Selling Away: Broker-Dealer Liability for Selling Away Transactions
By Bob Lawson, AIF®, CFE®, RFC®, LUTCF®
FINRA & Securities Expert Witness - FINRA Mediator & Arbitrator - Mediation Consultant
FINRA & Securities Expert Witness - FINRA Mediator & Arbitrator - Mediation Consultant
In the securities brokerage industry, "selling-away" refers to the prohibited practice of an Associated Person soliciting the sale of securities or investment products not approved with the broker is affiliated without prior written consent. In many instances, promoters of these products are marketing them as non-securities products that do not have to be sold through a broker-dealer by a registered person.
In a significant number of cases, associated persons have sold these investments to their customers away from the broker-dealer and without firm approval as required by FINRA Rule 3270. Selling-away often occurs in an independent branch or a satellite office, where Associated Persons are removed from the day-to-day oversight and supervision of their brokerage firm's compliance department. Investments involved in selling-away often include nontraditional products such as private placements, promissory notes, non-traded REITs, structured products, and viatical settlements.
These investments generally have little to no liquidity, high fees and lack transparency and commonly promise high-yields and returns with principal protection. These high-risk financial products are typically marketed directly to brokers by an issuer and then marketed to vulnerable investors with a thirst for higher yields or returns. These financial products are not commonly registered or approved for sale by any national or state regulatory agency and they fall under the radar of regulators.
What is most disturbing about these products is that many financial advisers do not fully understand the risks and complexities that are involved with these products. The commissions generated from these transactions can be two to three times higher than a traditional registered product and the temptation to increase their payday makes it difficult for many financial advisers to pass up, especially when they do not have to share a portion of their hefty commissions with their broker-dealer.
Though investments sold-away may indeed be legitimate investment vehicles, products sold outside the due diligence and scrutiny of brokerage firms frequently lack sufficient liquidity and solvency. These products generally have risk profiles that are unsuitable for most investors. Additionally, investments sold- away may be fraudulent and represent shares in Ponzi Schemes or in fictitious issuing companies. Cases involving products the broker-dealer did not approve or know about commonly “blow up” and harm the client’s overall investment portfolio.
In disputes involving “selling-away” and outside business activities, claimants regularly state that they relied on the advice of the associated person effecting the transaction as well as the reputation and scrutiny of the brokerage firm prior to purchasing the unapproved investment. However, respondent FINRA member firms routinely respond that they were unaware of off-the-books activities of an Associated Person, and as such, claim no liability. For claimants, this often makes it challenging, but not impossible, that a significant portion of any losses stemming from the investment will be recovered.
Though vicarious liability claims have generally been unsuccessful against FINRA member firms in disputes involving selling away, FINRA rules and panel interpretations have established that there are instances when brokerage firms can be held liable for the unauthorized actions of an Associated Person. This discussion outlines and discusses the applicable industry rules pertaining to selling away, and examines the situations when FINRA Arbitration Panels have held Member Firms vicariously liable in Selling Away related disputes.
Regulation of Selling Away
FINRA Rules 3270 and 3280 set requirements for Associated Persons and mandated procedures for Member Firms regarding the disclosure and review of outside business activities and private securities transactions. FINRA Rules 3110 and 3130 require Member Firms to supervise the actions of Associated Persons–placing an obligation on firms to adequately monitor activities within client accounts. Relating to instances of Selling Away, FINRA supervisory requirements extend to the detection and supervision of off-the-books transactions.
The following section introduces these key items of FINRA regulation.
Requirements of Associated Persons
FINRA Rule 3270: Outside Business Activities of Registered Persons
Registered Persons are required to provide written disclosure of any business activity outside scope of their employment. Firms must maintain a record of each written notice received as specified in Rule 17a-4(e)(1) of the Securities Exchange Act of 1934 (8):
"No registered person may be an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member, in such form as specified by the member."
