Friday, April 29, 2011


The new director of FINRA District #4 (Iowa, Kansas, Missouri, Minnesota, Nebraska, South Dakota, and North Dakota) along with the Deputy Regional Chief Counsel shared excellent insights today on FINRA's priorities and concerns in both the exam and enforcement arenas. Speaking to a small group of attorneys and industry members, District Director Scott DeArmey stated that the best word to describe FINRA is “change.”

According to Mr. DeArmey, the current priorities for FINRA's examiners include:

  • Short sales and Reg. SHO

  • Fraud detection

  • High frequency trading

  • Municipal securities

  • Private security transactions

  • Hiring and compensation practices.

Mr. DeArmey stressed that FINRA's examiners were applying a more stringent risk-based focus in order to respond more effectively with limited resources1.

Beyond FINRA industry exam issues, Mr. DeArmey announced and described FINRA's new office of Fraud Detection and Market Intelligence (OFDMI) and its whistle blower hotline. Finally, he noted that the FINRA rulebook consolidation process was “85% complete.”

Mr. DeArmey was followed to the podium by Deputy Regional Chief Counsel Jeff Ziesman. Mr. Ziesman gave a refreshingly candid review of issues with which FINRA enforcement is currently grappling. Beyond the noteworthy (and unproductive) conduct engaged in by enforcement targets from time to time, Mr. Ziesman gave a detailed explanation of the inner-mechanics of the enforcement process as well as the standards for awarding subject cooperation. Finally, Mr. Ziesman provided specific examples of prior cases in which members and their representatives were sanctioned for violating Rule 2010 as a result of their conduct during arbitration proceedings and settlements.

The Bar Association of Metropolitan St. Louis (BAMSL) hosted the event, and the chicken and green beans were superb.

1There are four types of FINRA exams: cycle examinations, cause examinations, trading and marketing surveillance examinations, and sweeps.

Friday, April 22, 2011


NASD Rule 3040 regarding Private Securities Transactions of Associated Persons has been around since 1985. NASD issued Notices to Members on the subject in 1985, 1991, 1994, 1996, 2001 and 2003. The title to the 2001 Notice was: “NASD Reminds Members of their Responsibilities Regarding Private Securities Transactions Involving Notes and Other Securities and Outside Business Activities.” In 2002, a law firm issued a “Client Memorandum” entitled “Be Alert: Regulators are Keeping a Watchful Eye on Outside Business Activities.” Notably, the memorandum began by stating: “Selling away and outside business activities have become hot topics for regulators. The NASD, in particular, has brought numerous formal disciplinary actions...”

Perhaps things really do stay the same the more they change. Earlier this month FINRA issued a news release about sanctions it levied against two firms and several registered representatives that failed to satisfy the mandates of Rule 3040.

On its face, Rule 3040 doesn't appear to be particularly complicated. But its compliance has been eluding industry members for over two decades now.

Rule 3040 requires an associated person to provide written notice to its FINRA member “describing in detail the proposed transaction and the person’s proposed role therein” when the person will be receiving “any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security.” The rule defines a “private security transaction.” Once the member receives the written notice, it can either deny approval of the associated person's proposed participation, or, if it approves: “[record] the transaction...on the books and records of the member and...supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.”

Despite the rule's clear mandate, FINRA's recent enforcement actions demonstrate that associated persons continue to forge ahead on private placements without getting permission from their member firm, and members continue to punt on their due diligence obligations before they give approval in response to a request. That due diligence obligation requires the broker-dealer to perform both a client-specific and reasonable-basis suitability analysis. The latter requires a reasonable investigation of the sale of the private transaction or placement. And simply relying upon information provided by the issuer of the security does not pass the muster as a “reasonable investigation.”

FINRA's news release provides additional details regarding the individual’s sanctioned for their participation in the sale of placements offered by Medical Capital Holdings and Provident Royalties, LLC and the firms for their lack of due diligence on these two placements, as well as those issued by DBSI, Inc. According to FINRA: “without performing proper due diligence, the firms could not identify and understand the inherent risks of these offerings.” Considering the multitude of firms that peddled DBSI notes and TICs in apparent oblivion of Rule 3040, one can surely anticipate future enforcement actions in this area.

