Law Offices of Place And Hanley

In January of 2012, FINRA announced their enforcement priorities.  Investment Fraud lawyers, Place & Hanley, have represented investors in claims similar to those in which FINRA enforcement is focusing.

FINRA announced their enforcement priorities focusing on the following areas.  See FINRA enforcement.

• Yield chasing, liquidity, transparency of cash flows, Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities, Non-Traded REITs, Exchange traded products, variable annuities, structured products, private placements, church bonds, promissory notes, life settlements, Microcap fraud, supervisory failures, cyber security, fees/commissions

Each of the foregoing is discussed in greater detail below.

If you or a loved one has investment losses, you may be entitled to a recovery.  Contact the Law Offices of Place and Hanley, PLLC for a free initial consultation at (866) 318-4725 or www.placeandhanley.com.

The Law Offices of Place and Hanley has offices in Asheville, North Carolina and are available by appointment in West Palm Beach, Florida.  The law firm has handled investor cases throughout the United States.

• Yield Chasing – Given the low yields on Treasuries, we are concerned that investors may be inadvertently taking risks that they do not understand or that are inadequately disclosed as they chase yields.

• Liquidity – The lack of a deep secondary trading market for certain investments make them unsuitable for many retail investors who have strong liquidity needs.
  Cash Flow Characteristics – The timing of anticipated cash flows should be in line with investor time horizons.

• Transparency of Cash Flows and Financial Condition – Transparent and accurate financial details should be available at the time an investment is made to ensure that investors are making an informed decision. The classification of cash flow returns is particularly important so investors know when returns are being paid from their own principal or from capital raised in subsequent offerings.

• Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities: Due to the embedded pre-payment option associated with mortgage-backed products, these securities carry significant re-investment risk, which can strongly affect the yield investors realize. Also, with collateralized mortgage obligations (CMOs), some tranches, such as interest-only strips or inverse floaters, carry much higher levels of risk than other tranches. Finally, the opaque nature of underlying collateral and the lack of a robust secondary market for some mortgage-backed securities should be considered when evaluating suitability.

• Non-Traded REITs: Although non-traded REITs may offer diversification benefits as a part of a balanced portfolio, they do have certain underlying risk characteristics that can make them unsuitable for certain investors. As an unlisted product without an active secondary market, these products offer little price transparency to investors and little liquidity. The related financial information for these products may often be unclear to the investor, which makes the true associated risks and value difficult to ascertain. With many products, there are questions about valuation and concerns that in some cases distributions to investors are paid with borrowed money, over a lengthy period of time, with newly raised capital, or by a return of principal rather than a return on investment. The source of the distribution may not be transparent.

• Municipal Securities: On the whole, municipal securities may offer significant benefits to many investors and can be an important component of a diversified portfolio. With some municipal securities, however, the lack of timely disclosures and complete financials often inhibit individual retail investors from making informed investment decisions, and may preclude associated persons from having a reasonable basis to recommend such a security. Member firms are reminded of their obligation to make suitable recommendations to their clients with respect to trading in the secondary markets. This includes obtaining sufficient information about the issuer to provide a reasonable basis that the recommendation is suitable. Separate and independent of the suitability obligation, member firms are also required, under MSRB Rule G-17, to disclose to their customers, at or prior to a sale of securities to a customer, all material facts about the transaction known by the dealer as well as all material facts about the security that are reasonably accessible to the market.2 Firms should ensure that representatives have access to this municipal issuer information (through MSRB’s Electronic Municipal Market Access (EMMA) system and/or other sources) to meet these requirements. Firms are also obligated to trade with their customers at prices that are fair and reasonable (including any markup or markdown).

• Complex Exchange-Traded Products: Certain exchange-traded products that employ sophisticated strategies or access more exotic markets can expose investors to unexpected results or unforeseen risks. For example, exchange-traded funds (ETFs) that employ optimization strategies using synthetic derivatives can expose individual investors to the risk of significant tracking errors. In other words, the performance of the ETF may differ from that of the underlying benchmark during times of stress or volatility in unanticipated ways. These risks can be exacerbated when the ETFs employ significant leverage.

