Heightened Supervision Shortfalls Bring Down Chief Compliance Officer

May 17, 2012

FINRA wonders how many more red flags one compliance officer needed to see

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, James Arnold Potter submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted.In the Matter of James Arnold Potter, Respondent (AWC 2010020803401, May 15, 2012). 


Potter entered the securities industry in June 1987; and from August 1, 2003, through the present, was associated with FINRA broker-dealer The Oak Ridge Financial Services Group, Inc.  Potter is registered with FINRA as a general-securities representative, general-securities principal, and investment-banking representative.  The AWC states that he has no prior formal disciplinary history. 

Heightened Supervision

Since January 2008, Potter has been Oak Ridge's Chief Compliance Office, responsible for reviewing and approving all transactions, and for reviewing all correspondence by the firm's representatives.

In 2009, a broker joined Oak Ridge (herein referred to as the "Broker") and his Form U-4 disclosed multiple prior customer complaints alleging unauthorized account activity - accordingly, he was placed on heightened supervision, which included quarterly letters sent to a sampling of Broker's customers, frequent discussions with him about his customers and his personal financial situation, and a heightened review of his correspondence. Subsequent to Broker's hiring, Oak Ridge learned of other disclosure events, including a September 2009 settlement with a customer who had alleged excessive trading.

SIDE BAR: One would think that after hiring a registered person who's a bit of the walking wounded that the employer firm would be on top of him.  Moreover, after hiring this guy with a troubled past, the firm learns that there's even more compliance issues than they first thought. The big question was whether the firm adequately responded to the additional red flags.

Potter And The Deathly Hallows of Compliance

Between the relevant period of May 1, 2009 and May 31, 2010, Potter was responsible for supervising Broker's transactions and for conducting all aspects of heightened supervision.  During the relevant period, the AWC alleges that Broker engaged in excessive trading in the accounts of four Oak Ridge customers; and that Potter reviewed and approved all of the transactions for those clients.  Among the supervisory tasks performed by Potter were reviews of daily trade blotters that showed the cited transaction and monthly "Active Account Reports," on which some of Broker's customers' accounts appeared.

For the period of February 2010 through April 2010, the Active Account Reports showed annualized turnover rates of between 4.51 to 15.08 and annualized cost-to-equity ratios of between 27% and 80%  for the four customers noted in the AWC. For one of those customers, Potter's supervisory notes "reflect no awareness" that the customer "would have had to realize extraordinarily high returns just to offset the commissions that he was paying . . ." Similarly, for the other three cited customers who also appeared on multiple activity reports, the AWC alleges that Potter's supervisory notes

make no mention of any concern for the cost-to-equity ratios or of any plan for curbing the commissions charged to those customers. Potter never contacted any of the Customers to discuss particular trades in their accounts, the frequency of trading, or the commissions that were charged to their accounts. Potter also never disapproved any of the trades . . .

Although the AWC concedes that Potter sent quarterly letters to a sampling of some five or six of Broker's customers, such correspondence allegedly "did not ask customers about particular transactions or trading patterns, He instead asked the customers to contact him if they had any questions or concerns regarding their accounts. . ."

FINRA concluded that the turnover and cost-to-equity figures that Potter received each month were red flags for excessive trading - all the more a concern when he learned in September 2009 that Broker had been the subject of an excessive-trading complaint while at another broker-dealer.  The AWC asserts that "a more searching inquiry and corrective action were necessary. Instead, Potter failed to respond adequately to these red flags, and preventable customer harm followed."

Finding Potter's conduct violated NASD Rule 3010 and FINRA Rule 2010, the AWC imposed the sanction upon him of a $5,000 fine and a suspension of twenty business days from associating in a principal capacity with any FINRA broker-dealer.

Bill Singer's Comment

In recent years FINRA has markedly turned up the heat on managers and supervisors - whereas in prior years, many of these folks might have gotten a rap on the knuckles or a pass.  Those days are long gone. All over the industry, at Merrill Lynch, JP Morgan, Goldman Sachs, UBS, Morgan Stanley, Wells Fargo - and even at smaller indies/regionals, supervisors and managers should be on edge.

There are a number of lessons here for compliance professionals. First and foremost, if you have someone designated for "heightened supervision," the regulators are going to scrutinize your conduct in the event things go awry.  There is virtually no room for error if you're on notice that you've been assigned to monitor one of Wall Street's walking wounded and you sort of ramble and amble your way through that exercise.  Sure, if the individual that you're overseeing doesn't slip, that's fine - on the other hand, you know how these things always seem to work out: The guy swears on a stack of bibles and his daughter's eyes that he's following procedure, and then you learn that he's been entering unauthorized trade . . . and that he has no daughter.

Finally, document what you do.  If there's a problem but you had no reasonable notice, your notes may be the decisive factor in demonstrating that you too were victimized by a dishonest registered person.  On the other hand, merely papering the file with going-through-the-motion reviews isn't going to calm down any regulator.