FINRA Issues Guidance on Suitability Rule Concerning Definition of "Customer" and "Investment Strategy"

Thursday, December 27, 2012

By way of background, FINRA Rule 2111 requires that a broker-dealer or registered representative “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer based on the customer’s investment profile.”

Recently-issued FINRA Regulatory Notice 12-55 provides additional guidance related to FINRA Rule 2111. Specifically, Notice 12-55 addresses the scope of the terms  “customer” and “investment strategy.”

According to Notice 12-55, “the term customer includes a person who is not a broker or dealer who either opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent . . . or using another similar arrangement” (i.e. even though the security is not held by the broker-dealer).

Notice 12-55 also addresses the application of the suitability rule in the context of a recommendation made by a broker-dealer or registered representative to a potential investor. In such a case, suitability obligations do not apply unless the potential investor executes the transaction through the broker-dealer or if the broker-dealer receives compensation. If and when a transaction occurs, suitability obligations immediately commence. However, the suitability of the recommendation is evaluated based on circumstances at the time of the recommendation.

Notice 12-55 also addresses the term “investment strategy.” Under 12-55, the term “investment strategy” is to be broadly construed, focusing on whether the recommendation was suitable when made. The “investment strategy” language would  “apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the ‘Dogs of the Dow,’ or in a market sector, regardless of whether the recommendations identify particular securities.” This language would also apply to general recommendations to customers to use a bond ladder, day trading, “liquefied home equity,” or margin strategy involving securities even if the recommendations do not reference particular securities. In addition, “the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.”

It is worth emphasizing that, under Notice 12-55, the suitability rule encompasses a broker-dealers’ recommendation of an investment strategy involving both security and non-security components.

Although Notice 12-55 appears to offer some helpful clarifications, it is interesting to note the inconsistent treatment between customers and potential customers. Moreover, despite various illustrations, the limit of Notice 12-55’s broad reach with regard to investment strategy is far from clear. Outside of the specific illustrations in Notice 12-55, it seems that it would be safe to assume that most investment advice would constitute “investment strategy,” particularly given that this term is to be broadly construed. Time will tell how Notice 12-55 will play out in practice.

Regulatory Notice 12-55, Guidance on FINRA's Suitability Rule

Davis Polk. Guidance on FINRA's Suitability Rule


Former New Hampshire Stockbroker Convicted in Maine Theft and Securities Fraud Case

Thursday, November 8, 2012

On November 2, 2012, Maine Securities Administrator Judith M. Shaw and Attorney General William J. Schneider that former New Hampshire stockbroker James A. Philbrook was found guilty by an Aroostook County jury of two felony charges stemming from an investment scheme that duped a St. Agatha couple out of $195,000.

Philbrook initially convinced the couple to invest $145,000 in developing a pay-per-view cable television production featuring Carmen Electra. The couple relied on Philbrook’s assurances that the production would net a substantial return. Unbeknownst to the couple, Philbrook used a substantial portion of the money for his personal gain.

Following that incident, Philbrook obtained another $50,000 investment from the couple which he used for his personal benefit.  

The jury rejected Philbrook’s claim that the funds provided by the couple were personal loans to be used at his discretion.

Philbrook is expected to be sentenced in October. The New Hampshire Bureau of Securities Regulation took administrative action against Philbrook on September 7, 2012, for the same conduct.

SEC Shows Much Progress to Be Made in Educating the Average Retail Investor

Friday, August 31, 2012

On August 30, 2012, The Securities and Exchange Commission (SEC) released a “Study Regarding Financial Literacy Among Investors.” The Study is mandated by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.  The results of the Study are based upon multiple sources, including online surveys, focus group research, public comments to the SEC and a Library of Congress review of studies of financial literacy among U.S. retail investors. 

The SEC concludes that “U.S. retail investors lack basic financial literacy . . . have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.” According to the Study: "[I]nvestors do not understand the most elementary financial concepts, such as compound interest and inflation,” nor do they understanding “the differences between stocks and bonds, and are not fully aware of investment costs and the impact on investment returns." 

Aside from shedding light on the general lack of knowledge in the retail investment population, a primary goal of the Study was to provide solutions. Most of these solutions centered on providing more transparency as well as more relevant and understandable information to the average investor.

