Imagine that a contractor installed a state-of-the-art sprinkler system but never connected it to any water source. Now start a fire. With that image in mind, consider today's BrokeAndBroker.com Blog, which discusses a recent FINRA regulatory settlement involving allegations that a member firm botched its use of so-called activity letters. It's a fairly compelling effort by FINRA but for the fact that the published settlement agreement raises a few questions that aren't answered.
Case 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, E.J. Sterling, LLC (now known as Allied Millennial Partners, LLC) submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of E.J. Sterling, LLC (now known as Allied Millennial Partners, LLC), Respondent (AWC 2015043310801, April 27, 2018).
The AWC asserts that E.J. Sterling, LLC, now known as Allied Millennial Partners, LLC ("EJS") has been a FINRA member firm since 1985 and employs about 28 registered personnel. The AWC asserts that the firm has "no relevant disciplinary history."
The AWC asserts that FINRA reviewed EJS's trading for the relevant period January 2014 through June 2015, and the self-regulatory-organization found that at least 33 accounts appeared to have been "excessively traded." The AWC states that the turnover rates for the cited accounts ranged from 20 to 140, and the cost-to-equity ratios ranged from 20% to 154%.
SIDE BAR: In the "Overview" section of the AWC, the "relevant period" is identified as "from January 2014 through June 2015," however, in the "Facts and Violative Conduct" section of the AWC, we are told that FINRA "conducted a review of the Firm's trading activity for the period January 2015 through July 2015." Consequently, the relevant period apparently ends in June 2014 whereas the review extended through July 2015. The June/July different endpoints may be explained as the distinction between the scope of a broader period under review versus the scope of the narrower period during which alleged violations occurred. On the other hand, the different months may be the result of a typo or poor editing by FINRA. BrokeAndBroker.com Blog assumes that the relevant period of January 2014 through June 2015 is accurate.
The AWC alleges that during the relevant period, EJS's Chief Compliance Officer (identified only as "SC" in the published settlement document) reviewed a monthly exception report provided to the firm by its clearing firm in order to detect potentially unsuitable excessive trading. If SC noticed potentially excessive trading:
he would sometimes send an "activity letter" to the customer advising the customer of the level of trading in his or her account. However, SC could not articulate when and under what circumstances he would send an activity letter, and the Firm had no procedures or other guidance addressing this issue.
During the relevant period, the AWC alleges that the activity letters sent by SC had asked customers to confirm their understanding of their account's trading activity and their ongoing consent to same by signing the letters and returning them to the firm. The activity letters purportedly contained the admonition that if a customer did not return an executed activity letter, EJS "may" restrict the account to liquidating transactions. SC purportedly explained to FINRA that if after 30 days a customer's activity letter was not returned in executed form, he would restrict the account to liquidating-only transactions.
Following FINRA's alleged review of a sample of 41 EJS accounts that had been sent activity letters, it was apparently determined that 21 had failed to return executed copies to EJS within 30 days. Of those cited 21 accounts, EJS failed to implement a liquidating-only status for 10 of the accounts.
FINRA deemed that in violation of NASD Rule 3010 and FINRA Rules 3110 and 2010, EJS had failed to establish, maintain and enforce a supervisory system and written supervisory procedures reasonably designed to identify and prevent unsuitable excessive trading in customer accounts. In accordance with the terms of the AWC, FINRA imposed upon EJS a Censure and ordered that the firm pay $35,000 "partial restitution" to five customers.
Bill Singer's Comment
A Matter of Relevancy
The AWC discloses that:
Finally, although the Securities and Exchange Commission specifically cited the Firm in December 2013 for failing to have adequate written procedures addressing the Firm's supervision of actively traded accounts, the Firm did not add any such written procedures until April 2016, more than two years later.
Notwithstanding the AWC's reference to the SEC citing EJS in 2013 for inadequate written procedures addressing actively traded accounts, the AWC asserts under the heading "Relevant Disciplinary History" that:
The Firm has no relevant disciplinary history.
Ummm . . . what? Obviously, FINRA thought the SEC's 2013 citation was noteworthy because a reference to it appeared in the AWC despite a prior blanket statement that EJS had no relevant prior disciplinary history. It may be that although the SEC "specifically cited" EJS for inadequate procedures, such a citation did not rise to the level of a "relevant disciplinary history." If that's the case, then FINRA should have indicated as much in the "Relevant Disciplinary History" with a short comment tor a footnote.
Speaking of FINRA's use of footnotes, the AWC states in Footnote 1 that:
In the interest of maximizing restitution to customers, FINRA imposed no fine after considering, among other things, the Firm's financial resources
I note that the footnote talks about the "interest of maximizing restitution to customers," but the wording of the sanction references a $35,000 "partial restitution." Maximizing and partial are not the same thing. If FINRA didn't impose any fine on EJS, why didn't the self-regulatory-organization order the firm to pay full restitution? Moreover, what did FINRA determine were the financial damages EJS's customers allegedly sustained as a result of the firm's failure to restrict 10 account to liquidating-only transactions?
Similarly missing from the AWC is an indication as to whether any of those 10 accounts were defrauded via unauthorized trading, which might have been detected earlier if the firm had implemented a reasonable activity letter protocol. Given that FINRA's decision to not impose a fine seems something along the lines of a quid pro quo for EJS's payment of restitution to its customers, it would have been appropriate to know whether the damages were calculated at $37,500, $75,000, or $250,000. I applaud FINRA's enthusiasm for redirecting fines in the form of restitution to the public. I'm not as enthusiastic about the opaque nature in which this bargain is implemented.