• Variable Annuities: Although variable annuity products can offer valuable benefits to investors seeking predictable annuity streams, tax deferral for investment gains and flexible investment choices, they do have certain risk characteristics that can make them unsuitable for some investors. These products often have long holding periods and significant surrender fees, making them unsuitable for investors who have a need for liquidity. High fees and expenses may result in reduced performance in the underlying holdings, and high commissions make the product a target for switching. FINRA Rule 2330 imposes enhanced responsibilities on member firms with respect to variable annuities. Among other things, the rule requires that the firm or associated person have a reasonable basis to believe that a customer would benefit from certain features of a deferred variable annuity, such as tax-deferred growth, annuitization, or a death or living benefit, and that the particular recommended deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated, and any rider or similar policy enhancements accompanying it are suitable for the customer. The rule, moreover, requires that the firm or associated person have a reasonable basis to believe that the customer has been informed, in general terms, of various features of deferred variable annuities. Firms are also required to implement surveillance procedures to detect any registered persons who are effecting deferred variable annuity exchanges at a rate that could indicate non-compliance with securities laws and rules, and to have procedures for taking corrective action if such activity is detected. The rule has a training component as well.

• Structured Products: These products may be marketed to retail customers based on attractive headline yields or the promise of some level of principal protection. However, they can be complex, and have cash flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. These products generally lack any active secondary market, which means investors must be willing to assume considerable liquidity risk in addition to market risk and the credit risk associated with the issuer of the product. These features can make the products unsuitable for some retail investors. For example, reverse convertibles are debt obligations that are typically tiedto the performance of a security or basket of securities. These securities, which may offer a high rate of return, have complex pay-out structures often tied to a “knock-in” level, and involve elements of options trading. In addition, reverse convertibles not only expose investors to the financial risks associated with the debt obligation, but also to those risks associated with the underlying basket of securities.

• Securities Offered Through Private Placements: Certain issuers seek to raise capital by offering unregistered securities in private placements. Many firms also offer securities in private placements to accredited investors under SEC’s Regulation D. Firms conducting private placements under Regulation D or any other applicable exemption from registration must conduct a reasonable investigation of the issuer, based upon the facts and circumstances, with careful attention to any “red flags,” to comply with the anti-fraud provisions and other FINRA rules, such as suitability. Proposed FINRA Rule 5123 (Private Placements of Securities) would help ensure that member firms and associated persons that sell applicable private placements provide relevant disclosures to each investor, and would also require that the private placement memorandum, term sheet or other disclosure document be filed with FINRA to help inform FINRA’s regulatory programs. In addition, firms are reminded that the definition of accredited investor has changed.

• Securities Acquired in Secondary Markets: As many high-profile companies have elected to remain private, secondary trading markets have emerged for their securities. However, despite their profile, many of these companies are difficult to value, as the issuers may not make financial statements publicly available. Acquiring interests in such securities through a pooled investment or single security “fund” introduces another layer of costs to the investor as well as risk associated with the fund manager.

• Church Bonds: The credit quality of the underlying issuer and its true financial condition are often not transparent. Investors may be unaware of the substantial credit and market risk they are assuming with such investments. The source and nature of the underlying revenue streams of the issuer that are required to service the instruments are often less than clear. Further, as sales are frequently made on an affinity basis, these securities can be vehicles for fraud.

• Promissory Notes: When investing in promissory notes, investors could assume substantial credit and market risk exposures that may not be transparent to them. Such notes may potentially be written by registered persons or by entities associated with registered persons, with or without their employing broker-dealer’s knowledge. Similarly, registered persons may offer and sell promissory notes issued by persons and entities not associated with a broker-dealer, again without their employing broker-dealer’s knowledge. At worst, such instruments are principally a vehicle to defraud clients who may believe that a broker-dealer is knowledgeable about the product and is recommending it as a suitable investment.

