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FINRA's Regulatory Mulligan: SEC Not Amused
Written: July 22, 2008

NASD Conduct Rule 2110: Standards of Commercial Honor and Principles of Trade
Members (and associated persons), in the conduct of their business, shall observe high standards of commercial honor and just and equitable principles of trade.
NASD Conduct Rule 3030:Outside Business Activities of an Associated Person
No associated person shall be employed by, or accept compensation from, any other person as a result of any business activity, other than a passive investment, outside the scope of his relationship with his employer firm, unless he has provided prompt written notice to the member.

Two for the Road

In April 2002, Debra McClure, a client of of American Express Financial Advisors. Inc. (AMEX) registered representative Wanda Sears since 1999 complained to AMEX about the unauthorized purchase of 450 shares of AOL Time Warner stock that appeared in her account in February. Sears disputed the allegation but AMEX reimbursed the client for her losses. 

In June 2002, Walter Gwaltney, a client of Sears since 1998, complained about an unauthorized purchase of 3,675 shares of XO Communications that appeared in his account in January 2002. Sears claimed that Gwaltney's wife authorized the trade, notwithstanding that this was not a joint account and the wife was not authorized to exercise discretion.

AMEX terminated Sears on April 5, 2002, for violating several company policies including exercising discretion on clients’ accounts and failure to report outside activity (tax preparation services). During the following two years, AMEX amended her Uniform Termination Notice (Form U5) to reflect numerous customer complaints and settlements that American Express discovered during the course of its own internal investigation.

I Do Declare 

The Financial Industry Regulatory Authority investigated Sears' conduct and in October 2003, McClure and the Gwaltneys both signed Declarations submitted to FINRA that the trades at issue were never discussed with Sears and were also unauthorized. McClure and Mr. Gwaltney subsequently testified at FINRA that the trades in their accounts were unauthorized. A former supervisor of Sears also testified as to conversations with numerous customers concerning complaints against Sears. Following a hearing, FINRA found Sears had violated NASD Business Conduct Rule 2110 by making unauthorized trades in customer accounts, and Conduct Rules 3030 and 2110 by preparing clients' tax returns for compensation without providing her employer with requisite written notice. http://www.finra.org/web/groups/enforcement/documents/oho_disciplinary_decisions/p018551.pdf

Sears appealed the FINRA Hearing Panel's September 19, 2006 decision, which found that she violated Rule 2110 by effecting at least 23 unauthorized trades and violated Rules 3030 and 2110 by engaging in unapproved outside business activities. The Hearing Panel had dismissed other charges alleging forgery and unauthorized fees.http://www.finra.org/web/groups/enforcement/documents/nac_disciplinary_decisions/p037858.pdf . The Panel barred Sears for the unauthorized trades and imposed only a one-year suspension for the outside business activities in light of the Bar.

On appeal, FINRA's National Adjudicatory Counsel (NAC) modified the Panel's findings to reduce the number of unauthorized trades to 20 and also lowered the Bar to a two-year suspension. In affirming the outside business violation, the NAC reduced the suspension from one year to six months. The NAC noted that Sears adduced additional evidence in the form of affidavits from three customers that materially contradicted the memorandum of her supervisor. Because the affidavits came directly from the customers, the NAC credited them and essentially removed those three customers from the number of unauthorized trades. In rejecting the balance of Sear's due process challenges, the NAC stated that "because FINRA is not subject to constitutional and common law due process requirements," due process does not apply at FINRA. As to other procedural/evidentiary matters, the NAC was not bothered by the introduction of declarations against Sears because she "had an opportunity at the hearing to cross-examine the FINRA investigator that prepared the declarations."


