The Financial Industry Regulatory Authority, Inc. (“FINRA”) issued an order (the “Order”) settling administrative proceedings against a clearing broker-dealer (the “Broker”), regarding various failures to comply with anti-money laundering (“AML”), financial reporting and supervisory obligations. This article summarizes FINRA’s findings, which the Broker has neither admitted nor denied.
The Broker primarily serves as a clearing broker, providing order processing, settlement and recordkeeping functions for introducing broker-dealers that do not maintain back-office facilities to perform these functions (collectively, “Clearing Services”). The Broker provides Clearing Services to introducing firms (“Introducing Brokers”) with significant numbers of accounts, conducting activity in low-priced securities, as well as third-party wire activity. The violations took place during the period between January 2009 and early 2013 (the “Relevant Period”), and were identified by FINRA during multiple examinations during the Relevant Period. In issuing the Order, FINRA noted that the Broker has been the subject of two recent disciplinary actions that were relevant to the violations addressed in the Order, and that the Broker’s numerous violations demonstrated a lack of supervisory controls and a failure by the Broker to devote adequate attention and resources to its compliance program.
Examinations of the Broker by FINRA during the Relevant Period revealed that the Broker had failed to (1) establish and implement policies and procedures reasonably designed to monitor for, detect and cause the reporting of transactions required to be reported under the Bank Secrecy Act ("BSA"), (2) establish and implement policies and procedures reasonably designed to achieve compliance with other requirements of the BSA and its implementing regulations, and (3) designate and identify to FINRA an individual responsible for implementing and monitoring the day-to-day operations of the AML program. Additionally, FINRA examinations of the Broker during the Relevant Period revealed that the Broker failed to prepare accurate customer reserve and net capital computations. As a result of these consistent and repeated violations of the Broker’s AML, financial reporting and supervisory responsibilities the Broker violated NASD Rules 1021, 3010, 3011, 3020, 3110 and 2110; FINRA Rules 1230, 3310, 4110, 4210, 4511 and 2010; Securities and Exchange Commission (“SEC”) Rules 15c3-1, 15c3-3, 15c3-5, 17a-3, and 17a-5; and Rule 204 of SEC Regulation SHO.
Of particular interest is the finding (discussed in the first paragraph below) that the Broker’s “defensive” suspicious activity reporting procedures, which resulted in filing Suspicious Activity Reports (“SARs”) without adequate investigation, violated the Broker’s AML responsibilities.
Set forth below is a summary of FINRA’s findings with respect to certain specific violations:
- Failure to Establish and Implement AML Policies and Procedures. FINRA found that during the period between January 1, 2009 and April 30, 2009 the Broker failed to establish and implement policies and procedures that were reasonably designed to detect and cause the reporting of transactions required under the BSA in violation of NASD Conduct Rule 3011(a) (now FINRA Rule 3310(a)) and FINRA Rule 2010. In making this finding FINRA noted that the Broker: (1) failed to implement a program to review transactions in order to adequately detect and then evaluate the presence of potential AML “red flags” with a view towards determining whether the presence of the “red flags” required follow up reporting (e.g. the Broker failed to ensure that all introducing brokers populated the Broker’s demographic AML information system with customer identification information); (2) failed to implement procedures to ensure that its employees were aware of established criteria for identifying red flags that were reasonably designed to monitor for suspicious activity (e.g. in monitoring for suspicious activity, the Broker’s employees identified accounts with a current account value in excess of $5,000 instead of identifying transactions that involved at least $5,000 as was required by the Broker’s procedures resulting in the Broker failing to identify or report suspicious activity if the account involved had a current value below $5,000); (3) failed to implement procedures reasonably designed to accurately and completely report suspicious activity through the identification and investigation of red flags; and (4) failed to ensure that timeframes and deadlines that were required by its written AML program were being followed, including those for Weekly AML Program Reviews and Risk Assessment Meetings. In connection with the third finding, FINRA stated that the Broker implemented a defensive SAR program that promoted the filing of SARs without first completing a review to investigate the suspicious activity or red flags that may have been identified. FINRA found that the Broker failed to establish procedures or implement a program that required, among others, the collection of sufficient and accurate information necessary to complete the SAR form, adherence to the guidelines for completing and filing SARS, and the retention of source documentation for the subject of its filings, including the internal exception reports.
FINRA also found that during the period between February 24, 2012 and May 20, 2012 the Broker failed to maintain an AML program in compliance with the BSA and FINRA Rule 3310. Specifically, FINRA found that during the period between February 24, 2012 and May 20, 2012 the Broker did not have an AML program that was reasonably designed to monitor for, detect and report suspicious activity in compliance with the BSA in violation of FINRA Rule 3310(a). In making this finding, FINRA noted that: (1) the Broker’s AML program did not adequately address the risks of the Broker’s business model, which included servicing Introducing Brokers with significant numbers of accounts conducting activity in microcap securities, as well as third party wire activity; (2) the Broker’s AML program relied in part on the Introducing Brokers for surveillance of suspicious activity, even though the Broker did not conduct any review of the Introducing Brokers’ AML programs; (3) the Broker’s procedures called for the use of manual reports for monitoring of suspicious activity, some of which had parameters that were not adequate to detect suspicious activity, and had limited staff and resources devoted to this monitoring; and (4) the Broker had failed to implement many parts of its suspicious activity monitoring program. Additionally, FINRA found that during the same period the Broker (1) failed to conduct due diligence on correspondent accounts for foreign financial institutions as required by the BSA and FINRA Rule 3010(b), and (2) failed to have an AML Officer with the appropriate training or knowledge required to function as an AML Officer.
