A Commission Focus on Retail Investors, Compliance

Compliance is a critical function for any business. Not only can it serve as a possible defense, or at least a mitigating factor if there is a malfeasance, it can also help ensure that the firm operates in accord with its goals and code of conduct while aiding in the delivery of services or products to client as recent cases illustrate (here and here). Failures, on the other hand, can result in liability for the firm and injury to its customers and clients as illustrated by two recent Commission enforcement actions.

In the Matter of Morgan Stanley Smith Barney LLC, Adm. Proc. File No. 3-18566 (June 29, 2018) is an action which names as a Respondent the dual registered investment adviser and broker-dealer. The proceedings center on a compliance failure. Specifically, beginning in about December 2015, and continuing for about the next year, firm employee Barry F. Cornell initiated about 110 unauthorized transactions totally about $7 million. Mr. Cornell misappropriated $5 million through the transactions.

The transactions center around an elderly married couple, their adult daughter and a trust for which the daughter serves as co-trustee. The client relationship traces to June 2015. Mr. Cornell served as the FA and was given discretion. He was to provide investment advice and manage the client investments in exchange for the payment of an advisory fee.

In December 2015 Mr. Connell began to secretly misappropriate funds from the advisory accounts of the daughter and trust by initiating numerous unauthorized third-party wires and checks to individuals. The transactions paid for Mr. Connell’s personal expenses. In executing the transactions Mr. Connell falsely represented to an assistant that he had obtained verbal conformation from the clients. At the time firm policies and procedures permitted its FAs to initiate third party disbursements based on oral confirmation for $100,000 or less per day. While a review was conducted by the Service Review Unit, there was no procedure for authenticating or confirming that the client had initiated the transaction. The firm did not require calls requesting such disbursements to be made on a phone for which there were tapes or records. There were certain “exception” reports but none applied to the situations here.

Client generated complaints eventually triggered an internal investigation which discovered the malfeasance. The firm self-reported, remediated the procedures and entered into a settlement which the clients, fully reimbursing them. The Order alleges violations of Advisers Act Section 206(4).

To resolve the proceedings Morgan Stanley agreed to implement a series of undertakings focused on certifying compliance with certain policies and procedures relating to preventing or detecting the kind of activity here. In accepting Respondent’s offer of settlement, the Commission considered the remedial actions of Respondent.

Respondent consented to the entry of a cease and desist order based on the section cited in the Order. The firm also agreed to pay a penalty of $3.6 million.

In the Matter of Alexander Capital, L.P. Adm. Proc. File No. 3-18561 (June 29, 2018) names as a Respondent the New York broker-dealer. Over a two year period beginning in 2012 the firm failed to reasonably implement certain policies and procedures related to its supervisors and the monitoring of suitability, turn-over in accounts, churning and unauthorized trading. Specifically, during the period three registered representatives engaged in activities with regard to customer accounts. Supervisory personnel failed to head red flags (see related proceedings cited below).

The firm’s policies and procedures contained sections discussing each of the points at issue here. For example, those policies and procedures provided that a suitable recommendation must have a reasonable basis. Accordingly, the registered representative was required to perform reasonable diligence to understand the potential risks and rewards associated with the recommended security or investment strategy. Supervisors were required to monitor the suitability requirements and documentation related to the recommendation. Supervisors were also required to ensure that all transactions were reviewed in such a manner as to reasonably detect and deter any instances of illegal churning in customer accounts which was strictly prohibited. In addition, supervisors were charged with overseeing trading and preventing unauthorized transactions.

While the firm policies and procedures contained these provisions, they were not properly implemented, resulting in the failure to identify inappropriate practices in customer accounts. For example, Respondent failed to develop and implement reasonable policies and procedures regarding suitability. The firm management was aware that FINRA Rule 2111 required that there be a reasonable basis for a recommendation. Yet the firm “failed to put in place reasonable mechanisms for supervisors to use to monitor registered representatives for compliance with their reasonable basis and customer-specific suitability obligations,” according to the Order.

Similarly, the firm failed to develop reasonable systems to implement its policies and procedures regarding churning. Specifically, the firm “failed to adequately train” the supervisors involved in the underlying violations here. And, the firm provided “no guidance concerning which particular exception reports the supervisors were supposed to use” with regard to unauthorized trading. Indeed, if “Alexander Capital had reasonably developed systems to implement the firm’s policies and procedures regarding reasonable basis and customer-specific suitability, churning and unauthorized trading, it is likely that the firm would have prevented and detected the violations of the federal securities laws. . .” by its employees the Order found. In resolving these proceedings the Commission considered the cooperation of Respondent.

Respondent agreed to implement a series of undertakings centered on retaining an independent compliance consultant who will review the firm’s policies and procedures and prepare a report. The firm is censured and agreed to pay disgorgement in the amount of $193,774.86, prejudgment interest of $23,436.78 and a penalty equal to the amount of the disgorgement. See also In the Matter of Philip A. Noto II, Adm. Proc. File No. 3-18562 (June 29, 2018)(proceeding alleging failure to supervise by firm registered representative as to two employees who engaged in underlying violations; resolved with an order barring Responding from serving in a supervisory capacity and the payment of a $20,000 penalty); In the Matter of Barry T. Eisenberg, Adm. Proc. File No. 3-18563 (June 29, 2018)(proceeding naming branch manager who supervised one of employees involved in underlying violations; resolved with limitation on right to serve as a supervisor with right to reapply after five years and payment of a $15,000 penalty).

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