2012 FINRA Annual Conference Materials - May 23 Session

Enforcement Case Trends 

Wednesday, May 23 

9:00 a.m. – 10:15 a.m.



9:00 a.m. – 10:15 a.m. 

After this program, you will be able to: 

• Discuss FINRA Enforcement priority program areas and recent trends in disciplinary actions to 

assist in focusing compliance efforts. 

• Understand the impact of enforcement investigations, settlements, Office of Hearing Officers 

(OHO) and National Adjudicatory Council (NAC) decisions, and enforcement policies and 

practices on your firm. 

• Summarize the investigation and disciplinary process to assist you in preparing for an 

investigation or disciplinary action. 

Moderator: 

Panelists: 

J. Bradley Bennett 

Executive Vice President 

FINRA Enforcement 

Gloria Greco 

Managing Director 

Bank of America 

Thomas Lawson 

Vice President and Chief Counsel 


Susan Light 

Senior Vice President 


Pamela K. Ziermann 

Senior Vice President, Compliance 

Dougherty Financial Group LLC 

Outline 

FINRA Enforcement priorities 

• Program changes 

• Substantive priorities 

Preparing for an enforcement investigation / proceeding 

• What should be handled in-house as compared to what should be outsourced (issues, 

including independence, cost considerations, other considerations) 

• Responding to information requests 

Compliance trends – issues drawn from Enforcement investigations and actions 

• Compliance areas of interest to small firms, including those areas where FINRA has found 

trends in enforcement cases / actions 

© 2012 Financial Industry Regulatory Authority, Inc. All rights reserved.1

Hot topics 

• Managing responsibilities when associated person serves multiple functions at the firm 

• FINRA Rule 4530 (self reporting) and impact on credit for cooperation / self-reporting 

• Disciplinary actions against compliance professionals 

• Sanction trends 

Speaker Biographies 

J. Bradley Bennett, Executive Vice President of Enforcement, joined FINRA in January 2011, and is 

responsible for overseeing FINRA’s Department of Enforcement. In this capacity, Mr. Bennett directs 

investigating and bringing all formal FINRA disciplinary actions against firms and their associated 

persons for violations of FINRA rules and federal securities laws. Previously, Mr. Bennett was a 

partner at the law firm Baker Botts in Washington, DC, where he specialized in financial and 

securities law violations. Before joining Baker Botts in 2001, he was an attorney at Miller, Cassidy, 

Larocca & Lewin. Mr. Bennett started his career at the Securities and Exchange Commission as a 

senior attorney in the Division of Enforcement, with responsibility for cases covering all facets of 

securities law, including accounting, broker-dealer regulation, tender offers and insider trading. Mr. 

Bennett serves as an adjunct professor of securities regulation at Catholic University's Columbus 

School of Law. He received his undergraduate degree from St. Lawrence University and his law 

degree from Georgetown University Law Center. 

Gloria Greco is Managing Director and the head of compliance for the Global Wealth & Investment 

Management organization at Bank of America. Ms. Greco also serves as co-Chief Compliance Officer 

for Merrill Lynch, Pierce, Fenner and Smith Incorporated. The team Ms. Greco leads performs various 

compliance functions related to the businesses serving retail clients, including providing advice to 

business management; participating in the management and governance of routines, developing 

compliance policies, training and supervisory controls; implementing independent testing and 

monitoring programs; and coordinating regulatory activities. The team also develops formal rule 

inventories, identifies key controls, conducts risk assessments and monitors regulatory changes to 

ensure appropriate modifications to the business and related controls are implemented. Ms. Greco 

specializes in topics related to broker-dealer and investment management regulations, and has 

experience dealing with compliance topics involving a broad array of investment and banking 

products, including investment advisory programs, mutual funds, alternative investments (private 

equity, hedge funds, commodities, real assets), structured investments, debt and equity products 

(new issue and secondary trading), insurance and annuities, lending and deposit banking products, 

foreign exchange, and options. Among her other areas of expertise are intellectual property rights and 

contract law, and compliance with anti-bribery, economic sanctions, campaign finance and antimoney 

laundering laws, ethical decision-making and managing conflicts of interest. Ms. Greco has a 

bachelor’s of business administration degree in management from Pace University and a law degree 

from Brooklyn Law School, and is admitted to the New York State Bar. During her long career starting 

at Merrill Lynch, Ms. Greco has held positions in various areas, including accounting, finance, 

purchasing, and technology. For the past eighteen years, she has worked as a legal and compliance 

professional in a variety of disciplines, handling diverse matters and holding various leadership 

positions. Ms. Greco serves on industry committees and panels, including the SIFMA Compliance & 

Regulatory Policy Committee and the FINRA Compliance Advisory Committee. 

Thomas B. Lawson is Vice President and Chief Counsel in the Department of Enforcement at the 

Financial Industry Regulatory Authority in Washington, D.C. Before working at FINRA, Mr. Lawson 

spent 11 years with the Division of Enforcement of the U.S. Securities and Exchange in Washington, 

D.C., serving the last three-and-one-half years as an assistant director in the Enforcement Division. 

He is a graduate of Hofstra University School of Law and Union College. 

Susan Light has been Senior Vice President in the FINRA Department of Enforcement since the 

integration of NASD and portions of NYSE Regulation on July 30, 2007. Prior to the consolidation, 

she served as senior vice president and department head in the Division of Enforcement of New York 

Stock Exchange Regulation. She is responsible for managing attorneys and investigators who 

investigate and prosecute violations of FINRA rules and federal securities laws. Ms. Light supervises 

such matters as financial and securities fraud, money laundering, subprime and auction rate 

securities, Regulation SHO, insider trading, stock manipulation, sales practice violations, mutual fund 


abuses and financial and operational violations. She serves on many regulatory panels on 

enforcement topics. Ms. Light was the NYSE enforcement team leader on the integration team with 

the NASD. At the NYSE, she was a member of several Exchange management committees and 

served as an ambassador for the Exchange in hosting foreign agencies that visited the Exchange. 

Prior to joining the Exchange in 1988, Ms. Light was a prosecuting attorney and supervisor in the 

Bronx District Attorney’s office for seven years. She received her bachelor’s degree with honors in 

1975 from the University of Michigan, her law degree in 1981 from Boston University School of Law, 

and her LL.M. in 1986 from New York University School of Law. Ms. Light has received the YWCA 

Women’s Achiever Award and the Department of Defense Patriotic Employer award. 

Pamela K. Ziermann, CSCP, is Senior Vice President, Compliance at Dougherty Financial Group 

LLC, where she has been for more than 19 years. Under the Dougherty Financial Group umbrella, 

Ms. Ziermann is responsible for compliance for one broker-dealer (Dougherty & Company LLC) and 

three investment advisers. Before joining Dougherty Financial, she was the trust and investment 

compliance officer for Marquette Banks. Prior to her compliance career, she was an auditor with 

Marquette Banks and Arthur Andersen. She has served on various industry committees. These 

include National Society of Compliance Professionals’ committees and FINRA’s Small Firm Advisory 

Board, New Account Form Task Force, Small Firm Rules Impact Task Force, Registration and 

Licensing Council and District Business Conduct Committee and Nominating Committee. She 

currently serves on the Municipal Securities Rulemaking Board Professional Qualifications Advisory 

Committee, the Securities Industry / Regulatory Council on Continuing Education and on the Board of 

Directors for the National Society of Compliance Professionals. 




9:00 a.m. – 10:15 a.m. 

Resources 

FINRA Enforcement Priorities 

I. Disciplinary Actions – Web-based Tool 

In May 2011, FINRA launched the FINRA Disciplinary Actions Online database, a web-based 

searchable system that makes its disciplinary actions accessible via its website at www.finra.org. 

The database enables users to perform searches for FINRA actions free of charge, seven days a 

week. Users may search for actions by case number, document text, document type, action date 

(by date range), a combination of document text and action date, individual name and Central 

Registration Depository (CRD ® ) number, or firm name and CRD number. The documents can be 

viewed online, printed or downloaded as text-searchable PDF files. 

The new database makes available disciplinary action documents including Letters of 

Acceptance, Waivers and Consent (AWCs), settlements, National Adjudicatory Council decisions, 

Office of Hearing Officers decisions and complaints. 

Disciplinary Actions discussed below can be found in the Disciplinary Actions Online 

database. 

II. Substantive Areas of Interest 

A. Fixed Income 

1. Municipal Securities 

a. On the whole, municipal securities may offer significant benefits to many 

investors and can be an important component of a diversified portfolio. With 

some municipal securities, however, the lack of timely disclosures and 

complete financials often inhibit individual retail investors from making informed 

investment decisions, and may preclude associated persons from having a 

reasonable basis to recommend such a security. Member firms are reminded 

of their obligation to make suitable recommendations to their clients with 

respect to trading in the secondary markets. This includes obtaining sufficient 

information about the issuer to provide a reasonable basis that the 

recommendation is suitable. Separate and independent of the suitability 

obligation, member firms are also required, under MSRB Rule G-17, to 

disclose to their customers, at or prior to a sale of securities to a customer, all 

© 2012 Financial Industry Regulatory Authority, Inc. All rights reserved. 1

material facts about the transaction known by the dealer as well as all material 

facts about the security that are reasonably accessible to the market. 1 Firms 

should ensure that representatives have access to this municipal issuer 

information (through MSRB’s Electronic Municipal Market Access (EMMA) 

system and/or other sources) to meet these requirements. Firms are also 

obligated to trade with their customers at prices that are fair and reasonable 

(including any markup or markdown). 

b. Cases / Investigations 

1) Southwest Securities – Paying Former Texas Municipal Issuer Officials 

and Others to Solicit Municipal Securities Business on its Behalf 

FINRA found that during the period from October 2006 through April 

2009, Southwest paid five individuals, including three former Texas 

municipal issuer officials, to solicit municipal securities business on its 

behalf. The consultants assisted Southwest in obtaining a total of 24 

municipal securities underwritings and two roles as financial advisor to 

Texas municipalities. Southwest paid the consultants more than 

$200,000 for their services. 

Pursuant to the consulting agreements that Southwest had with two of 

the individuals, the consultants were contracted to "promote the 

capabilities of Southwest's municipal bond department in their desire 

to earn mandates as financial advisor and municipal underwriter for 

public entities throughout Texas." For their services, the consultants 

were promised, among other things, a percentage of Southwest's 

profits from any municipal securities business they helped to solicit. 

In addition to the formal consulting arrangements, Southwest also 

made one-time payments totaling more than $26,000 to three other 

individuals in connection with their roles in obtaining municipal 

securities business for the firm. 

FINRA also found that Southwest violated the MSRB's rules by failing 

to file 10 MSRB Forms G-36(OS) and G-36(ARD) in a timely manner 

and for inaccurately reporting more than 300 municipal securities 

transactions to the MSRB. 

FINRA found that during the period from October 2006 through 

February 2009, Southwest had inadequate systems and procedures to 

supervise certain aspects of its municipal securities business. The 

firm's procedures had not been amended to reflect the 2005 

amendment to MSRB Rule G-38 that prohibited payments to 

unaffiliated individuals for the solicitation of municipal securities 

business. In addition, the firm failed to enforce its procedures regarding 

compliance with the MSRB rule that regulates political contributions. 

The firm's procedures required that all municipal finance professionals 

clear their political contributions through the Compliance Department 

prior to making the contributions; however, no such pre-approval 

1 Regulatory Notice 10-41 (September 2010), (FINRA Reminds Firms of Their Sales Practice and Due Diligence 

Obligations When Selling Municipal Securities in the Secondary Market.) 


process was ever implemented. In effect, Southwest's inadequate 

supervisory systems and procedures failed to detect that one of its 

municipal professionals had made a political contribution. This led to 

the firm engaging in prohibited municipal securities business in 

violation of MSRB Rule G-37, for which the Securities and Exchange 

Commission brought a regulatory action against Southwest in March 

2010. 

2) Cal PSA 

As has been reported in the press, FINRA is collecting information from 

certain FINRA firms relating to their membership in, contributions to, 

and activities in connection with the California Public Securities 

Association (“Cal PSA”), a municipal securities industry association. 

Cal PSA (California Public Securities Association) is funded by fees 

charged underwriters doing business in the state of California. The fees 

are calculated as a small percentage of municipal issuances. 

Approximately 25 FINRA members are members of Cal PSA. Cal PSA 

controls two political action committees and engages in political 

activity. 

3) Municipal Gas Bond 

B. Specific Unconventional Instruments 

1. Structured Products 

a. Generally 

These formal disciplinary actions primarily concern firms failing 

to provide official statements to customers, either because they 

had deficient procedures, or had adequate procedures that they 

did not follow. 

Settlements: 

Alliant Securities (Fine: $15, 000) (Case #2009018036601) 

Carty & Company (Fine: $25,000) (Case #200901803650) 

FMS (Fine: $100,000) (Case #2009019191401) 

GMS (Fine: $50,000) (Case #2009017280701) 

Janney Montgomery (Fine: $75,000) (Case #2009018503501) 

Lawson Financial (Fine: $25,000) (Case #2009018036301) 

Oppenheimer (Fine: $100,000) (Case #2009018400501) 

Structured products are securities derived from or based on a single security, 

a basket of securities, an index, a commodity, a debt issuance and/or a 

foreign currency. 2 There is no standardized definition of a structured product 

in the federal securities laws. Many structured products pay an interest or 

coupon rate substantially above the prevailing market rate. Broker dealers 

and their FAs may use these attractive yields or some level of principal 

protection to market the structured products to retail investors. However, 

structured products can be complex, and have cash flow characteristics and 

risk-adjusted rates of return that are uncertain or hard to estimate. These 

products generally lack any active secondary market, which means investors 

must be willing to assume considerable liquidity risk in addition to market risk 

and the credit risk associated with the issuer of the product. As a result of 

2 NASD NTM 05-59 


these inherent risks, the products may be unsuitable for some retail 

investors. 

For example, reverse convertibles (RevCons) are interest-bearing notes in 

which principal repayment is typically linked to the performance of a reference 

asset, often a stock, a basket of stocks, or an index. RevCons, which may 

offer a high rate of return, have complex payout structures often tied to a 

“knock-in” level, 3 and involve elements of options trading. RevCons not only 

expose investors to the financial risks associated with the debt obligation, but 

also to those risks associated with the reference asset. 

b. Principal Protected Notes 

Principal Protected Notes are a form of structured product. A feature of some 

structured products is a "principal guarantee" function, which offers protection 

of principal if held to maturity, provided the issuer remains solvent and does 

not default on the note. They have a fixed maturity, and typically combine a 

zero coupon bond with an option or other derivative product whose payoff is 

linked to an underlying asset, such as an equity index or basket of indices. 4 

Principal protection levels can vary – some products guarantee 100 percent 

return of principal, others guarantee as little as 10 percent. 

Pros and Cons of PPNs 

Benefits of structured products may include: 

• principal protection (depending on the type of structured product) 

• enhanced returns within an investment (depending on the type of 

structured product) 

Disadvantages of structured products may include: 

• credit risk - structured products are unsecured debt of the issuer; 

• lack of liquidity - structured products rarely trade after issuance and 

anyone looking to sell a structured product before maturity should expect 

to sell it at a significant discount; and 

• highly complex - the complexity of the return calculations means few truly 

understand how the structured product will perform relative to simply 

owning the underlying asset. 

Possible PPN-related Violative Conduct 

PPNs were sold by a number of broker-dealers to retail customers. The sale 

of PPNs by broker-dealers and their registered representatives raises 

concerns including, but not limited to, the suitability of the investments; the 

adequacy of disclosures at the point of sale; and supervision related to the 

training, marketing and sales. 

c. Structured Product and PPN Cases 

1) Santander Securities of Puerto Rico (Case #20080117193-01) ($2 

3 At maturity if the value of the referenced asset has fallen below a certain level (i.e., the “knock-in”), the investor receives 

less than a full return of principal either in the form of cash or shares of the referenced asset. 

4 NASD NTM 09-73 


million and over $7 million reimbursement to customers for losses) 

(April 2011) 

FINRA found significant deficiencies in Santander Securities' 

structured products business, including unsuitable sales of reverse 

convertible securities to retail customers, inadequate supervision of 

sales of structures products, inadequate supervision of accounts 

funded with loans from its affiliated bank and other violations related 

to the offering and sale of structured products. 

Santander Securities’ deficiencies began with the firm’s failure to 

have a process in place to review or approve structured products 

prior to permitting FAs to offer the product to a customer. 

Santander Securities brokers bore the responsibility of evaluating 

structured products without sufficient suitability guidance or required 

training on structured products. 

Moreover, the firm did not have effective procedures in place to 

monitor customer accounts for potentially unsuitable purchases of 

structured products and had no suitability policies governing product 

concentration. As a result, the firm failed to detect certain accounts 

with concentrated positions in certain risky structured products, 

specifically RevCons. 

Some Santander Securities brokers recommended that customers 

use funds borrowed from the firm’s banking affiliate to purchase 

RevCons, claiming that it would enable the customers to capture the 

spread between the interest they paid to the bank and the higher 

coupon rate they received from the structured product. However, the 

recommended use of leverage substantially increased the clients’ 

risk. Many customers lost money and owed additional money to the 

bank when the value of the RevCon declined and they sold the 

product at a loss. 

2) Morgan Stanley & Co. (Case #2008015963801) ($600,000 fine) 

(January 2012) 

Morgan Stanley failed to have a reasonable supervisory system and 

procedures in place to notify supervisors whether structured product 

purchases complied with the firm’s internal guidelines related to 

concentration (the size of an investment in relation to the customer’s 

liquid net worth) and minimum net worth. A sampling of structured 

product transactions revealed at least 14 unsuitable transactions for 

eight customers. Prior to settlement with FINRA (and as stated in 

the AWC) the firm entered into settlements with these customers. 

3) Joey W. Dean (Case #2008012833801) (Default Decision, barring 

Dean in all capacities) (Feb. 1, 2011) 

Dean made material misrepresentations to eight customers in the sale 

of structured products issued by Morgan Stanley. These products 

offered protection of principal if held to maturity, and variable monthly 

income that was determined by a formula linked to the Russell 2000 or 

the S&P 500. 

Dean told the customers that their principal was protected, which was 

accurate only if they held the notes to maturity (five years). He also 


misrepresented the rate of return when he told the customers that 

there was a guaranteed rate of return of 10% (in two cases 8%) 

However, there was no guaranteed rate of return and they could cease 

paying interest according to the income formula. 

In January 2008, the notes ceased paying monthly income. Dean did 

not inform three of the customers, knowing that they expected and 

withdrew regular monthly income. Instead, he began selling shares of 

their investments in the structured products to generate funds for the 

accustomed withdrawals. 

The sales were unauthorized and masked Dean’s misrepresentations 

regarding the guaranteed income. 

The eight customers were all recent retirees, most from a local paper 

factory. Dean concentrated 73% to 93% of the liquid net worth of the 

customers in the structured products. The Office of Hearing Officers 

stated that concentration in the unsecured products of a single issuer 

was inherently risky and unsuitable. 

4) Wells Fargo Investments LLC (Case #2008015651901) 

In December 2011, FINRA announced that it had fined Wells Fargo $2 

Million for unsuitable sales of reverse convertibles to elderly customers 

and failure to provide breakpoints on UIT sales. The firm consented to 

findings that it, through one of its representatives, engaged in 

unsuitable sales of reverse convertible securities to 21 customers. The 

firm also consented to findings that it failed to provide sales charge 

discounts on Unit Investment Trust (UIT) transactions to eligible 

customers and had insufficient systems and procedures to monitor for 

unsuitable reverse convertible sales and to ensure that UIT customers 

received discounts for which they were entitled. 

As part of the settlement, the firm was required to pay restitution to 

customers who did not receive UIT sales charge discounts and to 

provide restitution to certain customers found to have unsuitable 

reverse convertible transactions. 

FINRA also filed a complaint against the former Wells Fargo registered 

representative who recommended and sold the unsuitable reverse 

convertibles, and made unauthorized trades in several customer 

accounts, including accounts of deceased customers. 

FINRA found that the representative recommended hundreds of 

unsuitable reverse convertible investments to 21 clients, most of who 

were elderly and/or had limited investment experience and low risk 

tolerance. As of June 2008, he had 172 accounts that held reverse 

convertibles, with 148 of those accounts having concentrations greater 

than 50 percent of their total account holdings, and 46 having 

concentrations greater than 90 percent. Fifteen of the 21 customers 

were over 80 years old. The reverse convertible transactions exposed 

these customers to risk inconsistent with their investment profiles, and 

resulted in overly concentrated reverse convertible positions in their 

accounts. 

5) UBS Financial Services, Inc. (Case #2008015443301) ($2.5 million fine 

and restitution of $8.25 million) (April 2011) 

FINRA fined UBS and ordered restitution for omissions and 

statements made that effectively misled some investors regarding the 


“principal protection” feature of 100% PPNs Lehman Brothers 

Holdings Inc. issued prior to its September 2008 bankruptcy filing. 

FINRA found that UBS: 

• misled certain customers regarding the characteristics and 

risks associated with investing in the PPNs including material 

information regarding the 100% principal protection feature; 

• did not provide financial advisors (FAs) with sufficient guidance 

regarding the impact of issuer credit risk and widening credit 

default swap spreads, as they related to Lehman’s financial 

strength, on the PPNs and the communication of that 

information to clients; 

• failed to establish an adequate supervisory system including 

written supervisory procedures and the training of FAs 

regarding the sale of the Lehman-issued PPNs; 

• did not adequately analyze the suitability of sales of the 

Lehman- issued PPNs to certain UBS customers; 

• created and used advertising materials that had the effect of 

misleading some customers about specific characteristics of 

PPNs related to issuer credit risk. 

FINRA found that some of the UBS’ financial advisors did not 

understand the product, including the limitations of the “protection” 

feature. Consequently, certain financial advisors communicated 

incorrect information to their customers. 

Certain advertising materials suggested that a return of principal was 

guaranteed if customers held the product to maturity; however, UBS 

did not adequately disclose that the issuer’s credit risk could result in 

a loss of principal. 

Suitability procedures were also lacking. UBS did not have risk 

profile requirements for certain PPNs; therefore, the PPNs were sold 

to some investors for whom the product was not suitable, including 

investors with “moderate” and “conservative” risk profiles. 

2. Residential Mortgage-Backed Securities and Commercial Mortgage-Backed 

Securities (RMBS)/Collateralized Mortgage Obligations (CMOs) 

a. Generally 

Due to the embedded pre-payment option associated with mortgage-backed 

products, these securities carry significant re-investment risk, which can strongly 

affect the yield investors realize. Also, with collateralized mortgage obligations 

(CMOs), some tranches, such as interest-only strips or inverse floaters, carry much 

higher levels of risk than other tranches. Finally, the opaque nature of underlying 

collateral and the lack of a robust secondary market for some mortgage-backed 

securities should be considered when evaluating suitability. 

With respect to Residential Mortgage-Backed Securities (RMBS), Issuers of 

subprime RMBS are required to disclose historical performance information for 

past securitizations that contain mortgage loans similar to those in the RMBS 

being offered to investors. Historical delinquency rates are material to investors in 

assessing the value of RMBS and in determining whether future returns may be 

disrupted by mortgage holders' failures to make loan payments. As there are 

different standards for calculating delinquencies, issuers are required to disclose 

the specific method it used to calculate delinquencies. 


. Cases 

1) Northern Trust Securities (Case #2009018771601) ($600,000) (June 

2011) 

On June 2, 2011, FINRA announced that it had fined Northern Trust 

Securities $600,000 for deficiencies in supervising sales of 

collateralized mortgage obligations (CMOs) and failure to have 

adequate systems in place to monitor certain high-volume securities 

trades. 

FINRA found that from October 2006 through October 2009, 

Northern Trust failed to monitor customer accounts for potentially 

unsuitable levels of concentration in CMOs, in large part because it 

used an exception reporting system that failed to capture or analyze 

substantial portions of the firm's business, including all CMO 

transactions, certain trades of 10,000 equity shares or more, and 

certain trades of 250 or more of fixed-income bonds. FINRA found 

that from January 2007 to June 2008, 43.5 percent of the firm's 

business was excluded from review. 

The absence of systems to monitor equity trades of over 10,000 

shares or fixed income trades of over 250 bonds also resulted in a 

failure to review these trades for suitability, concentration, excessive 

trading, excessive markups or commissions, or for trading in 

restricted stocks. 

2) Credit Suisse Securities (Case #200801280890) ($4.5 million) and 

Merrill Lynch (Case #2008012808201) ($3 million) 

On May 26, 2011, FINRA announced that it had fined Credit Suisse 

Securities (USA) LLC $4.5 million, and Merrill Lynch $3 million for 

misrepresenting delinquency data and inadequate supervision in 

connection with the issuance of residential subprime mortgage 

securitizations (RMBS). 

FINRA found that in 2006, Credit Suisse misrepresented the historical 

delinquency rates for 21 subprime RMBS it underwrote and sold. 

Although Credit Suisse knew of these inaccuracies, it did not 

sufficiently investigate the delinquency errors, inform clients who 

invested in these securitizations of the specific reporting 

discrepancies or correct the information on the website where the 

information was displayed. Credit Suisse also failed to name or define 

the methodology used to calculate mortgage delinquencies in five 

other subprime securitizations. Additionally, Credit Suisse failed to 

establish an adequate system to supervise the maintenance and 

updating of relevant disclosure on its website. 

In a separate case, FINRA found that Merrill Lynch negligently 

misrepresented the historical delinquency rates for 61 subprime 

RMBS it underwrote and sold. However, in June 2007, after learning 

of the delinquency errors, Merrill Lynch promptly recalculated the 

information and posted the corrected historical delinquency rates on 

its website. Merrill Lynch also failed to establish a reasonable system 

to supervise and review its reporting of historical delinquency 

information. On January 1, 2009, Merrill Lynch was acquired by Bank 

of America, but the firm continues to do brokerage business under its 

own individual broker-dealer registration. 

3) Barclays Capital (Case #2008012808801) 


3) Non-Traded REITs 

a. Generally 

On December 22, 2011, FINRA announced that it had fined Barclays 

Capital $3 Million for misrepresentations related to subprime 

securitizations. The firm consented to findings that it misrepresented 

delinquency data and had supervisory deficiencies vis-à-vis the 

issuance of residential subprime mortgage securitizations (RMBS). 

FINRA found that from March 2007 through December 2010, Barclays 

misrepresented the historical delinquency rates for three subprime 

RMBS it underwrote and sold. The inaccurate delinquency data posted 

on Barclays' website was referenced as historical information in five 

subsequent RMBS investments and contained errors significant 

enough to affect an investor's assessment of subsequent 

securitizations. Additionally, Barclays failed to establish an adequate 

system to supervise the maintenance and updating of relevant 

disclosure on its website. 

Although non-traded REITs may offer diversification benefits as a part of a 

balanced portfolio, they do have certain underlying risk characteristics that can 

make them unsuitable for certain investors. As an unlisted product without an 

active secondary market, these products offer little price transparency to 

investors and little liquidity. The related financial information for these products 

may often be unclear to the investor, which makes the true associated risks 

and value difficult to ascertain. With many products, there are questions about 

valuation and concerns that in some cases distributions to investors are paid 

with borrowed money, over a lengthy period of time, with newly raised capital, 

or by a return of principal rather than a return on investment. The source of the 

distribution may not be transparent. 

On Oct. 4, 2011, FINRA issued an Investor Alert called Public Non-Traded 

REITs – Perform a Careful Review Before Investing to help investors 

understand the benefits, risks, features and fees of these investments. 

b. Cases 

1) Wells Investment Securities, Inc. (Case #2009019893801) 

In November 2011, FINRA announced that it had fined Wells 

Investment Securities, Inc. $300,000 for using misleading marketing 

materials in the sale of a non-traded Real Estate Investment Trust 

(REIT). 

Wells was the dealer-manager and wholesaler for the public offering of 

the REIT, which invested in timber-producing land. As the wholesaler, 

Wells reviewed, approved and distributed the marketing materials for 

the REIT. FINRA found that from May 2007 through September 2009, 

Wells reviewed, approved and distributed 116 advertising and sales 

materials containing misleading, unwarranted or exaggerated 

statements. For example, the REIT’s initial offering prospectus stated 

that it intended to qualify as a REIT for the tax year that ended Dec. 

31, 2006; however, it did not qualify for REIT election until the tax year 

that ended Dec. 31, 2009. The majority of the advertisements and 

sales literature failed to disclose the significance of the issuer’s non- 

REIT status or suggested that the issuer was a REIT at a time when in 

fact it had not qualified as a REIT. The communications also contained 


misleading statements regarding the issuer’s portfolio diversification 

and ability to make distributions and redemptions. 

Although non-traded REITs are generally illiquid, often for periods of 

eight years or more, they can avoid particular tax consequences if they 

qualify under certain Internal Revenue Service requirements. The 

advertisements at issue did not make it clear to potential investors who 

might be seeking such favorable tax treatment, that the investment at 

issue was not yet a REIT and therefore would not be able to offer the 

desired tax benefits at the time the ads were being used. 

FINRA's investigation also found that Wells failed to have supervisory 

procedures in place to ensure that sensitive customer and proprietary 

information stored on laptops were being adequately safeguarded by 

appropriate encryption technology. 

2) David Lerner Associates, Inc. – Complaint (Case #2009020741901) 

On May 31, 2011, FINRA announced that it had filed a complaint 

against David Lerner & Associates, Inc. (DLA), of Syosset, NY, 

charging the firm with soliciting investors to purchase shares in Apple 

REIT Ten, a non-traded $2 billion Real Estate Investment Trust 

(REIT), without conducting a reasonable investigation to determine 

whether it was suitable for investors, and with providing misleading 

information on its website regarding Apple REIT Ten distributions. 

DLA has sold and continues to sell Apple REIT Ten targeting 

unsophisticated and elderly customers with unsuitable sales of the 

illiquid security. 

Since January 2011, as sole underwriter for Apple REIT Ten, DLA 

has sold over $300 million of an open $2 billion offering of the REIT's 

shares. Apple REIT Ten invests in the same extended stay hotel 

properties as a series of other Apple REITs closed to investors. Apple 

REIT Ten and the closed Apple REITs were founded by the same 

individual, and are all under common management. DLA has been 

the sole underwriter for 

Apple REITs since 1992, selling nearly $6.8 billion of the securities 

into approximately 122,600 DLA customer accounts. DLA earns 10 

percent of all offerings of Apple REIT securities as well as other fees. 

Apple REIT sales have generated $600 million for DLA, accounting 

for 60 to 70 percent of DLA's business annually since 1996. 

The complaint against DLA alleges that since at least 2004, the closed 

Apple REITs have unreasonably valued their shares at a constant price 

of $11 notwithstanding market fluctuations, performance declines and 

increased leverage, while maintaining outsized distributions of 7 to 8 

percent by leveraging the REITs through borrowings and returning 

capital to investors. As sole distributor, DLA did not question the Apple 

REITs' unchanging valuations despite the economic downturn for 

commercial real estate. 

FINRA alleges that DLA failed to sufficiently investigate the valuation 

and distribution irregularities of the closed Apple REITs prior to selling 

Apple REIT Ten. As the sole underwriter of all of the Apple REITs, 

DLA was aware of the Apple REITs' valuation and distribution 

practices. Rather than conduct due diligence into those valuations and 

distribution irregularities to determine that they were reasonable and 

that the Apple REITs were suitable, DLA accepted the valuations and 

continued to 

record them on customer account statements. 


In its solicitation of customers to purchase Apple REIT Ten, DLA's 

website provided distribution rates for all of the previous Apple 

REITs. These distribution figures were misleading and omitted 

material information because they did not disclose recent 

distribution rate reductions or that distributions far exceeded income 

from operations and were funded by debt that further leveraged the 

REITs. 

3) David Lerner Associates, Inc. and David E. Lerner (Amended 

Complaint) (Case #2009020741901) 

On December 13, 2011, FINRA amended its Complaint against David 

Lerner Associates. The FINRA complaint alleges that the firm 

recommended and sold over $442 million of a $2 billion non-traded 

real estate investment trust (REIT) without performing adequate due 

diligence in violation of its suitability obligations. The complaint 

alleges that earlier REITs under the same management 

inappropriately valued the REITs’ shares at a constant artificial price 

notwithstanding years of market fluctuations, performance declines, 

increased leverage and excessive return of capital to investors. The 

firm, in its capacity as best efforts underwriter for all of the REITs, 

continued to solicit thousands of customers to purchase the REIT 

without performing adequate due diligence to determine that there 

was a reasonable basis to recommend the security to any customer. 

The complaint also alleges that the firm failed to disclose material 

information and made misleading omissions regarding prior REIT 

distributions on its website. 

The complaint further alleges that the firm, through David Lerner and 

other representatives, repeatedly gave seminar presentations to 

investors using seminar slides that were not fair and balanced, and 

did not provide a sound basis for evaluating the facts in regard to the 

REITs. 

In addition, the complaint alleges that Lerner made oral presentations 

regarding the REITs at seminars, which constituted a public 

appearance and were communications with the public under the 

FINRA advertising rules. The seminar slides and Lerner’s seminar 

presentations were not fair and balanced and omitted numerous 

material facts and qualifications that caused the communications to 

be misleading. The seminar slides and Lerner’s seminar 

presentations contained numerous false, exaggerated, unwarranted 

or misleading statements and claims regarding the valuations, 

performance, prospects, risks and practices of the REIT programs, as 

well as customer insurance protection through the firm and the 

prospects for a merger of the closed REITs. 

Moreover, the complaint alleges that to counter negative media 

attention regarding the firm and the REITs following the filing of the 

original complaint in this proceeding, Lerner sent letters to all of the 

firm’s customers that omitted material information causing the 

communication to be misleading. The letters also contained 

exaggerated, false and misleading statements regarding the 

valuations, performance, prospects, risks and practices of the REIT 

programs. The complaint also alleges that to induce new and existing 

customers to purchase the REIT, Lerner and the firm negligently 

made untrue representations of material fact or omissions of material 

fact regarding the prior performance, steady distribution rates, 

unchanging valuations, and prospects of the closed REITs and/or the 


current REIT. The firm and Lerner made the untrue statements and 

omitted the material facts with intent to defraud investors or with 

recklessness. 

4) Bond Funds 

a. Morgan Keegan (Case #2007011164502) 

On June 22, 2011, FINRA, the SEC and 5 state regulators from Alabama, 

Kentucky, Mississippi, South Carolina and Tennessee announced that each 

had settled enforcement proceedings against Morgan Keegan & Company, 

Inc. Morgan Keegan will pay restitution of $200 million for customers who 

invested in seven affiliated bond funds, including the Regions Morgan Keegan 

Select Intermediate Bond Fund (Intermediate Fund). Morgan Keegan's 

affiliate, Morgan Asset Management, managed the funds. 

FINRA found that from the beginning of Jan. 2006 to the end of Sept. 2007, 

Morgan Keegan marketed and sold the Intermediate Fund to investors using 

sales materials that contained exaggerated claims, failed to provide a sound 

basis for evaluating the facts regarding the fund, were not fair and balanced, 

and did not adequately disclose the impact of market conditions in 2007 that 

caused substantial losses to the value of the Intermediate Fund. 

The Intermediate Fund invested predominantly in structured products, 

including mezzanine and subordinated tranches of structured securities 

including sub-prime products. Morgan Keegan marketed the Intermediate 

Fund as a relatively safe, investment-grade fixed income mutual fund 

investment when, in fact, the fund was exposed to risks associated with its 

investments in mortgage-backed and asset-backed securities, and 

subordinated tranches of structured products. By the beginning of 2007, 

Morgan Keegan was aware that the Intermediate Fund was experiencing 

difficulties related to the holdings in the fund impacted by turmoil in the 

mortgage-backed securities market yet failed to adequately disclose those 

risks in the sales materials or internal guidance. In March 2007, when 

adverse market conditions began to affect the fund, over 54 percent of the 

portfolio was invested in asset-backed and mortgage-backed securities, and 

13.5 percent was invested in subprime products. 

b. Charles Schwab (Case #2008012876902) 

FINRA ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair 

Fund to be established by the Securities and Exchange Commission (SEC) to 

repay investors in YieldPlus, an ultra short-term bond fund managed by 

Schwab's affiliate, Charles Schwab Investment Management. The $18 million 

consists of the $17.5 million in fees that Schwab collected for sales of the fund, 

plus a fine of $500,000, both of which will have been designated as restitution 

to customers. 

FINRA's investigation found that despite changes in YieldPlus' portfolio that 

caused the fund to be disproportionately affected by the turmoil in the 

mortgage-backed securities market, Schwab failed to change its marketing of 

the fund. In written materials and in conversations with customers, some 

Schwab representatives omitted or provided incomplete or inaccurate material 

information relating to the fund's characteristics, risk and diversification, and 

continued to represent YieldPlus as a relatively low-risk alternative to money 


market funds and other cash alternative investments that had minimal 

fluctuations in net asset value (NAV). 

Between Sept. 1, 2006, and Feb. 29, 2008, Schwab sold over $13.75 billion in 

shares of YieldPlus to customers, which accounted for approximately 98 

percent of the amount Schwab customers invested in ultra short-term bond 

funds. During this time period, Schwab's solicited sales of YieldPlus totaled 

approximately $3.36 billion, approximately 40 percent of which were to 

customers 65 years of age or older. Schwab collected approximately $17.5 

million in fees from sales of the fund. 

5) UIT and Floating Rate Notes 

a. Generally 

A UIT is an investment product that consists of a diversified basket of 

securities, which can include risky, speculative investments such as highyield/below 

investment-grade or "junk" bonds. Floating-rate loan funds are 

mutual funds that generally invest in a portfolio of secured senior loans made to 

entities whose credit quality is rated below investment-grade, or "junk." 

b. Chase Investment Services Corporation (Case #2008015078603) 

In November 2011, FINRA announced that it ordered Chase Investment 

Services Corporation to reimburse customers more than $1.9 million for losses 

incurred from recommending unsuitable sales of unit investment trusts (UITs) 

and floating rate loan funds. FINRA also fined Chase $1.7 million. 

Chase consented to findings that Chase brokers recommended the purchase of 

UITs and floating rate loan funds to unsophisticated customers with little or no 

investment experience and conservative risk tolerances, without having 

reasonable grounds to believe that those products were suitable for the 

customers. FINRA also found that Chase failed to implement supervisory 

procedures to reasonably supervise its sales of UITs and floating rate loan 

funds. 

FINRA found that Chase did not provide its brokers with sufficient training and 

guidance regarding the risks and suitability of UITs and floating-rate loan funds. 

Two of the UITs on Chase's list of approved products held a large percentage 

of assets in closed-end funds that contained a significant percentage of highyield 

or junk bonds. Due to their composition, these particular UITs were not 

suitable investments for customers who had little or no investment experience 

and a conservative risk tolerance. Chase brokers made almost 260 unsuitable 

recommendations to purchase these UITs to customers with little or no 

investment experience and a conservative risk tolerance. The customers 

suffered losses of approximately $1.4 million as a result of investing in these 

unsuitable transactions. 

Similarly, the floating-rate loan funds sold by Chase were subject to significant 

credit risks and certain of the funds could also be illiquid. Accordingly, 

concentrated positions in the funds were not suitable for certain investors with 

conservative risk tolerances or those seeking preservation of principal. Despite 

this, Chase brokers recommended the purchase of floating-rate loan funds to 

customers who had conservative risk tolerances, were seeking preservation of 

principal or were seeking a highly liquid investment. These customers suffered 

unreimbursed losses of nearly $500,000 as a result of these unsuitable 

recommendations. 


c. UVEST (Case #2009016347101) (April 3, 2012) 

The firm consented to a $230,000 fine plus an undertaking to pay 

approximately $44,000 in restitution to customers. It also consented to findings 

that it, among other things, violated: 

• FINRA Rule 2010 and NASD Rules 2110 and 3010(a) and (b) when, 

between July 9, 2007 and September 20, 2009, it failed to apply 

“breakpoint” and “rollover and exchange” discounts (collectively “sales 

charge discounts”) to eligible customer purchases of Unit Investment 

Trusts. Also between July 9, 2007 and September 20, 2009, UVEST failed 

to establish, maintain and enforce an adequate supervisory system and 

WSPs reasonably designed to achieve compliance with its obligation to 

identify and ensure customers received sales charge discounts on all 

eligible UIT purchases. 

