FINRA released its annual regulatory and examination priorities letter for 2018, highlighting several points of emphasis for the regulator in the new year. Key in this list are sales practice concerns related to suitability; digital assets, such as cryptocurrencies and initial coin offerings; high-risk brokers and firms, such as those with a disciplinary history; continued recommendations of risky microcap or penny stocks; and use of margin.
Citing an increasing volume of complex products in the securities industry, FINRA plans to continue evaluating firms' suitability obligations. The priorities letter lists Unit Investment Trusts (UITs) and retirement plans and accounts as specific areas of concern within the suitability topic, with FINRA vowing to focus on the suitability of firms' and their registered representatives' recommendations of UITs and of securities within retirement accounts, including, but not limited to IRA rollovers and other securities transactions, including recommendations to switch from a brokerage account to an investment adviser account where that switch clearly disadvantages the customer.
With the Department of Labor's 2017 decision to delay enforcement of the fiduciary duty rule relative to retirement accounts, FINRA's announcement to focus on suitability takes on added meaning to ensure that investors' interests remain a priority.
Suitability violations can range from a representative's unsuitable over-concentration in risky securities, such as ex-Wells Fargo (Irvine, CA) brokers Charles Frieda and Charles Lynch's overconcentration of funds in speculative oil and gas securities, to a firm's systematic compliance failures, such as NEXT Financial's "habitual deficiencies" related to its failure to detect excessive trading, to unauthorized transactions not consistent with client investment objectives or risk tolerance preferences, such as former RBC Capital broker Lisa Lowi's purported unsuitable recommendations in high-risk securities despite her client's desire for income and principal protection.
Regulators are focusing attention on the emerging market of digital assets, such as cryptocurrency, due to its relative infancy and unproven supervisory, compliance, and operational infrastructure. FINRA has pledged to closely monitor digital asset developments, such as member firms' role in recommending and transacting cryptocurrencies and initial coin offerings. FINRA also will review how firms will supervise crypto securities.
The NASAA predicted cryptocurrency and cybersecurity trouble in its 2015 Investor Threats letter, including digital assets as a threat because of the difficulty in rules enforcement these cyber products pose to regulators, including issues of jurisdiction and actually being able to hold a virtual, "cloud-based" selling party accountable if a regulatory violation or fraudulent scheme were to cause harm to an investor.
High-Risk Brokers and Firms
Having acknowledged, in 2017, that high-risk and repeat-offender brokers and firms cause a disproportionate amount of financial damage, including securities fraud, FINRA once again will crack down on cockroach culture, such as the infamous case of Oppenheimer & Co.'s Mark Christopher Hutton, who had 12 disclosures in his BrokerCheck file prior to Oppenheimer hiring him. As one might surmise, after Oppenheimer hired Hutton, he engaged in fraudulent activity, including excessive trading, that the firm failed to detect, resulting in a $3.4 million order against Oppenheimer for failing to supervise its recidivist representative.
The 2018 letter additionally identifies unsophisticated and senior investors specifically as clients that are more susceptible to victimization from unscrupulous repeat-offender brokers and firms, and from those who engage in undisclosed outside business activities, violative loans, or other activities in which a broker or financial adviser sells away from the firm without authorization.
Microcap, Penny Stocks
FINRA identified four significant areas of fraud in its priorities letter: insider trading, microcap pump-and-dump schemes, issuer fraud, and Ponzi-type schemes. Of these four, only microcap pump-and-dump refers to a specific type of security, the penny stock, and a specific method of fraud in which the fraudster artificially inflates a stock's price before selling off en masse when the price reaches its deceptively high apex, leaving other investors to deal with the aftermath of a stock which has come crashing down. FINRA also included market manipulation as a separate topic in its priorities letter.
Often found on the OTC marketplace trading at values from as low as a mere fraction of one cent, shares of penny or microcap stocks are often sold in bulk, such as by the thousands or millions.
Due to the massive scale of penny stock trade volume, the potential for misconduct is large and there are no shortages of fraudulent pump-and-dump schemes to learn from. For instance, FINRA in 2016 barred Meyers Associates LP broker George Johnson for scheming to artificially inflate OTC penny stock IceWEB (OTCBB: IWEB), noting in its investigation of IWEB that Johnson had engaged in additional microcap fraud relative to the penny stock Snap Interactive, Inc. (OTCBB: STVI).
Don't let the "penny stock" name fool you, either. Former Wells Fargo (Las Vegas, NV) rep Donald Shelby Toomer purportedly engaged in a $30 million microcap pump-and-dump scheme in conspiring to manipulate the OTC Bulletin Board penny stocks Nutritional Holdings, Inc. (NXTH), Clear-Lite Holdings, Inc. (CLRH), and Mesa Energy Holdings, Inc. (MSEH).
Enforcement included the use of margin in its 2018 priorities letter because of the increased number of situations in which representatives have unsuitably solicited customers to engage in share purchases on margin—or otherwise employ margin in their accounts—without disclosing or otherwise making the customers aware of the risks associated with margin transactions. FINRA also found that some brokers entered into margin transactions without written authorization from their customers, and that others engaged in excessive margin trading within accounts that were authorized to trade on margin.
For example, FINRA fined and suspended Ameriprise Financial Services brokers Jack McBride and Stuart Pearl for unsuitable and financially harmful use of margin in client accounts. McBride allegedly executed purchases totaling $320,000 on behalf of one client, resulting in an insufficient balance to cover the purchase, causing a margin balance and charges of margin interest. When the customer complained, McBride purportedly attempted to settle the complaint away from the firm and provided his customer with exaggerated and misleading account balance information—overstating the account balances by as much as $370,000.
If you have invested with a broker, financial adviser, or firm who has recommended securities that were unsuitable given your investment objectives or risk tolerance level, or has engaged in illicit conduct including microcap fraud, market and stock price manipulation such as a pump-and-dump scheme, or who has engaged in margin or excessive trading without your knowledge or authorization, and this 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.