• Life Settlements: Sales of existing life insurance policies to third parties—referred to as life settlements—have raised regulatory concerns, as these products generally have very high commissions. In 2009, FINRA published Regulatory Notice 09-42 about member firms’ responsibilities in marketing variable life settlements, as these are securities under FINRA jurisdiction. Recent decisions issued by the Delaware Supreme Court highlight the risk that insurers may challenge the validity of a contract based on a lack of insurable interest.

• Microcap Fraud – Microcap or penny stocks are particularly vulnerable to market manipulation given the lack of transparency in their underlying business, lack of verifiable financial history and the opaque nature of their operations. We are particularly concerned with fraud schemes that can harm retail investors. FINRA’s focus includes, among other issues:

1. bulletin board postings or email spam that distributes false or misleading information by fraudsters attempting to pump up a microcap;
2. high pressure sales tactics employed by sales personnel;
3. the use of paid promoters to dispense “unbiased” opinions related to these microcaps; and
4. individuals who use brokerage firms to liquidate microcap holdings, whereby the firm may be facilitating an unregistered distribution. As part of their anti-money laundering (AML) responsibilities, member firms are obligated to monitor for suspicious activity and to file Suspicious Activity Reports where warranted.

• Reverse Mergers – The reverse merger market (where a private company merges into a public shell or so-called “backdoor registration”) represents a path for issuers to enter the U.S. public capital markets while foregoing the formal registration process associated with an IPO. Significant allegations of fraud have surfaced relative to this practice, particularly related to issuers based in China. Current and accurate information on these issuers is often scarce, and concerns have been raised regarding the quality of their audited financial statements. In December 2010, the SEC disciplined a U.S. auditor for overstating revenues of Chinese issuers.6 The heightened risk associated with these foreign issuers, who never went through an IPO or registration process in the U.S., increases the risk that any due diligence failures on the part of the broker-dealer may result in harm to investors.

• Private Securities Transactions and Outside Business Activities – Many firms permit registered representatives to engage in private securities transactions, as defined in NASD Rule 3040, and outside business activities, as defined in FINRA Rule 3270, potentially exposing the firm and investors to increased risks. NASD Rule 3040 and FINRA Rule 3270 provide details for the determination of applicability of these rules and certain related recordkeeping requirements. Firms must supervise private securities transactions notwithstanding the fact that the business may be conducted away from the firm. FINRA examiners will review firm supervision of private securities transactions and determinations made pursuant to Supplementary Material  to FINRA Rule 3270 regarding outside business activities.

• Integrity of Supervision and Internal Controls – Establishing and enforcing adequate supervisory systems and internal controls are fundamental requirements for member firms, not only to ensure compliance with applicable rules and regulations, but also to mitigate business risks for the firm. Each firm must maintain supervisory systems and underlying internal control procedures that are specifically tailored to its business model, the products and services it sells, and the types of clients or counterparties with which it does business. Firms that offer higher risk products or services should have corresponding supervisory policies and procedures that are reasonably designed, among other things, to ensure adequate due diligence and that these higher-risk products or services are limited and properly marketed to appropriate clients. In addition, firms that employ a decentralized operating model and have associated persons interacting with the investing public from remote locations are expected to maintain adequate supervisory structures to mitigate the enhanced business-conduct risks associated with the limited visibility into day-to-day activities. Firms may also need to consider implementing heightened supervisory procedures to comply with the federal securities laws and FINRA rules.

