Posts by Mary Hodges, Esq.

Form ADV Part 2A Item 14.A requires advisers to disclose compensation from non-clients received for providing investment advisory services to clients, as well as resulting conflicts and how the adviser addresses such conflicts. Compensation can include situations where the investment adviser obtains some type of financial incentive for recommending certain investments to a client. These arrangements could potentially impair an investment adviser’s ability to provide impartial advice.

The Asset Management Unit of the SEC has undertaken an enforcement initiative to shed more light on undisclosed compensation arrangements between investment advisers and brokers. For instance, on September 2, 2014, the SEC instituted administrative proceedings against an investment adviser, The Robare Group, Ltd., and its founders.

According to the SEC’s order, Robare Group committed fraud when it failed to disclose to clients that it was party to a compensation agreement with a broker-dealer that entitled Robare Group to a percentage of every dollar its clients invested in certain mutual funds offered by the broker-dealer. The SEC charged that this arrangement was not adequately disclosed to investors. For a number of years, Robare Group completely failed to disclose the arrangement on its ADV. Even though Robare Group eventually revised its ADV to disclose the arrangement, they failed to properly identify the potential conflicts of interest created by the arrangement. Moreover, the SEC took issue with way Robare Group described the arrangement. Robare Group disclosed that it “may” receive compensation from the broker when it was already receiving payments.

This should be an important lesson to investment advisers. Given the SEC’s recent emphasis on the subject, investment advisers should carefully scrutinize the way it discloses economic benefits to clients to make sure the disclosure is accurate and complete.

If you need assistance or have questions about disclosure of economic benefits, the Investment Advisor Rep Syndicate has experience with various investment advisor compliance issues.

The SEC has approved FINRA Rule 2081 that would disallow brokers from conditioning settlement of a customer dispute on a customer’s consent to the broker’s request for expungment from the Central Registration Depository (“CRD”). The CRD is the licensing and registration system used by all registered securities professionals. The system enables public access to information regarding the administrative and disciplinary history of registered personnel, including customer complaints, arbitration claims, court filings, criminal matters and any related judgments or awards. Because of the open nature of information available to its investors, registered professionals would like sensitive matters, such as customer complaints, expunged from the record.

The purpose of Rule 2081 is to make sure that full and reliable customer dispute data remains available to the public, brokerage firms, and regulators to prevent concealment by prohibiting the use of expungement as a bargaining chip to settle disputes with a customer. Furthermore, it allows regulators to make informed licensing decisions about brokers and dealers and improve FINRA’s transparency on broker-dealer complaint histories. This prohibition applies to both written and oral agreements and to agreements entered into during the course of settlement negotiations, as well as to any agreements entered into separate from such negotiations. The rule also precludes such agreements even if the customer offers not to oppose expungement as part of negotiating a settlement agreement and applies to any settlements involving customer disputes, not only to those related to arbitration claims.

On one hand, Rule 2018 will make it more difficult for brokers to sanitize their CRD report from a past claim, ensuring that future investors can more accurately assess the quality and integrity of a registered securities professional, ensuring protection from potential fraud and abuse.  On the other hand, settlements are a significant part of resolving FINRA claims in a timely manner.  If more FINRA claims reached arbitration, then the average FINRA claim would take substantially longer to adjudicate.  Ultimately, Rule 2081 could dissuade broker-dealers from settlement prior to arbitration because they may want to take their chances in arbitration, making an already potentially slow moving process, slower.

When investigating historical use of expungement in arbitration, pursuant to SEC Release No. 34-72649, the SEC found “despite the very narrow permissible grounds and procedural protections designed to assure expungement is an extraordinary remedy…, arbitrators appear to grant expungement relief in a very high percentage of settled cases.” In order to even seek expungement, FINRA Rule 2080 requires a showing that (1) the claim, allegation or information is factually impossible or clearly erroneous; (2) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (3) the claim, allegation or information is false.

In approving Rule 2081, however, the SEC cautioned FINRA that the new rule should not be the last word on the subject of expungement and that FINRA should continue to consider making improvements to the expungement process. In this regard, even though “the proposed rule change is a constructive step to help assure that the expungement of customer dispute information is an extraordinary remedy that is permitted only in the appropriate narrow circumstances contemplated by FINRA rules,” the SEC nonetheless remains concerned about “the high number of cases where arbitrators grant brokers’ expungement requests.” SEC Release No. 34-72649

Official rule language:

2081. Prohibited Conditions Relating to Expungement of Customer Dispute Information.

No member or associated person shall condition or seek to condition settlement of a dispute with a customer on, or to otherwise compensate the customer for, the customer’s agreement to consent to, or not to oppose, the member’s or associated person’s request to expunge such customer dispute information from the CRD system. See Regulatory Notice 14-31.

Cosgrove Law Group, LLC has experience with financial industry disputes including representing investors in recouping their losses and registered representatives seeking expungement. We also provide training, information, and compliance for registered professionals through the Investment Adviser Rep Syndicate .

