A Stockbroker’s Introduction to Investigations and Examinations Involving FINRA f/k/a NASD

Introduction

Stockbrokers a/k/a registered representatives, associated persons and financial advisors often do not understand what their obligations and responsibilities are and what causes a Financial Industry Regulatory Authority (FINRA) examination or investigation. Many reps do not even know the role that FINRA plays within the industry. This may be due to the fact that FINRA, a self-regulatory organization, is not a government entity and therefore, cannot criminally prosecute or sentence financial professionals to jail time for violation of industry rules and regulations. Regardless, all broker-dealers doing business with the investing public must register with FINRA. As registered members, broker-dealers, and the representatives working for them, have agreed to abide by industry rules and regulations, which include FINRA’s own rules.

FINRA conducts routine examinations or investigations to examine compliance with industry rules and regulations. Primarily this occurs by inspections occurring once every one, two, or three years depending on the firm’s size, business mix and its perceived risks. FINRA may also conduct an examination if it has reason to believe that a rule violation has occurred – an examination may be initiated based on Form U-4 or U-5 disclosure, an arbitration claim, a customer complaint, information received in the form of tip or information received from another regulator or law enforcement agency. The purpose of the examinations is to make sure that a firm is properly supervising it employees and business operations, has proper internal controls and systems in place and has sufficient capital. The examinations generally focus on unethical sales practice behavior such as conversion of funds a/k/a theft, forgery, fraud, selling away a/k/a unauthorized outside securities activities, unauthorized trading, undisclosed outside business activities and unsuitable recommendations.

When confronted with a FINRA examination, having representation by a knowledgeable securities attorney is important because all brokerage firm or “Members,” registered representative or “Associate Members” of FINRA have agreed to be subject to its rules, procedures, disciplinary proceedings and sanctions which could have dire consequences. These disciplinary proceedings are similar to courtroom trials, but under FINRA’s one-sided procedures and rules, member firms and their representatives are at a disadvantage. Representatives need to be on guard – FINRA can make referrals to the Securities & Exchange Commission (“SEC”) for fines, injunctions and/or to federal and state prosecutors for criminal prosecution. Therefore, much more than a firm or rep’s license is at stake.

FINRA EXAMS

At inception, FINRA examiners will usually send a written request for information to the broker-dealer as well as to the rep, which seeks basic information about a customer complaint or other disclosure. A request letter to the representative will often ask for a written response to the allegation, and a request letter to the firm will usually seek a written narrative of the complaint or other disclosure and the broker-dealer’s findings. A request letter to a firm may also include a request for relevant documents such as communications with customers and account records under FINRA Rule 8210. Once FINRA has obtained such information and materials, it will determine whether the issue is one over which FINRA has jurisdiction. FINRA will also determine whether there is a potential rule violation or if any other threshold has been met, which would allow it to continue to review the matter at issue.

FINRA examiners obtain the vast majority of information needed to conduct an investigation through written demands. Letters requesting information and documents and responses to specific questions sent to firms, representatives, and involved personnel are not unusual. In many cases, FINRA will require the representative to respond to a specific question with a signed, written statement. In addition, FINRA examiners may conduct phone interviews with representatives, managers, compliance employees, and customers to obtain relevant information. Although these interviews are considered informal, individual brokers should proceed with caution because anything they say may be used against them.

The majority of examinations that lead to a disciplinary action include an on-the-record interview (OTR), which requires the representative or other associated persons of a firm to meet with the regulators and answer questions under oath pursuant to FINTA Rule 8210. OTRs are similar to depositions taken in civil cases because the witness/representative is sworn to tell the truth, a court reporter is present to take down everything said in the interview, and a written transcript of the interview is prepared. Therefore, lying to FINRA could leave one open to perjury. Registered representatives are allowed to have an attorney appear at the OTRs with them, and often a good result depends on legal counsel preparing the rep for an OTR, and representing the representative during the OTR proceeding itself. This can prevent FINRA from using unfair tactics.

