set out in the SEC’s Enforcement Division Enforcement Manual. By the way, the Enforcement Manual does not give any guidance for settling proposed actions.

“Bad Boy” Waiver

Chairman Clayton also set a new policy for dealing with simultaneous offers of settlement and requests for waivers of the “bad boy” rules limiting the use of Regulations D (private placements) and A (public offers up to $50 million) and losing the status as a Well Known Season Issuer under the Securities Act.

Standards for Settlement: Compared with the Enforcement Manual

1. Cost of litigation. The Enforcement Manual states this as the sufficiency and strength of the evidence gathered by the staff;
2. Willingness of SEC to litigate zealously. The Enforcement Manual states this as staff resources available to pursue the matter;
3. Remedying harm to investors—e.g. return of money to injured investors. Enforcement Manual states this as harm to investors if an action is not commenced; and
4. A desire for certainty- i.e. put the matter behind it for the defendant/respondent. The Enforcement manual reflects this by stating that it considers the seriousness of the violative conduct and the age of the underlying misconduct.

Tying Settlement with a “Bad Boy” Waiver

Chairman Clayton went on to say that a request for a waiver of the “bad boy” disqualification may be made simultaneously with, and may be included in, the offer of settlement. The SEC is not obligated to accept both the settlement and the waiver. If the SEC staff rejects, in whole or in part, the waiver request, and the offer of settlement is accepted, in whole or in part, by the SEC , the defendant would have five (5) business days to notify the staff that it agrees to move forward with part of the settlement offer that was accepted or to withdraw its offer of settlement. If the defendant fails to advise the staff or advises that it rejects the proposal, the matter will move forward to litigation.

Questions: Comments

Please feel free to contact me, Morrie Simkin, phone 212 455 0476; email msimkin@secueritiesregslawyer.com with any questions or comments or to further discuss this blog.
July 2019

I attended a recent program sponsored by Winston & Strawn and Promontory Financial Group. Among the speakers were two former senior officials from the SEC’s Office of Compliance Inspection and Examination (OCIE). The program focused on SEC inspections of investment advisers. The two former OCIE officials made the following points that are applicable to all OCIE inspections:

1. Referral to Enforcement. Only some 6 to7% of OCIE examinations are referred to the SEC’s Enforcement Division;
2. Likelihood of Enforcement Action from a Referral. The Enforcement Division staff attorneys receive referrals from many sources- OCIE, FINRA, public complaints, Whistleblowers. In choosing which to pursue the staff will be guided in part by which cases are more likely to bring them some sort of reward- promotion, awards, publicity, etc.;
3. When to involve outside counsel during an inspection. This is a fact specific issue. How serous is the alleged deficiency; is it a repeat of a deficiency cited in a prior exam; is it in an item that the SEC has listed on their annual report of things they are focusing on in their inspection program.

Please feel free to contact me (phone 212 455 0476, email msimkin@securitiesregslaweyr.com) with any questions, comments or to discuss this further.

Rule and Business

FINRA requires a brokerage firm to have written supervisory procedures (WSP) that cover all the businesses in which it engages. The Financial Crimes Enforcement Network of the Treasury Department (FinCEN) requires brokerage firms to have written supervisory procedures to comply with the Bank Secrecy Act and the anti-money-laundering rules thereunder (AML WSP).

Good business practices dictate that a firm has procedures for its personnel to follow in conducting the firm’s business.

Enforcement and Business Costs

FINRA recently fined a broker $100,000, and had the broker undertake to rewrite its AML WSP to cover a significant line of the firm’s business. [Tradition Securities and Derivatives, Inc., FINRA AWC No. 2015045334101, December 18, 2018]

Damages. The firm will also suffer when an unhappy customer stops doing business with, or worse sues, the firm, and the firm either failed to follow its written supervisory procedures or didn’t have any covering the business that the customer was doing with the firm.

The Problem of the Off-the Shelf Manual

One problem is that too many firms buy compliance manuals off the shelf from “consultants” and others that cover a multitude of areas, but not necessarily all of the lines of business in which the specific firm engages. Some of these “manuals” run 100 pages or more. They give a false sense of compliance. ”Yeah, we got a compliance manual that covers the waterfront.”

That may have been Tradition’s situation. Yes. It had an AML Written Supervisory Procedure. But a major part of the firm’s emerging market bond trading desk was trading in foreign bonds issued by Venezuela and Argentina. The firm had no procedures dealing with the various currency controls in these countries, the notices about these countries published by the Financial Acton Task Force and the State Department. Trading in these bonds by foreign financial institutions, usually in DVP/RVP trades, were not triggered for review by the firm’s AML WSP for compliance with the firm’s Customer Identification Procedures, or Customer Due Diligence, or for review by the AML Compliance Officer.

Worse yet is where FINRA has posted a model compliance manual such as it has done with the Small FIRM Anti-Money Laundering Template. These are generic form manuals. They don’t cover many things—such as the exemptions from the rules covered in the model, or reflect interpretations or many rule changes since the manual was prepared. These are general forms and may not reflect all of the lines of business in which the firm engages.

Result

The result in this case was that the firm was fined, censured and made a costly undertaking.

Comments; Discussion

Please feel free to contact me (email msimkin@securitiesregslawyer.com or phone 212 455 0476) with your comments or to further discuss this.

The 5% mark-up policy has been in the NASD and FINRA rule books since 1943, now part of Rule 2121, Fair Prices and Commissions. But a recent settled FINRA enforcement case suggests that FINRA Enforcement no longer honors it.

A version of this blog was provided to FINRA Enforcement for their review and comment. Their comments are reflected in bold italics. FINRA Enforcement notes that they have brought proceedings involving mark-ups of less than 5%.

