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There seems to be a new trend in town: broker-dealers unleashing compliance or “reputation managers” upon rich-target independent branch operators.  Perhaps it isn’t really that new of a trend.  Indeed, after handling several such matters over the years, I am able to at least describe the modus operandi for these “internal raids”.

First, the broker-dealer’s “business side” identifies a branch with a substantial AUM.  As it stands, the broker-dealer is sharing in a small fraction of the revenue the branch is generating.  Coupled with an external factor, such as a desire to satiate regulators or even a mere personality conflict, executives at the highest level of the organization decide to raid the branch.  But they do it under the pretense of a newly born compliance concern, and they respond to old concerns with an utterly disproportionate sanction – termination without notice.  No Letter of Caution or fine, of course, as this would merely give the target rich financial adviser the opportunity to escape the WMD.

Upon termination the broker-dealer is oddly well prepared to immediately file a devastating U-5, send a highly prejudicial warning/solicitation letter to the adviser’s clients, and/or offer immediate home-office supervision or new OSJ opportunities to all of the branch’s financial advisers.  The impact upon the financial adviser is massive, as he is unable to become registered with a new broker-dealer until a naïve state regulator slowly plods through its investigation of the opportunistic and frequently defamatory U-5 disclosure.  The raiding broker-dealer will be slow but “cooperative” in responding to the regulator’s requests for documents.  In terms of private legal counsel, the financial adviser’s source of revenue will dry up at the very moment he or she needs to retain an army of lawyers.  The non-terminated financial advisers will cherry-pick their old boss’ clients.  (They will be ripe for the picking after the nasty letter they received about their now-terminated broker.)  By the time the adviser is registered with a new broker-dealer, his or her book is all but gone.

I have previously written a blog about the causes of action available to a financial adviser who has been raided in such a fashion.  But until FINRA panels start fully compensating the victims of these internal raiding schemes and awarding substantial punitive damage awards – the bombings will continue.  Moreover, state regulators need to issue provisional registration states to such financial advisors while they conduct their investigation.  Food for thought.

See alsohttp://securitiesandinvestmentblog.blogspot.com/2015/12/how-to-terminate-discredit-and.html

The Massachusetts Securities Division – one of the most active and sophisticated in the nation – recently issued a Policy Statement “to provide its state-registered investment advisers who establish concurrent or sub-advisory relationships with third-party robo-advisers with guidelines on how to best comply with the Massachusetts Uniform Securities act and meet the fiduciary duties owed to their clients.” That may be the longest sentence I have ever written.

So let’s start with the basics: what is a robo-adviser? Generally speaking, a robo-adviser is an online wealth management service that provides automated algorithm-based portfolio advice. Of course, a traditional adviser may also utilize software based data but they typically employ that data in the context of more personalized advice and wealth management or retirement planning. A few examples of robo-advisers in the marketplace today are Covestor, Market Riders, Asset Builder and Flex Score.

The problem, at least as I see it, is robo-advisers dressed up as fiduciaries. Some, and in particular one ubiquitous SEC registered RIA, actually promotes itself as a premium fiduciary with unparalleled individualized portfolio construction. In my opinion, it is not. Not even close. Unfortunately, the SEC has failed to take action against such cynical charades, but the Massachusetts Securities Division is doing what it can do within its jurisdictional constraints.

According to the new Massachusetts policy, any investment adviser registered pursuant to the Massachusetts Uniform Securities act must:

  • Must clearly identify any third-party robo-advisers with which it contracts; must use phraseology that clearly indicates that the third party is a robo-adviser or otherwise utilizes algorithms or equivalent methods in the course of providing automated portfolio management services; and must detail the services provided by each third-party robo-adivser;
  • If applicable, must inform clients that investment advisory services could be obtained directly from the third-party robo-adviser;
  • Must detail the ways in which it provides value to the client for its fees, in light of the fiduciary duty it owes to the client;
  • Must detail the services that it cannot provide to the client, in light of the fiduciary duty it owes to the client;
  • If applicable, must clarify that the third-party robo-adviser may limit the investment products available to the client (such as exchange-traded funds, for example); and
  • Must use unique, distinguishable, and plain-English language to describe its and the third-party robo-adviser’s services, whether drafted by the state-registered investment adviser or by a compliance consultant.

