The Financial Industry Regulatory Authority’s (“FINRA”) enforcement division brought 108 disciplinary actions against broker-dealer members during the first quarter of 2016.1 FINRA expelled two firms from membership during the period, and levied over $13 million in total fines for violations of securities laws. The fines averaged nearly $125,000, with several members receiving fines or restitution orders over $1 million. In several cases, the orders set forth by FINRA also led to “statutory disqualification” of individuals under Section 3(a)(39) of the Securities Exchange Act of 1934 (“Exchange Act”).
Some of the largest fines and enforcement actions resulted from violations relating to advertising, trading, research, registration, and qualification of associated persons. Below are some of the key fines during the period.
FINRA censured and fined a member $1 million for allegedly disclosing materially inaccurate information to investors. According to FINRA, the firm realized it published inaccurate performance information for one of its fixed income benchmark indices. The firm nonetheless continued to distribute the inaccurate material for an additional eight months. After spotting the error, the associated persons of the member failed to notify investors about the inaccuracies within a reasonable time frame. The material distributed by the firm was meant for institutional investors who manage their own portfolios and analyze the individual securities that make up the index.
The firm’s actions included the following:
- The firm’s Index, Portfolio and Solutions Group made several changes that affected the calculations of the index’s returns.
- The firm began using a new methodology to calculate coupon returns that had not been used to calculate the other indices that the firm offered to its clients.
- The firm changed its provider of coupon return data for the index’s underlying securities from an outside vendor to an internal system.
- The firm failed to conduct adequate testing during this adjustment period before publishing the next period’s benchmark report to subscribers.
Due to these actions, the new system’s calculation failed to reflect coupon return information prior to final review by management. The material understated subscribers’ received returns by an average of nearly 4 percent. The firm only became aware of the matter when subscribers to the reports noticed that the monthly returns in the portfolio were negative on some occasions. In reality, the subscribers were realizing different results than those disclosed by the firm. Eight months after several subscribers’ notifications, management actively began to correct its methodologies for calculating the index’s returns. The firm self-reported the issue through the Central Registration Depository (“CRD”) to comply with FINRA Rule 4530(b).
According to FINRA, the firm violated FINRA Rules 2210(d)(1)(B) and 3110(a).2 FINRA Rule 2210(d)(1)(B) states that no member may publish, circulate, or distribute any communication with the public that it knows contains any untrue statement of a material fact, or is otherwise false or misleading. In the case above, the firm should have tested its new methodology for calculating the performance of the underlying securities in the index. Firms should also designate individuals responsible for escalating customer notifications to the proper supervisor.
According to FINRA, the firm violated FINRA Rule 3110(a) by failing to have a system in place to supervise the activities of the firm’s associated persons. Members should revisit their policies and procedures to check if they have designated a registered principal to oversee and review all marketing materials before their publication. The firm should also designate the group that is responsible for conducting testing of its key systems, and should keep on file a report illustrating the results of the test.
During the first three months of 2016, a broker-dealer was fined $1,100,000 for allegedly conducting manipulative trading activity. FINRA permanently barred one individual associated with the member firm from acting in a principal capacity and ordered him to pay a civil fine of $50,000. The individual had failed to supervise the firm’s trading activity during the period. The firm also did not retain and supervise electronic communications between its traders during this time period.
Several of the firm’s traders were allegedly engaged in an illegal trading activity known as “layering.” This occurs when a trader enters a series of trades on one side of the market in order to obtain an advantageous price on the opposite side of the market. According to FINRA’s Market Regulation Unit, a total of 1,100 instances of potential layering activity took place and no supervision was occurring over the activities of the traders. For nearly one year, the firm’s traders allegedly entered large non-bona fide orders to buy securities below their current trading price. When traders at other firms saw this activity, they too would enter orders to buy the same security at levels closer to the offering price, assuming that the price would soon rise. Once the price reached a level at which the firm could make a profit, the firm then allegedly sold the securities from its own inventory. Upon executing the sell order, the firm canceled its large purchase orders.
The firm’s principal delegated most of the trading reviews to a compliance assistant. According to FINRA, the only reviews that the principal conducted were executed manually on one computer screen for over 600 of the firm’s traders. Additionally, management failed to review internal messaging between traders, and failed to make evidence of supervisory reviews available for FINRA’s inspection.
According to FINRA, the firm violated Rule 10b-5(c) under the Exchange Act, which prohibits a member from directly or indirectly using any means or instrumentality of interstate commerce, or any facility of a national securities exchange to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. The firm also allegedly violated FINRA Rule 4511 and Exchange Act Rules 17a-3 and 17a-4, which require firms to make and preserve books and records of the firm’s business.3 The firm’s failure to review electronic communications allegedly violated FINRA Rule 3110(b)(4)(B), which requires members to have supervisory procedures reasonably designed to review internal communications.
To meet its review obligations, firms can designate qualified persons to supervise trading activities. FINRA specifically requires supervisory reviews to be evidenced by a principal in writing (or electronically). A principal must also review internal messaging for potential abuses and red flags involving the member’s traders. Firms should include reviews of instant messaging, chats, or any other proprietary messaging platform as part of their electronic communications reviews. These reviews should identify the reviewer, the communications reviewed, and whether any communications were escalated to management. FINRA will not deem a review complete if the member’s documentation lacks adequate details.