- Failure to Establish and Implement Policies and Procedures Related to FBARS. FINRA found that the Broker failed to establish adequate written procedures and internal controls regarding the filing of Foreign Bank and Financial Accounts Reports (“FBAR”) in violation of NASD Conduct Rules 3011(b) and 2110 and FINRA Rule 2010, resulting in the Broker failing to file the required FBAR report for calendar year 2007.
- Customer Protection Rule Violations. FINRA found that the Broker committed a series of violations of SEC Rule 15c3-3 (the “Customer Protection Rule”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and FINRA Rule 2010 during the Relevant Period, including: (1) failing on certain dates in 2009 to accurately calculate the amount required to be maintained in the Broker’s Special Reserve Bank Account for the Exclusive Benefit of Customers (the “Reserve Bank Account”); (2) failing to comply with custody provisions of the Customer Protection Rule on at least 3 instances in March of 2009 by delivering shares when the Broker did not have sufficient shares to make such deliveries; (3) inaccurately computing the amount required to be reserved by the Broker in the Reserve Bank Account (“Customer Reserve Computations”) on several instances during 2010 resulting in significant deficiencies; (4) failing to properly classify securities in the Broker’s custody or control in violation of the custody provisions of the Customer Protection Rule; (5) making erroneous calculations in its Customer Reserve Computations as of February 28, 2011, November 30, 2011 and November 30, 2012; and (6) making erroneous calculations in its calculation of reserve requirements for the proprietary account of introducing brokers as of March 31, 2009 and November 30, 2012.
- Failure to Implement Procedures Related to Books and Records. During the period between January 2009 and April 2009 the Broker failed to maintain adequate procedures related to books and records in violation of NASD Rules 3010 and 3110 and FINRA Rule 2010. In making this finding FINRA noted that the Broker: (1) failed to have procedures in place for the solicitation and acceptance of checks from customers that were made payable to customers; (2) failed to evidence that it had obtained or reviewed written procedures from any of its correspondents that were allowed to offer check writing privileges to customers; (3) did not obtain or review the correspondent’s written internal control procedures designed to monitor customer property that is made payable to the correspondents; (4) allowed one correspondent firm to provide check writing capabilities to its customers and two correspondent firms to solicit and accept checks from customers that were made payable to the correspondents; and (5) did not maintain any records demonstrating that these check writing capabilities described above were included in the Broker’s due diligence, vetting and approval process of the correspondents.
- Filing of Inaccurate FOCUS Reports. The Broker’s Financial and Operational Combined Uniform Single Report (“FOCUS Report”) dated February 26, 2010 included several classification errors which resulted in misstatements on the FOCUS Report and in inaccurate books and records in violation of SEC Rules 17a-3 and 17a-5 under the Exchange Act and FINRA Rule 2010.
- Net Capital Rule Violations. FINRA found that the Broker committed a series of violations of SEC Rule 15c3-1 (the “Net Capital Rule”) under the Exchange Act and FINRA Rule 2010 including: (1) failing to take certain required capital charges in calculating its net capital as reflected on its February 26, 2010 FOCUS Report; (2) overstating its November 2011 net capital as a result of various misclassifications of allowable assets and improper netting of payable accounts; and (3) making additional errors in the calculation of its November 2012 net capital which required the filing of an amended FOCUS Report.
- Fidelity Bond Requirement. The Broker’s fidelity bond dated October 18, 2009 through October 18, 2010 did not state that FINRA would be notified if the Fidelity Bond is cancelled, terminated, or substantially modified as required by NASD Rule 3020 and FINRA Rule 2010.
- Other Supervisory Violations. FINRA found that during the Relevant Period the Broker committed a series of additional supervisory violations of NASD Rules 1021 and 3010; FINRA Rules 1230, 4110, 4210, 4511 and 2010; SEC Rules 15c3-5, 17a-3 and 17a-5; and Rule 204 of Regulation SHO. These violations related to: (1) violations of delivery and close out requirements of Regulation SHO; (2) failure to have adequate written supervisory procedures to address compliance with Rule 204 of Regulation SHO; (3) filing of incorrect FOCUS Reports; (4) inadequate supervision of control stocks; (5) improper outsourcing of back-office functions to a Canadian broker; (6) inadequate due diligence of microcap securities; (7) inadequate supervision of National Securities Clearing Corporation illiquid charges; (8) inadequate supervision of an executive’s personal email account; (9) inadequate controls for fixed income trading desk and correspondent order flow; (10) inadequate controls over funding and liquidity; (11) inadequate supervision of receive versus payment/delivery versus payment accounts; and (12) inadequate supervision of principals.
In addition to a censure and a fine in the amount of $1.0 million, the Broker is required: (i) to retain an independent consultant to conduct a comprehensive review of its relevant policies, systems, procedures and training; (ii) to submit proposed new clearing agreements to FINRA for approval while the consultant conducts its review; and (iii) for one year, submit certifications from its Chief Executive Officer and Chief Financial Officer stating that each has reviewed the Broker’s customer reserve and net capital computations for accuracy prior to submission.