If you want to review the flesh on these bones, click here. Now, if only the SEC, California, Missouri, Florida and… would follow Lantagne’s lead.

The Internet is awash with articles about “bad brokers” with clean U-4s, and “rouge brokers” obtaining expungements of valid customer complaints.  Indeed, studies have been published ostensibly demonstrating that state regulators poses more valuable information on their system than what appears on FINRA’s public Broker-Check data base.  In sum, there is a consensus that too many complaints are being expunged.  But whether that consensus is based on fact is subject to debate.

Regardless, FINRA has repeatedly responded to the hue and cry by making it increasingly difficult for a financial adviser to obtain an expungement of a customer complaint published on his or her professional record.  But amidst all of this anguish and gnashing of teeth, a politically incorrect truth has been left in the shadows.  I feel compelled to share it with you.  Here it is:  some customer complaints are baseless.  There; I said it.

Another often-overlooked fact is that FA’s are able to go straight to a court of law, rather than a FINRA arbitration, to obtain an expungement.  Almost exactly one year ago, FINRA issued new guidance to its arbitrators raising ever higher the procedural bars for a panel to recommend expungement[1].  Should a FA surmount the procedural hurdles and slim avenues to success, the FA still has to go to court to get the Award confirmed.  And, in that state court action, he or she still needs to name FINRA as a party so that they can show up and oppose the FINRA arbitrator’s recommendation.

But FINRA Rule 2080 actually reads as follows:

2080. Obtaining an Order of Expungement of Customer Dispute Information from the Central Registration Depository (CRD) System

(a) Members or associated persons seeking to expunge information from the CRD system arising from disputes with customers must obtain an order from a court of competent jurisdiction directing such expungement or confirming an arbitration award containing expungement relief.

(b) Members or associated persons petitioning a court for expungement relief or seeking judicial confirmation of an arbitration award containing expungement relief must name FINRA as an additional party and serve FINRA with all appropriate documents unless this requirement is waived pursuant to subparagraph (1) or (2) below.

(1) Upon request, FINRA may waive the obligation to name FINRA as a party if FINRA determines that the expungement relief is based on affirmative judicial or arbitral findings that:

(A) the claim, allegation or information is factually impossible or clearly erroneous;

(B) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or

(C) the claim, allegation or information is false.

(2) If the expungement relief is based on judicial or arbitral findings other than those described above, FINRA, in its sole discretion and under extraordinary circumstances, also may waive the obligation to name FINRA as a party if it determines that:

(A) the expungement relief and accompanying findings on which it is based are meritorious; and

(B) the expungement would have no material adverse effect on investor protection, the integrity of the CRD system or regulatory requirements.

(c) For purposes of this Rule, the terms “sales practice violation,” “investment-related,” and “involved” shall have the meanings set forth in the Uniform Application for Securities Industry Registration or Transfer (“Form U4″) in effect at the time of issuance of the subject expungement order.

It seems as if very few have read the actual rule.  I recently read an attorney blog that makes no mention of the direct-to-court avenue whatsoever!  Well, our attorneys are very familiar with both the state court and arbitration options and procedures.

There is actually some case law out there on a financial adviser’s right to go to court to seek an expungement.  In Lickiss v. FINRA, 208 Cal.App. 4th 1125 (2012), the California Court of Appeals reversed a lower court’s dismissal of the FA’s petition.  In fact, it held that the trial court abused its discretion by limiting itself to the criteria set forth in Rule 2080(b), rather than employing the court’s broad equitable power and discretion.  The Court of Appeals stated in part:

FINRA has established BrokerCheck, an online application through which the public may obtain information on the background, business practices and conduct of FINRA member firms and their representatives.   Through BrokerCheck, FINRA releases to the public certain information maintained on the CRD, thereby enabling investors to make informed decisions about individuals and firms with which they may wish to conduct business.   This data includes historic customer complaints and information about investment-related, consumer-initiated litigation or arbitration….

The issues surrounding Lickiss’s sale of CET stock occurred more than 20 years ago, and the one regulatory matter against him resolved 15 years ago in 1997.   Since then, his record has been clear, yet Lickiss attested that he suffers professional and financial hardship relating to the prior sale of CET stock because current and potential clients increasingly use the Internet to obtain his BrokerCheck history.

