SEC’s Investor Advisory Committee Recommends Extending Fiduciary Duty to Broker-Dealers

Section 911 of the Dodd-Frank Act established the Investor Advisory Committee to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace.  On November 22, 2013, the Committee issued a recommendation to extend the fiduciary duty to broker-dealers.

The Committee preliminarily stated its conclusion: that personalized investment advice to retail customers should be governed by a fiduciary duty, regardless of whether that advice is provided by an investment adviser or a broker-dealer.  In approaching this issue, the Committee noted that the SEC's goal should be to eliminate the regulatory gap that allows broker-dealers to offer investment advice without beings subject to the same fiduciary duty as other investment advisers.  However, the Committee noted that the SEC should not eliminate the ability of broker-dealers to offer transaction-specific advice compensated through transaction-based payments.

The Committee made two specific recommendations for action by the SEC.  First, the Committee recommended that the SEC should conduct a rulemaking to impose a fiduciary duty on broker-dealers when they provide personalized investment advice to retail investors.  Second, as a part of its rulemaking, the SEC should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers that covers basic information about the nature of services offered, fees and compensation, conflicts of interest, and disciplinary record.

In the stated "Supporting Rationale" for its recommendation that the SEC should engage in rulemaking to impose a fiduciary duty on broker-dealers when they provide personal investment advice, the Commission noted that in arriving at this decision they took into account a broad consensus among widely disparate groups that broker-dealers and investment advisers should be subject to a uniform fiduciary standard.  The Committee also noted that these various stakeholder groups generally agree that the fiduciary duty should not apply to all brokerage services, but only to those services that fall within a reasonable definition of personalized investment advice to retail customers.

The Committee also addressed some of the limited opposition that exists.  First, some argue that broker-dealers are already extensively regulated under existing law and self-regulatory organization rules.  The Committee believed, however, that while the existing regulatory scheme may adequately regulate broker-dealers when they act as salespeople, it does not offer adequate investor protection when they offer advisory services, since under the suitability standard they generally remain free to put their own interests ahead of those of their customers.  Second, some argue that regulation is not needed because investors are capable of choosing for themselves whether they prefer to work with a broker-dealer operating under a suitability standard or an investment adviser who is a fiduciary.  However, the Committee found that various studies had indicated that investors do not distinguish between broker-dealers and investment advisers, do not know that broker-dealers and investment advisers are subject to different legal standards, do not understand the difference between suitability standard and a fiduciary duty, and expect broker-dealers and investment advisers alike to act in their best interests when giving advice and making recommendations.

The Committee noted that the SEC has a range of options available to it in order to implement this regulatory goal.  These include the rulemaking authority under Section 913(g) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as existing authority under the Investment Advisers Act to regulate non-incidental advice by broker-dealers.

The Committee's second recommendation was that the Commission should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers.  The Committee believed that improved disclosure was necessary to help investors select a financial professional.  Relevant topics could include what services are provided, how the broker-dealer or investment adviser is compensated, and what conflicts of interest exist.

The Committee's recommendation is another step towards the establishment of a fiduciary duty standard for broker-dealers.  This position has already been applauded by the NASAA, which in a statement supporting the recommendation said that:  "A fiduciary standard for broker-dealers will guarantee that all financial professionals providing investment advice will act in the best interests of their clients, and in turn, enhance investor confidence in the financial services industry and securities markets."

FINRA Tags St. Louis Bond Underwriter for Improper Sports Ticket Gifting

FINRA recently accepted the offer of settlement of a St. Louis member firm. The uncontested offer of settlement was submitted approximately 9 months after FINRA's Department of Enforcement filed its Complaint. Enforcement accused the firm of improperly gifting tickets to various sporting events to employees of municipal securities issuers. The firm gifted over $2,000 tickets valued at almost $200,000 in a two-year period.

In concluding that the firm violated MSRB Rule G-27, FINRA emphasized three salient factors: 1) the firm did not host the recipients of the tickets at the events, 2) the firm gifted tickets only to those issuers who were clients, and 3) the bigger issuers received more and better tickets. MSRB Rule G-20 has an exemption for occasional gifts of tickets that requires the member firm to host the event. As a result, the St. Louis firm was censured and fined $200,000. Food for Thought! Go to the game!

How Bankruptcy May Affect Your Pending Expungement Claim

         Registered representatives terminated from broker-dealers may face several issues after the firm reports the reason for the reps’ termination on his or her Form U-5.  Depending on that reason, it may be difficult for that broker to become associated with another broker-dealer or find future employment in the financial industry.  As a result, terminated reps may experience financial difficulties while looking for employment.  If a rep believes the reason for termination that was reported on his or her U-5 was false, that rep may consider seeking expungement, or even damages associated with the U-5 filing.  This process takes time and costs money, especially if the rep engages legal counsel to assist with the arbitration.  If this results in financial difficulties for the rep, the rep should consider the case of In re Jimmy W. Clark before resorting to a remedy such as bankruptcy during the pendency of the arbitration. 

