Get Your Own Lawyer, Darn It!

Financial advisors facing an arbitration claim or regulatory inquiry often count on their broker-dealer or registered investment advisor for legal counsel. These “employers” will frequently provide them with an ostensibly independent “conflict counsel” after they retain their own counsel. Unfortunately, however, it is arguably little more than a charade when the “independent” attorney either has, or one day hopes to represent the broker-dealer or registered investment advisor.

Consider viewing the situation in the context of an attorney's ethical duty of loyalty, her fiduciary duty to put the client's interests first, and her obligation to avoid even the appearance of failing to do so. If you (the attorney) have been hired and paid by a large client that you covet to represent an individual financial advisor that you will never see again, would you not be hesitant to suggest the financial advisor save herself – even if it injures the interests of the large corporate client? Would you really warn the advisor if you caught wind of the broker-dealer's or registered investment advisor's intention to throw him or her under the bus, or even put their interests before your client's in just a small way? And these are not mere hypotheticals. I have seen these situations, and even been caught up in them.

Loyalty and independent judgment are essential elements in the lawyer's relationship to a client. Concurrent conflicts of interest can arise from the lawyer's responsibilities to another client, a former client, or a third person or from the lawyer's own interests. For specific Rules regarding certain concurrent conflicts of interest, see Rule 4-1.8. For former client conflicts of interest, see Rule 4-1.9. For conflicts of interest involving prospective clients, see Rule 4-1.18¹.

Many years ago, I was in a fairly “steady relationship” with a large broker-dealer. But my firm was more like a second fiddle to a larger law firm they had used for years. Upon the advent of a large regulatory action, the broker-dealer hired me to represent some of their former advisors and executives. I became uncomfortable with this arrangement when it became apparent to me that many of my clients had a strong defense to the allegations, in that the broker-dealer was in large part responsible for my clients' alleged omissions. But before that day of reckoning arrived, something happened. The broker-dealer's primary attorney decided to file what appeared to me to be a frivolous motion that would not be in the best interests of my individual clients. I informed the primary attorney that my clients would not be joining the motion as he had directed. I received a major ass-chewing from him, and an order to get in line. Long story short is that I did not comply with that demand, and the broker-dealer got sanctioned for the motion. My individual clients were relieved, and ultimately dismissed from the case for zero fines or sanctions. But the broker-dealer never hired me again.

In another case, a financial advisor hired me to file a breach of fiduciary duty action against his former broker-dealer's attorney. That attorney initially represented both the broker-dealer and the advisor during a regulatory investigation. That same attorney then proceeded to play an instrumental role in throwing that financial advisor under the bus. When the dust had settled, no pun intended, the broker-dealer and attorney paid almost $4,000,000 to my client for their respective roles in the subsequent U-5 defamation and breach of fiduciary duty.

Finally, in a more recent situation, the attorneys for a broker-dealer's employee never even broached the subject of a resolution between my client and her individual client. Her firm covets their relationship with the broker-dealer far more than I had even dared to imagine. Things went south fast in our previously cordial relationship when I had the audacity to raise the “appearance” issue with her. Nothing changed in terms of proper legal representation, other than the tenor of the relationship.

The moral of these stories is this: if you are in hot water together with your employer, avoid the temptation of having your employer pay your legal bills and pick your lawyer for you. And if you are representing a broker-dealer and they ask you to serve as an unbiased loyal counsel for an employee or independent contractor, “just say no." Food for thought.

1 Comment to: RULE 4-1.7: CONFLICT OF INTEREST: CURRENT CLIENTS (https://www.courts.mo.gov/courts/ClerkHandbooksP2RulesOnly.nsf/c0c6ffa99df4993f86256ba50057dcb8/d06710dff1830d2686256ca600521205?OpenDocument)

Second Circuit Finds That SEC is Immune from Lawsuit by Bernie Madoff Victims

In Molchatsky, et al. v. United States, 11-2510-cv(L), the Plaintiffs sought to hold the United States liable for SEC employees’ failure to detect Bernard Madoff’s Ponzi scheme and for the financial losses that Plaintiffs claim they suffered as a result. The Plaintiffs’ principal allegation was that the SEC negligently failed to uncover Madoff’s fraud despite receiving numerous complaints over a sixteen-year period. Plaintiffs claim that the SEC’s clear negligence exposes the agency to liability under the Federal Tort Claims Act (“FTCA”).

