Originally published in Bloomberg Law Reports, March 6, 2012
In the wake of the financial crisis of 2008 and revelations concerning high-profile fraud, including insider trading and Ponzi schemes, securities industry regulators have come under increased pressure to enhance investor protection measures. Against this backdrop, the Financial Industry Regulatory Authority (FINRA), the largest independent self-regulatory organization (SRO) of U.S. based securities firms, has made clear, in both words and actions, that it will aggressively pursue its enforcement agenda to root out misconduct, preserve the integrity of the securities markets, and promote operational transparency in FINRA's member firms.
For example, FINRA has recently publicized the expanded enforcement agenda of its Office of Fraud Detection and Market Intelligence, Market Regulation Department, and Office of the Whistleblower.1 An examination of these offices' activities reveals that FINRA is focused both on underlying misconduct as well as firms' implementation of, and compliance with, internal procedures and controls designed to prevent such misconduct from occurring in the first place. Going forward, we expect FINRA to continue to scrutinize firms' supervisory activities and infrastructure. Accordingly, firms, including individuals with managerial responsibilities, must be even more mindful of their compliance obligations and duties.
Increased Surveillance and Enforcement Activity in 2011 and Beyond
Spurred by calls to action by members of Congress, other regulators, watchdog groups and critics in the press, it is no surprise that FINRA was active and engaged in 2011. For example, it increased the number of examinations and disciplinary proceedings. In addition, punitive measures against member firms and individuals also saw an increase. Specifically, in 2011, FINRA conducted thousands of examinations, filed 1,488 disciplinary actions, expelled 21 firms from the securities industry, and barred 329 and suspended 475 brokers from associating with FINRA-regulated firms.2 FINRA collected more than $63 million in fines, demonstrating a 53 percent increase over 2010.3 Finally, FINRA ordered over $19 million in restitution to investors.4 These achievements highlight "across-the-board" increases over FINRA's 2010 statistics.5 We expect that this trend will continue.
FINRA also continued to refer many matters to the Securities and Exchange Commission (SEC). For example, in 2011, it made over 600 referrals to the SEC. These referrals included matters involving issuer fraud, "pump-and-dump" schemes, market manipulation, and account intrusions.6 In 2011, FINRA made 285 insider trading referrals to the SEC―the highest in FINRA's history.7 FINRA's Chairman and CEO, Richard Ketchum, has predicted that this type of collaboration between FINRA and the SEC will likely intensify.8
Regulatory and Examination Priorities in 2012
Earlier this year, FINRA published its 2012 Regulatory and Examination Priorities Letter (Letter), which reflects FINRA's determination to preserve the integrity of the securities markets and to protect customers. The Letter sets forth FINRA's continued concerns about certain conduct, including: (1) the sale of risky structured products and private placement interests to retail customers; (2) misappropriation of customer assets; (3) inadequacy of firms' barriers to safeguard customer and material non-public information; (4) the use of high-frequency algorithmic trading; (5) private securities transactions and outside business activities; and (6) the use of social media and electronic communications.9 FINRA also sounded some new enforcement themes, including fraudulent activity relating to "reverse mergers," misrepresentation of customer fees, the use of foreign finders, and conflicts of interest in the sale and marketing of complex instruments.10 Finally, FINRA announced a new initiative to collect information from financial institutions and broker-dealers regarding their risk management systems, including plans to circulate a Risk Control Assessment survey to member firms during the first quarter of 2012.11
FINRA's Efforts to Expand its Jurisdiction
FINRA has publicly sought greater regulatory authority. For example, at a September 2011 Congressional hearing on proposed legislation that would give a yet-to-be-named SRO rule-making authority over, and responsibility for, conducting examinations of investment advisers, Ketchum testified that FINRA is "uniquely positioned" to take on this role given its experience in conducting examinations.12 Ketchum also suggested that such authority would enhance FINRA's current programs by allowing it to "examine the full operations of dually registered firms, where currently we can only see the broker-dealer side of what is typically a fully integrated business."13 Reportedly, FINRA also lobbied Congress and the SEC on this and other related issues.14
While FINRA has sought to expand its influence, member firms continue to have limited recourse when it comes to challenging FINRA in court. Most significantly, in early 2012, the U.S. Supreme Court declined to hear an appeal in a lawsuit brought against FINRA by a brokerage firm. The Supreme Court's denial effectively upheld the Second Circuit's 2011 ruling that FINRA and its officers are "absolutely immune from private damages suits" incident to its regulatory function as an SRO.15 FINRA is shielded from judicial scrutiny in other important ways. For instance, FINRA often settles enforcement actions against member firms pursuant to consent letters in which the member firm neither admits nor denies the alleged violations. Unlike SEC settlements, whose "no admit, no deny" language has recently come under fire,16 FINRA settlements are not subject to judicial review.