McClure testified against Sears at the FINRA hearing. The FINRA panel clearly believed her. Gwaltney testified. The FINRA panel believed him. Two customers claiming unauthorized trades in their personal accounts went the extra mile and testified. Two warm, live bodies. Swearing to the truth. Looking Sears dead in the eye and calling her a cheat and a liar. Worse, Sears then got to tell her side of things and it doesn't look like she scored much on the credibility meter. However, in addition to finding against Sears for the two trades noted, FINRA also tacked on violations for an additional 18 unauthorized trades in the account of four more clients.

Eighteen trades and four clients in addition to the documented, specified, and testified-to allegations of McClure and Gwaltney. FINRA submitted Declarations alleging unauthorized trades from four other clients. Apparently, a FINRA examiner courteously prepared the Declarations (such thoughtful customer service!) and the customers signed them. Customer Laura Rossie accused Sears of twelve unauthorized trades. Customer Charles Hoskins added on four more. Customer Paul DiMarco tacked on one. Customer Diane Rinehard cleared the bases with one more.

Sears appealed FINRA's findings and sanctions to the Securities and Exchange Commission In the Matter of the Application of Wanda P. Sears, (Securities Exchange Act of 1934 Rel. No. 58075, July 1, 2008), http://sec.gov/litigation/opinions/2008/34-58075.pdf

Now, here's a tidbit that I didn't mention above: None of those additional four customers testified about the 18 trades at the hearing.

Neither Rossie, Hoskins, DiMarco, or Rinehard testified against Sears at the FINRA hearing! Not a single one swore to tell the truth and then testified.  All they did was sign a Declaration prepared by FINRA's staff. Sears' supervisor at AMEX was called, and he did testify to having spoken to those and other customers, and he did corroborate (or tried to) FINRA's allegations -- but it was still testimony about a conversation with a third party.  And Sears couldn't cross examine the third party; and she couldn't impeach their credibility.  Not exactly due process or fairplay.

Oh, so what. You lawyers and your procedural nonsense that coddles crooks. The FINRA panel didn't need to sit and listen to more of the same testimony. Why not just let the panel read the documentation that proved their allegations?

Chew on this: FINRA did not introduce to the panel any documentation about the additional 18 allegedly unauthorized trades! FINRA's lawyer tried to argue to the panel (and apparently succeeded there) that it was sufficient for the regulator to allege something and then for the regulator to simply introduce that complainant's Declaration. Almost from the Stephen Colbert School of Law--- it's so because I say so, and if you doubt it, look…here, I put it in writing and signed it.


(Your mouth opens as you try to say something but then you raise your hands, palms facing me, and then let them drop in annoyance). Bill, this Sears is guilty of outside business activity and the unauthorized trading in the two accounts where the clients testified. So what's the big deal here? Anyway, she knew way ahead of time that FINRA was also charging here with 18 specific unauthorized trades in those additional four accounts. That was in the Complaint filed by FINRA. Chapter and verse.

FINRA Sandbag?

Those additional 18 allegedly unauthorized trades were NOT identified nor the subject of any cause of action in FINRA's Complaint. Worse, the Complaint alleged unauthorized trading in the McClure and Gwaltney accounts (that much FINRA seems to have done right), but then added a third customer: Jean Thomas. Thomas was supposed to be called by FINRA but the Enforcement Staff didn't produce her to testify. She was 85 years old and recently hospitalized, and Enforcement described her likely testimony as cumulative and redundant. As such, the panel correctly made no findings with respect to her account.


The Courts and the SEC have often warned regulators that although Complaints need not specify ALL the details in the case to be prosecuted, there must be enough meat on those bones to ensure that the charged party understands the issue and afforded a full opportunity to justify his/her conduct. As the SEC so aptly crystallized the issue: It's less a matter of the adequacy of the pleading and more a matter of "the fairness of the whole procedure." Since FINRA is required under the '34 Act to "provide a fair procedure for the disciplining of members and persons associated with members," this concern is more than a passing fancy.