What does this mean?

To avoid an enforcement action, brokers trading with their customers as a principal, including as riskless principal, must justify their mark-ups based on the relevant factors in Rule 2121.01(b):

1. Type of security;
2. Availability in the market;
3. Price of the security;
4. Amount of money involved  in the trade;
5. Pattern of mark-ups; and
6. The nature of the member’s business.

If the trade is in a bond, other than a municipal bond, additional factors under Rule 2121.02 that must also be considered include:

1. Dealer’s contemporaneous cost;
2. The prevailing market price;
3. Prices of contemporary inter-dealer trades; and
4. If none of the above are available, the contemporaneous transactions in similar securities.

The Enforcement Case: facts presented.

In a recently settled Enforcement Case (NTB Financial Corporation, Acceptance, Waiver and Consent (AWC) Case No. 2015047738901, December 10, 2018) FINRA censured and fined the firm $45,000 for violating Rule 2121. The case involved 71 principal transactions in the third quarter of 2015 with customers involving one corporate bond. The total mark-up in these trades was $43,142.06 that the firm returned to these customers in anticipation of this action.

The 71 transactions occurred on 7 of the 65 trading days in the quarter. The table below lists the trade dates, the period of time between when NTB bought the bond on that day and when it sold the bond to its customers on the same day, and the mark-up percentages.

Trade Date	Number of Trades	Time between Purchase and Sale to Customer- hour and minutes	Mark-Up percentage
August 27, 2015	5	1:12	4.64%
August 27	2	1:12	4.84%
September 3	1	2:52	4.83
September 4	17	1:31	4.72
September 8	3	1:12	4.84
September 17	11	6:15	4.66%
September 22	6	0:12	5.02%
September 22	12	6:22	5.07%
September 25	14	3:48	5.01%

The Enforcement Case: facts omitted

There was no data or discussion of the contemporaneous prices of trades in the bond by other brokers.

NTB cleared on a fully disclosed basis through another broker. No information as to what, if any, compliance and other reports from the clearing broker required under FINRA Rule 4311 were made available to or utilized by NTB. There was no discussion of NTB’s Written Supervisory Procedures or compliance policies regarding mark-ups. There was no discussion of the market for the subject corporate bond—e.g. number of trades per day, execution prices, bids and asked at the time of these trades, NTB’s role in this market, etc. Nor was there any information as to any prior FINRA exams where principal trading by NTB was an issue.

FINRA Enforcement notes that a review of publicly available TRACE data on the unnamed bond showed that the next highest mark- up in a subsequent contemporaneous trade by another broker-dealer was 1.44%.

Instead, the AWC focused on the five (5) factors in Rule 2121.01(a) sets forth above. It did so without any discussion of their relevance to the fact that all the trades involved were slightly above or below the 5% mark-up policy.

If FINRA wanted to sanction the firm, but not de facto revoke the 5% policy it could just as easily brought the case as a violation of the best execution rule, Rule 5310.

FINRA Enforcement noted that it has brought cases involving mark-ups of less than 5%.

Takeaway

The FINRA rulebook continues to acknowledge the 5% mark-up rule. However, in a principal trade with a customer, brokers would be prudent to compare their mark-ups with those in contemporaneously executed trades as publicly reported- e.g. on TRACE.

Discussion

Please feel free to contact me (phone 914 646 8035 or email msimkin@securitiesregslawyer.com) with any questions or to discuss this further.

January 15, 2019

No one wants to overpay their registered representatives. But recent cases and the existence of a class of lawyers that sue firms for delays, failure to pay or underpayment of registered representatives require broker-dealers to review their payment practices.

According to Joe Sipkin, of Lerner & Sipkin CPA LLP, brokerage firms have many commission payment arrangements. Some firms pay weekly, others pay every other week, and some pay in the next month. All of these comply with New York’s Labor Law. If the rep brings in an investment banking deal, they agree to pay if and when the deal closes. If this agreement is written as described below, this also would be legally permitted.

Some brokerage firms pay their registered representatives a fixed draw and a percentage of commissions, fees and mark-ups/down charged their customers that exceed the draw. These commissions and fees in excess of the draw are usually paid in arrears. But if the registered representative is not employed at the time the payment would otherwise be made, many brokerage firms don’t pay it. This could lead to a suit or arbitration to recover double these amounts and legal fees.

Under New York’s Labor Laws a brokerage firm that fails timely to pay their registered representatives are liable for two (2) times the commissions not paid plus the legal fees of these brokers. These legal fees can easily exceed two times or more the disputed commissions. And, there is a group of lawyers looking for these suits.

How to Avoid This?

New York’s Labor Law allows the parties to a commission arrangement that would involve “substantial” sums to agree to a payment plan or agreement to defer payment beyond the law’s required payment date of the end of the next month. Such agreement or plan must be in writing, and must set forth:

1. The terms of employment;
2. A description of how commissions and draws are accrued and when they are payable; and
3. When monies accrued are earned, whether they are payable in case of termination by either party.

To avoid this litigation threat provide in the written plan or agreement what is the draw, how commissions are computed, that commissions in excess of draw are payable at the agreed rate or at a lesser rate, at the discretion of the employer, e.g. the employee has violated the firm’s rules or policies, or unanticipated charges arise for the salesman’s trades, and that these excess commissions are not “earned” if the registered representative is not employed by the firm on the stated date for payment.

Questions Comments

Please feel free to call (212 455 0476) or email me (msimkin@securitiesregslawyer.com) with your questions or comments.

November 2018
Morris Simkin