As soon as the FINRA examiners believe that they have gathered all the relevant information, documents, and other evidence, they prepare a report or memorandum concerning the examination and submit it to their supervisor. The supervisor’s role is to review the report/memorandum along with the evidence and make a recommendation to close the file without action, to pursue some type of informal disciplinary action, or to pursue a formal disciplinary case.

FINRA’S IMPORTANT RULES AND POWERS AT FINRA’S DISPOSAL

FINRA does not have jurisdiction over individuals not affiliated with the securities industry. Therefore, since FINRA cannot ask for or force cooperation from customers or their affiliated individuals. Quite a few examinations are never fully completed if such cooperation is necessary to establish evidence of a violation.
Ignoring FINRA’s requests for information or documents results in a significant penalty, often a lifetime ban from the industry. Still, FINRA makes use of FINRA Rule 8210, which serves as subpoenas on member firms. Rule 8210 requires broker-dealers, registered representatives, and any other individuals subject to FINRA’s jurisdiction to cooperate in an examination and provide written, electronic, and oral information. Reps may be barred from association from any FINRA member firm in any capacity for ignoring such requests. In certain circumstances, it may be better for a broker or rep not to cooperate with FINRA if facing criminal charges since statements and information can be subpoenaed by other law enforcement agencies or voluntarily turned over by FINRA to such agencies. When faced with a decision to cooperate with FINRA or not, broker-dealers and reps should always seek advice from an experienced securities attorney.

FINRA’s Bylaws provide for jurisdiction for purposes of Rule 8210 over formerly registered brokers and associated persons for two (2) years following termination of registration.

INFORMAL ACTIONS BY FINRA

An informal disciplinary action by FINRA or a “Letter of Caution” occurs when a representative is sent a letter explaining that FINRA has completed its examination and specifies certain industry rules believed to have been violated by the individual broker. In some cases, this letter will request that the broker reply acknowledging receipt of the letter and affirm that no additional violations will occur in the future. The issue is normally closed when a Letter of Caution has been sent and replied to unless FINRA staff is pursuing a formal action as well. Representatives should note that FINRA consistently follows up with its informal actions. So if a broker engages in unlawful conduct in the future, one can expect the informal disciplinary action to be referred to at a disciplinary hearing, which would show that the broker was warned about the alleged misconduct.

FORMAL DISCIPLINARY ACTION BROUGHT BY FINRA

FINRA may choose to initiate a formal disciplinary action once an examination is completed. Thereafter, the matter is turned over to an attorney working for FINRA, and the attorney will review the file to make sure that the examiners have all the necessary evidence and information to proceed. If the file is determined to be sufficient, the FINRA attorney will contact the Registered representative with a letter or phone call or both.

The attorney’s initial contact with the representative is to notify him or her about FINRA’s intention to take a disciplinary action against the broker for a violation of FINRA rules or other industry rules, regulations, and laws. A description of the rules or laws alleged to have been violated is usually provided, and the rep is given the opportunity to submit to FINRA additional information not provided and an argument as to why FINRA should not proceed with its action. This process is known as a “Wells Submission.”

A Wells Submission is important because FINRA is advising the representative that it intends to initiate a proceeding involving a disciplinary action against the member and/or the representative. A rep will have an obligation to amend his or her Form U-4 to reflect that he or she is under an investigation. If the representative does not disclose the investigation on the Form U-4, additional charges can be brought against the rep. The representative will have as long as a month to respond by submitting a Wells Submission to FINRA or to speak with the FINRA attorney about settling the case before a formal complaint is filed against the representative. A Wells Submission is simply a written argument by the broker-dealer or rep about why FINRA’s action is inappropriate, not necessary, or both. Wells Submissions may also contain additional information and evidence or legal argument not obtained during the examination that may remove the rep from the alleged misconduct or violation. A FINRA lawyer and a supervisor will review the Wells Submission, and if they choose to move forward with a disciplinary complaint, the Wells Submission will also be reviewed by FINRA’s Office of Disciplinary Affairs (ODA).

