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What are non-traditional exchange-traded funds (ETFs) and non-traded real estate investment trusts (REITs)? Why are independent broker dealers selling these complex products without proper supervision? FINRA wants to know and just slammed LPL Financial for doing such a thing.

This week, FINRA censured and fined LPL $10 million for broad supervisory failures in the sale of complex products such as leveraged ETFs and non-traded REITS. It also ordered LPL to pay an additional $1.7 million in restitution to certain customers who bought non-traditional ETFs.

This is a watershed moment for these and other complex products. First, LPL has over 14,000 brokers nationwide and is by a wide margin the largest independent broker dealer in the U.S. (Lincoln Financial Network with over 8,000 brokers is second). The biggest independent broker-dealer getting hit like this by FINRA is the equivalent of FINRA fining the old Merrill Lynch in wire house terms.

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An increasing issue in investment fraud cases is the liability of commercial banks for aiding and abetting fraud by an investment advisory firm that engages in fraud and then goes defunct. Such firms typically house their investment clients’ accounts with an independent broker dealer clearing firm that clears or processes the trading activity of the advisor. Cases against the clearing firm are typically resolved in arbitration at FINRA, and are subject to strong legal defenses based on claims of limited or nonexistent obligations of the clearing firm to the investor. Proof of the clearing firm’s knowledge and participation or knowing assistance in the fraud can sometimes be difficult, and what if the clearing firm itself has minimal assets? Another avenue to explore is the liability of the commercial bank that housed the non-investment bank accounts of the investment advisor. In the context of Ponzi schemes, such as Madoff, court cases have been brought with mixed results. But there are other forms of advisor misconduct that can implicate the bank as well.

When the nature of the fraud is outright theft or diversion of investor funds by the advisor this can occur through improper use by the advisor of its bank accounts. For example, the advisor may keep a bank account in its name and deposit customer funds into it, through various means, including having the check made out to the advisor “for the benefit of ” or “FBO” the investor. After the funds are deposited in the bank account in the name of the advisor it can often readily be stolen or diverted from the account by the advisor. Traditionally, bank laws have been structured to protect the banks from liability for routine check processing functions absent proof of aiding and abetting fraud. In the check processing part of the bank, until relatively recently, there would ordinary be little evidence of knowledge by the bank of wrongdoing. However, with the advent of strict anti-money laundering laws and regulations (AML), banks must now monitor for and report suspicious activity. Thus, improper activity by the advisor of the nature described above should be flagged by the bank’s own surveillance system. If the “red flags” of wrongful activity by the advisor in its bank accounts are disregarded by the bank, this can constitute evidence of the bank’s knowledge of and responsibility for the fraudulent activity. Expect to see more court cases being filed against commercial banks for investor losses stemming from fraudulent activity of investment advisors who manipulate their commercial bank accounts to cheat investors.

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On March, 30, 2015, H. Beck Inc. (“H. Beck”) submitted a Letter of Acceptance Waiver, and Consent (“AWC”) to settle allegations of sales practice violations by the Financial Industry Regulatory Authority (“FINRA”).  FINRA alleged that: 1) H. Beck failed to establish a reasonable supervisory system and written supervisory procedures to identify and apply applicable unit investment trust (“UIT”) sales charge discounts to customers; 2) H. Beck failed to reasonably supervise its registered representatives’ use of consolidated reports; and 3) H. Beck failed to enforce its written supervisory procedures regarding its non-registered representatives’ use of outside email accounts.  Without admitting or denying the facts alleged in the AWC, H. Beck submitted to censure and paid civil fines of $ 425,000 to settle the FINRA allegations. A full version of the FINRA AWC may be found here.

A UIT is a type of investment company that issues securities representing an undivided interest in a portfolio of securities.  UITS are usually issued by a sponsor that assembles the portfolio of securities, deposits the securities in a trust, and then sells units through a public offering.  Each UIT unit is a redeemable security that is issued for a specific term and entitles the investor to a proportionate share of the UIT’s net assets.  The UIT sponsor usually offers a variety of different ways for investors to reduce the sales charges for their purchases, such as offering a discount on purchases that are funded from Redemption proceeds from another UIT.

In the AWC, FINRA noted that on March 31, 2004, FINRA reminded its members of their obligation to develop written supervisory procedures to ensure that customers receive the appropriate sales charge discounts for their UIT investments.  See NTM 04-26, Unit Investment Trust Sales.  FINRA’s guidance instructs its members to make sure that UIT transactions take place “on the most advantageous terms available to the customer.”  Specifically, the AWC alleges that, in violation of NASD Conduct Rule 2110 and FINRA Rule 2010, from October 2008 through September 2013, H. Beck failed to give customers discounts for approximately $ 23 million of UIT investments purchase.  Additionally, for its failure to implement written supervisory procedure reasonably designed to ensure that customers received sales charge discounts, FINRA alleged that H. Beck violated NASD Conduct Rules 3010(a)-(b) and 2110, as well as FINRA Rule 2010.