The Study lists some common traits of retail investors. The Study found investors prefer to receive investment disclosures before investing (rather than afterwards, which often occurs). In reviewing disclosures, most investors preferred a visual format, using charts, bullets and graphs. The Study also identified information that most investors find useful and relevant in helping them make informed investment decisions. This includes information on fees, investment objective, performance strategy, and risks of an investment product. The Study also found that with regard to financial professionals, most investors care about professional background, disciplinary history and conflicts of interest.

It is anticipated that the SEC will act on this information to at least implement steps to give retail investors the tools they need to invest safely and successfully.
Click here for a link to the study.



On the Taxation of Annuities Held by a Trust (or other non-natural person) . . . .

Thursday, August 30, 2012

Beware!  When selling (or buying) an annuity, keep in mind that annuities are not always tax deferred no matter who the investor might be.  An annuity sold to a corporation or a trust is a case in point.  Under section 72(u) of the Internal Revenue Code, an annuity held by a trust may not be tax deferred.    

The consequences can be dire.  From the perspective of the investor (the corporation or trust buying the annuity) the IRS will be looking for payment of taxes on phantom income The Trust may not have liquidity to make those payments.  At a bare minimum those payments are unexpected and significantly erode the performance of the annuity. 

From the perspective of the representative involved in the sale, the buyer may have legal recourse on a theory of fraud, misrepresentation, suitability, or otherwise based on representations at the time of sale that the annuity would be tax deferred, when the opposite might actually be true, or for failure to disclose that income is not deferred.   The purchase of an annuity by a non-natural person should be a compliance red flagThe customer should be provided a complete disclosure and should be given adequate and correct information on the anticipated after-tax performance of the annuity.

There are a number of exceptions and complexities to tax treatment of annuities that are not held by a natural person.  A qualified accountant or financial services lawyer should be consulted to determine – before the annuity is in place – how the annuity will be treated by the IRS.
For more information, contact Sigmund Schutz or click here for more about Preti Flaherty's Financial Services Group.

Attorney Richard Ploss Discusses New Financial Planner Sanctions with Dow Jones Advisor Reporter

Monday, July 30, 2012

Preti Flaherty’s Trusts and Estates Practice Group Chair, Richard Ploss, was recently quoted by the Dow Jones Advisor on the new sanctions for financial planners. Wall Street Journal and Dow Jones Advisor reporter Arden Dale discussed the Certified Financial Planner Board of Standards Inc.'s new rules, which now address personal bankruptcy, borrowing from clients, breach of contract, criminal convictions, forgery and inappropriate relationships with clients. Read the article here.

Richard is a Certified Financial Planner (CFP), a Certified Public Accountant (CPA) and an attorney with Preti Flaherty. Richard holds a Trusts & Estates Practitioner (TEP) designation, granted by the Society of Trusts & Estates Practitioners in London.

Richard practices in the firm's Bedminster, New Jersey, Portland, Maine, Boston, Mass and Concord, NH offices. Learn more about his practice here.

An Employment Lawyer's Take on Disgruntled Financial Industry Professionals

Saturday, July 14, 2012

The tell-all Op-Ed published by Greg Smith in the New York Times on March 14, 2012, accusing Goldman Sachs of having a rotten corporate culture, reverberated across Wall Street and beyond.  Damage to the reputation of Goldman Sachs and the reputation of the Street as a whole?  Yes.  One of many related issues is what employers – including brokerage firms and others in the financial industry -- can do to avoid or mitigate a similar reputational and public relations disaster.  I spoke with Betty Olivier, a partner in Preti Flaherty’s employment law group to explore the topic.

Sig:      What are the legal considerations for an employer when faced with a potentially disgruntled employee’s departure?
Betty:  If the employer has any control over the exit itself, it may have the ability to enter into a separation agreement with the employee that can address post-employment conduct.  This type of arrangement typically would involve the employer having to pay the employee severance in exchange for the employee’s agreement to do or refrain from doing certain things.  This type of agreement often includes non-disparagement language.  However, it is most typically used with involuntary separations, and may not provide a viable option when the employee just walks out the door. 