Thursday, April 14, 2011

Federal Judge Denies Preliminary Class Action Settlement, State Securities Regulators Give Sigh of Relief

On March 18, the Federal District Court for the Northern District of Texas, refused to a $21 million partial class action settlement with Securities America, a division of Ameriprise Financial.

The case stems from the sale of hundreds of millions of dollars of private placement notes in Medical Capital Holdings, which the SEC deemed to be a fraud in 2009. After the fraud was discovered, many investors filed arbitration claims against Securities of America, others joined together in multiple class actions, and others proceeded individually. The Massachusetts and Montana securities regulators also filed enforcement actions in 2010 against the defendants, which are now in the late-stages of litigation. On February 18, Senior District Judge W. Royal Furgeson, Jr. temporarily stayed several of the arbitration actions proceeding through FINRA while the motion was pending, but refused to halt the state enforcement actions.

The settlement was proposed by representative plaintiffs in three related class actions: Billitteri et al v. Securities America et al, Toomey et al v. Hofhines et al, and McCoy et al v. Cullum & Burks Securities Inc. et al. The representative plaintiffs’ motion sought approval of a 23(b)(1)(B) limited fund settlement with two of the defendant broker-dealers, Securities America, Inc. and Securities America Financial Corporation.

The proposed settlement would have affected all investors, regardless of how they decided to make their legal claim. If granted, the settlement also could have enjoined the state enforcement proceedings. According to the North American Securities Administrators Association, “enjoining state securities regulators [could] have a far-reaching impact by undermining investor protection not only in Massachusetts and Montana, but in other jurisdictions as well.” NASAA further stated that such an effect would make citizens “more vulnerable to fraud and abuse in the offer and sale of securities.” On March 14, NASAA filed a Brief in Opposition to Plaintiff’s Motion for Preliminary Approval of Partial Class Settlement, arguing how approval of the settlement would undercut state regulators’ enforcement ability. The organization was one of many that filed briefs and memoranda with the court regarding this motion.

In his Order, Judge Furgeson, notes the large number of outside parties interested in the outcome of the proposed settlement. He also makes specific mention of the enforcement actions proceeding in the two states, which likely weighed on his decision. However, Judge Furgeson’s order explaining the reasoning behind his decision has not yet been filed.


In what is being reported as the largest Award ever issued by a FINRA panel in favor of an individual investor, Citigroup was ordered to pay over $50 million to two individual investors. The Award includes $17 million in punitive damages and $3 million in legal fees, despite severe limits on the ability to garner punitives and fees in FINRA arbitrations.

As reported in yesterday's Wall Street Journal, the two victorious investors dealt with the same broker at SmithBarney. Beyond the magnitude of the Award, this case is highly unusual in that the broker testified on behalf of the investors. It is unfortunate that this is such an unusual event because the broker's purported testimony is hardly incredible—the broker-dealer misled the broker about the level of risk associated with the municipal bond fund at issue.

Cosgrove Law, LLC has a claim pending against Fisher Investments in which its client alleges that it was misled as to the risk associated with Fisher's 100% equity fund in 2008. According to Fisher's marketing materials, the portfolio was designed to avoid substantial losses due to asset allocations within the portfolio and the hands-on stewardship of Mr. Fischer and his Investment Policy Committee. Ironically, a Fisher Analyst recently published an article in which he states, in part, “Folks...constantly exhibit huge overconfidence in their own great ideas, and display continuous belief they somehow have insights the rest of the world hasn't thought of.” According to the Fisher Investments Education Center, however, “The Fisher Investment Policy Committee…continuously monitors these drivers to ascertain if any of them are indicating an extreme reading, and if so, whether the market has discounted the factors yet. Only material readings not believed to be fully discounted into pricing are acted upon.” Fisher Investments also purports to “discover unique sources of information to exploit inefficiencies uncovered through unique analysis of widely available information.”

Both the Cosgrove Law, LLC client and the Citigroup clients lost over 50% of their portfolio’s value during the market downturn. Fisher Investments denies liability, as did Citigroup. The SEC is reportedly investigating Citigroup, and it will not confirm or deny the existence of an investigation of Fisher Investments.