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Merrill Lynch was fined almost $20 million by the Financial Conduct Authority (FCA) in London for incorrectly reporting more than 35 million transactions from 2007 to 2014. Merrill Lynch didn’t report, at all, another 120,000 transactions. It’s the largest fine ever levied by the FCA for reporting failures. While this may not seem like a big deal to the investing public, it is. The proper reporting of transactions is a hallmark of the securities industry. Without it, during tumultuous times, investors will not have a perfect view of the trades that occurred in their portfolios. Indeed, for some of the transactions, Merrill didn’t identify the counterparties on trades. This is problematic for over the counter derivative investors because investors couldn’t ascertain counterparty risk on their trades and if the trades went bad, it would be impossible for the investor to know how to potentially resolve the issue. What’s worse is that the FCA had warned Merrill in 2002 and fined Merrill in 2006 for the same types of infractions. In today’s fragmented, digital marketplace, proper reporting is absolutely necessary. Let’s hope the record fine is a wake up to call Merrill and others.

Here is a New York Times piece on it.

http://www.nytimes.com/2015/04/23/business/dealbook/british-regulator-fines-merrill-lynch-19-8-million-for-reporting-failures.html?smprod=nytcore-ipad&smid=nytcore-ipad-share&_r=0

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In another chapter of the continuing legal troubles facing UBS, AG and UBS Financial Services of Puerto Rico, Inc. (collectively “UBS”) for its marketing and sale of closed-end bond funds composed of Puerto Rican municipal debt (the “Puerto Rico Bond Funds”), two former UBS registered representatives, Jorge and Teresa Bravo (collectively, the “Bravos”), are suing the firm in an arbitration before the Financial Industry Regulatory Authority (“FINRA”) for its sales and management practices with respect to the Puerto Rico Bond Funds and are seeking $10 million in damages. Lax & Neville LLP has covered the developments in the Puerto Rico Bond Fund litigation extensively in our earlier blog posts and continues to investigate customer claims related to these investments. Links to those earlier posts may be found here, in chronological order: link 1, link 2, link 3, link 4, link 5.

The Bravos, who managed more than $ 120 million in client assets, were both senior vice presidents at UBS. According to news sources, the Bravos’ FINRA complaint alleges that UBS fraudulently maintained a conflict of interest, which it then concealed from its clients and the Bravos, in relation to its underwriting and marketing of the Puerto Rico Bond Funds. Through their FINRA complaint, the Bravos allege that UBS created a high-pressure environment to induce its registered representatives to sell more of the Puerto Rico Bond Funds to customers or risk being fired. The Bravos also allege that during that time, UBS cheated them out of money’s owed and ultimately forced them to leave the firm.

The UBS Puerto Rico Bond Funds have potentially cost investors billions of dollars in damages. If you have invested in the Puerto Rico Bond Funds with Jorge Bravo or Teresa Bravo, Contact Lax & Neville LLP today by calling 212-696-1999.

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In what has become a hot issue this Spring, the Labor Department yesterday proposed a new set of standards for brokers who offer advice in connection with 401(k)’s and other retirement accounts. Currently, brokers are required only to recommend products that are “suitable” for investors, which permits the sale of products that earn the broker high fees. Reuters reports that the new standards will require brokers to put their clients’ best interests first ahead of any personal financial gain. The Labor Department proposal will require “best interest” contracts between brokers and investors.

Rich Intelisano and Katz LLP represents investors in FINRA arbitrations and other litigations against broker-dealers and other financial firms.

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I noted in my March 20 post that the Chair of the SEC had just come out in favor of a rule requiring brokers to act in their clients best interests. While investors wait for the SEC to move forward on the issue, the New York City Comptroller, Scott Stringer, is proposing that New York State require brokers to disclose the present state of their relationship to clients – “I am not a fiduciary” and “I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks and expected returns for you.” The Wall Street Journal posited that New York’s adoption of such a requirement could spur other states to impose similar regulations.

A recent report by the Public Investors Arbitration Bar Association (“PIABA”) shows why Stringer’s proposal is critical. U.S. News describes the PIABA report which contrasted brokers’ advertising campaigns with the legal positions taken by those brokers in litigation against their clients. For example:

• Ad: “It’s time for a financial strategy that puts your needs and priorities front and center.”

