A: Yes.

Q: Do you wish to proceed?

A: Umm … yes?

This exchange, or something similar, should sound familiar to any lawyer who has been retained by a company to jointly represent it and those of its employees who have been called upon by the Financial Industry Regulatory Authority to provide on-the-record (OTR) testimony in connection with an enforcement investigation. While FINRA understandably asks the questions to help maintain the integrity of the testimony and obviate possible future attacks by the witness on the enforcement process, these questions are nonetheless awkward for both the witness and counsel alike.

Irrespective of FINRA’s intent, its questions hint at potential conflicts with the joint representation and make witnesses apprehensive. Adding to the discomfort of the situation is that the questions are posed at the outset of the OTR and often times by a non-attorney investigator. But if the matter has progressed to this stage, however, with the witness already under oath, counsel for the witness has undoubtedly already concluded that no conflicts exist that would prevent the concurrent representation of both the company and the witness.

From an ethical standpoint, there is nothing inherently inappropriate about concurrently representing the company and its employees. Indeed, as one court aptly put it, an “appearance of impropriety must be something more than a fanciful possibility and must have some reasonable basis.”[1]

Rule 1.7 of the Model Rules of Professional Conduct states that “a lawyer shall not represent a client if the representation involves a concurrent conflict of interest,” and that a conflict of interest exists if: “(1) the representation of one client will be directly adverse to another client; or (2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client, a former client or a third person or by a personal interest of the lawyer.”

Rule 1.7 also specifically provides that a lawyer may represent a client notwithstanding the existence of a conflict of interest, if: “(1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client; (2) the representation is not prohibited by law; and (3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal.”[2]

As stated in the rule, a lawyer must conduct sufficient due diligence to “reasonably believe” that she will be able to “provide competent and diligent representation to each affected client.” Naturally, this must be accomplished before the lawyer agrees to jointly represent the company and its employees.

More often than not, the lawyer is able to establish a “reasonable belief” that the interests of the company and employee are aligned, thereby providing an ethical basis to competently represent both clients. And when the interests of the firm and employee are aligned, it is advantageous for myriad reasons for both to engage the same counsel during the investigation.

Rule 1.7 also provides that after satisfying the “reasonable basis” requirement, lawyers need to obtain informed written consent from each affected client that they intend to represent.[3] Things can go awry if the lawyer gives short shrift to this process. 

The New York City Bar, for example, has issued several instructive ethics opinions that provide certain best practices for lawyers who intend to engage in the joint representation of multiple clients.

In Formal Opinion 2001-03, “Limiting the Scope of an Attorney’s Representation to Avoid Client Conflict,” the New York City Bar opined:

In obtaining consent from the client, the lawyer must adequately disclose the limitations on the scope of the engagement and the matters that will be excluded.  In addition, the lawyer must disclose the reasonably foreseeable consequences of the limitation.  In making such disclosure, the lawyer should explain that separate counsel may need to be retained, which could result in additional expense, and delay or complicate the rendition of legal services.[4]

In 2004, the New York City Bar recognized that “it has become increasingly common for lawyers to be asked to undertake simultaneous representation of a corporation and one or more of its officers, directors, employees or other constituents (sometimes collectively referred to as “constituents”) in the context of a governmental investigation.”[5] The New York City Bar further noted in the opinion that:

• before undertaking simultaneous representation of a corporation and one or more of its employees in the context of a governmental investigation, an attorney must carefully consider whether he can competently represent the interests of each client; 

• the attorney must give careful, fact-specific consideration to the risks and advantages to multiple representation and discuss those factors fully with each client before seeking their consent to multiple representation;

• throughout the representation, the attorney must remain alert to changing circumstances that may render continuation of multiple representation impermissible or inadvisable; and

• the attorney should give consideration to whether there are ways in which the multiple representation can be structured so as to minimize adverse consequences to her clients should a conflict between them arise.[6]

The New York City Bar further noted in this opinion that as a general matter there is no ethical bar to seeking a waiver of future conflicts.[7]

Numerous courts have considered and addressed the issue of concurrent representation of multiple clients. In Flycell Inc. v. Schlossberg LLC, for example, the court held that an “attorney may represent both an organization as well as one of the organization’s directors, officers, employees, members, shareholders or other constituents, if the dual representation does not create an unwaivable — or an unwaived — conflict of interest. … [A]conflict exists if dual representation either involves client interests that are antagonistic to one another, or creates a possibility that the lawyer’s judgment or loyalty will be compromised.”[8] 

In Mercedes v. Blue, the court considered former New York Disciplinary Rule 105[9] and held that the rule “permits joint representation even if the lawyer’s professional judgment ‘will or is likely to be adversely affected,’ provided that two conditions are satisfied — (1) that ‘it is obvious that he can adequately represent the interest of each’ client and (2) that each client consents to such joint representation after a full explanation by the lawyer of ‘the possible effect of such representation on the exercise of his independent professional judgment on behalf of each.’”[10]

Accordingly, there are several factors that lawyers should consider memorializing in writing with employee clients to satisfy the “informed consent” requirement, including that:

• the lawyer will jointly represent the company and employee;

• the interests of the company and employee are aligned based on information available at the time;

• the representation is limited to the specific matter;

• the company will pay the lawyer’s fees;

• information learned from the employee can be shared with the company;

• if a conflict is subsequently discovered then the employee consents to the hiring of separate counsel to represent them, and will not object to the lawyer’s continued representation of the company; and

• the employee waives any conflict that may arise in the future with respect to the lawyer continuing to represent the company in other matters, including matters that may be adverse to the employee.

Following these best practices should help safeguard a lawyer from the unpleasant situation of a conflict being discovered while concurrently representing the company and employee.

One prominent law firm, however, recently found itself embroiled in a multimillion-dollar dispute regarding concurrent representation and discovery of a conflict during the course of a FINRA Enforcement matter. That firm is now a defendant in a lawsuit that was filed in New York State Court by a former company employee whom the law firm was concurrently representing with his company employer in the enforcement matter. 

According to the complaint, the former employee alleges, among other things, that the law firm disclosed privileged communications, permitted testimony by others that was adverse to the employee, disclosed information to others that was learned during the course of the law firm’s representation of the employee, and violated the Rules of Professional Conduct, including Rule 1.7.

The complaint also sets forth the following purported fact pattern: (1) the former employee of a broker-dealer engaged the law firm to represent him in connection with a FINRA investigation; (2) the law firm was at the time also representing the broker-dealer on other matters, but advised the former employee that it did not see a set of circumstances where the former employee would likely be adverse to the broker-dealer; (3) the law firm sent the former employee a formal engagement letter, but the letter allegedly did not mention the potential conflict of interest arising from the law firm’s joint representation; (4) the letter failed to identify what rights the former employee would have if a conflict materialized; and (5) the law firm subsequently agreed to represent the broker-dealer in the same FINRA investigation. 

The complaint further alleges that at some point during the FINRA investigation, the law firm advised the former employee that it could no longer represent him in the investigation, but would continue to represent the broker-dealer and other of the broker-dealer’s employees. In response, the former employee purportedly demanded that the law firm terminate its representation of the broker-dealer and not share with the broker-dealer any of the privileged information learned from the former employee. The former employee ultimately retained separate counsel to represent him in the FINRA investigation. The law firm continued to represent the broker-dealer.