            Clark, a broker, was terminated by Charles Schwab after it received and investigated a ‎customer complaint that he placed unauthorized trades in their accounts.‎ ‎ Schwab reported that ‎reason for termination on his Form U-5. Clark instituted a FINRA arbitration proceeding ‎against Schwab and sought both monetary damages for alleged wrongful termination and defamation and CRD expungement of the statements Schwab made on his Form U5.  During the pendency of his FINRA arbitration (two years after his termination), Clark filed ‎for bankruptcy.

            Before the bankruptcy case was closed, Clark failed to disclose his bankruptcy to FINRA or Schwab and failed to include the pending claim as an asset in his bankruptcy or notify the bankruptcy trustee (“Trustee”).  After Schwab discovered Clark’s bankruptcy, Clark moved to re-open his bankruptcy and allowed the Trustee to pursue the arbitration claims on behalf of the bankruptcy estate.  Schwab and the Trustee settled Clark’s claims for a fraction of the alleged damages and broadly released Schwab from all claims.  The $120,000 settlement was essentially enough to pay the fees of the trustee ‎and his counsel and enable a distribution to the creditors. 

            Clark objected to the bankruptcy court arguing that (1) ‎his “claim” for expungement was personal and not property of his bankruptcy estate, (2) only ‎FINRA had authority to adjudicate and approve settlement of expungment claims, and (3) the ‎settlement was unfair.

Expungement as Personal Property

The court rejected Clark’s argument that his claim for expungement was his personal property, finding that it was merely a remedy rather than an independent claim.  In doing so, the court relied on FINRA Rule 2080 which specifically refers to expungement as “relief” and Notice to Members 04-16, which introduced Rule 2080 and advises respondents seeking expungement to request it in “his or her prayer for relief.”  Clark argued that expungement is vital to the preservation of his broker’s license, which is personal, non-transferable, and not part of the property of the Estate. The Court conceded that point, but found that the settlement did not concern Clark’s license.  The Court noted that neither Schwab nor the Trustee were trying to take away Clark’s license.  They were simply settling a cause of action ‎which might have an impact on the debtor’s ability to procure future employment.

FINRA’s Authority over the Settlement of Expungement Claims

            The court also rejected Clark’s claim that FINRA has exclusive jurisdiction over the settlement of expungement claims because the bankruptcy court was not ordering expungement.  The court found that nothing in the FINRA rules precludes parties from settling a dispute and the settlement between Schwab and the Trustee was consistent with the FINRA Rules. FINRA’s approval is required only if settlement of a FINRA ‎action includes the affirmative expungement of the Form U-5.

Fairness of the Settlement

The court noted that when a bankruptcy court considers approval of a settlement, it evaluates: (a) the ‎probability of success in the litigation; (b) the difficulties, if any, to be encountered in collection; ‎‎(c) the complexity of the litigation involved, and the expense, inconvenience and delay ‎necessarily attending it; and (d) the paramount interest of the creditors and deference to their ‎reasonable views on the settlement.  In considering these factors, the court found that while the settlement might not always be in the best interest of a debtor, it’s the interest of the creditors that takes precedent. 

Thus, a rep experiencing financial difficulties during the pendency of an arbitration that includes a request for expungement should consider the consequences of filing for bankruptcy. 

            The attorneys at Cosgrove Law Group, LLC have substantial experience representing individuals in various types of FINRA matters.    

FINRA Rule 2010: The Catch-All Provision

FINRA Rule 2010 states: “A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.”  The rule applies with equal force to associated persons.  This rule was adopted verbatim from its predecessor, NASD Rule 2110.  The foundation of Rule 2010 is Section 15A(b)(6) of the Securities Exchange Act of 1934, which requires FINRA, as a registered securities association, to have and enforce rules that “promote just and equitable principles of trade.”

There is no definition of “commercial honor,” “just and equitable,” or “principles of trade.”  So what exactly does Rule 2010 proscribe? 

In the caselaw developed under the rule, some types of misconduct, such as violations of federal securities laws and FINRA Conduct Rules, are viewed as violations of Conduct Rule 2010 regardless of the surrounding circumstances because members of the securities industry are required to abide by the applicable rules and regulations.

Beyond this strict liability for violation of another law or rule of conduct, only a few federal courts have had the opportunity to analyze the rule.  For example, in Heath v. SEC, 586 F.3d 122, 127 (2nd Cir. 2009), the NYSE Hearing Board found that the petitioner had disclosed confidential information, and had therefore violated NYSE Rule 476(a)(6), which, like Rule 2010, prohibits “conduct inconsistent with just and equitable principles of trade.”