FINRA's Enforcement Agenda for 2012
FINRA is expected to pursue many of its 2011 enforcement priorities, and add new ones, in 2012. A central component of FINRA's agenda is to ensure that member firms have adequate policies and procedures in place to prevent violative conduct. FINRA Rule 4530 ("Reporting Requirements"), which took effect in July 2011, further reflects its expectation that firms police themselves. Rule 4530 established a new self-reporting requirement for firms that conclude that they, or an associated person, have engaged in misconduct. The focus on firms' supervisory practices figures prominently in FINRA's actions concerning the sale of complex products to retail customers, insider and manipulative trading, customer fees, and other areas of enforcement surveyed below.
Sale of Complex/Structured Products to Retail Customers
FINRA recently reiterated its concern about the ever-increasing complexity of financial products sold by FINRA's member firms.17 As new "Know Your Customer" and "Suitability" rules are slated to go into effect later this year, FINRA has made clear that compliance with these rules requires heightened supervision and controls with respect to complex products, especially concerning sales to retail customers.18
In its January 2012 Regulatory Notice 12-03, FINRA explained that a "complex product" is "a security or investment strategy with novel, complicated or intricate derivative-like features . . . that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks."19 In that Notice, FINRA provided member firms with examples of complex products, including but not limited to:
- Residential and commercial mortgage-backed securities;
- Products for which there is not an active secondary market,
such as non-traded REITs;
- Structured products that include an embedded derivative
component (i.e., in which payment of yield depends upon a reference
asset);
- Products with contingencies in gains or losses, such as range
accrual notes; and
- Investments tied to the performance of obscure
markets.20
FINRA encourages firms to adopt procedures for vetting complex products and supervising their sale and marketing.21 Prior to recommending or selling such products, firms should perform diligence to ensure that a product or investment strategy is suitable "for at least some investors." To do so, a firm or registered representative must understand the nature of the product, as well as its potential risks and rewards.22 According to FINRA, member firms also should consider whether: (1) the product's investment objectives can be achieved by less complex products; (2) the potential yield justifies the risks to the principal; (3) the product is sufficiently "transparent" to be understandable by registered representatives and customers; and (4) the product is liquid and there is an active secondary market for it.23
FINRA's guidance does not end there. After approving complex products for marketing and sale, firms should conduct periodic reassessments to determine whether the products' risk profiles remain consistent with their approach to selling them and ensure that only authorized representatives are engaging in sales to retail customers.24 Firms also must conduct inquiries into retail customers' financial sophistication and discuss products with retail customers to help them understand the product's structure and potential risks.25
When firms are delinquent, FINRA will take action. For example, in December 2011, FINRA fined a financial institution $2 million for unsuitable sales of reverse convertible notes to elderly customers and customers with limited investment experience and low risk tolerance.26 FINRA also filed a complaint against the registered representative who recommended and sold the unsuitable notes and made unauthorized trades in customers' accounts. Among other things, FINRA found that the firm had inadequate procedures to monitor for unsuitable sales.27
FINRA has also promulgated new rules that create additional enforcement opportunities in 2012 and beyond that focus on protecting customers. The new rules enhance firms' obligations to "know their customers" and ensure that their customers' investments meet "suitability" requirements. FINRA Rule 2090 ("Know Your Customer") requires firms to use reasonable diligence with respect to opening and maintaining accounts and to know the "essential facts" required to effectively service the customer's account, including following special instructions, understanding the authority of those acting on behalf of the customer, and legal compliance.28 FINRA Rule 2111 ("Suitability") requires a firm or associated person to have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for the customer.29 These new rules are based upon prior National Association of Securities Dealers and New York Stock Exchange rules covering the same subject areas. The FINRA rules, however, create new or modified obligations and emphasize FINRA's determination to enforce their core purpose.
