Reprinted with permission of Securities Arbitration Commentator, Inc., Maplewood, NJ. www.sacarbitration.com .
Most lawyers who practice before the Financial Industry Regulatory Authority ("FINRA") appreciate the difference between "selling away" and "settling away." In the former, a registered representative participates in securities transactions which are not disclosed to or approved by the associated person's member firm.1 "Settling away" denotes an undisclosed, private agreement between a person associated with a FINRA member firm and a retail customer to resolve a customer complaint. As an industry practice, securities broker-dealers promulgate sales practice manuals which require associated persons to report customer complaints to their firms. When a customer complaint to a registered representative results in a private settlement which is not disclosed to the supervising broker-dealer, it frustrates the firm's ability to comply with FINRA reporting requirements. An unreported settlement circumvents FINRA's ability to police and regulate the conduct of individual registered representatives and their member firms. In addition, FINRA Rule 2150 prohibits members and their associated persons from guaranteeing a customer against loss in any securities account of the customer.2
A typical illustration would involve a customer of a registered securities representative. The hypothetical broker makes an unauthorized or erroneous $100,000 purchase in the customer's account, hoping for big profits. However, the improper trade results in a $60,000 loss, and the angry investor threatens to bring an arbitration against the broker to recoup the loss. The customer further threatens to report the improper trade to the regulators at FINRA. Seeking to avoid an administrative morass involving FINRA regulators, the firm's compliance department and its errors and admissions carrier, the registered representative proposes an off-the-record resolution to the customer: the broker agrees to make up the $60,000 shortfall from his own personal funds. In this scenario, the customer assents, negotiates the broker's check and then reports the payoff anyway, resulting in a FINRA regulatory prosecution of the broker. In addition, the customer may file an arbitration with FINRA Dispute Resolution.
DUTY TO REPORT CUSTOMER COMPLAINTS
Registered broker-dealers issue sales practice compliance manuals that require registered representatives to promptly report specified customer complaints to the firm. In addition, under most circumstances, FINRA rules obligate member firms to report customer complaints in their regulatory filings. FINRA Rule 3070 governs a member firm's obligation to report customer complaints. It provides in part:
(a) Each member shall promptly report to the Association whenever such member or person associated with the member:
* * *
(2) is the subject of any written customer complaint involving allegations of theft or misappropriation of funds or securities or of forgery;
* * *
(8) is the subject of any claim for damages by a customer, broker, or dealer which is settled for an amount exceeding $15,000 . . . ; 3
As can be readily seen from the text of Rule 3070, a member must report to FINRA a written customer complaint under enumerated circumstances. Such customer complaints are reported on the individual representative's Central Registration Depository (CRD) and the firm's regulatory record. In addition, FINRA's Form U-4 (Uniform Application for Securities Industry Registration or Transfer) asks the following questions, in part 14 (I):
(1) Have you ever been named as a respondent/defendant in an investment-related, consumer-initiated arbitration or civil litigation which alleged that you were involved in one or more sales practice violations and which:
(a) is still pending, or;
(b) resulted in an arbitration award or civil judgment against you,
regardless of amount, or;
* * *
(d) was settled, on or after 5/18/2009, for an amount of $15,000 or more?
(2) Have you ever been the subject of an investment-related, consumer-initiated (written or oral) complaint, which alleged that you were involved in one or more sales practice violations and which: . . . (b) was settled, on or after 5/18/2009, for an amount of $15,000 or more?
(3) Within the past twenty four (24) months, have you been the subject of an investment-related, consumer-initiated, written complaint, not otherwise reported under question 14I (2) above, which:
(a) alleged that you were involved in one or more sales practice violations and contained a claim for compensatory damages of $5,000 or more (if no damage amount is alleged, the complaint must be reported unless the firm has made a good faith determination that the damages from the alleged conduct would be less than $5,000), or;
(b) alleged that you were involved in forgery, theft, misappropriation or conversion of funds or securities?4
Thus, registered representatives should report investor complaints which fall into the foregoing categories.
The FINRA Manual does not explicitly forbid settling away. FINRA promulgates hundreds of conduct rules, but not one explicitly defines settling away. Nor has research disclosed any FINRA Notices to Members (NTM) that explicitly address this practice.