The FTCA is an exception to the rule that the United States is typically immune from suit. The district court determined that the Discretionary Function Exception (“DFE”), an exception to the exception to the rule of United States immunity, barred Plaintiffs’ claims. The DFE suspends the FTCA from applying to:

[a]ny claim based upon an act or omission of an employee of the Government, exercising due care, in the execution of a statute or regulation, whether or not such statute or regulation be valid, or based upon the exercise or performance or the failure to exercise or perform a discretionary function or duty on the part of a federal agency or an employee of the Government, whether or not the discretion involved be abused.

28 U.S.C. § 2680(a).

The Second Circuit Court of Appeals agreed with the district court. The court of appeals stated that the DFE is not about fairness, it “is about power,” National Union Fire Insurance v. United States, 115 F.3d 20 1415, 1422 (9th Cir. 1997); the sovereign “reserve[s] to itself the right to act without liability for misjudgment and carelessness in the formulation of policy,” id. “[T]he DFE bars suit only if two conditions are met: (1) the acts alleged to be negligent must be discretionary, in that they involve an ‘element of judgment or choice’ and are not compelled by statute or regulation and (2) the judgment or choice in question must be grounded in ‘considerations of public policy’ or susceptible to policy analysis.” Coulthurst v. United States, 214 F.3d 106, 109 (2d Cir. 2000) (quoting United States v. Gaubert, 499 U.S. 315, 322-23 (1991)) The court of appeals noted that Plaintiffs bear the initial burden to state a claim that is not barred by the DFE. See Gaubert, 499 U.S. at 324-25.

The court of appeals concluded that in the case before it, the Plaintiffs failed to make the necessary showing. The conduct Plaintiffs sought to challenge was “too intertwined with purely discretionary decisions” made by SEC personnel. Gray v. Bell, 712 F.2d 490, 515 (D.C. Cir. 1983); see generally id. at 515-16.

While the court expressed sympathy for Plaintiffs’ predicament (and at the same time expressing antipathy for the SEC’s conduct), it found that Congress’s intent to shield regulatory agencies’ discretionary use of specific investigative powers via the DFE was fatal to Plaintiffs’ claims. See Berkovitz by Berkovitz v. United States, 486 U.S. 531, 538 & 538 n.4 (1988) (quoting H.R.Rep. No. 1287, 79th Cong., 1st Sess., 616 (1945)). The court found that the first prong of the DFE was satisfied because the SEC retains complete discretion over when, whether and to what extent to investigate and bring an action against an individual or entity. See 15 U.S.C. § 78u(a)(1); 17 C.F.R. § 202.5(a)-(b). It also found that the second prong of the DFE was satisfied by virtue of the SEC’s choices regarding allocation of agency time and resources being sufficiently grounded in economic, social and policy considerations. See Bd. of Trade of City of Chicago v. SEC, 2 883 F.2d 525, 531 (7th Cir. 1989); cf. Coulthurst, 214 F.3d at 108-11.

The court concluded that the SEC’s actions, along with its “regrettable inaction,” were shielded by the Discretionary Function Exception, and affirmed the district court’s dismissal of Plaintiffs’ claims for lack of subject matter jurisdiction.

FINRA’s 2012 Year in Review

FINRA just released its 2012 Year in Review Report.  In its opening remarks, FINRA’s Chairman and CEO, Richard Ketchum, stated, “FINRA fulfilled its role as the first line of defense for investors through a comprehensive and aggressive enforcement program, supported by a realigned and more risk-based examination program and the provision, for the first time, of cross-market surveillance programs that more effectively detected electronic manipulative trading. Protecting investors and helping to ensure the integrity of the nation’s financial markets is at the heart of what we do every day.

Regulatory

FINRA noted that one of its regulatory highlights was the success of its referral program in which the Office of Fraud Detection and Market Intelligence (“OFDMI”) shares regulatory intelligence with the SEC and other law enforcement agencies. Its intelligence stems from OFDMI’s fraud and insider trading surveillance of nearly all U.S. equities markets.  In 2012, FINRA referred a total of 692 matters to the SEC and other law enforcement agencies, of which 347 involved insider trading and 260 involved fraud. 

