[In]Securities Guest Blog: When You Don't Know What It Is by Aegis Frumento Esq

July 23, 2020


When You Don't Know What It Is

On November 16, 1892, Edwin Johnson sold 1,000 barrels of cottonseed oil to Whitman & Co., fellow members of the New York Produce Exchange. A few weeks later, Whitman & Co. were denied delivery of their thousand barrels, because Johnson had in the interim sold it to someone else for a higher price. Shocked?! Really -- this is how profit-seeking businessmen behave, so get over it.

But because they couldn't get their oil, Whitman & Co. lost $8,000. As you can imagine, they were pissed. They filed charges against Johnson with the Exchange's complaint committee, and got him suspended for violating the Exchange's bylaws. Those by-laws, like the by-laws of most commercial exchanges at the time, forbade "proceedings inconsistent with just and equitable principles of trade."  

Johnson sued to get his seat back and lost. On appeal, the New York Court of Appeals ruled that the Produce Exchange could enforce sanctions under its bylaws for unjust conduct even when that conduct is perfectly legal. People ex rel. Johnson v. N.Y. Produce Exchange, 149 N.Y. 401 (1896)(Andrews, J.).  https://cite.case.law/ny/149/401/.  It was in fact Johnson's defense, and everyone agreed, that Johnson had done nothing illegal by simply breaching a sales contract. But screwing Whitman & Co. as he did was unjust and inequitable all the same. "It is manifest that a contract valid in form and enforceable by action [at law]," said the court, "may nevertheless have been induced by unfair dealing and that its performance may be evaded upon unjust or frivolous pretenses."  That was the first time that the phrase "inconsistent with just and equitable principles of trade" appeared in any court decision.

As a result of the Johnson case, that felicitous phrase soon caught on with the securities exchanges. By the time of the stock market crash of 1929, Article I of the New York Stock Exchange Constitution set forth as two of its governing principles "to maintain high standards of commercial honor and integrity among its members, and to promote and inculcate just and equitable principles of trade and business."

It was only natural, then, that when Congress got around to regulating the markets after the 1929 Crash, it would find use for those words. The Securities Exchange Act of 1934 required stock exchanges, and later the Maloney Act of 1938 required national associations (like the NASD, now FINRA), to have rules "designed . . . to promote just and equitable principles of trade."  Today, FINRA's Rule 2010 embodies that congressional mandate.  Rule 2010 says, in toto:

A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.

We can debate the extent to which FINRA Rule 2010 is honored more in the breach than in the observance.  It certainly appears to be a rule that is selectively enforced, often for the benefit of the large firms that are FINRA's moneyed constituency and against the interests of small firms and individual registered representatives. I've represented too many individual brokers charged with violating Rule 2010 (or one of its prior iterations) for conduct having the most tangential connection to their brokerage business. Indeed, practically any incident involving money, and many not even involving money, seems capable of giving rise to a Rule 2010 charge. The Rule, and the concepts it embodies, are so broad and ethereal that they can be applied to almost anything.

But where are the FINRA Rule 2010 charges against firms who act dishonorably, unjustly and inequitably towards their employees? I'm not aware of any. There are many ways in which firms can behave dishonorably, unjustly and inequitably against their employees, but I'm thinking particularly of the common practice of large firms to besmirch the reputations of their ex-brokers by marking up their CRD records as they show them the door. 

Last week, the BrokeAndBroker.com Blog reported the case of Bridgewater Associates manufacturing false charges of theft of confidential information against some of its former associates, and being hit with a substantial arbitration award as a result. See "Bridgewater Over Troubled FINRA Waters" (July 15, 2020) 
http://www.brokeandbroker.com/5328/bridgewater-finra-board/. Bridgewater is not a FINRA member firm, so that case does not directly implicate FINRA Rule 2010. But it behaved no differently than many a large broker-dealer would.

The way it often goes down in a FINRA firm is something like this. An individual registered rep leaves the firm intent on competing with the firm. The firm finds some reason to launch an investigation of the broker's conduct while an employee. Let's face it, the rules are so many and so arcane that it is difficult not to trip over one or another somewhere along the way. And we're not talking only about federal regulations and FINRA rules. There are also the firm's internal rules and policies and procedures. It would not be hard to find something to investigate.

Then the firm reports on the individual's Form U-5 that he or she is subject to an "internal review" of suspected securities law violations. This often happens even when the individual broker has voluntarily resigned. This "internal review" can continue for a long time. At the end, even if nothing comes of it, the suspicion of wrongdoing lingers on the individual brokers CRD record for years, indeed forever. Or, the "internal review" concludes that the broker violated some obscure term of employment, but the firm magnanimously terminates the "internal review" without taking action. Or the "internal review" finds some substantial misfeasance (like Bridgewater asserted) that is nevertheless unprosecuted. In call cases, the broker's CRD record remains marred unless and until the broker spends the time, energy and money for an expungement proceeding. 

A firm needs the barest excuse to start down this road. And regardless how much bad faith there may have been in commencing such an "internal review," it is never a FINRA Rule 2010 violation. Indeed, FINRA is itself complicit in many of these dishonorable and inequitable maneuvers. On the one hand, FINRA requires that reports be accurate. But on the other hand, FINRA instructs firms to be expansive in interpreting what needs to be reported on the Form U5. For example, the most critical questions ask about improper "investment-related" activities. FINRA instructs firms to "err on the side of interpreting the term 'investment-related' in an expansive manner." As a result -- and FINRA's Regulatory Notice 10-39 actually says this -- "a firm may be required to provide an affirmative answer to a question even if the matter is not securities related." 

So, questions concerning investment-related conduct may require answers about conduct that is not investment-related. Something's happening, but who knows what it is.

In Johnson's day, "just and equitable principles of trade" only meant that exchange members shouldn't cheat each other. Later, the federal securities laws required exchange members not to cheat their customers either. But firms can still act dishonorably, unjustly and inequitably against their own employees with impunity. FINRA Rule 2010 should protect them too.


Aegis J. Frumento

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.

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