It will be interesting to see how this recently filed lawsuit plays out. But in the interim, counsel should not be surprised if FINRA investigators are a bit more emboldened to “suggest” separate representation. Thus, lawyers should continue to approach this area with care by asking themselves what Hamlet would no doubt have asked himself if he was a lawyer, “to joint rep or not to joint rep?”

–By Dimitri Nemirovsky and Bryan I. Reyhani, Reyhani Nemirovsky LLP

Dimitri Nemirovsky and Bryan Reyhani are the founding partners of Reyhani Nemirovsky LLP in New York. The firm specializes in representing financial services clients in enforcement investigations, regulatory proceedings and private client arbitrations. Nemirovsky and Reyhani also advise clients on regulatory and compliance matters. 

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] State v. Loyal, 164 N.J. 418, 429, (N.J. 2000) (internal citations and quotation marks omitted).

[2] Rule 1.7 of the Model Rules of Professional Conduct.

[3] Id.

[4] New York City Bar Formal Opinion 2001-3.

[5] New York City Bar Formal Opinion 2004-2.

[6] Id.

[7] See also, New York City Bar Formal Opinion 2006-1: “Multiple Representations; Informed Consent; Waiver of Conflicts.”

[8] Flycell, Inc. v. Schlossberg LLC, 2011 U.S. Dist. LEXIS 126024, at *13 (S.D.N.Y. 2011). 

[9] On April 1, 2009, New York replaced its Code of Professional Responsibility with the Rules of Professional Conduct, which is aligned with the ABA Model.

[10] Mercedes v. Blue 2001 U.S. Dist. LEXIS 6468, at *1 (S.D.N.Y.  2001).

On January 16, 2013, FINRA Chairman and CEO, Richard Ketchum, spoke at the SIFMA Compliance and Legal Society monthly luncheon about FINRA’s regulatory plans and priorities for the upcoming year.  As set forth below, Mr. Ketchum covered topics that were previously identified by FINRA in its 2013 Regulatory and Examinations Priorities letter, which can be found here, and other significant regulatory issues about which member firms should be cognizant.

Complex Products Remain At The Forefront

Consistent with FINRA pronouncements in recent years, Mr. Ketchum opened his remarks by explaining that FINRA continues to be concerned about the suitability of complex products.  He noted that FINRA has focused on this area, both by publishing notices to members and initiating actions against member firms in connection with such products.  Mr. Ketchum also recognized, however, that not all complex products fall into the same category, e.g., steepeners, reverse convertibles and exchange-traded products.  He also acknowledged that in today’s low-interest-rate environment, it is difficult for advisors to meet client expectations with ordinary fixed-income securities.  This has resulted in a fundamental shift in the risk/reward formula as advisors have, in certain situations, distributed their clients’ investments into more-concentrated and potentially higher-yielding positions; often utilizing complex and less transparent products to chase yield.

Mr. Ketchum offered advice to both counsel and compliance officers alike, suggesting the need for dialogue with the business side to ensure: (1) that member firms are comfortable with their advisors’ understanding of the products they are selling; and (2) that the advisors are able to effectively and appropriately communicate the requisite information to their clients.  For example, Mr. Ketchum explained that structured products “need to feel different from traditional products,” and that firms should consider requiring advisors to memorialize their reasons for believing that a particular product is suitable for an investor and that the investor understood the downside risks.  Mr. Ketchum added that this “think about it” approach would “create an important cultural shift and a better environment for compliance oversight.”

Structured Products

Mr. Ketchum noted that risk disclosures related to structured products have been much improved in recent years.  But, on the other hand, the training and education of advisors seems to have “fallen through the cracks.”  As a result, advisors might not accurately convey to investors the actual risk profile of structured products.  Mr. Ketchum noted that the same “care and commitment” taken to create and approve structured products should extend to the marketing of such products.  He stressed that FINRA’s focus in 2013 is squarely on the sales and distribution of structured products, and whether advisors adequately communicate the risks and potential scenarios of the products to investors.

Exchange-Traded Funds And Products

Mr. Ketchum again focused on the training and education of advisors, and how effectively advisors are able to explain the range of exchange-traded products and funds to their clients.  Advisors have demonstrated all too often that they do not necessarily understand the underlying esoteric indices to which these products may be linked, or that the products may be illiquid.  They, therefore, fail to adequately communicate the various risks to prospective investors.

High-Yield Securities

In today’s market environment, Mr. Ketchum stated that the potential upside of high-yield securities is considerably less than in recent history, which has led investors to press their advisors for higher returns and caused higher-credit-risk companies to issue dubious debt with potentially higher yields.  The result is a shift toward non-investment grade securities being sold to investors with lower risk tolerances.  Mr. Ketchum opined that we are in the midst of a market cycle during which we should expect to see high-yield investments begin to default and underperform dramatically within the next several years.  While noting that there is nothing per se problematic with high-yield securities, assuming the risks are disclosed, Mr. Ketchum advised that member firms need to focus on suitability and concentration, and whether traditional financial products would be more appropriate for the investor, especially for those who require liquidity.

Non-Traded REITs And Closed-End Funds

These securities appear attractive to investors in a low-yield environment.  FINRA is concerned that investors may not understand that initial high-yielding distributions are “teasers” and that the sales costs associated with these products may erode principal.  Firms, therefore, should closely monitor the suitability of these investments and pay close attention to the information that advisors are communicating to investors.

Focus On Private Placements

Mr. Ketchum emphasized that private placements will be a “major focus” for FINRA this year. FINRA Rule 5123, effective as of December 3, 2012, requires, among other things, that member firms submit to FINRA any private placement offering documents used in connection with such sale within 15 calendar days of the date of first sale or indicate to FINRA that no offering documents were used.  Such submissions will allow FINRA to have a better grasp of private placement offerings in the marketplace.

Mr. Ketchum remarked that private placement documents have historically been prone to containing poor disclosures and often contain inadequate explanations regarding investment proceeds.  When selling private placements, firms’ compliance areas should engage in more proactive conversations with business personnel to ensure proper due diligence and that appropriate disclosures are being provided to investors.  Mr. Ketchum noted that firms: (1) have due-diligence obligations irrespective of their underwriter status; and (2) are expected to ask questions to satisfy their due-diligence obligations.  These obligations are heightened when a relationship exists between the firm and the issuer, or where the deal appears on its face to involve a conflict.

Handling Conflicts Of Interest

Mr. Ketchum advised that FINRA plans to take a closer look at how member firms deal with internal conflicts of interest, such as those that may exist between retail and investment banking clients of a firm.  In particular, FINRA’s focus will be on: (1) how member firms view, prioritize, and deal with conflicts; (2) whether conflicts are dealt with in one central location or diversified across different firm departments; and (3) who at a firm is held accountable for monitoring conflicts.  FINRA will review how conflicts may impact the firm from a cultural standpoint and how firms mitigate conflict risks.  Mr. Ketchum emphasized that firms must understand how both direct and indirect compensation “incentives” shape the decision making process.  Specifically, compliance officers should build consultative relationships with their business partners and understand which incentives may lead to incorrect decisions.

Mr. Ketchum noted that conflicts are a “living thing” about which firms need to have internal discussions to determine how best they should be addressed.  Firms should identify both who is responsible for dealing with the conflicts and how they are tracked, and document how conflicts can be mitigated.  Mr. Ketchum added that “reasonably” dealing with a conflict, including with properly documented disclosures, would be considered by FINRA as “good oversight” by the firm, but that firms should continue to improve conflicts documentation.  FINRA is preparing for publication in the near future best practices for addressing conflicts.