Prosecutions for settling away tend to reference FINRA Rule 2010 (formerly known as rule 2110). Rule 2010, which operates as a catch-all rule, provides that "[a] member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade."5 According to FINRA, "[i]f no other rule has been violated, a violation of [the predecessor to Rule 2010] requires evidence that the respondent acted in bad faith or unethically."6
Rule 2150, which prohibits a registered representative from guaranteeing an investor against loss, has also been applied to settling away prosecutions.7 While FINRA has not provided a clear and explicit definition of settling away, the practice is referenced in the FINRA Sanctions Manual, which is discussed below.
REPORTED FINRA PROSECUTIONS
Most reported FINRA Division of Enforcement prosecutions for settling away involve the payment of consideration from the subject registered representative in exchange for an explicit agreement from the customer not to press a threatened claim. A classic example of settling away is the reported decision in Department of Enforcement v. Sam Aubrey Foreman.8 In that case, a customer made oral complaints to his broker about alleged misrepresentations in a variable annuity product, and threatened "to sue him and the firm if he did not get his complaint resolved."9 The broker entered into a written agreement with the customer, and paid him $10,000 by personal check "to rectify my misrepresentation of this Hartford annuity."10 When the customer cashed the check and reported the misconduct anyway, the registered representative admitted that he had engaged in settling away -- two years previously. The firm compensated the investor for additional damages caused by the challenged investment. The broker was fined $10,000 by FINRA and suspended for 30 business days. Thus the facts of Foreman present the following factors: (a) an explicit complaint by the customer of wrongdoing by the registered representative (misrepresentation); (b) a threat to sue; (c) an offer to pay money to buy the customer's silence; (d) the actual payment of money to the customer as part of the quid pro quo arrangement; (e) a delay of two years of silence; and (f) actual damage to the firm, which was required to make a subsequent settlement with the customer.
The January 2009 FINRA Quarterly Disciplinary Review reports an incident in which a customer complained to an unnamed representative about a variable life insurance policy.11 According to FINRA, "the representative wrote a $19,000 check to the customer in an attempt to settle his complaint . . . ."12 The customer kept the $19,000 check and then complained to the firm, demanding rescission of the contract on top of the direct payment from the broker. This broker was disciplined with a ten day suspension and a $5,000 fine.
In District Business Conduct Committee v. Hsieh,13 the respondent broker settled two separate customer complaints by paying customers in an effort to placate them. The respondent was charged with settling claims away from the firm and guaranteeing customers against loss. In that case (which was decided under earlier sanctions guidelines), the hearing panel dispensed with a suspension and imposed a fine on the registered representative, noting that the broker was young and inexperienced; that he was motivated by a mistaken belief that the settlement of the complaints was proper; and that the customers and firm were made whole.
The FINRA Sanction Guidelines convey broad discretion to a hearing panel in assessing sanctions for settling away.14 In such cases, the FINRA Sanctions Guidelines recommend a monetary sanction of between $2,500 and $50,000, and a potential suspension ranging from one month to two years, and in an egregious case, a bar from the industry. In imposing a sanction, the hearing panel is instructed to consider such factors as the existence and nature of a written confidentiality clause between the customer and the recalcitrant broker; whether the broker voluntarily released the customer from its terms; whether the broker provided his or her employer with verbal notice of the settlement and the employer acquiesced; and whether the broker deceived his employer.
FINRA also tends to consider whether the private settlement is coupled with other improper conduct, clearly an aggravating factor. Moreover, the other conduct may form the basis for a separate charge. For example, in Department of Enforcement v. Paratore,15 the registered representative funded a private settlement with one customer by siphoning away funds which he misappropriated from four other customers. The coupling of deception with outright thievery was more than the FINRA National Adjudicatory Council could tolerate, and it barred the broker from the industry. In so doing, the Council wrote: "The settling of customer complaints without the knowledge or authorization of an associated person's member firm is the type of clandestine activity that harms customers whose interests are not properly served; it also harms member firms by preventing them by properly supervising their brokers."16 In other circumstances, as seen above, the hearing panel was placated with a mere fine and no suspension.17
Broker-dealer sales practice compliance manuals, as a rule, require individual registered representatives to report customer complaints to the firm's compliance department. This allows the firm to monitor and police its own brokers in order to ensure compliance with federal and state securities regulations. In addition, FINRA itself prosecutes registered representatives for entering into private settlements with customers which are not disclosed to their member firms. In doing so, FINRA has frequently underscored how the practice undermines the ability of broker-dealers as well as regulators to monitor registered representatives' dealings with the public.