Lickiss petitioned for expungement of his CRD records, asserting that the superior court had jurisdiction “pursuant to (1) FINRA Rule 2080(a);  [and] (2) the Court’s equitable and inherent powers to effectuate expungements.”…

FINRA removed the action to federal court.  Upon Lickiss’s motion, the federal district court remanded the matter back to the state superior court, ruling that it did not have subject matter jurisdiction over the case because there is no statute, rule or regulation imposing a duty on FINRA to expunge….

Had Lickiss merely petitioned the court for expungement relief under rule 2080, without also invoking the court’s equitable powers, that might be the end of the matter.   However, Lickiss explicitly invoked those powers….

Equity aims to do right and accomplish justice.  (Hirshfield v. Schwartz (2001) 91 Cal.App.4th 749, 770.)…

The equitable powers of a court are not curbed by rigid rules of law, and thus wide play is reserved to the court’s conscience in formulating its decrees…

This basic principle of equity jurisprudence means that in any given context in which the court is prevailed upon to exercise its equitable powers, it should weigh the competing equities bearing on the issue at hand and then grant or deny relief based on the overall balance of these equities…

The choice of a very narrow, rigid legal rule to assess the legal sufficiency of Lickiss’s petition—a choice that closed off all avenues to the court’s conscience in formulating a decree and disregarded basic principles of equity—was nothing short of an end run around equity…

This is not, as FINRA contends, merely a request for a remedy.   Rule 2080(a) essentially recognizes the right of members and associated persons to seek expungement of information from the CRD system by obtaining an order from a court of competent jurisdiction directing such expungement.

See also Lickiss v. FINRA, Fed.Sec. L. Rep. P.96, 345 (2011). Compare Updegrove v. Betancourt, 2016 WL 3442762 (2016).

If you are a FA who has a U-4 scarred by one or more clearly erroneous customer complaints, we would be happy to evaluate your prospects for success in seeking an expungement in state court or arbitration.  Your chances of erasing an unfair or unfounded complaint in a court of law at a reasonable cost might be better than you think.

 

[1] http://www.fa-mag.com/news/finra-continues-to-tighten-lid-on-expungements-with-newly-enhanced-arbitrator-guidance-23443.html

http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=15841&element_id=11616&highlight=2081#r15841

 

The North American Securities Administrators Association (NASAA) recently released its Enforcement Report for 2016, an annual publication providing a general overview of the activities of the state securities agencies responsible for the protection of investors who purchase investment advice or securities. Admittedly, the information undercounts many statistics due to differences in fiscal year reporting and a lack of response or underreporting for each survey question posed. However, trends in the 52 U.S. jurisdictions are still apparent in the report.[i]

 

For the first time since NASAA began tracking enforcement statistics, more registered than unregistered individuals and firms were subject to respondent status.[ii] During 2015, state securities regulators conducted 5,000 investigations and brought 2,000 enforcement actions against 2,700 respondents, which often involved more than one individual or company.[iii]

 

Sanctions imposed upon those who were found in violation of securities law ranged from incarceration to monetary relief and bans on trading. The year witnessed a combined 849 years of imprisonment, 410 years of probation, and 23 years of deferred prosecution, as well as $538m paid in restitution and $238m in fines/penalties.[iv] In addition to criminal and monetary repercussions, revocation and disbarment from the industry occurred for more than 250 individuals, while another 475 licenses/registrations were denied, suspended or conditioned.[v]

 

The five most common violations prompting these actions were, in order of frequency: Ponzi Schemes, Real Estate Investment Program Fraud, Oil & Gas Investment Program Fraud, Internet Fraud, and Affinity Fraud.[vi]

 

The NASAA report found that Ponzi scheme victims were often targeted through the internet or for identifiable attributes, such as race or religion. The report also found that vulnerable seniors were disproportionately victims; jurisdictions that reported on seniors found one-third of all investigations related to their victimization.[vii]

 

Prison terms have become more common for those conducting such schemes, such as Derek Nelson, found guilty of selling about $37m in promissory notes for property purchases that never took place. As a consequence, Mr. Nelson received 19 years in prison.[viii]

 

Real estate and oil and gas investment fraud was also a major concern for reporting NASAA members. Some states, such as Colorado, have sought judicial remedy and have secured investor protection by winning the right to have oil and gas interests subject to securities law.[ix]

 

The report clearly states that all fraud has been made easier to accomplish due to the internet, where only basic computer skills allow an individual from anywhere in the world to “enter” the homes of investors. Scott Campbell was sentenced to 20 years in prison for conducting a Ponzi scheme over the internet from Florida. Alabama garnered 18 convictions in an international bank scheme conducted through Craigslist.[x] Affinity frauds, in which an individual purports to be a member of a certain group, are much easier to accomplish given the anonymity of the internet.