Crowdfunding

The JOBS Act (Jumpstart Our Business Startups), which became effective in mid-2012, made equity crowdfunding a possibility, and such crowdfunding falls under FINRA’s jurisdiction.  Mr. Ketchum noted that FINRA is in the process of adopting rules for crowdfunding portals that will focus on broker-dealer affiliates and intermediaries, including who can represent, solicit and promote crowdfunding.  Mr. Ketchum acknowledged that firms will face difficulties regarding crowdfunding oversight. 

New Suitability Rule Guidance And The Rule Review Process

FINRA recently issued FAQs that Mr. Ketchum believes will assist member firms and associated persons and provide clarity about the new suitability rule.  He noted that a broker’s suitability obligations are not triggered until a potential investor becomes a client.  Mr. Ketchum reiterated FINRA’s stance that the rule employs a reasonableness standard with respect to firms’ oversight of trading in client accounts.

With regard to the implementation of new rules, Mr. Ketchum explained that he is trying to build “contrarianism” into FINRA, which will include the hiring of an economist to better ascertain the impact of newly enacted rules.  The review process will include a structured review and survey of firms to assist in determining the effectiveness of major rule enactments.

Consolidated Audit Trail

FINRA will accelerate its efforts in the near term to develop a plan for consolidated audit trails.  Mr. Ketchum noted that input from the industry is important and he wants to set up an industry committee to interact with FINRA.  Mr. Ketchum expects that a final RFP will be issued in the next few months.

High-Frequency Trading

While high-frequency trading remains a top priority for FINRA, Mr. Ketchum noted that FINRA has seen improvements in supervision.  FINRA expects firms to test their trading algorithms and intends to examine how firms conduct such testing.  Mr. Ketchum noted that compliance should be involved with high-frequency trading even though they have not been traditionally involved in the process.  FINRA will continue to look at “kill switches,” whether and how firms are able to revert to traditional trading designs, and the decision-making process when issues arise.

# # #

Reyhani Nemirovsky LLP represents financial services clients in regulatory matters, enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

Attorney advertising.  Prior results do not guarantee a similar outcome.

• William Wollman, Senior Vice President, FINRA;
• Suzanne McGovern, Assistant Director, U.S. Securities and Exchange Commission, Office of Compliance, Inspections and Examinations (“OCIE”);
• Debra Roth, Executive Director, Morgan Stanley;
• Michael Ludwig, Director and Head of Americas Regulatory Exams, Credit Suisse; and
• Ben Indek, Partner, Morgan, Lewis & Bockius LLP.

Ms. McGovern began the discussion by describing the SEC’s risk targeted exam sweeps — “RITES” — initiative, which she described as both a horizontal and vertical approach to sweep exams.  Ms. McGovern explained that subject matter ideas for sweeps come from a wide assortment of potential sources including regional offices, the identification of new risk areas in the marketplace, which can be gleaned from industry announcements and articles in the press, new legislation, new products, and new systems and platforms introduced by the industry.  The SEC wants to ensure that it understands new initiatives introduced into the marketplace by the industry and to obtain a handle early regarding what does and does not work.  Prior to the launch of any sweep, the SEC has an executive committee that vets and is responsible for approving sweep ideas.

Following a sweep, OCIE will prepare a written report summarizing its findings.  The report is then turned into a public report that includes both the good practices and violative conduct identified during the sweep.  The public reports are published in two formats: risk alerts for routine issues and whitepapers for high-profile issues.  In an attempt to expedite the process, OCIE has dedicated one staff member to preparing summary reports for public consumption, but these still go through the vetting and approval process prior to publication.  See OCIE’s studies and reports at http://www.sec.gov/about/offices/ocie/ocie_studies.shtml.

OCIE’s exams initiatives are currently focused on the following areas:

• governance of technology and controls;
• the Facebook IPO;
• seniors;
• non-exchange traded REITs;
• alternative trading systems;
• high-yield securities and how they are marketed; and
• due diligence.

Exam alerts that are forthcoming from OCIE relate to:

• investment adviser due diligence;
• options;
• reasonable inquiry (know your customer);
• structured products to retail clients; and
• broker-dealer services to investment advisers.

Ms. McGovern added that the SEC attempts to coordinate with FINRA to avoid sweep duplication and it has discussions with FINRA to determine which entity would be best suited to examine what firm.  She described such considerations as “granular.”

For more information about the SEC’s National Exam Program, see http://rnlawfirm.com/2012/05/16/hot-topics-in-the-secs-national-exam-program.  For additional information about the SEC’s examination program of IAs and dually registered firms, see http://rnlawfirm.com/2012/07/30/the-secs-examinations-program-of-ias-and-dually-registered-firms.

As for FINRA, Mr. Wollman explained that FINRA takes a horizontal approach to sweep exams by targeting multiple firms that are representative of the particular subject matter of interest in the sweep.  Sweeps can originate from various areas within FINRA, as well as from self-reporting.  Mr. Wollman added that some sweeps are conducted for the purpose of gathering information.  See FINRA’s sweep requests at http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/.

Before a sweep is authorized, a “sweep committee,” comprised of senior members from various FINRA departments, vets the proposed sweep.  FINRA attempts to ensure that sweeps are not duplicative of those conducted by the SEC or the CFTC, as examples.  FINRA also tries to limit the wasting of the examinee’s resources and uses sweeps as a method to improve investor protection.

While FINRA tries to avoid duplicative sweeps, Mr. Wollman acknowledged that there is some overlap between FINRA and OCIE, but that FINRA is working on a governance process to limit/avoid potential duplication.  Because there are over 4,000 member firms, Mr. Wollman explained that there needed to be a consistency in the requests to the firms.  By way of example, Mr. Wollman noted the recent business continuity plan (BCP) sweep that was issued in the wake of Hurricane Sandy.  He explained that prior to issuing the sweep, multiple regulators collaborated on the resultant sweep request, which included 31 individual requests. The requests resulted from a balancing of the various regulatory bodies’ interests involved following the storm. See the BCP sweep at http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P197274.

Mr. Wollman acknowledged that certain sweeps could be reactionary in response to an event in the industry.  He noted, however, that sweeps are outcome focused and not enforcement driven.

Similar to the SEC’s initiatives, Mr. Wollman noted that FINRA also is focused on examining firms that trade and sell non-exchange traded REITs, and especially communications related thereto.  FINRA also is focused on other products that have no transparency in the open marketplace.  Lastly, Mr. Wollman addressed the issue of interpreting another exchange’s rules, and stated that FINRA does not attempt to address non-FINRA rules and the possible violation of those rules.

For more information on FINRA’s exams, see http://rnlawfirm.com/2012/04/26/finra-exam-initiatives-2012.

The industry panelists focused on best practices on behalf of member firms and certain guidance regarding issues confronted during the course of a sweep.

In general, the panelists commented that it was best to be proactive.  For example, if a firm is not targeted during the course of a sweep, it still makes sense for the firm to conduct its own internal exam of the subject matter to determine if it has any issues that require remediation and possible self-reporting.  The panelists also noted that it is a best practice to engage counsel, whether in-house or external, when conducting such internal examinations to maintain privilege.

Another best practice identified by the panelists is to offer more information to the regulators than requested when such information helps to shed light on the situation and supports the firm’s position.  Moreover, when a request seeks information that the firm does not maintain in the ordinary course or in a readily accessible format, the firm should engage in dialogue with the regulator to see if the request can be altered to alleviate undue burden to the firm.

