Is FINRA Sleepwalking Through Member Firm Examinations?

June 20, 2018

In today's Blog we consider a compelling FINRA regulatory settlement involving a member firm's deficient written supervisory procedures. The self-regulatory-organization provides its members with something amounting to a primer on how to debug various policies and procedures. Those of us who are veterans to the industry's compliance scene know all too well the many written procedures that are littered with such useless terms as "[INSERT NAME]" or "TBD". Imagine there's a fire in your building and you come upon a fire box that says "In the event of fire pull handle" but there's no handle. Not a great time to be thinking up a Plan B. Notwithstanding FINRA's strong case, the regulator still has some explaining to do. Sort of like the fire department inspector who should have noticed during each and every inspection over the last five years that there was no handle attached to the fire box that was supposed to have one. 

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, Northeast Securities, Inc. (n/k/a Northeast Securities, LLC) submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Northeast Securities, Inc. (n/k/a Northeast Securities, LLC), Respondent (AWC 2014040769402, June 12, 2018).

The AWC asserts that since 1990, Northeast has been a FINRA member firm employing about 60 registered representatives at about 22 branch offices. The AWC asserts that "Northeast does not have any relevant disciplinary history."

2010 - 2016: Outside Brokerage Accounts

The AWC alleges that during the relevant period of January 2010 through December 2016, Northeast's Written Supervisory Procedures ("WSP") required:
  • representatives to disclose any outside brokerage accounts held in their own name, as well as accounts over which they had a financial interest and/or discretionary authority; and
  • duplicate account statements and trade confirmations to be sent contemporaneously to the "designated principal." 
The AWC asserts that rather than indicating an individual's name for the "designated principal," the WSP apparently defined that person "as the Firm's entire Compliance Department." Moreover, the WSP apparently stated that "designated principals" (this time plural) were tasked with:
  • reviewing duplicate confirmations and account statements, 
  • verifying that outside firms were notified of associated persons' association with the Firm, 
  • reviewing internal account documentation and trade records for evidence of unacceptable trading practices and 
  • reviewing annual attestations to see if a representative disclosed use of an outside account. 
Compounding the lack of a clear assignment of the role of "designated principal," was the fact that Northeast's WSP allegedly failed to clearly specify the frequency with which accounts should be reviewed. Further, the firm allegedly did not provide guidance about the way reviews should be performed; for example, there was no guidance about the types of information to be identified or analyzed or how reviews should be documented. Finally, the AWC asserts that the WSP did not assign to any specific individual the responsibility for verifying that designated principals had even performed their required tasks. 

During the relevant 2010 - 2016 period, Northeast allegedly failed to request and obtain duplicate account statements for certain outside brokerage accounts that had, in fact, been disclosed by associated persons. In 2016, for example, Northeast failed to obtain account statements for 20 of 81 disclosed outside brokerage accounts. The AWC alleges that the firm's failures to obtain the statements prevented the firm from performing a reasonable review of internal account documentation and trade records for evidence of any unacceptable trading practices, including insider trading and front-running. Worse, the AWC asserts that Northeast failed to review certain duplicate account statements that it did obtain. 

2014 - 2015: Emails

The AWC asserts that from January 2014 through October 2015, Northeast's WSP did not provide any guidance or requirements about the quantity of emails that should be reviewed or contain any provisions to reasonably ensure that a sufficient number of emails were being reviewed. Although the WSP required that emails be subjected to a search using certain lexicon terms; and reviewers review an additional random sample of email, no provision was made to provide guidance as to how such reviews were to be undertaken or what subsequent steps should be taken to escalate emails for further review. Making matters worse, the WSP alleged lacked guidance as to the timeliness with which email review should be completed. By way of example, the AWC notes that during the first six months after January 2014,  Northeast reviewed only 1.68% of the emails that were responsive to lexicon search terms and random selection, which constituted only 0.54% of total messages that passed through the firm's servers. In addition, during 2014 to 2015 months at issue, the AWC alleges that on 19 emails out of 7 million were escalated for further review. 


FINRA deemed that in violation of NASD Rules 3010(a), (b) and (d), FINRA Rules 3110(a), (b) and (d), and FINRA Rule 2010. Northeast failed to: 
  • maintain reasonable WSP with respect to supervision of outside brokerage accounts and review of electronic communications: and
  • reasonably supervise its review of outside brokerage accounts and electronic communications.
In accordance with the terms of the AWC, FINRA imposed upon Northeast a Censure and $50,000 fine. Additionally, Northeast agreed to the following undertakings (impressive in their scope), which include a provision for restitution, if necessary: 

a. Written Supervisory Procedures Review and Certification. Northeast will certif.!. to FINRA within ninety (90) days from the date this AWC is accepted, in a writing signed by a registered principal, that it has adopted and implemented policies, procedures and systems that arc reasonably designed to address each of the areas of conduct identified in this AWC. 

b. Outside Brokerage Account Review, Report and Restitution. Northeast will certify to FINRA within one hundred and eighty (180) days from the date this AWC is accepted, in a writing certified by a registered principal, that it has completed a retrospective review of all available or reasonably obtainable records related to outside brokerage accounts disclosed during the Outside Accounts Period reasonably designed to detect potential violations of the federal securities laws and FINRA rules, including those prohibiting insider trading and front-running. If the review shows that any customers were harmed by any misconduct identified during this retrospective review, the Firm is ordered to pay restitution, including interest,' to each such customer. It' for any reason Northeast cannot locate any customer entitled to restitution after reasonable and documented efforts within one hundred and fifty (150) days from the date this AWC is accepted, Northeast shall forward any undistributed restitution and interest to the appropriate escheat, unclaimed property or abandoned property fund for the state in which the customer is last known to have resided. A registered principal of Northeast will submit satisfactory proof of payment of restitution or of reasonable and documented efforts to effect restitution. Such proof shall be submitted to Dana M. Roth, Senior Counsel, FINRA - Enforcement Department, 200 Liberty Street, One Brookfield Place, New York. New York 10281-1003 within 180 days from the date this AWC is accepted. The Firm also will comply with all reporting obligations required by FINRA Rule 4530, the Uniform Application for Securities Industry Registration or Transfer (Form U4), and the Uniform Termination Notice for Securities Industry Registration (Form U5), as a result of its findings out of the retrospective review. 

