On Dec. 31, 2008, the Financial Industry Regulatory Authority (“FINRA”) accepted a Letter of Acceptance, Waiver and Consent (“AWC”) submitted by E*Trade Securities, LLC and E*Trade Clearing, LLC (collectively, “E*Trade” or the “Firm”), both of which are registered broker-dealers. The AWC alleged that E*Trade violated NASD Conduct Rules 3011(a) and (b) and 2110, and MSRB Rule G-41, which require that broker-dealers establish and implement: (i) policies and procedures that could reasonably be expected to detect and cause the reporting of transactions required under 31 U.S.C. § 5318(g) (the Suspicious Activity Reporting statute); and (ii) policies, procedures, and internal controls reasonably designed to achieve compliance with the Bank Secrecy Act (“BSA”) and the implementing regulations thereunder. Each of the E*Trade entities consented to these allegations by FINRA without admitting or denying FINRA’s findings.
The AWC focuses primarily on the need for a securities firm to monitor for suspicious trading activity. In particular, FINRA points to language in Special Notice to Members (“NTM 02-21”) which provides that a firm’s AML procedures are required to address, among other things, the monitoring of account activities, including but not limited to, trading and the flow of money into and out of accounts. In connection with a firm’s obligation to file with Treasury’s Financial Crimes Enforcement Network (“FinCEN”) “a report of any suspicious transaction relevant to a possible violation of law or regulation,” FINRA asserts that FinCEN’s SAR-SF identifies, among other activities, suspicious securities trading activity that is required to be reported, including “market manipulation,” “pre-arranged or other non-competitive trading,” and “wash or other fictitious trading.”
Firms should be aware that this AWC set forth a new standard with respect to the monitoring of suspicioussecurities transactions.
E*Trade’s Automated AML System Was Inadequate Because It Focused Primarily on Money Movement
According to the AWC, between Jan. 2003 and May 2007 (the “review period”), E*Trade primarily relied on an automated proprietary filter-based AML system to review accounts for money laundering activity. If an alert was generated by the AML system, Firm personnel then manually accessed a variety of sources (e.g., Internet resources, FinCEN reports, and OFAC alerts from CDC) and systems to review the account activity for, among other things, suspicious trading activity. Because the AML system alerts were triggered by money movements, FINRA alleged that it was unlikely that Firm personnel reviewed the alerts for suspicious trading activity, such as wash or matched trades, in the absence of any money movement. Because the Firm’s AML system did not flag and cause the review of accounts for suspicious trading activity unless accompanied by money movement, FINRA determined that it was not reasonably designed to achieve compliance with the BSA and implementing regulations thereunder, in contravention of NASD Conduct Rule 3011(b).
Referring to the principle that each financial institution should tailor its AML program to fit its business, FINRA alleged that E*Trade also failed to tailor its suspicious activity monitoring program to its business of facilitating investors’ self-directed electronic access to the market, through which the Firm processed on average, more than 110,000 customer orders daily with little or no human intervention. Thus, the Firm did not conduct computerized surveillance of customer account activity to monitor for matched or washed trading. Instead, the Firm relied on its System analysts, discussed above, and its employees to manually monitor for and detect suspicious trading activity without providing them with sufficient automated tools necessary to monitor for such activity. FINRA determined that such an approach to suspicious activity detection was unreasonable given E*Trade’s business model. FINRA cited, by way of example, 85,029 matched transactions, which were executed at E*Trade during a ten month period. While matched trading is not illegal in and of itself, FINRA pointed out that they are expressly prohibited by SEC rules when effectuated “for purposes of creating a false or misleading appearance of active trading in any security.”1 Accordingly, a matched trade could be an indication of suspicious activity requiring further review.
Although NTM 02-21 states that on-line firms should “consider conducting computerized surveillance of account activity to detect suspicious transactions and activity,” the AWC goes beyond this guidance stating that “on-line trading firms, such as E*Trade, are required to design and implement systems reasonably designed to detect trading activity in customer accounts that may be manipulative and thus reportable.” (emphasis added). Because E*Trade’s approach to suspicious activity detection was unreasonable given E*Trade’s business model, the Firm violated NASD Conduct Rule 3011(b).
E*Trade’s AML Policies and Procedures Violated NASD Conduct Rule 3011(a)
With respect to the Firm’s AML procedures, E*Trade’s employees were required to view transactions in the context of other account activity to determine whether a transaction was suspicious. E*Trade’s AML procedures defined “transactions” to include “deposits, withdrawals, wire transfers, securities trading, and investments.” As described above, during the review period, the Firm’s AML filter-based system triggered the review of potentially suspicious trading activity primarily when accompanied by money movement activity. Because the Firm did not have “separate and distinct monitoring procedures for suspicious trading activity in the absence of money movement,” FINRA determined that E*Trade’s AML procedures could not reasonably be expected to detect and cause the reporting of suspicious securities transactions, constituting a violation of NASD Conduct Rule 3011(a).
Under the AWC, each of the E*Trade entities consented to a censure and paid a civil monetary penalty of $500,000, for a total penalty amount of $1 million. These sanctions took into account E*Trade’s prompt corrective action to remediate its AML system and procedures after the initiation of FINRA’s investigation, but without prompting by FINRA, including the implementation of automated monitoring systems specifically designed to detect suspicious trading during the review period and the expansion of staff along with the retention of third party vendors dedicated to the monitoring function.