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FINRA Reminds Broker-Dealers and Investment Advisers to Comply with the SEC’s “Best Interest” Requirementsby Andrew Whiteman

FINRA Reminds Broker-Dealers and Investment Advisers to Comply with the SEC’s “Best Interest” Requirements

On June 5, 2019, the United States Securities and Exchange Commission issued Release No. 34-86031, titled Regulation Best Interest: The Broker-Dealer Standard of Conduct (“Regulation BI”), which provides for a best interest standard applicable to broker-dealers. The same day, the SEC issued Release No. IA-5248, titled Commission Interpretation Regarding Standard of Conduct for Investment Advisers (herein, “SEC Interpretation”). Both documents take effect on June 30, 2020, to allow sufficient time for financial professionals to implement the new requirements.

Differences between Broker-Dealers and Investment Advisers

There are important distinctions between brokerage firms and investment advisers. They are subject to different laws, regulated separately by different entities, and the duties they owe to their customers are distinct. Unfortunately, most investors are confused about the differences between broker-dealers and registered investment advisers.

Brokerage firms, known formally as broker-dealers, must register with the SEC but their primary regulator is the Financial Industry Regulatory Authority, known as “FINRA,” which acts under authority delegated by the SEC. All broker-dealers are regulated by FINRA regardless of the size of the firm, although the states have concurrent jurisdiction in certain areas.

Registered Investment Advisers (“RIAs”)are subject to the Investment Advisers Act of 1940. The SEC regulates investment advisers who manage $110 million or more in client assets. Advisers with less than $100 million in assets under management must register with the state in which they have their principal place of business. Those advisory firms that have greater than $100 million but less than $110 million in assets under management may elect to register with SEC. Those that do not will continue to be regulated by the states.

Historically, broker-dealers and investment advisers performed different functions in the marketplace. A broker-dealer is a company that is in the business of buying and selling securities on behalf of its customers or for its own account. The sales personnel who work for broker-dealers are known as brokers or, more formally, “registered representatives.” Traditionally, broker-dealers and registered representatives were compensated by commissions charged on each transaction and had no duty to the customer (for example, to monitor the performance of a security) after the sale was completed.

RIAs, on the other hand, are paid for providing securities advice to their customers. The services offered often include advice concerning a customer’s investment holdings, recommendations concerning securities purchases and sales, and follow-up monitoring of customer holdings. Financial professionals who are employed by investment advisers are often called investment advisers, but the formal designation is “investment adviser representatives” or “IARs.” RIAs and IARs are typically compensated based on a fixed fee that is equal to a percentage of the customers’ holdings.

The legal standards applicable to broker-dealers and RIAs are distinctly different. In keeping with the broker-dealer’s traditional sales function, the primary duty owed to the customers of a broker-dealer is transaction-based – a recommended transaction must be “suitable” for the customer. On the other hand, the RIA is held to a fiduciary standard in keeping with its duties to provide ongoing advice and monitoring.

Market forces have blurred the distinction between broker-dealers and RIAs. Most broker-dealers are dual-registered and offer a fixed fee arrangement as an option to commissions. Most brokerage firms offer financial planning services that are indistinguishable from the core service offered by RIAs. Although broker-dealers are not legally obligated to monitor customers’ holdings, most tell their customers that will do so. It is no wonder then that investors are confused about the differences between the two.

Following the financial crisis that began in September 2008, Congress sought to reform the standards applicable to broker-dealers to reflect the expanded nature of their business model. In July 2010, President Obama signed the Dodd-Frank financial reform law, which gave the SEC the authority to develop a uniform fiduciary standard for retail investment advice that was no less stringent than the standard applicable to investment advisers under the Investment Advisors Act of 1940. In January 2011, the SEC staff issued a report that recommended the SEC propose a uniform fiduciary rule. and on April 14, 2016, the Department of Labor issued its final version of the fiduciary rule. Full compliance with the new fiduciary standard was to occur by January 1, 2018. However, in August 2017, the Labor Department proposed that compliance with the fiduciary rule be delayed for 18 months, until July 1, 2019. By that time, President Trump had been elected. The new administration stated its opposition to imposing a fiduciary standard on broker-dealers, and Department of Labor’s rule was shelved.

Instead of adopting extending the fiduciary standard to broker-dealers, the SEC adopted Regulation Best Interest on June 5, 2018.