c. Risk-Based Email Review and Certification. Northeast will certify to FINRA within one hundred and eighty (180) days from the date this AWC is accepted, in a writing certified by a registered principal, that it has completed a risk-based retrospective review of emails sent or received by its associated personnel during  the Email Review Period reasonably designed to detect potential violations of the federal securities laws and FINRA rules, which may include the use of sampling. The Firm also will comply with all reporting obligations under FINRA Rule 4530, Form U4, and Form U5, as a result of its findings out of that review. 

Bill Singer's Comment

As to the content and context of this AWC, compliments to FINRA. A nice, tight presentation. Moreover, the regulator's concerns are valid. If you are going to create supervisory procedures then you need to ensure that there are clear assignments of responsibilities to specific individuals. Similarly, in the event that something does pop up on the compliance radar screen, you can't merely sit there and watch the blip -- you need to have procedures in place to ensure that your are following up. 

Notwithstanding the strength of FINRA's AWC, it's difficult not to wonder if FINRA staff sleep walked through several years of on-site examinations of Northeast. How did FINRA miss year after year after year the many WSP inadequacies cited in the AWC? Frankly, FINRA did Northeast no favors by failing to timely detect what seem to be glaring errors in the WSP. If some examiner had simply informed the firm, say eight years ago, that it needed to "name" a "designated principal," then the firm may well have said "Oops, my bad," and cleaned up the issue. Instead, it appears that there was negligence to go around for both the firm and FINRA.

Small FINRA Member Firm

Let's keep in perspective that Northeast employs all of 60 reps at 22 branches, which works out to about three folks per branch. As such, Northeast is not a FINRA member firm employing thousands of folks in hundreds of branches. Does a FINRA member firm's small size give it license to violate the industry's rules and regulations? Of course not. I merely offer the firm's size for context.  

Any warning?

The first issue that jumps out at me concerning the AWC is that the alleged outside brokerage account misconduct took place during nearly six years between January 2010 through December 2016. As such, did FINRA conduct an annual review (or any review) of this member in 2010, 2011, 2012, 2013, 2014, 2015 and 2016? If "yes," did FINRA bring the WSP deficiencies to Northeast's attention in any of those years -- or did the self-regulatory-organization fall asleep for some six years and when it finally awoke from its regulatory slumber decided to cover its own ass by loading up on Northeast pursuant to the 2018 AWC? 

FINRA's Statistics

Among the data displayed as of June 20, 2018, on FINRA's "Statistics" page  is that as of April 2018, FINRA oversaw 629,112 Registered Reps at 3,712 Member Firms and 156,418 Branch Offices. 

As of June 20, 2018, on FINRA's "About FINRA" page is the following:

More than 3,500 employees dedicated to market integrity and investor protection

Just doing the rough math, with about 3,712 member firms and some 3,500 FINRA employees, that's about -- almost -- one FINRA regulatory employee for each member firm. Keeping in mind that each and everyone of those employees is "dedicated to market integrity and investor protection," Given those statistice, I'm expecting that FINRA examines each of its member firms once a year. I mean, you know, given that the number of regulators to members is nearly 1:1, right?

WSP Out of Thin Air?

What gets lost in these FINRA Rule 3110 cases is that WSP are required to be in place before FINRA approves a firm for membership. Since 1990, little old FINRA member firm Northeast had a set of WSP; and during each and every examination over the ensuing 28 years, FINRA's dedicated employees should have asked the firm to produce its WSP and those dedicated regulators should have carefully read through the firm's WSP to ensure that the market retains its integrity and investors are protected. All of which raises an interesting question: At what point in time did Northeast's WSP become non-compliant with FINRA Rule 3110? 

Some tough questions

We know that Northeast's WSP was purportedly non-compliant as to outside brokerage accounts as early as January 2010 (which is the first date set forth in the AWC) but assuming that the firm didn't rewrite its procedures each year thereafter, exactly when did the outside account provisions become inadequate? Among the purposes of conducting examinations of member firms, is for FINRA to discover potential and actual violations, and to provide that information to the firms in order to prompt correction. Clearly, there has to be some remedial aspect to having exam staff visit a member firm beyond the somewhat dubious result of "Gotcha!" If nothing else, FINRA's expert and fresh eyes may detect inadvertent errors or misunderstanding and provide a warning to firms that are otherwise compliant. 

The AWC asserts that as early as January 2010, Northeast did not maintain reasonable WSP with respect to supervision of outside brokerage accounts and as early as January 2014 in terms of the firm's review of electronic communications. 

Wasn't the adequacy of Northeast's WSP on the exam checklist that FINRA's examiners used when they visited the member firm during those prior years? 

For how many years prior to 2015/2016 were Northeast's inadequate WSP extant but never detected by FINRA staff? 

During the years when the alleged lack of delegation of the "designated principal" references in the WSP were extant, did FINRA staff detect the omission and advise the firm to correct? 

Is FINRA asking us to believe that Northeast's WSP was compliant from 1990 through 2016 and that during that last year, the firm totally revised its WSP and, voila, all of the cited inadequacies spontaneously appeared?