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Who Are Your Customers?

Do you know who your customers are? FINRA only provides a vague definition for the word “customer.” Under Rule 12100(i), FINRA defines “customer” only as “any person other than a broker or dealer.” Recently, however, the definition became clearer. According to the Fourth Circuit, the definition of “customer” does not include investors who initiated investments on the advice of an individual who was connected indirectly to a FINRA firm. Raymond James Financial Services, Inc. v. Cary, No. 12-1053 (4th Cir. March 9, 2013).

In Cary, the individual investors sought to arbitrate claims against Raymond James Financial Services (“RJFS”), after the investors bought “allegedly fraudulent securities.” The investors had purchased securities directly from Inofin, Inc. (“Inofin”). Inofin’s president, Michael Cuomo, recruited his college roommate, Kevin Keough, a registered representative of Morgan Stanley, and David Affeldt, Keough’s friend and tax attorney, to refer investors to Inofin. Because Keough was employed by Morgan Stanley at the time, Cuomo and Keough agreed that Inofin would pay Keogh’s wife for the referrals. Affeldt and Keough’s wife agreed to equally share referral fees from Inofin.  Keough later joined RJFS, which is a FINRA member.

The investors brought claims against RJFS, which alleged violations of state securities laws, FINRA conduct rules, and that Keough assured them of their investments and sought to arbitrate their claims pursuant to FINRA Rule 12200.   Under Rule 12200 of the FINRA Code of Arbitration, a “customer” is allowed to bring arbitration proceedings against a FINRA member if the dispute arises in connection with the business activities of the member or its associated persons. 

In Cary, the investors argued that they were customers because they bought Inofin securities on the advice of an attorney who was a business and personal acquaintance of RJFS’ registered representative, Keough.  Because FINRA’s definition of “customer” is not instructive, the court, instead, relied on its previous definition of “customer” stating: “customer” means “an entity that is ‘not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities,’ namely, ‘the activities of investment banking and the securities business.’”

The court determined that the Inofin investors had no direct customer relationship with RJFS, or the registered representative. As a result, because the investors did not purchase the securities from RJFS, did not have any accounts at RJFS, and did not have any personal contact with the registered representative, the court determined that the investors did not fall within the definition of “customer.”



Expanding Leviathan’s Reach (with apologies to Thomas Hobbes)

On Friday, January 25, 2013, FINRA posted Regulatory Notice 13-06 (the “Notice”), which serves as official notice to the broker-dealer community that effective, February 25, 2013, under amended Rule 8210, FINRA examination staff may now request, inspect, and copy books and records about the outside non-investment related business activities of a firm’s associated persons or of the firm itself.  The operative phrase in the amended rule is any information in the “possession, custody or control” of the firm or any of its associated persons.  This would appear to include any records related to such outside endeavors as real estate, accountancy, insurance, or investment advisory activities of representatives doing such business away from their member firms.

In the adopting Notice, FINRA stated that the word “control” requires firms, associated persons, and other persons subject to FINRA’s jurisdiction to provide records that they have the legal right, authority, or ability to obtain upon demand even though the records are not in the immediate possession of the person subject to the request.

The extent of FINRA’s access to records is found in the catch-all phrase “possible violations of just and equitable principles of trade” and not only violations of FINRA rules, MSRB rules, and other federal securities laws. 

Noteworthy, too, is the term, “associated persons” as used in the amended Rule. An associated person is not just a registered representative of a firm, but includes a director, partner, officer, LLC member, or any other person occupying a similar status or performing similar functions.  This also includes any natural person involved in the investment banking or securities business that is directly or indirectly controlling or controlled by a member firm, whether or not that person is registered or exempt from registration.

It’s not too soon to amend your written policies and procedures to include the wider scope of the amended rule and/or send informational notices to senior management and registered representatives of the impending change related to FINRA’s expanded authority to access records of any of their outside business activities.  

President Obama nominates Mary Jo White as SEC Chairman

Since December 2012 the Securities and Exchange Commission announced that several key regulators would be leaving including Mary Shapiro, the agency’s chairman, three division heads, general counsel and the chief of staff.  