Yet, surprisingly, there is no rule in the FINRA Manual (nor those of its predecessors at the NYSE or NASD) specifically prohibiting the practice of settling away. Drawing upon Rule 2010, FINRA continues to prosecute registrants who privately settle away customer complaints. All the while, registrants and their counsel have been left to question whether settling away should be prosecuted as a discrete violation rather than as a violation of a cluster of general principles. While its Sanctions Guide and disciplinary action summaries have offered some guidance on this question, FINRA has yet to authoritatively define settling away -- or to proscribe the practice by explicit rule. This raises issues of fairness to registrants. As the Securities and Exchange Commission has observed in an opinion dismissing disciplinary charges against two registrants pursuant to FINRA Rule 3040, "the parameters of the rule must be sufficiently clear so that associated persons have fair notice of what conduct is proscribed."18 Thus, the question of settling away may be ready for a reevaluation.
In the interim, associated persons who elect to settle customer disputes without appropriate disclosure to their firms may face fines of up to $50,000 and suspensions of up to two years. In the severest of cases, where the sub rosa settlement is coupled with outright fraud or other illegal conduct, a registrant may even be permanently barred from the securities industry.
1. FINRA Rule 3030 prohibits an associated person from engaging in unapproved sale of securities for compensation: "No person associated with a member in any registered capacity shall be employed by, or accept compensation from, any other person as a result of any business activity, other than a passive investment, outside the scope of his relationship with his employer firm, unless he has provided prompt written notice to the member." FINRA Rule 3030, available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4404&element_id=3726&highlight=3040#r4404 . In addition, FINRA Rule 3040 prohibits an associated person from participating "in any manner in a private securities transaction" except upon written notice to the firm. FINRA Rule 3040, available at http://finra.complinet.com/en/display/display_plain.html?rbid=2403&element_id=3727&record_id=4405 .
2. FINRA Rule 2150, available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=11904&element_id=8692&highlight=2150#r11904 .
3. FINRA Rule 3070, available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4408&element_id=3730&highlight=3070#r4408 .
4. FINRA Form U-4 at *13-14 (rev. 05/2009), available at http://www.finra.org/web/groups/industry/@ip/@comp/@regis/documents/appsupportdocs/p015112.pdf (italics omitted).
5. FINRA Rule 2010, available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=6905&element_id=5504&highlight=2010#r6905 .
6. Department of Market Regulation v. Leighton and Pasternak, Complaint No. CLG050021, 2010 FINRA Discip. LEXIS 3, at *137-38 (NAC March 3, 2010) (citing In re Chris Dinh Hartley, Admin. Proc. File No. 3-11369, 2004 SEC LEXIS 1507, at *10 n.13 (July 16, 2004)).
7. FINRA Rule 2150, supra note 2.
8. Department of Enforcement v. Foreman, No. 20070094454, 2008 FINRA Discip. LEXIS 56 (OHO October 31, 2008).
9. Id. at *4.
11. Settling a Customer Complaint Without the Firm's Knowledge, FINRA Quarterly Discip. Rev., January 2009, at *3.
13. District Business Conduct Committee v. Hsieh, No. C01940022, 1995 NASD Discip. LEXIS 227 (NBCC June 20, 1995).
14. FINRA Sanction Guidelines at 34 (2007), available at http://www.finra.org/Industry/Enforcement/SanctionGuidelines/index.htm (Click "Sanction Guidelines" link for PDF version).
15. Department of Enforcement v. Paratore, No. 2005002570601, 2008 FINRA Discip. LEXIS 1 (NAC March 7, 2008).
16. Id. at *22.
17. See Hsieh, supra note 13.
18. In re Browne and Calandro, Admin. Proc. File No. 3-12926, 2008 SEC LEXIS 3113, at *38 (Nov. 7, 2008). Rule 3040 prohibits undisclosed private securities transactions of an associated person. See supra note 1.