• FINRA Rule 2010, NASD Rule 2110 and 3010(a) and (b) when, between 

July 9, 2007 and September 20, 2009, UVEST customers purchased UITs 

in 3,194 brokerage accounts, and UVEST failed to establish, maintain and 

enforce an adequate supervisory system and WSPs reasonably designed 

to achieve compliance with its obligation to provide UIT prospectuses to 

customers. 

6) Complex Exchange-Traded Products 

Complex Exchange-Traded Products: Certain exchange-traded products that 

employ sophisticated strategies or access more exotic markets can expose 

investors to unexpected results or unforeseen risks. For example, exchangetraded 

funds (ETFs) that employ optimization strategies using synthetic 

derivatives can expose individual investors to the risk of significant tracking errors. 

In other words, the performance of the ETF may differ from that of the underlying 

benchmark during times of stress or volatility in unanticipated ways. These risks 

can be exacerbated when the ETFs employ significant leverage. 

7) Variable Annuities 

Although variable annuity products can offer valuable benefits to investors seeking 

predictable annuity streams, tax deferral for investment gains and flexible investment 

choices, they do have certain risk characteristics that can make them unsuitable for 

some investors. These products often have long holding periods and significant 

surrender fees, making them unsuitable for investors who have a need for liquidity. 

High fees and expenses may result in reduced performance in the underlying 

holdings, and high commissions make the product a target for switching. FINRA Rule 

2330 imposes enhanced responsibilities on member firms with respect to variable 

annuities. Among other things, the rule requires that the firm or associated person 

have a reasonable basis to believe that a customer would benefit from certain 

features of a deferred variable annuity, such as tax-deferred growth, annuitization, or 

a death or living benefit, and that the particular recommended deferred variable 

annuity as a whole, the underlying subaccounts to which funds are allocated, and any 

rider or similar policy enhancements accompanying it are suitable for the customer. 

The rule, moreover, requires that the firm or associated person have a reasonable 

basis to believe that the customer has been informed, in general terms, of various 

features of deferred variable annuities. Firms are also required to implement 

surveillance procedures to detect any registered persons who are effecting deferred 

variable annuity exchanges at a rate that could indicate non-compliance with 

securities laws and rules, and to have procedures for taking corrective action if such 

activity is detected. The rule has a training component as well. 

8) Unregistered Securities Acquired in Secondary Markets 


As many high-profile companies have elected to remain private, secondary trading 

markets have emerged for their securities. However, despite their profile, many of 

these companies are difficult to value, as the issuers may not make financial 

statements publicly available. Acquiring interests in such securities through a pooled 

investment or single security “fund” introduces another layer of costs to the investor 

as well as risk associated with the fund manager. 

9) Church Bonds 

The credit quality of the underlying issuer and its true financial condition are often not 

transparent. Investors may be unaware of the substantial credit and market risk they 

are assuming with such investments. The source and nature of the underlying 

revenue streams of the issuer that are required to service the instruments are often 

less than clear. Further, as sales are frequently made on an affinity basis, these 

securities can be vehicles for fraud. 

II. 

Anti-Money Laundering 

A. Master/Sub Accounts 

1. FINRA Regulatory Notice 10-18 

FINRA issued Regulatory Notice 10-18 dealing with other issues that arise from 

master/sub accounts. The application of many FINRA rules, federal securities laws 

and other applicable federal laws depends on the nature of the account and the 

identity of its beneficial owners. At times, an account may take the form of a 

master/sub-account arrangement where the beneficial ownership interests in the 

various sub-accounts may or may not be identified to the firm. Certain master/subaccount 

arrangements raise questions regarding whether the master account and all 

sub-accounts have the same beneficial owner and, therefore, whether they can 

legitimately be viewed as one customer account for purposes of FINRA rules, the 

federal securities laws and other applicable federal laws. 

If a firm has actual notice that the sub-accounts of a master account have different 

beneficial ownership (but does not know the identities of the beneficial owners) or 

the firm is privy to facts and/or circumstances that would reasonably raise the issue 

as to whether the sub-accounts, in fact, may have separate beneficial owners (and 

therefore is on “inquiry notice”), then the firm must inquire further and satisfy itself as 

to the beneficial ownership of each such sub-account. This list is not exhaustive and 

is only included to reflect some types of “red flags” that would put a firm on inquiry 

notice that the sub-accounts may have separate beneficial owners, including but not 

limited to for example: 

• the sub-accounts are separately documented and/or receive separate reports 

from the firm; 

• the firm addresses the sub-accounts separately in terms of transaction, tax or 

other reporting; 

• the sub-accounts incur charges for commissions, clearance and similar 

expenses, separately, based upon the activity only of that subject sub-account; 

and, 

• the firm is aware of or has access to a master account or like agreement that 

evidences that the sub-accounts have different beneficial owners. 

When a firm becomes aware of the identities of the beneficial owners of the 

subaccounts pursuant to its duties arising from actual notice or inquiry notice 

outlined above, the firm will be required to recognize the sub- accounts as separate 


customer accounts for purposes of applying FINRA rules, the federal securities 

laws and other applicable federal laws. 

b. Cases 

1) Generally 

B. Direct Market Access 

FINRA has been focusing on whether or not firms have an adequate 

anti- money laundering program given the firm’s business model and 

in particular, whether or not the firm has an adequate system for 

detecting and reporting suspicious activity. Those firms with 

customers using certain master/sub account relationships can 

present particular issues for AML compliance. The general structure 

is one master account with various sub accounts. The arrangement 

is particularly attractive to day-traders because they may not be 

required to maintain a minimum account equity balance and their 

buying power may exceed the individual 4:1 margin-to-equity ratio 

required of accounts held directly at a broker-dealer. 

These types of accounts can create several issues. 

First, for AML purposes, sub-accounts, depending on how they are 

set up, may trigger CIP and customer due diligence obligations for 

the underlying accountholders (See Treasury/SEC Q&A on Omnibus 

Accounts and CIP obligations 10/1/03). But whether or not a firm has 

CIP obligations with subaccounts, it still has an obligation to monitor 

the accounts for suspicious activity. 

Second, the firm may be at risk for aiding and abetting an 

unregistered broker-dealer. (See SEC Release No. 60764 In the 

matter of GLB Trading and Robert Lechman). FINRA has made 

referrals to the SEC where we see a master account operating as an 

unregistered broker-dealer. 

FINRA's Enforcement Department is conducting a review of broker/dealers that provide 

Direct Market Access, Naked Access, Electronic Access or Sponsored Access ("DMA") to 

their customers. The sweep is reviewing the firm’s AML policies particularly as they 

related to master/sub account relationships and transaction monitoring for suspicious 

activity reporting. 

C. Suspicious Activity Monitoring 

1. First Clearing Corporation ($400,000 fine) (Case #2008012791101) (Jan. 26, 2011) 

D. Penny Stocks 

From at least January 1, 2007 through September 30, 2008, FCLLC failed to 

establish and implement an adequate AML compliance program for detecting, 

reviewing and reporting suspicious activity in certain fully disclosed accounts. 

FCLLC did not review or monitor the suspicious activity in most of the exception 

reports that it prepared for, and distributed to, introducing broker-dealers or 

otherwise conduct sufficient risk-based monitoring of activity in accounts introduced 

by its unaffiliated introducing broker-dealers. Instead, FCLLC reviewed a limited 

amount of potentially suspicious money movements and penny stock activity 

beginning in 2007. As a result, FCLLC failed to establish and implement a 

transaction-monitoring program reasonably designed to achieve compliance with 

the SAR reporting provisions of 31 U.S.C. 5318(g) and the implementing 

regulations as required by NASD Rule 3011(a). 


Penny stock transactions can be of higher risk as they are frequently used for 

unregistered distributions, market manipulations and securities fraud. Some firms 

essentially ignore the red flags because they are making money from the 

transactions and other firms do not seem to understand the risk of this business, 

particularly if it is new to them. 

1. AIS Financial, Inc. (Expulsion) (Case #2008012169101) (March 3, 2011) 

A hearing panel expelled AIS Financial for failing to implement and enforce an AML 

program. The panel found that AIS disregarded its AML responsibilities by ignoring 

prominent red flags and blatant suspicious activity for an extended period of time 

for financial gain. 

Motivated by commissions, the firm received from allowing its customers to 

liquidate billions of shares of penny stocks from numerous accounts, AIS turned a 

blind eye to the suspicious activity and concealed the activity from regulatory 

authorities. 

In one instance, the hearing panel found that AIS failed to report suspicious activity 

that occurred in two corporate accounts controlled by a money management firm 

based in Costa Rica, whose owner had been the subject of significant regulatory 

actions by the SEC for securities fraud for engaging in an Internet manipulative 

scheme. 

AIS permitted five accounts, controlled by a customer and his nephew, both of 

whom had disciplinary histories and criminal indictments for engaging in organized 

criminal activity and money laundering prior to opening accounts at AIS, to deposit 

and liquidate penny stocks in their accounts just two months after the SEC had 

charged them with securities fraud. 

In addition, the hearing panel found that AIS permitted approximately 20 customers 

to deposit and liquidate approximately 65 million shares of low- priced and thinly 

traded Asia Global Holdings Corp stock. The liquidations generated sales proceeds 

of approximately $5.1 million for the customers and commissions of $243,304 for 

the firm. 

2. Merrill Lynch, Pierce, Fenner & Smith (Case #2009020383001) 

On July 26, 2011, FINRA issued an AWC finding that Merrill Lynch failed to 

enforce its anti-money laundering compliance program (”AMLCP”) and written 

procedures by accepting third-party checks for deposit into a customer’s account 

that, contrary to the procedures, did not identify that customer by name. As a 

result, Maxwell Baldwin Smith (“Smith”), a registered representative at another 

member firm, was able to move over $9 million of misappropriated funds through 

his personal Merrill Lynch cash management brokerage account. FINRA 

censured the firm and imposed a $400,000 fine. 

From 1992 through at least June 2008, Smith convinced seven individuals, at 

least four of whom were elderly, to invest over $9 million in a private placement of 

an investment called a Health Care Financial Partnership Direct loan (”HCF”). 

One of the customers, who is now 95 years old, accounted for at least $8.6 million 

of the funds invested. Smith, however, did not invest the funds on the customers’ 

behalf. Unbeknownst to the customers, Health Care Financial was a sham entity 

and HCF was a fictitious investment. Instead of investing the funds as promised, 

Smith misappropriated the customers’ money by depositing their checks into his 

Merrill Lynch account, which, from 1992 through at least June 2008, was not used 

to effect any securities transactions. He then transferred those funds to a 

personal bank account by writing large dollar checks payable to himself and to 

cash. Smith used those funds to make purported ”interest payments” to the 


E. Foreign Finders 

unsuspecting customers or to purchase real estate, antiques and vacations for 

himself. 

The HCF investor checks were non-personal checks made payable to Merrill 

Lynch and, in most instances, Smith’s account number had been written on the 

check by the customer. The absence of Smith’s name on the checks gave no 

indication to those outside of Merrill Lynch, including Smith’s investors that the 

money was going to Smith’s personal account. 

In accepting these deposits, the firm failed to follow its written procedures 

because these ”non-personal checks” were accepted for deposit without 

containing the name of the Merrill Lynch client (Smith in this case) who owned the 

account. Had Merrill Lynch enforced its procedures, Smith would not have been 

able to move the proceeds of his misappropriation scheme through Merrill Lynch. 

Moreover, Merrill Lynch disregarded certain indications of Smith’s misconduct, 

such as the fact that he was: 1) depositing large amounts of money into, and then 

moving large amounts of funds out of, an account that had no market investment 

activity through the use of large dollar checks payable to himself or to cash; and 

2) depositing the funds of third parties with whom he had no apparent family or 

fiduciary relationship. By failing to enforce its written procedures and to develop 

and implement a reasonably-designed AMLCP, Merrill Lynch violated NASD 

Conduct Rules 3011(a), 3011(b) and 2110. 

1. General 

Foreign finders and related foreign affiliates pose compliance risks and may elevate 

a firm’s AML risk level. Recent examinations and enforcement cases have 

uncovered problematic arrangements with foreign finders. NASD Rule 1060(b) 

permits member firms, in limited circumstances, to pay transaction-related 

compensation to non-registered foreign persons or foreign finders. Specifically, the 

sole involvement of the foreign finder in the member firm’s business must be the 

initial referral of non-U.S. customers to the firm. FINRA reminds firms that the scope 

of permissible business activities and the associated regulatory requirements differ 

between foreign finders and foreign associates. Examiners have found finders 

whose activities go beyond an initial referral of non-U.S. customers to the firm and 

who are involved in the servicing of non-U.S. customer accounts, including having 

trading authority over accounts, entering customer orders directly to the clearing 

firm’s online platform, and processing new account documents and funds transfers. 

As a result of such activities, the foreign finders provisions in NASD Rule 1060(b) 

are not applicable, and the finder is required to be registered as a Foreign Associate 

pursuant to NASD Rule 1100, or in another appropriate registration category and be 

supervised as an associated person of the firm. Firms that engage foreign finders 

should ensure their procedures appropriately address the limited scope of activities 

permissible under such arrangements and potential risks. See Notices to Members 

01-81 and 95-37. 

A firm’s AML risk may be elevated by foreign finders and related foreign affiliates 

depending on the geographical regions involved, types of customers introduced, 

and products and services offered. Some of the red flags observed include 

customer accounts exhibiting significant account activity with very low levels of 

securities transactions, significant credit or debit card activity/withdrawals with very 

low levels of securities transactions, wire transfers to/from financial secrecy havens 

or high-risk geographic locations without an apparent business reason, and 

payment by third-party check or money transfer without an apparent connection to 

the customer. Relationships with foreign finders and related foreign entities have 

also been used to hide securities activities and payment of transaction-based 

compensation to previously disciplined individuals, and to engage in cross-trading 


for the inappropriate benefit of the finder. Prior to entering into these relationships, 

firms must have reasonably designed procedures to, among other things, assess 

and address the potential AML risks associated with the business, and monitor any 

subsequent activity conducted with foreign finders and related foreign entities. 

a. Bulltick Securities, LLC (Case #2009015969501) 

Bulltick was fined $125,000 for making transaction-based payments to a nonregistered 

foreign asset manager (foreign finder). FINRA also found that a 

non-registered foreign finder referred customer accounts to the firm that 

generated gross commissions of approximately $600,000 through the 

unsolicited, short-term trading of collateralized mortgage obligations. The firm 

was also found to have a deficient anti-money laundering program and 

supervisory systems and procedures. (Dec. 13, 2011). 

III. Section 5 

A. FINRA Regulatory Notice 09-05 

FINRA issued Regulatory Notice 09-05, Unregistered Resales of Restricted Securities, to 

remind firms and brokers of their obligations to determine whether securities are eligible for 

public sale before participating in what may be illegal distributions. It also discusses the 

importance of recognizing "red flags" of possible illegal, unregistered distributions and 

reiterates firms' obligations to conduct searching inquiries in certain circumstances to avoid 

participating in illegal distributions and to file suspicious activity reports where appropriate. 

1. Seaboard Securities Inc. (Case #2007008724801) 

On August 9, 2010, in an Order Accepting an Offer of Settlement, Seaboard was 

fined $125,000, $10,000 of which was joint and several with Anthony J. DiGiovanni, 

Sr. and $10,000 of which was joint and several with Sonya T. Hill. The firm was 

found to have participated in the distribution of approximately one billion shares of 

various unregistered securities in violation of Section 5. Firm failed to review for 

suspicious activity and make any appropriate filings. The firm was also required to 

retain and independent consultant to review procedures to conduct a 

comprehensive review of the adequacy of the Firm's AML program and its policies, 

systems and procedures (written and otherwise) and training relating to determining 

whether securities are freely tradable. 

2. Joseph Padilla (Hearing Panel Decision) (Case #2006005786501) 

A Hearing Panel (in a decision issued in October 18, 2010) found that Padilla 

participated in an illegal distribution of unregistered securities in violation of Section 

5 of the Securities Act of 1933. The findings stated that Padilla impermissibly relied 

upon others, including his firms’ compliance departments, transfer agents and 

clearing firms, to prevent any sales that might be unlawful. Padilla was suspended 

from association with any FINRA member in any capacity for six months. Padilla 

was fined $132,701, which includes disgorgement of commissions and an additional 

$10,000 fine. This decision has been appealed to the NAC and the sanctions are not 

in effect pending consideration of the appeal. 

3. Felix Investments LLC (Case #2010020933302) 

On March 14, 2012, FINRA issued an AWC from Felix Investments LLC and brokers 

William L. Barkow, Emilio A. DiSanluciano and Frank G. Mazzola. The Firm was 

censured, fined $250,000, and required to complete an undertaking. The 

undertaking requires the Firm to retain an independent consultant, who will review 

the adequacy of the Firm’s policies, systems and procedures and training, and 

recommend any changes, which the Firm shall implement, regarding ensuring: (1) 

Compliance with Section 5 of the Securities Act, in connection with solicitations of 


unregistered securities offerings; (2) All communications by the Firm and its brokers 

with the public comply with the content standards set forth in NASD Rule 2210(d); 

and (3) Supervisory reviews of email communications, and documentation of such 

reviews, as required by NASD Rule 3010(d)(1). Barkow and Mazzola were each 

separately fined $30,000 and suspended 15 business days. DiSanluciano was fined 

$20,000 and suspended for ten business days. 

The respondents consented to findings that Felix, acting through Barkow and 

Mazzola, marketed two unregistered offerings to potential investors through general 

solicitations, and thereby engaged in the public offering and sale of unregistered 

securities, in contravention of Section 5 of the Securities Act of 1933 and violation of 

FINRA Rule 2010. The offerings were for interests in private limited liability 

companies formed to invest in shares of Facebook, Inc.. 

The AWC also included findings of other violations including exaggerated, 

unwarranted and misleading statements and claims, in connection with the 

marketing of the offerings, books and records failures (emails), net capital 

deficiencies and related supervisory failures. 

On the same day that FINRA issued the AWC, the SEC filed a civil action in the U.S. 

District Court for the Northern District of California against Felix Investments LLC , 

Mazzola, and Facie Libre Management Associates LLC (owned and managed by 

Mazzola and Barkow) for fraud in connection with (1) the unregistered offerings of 

interests in LLCs formed to invest in shares of Facebook, relating to (a) self-dealing 

– earning secret commissions, (b) misrepresenting, among other things, that (i) they 

were selling funds with underlying Facebook shares when they knew the funds 

lacked ownership of certain Facebook shares, (ii) the LLCs were approved by 

Facebook, (iii) the LLCs possessed Facebook stock at $66 per share; and (2) false 

statements to investors in other pre-IPO funds, including about Twitter’s revenue 

and ownership of Zynga stock. The SEC seeks court orders prohibiting the 

defendants from engaging in securities fraud and requiring them to disgorge their illgotten 

gains and pay financial penalties. The fraud charges assert that the 

defendants violated Exchange Act of 1934 Section 10(b) and Rule 10b-5, Section 

17(a) of the Securities Act, and that defendants Mazzola and Facie Libre 

Management Associates LLC violated Section 206(A) of the Advisers Act and Rule 

206(4)-8 thereunder. 

B. Securities Offered Through Private Placements 

1. Generally 

Certain issuers seek to raise capital by offering unregistered securities in private 

placements. Many firms also offer securities in private placements to accredited 

investors under SEC’s Regulation D. Firms conducting private placements under 

Regulation D or any other applicable exemption from registration must conduct a 

reasonable investigation of the issuer, based upon the facts and circumstances, 

with careful attention to any “red flags,” to comply with the anti-fraud provisions and 

other FINRA rules, such as suitability. Proposed FINRA Rule 5123 (Private 

Placements of Securities) 5 would help ensure that member firms and associated 

persons that sell applicable private placements provide relevant disclosures to each 

investor, and would also require that the private placement memorandum, term 

sheet or other disclosure document be filed with FINRA to help inform FINRA’s 

regulatory programs. In addition, firms are reminded that the definition of accredited 

investor has changed. 6 

5 See Securities Exchange Act Release No. 65585 (October 24, 2011) and Securities Exchange Act Release No. 66203 

(January 26, 2012). 

6 See Securities Act Release No. 9287 (December 21, 2011). 


2. MedCap, Provident, DBSI – Cases 

Certain firms sold interests in private placements offered by Medical Capital Holdings, 

Inc., Provident Royalties, Inc., and DBSI, that ultimately failed. These issuers made a 

series of offerings, and the later offerings were often marketed based on the success 

of the earlier ones. 

FINRA issued ten AWCs and several complaints, mainly against principals and 

chief compliance officers. On April 7, 2011, FINRA announced the first group of 

AWCs, sanctioning two firms and seven individuals for selling private placements in 

MedCap and Provident without conducting a reasonable investigation: 

• Workman Securities Corp. was ordered to pay $700,000 in restitution to 

affected customers. (Case #20090188184) Robert Vollbrecht, Workman's 

former President, was barred in principal capacity, and fined $10,000. (Case 

#20090188184) 

• Timothy Cullum, former Chief Executive Officer, and Steven Burks, former 

President, of Cullum & Burks Securities, Inc. were each suspended in principal 

capacity for six months and fined $10,000. (Case #2009018818001) 

• Jeffrey Lindsey (Case #2009019125901) and Bradley Wells (Case 

#2009019125902), two former executives with Capital Financial Services, Inc., 

were each suspended for six months principal capacity and fined $10,000. 

• Jay Thacker, former Chief Compliance Officer for Meadowbrook Securities, 

LLC (f/k/a Investlinc Securities, LLC) was suspended for six months in any 

principal capacity and fined $10,000. (Case #2009019070101) 

• David Dube, former Owner, President, Chief Compliance Officer and Anti- 

Money Laundering Compliance Officer of (now-defunct) Peak Securities 

Corporation, was barred for due diligence and AML violations. (Case 

#2008011713801) 

In addition, FINRA issued the following AWCs: 

• Askar Corporation, $45,000 fine for due diligence violations related to its DBSI 

offerings. (Case #2009018558601) 

• Capital Financial Services, Inc., ordered to pay partial restitution of $200,000 

for violations of NASD Conduct Rules 2310, 3010 and 2110 and FINRA Rule 

2010 related to MedCap and Provident offerings. (Case #2009019125903) 

and Brian W. Boppre, a former principal, was suspended in any principal 

capacity for six months and fined $10,000 in connection with the sale of three 

Provident Royalties private placements and a Medical Capital private 

placement. (Case #2009019125904) 

• Investors Capital Corporation, ordered to pay partial restitution of 

approximately $400,000 for violations of NASD Conduct Rules 3010 and 2110 

and FINRA Rule 2010 related to Provident offerings (as well as an offering of 

an additional private placement). (Case #2009019069701) 

• NEXT Financial Group, Inc. and Steven Lynn Nelson (Case 

#2009019063801) – ordered to pay $2 million in restitution to affected 

customers and fined $50,000; Steven Lynn Nelson, the firm's Vice President 

for Investment Products and Services, was suspended in any principal 


Provident Royalties private placements. 

• Garden State Securities and Kevin John DeRosa (Case #2009018819201– 

Garden State Securities, Inc. and Kevin John DeRosa, a co-owner of the firm, 


C. Microcap Fraud 

were ordered to pay $300,000 in restitution on a joint-and-several basis to 

affected customers in connection with the sale of a Medical Capital private 

placement. DeRosa was also suspended for 20 business days in any capacity 

and for an additional two months in any principal capacity, and fined $25,000. 

Vincent Michael Bruno, the firm's Chief Compliance Officer at the time, was 

suspended for one month in a principal capacity and fined $10,000. (Vincent 

Michael Bruno – Case #2009018771701) 

• National Securities Corporation and Matthew G. Portes (Case 

#2009019068201) was ordered to pay $175,000 in restitution to affected 

customers, and Matthew G. Portes, Director of Alternative 

Investments/Director of Syndications, was suspended in any principal 



placement. 

• Equity Services, Inc. (Case #2009017240702) was censured, fined $50,000 

and ordered to pay nearly $164,000 in restitution in connection with the sale 

of a private placement DBSI, Inc. issued; Stephen Anthony Englese, (Case 

#2009017240703), Senior Vice President for Securities Operations, was 

suspended from association with any FINRA-regulated firm in any capacity for 

30 business days and fined $10,000; and Anthony Paul Campagna (Case 

#2009017240701), a registered representative, was suspended from 

association with any FINRA-regulated firm in any capacity for 30 business 

days and fined $25,000. 

• Securities America, Inc. (Case #2010022518101) – censured and fined 

$250,000 in connection with the sale of two Provident Royalties private 

placements. 

• Newbridge Securities Corporation (Case #2009016159401) – fined $25,000; 

Robin Fran Bush (Case #2009016159402), the former Chief Compliance 

Officer of Newbridge, was suspended in any principal capacity for six months 

and fined $15,000 in connection with the sale of four DBSI private placements 

and a Medical Capital private placement. 

• Leroy H. Paris, II (Case #2009019070102), former President and Chief 

Executive Officer for the now-defunct Meadowbrook Securities, LLC (f/k/a 

Investlinc Securities, LLC), of Jackson, MS, was suspended for six months in 

any principal capacity and fined $10,000 in connection with the sale of two 


placement. 

• Michael D. Shaw (Case #2009019388001) – formerly associated with VSR 

Financial Services, Inc., was barred from the industry in connection with the 

sale of a private placement offered by DBSI, Inc. and several additional 

private placements offered by other issuers. In addition, Shaw falsified 

customer account documents. 

The Findings: The MedCap/Provident/DBSI-related AWCs include the following 

violations: 

• Failure to conduct adequate due diligence, in violation of well-established 

standards and/or the firm’s own internal procedures 

• False and misleading misrepresentations or omissions to investors about the 

offerings, including inflated expectations of returns, the risk of the 

investments, and the past performance of other similar offerings by the same 

issuer 

• Suitability (reasonable basis and customer specific) 

• Unregistered offerings in violation of Section 5 


Microcap or penny stocks are particularly vulnerable to market manipulation given the lack of 

transparency in their underlying business, lack of verifiable financial history and the opaque 

nature of their operations. We are particularly concerned with fraud schemes that can harm 

retail investors. FINRA’s focus includes, among other issues: 

• bulletin board postings or email spam that distributes false or misleading information by 

fraudsters attempting to pump up a microcap; 

• high pressure sales tactics employed by sales personnel; 

• the use of paid promoters to dispense “unbiased” opinions related to these microcaps; 

and 

• individuals who use brokerage firms to liquidate microcap holdings, whereby the firm may 

be facilitating an unregistered distribution. As part of their anti-money laundering (AML) 

responsibilities, member firms are obligated to monitor for suspicious activity and to file 

Suspicious Activity Reports where warranted. 

D. Reverse Mergers 

The reverse merger market (where a private company merges into a public shell or socalled 

“backdoor registration”) represents a path for issuers to enter the U.S. public capital 

markets while foregoing the formal registration process associated with an IPO. Significant 

allegations of fraud have surfaced relative to this practice, particularly related to issuers 

based in China. Current and accurate information on these issuers is often scarce, and 

concerns have been raised regarding the quality of their audited financial statements. In 

December 2010, the SEC disciplined a U.S. auditor for overstating revenues of Chinese 

issuers. The heightened risk associated with these foreign issuers, who never went 

through an IPO or registration process in the U.S., increases the risk that any due 

diligence failures on the part of the broker-dealer may result in harm to investors. 

IV. Regulation S-P 

A. Generally 

SEC and FINRA rules require every broker-dealer to adopt written policies and procedures 

that address safeguards for the protection of customer records and information. We are 

looking at firms that do not have adequate Reg S-P policies or have had breaches in security 

and have not responded appropriately to the breach. Regulation S-P requires that financial 

institutions provide customers with a notice of their privacy policies. Further the Regulation 

prohibits these financial institutions from disclosing nonpublic personal information about a 

customer to nonaffiliated third parties unless, among other things, the firm gives the 

consumer certain required notices and a reasonable opportunity, before the firm discloses the 

information, to opt out of the disclosure. 

1. Lincoln Financial Securities, Inc. (Case #2009018720501)/Lincoln Financial Advisors 

Corp. (Case #2009020074601) (February 2011) 

On February 16, 2011, FINRA assessed total fines of $600,000 – a record for Reg 

SP – against Lincoln Financial Services, Inc. (LFS) of Concord, New Hampshire 

($450,000), and an affiliated firm, Lincoln Financial Advisors Corporation (LFA) of 

Fort Wayne, Indiana, ($150,000), for their failures to adequately protect non-public 

customer information. 

Both firms maintained a web-based system that combined non-public customer 

account information from various sources and allowed employees to view the 

customer account information within a single site. Home office personnel from both 

firms could access the system either by clicking on a link on the firm’s website or by 

using an Internet browser to go directly to the system’s website and log in with one of 

the shared user names and passwords. For extended periods of time – seven years 

for LFS and approximately two years for LFA – certain current and former employees 

were able to access customer account records through an Internet browser, using 

shared log-on credentials. Between the two firms, over one million customer account 

© 2012 Financial Industry Regulatory Authority, Inc. All rights reserved. 23

ecords were accessed through the use of shared user names and passwords. Since 

neither firm had policies or procedures to monitor the distribution of the shared user 

names and passwords, they were not able to track how many or which employees 

gained access to the site during this period of time. As a result of allowing 

uncontrolled access to the system, confidential customer records including names, 

addresses, social security numbers, account numbers, account balances, birth dates, 

email addresses and transaction details were at risk. 

In addition, LFS and LFA did not have procedures to disable or change the shared 

user names and passwords on a recurring basis even after a home office employee 

had been terminated. Many individuals left the two firms during the relevant time 

period, yet the shared user names and passwords were never changed, and the firms 

had no way of determining whether former employees continued to access 

confidential customer information using those same user names and passwords. 

FINRA also found that LFS representatives in the field used their own computers to 

conduct securities business, and were not required to install or utilize security 

applications such as antivirus, encryption or firewall software. As a result, brokers’ 

log-in credentials were at risk of being obtained by an unauthorized party, potentially 

exposing customer information that might have been downloaded to the brokerowned 

computer. 

V. Advertising 

A. National Foundation of America (August 2009 – January 2011) 

FINRA's investigated numerous registered representatives employed by various broker 

dealers who sold to elderly investors installment plan contracts offered by National 

Foundation of America ("NFOA") between 2006 and 2007. NFOA was a Tennessee non-profit 

corporation that misrepresented itself to the public as an approved charitable organization. In 

June 2007, amidst allegations that NFOA directors had used investor funds to pay personal 

expenses and purchase automobiles and property, the State of Tennessee placed NFOA in 

receivership and, later, into liquidation. 

The registered representatives failed to provide written notice to and receive approval from 

their broker-dealer employers prior to soliciting and selling the NFOA product, which was a 

security. These registered representatives also failed to conduct adequate due diligence of 

NFOA and sold the NFOA product by providing customers with misleading and unapproved 

sales materials and negligently misrepresenting that a tax deduction was available in 

connection with their investments in the NFOA product. 

a) James McKelvain – Case No. 20070088994-Offer of Settlement 

b) Russell Roeber – Case No. 2009 019041801-AWC 

c) Conrad Lawrence – Case No. 20090190422-Offer of Settlement 

d) Robert DeWald – Case No. 20090190416-AWC 

e) James J. Ahmann – Case No. 20090190410-AWC 

f) Jack Kennebeck – Case No. 20090190420-AWC 

g) Robert Pollock – Case No. 20090190423-AWC 

h) Randolph Andrew Fisher, Jr. – Case No. 2009019041802-Offer of Settlement 

i) Harry Derrick Winters – Case No. 2009019042401-Complaint 

j) Scott Browning – Case No. 20090190413-9552 

VI. Systems and Procedures to Identify and Prevent Losses from Trading and Back Office 

Operations 

A. Generally 

FINRA continues to examine for and bring enforcement proceedings relating to firms’ systems 

and procedures to identify and prevent losses to the firm, the firm’s customers, and other 


parties from trading done by the firm or from a firm’s back office operations. Such systems 

and procedures are an essential part of a firm’s supervision of these two areas. 

1. BNP Paribas Securities ($650,000) (February 2011) (Case #2008013504201) 

The firm failed to have adequate systems and procedures, such as independent 

price verification, to identify the risk of loss to the Firm that might arise when it 

allowed traders on its Listed Options Desk 1 to manually value their positions (rather 

than use the firm’s automated systems) and the risk of loss from arbitrage trades 

entered by its Stock Loan and Borrow (SLAB) Desks. As a result, BNP Paribas 

Securities was unaware of multi-million dollar losses incurred on both Desks. The 

firm was also sanctioned for filing an inaccurate Form U-5 for one trader on the 

Listed Options Desk. In settling the matter, FINRA took into consideration the firm’s 

self report and its extraordinary cooperation during FINRA’s investigation. 

2. UBS ($600,000 fine) (September 2010) (Case #2010022093601) 

The firm was sanctioned for failing to supervise the activities of a trader on its Fixed 

Income Emerging Markets Latin American Desk who, from January 2006 through 

May 2006, concealed more than $28 million in trading losses on non-deliverable 

forward (NDF) and Brazil 40 Bond transactions. Non-deliverable forward transactions 

were processed through two separate systems, each owned and maintained by 

UBS’s parent company, UBS AG in Zurich. The trader was able to make fictitious and 

inaccurate entries by exploiting shortcomings in these two systems. For example, he 

delayed entering actual trade data into one of the firm’s systems when the data 

concerned unprofitable transactions. In each instance, the result was to conceal an 

unrealized loss associated with an actual transaction and/or to create the appearance 

of a fictitious profit in connection with both actual and fictitious transactions. 

VII. Theft flowing from Supervisory Lapses 

A. Citigroup Global Markets, Inc. (Case #2008013231502) 

On August 9, 2011, FINRA announced that it fined Citigroup Global Markets, Inc. $500,000 

for failing to supervise a former registered sales assistant at the firm's branch office in Palo 

Alto, California. Over an 8 year period, the assistant misappropriated $749,978 from 22 

customers, falsified account records and engaged in unauthorized trades in customer 

accounts. 

The Assistant took advantage of Citigroup's supervisory lapses at the branch and targeted 

elderly, ill or otherwise vulnerable customers whom she believed were unable to monitor their 

accounts. The Assistant's victims included elderly widows, a senior with Parkinson's disease 

and her own father. FINRA previously barred the assistant for her actions. 

FINRA found that Citigroup failed to detect or investigate a series of "red flags" that upon 

further inquiry should have alerted the firm to the assistant’s improper use of customer funds. 

The red flags included exception reports highlighting conflicting information in new account 

applications and customer account records reflecting suspicious transfers of funds between 

unrelated accounts. Citigroup also failed to implement reasonable systems and controls 

regarding the supervisory review of customer accounts, thus enabling the assistant to falsify 

new account applications and other records. 

1. Merrill Lynch, Pierce, Fenner & Smith Inc. (Case #2608013990502) 

On October 3, 2011, FINRA fined Merrill Lynch, Pierce, Fenner & Smith Inc., $1 

million for supervisory failures that allowed a registered representative at Merrill 

Lynch's branch office in San Antonio, Texas, to use a Merrill Lynch account to 

operate a Ponzi scheme. 


Bruce Hammonds, the registered representative, convinced 11 individuals to invest 

more than $1 million in a Ponzi scheme he created and ran as B&J Partnership for 

over 10 months. Merrill Lynch supervisors approved Hammonds' request to open a 

business account for B&J and failed to supervise funds that customers deposited and 

Hammonds withdrew. FINRA permanently barred Hammonds from the securities 

industry in December 2009. Merrill Lynch reimbursed all investors who were harmed 

by Hammond's misconduct. 

FINRA found that Merrill Lynch failed to have an adequate supervisory system in 

place to monitor employee accounts for potential misconduct. Merrill Lynch's 

supervisory system automatically captured accounts an employee opened using a 

social security number as the primary tax identification number. However, if the 

employee's social security number was not the primary number associated with the 

account, the system failed to capture the account in its database. Instead, Merrill 

Lynch solely relied on its employees to manually input these accounts into its 

supervisory system. FINRA also found that from January 2006 to June 2010, Merrill 

Lynch failed to monitor an additional 40,000 employee/employee-interested 

accounts, which were not reported for certain periods of time and therefore not 

available on the supervisory system. 

B. Hedge Funds 

1. Fraud – MICG/Martinovich (February 2011) (Case #2009016230501) 

On February 3, 2011, FINRA expelled MICG Investment Management, LLC 

of Newport News, VA and barred Jeffrey A. Martinovich, the firm’s CEO and 

majority owner, for securities fraud, misusing investors’ funds and causing 

false account statements to be issued to investors in connection with their 

management of a proprietary hedge fund named MICG Venture Strategies, 

LLC (Venture Strategies). MICG and Martinovich organized, controlled and 

managed the hedge fund. 

FINRA found that the Respondents improperly assigned excessive asset 

values to two non-public securities owned by the hedge fund, and used the 

excessive asset values as the basis for paying unjustified management and 

incentive performance fees. 

FINRA found that, in order to inflate their management and incentive fees – 

which were dependent on the value of the hedge fund’s assets, MICG and 

Martinovich assigned unjustifiably high values to the assets, rather than 

relying on independent or legitimate valuations or valuation methods. For 

example, at various times, the Respondents valued an equity interest at more 

than triple the price at which it was contemporaneously being offered to them 

for sale. One of the assets was an interest in a company that acquired about 

a 93 percent ownership interest in the Derby Rams Football Club (a British 

professional soccer team), the team’s stadium and other related assets. 

FINRA also found that Martinovich also fraudulently induced an elderly, nonaccredited 

MICG customer to invest $75,000 in the hedge fund. Martinovich 

did not have reasonable grounds for believing the investment was suitable, 

and failed to disclose to the customer that Venture Strategies needed the 

funds to pay incentive and/or management fees from which MICG and 

Martinovich would derive financial benefit. 

C. Social Networking – FINRA Regulatory Notice 10-06 

In 2010, FINRA issued Regulatory Notice 10-06, Social Media Websites; 

Guidance on Blogs and Social Media Web Sites. The Regulatory Notice 

provided guidance to firms on applying the communications rules to social 

media sites, such as blogs and social networking sites. The goal of this 


Notice is to ensure that—as the use of social media sites increases over 

time—investors are protected from false or misleading claims and 

representations, and firms are able to effectively and appropriately supervise 

their associated persons’ participation in these sites. The Notice emphasized 

the need for each firm, when establishing its policies and procedures in this 

area, to develop policies and procedures that are best designed to ensure 

that the firm and its personnel comply with all applicable requirements. The 

Notice also emphasized that it was addressing the use by a firm or its 

personnel of social media sites for business purposes and did not purport to 

address the use by individuals of social media sites for purely personal 

reasons. 

1. Recordkeeping: Every firm that intends to communicate, or permit its 

associated persons to communicate, through social media sites must first 

ensure that it can retain records of those communications as required by 

Exchange Act Rules 17a-3 and 17a-4 and NASD Rule 3110. SEC and FINRA 

rules require that for record retention purposes, the content of the 

communication is determinative and a broker-dealer must retain those 

electronic communications that relate to its “business as such.” 

2. Suitability: If a firm or its personnel recommends a security through a social 

media site suitability requirements of NASD Rule 2310 apply. Whether a 

particular communication constitutes a ”recommendation” for purposes of 

Rule 2310 will depend on the facts and circumstances of the communication. 

(See Notice to Members (NTM) 01-23 (Online Suitability) for additional 

guidance concerning when an online communication falls within the definition 

of “recommendation” under Rule 2310.) 

3. Supervision: The content provisions of FINRA’s communications rules apply 

to interactive electronic communications that the firm or its personnel send 

through a social media site. While prior principal approval is not required 

under Rule 2210 for interactive electronic forums, firms must supervise these 

interactive electronic communications under NASD Rule 3010 in a manner 

reasonably designed to ensure that they do not violate the content 

requirements of FINRA’s communications rules. Firms may adopt supervisory 

procedures similar to those outlined for electronic correspondence in FINRA 

Regulatory Notice 07-59 (FINRA Guidance Regarding Review and 

Supervision of Electronic Communications). As set forth in that notice, firms 

may employ risk-based principles to determine the extent to which the review 

of incoming, outgoing and internal electronic communications is necessary 

for the proper supervision of their business. 