Now it is time to rebuild the agency.  On January 24, President Barack Obama announced the nomination of the next chairman of the Securities and Exchange Commission Mary Jo White.  Ms. White was the former U.S. attorney in Manhattan and may be best known for successfully prosecuting terrorists in the 1993 World Trade Center bombing trial and helped prosecute crime boss John Gotti.  She has served as a director of the Nasdaq Stock Exchange and served on its executive, audit and policy committees. Also of note, Ms. White has represented numerous individuals and corporations facing SEC enforcement proceedings. 

Mr. Obama said “It’s not enough to change the law.  We also need cops on the beat to enforce the law,” leading to speculation that the choice of Ms. White may be a signal that the President is looking for the SEC to be more aggressive about enforcement. 

President Obama’s remarks during press conference:



Holiday Cheer From FINRA

Last Monday, FINRA issued its new Regulatory Notice 12-55, “Suitability – Guidance on FINRA’s Suitability Rule.” This guidance backpedaled on a couple of significant matters provided in its previous guidance with respect to its definition of a “customer” under the new suitability rule.

In May, two months prior to the July 9, 2012, effective date for the new rule, FINRA issued Regulatory Notice 12-25 (“RN 12-25”), which defined the term “customer” to “include an individual or entity with whom a broker-dealer has an informal business relationship related to brokerage services, as long as that individual or entity is not a broker or dealer.” In an attempt to explain what an “informal business relationship” might mean, RN 12-25 stated that, “A broker-customer relationship would arise and the suitability rule would apply, for example, when a broker recommends a security to a potential investor, even if that potential investor does not have an account at the firm.”

The guidance issued last Monday withdraws the rather expansive “even if” clause above and now states that, “the term customer includes a person … who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent (e.g., ‘direct application’ business, ‘investment program’ securities, or private placements), or using another similar arrangement.” Therefore, the suitability rule does not apply to a potential investor unless that person becomes a customer of the firm or the representative who made the recommendation by opening an account and placing the trade, which essentially puts FINRA’s guidance back to the way it was always previously understood.


The second significant revision relates to the application of the suitability rule to non-securities products. In the guidance from May, FINRA applied the suitability rule widely to cover even non-securities product recommendations (e.g., fixed annuities or universal life insurance).  The new guidance draws some clarifying distinctions, but makes clear that the suitability rule applies only to the securities component of the recommendation or investment strategy.   However, as for a potentially “unsuitable” recommendation of a non-securities product, FINRA rules still pick up this misconduct under Rule 2120 (Standards of Commercial Honor and Principles of Trade), Rule 3270 (Outside Business Activities), and Rule 2210 (Communications with the Public).  For further information on this point, see endnote No. 18 in the new release, which is available by clicking here.

Given the new guidance, you’ll want to be sure that whatever new suitability policies and procedures you adopted under the new rule that went into effect on July 9, 2012, are revised accordingly to ensure you don’t inadvertently and unnecessarily subject your firm to the expansive requirements and related recordkeeping of the older guidance.

Monitoring Crowdfunding on the Internet

After the Jumpstart Our Business Startups (JOBS) Act was enacted, NASAA created a task force on Internet fraud investigations to monitor crowdfunding and other Internet offerings.  Read more about what state and Canadian securities regulators found during their analysis of Internet domain names and plans to coordinate multi-jurisdictional efforts to scan for fraud.

SEC Closes Second Highest Year in Enforcement Actions

The SEC announced last week that it filed 734 enforcement actions in its fiscal year that ended Sept. 30, 2012, which was only one shy of last year’s record of 735. The SEC noted that it saw the most significant increases in cases involving highly complex products, transactions, and practices, including those related to the financial crisis, trading platforms and market structure, and insider trading by market professionals.

The SEC also filed 134 enforcement actions related to broker-dealers, which was a 19% increase over the previous year.

For more information about the SEC’s enforcement action in the past fiscal year, read the full release here.

Investment Adviser Branch/Satellite Office Supervision

Often overlooked by investment advisers are supervisory procedures for branch or satellite offices.  During a routine investment adviser examination of a Michigan registered investment adviser, the Office of Insurance and Financial Regulation (“OFIR”) criticized the investment adviser for failure to have reasonable policies and procedures tailored to all of its business. While the firm did have written supervisory procedures, they were not reasonably designed cover all of its business activities,  particularly with regard to satellite or branch office locations. While not an exhaustive list, OFIR cited the following items as needing to be included in the firm’s policies and procedures:

  •  Documentation requirements:
    • How client files will be saved/preserved and transferred to the main office.
  • Correspondence procedures:
    • Covering hard copies and email.
    • Archiving and copying for home office review.
    • Complaint handling procedures.
  • Client meetings, how, when, and where with related documentation.
  • Branch/satellite office inspection/audit policies and procedures.
    • Specific audit steps, what records will be examined?
    • Review for unauthorized sales materials, performance reports, outside business activities.
    • Unannounced inspections and inspections by appointment (regulators request both).