Disciplinary and Enforcement

In addition to its referrals program, FINRA brought 1,541 disciplinary actions against registered firms and individuals, levied fines in excess of $68 million, and ordered $34 million in restitution to harmed investors.  FINRA expelled a total of 30 firms from the securities industry, barred 294 individuals, and suspended 549 brokers from associating with FINRA-regulated firms. 

Some of the complex products involved in 2012 disciplinary and enforcement actions were non-traded REITs, exchange-traded funds (ETFs), and structured products.  Other enforcement actions involved research analyst conflicts, mispricing, and improper reimbursement fees to lobbying groups. 

Another critical aspect of FINRA is its examinations of member firms and associated persons.  In 2012, FINRA initiated 1,846 routine examinations, over 800 branch office examinations, and 5,100 examinations resulting from customer complaints, terminations for cause, and other regulatory tips.  FINRA’s exam procedures were made more efficient due to advances in technology which has provided FINRA with a modernized framework that allows it to identify and prioritize areas of risk exposure at firms. 

Investor Protection

Of grave importance to investors was FINRA’s new suitability rule that was implemented July 9, 2012.  The rule requires broker-dealers and/or their associated persons “to have a ‘reasonable basis’ to believe a recommended investment is suitable for the customer, based on information obtained through ‘reasonable diligence’ to understand a customer’s investment profile.”  For more investor information on FINRA’s suitability rule, click here.

FINRA also proposed an investor-protection initiative in 2012 that attempts to address conflicts of interest relating to recruitment compensation practices of member firms offering incentives to recruit registered representatives.  Currently these compensation arrangements are not disclosed to the representative’s customers when they are asked to transfer their accounts to a representative’s new firm.  The rule would require the member firm to provide certain disclosures before a customer makes the final determination to transfer an account to the new firm.  The view the text of the proposed rule, click here.

In September 2012, FINRA obtained approval to file proposed rules that would require firms to include a reference and a link to BrokerCheck on their websites to make it easier for investors to obtain information on firms and brokers. FINRA also increased the user friendliness of BrokerCheck by including a zip code search and a combined search function that provides for easier access to the SEC’s Investment Adviser Public Disclosure (IAPD) database. 

In November 2012, FINRA Dispute Resolution released data which reflects the outcomes of cases heard under its all-public panel program that was implemented in February 2011 which allows investors the option of a panel comprised of all public arbitrators versus a panel made up of one arbitrator with securities industry experience (nonpublic arbitrator) and two public arbitrators. The all-public panel option represents an investor-friendly change to the program, designed to ensure a fair playing field for all parties. To date, the data indicates that in cases decided by three public arbitrators, customers were awarded damages 51 percent of the time, whereas in cases decided by a panel including one nonpublic arbitrator and two public arbitrators, investors were awarded damages 32 percent of the time.  For the full data report, click here.

Notably, FINRA and the FINRA Investor Education Foundation have continued to enhance its outreach strategies and investor education by distributing educational brochures, holding live events, and creating an Outsmarting Investment Fraud curriculum.  The Foundation also put  more focus into providing services for military families through their military financial readiness project. 

Crowdfunding

A hot new topic in 2012 was “crowdfunding” since new provisions relating to crowdfunding were introduced in the April, 2012 JOBS Act.  To ensure that the capital-raising objectives of the JOBS Act can be advanced while simultaneously protecting investors, FINRA has requested and solicited comments on specific rules it should adopt for registered funding portals that become FINRA members.  In addition, FINRA has also asked for comments on the application of its existing rules to broker-dealers engaging in crowdfunding activities. 

If you’re a FINRA member firm, associated person, or an investor involved in a potential FINRA-related claim, contact the experienced attorneys at Cosgrove Law Group, LLC for assistance. 

Focusing Only on Dodd-Frank? Then You Might Be Missing Something

Because the Dodd-Frank financial reform bill grabs headlines every day, other regulations are entering the scene almost undetected. Broker-dealers and registered investment advisors may not be aware of new upcoming regulations, which could impact their business.

The Dodd-Frank reform bill has shaken the marketplace and the regulatory bodies. In its aftermath, there have been a flurry of mandated studies, proposals and rulemakings, but it has also spurred other agencies and organizations into action. As such, new regulations are on the horizon besides just those implemented under Dodd-Frank authority.