The Chief Hearing Officer found that by disclosing confidential information, the petitioner had acted unethically, and therefore had violated NYSE Rule 476.  She reasoned:

It is commonly accepted that when a financial advisor takes on work that requires the communication of such sensitive, nonpublic information from the client to the advisor, the client has an expectation that the advisor will keep that information confidential.

Id. at 127.

The Chief Hearing Officer noted that employer’s Code of Conduct prohibited employees from disclosing confidential sensitive information learned on the job.  However, she concluded that the duty of confidentiality was not attributable merely to the employer’s Code of Conduct, but also:

[F]rom the ethical obligation to which every financial advisor becomes subject upon learning of sensitive, nonpublic information about a client in the normal course of business. It is a duty that should be self-evident to any experienced financial professional.

Id.

Petitioner appealed this decision to the SEC, and advanced two arguments relevant to this discussion: (1) the just and equitable principles of trade rule (“J & E Rule”) requires a finding of bad faith; and (2) petitioner did not receive fair notice that his conduct was sanctionable under the J & E Rule.  Id. at 130.

With regard to the first argument that a finding of bad faith is required for a J & E Rule violation, the court noted that it had long been the view that the J & E Rule is designed to enable SROs to regulate the ethical standards of its members. Id. at 132.  The court noted that in In the Matter of Benjamin Werner, 44 S.E.C. 622, 1971 WL 120499 (July 9, 1971), the SEC rejected the argument that NASD’s J & E Rule could only be violated by an unlawful act.  Id.  The SEC noted, “We have long recognized that [the J & E Rule] is not limited to rules of legal conduct but rather that it states a broad ethical principle which implements the requirements of Section 15A(b)” of the Exchange Act.   Id. at 132 (citing Werner, 1971 WL 120499 at *2 n. 9).  The court also noted that as early as 1966, Judge Friendly stated that the J & E Rule is “something of a catch-all which, in addition to satisfying the letter of the statute, preserves power to discipline members for a wide variety of misconduct, including merely unethical behavior.”  Id. (citing Colonial Realty Corp. v. Bache & Co., 358 F.2d 178, 182 (2d Cir. 1966).

In support of his argument that bad faith was required, the petitioner cited several SEC decisions and the Second Circuit’s decision in Buchman v. SEC, 553 F.2d 816 (2d Cir.1977).   In Buchman, 553 F.2d at 818, a broker-dealer was sanctioned by the SEC for violation of the NASD’s J & E Rule for failure to complete a contract with another broker-dealer for the sale of stock.  The broker-dealer that failed to complete the contract did so out of concern that to complete the contract would be in furtherance of fraud.  The Second Circuit vacated the SEC’s sanction order, finding that a breach of contract is unethical conduct in violation of NASD Rules only if it is found that a breach of contract is in bad faith.  Id. at 820.

The Heath court found that petitioner’s case was entirely distinguishable from the Buchman case in that, in the words of the Chief Hearing Officer, the petitioner “was [not] under any competing obligation to make the disclosures that he did or that any ‘equitable excuse’ relieved him of his ethical obligation to keep the information confidential.”  Heath, 586 F.3d at 136.  Rather, petitioner did it for self-serving reasons. Moreover, the court noted that the SEC correctly understood the bad faith requirement from Buchman to be limited to the breach of contract context.  Id. at 136-37.  Thus, the court concluded that, contrary to petitioner’s contention, the J & E Rule prohibits mere unethical conduct and does not require a showing of state of mind.  Id. at 137.

The petitioner next argued that neither the NYSE nor the SEC had articulated a mental state standard for a J & E Rule violation.  Id. at 139.  He contended that without an articulation of a mental state standard, registered members lacked “fair notice of the conduct that might be sanctioned.”  Id. 

The court stated in response that the SEC had made clear that no scienter is required and mere unethical conduct is sufficient outside the breach of contract context to find a J & E Rule violation.  Id.   Further, the SEC had made clear that “industry norms and fiduciary standards” are determinative as to what constitutes unethical conduct.  Id. (citations omitted).

The court went on to note that the Second Circuit had previously rejected the very argument that petitioner was making in Crimmins v. Am. Stock Exch., Inc., 503 F.2d 560 (2d Cir.1974) which adopted the district court’s conclusion that the J & E Rule was not unconstitutionally vague because “[a]s an experienced registered representative, plaintiff may be fairly charged with knowledge of the ethical standards of his profession . . . ”  Id. (quoting Crimmins, 503 F.2d at  )

The Heath court ultimately concluded that while Petitioner’s conduct was not as egregious as that of others who had been sanctioned by the NYSE, the SEC was correct that any reasonably prudent securities professional would recognize that the disclosure of confidential client information under the circumstances of the case constituted unethical conduct sanctionable under the J & E Rule.  Id. at 141.