4. Third Party Posts: The Notice also addresses the issue of third party posts 

and whether such posts become communications of the firm under Rule 

2210. As a general matter, FINRA does not treat posts by customers or other 

third parties as the firm’s communication with the public subject to Rule 2210. 

Thus, the prior principal approval, content and filing requirements of Rule 

2210 do not apply to these posts. Under certain circumstances, however, 

third-party posts may become attributable to the firm. Whether third-party 

content is attributable to a firm depends on whether the firm has (1) involved 

itself in the preparation of the content (”entanglement” theory) or (2) explicitly 

or implicitly endorsed or approved the content (”adoption” theory). 

D. Regulation SHO 

1. Generally 

In a short sale, the seller sells a security it does not own. When it is time to 

deliver the security, the short seller either purchases or borrows the security 

in order to make the delivery. Reg SHO requires a broker or dealer to have 


easonable grounds to believe that the security could be borrowed and 

available for delivery before accepting or effecting a short sale order. 

Requiring firms to obtain and document this "locate" information before the 

short sale is entered reduces the number of potential failures to deliver in 

equity securities. In addition, Reg SHO requires a broker or dealer to mark 

sales of equity securities as long or short. 

2. UBS Securities LLC (Case #20080144511) 

In October 2011 FINRA announced that it fined UBS Securities $12 Million 

for violating Regulation SHO (Reg SHO) and failing to properly supervise 

short sales of securities. As a result of these violations, millions of short sale 

orders were mismarked and/or placed to the market without reasonable 

grounds to believe that the securities could be borrowed and delivered. 

FINRA found that UBS' Reg SHO supervisory system regarding locates and 

the marking of sale orders was significantly flawed and resulted in a systemic 

supervisory failure that contributed to serious Reg SHO failures across its 

equities trading business. 

• First, FINRA found that UBS placed millions of short sale orders to the 

market without locates, including in securities that were known to be hard 

to borrow. These locate violations extended to numerous trading 

systems, desks, accounts and strategies, and impacted UBS' technology, 

operations, and supervisory systems and procedures. 

• Second, FINRA found that UBS mismarked millions of sale orders in its 

trading systems. Many of these mismarked orders were short sales that 

were mismarked as "long," resulting in additional significant violations of 

Reg SHO's locate requirement. 

• Third, FINRA found that UBS had significant deficiencies related to its 

aggregation units that may have contributed to additional significant 

order-marking and locate violations. 

As a result of its supervisory failures, many of UBS' violations were not 

detected or corrected until after FINRA's investigation caused UBS to 

conduct a substantive review of its systems and monitoring procedures for 

Reg SHO compliance. FINRA found that UBS' supervisory framework over its 

equities trading business was not reasonably designed to achieve 

compliance with the requirements of Reg SHO and other securities laws, 

rules and regulations until at least 2009. 

3. Credit Suisse Securities (USA) LLC (Case #20080144512) 

December 27, 2011, FINRA accepted an AWC whereby Credit Suisse 

Securities consented to a $1.75 million fine and findings that it violated 

Regulation SHO (Reg SHO) and failed to properly supervise short sales of 

securities and marking of sale orders. As a result of these violations, Credit 

Suisse entered millions of short sale orders without reasonable grounds to 

believe that the securities could be borrowed and delivered and mismarked 

thousands of sales orders. 

FINRA found that from June 2006 through December 2010, Credit Suisse's 

Reg SHO supervisory system regarding locates and the marking of sale 

orders was flawed and resulted in a systemic supervisory failure that 

contributed to significant Reg SHO failures across its equities trading 

business. During the time period, Credit Suisse released millions of short sale 

orders to the market without locates, including threshold and hard to borrow 


securities. The locate violations extended to numerous trading systems, 

aggregation units and strategies. In addition, Credit Suisse mismarked tens 

of thousands of sale orders in its trading systems. The mismarked orders 

included short sales that were mismarked as "long," resulting in additional 

violations of Reg SHO's locate requirement. 

As a result of its supervisory failures, many of Credit Suisse's violations were 

not detected or corrected by the firm until after FINRA's investigation caused 

Credit Suisse to conduct a substantive review of its systems and monitoring 

procedures for Reg SHO compliance. FINRA found that Credit Suisse's 

supervisory framework over its equities trading business was not reasonably 

designed to achieve compliance with the requirements of Reg SHO and other 

securities laws, rules and regulations throughout the period at least June 

2006 through at least December 2010. 

E. Research Analyst/Research Reports/Trading Huddles 

1. Citigroup Global Markets (Case #20080123101) 

On January 18, 2012, FINRA accepted an AWC whereby Citigroup Global 

Markets consented to a $725,000 fine and findings that it failed to disclose 

certain conflicts of interest in its research reports and research analysts' 

public appearances. 

Citigroup failed to disclose potential conflicts of interest inherent in their 

business relationships in certain research reports it published from January 

2007 through March 2010. Citigroup and/or its affiliates managed or comanaged 

public securities offerings, received investment banking or other 

revenue from, made a market in the securities of and/or had a 1 percent or 

greater beneficial ownership in covered companies, and did not make these 

required disclosures in certain research reports. 

In addition, Citigroup research analysts failed to disclose these same 

potential conflicts of interest in connection with public appearances in which 

covered companies were mentioned. 

FINRA found that Citigroup failed to disclose the required information 

because the database it used to identify and create the disclosures was 

inaccurate and/or incomplete due primarily to technical deficiencies. In 

addition, Citigroup failed to have reasonable supervisory procedures in place 

to ensure that the firm was populating its research reports with required 

disclosures. 

F. Prospectus Delivery 

1. Wells Fargo Advisors, LLC (Case #20100229218) 

On May 5, 2011, FINRA announced that it had fined Wells Fargo Advisors, 

LLC, $1 million for, among other things, its failure to deliver prospectuses in a 

timely manner to customers who purchased mutual funds in 2009. 

FINRA found that Wells Fargo failed to deliver prospectuses within three 

business days of the transaction, as required by federal securities laws, to 

approximately 934,000 customers who purchased mutual funds in 2009. The 

customers received their prospectuses from one to 153 days late. Wells 

Fargo had failed to take corrective measures to ensure timely delivery of the 

prospectuses after its third-party service provider, which Wells Fargo 

contracted with to mail prospectuses to customers, provided the firm with 


egular reports indicating that a number of customers had not received the 

prospectuses on time. 

Wells Fargo contracted with a third-party service provider in 2009 to mail the 

prospectuses to customers. However, after receiving quarterly reports 

showing that between four percent and nine percent of the firm's mutual fund 

customers failed to receive required prospectuses on time and after being 

notified in daily reports that a number of prospectuses still required delivery, 

Wells Fargo did not take adequate corrective measures to ensure future 

delivery of the prospectuses in a timely manner. 

G. Confirmations 

1. National Financial Services (Case #2010021681701) 

On July 25, 2011, FINRA issued an AWC finding that National Financial Services 

LLC (”NFS”) issued order confirmations to customers reporting a lower sales load 

percentage than the customers actually paid for certain Unit Investment Trust (”UIT”) 

transactions. NFS was censured, fined $200,000 and ordered to notify all affected 

customers that they received inaccurate confirmations from the firm with respect to 

the percentage sales loads charged on UIT transactions executed from February 

2007 to November 2009 – and provide an explanation of the reason for the 

inaccurate sales load information on the confirmations. 

From about February 2007 to November 2009, NFS issued approximately 90,000 

confirmations to customers for UIT transactions that reported an inaccurate sales 

load percentage. The percentage listed on the confirmations as the sales load was 

actually the dealer concession. The sales load that the customers paid was correct 

(within the range listed in the prospectus), but the confirmations reflected a lower 

percentage sales load than what was actually charged. In preparing the 

confirmations during this time period, NFS relied on a faulty data feed from a thirdparty 

provider. 

NFS also misstated the valuation methods used for the prices of nine alternative 

investment securities on customer account statements. As a clearing firm, NFS 

contracted with a third-party vendor that provided it with valuations for alternative 

investments held in customer accounts. NFS employees would manually input that 

information obtained from the vendor into the firm’s electronic systems. At various 

times from about April 2006 to August 2010, however, NFS employees mistakenly 

inputted the wrong information into the firm’s electronic systems. NFS placed the 

erroneous data on customer account statements, thereby misstating the valuation 

methods that were used to determine the prices of nine alternative investments. 

FINRA found that this conduct violated Rule 10b-10 of the Securities Exchange Act of 

1934, NASD Rules 2230 and 2110 and FINRA Rule 2010. 

H. Postage and Handling 

FINRA fined five broker-dealers for understating the amount of total commissions 

charged to customers in trade confirmations and on fee schedules by 

mischaracterizing a portion of the commission charges as fees for handling services. 

With respect to each of these firms, the handling fees were designed to serve as a 

source of additional transaction based remuneration for the firm and thus were far in 

excess of the cost of the handling-related services the firms provided. 

The cases resulted from a targeted review of improper fees charged by brokerdealers 

in which FINRA found that the firms were routinely charging customers for 

handling fees that far exceeded the actual cost of the direct handling-related services 

the firms incurred in processing securities transactions. In some cases, firms charged 


a handling fee of almost $100 per transaction and earned a substantial percentage of 

their revenue from these fees. 

FINRA sanctioned the following firms: 

• Pointe Capital, Inc. (Case #2009015974701) (n/k/a JHS Capital Advisors, Inc.), 

of Boca Raton, Florida, was fined $300,000. The firm charged customers a 

handling fee as high as $95 per trade in addition to a commission. (Additional 

violations included inadequate supervisory procedures.) 

• John Thomas Financial , of New York, NY, (Case #20090l634801) was fined 

$275,000. The firm charged its customers a handling fee as high as $75 per 

trade in addition to a commission. (Additional violations included effecting 

material changes in its business operations without prior approval from FINRA, 

and deficiencies in complaint reporting, supervisory controls and certifications, 

branch office supervision and recordkeeping.) 

• First Midwest Securities, Inc., of Bloomington, IL, (Case #2009016348801) was 

fined $150,000. The firm charged customers a handling fee as high as $99 per 

trade in addition to a commission. (Additional violations included unfair and 

unreasonable markups/markdowns and inadequate written supervisory 

procedures.) 

• A&F Financial Securities, Inc., of Syosset, NY, (Case #2009016292001) was 

fined $125,000. The firm charged its customers a handling fee of $65 per trade 

in addition to a commission. (Additional violations included inadequate 

supervisory system and procedures, and failure to comply with continuing 

education requirement.) 

• Salomon Whitney LLC, of Babylon Village, NY (Case #2010022181901) was 

fined $60,000. The firm charged its customers a handling fee as high as $69 per 

trade in addition to a commission. 

In settling FINRA’s actions, the firms agreed to implement corrective action to remedy 

the handling fee-related violations. The firms agreed to fully and accurately disclose 

the specific service performed and the related fee on confirmations and any other 

communications with a customer where fees are discussed. In addition, they will 

identify all transaction-based remuneration as commissions or mark-ups (markdowns) 

rather than as postage, handling or any other miscellaneous fee. The firms 

also agreed to revise their written supervisory procedures and to provide training to 

the firms' registered representatives and associated persons related to transactionbased 

remuneration, reasonable fees, their appropriate disclosure to customers and 

retention of related records. 

I. Failure to Supervise Tax Dividends 

a. Morgan Stanley & Co. Inc. n/k/a Morgan Stanley & Co. LLC. (Case 

#2008015717101) 

On June 28, 2011, FINRA issued an AWC fining the firm $575,000 for failing to 

establish and/or enforce adequate written supervisory procedures, and failing to 

adequately supervise total return swaps and off-shore stock loans. These 

transactions were designed to generate for certain off-shore clients a perceived 

tax advantage related to dividend income on U.S. equities. The advantage was 

known by various terms, including yield enhancement, and represented the 

amount that would have been withheld in taxes on a dividend, but that the client 

obtained through a transaction with the firm and/or its affiliates. In both types of 

transactions, the client did not hold the stock on the dividend record date but, 

instead, the firm structured the transaction as a swap or loan, and provided yield 

enhancement as part of a securities derivative or stock loan-related payment. 

The clients sold the underlying equity before entering the swap, and brought that 

equity back after the swap terminated. The yield enhancement payments were 


appropriate only if the client surrendered beneficial ownership of the underlying 

equity during the life of the swap and engaged in market risk in the buying and 

selling of the equity. The firm was unable to substantiate the propriety of some 

yield enhancement payments because of supervisory deficiencies involving the 

use of transactions known as "crosses," short-term transactions and market-onclose 

pricing. 

Regarding off-shore stock loans, FINRA found that the firm failed to establish 

written supervisory procedures and lacked effective working control of business 

operations that involved firm clients, client securities that were custodied in 

accounts at the firm, and firm personnel. The firm allowed affiliates to initiate and 

conduct the off-shore stock loan transactions without sufficient oversight from the 

firm. As a result, the firm was unable to substantiate that these transactions were 

conducted in a manner that made certain the yield enhancement payments were 

appropriate. 

J. Arbitration 

a. Attempts to limit the arbitrability of claims 

i. Merrill Lynch (Case #2009020188101) 

In January 2012, FINRA accepted an AWC whereby Merrill Lynch, 

Pierce, Fenner & Smith consented to a $1 million fine and findings that it 

failed to arbitrate disputes with employees relating to retention bonuses. 

Registered representatives who participated in the bonus program had to 

sign a promissory note that prevented them from arbitrating 

disagreements relating to the note, forcing the registered representatives 

to resolve disputes in New York state courts. 

FINRA found that Merrill Lynch, after merging with Bank of America in 

January 2009, implemented a bonus program to retain certain highproducing 

registered representatives and purposely structured it to 

circumvent the requirement to institute arbitration proceedings with 

employees when it sought to collect unpaid amounts from any of the 

registered representatives who later left the firm. FINRA rules require that 

disputes between firms and associated persons be arbitrated if they arise 

out of the business activities of the firm or associated person. 

In January 2009, Merrill Lynch paid $2.8 billion in retention bonuses 

structured as loans to over 5,000 registered representatives. The 

promissory notes required registered representatives to agree that 

actions regarding the notes could be brought only in New York state 

court, a state that greatly limits the ability of defendants to assert 

counterclaims in such actions. 

Also, Merrill Lynch structured the program to make it appear that the 

funds for the program came from MLIFI, a non-registered affiliate, rather 

than from the firm itself, allowing it to pursue recovery of amounts due in 

the name of MLIFI in expedited hearings in New York state courts to 

circumvent Merrill Lynch's requirement to arbitrate disputes with its 

associated persons. 

Later that year, after a number of registered representatives left the firm 

without repaying the amounts due under the loan, Merrill Lynch filed over 

90 actions in New York state court to collect amounts due under the 

promissory notes, thus violating a FINRA rule that requires firms to 

arbitrate disputes with employees. 

2. Restricting ability to participate in class actions. 


III. PROCEDURAL ISSUES 

A. Credit for Cooperation 

a. Charles Schwab (Case #2011029760201) 

FINRA filed a complaint against Charles Schwab & Company charging the 

firm with violating FINRA rules by requiring its customers to waive their 

rights to bring class actions against the firm. FINRA's complaint charges 

that in October 2011, Schwab amended its customer account agreement to 

include a provision requiring customers to waive their rights to bring or 

participate in class actions against the firm. Schwab sent the amended 

agreements to nearly 7 million customers. The agreement also included a 

provision requiring customers to agree that arbitrators in arbitration 

proceedings would not have the authority to consolidate more than one 

party's claims. FINRA's complaint charges that both provisions violate 

FINRA rules concerning language or conditions that firms may place in 

customer agreements. 

FINRA's complaint seeks an expedited hearing because Schwab's conduct 

is ongoing, as the firm has continued to use account agreements 

containing these provisions in opening more than 50,000 new customer 

accounts since October 2011. 

1. Guidance Regarding Credit for Extraordinary Cooperation, FINRA Regulatory 

Notice 08-70 (November 2008) 

www.finra.org/Industry/Regulation/Notices/2008/P117453 

FINRA issued the guidance to apprise firms of the circumstances in which 

extraordinary cooperation by a firm or individual may directly influence the 

outcome of an investigation. The types of extraordinary cooperation by a firm or 

individual that could result in credit can be categorized as follows: (1) selfreporting 

before regulators are aware of the issue; (2) extraordinary steps to 

correct deficient procedures and systems; (3) extraordinary remediation to 

customers; and (4) providing substantial assistance to FINRA’s investigation. 

These steps alone or taken together can be viewed in a particular case as 

extraordinary cooperation and, depending on the facts and circumstances, can 

have an impact on FINRA’s enforcement decisions. 

In connection with the attorney-client privilege, the waiver or non-waiver of the 

privilege itself will not be considered in connection with granting credit for 

cooperation. Moreover, it is not the waiver of attorney-client privilege that 

warrants credit for cooperation but rather the extraordinary assistance to the 

staff in uncovering the facts in an investigation that yields the benefit. 

There is significant regulatory value in crediting conduct that rises to the level of 

extraordinary cooperation. Such cooperation may put the regulator on notice of 

regulatory problems before it finds them during an examination or investigation 

or assist the regulator in resolving matters more quickly, thereby allowing it to 

deploy regulatory resources more efficiently. This enables FINRA to achieve its 

mission of investor protection and market integrity more effectively. 

Credit for extraordinary cooperation in FINRA matters may be reflected in a 

variety of ways, including a reduction in the fine imposed, eliminating the need 

for or otherwise limiting an undertaking, and including language in the 

settlement document and press release that notes the cooperation and its 

positive effect on the final settlement by FINRA Enforcement. In an unusual 

case, depending on the facts and circumstances involved, the level of 


extraordinary cooperation could lead FINRA to determine to take no disciplinary 

action at all. 

By publishing these standards of cooperation, FINRA seeks to increase 

transparency as to the basis for sanctions imposed in cases and to encourage 

firms to root out, correct and remediate violative behavior. By making clear that 

FINRA has given credit for extraordinary cooperation in a particular case, FINRA 

will inform firms and associated persons of the types of conduct considered and 

the degree to which such actions are to the individual or firm’s benefit. 

It is important to note that the level of cooperation is just one factor to be 

considered in determining the appropriate disciplinary action and sanctions. 

Other factors include the nature of the conduct, the extent of customer harm, the 

duration of the misconduct, and the existence of prior disciplinary history, all of 

which impact the appropriate sanction in any particular matter. 

b. UBS Securities LLC (Case #20080144511) (Reg SHO, see above) 

The Firm's Corrective Actions during the Course of FINRA Enforcement's 

Investigation 

FINRA notes that as the system-related locate and order marking problems 

described above were identified during the course of FINRA Enforcement's 

investigation, the Firm implemented changes to its systems and procedures 

that were designed to prevent a recurrence of these violations. 

This Firm's Substantial Assistance to FINRA Enforcement's Investigation 

FINRA acknowledges that in 2010, the Firm undertook an internal review of its 

supervisory policies, procedures and systems relating to Reg SHO. The Firm 

reported the findings of its internal investigation to FINRA. The sanctions … 

reflect the credit that UBS has been given for conducting an investigation of 

these issues and providing the results to FINRA. 

B. FINRA Regulatory Notice 11-06 – Reporting the Results of Internal Investigations 

New FINRA Rule 4530(b), which became effective in July 2011, requires a member 

firm to report to FINRA within 30 calendar days after the firm has concluded, or 

reasonably should have concluded, on its own that the firm or an associated person of 

the firm has violated any securities, insurance, commodities, financial or investment 

related laws, rules, regulations or standards of conduct of any domestic or foreign 

regulatory body or self-regulatory organization (SRO). This requirement is generally 

modeled after a requirement in the NYSE rule. 

The new rule does not require firms to report every instance of noncompliant conduct. 

With respect to violative conduct by a firm, this provision requires the firm to report only 

conduct that has widespread or potential widespread impact to the firm, its customers 

or the markets, or conduct that arises from a material failure of the firm’s systems, 

policies or practices involving numerous customers, multiple errors or significant dollar 

amounts. Regarding violative conduct by an associated person, the provision requires 

a firm to report only conduct that has widespread or potential widespread impact to the 

firm, its customers or the markets; conduct that has a significant monetary result on a 

member firm(s), customer(s) or market(s); or multiple instances of any violative 

conduct. 

For purposes of compliance with the “reasonably should have concluded” standard, 

FINRA will rely on a firm’s good faith reasonable determination. If a reasonable person 

would have concluded that a violation occurred, then the matter is reportable; if a 

reasonable person would not have concluded that a violation occurred, then the matter 

is not reportable. 


Additionally, a firm determines the person(s) within the firm responsible for reaching 

such conclusions, including the person’s required level of seniority. However, stating 

that a violation was of a nature that did not merit consideration by a person of such 

seniority is not a defense to a failure to report such conduct. Further, it may be 

possible that a department within a firm reaches a conclusion of violation, but on 

review senior management reaches a different conclusion. Nothing in the rule prohibits 

a firm from relying on senior management’s determination, provided such 

determination is reasonable as described above. 

Moreover, the reporting obligation under FINRA Rule 4530 and the internal review 

processes set forth under other rules (e.g., FINRA Rule 3130) are mutually exclusive. 

While internal review processes may inform a firm’s determination that a specific 

violation occurred, they do not by themselves lead to the conclusion that the matter is 

reportable. 

For example, FINRA would not view a discussion in an internal audit report regarding 

the need for enhanced controls in a particular area, standing alone, as determinative of 

a reportable violation. It should also be noted that an internal audit finding would serve 

only as one factor, among others, that a firm should consider in determining whether a 

reportable violation occurred. 

Lastly, the new rule provides that certain disciplinary actions taken by a firm against an 

associated person must be reported under a separate provision rather than under the 

internal conclusion provision. 


Written Supervisory Procedures (Small Firm Focus) 


9:00 a.m. – 10:15 a.m.

Written Supervisory Procedures (Small Firm Focus) 


9:00 a.m. – 10:15 a.m. 

After attending this session, you will be able to: 

• Understand the elements necessary to write supervisory procedures (WSPs). 

• Identify how to achieve buy-in and involvement. 

• Manage the WSP process. 

Moderator: 

Panelists: 

Joseph McCarthy 

Senior Vice President and Regional Director 

FINRA West Region 

Mark Cresap 

President 

Cresap, Inc. 

John Komoroske 

Vice President 

FINRA Member Relations 

Paige Pierce 

President and Chief Financial Officer 

RW Smith & Associates Inc. 

Outline 

Where to begin? 

• Supervisory scheme, system and procedures 

• Identifying your audience 

• Fulfilling the need 

• Finding the right level of detail 

• Pitfalls of the template approach 

Instilling and supporting a culture of compliance 

• Establishing buy-in 

• Cultivating engagement 

• Owning the process, owning the procedures 

• Complying with the rules 

Version control 

• Keeping pace with regulatory change 

• How often is frequently? 

• Internal and external inputs 



Mark W. Cresap III is the President and owner of Cresap, Inc., a position he has held since 1990. 

Cresap, Inc. is a fully disclosed broker-dealer and Pennsylvania-registered investment advisor with 40 

registered representatives. Previously, from 1980 to 1989, Mr. Cresap was the President of PML 

Securities (aka 1717 Capital Management), a broker-dealer subsidiary of Provident Mutual Insurance. He 

was responsible for over 1,800 registered representatives. Before that, Mr. Cresap worked as a regional 

sales director for CIGNA Securities and as a registered representative for W. H. Newbolds & Sons. Mr. 

Cresap currently serves as chair of the FINRA Small Firm Advisory Board and previously served as a 

FINRA District Committee chair, FINRA Nominating Committee chair, and as a member of the FINRA 

Membership Committee. He received his bachelor’s degree from Williams College. 

John Komoroske is Vice President in the FINRA Office of Member Relations and has been with FINRA 

for 24 years. Previously, he was with the FINRA Office of Investor Education, where he directed the 

Senior Investor Protection Project. Prior to that, he was a senior adviser to FINRA’s President Mary 

Schapiro—who has since moved on to chair the SEC—and before that he was a director of congressional 

and state liaison for FINRA. Mr. Komoroske was also at the SEC for six years as a special counsel to the 

director of the Division of Investment Management and to the SEC's Executive Director. Prior to the SEC, 

Mr. Komoroske was a budget examiner in the White House’s Office of Management and Budget. He was 

also a special assistant U.S. attorney in the Eastern District of Virginia. Mr. Komoroske has a bachelor’s 

degree in political science and Chinese from Union College in New York and law and master’s of public 

administrations degrees from Indiana University. 

Joseph McCarthy is Senior Vice President and Regional Director of FINRA’s Western Region, 

composed of the Denver, Seattle, San Francisco and Los Angeles District Offices. The Western Region is 

responsible for regulating approximately 800 firms in 13 states. Mr. McCarthy joined the Denver District 

Office in July 2002 as district director. Previously, he was a deputy director of the NASD New York District 

Office. Mr. McCarthy started in the industry working in the compliance department of a New York-based 

broker-dealer as a general securities principal. He holds a bachelor’s degree in English, an MBA, and a 

master’s degree in organizational leadership. Mr. McCarthy is designated as a Certified Regulatory and 

Compliance Professional through the FINRA Institute at Wharton. 

Paige W. Pierce is President and Chief Financial Officer of RW Smith & Associates Inc., having more 

than 28 years of senior-level investment industry experience with major corporate entities and regional 

firms in the North American capital markets. Ms. Pierce is an experienced, innovative and visionary 

hands-on strategic planner. She has extensive trading and sales, compliance, operational, business and 

product development, as well as strategic partner development experience both domestically and 

internationally. In her current position, she oversees the firm’s growth and strategy, works closely with 

industry regulatory agencies and continues to focus on ensuring retail-focused firms and their customers 

have access to market pricing, information flow, extended distribution, transparency and the wholesale 

market. Prior to rejoining RW Smith, Ms. Pierce served as a chief financial officer of Agincourt, Ltd., a 

Bermuda-based NASD member broker-dealer that designs structured securities products for the fixed 

income institutional market in the United States and abroad. At Agincourt, she supported the firm’s 

investment banking activities for both tax-exempt and taxable issuers, operational management and 

strategic planning. Prior to that, she was a vice president and manager of portfolio operations at LaSalle 

National Bank/ABN-AMRO, chief financial officer at Lee Asset Management Company, and chief financial 

and operating officer at Ross Sinclaire & Associates, a full service broker-dealer. Ms. Pierce began her 

financial career in 1983 at PaineWebber, Inc. Ms. Pierce actively serves as a member of the Securities 

Industry and Financial Markets Association Small Firms Advisory Committee, Municipal Executive 

Committee, Municipal Broker’s Broker Committee (Chair 2008-2011), and the Emergency Markets & 

Calendar Committee. In 2008, she was elected to serve a three-year term on the Financial Industry 

Regulatory Authority District 3 Committee (Chair 2010-2011) and currently serves on the Financial 

Industry Regulatory Authority Fixed Income Committee. She serves as hearing panelist or arbitrator for 

cases brought by or through FINRA and is a frequent speaker at industry events. Ms. Pierce co-founded 

the Women in the Investment Industry PSA group, is a member and Network Chair of the Utah Chapter of 

the Young Presidents’ Organization, and previously held the position of Chair of the YPO Pacific Region 

Women’s International Network (2007-2009). She was chosen by The Bond Market Association to 

represent the small firm sector of the municipal bond market in Municipal and Credit Markets meetings 

with the Federal Reserve Chairman, and Vice Chair. In 2008, Ms. Pierce was appointed by the United 

States Air Force 288th Fighter Wing as Honorary Commander at Hill Air Force Base in Utah and serves to 

this day with pride. She is also currently a board of director for CHOICE Humanitarian and Judge 

Memorial High School in Salt Lake City, Utah. 


Supervisory Scheme 

Written Supervisory Procedures – 

Small Firm Focus 

FINRA Annual Conference 

May 21 – 23, 2012 • Washington, DC 

• NASD Rules 3010 and 3012 and FINRA Rule 3130 form 

a complementary regulatory scheme for the 

supervision of member firms. 

• NASD Rule 3010 – ESTABLISH a supervisory system and 

ADOPT adequate Written Supervisory Policies and 

Procedures. 

• NASD Rule 3012 – TEST and VERIFY supervisory procedures; 

if necessary, AMEND policies and procedures. 

• FINRA Rule 3130 – CEO CERTIFIES firm has PROCESS to 

adopt adequate Supervisory Policies and Procedures. 

2012 FINRA Annual Conference • © 2012 FINRA. All rights reserved. 

1 

Supervision Rule Update 

Supervision Rule Update 

• New FINRA Rule 3110 to combine: 

• NASD Rule 3010 (establish supervisory system and adopt 

WSPs) 

• NASD Rule 3012 (test, verify, and amend procedures) 

• Changes: 

• Supervision i of all member business lines 

• Principal written review of investment banking and securities 

transactions 

• Routine principal physical presence in OSJ 

• Risk based communications review and delegation to 

unregistered staff 

• Supervision of producing managers 

• Changes (cont’d): 

• Testing and verification of supervision of supervisors 

• New annual report requirements for supervision testing of 

>$150M firms 

• Status: 

• Filed July 11, 2011 

• Withdrawn October 4, 2011 


2 


3 

1

Supervision Overview 

• ESTABLISH a system 

• MAINTAIN the system 

• UPDATE the procedures 

• IMPLEMENT 

Supervisory Rules Overview 

• NASD Rule 3010(b) and NASD Notice to Members 99- 

45 

• Supervisory System and Written Supervisory 

Procedures: 

• Each member shall establish and maintain a system to 

supervise the activities i i of each registered representative and 

associated person that is reasonably designed to achieve 

compliance with applicable securities laws and regulations. 

• As part of this supervisory system, each firm must establish 

and maintain written procedures to supervise the types of 

business in which it engages and to supervise the activities of 

registered representatives and associated persons. 

2012 FINRA Annual Conference • © 2012 FINRA. All rights reserved. 4 


Written Supervisory Procedures Overview 

• Written Supervisory Procedures: 

• Who is assigned supervisory responsibilities 

• A record of each associated person who has supervisory 

responsibilities, including date assigned 

• Procedures for each business line 

• Applicable securities laws each supervisor is responsible for 

following 

• WSPs updated to reflect changes to the supervisory 

system 

• Firm informs associated persons of WSP changes 

WSP Information 

• All Written Supervisory Procedures should contain 

the following: 

• Who has the responsibility for a supervisory function 

– Example: John Doe will review for mutual fund breakpoints 

• What the supervisor will review 

– Example: Exception Reports, New Account Forms, Commission Runs 

• When and how often a review will be conducted 

– Example: Daily, monthly, quarterly 

• How the review will be conducted, evidenced and retained 

– Example: Initialing and dating the P&S blotter 



2

Before Writing Procedures 

• Do’s of Written Supervisory Procedures: 

• Review firm’s membership agreement and Form BD first 

• Adopt procedures tailored to the firm 

• Review business mix of the firm and resources of supervisors before 

drafting WSPs 

• Review recent regulatory examinations and internal audit reviews 

• Know current regulatory priorities 

iti 

• Have others review the WSP draft 

– Share with assigned supervisors and firm’s counsel 

• Be concise and “keep it simple” 

• Keep procedures flexible 

• Notify supervisors of their responsibilities 

– Give a copy of the delegation guide 

• Identify staff to handle WSP questions and interpretations 

Before Writing Procedures 

• Don’ts of Written Supervisory Procedures: 

• Don’t adopt procedures supervisors cannot do because of time 

constraints 

– e.g. Review ALL account statements for the branch EVERY month 

• Don’t adopt procedures supervisors cannot do out because of the 

information they have 

– eg e.g. Don’t expect a supervisor to find concentration issues from a daily 

blotter – provide a separate concentration report 

• Don’t adopt rigid procedures supervisors cannot adapt to individual 

situations 

• Don’t forget to update procedures for business and regulation 

changes 

• Don’t throw out old procedures 

– Attach the new procedures (dated) and keep 


8 


Updating Procedures 

Updating Procedures 

• Who will this rule affect? 

• Specific areas / firm wide 

• Who will supervise activity? 

• Qualifications (additional testing needed) 

• How often should the supervisory activity occur? 

• What training? 

• Include in Firm Element of Continuing Education 

• What reports or information is available to ensure 

compliance? 

• Implementation require technology changes? 

• Additional staff needed? 


10 

• Meet with supervisors and personnel from affected 

areas to get input 

• Can current procedures and forms be altered for compliance 

with the new rule? 

• Write a first draft and get personnel / supervisors’ 

comments 

• Include “red flags” that show noncompliance with the rules 

• Update delegation guides 

• Submit final draft for legal department and 

management approval 

• Distribute to all employees 

• Employees sign they got and reviewed the new policies and 

procedures 


3

FINRA Tools and Resources 

• Regulatory Coordinator 

• Weekly Update Email – www.finra.org/subscriptions 

• Improving Examination Results – 

www.finra.org/improvingexamresults 

• Examination Priorities – www.finra.org/exampriorities 

• Manual Online – www.finra.org/finramanual 

• FINRA Regulatory Notices – www.finra.org/notices 

• Rule Conversion Chart – www.finra.org/ruleconversionchart 

• Compliance Resources – www.finra.org/compliancetools 

• Compliance Education and Training – www.finra.org/education 

• Issues Center – www.finra.org/Industry/Issues/ 


4

Trading and Market Developments 


9:00 a.m. – 10:15 a.m.

Trading and Market Developments 


9:00 a.m. – 10:15 a.m. 


• Understand FINRA’s new trading rules, updates on OATS and consolidated audit trail and large 

trader reporting. 

• Discuss new SEC rules for sponsored access, limit up / limit down and quoting obligations. 

• Understand compliance with the Regulation SHO circuit breaker price restriction test. 

• Discuss recent findings from trading and market making surveillance exams. 

Moderator: 

Speakers: 

John Malitzis 


FINRA Market Regulation 

Bob Colby 

Partner 

Davis Polk & Wardwell LLP 

Christopher Concannon 

Partner and Executive Vice President 

Virtu Financial LLC 

Mary Beth Findlay 

Director, Legal and Compliance 

Credit Suisse Securities (USA) LLC 

Jon Kroeper 

Senior Vice President, Quality of Markets Section 


David Shillman 

Associate Director 

U.S. Securities and Exchange Commission 

Outline 

Flash crash and regulatory response 

• Flash crash – experiences 

• Volatility trading pause 

• Market maker quoting obligations 

• Regulation SHO amendments and the Up-Bid Rule 

Broader structural changes 

• Limit up / limit down 


• Affirmative obligations 

• Consolidated audit trail and OATS for NYSE listed securities 

High-frequency trading (HFT) 

• Historical overview of HFT 

• Defining HFT 

• Market quality impact 

• Regulatory impact 

Market Access Rule 

• Overview of rule 

• Regulatory impact 


Robert Colby is Partner in Davis Polk’s Washington, DC office. He advises on complex regulatory 

and compliance matters involving securities and derivatives for broker-dealers, financial institutions, 

markets and clearing organizations. Before joining Davis Polk in 2009, Mr. Colby served for 17 years 

as a deputy director of the Securities and Exchange Commission’s Division of Trading and Markets, 

where he was responsible for the regulation of broker-dealers, securities markets, and clearing 

organizations. Previously, he was a chief counsel of the Division and a chief of the Division’s Branch 

of Market Structure for 11 years. Mr. Colby is recognized as a leading lawyer by Chambers USA 

2010, where he is identified as “greatly respected by peers and valued by clients for his ‘fantastic, 

pragmatic advice’ in the broker-dealer area.” Mr. Colby holds bar admissions in Washington DC and 

New York. He received his bachelor’s degree from Bowdoin College and his law degree from Harvard 

Law School. 

Chris Concannon is Partner and Executive Vice President of Virtu Financial LLC, a U.S.-based 

proprietary trading company, which is a member of all U.S. and European exchanges and a member 

of DTC. Mr. Concannon’s responsibilities include overseeing global operations, strategy and business 

development, including Virtu Financial’s operations in Europe, Canada and Asia. Prior to joining Virtu 

Financial, Mr. Concannon was an executive vice president of the Nasdaq OMX Group, Inc from 2003 

until May 2009. At Nasdaq OMX Group, Mr. Concannon was responsible for running all U.S. equity 

and options markets, including the Nasdaq Stock Market, Nasdaq BX and Nasdaq PHLX. Mr. 

Concannon was also responsible for founding and running the International Derivatives Clearing 

Group (IDCG), a CFTC-registered clearing house, and Nasdaq OMX Europe, Nasdaq’s European 

multi-lateral trading facility. During his tenure at Nasdaq OMX Group, Mr. Concannon was critical in 

setting the company’s global strategies; integrating Nasdaq’s acquisitions of the OMX Group, the 

Boston Stock Exchange, the Philadelphia Stock Exchange and INET ECN; and launching a new 

equities market in Europe and a new options market in the U.S. Prior to joining NASDAQ, Mr. 

Concannon was a president of Instinet Clearing Services, Inc., where he managed the clearing and 

executions services business Instinet Clearing offered to numerous broker-dealer clients. Throughout 

his career with Instinet, Mr. Concannon also served as a special counsel and senior vice president of 

business development, where he coordinated and advised senior management on the integration of 

Instinet and Island ECN. From 1997 to 1999, Mr. Concannon was an associate at Morgan, Lewis & 

Bockius LLP in their New York and Washington offices. While an associate at Morgan Lewis, Mr. 

Concannon advised numerous major broker-dealers on all aspects of securities laws and regulations. 

From 1994 to 1997, Mr. Concannon was an attorney with the U.S. Securities and Exchange 

Commission in the Division of Trading and Markets, where he specialized in the review and approval 

of the rules of the various exchanges and self-regulatory organizations, the regulation of securities 

underwriting and the regulation of the clearance and settlement of securities transactions in the U.S. 

Mr. Concannon currently serves as a director on the Board of the Depository Trust & Clearing 

Corporation. As a member of the Board, he also serves on the Board Risk Committee and the 

Business & Products Committee. Mr. Concannon also serves as a director on the Board of the BATS 

Exchange and the Philadelphia Foundation (since 2008). Mr. Concannon has served as a director on 

the following boards between 2007 and 2009: The Nasdaq Stock Market, the Boston Stock 

Exchange, the Philadelphia Stock Exchange, Nasdaq Europe Ltd., Nasdaq Clearing Corporation, 


Stock Clearing Corporation of Philadelphia. Mr. Concannon received a bachelor’s degree from the 

Catholic University of America in 1989, a master’s of business administration from St. John’s 

University in 1991, and a law degree from the Columbus School of Law, the Catholic University of 

America in 1994. He is a member of the New York Bar, New Jersey Bar and the District of Columbia 

Bar. 

Mary Beth Findlay is the Head of Securities Compliance covering Fixed Income Sales and Trading, 

Equities Sales and Trading, Prime Services and Operations Compliance at Credit-Suisse Securities. 

Prior to joining Credit-Suisse, she was a senior managing director at Bear Stearns as head of Fixed 

Income Compliance as well as head of Equity Derivatives and Proprietary Trading Compliance. Ms. 

Findlay has almost 18 years of industry experience, having previously worked at other global 

investment banks including Goldman Sachs, Nomura and Sanwa Financial Products. 

John F. Malitzis is Executive Vice President in FINRA’s Market Regulation Department. Mr. Malitzis 

oversees surveillance of the New York Stock Exchange and American Stock Exchange equity 

markets. He is also responsible for both the equity trading and options markets trading examination 

programs. Immediately prior to joining FINRA, Mr. Malitzis was an executive vice president for the 

Division of Market Surveillance for NYSE Regulation. In this capacity, he oversaw the surveillance of 

trading in NYSE and Amex-listed securities by member firms, and monitored for compliance by 

member firms with NYSE and Amex rules as well as the federal securities laws. Mr. Malitzis joined 

the NYSE Regulation in October 2004. Prior to NYSE Regulation, he was a senior vice president and 

associate general counsel for the Institutional Equities Division of Citigroup Global Markets, Inc. For 

nearly nine years, Mr. Malitzis was employed by the NASD/The Nasdaq Stock Market, in the General 

Counsel’s office and later in Transaction / Market Services. Prior to the NASD, Mr. Malitzis was a trial 

attorney for the Commodities Futures Trading Commission and a Law Clerk at the U.S. Department 

of Labor. Mr. Malitzis also has taught at the Catholic University, Columbus School of Law. Mr. Malitzis 

received his law degree from Boston College Law School. 