Regulation Best Interest is Applicable to Broker-Dealers

The stated purpose of Regulation BI is to establish a standard of conduct for broker-dealers and their associated persons when they make recommendations to retail customers for any securities transaction or investment strategy involving securities. According to the SEC’s 771-page release, the Regulation BI enhances the broker-dealer standard of conduct by requiring broker-dealers “to act in the best interest of the retail customer at the time the recommendation is made,” to refrain from “placing the financial interest of the broker-dealer ahead of the interests of the retail customer,” to “address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest,” and, in certain instances, to mitigate or eliminate conflicts.

The SEC’s Interpretation of Investment Advisers’ Fiduciary Duties to Customers

The SEC Interpretation is not a rule, like Regulation Best Interest. Rather, the SEC Interpretation provides the SEC’s views on the nature and extent of fiduciary duty owed by Investment Advisers under the Investment Advisers Act of 1940 (“Advisers Act” or “Act”). The Advisers Act itself does state that investment advisers are fiduciaries to their customers. Rather, courts have found that section 206 of the Act (29 U.S.C. § 80b-6) establishes federal fiduciary standards to govern the conduct of investment advisers. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (“Courts have imposed on a fiduciary an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ his clients.”).

FINRA’s Regulatory Notice 19-26

Regulatory Notice 19-26 sets forth the requirements for broker-dealers and investment advisers to comply with the new laws by June 30, 2020.

© Andrew Whiteman 2019
*****
The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Click here for more information about our securities litigation and arbitration practice. Please contact us for more information.

The FINRA Arbitration Proceessby Andrew Whiteman

The FINRA Arbitration Process

Almost all disputes involving securities brokers and their customers are resolved by arbitration under a process administered by the Financial Industry Regulatory Authority (“FINRA”).  FINRA was created on July 30, 2007, through the merger of the National Association of Securities Dealers, Inc. and the New York Stock Exchange. FINRA is the largest non-governmental regulator of securities firms doing business in the United States. It oversees nearly 5,100 brokerage firms and more than 676,000 registered securities representatives. FINRA operates under a charter granted by the Securities and Exchange Commission to regulate the activities of its broker-dealer members and the members’ registered representatives.

When a customer opens a brokerage account with a broker-dealer, the customer is usually required to sign new account papers that call for arbitration under the rules of FINRA Dispute Resolution, an arm of FINRA. FINRA Dispute Resolution operates an arbitration program for the resolution of disputes related to the activities of its members. As a result, virtually all disputes between customers and brokerage firms will be decided by a panel of arbitrators appointed by FINRA Dispute Resolution.

FINRA arbitration may be likened to a private court system. The case is initiated by the customer’s attorney filing a complaint on behalf of the customer. Sixty days after the complaint is served, the respondents will be required to serve an answer. After the answer is filed, FINRA distributes lists of potential arbitrators. The parties are asked to reject arbitrators they do not want and rank those remaining. FINRA then selects three arbitrators from the lists returned by the parties. Typically, one of the three arbitrators will have a background in the securities business. The other two arbitrators are typically professionals (often attorneys) or businesspersons.

After arbitrators are selected, the panel will confer with the attorneys via telephone for the purpose of ironing out any discovery disputes and establishing a hearing schedule.  The customer can expect that the hearing will take place approximately six to nine months after the telephone conference.

After the initial pre-hearing conference, the parties engage in a process called “discovery” by which information and documents are exchanged. Discovery in FINRA cases is much more limited than what is allowed in court litigation. Extensive interrogatories and depositions are generally not allowed.

The customer has the right under FINRA arbitration rules to have the hearing take place where the customer resided at the time the transactions in question took place. The hearing of the dispute is typically held in an informal setting such as a hotel conference room. Each side presents evidence by witnesses and documents, with the claimant having the right to go first. Hearings typically continue for three to four days. The parties are generally notified of the decision within 15 to 30 days after the hearing concludes.

The customer, in addition to paying legal fees, is responsible for expenses charged by FINRA for administering the case. FINRA charges a filing fee of up to $2,250 depending on the amount that is being claimed. Up to $1,500 of the filing fee will be refunded if the case is settled before ten days prior to the first scheduled arbitration hearing date. FINRA also assesses hearing session fees for each half-day hearing session. Like the filing fee, the hearing session fee is assessed on a sliding scale based on the amount in dispute. The maximum half-day hearing session fee is $1,500. The arbitrators have the discretion to allocate the hearing session fees between the parties. Oftentimes, the arbitrators split the hearing session fees equally between the parties.

After the close of the hearing, the arbitration panel deliberates and decides whether the claimant is entitled to relief. Majority rules, a unanimous decision is not required.