 

The industry’s heightened attention to elder abuse has not shielded those responsible for supervision or oversight. Wells Fargo Advisors, LLC and Fulcrum Securities, LLC were ordered to pay $470,000 to investors for their failure to oversee Christopher Cunningham of Virginia, who defrauded elderly clients in a Ponzi scheme. For his part, Cunningham was disbarred and sentenced to 57 months in federal prison.[xi]

 

Attorneys are not immune to abusing their positions in order to perpetrate fraud. According to the report, Michael Kwasnik, an estate planning attorney, used his position of trust to perpetrate a $10m Ponzi scheme against elderly victims in New Jersey. The Court found that he had taken advantage of the attorney-client trust. Earlier in the year, Kwasnik also pled guilty to securities fraud in Delaware, utilizing the client trust account of his law firm to commingle monies from both frauds. Though Mr. Kwasnik received no jail time, he was ordered to repay millions in lost monies, amongst other judgments.[xii]

 

What may be the single worst case of elder victimization presented in NASAA’s annual report was perpetrated by Sean Meadows, owner of a financial planning and asset management firm, Meadows Financial Group LLC (MFG). Meadows perpetrated a $13m Ponzi scheme against 100 individuals, some disabled, poor, or terminally ill. He took the life savings of most, luring them into draining their retirement accounts. Many lost their homes, ability to care for their families, and even pay for cancer treatments.[xiii]

 

Meadows convinced his victims to pull money out of tax-deferred accounts to invest with MFG, promising these transactions would be tax-free rollovers. He then convinced these same individuals to allow him to do their taxes, in order to cover up the scheme. He either filed fraudulent tax returns or filed nothing at all. As a result, in addition to losing retirement savings, many incurred significant tax liabilities. For his crimes, Meadows received 25 years in prison.[xiv]

 

As the NASAA report makes clear, positive steps are being taken by its members to address the fraudulent and criminal activities of some individuals and firms. Laura Posner, NASAA Enforcement Section Chair, believes enhanced regulatory scrutiny is responsible for the increase in action documented by the report.[xv] However, it is still necessary to be on alert for promises that seem too good to be true. If you feel you may have fallen victim, please seek consultation from an attorney immediately.

 

[i] North American Securities Administrators Association (2016) NASAA 2016 Enforcement Report (Based on 2015 Data) [Electronic Format]. Retrieved from: http://nasaa.cdn.s3.amazonaws.com/wp-content/uploads/2016/09/2016-Enforcement-Report-Based-on-2015-Data_online.pdf. (pp. 11)

[ii] Ibid. pp. 5

[iii] Ibid. pp. 2

[iv] Ibid. pp. 3

[v] Ibid. pp. 4

[vi] Ibid. pp. 4

[vii] Ibid. pp. 5

[viii] Ibid. pp. 6-7

[ix] Ibid. pp. 4-5

[x] Ibid. pp. 7

[xi] Ibid. pp. 7

[xii] Ibid. pp. 9

[xiii] Ibid. pp. 9-10

[xiv]Ibid. pp.  9-10

[xv] NASAA Releases Annual Enforcement Report (9.13.2006) [Electronic Format]. Retrieved from: http:nasaa.org/40256/nasaa-releases-annual-enforcement-report-2

The SEC and DOJ brought a slew of cases against IAR’s and RIA’s in the first half of 2015. At least six cases were filed just last month alone. Here is a brief summary of a sampling of those cases.

