In a move intended to emphasize that FINRA’s ultimate mandate is to protect investors, the SRO’s National Adjudicatory Council last week issued newly-revised Sanction Guidelines including tougher ranges of recommended punishments to be meted out against member firms or brokers who commit fraud or make unsuitable recommendations to customers.

Since 1993, FINRA has maintained and published “Sanction Guidelines” setting forth common securities rule violations and the range of disciplinary actions FINRA can issue for such violations, including monetary fines as well as suspensions, bars from the industry and other sanctions.

Specifically, the revised Guidelines, announced in Regulatory Notice 15-15 available on FINRA’s website at www.finra.org, contain revisions to the Sanctions relating to two specific areas: (i) fraud, misrepresentations or material omissions of fact; and (ii) suitability and the making of unsuitable recommendations to investing customers. According to the Notice, the ramped-up sanctions are meant to reinforce that fraudulent conduct is unacceptable, and that FINRA adjudicators on the Regulatory side should consider strong sanctions for such conduct, including barring or expelling repeat offenders, particularly where aggravating factors outweigh mitigating ones. With regard to unsuitability, the heightened punishments include an increase in the high-end range of suspensions from one year to two, as well as recommending bars, suspensions or expulsions for the most egregious recidivists.

What are non-traditional exchange-traded funds (ETFs) and non-traded real estate investment trusts (REITs)? Why are independent broker dealers selling these complex products without proper supervision? FINRA wants to know and just slammed LPL Financial for doing such a thing.

This week, FINRA censured and fined LPL $10 million for broad supervisory failures in the sale of complex products such as leveraged ETFs and non-traded REITS. It also ordered LPL to pay an additional $1.7 million in restitution to certain customers who bought non-traditional ETFs.

This is a watershed moment for these and other complex products. First, LPL has over 14,000 brokers nationwide and is by a wide margin the largest independent broker dealer in the U.S. (Lincoln Financial Network with over 8,000 brokers is second). The biggest independent broker-dealer getting hit like this by FINRA is the equivalent of FINRA fining the old Merrill Lynch in wire house terms.

An increasing issue in investment fraud cases is the liability of commercial banks for aiding and abetting fraud by an investment advisory firm that engages in fraud and then goes defunct. Such firms typically house their investment clients’ accounts with an independent broker dealer clearing firm that clears or processes the trading activity of the advisor. Cases against the clearing firm are typically resolved in arbitration at FINRA, and are subject to strong legal defenses based on claims of limited or nonexistent obligations of the clearing firm to the investor. Proof of the clearing firm’s knowledge and participation or knowing assistance in the fraud can sometimes be difficult, and what if the clearing firm itself has minimal assets? Another avenue to explore is the liability of the commercial bank that housed the non-investment bank accounts of the investment advisor. In the context of Ponzi schemes, such as Madoff, court cases have been brought with mixed results. But there are other forms of advisor misconduct that can implicate the bank as well.

When the nature of the fraud is outright theft or diversion of investor funds by the advisor this can occur through improper use by the advisor of its bank accounts. For example, the advisor may keep a bank account in its name and deposit customer funds into it, through various means, including having the check made out to the advisor “for the benefit of ” or “FBO” the investor. After the funds are deposited in the bank account in the name of the advisor it can often readily be stolen or diverted from the account by the advisor. Traditionally, bank laws have been structured to protect the banks from liability for routine check processing functions absent proof of aiding and abetting fraud. In the check processing part of the bank, until relatively recently, there would ordinary be little evidence of knowledge by the bank of wrongdoing. However, with the advent of strict anti-money laundering laws and regulations (AML), banks must now monitor for and report suspicious activity. Thus, improper activity by the advisor of the nature described above should be flagged by the bank’s own surveillance system. If the “red flags” of wrongful activity by the advisor in its bank accounts are disregarded by the bank, this can constitute evidence of the bank’s knowledge of and responsibility for the fraudulent activity. Expect to see more court cases being filed against commercial banks for investor losses stemming from fraudulent activity of investment advisors who manipulate their commercial bank accounts to cheat investors.

Merrill Lynch was fined almost $20 million by the Financial Conduct Authority (FCA) in London for incorrectly reporting more than 35 million transactions from 2007 to 2014. Merrill Lynch didn’t report, at all, another 120,000 transactions. It’s the largest fine ever levied by the FCA for reporting failures. While this may not seem like a big deal to the investing public, it is. The proper reporting of transactions is a hallmark of the securities industry. Without it, during tumultuous times, investors will not have a perfect view of the trades that occurred in their portfolios. Indeed, for some of the transactions, Merrill didn’t identify the counterparties on trades. This is problematic for over the counter derivative investors because investors couldn’t ascertain counterparty risk on their trades and if the trades went bad, it would be impossible for the investor to know how to potentially resolve the issue. What’s worse is that the FCA had warned Merrill in 2002 and fined Merrill in 2006 for the same types of infractions. In today’s fragmented, digital marketplace, proper reporting is absolutely necessary. Let’s hope the record fine is a wake up to call Merrill and others.

Here is a New York Times piece on it.

http://www.nytimes.com/2015/04/23/business/dealbook/british-regulator-fines-merrill-lynch-19-8-million-for-reporting-failures.html?smprod=nytcore-ipad&smid=nytcore-ipad-share&_r=0

In what has become a hot issue this Spring, the Labor Department yesterday proposed a new set of standards for brokers who offer advice in connection with 401(k)’s and other retirement accounts. Currently, brokers are required only to recommend products that are “suitable” for investors, which permits the sale of products that earn the broker high fees. Reuters reports that the new standards will require brokers to put their clients’ best interests first ahead of any personal financial gain. The Labor Department proposal will require “best interest” contracts between brokers and investors.