The Wall Street Journal article can be located at An article regarding a prior SEC and NASD investigation of Fisher Investments can be located at

Wednesday, April 13, 2011

The Supreme Court Reaffirms Total Mix Test for Materiality

The U.S. Supreme Court adopted the position urged by the SEC’s amicus brief, affirming its traditional test of materiality in 10b-5 actions in Matrixx Initiatives, Inc., v. Siracusano on March 22, 2011. The unanimous ruling rejected the petitioner’s contention that there should be a bright-line test for materiality in a securities fraud suit, a position that the Court also previously rejected in Basic Inc. v. Levinson.

The complaint alleges that Matrixx made false statements in 2003 about a cold remedy nasal spray, Zicam. The statements publicized the success of the nasal spray, which made Matrixx increase its earning guidance based on increased Zicam sales. However, the company had information from multiple sources showing that the nasal spray could cause loss of smell.

After several product liability suits had been filed, Matrixx continued to state that Zicam was safe and that none of the clinical trials supported findings that the nasal spray caused loss of smell. After an FDA investigation report was released, Matrixx’s share price dropped.

The District Court dismissed the original complaint holding that a pharmaceutical company is not required to disclose such reports unless they are statistically significant—consistent with precedent in the Second Circuit. However, the Ninth Circuit Court of Appeals reversed concluding that the statistically significant test was contrary to the test for materiality set forth by the Supreme Court in Basic and TSC Industries, Inc v. Northway, Inc.. In TSC and Basic, the Court articulated the “total mix” test, which sets the threshold for materiality as satisfied when there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available."

The Supreme Court affirmed the Court of Appeals, holding that “the materiality of adverse event reports cannot be reduced to a bright-line rule. Although in many cases reasonable investors would not consider reports of adverse events to be material information, respondents have alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.” Namely, that Zicam is Matrixx’s key product.

In its reasoning, the Supreme Court again rejected adopting a bright-line approach. Arguments in favor of a bright-line rule are based on the idea that statistical significance is the only indication of causation. However, the Court stated that lack of statistically significant data does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events. The Court concluded that investors may utilize a similar approach: considering context, not just statistical significance for determining causation. Similarly, the question of materiality is based on a contextual inquiry.

In Matrixx, the Court held that the total mix standard for materiality was met because Matrixx received information and reports that indicated a plausible causal link between Zicam and loss of smell. The court held this is sufficient to meet materiality at the pleading stages.

SEC Charges Brokerage Executives With Violations of Regulation S-P

On April 7, 2011, the SEC charged three former brokerage executives for failing to protect confidential information about their customers in violation of Regulation S-P. Regulation S-P prohibits any broker or dealer, any investment company, or any investment adviser registered with the SEC under the Investment Advisers Act of 1940 from disclosing any nonpublic personal information about a consumer to a non-affiliated third party. "Nonpublic personal information" can include, among other things, the fact that an individual is or has been one of your customers or has obtained a financial product or service from you.

The SEC found that while GunnAllen Financial, Inc., was winding down its business operations last year, its former president and former national sales manager violated customer privacy rules by improperly transferring customer records to another firm. The SEC also found that the former chief compliance officer failed to ensure that the firm's policies and procedures were reasonably designed to safeguard confidential customer information.

According to the SEC's orders, GunnAllen's former president authorized the former national sales manager to take information from more than 16,000 GunnAllen accounts to his new employer. The former sales manager downloaded customer names and addresses, account numbers, and asset values to a portable thumb drive, and provided the records to his new employer after resigning from GunnAllen. The SEC found that the record transfer violated Regulation S-P because account holders were only informed about it after the fact.

Without admitting or denying the SEC's findings, the individuals consented to the entry of an SEC order that censures them and requires them to cease and desist from committing or causing any violations or future violations of the provisions charged. The order also imposed financial penalties against them. This is the first time that the SEC has assessed financial penalties against individuals charged solely with violations of Regulation S-P.

A copy of the SEC's press release can be found here.