Registered representatives should also keep in mind that Wells Submissions are not confidential and might be used against the registered representative by FINRA or even claimants in an arbitration if the submission is subpoenaed in a concurrent or subsequent matter. If the Wells Submission is not successful and the case does not settle and the rep chooses to fight the charges, he or she will answer the complaint and request a hearing before a hearing panel. The panel’s role is to hear the evidence, determine whether a violation occurred, and determine the appropriate sanctions. If the registered representative chooses to not participate in the process, the process will continue and a default decision can be issued against him or her, which may come with sanctions.

PART II

SETTLEMENT PURSUANT TO LETTER OF ACCEPTANCE, WAIVER, AND CONSENT (AWC)

In many cases, FINRA “Members” and “Associate Members” will settle a FINRA action before a formal disciplinary complaint has been issued. These types of settlements are done through a Letter of Acceptance, Waiver, and Consent (AWC) in which a broker-dealer or rep “neither admits nor denies the allegations.” However, a broker must agree to the findings of facts, violations and to sanctions. An AWC resolves the matter once finalized, and FINRA cannot return with another action alleging violations based on the same conduct contained in the AWC. Most reps who settle through an AWC do so to avoid the hearing process either because they cannot afford to retain an attorney and defend themselves or because they are no longer working in the securities industry and/or do not plan on returning.

These findings, which are final and published on FINRA’s website, can have a major and permanent impact on the individual broker’s reputation, so it is important to know what the alleged conduct is and how the registered representative has been charged. Furthermore, a broker-dealer and/or registered representative should be aware of the consequences of entering into a settlement. While some brokers may not be disturbed by not being eligible to find employment in the securities industry again, they should understand that a disciplinary action might have an impact on the ability to work in other fields that require licenses like insurance or banking. Given the possibility of adverse effects beyond settlement, reps and firms would be smart to hire an experienced securities lawyer to advise them through this process.

If the rep or firm and FINRA agree on a settlement, FINRA’s lawyer will draft the AWC for the broker to sign and return. The AWC must be approved by both FINRA’s prosecuting 7 office and reviewed and approved by the ODA. Once the ODA approves the settlement, the case is resolved in accordance with the terms of the AWC. If the ODA does not approve the settlement, the FINRA lawyer will typically relay the required changes by the ODA to the rep or firm, who can litigate the matter or agree to the revised terms.

WHAT TO EXPECT FROM THE DISCIPLINARY HEARING

After the complaint is filed with FINRA’s Office of Hearing Officers, a notice that the complaint has been filed as well as a copy of the complaint is mailed to the broker-dealer and/or registered representative. The notice contains deadlines for the broker to file a written answer, information on the hearing location, discovery details, and other important information. The broker-dealer or registered representative will usually respond by admitting or denying the allegations and requesting a hearing. If an answer is filed and a hearing is requested, the hearing officer assigned to the case will hold a pre-hearing conference with the parties and schedule the case, which includes setting deadlines for discovery, motions, setting a briefing schedule, witness and exhibit lists, and scheduling the hearing dates. The hearing officer is an employee of FINRA and serves as the Chairperson of the hearing panel that will resolve the case. The other two panelists typically come from a regional committee comprised of industry professionals.

The subject of the disciplinary action a/k/a the respondent is entitled to discovery in the case and is permitted to review and copy documents in the investigative file. However, a respondent is not entitled to all of FINRA’s documents pertaining to the case, under FINRA’s rules. Registered representatives should note that enforcement officials do not have the power to obtain discovery from the respondent, though FINRA may issue investigative letters under Rule 8210 from a broker-dealer requesting information of facts relating to certain affirmative defenses or facts a respondent may make reference to in his or her answer.

