Experiences from FINRA Disciplinary Review Panels

“Familiarity breeds contempt”

It’s an old saying that proves itself relevant again and again.  When looking over the headlines or  through the trade publication emails that fill our inboxes, even the most casual observer can find examples of someone whose closeness to a situation made them blind to the peril with which they were flirting.  And the headlines?  Each one is only about the aftermath, telling the story after everything comes crashing down. And it all begins with the most myopic statement of all: “It can’t/won’t happen to me.”  Yet, it can, and it does. In this Risk Management Update, we provide a few brief case studies to illustrate this.


Case Study 1

Consider the following: “Jim”* was a financial representative who worked with highly specialized products, in this case, church bonds.  Jim placed several of his clients into certain church bonds because, at the time, they seemed like worthwhile investments that happened to align with the clients’ objectives—financial and otherwise.

Subsequent to these placements, Jim’s clearing/custodian firm, “ABC Securities”*, began experiencing difficulty finding reliable information to price the bonds for purposes of valuation reporting to clients and to Jim.  After about a year of pricing difficulty, ABC Securities ceased offering valuation information for these bonds altogether.

Jim realized—as did his clients—that ABC exiting from the valuation of these assets would result in zero-dollar values being displayed for those assets on his clients’ statements.

At this point, Jim made a decision. He had many years of experience in the financial services industry and working with these kinds of specialized bonds, so Jim would leverage that experience and determine his own valuations of the bonds to present to his clients.  Working with the bond issuers’ trustees, he obtained up-to-date information as to the bonds’ statuses, none of which were good.  In his research, he found terms like “in default”, “bankruptcy”, “payments in arrears”, “partial payments”, and “attempted sale of partially completed property”.

Proceeding with that information, Jim developed a valuation methodology that valued most of the bonds at 80% or more of face value.  Additionally, he provided his clients with descriptions of the issuers’ financial situations using terms such as “rock solid”, “premier issuer”, “best year”, and, for those issuers in more severe financial circumstances, “rehabilitation”.  His valuation methodology was inconsistent with that typically used in the industry to create valuations for thinly traded debt securities.  Meanwhile, the issuers’ creditworthiness deteriorated.

As time went on, some of Jim’s clients became increasingly skeptical of the bonds.  So Jim arranged for a series of cross-trades, using his valuation methodology as the basis of what clients paid during the cross-trades.

As we can see from this example, Jim allowed his familiarity with the business and these products to lull him into a false sense of skillfulness when in fact, his valuation methodology bore little resemblance to the realities of the bond issuers.

Jim’s activities were subsequently discovered during a regulatory examination, which uncovered other issues in addition to his bond valuations.  Jim paid the price; ultimately, he was barred from the industry.

Ok, I know what you are thinking.  “Well, of course!  Obviously, you shouldn’t try to create valuations for exotic securities!”  I get it; something so obvious, one would think, would be plainly obvious to anybody else.  But how about those situations that are less obvious?


Case Study 2

Consider the following: “Dan”*, a 40-year veteran of the financial services industry, had extensive experience dealing with private placement investments.  Over the years, Dan had experienced a great deal of success with the private placements he arranged for his clients.  However, as with anything in the financial services industry, past success is not a 100% guarantee of future performance.  Following a particularly severe private placement failure that resulted in several of his clients losing large sums of money, both he and his clients sought an opportunity to recoup the losses.

Such an opportunity came in the form of Dan’s former associate, “Tim”*.  Tim excitedly shared with Dan news of a private placement being put together for a real estate development that showed great promise.  Of note was Tim’s assertion that this project was a “can’t miss” opportunity: the fundamentals underlying the development’s future success were sound, to the point that any clients who invested in the private placement could be sure to profit handsomely.  The project was pitched to Dan as a way for his clients to recover their losses from the previous private placement and then some.  All Dan’s clients needed to do was invest 10% of the amount they lost on the previous private placement and this new project would do the rest.  And even in the unlikely event that the project failed, the private placement’s promoter, “William”*, stated that significant collateral—in the form of millions of dollars’ worth of rare fine art and other highly-sought collectables—would be offered and auctioned off to make clients whole.

Dan was skeptical at first.  In his extensive experience with private placements, guarantees to investors against a project’s failure were not something he had heard of.  But being a good representative trying to do right by his clients, he conducted some due diligence and became satisfied, initially, that the stated collateral did indeed exist.  As time passed, he became increasingly comfortable with the terms of the private placement and began promoting it to his clients.