Jon Kroeper is the Senior Vice President of the Quality of Markets Section of FINRA’s Market 

Regulation Department. The Quality of Markets Section is responsible for the conduct of post-trade 

surveillance and investigations related to data integrity, market conduct rules and trading 

manipulation matters in the U.S. equity and fixed income markets regulated by FINRA as a selfregulatory 

organization and as a provider of regulatory services to other U.S. SROs. Prior to joining 

FINRA's predecessor NASD in early 2007, Mr. Kroeper served as a counsel to U.S. Securities and 

Exchange Commission Chairman Chris Cox in 2006 and 2007, and a counsel to Commissioner Paul 

S. Atkins in 2005. From 2000 to 2005, Mr. Kroeper was a first vice president and associate general 

counsel for Instinet Group Incorporated. Mr. Kroeper began his career as at the U.S. SEC in 1994, 

serving as a senior counsel in the Division of Market Regulation and subsequently as a counsel to 

Commissioner Laura S. Unger. Mr. Kroeper received a bachelor’s degree from Georgetown 

University and a law degree cum laude from Chicago-Kent College of Law. 

David Shillman is Associate Director in the SEC’s Division of Trading & Markets, where he is 

responsible primarily for oversight of the U.S. equity markets. Prior to that time, he served as a 

counsel to the director, senior special counsel – International, and a special counsel in the Office of 

Chief Counsel, all in the Division of Market Regulation. Mr. Shillman was in private practice in New 

York and Washington, D.C. before joining the SEC in 1995. He is a graduate of Northwestern 

University and the University of Michigan Law School. 


Current Market Structure Issues in the U.S. Equity and 

Options Markets 

February 2012 

© 2012 Davis Polk & Wardwell LLP 

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is 

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Contents 

I. The Framework of the Equity Trading Markets ................................................................................................ 1 

A. Regulation ATS ...................................................................................................................................... 1 

1. Exchange Regulation ...................................................................................................................... 1 

2. Development of Property Trading Systems ..................................................................................... 1 

3. Regulation of Alternative Trading Systems ...................................................................................... 2 

4. Electronic Communication Networks ............................................................................................... 3 

B. Regulation NMS ..................................................................................................................................... 3 

1. Issues Pre-Reg NMS ....................................................................................................................... 3 

2. Adoption of Reg NMS ...................................................................................................................... 4 

3. Sub-Penny Rule .............................................................................................................................. 5 

4. Market Data Revenues .................................................................................................................... 6 

5. Market Data Rules ........................................................................................................................... 6 

6. Implementation of Reg NMS ........................................................................................................... 6 

C. Short Sale Rules .................................................................................................................................... 7 

1. Emergency Rules ............................................................................................................................ 7 

2. Delivery Obligations ........................................................................................................................ 7 

3. Short Sale Rules – Marking Issues ................................................................................................. 8 

4. Short Sale Rules – Price Test Rules ............................................................................................... 9 

II. Issues in the Equity Markets .......................................................................................................................... 10 

A. Dark Pools ........................................................................................................................................... 10 

1. Hidden Quoting ............................................................................................................................. 10 

2. Opaque Transaction Reporting ..................................................................................................... 11 

3. Fragmentation ............................................................................................................................... 12 

4. Unfair Access ................................................................................................................................ 12 

5. Competitive Issues ........................................................................................................................ 13 

B. Flash Orders ........................................................................................................................................ 13 

1. Background ................................................................................................................................... 13 

2. The SEC Proposal ......................................................................................................................... 14 

3. EDGX Step-up Order Proposed Rule Amendments and SEC Disapproval Proceedings .............. 15 

C. High Frequency Trading ...................................................................................................................... 15 

1. Co-location .................................................................................................................................... 15 

2. Market Access ............................................................................................................................... 16 

D. Circuit Breaker Pilot ............................................................................................................................. 17 

E. Proposed Limit Up-Limit Down Plan .................................................................................................... 17 

F. NYSE Proposed Retail Order Flow Program ....................................................................................... 18 

III. Issues in the Options Markets ........................................................................................................................ 18 

A. Penny Pilots ......................................................................................................................................... 18 

B. Dollar Strikes ....................................................................................................................................... 19 

C. Execution Quality Statistics for Options ............................................................................................... 19 

D. Maker-Taker Fees for Options ............................................................................................................. 19 

E. Options Fragmentation and Internalization .......................................................................................... 20 

F. Decentralized Options Linkage Plan .................................................................................................... 22 

1. Trade Throughs ............................................................................................................................. 22 

2. Locked and Crossed Markets ........................................................................................................ 22 

3. Implementation .............................................................................................................................. 23 


i

G. Options Market Access Fee Cap and Anti-Discrimination Rule ........................................................... 23 

IV. Market Access and Surveillance .................................................................................................................... 23 

A. The Joint CFTC-SEC Advisory Committee Recommendations Regarding Regulatory Responses to the 

Flash Crash ......................................................................................................................................... 23 

B. Large Trader Reporting System ........................................................................................................... 24 

C. Consolidated Audit Trail ....................................................................................................................... 25 

D. FINRA Blueprint for a Consolidated Audit Trail .................................................................................... 26 

E. Clearly Erroneous Trades .................................................................................................................... 26 

F. Enhanced Quotation Requirements for Market Makers ....................................................................... 26 

V. Institutional Best Execution ............................................................................................................................ 27 

A. Policies and Procedures ...................................................................................................................... 27 

B. Periodic Review ................................................................................................................................... 27 

C. Client Disclosures ................................................................................................................................ 27 

D. Soft Dollars and Other Conflicts ........................................................................................................... 27 

1. Soft Dollars .................................................................................................................................... 27 

2. Client–Directed Brokerage ............................................................................................................ 28 

Glossary of Selected Market Structure Terms .................................................................................................... A-1 


ii

I. The Framework of the Equity Trading Markets 

The regulatory framework governing the U.S. equity markets was given its current shape by the SEC’s 

adoption of Regulation ATS in December 1998 and Regulation NMS in June 2005. These regulations 

revised and codified a series of rules adopted by the SEC in the years surrounding the enactment of the 

Securities Act Amendments of 1975 (the “1975 Amendments”). The regulations also built on a structure 

of self-regulatory organization rules, including rules of the exchanges and the Financial Industry 

Regulatory Authority (“FINRA”), which was formed in 2007 through the merger of the National Association 

of Securities Dealers, Inc. (“NASD”), and the member regulation functions of the New York Stock 

Exchange (“NYSE”). 

A. Regulation ATS 

The SEC adopted Regulation ATS and accompanying Rule 3b 16 to update the scheme of exchange 

regulation devised by Congress in 1934 in an era in which order interaction and price discovery functions 

were best fulfilled by trading on physical exchange floors. Exchange Act Release No. 40760 (December 

8, 1998) (adopting Regulation ATS and Rule 3b-16) (the “Regulation ATS Adopting Release”). 

1. Exchange Regulation 

The Securities Exchange Act of 1934 (the “Exchange Act”) codified the then prevalent system of 

exchanges operating as membership organizations that established trading rules and imposed brokerdealer 

capital, business conduct and fixed commission requirements as a condition of membership. 

(i) 

Section 3(a)(1) of the Exchange Act broadly defines the term exchange as “any organization, 

association, or group of persons, whether incorporated or unincorporated, which constitutes, 

maintains, or provides a market place or facilities for bringing together purchasers and sellers of 

securities or for otherwise performing with respect to securities the functions commonly 

performed by a stock exchange as that term is generally understood, and includes the market 

place and the market facilities maintained by such exchange.” 

(ii) Section 5 of the Exchange Act requires exchanges to register with the SEC, and Section 6 

requires a registered exchange to operate as a self-regulatory organization with rulemaking and 

disciplinary authority over its members. 

(iii) 

Because of their self-regulatory role, exchanges are required pursuant to Section 6 and Section 

19 (as revised in 1975) to act by formal rule, to not unreasonably discriminate in admitting new 

members, and to follow fair disciplinary procedures in actions against members. Exchanges are 

also required to provide members with fair representation in the governance of the exchange and 

to equitably allocate reasonable dues, fees and other charges among its members. 

2. Development of Property Trading Systems 

The growing availability of widespread, inexpensive automation and electronic communication systems 

gave rise to electronic trading systems that challenged the dominance of the floor-based exchange 

trading model. As a result, beginning in the 1970s exchanges began automating some of their order 

delivery and execution systems, the NASD developed the Nasdaq electronic quotation system for overthe-counter 

stocks and broker-dealers began developing electronic proprietary trading systems. 

(i) 

(ii) 

The proprietary trading systems operated by broker-dealers and others operated on a for-profit 

basis and sought to avoid being regulated as an exchange. 

The SEC staff issued a series of no-action letters to proprietary trading systems. See, e.g., Letter 

from Richard G. Ketchum, Director, Division of Market Regulation, SEC, to Daniel Brooks, 

Davis Polk & Wardwell LLP

Cadwalader, Wickersham & Taft, Fed. Sec. L. Rep. CCH 78,997 1986 WL 67657 (SEC) (Sep. 8, 

1986). In 1994 the SEC adopted a recordkeeping and reporting rule for these systems. 

Exchange Act Release No. 35124 (Dec 20, 1994). 

3. Regulation of Alternative Trading Systems 

In 1998, the SEC adopted Rule 3b-16 to define which automated trading systems were exchanges, and 

Regulation ATS to exempt certain automated trading systems from registration as an exchange, subject 

to conditions that applied the core elements of exchange regulation to exempted “alternative trading 

systems.” See the Regulation ATS Adopting Release. 

(i) 

(ii) 

Regulation ATS contains conditions that need to be satisfied to be exempt from the requirement 

to register as an exchange under Section 6 of the Exchange Act: 

(a) 

(b) 

(c) 

(d) 

Broker-Dealer Status. Rule 301(b)(1) of Regulation ATS requires that the ATS be 

registered as a broker-dealer under Section 15 of the Exchange Act or be operated by a 

registered broker-dealer. 

No SRO Powers. Rule 300(a) makes clear that an ATS cannot exercise self-regulatory 

powers, such as regulating its members’ or subscribers’ conduct when engaged in 

activities outside of that trading system. 

Name. Rule 301(b)(11) provides that an ATS cannot use the word “exchange,” “stock 

market” or similar terms in its name. 

Dominance of the Market. Also, the SEC can determine that a dominant alternative 

trading system should be registered as an exchange. Rule 3a-1(b)(1) provides certain 

bright line thresholds in this regard: the rule provides that an exchange is not exempt 

under Rule 3a-1(a) if during three of the preceding four calendar quarters it had fifty 

percent or more of the average daily dollar trading volume in any security and five 

percent or more in any class of security, or forty percent or more of the average dollar 

trading volume in any class of securities and the SEC after notice has determined that 

the exemption is not appropriate. 

The core exchange elements that are applicable to ATSs include: 

(a) 

(b) 

SEC Registration and Reporting. Rule 301(b) requires an ATS to register with the SEC 

using Form ATS and to undertake certain ongoing notice and reporting obligations 

(subsuming the 1994 recordkeeping and reporting requirements). 

Order Display and Execution Access. Rule 301(b)(3)(ii) provides that with respect to 

any NMS stock in which the ATS during at least four of the preceding six calendar 

months had an average daily trading volume of five percent or more of the aggregate 

average daily share volume, the ATS shall provide to a national security exchange or 

association the prices and sizes of the orders at the highest buy price and the lowest sell 

price for such NMS stock displayed to more than one person in the ATS (other than 

employees), for inclusion in the quotation data published by the exchange or association. 

(1) With respect to any order displayed pursuant to Rule 301(b)(3)(ii), the ATS 

displaying the order shall provide to any broker-dealer that has access to the 

national securities exchange or association to which the ATS provides the prices 

and sizes of displayed orders the ability to effect a transaction with such orders 

that is equivalent to the ability of such broker-dealer to effect a transaction with 

other orders displayed on the exchange or by the association, and at the price of 

the highest priced buy order or the lowest priced sell order displayed for the 

lesser of the cumulative size of such priced orders entered therein at such price, 

or the size of the execution sought by such broker-dealer. 

Davis Polk & Wardwell LLP 2

(2) See Section II.A for a discussion of the SEC’s November 2009 proposal. 

(c) 

(d) 

Fair Access. Rule 301(b)(5) requires an ATS to provide fair access to its system with 

respect to any security that the ATS had five percent or more of the average daily volume 

in that security for at least four of the six preceding calendar months. 

(1) Rule 301(b)(5)(iii) contains an exception for passively priced alternative trading 

systems that match customers’ orders for a security with other customer orders, 

provided that such customers’ orders are not displayed to any person (other than 

employees), and such orders are executed at a price for such security 

disseminated by an effective transaction reporting plan, or derived from such 

prices. 

(2) The fair access requirement is more expansive than the requirement that access 

is provided to a specific displayed quote, as access into a system would provide 

access to enter limit orders, view the depth of book in a given security and 

participate in any unique order features offered by the ATS. 

Capacity, Integrity and Security of Automated Systems. Rule 301(b)(6) requires the 

computer systems of an ATS to be periodically tested and reviewed for reliability and for 

the ATS to develop disaster recover plans, once the ATS reaches 20 percent of average 

daily trading volume. 

4. Electronic Communication Networks 

Regulation ATS facilitated the development and registration of approximately 40 trading systems, most 

notably entities acting as Electronic Communication Networks (“ECNs”), which are ATSs that make their 

quotes available to the public. 

B. Regulation NMS 

The SEC adopted Regulation NMS in June 2005 to address a combination of issues arising under the 

national market system rules and plans that had been adopted pursuant to the 1975 Amendments. See 

Exchange Act Release No. 51808 (June 9, 2005) (the “Regulation NMS Adopting Release”). 

1. Issues Pre-Reg NMS 

Changing market conditions put pressure on the market structure rules developed primarily in the 1970’s. 

(i) 

(ii) 

Increasingly, trading of the securities spread across many markets (“fragmentation”), and retail 

customer orders were executed internally by market makers and trading systems without 

exposure of these orders to other traders (“internalization”). These developments raised 

concerns that the pricing function of the market could be impaired, as customer limit orders 

displayed in one market were ignored while trades for other customers received worse execution. 

The SEC in 2000, under pressure from Congress, required the SROs to move to decimal pricing 

of trading systems. See Exchange Act Release No. 42914 (June 8, 2000), 42685 (April 13, 2000), 

and 42360 (Jan. 28, 2000). 

(a) 

(b) 

(c) 

Decimalization resulted in quoting and trading equities in pennies, rather than eighths or 

sixteenths of a dollar. 

Decimalization reduced quote spreads and improved retail execution prices, but also 

reduced the size of displayed quotes and raised concerns regarding reduced liquidity. 

Decimalization also facilitated in subpenny increments. 


(iii) 

In particular, the development of electronic markets and the spread of automated executions and 

order routing created tensions with floor-based markets where much of the order execution 

process was still manual, and for the Intermarket Trading System (the “ITS”), which was an SROoperated 

order routing system that linked the exchanges and the over-the-counter (“OTC”) 

market in listed securities. 

(a) 

(b) 

The SRO plan governing the ITS prohibited participant exchanges and OTC market 

makers from trading at prices inferior to the displayed quote of a participant market (i.e., 

“trading through” the quotes), unless the participant that traded-through the displayed 

quote routed a commitment to the participant market whose quote was traded-through 

and gave that participant at least 30 seconds to respond to the commitment. The ITS 

Plan also restricted its participants from displaying quotes that locked or crossed the 

quote of another participant. 

As a result, no ITS participant could trade at a faster pace than the slowest ITS 

participant market, if this trading would result in trade-throughs or locking the quotes of 

the slower market. 

2. Adoption of Reg NMS 

In response to these concerns and to catalyze change in exchange floor-based trading without risking 

inferior executions for customer orders, the SEC in June 2005 adopted Regulation NMS, which added 

several new rules and amended others. See the Regulation NMS Adopting Release. Regulation NMS 

introduced three new rules: (1) the Order Protection Rule (Rule 611); (2) the Access Rule (Rule 610); (3) 

the Sub-Penny Rule (Rule 612); and amended the Market Data Rules (Rules 600, 601 and 603) 

(i) 

(ii) 

Order Protection Rule. Rule 611(a)(1) requires a trading center to establish, maintain, and 

enforce written policies and procedures that are reasonably designed to prevent trade-throughs 

on that trading center of protected quotations in NMS stocks that do not fall within any of the 

exceptions described below. 

(a) 

(b) 

(c) 

The purpose of this rule is to eliminate all trade-throughs that reasonably can be 

prevented, while also recognizing the inherent difficulties of eliminating trade-through 

transactions that, despite a trading center’s reasonable efforts, may occur. 

The order protection rule updated and replaced the ITS trade-through rule and extended 

to all trading in Nasdaq and exchange-listed equities. 

The order protection rule requires policies and procedures and was not intended to make 

each trade-through a violation of the rule. Examinations by the SEC and SROs have 

focused on the adequacy of procedures. 

Exceptions to Order Protection Rule. 

(a) 

(b) 

(c) 

(d) 

(e) 

Rule 611(b)(1): excepts transactions if the trading center that was traded through was 

experiencing a failure, material delay, or malfunction of its systems or equipment when 

the trade through occurred. This exception is sometimes referred to as the “self-help” 

exception. 

Rule 611(b)(2): excepts transactions other than “regular way” contracts. 

Rule 611(b)(3): excepts single-price opening, reopening or closing transactions. 

Rule 611(b)(4): excepts transactions executed at a time when protected quotations were 

crossed. 

Rule 611(b)(5): allows a trading center immediately to execute any order identified as an 

intermarket sweep order. 


(iii) 

(f) 

(g) 

(h) 

(i) 

Rule 611(b)(6): allows a trading center to route intermarket sweep orders and thereby 

clear the way for immediate executions at the intermarket sweep orders’ price, which 

enables traders to control the execution of their orders. 

Rule 611(b)(7): excepts the execution of an order at a benchmark price that is not based, 

directly or indirectly, on the quoted price of an NMS stock at the time of execution and for 

which the material terms are not reasonably determinable at the time the commitment to 

execute the order is made (e.g., a VWAP order). 

Rule 611(b)(8): excepts transactions based on “flickering quotations”, where the order 

that trades through matches a price displayed by the trading center within one second 

prior to execution of the trade-through. 

Rule 611(b)(9): excepts certain “underwater” stopped orders, where the price of the 

execution of the order is, for a stopped buy order, lower than the national best bid at the 

time of execution or, for a stopped sell order, higher than the national best offer at the 

time of execution. 

Access Rule. The SEC has stated that for the national market system to fulfill its statutory 

objections, fair and efficient access to each of the individual markets that participate in the 

national market system is essential. This principle is a recurring issue as markets innovate and 

develop; in particular, it has been raised in the discussions concerning high frequency trading and 

dark pools. 

(a) 

(b) 

(c) 

(d) 

Rule 610(a) prohibits an SRO from imposing unfairly discriminatory terms that prevent or 

inhibit any person from obtaining efficient access through a member of the SRO to the 

quotations in an NMS stock displayed by the SRO trading facility. 

Rule 610(b)(1) requires any trading center that displays quotations in NMS stocks 

through an SRO display-only facility to provide a level and cost of access to such 

quotations that is substantially equivalent to the level and cost of access to quotations 

displayed by SRO trading facilities. 

Rule 610(c) caps the fees that can be charged for access to protected quotations and 

manual quotations at the best bid and offer at three-tenths of a cent per share, a purely 

pragmatic amount that reflected market practice at the time. It also allows market makers, 

in addition to alternative trading systems, to charge these fees. For a critique of these 

fees, see James J. Angel, Lawrence E. Harris and Chester S. Spatt, Equity Trading in the 

21 st Century (February 23, 2010), available at 

http://www.knight.com/newsroom/pdfs/EquityTradinginthe21stCentury.pdf. 

(1) The fees are not reflected in the displayed quote. 

(2) The rule generally does not include fees not triggered by the execution of orders 

against protected quotations, such as periodic fees. 

Rule 610(d) requires that each national securities exchange and national securities 

association establish, maintain and enforce written rules to preclude display of quotations 

that lock or cross any protected quotation in an NMS stock. 

3. Sub-Penny Rule 

(i) 

Rule 612 provides that no market participant “shall display, rank, or accept from any person a bid 

or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller 

than $0.01 if that bid or offer, order or indication of interest is priced equal to or greater than $1.00 

per share.” 


(ii) 

Rule 612 does not prohibit a sub-penny execution resulting from a midpoint or VWAP algorithm or 

from price improvement, so long as the execution did not result from an impermissible sub-penny 

order, ranking, or quotation. 

4. Market Data Revenues 

The SEC adopted amendments to the joint industry plans for consolidated quote and transaction 

reporting. Under the plans, SROs operate market information networks, which collect market data from 

the networks’ individual SRO participants and distribute such market data to broker-dealers and data 

vendors for a fee. The SEC adopted amendments to the plans with a goal of incorporating a broad-based 

measure of the contribution of an SRO’s quotes and trades to the consolidated data stream. The formula 

uses the following two steps: 

(i) 

(ii) 

First, a network’s distributable revenue is allocated among the many individual securities included 

in the network’s data stream. 

Second, the revenues that are allocated to an individual security are allocated among the SROs 

based on measures of the usefulness to investors of the SROs’ trades and quotes in the security. 

5. Market Data Rules 

Regulation NMS also includes rules regarding the dissemination of quotation and transaction data, and 

the distribution, consolidation and display of information regarding quotations for and transactions in NMS 

stocks. 

(i) 

(ii) 

(iii) 

(iv) 

(v) 

Rule 601 requires members of an SRO to transmit their trades to the SRO, but also allows such 

members to distribute their own data independently, with or without fees. 

Rule 603(a)(1) requires that any market information distributed by an exclusive processor, or by a 

broker-dealer that is the exclusive source of the information, be made available to vendors on 

terms that are fair and reasonable. 

Rule 603(a)(2) requires that any SRO or broker-dealer that distributes market information must do 

so on terms that are not unreasonably discriminatory. 

Rule 603(b) requires SROs to continue to participate in joint SRO plans to consolidate and jointly 

disseminate quotation and transaction information for NMS stocks, but allows an SRO to 

distribute its data independently, with or without fees. 

Rule 603(c) requires data vendors and broker-dealers to provide consolidated information on 

quotations and trades in an equivalent manner to any other information on quotations and trades 

provided by the data vendor or broker-dealer when used in a context in which a trading or orderrouting 

decision could be implemented. Rule 603(c) does not apply to market data provided on a 

purely informational web site that does not offer any trading or order-routing capability. 

6. Implementation of Reg NMS 

(i) 

Regulation NMS fundamentally changed the way that the market operates. Implementation of 

Regulation NMS entailed a cooperative effort by the regulators and the industry to resolve open 

issues and implement appropriate systemic changes. The trading systems at every firm and 

exchange had to be changed to accommodate the new trading rules. The SEC issued a series of 

FAQs resolving many repeat questions. See Responses to Frequently Asked Questions 

Concerning Rule 611 and Rule 610 of Regulation NMS, 

http://www.sec.gov/divisions/marketreg/nmsfaq610-11.htm and Responses to Frequently Asked 

Questions Concerning Rule 612 of Regulation NMS, 

http://www.sec.gov/divisions/marketreg/subpenny612faq.htm 


(ii) 

After a massive two-year effort, the NMS trading rules were effectively implemented in August 

2007 without major market disruption. To date, the rules have worked effectively to regulate 

trading in the equity markets. As discussed below, in 2009 and 2010, the SEC began addressing 

a series of market developments in the wake of Regulation NMS. 

C. Short Sale Rules 

1. Emergency Rules 

During the financial crisis of the fall of 2008, the SEC imposed a series of emergency orders to rein in 

short selling in stocks of financial companies. See, e.g., Exchange Act Release No. 58166 (July 15, 2008) 

(order requiring pre-borrows for certain listed securities). The SEC also adopted on an emergency basis 

temporary interim final Rule 204T, designed to reduce fails to deliver equity securities, particularly those 

arising from short sales, and Rule 10a-3T, designed to provide the SEC with information regarding the 

short positions of all major market participants. See Exchange Act Release No. 58773 (Oct. 14, 2008) 

(adopting interim final temporary Rule 204T) and 58785 (Oct. 15, 2008) (adopting interim final temporary 

Rule 10a-3T). As discussed below, the SEC made permanent Rule 204 in July 2009, and adopted a new 

price test short sale rule in February 2010. 

2. Delivery Obligations 

On July 27, 2009, the SEC adopted Rule 204, making permanent the firm delivery and close out 

requirements of Rule 204T. Exchange Act Release No. 60388 (July 27, 2009). 

(i) 

(ii) 

(iii) 

(iv) 

(v) 

Accelerated Close-Outs. Rule 204(a) provides that participants of registered clearing agencies 

must deliver equity securities to the clearing agency by the settlement date, or if a participant has 

a fail to deliver position at the clearing agency relating to a short sale, the participant must 

immediately close out the position by either borrowing or purchasing the shares before the 

beginning of trading hours on the first settlement day after the settlement date or suffer a penalty. 

Fails relating to long sales or bona fide market making activity have two additional settlement 

days before they must be closed out. 

Pre-Borrow Penalty. Rule 204(b) provides that if a participant fails to close out an open fail by 

the deadline, the participant and any broker-dealer from which it receives trades for clearance 

and settlement become subject to a penalty (the “Pre-Borrow Penalty”) requiring them to first 

borrow or arrange to borrow the security before accepting any short sales orders or effecting 

short sales for its own account in the security. The Pre-Borrow Penalty remains in effect until the 

open fail is closed out by purchasing (not borrowing) the securities. 

Pre-Fail Credit. Rule 204(e) provides that a broker-dealer can avoid the close-out requirement 

or Pre-Borrow Penalty by purchasing or borrowing enough shares to offset its fail, subject to 

certain conditions, including the amount and timing of the purchase (“Pre-Fail Credit”). 

Allocations and Certifications. The temporary rule contained exceptions for broker-dealers and 

market makers who certify that they have not incurred fails in respect of the relevant securities, 

for market makers who demonstrate that they do not have open short positions at the time of 

additional short sales and for participants who “reasonably allocate” a portion of a fail-to-deliver 

position to another broker-dealer for whom it clears trades. These exceptions were adopted as 

Rule 204(d). 

Adjustments from the Temporary Rule. The SEC made the following adjustments from the 

temporary rule: 


(vi) 

(vii) 

(viii) 

(a) 

(b) 

(c) 

(d) 

Flexibility to Purchase or Borrow. The final rule adds flexibility by allowing borrowing 

to close out long fails, market maker fails or for Pre-Fail Credit. In these cases the 

temporary rule only allowed purchases. 

Pre-Fail Credit Conditions Relaxed. Unlike the temporary rule, which conditioned the 

availability of Pre-Fail Credit on the broker-dealer acquiring an amount of securities equal 

to the amount of the open short position in the security, the final rule provides that only 

the amount of the fail-to-deliver position at the registered clearing agency must be 

purchased or borrowed. 

Additional Securities Available for Extended Close-Out Period. The final rule 

expands the category of securities that qualify for an extended close-out period from only 

Rule 144 securities to other securities that the seller is “deemed to own” and intends to 

deliver, such as securities not yet received after exercising an option or warrant. The 

final rule also reduces the close-out time frame for these securities from the 36th 

consecutive settlement day to the 35th calendar day following the settlement date. 

Market Maker Exception From Pre-Borrow Penalty Removed. The final rule removes 

the temporary rule’s exception from the Pre-Borrow Penalty for market makers that do 

not have an open short position in the security. The SEC explained that the exception is 

unnecessary because a market maker, like any broker-dealer, can be relieved of the Pre- 

Borrow Penalty by certifying that it is not responsible for the fail. 

Sham Close-Outs. The final rule also added a new subsection to reemphasize the SEC’s 

concerns regarding attempts to evade the requirements of Rule 204 through sham close-outs. 

New Rule 204(f) specifies that the purchase or borrow of securities will not qualify as a close-out 

if the participant knows or has reason to know the securities will not actually be delivered in 

settlement. 

(a) 

Shortly after adoption of Rule 204, the SEC announced enforcement actions for sham 

close outs. Specifically, on August 5, 2009 the SEC alleged that “the traders and their 

firms improperly claimed that they were entitled to an exception to the locate requirement, 

and engaged in transactions that created the appearance that they were complying with 

the close-out requirement.” See SEC Press Release 2009-179 (August 5, 2009). 

Record Keeping and Compliance. The adopting release also reinforced the importance of 

good record keeping and compliance procedures, and indicated the SEC’s intent to examine 

firms for compliance. In addition, because Rule 204 applies to all equity securities, it effectively 

supplants (but does not actually remove) the close-out requirements for “threshold” securities 

under Rule 203(b)(3) of Regulation SHO. 

Trading Impact. While Rule 204 does not directly control the price or manner of trading, its 

delivery requirements effectively limit the scale and duration of naked short selling, because of 

the need to cover the short sales by T+4 to avoid the preborrow requirement. 

3. Short Sale Rules – Marking Issues 

On August 28, 2009, the staff of the Division of Trading and Markets released updates to its Regulation 

SHO FAQs, providing guidance that is relevant to the compliance practices of broker-dealers and high 

frequency trading firms. Division of Market Regulation: Responses to Frequently Asked Questions 

Concerning Regulation SHO, available at http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm. 

The SEC staff is discussing the application of these FAQs and possible further relief with industry 

members. 

(i) 

Marking Multiple Orders “In Flight.” Broker-dealers whose clients are high frequency traders 

are faced with the question of how to mark orders when the client enters multiple orders nearly 


(ii) 

simultaneously, and after execution of the first order, the client will be net short in the position. 

For example, a high frequency trader that is net long 1,000 shares may enter multiple orders 

nearly simultaneously to sell 1,000 shares, with the intent of cancelling all trades that remain 

outstanding after one trade is executed. The staff’s new guidance, found in Question 2.5 of the 

Regulation SHO FAQs, states that the staff’s view of Rule 201(g)(1) is that after the first long sale 

order is entered to sell 1,000 shares, “it is no longer reasonable to expect that delivery can be 

made by settlement date on additional orders to sell the same shares.” Therefore, a brokerdealer 

must mark only one order long, and the additional orders must be marked short. 

Marking an Order Where the Seller is Net Long for Only Part of the Order. The staff 

provided guidance in Question 2.4 of the Regulation SHO FAQs, stating that where a seller is net 

long a security but desires to enter an order to sell for more than its net long position, the sell 

order for the sale of the long shares must be marked long, and the sell order for the additional 

shares must be marked short. For example, if a seller is net long 500 shares, but wants to sell 

600 shares, only 500 shares can be marked long. The excess 100 shares must be marked short. 

The staff intended to make clear that Rule 200(g)(1) requires mixed orders to be entered as two 

separate orders, and to correct divergent market practices (including marking mixed orders as 

short). The industry is attempting to have these FAQ’s modified to better reflect actual practice. 

(iii) Relying on a Locate of a Foreign Broker-Dealer. The staff provided guidance in Question 4.6 

of the Regulation SHO FAQs regarding reliance on a locate of a non-U.S. registered brokerdealer. 

Previously, there had been varying interpretations among market participants regarding 

whether Rule 203(b)(2)(i), which subject to certain exceptions allows a U.S. broker-dealer to rely 

on a locate of another U.S. broker-dealer, extended to non-U.S. registered broker-dealers from 

certain countries that have incorporated Regulation SHO’s locate requirements into their local 

regulatory regime. The staff has put this question to rest, stating unequivocally that the Rule 

203(b)(2)(i) “broker to broker” exception “applies only to transactions undertaken between brokerdealers 

registered in the U.S. pursuant to the requirements of Rule 15(a) of the Securities 

Exchange Act of 1934.” U.S. broker-dealers, therefore, must treat non-U.S. registered brokerdealers 

in the same manner as a non-broker-dealer customer. Specifically, the U.S. brokerdealer 

must have a reasonable belief that the non-U.S. registered broker-dealer will have the 

securities available for delivery on the date delivery is due, and must document such information 

as provided by Regulation SHO. 

4. Short Sale Rules – Price Test Rules 

In response to the widely held belief that the SEC’s elimination in 2007 of the historic uptick short sale 

restriction, Rule 10a-1, unleashed waves of short selling abuse in the markets, and the political pressure 

placed on the SEC, on February 24, 2010 the SEC adopted a revised price test. The new rule became 

effective on March 10, 2010, and compliance was required as of February 28, 2011. 

(i) 

The new short sale rule, Rule 201 of Regulation SHO, institutes what the marketplace has termed 

a “circuit breaker with a passive upbid requirement” rather than a full-time restriction on short 

sales. 

(a) 

(b) 

(c) 

The restriction goes into place upon a 10% decline in the price of an NMS stock from its 

previous day’s closing price. 

Rule 201 effectively restricts the display or execution by exchanges and other trading 

centers of a short sale order in such stock to a price above the national best bid for the 

remainder of the trading day and the next trading day. 

The Rule will be implemented through policies and procedures of trading centers and 

broker-dealers that are not, themselves, trading centers. 


(ii) 

II. 

(d) 

(e) 

There are limited exceptions from the basic requirement, including arbitrage and odd lot 

transactions. There is no exception for market making in NMS stocks or options market 

making. 

In its adopting release, the SEC states that Rule 201 strikes a balance between the goal 

of preventing short selling from being used to exacerbate a declining market in a security 

and the need to allow for the smooth functioning of the markets, including the provision of 

liquidity and price efficiency. 

In connection with Rule 201, the SEC also amended Rule 200 of Regulation SHO to require all 

brokers and dealers to mark all orders for sale of an equity security as “long,” “short,” or “short 

exempt.” 

(a) 

(b) 

(c) 

Short sale orders may only be marked “short exempt” under two scenarios. First, an 

order can be marked “short exempt” under Rule 201(c) if it is at a price above the current 

national best bid at the time of submission. Second, orders may be marked “short exempt” 

pursuant to one of the exceptions from Rule 201. In order to mark orders as “short 

exempt,” a broker-dealer must have written policies and procedures that are reasonably 

designed to prevent inaccurate marking and it must regularly monitor for and remedy any 

problems with the policies and procedures. 

Narrow exceptions to Rule 201 are effected through provisions allowing broker-dealers to 

mark “short exempt” those orders that it reasonably believes fall into certain defined 

categories. These include seller’s delay in delivery; odd lot transactions by market 

makers; overallotments and layoffs, riskless principal transactions to facilitate customer 

transactions, VWAP transactions, and domestic and international arbitrage transactions. 

There are no exceptions from Rule 201 for bona fide hedging, bona fide market making 

(including market making in OTC and listed derivatives, options, convertible securities, or 

exchange-traded funds), benchmark trades otherwise exempted from Regulation NMS, 

sales effected in connection with capital raising transactions, “exchange for physicals,” 

exchange traded fund transactions or market on close or market on open transactions. 

The SEC has authorized a two year study of the options markets to determine the effect 

of the new rule and lack of exemption for option market makers. 

Issues in the Equity Markets 

A. Dark Pools 

The SEC released on November 13, 2009 a proposal (the “Dark Pools Release”) to increase the 

transparency of dark pools and mitigate fragmentation. See Exchange Act Release No. 60997 

(November 13, 2009). In addition, the SEC addressed certain issues relating to dark pools in its 2010 

Concept Release. The SEC has raised five main issues regarding dark pools, each of which is discussed 

below. 

1. Hidden Quoting 

The Regulation NMS construct is that quotes and customer limit orders of exchanges and over-thecounter 

market makers must be displayed in the public quotation stream (operated by CTA/CQ and 

Nasdaq) unless the orders and quotes are dark, i.e., displayed only to one other person. However, limit 

orders and quotes on an ATS can be displayed within the ATS system and to others without being 

displayed in the public quotation stream until the ATS executes more than 5% market share in the 

particular stock that is quoted. 


(i) 

(ii) 

Indications of Interest. The staff has long worried that indications of interests (“IOIs”) are used 

to circumvent the quoting requirements. The quote rule excepts IOIs from the general 

requirement that quotes be displayed to the public. See Rule 600. The Dark Pools Release 

proposes to amend the definition of bid or offer to only exclude IOIs that are not actionable. If an 

IOI explicitly or implicitly communicates enough information on which to base a response, and by 

its terms or by consistent practice the IOI can be executed against, it will be viewed as an order, 

not an IOI, under Regulation ATS. Essentially, the test is whether the IOI effectively represents a 

firm quote. If the IOI is viewed as a quote or order, then it will be subject to the display 

requirement thresholds under Regulation ATS. 

(a) 

There is an exception to the proposed rule for IOIs of $200,000 or more that are 

communicated only to those who are reasonably believed to represent current contraside 

trading interest of equally large size. 

Quoting threshold. Questions also have been raised whether the 5% threshold for inclusion of 

ATS quotes in the public quotation stream should be lowered. 

(a) 

(b) 

(c) 

The Dark Pools Release proposes to lower the volume threshold for inclusion of ATS 

quotes in the public quotation stream to 0.25%. The threshold that triggers general fair 

access requirements would remain at 5%; therefore, an ATS that crosses the 0.25% 

display threshold would only be required to provide access to the particular quote that is 

displayed. 

(1) As a means of promoting liquidity for large orders, the SEC also proposed to 

provide an exception from the ATS quote requirement for quotes for $200,000 or 

more communicated only to those who are reasonably believed to represent 

current contra-side trading interest of equally large size. 

(2) The 2010 Concept Release requests comment on whether the trading volume 

threshold in Regulation ATS that triggers fair access requirement should be 

lowered from 5%. 

Exchanges have argued that just as their quotes must be made publicly available and 

included in the public quotation stream irrespective of volume levels, so ATS quotes 

should be included in the quote stream without a market share threshold. 

OTC market maker quotes in listed stocks must be made available at a 1% market share 

threshold. 

2. Opaque Transaction Reporting 

The SEC staff has stated that current ATS trade reporting practices make it difficult for the public to 

assess dark pool trading volume and evaluate which dark pools may have liquidity in particular stocks. 

The Dark Pools Release proposes to require real-time post-trade reporting of the identity of individual 

ATSs. 

(i) 

Market Identifiers. Currently, ATSs report their transactions to a Transaction Reporting Facility 

(“TRF”) operated by Nasdaq or the NYSE in conjunction with FINRA, or to FINRA’s own TRF 

(the Alternative Display Facility, or “ADF”). This activity is recorded generically as having 

occurred “over-the-counter.” Each ATS trade is reported individually by the TRF to the 

consolidated transaction reporting systems and is publically disseminated by the CTA or Nasdaq 

with the identifier of the particular TRF. 

(a) 

While many market participants know where the larger ATSs report their trades, some 

ATSs split their reports between TRFs, and TRFs commonly receive trade reports from 

multiple reporting entities. As a result, it is difficult to ascertain the trading volume of an 

ATS from public TRF transaction reports. 


(ii) 

(iii) 

(b) 

Trading reporting is important to ATSs that principally trade blocks for institutions, which 

may not have completed a block transaction on the ATS when pieces of the block are 

reported. Identifies trade reports from a block trading ATS may disclose that a block is 

being executed, moving the market in a way that impairs execution of the block. 

Reporting Conventions. Many ATSs, including dark pools, make their trading volume statistics 

available on their websites, but these statistics are not standardized. ATS statistics often doublecount 

buy and sell orders that are crossed as one trade, or include volume routed away from the 

ATS in the ATS’s volume. Therefore, ATS reporting data requires substantial interpretation 

before the trading volumes of multiple ATS can be compared. 

Real-Time Disclosure. The Dark Pools Release proposes to require real-time disclosure of “the 

identity of individual ATSs on trade reports in the public data stream, in the same way exchange 

trades are identified.” As with other proposals in the release, block-size trades of $200,000 or 

more would be excepted from this requirement. The SEC does not propose to require the trades 

of OTC market makers to be individually identified. 

3. Fragmentation 

The SEC and many market participants have raised concerns regarding market fragmentation for many 

years. The most recent fulsome discussion of fragmentation by the SEC was in a 2000 release noticing 

the NYSE’s elimination of their off-board trading restrictions rule, Rule 390 (Exchange Act Release No. 

