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NEWSLETTERS & ALERTS
B/D Fined for Poor Supervision Over 3rd-Party Payments, But Customers Pay the Price [Part 2 of 2]
by Howard Haykin
This is Part 2 of a 2-part report on FINRA sanctions against a broker-dealer that allegedly had poor supervision over 3rd-party payments. In Part 1, we highlighted the facts and circumstances underlying the settlement between FSC Securities and FINRA. Here, in Part 2, we offer an illustration into the consequences that can befall firm customers when private securities transactions are not supervised at the broker-dealer level.
BACKGROUND. As reported in FINRA Disciplinary Actions for June 2017, FSC Securities Corporation, an Atlanta, GA-based broker-dealer, was charged with having failed to establish, maintain, and enforce a supervisory system that was reasonably designed to review and monitor 3rd-party check requests from customer accounts. FSC Securities, which operates an independent contractor model with over 1,000 registered reps working out of over 600 branches located nationwide, agreed to pay a $200K fine to settle the case with FINRA.
INDIVIDUALS AND ENTITIES IN TODAY'S POST.
- FSC Securities Corporation – a broker-dealer and FINRA-member since 1977.
- PFG Fund – a private investment fund that purportedly sought “positive total returns with low volatility” through various investments, including equity securities trading in U.S. markets.
- PFGAM, LLC – the investment advisor that managed the PFG Fund.
- “A.P.”, an Individual – a one-time broker with FSC Securities, who voluntarily left in January 2008 and, one month later, created the PFG Fund and the PFGAM, LLC, investment advisor.
- “J.Z.”, an Individual – an FSC Securities broker and OSJ Principal, and the broker who sold memberships in PFG Fund to FSC Securities customers.
A.P. and J.Z. were FSC registered reps, and they worked in the same OSJ office. In January 2008, when A.P. voluntarily left the firm, J.Z. became the principal for FSC’s OSJ office, and some of A.P.'s accounts were assigned to J.Z. One month after departing the firm, A.P. formed a private investment fund (the PFG Fund) and an investment advisor (PFGAM, LLC). PFGAM initially registered with the state of Georgia and later became registered with the SEC. [Incidentally, the FSC OSJ office and PFGAM, LLC, operated out of the same business address – and, for all we know, they might have shared office space.]
Beginning in March 2009, A.P. recruited J.Z. to recommend the PFG Fund to J.Z.'s FSC customers; in turn, A.P. agreed to pay J.Z. a percentage of the fees that A.P. was receiving for managing customer funds through the PFG fund. J.Z. never informed FSC Securities about the arrangement, and he never sought the firm’s approval. In June 2010, J.Z. voluntarily left FSC and became employed with PFGAM. On or about February 2012, A.P. sold the investment advisor to J.Z.
PFG FUND LOSSES AND FRAUD. We later learn that PFG fund ultimately lost millions of dollars through speculative trading and other investments. To cover up the losses, A.P. created false account statements that fraudulently reflected fictitious assets and investment returns. The PFG fund collapsed in June 2012 when A.P. disappeared and was presumed dead. The FSC Securities customers who invested in the PFG fund suffered significant losses. J.Z. remained with the advisor until December 2012.
SO, THIS MUCH WE KNOW.
- J.Z. engaged in private securities transactions when he sold membership interests in PFG Fund to customers of FSC Securities.
- J.Z. never disclosed the private securities transactions to the firm, and he never sought the firm’s approval for soliciting investors.
- J.Z., however, indirectly notified FSC Securities when he submitted to the firm Letters of Authorization (LOA’s) signed by each of the 15 firm customers, which authorized in aggregate approximately $1.6 million to be transferred from their firm brokerage accounts to a bank account controlled by the fund.
- That said, FSC Securities failed to recognize the relevance of the 3rd-party payments. And so, without knowledge of the private securities transactions or of the existence of the PFG Fund, the firm never conducted any reviews on behalf of its customers who had invested in the fund through J.Z.
- Needless to say FSC Securities's failure was an 'opportunity lost' to detect J.Z.’s misconduct – which was to have engaged in undisclosed private securities transactions. When FSC Securities approved and processed the transmittal of the $1.6 million in customer funds to the fund, the firm was no longer accountable and "the trail went cold."
FINANCIALISH TAKE AWAYS. FINRA constantly drums into everyone’s heads the importance of “above board” handling of outside business activities and private securities transactions. Yet, judging from the number of violations that appear every month, it's clear that many brokers are reticent to disclose activities that are transacted “away from the firm” for fear the firm will say NO.
Yet, the rules and firm policies are established principally to protect customers. And then we come upon a case, like this, where customers lose substantial amounts of money when the incompetence of a registered investment advisor at managing money is hidden by that same advisor's fraudulent actions. A broker-dealer's customers were essentially left defenseless, in large because... (i) their broker refused to disclose the transactions to his broker-dealer; and, (ii) the broker-dealer had inadequate internal policies and supervisory procedures to detect suspicious 3rd-party payments. And neither will likely be held liable for these losses.
SOMETHING HAS TO BE DONE. Status quo is not acceptable.
- Stories like this one need to presented to all firm personnel - registered and non-registered, alike - if only to reinforce the inherent danger and risks of unsupervised outside business activities and private securities transactions.
- Dialogs must improve between broker-dealers and their registered persons, so that they work together as partners toward common goals.
- Customers must be provided with disclosures that more fully spell out the attendant risks of private securities transactions.
These recommendations are not intended to be an "end all, be all." But they're a start. Just like Financialish's efforts to shine a light on the problems. Like chicken soup, our efforts can’t hurt – and perhaps they might help.
In the meantime, Financialish is pleased to see that FINRA is presently collecting comments from its membership on these issues; hopefully, constructive action will come out of these efforts.