For FINRA, Unlike The SEC, Blaming The BD Always Seems To Be The Answer

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FINRA Enforcement has often been accused (again, admittedly, by me, and not too infrequently) of going after the “low-hanging fruit,” that is, taking the easy case when it presents itself.  Putting aside the question whether this observation is accurate or not – for what it’s worth, I think the answer is that it is often, but not always, true – a recent case triggers a better, more nuanced question: does FINRA Enforcement sometimes bring the wrong case, because it is easier?

Here is what made me think of this: a series of cases concerning a mutual fund called the LJM Preservation & Growth Fund (the “LJM Fund”).  You probably recall hearing about it.  The LJM Fund was a so-called “alternative” mutual fund.  Here is how FINRA defines that:

Alternative mutual funds are publicly-offered mutual funds that seek to accomplish the funds’ objectives through non-traditional investments and trading strategies. . . .  Alternative mutual funds are often marketed as a way for retail customers to invest in sophisticated, actively-managed hedge fund-like strategies that will perform well in a variety of market environments. Alternative mutual funds generally purport to reduce volatility, increase diversification, and produce non-correlated returns and higher yields compared to traditional long-only equity and fixed-income funds, all while offering daily liquidity.

The LJM Fund’s investment strategy involved, in part, collecting premiums from the sale of out-of-the-money options on the S&P 500 futures index.  (While the LJM Fund also bought options, overall, it was “net short.”)  Actually, this is a perfectly fine strategy, provided you are in a relatively flat trading environment.  In that setting, all you do is collect the premiums, watch the options you’ve sold expire worthless, and sit back and look like a genius.  In times of volatility, however, it carries the risk of significant losses as those out-of-the-money options suddenly become in-the-money.

On casual review, the LJM Fund apparently looked like any other of the hundreds of mutual funds that appear on the long lists of available mutual funds provided by clearing firms.  It did not readily appear to be an alternative or complex fund, and so was sold by several BDs to customers with conservative or moderately conservative investment objectives.

As you might expect in a story that starts out like this, the worst case scenario did, in fact, happen: on February 5, 2018, the S&P 500 fell 113 points, a loss of about 4.1%.  In just two days, the LJM Fund (and its companion private funds) lost 80% of their value, i.e., over $1 billion (yes, billion with a “b”).  A month later the Fund was liquidated and closed.  Customers suffered large losses.

So, what did FINRA do about this?  You can guess.  It took the easy path.  It went after BDs which had sold the LJM Fund.  In March this year, FINRA accepted AWCs from three such BDs.  The principal allegation that FINRA made was that the firms permitted the sale of the LJM Fund without having conducted reasonable due diligence, i.e., without fully understanding that it was an alternative fund, with unique risks that set it apart from all those vanilla mutual funds that also appeared on the sales platform.

In other words, as FINRA saw it, the customer losses were the fault of the selling BDs.  And that’s how FINRA always sees the world, in much the same way as PIABA lawyers do: it’s always the selling BD’s fault.

Yet, fast forward a few months from March to about a week ago, when the SEC filed a complaint against investment advisers LJM Funds Management, Ltd. and LJM Partners, Ltd. and their portfolio managers, Anthony Caine and Anish Parvataneni.[1]

These are the individuals and entities who ran the LJM Fund.  And what did the SEC allege that these defendants did wrong?  According to the SEC’s Litigation Release, they “fraudulently misled investors and the board of directors of a fund they advised” – i.e., the LJM Fund – “about LJM’s risk management practices and the level of risk in LJM’s portfolios.”  More specifically, while “LJM adopted a short volatility trading strategy that carried risks that were remote but extreme,” allegedly, some of the defendants, “in order to ease investor concerns about the potential for losses . . . made a series of misstatements to investors and the mutual fund’s board about LJM’s risk management practices, including false statements about its use of historical event stress testing and its commitment to maintaining a consistent risk profile instead of prioritizing returns.”

The SEC complaint further alleges “that, beginning in late 2017, during a period of historically low volatility,[some defendants] increased the level of risk in the portfolios in order to chase return targets, while falsely assuring investors that the portfolios’ risk profiles remained stable.”

In other words, at least according to the SEC complaint, these Defendants, who were well aware that “the funds’ investors and their financial advisors were primarily concerned about the risk of loss – including estimated worst-case loss scenarios – and how the risk of investment loss was managed,” intentionally and craftily created a false narrative about the LJM Fund’s risk management practices designed to mask the true risks associated with the fund.  And mask these risks not just from investors, but, as well, from the investors’ financial advisors.  That is, from the same BDs that FINRA decided to sanction because somehow, they failed – LIKE EVERYONE ELSE – to figure out that the folks running the LJM Fund were – allegedly – fraudulently hiding its real risks.

So, now we get to the point: for FINRA, it seems that when customer losses occur, especially after spectacular blow-ups like the sudden explosion of the LJM Fund, it goes after any BD that managed to have its fingerprints on things.  Rather than taking a more deliberative approach, one that takes into full consideration the fact that we are strictly dealing with a “reasonableness” standard of supervision, and one that is open to the possibility that the BD itself may have been a victim of someone else’s fraud, FINRA takes the “easy” route, as it did here with the three firms from which it exacted the AWCs, and just blames the BD.

Attentive readers may recall that not too long ago I wrote a blog generally complaining of claimants’ counsel who troll for clients by posting notices on their websites of supposed “investigations” that they are conducting of some alleged fraud, and specifically pointing out the intensive campaign they’ve waged to induce investors in GPB to file arbitrations against the BDs that sold GPB.  All that despite the fact that, according to the SEC, the selling BDs were not the bad guys, but were themselves the victims of the alleged fraud that was perpetrated by GPB.

Yet, notwithstanding this conclusion by the SEC, who among us would be surprised in the slightest if FINRA starts filing Enforcement actions against the selling BDs, alleging some supposed failure to have conducted adequate due diligence on GPB?  Sadly, the answer is none of us.  Because we know from its historic practice of playing the role of claimants’ counsel, that FINRA will, inevitably, blame the BDs.  Because it’s easy.

[1] Rather remarkably, mere minutes after I initially posted this blog, I received an email from the “strategic communications and media relations firm” that represents LJM Funds Management.  According to the firm’s website, among the services it offers to its clients is “reputation management,” which is described as follows: “We actively monitor and advise our clients on market and public sentiment around their businesses in the media and online.”  To that end, I was asked to share with you a statement from Mr. Caine in which he (1) denies the allegations, (2) insists that he has “summarily rejected” the SEC’s settlement offer, and (3) states his intent to “vigorously defend these false claims while continuing to aggressively pursue actions to seek financial recourse for LJM investors,” among other things.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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