42450 (February 23, 2000)). The SEC more recently addressed the issue of market fragmentation in its 

2010 Concept Release. 

(i) 

(ii) 

In the 2000 release, the SEC proposed the following potential options for addressing 

fragmentation: 

(a) 

(b) 

(c) 

(d) 

(e) 

(f) 

Requiring greater disclosure by market centers and brokers concerning the quality of 

trade executions and order routing practices (implemented by adoption of the execution 

quality statistics rules, Rules 605 and 606 of Regulation NMS) 

Restricting internalization and payment for order flow (indirectly addressed by trading in 

pennies); 

Requiring exposure of market orders to price competition; 

Adopting an intermarket prohibition against market makers trading ahead of previously 

displayed and accessible limit orders; 

Providing intermarket time priority for limit orders or quotations that improve the NBBO; 

and 

Establishing price/time priority for all displayed trading interest (partially implemented in 

Regulation NMS by providing for price priority for displayed quotes) 

The 2010 Concept Release requested comment on whether the SEC should consider a trade-at 

rule that would prohibit any trading center from executing a trade at the price of the national best 

bid and offer unless the trading center was displaying that price at the time it received the 

incoming contra-side order. Such a rule would eliminate dark pools. The 2010 Concept Release 

also discusses potential expansion of the trade-through rule to provide trade-through protection to 

the displayed “depth-of-book” quotations of a trading center, which could also have significant 

competitive impact. 

4. Unfair Access 

A fundamental premise of the national market system is that market participants should have the 

opportunity to participate in a market at least when it reaches a significant size. To that end, exchanges 


were required to provide fair access for broker-dealers to become members. Accordingly, Regulation 

ATS originally required ATSs to establish fair access procedures when they reached a 20% market share 

threshold. The SEC as part of the Regulation NMS adoption process reduced the threshold for 

application of the ATS fair access requirements from a 20% to a 5% market share. See Rule 301(b)(3)(iii). 

5. Competitive Issues 

Regulation ATS exempted from exchange regulation those trading systems that were operated as brokerdealers, 

did not act as self-regulators, and did not hold themselves out as exchanges. In the place of 

exchange regulation, Regulation ATS applied the most fundamental exchange requirements to ATSs that 

crossed market share thresholds. 

(i) 

Registered exchanges, such as NYSE, have expressed the view that ATSs should be regulated 

in parity with exchanges, as the need to encourage ATS competition to exchange markets no 

longer exists. See NYSE Euronext Comment Letter, available at 

http://www.sec.gov/comments/s7-27-09/s72709-63.pdf 

B. Flash Orders 

In 2009, controversy erupted over “flash orders,” with critics claiming that flash orders provide an unfair 

advantage to those who see the flashed order to the exclusion of other investors, including retail investors, 

and proponents arguing that flash quotes are nothing more than the electronic version of practices that 

previously occurred throughout the equity markets. The controversy culminated in the SEC proposing to 

ban the use of “flash orders” on equities and options exchanges and large ATSs. 

1. Background 

(i) 

(ii) 

(iii) 

(iv) 

(v) 

The term “flash orders” essentially refers to a practice whereby a trading center will show 

participants of the trading center marketable orders of other participants for a few milliseconds, 

typically at the marketable quote price. Market participants with the requisite electronic 

connections can then execute the orders at the flash price or better. If the order is not 

immediately executed, it will be withdrawn without exposure to the entire market place. 

“Flash orders” have crystallized the concern of many observers that a “two-tiered” market is 

emerging. These concerns include the exposure of the order only to particular market 

participants rather than the entire public market and the potential for certain participants to view 

the flash order and trade ahead of it in the market, resulting in worse execution prices for the 

customer order. 

“Flash orders” also raise fragmentation concerns because they provide market participants the 

opportunity to selectively trade with a flashed order without the need to publish a quote, while not 

providing displayed quotes the chance to trade with the order. 

On August 4, 2009, the SEC Chairman Shapiro announced that the SEC would seek to ban flash 

orders through a notice and comment rulemaking. See 

http://dealbook.blogs.nytimes.com/2009/08/04/sec-to-seek-flash-trading-ban-schumer-says/. On 

August 6, 2009, Nasdaq and BATS announced that they would voluntarily shut down their 

respective flash order systems on September 1, 2009. See Exchange Act Release No. 60569 

(August 26, 2009) (notice of BATS rule change) and 60570 (August 28, 2009) (notice of Nasdaq 

rule change). 

In addition, in May 2009, FINRA issued a regulatory notice to remind member firms of their 

obligation to provide accurate information “when disseminating, or using services to disseminate, 

indications of interest to the marketplace.” See FINRA Regulatory Notice 09-28. 


2. The SEC Proposal 

In order to ban the use of “flash orders,” the SEC has proposed amending the quote rule of Regulation 

NMS, requiring ATSs that have crossed the threshold for the public display of quotes to display flash 

orders, and deeming flash orders as orders that would violate Regulation NMS’s prohibition on lock or 

crossing orders. Significantly, the SEC states in the release that certain market mechanisms and order 

types, such as price improvement auctions and immediate or cancel orders, that bear some functional 

similarities to flash orders will not be affected by the proposal. Exchange Act Release No. 60684 

(September 18, 2009). 

(i) 

(ii) 

(iii) 

(iv) 

Amendment to the Quote Rule. The SEC proposes to eliminate paragraph (a)(1)(i)(A) of Rule 

602 of Regulation NMS, which today excludes from the requirement to display quotes “[a]ny bid 

or offer executed immediately after communication and any bid or offer communicated by a 

responsible broker or dealer other than an exchange market maker which is cancelled or 

withdrawn if not executed immediately after communication.” As a result, flash orders on an 

exchange would need to be included in the exchange’s public quote. 

Display Requirements for Flash Orders on ATSs. Rule 301(b)(3)(ii) of Regulation ATS 

provides that if an ATS meets a 5% volume threshold in an exchange-traded stock, it must submit 

its quotes in such stock to be included in the consolidated quote stream. The proposal would 

apply Rule 301(b)(3)(ii) to orders that either are immediately executed or withdrawn if not 

immediately executed, and that would otherwise be included in the consolidated quote stream 

under Rule 301(b). Therefore, an ATS would be required to send to the consolidated quote 

stream flash orders for stocks that the ATS is required to quote publicly. 

Proposed Interpretation of Locked or Crossed Market Requirements. Rule 610(d) of 

Regulation NMS requires national securities exchanges and associations to establish, maintain 

and enforce rules to reasonably avoid displaying “locking” or “crossing” quotations. If the 

amendment to Rule 602 is adopted, the SEC would consider the display of quotations that either 

are immediately executed or withdrawn if not immediately executed to be the display of 

quotations that are subject to Rule 610(d). Therefore, orders with marketable prices could not be 

flashed without being a locking or crossing order subject to Rule 610(d). The SEC would also 

adopt an interpretation of the locked and crossed markets provisions of the Linkage Plan for 

options that would have a similar result in the case of flash orders for listed options. 

Reopening of Comment Period. On July 2, 2010, the SEC reopened for 30 days the period for 

public comment on its flash ban proposal with respect to listed options. Of the ninety-three 

commenters that submitted views on the flash ban proposal, twelve opposed the proposal 

generally, while nine opposed the proposal specifically for the listed options markets. Some of 

the commenters that opposed the proposal with respect to listed options noted that there is no 

regulatory cap on fees charged by listed options exchanges to access their best priced quotations, 

unlike in the cash equity markets, and that access fees are significantly higher in the listed 

options markets than in the cash equity markets. Furthermore, commenters were concerned that 

elimination of the flash order exception could lead to even higher access fees for listed options. 

The SEC is requesting comments on, among other issues, the effect of a proposed cap on 

access fees for listed options (see Section III.G) and the execution quality for flash orders in the 

listed options markets. The SEC stated in its release that it is particularly interested in data on 

the extent to which flash orders, if they are not executed in the flash process, “miss the market” 

by receiving either an inferior price through an execution against a displayed quotation or no 

execution at all. See Exchange Act Release No. 62445 (July 2, 2010). 


3. EDGX Step-up Order Proposed Rule Amendments and SEC Disapproval Proceedings 

On February 18, 2011, in an action that illustrates the SEC’s continued efforts to minimize or eliminate the 

use of “flash” orders, the SEC instituted proceedings to determine whether to disapprove EDGX 

Exchange, Inc.’s proposed rule change to amend its step-up order rules. Currently, step-up orders, 

defined as a market or limit orders with the instruction that the orders be displayed to users at or within 

the NBBO price, are displayed for up to 5 milliseconds with the first responsive user order executing 

against the step-up order. The proposed rule change would extend the display period to 10 milliseconds 

and would execute responsive user orders priced at or within the NBBO on a price/time priority basis. In 

addition, EDGX proposed expanding the orders that could trade with the flashed order to include user 

orders entered outside the step-up process priced better than, but not outside, the NBBO at the end of 

the step-up display period. Finally, the proposed rule would allow for mid-point match orders, defined as 

an order with an instruction to execute at the midpoint of the NBBO, entered in response to step-up 

orders to participate. See Exchange Act Release No. 63930 (February 18, 2011). 

C. High Frequency Trading 

High frequency trading refers to automated trading through frequent orders driven by complex algorithms. 

Many firms that engage in high frequency trading seek to end the day with little or no exposure to the 

market. Speed of information flows and order flows is critical to high frequency trading firms. High 

frequency trading has been accelerating, and raises perceived issues of fairness. From a regulatory 

perspective, an array of issues arise in the context of high frequency trading, including: co-location, the 

risks of naked/sponsored access, and the SEC’s means of collecting information about the orders and 

transactions of large traders that are not necessarily registered broker-dealers, each of which the SEC 

has discussed in rule proposals or its Concept Release on Equity Market Structure (“2010 Concept 

Release”). See Exchange Act Release No. 61358 (January 13, 2010) and 61908 (April 14, 2010). The 

Commodity Futures Trading Commission (the “CFTC”) has also addressed co-location in a rule proposal 

(“CFTC Co-location Proposal”). See Co-Location/Proximity Hosting Services, 75 Fed. Reg. 33198 

(proposed June 11, 2010). 

1. Co-location 

Co-location refers to providing space for the servers of market participants in the same data center 

housing the matching engines of a trading center. High frequency trading systems can enter and cancel 

orders so quickly in response to quotations that the delay of a fraction of a second from transmission from 

a distant location could cause the market participant to miss the opportunity to trade. As a result, high 

frequency traders are engaged in an arms-race to obtain the lowest latency possible. Trading centers 

seek to maximize their trading volumes by offering high frequency traders the chance to collocate in their 

data centers in the hope of stealing their order flow from other more remote markets. Regulators will 

mostly be concerned with fair access principles, ensuring that all members have an equal and reasonable 

opportunity for access to the co-location facility. The CFTC has proposed a rule that would apply to 

designated contract markets (“DCMs”), derivatives transaction execution facilities (“DTEFs”), and exempt 

commercial markets (“ECMs”) that list significant price discovery contracts (“SPDCs”) that offer colocation 

or proximity hosting services (defined in the proposal as “trading market and certain third-party 

facility space, power, telecommunications, or other ancillary products and services that are made 

available to market participants for the purpose of locating their computer systems/servers in close 

proximity to the trading market’s trade and execution system”). See CFTC Co-location Proposal. The 

proposal has four main elements: 

(i) 

Equal Access. The proposed rule would require that co-location and proximity hosting services 

be available to all qualified market participants willing to pay for the services, and that fair and 

open access also be available to third-party hosting service providers seeking to provide 

proximity hosting services to market participants. 


(ii) 

(iii) 

(iv) 

Fees. The proposed rule would require DCMs, DTEFs, and ECMs with SPDCs to ensure that 

fees to market participants remain equitable, and to not offer preferential connectivity pricing 

arrangements to any market participant on any basis. The proposal states the CFTC's view that 

an equitable fee would be “a uniform, non-discriminatory set of fees for the various services 

provided, including but not limited to fees for cabinet space usage, installation and related power 

provided to market participants, connectivity requirements, and maintenance and other ancillary 

services.” 

Latency Transparency. Under the proposal, DCMs, DTEFs, and ECMs with SPDCs must 

disclose monthly to the public on their websites the longest, shortest, and average latencies for 

each connectivity option. The CFTC is studying an alternative approach for disclosing latency 

information that would be based on the percentile of speed rather than the longest, shortest, and 

average latencies. 

Third-Party Providers. Under the proposed rule, DCMs, DTEFs, and ECMs with SPDCs that 

approve specific third parties to provide proximity hosting services to market participants must 

obtain from those third parties sufficient information to carry out their SRO and other regulatory 

obligations. The proposal states the CFTC’s view that DCMs, DTEFs, and ECMs with SPDCs 

should enter into contractual agreements with those third parties to ensure compliance with this 

provision. 

2. Market Access 

To reduce latencies for high frequency trades, sponsored and naked access systems were provided by 

broker-dealers to clients. Sponsored access is the practice of high frequency traders that are not 

themselves broker-dealers obtaining access to markets through a broker-dealer’s trading identifier. 

Unfiltered or “naked” access is sponsored access without the broker-dealer whose trading identifier is 

being used not applying any pre-trade risk-management systems to review the orders being transmitted 

to the markets. 

(i) 

(ii) 

(iii) 

(iv) 

The appeal of sponsored access is that it provides anonymity, and for high frequency traders it 

saves microseconds. 

Sponsored access raises a series of supervision, compliance and risk-management issues. The 

key problem is that the exchange member sponsoring the trader may not see or control the trader 

who they have connected to the exchange, and trader is not an exchange member subject to 

exchange regulation. Sponsored access raises the risk of overwhelming waves of unauthorized 

trades sweeping the market. 

On January 13, 2010, the SEC approved a Nasdaq rule to modify the framework governing the 

manner in which members provide access to Nasdaq’s execution system. See Exchange Act 

Release No. 61345 (January 13, 2010). The Nasdaq rule requires that sponsoring firms assume 

responsibility for their customers’ trading activity and have effective financial and regulatory 

oversight of the sponsored customer. The rule also requires that sponsored access providers 

make available to Nasdaq all information necessary to provide effective exchange oversight. The 

rule does not require the sponsored participant’s trade to first pass through the sponsoring 

member’s risk management system. The impact of the Nasdaq rule, however, is limited due to 

the stricter requirements of Rule 15c3-5, discussed below. 

On November 3, 2010, the SEC adopted Rule 15c3-5, which requires broker-dealers providing 

access to trading directly on an exchange or alternative trading system, including those providing 

sponsored or direct market access to customers or other persons and ATSs providing access to 

the ATS to non-broker-dealers, to implement risk management controls and supervisory 

procedures reasonably designed to manage the financial, regulatory, and other risks of this 

business activity. The required controls and procedures would effectively prohibit the practice of 


unfiltered or naked access to an exchange or ATS. See Exchange Act Release No. 63241 

(November 3, 2010). 

(a) 

(b) 

(c) 

(d) 

Under the rule, a broker-dealer providing market access may reasonably allocate, by 

written contract, control over specific regulatory risk management controls and 

supervisory procedures to a customer that is a registered broker-dealer. To do so, the 

broker-dealer providing market access must have a reasonable basis for determining that 

such broker-dealer customer has better access to the ultimate customer and its trading 

information such that it can more effectively implement the specified controls and 

procedures. However, even if responsibilities are allocated between broker-dealers, the 

broker-dealer providing access has ultimate responsibility for the obligations under the 

rule. 

The rule requires the financial and regulatory risk management controls and supervisory 

procedures to be under the direct and exclusive control of the broker-dealer with market 

access. 

In addition, broker-dealers that are subject to the proposed rule are required to establish, 

document, and maintain a system for regularly reviewing their risk management controls 

and supervisory procedures. They must include an annual review to assure the 

effectiveness of the controls and procedures. The review would need to be conducted in 

accordance with written procedures that are reasonably designed to assure that the 

broker-dealer’s controls and procedures are adjusted as necessary. 

Compliance with Rule 15c3-5 was required as of July 14, 2011, however the SEC 

extended until November 30, 2011, the compliance date for (i) the portion of the rule that 

requires firms to implement controls to prevent orders that exceed pre-set credit or capital 

thresholds, (ii) all elements of the rule as they apply to fixed income securities, and (iii) for 

floor brokers handling orders on a manual basis, the requirements to have controls in 

place on an automated basis. See Exchange Act Release No. 64748 (June 27, 2011) 

and 65132 (Aug. 15, 2011). 

D. Circuit Breaker Pilot 

In response to the aberrational pricing experienced by many issuers during the flash crash of May 6, 2010, 

the exchanges and FINRA initially adopted circuit breaker rules that pause trading in any component of 

the S&P 500 index if its price dropped or rose 10 percent or more in five minutes. This pause gives time 

for new buy orders to be entered when prices fall sharply, to avoid aberrational trade prices from gaps in 

liquidity. The pause lasts five minutes and operates from 9:45 a.m. to 3:35 p.m. Eastern time. These 

circuit breaker rules were implemented on a pilot basis initially through December 10, 2010. In an 

attempt to protect a wider range of issuers, the SEC, the exchanges and FINRA proposed on June 30, 

2010 to expand the previously adopted circuit breakers by approximately 500 additional stocks by 

including the Russell 1000 index in the pilot, and also to include over 300 ETFs. The expansion included 

ETFs that represent the S&P 500 index, the Russell 1000 index, the Nasdaq 100 index and the Dow 

Jones Industrial Average. See Exchange Act Release No. 62408 (June 30, 2010). Beginning on August 

8, 2011, the trading pause pilot rule was further expanded to include all NMS stocks. The effective date 

of the pilot program has been extended to July 31, 2012. See Exchange Act Release No. 64735 (June 

29, 2011), 65071 (August 9, 2011), and 66134 (January 11, 2012). 

E. Proposed Limit Up-Limit Down Plan 

On April 5, 2011, FINRA and the securities exchanges proposed a “Limit Up-Limit Down” mechanism. If 

approved by the SEC, FINRA and the securities exchanges would establish procedures to prevent trading 

in equity securities covered by the mechanism outside of specific price bands during regular trading hours. 


If trading is unable to occur within those price bands for more than 15 seconds, there would be a fiveminute 

trading pause. See generally Letter from Janet L. McGinness, Senior Vice President – Legal & 

Corporate Secretary, Legal & Government Affairs, NYSE Euronext, to Elizabeth M. Murphy, Secretary, 

Securities and Exchange Commission (April 5, 2011); “Plan to Address Extraordinary Market Volatility 

Submitted to the Securities and Exchange Commission Pursuant to Rule 608 of Regulation NMS Under 

the Securities Exchange Act of 1934.” The SEC has not yet determined whether to approve the Limit Up- 

Limit Down proposal. 

F. NYSE Proposed Retail Order Flow Program 

On October 19, 2011, NYSE and NYSE Amex (together, the “Exchanges”) each filed a proposed rule 

change with the SEC to establish a Retail Liquidity Program on a pilot basis. The proposed Retail 

Liquidity Program would allow the Exchanges to offer dark liquidity and sub-penny price improvements. 

Under the proposals, a new class of market participants called Retail Member Organizations would be 

able to submit a new type of order, called a Retail Order, to the Exchanges. Once a Retail Member 

Organization submitted a Retail Order, a new class of market participants called Retail Liquidity Providers 

would then be required to provide price improvement, in the form of non-displayed interest that is better 

than the best protected bid or offer, called a Retail Price Improvement Order. Other Exchange member 

organizations would be allowed, but not required, to submit Retail Price Improvement Orders. Separately, 

the Exchanges requested an exemption from the Sub-Penny Rule as the proposals contemplate the 

Exchanges accepting and ranking orders in securities priced at $1.00 or more per share in sub-penny 

increments. According to the Exchanges, the Retail Liquidity Program is designed to attract additional 

retail order flow to the Exchanges and provide the potential for price improvement for retail orders. See 

Exchange Act Release No. 65671 (November 2, 2011) and 65672 (November 2, 2011). 

On February 7, 2012, the SEC instituted proceedings to determine whether the proposals should be 

disapproved. Several commenters have expressed concerns about the proposals’ impact on the Sub- 

Penny Rule and raised concerns about whether the proposals impede fair access and implicate rules and 

standards relating to best execution and order protection. See Exchange Act Release No. 66346 

(February 7, 2012). 

III. 

Issues in the Options Markets 

A. Penny Pilots 

• Options markets, unlike equities markets, did not move to trading in pennies during the switch to 

decimalization. Instead, options priced at or above $3.00 traded in $.10 quote increments, and 

options priced under $3.00 traded in $.05 quote increments. 

• Option exchanges have long argued that moving to quotations in pennies would overwhelm the 

capacity of the vendors and firms to trade and process market data on options. They also have 

argued that trading in pennies would reduce liquidity at the quoted price, as occurred in the 

equities market. However, order drivers exchanges argued that penny trading would reduce 

spreads and improve retail executions. 

• Beginning in early 2007, at the insistence of the SEC, the six options exchanges began quoting 

certain options (generally those priced below $3.00) in pennies on a pilot basis. 

• Certain market participants have argued that $1.00 is the right break point for quoting in 

pennies. 

• The penny pilot program has expanded in phases. The SEC approved an extension of the pilot 

to December 31, 2010. As of February 1, 2010, 138 option classes were traded, another 150 will 

be added in May and August. 


• A March 17, 2010 Bloomberg article reported that, according to ICE, trading in pennies 

represents 70% of all options trading volume. 

B. Dollar Strikes 

• Most options classes offer series listed at $2.50 or $5.00 strike prices. The current dollar strike 

program allows ISE, NYSE Arca, NYSE Alternext and CBOE to select 55 stocks on which options 

series may be listed at $1 price intervals, so long as the underlying stock price is less than $50.00. 

• Each exchange may list strike prices at $1 intervals from $3 to $50, but no $1 strike price 

may be listed that is greater than $5 from the underlying stock’s closing price in its primary 

market on the previous day. Each exchange also may list $1.00 strikes on any other option 

class designated by another securities exchange that employs a similar program under 

their respective rules. The exchanges may not list long-term option series at $1 strike price 

intervals for any class selected for the program. Each exchange is restricted from listing 

any series that would result in strike prices being $0.50 apart. See Exchange Act Release 

No. 59587 (March 17, 2009). 

• The SEC reasons that the program provides investors with added flexibility in the trading of 

equity options and furthers the public interest by allowing investors to establish equity 

options positions that are better tailored to meet their investment objectives, particularly 

given current market conditions. 

• Effective January 13, 2010, the SEC approved the listing of long-term option series (“LEAPS”) in 

$1 stock price intervals up to $5 in up to 200 option classes on individual stocks. See Exchange 

Act Release No. 61347 (January 13, 2010). 

• On March 17, 2010, Nasdaq proposed to permit the concurrent listing of $3.50 and $4 strikes for 

option classes participating in the $1 Strike Price Program. See File No. SR-NASDAQ-2010-038. 

C. Execution Quality Statistics for Options 

• The SEC would like to see brokers base routing decisions more on execution quality and less on 

the receipt of payment for order flow. However, because of the complications of multiple series, 

the SEC did not apply its execution quality statistics rule, Rule 605 of Regulation NMS, to listed 

options, although its order routing disclosure rule, Rule 606, does apply to listed options. 

• In July 2008, SIFMA issued recommendations for improving the quality of execution reports for 

options exchanges. 

• Under the SIFMA proposal, data would be uniform, making comparison easier. 

• Brokers do not seem convinced that the data will have a major impact on routing. 

• It remains to be seen whether the SEC will engage in rulemaking activity, or if the SEC is satisfied 

with the industry’s efforts. 

D. Maker-Taker Fees for Options 

• The equity market fee structure developed by ECNs of paying liquidity providers if their limit order 

is executed, and charging liquidity takers if they execute against displayed liquidity (so called 

“maker/taker fees”), has expanded in the options markets, where maker-taker fees raise similar 

issues as in the equity markets 

• Rule 610(c) of Regulation NMS capped fees for taking liquidity for NMS stocks at $.003 but 

did not cap maker taker fees for options. 


• Options taker fees can be substantially higher than equity taker fees, including fees as high 

as $0.45. 

• Options markets participants have railed against these fees. See 

http://www.tradersmagazine.com/issues/20071004/2933-1.html?pg=1 

• In May 2008, Erik Sirri, Director of the SEC Division of Trading and Markets, in a speech 

expressed sympathy for restraining excessive taker fees, and said they should not exceed a cent 

a contract. He also said that “SEC staff will continue to monitor developments in changes to the 

fee structures, and corresponding changes in behavior, in the options markets, to gauge the 

impact and see if further action is warranted.” Available at 

http://www.sec.gov/news/speech/2008/spch050208ers.htm. 

• In July 2008, Citadel petitioned the SEC to institute a rulemaking proceeding to limit the fees that 

options exchanges may charge non-members to obtain access to quotations to $.20 per contract. 

See http://www.sec.gov/rules/petitions/2008/petn4-562.pdf. 

• In April 2010, the SEC proposed capping access fees on the listed options market. See 

Section III.G below. 

E. Options Fragmentation and Internalization 

• Unlike equities, trades in standardized options can only be executed on an exchange. As a result, 

there is no active OTC trading in standardized options. Recently, several ATSs have developed 

to trade options through matching orders and executing them on an exchange. 

• Unlike futures, standardized options are issued and cleared by a single clearing agency, the 

Options Clearing Corporation, and are fungible across options exchanges. Thus, an options 

position purchased on one exchange can be offset and closed through purchase of the same 

options series on another exchange. 

• Although options had been traded by multiple exchanges before 1977, after its Special 

Study of the Options Markets in 1978 the SEC determined not to permit multiple trading of 

additional options on listed stocks. Instead, new options on listed stocks were allocated to 

an individual exchange pursuant to an Allocation Plan. Subsequently, the SEC allowed 

multiple trading on options on new products, including GNMAs, broad and narrow-based 

stock indices, Treasury securities, foreign currencies, and over-the-counter equities. 

• In May 1989, the SEC reversed its policy and adopted Rule 19c-5, which prohibited options 

exchanges from having rules that limit their ability to list any stock options class because 

that options class is listed on another options exchange. 

• Thus, from January 20, 1990, each exchange was permitted to list any equity option that 

was being listed for the first time, i.e., that had not been previously traded on any exchange. 

Multiple listing of equity options that were already being traded as of January 20, 1990 was 

phased in over a period of time ending in late 1994. Thus, by the end of 1994, each option 

exchange could list any equity option class. 

• The SEC undertook these changes because it determined that competition among 

exchanges for options business would benefit investors by narrowing spreads. 

• Following the adoption of Rule 19c-5, the four options exchanges adopted a joint plan to 

provide procedures for listing new equity options (“Options Plan”), which allowed each 

exchange to pre-announce its intention to list a new equity option class, established a 

twenty-four hour time frame for other exchanges to announce their intention to list the same 

option, and provided waiting periods before any exchange could start trading that option. 


• In practice, however, competition in initial listed options did not develop, and many actively 

traded equity options were traded only on one exchange. No exchange faced ongoing 

competition on their options from another exchange, other than in the initial listing window, 

until the summer of 1999. 

• Multiple trading began in earnest in the summer of 1999 as a result of two significant 

actions: 

• In November 1998, the International Securities Exchange announced its intent to 

register as an options exchange and to engage in multiple trading of the mostactively 

traded options. 

• In January 1999, the Department of Justice and SEC initiated investigations of the 

options exchanges for conspiring to limit multiple trading in options, in violation of 

Rule 19c-5. These actions were settled in September, 2000, with an SEC censure of 

the four options exchanges, and a consent decree of the Justice Department. 

• Beginning in August 1999, the then five options exchanges began trading options listed 

initially on another exchange, and soon almost all actively traded options became multiply 

traded. 

• The remaining actively traded options that are not multiply traded are options on indices subject 

to exclusive or preferential licensing arrangements. Because of licensing restrictions, these 

options are solely listed on one exchange. Some of these options are among the most actively 

traded options. 

• In 2002, the ISE petitioned the SEC to amend Rule 19c-5 to prohibit an options exchange 

from being a party to exclusive or preferential licensing arrangements with respect to index 

option products and options overlying other instruments, including options on securities 

whose value is based on an index. See http://www.sec.gov/rules/petitions/petn4-469.htm. 

The SEC has not taken action on the petition. 

• In September 2005, the SDNY held that two index providers, Standard & Poor’s (“S&P”) 

and Dow Jones, did not have a protectible property interest in options on the SPDRs and 

DIAMONDS exchange traded funds based on their indices. See the McGraw-Hill 

Companies, Inc. v. International Securities Exchange, Inc., and Dow Jones & Co., Inc. v. 

International Securities Exchange, Inc., consolidated as No. 05 Civ. 112 (HB), 2005 U.S. 

Dist. LEXIS 18674 (S.D.N.Y. Sept. 1, 2005). 

• Over the objections of commenters, the SEC originally adopted Rule 19c-5 without conditioning 

multiple trading on the development of an intermarket linkage like the ITS in the equity markets. 

However, as multiple trading developed, the SEC determined that the options exchanges would 

need to create systems to help ensure that customers receive best execution of their orders. 

Thus, the SEC issued an order requiring the exchanges to develop a linkage plan, and the 

exchanges implemented that linkage in 2000. Exchange Act Release No. 42029 (October 19, 

1999). 

• Multiple trading of options resulted in benefits for customers, as well as pressures on exchanges 

to provide opportunities to order entry firms to trade with their orders. Concerns about the 

responses to these internalization pressures grew. In 2004, the SEC published a concept release 

to discuss the issues raised by these internalization pressures, in which it described the 

consequences of multiple trading. Exchange Act Release No. 49175 (February 3, 2004). 

• The SEC said that greater competition among options exchanges for order flow has 

manifested itself in many ways. Exchange transaction fees for customers have all but 

disappeared. Spreads are narrower. Markets have expanded and enhanced the services 


they offer and introduced innovations to improve their competitiveness. At the same time, 

inducements to order flow providers, including payment for order flow and internalization 

opportunities, have increased. 

• In the release, the SEC sought comment on a range of potential responses to the 

internalization issues of options, but took no direct action to address the issues after the 

concept release was published. 

• Pressure on exchanges to accommodate internalization of orders by order entry firms or market 

makers who pay for order flow have continued. Although largely resisted by the SEC, these have 

resulted in a complicated web of rules allowing different degrees of interaction with customer 

orders. 

• On July 1, 2011 the SEC approved a six-month pilot program proposed by BATS Exchange, Inc. 

(“BATS”) that would allow buy and sell orders on options contracts to be directed to certain 

broker-dealers by particular market makers on BATS Options. The pilot program was heavily 

criticized in a letter to the SEC by the other eight options exchanges. On July 19, BATS withdrew 

its market-maker plan, citing the need to address concerns that had been raised about the pilot 

program. 

F. Decentralized Options Linkage Plan 

On July 30 2009, the SEC approved a revised options order protection and locked/crossed market plan 

for the options market. Exchange Act Release No. 60405 (July 30, 2009). Prior to the adoption of the 

revised plan, the options market was operating under the original options market linkage plan, which was 

adopted to minimize trade throughs and to avoid a locked or crossed market. See Exchange Act Release 

No. 43086 (July 28, 2000). The revised plan was adopted in response to growth in the volume of options 

traded and the move towards quoting in pennies. In addition, the revised plan replaces the original 

central linking mechanism with a decentralized structure. The revised plan also permits the use of 

intermarket sweep orders, which were not incorporated into the old plan. The revised plan in many ways 

tracks Regulation NMS. 

1. Trade Throughs 

The revised plan requires each participant to establish, maintain, and enforce written policies and 

procedures as approved by the SEC that are reasonably designed to prevent trade throughs in all options 

series overlying a security or group of securities which class is available for trading on two or more 

exchange that are participants in the plan. Each participant is required to conduct surveillance of its 

market on a regular basis to ascertain the effectiveness of the policies and procedures to prevent trade 

throughs. 

(i) 

The plan provides a number of exceptions for certain transactions from the prohibition against 

trade throughs, and participants are required to establish, maintain and enforce written policies 

and procedures reasonably designed to assure compliance with the terms of the exception to the 

extent any exceptions is relied upon. Exceptions are included for: systems issues, trading 

rotations, crossed markets, intermarket sweep orders, quote flickering, non-firm quotes, complex 

trades, customer stopped orders, stopped orders and price improvement, and benchmark trades. 

These exceptions closely parallel the exceptions to the trade through prohibition in Regulation 

NMS. 

2. Locked and Crossed Markets 

The revised plan requires reach participant to establish, maintain, and enforce written rules that require 

their members reasonably to avoid displaying locking or crossing quotes, and requires participants to 

have written rules that are reasonably designed to assure reconciliation of any lock or cross. 


3. Implementation 

The revised plan was implemented on August 31, 2009. 

G. Options Market Access Fee Cap and Anti-Discrimination Rule 

The SEC recently issued a proposal that would cap exchange access fees for listed options and also 

prohibit exchanges from imposing unfairly discriminatory terms that inhibit access to quotations in listed 

options. This proposal would extend to listed options Rule 610(c) and Rule 610(a) of Regulation NMS, 

which currently apply only to listed stocks. See Exchange Act Release No. 61902 (April 14, 2010). 

• The proposal may yield a number of options market structure benefits, including: 

• limiting the extent to which exchange fees cause actual execution costs for listed options to 

differ from the exchanges’ published quotations; 

• rationalizing the operation of inter-market trade through requirements (because exchange 

access fees are not included in the published quotation, some orders may be routed to 

another market even though, when the other market’s fees are taken into account, the overall 

cost of execution is inferior to that on the market to which the order was sent in the first place); 

• reducing the practical issues with banning flash orders in the options market, as proposed by 

the SEC (the disparity between actual execution cost and best priced quotations that results 

from unlimited exchange access fees, coupled with the complexity and diversity of exchange 

fee schedules, may result in an incentive for options markets to permit their members to use 

flash orders); and 

• preventing an exchange from imposing unreasonably discriminatory fees on nonmembers 

seeking indirect access to the exchange’s published quotations through a member. 

• However, the proposal would diminish the effectiveness of the maker/taker exchange model, in 

which some exchanges attract aggressively priced limit orders by paying rebates for posting 

quotations that are ultimately executed against, and finance those rebates through access fees. 

Ironically, this likely would encourage markets to compete for customer orders through exchangesponsored 

payment for order flow programs, which many have criticized on public policy grounds. 

• In addition, the proposal could have an impact on the economics of offering exclusively licensed 

options or proprietary products that are available on only one exchange, as such products would 

be subject to the access fee cap. 

IV. 

Market Access and Surveillance 

The SEC has issued several proposals that seek to improve market surveillance and to address issues 

with market structure that became evident on May 6, 2010, when the markets suffered a precipitous drop 

that has become known as the flash crash. 

A. The Joint CFTC-SEC Advisory Committee Recommendations Regarding 

Regulatory Responses to the Flash Crash 

On February 18, 2011, the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues 

published its report on the market events of May 6, 2010. It focused on the following issues: (i) volatility; 

(ii) co-location and direct access; and (iii) liquidity enhancement. The report stated that the Committee: 

• supports steps taken by the SEC to adopt circuit breakers, addresses breaking erroneous trades 

and implements rules that effectively eliminate the use of stub quotes; 

Davis Polk & Wardwell LLP 23

• recommends that the SEC implement a “limit up/limit down” process and clarify whether this 

process would apply to securities options and single stock futures exchanges; 

• recommends that pause rules be expanded to cover most actively traded securities; 

• recommends that the CFTC evaluate requiring pre-trade risk safeguards; 

• recommends evaluating whether existing circuit breakers should be modified to, for example, 

reduce initial trading halt time periods or use the S&P 500 Index as the triggering mechanism; 

• supports the SEC’s “naked access” rulemaking; 

• recommends that the CFTC impose strict supervisory requirements on DCMs and FCMs that 

employ or sponsor firms implementing algorithmic order routing strategies, and that both 

Commissions consider directly restricting “disruptive trading activities” with respect to extremely 

large orders or strategies; 

• recommends that the SEC consider changes in maker/taker pricing practices, including building 

in incentives for the Exchanges to provide for “peak load” pricing models; 

• recommends that the SEC consider ways to encourage market makers to regularly provide buy 

and sell quotations that are “reasonably related to the market;” 

• recommends that the SEC and CFTC should explore ways to fairly allocate the costs imposed by 

high levels of order cancellations; 

• recommends that the SEC should conduct further analysis regarding broker-dealers and 

internalized orders, including whether to require that internalized orders only be executed at a 

price materially superior to the best bid or offer and whether to subject firms internalizing orders 

to certain market maker obligations during volatile market periods; 

• recommends that the SEC consider implementing “trade at” requirements that orders be routed to 

the markets with the best displayed price, unless such best price is improved upon by a minimum 

amount and consider offering greater protection to limit orders placed off the current quote or to 

increase disclosure of relative liquidity in each book; 

• recommends that the Commissions consider mandating reporting requirements for measures of 

liquidity and market imbalance for large market venues; and 

• recommends that the SEC should make it a priority to implement a consolidated audit trail for the 

US equity markets. 

B. Large Trader Reporting System 

To increase its ability to monitor high frequency trading and institutional trading, the SEC in July 2011 

adopted a rule to establish a large trader reporting system. The rule will require large traders in NMS 

stocks (any persons who trade two million shares or shares with a fair market value of $20 million in a 

single day, or twenty million shares or shares with a fair market value of $200 million in a single month) to 

register with the SEC and obtain a unique large trader identification number, which they must provide to 

their registered broker-dealers with every order. The SEC will use the large trader identification number 

to collect information about the orders and transactions of large traders across registered broker-dealers, 

analyze their activity and monitor the impact of their trades on the markets. This information will also be 

used for enforcement purposes and to reconstruct trading activity following periods of unusual market 

volatility. The rule became effective on October 3, 2011. Large traders were required to comply on 

December 1, 2011, and registered broker-dealers must comply by April 30, 2012. See Exchange Act 

Release No. 64976 (July 27, 2011). 

• Registered broker-dealers will be required to keep records of large traders’ transactions, be able 

to report this information to the SEC by the morning after the transactions were effective (unless 


in unusual circumstances where the SEC requests a same-day submission) and monitor for 

compliance by putative large traders with the registration requirements. 

• The information submitted to the SEC by large traders will be kept confidential and will not subject 

to public reporting. 

• The rule will impose a burden on persons that engage in significant trading in NMS stocks to 

develop and maintain centralized information concerning affiliate and broker-dealer relationships. 

While the proposal contains provisions that would permit a parent company to assume 

compliance obligations for controlled affiliates, and vice-versa, the registration requirements 

would nonetheless present particular challenges for financial conglomerates that do not currently 

obtain or manage this information centrally and for companies that do not exert sufficient practical 

control over affiliates to permit adequate compliance oversight. Because the trigger level for 

registration is relatively low and has few exceptions, many entities could cross the threshold level 

unexpectedly (such as by acquiring a block of NMS stocks with a value of $20 million in a single 

corporate transaction) and then be subject to registration and updating requirements for at least a 

year. 

• The broad jurisdictional reach of the registration requirements means that many non-U.S. 

investors and investment managers will likely be subject to the registration requirements merely 

because their trades are effected indirectly through or their accounts are carried at U.S. brokerdealers. 

Because registered broker-dealers are permitted to effect trades for unidentified large 

traders, there is a risk of noncompliance, particularly among traders who use non-registered 

broker-dealer intermediaries to effect their transactions. 

C. Consolidated Audit Trail 

Trading activity in NMS stocks is currently tracked through a number of uncoordinated systems, including 

FINRA’s Order Audit Trail System, the NYSE’s Order Tracking System and the multi-SRO Consolidated 

Options Audit Trail System. No single system tracks orders routed through multiple SROs or all activity in 

a particular NMS stock across all SROs. As a result, FINRA is preparing to merge OATS and OTS. And 

the SEC in May 2010 proposed a rule that would require FINRA and the SROs to adopt a plan for the 

development, implementation and maintenance of a consolidated audit trail (the “CAT”) for the listed 

equities and options markets. The SEC’s proposal would set in motion a vast, multi-year project that 

would culminate in the creation of a comprehensive, real time data repository for all information 

concerning orders and executions. This repository would permit the SEC and the SROs to query and 

analyze in real time all trading activity in covered securities. See Exchange Act Release No. 62174 (May 

26, 2010). 

• The CAT would ultimately revolutionize securities surveillance and enforcement by eliminating 

many of the delays and much of the imprecision resulting from the disparate, unlinked and in 

many cases manual processes that currently exist. 

