FINRA Sanctions Lack of Proactive Compliance

November 3, 2016

In two recent Financial Industry Regulatory Authority disciplinary settlements, the regulator addressed hedge fund sales by a registered representative and his firm's apparent failure to do much in the way of overseeing that activity. FINRA has fired a warning shot across the bow of in-house compliance staff who fail to pursue proactive compliance.

Cases In Point

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, Donald K. Gross and Rembert D. McNeer III submitted separate Letters of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted.

In the Matter of Donald K. Gross, Respondent (AWC 2013039548401, October 27, 2016)
In the Matter of Rembert D. McNeer III, Respondent (AWC 2015045602601, October 31, 2016)

The Gross AWC

In 1989, Gross first became registered with FINRA member firm Summit Equities, Inc., where he is presently employed. The AWC asserts that Gross had no prior relevant formal disciplinary history with the Securities and Exchange Commission, any self-regulatory organization or any state securities regulator.

$6.2 Million in IME Fund Sales

The AWC asserts that from June 2011 through September 2011, Gross sold to 11 Summit customers about $6.2 million in limited partnership interests in the IME Fund, a hedge fund that traded options. IME had agreed to pay to Gross a percentage of the fund's advisory fees. When IME Fund collapsed in September 2011, the 11 investors lost about 95% of their investments.

The PST Rulebook

In 2011, Summit prohibited its registered representatives from participating in private securities transactions without the firm's prior written approval. Further, Summit registered representatives were required to disclose all private securities transactions on their annual compliance certifications.

The current FINRA Private Securities Transactions ("PST") Rule states:

FINRA Rule 3280: Private Securities Transactions of an Associated Person

(a) Applicability

No person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule.

(b) Written Notice

Prior to participating in any private securities transaction, an associated person shall provide written notice to the member with which he is associated describing in detail the proposed transaction and the person's proposed role therein and stating whether he has received or may receive selling compensation in connection with the transaction; provided however that, in the case of a series of related transactions in which no selling compensation has been or will be received, an associated person may provide a single written notice.

(c) Transactions for Compensation

(1) In the case of a transaction in which an associated person has received or may receive selling compensation, a member which has received notice pursuant to paragraph (b) shall advise the associated person in writing stating whether the member:

(A) approves the person's participation in the proposed transaction; or

(B) disapproves the person's participation in the proposed transaction.

(2) If the member approves a person's participation in a transaction pursuant to paragraph (c)(1), the transaction shall be recorded on the books and records of the member and the member shall supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.

(3) If the member disapproves a person's participation pursuant to paragraph (c)(1), the person shall not participate in the transaction in any manner, directly or indirectly.

(d) Transactions Not for Compensation

In the case of a transaction or a series of related transactions in which an associated person has not and will not receive any selling compensation, a member which has received notice pursuant to paragraph (b) shall provide the associated person prompt written acknowledgment of said notice and may, at its discretion, require the person to adhere to specified conditions in connection with his participation in the transaction.

(e) Definitions

For purposes of this Rule, the following terms shall have the stated meanings:

(1) "Private securities transaction" shall mean any securities transaction outside the regular course or scope of an associated person's employment with a member, including, though not limited to, new offerings of securities which are not registered with the Commission, provided however that transactions subject to the notification requirements of NASD Rule 3050, transactions among immediate family members (as defined in FINRA Rule 5130), for which no associated person receives any selling compensation, and personal transactions in investment company and variable annuity securities, shall be excluded.

(2) "Selling compensation" shall mean any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security, including, though not limited to, commissions; finder's fees; securities or rights to acquire securities; rights of participation in profits, tax benefits, or dissolution proceeds, as a general partner or otherwise; or expense reimbursements.

READ the BrokeAndBroker.com Blog Analysis of FINRA's Current PST Rule

FINRA deemed Gross's hedge fund participation as constituting his involvement in PST for which he had failed to provide his firm with the required notice or obtain its permission. Similarly, the AWC asserts that on June 2011, Gross failed to disclose on his annual Summit compliance certification that he was participating in the then ongoing IME Fund offering.

2013 IRS Tax Lien

The AWC asserts that on May 14, 2013, the Internal Revenue Service ("IRS") filed a $438,991 tax lien against Gross and that he had knowledge of the lien around the time of its filing.

The Tax Lien Rulebook

Article V of FINRA's By-Laws: Registered Representatives and Associated Person, provides as follows:

Application for Registration

Sec. 2. (a) Application by any person for registration with the Corporation, properly signed by the applicant, shall be made to the Corporation via electronic process or such other process as the Corporation may prescribe, on the form to be prescribed by the Corporation and shall contain:

(1) an agreement to comply with the federal securities laws, the rules and regulations thereunder, the rules of the Municipal Securities Rulemaking Board and the Treasury Department, the By-Laws of the Corporation, NASD Regulation, and NASD Dispute Resolution, the Rules of the Corporation, and all rulings, orders, directions, and decisions issued and sanctions imposed under the Rules of the Corporation; and
(2) such other reasonable information with respect to the applicant as the Corporation may require.

