FINRA’S NATIONAL ADJUDICATORY COUNCIL REVERSES HEARING PANEL’S FINDING OF FAILURE TO SUPERVISE

June 2, 2010 By Jay Eng

On Maarch 3, 2010, FINRA’s National Adjudicatory Counsel entered a decision reversing a Hearing Panel’s finding that the CEO and institutional sales desk manager for a broker-dealer failed to reasonably supervise an institutional sales trader. The NAC noted among other things that:

“It is clear to us that Market Regulation’s claims and the Extended Hearing Panel majority’s findings that [respondents] failed as supervisors are informed and colored in this case by their faulty views of [the sales trader's] conduct and a tenuous ‘industry standard’ that they claim limited the ‘profits’ he could garner for [the broker-dealer] from his trading.”

In the Matter of Department of Market Regulation v. Leighton and Pasternak, Complaint No. CLG050021 (NAC Mar. 3, 2010).

SEC SETTLES NAKED SHORT SELLING CHARGES WITH FIRMS

August 14, 2009 By Jay Eng

On August 5, 2009, the SEC entered into two (here and here) consent decrees for alleged violations of Regulation SHO by traders who engaged in “naked” short sales. In one of the settlements, the SEC charged the firm’s COO for failure to supervise its trader. The SEC states “[i]n a ‘naked’ short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period, and the seller fails to deliver the securities to the buyer when delivery is due.”

Generally, Regulation SHO requires market participants “seeking to effect a short sale to borrow, arrange to borrow, or have reasonable grounds to believe that a security can be borrowed prior to effecting the short sale,” i.e. the “locate requirement.” Market makers may be exempt from the locate locate requirement if they are engaged in bona fide market making activities. Regulation SHO also required “fail-to-deliver” positions in certain securities that have lasted for 13 consecutive settlement days to be closed out immediately. Fail-to-deliver occurs when a seller fails to deliver a security to the buyer when delivery is due. Unlike the locate requirement, market makers are not excepted from such close-out requirement.

FINRA’S Notice to Firms That “Inverse and Leveraged ETFs That Reset Daily Typically Are Unsuitable for Retail Investors Who Plan to Hold Them for Longer Than One Trading Session”

August 3, 2009 By Jay Eng

On June 11, 2009, FINRA issued Regulatory Notice 09-31 regarding “Non-Traditional ETFs” stating:

Exchange-traded funds (ETFs) that offer leverage or that are designed to perform inversely to the index or benchmark they track—or both—are growing in number and popularity. While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatilemarkets.

This Notice reminds firms of their sales practice obligations in connection with leveraged and inverse ETFs. In particular, recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must have adequate supervisory procedures in place to ensure that these obligations are met.

FINRA FINES BROKER-DEALERS FOR FAILURE TO SUPERVISE SHORT-TERM SALES OF CLOSED-END FUNDS IN IPO’s

July 28, 2009 By Jay Eng

On July 28, 2009, FINRA fined two broker-dealers for failures to supervise which resulted in the unsuitable short-term sales of closed-end funds (“CEF”) purchased at the funds’ IPO. CEFs are investment companies that sell a fixed number of shares in an IPO with built-in sales charges. Thus, after the IPO, the shares trade in the secondary market, generally at a discount from the IPO price. The CEFs at issue had sales charges of 4.5 percent, as well as a “penalty bid period” of generally 30 to 90 days immediately following the IPO.

FINRA noted that “Closed-end funds possess complex features that can give rise to unsuitability for short-term investors, particularly when purchased at the initial public offering.” During the relevant period, brokers would lose their sales commission if their clients sold the CEFs purchased at the IPO. FINRA found that despite knowledge that CEFs purchased at the IPO are more suitable for long-term investments, the broker-dealers did not have adequate supervisory systems and procedures designed to detect and prevent unsuitable short-term trading of CEFs.

FINRA FINES BANK BROKER-DEALERS $1.65 MILLION FOR FAILURE TO SUPERVISE

July 26, 2009 By Jay Eng

On July 23, 2009, FINRA announced that it had fined five bank broker-dealers a total of $1.65 million for deficient supervision and procedures. Brokers at each of the firms operated out of branches of affiliated banks and sold variable annuities (“VA”), mutual funds or unit investment trust (“UIT”) transactions to bank customers. The brokerage customers were referred by bank personnel, and sales of these products represented a significant portion of each firm’s business. FINRA made numerous findings of inadequate supervision related to these products.

• At one firm a former broker “made 32 unsuitable sales to 25 elderly bank customers, recommending each customer purchase a VA with an enhanced death benefit rider. The customers, all 78 years old or older, were either too old to be eligible for the rider, or very close to the ineligible age. Those customers who purchased the VA with the enhanced death benefit rider received little or no benefit from the rider despite paying higher fees for it over the life of the annuity.” FINRA found that the firm “failed to take adequate remedial steps in response to red flags indicating that the broker was engaging in unsuitable VA transactions, including nine customer complaints filed against the broker about her annuity sales, and the broker’s practice of consistently engaging in a pattern of selling elderly bank customers the same variable annuity with the same enhanced death benefit rider.”

• At another firm which used trade blotters to assess suitability and approve VA and mutual fund transactions. FINRA found that such procedures “did not capture key information, such as the customer’s investment time horizon, risk tolerance and other financial assets – all details that are necessary for the principal to conduct an adequate suitability review.” Further, “important suitability information on the blotters was presented in a way that did not reflect customers’ true income or net worth; the blotter reflected only the highest number in the range of values from which it was taken.”

• Another firm “instructed its principals to consider factors such as a customer’s source of funds, health and investment time horizon without collecting or recording all the information necessary for principals to assess suitability and to consider factors such as the client’s age, need for tax deferral and liquidity without providing guidance on how to apply such factors in their suitability review.”

• Still, other firms “provided no factors to guide principals in determining suitability.”

In settling these matters, none of the firms admitted nor denied the charges, but consented to the entry of FINRA’s findings.

FINRA FINES BROKER-DEALER $1 MILLION FOR FAILURE TO SUPERVISE

July 25, 2009 By Jay Eng

On July 22, 2009, FINRA announced that it has fined a broker-dealer $1 million for supervisory violations that primarily involved the failure to supervise its approximately 130 OSJ branch managers. Between January 2005 and November 2006, the firm permitted its OSJ branch managers to self-supervise their own handling of customer accounts without adequate review. In November 2006, the firm adopted a system to provide principal review of the OSJ managers’ transactions. However, this system was also “unreasonable” because it required three regional managers to “review thousands of transactions each month with limited access to client suitability information”.

FINRA found that the “the lack of reasonable policies and written procedures resulted in the firm’s failure to detect churning of customer accounts by an OSJ manager … as well as excessive markups and markdowns on corporate bond trades by another two brokers.”

FINRA also stated that “the firm failed to reasonably satisfy its obligations because, among other failures, it did not adequately test the firm’s supervisory systems or provide adequate review of OSJ branch managers.” According to FINRA, “firms must appoint one or more principals to ‘establish, maintain, and enforce a system of supervisory control policies and procedures.’”

FINRA further found that the firm’s systems and procedures governing variable annuity exchanges were not reasonable because the firm’s written supervisory procedures did not provide adequate guidance concerning the criteria that should be considered in recommending variable annuity exchanges to its customers including, for example, a comparison between the features, costs and benefits of the old and new products.

FINRA also found that the firm failed to apply its written heightened supervision procedures and failed to fingerprint firm employees resulting in it hiring a statutorily disqualified person.

In settling this matter, the broker-dealer neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.