Authored by Mercedes Hansen

Social media such as Facebook, Twitter, LinkedIn, or blogs have become popular mechanisms for companies to communicate with the public. Social media allows companies to communicate with clients and prospective clients, market their services, educate the public about their products, and recruit employees. Social media converts a static medium, such as a website, where viewers passively receive content, into a medium where users actively create content. However, this type of interaction poses certain risks for investment advisers and this topic has been a hot button for securities regulators.

The SEC previously issued a National Examination Risk Alert on investment adviser use of social media. As a registered investment adviser, use of social media by a firm and/or related persons of a firm must comply with applicable provisions of the federal securities laws, including the laws and regulations under the Investment Advisers Act of 1940 (“Advisers Act”). The Risk Alert noted that the various laws and regulations most affected by social media are anti-fraud provision, including advertising, compliance provisions, and recordkeeping provisions. Advisers Act Rule 206(4)-7 requires firms to create and implement social media policies, and periodically review the policy’s effectiveness.

Anti-fraud provisions with respect to advertising are probably most affected by the use of social media. All social media use and communications must comply with Rule 206(4)-1. While advertising policies should already be included in a firm’s compliance manual, such policies may not be sufficient enough to address some of the concerns with advertising in the context of social media. Establishing a specific policy to address social media may be prudent.

The area of advertising that has caused the most confusion is the prohibition on the use of testimonials. The SEC has previously defined testimonial to include a statement of a client’s experience with, or endorsement of, any investment adviser. Firms and IARs must ensure that third-party comments on their social media sites do not constitute a testimonial. Furthermore, the SEC vaguely discussed whether the popular “like” function on many social media sites would be deemed a testimonial:

“[T]he staff believes that, depending on the facts and circumstances, the use of “social plug-ins” such as the “like” button could be a testimonial under the Advisers Act. Third-party use of the “like” feature on an investment adviser’s social media site could be deemed to be a testimonial if it is an explicit or implicit statement of a client’s or clients’ experience with an investment adviser or IAR. If, for example, the public is invited to “like” an IAR’s biography posted on a social media site, that election could be viewed as a type of testimonial prohibited by rule 206(4)-1(a)(1).”

The types of policies that firms must create concerning advertising and testimonials depend greatly on the function of a specific website. For instance, approving the firm or IARs use of certain websites may turn on whether that website allows for review and approval of third-party comments before such comments are posted on the site or whether the “like” function can be disabled. A firm’s monitoring capabilities and the latitude it wants to provide employees with respect to personal use of social media cannot be ignored either.

The SEC has outlined various factors that should be considered by an investment adviser when evaluating the effective of their compliance program. These factors are:

  • Usage and content guidelines and restrictions on IAR use of social media whether on behalf of the firm or for personal use;
  • Mechanisms for approval of social media use and content;
  • Monitoring of social media use by the firm and IARs and the frequency of monitoring;
  • Consideration of the function or risk exposure of specific social media sites;
  • Establishing training and requiring IAR certification;
  • Whether access to social media poses information security risks; and
  • Firm resources that can be dedicated to implementation of social media policies.

There are various considerations firms must take into account when establishing social media policies or evaluating the effectiveness of its existing policies. If your firm needs assistance, the Investment Adviser Rep Syndicate can assist with creation or review of such policies.

A customary practice in the securities industry is for financial advisors to receive a transition bonus above and beyond an advisor’s standard commission compensation upon joining to a new firm. The bonus amount is usually determined using a certain percentage or multiplier of the advisor’s trailing 12-month production. These are usually referred to as “promissory notes” or Employee Forgivable Loans (“EFL”). Promissory notes are often used to solicit new employees/contractors from another brokerage firm. However, this “incentive” is usually cloaked with many restrictions. Typically these loans are forgiven by the firm on a monthly or annual basis but the advisor has to commit to the firm for a specified number of years or be required to pay the balance back to the firm should the advisor leave before the end of the term.

Brokerage firms can enforce promissory notes through FINRA arbitration. Promissory note cases are one of the most common types of arbitration and the brokerage firms experience a high success rate with these cases. These proceedings are governed, in part, by FINRA Rule 13806 if the only claim brought by the Member is breach of the promissory note. This rule allows the appointment of one public arbitrator unless the broker rep. files a counterclaim requesting monetary damages in an amount greater than $100,000.  If the “associated person” does not file an answer, simplified discovery procedures apply and the single arbitrator would render an Award based on the pleadings and other materials submitted by the parties. However, normal discovery procedures would apply if the broker rep. does file an answer. Thus, if a broker wants to make use of common defenses to promissory note cases and obtain full discovery on these issues, the broker should ensure that he or she timely files an Answer.

A recent trend with promissory notes is that the advisor’s employer does not actually own the Note. Sometimes this entity holding the note upon default is a non-FINRA member company, such as a subsidiary of the broker-dealer or holding company set up specifically to hold promissory notes. Many believe the practice of dumping promissory notes into a subsidiary is to circumvent the SEC requirement that brokerage firms hold a significant amount of capital (one dollar for each dollar lent) to protect against loan losses.  By segregating promissory notes into a separate entity, firms likely can retain much less to meet its capital requirements.