Finally, the panelists noted that all sweeps and exams should be taken seriously.  Even when a sweep letter may appear to be minor or innocuous, it can negatively impact a firm if not responded to properly.

# # #

Reyhani Nemirovsky LLP represents financial services clients in regulatory matters, enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

Attorney advertising.  Prior results do not guarantee a similar outcome. 

Your Q&A is your opportunity to get your questions answered by industry leaders.

Q.  What are the main takeaways for advisors of the recent California court ruling on broker-dealers clearing their FINRA records of past customer complaints?

– Advisor, high-net-worth focus, California

Answered by Dimitri Nemirovsky, the cofounding partner of the Reyhani Nemirovsky law firm. Bryan Reyhani, the other cofounding partner of the firm, cowrote this response.

A.  A recent California court ruling may well be a game-changer for advisors seeking to remove customer complaints and disciplinary actions from their Financial Industry Regulatory Authority (FINRA) records.

In Lickiss v. Financial Industry Regulatory Authority, the California Court of Appeal for the First Appellate District reversed a trial court’s dismissal of an expungement request by an advisor, Edwin Lickiss. Expungement is the removal of records from public inspection. Rejecting FINRA’s longstanding position regarding the process by which advisors can expunge their record, the court held that advisors had permission to seek the clearing of their records on grounds of basic equity or fairness. A final decision is still pending.

The framework for obtaining expungement relief is set forth in FINRA Rule 2080. The provision states that advisors seeking such remedies must obtain a court order directing the relief, or a court order confirming an arbitration award contained it. The rule requires that the party seeking expungement name FINRA as a party.

FINRA may waive the latter requirement if it determines that: the allegation or information is factually impossible or clearly erroneous; the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or the allegation or information is false.

FINRA may also waive the naming requirement if it determines that “the expungement relief” and accompanying findings on which it is based are meritorious. It can also do so if the information removal would have no material adverse effect on investor protection, the integrity of FINRA’s record system or regulatory requirements.

Lickiss filed his petition in California state court seeking to remove from FINRA’s Central Registration Depository 17 customer complaints and arbitrations and one regulatory enforcement action. He argued that the court had jurisdiction pursuant to FINRA Rule 2080 and its inherent equitable power to clear his record.

The advisor also argued that the disclosures related to matters dating back to the mid-1990s, that his record had remained clean since that time, and that the disclosures all related to investments in a single equity trust that went bankrupt in 1993.

Lickiss urged the court to balance the equity of his expungement request by weighing the harm the disclosures created for his business against the potential harm to investors that clearing his FINRA disclosures would cause.

FINRA asked the court to dismiss Lickiss’s petition on the basis of Rule 2080, arguing that equity permitted the court to rely exclusively on the rule and that Lickiss failed to meet the rule requirements.

Although the trial court agreed with FINRA and granted its motion to dismiss, the Court of Appeal reversed that decision and remanded the case back to the trial court for further proceedings. The Court of Appeal reasoned that by narrowly and rigidly assessing the legal sufficiency of Lickiss’s petition, the trial court “disregarded basic principles of equity” and the decision “was nothing short of an end run around equity.”

The Court of Appeal further noted that Rule 2080 is a “procedural rule that does not provide any substantive criteria as to when expungement would be appropriate.” Lickiss asked the court to make a fair ruling. He argued that his expungement request should be granted because the decades-old disclosures on his Central Registration Depository documents were impeding his ability to generate business and that granting the expungement would not be a detriment to the public. The Court of Appeal mentioned those factors in explaining its decision to overturn the trial court’s pro-FINRA ruling.

It will be interesting indeed to see how the trial court rules on Lickiss’s request given the reasoning by the Court of Appeal. If the trial court grants Lickiss’s expungement request, FINRA will likely move to appeal the ruling.

If the court rules in favor of Lickiss, obviously the precedent will open the floodgates and advisors will file similar cases in droves. If the court rules against Lickiss, I don’t think there will be a chilling effect. What I think we will see, because the appeals court ruled that trial courts have the authority to make equitable rulings, are advisors rolling the dice, especially in other jurisdictions.

Notwithstanding the outcome of the case, however, the Lickiss decision will likely lead to similar filings in state courts around the country by advisors seeking to expunge their Central Registration Depository records on grounds of basic fairness and equity. While this is a case pending in California, advisors in other jurisdictions can file me-too cases hoping for a favorable result based on the unique facts and circumstances of their cases. That will have implications for the wealth management community, some of whose members may be granted a clean slate, and high-net-worth investors themselves, who use the records for advisor due diligence.

With FINRA’s recent implementation of its new suitability rule, member firms and brokers must address the enhanced requirements and responsibilities created by the new rule. Among the more significant changes, FINRA now considers a recommendation to “hold” a security a “call to action” that is the same as a recommendation to buy or sell a security. Thus, while the new rule imposes more onerous responsibilities on firms and brokers, it may allow them to better address underutilization issues with the regulators by perhaps justifying “limited activity” fee-based accounts.

The New Suitability Rule

With certain notable modifications and additions, FINRA’s new suitability rule — Rule 2111 — is derived from NASD Rule 2310. Rule 2111 codifies the three main interpretations of Rule 2310: (1) reasonable-basis suitability — where a broker must use “reasonable diligence” to determine risks and rewards associated with a security and to determine whether an investment may be suitable for at least some investors; (2) customer-specific suitability — based on a customer’s investment portfolio; and (3) quantitative suitability — where a broker in control of a customer account must ensure that transactions are not excessive when viewed in the aggregate.[1]

Rule 2111 also addresses investment strategies, noting that an “investment strategy” may be considered a recommendation and may be interpreted broadly to include “holds.”[2] And because a recommendation to hold a security, rather than to buy or sell, is now a recommendation that must meet suitability requirements, a transaction in the traditional sense does not actually need to occur for brokers to be subject to the new suitability rule.[3]

When considering whether a recommendation is suitable for an investor, brokers must now consider additional factors prescribed in Rule 2111 such as age, investment experience, time horizon, liquidity needs and risk tolerance.[4] In general, compliance with Rule 2111 is risk-based, so firms must deduce the level of risk associated with a recommendation and the type of documentation that might be required to satisfy the rule.[5]

The goal of the new rule is to ensure that recommendations are made in the customer’s “best interest.”[6] However, Rule 2111 only applies to recommendations when they are actually made, meaning that firms and brokers do not have an ongoing responsibility to monitor securities after having made an initial recommendation.

Also noteworthy about the new suitability rule is that implicit recommendations to hold do not require compliance with Rule 2111. If, for example, during a transfer of assets from an employer-sponsored 401k account to an individual retirement account, a customer asks her broker whether any changes should be made to her portfolio and the broker suggests that the client not make any changes, the advice to hold would probably not trigger Rule 2111 or require documenting the advice.[7]

The same would hold true when a broker remains silent about whether an investor should sell a security.[8] Rule 2111 will, however, be triggered when a broker makes an “explicit recommendation.” This includes situations, from a risk-based perspective, where a broker recommends that her client hold a security that was originally recommended to the client by a different broker.[9]

History of Fee-Based Accounts

Before fee-based accounts became popular in the late 1990s, investors were mostly limited to opening commission-based accounts in which they were charged a fee for each transaction. Commission-based accounts were the industry norm for decades.[10]

By 1994, however, the U.S. Securities and Exchange Commission expressed concerns over potential conflicts of interests at investment banks and the increased number of Americans who were opening brokerage accounts and becoming investors in the securities markets.[11] As the number of direct investors rose to one-in-three Americans in 1995, regulatory concern for improved investor protection had become a focus.[12]

In 1994, Arthur Levitt, then Chairman of the SEC, requested a committee report for both the securities industry and investors regarding “best practices” to eliminate, or at least mitigate, perceived conflicts of interest.[13] This resulted in the Tully Report, which highlighted that fee-based accounts appeared to reduce potential conflicts between member firms and traditional commission-based account holders.[14]

The fee-based system is based on a percentage of total assets in an account, with annual fees generally ranging between 1 percent and 1.5 percent of total assets. Customers generally pay an annual fee for trades, investment advice, and custodial and recordkeeping services, among other things, regardless of whether transactions occur.