FINRA does not have an appeals process by which a party may challenge the arbitrators’ decision. A party may challenge the arbitration award in court, but the grounds on which a court may overturn an arbitration award are quite limited. Under federal and state laws, a court may vacate an arbitration award if (1) the award was procured by corruption, fraud, or undue means; (2) there was evident partiality or corruption by the arbitrators; (3) the arbitrators were guilty of misconduct in refusing to postpone the hearing, or in refusing to hear relevant evidence, or of any other misbehavior by which the rights of any party was prejudiced; (4) the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award on the subject matter submitted was not made; (5) the arbitrators disregarded a clearly defined law or legal principle that they were aware applied to the matter before them; or (5) there is no factual or reasonable basis for the award. Most arbitration awards are upheld by the courts.

Absent a challenge to the award, an industry party must pay arbitration awards within 30 days or risk suspension of his or its FINRA licenses.

While securities arbitration is a more streamlined process than litigation in court, the rules at play are complex. Investors need representation by attorneys who are experienced in FINRA rules and arbitration practice.

© Andrew Whiteman 2019

*****

Whiteman Law Firm has handled hundreds of securities matters over the past 40 years. Click here for more information about our securities litigation and arbitration practice. Please contact us for more information.

The SEC Interprets Investment Advisers’ Fiduciary Duty to Customersby Andrew Whiteman

The SEC Interprets Investment Advisers’ Fiduciary Duty to Customers

On June 5, 2019, the United States Securities and Exchange Commission issued Release No. IA-5248, titled Commission Interpretation Regarding Standard of Conduct for Investment Advisers (herein, “SEC Interpretation”).[1]  The same day, the SEC issued Release No. 34-86031, titled Regulation Best Interest: The Broker-Dealer Standard of Conduct (herein, “Regulation BI”). The SEC Interpretation applies to investment advisers registered under the Investment Advisers Act of 1940 (“Advisers Act”). Regulation BI applies to broker-dealers registered under the rules of the Financial Industry Regulatory Authority (“FINRA”). The SEC Interpretation and Regulation BI provide similar “best interest” standards to govern dealings between financial professionals and their customers. To allow sufficient time for financial professionals to implement the new requirements, the new rules become effective on June 30, 2020. This blog discusses the SEC Interpretation. A prior blog covered Regulation BI.

The SEC Interpretation is not a rule, like Regulation BI. As such, the SEC Interpretation merely provides the SEC’s views on the nature and extent of the fiduciary duty owed by investment Advisers under the Advisers Act. The Advisers Act itself does state that investment advisers are fiduciaries to their customers. Courts have held that section 206 of the Act (29 U.S.C. § 80b-6) establishes federal fiduciary standards to govern the conduct of investment advisers. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (“Courts have imposed on a fiduciary an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ his clients.”).

The fiduciary duty owed by investment advisers encompasses both a duty of care and a duty of loyalty. In Capital Gains, the U.S. Supreme Court wrote that section 206 of the Advisers Act reflects a Congressional recognition “of the delicate fiduciary nature of an investment advisory relationship” as well as a Congressional intent to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.” 375 U.S. at 191-92.

Best Interest = Duty of Care and Duty of Loyalty

The SEC used the term “best interest” to encompass both the duty of care and the duty of loyalty. SEC Interpretation, p. 8. The duty of care requires the investment adviser to provide advice in the best interest of its client, based on the client’s financial situation and goals. Id. Importantly, the SEC does not require that an adviser avoid all conflicts of interest in its dealings with its clients. Instead, the SEC Interpretation states that an adviser satisfies its duty of loyalty if it “makes full and fair disclosure of all conflicts of interest which might incline an investment advisor – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict.” Id.

Duty of Care

According to the SEC, the duty of care is primarily satisfied by providing investment recommendations that are “suitable” for the client. Interpretation. p. 12. “Suitability” is a concept borrowed from the regulation of broker-dealers by FINRA. See FINRA Rule 2111. Investment adviser recommendations must be “suitable” for the customer in light of information disclosed by the customer concerning the customer’s investment profile, ie. the client’s financial situation, level of financial sophistication, investment experience, and financial goals. Interpretation, p. 9.

Duty of Loyalty

The SEC Interpretation states that the duty of loyalty requires that “an advisor not subordinate its clients’ interests to its own” and “not place its own interest ahead of its client’s interests.” However, this duty of loyalty is met, not by requiring that the adviser “put its client’s interests first,” which was the language of the 2018 Proposed Interpretation, but by making “full and fair disclosure to its clients of all material facts relating to the advisory relationship.”

