FINRA member firms will soon face obligations set forth in FINRA Rule 3110(e), which takes effect on July 1, 2015 and requires that firms verify the accuracy and completeness of the information contained in an applicant's Form U4. The amended rule also requires that firms adopt written procedures that will require them to search public records to complete their pre-hire due diligence.  While this amendment applies to new hires and transfers after July 1st, firms should take cautionary notice of FINRA’s expectation that they ensure that current employees have complied with their reporting obligations.   

In its annual Regulatory and Examination and Priorities Letter for 2015, FINRA specifically stated that it expected firms to have procedures in place to ensure timely and accurate reporting.  Specifically, FINRA stated: “… examiners will review whether required disclosures are complete, accurate and made within the required time periods; determine whether firms have controls, processes and procedures in place to ensure timely filings; and determine whether public records reviews are occurring.”  This statement, as well as FINRA’s ratcheting up of fines in reporting cases and statements of FINRA senior management, sends a very clear message that reporting and supervisory obligations of firms are truly a FINRA priority.  We expect that 2015 will be the year for significant U4 reporting actions against firms.

What to Expect

Outsized fines are here to stay for the foreseeable future when there are extensive lapses in timely amending U4s.  FINRA has signaled on numerous occasions the importance of this reporting obligation over the past year.

Looking ahead:

  • Be proactive in reviewing public databases and investigating any judgments or liens against registered representatives.  Effective proactive due diligence is critical because FINRA’s massive search – given the  scope – is bound to lead to some inaccuracies. There will be inevitable false positives, that is, debts appearing in a public records search that are unsupported by court documents, debts paid off that are still shown as unsatisfied, and judgments or liens that arose and were satisfied when a registered representation was not associated.  Each of these situations may be presented in FINRA review, but upon deeper investigatory efforts would truly be nonreportable events.
  • It is expected that a variety of factors will be considered in assessing whether enforcement actions will be taken against firms based on unreported or late reported events.  Factors include: number of registered representatives, the number of undisclosed events, and whether there are other aggravating factors, e.g., a prior disciplinary history or red flags.
  •  If FINRA chooses to adopt a “per violation” calculus in assessing fines, as they did in the 2004 late U4/U5 reporting sweep, the numbers we could be seeing could be significant. (NASD Fines 29 Firms Over $9.2 Million for Late Reporting (Nov. 30, 2004);; NASD Fines Morgan Stanley $2.2 Million for Late Reporting, Firm Temporarily Suspended from Registering New Brokers (July 29, 2004) 

Key Recommendations:

  • Conduct a public records search

       Review public records for any judgments or liens against registered representatives.

  • Obtain Documents

       Upon learning of any unsatisfied judgments or liens, obtain court documents, checks, monthly statements, and any other records to prove payment, to verify the debt’s existence and any satisfaction thereof.  Do not be complacent.

  • Investigate

      When the payroll department or any other division or personnel learns that there may be an action against a registered representative, through a garnishment order or other resource, investigate it. 

  • Report

       If a potential judgment or lien exists, amend and report it within thirty days (that is, respond “yes” to question 14M).  If there is any uncertainty as to the existence of the judgment or lien, explain so in the DRP that supplements question 14M. The U4 is a living document, so if after the thirty days the judgment or lien is satisfied, update the U4.

Information Gathering

FINRA has identified Form U4 and U5 reporting as an essential part of investor protection.  (Would you take investment advice from a broker who has had questionable practices with respect to managing his/her own finances?  If that causes you to stop and think twice, then you can understand why FINRA expects that investors need information relevant to their decision to work with a broker and why FINRA considers important information shedding light on a broker’s management (or lack of management) of his/her own financial situation, including paying outstanding debts.)    

In its Regulatory Notice 15-05, covering Rule 3110(e), FINRA states that firms should consider “all available information” in the pre-registration process. FINRA also suggests member firms should consider using private background checks, credit reports and reference letters for this purpose.  In addition, at a minimum, firms must conduct public record searches—a new, mandatory requirement—which includes reviews of an applicant’s criminal records, bankruptcy records, civil litigations and judgments, liens, and business records. 

Last year, a Wall Street Journal article reported that its analysis showed that more than 1,600 brokers with bankruptcy filing from 2004 until 2012 had not been disclosed on their public CRD records. (Jean Eaglesham and Rob Barry,Stockbrokers Fail to Disclose Red Flags (March 5, 2014).)  FINRA subsequently announced Board approval for an amendment to its supervision rule to require that firms verify the accuracy and completeness of the information contained in an applicant's Form U4 and adopt written procedures that include searching public records. In addition, FINRA stated that they were going to conduct a one-time search on all registered persons to ensure the accurate and timely reporting of material financial information.  FINRA has spent the past year reviewing public databases for material financial information that is required to be reported. (See, Reg. Notice 15-05 (p. 6)); FINRA Board Approves Amendment to Supervision Rule Requiring Firms to Conduct Background Checks on Registration Applicant (press release April 24, 2014).  