Upon receipt of a written notice of an Outside Business Activity, Member Firms shall consider whether the activity will: 1) interfere with or compromise the Associated Person’s responsibilities to the firm and/or customers; or 2) be viewed by the public as part of the firm’s business. Based on these factors, firms must evaluate the advisability of approving or limiting the Outside Business Activity.
FINRA Rule 3280: Private Securities Transactions of an Associated Person
Associated Persons are required to provide written notice for all securities transactions outside the scope of their employment at the firm, whether or not the persons receive compensation for the transactions:
No person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule. Prior to participating in any private securities transaction, an associated person shall provide written notice to the member with which he is associated describing in detail the proposed transaction and the person's proposed role therein and stating whether he has received or may receive selling compensation in connection with the transaction; provided however that, in the case of a series of related transactions in which no selling compensation has been or will be received, an associated person may provide a single written notice.
Upon receipt of a written request for a Private Securities Transaction for which compensation is to be received, the firm must provide a written response to the Associated Person stating whether the firm approves or denies his or her participation in the proposed transaction. If approved, the transaction must be recorded on the firm’s books and records and supervised as though executed by the Member Firm.
If the proposed Private Securities Transaction does not involve compensation, firms must provide written acknowledgement of the receipt of the request and may impose constraints on the Associated Person’s participation in the transaction.
Firm Supervisory Responsibilities
FINRA Rule 3110: Supervision
Member Firms must establish, maintain and enforce a supervisory system to monitor the activities of each Associated Person to achieve compliance with FINRA Rules in addition to all applicable securities laws and regulations. This rule requires firms to maintain Written Supervisory Procedures (“WSP”),
including provisions for the inspection of all internal communications, correspondence, transactions and
FINRA Rule 3130: Annual Certification of Compliance and Supervisory Processes
Supervisory systems provided for in Rule 3110 must be examined and certified as “reasonably designed” at least once a year. The Chief Executive Officer or equivalent officer(s) are required to review and certify their internal compliance policies and WSP. Firms are also required to hold an annual compliance meeting for Registered Representatives to discuss and review compliance-related matters.
Discussion: Potential for Firm Liability
Although FINRA Rules 3270 and 3280 place the obligation on Associated Persons to disclose Outside Business Activities and Private Securities Transactions for firm approval, the firm may not be indemnified if proper supervisory requirements were not upheld.
In determining firm liability in Selling Away disputes, FINRA Arbitration Panels frequently base their decisions on whether the Member Firm was aware of and failed to act on unauthorized activities or should have known about them. Establishing whether a firm should have been aware of Selling Away is based on an examination of three factors of the firm’s supervisory control system. Arbitrators consider:
1) Whether the firm established a “reasonable” supervisory control system
2) Whether the firm implemented and maintained this system
3) Whether the firm adequately acted upon and investigated “red flags”
If a Member Firm is found to be deficient in one or more of these areas, arbitrators may hold it liable for the off-the-books activities of its Associated Person.
1. Whether the Firm Established a “Reasonable” Supervisory Control System
FINRA Arbitrators examine whether the firm had a reasonable supervisory control system in place that adequately enforced all FINRA and MSRB Rules and applicable securities laws and regulations. A Member Firm with an inadequate supervisory system may be found liable as Arbitrators may maintain that a reasonable system may have either prevented or detected Selling Away.
An example of such an instance is the matter of Pochat v. Merrill Lynch, Pierce, Fenner & Smith, Inc. In 2012, a U.S. District Court upheld a ruling by a FINRA Arbitration Panel that found Respondent Merrill Lynch liable for failing to establish a reasonable supervisory control system. This ruling was based the existing system’s limitations in enforcing compliance with FINRA Rules 3270 and 3280.
In the Ruling, the Arbitration Panel cites Merrill Lynch’s failure to establish policies requiring the disclosure of Outside Business Activities and Private Securities Transactions within the firm’s Argentinian division. As a result, a Registered Representative solicited and effected the sale of an off-the books private placement for an established client, ultimately resulting in substantial losses due to financial duress experienced by the issuing company. The Panel concluded that Merrill Lynch lacked policies enforcing FINRA’s disclosure requirements that a reasonable system would have prevented this instance of Selling Away and fined the Respondent.