As Dan continued to promote the private placement to his clients, he decided to revisit the collateral question based on an inquiry made by one of his clients.  During that research, he uncovered certain facts that caused him to doubt his understanding of the collateral.  Concerned, he reached out again to Tim.  During his discussion with Tim, Dan was told “don’t worry about it, the collateral is good”.  But Dan felt he had unanswered questions as to whether Tim or William had the authority to liquidate the collateral in the event the development failed.  Dan learned that neither Tim nor William was the actual owner of the collateral and was unable to establish the connection between the two with the owner of the collateral.  However, Dan was comfortable enough with Tim from their past work to simply take his word for it, despite his misgivings.  Dan continued to promote the private placement to his clients, supplementing his promotional efforts with information about the collateral.

Over the course of Dan’s promotional efforts, the private placement eventually came to the attention of his firm.  The firm, however, rather than asking about whether this was an Outside Business Activity, instead assumed that the private placement was part of the firm’s business and, under that assumption, merely took issue with Dan’s use of his personal email for firm-related business purposes.  Dan, for his part, promised to use his firm-issued email address for all future communications to clients related to the private placements, never disclosing to his firm that this private placement was actually an OBA.

Later yet, Dan began researching further into the collateral and discovered that it was likely that the owner of the collateral had no idea that the property in question had been pledged as collateral for the private placement.  When Dan confronted Tim directly about the matter, Tim reassured Dan that the collateral was safe and would be used to make investors whole should the project fail, but admitted that the owner of the collateral was not part of the private placement team.  Dan subsequently confirmed the same with William.

Dan took this revelation to mean that the guarantee of the collateral was not as strong as he thought, and, realistically, that the guarantee probably did not exist at all.  He resigned from his involvement with the private placement.  However, he failed to announce his withdrawal to his clients, leaving them invested in the private placement with no idea he was no longer involved.

The development project eventually failed.  No collateral was ever liquidated to make Dan’s clients whole.  And Dan’s firm began fielding complaints about the private placement.  The firm, realizing that the investment was actually an OBA and not something offered through the firm, contacted Dan to gather as much information as possible about the private placement.

Upon concluding the investigation, the firm declined to impose any disciplinary action against Dan, despite the fact that he violated firm policies related to OBAs.  But whatever happened internally at the firm would pale in comparison to what came next.

Some of the private placement clients contacted regulators, who opened investigations into the matter.  What had begun as just another run of the mill business opportunity became a major incident that would result in enforcement actions that barred Dan from the industry, imposed a fine and suspension on Dan’s supervisor, and fined their firm as well.

While familiarity can cause one to blunder and stumble their way into an enforcement action, so too can unfamiliarity with a business line and taking on a new challenge while assuming that everything is “all right”.


Case Study 3

 Consider the following: In a departure from its typical brokerage and investment advisory businesses, a firm decided to take on Health Reimbursement Arrangements as a line of business.  The new HRA business line would be housed in a separate legal entity to provide separation from the brokerage and investment advisory businesses but was owned by the same principals.

The HRA line was operated through a separate bank account that received client contributions and paid client claims.  Many HRA clients also were clients of the investment advisory business.

Before long, the SEC discovered the arrangement.  Upon further investigation, they determined that the arrangement fell under the Custody Rule and declared the firm, through this separate entity run by the firm’s principals, to have custody of client assets and was therefore subject to all of the attendant custody-related requirements.

The firm, however, has taken the position that it did not have custody: the Form ADV did not disclose that the firm had custody of these assets and they had never engaged an accounting firm to conduct a surprise examination.  Due to these oversights, the SEC pursued an enforcement action, resulting in the firm being hit with a substantial fine.



These three cases are meant to illustrate how easy it can be to run afoul of both internal compliance requirements and industry regulations, even without an intent to do harm. In order to tighten your compliance program to help prevent scenarios like the foregoing coming to fruition, as a best practice, the annual review of your policies and procedures manual should go beyond just making sure procedures are updated and consistent with industry rules.  For example, consider taking a comprehensive inventory of all of the business lines in which your firm is engaged, who at the firm is responsible for those business lines, and how compensation is paid for each line.  Then search through the manual to determine whether your current policies and procedures effectively address each of those elements of your business.  This way, you can identify gaps that were previously unknown and create a roadmap for how to mitigate any such gaps to help ensure that your manual is effectively addressing your entire business.

As for known activities that feel unusual: stop, think, and seek outside help if necessary.  There is nothing worse than inadvertently violating industry regulations when you thought nothing was wrong.

At Core Compliance, we can assist investment advisers and broker-dealers with the review of your compliance programs in an effort to ensure that your policies and procedures are not only up-to-date from a regulatory perspective, but are also effectively and comprehensively tailored to your specific business model. For more information, please contact us at info@corecls.com, at (619) 278- 0020 or visit our website at www.corecls.com.


Author:  Matthew Rothchild, Sr. Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.

This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.