Sig:      So when an employee just walks out the door, up and quits, are there options available to an employer in addressing that kind of situation?
Betty:  Often written employment agreements executed at the beginning of employment include language that can reduce the risk.  It will always be difficult for an employer to dictate what an employee does after the relationship ends, but there are provisions that can be included in employment agreements that address some types of post- employment conduct.  For example, many employers have written confidentiality and non-disclosure agreements with their employees, and the language in those agreements can regulate the kind of things an employee can say about a company on the way out the door. 

Sig:      Those agreements don’t typically restrict opinions about the company, do they?
Betty:  No, they are generally designed to protect confidential information, but may be of some use in limiting what an employee says about a company or in limiting the assertion of certain facts as supporting opinions.

Sig:      If ongoing compensation is owed, that would be potentially an incentive for the employee to abide by those terms or risk forfeiting compensation.
Betty:  Not necessarily. If the compensation owed is for services provided while the employee was employed, the employer can’t condition payment on an agreement to behave after the relationship ends. If there is an agreement to make a post-termination payment and that payment is conditioned on the employee abiding by confidentiality and nondisparagement obligations, among other things, that payment might provide the incentive.  Employers have to be careful about imposing certain types of restrictions on certain employees, and avoid claims of improper restrictions on those employee’s right to speak.  There has been a lot of activity with the National Labor Relations Board regarding employer policies that restrict employees from talking to each other about terms and conditions of employment.  One would have to look very closely at any restrictions proposed to make sure that language is not construed to be overly broad or violative of an employee’s right to engage in concerted activity.

Sig:      In this situation, presumably to convince the New York Times to publish his Op-Ed, Mr. Smith presumably took with him internal company emails and documentation to confirm the accuracy of the facts that he reports in his Op-Ed.  What’s your reaction to that?
Betty:  That, hopefully, is the kind of behavior most employers take action to protect against when they hire employees.  Email on an employer’s server is the property of the employer, not the employee.  Many e-mails may contain confidential proprietary information. Employers  should have some arrangement that prohibits employees from taking Company property with them when they leave employment. 

Sig:      The situation with Greg Smith is extreme both in terms of the highly public nature and content of the article is published.  The New York Times Op-Ed page is about as public as one could get.  The accusations themselves are harsh.  You get a call from the HR director or CEO of a client saying have you read this morning’s local paper, have you seen the article by my former Vice President?  It contains harsh accusations about the company’s culture or its treatment of clients.  What options are available to the company from an employment perspective.
Betty:  If the statements are false and defamatory, the employer may be able to pursue a defamation claim.  There can be downsides to that course of action, however.

Sig:      One of the issues there is whether a legal claim or response further risks damage to reputation by keeping the story in the news and creating a forum for more back and forth over what really happened.  What are your thoughts as to what should be done from a public relations standpoint?
Betty:  You raise a very important point. Companies should consider whether the commencement of a lawsuit might carry with it certain risks, and weigh those risks against the benefit of pursuing a claim. If a company is considering using the media to respond to a disgruntled former employee’s claims, it should consider the very issue you raise – that is, whether they will only draw more attention to a bad situation. There are firms that can help companies deal with this kind of public relations nightmare, and it may be worth a company’s while to retain professional assistance.  The point is that the response is not strictly or even primarily a "legal" one.

New Hampshire Ramps Up Efforts to Warn of Investment Scams

Friday, June 8, 2012

The New Hampshire Bureau of Securities Regulation (NHBSR) recently announced the launch of a television ad campaign in an effort to raise public awareness of con artists in the investment world, the cost of which will be funded by the Investor Protection Trust (IPT). The IPT, founded in 1993, is part of a multi-state settlement to resolve charges of misconduct and serves as an independent source of non-commercial investor education materials.

According to the NHBSR, would-be investors should approach any potential investment opportunity with caution, and proceed only after ample investigation. In particular, if nothing else, investors should check whether a seller is licensed and whether an investment product is registered.

Of course, investors are always encouraged to dig deeper when it comes to any potential investment. Investors are also encouraged to contact the NHBSR with any questions. According to Barry Glennon, Deputy Director of the Bureau, “Before you invest your hard-earned money, it is vitally important to call the Securities Bureau to investigate both the promoter and the investment.”