Readdressing this issue, in FINRA’s annual Regulatory and Examination and Priorities Letter for 2015, it re-stated that “FINRA examiners will review whether required disclosures are complete, accurate and made within the required time periods; determine whether firms have controls, processes and procedures in place to ensure timely filings; and determine whether public records reviews are occurring.”  In essence, FINRA expects that due diligence procedures similar to those required for new hires or transfers are also occurring with current employees.

Notably, there are more than 637,000 registered representatives associated with FINRA member firms.  (See,  Fast forward nearly a year later, we are starting to see the repercussions of FINRA’s search and its discoveries.  Given the hundreds of thousands of registered individuals under review, it is not surprising that FINRA’s review generated significant numbers of hits from public databases.  Firms should expect that they face potential liability depending on, among other things, the number of individuals who have unreported events, the number of unreported events, and whether there are aggravating factors, such as prior relevant disciplinary history or the existence of red flags providing notice to the firm of potential reporting issues.  

Failing to Report or Late Reporting

FINRA By-Laws provide that a firm is obligated to file an amended Form U4 no later than 30 calendar days after learning of the facts or circumstances that cause the firm to amend the U4.  The issue of red flags surfaced as early as December 2012, when FINRA fined a broker-dealer $35,000 for not having supervisory procedures in place to ensure that the Payroll Department notified the Compliance Resolution Department of garnishments that might trigger reportable events.  The firm’s Payroll Department periodically received garnishment notices from judgment creditors, tax levies, from federal or state taxing authorities and/or bankruptcy wage withholding orders and failed to have a process in place to notify the Compliance Department.  Hindsight review prompted by FINRA inquiry, determined that 16 garnishment notices required amendments to 13 registered representatives.  In November 2014, FINRA fined another member firm $12,500 for failing on several occasions to amend one representative’s Form U4 to disclose several judgments and IRS liens and develop and maintain supervisory procedures to disclose unsatisfied liens and judgments of registered representatives on Forms U4.

In March 2015, FINRA significantly ratcheted up fines in this area.  On Friday, March 6th, FINRA fined yet a third member firm $350,000 for reporting failures for approximately 80 brokers between 2011 and 2013, in circumstances where the firm was receiving garnishment notices on registered persons. One potentially aggravating fact, as described in the AWC, is that the firm became aware in February 2013 that they had a deficiency in this area and voluntarily took steps to amend their written supervisory procedures (WSPs) and put in a place a process to have payroll notify compliance.  They failed to properly implement the process until July 2014. 

On the following Tuesday, March 10th, FINRA fined a fourth broker-dealer $500,000 over its alleged failure to report judgments and liens imposed upon registered representatives under similar circumstances.  Over a three-year period, FINRA found that the firm failed to amend the disclosure forms of about 103 registered representatives who had unsatisfied liens and judgments filed against them.  FINRA officials raised the issue that the firm’s payroll department was put on notice of these outstanding debts because it had processed numerous wage garnishment orders for the registered representatives.  FINRA also noted that broker-dealer failed to document that it reviewed employee disclosures made in annual compliance certifications for reportable events, despite registered representatives reporting being subject to “financial difficulties such as liens.”  One aggravating factor was that the firm had been fined $370,000 in 2007 for failing to file timely U4 and U5 amendments and lacking supervisory procedures. The firm had also agreed at that time to have internal audit evaluate the effectiveness of its systems and procedures for U4/U5 reporting obligations.   

Reporting Merges with Supervision Responsibilities

In the past, enforcement cases involving failures to timely amend U4s were generally brought against individual registered representatives.  It was the obligation to the registered person to apprise the firm of any reportable event. If they failed to do so and a U4 was not timely amended, the individual was charged and the matter was framed as a reporting violation.  This reporting obligation, however, merges with supervision responsibilities based on either the scope of the failures to report (number of registered persons and/or number of events that are not timely reported) or red flags by the firm that put the firm on notice that there might be reporting issues. As noted, the UBS and Vanguard cases have been described as reporting issues with a matter of supervisory lapses.    

FINRA’s fine against a member firm last week, places extra weight on FINRA’s supervisory expectations of member firms.  FINRA fined the member firm $2.5 million for failing to supervise a broker who had stolen money from his customers and excessively traded their brokerage accounts.  The firm was disciplined for, among other things, having a “lax supervisory structure” which originated at the time of the broker’s hiring.  FINRA stated in its press release that the firm failed to adequately investigate the broker prior to hiring him, even though he was subject to twelve reportable events, including criminal charges and seven customer complaints.  FINRA also found that the firm failed to timely report more than 300 reportable events relating to other brokers.  

Concluding Thoughts

Hopefully, due to FINRA’s relatively recent focus on these reporting obligations and the awareness that information may be publicly available, FINRA will take an appropriately measured approach and not view disciplinary actions against firms as “shooting fish in a barrel.”

That said, while we expect FINRA to take a balanced and measured approach, actions by firms will speak louder than words.  FINRA’s actions against the member firms discussed above illustrate its focus on supervision and firms’ due diligence.  In turn, firms’ actions, through proactive due diligence, can mitigate the potential disciplinary sanction.  So…act now!