• However, the SEC’s proposal would place on the SROs a very significant cost and burden of 

developing and operating the industry utility that would be the core of the CAT, retooling current 

surveillance methodologies and enforcing compliance by member broker-dealers. Broker-dealers 

also would have to shoulder considerable costs of compliance. Broker-dealers also may be 

charged substantial order entry fees to fund the CAT. 

• The vast breadth of the information to be collected by the CAT would raise significant issues of 

customer privacy, the potential for leakage of sensitive information regarding trading activity and 

concerns that such information could be used for commercial or other non-regulatory purposes. 

Also, the extensive collection of customer information might cause publicity-shy traders to shun 

U.S. markets or to devise indirect trading arrangements to avoid disclosing their identities. 


D. FINRA Blueprint for a Consolidated Audit Trail 

FINRA filed a comment letter in connection with the proposed CAT rule attaching a draft blueprint 

describing FINRA’s proposal to build a CAT by leveraging existing data sources and systems. The 

proposal would leverage its OATS System, and other existing systems and infrastructure, to create a CAT 

that meets the primary objectives of the SEC proposal. See Letter from Richard Ketchum, Chairman and 

CEO of FINRA, to Carlo Florio and Robert Cook dated April 6, 2011. 

E. Clearly Erroneous Trades 

Also in response to the flash crash of May 6, 2010, the SEC, the exchanges and FINRA proposed on 

June 21, 2010 to tighten the rules for nullifying trades as clearly erroneous. The flash crash prompted 

this proposal because on May 6, the exchanges broke trades in a process that was criticized as not 

transparent. See SEC Press Release 2010-104 (June 17, 2010). The proposed rules specify a series of 

thresholds for breaking trades that would allow market participants greater certainty as to which trades 

will be broken. As approved, the rules were to be in effect on a pilot basis through December 10, 2010. 

See Exchange Act Release No. 62333 (June 21, 2010). The effective date of the pilot program has been 

extended to January 31, 2012. See Exchange Act Release No. 65075 (August 9, 2011). See also 

Exchange Act Release 65101 No. (August 11, 2011) (modifying the terms of the pilot). 

• The rules specify that for stocks subject to single-stock circuit breakers, exchanges will nullify as 

clearly erroneous the following trades: 

• For stocks priced $25 or less, trades at prices at least 10 percent away from the circuit 

breaker trigger price. 

• For stocks priced more than $25 to $50, trades at prices at least 5 percent away from the 

circuit breaker trigger price. 

• For stocks priced more than $50, trades at prices at least 3 percent away from the circuit 

breaker trigger price. 

• Where circuit breakers are not yet applicable, the rules specify that for events involving multiple 

stocks whose executions occurred within a period of five minutes or less, exchanges will break 

the following trades: 

• For events involving between five and twenty stocks, trades at prices at least 10 percent 

away from the reference price (typically the last sale before pricing was disrupted). 

• For events involving twenty or more stocks, trades at prices at least 30 percent away from 

the reference price (which may be different from last sale). 

F. Enhanced Quotation Requirements for Market Makers 

On November 5, 2010, the SEC approved rule changes for FINRA and most of the exchanges regarding 

enhanced quotation requirements for market makers. The proposed rules would require market makers 

to maintain two-sided quotes within a certain percentage of the NBBO. For securities subject to the 

individual stock circuit breaker pilot, quotes must be no more than two percentage points away from the 

circuit breaker trigger, i.e., 8%. Once a compliant quote is entered, it may rest without adjustment until 

such time as it moves within 1/2 of 1% of the applicable circuit breaker, i.e., 9.5%, at which point the 

market maker must immediately move its quote back to at least the permissible 8% level. During times in 

which a trigger pause is not applicable (i.e., before 9:45 a.m. and after 3:35 p.m.), a trigger percentage of 

22% will be assumed. Thus, a market maker must maintain a quote no further than 20% away from the 

NBBO and the quote may rest without adjustment until it is more than 21.5% from the NBBO. For 

securities not subject to any individual stock circuit breaker, there is an assumed hypothetical 32% circuit 


eaker. If there is no NBBO, the last reported sale price is used as the applicable reference price. See 

Exchange Act Release No. 63255 (November 5, 2010). 

V. Institutional Best Execution 

Pursuant to common law fiduciary obligations, investment advisers have a duty to provide “best execution” 

to their clients. In satisfying its best execution obligation, an adviser must execute securities transactions 

for clients in such a manner that the clients' total cost or proceeds in each transaction is the most 

favorable under the circumstances. In assessing whether this standard is met, an adviser should consider 

the full range and quality of a broker's services, including, among other things, execution capability, 

commission rate, financial responsibility, responsiveness to the adviser, and the value of any research 

services provided. In other words, the analysis takes into account cost, as well as qualitative factors. 

See Exchange Act Release No. 23170 (April 23, 1986); see also Newton v. Merrill, Lynch, Pierce, Fenner 

& Smith, 135 F.3d 266 (3d Cir. 1998); and SEC Market 2000 Report, Study V, Best Execution (the 

“Market 2000 Report”). 

A. Policies and Procedures 

To satisfy the duty of best execution, investment advisers should implement policies and procedures 

designed to ensure best execution of client orders (as described above). 

B. Periodic Review 

The duty of best execution includes an obligation to periodically review performance in light of market and 

technology changes, and that the review should be comparative, i.e., a review of competing markets to 

ensure that the best markets are being used. See Sec Exchange Act Release No. 23170 (April 23, 1986); 

see also Newton v. Merrill, Lynch, Pierce, Fenner & Smith, 135 F.3d 266 (3d Cir. 1998). 

• In order to conduct the periodic review, a committee of senior personnel could be formed to 

undertake the task. The committee could be guided by written guidelines, with objective criteria 

that are applied consistently. 

• Many times third parties are engaged to analyze data and assist in the determination of whether 

best execution is being achieved. 

• It is prudent to document the entire review process, including the factors considered and 

guidelines that were applied. 

C. Client Disclosures 

Investment advisers should also review client disclosure to be certain that its policies and execution 

practices are consistent with Form ADV disclosures. Policies and procedures should be described 

accurately, and any potential conflicts should be fully disclosed. 

D. Soft Dollars and Other Conflicts 

It is important to consider whether other factors that could be conflicts are influencing execution decisions. 

These areas include soft dollars and client-directed brokerage issues. 

1. Soft Dollars 

Section 28(e) of the Exchange Act provides a safe harbor against fiduciary duty claims for advisers that 

use commissions paid for customer orders to obtain brokerage and research services. Specifically, 

Section 28(e) provides a person who exercises investment discretion over client accounts from claims of 


each of fiduciary duty if that person causes client accounts to pay more than the lowest available 

commission rate, provided that the adviser determines in good faith that the commission charges are 

reasonable in relation to the brokerage and research services. There is a conflict between choosing a 

broker for its execution services and its provision of soft dollars. Therefore, this potential conflict should 

be considered and disclosed. See the Market 2000 Report. 

2. Client–Directed Brokerage 

Client-directed brokerage refers to the practice of a client directing commissions to a specified broker. 

The potential for a conflict arises because some advisers may feel pressure to use a broker to which 

significant commissions are otherwise directed, even if that broker is not best suited to handle a particular 

trade. Apparently clients may give brokers routine instructions to use the broker as consistent with best 

execution. See the Market 2000 Report. 

■ ■ ■ 

If you have any questions regarding the matters covered in this publication, please contact any of the 

lawyers listed below or your regular Davis Polk contact. 

Gerard Citera 212 450 4881 gerard.citera@davispolk.com 

Robert L.D. Colby 202 962 7121 robert.colby@davispolk.com 


Annex A 

Glossary of Selected Market Structure Terms 

ATS refers to an “alternative trading system” that acts as a venue for trading securities and is subject to 

regulation under Regulation NMS. Alternative trading systems are typically electronic trading systems 

involving multiple parties (although manual interdealer broker systems are also ATSs). ATSs are required 

to register with the SEC as broker-dealers and as an alternative trading systems, and are subject to 

requirements for quoting, fair access, systems reliability and information confidentiality at differing 

thresholds of market share. They also cannot call themselves exchanges. 

Co-location refers to the practice of exchanges, ATSs or third parties providing space for the servers of 

market participants in the same data center housing the matching engines of the trading center. Colocation 

is favored by high frequency traders because it affords lower latency in the transmission of the 

order from the trader to the market center. 

Dark Pools refers narrowly to ATSs that do not display bids and offers in the public quotation stream. 

More broadly, Dark Pools refers to sources of liquidity not reflected in public quotes, such as dark orders 

on exchanges and internalization of orders by a broker-dealer. 

Decimalization refers to the transition from quoting stock prices in 1/16ths or 1/8ths of a dollar to quoting 

in pennies, or decimals. The transition to decimal pricing occurred in 2000. 

Direct Market Access refers to the practice of a broker-dealer providing its client with the ability to route 

orders directly to a market using the broker-dealer’s market participant identifier, or MPID. Direct Market 

Access sometimes refers only to orders that are routed through a broker-dealer’s systems for credit and 

regulatory checks before routing on the market; in this context, orders that are not routed through the 

broker-dealer’s systems are referred to as sponsored access or naked access. 

ECN refers to an “electronic communications network,” which is an ATS used in part by market makers 

that displays orders within its system. ECNs do not include dark crossing systems or over-the-counter 

market makers’ trading as principal with customers. 

Exchange refers to a national securities exchange registered with the SEC. Examples include the New 

York Stock Exchange and Nasdaq. Exchanges are subject to greater regulatory oversight than ATSs. 

Flash Orders refers to a practice whereby a trading center will for a few milliseconds show to subscribers 

customer buy orders priced at the national best offer, or customer sell orders priced at the national best 

bid. Subscribers with fast electronic connections can then execute the orders at the flash price. If the 

order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed 

to other exchanges. Flash orders are only tangentially related to high frequency trading. 

High Frequency Trading refers to automated trading by complex algorithms that enter and often cancel 

orders frequently, often thousands of times a minute. Many firms that engage in high frequency trading 

seek to end the day with little or no exposure to the market. Various strategies are used, including 

statistical arbitrage, market making and event-based strategies. In general, the term is vague and 

probably has different meanings to different people. 

Indication of Interest refers to an order that requires further agreement before it can be executed. There 

is significant debate as to the point at which an Indication of Interest, or IOI, should be treated as 

“actionable,” i.e., as a firm order, thereby requiring a facts and circumstances analysis in many cases. 

Limit Order refers to an order to execute a transaction at a specified price. Marketable limit orders are 

buy limit orders at or above the national best offer to sell, and sell limit orders at or below the national 

Davis Polk & Wardwell LLP A-1

est bid to buy. Non-marketable limit orders are buy limit orders below the national best offer, and sell 

limit orders above the national best bid. 

Locked and Crossed Market refers to a national best bid to buy that is at the same price as the national 

best offer to sell (Locked Market) or at a higher price than the national best offer to sell (Crossed Market). 

Exchanges are required by Regulation NMS to have rules to deter and correct locked and crossed 

markets. Locked and crossed markets occur when a quote is temporarily inaccessible, or when the 

quotes have access fees that discourage hitting the quote. 

Naked Access refers to direct market access where the non-broker-dealer connects directly to the 

market without first having its orders pass through the broker-dealer’s system, including its risk 

management controls. 

Naked Short Sale refers to a short sale where the seller does not borrow or otherwise have available to 

deliver the shares that are sold short. 

Sponsored Access usually is synonymous with Naked Access. 

Spread refers to the difference in price between the national best bid to buy and the national best offer to 

sell. 

Trade-through refers to transacting an order on one market center when a more advantageous price is 

available at another market center, i.e., “trading-through” the order. The order protection rule of 

Regulation NMS requires a trading center to establish, maintain, and enforce written policies and 

procedures that are reasonably designed to prevent trade-throughs, subject to numerous exceptions. 

Rule 611(a)(1). 

Upstairs Market refers to the market for trades executed internally by a broker-dealer or over-the-counter 

with another broker-dealer rather than on an exchange. Dark Pools have been analogized to the 

“upstairs market” for block trading that was prominent in the era of stock exchange dominance. 

Davis Polk & Wardwell LLP A-2

Key Technology Priorities for Broker-Dealers 


9:00 a.m. – 10:15 a.m.

Key Technology Priorities for Broker-Dealers 


9:00 a.m. – 10:15 a.m. 

Moderator: 

Panelists: 

Steven Joachim 


FINRA Transparency Services 

Anna Ewing 

Executive Vice President and Chief Information Officer 

NASDAQ OMX Group, Inc. 

Paul “Buzz” Moschetti 

Global Head of Architecture for Investment Bank Division 

JPMorganChase 

Michael Roca 


Jeffries & Company, Inc. 

Robert Thielmann 

Senior Vice President, Chief Information Officer 

Janney Montgomery Scott 

Speaker Biographies: 

Anna Ewing is Executive Vice President and Chief Information Officer of The NASDAQ OMX Group 

Inc. (NASDAQ: NDAQ), operator of the world’s largest exchange. At $12.7 trillion, NASDAQ’s main 

U.S. exchange was the largest single pool of liquidity in the world in 2011 based on value traded. Ms. 

Ewing has more than 25 years experience in delivering client-focused technology in the financial 

services industry. In her role at NASDAQ OMX, she is responsible for Global Technology Services 

and the Market Technology business unit, which provides commercial technology solutions to more 

than 70 exchanges and markets around the world. Integral to Ms. Ewing’s role is overseeing the 

exchange’s technology roadmap. Since assuming her position, Ms. Ewing has been the technology 

architect for NASDAQ OMX’s transformation from a single U.S. cash equities market to an exchange 

company with 24 markets around the globe, covering all major asset classes. In addition to the OMX 

merger, Ms. Ewing and her team have re-platformed company acquisitions including BX, formerly the 

Boston Exchange and NASDAQ OMX PHLX, and have successfully rolled out the INET trading 

system in all NASDAQ OMX equity markets across the world. Most recently, Ms. Ewing oversaw the 

acquisition of SMARTS, the world’s leading provider of market surveillance technology for exchange, 

regulator and broker markets worldwide. As a widely recognized expert, technology innovator and 

driver of company and industry growth, she participates and is frequently featured as a speaker at a 

variety of events globally. Prior to joining NASDAQ, Ms. Ewing was with CIBC World Markets in New 

York and Toronto, where she served as a managing director of Global Applications Services and as a 

founding member of CIBC.com. Before that, Ms. Ewing served as a vice president at Merrill Lynch, 

where she held various leadership positions within technology. She is a graduate of Schulich School 


of Business at York University in Toronto. Ms. Ewing holds a master’s of business administration from 

York University in Toronto, where she majored in management information systems. 

Steven A. Joachim is the Executive Vice President of Transparency Services at FINRA, formerly 

NASD. His responsibilities include TRACE, the FINRA facility for reporting and disseminating 

corporate bond, agency debenture and securitized product transactions; the Alternative Display 

Facility, FINRA’s listed equity quote and trade reporting vehicle; the Trade Reporting Facilities, 

FINRA’s joint ventures with Exchanges for printing listed equity trades; and the over-the-counter 

equity transparency facilities, including OTC Bulletin Board. Prior to his arrival at the FINRA, Mr. 

Joachim was a senior vice president, chief operating officer, chief strategy officer and general 

manager for Plural from 1997 to 2001. Plural was a custom interactive software development and 

strategy firm and is now owned by Dell Professional Services. In 1983, he began a nearly 15-year 

stint with Merrill Lynch. During his career at Merrill Lynch, he served as head of Institutional 

Marketing, a first vice president, a business architect for Capital Markets and a chief technology 

officer for Global Equity Markets, a director, Floor Brokerage Services and business manager, Global 

Equity Trading. Throughout his career at Merrill, he managed operations in Asia, Europe and the U.S. 

From 1981 to 1983, Mr. Joachim worked for Bankers Trust Company as a vice president, area 

consultant for Lending and Money Transfer Operations. He also served as a managing consultant 

with Cresap McCormick and Paget, Inc. Mr. Joachim has served as the Chairman of the International 

Forum for Investor Education, a member of the Philadelphia Stock Exchange Board of Governors, 

Board of Directors for Merrill Lynch Specialists, Inc. and Board of Directors for Wilco, Inc. He has also 

been a member of the Nasdaq Industry Advisory Committee and the American Stock Exchange 

Upstairs Member Advisory Committee. He was recently asked to join the Advisory Board of the 

Stevens Institute of Technology Financial Systems Center. Mr. Joachim has a master’s degree in 

political science from Duquesne University in Pittsburgh, PA, and a master’s degree with distinction in 

public management and a bachelor’s degree in mathematics from Carnegie Mellon University in 

Pittsburgh, PA. 

Paul “Buzz” Moschetti is the Global Head of Architecture for the Investment Bank division of 

JPMorganChase. His current responsibilities include information and software architecture vision and 

strategy, business applications and process development, and solutions standards and leadership for 

a $2.2 billion budget funding 9000 professionals worldwide for all lines of business including equity 

and debt capital markets, listed and OTC derivatives, commodities, institutional, proprietary, and 

customer trading, settlement and clearance, and research. Prior to his current position, he was a chief 

architecture officer of Bear Stearns with similar responsibilities. Earlier in his career at Bear Stearns, 

he was a director of technology for the Financial Analytics and Structured Transactions Group 

(F.A.S.T.) in the Fixed Income department and led the design and development of that unit’s HYDRA 

and BondStudio portfolio valuation applications suite. His areas of expertise include enterprise data 

design, systems integration and multi-language tiered software leverage. Mr. Moschetti holds a 

bachelor’s degree from the Massachusetts Institute of Technology. 

Michael B. Roca joined Jefferies & Company, Inc., in 2005. He is the Senior Vice President for 

surveillance and technology in the Compliance Department. He is responsible for the Compliance 

Department’s technology needs, including its various surveillance systems. He is also the 

Compliance Officer assigned to the Technology Division of the firm. Prior to joining Jefferies, he was 

with Merrill Lynch for three years as a director of technology compliance in the Office of the General 

Counsel. Prior to Merrill Lynch, he was with Donaldson, Lufkin & Jenrette for 11 years, where he was 

a vice president in the Compliance Department functioning as the global technology director for the 

Legal and Compliance Division. Mr. Roca graduated from Fordham University in the Bronx, NY in 

1990 with a bachelor’s degree in business and information systems. 

Bob Thielmann is Senior Vice President, Chief Information Officer, and member of the Management 

Committee for Janney Montgomery Scott LLC, a regional broker-dealer and full-service financial 

services firm headquartered in Philadelphia with professionals in 103 branch offices primarily located 

along the East Coast. A seasoned financial services executive, Mr. Thielmann has 20 years business 

and technical experience spanning multiple industry channels including securities clearing, 

independent financial advisors, and full-service retail brokerage and capital markets. Mr. Thielmann 

joined Janney in 2008 and manages all technology infrastructure, development and service 

operations. Prior to Janney, Mr. Thielmann was a divisional CIO for the AIG Advisor Group and 

SunAmerica Asset Management Corporation for five years beginning in 2003. AIG Advisor Group is a 


subsidiary of AIG Retirement Services, owning five broker-dealers servicing the second largest 

collective group of independent financial advisors in the United States. Before AIG, Mr. Thielmann 

spent 14 years as a director at Pershing LLC, a subsidiary of the Bank of New York Mellon and the 

largest domestic securities clearing firm, where Bob held various leadership positions spanning from 

eCommerce development to portfolio and trading services. Mr. Thielmann is a member of the FINRA 

Technology Advisory Council (FTAC), Chairperson of the Thomson Reuters Executive Business 

Users Committee (EBUC), and Chairperson for the Securities Industry and Financial Markets 

Association (SIFMA) Technology Management Committee (TMC). He has served on the SIFMA Data 

Management Division Executive Committee and was previously co-chair of the DMD Information 

Technology Committee. Mr. Thielmann holds several industry licenses, including Series 7, 63 and 24. 

Mr. Thielmann holds a bachelor’s degree from the University of Illinois and a master’s of business 

administration from Rutgers University Graduate School of Management. 


Independent Contractor Oversight 


10:30 a.m. – 11:45 a.m.



10:30 a.m. – 11:45 a.m. 


• Examine for deficiencies within your firm’s supervisory system. 

• Identify key steps to be taken during a compliance branch office inspection. 

Moderator: 

Panelists: 

Daniel Sibears 


FINRA Member Regulation, Shared Services 

Mari Buechner 

President and Chief Executive Officer 

Coordinated Capital Securities, Inc. 

Neal Sullivan 

Partner 

Bingham McCutchen, LLP 

Paul Tolley 

Chief Compliance Officer 

Commonwealth Financial Network 

Outline 

Contrast the types of business structures under the independent contractor model 

• Hybrid business model 

• Revenue sharing arrangements 

Potential risks associated with the independent contractor model 

• Outside Business Activities 

• Compliance risks 

• Reputation risks 

FINRA examination findings 

• Supervisory systems violations 

• Deficient branch office inspection programs 

• Red flags missed during branch office inspections 

Strong supervisory practices 

• Focus exams based on the risks specific to that business and location 

• Risk-based approach in determining the frequency and intensity of branch office examinations 

• Inclusion of unannounced branch office examination into the compliance program 

• Procedures designed to avoid conflicts of interest in branch supervision 



Mari J. Buechner is President and Chief Executive Officer of Coordinated Capital Securities, Inc. 

(CCS). With over 20 years of industry experience, Ms. Buechner has comprehensive executive 

management expertise in compliance, finance, marketing, operations, service and technology. In 

2008, Ms. Buechner was elected to serve on the FINRA Board of Governors and is a past member of 

FINRA Small Firm Advisory Board and the FINRA District 8 Committee. Ms. Buechner currently 

serves on the FINRA Independent Dealer/Insurance Affiliate Committee and volunteers her time to 

work on various ad hoc committees and educational programs. She has been recognized as one of 

the “Top 50 Women in Wealth Management” (Wealth Manager, April 2009) and formerly served as 

chairman of the board for the Financial Services Institute. Ms. Buechner graduated from the 

University of Wisconsin-Madison in 1987 with a bachelor’s degree in finance and marketing. 

Daniel M. Sibears is the Executive Vice President of Member Regulation Programs at FINRA. His career 

has focused on securities regulation, supervision, compliance and enforcement, and his legal and 

management background includes private practice, the Michigan Court of Appeals, the U.S. Securities & 

Exchange Commission, NASD and FINRA. Collectively, the three units of FINRA’s Member Regulation 

Department include more than 1,000 staff members in New York City, Washington, D.C., and the 15 

District Offices geographically disbursed throughout major financial centers in the United States. Cycle 

and cause examinations, financial surveillance, examination risk assessment, membership admissions, 

fixed income regulation, statutory disqualifications, staff training, sales practice and financial policy, 

broker-dealer preventive compliance programs, and international regulatory relations are all administered 

through Member Regulation. In addition to Member Regulation, Mr. Sibears serves as a liaison with 

federal and international agencies, as well as with certain FINRA committees, on policy, regulatory and 

strategic matters. Mr. Sibears was centrally involved in the creation of the securities industry continuing 

education program for U.S. broker-dealers, as well as the FINRA Institute at Wharton. Mr. Sibears is the 

former chairman of the Board of Trustees for the National Endowment for Financial Education. At NASD 

(now FINRA), Mr. Sibears also served two years as a vice president of District Oversight, three years as a 

director of Regulatory Policy, and eight years as a director of the Anti-Fraud Department (now the 

Enforcement Department). Mr. Sibears received his undergraduate degree from Oakland University and 

his law degree, cum laude, from Michigan State University College of Law. Mr. Sibears is licensed to 

practice law in the Commonwealth of Massachusetts and the State of Michigan, and is admitted to 

practice before various federal courts. 

Neal Sullivan is Co-chair of Bingham’s Securities Area, a 120-attorney group within the firm. He regularly 

represents clients before the SEC, FINRA and other self-regulatory organizations and state securities 

agencies. In addition, he has extensive experience with private and public investigations and enforcement 

proceedings brought by the SEC, FINRA and its predecessor entities (NASD and NYSE), and state 

agencies. Mr. Sullivan serves as an outside counsel to the Boston Options Exchange as well as the 

Financial Services Institute. He has appeared before the U.S. Congress to provide testimony on SEC 

proposals and proposed federal oversight of the U.S. capital markets. He is the former executive director 

of the North American Securities Administrators Association and a former vice president, regulation, of 

the Boston Stock Exchange. Prior to his tenure at the Boston Stock Exchange, he was a chief of the 

Massachusetts Securities Division. He has authored several published articles on regulation of brokerdealers. 

Mr. Sullivan appears regularly on industry and legal panels that address issues of concern to the 

securities industry. He co-chairs the PLI annual program on Broker-Dealer Regulation (2007 to 2012). 

Paul Tolley has been the Chief Compliance Officer at Commonwealth Financial Network since August 

2006. As CCO of Commonwealth, he is responsible for establishing, administering and enforcing 

Commonwealth’s broker-dealer and investment adviser supervisory and compliance policies and 

procedures. He is also responsible for the general management and leadership of the firm’s Compliance 

and Licensing staff. Mr. Tolley has 20 years of compliance experience and a strong background in brokerdealer 

and investment advisory compliance best practices. Prior to joining Commonwealth, he was a first 

vice president and chief compliance officer for National Planning Holdings of Santa Monica, California, 

where he oversaw compliance for the four independent broker-dealers within the NPH broker-dealer 

network. He has also served in senior compliance positions at Cambridge Investment Research and LPL 

Financial Services. Mr. Tolley holds FINRA Series 4, 7, 24, 53, 63 and 65 securities licenses. He is a 

former member of the Board of Directors of the Financial Services Institute and served as a past chair of 


the FSI Advisory Compliance Council, and he is a member of the National Society of Compliance 

Professionals. He earned his bachelor’s degree in business administration from Northeastern University 

in Boston. 


National Examination Risk Alert 

By the Office of Compliance Inspections and Examinations 

In this Alert: 

Topic: Broker-dealer 

branch inspections 

Objectives: Encourage 

firms to create effective 

policies and procedures for 

their branch inspections. 

Key Takeaways: 

A broker-dealer’s branch 

inspection program is a key 

part of its supervisory 

system. 

Exam staff have found a 

number of deficiencies in 

branch inspections 

conducted by firms. 

This Risk Alert presents a 

joint report by OCIE staff 

and FINRA staff, 

highlighting a number of 

practices that examiners 

have observed that are 

found in effective branch 

office supervisory systems. 

in cooperation with the Financial Industry Regulatory Authority 1 

Information for Managers and Chief Compliance Officers 

Volume I, Issue 2 November 30, 2011 

Broker-Dealer Branch Inspections 

The branch inspection process is a critical component of a 

comprehensive risk management program and can help protect 

investors and the interests of the firm. OCIE and FINRA examination 

staff have observed that firms that execute this process well typically: 

tailor the focus of branch exams to the business conducted in 

that branch and assess the risks specific to that business; 

schedule the frequency and intensity of exams based on 

underlying risk, rather than on an arbitrary cycle, but examine branch 

offices at least annually; 

engage in a significant percentage of unannounced exams, 

selected through a combination of risk based analysis and random 

selection; 

deploy sufficiently senior branch office examiners who 

understand the business and have the gravitas to challenge 

assumptions; and 

design procedures to avoid conflicts of interest by examiners 

that may serve to undermine complete and effective inspection. 

1 

The Securities and Exchange Commission (“SEC”), as a matter of policy, disclaims responsibility for any 

private publication or statement by any of its employees. The views expressed herein are those of the staff 

of the Office of Compliance Inspections and Examinations (“OCIE”) in coordination with other SEC staff, 

including in the Division of Trading and Markets, and do not necessarily reflect the views of the 

Commission or the other staff members of the SEC. This document was prepared by OCIE staff in 

consultation with the staff of the Financial Industry Regulatory Authority (“FINRA”) and is not legal 

advice. 

1

Conversely, firms with significant deficiencies in the integrity of their overall branch inspection 

process, typically: 

 

 

 

 

 

 

 

utilize generic examination procedures for all branch offices, regardless of business mix 

and underlying risk; 

try to leverage novice or unseasoned branch office examiners who do not have significant 

depth of experience or understanding of the business to challenge assumptions; 

perform the inspection in a “check the box” fashion without questioning critically the 

integrity of underlying control environments and their effect on risk exposure; 

devote minimal time to each exam and little, if any, resources to reviewing the 

effectiveness of the branch office exam program; 

fail to follow the firm’s own policies and procedures by not inspecting branch offices as 

required, announcing exams that were supposed to be unannounced, or failing to generate 

a written inspection report that included the testing and verification of the firm’s policies 

and procedures, including supervisory policies and procedures; 

fail to have adequate policies and procedures, particularly in firms that use an 

independent contractor model and that allow registered personnel to also conduct 

business away from the firm; and 

lack heightened supervision of individuals with disciplinary histories or individuals 

previously associated with a firm with a disciplinary history. 

A well-designed branch inspection program is both: (1) a necessary element (but not the only 

element) of a firm’s compliance and reasonable supervision of its branch offices and branch 

office personnel under Section 15(b)(4)(E) of the Securities Exchange Act as well as FINRA 

rules; and (2) an integral component of the firm’s risk management program. The branch 

inspection provides the firm with the opportunity to validate its surveillance results from branch 

offices and to gather on-site intelligence that supplements the ongoing management and 

surveillance of the branch from a business and risk management standpoint. 

Risk-Based Inspections 

An effective risk assessment process will help drive the frequency, intensity and focus of branch 

office inspections; it should also serve as an important consideration in the decision to conduct 

the exam on an announced or unannounced basis. Therefore, branch offices should be 

continuously monitored with respect to changes in the overall business, products, people and 

practices. Branch inspections should be conducted by persons that have sufficient knowledge 

and experience to evaluate the activities of the branch, and should be overseen by senior 

personnel such as the CCO or other knowledgeable principal. Further, procedures should be 

designed to avoid conflicts of interest that may serve to undermine complete and effective 

inspections because of the economic, commercial or financial interests that an examiner holds in 

the associated person or branch being inspected. 

Branch office inspections provide an opportunity for oversight that should enhance the firm’s 

routine surveillance and supervisory activities. For instance, branch office inspections may allow 

a firm to better identify the nature and extent of outside business activities of registered branch 

office personnel. Outside business activities conducted by registered persons may carry added 

risk because these activities may be perceived by customers as part of the member’s business. 

2

Confirming that the scope of outside business activities of registered branch office personnel 

conform to those activities authorized by the firm is an important component of the branch office 

inspection, and addresses a risk that may be more difficult to monitor. For much the same 

reasons, unannounced inspections (which do not provide an opportunity to hide, alter or destroy 

documentation or other information reflecting such activities) are a critical element of any well 

designed branch office inspection program and should constitute a significant percentage of all 

exams conducted. 

This ongoing risk analysis should be a key element of the firm’s exam planning process and lead 

to more frequent examinations of offices posing higher levels of risk than dictated by the firm’s 

non-risk based cycle, and lead firms to engage in more unannounced exams of such offices. 

Some areas of high risk to consider are: sales of structured products; sales of complex products, 

including variable annuities; sales of private or otherwise unregistered offerings of any type; or 

offices that associate with individuals with a disciplinary history or that previously worked at a 

firm with a disciplinary history. NASD IM-3010-1 also lists additional factors to consider in 

making this determination. 

Pursuant to NASD Rule 3010(c)(2), each branch office inspection must include a written report 

that includes, at a minimum, testing and verification of the firm’s policies and procedures in 

specified areas. As discussed further below, it is a good practice for this report to note any 

deficiencies and areas of improvement, as well as outline agreed-upon actions, including 

timelines, to correct the identified deficiencies. 

Oversight of Branch Office Inspections 

A broker-dealer’s internal branch inspection program is a necessary part of its supervisory 

system and a strong indicator of a firm’s culture of compliance. To test the quality of brokerdealers’ 

required inspections of branch offices, SEC and FINRA examiners may seek to review 

and verify items related to an effective branch examination program, particularly matters such as 

supervisory procedures regarding customer accounts and sales of retail products. For example, 

examiners may review the following: 

 

 

 

 

 

policies and procedures, including supervisory procedures as they pertain to the 

supervision of customer accounts, including those serviced by income producing 

managers; 

policies and procedures relating to the handling of money and securities physically 

received at the branch; 

validation of changes in customer addresses and other account information in accounts 

serviced by the branch; 

procedures related to transmittals of funds between customers and third parties, and 

between customers and registered representatives (“RRs”); 

firm testing of policies and procedures related to specific retail products, including: 

o sales of structured products; 

o private and other unregistered offerings; 

o municipal securities; 

o mutual funds; and 

o variable annuity sales and exchanges; 

3

firm testing in retail sales practice areas, including: 

o verification of customer account information; 

o supervision of customer accounts; 

o written supervisory procedures (“WSPs”); 

o new account review, suitability of investments; 

o unauthorized trading; 

o churning; 

o allocations of new issues; 

o licensing; and 

o training; 

advertising and other communications with the public or with customers (such as email 

and other written correspondence) and compliance with approval procedures; 

evidence of unreported outside or other unauthorized business activities by review of: 

customer files, written materials on the premises and at any satellite locations, branch 

office accounting records, appointment books and calendars, phone records, bank 

records; 

procedures for handling of customer complaints; 

risk-based reviews of bank accounts of the branch and affiliated entities, third-party wire 

transfers, and branch signature guarantee log; and 

procedures to uncover use of unauthorized computers or other electronic devices and/or 

social media. 

Requirements and Guidance Pertaining to Broker-Dealer Branch Inspections 

The responsibility of broker-dealers to supervise their associated persons is a critical component 

of the federal regulatory scheme. Sections 15(b)(4)(E) and 15(b)(6)(A) of the Exchange Act 

authorize the Commission to impose sanctions on a firm or any person that fails to reasonably 

supervise someone that is subject to the supervision of such firm or person who violates the 

federal securities laws. In order to defend such a charge, a broker-dealer could show that it has 

established procedures that would reasonably be expected to prevent and detect a violation by 

such other person, and has a system for applying such procedures that has been effectively 

implemented. Such a system must be designed in such a way that it could reasonably be expected 

to prevent and detect, insofar as practicable, securities law violations. 

The staff of the SEC’s Division of Trading and Markets (formerly known as the Division of 

Market Regulation) has noted that an effective branch office inspection program is a vital 

component of a supervisory system reasonably designed to oversee activities at remote branch 

offices. 2 A number of Commission decisions in the area, both settled and litigated, set forth 

principles that can guide firms in constructing an effective branch office inspection program. 3 

2 

3 

Staff Legal Bulletin No. 17, Remote Office Supervision (March 19, 2004) (“SLB 17”). 

See, e.g., Consolidated Investment Services, Inc., Rel. No. 34-36687(Jan. 5, 1996) (where the Commission 

notes that: “We also agree with the law judge that surprise inspections of [the branch office] would have 

been a prudent course of action”); Signal Securities, Inc.,, Rel. No. 34-43350 (Sep. 26, 2000) (citing 

Consolidated Investment Services); and Quest Capital Strategies, Rel. No. 34-44935 (Oct. 15, 2001) 

()(where the Commission stated that : “A surprise inspection is a compliance tool that is necessarily 

available to every securities firm in carrying out its supervisory responsibilities.”); Royal Alliance 

Associates, Inc., Rel. No. 34-38174 (Jan. 15, 1997) (settled matter); see also SLB 17. 

4

Those cases suggest that regular branch office inspections over reasonably short intervals, 

including unannounced inspections, are the cornerstone of a well designed branch office 

inspection program. 4 The Commission has sanctioned firms that have not conducted 

unannounced examinations of their branch offices. 5 Where a firm only conducts pre-announced 

examinations, that could create opportunities for branch office personnel to alter or destroy, 

documents, or commit other securities law violations, resulting in major fines for the firm. 6 As a 

result, OCIE and FINRA staff believe that a well-constructed branch office inspection program 

should include unannounced inspections, based on a combination of random selection, risk-based 

selection and for cause exams. 

Beyond the timing and nature of the inspections, OCIE and FINRA staff also believe that past 

guidance suggests that a well-constructed branch office supervisory program should include: 

procedures for heightened supervision of remote branch offices that have associated persons with 

disciplinary histories; independent verification of the nature and extent of outside business 

activities; senior management’s involvement in assuring that adequate procedures are in place 

and that sufficient resources are devoted to implementing those procedures; periodic 

reassessment of supervisory responsibilities; adequate delineation of supervisory responsibilities; 

periodic reassessment of supervisory responsibilities; thorough investigation and documentation 

7 

of customer complaints; and a system of follow up and review of those and other red flags. 

FINRA rules and rule interpretations provide additional requirements and guidance in the area. 

NASD Rule 3010(b) requires every member broker-dealer to establish, maintain and enforce 

written procedures to supervise the types of business in which it engages and to supervise the 

activities of RRs, registered principals, and other associated persons that are reasonably designed 

to achieve compliance with applicable securities laws and regulations, and with the applicable 

FINRA rules. 

Notice to Members 99-45 instructs broker-dealers to adopt and implement a supervisory system 

that is “tailored specifically to the member’s business and must address the activities of all its 

registered representatives and associated persons.” 8 Procedures that merely recite the applicable 

rules or fail to describe the steps the firm will take to determine compliance with applicable 

securities laws and regulations are not reasonable. 9 A broker-dealer’s procedures should instruct 

the supervisor on the requirements needed to be in compliance with the regulations. 10 The 

4 

5 

6 

7 

8 

9 

10 

See, e.g., Consolidated Investment Services, Inc., Rel. No. 34-36687(Jan.5, 1996); Signal Securities, Inc., 

Rel. No. 34-43350 (Sep. 26, 2000); Quest Capital Strategies, Rel. No. 34-44935 (Oct. 15, 2001). 

See, e.g., Quest Capital Strategies, Inc., Rel. No. 34-44935 (Oct. 15, 2001) and NYLIFE Securities Inc., 

Rel. No. 34-40459 (September 23, 1998) (settled matter). 

See, e.g., Fidelity Brokerage Services, LLC, Rel. No. 34-50138 (Aug. 3, 2004) (pre-announced inspections 

resulted in, among other things, employees altering and destroying documents; sanctions included a 

$1,000,000 fine payable to the SEC, plus a $1,000,000 fine payable to the NYSE) (settled matter). 

See, e.g., Prospera Financial Services, Admin. Pro. File No. 3-10306, Rel. No. 34-43352 (September 26, 

2000) (settled matter) for a discussion of the above elements of a branch office supervisory program; see 

also SLB 17 for further discussion of these and other elements of an effective branch office supervisory 

system. See also NASD IM-3010-1 (Standards for Reasonable Review). 

NASD Notice to Members 99-45 (June 1999) at 294. 

Id. at 295. See also NASD Notice to Members 98-96 (Dec. 1998). 

NASD Notice to Members 99-45 (June 1999) at 293-94 (giving examples of situations in which “written 

supervisory procedures would instruct the supervisor” in how to document compliance). 

5

procedures should describe the activities the supervisor will conduct along with the frequency as 

to when the reviews will be conducted. 11 

NASD Rule 3010(c)(1) requires each member to conduct a review, at least annually, of the 

businesses in which it engages. A broker-dealer must conduct on-site inspections of each of its 

office locations; Office of Supervisory Jurisdictions (“OSJs”) 12 and non-OSJ branches that 

supervise non-branch locations at least annually, all non-supervising branch offices at least every 

three years; and non-branch offices periodically. For these other branch offices, firms should 

consider whether a cycle of less than three years would be more appropriate, using factors such 

as the nature and complexity of the branch’s securities business, the volume of business done, 

and the number of associated persons assigned to each branch. 13 Pursuant to NASD Rule 

3010(c)(1), broker-dealers must document the examination schedules for each non-supervisory 

branch and non-branch office in their WSPs, including a description of the factors used to 

determine the examination cycle for such locations. The rule also requires broker-dealers to 

record the dates each inspection was conducted. 14 

Pursuant to NASD Rule 3010(c)(2) the reports reflecting these reviews and inspections must be 

kept on file by the broker-dealer for a minimum of three years. NASD Rule 3010(c)(3) generally 

prohibits a branch office manager or any other person within the office with supervisory duties 

(or any person supervised by such person) from conducting an inspection of the office. 15 

11 

12 

13 

14 

Id. 