The SEC likely has the same concerns with respect to branch/satellite offices of investment advisers registered with it. In various investment adviser compliance conferences, SEC speakers have pointed to FINRA’s guidance for broker-dealer branch offices as a starting point for designing investment adviser branch office supervision programs. To get started enhancing your own firm’s branch/satellite office supervisory system, see FINRA’s Regulatory Notice to Members 11-54 where FINRA and the SEC issued joint guidance on effective policies and procedures for broker-dealer branch inspections available here.  Contact any member of the Broker Dealer/Investment Adviser Practice Group if you need assistance with your branch office policies and procedures.

Be Aware, Email Based Wire Fraud Is On The Rise

The FBI and FINRA have recently issued alerts about the rise in email-based scams that request advisers to wire client funds.

The alerts warn that scammers are hacking into email accounts to gain access to personal information.  The scammers have become more sophisticated, than in the past.  They study the tone and style of the intended victim’s emails, look for personal information, such as account numbers and signature blocks, and then send phony emails to the victim’s financial contacts.

Over the past few months, our clients have shared the following real-life scenarios:

  • Adviser receives an urgent email request for funds to purchase a condo inFlorida.  Since the client was planning to purchase a condo inFlorida, this request seems legitimate.  The introduction in email even matched the familiar greeting between client and adviser of “Hey Buddy.” 
    • The “real” client realized that their email was hacked and informed adviser before funds were sent. 
  • Adviser receives an urgent request for funds by email with a follow up phone call to adviser’s office.
    • Adviser knows the client well and does not recognize the voice of the caller.  Adviser does not send funds, contacts the “real” client and the client’s custodian about the attempted fraud.
  • Adviser receives an urgent email request for funds that states the client is traveling and will not be available by phone.  Client will sign any required documents the next day, but money must be sent today.  Since client travels often, the request seems appropriate. 
    • Adviser sends funds and learns later that the request was not legitimate.

Although there is no guarantee that you can prevent becoming a victim of fraud; financial advisers should review their current practices and where necessary institute additional procedures to help detect fraud and protect client assets.  Advisers should consider implementing the following practices:

  • Review current procedures to determine potential risks to clients and the firm
  • Educate clients about the potential for fraud and phishing attacks 
  • Inform clients of any newly instituted procedures to help detect scammers 
  • Consider having clients send request verification to facsimile instead of email
  • Review email requests for odd phrases, grammatical errors, poor punctuation and spelling errors that might alert you to a fraudulent request
  • Urgent requests or statements that the client is not currently available may be cause for alarm.  Investigate first before sending funds
  • No matter how urgent the request for funds, do not send funds without first confirming by phone or fax that the client’s request is legitimate.
  • Make sure that when you confirm the request by phone that the voice and speech pattern match the voice and speech pattern of your client
  • Work with the client’s custodian to help identify best practices

Remember, scammers continue to change their method of attack to attempt to deceive even the most sophisticated systems.  Review procedures and inform staff and clients to be vigilant.  Although clients expect good customer service, take time to verify requests before the client and you become a victim of a scam.

Additional information about how to detect fraud and scams may be found using these links. 

FBI: http://www.ic3.gov/media/2012/EmailFraudWireTransferAlert.pdf and FINRA:  http://www.finra.org/investors/protectyourself/investoralerts/fraudsandscams/p125460?

Rollover Recapture: A Review

Several of our registered investment adviser and broker-dealer clients have recently asked whether it is permissible for an adviser or broker-dealer to make a recommendation to a 401(k) plan participant that he roll over his account into an IRA. This activity is often referred to as “cross selling” or “rollover recapture.” Because there is not a single answer to this question, we thought it would be helpful to review the current Department of Labor (DOL) guidance on this issue.