Glennon noted the risk associated with high-return investments: “Citizens should understand that ‘high return’ investments often carry high risk including the risk that the investment may yield no return, or, worse, a substantial loss to the investor.”

New Hampshire is unfortunately entirely too familiar with investment scams. In recent years, New Hampshire investors have been victims of various con-artists, resulting in significant losses to some investors.,0,3662775.story

Maine Office of Securities Puts an Oar in the Water on Crowdfunding

Wednesday, May 23, 2012

Crowdfunding is an online money-raising strategy that began as a way for the public to donate small amounts of money, making it easier to raise capital for young companies. Under the federal Jumpstart Our Business Startups (JOBS) Act (HR 3606), small businesses and entrepreneurs will be able to tap into the “crowd” in search of investments to finance their business ventures.

Among other things,  the JOBS Act amends § 4 of the Securities Act of 1933 to create a new exemption for offerings of “crowdfunded” securities. This amendment effectively exempts  issuers from the requirements of §5 of the Securities Act when they offer and sell up to $1 million in securities, provided that individual investments do not exceed certain thresholds and the issuer satisfies conditions in the JOBS Act, some of which will required SEC rulemaking.

The regulators are still catching up. Congress directed the Securities and Exchange Commission  to adopt rules within 270 days to implement a new exemption to allow crowdfunding. Until the SEC adopts these rules, no one can act as an intermediary or take advantage of the crowdfunding statute. On April 23, 2012, the SEC issued the following warning:

On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. The Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.

Maine’s Office of Securities recently issued a similar advisory warning would-be investors to tread carefully when contemplating crowdfunding investment opportunities.  According to the Office of Securities, the prudent approach would be to wait until SEC rules are adopted regulating crowdfunding. The bottom-line for investors is “wait and see” when it comes to crowdfunding.

Review of Enforcement Activity by the Maine Office of Securities Under Gov. LePage Shows Little Change as Compared to Similar Activity Under the Prior Administration

Monday, May 21, 2012

With some exceptions, the Maine Office of Securities under Gov. LePage has been as active as the Office was under Gov. Baldacci, at least measured by the number of actions taken.

Enforcement-related administrative orders have remained stable in number as compared to recent years. To date, as of January 1, 2012, there have been 9 enforcement-related administrative orders. In 2011, there were 11 enforcement-related administrative orders. These orders dealt with a range of offenses, from acting as a broker-dealer or investment adviser while not properly licensed, failing to comply with prior orders of the Office of Securities, borrowing funds from clients, “unlawful, dishonest or unethical practices” and the sale of unregistered securities. In 2009, there were 9 administrative orders. There were 19 such orders in 2010. At the current pace, the Office of Securities is on track to issue a larger number of administrative enforcement orders than any of the past three years with the exception of 2010. 

To date in 2012, there have been 3 criminal and/or civil enforcement actions. In 2010 and 2011, there were 7 such enforcement actions in each year. In 2008 and 2009, the State brought three enforcement actions. These actions included claims of theft by deception, theft by misapplication and securities, fraud, diversion of money for personal use, and making false statements of material facts. By all accounts, the Office of Securities is on track with the past 2 years in this area.

Recent months have seen a sharp decline in consent agreements. Since January 1, 2011, there have been 4 consent agreements, There have been none so far in 2012. In 2010, 4 consent agreements were executed. In 2009, 3 such agreements were executed. The overwhelming majority of these consent agreements pertained to licensing issues. The Office of Securities has been more active in the past, with 15 such consent decrees in 2006 alone.

The overwhelming amount of actions deal with licensing issues. It seems this will continue to be an issue as more out-of-state investment entities perform work for Maine residents.  Overall, under the LePage administration, enforcement actions have remained fairly constant in number.

Schwab's Bid to Avoid FINRA Arbitration Rejected by Federal Court

Tuesday, May 15, 2012

A federal judge has dismissed a federal lawsuit brought by Charles Schwab, Inc. (Schwab) against the Financial Industry Regulatory Authority, Inc. (FINRA) in the United States District Court for the Northern District of California.  U.S. Magistrate Judge Elizabeth LaPorte found that federal court was not the proper forum for the dispute between Schwab and FINRA, which instead must first be adjudicated by FINRA's internal arbitration process.  The court's finding means that the industry cannot have it's cake and eat it too by aggressively enforcing the binding arbitration provision in its customer agreements while simultaneously running to federal court when it wants an injunction to stop a proceeding pending against itself.