Last summer, in addition to passing Dodd-Frank, Congress also passed the Foreign Account Tax Compliance Act (FACTA), which imposes stricter IRS filing requirements on those having overseas assets of more $50,000 US dollars. This legislation has significant effect on institutions that hold assets for U.S. investors. FACTA will take effect in 2013.

FINRA revised its suitability rule (currently NASD Rule 2310), which is slated to go into effect on July 9, 2012. The revised rule adds five new elements that broker dealers and firms must consider: client liquidity, age, investment experience, time horizon, and risk tolerance.

FINRA also has implemented new trade-reporting requirements. In May 2011, FINRA began requiring brokerage firms to start using its Trade Reporting and Compliance Engine (TRACE) system to report trades of asset-backed securities. This coming October, broker dealers will have to begin reporting more trades and additional, previously undisclosed data into FINRA’s Order Audit Trading System.

The Department of Treasury’s Financial Crimes Enforcement Network (Fincen) has been discussing the possibility of subjecting registered investment advisory firms and hedge funds to its anti-money laundering rules. Although nothing has been implemented yet, Fincen is considering making it a requirement for these firms to file suspicious-activity reports (SARs) like banks and broker dealers.

With all of these new regulations and those yet come, it is important to have legal counsel that knows and understands the changing regulatory environment.

Study Finds It Might Be Better to Fight the SEC & FINRA Than Settle

A study conducted by financial services law firm Sutherland Asbill & Brennan finds that it sometimes pays for broker-dealers and registered representatives to take on regulators. The study analyzes the outcomes of disciplinary and administrative proceedings between October 2008 and September 2010—the SEC’s 2009 and 2010 fiscal years.

Some key findings:

• 57% of the time, the SEC fails to prove fraud charges, but FINRA had a 100% success rate (4 of 4 fraud charges were proven).

• 33% of SEC respondents were successful in receiving reduced sanctions when cases were appealed from SEC Administrative Law Judge (ALJ) to the full Commission

• 33% of the time the ALJ or the Hearing Panel imposed lower monetary sanctions than the amount FINRA or SEC staff initially sought, but 33% of the time the ALJ or Hearing Panel imposed higher monetary sanctions.

• 28% of SEC respondents got charges dismissed compared with 8.6% of FINRA respondents (out of 237 litigated charges)

• FINRA respondents represented by counsel were significantly more successful than pro se respondents. Since 2006, only one pro se FINRA respondent successfully got charges dismissed.

Often firms and individuals think it is better to settle with the regulators. However, based on the findings of this study, in some circumstances—usually where fraud is charged, respondents will fare better if they come before a judge or hearing panel. Further, the study purports to establish that there might not actually be a “settlement discount,” which is a tactic used by the regulators to incentivize settlement before entering into litigation. However, the study admits that the sample used to determine this finding is not likely a representative sample.

The bottom line: seek legal counsel before making the decision to settle or litigate. Again, the study only finds that litigants are more successful some of the time over those who settle.

Saving a Buck on Your Compliance Program Might Cost You in the Long Run

If you are an independent investment adviser or small broker dealer that has realized it has a need for compliance assistance, you should choose your compliance counsel carefully. First, if your compliance adviser is not an attorney, your communications with that adviser is unlikely to be protected by the attorney-client privilege in the event of a regulatory inquiry or an enforcement proceeding. If you do choose an attorney in which to place your trust, you should make sure that they have previously been through several SEC, State and FINRA audits, and that he or she is adequately insured. Getting a clear picture of your compliance status is critical, but it might backfire if it can be stolen from you through an investigatory subpoena or civil investigatory demand. Compliance is a far ranging task, and you should apply several sets of eyes to getting it done right. Our firm has helped independent investment advisers with ADV updates and a variety of other regulatory issues. It can be an unnerving task, as there are so many issues and levels that need to be addressed with analytical precision and a depth of knowledge seldom possessed by a single individual. Beyond representing aggrieved investors and brokers in industry disputes, our firm has represented a variety of industry participants that would have been well-served by a preventative compliance program. It will be far more expensive to cure a lapse in compliance than it will to hire a compliance firm or law firm with substantial regulatory as well as industry compliance experience. Members and associates of our firm have been on both sides of regulatory audits and inquiries, and we are ready to help you avoid accidentally triggering a costly customer complaint or regulatory inquiry, investigation or Order.