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On April 6, 2018, the Securities and Exchange Commission (“SEC”) announced that three investment advisors, PNC Investments LLC, Securities America Advisors Inc., and Geneos Wealth Management (the “Advisors”) have settled charges with the SEC. The Advisors paid $12 million in restitution to clients harmed by the Advisor’s breach of their fiduciary duties.

The SEC found that these Advisors “violated their duty to seek best execution” by investing client assets in high cost mutual funds, when lower cost shares of the exact same funds were readily available. The SEC determined that the Advisors made these investment decisions simply for the purposes of self-enrichment.

Under the “Share Class Selection Disclosure Initiative,” the SEC is granting eligible Financial Advisors until June 2, 2018 to disclose and self-report any misconduct surrounding mutual fund purchases. The SEC’s Enforcement Division is willing to extend leniance to financial advisors, including recommending favorable settlement terms and waiving civil penalties, during this grace period granted under this Initiative.

On March 27, 2018 the Securities and Exchange Commission (“SEC”) announced charges against Wedbush Securities Inc. (“Wedbush”) for failing to supervise employee Timary Delorme (“Delorme”).  The SEC Complaint alleges that Wedbush repeatedly failed to monitor or prevent Delorme’s activities, despite numerous red flags that Delorme was engaging in illicit activities.

The SEC complaint further alleges that Delorme was working in concert with Izak Engelbrecht — who was previously charged by the Commission and criminal authorities in separate actions – and received kickbacks and undisclosed benefits from Engelbrecht in exchange for buying penny stocks in customer accounts.  Wedbush failed to flag these high risk, unsuitable penny stock transactions, and failed to halt this fraudulent kickback scheme despite multiple FINRA inquiries regarding Delorme’s penny stock trading activity, and a customer complaint email to Wedbush detailing the specific scheme Delorme was engaged in.

A separate order against Delorme found that she had violated federal securities laws.  Without admitting or denying the findings, Delorme agreed to pay a $50,000 fine, and to a lifetime ban from the securities industry.  SEC Officer Marc P. Berger, Director of the New York Regional Office, issued a statement in regards to this investigation, saying “Brokerage firms play an important role in protecting retail investors from abusive conduct by brokers like Delorme; this case sends a clear message that we will not tolerate broker-dealers that fail to exercise appropriate supervision over employees, as alleged here.”

On March 19, 2018, the Securities and Exchange Commission (“SEC”) announced its highest-ever whistleblower award, with the three recipients of the award receiving a total of approximately $83 million.  The award involved three whistleblowers, two of whom split $50 million, and one of whom provided greater assistance in the process, thereby receiving $33 million.  The $83 million award represents 20% of the $415 million fine levied against Merrill Lynch (“Merrill”) by the SEC.

This fine was the result of Merrill gaming SEC Rule 15c3-3 – a regulation that mandates broker-dealers keep customer cash separate from firm cash, so that in the event of a bankruptcy, customer funds would not be jeopardized.  Merrill circumvented this rule by writing derivative contracts that would allow customer cash to be held in Merrill accounts.  Merrill customers suffered no actual loss from these derivative contract trades that they were entered into, as the sole purpose of the contracts was not market exposure, but a way to account customer assets as being on Merrill books, so that for example the firm could have more cash with which to leverage.

This bespoke derivative contract that Merrill designed, called a “leveraged conversion” had no real economic substance, however it impacted the way “customer cash” was calculated. These contracts made it appear customers owed Merrill money that they did not, because the debt was simply notional.  Merrill actually sought SEC approval on these leveraged conversions, and was granted it.  The SEC likely granted this approval because they thought the intent of the trades was to help Merrill clients finance inventory, or had some other tangible benefit – they would not have approved the leveraged conversions had they known Merrill designed these contracts purely to skirt SEC Rule 15c3-3.

In late 2017, the Justice Department ordered Wells Fargo & Co. (“Wells Fargo”) to conduct an investigation of its Wealth Management Division (“WFA”), after whistleblowers at the bank alleged sales practice abuses.  Wells Fargo released a statement saying that their board was investigating “whether there have been inappropriate referrals or recommendations, including with respect to rollovers for 401(k) plan participants, certain alternative investments, or referrals of brokerage customers to the company’s investment and fiduciary services business.”

Wells Fargo has faced continual and mounting regulatory pressure, with a $185 million penalty in September 2016 for the fraudulent opening of 3.5 million accounts.  In February 2018, the Federal Reserve took the unprecedented enforcement action of issuing a cap on Wells Fargo’s assets, citing oversight issues.  This investigation, initiated by the Justice Department, may only uncover more unsuitable or fraudulent practices at the troubled bank. Wells Fargo also found that it had improperly over-charged 800,000 auto loan customers, and 110,000 mortgage customers – Wells Fargo is now refunding approximately $100 million to these improperly charged customers.