2. Whether the Firm Implemented and Maintained the Supervisory Control System
In addition to establishing an adequate supervisory control system, Member Firms are required to adhere and maintain the provisions of their WSP. FINRA Arbitrators examine whether these policies and procedures were implemented and maintained for supervising the activities of Associated Persons.
An example of such an instance is the matter of Battle v. Northeast Securities, Inc. (2008)11 where a Member Firm was found liable for failing to implement adequate supervisory procedures. In this dispute, a Registered Representative of Northeast Securities, Inc. solicited sales of promissory notes to a customer at the Member Firm, among others. However, the investments sold by the Representative were fraudulent and at the center of a Ponzi scheme. Although it was determined that Northeast Securities, Inc. did have a reasonable supervisory system in place, the Arbitration Panel concluded that the firm’s
compliance department failed to implement these policies in a reasonable manner, rendering the firm liable for the prohibited activities.
As was the case for Northeast Securities, Inc., a FINRA Arbitration Panel may deem that a firm would have known of an Associated Person’s Selling Away activities if a reasonable supervisory system had been implemented and enforced. Firms that fail to implement these policies effectively may be found liable in Selling Away disputes if it is determined that compliance personnel were “asleep at the wheel” and allowed suspicious activities to occur undetected.
3. Whether the Firm Acted Upon and Investigated “Red Flags” Member Firms may be held liable if it is determined that compliance personnel failed to act on and investigate or willfully turned a “blind eye” toward suspicious activities indicative of Selling Away. Here, the question is not whether the firm should have known of the unauthorized activity, but rather if the
firm attempted to intervene and investigate.
The 2007 matter of Chandler v. FSC Securities Corporation12 demonstrates an instance where a firm failed to investigate a series of red flags and was found liable by a NASD Arbitration Panel for a Representative’s Selling Away of fraudulent securities. Per the Panel’s ruling, the firm’s repeated failures to thoroughly investigate suspicious activities created “an extremely cozy environment” for the Registered Representative to defraud customers through the sale of fraudulent securities.
Here, the offending Registered Representative maintained a separate insurance office in which he claimed to firm compliance not to affect the sale of any securities. However, the Representative represented to firm customers through his correspondence and business cards that his office was indeed registered as a branch of the broker-dealer. It was from this office that the Registered Representative sold the fraudulent securities to clients. As the misrepresentation of the registration status of an office violates FINRA Rules, this activity should have prompted investigation from the firm’s compliance department.
Additionally, the firm failed to conduct reasonable due diligence in hiring the Registered Representative by failing to review his Form U5. Specifically, allegations made by the representative’s former affiliated broker-dealer included a “bogus business” and “forgery”. When questioned by the panel, the representative’s former supervisor at FSC Securities Corporation admitted that he had not examined these allegations before hiring him.
As a result of the firm’s failure to act upon cumulative red flags, the firm was found liable for losses experienced by the defrauded investors. In such instances, it is the obligation of compliance personnel to sufficiently investigate suspicious activities and occurrences. Any activities indicating Selling Away and detected by the firm’s supervisory control system must be acted upon promptly – often observed through incoming and outgoing correspondence, trade blotters and customer account statements.
Circumstances where Firms may not be Liable Under certain circumstances, the off-the-books activities of an Associated Person cannot be detected by a reasonably designed and maintained supervisory control system. In these instances, the Associated Person’s unauthorized activities occur outside the scope of the compliance department at the firm and provide no opportunity for detection.
