On February 4, 2014, the Financial Industry Regulatory Authority, Inc. (“FINRA”) accepted a Letter of Acceptance, Waiver and Consent (the “AWC”) from a member firm (the “Firm”) and its former anti-money laundering (“AML”) compliance officer (the “AML Compliance Officer”) regarding alleged failures to comply with FINRA’s AML rule. FINRA found that from January 1, 2009 through June 30, 2013 (the “Relevant Period”) the Firm and the AML Compliance Officer failed to have an adequate AML program in place to monitor and detect suspicious activity in low-priced securities (“penny stocks”). FINRA also found that the Firm failed to (i) sufficiently investigate potentially suspicious penny stock activity, (ii) establish an adequate supervisory system to prevent the distribution of unregistered securities and (iii) conduct adequate AML testing and training. This article summarizes FINRA’s findings, which the Firm and the AML Compliance Officer neither admitted nor denied in connection with executing the AWC.
The Firm’s primary business is as a custodian bank. The Firm operates pursuant to an exclusion from broker-dealer registration but was a member of the New York Stock Exchange and became a FINRA member in 2008.
FINRA Rule 3310 requires member firms to develop and implement a written AML program reasonably designed to achieve and monitor the member’s compliance with the requirements of the Bank Secrecy Act (the “BSA”) and the regulations thereunder. This Rule also requires that AML programs include, at a minimum, (i) policies and procedures that can be reasonably expected to detect and cause the reporting of transactions required under the BSA, (ii) policies, procedures and internal controls reasonably designed to achieve compliance with the BSA and the regulations thereunder, (iii) annual testing for compliance, (iv) designation of an individual or individuals responsible for overseeing the AML program and (v) ongoing training for appropriate personnel. In addition, the BSA obligates financial institutions, such as the Firm, to investigate customer activity on a risk basis.
During the Relevant Period, the Firm directly executed sales or, as custodian, delivered the securities underlying the sale of at least six billion shares of penny stocks. In addition, the Firm conducted penny stock transactions on behalf of certain customers in known bank secrecy havens. FINRA asserted that omnibus accounts transacting in higher-risk activities, such as suspicious penny stock transactions, merited additional scrutiny, particularly such transactions that involved customers in known bank secrecy havens.
Set forth below is a summary of FINRA’s findings with respect to the specific violations:
- Failure to Establish and Implement AML Policies and Procedures. FINRA found that, during the Relevant Period, the Firm and the AML Compliance Officer violated FINRA Rule 3310(a)(and its predecessor, NASD Conduct Rule 3011(a)) and FINRA Rule 2010 by failing to establish and implement policies and procedures that were reasonably designed to detect and cause the reporting of potentially suspicious activity. Specifically, FINRA found that the Firm’s AML program failed to adequately monitor and detect, and sufficiently investigate, potentially suspicious penny stock activities and transactions that were brought to the Firm’s attention. Although the Firm had a compliance program that included suspicious activity surveillance, FINRA also found that the Firm and the AML Compliance Officer failed to establish an adequate surveillance system to review penny stock transactions conducted through the Firm and to tailor the Firm’s AML procedures to adequately detect, investigate and report suspicious activity, particularly patterns of suspicious penny stock activity, or red flags related to penny stock transactions. In making these findings, FINRA asserted that the Firm and the AML Compliance Officer were aware of the heightened risks associated with penny stock activity and the Firm’s severely limited ability, when it was dealing with financial institutions in bank secrecy havens, to obtain information about beneficial owners of those stocks or the circumstances under which the shares were acquired. In addition, the Firm failed to meet its SAR reporting and updating requirements.