Disclosure

The SEC Interpretation gives several examples of matters that require full and fair disclosure. Dual-registered broker-dealers and investment advisors must disclose “the circumstances in which they intend to act in their brokerage capacity and the circumstances in which they intend to act in their advisory capacity.” Disclosure of the capacity in which the adviser is acting may be made at the commencement of the relationship. A dual registrant acting in its advisory capacity should disclose any circumstances in which its advice will be limited to a menu of certain products offered through an affiliated broker-dealer or an affiliated investment adviser. SEC Interpretation, p. 22. In addition, an adviser must eliminate or “expose through full and fair disclosure all conflicts of interest which might incline the investment adviser – consciously or unconsciously – to render advice which was not disinterested.” While such disclosure and the client’s informed consent prevent the presence of the conflicts from violating the adviser’s fiduciary duty, such disclosure and consent do not themselves satisfy the adviser’s duty to act in the client’s best interest. SEC Interpretation, p. 23. The SEC sees the advisers’ delivery to their clients of the “brochure,” under Part 2A of Form ADV, as the primary means for advisers to satisfy their duty of disclosure.

Best Interest? What’s That?

Strangely, given the importance of the term “best interest,” nowhere in the Interpretation does the SEC define. it. All the SEC Interpretation tells us is that “an investment advisor’s obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty.” SEC Interpretation, p. 23, at n.58. The SEC’s failure to be more definite about when “best interest” is and is not satisfied is unfortunate and unhelpful.

To say that full and fair disclosure of material facts and conflicts of interest satisfies the adviser’s fiduciary duty but not necessarily the duty to act in the customer’s best interest begs the question – what exactly is the adviser’s duty to its clients? The SEC’s formulation resembles a dog that chases its tail but never catches it. An adviser’s fiduciary duty, we are told, consists of a duty of care and a duty of loyalty. Care and loyalty require the adviser to “act in the ‘best interest’ of the client at all times.” SEC Interpretation, p. 8. To meet its duties, the adviser’s recommendation must be “suitable.” While never mentioning the FINRA suitability standard applicable to broker-dealers under FINRA Rule 2111, the SEC Interpretation for the first time adopts it as the standard applicable to investment advisers. SEC Interpretation, pp. 12-18.

The duty of loyalty requires that an adviser may not place its own interest ahead of those of its client. Disclosures made in a “brochure” provided at the outset of the adviser-client relationship may satisfy the adviser’s fiduciary duty, but disclosure and consent “do not themselves satisfy the adviser’s duty to act in the client’s best interest.”

Criticism

The SEC Interpretation has been widely criticized on many grounds. For one thing, the Proposed Interpretation stated explicitly that “the duty of loyalty requires an investment adviser to put its client’s interests first.” Proposed Interpretation, p. 15. The version adopted by the Commission replaced that sentence with the statement that the duty of loyalty “requires that an adviser not subordinate its clients’ interests to its own,” which the SEC explained means that an advisor cannot favor its own interests over those of a client. SEC Interpretation, p. 21. In an accompanying footnote, the SEC stated that it had made a mistake by referring to “placing clients’ interests first” in the Proposed Interpretation. According to the SEC, it had previously adopted the formulation that the best interest duty “includes the obligation not to subrogate clients’ interests to its own.” The SEC conceded that advisers commonly used “a plain English formulation” – putting the client’s interests first – as a means of explaining their duty of loyalty in a way “that may be more understandable to retail clients,” but argued that this was not the legal standard. SEC Interpretation, pp. 21-22, at n.54.

The failure to require advisers to place their clients’ interests first is the main point stressed by Commissioner Robert L. Jackson, the lone dissenter to both the SEC Interpretation and Regulation Best Interest. In a statement released on the day the Commission voted, Commissioner Jackson pointed to empirical evidence. According to Commissioner Jackson, the vast majority of firms that describe their fiduciary duty to their clients tell the public that they place their clients’ interests first. The Commission’s Interpretation retreats from that standard. In Commissioner Jackson’s words, “the Commission is wrapping a policy choice in legalese” and the Commission’s refusal to require advisers to place client interests first is contrary to the prevailing standard of care.

[1] On April 18, 2018, the Commission published for comment a proposed interpretation regarding the standard of conduct for investment advisers. See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. 4889 (Apr. 18, 2018) (“Proposed Interpretation). The SEC Interpretation was adopted after the SEC considered comments made in response to the Proposed Interpretation.

© Andrew Whiteman 2019

*****

The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Click here for more information about our securities litigation and arbitration practice. Please contact us for more information.

The SEC Adopts Regulation Best Interestby Andrew Whiteman

The SEC Adopts Regulation Best Interest

On June 5, 2019, the United States Securities and Exchange Commission issued Release No. 34-86031, titled Regulation Best Interest: The Broker-Dealer Standard of Conduct. This much-anticipated rule takes effect on June 30, 2020.