(b) The Corporation shall not approve an application for registration of any person who is not eligible to be an associated person of a member under the provisions of Article III, Section 3.

(c) Every application for registration filed with the Corporation shall be kept current at all times by supplementary amendments via electronic process or such other process as the Corporation may prescribe to the original application. Such amendment to the application shall be filed with the Corporation not later than 30 days after learning of the facts or circumstances giving rise to the amendment. If such amendment involves a statutory disqualification as defined in Section 3(a)(39) and Section 15(b)(4) of the Act, such amendment shall be filed not later than ten days after such disqualification occurs.

In addition to the above By-Law provision, FINRA Rule 1122: Filing of Misleading Information as to Membership or Registration, provides:

No member or person associated with a member shall file with FINRA information with respect to membership or registration which is incomplete or inaccurate so as to be misleading, or which could in any way tend to mislead, or fail to correct such filing after notice thereof.

Finally, the Uniform Application for Securities Industry Registration ("Form U4") asks the following:

Financial Disclosure

14K. Within the past 10 years:
(1) have you made a compromise with creditors, filed a bankruptcy petition or been the subject of an involuntary bankruptcy petition?
(2) based upon events that occurred while you exercised control over it, has an organization made a compromise with creditors, filed a bankruptcy petition or been the subject of an involuntary bankruptcy petition?
(3) based upon events that occurred while you exercised control over it, has a broker or dealer been the subject of an involuntary bankruptcy petition, or had a trustee appointed, or had a direct payment procedure initiated under the Securities Investor Protection Act?

14L. Has a bonding company ever denied, paid out on, or revoked a bond for you?

14M. Do you have any unsatisfied judgments or liens against you?

The AWC asserts that Gross failed to answer "YES" to 14M on the Form U4 and otherwise disclose the existence of the tax lien.

FINRA Sanctions

FINRA deemed Gross conduct to have constituted his participation a private securities transaction for compensation in violation of NASD Rule 3040 and FINRA Rule 2010; and his failure to disclose his participation in the fund offering as a violation of FINRA 2010. Further, FINRA deemed Gross to have willfully failed to timely disclose the tax lien on his Form 4 in violation of Article V, Section 2(c) of the FINRA By-Laws and FINRA Rules 1122 and 2010.

In accordance with the terms of the AWC, FINRA imposed upon Gross a $10,000 fine and a two-year suspension from association with any FINRA member firm in any capacity.

Statutory Disqualification

Included in the AWC is this provision:

I understand that this settlement includes a finding that I willfully omitted to state a material fact on a Form U4, and that under Section 3(a)(39)(F) of the Securities Exchange Act of 1934 and Article III, Section 4 of FINRA's By-Laws, this omission makes me subject to a statutory disqualification with respect to association with a member.

Bill Singer's Comment

Under the heading of "Customer Dispute - Settled" FINRA's online BrokerCheck records for Gross disclose that on December 20, 2013, a FINRA Arbitration claim seeking $4,514,299 was filed and on April 2, 2015, settled for $2,000,000, of which Gross contributed $1,050,000. As set forth under "Allegations:"

EIGHT LIMITED PARTNERS IN ILLUME FUND, LP ("ILLUME") FILED TWO SEPARATE ARBITRATIONS (13-03396 AND 13-03722) AGAINST SUMMIT, WHICH WERE COMBINED PRIOR TO SETTLEMENT. THE STATEMENTS OF CLAIM ALLEGED MISCONDUCT BY MR. GROSS IN 2011 IN CONNECTION WITH THE SALE OF THE ILLUME LIMITED PARTNERSHIP INTERESTS. MR. GROSS SOLD THOSE LIMITED PARTNERSHIP INTERESTS THROUGH GEH, HIS OWN BROKER-DEALER WHICH WAS NOT AFFILIATED WITH SUMMIT. THE CLIENTS, WHO WERE ALL SOPHISTICATED AND EXPERIENCED, ALL ACKNOWLEDGED IN WRITING AT THE TIME OF THE INVESTMENTS THAT SUMMIT HAD NOTHING TO DO WITH THE INVESTMENTS. HOWEVER, CLAIMANTS ALLEGED THAT MR. GROSS MISREPRESENTED ILLUME AND THAT SUMMIT HAD A DUTY TO SUPERVISE MR GROSS IN CONNECTION WITH THE SALES OF THE ILLUME INVESTMENTS THROUGH GEH. GEH AND GROSS WERE INITIALLY NAMED AS RESPONDENTS IN 13-03396 BUT WERE DISMISSED FROM THE CASE AFTER GROSS AND GEH FILED BANKRUPTCY PETITIONS FOR REASONS UNRELATED TO ILLUME AND PRIOR TO SETTLEMENT. GEH AND GROSS WERE NEVER NAMED AS RESPONDENTS IN 13-3722. SUMMIT SETTLED WITH CLAIMANTS WHO, AMONG OTHER THINGS, ASSIGNED ALL OF THEIR CLAIMS AGAINST ILLUME AND ITS MANGER TO SUMMIT.