Insider Trading
FINRA has kept a spotlight on insider trading, as evidenced by the Office of Fraud Detection and Market Intelligence's retention of a staff of 130 people and referral of hundreds of potential insider trading cases to the SEC in the past year.30 FINRA's insider trading surveillance often focuses on suspicious-looking trades entered into by hedge funds and retail investors. A suspicious trade may have unusual price and volume activity in advance of mergers or earnings announcements. Reportedly, FINRA opens an investigation following more than 90 percent of mergers,31 typically conducting an inquiry into how the transaction was publicized and focusing on who knew about the deal prior to its announcement to determine if improper trading occurred. FINRA eventually provides the results of its investigation to the SEC. For example, in 2011, the SEC brought civil fraud charges against four Chinese citizens and a Chinese firm for "highly profitable" insider trading following a FINRA referral.32 FINRA was alerted to the alleged misconduct through the individuals' use of long inactive U.S. brokerage accounts to purchase massive amounts of shares in a company shortly before its acquisition.33
Short Sales and Manipulative Market Activity
FINRA continues to reprimand firms for failing to comply with short selling regulations and other rules designed to prevent market manipulation. In so doing, FINRA is enforcing SEC Regulation SHO and Regulation M, targeting firms' failure to supervise short sale orders and failure to prevent and detect electronic programming issues that lead to misidentification of short sales. FINRA also continues to investigate other forms of market manipulation, including: (1) front running (when a firm or associated person provides material non-public information concerning an imminent block transaction to customers who then trade on the basis of that information); (2) spoofing (the spurious purchase and sale of large volumes of securities in order to artificially inflate or deflate their price); and (3) flipping (when dealers or institutional investors purchase shares in an offering and then immediately resell them to retail investors).
Customer Fees
FINRA will investigate firms that fail to disclose or mischaracterize fees to investors, or charge excessive fees for their services.34 For example, in September 2011, FINRA fined five broker-dealers for understating the commission they charged customers on trade confirmations and on fee schedules by mischaracterizing the commission charges as handling charges.35 FINRA found that these fees were "far in excess" of the cost of the firms' actual handling services, and were, in reality, designed to serve as a source of additional payments.36 FINRA also found that the firms had inadequate supervisory procedures to prevent such abuse.37
Objectivity of Research Reports
To ensure that firms safeguard the objectivity of, and make appropriate disclosures regarding, research reports provided to retail customers, FINRA will evaluate whether there are appropriate "firewalls" between sales departments and research departments. In January 2012, FINRA fined a member firm $725,000 for failing to disclose, in certain research reports, its role in managing the public offerings of the subject company, the revenue that it received from the company, or the extent of its ownership of shares in the company. FINRA also found that the firm failed to have reasonable procedures in place to ensure that the firm would make the required disclosures.38
Reverse Mergers
In a "reverse merger," a foreign issuer that did not go through the registration process in connection with an initial public offering in the United States merges with a U.S. public shell company and thereby achieves "backdoor registration."39 FINRA will continue to monitor the proliferation of reverse mergers and their accompanying potential risks to investors, including the significant allegations of fraud surrounding this practice, particularly relating to China-based issuers.40
Foreign Finders
FINRA will scrutinize foreign finders' activity that appears to go beyond the initial referral of non-U.S. customers to U.S.-based member firms. A foreign finder is a non-U.S. finder hired by a firm to solicit investments from foreign customers. A foreign finder is not considered an associated person of a member firm, and therefore FINRA restricts its activity on behalf of a firm to referrals. FINRA has expressed its concern that foreign finders (particularly in developing countries) are increasingly acting as associates of U.S.-based firms and essentially selling the firms' products and trading in customers' accounts.41
Conclusion
As the above analysis demonstrates, FINRA actively pursued its enforcement agenda in 2011 and is expected to continue that trend in 2012. FINRA's robust enforcement activities indicate that it is primarily focused on protecting retail customers by policing the sale of complex products, protecting the markets from manipulation, identifying potential insider trading, and monitoring certain foreign actors. Member firms should implement and maintain adequate supervisory procedures, as well as internal controls, to detect violative activity in these areas.