On January 21, 2015, the SEC filed fraud charges and an asset freeze against a Fort Lauderdale, Florida-based investment advisory firm, its manager, and three related funds in a scheme that raised more than $17 million. The SEC’s complaint filed in federal court in the Southern District of Florida charged Elm Tree Investment Advisors LLC, its founder and manager, Frederic Elm, and Elm Tree Investment Fund LP, Elm Tree “e”Conomy Fund LP, and Elm Tree Motion Opportunity LP. According to the complaint, Elm, formerly known as Frederic Elmaleh, his unregistered investment advisory firm, and the three funds misled investors and used most of the money raised to make Ponzi-like payments to the investors. The complaint alleges that Elm used the funds to buy a $1.75 million home, luxury automobiles, and jewelry, and to cover daily living expenses.

On March 6, 2015, an investment adviser was hit with felony charges alleging that he defrauded clients of more than $1 million while running his own investment firm in Chicago. Philip E. Moriarty II is accused of six counts of wire fraud related to allegations that he defrauded investors of at least $1.1 million while he was the CEO of First Street Capital Partners in Chicago from 2008 to 2010. He’s accused of convincing four investors that they were investing in his businesses through the use of fraudulent documentation, and then spending the funds on personal expenses, including payments to a golf, hunting and fishing club, and $23,000 to a boarding school in New Hampshire.

Late that month, the SEC filed fraud charges against an investment adviser and her New York-based firms accusing them of hiding the poor performance of loan assets in three collateralized loan obligation (CLO) funds they managed. The SEC’s Enforcement Division alleged that Lynn Tilton and her Patriarch Partners firms breached their fiduciary duties and defrauded clients by failing to value assets using the methodology described to investors in offering documents for the CLO funds. Tilton and her firms allegedly have avoided significantly reduced management fees because the valuation methodology described in fund documents would have given investors greater fund management control and earlier principal repayments if collateral loans weren’t performing to a particular standard.

In April, 2015, a former JPMorgan Chase investment adviser was arrested on charges he stole $20 million from customers and spent the funds on unprofitable trading and other personal expenses. Michael Oppenheim allegedly took money from at least seven bank clients in a fraud scheme he operated from March 2011 to March 2015. Oppenheim worked as a JPMorgan investment adviser. He advised approximately 500 clients who collectively kept roughly $89 million in assets under his management, according to a criminal complaint filed by Manhattan federal prosecutors.

Later in April, a former Merrill Lynch and Smith Barney investment adviser already serving a federal prison term for investment fraud pleaded guilty to additional fraud charges in connection with a nearly two-decade-long scheme to defraud clients of hundreds of thousands of dollars. Jane E. O’Brien of Needham, MA, pleaded guilty to three counts of mail fraud, two counts of wire fraud, and two counts of investment adviser fraud. As alleged in the indictment, between 1995 and 2013, O’Brien defrauded several clients for whom she provided investment advisory services. As part of the scheme, O’Brien misappropriated funds entrusted to her through a variety of means, including persuading clients to withdraw money from their bank and brokerage accounts to invest. After gaining control of her clients’ money, however, O’Brien made no such investments. Instead, she used the misappropriated client funds for a variety of improper purposes, including paying personal expenses, paying purported investment returns, or repaying personal loans to other clients. Finally, in order to perpetuate her fraud and conceal it from her clients, O’Brien made false statements and misrepresentations to clients, including by making lulling payments to clients and otherwise providing them with false assurances of their financial security.

On May 15, 2015, Bryan Binkholder of St. Louis was sentenced to 108 months in prison on multiple fraud charges involving his financial planning and investment strategy businesses. In addition to the prison sentence, he was also ordered to pay $3,655,980 in restitution to the victims. According to court documents, Binkholder labeled himself “The Financial Coach” and provided investment and financial planning advice to the public through his affiliated websites and an investment related talk-radio show that aired on local radio stations. In 2008, he developed a real estate investment he termed “hard money lending.” Using his platform as an investment advisor and financial talk show host, Binkholder solicited his clients and others to invest in the hard money lending program. As part of his sales pitch he represented that he had relationships with developers who were not able to secure financing from traditional banks. As part of the hard money lending program, Binkholder told investors that they would invest money with him, and he would act as a bank and provide short term loans to these developers at a high rate of interest which would be shared with the investor. Instead of exclusively making hard money loans as promised, he took in millions of dollars of investor money, made only a small number of hard money loans and caused investors to lose more than $3,000,000.

