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The Financial Industry Regulatory Authority’s (“FINRA”) enforcement division issued a record dollar amount in fines for disciplinary actions against registered broker-dealers in 2016. As the tables below illustrate, while the total number of fines decreased, the dollar amount of those fines more than doubled the amount issued in 2013.
FINRA reported 29 fines of $1 million or more in 2016, up from 23 in 2014 and 21 in 2015. Overall, FINRA levied two more fines in the fourth quarter of 2016 than it did in the same quarter last year. In dollars, the fines increased roughly 46% from the fourth quarter of 2015 to $60,659,000 in the fourth quarter of 2016. Some of the largest fines in terms of dollar amount are mentioned below.
FINRA fined 12 broker-dealers $14 million in aggregate for alleged significant deficiencies relating to the preservation of broker-dealer customer books and records. Rule 17a-4(f) of the Securities and Exchange Act (“Exchange Act”) requires brokers-dealers that store records solely by electronic means to maintain those records in write once, read many (“WORM”) format.1 FINRA found that each of the 12 members allegedly failed to maintain business-related electronic records in a non-rewriteable, non-erasable format.
FINRA also censured two members, fined them $4 million jointly, and ordered them to conduct a review of their policies and procedures related to recordkeeping. According to information in the firms’ Acceptance, Waiver and Consent (“AWC”) letters, the recordkeeping failures resulted from an error in a data repository system used by both firms. This error spanned multiple systems and affected multiple categories of broker-dealer records, causing the firms’ failure to maintain approximately 350 million records in WORM format. The types of records included blotters of purchases, sales, receipts and deliveries of securities, and credits and debits for customers’ cash and margin accounts.
FINRA also cited the firms for their alleged failure to comply with paragraph (f)(3)(vii) of Rule 17a-4, which requires brokers-dealers to retain at least one independent third party that can access and download information from their electronic storage media. FINRA alleged that, in several instances, the firms failed to obtain attestations indicating their third-party vendors would furnish electronic records in the event the broker-dealers were unable to do so.
Brokers-dealers should take several steps before electing to store business-related records solely in electronic format. Firms should affirm that they maintain the records in WORM format pursuant to Rule 17a-4(f)(2)(ii), and that they utilize storage media from an independent third-party vendor. Members must notify their designated examining authority through the firm’s Gateway System at least 90 days prior to employing electronic storage media. The member should include a representation letter (often referred to as an undertaking letter) from the vendor that has agreed to access and download information from their electronic storage media. ACA has noted in its reviews that firms frequently overlook the requirement to retain an independent third party that can access and download information from their electronic storage media. Lastly, firms should revisit Question 8A of Form BD to ensure that they properly disclose any recordkeeping arrangements.
In the fourth quarter, FINRA censured a broker-dealer, fined it $12,500,000 and ordered it to provide a written certification to FINRA that it adopted and implemented a supervisory system and written procedures concerning its internal communications. The firm allegedly ignored numerous red flags from internal audit findings and recommendations, internal warning signs, and internal risk assessments indicating inadequate supervision of its associated persons’ internal speaker system. As a result, the firm failed to prevent its associated persons from communicating material nonpublic information to customers of the broker-dealer.
The firm’s associated persons disseminated information internally through an intercom speaker system. The equity research department used the intercom speaker system to transmit breaking news to other employees in the division. The firm’s “markets” division, which was responsible for sales and trading, used the system to provide certain employees with real-time information about the order activity in the securities markets. The firm acknowledged that both departments received proprietary and confidential information. For a period of five years leading up to FINRA’s examination, the firm lacked written policies and procedures that prohibited employees from sharing confidential information with employees or non-employees who lacked a legitimate need to know the information. In addition, the firm lacked policies and procedures governing who should have access to information, and how the firm should supervise employees.
FINRA Rule 3110(a) requires each member to establish and maintain a system to supervise the activities of each registered representative, registered principal, and other associated person.2 The firm’s supervisory system should be tailored to the specific business in which the firm engages, and must set out processes and controls that will detect violations and ensure compliance with the securities laws. Firms should take several steps to ensure that they adequately supervise their proprietary and confidential information. Members should also engage a party independent of the firm’s securities and investment banking businesses to conduct an analysis to specifically review procedures regarding the handling of confidential information. The analysis should include interviews with key personnel and an overview of the systems in use at the firm. It is important that a firm test its supervisory processes, and then address findings, taking action to correct them where necessary. The action plan should be documented and maintained with the firm’s records.
Ten broker-dealers were fined roughly $8 million during the fourth quarter. The violations occurred as a result of alleged failures to properly supervise sales of variable annuities. FINRA alleged that one firm failed to identify and investigate red flags in sales of its L-Share contracts. As a result, FINRA censured the member, levied a $2,750,000 fine, and ordered the firm to pay back customers who purchased L-Share contracts from it over the course of a five-year period.