As the investigation into WFA continues, more improper sales practice abuses may be uncovered.  If clients are pushed into high fee accounts, encouraged to buy products on margin (while paying margin interest), overly concentrated in specific sectors, or paying over 300 basis points in fees, there may be regulatory enforcement actions that demand arbitration.  In addition to the customers who may have suffered from Wells Fargo’s unsuitable/and or fraudulent actions, Financial Advisors who transitioned to WFA unaware of the problems they were transitioning into, may also have suffered damages.

On February 12, 2018, the Securities and Exchange Commission (“SEC”) instituted an enforcement action against Deutsche Bank Securities Inc. (“Deutsche Bank”) (the “Order”).  At the conclusion of this Deutsche Bank was ordered to pay $3.7 million back to customers, with $1.48 million as disgorgement penalties.

According to the Order, during the course of its investigation, the SEC found that traders and salespeople at Deutsche Bank made false statements surrounding the sale of commercial mortgage-backed securities (CMBS).  The investigation found that Deutsche Bank employees would tell costumers that they had on a certain date purchased a bundle of CMBS for a certain price – when in fact that bundle of CMBS may have been purchased at a far earlier date for an entirely different price.

There have been several lawsuits, arbitrations, investigations, and enforcement actions surrounding the obligations of traders and salespeople to customers in regards to revealing or accurately disclosing previous purchase prices of securities.  Most of these cases hinge on the question of whether or not a sales person revealing their purchase price of a security is a materially relevant fact.  Defendants in these matters have taken the position that accurate representations of securities previous purchase prices are not materially relevant, because buyers have their own valuation methods, and can analyze the market themselves – and they would not be buying large blocks of securities if they did not think they were worth the asking price.  They also argue that most buyers of large blocks of securities, who interact with investment banking salespeople, are institutional buyers, and therefore have their own teams of analysts to perform valuation. Regulators and Plaintiffs attorneys take the position that traders should never be able to lie to their customers, and that the actual prices paid are not simply proprietary information, but materially relevant facts that must also be disclosed to a prospective purchaser.

In November, the Financial Industry Regulatory Authority (“FINRA”) ordered Stephen Todd Walker (“Walker”), a former Morgan Stanley (“MSSB”) Advisor, to pay approximately $2 million to cover remaining promissory note balances and arbitration costs (the “Award”).  Promissory note cases can be difficult to win, as the contractual language stipulating terms of repayment is typically very explicit as to the obligations of the promissory note holder.

MSSB terminated Walker in 2010, and he left for Oppenheimer with a large book of business and a small team of Financial Advisors and Assistants.  MSSB promptly sued Walker for breach of his promissory note agreements, with MSSB seeking repayment of the $1.67 million balance.  Walker filed counterclaims against MSSB for “tortious interference” with his client relationships, unfair competition, improper conversion of property, and defamation, that sought damages of $52 million.  The suit culminated in 160 pre-hearing and hearing sessions between 2011 and September 2017.

After a protracted 7-year arbitration battle, a three-person FINRA Arbitration Panel (the “panel”) ruled that Walker must pay $1.67 million in promissory note balances back to the firm, and pay $301,000 in attorneys’ fees (prevailing party attorneys’ fees can be contractually stipulated in promissory note agreements).  The Panel did however grant Walker $525,000 in compensatory damages from MSSB, making his total outstanding liability from the Award $1,446,000.

On December 13, 2017, an Arbitrator from the American Arbitration Association rendered an award totaling approximately $1,000,000 against Allegis Investment Advisors, LLC (“Allegis”).  The Arbitrator found that Allegis breached its fiduciary duty by investing clients’ funds into entirely unsuitable, and high risk option strategies.  There will likely be more claims brought against Allegis, as the total amount of potential damages to its clients exceeds $33,000,000.  Allegis is a SEC registered investment advisory firm headquartered in Idaho Falls, ID.  It has approximately $654 million in assets under management, and caters primarily to high net worth individuals.

Selling very large numbers of Put options on indexes is an incredibly risky investment strategy. Specifically, the strategy Allegis implemented entailed the collection of a small premium on the Russell 2000 index (“RUT”) – from the option sale – however risked the possibility of complete and total loss of capital supporting the trade.  Allegis employed this RUT option strategy with certain clients’ life and retirement savings.

