Summary of FINRA Regulatory Actions 2018

The total dollar amount of fines in 2018 that the Financial Industry Regulatory Authority’s (“FINRA”) Enforcement Division ordered against its member firms increased slightly to $74 million from $68 million in 2017. While the total dollar amount increased nearly nine percent, the total number of fines decreased to 209 in 2018, compared to 318 in 2017. Both the number and dollar amount of fines assessed by FINRA have fallen significantly since 2014, as the charts below show. In 2014, FINRA fined broker-dealers a record amount of nearly $129 million dollars, roughly 10 percent greater than the total dollar amount assessed in 2017 and 2018 combined.

In 2018, 12 disciplinary actions resulted in individual fines greater than $1 million, compared with 18 in 2017 and 26 in 2016. The largest individual fines in 2018 stemmed from disciplinary actions involving alleged failures related to initial public offerings (“IPOs”), anti-money laundering (“AML”) activities, direct market access and registration. During the fourth quarter of 2018, FINRA levied 39 fines totaling almost $29 million, the largest quarterly total throughout all of 2018. During the first half of 2018, 30 of the 130 fines assessed resulted from alleged violations of FINRA’s trade reporting rules. On average, the trade reporting fines totaled $30,000 each. In contrast, trade reporting deficiencies resulted in only six fines in the second half of 2018, including one of the 12 noted above that exceeded $1 million. According to FINRA’s disciplinary announcements, 16 broker-dealers paid restitution as a result of alleged unsuitable recommendations of certain mutual fund shares to retail customers. In addition, FINRA expelled four broker-dealers for alleged violations involving sales of unregistered securities, churning activity, market manipulation and fraud. Details on some of the largest fines brought against broker-dealers in the fourth quarter of 2018 appear below. A table breaking down each category of the primary causes of FINRA fines and the total number and dollar amounts paid in 2018 can be found at the conclusion of this article.

Initial Public Offerings

FINRA Rule 5130 prohibits registered broker-dealers and their associated persons from selling equity shares in a new issue to certain “restricted persons” as defined in FINRA Rule 5310(i).¹ Restricted persons include broker-dealer personnel and their immediate family members, other broker dealers, finders, portfolio managers, and any person or entity who is listed on Schedule A and Schedule B of a registered broker-dealer’s Form BD. One firm allegedly violated Rule 5130 by making sales to restricted persons during an eight-year span, according to the firm’s Letter of Acceptance, Waiver, and Consent (“AWC”). The firm was censured, fined $5,500,000 and forced to disgorge the revenues that it had received from the violative sales.

Over the eight-year period, the broker-dealer allegedly made at least 1,462 sales of IPO shares in 325 different public offerings to customer accounts in which restricted persons held a beneficial interest. The broker-dealer obtained IPO eligibility certifications from its customers for their accounts held at the firm, but the firm’s system for tracking the IPOs did not compare customer certifications against information in the firm’s possession indicating that the customer was a restricted person. According to the AWC, the firm and its associated persons knew or should have known that the customers who purchased shares of the offerings were restricted. FINRA’s findings included instances where the firm sent duplicate statements and confirmations to other broker-dealers when accounts owned by immediate family members of the firm’s registered representatives purchased shares of new issues.² FINRA also alleged that the firm failed to reasonably respond when it learned that it sold IPO shares to restricted persons. For example, the firm sold shares to accounts of immediate family members of the firm’s representatives less than a year after an internal review had already identified multiple occasions of the same activity.

Firms can prevent noncompliance with FINRA Rule 5130 by taking several steps. For example, the firm should ensure all new accounts that belong to customers employed by other broker-dealers are flagged at the time of onboarding. The firm should also integrate into its trade surveillance systems the information for the flagged customer accounts and outside brokerage accounts of its employees so that it can adequately flag IPO share purchases in these accounts. 

