The Financial Industry Regulatory Authority’s (“FINRA”) enforcement division brought 129 disciplinary actions against FINRA members during the first half of 2018. The number of fines FINRA assessed during the period represented a significant reduction from the amount in the first half of 2017, during which FINRA levied 168 disciplinary actions against members. The total dollar amount of fines year over year has stayed nearly the same, totaling roughly $30 million for each period. Based on the chart below, the total dollar amount in fines levied on firms in the first half of the year increased from over $43 million in 2014 to a peak of slightly more than $77 million in 2016, before decreasing again through 2018. The total number of fines in the first half of each calendar year has decreased every year since 2014. Some of the largest fines and enforcement actions during the first and second quarters of 2018 resulted from violations related to anti-money laundering (“AML”) requirements, variable annuities sales, registration, and branch office supervision. Details on some of the largest fines in these categories in terms of dollar amount follow, and the end of this summary includes a breakdown of the total number and dollar amount of fines paid during the first half of 2018.
FINRA fined nine member firms for violations of FINRA Rule 3310 during the first half of the calendar year. The nine disciplinary actions amounted to nearly $20 million in fines. The number of AML violations increased over the same period last year. During the first half of 2017, FINRA fined six-member firms over $3 million for violations of AML rules. Most notably, FINRA censured one member firm (“Firm 1”) and fined it $20,000 for allegedly failing to comply with FINRA Rule 3310(c), which requires certain member firms to conduct an independent testing of the firm’s AML program at least annually.1
According to a Letter of Acceptance, Waiver, and Consent (“AWC”), Firm 1 did not conduct an annual independent testing of its AML program for three consecutive calendar years. The firm’s primary line of business involved acting as a placement agent for private offerings. During FINRA’s review period, the firm sold 13 private offerings and received transaction-based compensation. The firm solicited 33 investors, both individuals and entities, to invest in the offerings. The firm allegedly also failed to complete customer identification and to verify the identities of these investors as required by the firm’s customer identification program (“CIP”) and 31 C.F.R. 1023.220. In addition, the firm allegedly failed to maintain information for each customer account as required by FINRA Rule 4512. According to the AWC, Firm 1 did not maintain records of subscription agreements, confirmations and other documents in connection with the private placement offerings.
FINRA requires that each of its member firms have a qualified outside party or independent personnel conduct annual independent testing of its AML program. However, if the member does not execute transactions for customers, hold customer accounts, or act as an introducing broker with respect to customer accounts, then the test can be conducted every two years. FINRA does not consider testing to be independent if the person conducting the test is the firm’s AML compliance officer, anyone involved in the day-to-day functions of the AML program, or anyone who reports to any of these individuals.
Placement agents who sell private offerings to investors have a CIP obligation to fulfill unless the investor is an entity that has equity shares that are listed on a national securities exchange or is a financial institution regulated by a federal functional regulator, government department, or agency. Firms need to evidence CIP by having the customer complete a new account form or a subscription agreement which generally includes the customer’s name, date of birth, address and taxpayer identification number. Members should also obtain a copy of a driver’s license or passport for an individual customer. For entities, the firm should collect a copy of the entity’s formation documents, such as an operating agreement or corporate bylaws. In addition, firms must collect CIP for at least one control person of the entity and anyone who directly or indirectly owns 25% of the entity.
Variable Annuities Sales
FINRA censured five broker-dealers and levied just over $4,780,000 in fines in connection with alleged violations of FINRA Rule 3110 and FINRA Rule 2330.2 One member received censure and a $4,000,000 fine, in addition to required payments of $2,000,000 in restitution to customers with whom it executed variable annuity (“VA”) exchanges during a three-year period. According to the firm’s AWC, FINRA staff identified 250 unsuitable VA exchanges during an inspection of the firm’s VA business practices. As a result of the examination, FINRA ordered the member to implement additional supervisory procedures and controls for the VA exchange business and hire an independent consulting firm to evaluate the firm’s supervisory system. The findings and observations report issued to the member noted that the consulting firm recommended six enhancements to the firm’s supervisory system. FINRA’s recent review of the firm’s VA exchange business found that the member did not implement the consulting firm’s recommendations until four years after it was required to do so.