The Schwab/FINRA dispute may still make its way to federal court since FINRA arbitration decisions can  ultimately be appealed to a federal appeals court.  A federal court, however, under this decision, cannot be the court of first instance for such a dispute.

Bill Introduced to Have FINRA Oversee Investment Advisors

Friday, April 27, 2012

On Wednesday, April 25, 2012, House Financial Services Committee Chairman Rep. Spencer Bachus (R-Ala) and Rep. Carolyn McCarthy (D-N.Y.) introduced legislation that, if passed, could make FINRA the self-regulatory organization for financial advisers.  Investment Adviser Oversight Act of 2012. Presently, the SEC has oversight of financial advisers.  The bill would permit the creation of one or more self-regulatory organizations, known as National Investment Adviser Associations, which would report to the SEC. Advisers with retail clients would be required to belong to one of the associations and pay membership dues. 

For any number of reasons, the SEC has been unable to adequately examine the overwhelming majority of investment advisers. The statistics speak for themselves.  There are approximately 12,000 registered advisers in the U.S., the vast majority of whom never undergo regular examination by the SEC.  According to Rep. Bachus, the average SEC-registered investment adviser can expect to be examined less than once every 11 years” and “only 8 percent of investment advisers were examined by the SEC in 2011, compared to 58 percent of broker-dealers. “

Critics of the bill believe that building on the SEC’s existing infrastructure and experience is a better option than creating an added layer of regulation.  Proponents of the bill cite the need for regulation, particularly given that many consumers have little if any understanding of the different titles that investment professionals use.  Proponents of the bill believe oversight by FINRA would increase protection for investors by subjecting advisers to at least the same level of scrutiny as broker-dealers.

Whatever the outcome, it will be interesting to watch this unfold. According to industry officials, a vote is expected as early as May 2012.  Please contact John Cronan at 207.791.3000 for more information or with any questions.

Misrepresentation Case Against Bank Directors, Officers, and Accountant Comes to Federal Court in Maine

Wednesday, April 25, 2012

A case accusing former directors and officers of the Savings Bank of Maine Bancorp and its auditor alleging misrepresentation and professional malpractice in connection with an $18 million loan just landed on Maine shores.  The complaint alleges that the loan was written down by half to $9 million.

The case, Bankers' Bank Northeast v. Ayer, et al., Docket No. 1:12-cv-00127-GZS was pending for about 14 months in Connecticut federal court until that court granted a motion to dismiss for lack of personal jurisdiction as to one of the defendants and, instead of dismissing, transferred the case to federal court in Maine.  The case was formally entered on the docket of the Maine federal court on April 17, 2012.  The case has been assigned to Judge George Z. Singal. 

Last week, the Bangor Daily News published an article covering the transfer of the case and summarizing some of the allegations, which defendants have denied, "Federal Suit Against Former Maine Bank Officials, Accountant Moved to Bangor Court."

Preti attorneys Gregory P. Hansel and Sigmund D. Schutz have been selected as Maine counsel to defend a group of former Bank officers named in the lawsuit.

Welcome to the New England Securities Litigation & Arbitration Blog!

Tuesday, April 24, 2012

The goal of this new blog is to inform, educate, and engage on legal issues impacting the financial services industry with a particular focus on securities, financial industry, and fiduciary litigation and arbitration in Maine, Massachusetts, and New Hampshire.  

We are lawyers who handle securities industry and stockbroker disputes with customers, disputes with insurers and insurance agents over sales and other practices, disputes with registered investment advisors, directors and officers liability, trust and fiduciary disputes, and financial services litigation and arbitration.  We practice in state and federal trial court, state and federal appeals courts, and in arbitration.  We have arbitrated before the Financial Industry Regulatory Authority (FINRA), the American Arbitration Association (AAA), and other forums. 

We also have regulatory defense experience in connection with investigations and enforcement actions before agencies involved in securities and insurance regulation throughout the region. 

 Please comment, ask questions, and contact us.  Welcome!