The stated purpose of Regulation BI is to establish a standard of conduct for broker-dealers and their associated persons when they make recommendations to retail customers for any securities transaction or investment strategy involving securities. According to the SEC’s 771-page release, the Regulation BI enhances the broker-dealer standard of conduct by requiring broker-dealers “to act in the best interest of the retail customer at the time the recommendation is made,” to refrain from “placing the financial interest of the broker-dealer ahead of the interests of the retail customer,” to “address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest,” and, in certain instances, to mitigate or eliminate conflicts.

The actual regulation takes up less than six pages, while the remainder of the 771 pages consists of the SEC’s attempt to explain why this new regulation, rather than the much broader fiduciary rule that it replaces, is in the best interest of retail investors. In fact, Regulation BI is in many ways a step backward. The new was universally opposed by investor advocates, including the Public Investors Arbitration Bar Association, and falls far short of the protections investors deserve. The rule purports to require that brokers adhere to a “best interest” standard but does not actually require that they act in their customers’ best interests. The standard does not prevent brokers from placing their own interests first. It provides that brokers are not required to monitor customer accounts unless they agree “to provide the retail customer with specified account monitoring services.” Regulation BI permits broker-dealers to place their interests ahead of customers if they disclose the conflict.

The history of efforts to reform the standards applicable to broker-dealers has its origin in financial crisis that began in September 2008. In July 2010, President Obama signed the Dodd-Frank financial reform law, which gave the SEC the authority to develop a uniform fiduciary standard for retail investment advice that was no less stringent than the standard applicable to investment advisers under the Investment Advisers Act of 1940. The same year, the United States Department of Labor released a rule designed to limit conflicts of interest for financial advisers who worked with customer retirement accounts. In January 2011, the SEC staff issued a report that recommended the SEC propose a uniform fiduciary rule. On April 14, 2016, the Department of Labor issued its final version of the fiduciary rule. Full compliance with the rule was to occur by January 1, 2018. In August 2017, the Labor Department proposed that compliance with the fiduciary rule be delayed for 18 months, until July 1, 2019. By that time, President Trump had been elected. The new administration stated its opposition to imposing a fiduciary standard on broker-dealers, and Department of Labor’s rule was shelved. Regulation BI is its replacement.

The SEC commissioners adopted Regulation BI by a vote of three to one, with Commissioner Robert L. Jackson, Jr. casting the sole dissenting vote. Commissioner Jackson issued a statement in which he wrote “today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.” The Dodd-Frank law gave the SEC full authority to adopt a strong, pro-investor fiduciary standard that covered broker-dealers. Unfortunately, the SEC failed to do so.

© Andrew Whiteman 2019

*****

The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Click here for more information about our securities litigation and arbitration practice. Please contact us for more information.

 

 

Andrew Whiteman Assists Securities Law Clinics with Amicus Brief Filingby Andrew Whiteman

Andrew Whiteman Assists Securities Law Clinics with Amicus Brief Filing

On April 19, 2019, Andrew Whiteman filed an amicus curiae brief in the United States Court of Appeals for the Fourth Circuit on behalf of three law school law clinics: University of Miami School of Law Investor Rights Clinic, Elizabeth Haub School of Law at Pace University Investor Rights Clinic, and St. Johns University School of Law Securities Arbitration Clinic (the “Clinics”).

An amicus curiae brief, also known as a “friend of the court brief,” is filed in an appellate court by a non-party to the dispute who has an interest in the outcome of the court’s disposition. The Clinics filed their brief in support of the appeal by the plaintiff-appellants, Rohit Saroop, Preya Saroop, and George Sofis (“Plaintiffs”). The Plaintiffs won their FINRA arbitration case. However, the arbitration decision was vacated by a judge of the United States District Court for the Eastern District of Virginia. The Plaintiffs then appealed the case to the Fourth Circuit Court of Appeals.

The case involves the following facts. In January 2017, an arbitration panel appointed by the Financial Industry Regulatory Authority (“FINRA”) rendered an arbitration award in favor of Plaintiffs against the defendant, Interactive Brokers LLC (“Interactive”). Interactive filed a motion in the District Court to vacate the arbitration award. The Plaintiffs moved to confirm it. The District Judge remanded the arbitration decision back to the panel of arbitrators for clarification of the basis for their award in favor of the Plaintiffs. After the remand, the panel issued a slightly modified version of their initial award in January 2018, again in favor of the Plaintiffs.