The total dollar amount of fines in 2018 that the Financial Industry Regulatory Authority’s (“FINRA”) Enforcement Division ordered against its member firms increased slightly to $74 million from $68 million in 2017. While the total dollar amount increased nearly nine percent, the total number of fines decreased to 209 in 2018, compared to 318 in 2017. Both the number and dollar amount of fines assessed by FINRA have fallen significantly since 2014, as the charts below show. In 2014, FINRA fined broker-dealers a record amount of nearly $129 million dollars, roughly 10 percent greater than the total dollar amount assessed in 2017 and 2018 combined.

Anti-Money Laundering

During the fourth quarter of 2018, FINRA assessed four broker-dealers a total of $11,100,000 in fines for alleged conduct related to AML activities. One firm accounted for $10 million of that total. According to its AWC, the firm allegedly failed to conduct investigations and reasonable surveillance of wire and foreign currency transfers. 

The failures allegedly resulted from program flaws in the firm’s automated transaction monitoring system. The system was designed to monitor potentially suspicious wires by comparing the wire details to certain parameters established by the AML staff. The monitoring system depended on information transmitted from other firm systems to generate potential suspicious activity alerts. According to FINRA, the automated program the firm used to settle certain incoming wires did not transmit data to the firm’s transaction monitoring system. Consequently, the firm failed to surveil nearly $30 billion in wire transactions. More than $16 billion originated from countries that the firm had designated as high-risk jurisdictions. 

In addition, when the transaction monitoring system identified potentially suspicious activity, it generated an alert which it assigned to a member of the firm’s AML staff. The staff member was responsible for investigating the alert to determine whether the firm should file a suspicious activity report with the Financial Crimes Enforcement Network. FINRA found that the staff’s comments about the alerts at times failed to explain the investigative steps taken to reach the conclusions which allowed them to close the alerts. According to the AWC, the firm’s AML staff had extraordinary workloads that likely contributed to the unreasonable reviews of the activity.

Direct Market Access

FINRA censured and fined a broker-dealer $1,100,000 for failing to comply with Securities Exchange Act of 1934 (“Exchange Act”) Rule 15c3-5. This rule, commonly referred to as the “Market Access Rule,” requires broker-dealers trading in securities directly on an exchange or alternative trading system (“ATS”) to implement risk management controls. These controls and supervisory procedures must be reasonably designed to manage the financial and regulatory risks of this business activity. The rule also includes those broker-dealers that provide sponsored or direct market access to customers or other persons. FINRA Market Regulation’s investigation determined that the firm failed to establish, document and maintain a system of risk management controls and supervisory procedures reasonably designed to prevent the entry of orders that exceeded pre-set credit thresholds in the aggregate for each customer of the broker-dealer.

According to the AWC, the broker-dealer used a wide variety of systems through which its market access clients and traders entered orders for routing to and execution on various U.S. securities markets. These systems subjected orders to a series of controls and filters. The firm’s institutional equities division’s order flow was classified as “high touch” by the firm because these types of orders passed through a trader at the firm prior to being submitted to the market. The SEC has stated that when establishing pre-set credit and capital thresholds, it expects broker-dealers to make such determinations based on appropriate due diligence as to the customer’s business, financial condition, and trading patterns. Firms should also document their decision. The firm allegedly established an aggregate capital limit based on excess net capital, from which it assigned sub-limits to each high-touch sales trader. The firm established these sub-limits in lieu of individual credit limits based on due diligence for each trader’s customer risk profile. In addition, the firm allegedly failed to use pre-trade soft blocks to prevent the submission of orders in excess of the firm’s aggregate capital limit. According to the AWC, the firm relied on personnel to perform real-time reviews of alerts when high-touch orders reached escalated percentages of a pre-set aggregate limit. FINRA determined that this framework did not comply with the Market Access Rule, which requires broker-dealers with direct market access to have pre-trade controls in place to prevent or reject the entry of risky orders.