The final hearing is not as formal as courtroom trial, but operates in a similar fashion. The hearing commences with opening statements by both the FINRA attorney and the respondent’s lawyer. Afterward, FINRA will call witnesses to testify about the facts supporting the Compliant’s allegations and explain and introduce into evidence the exhibits used against the respondent. The respondent is then given the opportunity to conduct cross-examinations of the witnesses called by FINRA. After FINRA has finished presenting its case, the respondent’s attorney is given the opportunity to call witnesses to testify, introduce and explain exhibits, and testify if he or she chooses. Similarly, the FINRA attorney is then given the opportunity to cross-examination of any witnesses called by the respondent, which includes the respondent if he or she testified.

Following the close of all the evidence, each attorney will give their closing arguments and ask the panel to rule in favor of their respective clients – to find that FINRA failed to prove or proved the allegations against the individual broker and impose or deny sanctions. Hearing panels often make their decisions quickly, but it may not be immediately delivered to the parties. The hearing officer issues a written decision, which outlines the party’s pleadings, admitted evidence and testimony, and the legal rationale for the panel’s ruling, is typically issued several months after the hearing is concluded. Upon issuance of the hearing panel’s decision, the case is closed and the sanction imposed by the panel will go into effect unless an appeal is made or a final review is called for by the National Adjudicatory Council (“NAC”). The outcome of the case is reported on the registered representative’s U-4 and is available to the public under FINRA’s Broker Check service.

APPEAL OF THE FINRA HEARING OFFICER’S DECISION

Appeals in FINRA disciplinary actions function differently from appeals in civil cases in federal or state court. In a civil case, if neither party decides to appeal the decision, the case remains closed and resolved. In a FINRA disciplinary action, the NAC has discretion to review the case and force the parties through an appeal. The NAC’s purpose is to review case findings, evaluate the proposed sanctions, and affirm or reverse the hearing panel’s decision. Respondents, i.e., broker-dealers and/or registered representatives, or prosecuting FINRA officers can also appeal a hearing panel’s decision. These appeals are heard by the NAC, which can affirm, reverse, or modify the decision.

The NAC’s decision can continue for several months or a year, and representatives registered with their firms are allowed to work during this period because sanctions imposed by the hearing panel do not go into effect while the NAC is reviewing or hearing the appeal. No additional evidence or testimony is presented, but the parties may submit written briefs. Parties are given the opportunity to make their oral arguments before a subcommittee of the NAC, which will recommend a decision to the NAC. A final decision is ultimately announced by the NAC. If a broker believes that the NAC’s decision is unsupported, he or she can make a final appeal to the Securities and Exchange Commission (“SEC”). Remarkably, FINRA would not be entitled to an appeal beyond the NAC if it were to lose its appeal.

COLLATERAL ISSUES INVOLVING FINRA EXAMS and INVESTIGATIONS

Registered representatives should consider the related issues that may arise following a FINRA disciplinary action. These issues may very well include consequences that impact current or future employment prospects, create civil liability to customers, and frustration of efforts to get registered in the various states. For example, if a registered representative has violated an industry rule that is also considered a crime, any information obtained by FINRA in its prosecution can be used by criminal prosecutors against the registered representative. Another example involves the possible use of information and admissions obtained in a FINRA disciplinary action by customers who have suffered investment losses and have filed arbitration claims against the registered representative and his or her broker-dealer.

A FINRA disciplinary action can also impact existing or future employment if an employing broker-dealer’s policy is to not employ registered representative with a disclosure on their record. This means that a while pending resolution of the regulatory examination, the registered representative may have to seek other employment opportunities. Even if the registered representative manages to stay with his or her current firm, it may be difficult to retain and attract new customers after his or her record has been sullied with a disclosure due to the preponderance of people utilizing Broker Check. Moreover, registered representative may incur licensing complications during and/or after a FINRA action. In many cases, registered representative with regulatory disclosures face longer wait periods after an application for licensure is submitted to various states. Registered representatives would be wise to retain an experienced securities lawyer to assist them in determining whether any collateral issues that may arise and assess what the best course is for obtaining a long-term satisfactory outcome.