Upon review of the modified award, the District Court granted Interactive’s motion to vacate the award and remanded the arbitration case to a new panel of FINRA arbitrators for reconsideration of Interactive’s counterclaims against the Plaintiffs. The District Judge decided to vacate the award after finding that arbitrators based their award against Interactive solely on the ground that Interactive violated a FINRA conduct rule, Rule 4210. The Court ruled that the arbitrators’ decision constituted “manifest disregard of the law” because the law is clear that there is no private right of action to enforce FINRA conduct rules, the panel knew of and understood the law on this point, they found the law to be applicable to the case, and they ignored it.

The Clinics’ amicus brief makes several points. FINRA’s arbitration rules do not require the claimant to specify any cause of action or legal theory in a statement of claim. FINRA arbitration rules do not require the arbitrators to specify any cause of action or legal theory in an award. Under established legal precedent, the arbitrators did not manifestly disregard the law, and the District Court erred in its finding concerning the arbitrators’ rationale for the award.

This is an important case for several reasons. First and foremost, the judicial power to review of arbitration decisions is extremely limited. Judicial review of arbitration decisions has been described as “severely circumscribed” and “among the narrowest known at law.” Apex Plumbing Supply, Inc. v. U.S. Supply Co., 152 F.3d 188, 193 (4th Cir. 1998). The Fourth Circuit has stated that “a court sits to determine only whether the arbitrator did his job – not whether he did it well, correct, or reasonably, but simply whether he did it.” Wachovia Securities, LLC v. Brand, 671 F.3d 472, 478 (4th Cir. 2012). In this case, the District Court’s finding that the arbitrators’ decision was based solely on a violation of a FINRA rule is highly questionable. The Court’s analysis of the “manifest disregard” standard seems deeply flawed. It rests in part on the premise that the case law is clear that an arbitration award cannot be based on a violation of a FINRA rule. The Court cited numerous cases that have held that a FINRA Rule may constitute evidence of the broker-dealer’s duty of care to his customer, but held that those cases were inapplicable because “it was apparent on the face of the arbitrator’s decision that a violation of FINRA Rule 4210” was the sole basis for liability. Finally, the Court’s ruling that the arbitrators knew the law, understood it, knew the law was controlling, and disregarded it is based on what was in Interactive’s arbitration brief. This finding is problematical because the Plaintiffs’ submission to the panel contested Interactive’s argument and cited contrary authority.

This case provides the Fourth Circuit to provide additional guidance on the scope of judicial review of arbitration decisions.

A copy of the District Court’s opinion is here.

A copy of the Clinics’ amicus brief is here.

It is expected that the Fourth Circuit will rule on the case within six to nine months.

© Andrew Whiteman 2019

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The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Please contact us for more information.

 

FINRA Requires Brokerage Firms to Communicate with Customers when a Broker Leaves the Firmby Andrew Whiteman

Ask questions if your broker leaves his firm.

According to new regulatory guidance from the Financial Industry Regulatory Authority, known as FINRA, member firms are required to do the following:

  1. In the event of a registered representative’s departure, the member firm should promptly and clearly communicate to affected customers how their accounts will continue to be serviced; and
  2. The firm should provide customers with timely and complete answers when the customer asks questions about a departing registered representative

The new requirements are spelled in Notice to Members 19-10, which was issued on April 5, 2019. The purpose of the new guidance is to ensure that customers can make a timely and informed choice about where to maintain their assets when their registered representative leaves a firm. Customers should not experience any interruption in service as a result of a representative’s departure. Member firms should have policies and procedures in place to assure that customers serviced by a departing registered representative will continue to be serviced, including how and to whom the customer may direct questions and trade instructions and the identity of the representative to whom the customer will be assigned at the member firm.

NTM 19-10 also states that the member firm should “communicate clearly, without obfuscation, when asked questions” by customers about the departing registered representative. Provided the departed representative has consented to disclosure of his or her contact information to customers, the firm must provide the departed representative’s contact information, such as phone number, e-mail address, or mailing address. All information provided by the member firm about the departing representative must be “fair, balanced and not misleading.”

Thus, under NTM 19-10, a member firm (1) must immediately notify customers that their representative has departed and assign a new representative to the customers, (2) may not attempt to hinder or delay customers’ efforts to contact their former registered representative by refusing to provide his contact information when authorized to disclose it, and (3) must provide fair, balanced, and not misleading answers to all customer questions resulting from the representative’s departure.

Senators Warner and Kennedy Introduce Bill to Expand SEC Powers to Assist Investorsby Andrew Whiteman

On March 14, 2019, Senators Mark Warner (D-Va.) and John Kennedy (R-La.), both members of the Senate Banking Committee, introduced the Securities Fraud Enforcement and Investor Compensation Act. This legislation would give the Securities and Exchange Commission power to seek restitution for retail investors harmed by securities fraud scams.