Such accounts provide an alternative to paying individual commissions and became popular around the time of the online trading boom during the late 1990s. Fee-based accounts have become an increasingly popular alternative to commission-based accounts,[15] with assets in such accounts ballooning fifty percent by the early 2000s, and currently estimated at approximately $300 billion.[16]

Regulators initially favored fee-based accounts because they reduced the potential customer-broker conflicts about which regulators were concerned. In fact, the SEC created a rule specifically exempting brokers that operated fee-based accounts and were offering “incidental advice” to customers from having to register as “investment advisers” under the Investment Advisers Act of 1940. As noted in one very early release, “brokers and dealers commonly give a certain amount of advice to their customers in the course of their regular business and that it would be inappropriate to bring them within the scope of the [Advisers Act] merely because of this aspect of their business.”[17]

The SEC’s concern was that overregulation of fee-based accounts would curtail their success and curb beneficial developments for both brokers and customers. But, amid 1,700 comments to the SEC’s proposed rule (first in 1999, and again in 2005),[18] an obvious divide emerged between broker-dealer support for the rule and investment adviser opposition.[19] In 2007, the District of Columbia Circuit Court struck down the SEC rule, claiming that the SEC had overstepped its authority in exempting brokers from the ‘40 Act.[20]

Problem of Under-Utilization in Fee-Based Accounts

While the concern with commission-based accounts is that brokers might trade too frequently and at a rate that does not comport with customer needs, regulators have focused on fees being charged to customers in fee-based accounts where there is minimal to no activity.[21]

Regulators quickly responded to the conundrum between the positive movement toward fee-based accounts and the potential for abuse by virtue of inactivity. In November 2003, the NASD published Notice to Members 03-68 to remind member firms that they should have “reasonable grounds for believing that a fee-based program is appropriate for that particular customer” before opening a fee-based account.[22]

Among the things that the NASD advised member firms and associated persons to consider before making recommendations were “services provided, the projected cost to the customer, alternative fee structures available and the customer’s fee structure preference.”[23] The NASD also reminded firms to continue to supervise fee-based accounts to ensure that they remain beneficial for each customer.[24]

In 2005, two broker-dealers entered into settlements with the NASD regarding the supervision of their fee-based brokerage platforms. One firm paid a $1.5 million fine and $4.6 million in restitution to affected account owners. The other paid a $750,000 fine and $138,000 in restitution.

On June 22, 2005, the SEC approved NYSE Rule 405A (“Non-Managed Fee-Based Account Programs — Disclosure and Monitoring”). The rule required brokers to disclose information to customers about the types of services they would offer, and other options that might be available, before opening a fee-based account.[25] Firms were also required to disclose how they calculated costs. In addition, Rule 405A required firms to track the “health” of fee-based accounts to ensure that adherence with the fee-based structure would continue to benefit each of their customers.[26]

How Firms Have Addressed Utilization Concerns

In response to increased scrutiny of fee-based account utilization by regulators, some firms initially began looking for alternative systems that required less disclosure, while other firms increased disclosures to customers by informing them of the costs they would have incurred had they been enrolled in commission accounts.

Some firms immediately established non-disclosure advisory programs to which they began migrating assets, while other firms made no changes to their fee-based platforms.For fear of failing to comply with the new regulations, several firms announced plans to close fee-based accounts if they became inactive or if customers failed to sign disclosure forms.

An assessment of the current market, however, signals that fee-based accounts are here to stay. Statistics indicate that the industry continues to move in the direction of fee-based accounts and away from commission-based relationships.[27] The remaining hurdle in this continued movement towards fee-based accounts is how firms will implement appropriate supervisory programs in line with the new suitability rule.[28]

Recommendations to Hold in the Context of Fee-Based Accounts

The question that arises is whether the new suitability rule will lend support to member firms regarding limited-activity fee-based accounts. The Tully Report warned that fee-based accounts would be inappropriate for customer-accounts with low frequency trading, and regulators quickly became concerned that investors would be paying fees even when brokers were not performing adequate services. Now that the new rule considers advice to hold a recommendation, the utilization analysis of fee-based accounts becomes more opaque.

A broker can now theoretically provide, for example, ten hold recommendations within a quarterly period in a fee-based account, and perhaps create adequate grounds for the firm to conclude that the fee-based account had not been underutilized and was thus, “suitable.”

Of course, when a broker makes a hold recommendation, he or she will have to believe that the recommendation aligns with the customer’s investment goals given the customer’s trading history and financial capabilities. As the new suitability rule states, a reasonable suitability check will be particularly necessary if a recommendation contains high risk. The suitability rule therefore guards against imprudent recommendations, even when a broker is simply suggesting a hold.

One way for firms to circumvent confusion about the suitability of hold recommendations is to enhance documentation records for fee-based accounts. That is, ensure that the firm’s systems track recommendations to hold in a manner similar to the way the firm tracks buy and sell recommendations. This may require firms to provide additional training to their brokers and revise certain policies and procedures. While firms decide how to handle the hold requirement imposed by the new rule, it is unlikely that they will opt to move away from the fee-based model.

Conclusion

What’s certain about FINRA’s new suitability rule is that it imposes added requirements for firms and brokers. But it may also, albeit unintentionally, have created an opportunity for firms in regard to dealing with utilization issues in fee-based accounts.

By requiring firms to supervise and perhaps document hold recommendations, the new rule may offer a solution — with the ability to quantify hold recommendations and thereby validate apparent “inactivity” in an account — for situations where brokers provide ongoing advice to fee-based customers who do not “actively” trade in their accounts. Because we are only two months into the new world of suitability, it will be interesting indeed to see how the industry responds to and how firms integrate the new suitability rule with respect to fee-based accounts.

–By Bryan I. Reyhani, Dimitri Nemirovsky and Teisha Ruggiero, Reyhani Nemirovsky LLP

Bryan Reyhani and Dimitri Nemirovsky are the founding partners of Reyhani Nemirovsky. The firm specializes in representing financial services clients in enforcement investigations, regulatory proceedings and private client arbitrations. Reyhani and Nemirovsky also advise clients on regulatory and compliance matters.

Teisha Ruggiero is a J.D. candidate at Brooklyn Law School.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Additional Guidance on FINRA’s New Suitability Rule, Regulatory Notice 12-25 (May 2012), http://www.finra.org.

[2] Id.

[3] Id. at 6.

[4] Id. at 2.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Daniel P. Tully, Report of the Committee on Compensation Practices (April 10, 1995), http://www.sec.gov/news/studies/bkrcomp.txt.

[11] Id. at 3.

[12] Id.

[13] Id. at 1.

[14] Id. at 7.

[15] Fee-Based Compensation. Notice to Members 03-68 (November 2003), http://www.finra.org.