Two instances during the previous quarter involved members violating FINRA’s research rules. One member received censure and a $500,000 fine for violations of several sub-sections of NASD Rule 2711, which has now been superseded by FINRA Rule 2241.4
The member failed to disclose the percentage of covered companies in its research reports for which it had provided investment banking services during the previous 12-month period. For nearly two years, the member published over 40,000 research reports, of which approximately 70 percent contained inaccurate client percentage disclosures. The inaccuracies resulted from an IT coding error in the firm’s disclosures database, which caused the firm to use outdated information to report client percentage disclosures.
In more than 3,000 research reports involving 85 issuers, the firm failed to disclose that the member was making a market in the securities at the time of the report’s publication. According to FINRA, this violated FINRA Rule 2241(c)(4)(G), which requires members to disclose in any research report whether the member was making a market in the securities of the subject company. The firm allegedly failed to make the required disclosures for a period of approximately seven years.
To comply with FINRA Rule 2241, firms should monitor the accuracy of the information captured in the firm’s disclosures databases. This review should be evidenced in writing and approved by a registered principal. Firms can also conduct spot-check reviews on reports to identify evidence of accurate client disclosure information.
Registration and Qualification of Associated Persons
FINRA censured a member and levied a fine of $1,250,000 for alleged failures to conduct adequate background checks on nearly 4,500 of its associated persons. FINRA also disciplined the firm for failing to fingerprint or properly screen its associated persons before hiring them. According to FINRA, the firm violated Rule 17a-3 and 17f-2 of the Exchange Act.5 The firm also violated Article III, Section 3(b) of the FINRA By-Laws.6
After completing an acquisition involving the member and a very large financial institution, the member failed to create a system to identify the nonregistered associated persons it was required to screen and fingerprint. Many of the new associated persons held job functions that required them to be fingerprinted. Although the firm did have a vendor responsible for fingerprinting associated persons, the firm and its new affiliated entities had no system in place to coordinate or monitor the fingerprinting process after the acquisition.
During this period, a person subject to statutory disqualification under Section 3(a)(39) of the Exchange Act became associated with the firm. The firm’s failure to submit fingerprint cards to FINRA resulted in the firm missing an arrest and felony conviction that took place within the previous 10-year period.
ACA notes that members receive notification from the Federal Bureau of Investigation (“FBI”) in CRD if any criminal history is available based upon a person’s fingerprints.7 All members are required to submit an MC-400 application with FINRA if they choose to associate an individual subject to a statutory disqualification. The member also did not have a questionnaire or an application that could identify the associated person’s criminal history.
Broker-dealers should complete a background check for all associated persons as part of the onboarding process. As stated in Regulatory Notice 15-05, firms must gather all necessary information available to make an evaluation of the individual’s business reputation, qualifications, and experience before filing an application for registration. FINRA also requires members to verify the accuracy of the information provided by the associated person within 30 days of filing a Form U4 or Form NRF in CRD. In addition to screening associated persons, all members must require their associated persons to submit fingerprint cards to FINRA. Firms should maintain the results of the background checks and the results that the FBI published through CRD in the employee’s file with the member. The firm should also maintain a copy of the fingerprint card. ACA recommends that the parties involved in onboarding new associated persons notify their supervisors once they complete the screening and fingerprinting process.
Other Significant Events
FINRA and the SEC permanently barred two principals of a member from acting as a broker or investment adviser, or otherwise selling securities or providing investment advice to the public. Both individuals allegedly paid for expenses of entities they owned using capital raised in a private offering. Each individual also allegedly misrepresented and omitted material facts in communications with investors of the private fund. According to FINRA, one of the individuals allegedly failed to properly update his Form U4 to disclose outstanding judgments. The individual filed several Form U4 amendments in a 10-month period, but failed to disclose eight outstanding judgments that were filed against him.
ACA notes the following key securities laws and FINRA rules that were referenced in actions during the first quarter of 2016:
- FINRA Rule 2210
- FINRA Rule 3110
- Exchange Act Rule 10b-5(c)
- FINRA Rule 4511
- Exchange Act Rule 17a-3 and 17a-4
- FINRA Rule 2241
- Exchange Act Rule 17f-2
- FINRA Rule 2121
ACA Compliance Group’s Broker-Dealer Services Division helps firms ensure their compliance with regulatory requirements. Our services include compliance program development, trading reviews, conflicts management analysis, corrective action assessments, supervisory control and AML testing, written supervisory procedure assistance, initial and ongoing membership application help, and customized regulatory and compliance consulting.
Please contact Dee Stafford at firstname.lastname@example.org for more information.
1See 2016 Monthly Disciplinary Actions
2See FINRA Rule 2210 and FINRA Rule 3110
3See FINRA Rule 4511
4See FINRA Rule 2241
5See Exchange Act Rule 17f-2
6See Article III, Section 3(b)
7See FINRA Statutory Disqualification Process