Suitability, unauthorized discretion, and conversion of customer funds recently caught FINRA's attention, along with 6 others violative actions by brokers and associated persons.  Follow the odyssey as Compliance-Insights sums up what "what went wrong" in these message cases.   [Case studies 7, 8, 9 appear after jump.]

1. Entering Fictitious Trades and Causing Inaccurate Firm Records.
2. Improper Transfer of Confidential and Proprietary Information.
3. Misrepresenting Information Regarding Prospectus Delivery.
4. Willful Failure to Disclose Material Information on a Form U4.
5. Misappropriation of Customer Funds and Failure to Respond to FINRA Investigation.
6. Improperly Engaging in Outside Business Activities and Failing to Respond to FINRA Information Requests.
7. Unsuitable Recommendations.
8. Improper Exercise of Discretion, Unsuitable Recommendations and Failure to Disclose Risks.
9. Conversion of Customer Funds.

7. Unsuitable Recommendations. An RR had a customer who was contemplating early retirement in the near future, seeking growth and income, and wanting to withdraw a monthly amount without paying the IRS tax penalties.  The broker recommended class A shares of 3 mutual funds and a cash management trust.  The customer agreed and invested his entire retirement savings of $530,000 in those products, paying an upfront load of nearly $10,000 for the mutual fund shares - which carried an annual expenses of nearly $3,000.  The RR received $6,900 in connection with the purchase.   Later that day, the RR learned about a particular deferred variable annuity (V/A) with an income protection rider, which led the RR to consider his options - here's how C-I imagines the RR's internal conversation might have gone:

Hmmm, the RR mutters. "Too bad I didn't know about this variable annuity sooner!   Anyway, I've never this type of product before, so it doesn't matter.  However, it does come with a big up-front commission!  There must be a way I can do it ...  at least to justify it.  Got it!  First, I'll unwind this morning's trades..."

The RR proceeds to recommends to the customer that he liquidate the mutual fund shares he bought earlier that day, and use the proceeds to purchase the deferred V/A.  The customer agrees and the "swap" is completed.  This second round of transactions only cost the customer $10,500 - bringing his one day's costs to about $20,500.   The RR, meanwhile, got his big payday, receiving $21,145 in compensation on the V/A sale. Subsequently, the V/A company miscalculated the customer’s monthly withdrawal and failed to factor into the calculation the customer’s tax limitations, thereby rendering the annuity’s income protection rider moot.  The RR failed to notice the miscalculation until a later date. FINRA's take on these 2 transactions on a single day was unsuitable for the customer because:  (i) customer unnecessarily paid an upfront sales charge for the mutual funds and substantially higher annual fees;  and, (ii) customer is now over-concentrated in an illiquid deferred V/A.

The RR agreed to settle FINRA's charges that he conduct violated NASD Rules 2310 (recommendations to customers) and 2110 (ethical standards), and NASD IM-2310-2 (fair dealing with customers), by accepting a $5K fine and a 1-month suspension.

[C-I Note: The customer costs - covering his unsuitable investments and his unnecessary expenses - are much greater than the costs of the RR's sanctions.  While we have few facts to work with, it is our opinion that the transactions should be rescinded and the customer made whole - with the RR and/or the firm (which approved the 2 sets of purchases) covering all costs.]

8. Improper Exercise of Discretion, Unsuitable Recommendations and Failure to Disclose Risks. For more than 2 years, an RR exercised discretionary authority in a husband and wife’s joint account without obtaining their prior written authorization and his employer firm’s written acceptance of the account as discretionary.   To make matters worse, the RR:

• engaged in excessive and unsuitable trading in the account, which generated substantial losses and high transaction costs;  over time, the annualized cost-to-equity ratio was 35%;
• used margin to trade in the account;
• recommended that the customers use funds borrowed against their primary residence and vacation home;
• failed to disclose to the customers the risks associated with trading on margin and engaging in high-frequency trading;

FINRA found that the RR's conduct violated NASD Rules 2510 (discretionary accounts) and 2110 (ethical standards), and that his unsuitable and excessive trading violated NASD Rules 2310 (recommendations to customers) and 2110 (ethical standards), and NASD IM-2310-2 (fair dealing with customers).  The RR was barred from the industry.

9.  Conversion of Customer Funds. The CCO of a broker firm converted about $14,000 from 2 firm customers.  First, he used a fictitious LOA (letter of authorization) to transfer securities and cash worth $4,000 from a customer account to a personal trust account that he had established at his firm.  He also used the firm’s systems to temporarily change the address on the customer’s account to his own work address - preventing the customer from learning about the transfer. One month later, the CCO used a fictitious retirement account distribution form and LOA to transfer various securities and cash worth about $10,000 from a customer’s IRA account to his account.  The CCO used the converted funds for his own personal benefit.

This registered person’s conduct violated FINRA Rules 2150(a) (improper use of customer funds or securities) and 2010 (ethical standards), he was barred from the industry.

For further details, go to:   [FINRA Quarterly Disciplinary Review, January 2012].