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There has been a spate of litigation in recent years over whether broker dealers can contract out of FINRA arbitration and litigate in court instead. Goldman, Sachs & Co. v. Golden Empire Schools Financing Authority, 764 F.3d 210 (2d Cir. 2014) is a recent example in the Second Circuit. Since 1989 the courts have blessed industry mandated FINRA arbitration as contained in the industry’s standard form customer agreement. Thus, investors effectively have no choice but to resolve investment disputes through arbitration. The industry has benefited from less costly and efficient arbitration and the avoidance of jury verdicts, and until recently, the FINRA rule requiring an industry representative on every panel. The trade off to enforcement of mandatory arbitration in favor of the industry was supposedly a fair and more efficient dispute resolution process for the investor.

Now, however, as FINRA reforms over the years have made arbitration more fair for investors, and as the cases brought against broker dealers have become larger and more complex, the industry is shifting strategy and attempting to have large and complex cases litigated in court. The means of choice for the industry to accomplish this are court forum selection clauses in contracts brokers obtain from the investor in an effort to trump any FINRA arbitration requirement.

Why would the industry like to be able to escape FINRA arbitration in a large and complex case? The answer lies in the nature of the investment documents usually associated with these cases which investors are required to sign as part of complex investment purchases. These investments typically have standard form risk disclosures which investors must acknowledge before investing. Such disclosures can sometimes be fatal to a court claim where they often form the basis for a motion to dismiss the case before discovery or trial, based on the more stringent pleading requirements of court litigation. In FINRA arbitration, on the other hand, absent rare circumstances, the investor is guaranteed a hearing on her case and motions to dismiss are not allowed.

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On March 30, 2015, the Financial Industry Regulatory Authority (“FINRA”) barred broker Anthony “Tony” Warren Thompson (“Thompson”) and expelled his firm, TNP Securities LLC (“TNP Securities”), for making material misrepresentations and omissions in connection with the sale of private placement securities in violation of various FINRA Rules and securities laws. The securities in question were a series of promissory notes sponsored by three Thompson National Properties, LLC (“TNP”) subsidiaries known as the: TNP 12% Notes Program, LLC (“12% Notes LLC”); TNP 2008 Participating Notes Program, LLC (“PNotes LLC”); and the TNP Profit Participation Notes Program, LLC (“PPP Notes LLC”) (collectively, the entities are referred to as the “Guaranteed Notes LLCs” and the notes they issued are collectively referred to as the “Guaranteed Notes”).

Thompson first became registered with FINRA in 1972 and except for two brief periods in 2008 and 2009, he remained registered until 2013. Previously, Thompson, through TNP, was known for selling private real estate investments know as tenants-in-common exchanges. TNP Securities is a wholly owned subsidiary of TNP that served as a wholesale broker-dealer for the Guaranteed Notes.

On September 18, 2013, FINRA filed its initial complaint (“Complaint”) against Thompson and TNP Securities. Originally, the complaint alleged seven counts against Thompson and TNP. However, pursuant to a stipulation, FINRA agreed to dismiss three of those counts, leaving the remaining four counts as follows: (1) FINRA allged that in connection with the sale of the Guaranteed Notes, Thompson and TNP, intentionally or with reckless disregard to the truth, made material misrepresentations and omissions in violation of Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, NASD Rules 2120 and 2110, and FINRA Rules 2020 and 2010; (2) FINRA alleged that those misrepresentations and omissions of material fact were made negligently in violation of Sections 17(a)(2) and (3) of the Securities Act of 1933, NASD Rule 2110, and FINRA Rule 2010; (3) FINRA alleged that Thompson violated FINRA Rule 2010 by sending misleading communications to investors when he circulated a solicitation seeking their consent to increase the level of PNotes LLC proceeds that could be used for investing in TNP; and (4) FINRA alleged that TNP Securities failed to supervise the offering of the PPP Notes in violation of NASD Rule 3010 and FINRA Rule 2010.

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Reuters reported that Mary Jo White, Chair of the U.S. Securities and Exchange Commission, came out in favor of creating of new rules to harmonize standards of care between investment advisers and brokers. Currently, investment advisers must act in a client’s best interest, while brokers may continue to sell products that primarily benefit their or their firm’s financial interests – so long as such products are “suitable” for the clients.

Wall Street has opposed efforts by the Department of Labor to craft rules governing such broker conduct and requiring them to put client’s interest first. White’s comments this week suggest that the SEC may be preparing to weigh in on the issue.

Rich Intelisano and Katz LLP represents investors in FINRA arbitrations and other proceedings against both investment advisers and brokers.

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