[16] Lori A. Martin, Financial Planning Association v. SEC: Fee Based Brokerage (May 2007), http://www.sifma.org.

[17] See Opinion of the General Counsel Relating to Section 202(a)(11)(C) of the Investment Advisers Act of 1940, Investment Advisers Act Release No. 2 (Oct. 28, 1940) [11 FR 10996 (Sept. 27, 1946)] (“Advisers Act Release No. 2”).

[18] 70 Fed. Reg. 2718 (proposed Jan. 14, 2005).

[19] Id.

[20] See Financial Planning Ass’n v. S.E.C., 482 F.3d 481 (2007).

[21] Tully, Supra note 12.

[22] Fee-Based Compensation, Supra note 17.

[23] Id. at 744.

[24] Id.

[25] Information Memo 05-51 (July 26, 2005), http://www.cecouncil.com/Documents/00002282.htm.

[26] Id.

[27] Financial Planning Association v. SEC: Fee Based Brokerage, Supra note 18.

[28] Additional Guidance on FINRA’s New Suitability Rule, Supra note 1, at 2 (FINRA acknowledges that member firms will inevitably have different approaches for complying with the new rule).

All Content © 2003-2012, Portfolio Media, Inc.

Mr. Joseph was recently appointed to lead the IA/Investment Company examinations program in the SEC’s New York Regional Office, which covers New York and New Jersey registrants.  Mr. Joseph was previously a Staff Attorney, Branch Chief and Assistant Director in the SEC’s Division of Enforcement in Washington, D.C., and New York.  He acknowledged that with his new post in Exams, he has a different mindset now and that he is no longer a prosecutor.  He further stated that he is a “blank slate” and welcomes industry input, noting that he would like to improve communications with the industry.

Exams’ Mission Statement

Exams has a four-pronged mission statement:

1. Improve compliance;
2. Prevent fraud;
3. Monitor risk; and
4. Inform policy.

Mr. Joseph underscored that while he is no longer with Enforcement, Exams intends to leverage the SEC’s internal resources with the goal of accomplishing Exam’s mission statement and preventing wrongdoing, particularly fraud.

Recent OCIE Developments

During the past year, OCIE has undergone many changes.  Most significantly, it has shifted its exams to a risk-based approach, both in the selection of exam targets and scope of each exam.  OCIE now gathers substantial data at the outset of an exam to better understand the business, appropriately identify risk areas, and ascertain the scope of the exam accordingly.  To facilitate efficient and appropriate exams, Mr. Joseph stated that OCIE’s examiners should: (1) possess substantial information about the target’s business; (2) be well informed about the areas they are examining; and (3) be armed with better resources than in prior years.

OCIE also has developed specific working groups to target various issues, including structured products, valuation, fixed income and municipal markets, marketing and sales practice, and has implemented project-based staffing models that are tied to the skills and training of the examiners.

OCIE has increased its use of technology and has standardized its exam policy manual, which is to be used as a guide by examiners for how to conduct exams.  The standardized manual allows for coordination internally across offices, including the sharing of information and analyses, and Mr. Joseph intends to use the internal data to coordinate future examinations.

Mr. Joseph addressed Dodd-Frank and the requirement that examinations be completed within 180 days.  He noted that Exams’ goal will be to complete examinations as soon as possible, and to minimize “mission creep” – when Exams targets a perceived risk area and then ends up targeting another area.  While Exams will not turn a blind eye to substantial issues they encounter outside of its initial target area, its preference is to conduct a targeted examination.

For a complete summary of the current hot topics in the SEC’s National Exam Program, please see http://rnlawfirm.com/2012/05/16/hot-topics-in-the-secs-national-exam-program.

IA Issues

Mr. Joseph identified several “speed dial” topics for IAs:

• IAs are fiduciaries and must act at all times in the best interests of their clients;
• Fees and expenses must be adequately disclosed and appropriately allocated;
• Inside information must be properly monitored and conflicts of interest properly disclosed.  Compliance must work to mitigate such conflicts;
• Compliance with internal policies and procedures, and review and update of policies and procedures;
• Firms must have a designated COO who is empowered and understands both the B-D and IA sides of the business;
• Books and records must be properly maintained and readily available.  Mr. Joseph stressed that there must be sufficient and adequate cooperation with examiners and professionalism towards the examiners;
• Firms must have code of ethics policies and practices that are enforced, including rules concerning personal trading; and
• Firms must comply with advertising rules, especially when an IA is located in a remote location.  Exams expects firms to review the remote locales to make sure the advertising rules are being followed.

Dual Registrant Issues

The following topics are at the forefront for dual registrants:

• Conflicts of interest – in and of itself, there is an inherent conflict between B-Ds and IAs, so firms must have in place appropriate information barriers;
• Cross trades and principal transactions – cross trades must be appropriately priced and firms must have systems in place to ensure that pricing is appropriate, with random “spot checks” by compliance.  Firms must adequately disclose when they act as principal and, when necessary, waivers must be signed by clients.
• The COO cannot be nominally named and must not be a “shell” or too closely aligned with the business units.  On the other hand, the COO must be knowledgeable about the firm’s business.  The COO must be empowered to act and there must be an adequate compliance structure;
• Best execution issues, with advisory units conducting necessary reviews;
• Code of ethics; and
• Trade allocation process, including front-running and cherry picking.

Recommendations

• OCIE expects to see an appropriate tone from senior management and a “culture of compliance” within firms;
• There should not be too close a relationship between the business and compliance, which can lead to “compliance contamination”;
• Compliance processes and systems must be scalable and flexible to changes in the business;
• Firms should not try to hide significant issues. Mr. Joseph recommends that firms ferret out issues and bring them to OCIE’s attention with a recommended corrective action strategy, similar to FINRA’s self-reporting requirements; and
• Those responsible for compliance must understand the firm’s products, platform and strategies.

Mr. Joseph noted that Exams does not intend to shift its focus given his recent appointment.  Based on his experience with Enforcement, however, he is acutely aware of what makes a strong Enforcement case.  Firms, therefore, should expect a bit more rigor by OCIE in its analysis of compliance issues.

# # #

Reyhani Nemirovsky LLP primarily represents financial services clients in regulatory matters, enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

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On June 19, 2012, James Wrona, Vice President & Associate General Counsel of FINRA, spoke at the SIFMA Compliance and Legal Society monthly luncheon about the new Know Your Customer and Suitability rules.  A summary of the presentation follows.

FINRA Rule 2090, Know Your Customer

Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.

Rule 2090 was modeled after NYSE Rule 405(1).  The rule comes into play at the account opening stage and does not hinge on whether a recommendation is actually made to the customer. The “essential facts” to “knowing the customer” are those required to:

• Effectively service the customer’s account;
• Act in accordance with any special handling instructions;
• Understand the authority of each person acting on behalf of the customer; and
• Comply with applicable laws, regulations and rules.

FINRA Rule 2111, Suitability

(a) A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

Rule 2111 is modeled after NASD Rule 2310.  In addition to the factors that required consideration under Rule 2310 – a customer’s financial status, tax status and investment objectives – Rule 2111(a) delineates additional factors to consider when making a suitability determination.  Importantly, the rule requires members and associated persons to document with specificity when one or more of the Rule 2111(a) factors “are not relevant components of a customer’s investment profile in light of the facts and circumstances of the particular case.”  Mr. Wrona explained that defined terms were not included in the rule because FINRA desired “flexibility.”