An OSJ is defined under NASD Rule 3010(g) as any office of a member at which any one or more of the 

following functions take place: (a) order execution and/or market making; (b) structuring of public 

offerings or private placements; (c) maintaining custody of customers' funds and/or securities; (d) final 

acceptance (approval) of new accounts; (e) review and endorsement of customer orders; (f) final approval 

of advertising or sales literature, except for an office that solely conducts final approval of research reports; 

or, (g) responsibility for supervising the activities of associated persons at one or more other branch offices. 

NASD Rule 3010(c)(1)(B). 

NASD Rule 3010(c), which governs “Internal Inspections,” requires that each broker-dealer review the 

activities of each of its offices including the periodic examination of customer accounts to detect and 

prevent irregularities or abuses. The rule also requires that the written inspection report include, without 

limitation, the testing and verification of the member's policies and procedures, including supervisory 

policies and procedures in the following areas: 

 

 

 

 

 

 

Safeguarding of customer funds and securities; 

Maintaining books and records; 

Supervision of customer accounts serviced by branch office managers; 

Transmittal of funds between customers and RRs and between customers and third parties; 

Validation of customer address changes; and 

Validation of changes in customer account information. 

15 

However, the rule provides an exception from this requirement for a firm so limited in size and resources 

that it cannot otherwise comply. Under NASD Rule 3010(c)(3) the basis for this exception must be 

documented in the report for each inspection conducted in reliance on the exception. 

6

Review of Effective Practices 

As noted throughout this Risk Alert, SEC and FINRA examiners have identified some practices 

that are characteristic of many effective supervisory procedures and effective branch office 

supervisory systems. 16 Such practices are consolidated here: 

 

 

 

 

 

 

 

 

 

 

Using risk analysis to identify whether individual non-supervising branches should be 

inspected more frequently than the FINRA-required minimum three-year cycle. Branches 

that meet certain risk criteria based on risk ratings are inspected more often. In addition, 

some firms conduct “re-audits” more frequently than required when routine inspections 

reveal a higher than normal number of deficiencies, repeat deficiencies or serious 

deficiencies. Typically, these re-audits and audits for cause are unannounced inspections. 

Using surveillance reports, employing current technology and techniques as appropriate, 

to help identify risk and develop a customized approach for the firm’s compliance 

program and branch office inspections that considers the type of business conducted at 

each branch. 

Employing comprehensive checklists that incorporate previous inspection findings and 

trends from internal reports such as audit reports. 

Conducting unannounced branch inspections. Firms elected to conduct unannounced 

examinations either randomly or based on certain risk factors. These “surprise” exams 

may yield a more realistic picture of a broker-dealer’s supervisory system, as it reduces 

the risk that individual RRs and principals might attempt to falsify, conceal or destroy 

records in anticipation for an internal inspection. 

Including in the written report of each branch inspection any noted deficiencies and areas 

of improvement. The report should also outline agreed upon actions, including timelines, 

to correct the identified deficiencies. 

Using examiners with sufficient experience to understand the business being conducted at 

the particular branch being examined and the gravitas to challenge assumptions. 

Designing procedures to avoid conflicts of interest by examiners that may serve to 

undermine complete and effective inspection. 

Involving qualified senior personnel in several branch office examinations per year. 

Incorporating findings on results of branch office inspections into appropriate 

management information or risk management systems; and using a compliance database 

that enables compliance personnel in various offices to have centralized access to 

comprehensive information about all of the firm’s RRs and their business activities. Such 

a system appears to be highly useful to the compliance personnel at the OSJ and 

elsewhere for quickly accessing information and for supervising independent contractor 

RRs dispersed across a broad geographic area. 

Providing branch office managers with the firm’s internal inspection findings and 

requiring them to take and document corrective action. 

16 

Firms are encouraged to consider the practices described herein in assessing their own procedures and 

implementing improvements that will best protect their clients. Firms are cautioned that these factors and 

suggestions are not exhaustive, and they constitute neither a safe harbor nor a “checklist” for SEC staff 

examiners. Other practices besides those highlighted here may be appropriate as alternatives or 

supplements to these practices. While some of the effective practices above are existing regulatory 

requirements, the adequacy of a supervisory program can be determined only with reference to the profile 

of the specific firm and the specific facts and circumstances. 

7

Tracking corrective action taken by each branch office manager in response to branch 

audit findings. 

Elevating the frequency and/or scope of branch inspections where registered personnel 

are allowed to conduct business activities other than as associated persons of a brokerdealer, 

for example away from the firm. 

Conclusion 

This alert reminds broker-dealers that their branch office inspections must be conducted with 

vigilance. It describes certain supervisory tools that, based on OCIE and FINRA staff 

examinations and Commission enforcement cases, are characteristic of good supervisory 

procedures for branch office inspections, including the use of unannounced onsite inspections. 

While this alert summarizes recognized precedent and standards, and provides OCIE and FINRA 

staff views with regard to means to enhance branch inspections, it does not provide an exhaustive 

list of steps to effectively discharge responsibilities. A well-designed branch office inspection 

program is a necessary element – but not the only element – of reasonable supervision of a firm’s 

branch offices and branch office personnel. 

We recognize that each firm is different and that firms need flexibility to adopt procedures to suit 

their individual structures and business needs. Our suggestions as to compliance methods are not 

meant to be exclusive or exhaustive and do not constitute a safe harbor. Rather, this report may 

assist firms in crafting more effective policies and procedures for branch office inspections to 

prevent and detect misconduct. We urge firms to review their policies and procedures in this 

regard to determine if they are reasonably designed to prevent and detect violations of applicable 

law and rules. 

8

SECURITIES EXCHANGE ACT OF 1934 

Release No. 66212A / January 23, 2012 

INVESTMENT ADVISERS ACT OF 1940 

Release No. 3360A / January 23, 2012 

ADMINISTRATIVE PROCEEDING 

File No. 3-14710 

CORRECTED 

UNITED STATES OF AMERICA 

Before the 

SECURITIES AND EXCHANGE COMMISSION 

In the Matter of 

Respondents. 

1 st DISCOUNT BROKERAGE, 

INC. and MICHAEL R. 

FISHER 

ORDER INSTITUTING ADMINISTRATIVE 

PROCEEDINGS PURSUANT TO SECTION 

15(b) OF THE SECURITIES EXCHANGE 

ACT OF 1934 AND SECTIONS 203(e) AND 

203(f) OF THE INVESTMENT ADVISERS 

ACT OF 1940, MAKING FINDINGS, 

IMPOSING REMEDIAL SANCTIONS AND A 

CENSURE ORDER AS TO 1 st DISCOUNT 

BROKERAGE, INC., AND MAKING 

FINDINGS AND IMPOSING REMEDIAL 

SANCTIONS AS TO MICHAEL R. FISHER 

I. 

The Securities and Exchange Commission (“Commission”) deems it appropriate and in the 

public interest that public administrative proceedings be, and hereby are, instituted pursuant to 

Section 15(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Sections 203(e) and 

203(f) of the Investment Advisers Act of 1940 (“Advisers Act”), against 1 st Discount Brokerage, 

Inc. (“Respondent 1DB” or “1DB”) and Michael R. Fisher (“Respondent Fisher” or “Fisher”) 

(1DB and Fisher being sometimes hereinafter referred to individually as a “Respondent" and 

collectively as the "Respondents”). 

II. 

In anticipation of the institution of these proceedings, each Respondent has submitted an 

Offer of Settlement (the “Offers”) which the Commission has determined to accept. Solely for the 

purpose of these proceedings and any other proceedings brought by or on behalf of the

Commission, or to which the Commission is a party, and without admitting or denying the findings 

herein, except as to the Commission’s jurisdiction over Respondents and the subject matter of 

these proceedings, which are admitted, each Respondent consents to the entry of this Order 

Instituting Administrative Proceedings Pursuant to Section 15(b) of the Securities Exchange Act of 

1934 and Sections 203(e) and 203(f) of the Investment Advisers Act of 1940, Making Findings, 

Imposing Remedial Sanctions and a Censure Order as to 1 st Discount Brokerage, Inc., and Making 

Findings and Imposing Remedial Sanctions as to Michael R. Fisher (the “Order”), as set forth 

below. 

III. 

that: 

On the basis of this Order and each of the Respondents’ Offers, the Commission finds 1 

Summary 

These proceedings arise out of 1DB’s and Fisher’s failure reasonably to supervise Michael 

J. Park (“Park”) with a view to preventing and detecting his violations of Section 17(a) of the 

Securities Act of 1933 (“Securities Act”), and Sections 10(b) and 15(a) of the Exchange Act and 

Rule 10b-5 thereunder. From 2002 to 2008, while Park was a registered representative associated 

with 1DB, he operated a Ponzi scheme which defrauded over 50 investors of nearly $9 million. 

1DB did not have policies and procedures reasonably designed to detect and prevent 

violations of the securities laws by registered representatives like Park. Had 1DB had such 

reasonable policies and procedures, it would have likely uncovered Park’s fraud. Specifically, had 

1DB had reasonable policies and procedures in the review of the “doing business as” business 

accounts of its registered representatives, it is likely that 1DB would have observed a substantial 

influx of money from 1DB’s existing customers into Park’s business account, through which he 

conducted his Ponzi scheme. In addition, 1DB had no policy requiring compliance auditors who 

were conducting audits to review the work papers and reports of previous compliance audits. Had 

1DB had reasonable policies and procedures in this regard, it would have been apparent that Park 

had a history of insufficient or absent signage. As a result, auditors were unable to identify a 

reoccurring issue that, with follow-up, could have uncovered that Park took steps to conceal from 

his customers his association with 1DB for fear that they would alert the firm to his suspicious 

investment scheme. 1DB also failed to conduct unannounced audits in the Nashville office as 

specifically required in the firm’s procedures. Had 1DB implemented a system to follow its own 

procedure of conducting unannounced audits in the Nashville office, it is likely that 1DB would 

1 The findings herein are made pursuant to Respondents’ Offers of Settlement and are not binding 

on any other person or entity in this or any other proceeding. 

2

have found evidence of Park’s Ponzi scheme. For example, an unannounced audit would have 

revealed that Park did not consistently provide signs to indicate to customers his association with 

1DB. 

From 2004 to 2008, Fisher was delegated the responsibility to oversee 1DB’s Heightened 

Supervision Committee (“HSC”). Pursuant to 1DB’s compliance and sales management manuals, 

the HSC is a part of 1DB’s supervisory structure. As the designated head of the HSC, Fisher was 

responsible for having a system to implement the firm’s policies and procedures regarding the 

periodic review of all activities of 1DB’s registered representatives. Had 1DB, through Fisher, 

developed such a system for periodic reviews of the activities of all of 1DB’s registered 

representatives, the HSC would have reviewed Park’s activities and would have found several red 

flags, including inadequate or missing signage that required Park to disclose his association with 

1DB, a customer complaint of unauthorized trading, and declining commissions. With respect to 

the declining commissions, any follow up by the HSC would have reasonably focused on Park’s 

remaining customer accounts and contacting those customers, many of whom were also victims of 

Park’s Ponzi scheme. As a result of Fisher’s failure to implement the firm’s policies and 

procedures regarding the periodic review of all activities of 1DB’s registered representatives, Fisher 

failed reasonably to supervise Park with a view to preventing and detecting his violative conduct. 

Respondents 

1. 1 st Discount Brokerage, Inc. is a Florida corporation head-quartered in West 

Palm Beach, Florida and operates as an introducing broker through over 80 offices and over 200 

independent financial consultants. 1DB has been registered with the Commission as a brokerdealer 

since 1995 and as an investment adviser since 2007. 

2. Michael R. Fisher, age 49, of Helen, Georgia, was during the relevant times, 

the executive-vice president for 1DB. From September 2004 through May 2008, Fisher had 

primary responsibility at 1DB, as defined within the firm’s compliance and sales management 

manual, to oversee 1DB’s HSC. The HSC was a committee created by 1DB to, according to the 

firm’s compliance and sales management manual, “reduce the firm's exposure as a result of 

inappropriate [registered representative] conduct that might otherwise go undetected.” 

Other Relevant Person 

3. Michael J. Park is a former registered representative employed by 1DB from 

August 21, 2002 to June 26, 2008. On October 29, 2008, a judgment was entered by consent in an 

action brought by the Commission against Park permanently enjoining him from future violations 

of Section 17(a) of the Securities Act and Sections 10(b) and 15(a) of the Exchange Act and Rule 

10b-5 thereunder in the United States District Court for the Middle District of Tennessee. On 

December 18, 2008, the Commission barred Park from associating with any broker, dealer, or 

investment adviser. On February 27, 2009, Park pled guilty to wire and mail fraud charges brought 

by the United States Attorney’s Office for the Middle District of Tennessee. In his criminal plea, 

Park admitted to operating a fraudulent scheme from 2001 to 2008 that defrauded 28 investors in 

3

excess of $8.6 million. In September 2010, Park was sentenced to a 96 month term of 

incarceration. The Financial Industry Regulatory Authority, Inc.’s Central Registration Depository 

shows that prior to joining 1DB Park received three customer complaints in connection with his 

employment at a prior Commission registered broker-dealer from July 1995 to June 1998. Two of 

the complaints alleged excessive commissions and margin interest on unsuitable trades. This prior 

broker-dealer terminated Park in connection with a complaint that he had received loans from two 

customers without receiving the firm’s permission. From January 1999 to February 2000, Park 

worked for another Commission registered broker-dealer. This other broker-dealer terminated 

Park for forging a client’s signature on a letter of authorization instructing the firm to charge a 

$3,500 loss to the client. 

Background 

4. From 2001 to 2008, Park operated a Ponzi scheme that defrauded more than 

50 investors, some of whom were 1DB customers, out of almost $9 million. Park operated his 

fraudulent scheme through his securities business, which did business as Park Capital Management 

Group, Inc. (“PCMG”). Park convinced investors to transfer money to him to manage through 

PCMG by representing to them that they would earn substantial returns on their PCMG accounts 

through investments in publicly traded securities and/or in investment pools that Park managed. 

Once the investors transferred funds to PCMG, Park misappropriated the funds to subsidize his 

extravagant life-style which included a $1.7 million house, expensive cars, and private school 

tuition for his children. 

5. From 2002 through 2008, Park was a registered representative of 1DB. The 

firm, however, failed to detect Park’s fraud due, in part, to multiple failures in its supervisory 

system, many of which directly related to Fisher’s individual failure to implement the HSC as 

plainly specified in the firm’s written compliance policies and procedures. 

1DB’s Failure to Have Reasonable Policies and Procedures 

Regarding its Compliance Audits 

Failure to Review “Doing Business As” Accounts 

6. 1DB employs an independent contractor broker model, which requires 

greater supervision than that of a traditional wire house brokerage firm. See, e.g., In the Matter of 

Royal Alliance Assocs., Inc., Exchange Act Rel. No. 38174 (Jan. 15, 1997). Despite the need to 

have stronger supervision, 1DB failed to establish reasonable policies and procedures for its review 

of Park’s operations. 

7. At 1DB, independent contractors, like Park, typically operate their securities 

business through a “doing business as” (“DBA”) name and pay expenses for the business by using 

an account under the DBA’s name (“DBA Account”). Although 1DB’s compliance audit modules 

required review of limited information about a registered representative’s DBA, the procedures 

were not reasonably designed to prevent and detect underlying securities law violations by 

registered representatives like Park. 

4

8. 1DB’s review of Park’s DBA – PCMG – was limited to investigating 

whether 1DB was a party to any leases or contracts entered into by the registered representative. 

9. Had 1DB had reasonable policies and procedures regarding the review of 

Park’s DBA, 1DB’s auditors could have discovered Park’s Ponzi scheme. 

10. Specifically, Park used the DBA Account to accept investments from 

victims and to make payouts. For example, Park described in the DBA Account records a May 

2007 $40,000 deposit by one of his victims as an “Initial Stock purchase.” Park described a 

September 2005 check written to one of the investors as a “Liquidation of Account.” 

11. A review of Park’s DBA Account would have likely uncovered the 

suspicious activity in the account and led to an investigation revealing Park’s Ponzi scheme. 

Failure to Require Compliance Auditors to Review 

Compliance Audit Reports from Previous Years 

12. During the relevant time period, 1DB failed to have reasonable policies or 

procedures requiring compliance auditors to review compliance audit reports from previous years. 

Each year, 1DB compliance auditors conducted announced audits of its registered representatives’ 

operations. The auditor documented the compliance audit by completing an audit report with 

information about the operations, appearance, and possible deficiencies in the registered 

representative’s business. 

13. 1DB’s auditors in subsequent audits could have used the information 

contained within prior audit reports to identify potential red flags. However, 1DB did not provide 

subsequent auditors with the previous audits. As a result, current auditors had no benchmark to 

compare a registered representative’s current activities to his or her past compliance conduct. 

Consequently, the current auditor did not have the requisite information to identify reoccurring, 

potential red flags. 

14. In the immediate matter, 1DB auditors failed to identify a reoccurring red 

flag: Park’s failure to have adequate signage outside of his office that would have provided 

investors notice of Park’s affiliation with 1DB. Compliance auditors audited Park’s office 

annually from 2002 to 2007, inclusive. However, due to 1DB’s failure to provide audits from 

previous years, auditors did not have an opportunity to identify Park’s consistent failure to have 

proper signage, which was a red flag that Park was trying to conceal his affiliation with his broker 

in order to avoid a complaining customer alerting 1DB of his fraudulent conduct. 

15. Specifically, Park failed to have adequate signage for three years in a row. 

In 2004, a 1DB compliance auditor noted that Park’s signage at the front of his office door did not 

state that Park sold securities through 1DB. In 2005, a different auditor noted again a deficiency in 

Park’s signage, namely that it was a temporary sign. In 2006, a third auditor noted that, as with the 

audit in 2004, Park’s sign did not display 1DB’s name. Because the auditors were not provided 

5

with previous audits, they were unable to realize that Park’s failure to have proper signage was not 

inadvertent, but was intended to conceal Park’s association with 1DB so that investors in his Ponzi 

scheme would not contact 1DB regarding Park’s suspicious investment scheme. 

16. Had 1DB’s compliance auditors received and reviewed previous audits of 

Park’s operations, they would have likely discovered the recurring, red flag of Park’s inadequate 

signage. Such discovery would have led 1DB to conduct a future examination of PCMG 

uncovering Park’s Ponzi scheme. 

Failure to Conduct Unannounced Compliance Audits, as Required by the 

Compliance and Sales Management Manual 

17. 1DB could have reasonably discovered Park’s fraud had it conducted 

unannounced audits of Park and PCMG as specifically required in the firm’s compliance and sales 

management manual. 1DB conducted annual audits of its registered representatives. However, the 

firm informed the registered representatives of the audit one month in advance. 

18. 1DB’s failure to have unannounced audits at Park’s office contravened its 

compliance and sales management manual that stated that the firm would conduct “[u]nannounced 

inspections and audits, including reviewing customer accounts and other records, [and] sales 

methods.” 

19. With Park, each year of his affiliation with 1DB he received a “reminder” a 

month in advance of the upcoming audit. Such a reminder afforded Park the opportunity to 

conceal his fraudulent activity. For example, Park put up temporary signage for announced 

compliance audits and then removed them once the compliance audits were completed. 

20. Had 1DB conducted unannounced compliance audits, it would have likely 

noted Park’s failure to have any 1DB signage, which would have led to further examination of 

Park’s activities and detection of his Ponzi scheme. 

Fisher’s Failure in His Delegated Responsibilities 

over 1DB’s Heightened Supervision Committee 

21. In 1997, 1DB created a HSC in response to a 1997 National Association of 

Securities Dealers, Inc.’s (“NASD”) Notice to Members recommending firms create heightened 

supervision procedures. The HSC’s charge, according to 1DB’s compliance and sales 

management manual, is to provide “continued special supervision of registered representatives” 

and “reduce the firm's exposure as a result of inappropriate RR conduct that might otherwise go 

undetected.” 

22. The HSC is a part of 1DB’s supervisory system as evidenced by the fact 

that its duties and responsibilities are set forth in the compliance and sales management manual 

under the section entitled “STANDARDS OF SUPERVISION.” Among other things, the HSC is, 

according to the compliance and sales management manual, to conduct “periodic reviews of 

6

activities of all 1DB [registered representatives], including their [Central Registration Depository] 

disclosures and customer complaint history.” 

Fisher Delegated with Overseeing the Heightened Supervision Committee 

23. 1DB’s compliance and sales management manuals state that the HSC is to 

conduct periodic reviews of the activities of all of 1DB’s registered representatives. From 2004 to 

2008, Fisher, 1DB’s executive-vice president, was delegated the responsibility for having a system 

to implement the firm’s policies and procedures for such periodic reviews. However, Fisher failed 

to implement the firm’s policies and procedures. 

Red Flags of Park’s Conduct the Heightened Supervision Committee Missed 

Because it Failed to Conduct Periodic Reviews of 1DB’s Registered Representatives 

24. Had the HSC conducted such a review of Park, it would have discovered 

several red flags regarding Park’s conduct. First, the HSC would have discovered that Park 

repeatedly violated NASD Rule 2210, requiring communications with the public to not be 

misleading, and the firm’s requirement for clear signage with respect to his office and its affiliation 

with 1DB. To the extent Park had any signage, it was insufficient. 

25. Second, the HSC’s review of Park’s activities likely would have included 

inquiry into his declining commissions. Park’s annual commissions declined from their high in 

2003 of $72,000 to an annualized low in 2008 of $9,500. An inquiry into this dramatic decline 

would have included examining Park’s remaining customer accounts and contacting customers 

who were closing or liquidating their accounts. Contacting these customers would have revealed 

that many of them were closing and/or liquidating their accounts in order to invest with Park’s 

other business, a Ponzi scheme. 

26. Third, the HSC’s review of Park’s activities would have revealed that in 

March 2007 a 1DB customer filed a complaint alleging that Park engaged in unauthorized trading 

in the customer’s account. Because there was no review of Park’s activities, this complaint was 

never investigated by the HSC. If this complaint had been investigated, it is likely that the HSC 

would have contacted other customers regarding Park’s handling of their accounts, which likely 

would have led to the detection of Park’s Ponzi scheme. 

27. As a result of the conduct described above, 1DB failed reasonably to 

supervise Park within the meaning of Section 15(b)(4)(E) of the Exchange Act, and within the 

meaning of Section 203(e) of the Advisers Act, when it failed to supervise Park with a view to 

preventing and detecting his violations of the federal securities laws. 

28. As a result of the conduct described above, Fisher failed reasonably to 

supervise Park within the meaning of Section 15(b)(4)(E) of the Exchange Act, and within the 

meaning of Section 203(f) of the Advisers Act, when he failed to supervise Park with a view to 

preventing and detecting his violations of the federal securities laws. 

7

29. In March 2009, 1DB entered into a voluntary settlement agreement with all 

of Park’s victims, the majority of whom were not customers or clients of 1DB and had no 

contractual or other legal connection with 1DB. Pursuant to the voluntary settlement, 1DB 

contributed $2 million to be distributed among Park’s victims. 

Remedial Efforts 

In determining to accept the Offers, the Commission considered remedial acts promptly 

undertaken by the Respondents and cooperation afforded the Commission staff. 

IV. 

In view of the foregoing, the Commission deems it appropriate and in the public interest to 

impose the sanctions agreed to in each of the Respondent’s Offers. 

Accordingly, pursuant to Section 15(b) of the Exchange Act and Sections 203(e) and 203(f) 

of the Advisers Act, it is hereby ORDERED that: 

A. Respondent 1DB shall pay civil penalties of $40,000 to the Securities and 

Exchange Commission. Payment shall be made in the following installments: four installments of 

$10,000 with the first payment to be made within ten days of the entry of the administrative order, and 

the remaining installment payments made 120, 240 and 360 days after the date of the administrative 

order. If any payment is not made by the date the payment is required by this Order, the entire 

outstanding balance of disgorgement, prejudgment interest, and civil penalties, plus any additional 

interest accrued pursuant to 31 U.S.C. 3717, shall be due and payable immediately, without further 

application. Payments shall be: (A) made by wire transfer, United States postal money order, 

certified check, bank cashier's check or bank money order; (B) made payable to the Securities and 

Exchange Commission; (C) hand-delivered or mailed to the Securities and Exchange Commission, 

Office of Financial Management, 100 F St., NE, Stop 6042, Washington, DC 20549; and (D) 

submitted under cover letter that identifies 1DB as a Respondent in these proceedings, the file 

number of these proceedings, a copy of which cover letter and money order or check shall be sent 

to William P. Hicks, Associate Director, Division of Enforcement, Securities and Exchange 

Commission, 950 East Paces Ferry Road, Suite 900, Atlanta, GA 30326. 

B. Respondent 1DB is censured. 

C. Respondent Fisher be, and hereby is, suspended from association in a supervisory 

capacity with any broker, dealer, or investment adviser with the right to reapply for association in a 

supervisory capacity after nine (9) months to the appropriate self-regulatory organization, or if there is 

none, to the Commission. 

D. Any reapplication for association by Respondent Fisher will be subject to the 

applicable laws and regulations governing the reentry process, and reentry may be conditioned 

upon a number of factors, including, but not limited to, the satisfaction of any or all of the 

following: (a) any disgorgement ordered against the Respondent, whether or not the Commission 

has fully or partially waived payment of such disgorgement; (b) any arbitration award related to the 

8

conduct that served as the basis for the Commission order; (c) any self-regulatory organization 

arbitration award to a customer, whether or not related to the conduct that served as the basis for 

the Commission order; and (d) any restitution order by a self-regulatory organization, whether or 

not related to the conduct that served as the basis for the Commission order. 

E. Respondent Fisher shall pay civil penalties of $10,000 to the Securities and 

Exchange Commission. Such payment shall be made within ten days of the entry of the 

administrative order. If such payment is not made by the date the payment is required by this 

Order, the entire outstanding balance of disgorgement, prejudgment interest, and civil penalties, 

plus any additional interest accrued pursuant to 31 U.S.C. 3717, shall be due and payable 

immediately, without further application. Payment shall be: (A) made by wire transfer, United 

States postal money order, certified check, bank cashier's check or bank money order; (B) made 

payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the 

Securities and Exchange Commission, Office of Financial Management, 100 F St., NE, Stop 6042, 

Washington, DC 20549; and (D) submitted under cover letter that identifies Michael R. Fisher as a 

Respondent in these proceedings, the file number of these proceedings, a copy of which cover 

letter and money order or check shall be sent to William P. Hicks, Associate Director, Division of 

Enforcement, Securities and Exchange Commission, 950 East Paces Ferry Road, Suite 900, 

Atlanta, GA 30326. 

F. Such civil money penalties may be distributed pursuant to Section 308(a) of the 

Sarbanes-Oxley Act of 2002, as amended (“Fair Fund distribution”). Regardless of whether any 

such Fair Fund distribution is made, amounts ordered to be paid as civil money penalties pursuant 

to this Order shall be treated as penalties paid to the government for all purposes, including all tax 

purposes. To preserve the deterrent effect of the civil penalty, Respondents agree that in any 

Related Investor Action, they shall not argue that they are entitled to, nor shall they benefit by, 

offset or reduction of any award of compensatory damages by the amount of any part of 

Respondents’ payments of civil penalties in this action (“Penalty Offset”). If the court in any 

Related Investor Action grants such a Penalty Offset, Respondent agrees that they shall, within 30 

days after entry of a final order granting the Penalty Offset, notify the Commission’s counsel in 

this action and pay the amount of the Penalty Offset to the United States Treasury or to a Fair 

Fund, as the Commission directs. Such a payment shall not be deemed an additional civil penalty 

and shall not be deemed to change the amount of the civil penalty imposed in this proceeding. For 

purposes of this paragraph, a “Related Investor Action” means a private damages action brought 

against Respondent by or on behalf of one or more investors based on substantially the same facts 

as alleged in the Order instituted by the Commission in this proceeding. 

By the Commission. 

Elizabeth M. Murphy 

Secretary 

9



10:30 a.m. – 11:45 a.m. 

Resources 

SEC Resources 

• National Examination Risk Alert, Broker-Dealer Branch Inspections, (Nov. 30, 2011) 

www.sec.gov/about/offices/ocie/riskalert-bdbranchinspections.pdf 

• Staff Legal Bulletin No.17:Remote Office Supervision: 

www.sec.gov/interps/legal/mrslb17.htm 

• In the Matter of 1 st Discount Brokerage, Inc. and Michael R. Fisher, Rel. No. 34-66212A (Jan. 

23, 2012) 

www.sec.gov/litigation/admin/2012/34-66212a.pdf 

• New York Life Securities Inc., Rel. No. 34-40459 (September 23, 1998) 

www.sec.gov/litigation/admin/3440459.txt 

• In the Matter of Royal Alliance Associates, Inc. Rel. No. 34-38174 (Jan. 15, 1997) 

www.sec.gov/litigation/admin/3438174.txt 

FINRA Resources 

• FINRA Regulatory Notice 11-54, FINRA and SEC Issue Joint Guidance on Effective Policies 

and Procedures for Broker-Dealer Branch Inspections (November 2011) 


• NASD Notice to Members 99-45, NASD Provides Guidance on Supervisory Responsibilities 

(June 1999) 


• Financial Industry Regulatory Authority, Letter of Acceptance, Waiver and Consent No. 

2010020872301 (Re: John Derek Lane) 

http://disciplinaryactions.finra.org/viewDocument.aspx?DocNb=28888 


• NASD Rule 3010. Supervision 

http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4395&element_id=3 

717&highlight=3010#r4395 

• NASD IM-3010-1 Standards for Reasonable Review 

http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4396&element_id=3 

718&highlight=IM-3-10-1#r4396 


Ethics for Securities Attorneys 


10:30 a.m. – 11:45 a.m.



10:30 a.m. – 11:45 a.m. 


• Minimize the risk of a company employee claiming an attorney-client relationship when none was 

intended. 

• Identify the risks and benefits of an attorney concurrently representing the company and an 

employee. 

• Limit the scope of an attorney’s concurrent representation of an employee and the company. 

Moderator: 

Panelists: 

Marc Menchel 

Executive Vice President and General Counsel 

FINRA Office of General Counsel 

Alan Lawhead 

Vice President and Director 


James Tricarico 

Principal and General Counsel 

Edward Jones 

James Walker 

Partner and General Counsel 

Richards Kibbe & Orbe LLP 

Outline 

Internal investigations 

• Why investigate 

• Goals of the investigation 

• Report back to whom? 

• Outside and in-house counsel roles 

• In-house counsel and attorney-client privilege 

Scope of representation 

• Corporation as client 

• Client conflicts – rules 

• Simultaneous representation 

• Who holds the privilege? 

• Upjohn warning 

Avoiding conflicts of interest 

• Multiple representations and advance waivers 


• Limited scope of representation 

• Clearly limiting the scope 

• Concurrent representation – engagement letter 

Waiver of privilege 

• Purpose of waiver 

• Ethical requirements 

• SEC and FINRA policies 

• Selective waiver and confidentiality 


Alan Lawhead is Vice President and Director of the Appellate Group in FINRA's Office of General 

Counsel in Washington, DC. He joined FINRA in 1997. He leads a group of appellate attorneys who 

defend FINRA’s decisions that are on appeal to the Securities and Exchange Commission. The 

Appellate Group also provides legal advice to FINRA’s appellate body, the National Adjudicatory 

Council, which rules on disciplinary cases, membership applications, statutory disqualification 

applications, and examination waivers. Before joining FINRA, Mr. Lawhead worked as a litigation 

associate with the law firm of Gibson Dunn & Crutcher LLP, in California. He served as a law clerk to 

the Honorable John S. Rhoades of the U.S. District Court for the Southern District of California. Mr. 

Lawhead earned his law degree, cum laude, and a master’s of business administration from 

Georgetown University and his bachelor’s degree from the University of Southern California. 

Marc Menchel is Executive Vice President and General Counsel of Regulation, Office of General 

Counsel at FINRA. He held the same title at NASD, which consolidated with NYSE Member 

Regulation to form FINRA in 2007. Before joining NASD, Mr. Menchel was an executive vice 

president and general counsel of Tucker Anthony from July 1995 to April 2002—one of the largest 

regional broker-dealers in the country—where he was also a member of the Board of Directors. 

During his time with Tucker Anthony, Mr. Menchel also served as a member of the Executive 

Committee of the Security Industry Association’s (SIA) Compliance and Legal Division. From August 

1989 to June 1995, Mr. Menchel held various legal positions with Prudential Securities Incorporated. 

During the last four years of his tenure at Prudential, he held the position of a senior vice president 

and international counsel with overall responsibility for the firm’s legal and compliance affairs in 

Europe, Asia, Australia and South America. Mr. Menchel began his career in the securities industry in 

August 1980 with Thomson McKinnon, where he was an associate general counsel and deputy 

compliance director. Mr. Menchel holds a bachelor’s degree from Davidson College and a law degree 

from Syracuse University College of Law, and he is a member of the New York State Bar. 

James A. Tricarico Jr. joined Edward Jones in 2006 as Principal and General Counsel. Prior to 

joining the firm, he served as the co-head of the broker-dealer practice for Duane Morris LLP in New 

York City. Previously, he was general counsel and executive vice president of Prudential Securities, 

Inc., where he was also a member of that firm’s Operating Council. Mr. Tricarico has focused his 

practice in the areas of financial services, litigation, regulatory counseling and enforcement. At 

Edward Jones, Mr. Tricarico has responsibility for legal, compliance and government relations. He is 

a member of the Executive and Management committees and is chairman of the firm’s Audit 

Committee. Mr. Tricarico is admitted to the Bar in Missouri and New York. He is a member of the 

Board of Directors for the Securities Industry and Financial Markets Association (SIFMA), and also a 

member of their Compliance and Legal Society's Executive Committee, of which he is a former 

president. In addition, he is on the General Counsels Committee of SIFMA. He is a member of the 

National Arbitration and Mediation Committee of FINRA Dispute Resolution. Mr. Tricarico served for 

four years as the editor-in-chief of the Journal of Investment Compliance. In addition, he is a member 

of the board of the St. Louis Historical Society and the SEC Historical Society. A graduate of Fordham 

University, Mr. Tricarico graduated cum laude from New York Law School in 1977. 

James Walker is Partner and General Counsel at Richards Kibbe & Orbe LLP, and concentrates in 

internal investigations, white-collar criminal defense, civil litigation, professional liability and legal 

ethics. Mr. Walker represents companies, audit committees, audit committee directors, corporate 

officers, securities industry professionals, and other individuals in federal and state criminal and civil 


investigations of potential violations of the securities laws and the Foreign Corrupt Practices Act. He 

represents law firms and lawyers in government and internal investigations of potential criminal, 

regulatory and/or professional misconduct, and in related criminal and civil litigation and regulatory 

proceedings. Mr. Walker has been on the New York City Bar's Professional Discipline, Professional 

and Judicial Ethics, Professional Responsibility and Securities Regulation Committees, and on the 

New York State Bar Association Committee on Professional Ethics, where he has been a member 

since 1996. He has drafted numerous ethics opinions and reports on ethics issues. Mr. Walker is a 

frequent lecturer on legal ethics, internal investigations and corporate governance, and has written 

articles on attorney-client privilege, professional ethics, internal investigations and issues arising 

under the securities laws. 




May 21-23, 2012 • Washington, DC 

1. Internal Investigations and the Role 

of Outside and In-House Counsel 

Why Investigate? 

• What triggers an internal investigation? 

• A prosecutor or regulator provides notice that a company may have 

been involved in fraudulent scheme. 

• The company is notified that a government or regulatory investigation 

or lawsuit has been commenced or is imminent that targets the 

company. 

• A whistleblower complaint by an employee. 

• A Human Resources complaint by a company employee. 

• Issues are raised by the company’s external auditor. 

• Discovery of an inappropriate business practice that may lead to 

litigation exposure. 

• The company is served with a civil complaint. 

• Allegations of misconduct regarding the company or its employees 

appear in the press. 


• Rule 1.13 Reporting up: If a lawyer discovers that someone 

associated with the organization has, or intends to, do 

something that is a violation of the legal obligation to the 

organization or a violation of law that may be imputed to 

the organization and likely to substantially injure the 

organization, the lawyer has a duty to proceed “as 

reasonably necessary in the best interest of the organization 

of the organization,” which may include “referring the 

matter to higher authority in the organization.” 

2 

3 

1


• If, despite the lawyer’s efforts, the highest authority that can 

act on behalf on behalf of the organization fails to address the 

act, or refusal to act, that violates the law and the lawyer is 

reasonably certain that this will result in substantial injury to 

the organization, the lawyer may reveal the information relating 

to the representation whether or not Rule 1.6 would permit 

disclosure “to the extent the lawyer believes reasonably 

necessary to prevent substantial injury. 

• This will not apply to the lawyer’s representation of an 

organization in an investigation of an alleged violation of law, 

or to defend the organization or a constituent against a claim 

arising out of an alleged violation of law. 

Understanding the Goals of the Investigation, 

the Client, and the Implications of Each 

• Goals of the investigation: 

• Evaluate Liability: An internal investigation can assist in 

determining the extent of potential criminal or civil liability. 

• Manage Disclosure: An investigation, even with damaging 

results, allows the firm to control the disclosure of information, 

and can be used to the company’s advantage to show that it is 

not engaged in a cover-up, but rather is attempting to correct 

misconduct. 

• Shape the Response: Information gathered can assist in 

forming an effective response to the government, and may 

uncover evidence that can be used to persuade the government 

that its investigation should be narrower than it might 

otherwise be. 

4 

5 



• Make Informed Determinations about Making a Referral: The 

investigation will provide the company with information 

concerning any alleged misconduct by one of its employees that 

will assist the firm to determine whether to refer the matter to a 

disciplinary authority, regulator, and/or prosecutor. 

• Control Exposure: By quickly and effectively investigating its 

own misconduct, a company can demonstrate its good faith in 

doing the right thing, which may prevent a government 

investigation. It can also give the firm more control over the 

nature and focus of any government investigation. 

• Minimize Liability: By conducting a thorough investigation and 

cooperating with the government, a company may convince the 

government to reduce any contemplated penalty, or to not take 

any action. 



• Who is the client? 

• The Audit Committee or other Special Independent Board Committee: 

Reporting to the Audit Committee or other special independent committee of 

the Board enhances the argument that the investigation is being done for the 

purpose of obtaining an independent assessment of whether any misconduct 

has occurred and to determine appropriate next steps, including disclosure to 

a government official and/or remediation. It also enhances the claim that the 

legal work performed was privileged as to the special committee, provided 

any investigation report and communications with the investigating attorneys 

were not disclosed to anyone who was not on the special committee. 

• General Counsel’s Office: Reporting to a representative of the company’s 

General Counsel’s Office may enhance the position that the purpose of the 

investigation was to render legal advice, a necessary element in asserting 

privilege over the report and supporting interview notes. 

• Firm Management: A report to management responsible for making 

business decisions threatens the assertion of privilege over the investigation. 

6 

7 

2



Outside/In-House Counsel Roles in 

Internal Investigations 

• In In re Leslie Fay Securities Litigation, 161 F.R.D. 274 

(S.D.N.Y. 1995): The court held that attorneys’ notes of 

employee interviews were not protected as work product 

because the investigation was conducted primarily for 

business reasons. 

s 

• In making this determination, the court found significant 

that the investigative report was used by company 

management to implement new financial controls, and to 

reassure lenders, trade creditors, customers and 

stockholders that the wrongdoers were being rooted out and 

that the conduct would not be repeated. 

• Between in-house and outside counsel, who should 

handle an investigation of possible misconduct? 

• In-house counsel may be best equipped to handle 

business-related issues, personnel issues and certain 

whistleblower complaints. 

• In other instances, in-house counsel may not have the 

resources to meet the demands of the investigation. 

8 

9 



• Outside counsel may bolster the credibility of the 

investigation, particularly where prosecutors, regulatory 

agencies or disciplinary authorities are involved, or if highranking 

lawyers in the firm are implicated. 

• Failure to engage independent d outside counsel may 

undercut the extent to which the government can rely on 

representations about any investigation of suspected 

misconduct. 

In-House Counsel Communications and 

Attorney-Client Privilege 

• Communications between in-house counsel and a client are 

reviewed more closely to determine whether they are 

privileged, which depends on: 

• the nature of the in-house counsel’s position in the company 

(e.g., purely legal counsel, mixed business and legal advisor, 

or purely a business advisor) 

• the nature of the specific communication (e.g., whether the 

client sought legal advice, or counsel was rendering legal 

advice); 

• the individuals included in the communication (e.g. whether 

anyone in the communication is outside the privileged 

relationship and/or was not present for the purpose of 

seeking or requesting legal advice). 

