Wall Street's Self Regulator Prohibits Guarantees Against Customer Loss

March 13, 2013

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, George Lincon submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of George Lincon, Respondent (AWC 20110258700, February 6, 2013).

Lincoln entered the securities industry in 1999 and was registered with EKN Financial Services, Inc. ("EKN") from January 2004 through October 2012. The AWC asserts that he had no prior relevant disciplinary history.

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Between September 2010 and October 2010, the AWC alleges that Lincon, provided to three EKN customers the following statement on firm letterhead, which he signed:

We, EKN Financial Services, Inc. (EKN)� guarantee the immediate return of the original amount of investment to the client at the end of the investment period . . . EKN waives any right it may have to offset, set off or withhold the investment for whatever reason . . . At all times the investment account will maintain the original investment in either cash securities or hard assets . . . [I]t is guaranteed that at no time the investment of the client will be used for any payments or any transfers, without any equivalent or higher value security available for the client account . . . This addendum will be valid for any additional funds added to the original investment.

What's the essence of the above communication? EKN is offering to "guarantee the immediate return of the original amount of investment" and that said investment will be maintained in cash, securities, or hard assets.

My, what a great offer! Three customers of Lincon's were being presented with a can't-lose proposition. Whatever they put in to their EKN accounts was guaranteed against loss! Sounds to me like a great idea - you know, a broker-dealer is putting its money (well, okay, the customer's money) where its mouth is. Just imagine if this idea caught on and took root on Wall Street. Instead of all the hyperbole about suitability and recommending investments, brokerage firms take it to the next level by guaranteeing you against losses. I don't know about you but where do I sign up?

FINRA's Got This Rule

Except, you know, all this apparent pro-consumer stuff isn't quite the fabric of Wall Street. Take a gander at FINRA Rule 2150 [Ed: emphasis added]:

FINRA Rule 2150: Improper Use of Customers' Securities or Funds; Prohibition Against Guarantees and Sharing in Accounts
(a) Improper Use
No member or person associated with a member shall make improper use of a customer's securities or funds.
(b) Prohibition Against Guarantees
No member or person associated with a member shall guarantee a customer against loss in connection with any securities transaction or in any securities account of such customer.
(c) Sharing in Accounts; Extent Permissible
(1)(A) Except as provided in paragraph (c)(2), no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member; provided, however, that a member or person associated with a member may share in the profits or losses in such an account if:
(i) such person associated with a member obtains prior written authorization from the member employing the associated person;
(ii) such member or person associated with a member obtains prior written authorization from the customer; and
(iii) such member or person associated with a member shares in the profits or losses in any account of such customer only in direct proportion to the financial contributions made to such account by either the member or person associated with a member.
(B) Exempt from the direct proportionate share limitation of paragraph (c)(1)(A)(iii) are accounts of the immediate family of such member or person associated with a member. For purposes of this Rule, the term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, children or any
relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.
(2) Notwithstanding the prohibition of paragraph (c)(1), a member or person associated with a member that is acting as an investment adviser may receive compensation based on a share in profits or gains in an account if:
(A) such person associated with a member seeking such compensation obtains prior written authorization from the member employing the associated person;
(B) such member or person associated with a member seeking such compensation obtains prior written authorization from the customer; and
(C) all of the conditions in Rule 205-3 of the Investment Advisers Act (as the same may be amended from time to time) are satisfied.
• • • Supplementary Material: -----
.01 Inapplicability of Rule to Certain Guarantees. For purposes of paragraph (b) of this Rule, a "guarantee" that is extended to all holders of a particular security by an issuer as part of that security generally would not be subject to the prohibition against guarantees.
.02 Permissible Reimbursement by Member of Certain Losses. Nothing in this Rule shall preclude a member, but not an associated person of the member, from determining on an after-the-fact basis, to reimburse a customer for transaction losses; provided, however, that the member shall comply with all reporting requirements that may be applicable to such payment. For example, if the payment can reasonably be construed as a settlement, the member shall report the payment as a settlement under the applicable reporting requirement(s). In addition, nothing in this Rule shall preclude a member, but not an associated person of the member, from correcting a bona fide error. This Supplementary Material .02 does not apply to an associated person of a member because of the concern that any such payment may conceal individual misconduct.
.03 Record Retention. For purposes of paragraph (c) of this Rule, members shall preserve the required written authorization(s) for at least six years after the date the account is closed.
.04 Applicability of Other Rules to Sharing Arrangements. Members and associated persons should be aware that participation in a sharing arrangement permitted under paragraph (c) of this Rule does not affect the applicability of other FINRA rules, including paragraph (b) of this Rule, FINRA Rule 3270 and NASD Rules 3040 and 3050, to such sharing arrangement.