The rule codifies the three main suitability obligations:

• Reasonable-basis suitability;
• Customer-specific suitability; and
• Quantitative suitability.

To satisfy the reasonable-basis obligation, the member or associated person must understand and be familiar with the complexity and risks associated with the recommended security or investment strategy, and must have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable.  The rule states that the “lack of such an understanding when recommending a security or strategy violates the suitability rule.”

The customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on the factors outlined in Rule 2111(a) as part of the client profile.

Quantitative suitability requires members or associated persons with actual or de facto control over a customer’s account to have a reasonable basis for believing that a series of recommended transactions, even if suitable as unique standalone recommendations, are not excessive and unsuitable for the customer when taken together.  Excessive trading can be found using traditional churning measures such as turnover rate and cost-equity ratio.

Mr. Wrona explained that there would be an enhanced suitability review in connection with the purchase, exchange and initial subaccount allocations of variable annuities.  The enhanced suitability review will not apply to reallocation of subaccounts and subsequent deposits of funds after the initial purchase or exchange.

Recommendations Trigger Rule 2111

Rule 2111 is triggered when a broker makes a recommendation.  Among the shifts in the new rule, a “recommendation” will now also include recommendations relating to an investment strategy and recommendations to “hold” a security or securities.  Mr. Wrona explained that a hold recommendation had to be an explicit recommendation, adding that “explicit” was the “magic word.”  Mr. Wrona further explained that there is no continuing obligation to make further recommendations to a customer after the initial hold recommendation, such as when a stock price continues to decline, and noted that the suitability of the hold recommendation would be an “as of” evaluation based on when the actual recommendation to hold was made.

When determining whether communications constitute recommendations, Mr. Wrona explained that FINRA intends to broadly interpret the rule.  The inquiry would be “objective” based on whether a “reasonable investor” would interpret the content, context and manner in which the communication was presented as a call to take action.  Mr. Wrona also explained that recommendations could be made to prospective customers (i.e., investors who do not have a contractual relationship with the firm), and that FINRA will continue to use its traditional and long-established “customer” definition.  Moreover, Mr. Wrona explained that there does not need to be an actual transaction because FINRA’s focus will be on the recommendation rather than whether a transaction was actually effectuated.

As set forth in Rule 2111, FINRA will exclude the following communications so long as they do not include a recommendation:

• General financial and investment information, including: (i) basic investment concepts, such as risk and return, diversification, dollar cost averaging, compounded return, and tax deferred investment; (ii) historic differences in the return of asset classes (e.g., equities, bonds, or cash) based on standard market indices; (iii) effects of inflation; (iv) estimates of future retirement income needs; and (v) assessment of a customer’s investment profile;
• Descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and the investment options available under the plan;
• Asset allocation models that are: (i) based on generally accepted investment theory; (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model or any report generated by such model; and (iii) in compliance with NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools) if the asset allocation model is an “investment analysis tool” covered by NASD IM-2210-6; and
• Interactive investment materials that incorporate the above.

Institutional Investor Exemption, Rule 2111(b)

(b) A member or associated person fulfills the customer-specific suitability obligation for an institutional account, as defined in Rule 4512(c), if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities and (2) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations. Where an institutional customer has delegated decision-making authority to an agent, such as an investment adviser or a bank trust department, these factors shall be applied to the agent.

Rule 4512(c) defines “institutional account” as the account of: (1) a bank, savings and loan association, insurance company or registered investment company; (2) an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); or (3) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.  Prior FINRA guidance in IM-2310-3 had defined an institutional customer as an entity other than a natural person with at least $10 million invested in securities in the aggregate in its portfolio and/or under management.

Rule 2111(b) modifies the institutional customer exemption to require members or associated persons to (i) have a reasonable basis for believing the institutional customer understands the investment and (ii) have the institutional customer attest to undertaking an independent analysis of the investment.  Mr. Wrona explained that firms need to obtain affirmative indications from institutional customers because negative consents will not satisfy the rule.

Mr. Wrona noted that a risk-based approach to supervision of the new Suitability rule would be sufficient, and that firms will need to make judgment calls that are reasonable.  Mr. Wrona also mentioned that the Suitability rule would not apply to firms with the limited role of order taker.

# # #

Reyhani Nemirovsky LLP primarily represents financial services clients in regulatory matters, enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

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http://abovethelaw.com/2012/06/size-matters-how-a-bad-economy-means-good-business-for-a-new-boutique-firm/

Mr. di Florio covered three areas during his presentation: (1) development of the SEC’s National Exam Program (“NEP”); (2) top NEP findings in 2011; and (3) the SEC’s key focus areas for NEP in 2012.

1.  Development of the Exam Program

One National Program

Mr. di Florio discussed the development of NEP, the SEC’s self-assessment of NEP to date and its implementation of improvements, and NEP generally.  The SEC has moved from twelve separate autonomous programs to a single national exam program.  There is now a single governing structure responsible for the national team.

To further enhance NEP, OCIE implemented a NEP policies and procedures manual in January 2012.  OCIE also appointed a Chief Compliance Officer for NEP and established an ethics committee to support NEP.

Mr. di Florio noted that a primary goal of OCIE is to bring consistency to the Exam Program.  Mr. di Florio also noted that OCIE has hired knowledgeable individuals with relevant industry experience, and recruited individuals with specialized skill sets to consult on exams.

Technological Enhancements

OCIE has made significant improvements with its use of technology, which has resulted in greater efficiency during the examination process, including the ability to more efficiently gather and review data and risk analytics.  OCIE no longer utilizes Word and Excel templates to gather information.  It now uses an Oracle software platform, which automates the process.

Different Area Functions

Mr. di Florio described the differing functions within OCIE.  The Office of Risk Analytics and Surveillance helps to identify firms and issues about which Exams should be focused.  The Office of Data Analytics examines and analyzes the data gathered during exams. The Office of Large Firm Monitoring was established to understand business models, products and services of large firms, and to assist with targeting exams to specific areas within large firms.  No matter the area, however, the SEC has established “regulatory colleges” to enhance learning and “cross sharing” of information, to avoid having the various departments operate in isolation as they had in the past.  Mr. di Florio believes that the sharing of information is important in improving the exam process.

Risk Alerts

Using National Examination Risk Alerts, OCIE shares with the member community what it believes are its most important findings.  The alerts are designed to bring to the attention of the member community the most important issues that come to light during the examination process and should help firms to improve their compliance programs.  (For example, the most recent alert issued by OCIE can be accessed at: http://www.sec.gov/about/offices/ocie/riskalert-muniduediligence.pdf.)

A Firm’s Total Compliance Model

Mr. di Florio advised that OCIE is focused on the totality of a firm’s compliance model and looks at the “forest” in addition to all the “trees.”  OCIE is interested in the firm’s core risk model, and each step involved therein.  It wants to see, among other things, the firm’s front line of defense (basic training and supervision), the independence of the audit process, and how senior management interacts with employees and oversees risk and control.

2.  The Top 2011 NEP Findings

i.  Deficiencies concerning reserve capital and net capital requirements;

ii.  Proper accounting and custody of customer funds;

iii.  Deficiencies regarding compliance controls;

iv.  Supervision (independent contractor situations);

v.  Sales practices (suitability, churning, unauthorized trading);

vi.  Order handling; and

vii.  Distribution issues.

