I apologize for taking so long between posts, but, to be fair, there’s been a lot going on in the past week or so that has captured my attention!  I wish everyone a happy and SAFE new year! – Alan

While undoubtedly FINRA will be issuing its annual “examination priorities” letter any day now, that is hardly the best way to figure out exactly what FINRA is paying attention to now (as that letter kind of reads the same, year after year).  Rather, it is much more effective to read the results of the latest Enforcement actions.  That will really tell you the kinds of cases that FINRA is bringing, the kinds of respondents it is naming, and the sort of sanctions it is meting out.

There have a bunch of interesting cases of late, and I intend to get to them all eventually, but I thought I would start with this AWC from New Year’s Eve, a churning mess involving Worden Capital Management and its owner, Jamie Worden.  I realize that I just posted a piece about churning in November, but this case merits its own attention.

According to the summary, for about a 4-and-1/2-year period, the firm and Mr. Worden

failed to establish, maintain, and enforce a supervisory system, including written supervisory procedures (WSPs), reasonably designed to achieve compliance with FINRA’s suitability rule as it pertains to excessive trading.  As a result, WCM registered representatives made unsuitable recommendations and excessively traded customer accounts, causing customers to incur more than $1.2 million in commissions.

Let’s explore what happened.

First of all, you should know that the bulk of the firm’s business consisted of “registered representatives recommending active short-term trading to retail customers with speculative investment objectives.”  Given that, and given the fact that Rule 3110 mandates that a firm’s WSPs must be specifically tailored to the kinds of business that it actually conducts, it seems pretty dang clear that the suitability section of WCM’s WSPs should have contained a pretty hefty portion devoted to the supervision of churning, a/k/a quantitative unsuitability.

Well, not so much.  Turns out that the WSPs were, in fact, pretty skimpy where it mattered.

First, while the WSPs appropriately noted “that factors such as the turnover rate, the cost-to-equity ratio, and in-and-out trading might be indicative of a suitability violation,” they “did not define those terms.”  Second, and worse, the WSPs “also failed to explain what actions to take when supervisors and principals observed such activity.”  Finally, “although branch managers were responsible for supervising trading activity at their assigned branches, the WSPs were silent on how they should perform that supervision.”

In other words, the WSPs not only failed to describe what supervisors should have been looking for, they also failed to detail how the supervisors should have been conducting such reviews, or what to do if they actually found a problem.  0 for 3.

The AWC goes on to describe the ways that WCM did attempt to keep any eye out for churning, but, as you will see, they were so patently insufficient that FINRA found that they “were individually and collectively unreasonable.”

The principal unreasonable thing that the firm did was not provide its supervisors with the proper tools they needed to perform their job.  WCM supplied its branch managers daily trade blotters.  But, because the blotters “were not designed to flag excessive activity,” they didn’t contain the typical data one needs to spot churning.  Some branch managers were alert enough to independently calculate the cost-to-equity ratios – which, according to the AWC, “revealed high levels of trading activity in customer accounts” – but they failed to take reasonable steps to address what they discovered.

Apparently, WCM also used a Monthly Active Account Report, which “flagged customer accounts meeting certain thresholds such as high commission-to-equity ratios, high volume of trades, and losses greater than 20% of an account’s equity during the month.”  Wow, sounds great, right?  Indeed, the report “routinely flagged dozens of customer accounts each month.”  Even better, the report is doing what it was designed to do!

Sadly, even a good report is useless if you ignore it, or don’t understand it.

Here, Mr. Worden delegated a guy to review the report, but, alas, Mr. Worden failed to train him how to read it.  As a result, the poor delegate “could not define or calculate a cost-to-equity ratio or turnover rate.”  Thus, even though the report generated “high cost-to-equity ratios and turnover rates to identify potentially violative conduct,” that data was meaningless to the supervisor, who “wrongly assumed all active trading was suitable for customers with a speculative investment objective.”

Take, for example, the March 2017 Monthly Report.  It flagged 91 accounts, approximately 10% of all firm accounts that traded during that month.  Those accounts – which appeared on the report multiple times – “should have attracted scrutiny because the accounts had (1) annualized cost-to-equity ratios and turnover rates well above the traditional guideposts of 20% and 6, respectively, (2) large numbers of transactions and high commissions, and (3) substantial losses.”  Unfortunately, there was no such scrutiny.

Finally, it is particularly instructive to note that the AWC takes the delegate to task for the activity letter (or happiness, or comfort letter, as some refer to it) that he sent to flagged customers.  Rather than telling them in clear terms that their accounts were potentially being churned, his letter “merely stated that the firm ‘trust[ed]’ customers were receiving ‘trade confirmations and monthly statements on a timely basis and are reviewing them for accuracy.’”  This comports with the advice that I have been giving for decades, that it is actually worse to send a BS activity letter than not to send anything.  If you are going to notify a customer that his or her account has exceeded one or more objective criteria consistent with excessive trading, you need actually to spell out the numbers.  While such a letter is, obviously, more likely to induce the recipient to conclude his account has been mishandled,[1] at least you will get some credit with the regulator (and, perhaps, an arbitration panel) when it comes to the supervisory aspect of the case.

Compounding his problem, Mr. Worden also failed to ensure that his delegate was actually conducting the review.  And, in a triumvirate of supervisory failures, “although Worden had access to the Monthly Reports and occasionally reviewed the reports [himself], he never acted on the dozens of accounts that routinely were flagged because he believed active trading was suitable for speculative customers.”  Indeed, to the contrary, Mr. Worden “rejected the CCO’s recommendation that at least four representatives be disciplined for unsuitable recommendations.”

As for sanctions, as ugly as these supervisory problems appear to have been, and despite the fact the AWC also includes violations of two other rules, one relating to a plan by Mr. Worden and the firm to interfere with 288 customers’ efforts to transfer their accounts from WCM to another BD, and another involving the firm’s failure to timely disclose customer arbitrations on Forms U-4 and U-5, they don’t appear to be too bad.  Sure, there’s the hefty restitution piece – to the tune of $1.2 million – that we have come to expect to see under Jessica Hopper’s reign as head of Enforcement – but Mr. Worden got slapped with a mere $15,000 fine, a measly three-week suspension in all capacities, and a three-month supervisory suspension.  The firm got a $350,000 fine.  Not cheap, but not horrible, under the circumstances.

What are the lessons we can glean from this New Year’s Eve settlement?

• Make sure your WSPs are specific to your business.
• Make sure the principals to whom you delegate supervisory responsibilities are properly qualified, by training and/or pertinent experience, to do the job.
• After you delegate supervisory responsibilities, take steps – demonstrable, provable steps – to follow up and ensure that they are, in fact, doing what they are supposed to be doing.
• Provide your delegates with the tools to do their job. Spring for the exception reports that your clearing firm offers.
• Don’t play games with your customers. If you are going to go to the trouble of sending them a letter about their account activity, make it meaningful.
• If you do something wrong, and it costs your clients money, pay it back to them. Do it before FINRA makes you.

[1] As proof of this point, the AWC recites that “WCM briefly implemented a more detailed active account letter that reflected, among other things, the amount of commissions paid by the customer and the number of transactions,” but “the firm ceased using this letter after one month because it caused customers to express concerns about their accounts.”  Ha!