In his own BrokerCheck statement responding to the customers' allegations, Gross stated:

THE ILLUME INVESTMENTS WERE SUITABLE FOR CLAIMANTS AND NO MISREPRESENTATIONS WERE MADE CONCERNING ILLUME. LOSSES SUFFERED BY THE LIMITED PARTNERS, INCLUDING ME, WERE CAUSED BY THE GENERAL PARTNER AND INVESTMENT MANAGER FOR ILLUME IN AUGUST 2011. I WAS NOT REPRESENTED IN THE MEDIATION THAT LED TO THE SETTLEMENT BY SUMMIT.

The McNeer AWC

In 1984, McNeer first became registered with FINRA member firm Summit Equities, Inc. and in 1988 he was registered with that firm as a General Securities Principal. McNeer voluntary terminated from Summit in September 2015. The AWC asserts that McNeer had no prior relevant formal disciplinary history with the Securities and Exchange Commission, any self-regulatory organization or any state securities regulator.

Supervision of DG

During the relevant period of 2001 through 2012, the AWC asserts that McNeer was Summit's Chief Compliance Officer and designated as the immediate supervisor of an individual only referenced as "DG." As alleged in the McNeer AWC:

In 2001, Summit allowed DG to form a broker-dealer, GEH, to sell the securities of DC, a hedge fund that DG controlled. The Firm, through McNeer, placed two restrictions on DG's association with GEH. First, McNeer instructed DG that he would be permitted to sell only DC securities through GEH. Second, McNeer required "that all sales or placement of any security product must be booked and received through Summit Equities, Inc."

Contrary to McNeer's instructions, DG used GEH to sell the securities of several different hedge funds other than DC and never reported these sales to the Firm as required by McNeer and the Firm's procedures governing private securities transactions. For example, from June 2011 through September 2011, DG sold approximately $6.2 million in limited partnership interests in IME Fund, a hedge fund that traded options, to 11 accredited investors, all of whom were Summit customers. DG never disclosed these sales to Summit. In September 2011, the IME Fund collapsed, and investors lost approximately 95% of their investments.

Down Memory Lane

Ummm . . . any of that sound remotely familiar? Wanna guess the identity of "DG?"

FINRA entered into In the Matter of Donald K. Gross, Respondent (AWC 2013039548401, October 27, 2016) four days before entering into In the Matter of Rembert D. McNeer III, Respondent (AWC 2015045602601, October 31, 2016). Would anyone like to take a shot at why the McNeer AWC doesn't name DG by name? I mean, c'mon, assumming that DG is Donald K. Gross, the guy already entered into a settlement with FINRA before the self-regulatory organization settled with McNeer. And before some of you clever folks come up with all sorts of explanations about the need to protect the innocent, keep in mind that both the Gross AWC and the McNeer AWC both name non-parties Summit and the IME Fund; and the McNeer AWC names non-party broker-dealer GEH. Moreover, FINRA's online BrokerCheck essentially spells out chapter and verse of the underlying facts.

Failure to Take Steps

While you're pondering FINRA's odd protocol of who and what gets named and who and what doesn't get named in its AWCs, consider this conclusion in the McNeer AWC:

McNeer failed to adequately supervise DG's activities through GEH. McNeer never examined GEH's books and records, reviewed DG's GEH emails or conducted an on-site visit of GEH's office. In fact, McNeer failed to take any steps to supervise DG's sales activities through GEH or to ensure that DG complied with the Firm's restrictions on DG's sales through GEH.

In addition, McNeer failed to detect several "red flags" that should have alerted him to DG's IME Fund activity. For example, in May and July 2011, DG requested $2.5 million in wire transfers from the Summit accounts of five customers to fund their investments in the IME Fund. McNeer approved two of the wire transfers in his capacity as a Firm principal, but never questioned DG about these transactions.

FINRA Sanctions

FINRA deemed McNeer's conduct to constitute a failure to adequately supervise DG's private securities transactions and ensure that they complied with the requirements of NASD Rule 3040. The regulator alleged that McNeer violated NASD Rules 2110, 3010 and 3040, and FINRA Rule 2010.

In accordance with the terms of the AWC, FINRA imposed upon McNeer a $10,000 fine and a one-year suspension from association with any FINRA member firm in any principal capacity

Bill Singer's Comment

Despite FINRA's somewhat silly game of hide-and-seek with "DG," I like the presentation in these two AWCs. The self-regulator makes a particularly strong case that effective in-house compliance requires asking questions, walking a beat, and connecting dots. In my experience spanning some three decades on Wall Street, far too many compliance officers park their carcasses in an office that is often hidden away from the nervous eyes of those who are supposed to be supervised. That act of burying a Compliance Department in a corner of a floor that's not connected to the retail brokers or trading desks isn't happenstance -- it's a foolish and somewhat cynical bit of planning. Above the door to every Compliance Department should be this warning:

Every breath you take

Every move you make
Every bond you break
Every step you take
I'll be watching you

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FINRA Sanctions Lack of Proactive Compliance

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