In its annual Regulatory and Examination Priorities Letter for 2017, FINRA revealed several observations from the past year regarding areas of weakness and recommendations on how to strengthen or update these programs in order to achieve compliance, risk mitigation, and, ultimately, better serve and protect investors.
Heading into 2017, FINRA identified firms' hiring of high-risk and recidivist brokers, sales practices, and the operational risk of cybersecurity as among the areas needing the most attention due to the risk violations in these areas pose.
Hiring of High-Risk and Recidivist Brokers
Informally known as cockroach culture, a recidivist broker is simply a registered representative who, having racked up one or more disclosures in their FINRA file—possibly including termination or discharge from a previous employer—is hired by another FINRA member firm.
A March 2016 industry-wide study found that seven percent of all financial advisers have a disciplinary disclosure in their BrokerCheck file (available to the public at brokercheck.finra.org). This study additionally tracked recidivist brokers by the firms who employed advisers with a history of misconduct, finding that in the case of worst offender Oppenheimer & Co., nearly 20% of employed advisers had some history of misconduct.
For instance, FINRA in November ordered Oppenheimer to pay $3.4 million in fines and restitution for failing to supervise representative Mark Christopher Hotton, who himself had previously been named a defendant in a civil action alleging, amongst other things, fraud. Even with discipline clearly listed in his file, according to FINRA, Oppenheimer failed to detect several red flags and hired Hotton, who proceeded to engage in excessive trading, fraudulent conduct, and other suspicious activities while associated with Oppenheimer.
FINRA's report stated that Hotton had 12 disclosures in his file, including criminal charges, prior to his hiring at Oppenheimer.
FINRA's commitment to protecting senior/elderly investors from fraud, abuse, and improper advice is a point of emphasis nearly every year, likely because the abuse tends to take on newer and more modern forms of nefariousness.
This year, FINRA is looking more closely at microcap or penny stock fraud. For example, FINRA barred former Wells Fargo (Las Vegas) advisor Donald Shelby Toomer in October in connection with an indictment related to an alleged $30 million pump-and-dump penny stock fraud. Both FINRA and the SEC investigated claims that Toomer received significant financial kickbacks in exchange for unsuitably recommending certain penny stocks to customers (the pump), only to sell large quantities of the selected microcap stocks when prices were artificially inflated (the dump), leaving his customers on the hook for massive losses.
To combat suitability concerns, FINRA will use the "reasonable basis" and "customer-specific suitability" standards of review: succinctly, brokers should only recommend stocks/securities to customers when those specific investments are (1) reasonable, and (2) suitable for the individual customer, in light of his/her investment objectives, risk tolerances, and financial goals.
For instance, many investors, including retirees and other elderly individuals, lost money in oil and gas investments earlier in 2016 when crude oil dropped below $50 a barrel. At the time, one report found that some brokers failed to adequately disclose risks related to proprietary energy, recommended overconcentration in poorly-performing stocks, and violated additional industry and firm policies in regard to these sales practices.
Accordingly, excessive concentration in certain stocks or areas, excessive trading activity (including short-term trading of products designed to be held long-term, or short-trading in accounts of customers whose objectives are for long-term holding), outside business activities that could pose a conflict of interest, and similar red flags will make their way to FINRA's radar in 2017.
In the electronic realm, FINRA will recommit resources toward the enforcement of required electronic communications retention (e.g., requirement that electronic correspondence, such as e-mails from the firm to a customer, must be retained), and similarly hold firms accountable for supervision in such a way that the firm can review the records for inappropriate business conduct.
For instance, Davood Kohan allegedly settled a customer complaint away from and without notifying employer First Allied Securities of San Francisco, which only came to light when the customer and Kohan disagreed about payments he purportedly owed to the customer.
Cybersecurity deficiencies plagued many firms in 2016, in one case manifesting in a whopping $14.4 million fine for data protection failures when 12 firms failed to maintain electronic records in an industry standard format (called WORM) designed to prevent alteration or destruction of important electronic records. One of those firms—LPL Financial—had previously, in 2015, been fined $10 million and ordered to pay $1.6 million in restitution for multiple supervisory failures related to books and record keeping deficiencies.
In other words, not only is FINRA concerned about firms' ability to protect sensitive data, such as passwords, assets, data, and personal information from outside attacks, the regulator is also concerned with preserving internal and external communications, while holding brokers accountable for evidence of misconduct—and making sure electronic records are safe from inappropriate manipulation or deletion from the inside.
If you have invested with a firm whose lack of due diligence related to a recidivist or high-risk broker, or with a representative whose improper sales practices—such as unsuitable recommendations, undisclosed conflicts of interest such as outside business activities, or excessive trading/concentration—failure to maintain adequate books and records, or other misconduct has proven harmful to your investments or interests please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.