In a 2005 Advisory Opinion (AO), the DOL responded to a request for guidance concerning advice, including advice about rollovers and other services provided directly to plan participants by financial planners and advisers. The AO contained three questions and answers that are summarized below.

Q1: Is an individual who advises a participant for a fee on how to invest the assets in the participant’s 401(k) plan account, or who manages the investment of the participant’s 401(k) plan account, a fiduciary with respect to the 401(k) plan within the meaning of ERISA Section 3(21)(A)?

A1: Yes. Directing the investment of a plan constitutes the exercise of authority and control over the management or disposition of plan assets and the person directing the investments would be an ERISA fiduciary, even if the person is chosen by the participant and has no other connection to the plan.

Q2: Does the recommendation that a participant roll over his account balance to an IRA constitute investment advice with respect to plan assets?

A2: Merely advising a participant to take an otherwise permissible plan distribution, even when that advice is combined with a recommendation as to how the distribution should be invested, is not investment advice under ERISA. Where, however, the adviser or broker-dealer is already a fiduciary to the plan (because he is already providing investment advice or management at either the plan or participant level), then responding to participant questions concerning the advisability of taking a distribution or the investment of amounts distributed from the plan is a fiduciary act subject to ERISA’s fiduciary obligations (which require the fiduciary to act prudently and solely in the interest of the participant). Additionally, if, for example, an adviser or broker-dealer who is a fiduciary causes a 401(k) plan participant to take a distribution and then invest the proceeds in an IRA account managed by the fiduciary (or an affiliated company), the fiduciary may be using plan assets in his own interest in violation of ERISA’s self dealing prohibited transaction rules.

Q3: Would an adviser or broker-dealer who is not otherwise a fiduciary and who recommends that a participant take a plan distribution and invest the funds in an IRA engage in a prohibited transaction if the adviser or broker-dealer will earn management or other investment fees related to the IRA?

A3: No. A recommendation that a participant take an otherwise permissible distribution by someone who is not connected to the plan, even when combined with a recommendation as to how to invest the distributed funds, is not investment advice under ERISA.

The AO does not prohibit an adviser or broker-dealer who is a fiduciary from making a rollover recommendation, provided the adviser or broker-dealer considers only what is in the best interests of the participant. Depending on the participant’s situation, it may be in the participant’s best interest to remain in the plan. If a participant determines that a rollover into an IRA is more appropriate, an adviser or broker-dealer who is a fiduciary cannot receive any commission or other incentive payment in connection with a rollover from the 401(k) plan into an IRA. In addition, if the funds are rolled over into an IRA managed by an adviser or broker dealer who is a fiduciary, the fee charged by the IRA should be the same or lower than the fee currently being paid to the adviser or broker-dealer by the 401(k) plan or the participant. Such transactions likely would not run afoul of ERISA’s self-dealing prohibited transaction rules.

SEC announces first whistleblower payout under Dodd-Frank bounty program

Yesterday, the Securities and Exchange Commission announced that it has issued its first whistleblower award under the new bounty program established after the 2010 Dodd-Frank Act. Under the Act, whistleblowers may be rewarded between 10 and 30 percent of any money collected in an SEC enforcement action where more than $1 million in sanctions is awarded.

According to yesterday’s SEC press release, the whistleblower in this case has received $50,000, representing 30 percent of the amount collected from the defendant in this “multi-million dollar fraud”. The SEC noted that the whistleblower was eligible to receive further payouts when and if any additional money is collected from this defendant, or if sanctions are awarded against other defendants in this matter. As required by law, the whistleblower’s identity is being kept confidential. Similarly, the particular enforcement action was not identified.

For practitioners, and especially in-house counsel, it will be important to see how this whistleblower bounty program continues to develop. After the Dodd-Frank Act was passed in 2010, there was concern that whistleblowers would bypass internal reporting systems and, instead, take their grievances and observations directly to the SEC in hopes of collecting a large payout for their information. If the SEC continues to award 30 percent bounties, it may entice individuals to skip internal reporting in favor of the bounty program. However, while this individual received the maximum possible payout under the program, it is interesting to note that the SEC denied the second whistleblower’s claim for a portion of the monetary sanctions in this case. In support of that decision, the SEC notes that the information supplied by this second claimant “did not lead to or significantly contribute to the SEC’s enforcement action, as required for an award.”

For further information on the bounty program or this particular award, please see the SEC press release.

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