Ari M. Berman is a partner in the Complex Commercial Litigation practice group in the New York office of Vinson & Elkins LLP. His practice focuses on securities litigation and enforcement matters and commercial disputes. He has significant experience representing financial institutions, underwriters, officers, and directors in various contexts, including investigations and enforcement proceedings by the SEC, FINRA, and other regulatory agencies.
Benjamin D. Tievsky is an associate in the Complex Commercial Litigation practice group in the New York office of Vinson & Elkins LLP. His practice focuses on securities litigation and enforcement matters and commercial disputes.
Footnotes
1 See FINRA Press Release, FINRA's 2011 Activities Highlight Commitment to Investor Protection (Dec. 16, 2011).
2 See FINRA Statistics.
4 Id.
5 Id.
6 See FINRA Congressional Testimony, Vice Chairman Steven Luparello (Dec. 14, 2011).
7 Id.
8 Suzanne Barlyn, FINRA Chief Sees Closer Ties with SEC, Thomson Reuters News & Insight, Jan. 20, 2012.
9 See FINRA 2012 Regulatory and Examination Priorities Letter (Jan. 31, 2012).
10 Id.
11 Id.
12 FINRA Congressional Testimony, Chairman Richard Ketchum (Sept. 13, 2011).
13 Id.
14 FINRA Spent $280K Lobbying in Third Quarter, Bloomberg Businessweek, Dec. 19, 2011.
15 Standard Inv. Chartered, Inc. v. Nat'l Ass'n of Sec. Dealers, Inc., 637 F.3d 112 (2d Cir. 2011), cert. denied, No. 11-381, 2012 BL 12416 (U.S. Jan. 17, 2012).
16 Edward Wyatt, Judge Blocks Citigroup Settlement With S.E.C., N.Y. Times, Nov. 28, 2011; Alison Frankel, Citi's FINRA deal: Why 'neither admit nor deny' isn't a problem, Reuters Blog, Jan. 18, 2012; SEC v. Citigroup Global Mkts Inc., No. 11-CV-7387, 2011 BL 307391 (S.D.N.Y. Nov. 28, 2011).
17 See supra note 9.
18 FINRA Regulatory Notice No. 12-03 (Jan. 17 2012).
19 Id. at 1.
20 Id. at 3-5; see also supra note 9.
21 See supra note 18 at 1.
22 Id. at 5-6.
23 Id. at 6.
24 Id. at 7.
25 Id. at 8-9.
27 Id.
28 See FINRA Regulatory Notice No. 11-25 (May 18, 2011).
29 Id.
30 Ben Protess, For Wall Street Watchdog, All Grunt Work, Little Glory, N.Y. Times Dealbook, Dec. 1, 2011.
31 Id.
32 Nathalie Tadena, Four Charged Over Trading, Wall St. J., Dec. 7, 2011.
33 Id. Another example is FINRA's October 2011 referral to the SEC of 19 examples of possible insider trading by SAC Capital Advisors, whose trades drew FINRA's attention because they were made before market-moving events including the release of clinical trial results for new drugs. See Joshua Gallu and Saijel Kishan, SAC Capital Netted $14M in Trading Flagged by Finra, Bloomberg, Oct. 25, 2011.
34 See supra note 9.
35 FINRA Press Release, FINRA Fines Five Broker Dealers for Improper Handling Fees (Sept. 7, 2011).
36 Id.
37 Id.
39 See supra note 9 at 6.
40 Id.
41 Id. at 8.
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