In many cases, fraudulent investment schemes are not detected for many years. For example, Bernie Madoff was able to defraud investors for decades before his investment fund was revealed to be a Ponzi scheme in 2009. A ruling by the United States Supreme Court in Kokesh v. Securities and Exchange Commission ruled that the SEC must bring disgorgement claims within five years from when the claim accrued. The SEC reported in its 2018 enforcement report that the Court’s ruling could cause the SEC to forgo up to $900 million in disgorgement claims.

The bill addresses this problem by granting the SEC the power to seek a new remedy – restitution – for a period of up to ten years.

A summary of the legislation may be found here.

© Andrew Whiteman 2019

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The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Please contact us for more information.

 

 

 

 

SEC Announces Results of Share Class Selection Disclosure Initiativeby Andrew Whiteman

On March 11, 2019, the Securities and Exchange Commission announced that it had settled charges with 79 investment advisers who agreed to return more than $125 million to their clients, with a substantial majority of the funds going to retail investors. The SEC entered into the settlements after the  advisers self-reported violations of the Investment Advisers Act under the SEC’s Share Class Selection Disclosure Initiative (“SCSDI”).

In recent years, the SEC has increased its enforcement activities in the area of mutual fund share selection. Beginning in 2016, the SEC has brought numerous enforcement actions against advisers who received undisclosed payments of 12b-1 fees as a result of recommending the purchase of higher-cost mutual fund shares to their clients. See, e.g., In re PPS Advisors, Inc., Investment Advisers Act Rel. No. 5084 (December 20, 2018).

On February 12, 2018, the SEC announced the SCSDI, which allowed advisers who self-reported violations of federal securities laws relating to mutual fund share class selection, and who had promptly returned money to harmed clients, to avoid civil penalties. Likewise, in guidance from the Office of Compliance Inspections and Examinations (“OCIE”), the SEC stated that an adviser who advises his clients to invest in a mutual fund share class that is more expensive than other available others “when the adviser is receiving compensation that creates a potential conflict of interest and that may reduce the client’s return” may violate its fiduciary duty and the antifraud provisions of the Adviser’s Act, particularly when the adviser has not provided a full and fair disclosure of the conflict and obtained the client’s informed consent. See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Rel. No. IA-4889 (April 18, 2018) (“Proposed Interpretation”), p. 12.

In an announcement dated May 1, 2018, the SEC clarified that the SCSDI does not apply to adviser share class recommendations “where one share class is higher-cost than another share class but neither share class pays a 12b-1 fee or where the adviser has no financial conflict of interest.”

While the SEC has long held the view that an adviser owes its clients a duty of “best execution,” the SEC’s earliest interpretation of that duty focused on the quantitative and qualitative factors that bear on an adviser’s selection of broker-dealers to execute securities transactions. See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Rel. No. 23170 (April 28, 1986) (“1986 Interpretive Release”), at n.58. Beginning in 2016, the SEC included a best execution violation in some settled mutual fund share class selection cases, see, e.g., In Re Everhart Financial Group, Inc. Investment Advisers Act Rel. No. 4314 (January 14, 2016), ¶ 16 (citing the 1986 Interpretive Release), but has not done so in all such cases. See, e.g., In re Envoy Advisory, Inc., Investment Advisers Act Rel. No. 4764 (Sept. 8, 2017).

The SEC has not provided clear guidance as to what is meant by the duty to provide “best execution” in the mutual fund share class area. The SEC has never stated that the purchase of a higher cost class of mutual fund when a lower-cost alternative is available is always a violation of section 206(2) of the Advisers Act. Instead, the SEC’s stepped-up enforcement activity focuses primarily on advisers who failed to disclose the conflict of interest created by their receipt of 12b-1 fees. Conversely, numerous SEC publications indicate that best execution depends on the facts and circumstances. The 1986 Interpretive Release, while not specific to mutual fund share selection, states “The Commission wishes to remind money managers that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” Id., at nn.58-59. Likewise, in another OCIE publication, titled Compliance Issues Related to Best Execution by Investment Advisers (“OCIE Compliance Issues), the SEC stated that the adviser must execute transactions for clients in such a manner that the client’s total costs in each transaction are “the most favorable under the circumstances.Id., p. 1 (emhasis added). The adviser’s conduct must be analyzed, not in hindsight, but “under the particular circumstances occurring at the time of the transaction.” Proposed Interpretation, pp. 13-14.

