Alert January 15, 2008

FINRA Fines Broker-Dealer for Improper Soft Dollar, Hedge Fund Marketing and Compensation Activities

FINRA announced that it had fined a broker-dealer operating a hedge fund services business $450,000 for failing to adopt adequate supervisory procedures for its soft dollar and other activities related to its hedge fund clients.  FINRA found that the broker‑dealer’s inadequate procedures allowed it to make $325,000 in soft dollar payments to a hedge fund manager without reasonable inquiry into red flags raised by the invoice the manager had submitted to the broker-dealer.  The invoice requested that the broker-dealer issue one check for $75,000 to an individual for “consulting services” and a second check for just under $250,000 to the manager for “research expense reimbursement.”  FINRA noted the following red flags raised by the invoice:  It requested that the broker‑dealer pay the manger directly for expenses that had purportedly been provided by a third party; the invoice did not describe what research had been provided to the manager or who had provided the research; and the invoice failed to describe the “consulting services” the individual provided.  In addition, the hedge fund manager did not provide the broker-dealer with any invoice or back‑up documentation from the individual consultant or from any research provider to support the invoice.  FINRA characterized the invoice as “suspect on its face.”

The other supervisory failures cited by FINRA included allowing the drafting and distribution of hedge fund sales materials that did not adequately disclose material investment risks to potential hedge fund investors.  These sales materials were not approved by a registered principal, and were not properly recorded and maintained in the broker‑dealer’s files, as required by FINRA rules.

FINRA also found that the broker‑dealer entered into an improper compensation arrangement with two of its brokers who also managed a hedge fund, allowing them to receive bonuses paid from a “profit pool” derived in part from commissions received by the broker‑dealer on trading by their fund, contrary to representations made to investors in the fund’s offering documents and a separate agreement among the broker-dealer, the brokers and an outside firm that marketed the hedge fund.  FINRA imposed a $100,000 fine and 20 day suspension on each of the two brokers.

Among its other findings, FINRA determined that the broker-dealer failed to retain and preserve certain of its employees’ e-mails and instant messages between January 2003 and December 2004, as required by federal securities laws and FINRA rules, and that this failure hampered FINRA’s ability to investigate the firm’s activities.