On May 21, 2015, The Securities and Exchange Commission filed fraud charges against an Atlanta-based investment advisory firm and two executives accused of selling unsuitable investments to pension funds for the city’s police and firefighters and other employees. The SEC’s Enforcement Division alleged that Gray Financial Group, its founder and president Laurence O. Gray, and its co-CEO Robert C. Hubbard IV breached their fiduciary duty by steering these public pension fund clients to invest in an alternative investment fund offered by the firm despite knowing the investments did not comply with state law. Georgia law allows most public pension funds in the state to purchase alternative investment funds, but the investments are subject to certain restrictions that Gray Financial Group’s fund allegedly failed to meet. The SEC alleged that Gray Financial Group collected more than $1.7 million in fees from the pension fund clients as a result of the improper investments.

On June 3, 2015, the SEC filed two cases against purported investment advisers who falsified their credentials. In one case, the SEC charged that Todd M. Schoenberger of Delaware solicited at least a dozen people to invest in promissory notes issued by LandColt Capital, an unregistered advisory firm. According to the SEC, he said the notes would be repaid from management fees. Just a few days later, a Chicago investment adviser was arrested on federal charges that he defrauded his clients of at least $1 million, some of which he allegedly gambled away at local casinos. Alan Gold was charged in a criminal complaint that was unsealed following his arrest.

On June 11, 2015, the United States Attorney for the Western District of Wisconsin announced the unsealing of a 21-count indictment charging Pamela Hass with wire fraud and money laundering. The indictment also contains a forfeiture allegation seeking $460,831.27 in criminal proceeds. The indictment alleges that Hass engaged in a wire fraud scheme to defraud investors by promising returns from an investment in internet pop-up ads. According to the indictment, Hass falsely told investors they would obtain a return of anywhere from five to 20 times their original investment, and that if the investment failed, she would personally guarantee the return of the original investment plus 7 percent interest.

Also last month, The Securities and Exchange Commission announced fraud charges against a Washington D.C.-based investment advisory firm’s former president accused of stealing client funds. The firm and its chief compliance officer separately agreed to settle charges that they were responsible for compliance failures and other violations. SFX Financial Advisory Management Enterprises is wholly-owned by Live Nation Entertainment and specializes in providing advisory and financial management services to current and former professional athletes. The SEC alleged that SFX’s former president Brian J. Ourand misused his discretionary authority and control over the accounts of several clients to steal approximately $670,000 over a five-year period by writing checks to himself and initiating wires from client accounts for his own benefit.

Just a day later, Kenneth Graves, a former investment adviser representative in Corpus Christi whose license to sell securities was revoked last year by the Texas Securities Commissioner, was indicted on fraud charges related to the sale of investment contracts and excessive fees for his firm’s services. The indictmentalleges that Graves defrauded six clients of his firm, Warren Financial Services LLC, through the sale of $420,720 in investment contracts. The indictment alleges that in a separate fraud in 2013 and 2014, Graves misapplied $128,918 in fees he had collected from clients of Warren Financial.

Finally, on June 17, 2015, the SEC announced fraud charges against a Massachusetts-based investment advisory firm and its owner for funneling more than $17 million in client assets into four financially troubled Canadian penny stock companies in which the owner had an undisclosed financial interest. The SEC alleged that clients at Interinvest Corporation may have lost as much as $12 million of their $17 million investment based on the recent trading history of shares in the penny stock companies, some of which were purportedly in the business of exploring for gold or other minerals. Interinvest’s owner and president Hans Black served on the board of directors of these companies, which have collectively paid an entity he controls approximately $1.7 million. Black’s involvement with these companies and his receipt of payments from them created a conflict of interest that he and Interinvest failed to disclose to their advisory clients.

On a final note–Investors and accountants should take the time to read Brian Carroll’s article regarding investment advisory fraud in the Journal of Accounting.

In addition to founding the Investment Adviser Rep Syndicate, David Cosgrove, a former regulator and prosecutor, is the founding Member and Manager of Cosgrove Law Group, LLC. The law firm represents both investors and investment advisers across the nation. In doing so, the firm’s members have a unique strategic advantage and insight when it comes to litigation or conflict resolution in the financial services and investment arena.

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.