3.  2012 NEP Focus

i.  New issue due diligence (see e.g., Risk Alert referenced above);

ii.  Supervision of broker/dealer employees – the NEP is focused on the weaknesses of recommendations concerning structured and complex products, and products that generate high commissions such as private placements.  OCIE also is concerned with supervision of employees in remote locations;

iii.  Fraud – OCIE remains concerned with and still comes across Ponzi schemes, pump and dump operations and affinity fraud.  When issues such as these arise, a referral is immediately made to Enforcement to quickly address the issues;

iv.  Unregistered activities – in particular, private placements;

v.  Trading risk – short sales, best execution, high-frequency trading and algorithmic trading.

vi.  New regulation risks – the Market Access Rule, incentive compensation rules, swaps and the Volcker Rule, to name a few.  OCIE wants to make sure firms are properly preparing their employees; and

vii.  Large firm risks – OCIE coordinates with the CFTC, the Fed, and other regulators to address large firm risks.  Large firm liquidity is also a concern, as are sales practice procedures.

4.  Q&A

In addressing questions from the attendees, Mr. di Florio commented that there are generally two aspects to compliance – one is a core compliance model and the second is a “softer” compliance culture.  The core compliance model generally consists of a core fundamental process – proper training, good communication, effective monitoring, and issue management (identify, escalate and remediate).  The “softer” aspect of a firm’s compliance model is the firm’s culture with senior management setting the tone.  Senior management sets the tone of a firm in addressing critical issues properly, such as whether a firm “can” enter into a transaction as opposed to whether a firm “should” enter into a transaction.  These types of decisions play an important role in OCIE’s view of a firm’s compliance culture.

Regarding international regulators, Mr. di Florio noted that OCIE has increased its cooperation with international agencies to address domestic and international issues, some of which is mandated by the Dodd-Frank Act.

Finally, Mr. di Florio commented on OCIE’s examiners and the maturation of NEP.  There are approximately 900 examiners across 12 different offices that conduct approximately 1600 exams per year.  Approximately two years ago, OCIE reached out to industry groups, registrants and stakeholders, to obtain feedback on the quality of the examiners and the examination process.  General complaints about the examination process centered on the examiners not understanding products and the various business lines, and that they were generally younger and “greener.”  Deficiency letters also tended to be issued without any dialogue.  OCIE has moved quickly to address these issues with training and specialized working groups.  Mr. di Florio reiterated that OCIE is striving for exam consistency across the country.

# # #

Reyhani Nemirovsky LLP primarily represents financial services clients in regulatory matters, enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

Attorney advertising.  Prior results do not guarantee a similar outcome.

Ms. Axelrod covered six areas during her presentation: (1) risk management; (2) data collection; (3) dialogue with member firms; (4) structured products; (5) the whistleblower program and Rule 4530; and (6) FINRA’s new suitability rule.  With respect to referrals to Enforcement, Ms. Axelrod noted that Exams works side-by-side with Enforcement to evaluate matters, which necessarily involves senior management.  She also noted that an examiner cannot refer a matter to Enforcement on their own.

1.  Risk Management

Ms. Axelrod advised that the Staff’s current focus is on contemporaneous and future risk, and the identification of “problem firms.” When looking at a firm, the Staff takes into account the firm’s internal evaluation of business risk, its culture of compliance and people — especially management — at the firm, the firm’s business model and prior disciplinary history.  The Staff ranks firms to identify where they need to focus their efforts.  There were 1,900 exams in 2011, which was down approximately 10% from prior years.

The Staff will assess risk controls at firms to get a better understanding of a firm’s business model.  To do so, the Staff now requests more data from firms prior to an onsite visit, and FINRA has been training examiners to better understand a firm’s business, the products being sold and the risk management structure that is in place.  The Staff also expects to conduct more unannounced onsite visits.

The Staff believes that its implementation of risk control assessment surveys was successful and useful in the examination process.  The Staff will continue to update and revise the surveys based on comments and feedback received to date.  Approximately 2100 member firms completed such surveys last year.  In response to often heard concerns about the Staff’s use of such surveys, Ms. Axelrod specifically noted that the surveys are not intended to be utilized as a “gotcha” tool in the examination process, and that the Staff is not looking to catch firms that may have omitted certain information.

2. Data Collection

The Staff has found it helpful to request and analyze firm data in advance of an exam.  This has been in a pilot program and has proven successful.   Requesting data in advance helps the Staff to focus on problem areas, including particular branch offices and registered representatives.  As Ms. Axelrod stated, this process makes for a “smarter exam program,” and the Staff expects to expand the practice.  The Staff will spend more time analyzing data offsite and less time onsite.  The typical examiner is on the road for three weeks and in the office for one week per month, a burdensome schedule the Staff would like to ease to better retain experienced examiners.

3. Increased Transparency

The Staff expects increased transparency and dialogue with firms.  When a firm identifies an issue, the Staff expects the firm to submit an action plan of how the firm expects to address the problem.  Although there may still be an Enforcement referral, an early dialogue will allow the Staff to air concerns ahead of time, and creates both a better compliance culture and investor protection.

4. Structured Products

FINRA will continue to scrutinize structured products.  Ms. Axelrod identified the following areas that firms should focus on:

a)    Firms need to know who structured products are being sold to, and continue to monitor structured products in customer accounts post-initial sale;

b)    Sales materials must be clear and effectively disclose the risks involved.  Ms. Axelrod noted that she often personally reviews sales material and the complexity of certain products requires multiple reviews to have an appropriate level of understanding;

c)    Because many structured products are sensitive to interest rates, firms need to be cognizant of interest rates and how even minimal interest rate fluctuation could impact a client’s investment/portfolio;

d)    Risk tolerance of customers investing in structured products;

e)    Concentration levels of structured products post-initial purchase;

f)     Time horizons — an illiquid structured product may not be suitable for a short-term investor;

g)    “Training, training, training.”  Registered representatives must be able to accurately and effectively describe the products to their clients;

h)    Firms should not be telling clients to buy certain investments when another area of the firm is selling the same investments;

i)      The new suitability rule’s focus on complex products; and

j)      Investor protection.

5. Whistleblower Program and Rule 4530

The whistleblower program remains strong at FINRA with a sizeable dedicated staff.  The program has also been successful because of timely responses by the Staff.  The Staff has also become fairly good at evaluating tips during “initial triage,” and crafting effective plans to deal with the situation.  The Staff has made a significant number of referrals to Enforcement and to other regulators.

With respect to Rule 4530 filings, the Staff has not seen “over-reporting.”  There were approximately 100 filings last year, which was within the Staff’s expectations.  The Staff does not want to sue firms for “close calls,” and appreciates that firms will “know reportable matters when they see them.”

For institutions, the matters reported have included operational issues, books and records, trade and focus reporting, margin calculation, fee requirements and prospectus delivery.  For individuals, the filings have included unauthorized trading, forgery, improper loans, undisclosed liens and record retention.

6. New Suitability Rule

The Staff encourages firms to be proactive and transparent with how they expect to systematically ensure compliance with the new rule.  The Staff also expects open communication and disclosure about this.

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Reyhani Nemirovsky LLP primarily represents financial services clients in enforcement proceedings, arbitrations and litigations.  The firm also provides advice and counsel on wide-ranging regulatory and compliance matters.

For more information about the firm, please visit www.rnlawfirm.com, or contact us by email at info@rnlawfirm.com or by telephone at (212) 897-4030.

Reyhani Nemirovsky LLP, 200 Park Avenue, 17^th Floor, New York, NY 10166.

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