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Regulatory Sanctions

Failed Supervision at NEXT Financial Enabled Broker to Fleece Customer Accounts

March 22, 2018

by Howard Haykin


If you haven’t already read the adjoining Financialish post, A Broker’s Death Wish (Or A Case of Failed Supervision, you're encouraged to do so; it’s the lead-in to this article. Whereas that case study dealt with a broker's churning of his customer's accounts, this case study deals with the broker-dealer's inherent compliance and supervisory failures, which FINRA says enabled the broker to commit his violative actions.
It's unusual for FINRA to place enormous blame on a broker-dealer (and its supervisory and compliance personnel) for the violative actions of one of its brokers. As readers of Financialish know, I have repeatedly raised this issue and will continue to do so until FINRA demonstrates a fair and consistent application of responsibility to member firms and their supervisory-types for ‘crimes against customers’. [Comments and dissenting opinion are most welcomed.]


FINRA AWC #2015043319901.    NEXT Financial Group agreed to pay a $750K fine and to retain an Independent Consultant to settle FINRA charges that, among other things, it failed to implement a system reasonably designed to detect excessive trading. NEXT, a Houston, TX-based FINRA member since 1999, is a general securities broker-dealer that currently has some 612 registered persons operating out of 411 registered branch offices.


FINRA FINDINGS.    FINRA cited NEXT for its failure to implement a system reasonably designed to detect excessive trading. From May 2014 through September 2015, the firm failed to establish, maintain, and implement a supervisory system reasonably designed to detect and address excessively traded accounts. The supervisory failings resulted from inadequate corrective action taken by the Firm in response to prior FINRA disciplinary actions, which included a failure to use exception reports or any other reasonably designed system to detect excessive trading. In addition, the Firm failed to identify excessive trading due to lack of clarity regarding supervisory responsibilities on the part of compliance personnel. 


NEXT RESPONDED TO PRIOR DISCIPLINARY ACTIONS BY UTILIZING FAULTY EXCEPTION REPORTS.    In the wake of prior supervisory failures identified in the 2009 and 2010 settlements with FINRA, NEXT began using exception reports to monitor for excessive trading. Those exception reports, however, had inappropriate parameters and were not reasonably designed to detect active trading.


As a result, an account that had been excessively traded for the last 6 months of the prior year, might not appear as an excessively traded account once a new year begun.


Similarly, NEXT tracked year-to-date trade values to determine the volume of transactions occurring in an account. This calculation was also flawed, because the Firm combined buys and sells, resulting in an understated ratio.


Another measurement commonly used to evaluate active trading is the cost-to-equity ratio. Generally, this is the value of the account compared to the commissions charged and is reflected as a percentage. The ratio is used to determine the percentage of return an account would need to achieve to break even, considering the commissions charged. The Firm's exception reports were calculating the cost-to-equity ratio using a monthly equity value, rather than averaging the equity over a specified period of time. The resulting cost-to-equity ratio was often deceptively low due to the system used for the calculation.


Furthermore, in determining the commissions to use far the cost-to-equity ratio, NEXT included only commission figures and no markups and markdowns which were additional costs that the customers incurred in connection with bond trades. Consequently, the actual costs could be higher than reflected in the Firm's exception reports.


NEXT’S design of the exception reports resulted in the possibility that the exception reports would not identify excessive trading.


NEXT CONTINUED ITS FAILURE TO MONITOR CREATION AND REVIEW OF DOCUMENTATION USED TO SUPERVISE EXCESSIVE TRADING.    In the 2009 Settlement, the Firm was relying on delivery of Purchase & Sales blotters to the Regional Managers to review far excessive trading. At that time, many of the blotters were not delivered, resulting in no supervisory review of excessive trading for certain registered representatives. In 2014 and 2015, similar problems arose with the new exception reports intended to address active trading.


The Surveillance Department was tasked with creating and reviewing exception reports related to excessive trading. From May 2014 through September 2014, the Surveillance Department generated the exception reports, but never reviewed the reports. Subsequently, from October 2014 through September 2015, the Surveillance Department neither created nor reviewed the reports. Due to a lack of oversight, the Compliance Department was unaware that the reports were not being created or reviewed. Only during the FINRA cycle exam in September 2015 did the Firm identify the problem and begin to bring its reports current.


NEXT FAILED TO DETECT EXCESSIVE TRADING DUE TO ITS UNREASONABLY DESIGNED PROCEDURES.    Throughout 2014 and 2015, a NEXT Registered Rep (Joseph Cotter) engaged in excessive trading in the accounts of a Customer. The time period of the excessive trading included the entire 14 months that the Surveillance Department failed to review the active trading exception reports. The Customer was an investor who routinely accepted the Registered Rep’s recommendations. During the 2-year period, the Registered Rep’s trading resulted in an average turnover rate of 9.84 and, an average cost-to-equity ratio of 23% (converted to a percentage) in an IRA account of the Customer. In a second account, the trading resulted in an average turnover rate of 5.3 and an average cost-to-equity ratio of 20% (converted to a percentage). The trading generated total gross commissions of $147,718. During this same period, the Customer's accounts experienced losses of $391,893. NEXT, however, failed to address the activity until 2016 due to flaws in its supervisory system.


NEXT PROCEDURES CONTINUED TO LACK CLARITY RE: SUPERVISION AND ESCALATION OF EXCESSIVE TRADING.    The Registered Rep’s excessive trading activity was not reasonably supervised by the Firm due to the lack of exception report creation, lack of exception report review, and lack of clarity regarding escalation.


In July 2013, the Registered Rep’s direct supervisor first raised concerns with Compliance regarding trading by the Registered Rep. Compliance tasked a manager with conducting a branch audit of the Registered Rep’s branch. Despite repeated inquiries from Registered Rep’s direct supervisor regarding the trading review, the branch audit was not completed until over a year later, in October 2014.


In response to the audit question "Are them an unusually large number of transactions in a single account?” the auditor answered "Yes," identifying 4 accounts, including an account for the Customer. The auditor further noted that the 4 accounts represented 48% of all trades entered by the Registered Rep in 2014. The audit results, however, were never escalated. There is no evidence that anyone followed up to ensure the audit was completed or reviewed the results. As a consequence, the Registered Rep continued to excessively 'trade the Customer’s account until February 2016 without any meaningful response from the Firm. In February of 2016, the Customer complained to the Firm. As a result of the investigation that occurred in connection with the Customer's complaint, the Firm terminated Representative 1 and settled with the Customer for $386,646.


The supervisory violations in the 2009 Settlement resulted in part from lack of clarity over the person responsible for supervising a registered representative engaged in excessive trading. Similarly, in 2014 and 2015, the Firm lacked clarity regarding the person responsible for responding to Representative 1's excessive trading. If the Finn had instituted reasonably designed procedures to ensure branch audits were completed and findings of excessive trading acted upon, the Firm could have prevented the excessive trading by Representative 1 in the Customer's account.


FINANCIALISH TAKE AWAYS.    Despite NEXT Financial's good intentions, and the firm's "second chance at getting it right" (i.e., by addressing issues raised in prior FINRA disciplinary actions), the firm and its (supervisory and compliance) personnel repeatedly committed costly mistakes. The systemic and supervisory failures cited in this case point to the urgency in getting things right the first time around.


This case was reported in FINRA Disciplinary Actions for December 2017.

For details on this case, go to ...  FINRA Disciplinary Actions Online, and refer to Case #2015043319901.