FINRA Chief Comments On Issues Relating To Unification Of NASD And NYSE Enforcement

On September 20, 2007, the DC Bar sponsored a luncheon program entitled "Learn What You Need To Know About FINRA From The New Enforcement Director Of This Combined NASD And NYSE Enforcement Entity." The featured speaker at the discussion was Susan L. Merrill, Executive Vice President, Chief of Enforcement, at the Financial Industry Regulatory Authority (FINRA), who previously served as Chief of Enforcement at the NYSE from 2004 to 2007. Merrill explained FINRA’s new structure and discussed key issues being addressed by FINRA.

FINRA Priorities

Merrill identified a number of priorities for FINRA for 2007 and beyond:

Subprime mortgages. Merrill stated that FINRA was investigating valuation issues related to CMOs and CDOs, particularly whether members’ internal valuation of these products differed from valuations being provided to customers, and the variation in written quotes provided to customers. The investigations are focused on whether members valued products differently in an attempt to avoid showing weakness in the market for subprime securities.

Senior investors. Merrill noted the recently publicized FINRA sweep concerning potentially abusive practices involving senior investors. She observed that 75 percent of all assets are managed by households headed by a person over the age of 50. Moreover, 30 percent of investment scams targeted senior investors even though seniors represent only 15 percent of the population. These numbers evidenced a need to ensure that representationsdirected to seniors were not misleading. FINRA is particularly concerned about the use of professional designations used by members, such as the term "senior experts." FINRA is investigating how its members earned these professional designations,including whether they were required to attend courses and the experience level required. Merrill highlighted, as an extreme example, programs that issue certifications for a fee without requiring any coursework.

Merrill noted that FINRA recently posted Regulatory Notice 07-43 on its web site.¹ The Regulatory Notice provides guidance to members on best practices relating to senior investors. For example, members should consider the investor’s age and life stage, not just their liquidity needs.

Hedge funds. Merrill stated that FINRA was investigating the relationship between hedge funds and the broker dealers who service hedge funds. Merrill noted that when servicing hedge funds, broker dealers may be tempted to give hedge funds special treatment. She added that FINRA was investigating potential insider trading, soft dollar arrangements, so-called "hedge fund hotels" (where the broker dealer provides a hedge fund with office space but provides no other supervision), and other potential conflicts of interest.

Operational deficiency cases. Merrill stated that FINRA is investigating members who fail to invest in their back offices, leading to problems resulting from failure to merge their technology systems or failure to properly upgrade their systems. These problems are causing delays in confirms and prospectuses.

Regulation SHO. Merrill stated that FINRA is also investigating members who fail to deliver stock within 13 days in violation of Regulation SHO.²

Excessive markups. Merrill noted NASD’s long-standing guideline that markups charged by members should not exceed 5 percent. However, as has been repeatedly held in numerous NASD cases, this 5-percent guideline far exceeds what is reasonable for many types of securities. Merrill used the example of Treasury securities, where she commented that a markup of 4.9 percent would be per se unreasonable. Merrill added that FINRA is considering whether to modify the guideline.

Variable annuities. Merrill explained that the SEC’s approval of a new suitability rule, FINRA Proposed Rule 2821, which establishes sales practice standards and supervisory requirements for deferred variable annuity transactions, will give FINRA a valuable new tool.³ This will continue to be an area of Enforcement attention for FINRA.

Fee-based accounts. Merrill noted that FINRA will continue to investigate suitability issues concerning the use of fee-based accounts for relatively inactive customer accounts, though she noted that the recent DC Circuit opinion in Financial Planning Ass’n v. S.E.C.⁴ will greatly limit the use of such accounts.