An example of such an instance of undetectable activities is found in the matter of Bowman v. UBS Financial Services, Inc.13. This 2015 dispute involves a Registered Representative’s solicitation of firm customers to invest in a now defunct lumber mill which he maintained an ownership stake. This Outside Business Activity was disclosed to the Registered Representative’s employing firm, UBS Financial Services, and was approved under the explicit prohibition of involving firm customers. The Representative proceeded to sell interests of the lumber mill to firm customers by employing what the Panel deemed to be “deceptive strategies” in an effort to avoid detection by UBS Financial Services’ compliance department. Most notably, the Registered Representative conducted all correspondence on a non-business email address and instructed the firm’s customers to use personal bank accounts to purchase the investments. By undertaking such measures, the offending Representative was able to circumvent the oversight of the firm’s compliance department. Ruling in favor of the Respondent, the Panel determined that the firm established and implemented an adequate and reasonable supervisory system and had no way of detecting the unauthorized activity.
Supervisory control systems are designed to monitor firm-related activities of Associated Persons and client accounts. In instances where an Associated Person has exclusively conducted all unauthorized activities outside of the Firm and the reasonable scope of its supervision, it cannot necessarily be established that the Firm “should have known” of the activities.
In addition to damages owed to the Claimant, FINRA has the authority to issue monetary sanctions upon offending Member Firms. Sanctions are often issued as a response to repetitive and increasingly severe violations. FINRA imposes sanctions as a strong deterrent to prevent repeat violations by Member Firms in order to protect investors and strengthen market integrity.
FINRA may promulgate sanctions when Member Firms have been found negligent in their supervisory requirements in disputes involving Selling Away. A recent example of such an action can be found in the Securities & Exchange Commission and FINRA’s joint enforcement action against Signator Investors, Inc. The firm was censured and fined $450,000 for a failure to enforce the firm’s WSP to maintain compliance with FINRA Rule 3110, allowing a Registered Representative to sell fraudulent securities to firm customers. When determining whether sanctions are warranted, FINRA considers the following factors:
1) Whether the unauthorized activity involved customers of the firm.
2) Whether the unauthorized activity resulted directly or indirectly in injury to customers of the firm, and if so, the nature and extent of the injury.
3) The duration of the unauthorized activity, the number of customers, and the dollar volume in sales.
4) Whether the responding registered person misled their employer about the existence of the unauthorized activity or otherwise concealed the activity from the firm.
5) Whether the product involved in the unauthorized has been found to involve a violation of federal, state, or Self-Regulatory Organization (SRO) rules.
6) Whether the Member Firm has a history of disputes involving unauthorized activities.
7) The general severity of the violation.
The provisions of FINRA Rule 3110 require Member Firms to establish a reasonable supervisory system to enforce compliance with FINRA and MSRB Rules and all applicable securities laws and regulations. In addition, FINRA Rule 3130 requires Member Firms to annually review and certify their internal policies and procedures, as well as conduct annual compliance meetings to educate Associated Persons of firm policies. In turn, Member Firms are required to monitor for instances of unauthorized Outside Business Activities and Private Securities Transactions and to act upon them accordingly.
Although FINRA Member Firms often claim that they are not liable for the actions of an Associated Person Selling Away, the Firm may be held accountable if they should have been aware of the unauthorized activities. If the Associated Person’s Selling Away was effected within the scope of their Member Firm’s surveillance system, and it was neither detected nor acted upon by compliance personnel, there may be sufficient grounds for firm liability and/or sanctions.
ABOUT THE AUTHOR: Robert D. Lawson, CFE®, AIF®, RFC®, LUTCF®
Robert Lawson serves as the President and CCO of Barrington Capital Management, Inc., a Registered Investment Advisory Firm. Mr. Lawson has over 30 years of experience in the financial services industry. Additionally, he serves as a non-public FINRA and NFA Dispute Resolution Arbitrator.
Mr. Lawson serves as a public mediator and arbitrator as a Qualified Neutral under Minnesota Rule 114 of Standard Practice in Mediation and Arbitration. He is Memberships Chair for the Minnesota State Bar Association ADR Council and Board Member of The Securities Experts Roundtable.
Copyright Bob Lawson, AIF®, CFE®, RFC®, LUTCF®
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.