Thus defeat is snatched from the jaws of victory and FINRA sent to the SEC's woodshed. Here is the damning language, verbatim (footnotes omitted):

Here, the record does not indicate that Sears had adequate notice that the claims made by the four other customers in the Declarations were intended to provide a basis for additional findings of violation. There is no reference to any of these four additional customers in the complaint. Enforcement's pre-hearing brief discussed only the trades that the complaint alleged were unauthorized. Although Enforcement introduced the Declarations at the hearing, it adduced no underlying documentation related to the trades, and it did not indicate that it sought to hold Sears liable for those trades. In closing arguments, Enforcement counsel asserted only that the evidence of unauthorized trading in the accounts of McClure and Gwaltney was "corroborated by the other [D]eclarations." Enforcement's proposed findings of fact did not seek a finding that Sears engaged in unauthorized trading in the accounts of Rossie, Hoskins, DiMarco, or Rinehard, and its post-hearing brief urged only that the Hearing Panel find that "Sears violated NASD Conduct Rule 2110 by effecting [the] unauthorized transactions as alleged in the Complaint."

FINRA, however, found that Sears violated Rule 2110 by executing unauthorized trades in the accounts of not only McClure and Gwaltney but also in the accounts of Rossie, Hoskins, DiMarco, and Rinehard. Under the circumstances, we conclude that it is not appropriate to hold Sears liable for additional Rule 2110 violations based on the Declarations because it appears Sears lacked adequate notice that the Declarations were an additional basis for FINRA's allegations.  We therefore set aside the additional findings of unauthorized trading based on the Declarations.

In issuing its Opinion, the SEC sustained the sanction imposed on Sears for failing to disclose an outside business activity in violation of FINRA Rules 3030 and 2110; but ordered that the sanction imposed by FINRA on Sears for engaging in unauthorized transactions in violation of FINRA Rule 2110 be vacated and remanded to FINRA for further proceedings.

A Difficult But Important Point

George Bernard Shaw said that "The love of fairplay is a spectator's virtue; not a principal's."  Those of us who love sports have been saddened in recent years by the revelations of steroids, point shaving, bribery of officials, and outright cheating.  Why do we care if our team wins by cheating?  Because the victory is cheapened, as is the sport.  Much the same can be said for regulatory and criminal proceedings.  Win but win fairly.  It strengthens the system.

If you read the full FINRA case involving Sears, it does not paint a flattering picture of her or our industry.  You will likely be repulsed, as I was, by the allegations involving numbers of vulnerable clients.  My analysis here is not intended as a paen for Sears or her conduct; rather, my commentary is a warning. You cannot cut corners when regulating Wall Street. You cannot sleepwalk through the job of regulating when our economy is melting down and the opportunities for misconduct are ripe.

There was a strong enough case here against Sears involving two customers and unauthorized trading in their accounts (plus the apparent slam-dunk case involving the outside activity). As a former regulatory prosecutor myself, I am all too aware of the desire by some regulators to gild the lily and throw in a kitchen sink of charges NOT with the knowledge that you can prove your case but with a misplaced "hope."  Worse, sometimes the piling on of charges is viewed as a perfectly acceptable tactic to force settlement.

I have no first-hand knowledge of the decision making process in FINRA's prosecution of Sears, but I do know one thing: In this country and in this industry we must insist upon fairplay when the arena is controlled by the same folks who conduct the investigation, file the charges, hear the case, and impose the sanctions.  I am less appalled with the SEC's description of the lack of adequate notice of charges by FINRA, than I am with FINRA's failure to catch this practice and nip it in the bud.  Why was the Sears Complaint approved in the form it was?  How much more work would have been required to specify the details--the names of stocks, the dates of trades, etc.?

And what is the net result of all this strong arming and gamesmanship?  More delay and more cost.  The case now comes back into FINRA's lap.  Resources are wasted on a remanded case when there are many other pressing matters requiring FINRA's attention. This is not the time for a regulatory Mulligan.

Are there any among you who still doubt the need to overhaul our nation's financial regulatory system?


Topics: FINRA  SEC  appeal  unauthorized trading  
 
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