Broker-dealers with market access should do several things to mitigate deficiencies in their risk management controls.³ First, firms should confirm that customer-specific credit limits have been established for market access clients. Firms should consider the financial characteristics of each market access client when establishing these credit limits. Second, firms should employ hard blocks on any order management system used by firm traders or market access clients of the firm with direct access to an exchange or ATS. Based on the AWC above, FINRA has taken the position that firms would not comply with Rule 15c3-5 if they rely solely on a post-trade alert system. Additionally, broker-dealers with market access should review the overall effectiveness of the firm’s risk management controls and supervisory procedures at least annually as required by Rule 15c3-5(e).  They should also document the result of the review in a report. The chief executive officer (or an equivalent officer) of the broker-dealer must certify annually that the risk management controls and supervisory procedures comply with Rule 15c3-5 and that the broker-dealer conducted the review during the calendar year.

Registrations

In the fourth quarter, FINRA censured and fined a broker-dealer $2,750,000, and ordered the firm to review five years of customer complaints to achieve compliance with Article V Sections 2 and 3 of FINRA’s By-Laws. FINRA also ordered the firm to submit a report documenting the conclusions of the reviews conducted. The firm allegedly failed to establish and enforce a supervisory system reasonably designed to achieve compliance with Form U4 and Form U5 reporting requirements. 

According to the AWC, the firm allegedly failed to amend its registered representatives’ Forms U4 and U5 to disclose at least 31 reportable customer complaints alleging sales practice violations. Question 14I(3) on Form U4 requires that registered representatives disclose investment-related, consumer-initiated written complaints in which the registered representative is involved in sales practices violations and the complaint contains a claim for compensatory damages of $5,000 or more. Question 7E(3) on Form U5 requires that the details of customer complaints from the Form U4 be disclosed if the complaint occurred while the registered representative was employed by the broker-dealer. The firm failed to report the complaints because it incorrectly interpreted the question on the Form U4 to mean that it was not required to report complaints that did not expressly request compensation, even in instances when the complaint made it clear that the investor was seeking compensation for losses incurred. FINRA identified 149 instances in which the firm allegedly did not file required amendments to Forms U4 and U5 in a timely manner. 

Broker-dealers should also pay particular attention to the disclosure questions in Section 14 on the Form U4.  These questions are very broad and are also related to criminal records, terminations, financial disclosures, such as compromises with creditors, and existence of unsatisfied judgements or liens. FINRA Rule 4530(a)(1)(B) requires members and associated persons to report any written customer complaint involving allegations of theft or misappropriation of funds or securities or forgery to FINRA no later than 30 calendar days after the firm becomes aware of the existence of such event.⁴ Firms are required to file the complaint through the 4530 application in the Firm Gateway system within 30 days of becoming aware of the complaint. Firms should also disclose the details of this complaint on the registered representative’s Form U4 under the applicable question. If the customer complaint does not involve allegations of theft, misappropriation of funds or securities, or forgery, the firm still must file the details of the complaint through the 4530 application on a quarterly basis. 

ACA notes that the following key securities laws and FINRA rules were referenced in actions during the fourth quarter of 2018: 

• FINRA Rule 5130
• FINRA Rule 3210
• Exchange Act Rule 15c3-5
• FINRA Rule 4530

ACA Compliance Group’s Broker-Dealer Services Division assists firms comply with regulatory requirements. Our services include compliance program development, trading reviews, conflicts management analysis, corrective action assessments, supervisory control and AML testing, written supervisory procedure assistance, initial and ongoing membership application help, and customized regulatory and compliance consulting.

For More Information

Please contact Dee Stafford for more information.

 

¹ See FINRA Rule 5130

² See FINRA Rule 3210

³ The term “market access” is defined in Rule 15c3-5 as having access to trading in securities on an exchange or alternative trading system as a result of being a member or subscriber of the exchange or alternative trading system or having access to trading in securities on an alternative trading system provided by a broker-dealer operator of an alternative trading system to a non-broker-dealer.

⁴ See FINRA Rule 4530