If you're not a Wall Street compliance professional or registered person, you probably never realized that the full power of industry regulation has been amassed to make sure that your stockbroker doesn't guarantee you against losses or that he/she is prohibited from sharing the profits in your account. Heaven forbid that a brokerage firm or stockbroker would even dare to recommend an investment involving your life's savings and then guarantee you against loss. Similarly, why would we ever want to end the pernicious system of paying commissions on each and every trade - or paying a flat percentage of our assets under management - when we could simply say to the registered person touting an investment that we'll agree to share the profits if the investment pans out, but we ain't paying a damn cent in commissions or fees just for the opportunity of betting on the roll of the dice.

Sanctions

As FINRA characterized Lincon's signed statement above, it was an impermissible effort to guarantee each of the three recipient clients against losses in violation of FINRA Rule 2010 and FINRA Rule 2150(b). In accordance with the terms of the AWC, FINRA imposed upon Lincon a $5,000 fine due upon reassociation with a member firm and a 10 business-day suspension from association with any FINRA member firm in any capacity.

Bill Singer's Comment

Why did Lincon provide the above statement? Unfortunately, the AWC fails to present any explanation and we are left to our own devices - which if you ask me (go ahead, ask me), sort of turns the whole purpose behind publishing these settlements into a fairly useless exercise. You would sort of like to believe that the regulation of Wall Street, particularly by a so-called self-regulatory organization such as FINRA, aspires to more than the likes of a Monty Pythonesque wink-wink-nudge-nudge; however, when a regulator engages in hide-and-seek with background facts, we truly seem to be left on the outside looking in of some incomprehensible ritual.

Then there's the more troubling question raised by this case. Ask all those federal, state, and SRO regulators about guarantees and profit-sharing and they'll have a whole batch of pat answers and explanations for you about how such practices undermine the credibility of the securities industry. Really?

In the end, just think about it. On your own. Rationally. What's truly wrong about altering the client relationship from one in which you pay for each and every trade regardless of profitability, to one in which those recommending investments "guarantee" your principal against loss or are compensated solely from ensuing profits (if any). Sure, the Devil is in the details, but as I see it, the key concern is how to ensure and insure that there are sufficient funds to back up a guarantee. A legitimate concern is making sure that there is something backing up the promise. You can't have a firm or stockbroker touting $20 million worth of investments in some high-tech bit of garbage but only having $17.95 in Net Capital to back up that pledge. On the other hand, anyone ever hear of insurance? Anyone ever hear of a collateralized risk pool? Anyone ever hear of an escrow fund subject to independent audit and verification?

Overlooked in the FINRA prohibition against guarantees is that the byproduct of permitting guarantees would likely be enhanced due diligence and risk analysis by those making such promises. Just imagine how much more investigation brokerage firms would do concerning all the garbage that they touted if they had to guarantee customers against loss of principal or if they were only going to get paid a success fee from profits.

To be clear, very clear, I am NOT advocating that every broker-dealer or registered representative be required to conduct business based solely upon guarantees or profit sharing. I am an unrepentant believer in competition in the market place. I am merely advocating that such the option be available to those who opt to pursue it and can satisfy the financial safety net.

Still - FINRA retains a rule against guarantees and profit-sharing on its books. You gotta wonder why. When I wonder about such rules, it often leads me examine the "self" in self regulation; which then leaves me with that troubling feeling that maybe, just maybe, powerful industry factions want something outlawed because it may cut into their bottom line. Not exactly a pro-consumer orientation. Gee, now there's a revelation from Wall Street.

Also read these "Street Sweeper" columns:

Customer's Oddball ETF UIT Guarantee Allegation Proves A Winner
FINRA Punishes Customer Loss Reimbursement By Stockbroker
FINRA Sanctions MetLife Manager In Elderly Client's Account Opening

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