As can be seen from the Heath case, Rule 2010 prohibits “unethical” conduct, and there is no requirement that there be a finding of “bad faith” or any other state of mind.  But again, there is nothing that clearly defines when behavior will be considered unethical.  Even the Heath court found that disclosure of confidential client information “under the circumstances of this case” constituted unethical conduct, thus leaving open the possibility that disclosure of confidential information could take place under circumstances in which it would not be considered a violation of Rule 2010.

Here is a sampling of other conduct found by the SEC, FINRA and NASD as violative of Rule 2010:

• Downloading customer nonpublic information, including account numbers and net worth figures, and sending them to the associated person’s future branch manager at a competitor’s firm.
• Misappropriating money from insurance customer.
• Serving as a treasurer of political club and breaching “significant fiduciary obligations” to the club when associated person misappropriated club funds.
• Improperly obtaining a donation for his daughter’s private school tuition from his member firm’s matching gifts program by misrepresenting that he had contributed personal funds.
• Improperly obtaining reimbursement for country club initiation fees from his employer firm.
• Trying to persuade back-office employee to credit associated person unearned commissions.
• Passing bad checks to associated person’s employer.
• Forging a client signature to a check and converting the funds to the associated person’s account.
• Failing to disclose bankruptcy petitions, unsatisfied judgments, and civil lawsuits on Form U-4.
• Affixing customer signatures or otherwise altering customer documents, including distribution forms, redemption forms, and account transfer forms.
• Failing to comply with a court judgment by paying attorneys’ fees and costs awarded to a customer in litigation that associated person initiated against customers challenging an arbitration award they had won against him.

As can be seen, while Rule 2010 does not provide regulators with carte blanche to pursue violations, the reach of Rule 2010 is broad.  Even unethical conduct that is not securities-related is prohibited by Rule 2010 if it occurs in the conduct of the member or associated person’s business.  In evaluating what conduct runs afoul of Rule 2010, FINRA members and associated persons must rely on not only the FINRA written Conduct Rules, but also on their experience and exposure to industry norms, as well as their general sense of what is right or wrong.

SEC Proposes Rules on JOBS Act Crowdfunding Provisions

With constant advances in technology, crowdfunding has been a popular source used in a number of areas to raise money for various types of projects.  Its aim is to receive small contributions from a large amount of people.  Prior to the passage of the JOBS Act, this mechanism of raising capital was never used for the offer or sale of securities.  The crowdfunding exemption was intended to bridge the gap in raising funds and overbearing regulations for small businesses.    

The immediate concern for this type of fundraising is investor protection.  Thus, the SEC was tasked with formulating rules that allow for implementation of the crowdfunding provisions while safeguarding the market and investors.  Just recently, the SEC proposed rules that would “permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.”  Since the proposed rules encompass nearly 600 pages, the following is a brief overview of some of the important issues.  

According to the proposed rules, the maximum amount a company could raise from crowdfunding offering within a 12-month period is $1 million.  Over the course of the 12-month period, the maximum investment per investor is based on the annual income or net worth.  For investors with both an annual income and net worth less than $100,000, the maximum investment is the greater of $2,000 or 5% of their annual income or net worth.  For investors with either annual income or net worth equal to or more than $100,000, the maximum investment is 10% of their annual income or net worth, whichever is greater.  However, investors are not permitted to purchase more than $100,000 of securities through crowdfunding during the 12-month period.   

Companies conducting a crowdfunding offering are required to file certain information with the SEC.  This information is to be made available to investors, potential investors, and the intermediary facilitating the crowdfunding. Such information includes the following: (1) information about officers and directors as well as owners of 20 percent or more of the company; (2) a description of the company’s business and the use of proceeds from the offering; (3) the price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount; (4) certain related-party transactions; (5) a description of the financial condition of the company; and (6) financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.  Any company relying on the use of crowdfunding to raise capital must file an annual report with the SEC and provide that report to investors. 

In order to achieve investor protection, the JOBS Act requires crowdfunding to take place through an SEC-registered intermediary.  This can be either a broker-dealer or a funding portal.  In a nutshell, the proposed rules would require intermediaries to take measures to reduce the risk of fraud, provide investors with educational materials and information about the issuer and offering, provide communications channels on the online platform that permit investors to discuss the offering, and facilitate the offer and sale of crowdfunded securities. The proposed rules prohibit funding portals from the following: (1) offering investment advice or making recommendations; (2) soliciting purchases, sales or offers to buy securities offered or displayed on its website; (3) imposing certain restrictions on compensating people for solicitations; and (4) holding, possessing, or handling investor funds or securities.

The SEC is providing 90 days of public comment before determining whether to adopt the proposed rules.  To review the proposed rules in their entirety, click here.