During FINRA’s review period, the firm sold variable annuity contracts with various share classes. The firm’s L Shares have a shorter surrender period than other share classes. Therefore, the firm charges slightly higher annual fees for L-Share contracts than it charges for most other share classes. The firm began selling L Shares with a long-term income rider, which provides contract holders with a means of a guaranteed future income stream after the expiration of a holding period. The firm’s typical long-term income rider holding period was 10 years, and cost contract holders up to an additional 1%–1.5% per year. The firm did not identify the sale of an L-Share contract combined with a long-term income rider as a red flag, and as a result approved roughly 1,315 L-Share contract sales to unsuitable customers. The firm’s Principal Review Desk failed to consider suitability issues related to the selection of different share classes, and the firm did not provide training or guidance to the employees who sold the products to customers.
FINRA Rule 2330(d) requires that firms implement surveillance procedures to determine if their associated persons effect deferred variable annuity exchanges at rates that are unsuitable for the investor. Rule 2330(e) requires firms to develop specific training programs to ensure that associated persons who effect, and registered principals who review, transactions in deferred variable annuities comply with the requirements of the rule, and that they understand the material features of deferred variable annuities. The firm should review each customer profile to ensure the customer’s investment objective, investment experience, investment time horizon, liquidity needs, and risk tolerance suit the features offered in the contract. FINRA has focused its reviews on identifying unsuitable recommendations where customers should have been sold a different share class based on their financial profiles. In addition, members that sell variable annuities should include training for their employees throughout the year. The training should enable reps to offer customers proper explanations of surrender fees, operating expenses, and share classes.
FINRA levied a total of 24 disciplinary actions involving violations of trade reporting rules during the fourth quarter, assessing an aggregate total of roughly $3.6 million in fines. One member was censured and fined $2.8 million for alleged systemic issues concerning trade reporting to the Order Audit Trail System (“OATS”), as well as books and records violations. FINRA’s Trading and Financial Compliance Examination Group’s findings stemmed from a review that covered three days of trading activity.
The firm submitted millions of inaccurate trades to the FINRA Trade Reporting Facility. During the review period, the firm also submitted incomplete or inaccurate reportable order events to OATS. Some of the issues included inaccurately placed time stamps, new-order reports for modifications of existing orders, broker-dealer orders reported as customer orders, and intermarket sweep orders (“ISOs”) without the required ISO special handling code. According to the AWC, the firm violated FINRA Rules 7230A, and 7450, and received additional fines for violating Exchange Act Rule 10b-10 and Rule 605.3
Other Significant Events
FINRA censured one broker-dealer and fined it $150,000 for violating FINRA Rule 1122, which states that no member shall file with FINRA information with respect to membership or registration which is incomplete or inaccurate.4 The broker-dealer filed a continuing membership application to notify FINRA of a change of ownership. The application disclosed a partnership including the firm’s CEO, a consulting company, and a clearing corporation as the new owners of the member. The application failed to disclose that the CEO received funds for the purchase price from a statutorily disqualified person. The key persons from the consulting company discovered the true source of the funds and withdrew from the transaction. In the course of providing registration assistance for members seeking changes in ownership, ACA has noted that approval of the application is often contingent upon the transparency of the ultimate sources of the new member’s funding. Applicants can also delay an application’s approval if they fail to provide at least three months of bank statements from the account funding the member and from the account in the name of the broker-dealer entity.
Since 2013, FINRA has also issued 42 disciplinary actions to members who offer private placements of securities to investors. In that time, FINRA has also levied nearly $3 million in fines to members that structure, advise on and solicit investors in these products. In the fourth quarter, FINRA censured one member and fined it $15,000 for violations of Exchange Act Rule 15c2-4 and FINRA Rule 3110.5 According to information in an AWC, the firm acted as placement agent in a contingency private placement offering of securities. The firm raised and accepted funds from investors in this offering without establishing a separate bank account or an escrow account. Instead, the firm raised money from investors for nearly four months and placed the funds in an account in the name of the issuer until the firm reached the minimum amount of funds set by the subscription agreement. In 2016, FINRA published guidance for members on the requirements for handling investor funds in best efforts contingency offerings. A broker-dealer that has a minimum net capital requirement of $250,000 may receive and hold investor funds in a separate bank account in its control. Under no circumstances can a participating broker-dealer who is an affiliate of an issuer hold investor funds. The funds must be transmitted to an independent bank escrow agent. A broker-dealer that is required to maintain at least $5,000 in net capital may not receive investor funds directly or indirectly. All investor funds raised by firms operating under the $5,000 requirement are required to forward all purchases to an independent bank escrow agent. The escrow agent must meet the definition of a “bank” under Exchange Act Section 3(a)(6), although SEC staff has provided no-action relief to other entities such as broker-dealers who have the ability to hold customer funds and securities.6
ACA notes the following key securities laws and FINRA rules referenced in actions during the fourth quarter of 2016:
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.
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