- Failure to Adequately Supervise Activity in Foreign Financial Institution Accounts. FINRA found that, during the Relevant Period, the Firm violated FINRA Rule 3310(b) and FINRA Rule 2010 by failing to establish and implement policies, procedures and internal controls reasonably designed to achieve compliance with the BSA, which, among other things, requires all financial institutions to conduct risk-based due diligence on correspondent accounts for foreign financial institution customers (“FFIs”). Specifically, FINRA found that the Firm did not adequately conduct periodic activity reviews of the accounts for FFIs to determine whether securities activity was consistent with the information provided by the account holder at the account’s inception, including the type, purpose and anticipated activity, and whether accounts were being used for higher risk activity than originally forecast by the customer.
- Failure to Conduct Adequate AML Testing. FINRA found that, during the Relevant Period, the Firm failed to conduct adequate AML testing. FINRA Rule 3310(c) requires member firms to arrange independent testing for compliance with its AML program. Although the Firm conducted such tests, FINRA found that the tests failed to address the primary risks associated with the Firm’s brokerage business involving penny stocks, including the identification of any of the shortcomings in the trade monitoring and asset movement monitoring related to penny stocks. FINRA also found that, during certain years of the Relevant Period, the tests failed to address penny stock activity despite such activity involving high risk transactions for the Firm’s customers.
- Failure to Conduct Adequate AML Training. FINRA found that, during the Relevant Period, the Firm failed to conduct adequate AML training. FINRA Rule 3310(e) requires that member firms provide ongoing training for appropriate personnel. FINRA found that the Firm failed to adequately train its AML staff to understand the purpose of alerts relating to penny stock activity generated by the Firm’s automated AML surveillance systems and to understand the risks involved with penny stock activity, noting the Firm did not provide its AML staff with adequate materials regarding the risks and red flags associated with penny stock activity or adequate training for AML staff on how to accurately review and detect suspicious activity related to penny stocks.
- Failure to Establish, Maintain and Enforce a Supervisory System to Achieve Compliance with Section 5 of the Securities Act of 1933. FINRA found that the Firm violated NASD Conduct Rule 3010 by failing to establish, maintain and enforce a supervisory system that is reasonably designed to achieve compliance with applicable securities laws and regulations and NASD Rules. In connection with the sale of a security, Section 5 of the Securities Act of 1933 requires that a registration statement be in effect for such security or the security be exempt from registration. FINRA found that the Firm was aware that customers were depositing and selling large blocks of penny stocks and, contrary to its obligations under NASD Conduct Rule 3010 and FINRA regulatory guidance, failed to ensure that adequate supervisory reviews were performed to determine whether the securities sold were registered or being sold subject to an exemption. Specifically, FINRA found that the Firm failed, prior to the sale of penny stocks, to take appropriate steps to conduct a searching inquiry in two situations. First, in connection with the sale of securities deposited without a Rule 144 restrictive legend, the procedures failed to instruct Firm employees to inquire, in the face of red flags, as to whether the penny stocks were actually subject to a restriction. FINRA cited examples of customer transactions involving the deposit and immediate sale of large blocks of securities and news sources indicating that such securities were subjects of “pump and dump” schemes. Second, in connection with the sale of securities deposited with a restrictive legend, the Firm failed to establish and implement adequate written supervisory procedures to fulfill its obligations to conduct a searching inquiry to determine whether the securities were eligible for immediate resale to the public. According to FINRA, the Firm primarily relied on attorneys and transfer agents selected by the penny stock issuer to lift the restrictive legends, in direct contravention of regulatory guidance.
The Firm consented to a censure and a fine of $8 million. The AML Compliance Officer consented to a one-month suspension from association with any FINRA member in any capacity and a fine in the amount of $25,000.
In addition to consenting to a censure and a fine of $8 million, the Firm took certain corrective actions, which included ceasing sales of penny stocks, conducting an internal audit review of trade surveillance, enhancing employee training and periodic reviews of certain accounts and adopting additional policies and procedures to enhance compliance with its obligations under Section 5 of the 1933 Act. Based on a strategic business review, the Firm stated in an accompanying Corrective Action Statement that it had decided to close its equity brokerage business effective June 2014, which the Firm asserted would eliminate the risks associated with executing transactions in penny stocks.