Wednesday, November 13, 2013

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.


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.

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