During the review period, FINRA also noted that roughly 77% of a sample set of VA exchange forms contained misstatements and omissions of relevant information. For example, some forms overstated the total fees of the customer’s existing VA or misstated fees associated with various riders. Other forms in the sample understated or failed to disclose the existing VA’s accrued living death benefit value, which the customer would forfeit upon executing the proposed exchange. Still other forms indicated a proposed VA had a living benefit rider which did not actually exist. The firm had a principal review desk to determine whether or not to approve each annuity transaction that was submitted by its registered representatives, but the misstatements and omissions in the sample indicated that the firm’s principals and registered representatives failed to show a reasonable basis for recommending the transactions.
FINRA censured and fined three members a total of $70,000 for alleged violations of National Association of Securities Dealers (“NASD”) Rule 1021, which states that all persons engaged in the securities business who function as principals must be registered as principals.3 Rule 1021(b) defines a principal as anyone associated with a member firm who engages in the supervision or management of the firm’s securities business.
One member allegedly permitted an individual from an affiliate who was not registered with the broker-dealer to act as a principal on a number of different securities-related activities that required a principal registration with the member firm. These activities included directing associated persons on disbursement of funds from escrow accounts, speaking with bank personnel about escrow agreements, and answering client questions related to the business operations of the firm. In another instance, FINRA censured a member firm and fined it $10,000 upon discovering that, for a period of two years, the firm permitted an individual registered as a general securities representative to function as a principal without holding the proper licenses with the firm. According to the AWC, the general securities representative identified himself as the president and participated in decisions regarding employment status of other registered representatives at the firm, as well as the distribution of sales bonuses to two registered representatives.
Firms can prevent noncompliance with NASD Rule 1021 by taking several steps. First, a member firm should identify at least two persons responsible for the supervision and management of each of the firm’s approved business activities and register those individuals as principals in the category of registration appropriate to the functions the member performs. Second, members should designate persons to be responsible for final approval of a member firm’s required reviews, such as securities transactions, electronic communications, insider trading, hiring and firing registered representatives, and acceptance of new accounts. Those designated principals should either maintain a principal’s license or be a delegate that reports their activity to a registered principal.
Branch Office Supervision
FINRA censured and fined one member firm for alleged violations of FINRA Rule 3110(c). The rule states that each member shall inspect at least annually (on a calendar-year basis) every OSJ and any branch office that supervises one or more nonbranch locations.
According to the AWC, the firm conducted remote inspections for three OSJ branch office locations and also failed to conduct inspections of two non-OSJ branches that have been registered with the firm since 2009. FINRA Rule 3110(c)(1)(B) requires firms to inspect non-OSJ branch offices at least every three years. The firm also failed to conduct inspections of eight out of 34 nonbranch office locations, seven of which had been opened since 2001. Member firms must conduct reviews of their nonbranch office locations on a regular, periodic basis. FINRA Rule 3110.13 establishes a general presumption that a nonbranch office will be inspected at least once every three years. Members may use a longer periodic schedule, as long as they can document in its written supervisory and inspection procedures the factors used in determining the appropriateness of a longer periodic inspection schedule.
Member firms can prevent noncompliance with FINRA Rule 3110(c) by taking several steps. A member should maintain a schedule of all of the firm’s office inspections, along with the date of each inspection. Every member should determine whether each office is an OSJ, or a non-OSJ branch or nonbranch office based on the definitions in FINRA Rule 3110(e). FINRA Rule 3110 allows member firms to have firm personnel conduct inspections of their office locations under two conditions: associated persons cannot conduct inspections on the offices in which they work, and the individual conducting the inspection must not report to or come under supervision of an associated person at the office location to be inspected. Each review should, at a minimum, test the firm’s policies and procedures in areas such as safeguarding customer funds and securities, maintenance of books and records, supervision of supervisory personnel, transmittal of funds, and changes of customer account information. The member should also maintain a report of the findings of each inspection. FINRA has requested that members provide copies of inspection reports, as well as a remediation plan for any findings, to ensure firms resolve all noted deficiencies. Any deficiencies noted in a report that have not been remediated in a timely manner would attract increased regulatory attention.
ACA notes the following key securities laws and FINRA rules referenced in actions during the first half of 2018:
- FINRA Rule 3310
- C.F.R. 1021.220
- FINRA Rule 2330
- NASD Rule 1021
- FINRA Rule 3110
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.
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 investors. 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. Members that sell variable annuities should include training for their employees throughout the year. The training should enable reps to offer customers explanations of surrender fees, operating expenses, and share classes. Firms should also ensure that principals responsible for approving VAs receive training on how to verify VA product information or how to use product information to conduct a meaningful comparison of two products in the case of an exchange.
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