Because a non-FINRA member firm may ultimately attempt to enforce the promissory note, questions arise as to how an entity can use FINRA arbitration to pursue claims against an agent.  The Note likely contains a FINRA arbitration clause but this may create questions of the enforceability of the arbitration clause. Furthermore, non-FINRA member entities cannot take advantage of FINRA’s expedited proceedings for promissory notes under Rule 13806 as this rule only applies to “a member’s claim that an associated person failed to pay money owed on a promissory note.”

However, in order to make use of the simplified proceedings under Rule 13806, some member-firms have started a practice of sending a demand letter to the broker requesting full payment be made to the broker-dealer, rather that the entity that actually owns the note.  Broker-dealers have also attempted to simply add the Note-holder as a party to the 13806 proceedings. Reps should immediately question the broker-dealer’s standing to pursue collection or arbitration, the use of Rule 13806 to govern the arbitration, and potentially consider raising a challenge to a non-FINRA member firm attempting to enforce its right through FINRA arbitration.

If you have recently received a demand letter seeking collection of a promissory note or are party to an arbitration, you may wish contact the Investment Adviser Rep Syndicate or the attorneys at Cosgrove Law Group, LLC.

Thinking about making a career change and switching firms?  Your thoughts about wanting to switch firms or even opening your own shop are not uncommon.  There may be various reasons why making a change may be in your best interest.  Before doing so, however, there are some legal and professional considerations with regard to your clients that deserve your attention.

When determining whether to change firms, the question of whether it is in your clients’ best interest should be part of the equation.  Building your client base and meeting their needs is crucial to your overall success as an adviser.  Thus, you should have an understanding of the culture and environment of the new firm and analyze how these may or may not be beneficial for your clients before deciding to jump ship.  For instance, if you have a business that is heavily concentrated in certain products or if you are considering expanding the products you offer, make sure the firm can offer the support you need.  You should also consider if there is a change in the fee or commission structure at your new firm and whether it will cost your clients more to move their accounts.  Will some of your clients have to sell any portion of their portfolio in order to move?  These are questions you will need to answer before making a decision.

If you do decide to seek employment with another firm, you’re probably wondering how to inform your clients.  This area can get murky.  You should thoroughly review the contracts you signed with your current employer.  It is likely that these agreements govern your rights upon terminating your employment.  For instance, many employment and independent contractor agreements and contain clauses that prohibit an adviser from soliciting clients, or even other co-workers from moving their accounts or joining you at your new firm.  You may also be prohibited from informing your clients that you are joining a new firm or taking any information about your clients to your new firm.

If you are a registered representative, find out if both your current firm and the firm you are seeking employment with participate in the Protocol for Broker Recruiting.  This program is administered by SIFMA and seeks to “further the clients’ interests of privacy and freedom of choice in connection with the movement of their Registered Representative between firms.”

If both firms participate in the Protocol, reps may take only the following account information to his or her new firm: client name, address, phone number, email address, and account title of the clients that they serviced while at the firm (“the Client Information”) and are prohibited from taking any other documents or information.  Reps must also submit written resignations to local branch management and must include a copy of the Client Information that the rep is taking with him or her and include the account numbers for the clients serviced by the rep.  If you’ve complied your own information or notes about your clients during your career, taking this information with you is a common Protocol violation which could potentially lead to legal proceedings.  Remember that these rules only apply if both your current firm and the firm you are moving to belong to the Protocol.

If both firms do not participate in the Protocol, then look to your employment contract to see what restrictions may be placed on informing and soliciting customers.  These prohibitions could create a dilemma for advisors.  Even if there are no restrictions in your contract you should still consider the possible implications of alerting your clients about a new position.  From a legal standpoint, the most protective measure is likely not informing your clients that you are jumping ship, but is that the best decision professionally?  Clients may be confused upon learning about your departure and unsure of the circumstances surrounding the departure which may cause them to speculate and possibly resist moving their accounts to your new firm.  Some clients that you maintain close relationships with may feel offended that they were uninformed of your career choice.  Thus, if there is not some sort of contractual bar to letting your clients know you are switching firms, it’s probably best to inform them.

If you do decide to tell you clients that you are accepting a position with a new firm, you should almost never tell them of your plans until your current employer is informed.  You do not want to risk your employer finding out about your departure before you are ready to tell them.  When you do let your clients know about your opportunity, be sure to explain why the move is in their best interest and never say anything disparaging about your current employer even if your departure was the result of a tumultuous situation.  Be ready to inform your clients about any changes in the fee or commission structure, or any change in their portfolio that would result from moving their accounts.  Make a point to emphasize the benefits but always give your clients the material information they need to make an informed decision.

If at any point during your decision making process you are unsure of what restrictions are contained in your employment agreement, or the requirements of the Protocol, contact an attorney to assist you in understanding your rights and protect yourself during your transition.