In the area of mutual fund share class selection, the SEC stated in the Proposed Interpretation that the purchase of the least expensive investment product might not satisfy the adviser’s fiduciary duty:

Furthermore, an adviser would not satisfy its fiduciary duty to provide advice that is in the client’s best interest by simply advising its client to invest in the least expensive or least remunerative investment product or strategy without any further analysis of other factors in the context of the portfolio that the adviser manages for the client and the client’s investment profile.

Proposed Interpretation, p. 12. An adviser must have a “reasonable belief” that the investment advice is in the best interest of a client after the adviser has conducted a “reasonable investigation” into the investment. Id., at pp. 12-13. In the adviser’s analysis, the customer’s time horizon is important. For customers with short time horizons, a lower-cost fund share class “may be more costly relative to other mutual fund share classes.” See Regulation Best Interest (Proposed Rule), p. 311.

Thus, it would not be consistent with SEC guidance to require that investment advisers recommend only the lowest-cost mutual funds, without considering whether a different share class may be appropriate under the circumstances. There are valid reasons why an adviser may determine that it is reasonable for a client to invest in a higher-fee share class, even when a lower-cost fund class is available. These include, for example, the imposition of transaction fees on one class but not another, the size of the transaction, the investor’s time horizon, and operational considerations. The adviser’s conduct must be analyzed at the time of the transaction, not in hindsight.

© Andrew Whiteman 2019

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The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Please contact us for more information.

 

FINRA Extends Deadline for Firms to Self-Report Violations under its 529 Share Class Initiativeby Andrew Whiteman

FINRA has extended the deadline for firms to self-report violations under its 529 Plan Share Class Initiative.

The Financial Industry Regulatory Authority (“FINRA”) announced on March 6, 2019, that it is extending the deadline for firms to self-report violations under FINRA’s 529 Plan Share Class Initiative to April 30, 2019. Participating firms must confirm their eligibility by submitting the additional evidence specified in Regulatory Notice 19-04 by May 31, 2019. In addition, FINRA has published a set of frequently asked questions about its 529 Plan Share Class Initiative in response to inquiries it has received from firms and trade associations.

On January 28, 2019, FINRA issued Regulatory Notice 19-04 and announced its “529 Plan Share Class Initiative.” According to the Notice, the purpose of the 529 Plan Share Class Initiative is to allow firms the opportunity to self-report violations related to recommendations that customers of 529 plans purchase shares in classes that carry expenses that are higher than the expenses charged by otherwise identical funds offered by the same issuer.

A 529 plan is a popular investment vehicle that allows individuals to invest money for the educational expenses of a designated beneficiary. According to FINRA’s Regulatory Notice, Class A shares typically impose a front-end sales charge, but lower annual fees compared to other classes. Class C shares typically impose no front-end sales charge but carry higher annual fees than Class A shares. These classes may have a different cost impact on the customer depending on the length of time the customer holds the securities. For most long-term investors, the fees charged by Class C share funds over the life of the investment will be greater than if the customer had purchased Class A shares. FINRA’s Notice suggests that the break-even point may be six or seven years, meaning that when assets are expected to be invested for more than six to seven years (for example, in a 529 plan purchased for the future college expenses of a beneficiary who is 12) an A share fund might be the more cost-effective choice.

FINRA’s Department of Enforcement will recommend that FINRA accept favorable settlement terms for firms that self-report violations and provide FINRA with a detailed remediation plan. FINRA anticipates that the settlement of a self-reported violation will include restitution to customers for the financial impact of the higher-cost share class and a censure, but no fine. Recommended settlements will also include either an acknowledgment that the firm has or will voluntarily undertake corrective actions.

© Andrew Whiteman 2019

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The lawyers at Whiteman Law Firm have been handling securities matters for over 30 years. Please contact us for more information.

 

 

Securities arbitration – Should you hire an attorney?by Andrew Whiteman

Here is a well-written article, co-authored by FINRA and PIABA, about why investors who are considering securities arbitration should hire an attorney.

Securities Arbitration – Should You Hire an Attorney?

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The lawyers at Whiteman Law Firm have been representing investors in securities claims for over 30 years. We represent individuals and businesses who have suffered financial losses due to fraudulent investment schemes sold by unscrupulous or inept investment promoters, stockbrokers, investment advisors or insurance salesmen. If you have suffered losses due to the misconduct of an investment professional, you need competent attorney representation to help you recover your losses. Whiteman Law Firm assists investors to recover losses through litigation and arbitration. Our attorneys represent investors in all types of securities disputes. We handle everything from complex federal and state court litigation to individual customer arbitrations. We can review the facts of your case on a confidential, no-cost basis, and advise you on your options for recovering your investment losses.

Please contact us for more information.

 

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