In addition to the enforcement priorities detailed above, Merrill also discussed certain outstanding matters related to the NYSE-NASD combination. These included the following:

Reconciling NASD and NYSE Cooperation and Sanctions Guidelines. Merrill identified reference materials created by the NASD and NYSE regarding cooperation and sanctions. The NASD’s published Sanctions Guidelines include references to credit for cooperation in the "Principal Considerations" section of those Guidelines.⁵ But NASD has no separate statement of its policy on cooperation. The NYSE published two Information Memoranda: 05-65, which addressed the forms of cooperation valued by the NYSE; and 05-77, which addressed factors to consider in assessing a penalty.⁶ The NYSE Memorandum addressing penalties reflects many of the same principles as the NASD Sanctions Guidelines. However, the NYSE memoranda apply only to NYSE matters, and will not carry over to FINRA cases. Merrill explained that FINRA is considering whether to establish new guidelines that reconcile the NYSE Information Memoranda with the NASD Sanctions Guidelines.

Merrill emphasized the importance of giving FINRA members credit for cooperation. She cited recent cases in which fines were reduced 50 percent or more because the member self-reported or provided other significant cooperation. However, Merrill highlighted the issue of whether credit should be given for waiver of the attorney-client privilege. She explained that the NYSE Information Memoranda emphasized respect for the privilege, and that although cooperation without waiver was possible, a waiver itself was powerful evidence of cooperation and deserved some credit. By contrast, Merrill cited a recent statement by SEC Commissioner Paul Atkins that the "Commission should not view a company’s waiver of privilege as a factor that will afford cooperation credit."⁷ Merrill also noted the recent KPMG decision, which found that the DOJ’s consideration of privilege waivers in its own guidelines (the "Thompson Memorandum") was unconstitutional.⁸ Merrill explained that in light of these recent events, FINRA was evaluating the cooperation issue internally.

With respect to sanctions, Merrill noted recent decisions by the DC Circuit and Second Circuit addressing sanctions imposed by the NASD and the SEC, respectively.⁹ Both decisions emphasized the need to look at the facts and circumstances of each case, and both decisions explained that sanctions imposed by the regulators must be remedial and not punitive. Merrill stated that FINRA would also consider "creative," non-monetary sanctions, citing cases where the penalties included the following: prohibitions on selling PIPE products for six months;¹⁰ a prohibition on new hires due to untimely U-4 filings;¹¹ a prohibition on the publication of a research analyst’s name for eighteen months;¹² and a prohibition on the creation of new mutual fund accounts against a member firm accused of "facilitating deceptive market timing practices and ... failing to have an adequate supervisory system to prevent deceptive market timing and late trading."¹³

Reconsideration of Coordination with SEC. Merrill announced that FINRA currently is re-examining its philosophy of engaging in joint investigations with the SEC. Merrill explained that this debate arose as a result of complications from the "state actor" issue. As a governmental entity, or state actor, the SEC is required to provide constitutional protections, whereas FINRA (and its predecessors, NASD and NYSE) has long been viewed by the courts as a private actor not subject to the same constitutional requirements. Merrill noted that in some cases it was helpful to have two regulators working on a matter, whereas in other cases the SEC could handle the matter on its own. Merrill said there are ongoing discussions with the SEC regarding whether FINRA can

Publicity regarding AWCs and Sweeps. Merrill responded to questions concerning the lack of publicity given by FINRA to many of its Letters of Advice, Waiver and Consent (AWCs) and to its regulatory sweeps. She indicated that FINRA had not yet determined whether sweeps should be more routinely publicized, but indicated a recognition that firms can properly benefit by improving their procedures if sweeps are publicized, as occurred with the recent sweep concerning senior investors. Merrill also acknowledged the potential need to reconcile differences between the NYSE policy of attaching a copy of its Hearing Panel Decisions to its press releases, and the NASD practice of not making AWCs available unless requested. Merrill noted that a rule change would have to be approved by the FINRA Board to effect any change.

Office of Disciplinary Affairs. Merrill noted that NASD’s Office of Disciplinary Affairs, whose approval is needed by Enforcement before instituting or settling Enforcement actions, is likely to continue in its current form at FINRA, because it was created in response to the 21(a) Report issued by the SEC in 1996.¹⁴

Timing of Issuance of FINRA Rulebook. Merrill noted that the new, unified FINRA Rulebook, reconciling NYSE and NASD Rules, has a target date for completion by the end of 2008, but that this may prove to be "unrealistic."