According to a variety of authorities including the SEC, the much-debated fiduciary duty for registered investment advisers and their representatives includes a subset of responsibilities[1].  Common sense would, or should tell you that the appropriate damage calculation for a breach of fiduciary duty will be directly dependent upon and vary according to the particular unfulfilled responsibility.  For example, a breach of the fiduciary duty regarding conflicts of interest or honesty, as opposed to mere suitability, will call for out-of-pocket damage compensation if these breaches occurred before any market-losses at issue.  Even in a suitability only arbitration, however, expert witnesses may debate the applicability of out-of-pocket loss calculations as opposed to model portfolio based market-adjusted damage calculations.

It is common in breach of fiduciary duty cases involving trustees to award damages in the amount necessary to make the beneficiary whole. Restatement of Trusts, Second, § 2205, (1957), provides that proof of harm from a breach of fiduciary duty entitles an injured party to whom the duty was owed to damages that: (a) place the injured party in the same position it would have been in but for the fiduciary breach;(b) place the non-breaching party in the position the party was in before the breach; and (c) equal any profit the breaching fiduciary made as a result of committing the breach. See also Restatement (Second) of Torts § 874 (1979) (“One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation.”).

Delaware law is consistent with this principle. In Hogg v. Walker, 622 A.2d 648, 653 (Del. 1993), the court noted that “where it is necessary to make the successful plaintiff whole” for a breach of fiduciary duty, courts have been willing to allow the plaintiff to recover a portion of trust property or its proceeds along with a money judgment for the remainder. The court in Hogg stated that “[i]t is an established principle of law in Delaware that a surcharge is properly imposed to compensate the trust beneficiaries for monetary losses due to a trustee’s lack of care in the performance of his or her fiduciary duties.” Id. at 654.[2]; see also Weinberger v. UOP, Inc., 457 A.2d 701, 714 (Del. 1983) (stating that in measuring damages for breach of fiduciary duty the court has complete power “to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages.”); Harman v. Masoneilan Intern., Inc., 442 A.2d 487, 500 (Del. 1982) (finding that “the relief available in equity for tortious conduct by one standing in a fiduciary relation with another is necessarily broad and flexible.”) (citing See Restatement (Second) of Torts, § 874 (1979)).

In O’Malley v. Boris, 742 A.2d 845, 849 (Del. 1999), the court stated that the relationship between a customer and stock broker is that of principal and agent. The court stated a broker must act in the customer’s best interests and must refrain from self-dealing, and that these obligations are at times described “as fiduciary duties of good faith, fair dealing, and loyalty.” (emphasis added) Id. The court further found that fiduciary duties of investment advisors “are comparable to the fiduciary duties of corporate directors, and are limited only by the scope of the agency.” Id.   Bear, Stearns & Co. v. Buehler, 432 F.Supp.2d 1024, 1027 (C.D.Cal. 2000) (finding that reasoning from case addressing breach of fiduciary duty by a trustee was persuasive in case involving investment advisor because, “[l]ike a trustee, an investment advisor may be considered a fiduciary.”).

In sum, it is critical to identify the particular duty at issue in order to arrive at a proper damage calculation.  The broker’s duty of suitability is essentially a limited duty of care akin to the one at play in a negligence matter. The fiduciary duty, however, carries within it an entire penumbra of duties of which portfolio/investment suitability is just one.  If an alleged breach of fiduciary duty is limited to the adviser’s responsibility to recommend or make a suitable investment only, the damage calculations may indeed mirror the broker-dealer damage calculation.  An adviser’s breach of its fiduciary duty beyond the mere standard of investment care, however, requires the finder-of-fact to calculate “make-whole” damages.

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[1]Miley v. Openheimer, 637 F.3d 318 (1981) is “the seminal case on damages in a suitability case[.]”

[2] A “surcharge” is relief in the form of monetary compensation for a loss resulting from a trustee’s breach of duty. The Supreme Court in CIGNA Corp. v. Amara, 131 S.Ct. 1866, 1880 (2011), stated that an ERISA fiduciary can be “surcharged” or ordered to pay money damages under the ERISA provision allowing a participant or beneficiary of the plan to obtain “other appropriate equitable relief.” In making this determination, the court stated that “[t]he surcharge remedy extended to a breach of trust committed by a fiduciary encompassing any violation of a duty imposed upon that fiduciary.” The court went on to conclude that “insofar as an award of make-whole relief is concerned, the fact that the defendant in this case, . . . , is analogous to a trustee makes a critical difference.”

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