Rich Intelisano and Katz LLP represents investors in FINRA arbitrations and other litigations against broker-dealers and other financial firms.

I noted in my March 20 post that the Chair of the SEC had just come out in favor of a rule requiring brokers to act in their clients best interests. While investors wait for the SEC to move forward on the issue, the New York City Comptroller, Scott Stringer, is proposing that New York State require brokers to disclose the present state of their relationship to clients – “I am not a fiduciary” and “I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks and expected returns for you.” The Wall Street Journal posited that New York’s adoption of such a requirement could spur other states to impose similar regulations.

A recent report by the Public Investors Arbitration Bar Association (“PIABA”) shows why Stringer’s proposal is critical. U.S. News describes the PIABA report which contrasted brokers’ advertising campaigns with the legal positions taken by those brokers in litigation against their clients. For example:

• Ad: “It’s time for a financial strategy that puts your needs and priorities front and center.”

There has been a spate of litigation in recent years over whether broker dealers can contract out of FINRA arbitration and litigate in court instead. Goldman, Sachs & Co. v. Golden Empire Schools Financing Authority, 764 F.3d 210 (2d Cir. 2014) is a recent example in the Second Circuit. Since 1989 the courts have blessed industry mandated FINRA arbitration as contained in the industry’s standard form customer agreement. Thus, investors effectively have no choice but to resolve investment disputes through arbitration. The industry has benefited from less costly and efficient arbitration and the avoidance of jury verdicts, and until recently, the FINRA rule requiring an industry representative on every panel. The trade off to enforcement of mandatory arbitration in favor of the industry was supposedly a fair and more efficient dispute resolution process for the investor.

Now, however, as FINRA reforms over the years have made arbitration more fair for investors, and as the cases brought against broker dealers have become larger and more complex, the industry is shifting strategy and attempting to have large and complex cases litigated in court. The means of choice for the industry to accomplish this are court forum selection clauses in contracts brokers obtain from the investor in an effort to trump any FINRA arbitration requirement.

Why would the industry like to be able to escape FINRA arbitration in a large and complex case? The answer lies in the nature of the investment documents usually associated with these cases which investors are required to sign as part of complex investment purchases. These investments typically have standard form risk disclosures which investors must acknowledge before investing. Such disclosures can sometimes be fatal to a court claim where they often form the basis for a motion to dismiss the case before discovery or trial, based on the more stringent pleading requirements of court litigation. In FINRA arbitration, on the other hand, absent rare circumstances, the investor is guaranteed a hearing on her case and motions to dismiss are not allowed.

Reuters reported that Mary Jo White, Chair of the U.S. Securities and Exchange Commission, came out in favor of creating of new rules to harmonize standards of care between investment advisers and brokers. Currently, investment advisers must act in a client’s best interest, while brokers may continue to sell products that primarily benefit their or their firm’s financial interests – so long as such products are “suitable” for the clients.

Wall Street has opposed efforts by the Department of Labor to craft rules governing such broker conduct and requiring them to put client’s interest first. White’s comments this week suggest that the SEC may be preparing to weigh in on the issue.

Rich Intelisano and Katz LLP represents investors in FINRA arbitrations and other proceedings against both investment advisers and brokers.

The New York Times announced today that the nation’s biggest banks, according to certain “stress” tests, appear to be able to survive a serous downturn in the economy, where housing and securities markets severely decline and unemployment rises to 10%. Whether passing the stress test equates to a clean bill of heath for surviving the next serious recession depends on the metrics used to measure the banks’ health under various scenarios. Does that mean we are relying on the “quants” for the proper metrics, the math wizards who were lured away from math and scientific pursuits to help Wall Street create exotic and complicated investment products in the last 15 years? Yes. Remember that quants and their metrics gave Wall Street the cover it needed to classify risky housing securities products as investment grade, resulting in billions in losses for investors in the housing bust. It turned out the models the quants used were flawed: for one thing they sometimes didn’t go back far enough in financial history in building assumptions for the models. The banks’ passing the stress test is only as meaningful as how the stress test models are built, and we are once again in the hands of the financial quants in making that determination.

Reuters reports that Morgan Stanley’s annual 10-K, filed March 2, 2015, indicates that the New York Attorney General intends to file a lawsuit related to 30 subprime securitizations sponsored by the company. This follows lawsuits and similar allegations by attorneys general in California, Virginia and Illinois. The New York Attorney General indicated that the lawsuit would allege that Morgan Stanley misrepresented or omitted material information related to the due diligence, underwriting and valuation of loans and properties. In the 10-K, Morgan Stanley stated that it does not agree with the allegations.

Morgan Stanley also reached a $2.6 billion agreement in principle last month with the U.S. Department of Justice and the U.S. Attorney’s Office for the Northern District of California to resolve claims related to what it called “residential mortgage matters.”

It remains to be seen whether investors will reap any of the benefits of these government actions seeking to mend the damage done by the subprime mortgage crisis and the proliferation of mortgage-backed securities (MBS), residential mortgage backed securities (RMBS), and collateralized debt obligations (CDOs).