Allegis neglected to inform their clients that this RUT option strategy involved a massive asymmetrical risk reward ratio with potential for complete and total loss of capital.  With a derivative strategy such as this, approximately 97% of the time the options will expire Out of the Money, and the small premiums collected from the RUT option sale can be kept.  However, approximately 3% of the time the price of the RUT Index could move far enough from its expected volatility, leading to complete loss of capital.

On October 30, 2017 Morgan Stanley announced that it would exit the Protocol for Broker Recruiting (the “Protocol”), effective on Friday, November 3rd.  Firms such as Morgan Stanley and Merrill Lynch signed on to the Protocol in 2004, in an effort to limit costly litigation or arbitration claims that can arise when brokers transition to new firms, or set up arrangements such as a Registered Investment Advisor (“RIA”). The Protocol is intended to outline an orderly system for transitions, by limiting the client information brokers can bring with them during job changes to the following: names; addresses; phone numbers; email addresses; and account title. Other client information and documents are not permitted to be taken. The Protocol additionally restricts brokers from telling clients they are planning to move, or from committing any other forms of pre-solicitation.

While the Protocol is advantageous to firms in terms of reducing litigation and compliance costs, these benefits are offset by the downside of increased volume of broker transitions. The frictional costs and risks associated with a broker moving his or her book of business are reduced by the Protocol —thereby giving brokers more bargaining power in recruitment deals, and instigating recruitment package bidding wars between banks.

Morgan Stanley released a statement, titled “Morgan Stanley Announces a New Talent Investment Strategy to Deliver Added Value to Clients.” The statement mentions technology solutions for strengthening investment objectives for clients, a focus on building client relationships, and other marketing tactics, all used as a prelude to justify leaving the Protocol, under the auspices of protecting client interests. Morgan Stanley emphasized that they will focus on building existing talent: “[t]hese investments further the Firm’s previously stated commitment to reducing recruiting efforts in order to refocus those resources on existing talent,” a strategy intended to reduce costs.

Lax & Neville is currently investigating the activities of Michael D. Mathias, a broker associated with Summit Brokerage Services, Inc. (“Summit”).  Mr. Mathias, who has been in the industry for three decades, has a long history of sales practice abuses, including making unsuitable recommendations to his clients.  He has over twenty customer complaints or arbitrations listed on his record (CRD No. 1349406).  The vast majority of these complaints or arbitrations were resolved in the customer’s favor and roughly half required a personal contribution from Mr. Mathias.  Almost all involve the recommendation of high commission products, including limited partnerships and variable annuities.

In particular, Lax & Neville is focusing its investigation on the unsuitable recommendation and sale of variable annuities.  The recommendation and sale of variable annuities has long been a concern within the securities industry.  NASD and FINRA have released a number of investor alerts and notices to members on the subject, emphasizing that certain suitability requirements must be met to recommend variable annuities (NASD Notice 96-86), highlighting the importance of supervisory procedures to ensure that the suitability requirements are met (NASD Notice 07-06), and warning potential investors of the liquidity issues, high fees, and market risks associated with variable annuities (FINRA Investor Alert 12-00045).

In June 2004, the SEC and NASD released the joint report “On Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products.”  The report recognized that high commissions helped drive the sale of variable annuities but that the high fees and surrender charges associated with the product made them inappropriate for a wide variety of investors.  The report then identified a number of factors that could assist in “identifying abusive sales practices and violations,” including

On October 16, 2017, The Financial Industry National Regulatory Authority (“FINRA”) announced a $3.4 million dollar fine against Wells Fargo, in connection to Wells Fargo brokers improperly placing retail clients in volatility linked products. Many of these volatility linked exchange-traded products (“ETPs”) such as the VXX, XIV, TVIX, and other variations of volatility indexes, that attempt to match, inverse, or leverage Chicago Board of Exchange volatility metrics, are highly complex products that are not suitable for all investors.  FINRA found in its investigation that Wells Fargo registered representatives recommended these ETPs to customers without fully understanding the risks they entail.

ETPs are uniquely volatile products that degrade in value significantly over time and are designed primarily for short term holds when part of a comprehensive hedging strategy or in anticipation of a binary event or large market move. ETPs are not designed to be bought and held in customer accounts for any significant time period, which is a practice Wells Fargo registered representatives were recommending to their customers. As a reminder to financial industry professionals of the obligations they have to customers when recommending volatility ETPs, FINRA released a new Regulatory Notice 17-32 reiterating and reminding firms of their obligations surrounding ETPs.

FINRA found that Wells Fargo failed to implement a sufficient or credible supervisory system to oversee solicited sales of volatility linked ETPs. Broker soliciting sales of volatility linked ETPs should already be cognizant of the significant risks they entail, the limited hold time, and the potential for significant losses.