• Information Technology and Cyber Security – FINRA continues to be concerned about information technology (IT) and cyber security threats. Such concerns include security and authentication practices for high-risk Web-facing systems and the potential variability in security controls and testing protocols as the outsourcing of core IT functions to lower cost on- and off-shore providers continues. In a related area, FINRA has received an increasing number of reports of incidents of customer funds stolen as a result of instructions emailed to firms from compromised customer email accounts. These incidents highlight the risks for firms in accepting instructions to transmit or withdraw funds via email. FINRA recommends that firms reassess their policies and procedures to ensure they are adequate to protect customer assets from such risks (see Regulatory Notice 12-05).
• FINRA also recognizes the significant effort firms have dedicated towards addressing discrete, one-off threats, such as individual account intrusions or the actions of rogue employees, but would like to caution that the sophistication of potential electronic attacks against the financial services industry has increased significantly. Larger, more coordinated threats, commonly known as advanced persistent threats, have emerged. Firms should be equally cognizant of and prepared for these more sophisticated threats.

• Outsourcing – As firms continue to seek opportunities to cut expenses and focus on core business, they have increasingly used third parties to carry out certain functions. Although firms may use a third-party service provider to perform certain functions and activities, FINRA noted in Notice to Members 05-48 that the use of a third party does not relieve the member firm of its responsibility to achieve compliance with all applicable securities laws, regulations and rules. Proposed FINRA Rule 3190 governing the use of third-party service providers (see Regulatory Notice 11-14) is intended to codify this guidance. Among other requirements, proposed Rule 3190 codifies existing expectations that firms conduct ongoing due diligence in regard to their third-party service providers to ensure that they are capable of performing the outsourced functions.
• Fees – We remain concerned about firms charging retail investors hidden, mislabeled or excessive fees. Fair dealing with customers requires that firms charge only reasonable fees and disclose those fees up front and in a manner that retail investors can make informed investment decisions. Furthermore, under NASD Rule 2340, any miscellaneous charges must be reasonable and related to the services performed. In 2011, FINRA brought cases against several broker-dealers that charged such excessive fees in the form of postage and handling charges that were unrelated to actual costs, and we will continue to investigate firms that appear to be taking advantage of investors through fee schemes.

• Foreign Finders – Foreign finders and related foreign affiliates pose compliance risks and may elevate a firm’s AML risk level. Recent examinations and enforcement cases have uncovered problematic arrangements with foreign finders.8 NASD Rule 1060(b) permits member firms, in limited circumstances, to pay transaction-related compensation to non-registered foreign persons or foreign finders. Specifically, the sole involvement of the foreign finder in the member firm’s business must be the initial referral of non-U.S. customers to the firm. FINRA reminds firms that the scope of permissible business activities and the associated regulatory requirements differ between foreign finders and foreign associates. Examiners have found finders whose activities go beyond an initial referral of non-U.S. customers to the firm and who are involved in the servicing of non-U.S. customer accounts, including having trading authority over accounts, entering customer orders directly to the clearing firm’s online platform, and processing new account documents and funds transfers. As a result of such activities, the foreign finders provisions in NASD Rule 1060(b) are not applicable, and the finder is required to be registered as a Foreign Associate pursuant to NASD Rule 1100, or in another appropriate registration category and be supervised as an associated person of the firm. Firms that engage foreign finders should ensure their procedures appropriately address the limited scope of activities permissible under such arrangements and potential risks. See Notices to Members 01-81 and 95-37.
• A firm’s AML risk may be elevated by foreign finders and related foreign affiliates depending on the geographical regions involved, types of customers introduced, and products and services offered. Some of the red flags observed include customer accounts exhibiting significant account activity with very low levels of securities transactions, significant credit or debit card activity/withdrawals with very low levels of securities transactions, wire transfers to/from financial secrecy havens or high-risk geographic locations without an apparent business reason, and payment by third-party check or money transfer without an apparent connection to the customer. Relationships with foreign finders and related foreign entities have also been used to hide securities activities and payment of transaction-based compensation to previously disciplined individuals, and to engage in cross-trading for the inappropriate benefit of the finder. Prior to entering into these relationships, firms must have reasonably designed procedures to, among other things, assess and address the potential AML risks associated with the business, and monitor any subsequent activity conducted with foreign finders and related foreign entities.