10 

11 

3

In-House Counsel Communications and 

Attorney-Client Privilege 

• Roth v. Aon Corp., Case No. 04 C 6835, 2008 U.S. Dist. Lexis 106161 (N.D. Ill. 

Jan. 8, 2009): Attorney-client privilege protected an e-mail and an attachment 

sent by a company’s CFO to the Deputy General Counsel and several non-lawyer 

executives in which the CFO requested comments to a draft of the company’s 

Form 10-K. “Determination of what information should be disclosed for compliance 

is not merely a business operation, but a legal concern.” 

• In re Vioxx Products Liability Litig., 501 F. Supp. 2d 789, 800 (E.D. La. 2007): The 

court rejected the argument that pervasive FDA regulation made nearly all 

communications with in-house counsel about company affairs privileged, and 

requires case-by-case analysis of the “primary purpose” of each communication. 

• In re Seroquel Products Liability Litig., NO. 6:06 –MD-1769-Orl-22DAB, 2008 WL 

1995058, at *7 (M.D. Fla. May 7, 2008): Communication with in-house counsel 

must be primarily to facilitate rendering legal advice for a privilege to apply. Here, 

the Company failed to show communications of “technological, science, public 

relations, or marketing” documents with attorneys and non-attorneys were made 

“primarily to facilitate the rendition of legal advice.” 



• Courts have taken different views on the application of the attorney-client 

privilege to investigations conducted by in-house counsel. 

• United States v. Davis, 131 F.R.D. 391, 405 and n. 9 (S.D.N.Y. 1990): The 

results of internal corporate reviews, whether undertaken at the direction of 

in-house counsel or outside counsel, may be protected from disclosure 

under the attorney-client privilege and/or the work-product doctrine as long 

as in-house counsel was "functioning i as an attorney.” 

• SR Intern. Business Ins. Co. Ltd. v. World Trade Center Properties LLC, 

2002 WL 1455346, at *4 (S.D.N.Y. Jul 03, 2002): Documents collected at 

in-house counsel's direction, information learned in the course of the 

investigation undertaken under her supervision, and all drafts prepared to 

respond to investor questions and communications relating to such 

questions and responses thereto were not protected from disclosure where 

the underlying facts were not privileged. The fact that information was 

gathered by an attorney did not make the information privileged. 

12 

13 

Ethics and Internal Investigations: Who is 

the Client? Who Holds the Privilege? 

2. Scope of Representation 

• Erica Equities, the head trader of BankCo gets called into a 

meeting with an in-house attorney, Irene Inhouse, and 

BankCo’s regular outside counsel, Oscar Outsider, to 

discuss a FINRA inquiry regarding possible insider trading 

at BankCo. Erica has been Irene’s off-and-on lunchtime 

running partner over the years. Oscar represented Erica 

personally in SEC depositions two years ago (which Irene 

also attended as a lawyer for Erica and BankCo) in an 

investigation of BankCo’s trading of certain swap positions 

that commenced two years ago and remains ongoing. 

14 

4



• After some small talk, Oscar announces that for the 

purpose of this interview, he and Irene represent BankCo, 

and not Erica individually; the privilege that applies to the 

discussion that takes place belongs to BankCo, and not to 

Erica; and that BankCo may, in its sole discretion, decide 

to share the information he provides with government 

officials in connection with pending civil or criminal 

investigations, or disclose any information he provides to 

the public. 



• Erica is suddenly very uncomfortable, and asks them 

whether she needs another lawyer to represent her in this 

interview. Oscar tells her they cannot advise her in this 

matter other than to tell her she is free to seek her own 

attorney in connection with the interview. Erica asks 

whether she has to answer their questions, and Irene tells 

her she is free to refuse to answer the questions, but Irene 

will have to tell management at BankCo that Erica refused 

to cooperate with the investigation, which may affect 

Erica’s continued employment at the firm. Erica then says 

“but you represent me – you are my lawyers too, aren’t 

you? 

15 

16 



• No, because Oscar provided an Upjohn warning that makes 

plain that he and Irene represent only BankCo for the 

purposes of this interview. 

• No, because in-house counsel (Irene) always represents the 

company unless counsel affirmatively agrees to represent an 

employee, and there has been no new engagement of 

outside counsel (Oscar) to represent Erica in this matter. 

• Possibly, because the swaps trading investigation is 

ongoing, and neither Oscar nor Irene had Erica sign a 

conflict waiver with respect to this investigation. 



• Relevant Conflict Rules 

• Rule 1.7: prohibits representing a client where the representation 

will be materially limited by conflicting interests of the lawyer, 

including a current representation that is adverse or a conflicting 

personal interest. 

• Rule 1.18: provides that even where no attorney-client relationship 

is created, consistent with Rule 1.9 a lawyer who has discussions 

with a prospective client cannot use or reveal information in the 

consultation that is confidential information of a former client, or 

represent a client in the same or substantially related matter as a 

prior client where their interests are materially adverse. 

• Rule 1.13: “A lawyer employed or retained by an organization 

represents the organization acting through its duly authorized 

constituents.” 

17 

18 

5

Simultaneous Representation Dilemma 

Pros 

Cons 

• Cost effective for company • Employee may be less 

• Improves information flow. forthcoming. 

• Lawyer is better prepared 

to mount a defense. • Dual representation may 

present Rule 1.7 or 1.9 

conflicts. 

• Objections from 

government investigators. 

• Waivers will be necessary 

and may be subject to 

challenge. 



• United States v. Nicholas, 606 F. Supp. 2d 1109 (C.D. Cal. 

Apr. 2009): evidentiary hearing held to determine whether 

outside counsel acted inappropriately when it disclosed to 

Broadcom’s auditor and the government statements made 

to the lawyers by Broadcom’s chief financial officer, William 

Ruehle. 

• Statements were made during interview in connection with 

stock options backdating investigation. 

• Outside counsel jointly represented Broadcom and Ruehle 

in a prior unrelated civil matter, and currently represented 

Ruehle and Broadcom in two civil lawsuits relating to stock 

options backdating. 

19 

20 



• Ruehle claimed the firm violated his attorney-client 

privilege by disclosing his statements – Ruehle claimed 

the privilege was not invalidated by outside counsel’s 

claim that he was given an Upjohn warning. 



• "Upjohn warning": "Upjohn warning" refers to a warning 

given by the lawyer for the company at the outset of an 

interview of an employee. 

• The lawyer represents the company and not the individual 

employee. 

• The privilege protecting the conversation belongs to the 

company. 

• Anything the employee says may be disclosed to an outside 

party at the company's discretion. 

21 

22 

6





• Bad facts for the law firm: 

• Ruehle did not recall receiving an Upjohn warning. 

• No warning was reflected in any lawyer’s notes. 

• Court deemed any warning that was provided “woefully 

inadequate” because the Irell lawyers failed to inform 

Ruehle that Irell did not represent him. 

• Held 

• The firm should have provided a written waiver of the 

“clear conflict” presented by its concurrent representations 

of Broadcom and Ruehle before it would have been 

permitted to disclose Ruehle’s statements to the 

government. 

• Ruehle’s statements to the outside lawyers were 

suppressed. 

• The outside lawyers were referred to the California State 

Bar for “appropriate discipline.” 

23 

24 



• Suppression reversed on appeal (U.S. v. Ruehle, 583 F.3d 

600 (9th Cir. 2009)). 

• Reversal was based on the lower court erroneously applying 

the state law privilege standard in a proceeding governed by 

the federal common law standard. 

• Ninth Circuit declined to address the lower court’s ruling that 

the attorneys had violated state ethical rules by undertaking 

the dual representation without obtaining a written conflict 

waiver. 

• The Court noted that allegedly counseling disclosure of the 

statements without obtaining a written consent from 

Ruehle was “troubling.” Id. at 613. 



• The Upjohn warning must be complete and clear. 

• See In re Grand Jury Subpoena, 415 F.3d 333, 340 (4th 

Cir. 2005) (against claim that privilege barred disclosure of 

statements made during internal investigation interview 

where in-house and outside counsel stated “we can 

represent you as long as no conflict appears,” the Fourth 

Circuit concluded that no attorney-client relationship had 

been formed because the lawyers did not affirmatively 

state that they represented the employees but cautioned 

against “watered down” Upjohn). 

25 

26 

7

Multiple Representation in Enforcement 

Proceedings: Scope of the Representation 

3. Avoiding Conflicts of Interest 

• Carrie Crooked is the Head of Finance at Badnews Bank. Badnews is under 

investigation by the New York Attorney General’s Office (“NYAG”) for potentially 

defrauding investors through accounting practices that hid the diminishing value 

of mortgage assets on its balance sheet. Bigfirm, regular outside counsel to 

Badnews, agrees to represent Carrie in a deposition at the NYAG’s office. Bigfirm 

gives Carrie an engagement letter outlining the nature of the simultaneous 

representation. The letter states that Bigfirm’s representation of Carrie will 

include assisting with the preparation of Carrie for her NYAG interview, 

representing her at the interview (if permitted), and in any follow-up relating to 

the investigation. The letter contains Carrie’s acknowledgement that Bigfirm may 

share information it learns from Carrie “with the Bank or others in its discretion” 

and may withdraw from the representation of Carrie and continue to represent 

the Bank if a conflict arises. The letter also reflects Carrie’s waiver of any conflict 

in Bigfirm’s continued representation of Badnews Bank after ceasing the 

representation of Carrie, including Bigfirm’s ability “to litigate, sue or crossexamine” 

Carrie. 

27 



• Carrie signs the letter then meets with lawyers from Bigfirm to 

prepare for the interview. During the meeting, Carrie says she has 

no explanation for the inconsistencies in the valuation information 

regarding the Bank’s mortgage assets, but credibly explains how 

most of this information is created by people who report up to her 

and on whom she must reasonably rely. 

• A Bigfirm attorney is present for Carrie’s interview the next day. In 

response to the NYAG attorney asking her to describe her role in the 

Bank’s reporting of its mortgage assets, Carrie describes how she 

spearheaded the effort to cook the books to inflate the value of the 

Bank’s worthless mortgage assets. After the interview, Bigfirm 

informs the Bank of Carrie’s testimony, and then notifies Carrie that 

it is withdrawing from its representation of her. The next day, the 

Bank fires Carrie. The following day, the NYAG files an action against 

Carrie. 



• Carrie files a lawsuit against Bigfirm claiming breach of 

fiduciary duty and malpractice. Carrie will: 

• Lose the lawsuit because she consented to Bigfirm’s ability 

to share information with others. 

• Prevail because upon hearing of Carrie’s pastcriminal 

conduct, the Bigfirm attorney had a duty to take steps to 

minimize any potential harm to Carrie, and as her lawyer 

could not disclose the conduct to the Bank because doing so 

would violate the duty to preserve a client’s confidential 

information even when that information is known to others. 

• Prevail because the waiver Bigfirm had Carrie sign was 

overbroad and the consent was not sufficiently “informed.” 

28 

29 

8



• The New York Rules of Professional Conduct, Rule 1.2(c), 

provides that lawyers “may limit the scope of the 

representation if the limitation is reasonable under the 

circumstances, the client gives informed consent and 

where necessary notice is provided to the tribunal and/or 

opposing counsel.” 

• New York (N .Y. City Op. 2001-3) and DC ((D.C. Bar 343 

(2008)) have issued ethics opinions concluding that under 

1.2(c), a lawyer may limit the scope of a representation for 

the specific purpose of avoiding conflicts. 



• N.Y. City Op. 2001-3(2001) 

• May limit scope of lawyer’s representation to avoid a conflict 

provided: 

• the lawyer’s continuing representation of the client is not so 

restricted as to render her counsel inadequate, and 

• the client for whom the lawyer will provide limited 

representation consents to the limitation upon full disclosure 

of the limitations of the scope of the engagement and any 

matters that will be excluded. 

• The lawyer must disclose the reasonably foreseeable 

consequences of the limitation, and should explain that 

separate counsel may be needed, which could result in 

additional expense, delay or complication to the proceedings. 

30 

31 



• Examples: 

• Civil litigation: A lawyer defending a client in litigation 

determines there are potential cross-claims involving a current 

client that the firm represents in unrelated matters. The lawyer 

may, with the informed consent of the client whose engagement 

is being limited, it limit it her engagement to the defense of the 

case and exclude representation of the client with respect to 

any potential cross-claims against the other firm client. 

• Auction Representation: A lawyer who is representing one 

company in an auction and discovers another current client is 

also bidding (represented by other counsel) may limit the 

representation of the first client to exclude representation of the 

client in any negotiation with the other client who is bidding. 



• Understand the difference between clearly limiting the scope of 

a representation and being ambiguous as to the scope of the 

representation. 

• Complaint, Pendergest-Holt v. Sjoblom and Proskauer Rose, 

L.L.P., No. 3:09-cv-00578 (N.D. Tex. Mar. 30, 2009). 

• Pendergest-Holt, then the chief investment officer of Stanford 

Financial Group, provided SEC testimony in connection with 

the investigation of Stanford’s alleged Ponzi scheme. 

• Complaint: Outside counsel to Stanford Financial Group told 

the SEC lawyers that he represented Stanford Financial 

Group, but subsequently added that he represented 

Pendergest-Holt as an officer or director of one of the 

Stanford affiliated companies. 

32 

33 

9



• Complaint: during testimony Sjoblom learned that his 

retainer agreement required him to represent the Stanford 

Group, its related companies, and its officers and directors, 

but not Pendergest-Holt in her individual capacity. 

• Outside counsel never told Pendergest-Holt that: 

• she needed separate representation, 

• she had Fifth Amendment rights, 

• there were risks associated with testifying before the SEC, or 

• her communications with Proskauer and Sjoblom were not 

protected by the attorney-client privilege. 



• Pendergest-Holt was arrested and charged with obstruction 

of the SEC investigation, and subsequently indicted on 

charges that included obstruction at her deposition. 

• She filed a lawsuit against the lawyer and the firm for 

malpractice because of the ambiguity as to her 

representation by Sjoblom and the law firm and the alleged 

failure to advise her of her rights, but later withdrew the 

lawsuit. 

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35 



• Grand Jury Subpoena, 415 F.3d at 340. 

• “[Had] investigating attorneys, in fact, entered into an 

attorney-client relationship with [the company’s employees] . 

. . they would not have been free to waive the [employees’] 

privilege when a conflict ct arose. . . . [T]hey could not have 

jettisoned one client in favor of another. Rather, they would 

have had to withdraw from all representation and to maintain 

all confidences. Indeed, the court would be hard pressed to 

identify how investigating counsel could robustly investigate 

and report to management or the board of directors of a 

publicly traded corporation with the necessary candor if 

counsel were constrained by ethical obligations to individual 

employees.” 



• Simultaneous representation of a company and one of its 

employees may jeopardize the in-house lawyer’s ability to 

represent the corporate client in future matters. 

• Internal investigations: leave no doubt as to the 

representation. 

• If outside or inside counsel previously represented the 

employee, consider obtaining written consent from the 

employee to dissolve the prior attorney-client 

relationship and waive any privilege that the employee 

otherwise might assert. 

36 

37 

10



• If concurrent representation of the company and an 

employee is desirable after weighing the costs and benefits, 

memorialize the representation and scope thereof (including 

any limitations) in a written engagement letter that also: 

• Describes the lawyer’s concurrent representation ti of the 

corporation (and possibly affiliates); 

• Describes the risks and advantages of the concurrent 

representation; 



• Notes the risks and advantageous of sharing counsel with 

the company and having company cover the legal fees. 

• States that the interests of the corporation and the 

employee are aligned, but provides that if a conflict should 

arise, the employee consents to the lawyer’s continued 

representation of the corporation; and 

• States that the information that the lawyer learns from the 

corporate employee will not be kept confidential from the 

corporation; 

38 

39 



• Obtains the individual employee’s consent that the 

corporation may, in its sole discretion, decide to share the 

information that the lawyer learns from the corporate 

employee with third parties, including the government; 

• Provides that the employee also waives any conflict that may 

arise in the future with respect to the lawyer’s representation 

of the corporation, including in matters in which the interests 

of the corporation are adverse to the interests of the 

individual employee. 

4. Waiver of the Privilege 

40 

2012 FINRA Annual Conference• © 2012 FINRA. All rights reserved. 

11

Cooperation with Regulators 

• SEC Policy 

• Attorney-client privilege and attorney work product protections 

are recognized. 

– The staff must respect legitimate assertions of the attorney-client 

privilege and attorney work product protections. … The staff should not 

ask a party to waive the attorney-client privilege or work product 

protection without prior approval of the Director or Deputy Director. 

• SEC Division of Enforcement, Enforcement Manual, Section 

4.3. 

SEC Cooperation Credit 

• Policy 

• A party may choose to voluntarily disclose privileged 

communications or documents. … the SEC does not view a 

party’s waiver of privilege as an end in itself, but only as a 

means (where necessary) to provide relevant and sometimes 

critical information to the staff. 

• SEC Division of Enforcement, Enforcement Manual, Section 

4.3. 

• Further guidance on cooperation. See Report of Investigation 

and Commission Statement on the Relationship of Cooperation 

to Agency Enforcement Decisions, Exchange Act Rel. No. 

44969 (Oct. 23, 2001)(the Seaboard Report). 


41 


42 

FINRA Policy 

• Recognition of Privilege 

• “FINRA as a general matter recognizes the attorney-client 

privilege in its adjudicatory forum.” 

• FINRA Regulatory Notice 08-70, n.9 (Nov. 2008). 

• Extraordinary Cooperation 

• “[T]he waiver or non-waiver of the privilege itself will not be 

considered in connection with granting credit for cooperation.” 

• “[A] firm could still receive credit for extraordinary cooperation 

if it found other ways to inform FINRA staff of pertinent facts 

without waiving the privilege.” 

• FINRA Regulatory Notice 08-70, n.9 (Nov. 2008). 

Selective Waiver 

• Concept: The production of attorney-client privileged or 

attorney work product documents to the government or a 

regulatory body does not waive the protection as to other 

parties. The privilege remains intact. 

• Limited Acceptance; Significant Rejection 

• Eighth Circuit – Diversified Indus. v. Meredith, 572 F.2d 596 (8th 

Cir. 1977) (selective waiver doctrine approved). 

• First, Third, Sixth, Tenth and DC Circuits have rejected. 

• See In re Qwest Commc’ns Int’l, 450 F.3d 1179, 1187-89 (10th Cir. 

2006) (surveying and discussing Circuit Court rulings). 

• Permian Corp. v. United States, 665 F.2d 1214 (D.C. Cir. 1981) 

(rejecting the limited waiver doctrine and holding that 

corporation’s voluntary disclosure to the SEC of documents 

protected by attorney-client privilege waived the privilege). 


43 

2012 FINRA Annual Conference• © 2012 FINRA. All rights reserved. 44 

12

Selective Waiver 

Confidentiality Agreements and Selective Waiver 

• Second Circuit – Case-by-case 

• For a claim of attorney work product protection, the Second 

Circuit has declined to outright reject the selective waiver 

doctrine. In Steinhardt Partners L.P., 9 F.3d 230, 236 (2d Cir. 

1993), the court wrote that it: 

– “decline[d] to adopt a per se rule that all voluntary 

disclosures to the government waive work product protection.” 

• The Second Circuit noted that claims of privilege should be 

evaluated on a case-by-case basis. It also noted that it was not 

considering situations in which the SEC and a company had 

entered into a confidentiality agreement. 

• Second Circuit District Courts: mixed results 

• Selective waiver doctrine and its policy reasons have been 

rejected. 

• In re Initial Public Offering Sec. Litig., 249 F.R.D. 457 (S.D.N.Y. 

2008). 

• Selective waiver has also prevailed. 

• Police and Fire Retirement System v. SafeNet Inc., No. 06 Civ. 

5797 (S.D.N.Y. Mar. 12, 2010). 

2012 FINRA Annual Conference• © 2012 FINRA. All rights reserved. 45 


46 

Confidentiality Agreements 

Limiting Waiver 

• SEC Enforcement Manual has a Model Confidentiality 

Agreement. 

• The Manual instructs that: “the staff should exercise 

judgment when deciding whether to enter into a 

confidentiality agreement with a company under 

investigation.” i i • Federal Rule of Evidence 502(a) addresses the scope 

of waiver after disclosure of privileged information. 

• Broad subject matter waiver is disfavored. 

• Judge Rakoff has ruled that a company’s production of some 

memos of investigative interviews to the government does not 

waive the privilege as to other interview memos. 

• United States v. Treacy, S2 08 CR 366 (JSR) (S.D.N.Y. 

Mar. 23, 2009), aff’d in part and remanded in part on 

other grounds, 639 F.3d 32 (2d Cir. 2011). 


47 


48 

13



10:30 a.m. – 11:45 a.m. 

Resources 

Rules 

• ABA Model Rule of Professional Conduct 1.6 

www.abanet.org/cpr/mrpc/rule_1_6.html 









• Fed. R. Evid. 502 & Fed. R. Evid. 502 advisory committee’s note 

http://federalevidence.com/node/286 

• New York Rule of Professional Conduct 1.2(c) 

www.nycla.org/siteFiles/NYRulesofProfessionalConduct4109_362.pdf 

Cases 

• Clarke T. Blizzard, Investment Advisers Act Rel. No. 2032, 2002 SEC LEXIS 1087, at *11 

(Apr. 24, 2002) 

• Diversified Indus. v. Meredith, 572 F.2d 596 (8th Cir. 1977) 

• In re Grand Jury Subpoena, 415 F.3d 333, 340 (4th Cir. 2005) 


• In re Initial Public Offering Sec. Litig., 249 F.R.D. 457 (S.D.N.Y. 2008) 

• In re Leslie Fay Sec. Litig., 161 F.R.D. 274 (S.D.N.Y. 1995) 

• Permian Corp. v. United States, 665 F.2d 1214 (D.C. Cir. 1981) 

• Police and Fire Ret. Sys. v. SafeNet Inc., No. 06 Civ. 5797, 2010 WL 935317 (S.D.N.Y. Mar. 

12, 2010) 

• In re Qwest Commc’ns Int’l, 450 F.3d 1179, 1187-89 (10th Cir. 2006) 

• Roth v. Aon Corp., No. 04 C 6835, 2008 U.S. Dist. LEXIS 106161 (N.D. Ill. Jan. 8, 2009) 

• In re Seroquel Prods. Liab. Litig., No. 6:06-MD-1769-Orl-22DAB, 2008 WL 1995058, at *7 

(M.D. Fla. May 7, 2008) 

• SR Intern. Bus. Ins. Co. Ltd. v. World Trade Ctr. Props. LLC, 2002 WL 1455346, at *4 

(S.D.N.Y. July 3, 2002) 

• In re Steinhardt Partners L.P., 9 F.3d 230, 236 (2d Cir. 1993) 

• United States v. Davis, 131 F.R.D. 391, 405 & n.9 (S.D.N.Y. 1990) 

• United States v. Nicholas, 606 F. Supp. 2d 1109 (C.D. Cal. 2009) 

• United States v. Ruehle, 583 F.3d 600 (9th Cir. 2009) 

• United States v. Treacy, S2 08 CR 366 (JSR), 2009 U.S. Dist. LEXIS 66016 (S.D.N.Y. Mar. 

23, 2009), aff’d in part and remanded in part on other grounds, 639 F.3d 32 (2d Cir. 2011) 

• In re Vioxx Prods. Liab. Litig., 501 F. Supp. 2d 789, 800 (E.D. La. 2007) 

Bar Opinions 

• DC Bar Ethics Opinion 343, Application of the “Substantial Relationship” Test When Attorneys 

Participate in Only Discrete Aspects of a New Matter (2008) 

www.dcbar.org/for_lawyers/ethics/legal_ethics/opinions/opinion343.cfm 

• New York Bar Formal Opinion 2001-03, Limiting the Scope of an Attorney’s Representation to 

Avoid Client Conflicts (2001) 

www.abcny.org/ethics/ethics-opinions-local/2001-opinions/1038-formal-opinion-2001-3 

SEC Documents 

• Report of Investigation and Commission Statement on the Relationship of Cooperation to 

Agency Enforcement Decisions, Exchange Act Rel. No. 44969 (Oct. 23, 2001) (“Seaboard 

Report”) 

www.sec.gov/litigation/investreport/34-44969.htm 

• SEC, Division of Enforcement, Enforcement Manual, Section 4.3.1 (Mar. 9, 2012) 

www.sec.gov/divisions/enforce/enforcementmanual.pdf 


FINRA Regulatory Notice 

• FINRA Regulatory Notice 08-70, FINRA Provides Guidance Regarding Credit for Extraordinary 

Cooperation (Nov. 2008) 


Memorandums 

• James Q. Walker, Daniel C. Zinman and Shari A. Brandt, Recent S.D.N.Y. Opinion Further 

Restricts the Use of Selective Waivers (Feb. 2008) 

www.rkollp.com/assets/attachments/RSKO-438842-v1-Memo_on_Scheindlin_Decision.pdf 

• Shari A. Brandt and James Q. Walker, Ninth Circuit’s Reversal of Evidence Exclusion in 

Broadcom Case Does Not Alter Lessons Learned Regarding Upjohn Warnings (Oct. 7, 2009) 

www.rkollp.com/assets/pdf/publication_87.pdf 


Electronic Market Access 


10:30 a.m. – 11:45 a.m.



10:30 a.m. – 11:45 a.m. 


• Obtain an overview of structure, flow of transactions, and supervisory and compliance risks 

associated with firms that facilitate direct electronic access. 

• Discuss suspicious trading identified, financial control issues, and supervisory and AML concerns. 

Moderator: 

Panelists: 

Emily Gordy 



Sarah Green 

Senior Director, AML Compliance 


Daniel M. Hawke 

Regional Director, Philadelphia and Unit Chief, Market Abuse Unit 

U.S. Securities and Exchange Commission 

William Park 

Senior Director 


Susan Tibbs 

Vice President, Quality of Markets 


Outline 

Overview of prior cases involving direct electronic access 

• Trillum case study 

• Pinnacle case study 

• E-Trade case study 

• Scottrade case study 

Structure of direct market access firms 

• Discuss structure and market impact, general flow of trading 

Compliance and enforcement issues 

• Suspicious trading 

o Prearranged matched and washing trading 

o Quote manipulations 

• Financial controls to prevent entry of orders that exceed credit or capital limits 

• Supervisory and compliance infrastructure 



Emily P. Gordy is Senior Vice President, Chief of Staff and Deputy of FINRA’s Department of 

Enforcement. Ms. Gordy has responsibility for day-to-day management of the department and policy 

issues arising in the department's investigations and cases. Ms. Gordy has held various management 

positions within the Enforcement Department, including enforcement policy, deputy and regional 

enforcement head. Prior to joining Enforcement, Ms. Gordy was an associate vice president/director, 

Office of Regulation Policy, in the Department of Member Regulation, providing guidance to the 

District Offices on a wide range of legal and policy issues. Ms. Gordy joined NASD in July, 2000 as a 

senior attorney with the Office of Regulation Policy. Prior to joining NASD, Ms. Gordy spent 13 years 

with the U.S. Securities and Exchange Commission, first in the SEC’s Office of the General Counsel 

and then with the SEC’s Division of Enforcement, Office of Chief Counsel. Ms. Gordy held positions 

of increasing responsibility in the SEC’s Division of Enforcement/Office of Chief Counsel; at the time 

of her departure, she was serving as a deputy chief counsel. Ms. Gordy earned her undergraduate 

degree in political science at Gettysburg College and her law degree from American University. 

Sarah D. Green is Senior Director in the Enforcement Department at FINRA, specializing in antimoney 

laundering (AML) and other Bank Secrecy Act issues. She has responsibility for consulting 

with examination and enforcement staff on AML and other issues, as well as training staff 

organizationwide on the handling of suspicious activity reports (SARs). Ms. Green is also responsible 

for FINRA AML guidance and external training of financial industry professionals domestically and 

internationally. Previously, she was the Bank Secrecy Act Specialist in the Division of Enforcement’s 

Office of Market Intelligence (OMI) at the U. S. Securities and Exchange Commission. In this role, she 

oversaw the commission’s review and use of SARs, consulted with enforcement staff on anti-money 

laundering and SAR handling issues, and facilitated information sharing between enforcement and 

SEC’s Office of Compliance Inspections and Examinations (OCIE). Prior to joining OMI, Ms. Green 

was a branch chief in OCIE, managing the commission’s AML examination program for brokerdealers 

on a day-to-day basis, including developing examination modules, conducting training for 

SEC and self-regulatory organization (SRO) staff, and coordinating with the SROs on all aspects of 

AML examination and enforcement. Ms. Green represents FINRA on the Bank Secrecy Act Advisory 

Group and has been a member of FinCEN’s Data Management Council. She is a frequent speaker on 

AML, and has provided technical assistance for domestic and international audiences. Prior to joining 

the Commission, she was an associate in the Corporate and Securities practice group at Gardner 

Carton & Douglas LLP. Ms. Green received her law degree from the William and Mary School of Law 

and her bachelor’s from Hamilton College. 

Daniel Hawke is the Unit Chief of the SEC Division of Enforcement's Market Abuse Unit and the 

Director of its Philadelphia Regional Office. In his capacity as Unit Chief, Mr. Hawke oversees 

nationwide investigations into large-scale insider trading networks and rings – so-called "organized" 

insider-trading, large cap market manipulations, system-based and platform-driven trading violations 

such as front running, collusive trading, best execution and abusive short selling violations as well as 

other systemic, institutional regulatory violations, internal control violations and other abusive market 

practices. In his capacity as Regional Director, Mr. Hawke oversees the Commission's regulation and 

enforcement programs in Pennsylvania, Delaware, Maryland, Virginia, West Virginia and the District 

of Columbia. Mr. Hawke joined the SEC's Philadelphia Office in March 2005 as head of its 

enforcement program. Between 1999 and 2005, he served as a branch chief and senior counsel in 

the SEC's Division of Enforcement in Washington, D.C. where he was involved in bringing significant 

enforcement actions involving public company accounting and financial disclosure, broker-dealer 

regulation, insider trading and Regulation FD. He is the recipient of the Commission's Stanley Sporkin 

Award and the Ellen B. Ross Award. Prior to joining the Commission, Mr. Hawke was a litigation 

partner at the law firm of Tucker, Flyer & Lewis in Washington, D.C. Mr. Hawke is a graduate of 

Boston University School of Law, where he was Editor-in-Chief of the Boston University International 

Law Journal, and a graduate of Tulane University where he received his bachelor's degree in political 

science. 

Bill Park is Senior Director, Enforcement, at FINRA, and has been responsible for detecting, 

investigating, and leading examinations in a wide variety of complex securities matters throughout his 

tenure at the regulator. Mr. Park started with FINRA Enforcement over 15 years ago as an 


investigator; and before that, he worked in the trading back office of Legg Mason Wood Walker. 

Currently, Mr. Park leads the FINRA Enforcement Case Development Team, where he is responsible 

for identifying and developing investigations into high impact, novel and complex areas. Over the 

years, Mr. Park has developed significant experience and expertise in examinations involving fraud, 

suspicious trading schemes and AML issues. Mr. Park has been qualified as a securities industry 

expert in various federal courts and has testified in several criminal securities proceedings. Mr. Park 

is a Certified Fraud Examiner, Certified Financial Services Auditor, Certified Anti-Money Laundering 

Specialist and a Certified Regulatory and Compliance Specialist. Mr. Park holds an undergraduate 

degree in economics from Virginia Tech. 

Susan Tibbs is Vice President in the Quality of Markets area of Market Regulation at FINRA. In this 

capacity, she manages manipulation surveillance and investigations for multiple FINRA clients, 

including NASDAQ, NASDAQ OMX BX, and NASDAQ OMX PSX, and investigations for BATS, 

BATS Y, EDGA and EDGX Exchanges. She has been a member of the Market Regulation 

Department for more than 15 years. Over the years, she worked on surveillance and investigations 

related to multiple product types and complex investigations related to various forms of market 

manipulation including layering. Her most recent work includes management of high-frequency 

trading investigations. She received her law degree from Thomas M. Cooley Law School and her 

bachelor’s degree from The George Washington University. 


National Exam Risk Alert 

By the Office of Compliance Inspections and Examinations 1 

In this Alert: 

Topic: Regulatory concerns related 

to master/sub-account structures. 

Key Takeaways: 

Master/sub-account trading 

arrangements can pose the 

following risks, among others: 

Money laundering; 

Insider trading; 

Market manipulation; 

Account intrusions and 

information security; 

Unregistered broker-dealer activity 

and excessive leverage. 

New Rule 15c3-5 requires brokerdealers 

to have controls and 

procedures reasonably designed to 

manage the financial, regulatory 

and other risks associated with 

providing a customer or other 

person with market access. 

This alert highlights examination 

points of inquiry and compliance 

suggestions to address these risks. 

Volume I, Issue 1 September 29, 2011 

I. Introduction 

Master/Sub-accounts 

The Securities and Exchange Commission’s (“Commission”) 

National Exam Program (“NEP”) has identified the master/subaccount 

trading model as a vehicle that could be used to further 

violations of the federal securities laws as well as other laws and 

regulations. In particular, misuse of the account structure raises 

significant regulatory concerns with respect to: (i) money 

laundering, (ii) insider trading, (iii) market manipulation, (iv) 

account intrusions, (v) information security, (vi) unregistered 

broker-dealer activity, and (vii) and excessive leverage (e.g., 

inadequate minimum equity for pattern day traders). 2 

Generally, in the master/sub-account trading model, a top-level 

customer opens an account with a registered broker-dealer (the 

“master account”) that permits the customer to have subordinate 

accounts for different trading activities (“sub-account”). In many, if 

not most, instances, the customer opening the master account is a 

limited liability company (“LLC”), limited liability partnership 

(“LLP”) or similar legal entity or another broker-dealer with 

numerous other persons trading through the master account 

(“traders”). The master account will usually be subdivided into 

subunits for the use of individual traders or groups of traders (“subaccounts”). 

In some instances, these sub-accounts are further 

divided to such an extent that the master account customer and the 

1 

The Securities and Exchange Commission (“SEC”), as a matter of policy, disclaims responsibility for any 

private publication or statement by any of its employees. The views expressed herein are those of the staff 

of the Office of Compliance Inspections and Examinations, in coordination with other SEC staff, including 

in the Division of Trading and Markets, and do not necessarily reflect the views of the Commission or the 

other staff members of the SEC. This document was prepared by the SEC staff and is not legal advice. 

2 

Under NASD Rule 2520, the term “pattern day trader” means any customer who executes four or more 

trades within five business days. If day-trading activities do not exceed six percent of the customer’s total 

trading activity for the five-day period, the clearing firm is not required to designate such account as pattern 

day traders. This rule applies to all broker-dealers that are FINRA members. 

1

egistered broker-dealer with which the master account is opened may not know the actual 

identity of the underlying traders. Nevertheless, the master account customer usually tracks the 

trading activities in each sub-account, and will often evaluate the account for risk and/or provide 

a sub-account with additional trading leverage. Although these arrangements may be used for 

legitimate business purposes, some customers who seek these master/sub-account relationships 

often structure their account with the broker-dealer this way in an attempt to avoid or minimize 

regulatory obligations and oversight. 

Promoters of these trading arrangements, who may be customers or other entities, often target 

potential traders in both the US and abroad with the promise of increased leverage and lower 

capital contributions than these persons would otherwise be allowed as day traders at a registered 

broker-dealer. The sub-account traders then usually engage in day-trading and/or other 

leveraged trading activity, with the trades executed via trading systems or other platforms 

provided by the master account customer/owner, whom the registered broker-dealer has 

authorized to use its Market Participant Symbol (or MPID). 

The Commission recently adopted Rule 15c3-5 (“Market Access Rule” or the “Rule”) under the 

Securities Exchange Act of 1934 (“Exchange Act”). 3 The Market Access Rule applies to 

broker-dealers with market access to an exchange or alternative trading system, as well as to 

broker-dealers that provide customers or other persons with access to trading securities directly 

on an exchange or alternative trading system through the use of the broker-dealer’s MPID or 

otherwise. 4 Under the Rule, the broker-dealer is responsible for having risk management 

controls and supervisory procedures reasonably designed to ensure compliance with all laws, 

rules and regulations imposed under the federal securities laws or by self-regulatory 

organizations (“SROs”) in connection with market access (“regulatory requirements”). 5 

Specifically, the Market Access Rule requires broker-dealers to have a system of risk 

management controls and supervisory procedures reasonably designed to manage the financial, 

regulatory and other risks of this business activity associated with providing a customer or other 

person with market access, including restricting access to the broker-dealer’s trading systems and 

technology that provide access to persons pre-approved and authorized by the broker-dealer. 6 

Most of the provisions of the Market Access Rule became effective on July 14, 2011. 7 

3 

4 

5 

6 

7 

Exchange Act Release No. 63241 (Nov. 3, 2010), 75 FR 69792 (Nov. 15, 2010) (“Adopting Release”), 

codified at 17 C.F.R. §15c3-5. 

Rule 15c3-5(a)(1), 17 C.F.R. § 240.15c3-5(a)(1) defines market access as: (i) Access to trading in securities 

on an exchange or alternative trading system as a result of being a member or subscriber of the exchange or 

alternative trading system, respectively; or (ii) Access to trading in securities on an alternative trading 

system provided by a broker-dealer operator of an alternative trading system to a non broker-dealer. See 

also Adopting Release at 69796-97. 

Rule 15c3-5(c)(2), 17 C.F.R. § 240.15c3-5(c)(2). See also Adopting Release at 69797-98. 

Rule 15c3-5(b), 17 C.F.R. § 240.15c3-5(b) . 

The Commission extended the compliance date, until November 30, 2011, for all of the requirements of 

Rule 15c3-5 for fixed income securities, and the requirements of Rule 15c3-5(c)(1)(i) for all securities. 

Rule 15c3-5(c)(1)(i) requires that the risk management controls must be reasonably designed to: “[p]revent 

the entry of orders that exceed appropriate pre-set credit or capital thresholds in the aggregate for each 

customer and the broker or dealer and, where appropriate, more finely-tuned by sector, security, or 

otherwise by rejecting orders if such orders would exceed the applicable credit or capital thresholds.” 

2

The master/sub-account structure creates potential risks of noncompliance with legal 

requirements. 

One of the most significant risks associated with these arrangements is that, many times, the 

registered broker-dealer obtains and maintains information only with respect to its customer, the 

owner of the master account (i.e., the LLC or LLP). As mentioned above, because sub-accounts 

may be further divided, the broker-dealer may not know who is utilizing its MPID and trading in 

the sub-accounts. This lack of information may expose the registered broker-dealer to legal and 

reputational risks. The Market Access Rule is intended in part to address these risks by requiring 

broker-dealers to establish, document and maintain a system of risk management controls and 

supervisory procedures that are reasonably designed, among other things, to ensure compliance 

with all regulatory requirements that are applicable in connection with market access. 8 

Identified below are certain risks associated with the master/sub-account trading model. Failing 

to reasonably address these risks could place the broker-dealer in violation of the federal 

securities laws and rules thereunder, including the Market Access Rule, as well as applicable 

SRO rules. 

Money Laundering, Terrorist Financing and Other Illicit Activity – The Bank 

Secrecy Act (“BSA”), 9 initially adopted in 1970, establishes the basic framework for anti-money 

laundering (“AML”) obligations imposed on financial institutions. 10 The BSA, as amended, is 

intended to facilitate the prevention, detection, and prosecution of money laundering, terrorist 

financing, and other financial crimes. Among other things, the BSA requires broker-dealers to: 

(i) establish and implement an effective AML program, 11 (ii) establish a Customer Identification 

Program (“CIP”), 12 and (iii) monitor, detect and file reports of suspicious activity (the “SAR 

Requirement”). 13 Moreover, Exchange Act Rule 17a-8 requires broker-dealers to comply with 

the reporting, recordkeeping and record retention requirements in regulations under the BSA. 14 

On September 1, 2010, as part of concurrent enforcement actions with the Financial 

Crimes Enforcement Network of the Department of the Treasury, 15 the Commission found that 

Pinnacle Capital Markets violated Exchange Act Section 17(a) and Rule 17a-8 thereunder by 

8 

9 

10 

11 

12 

13 

14 

15 

Adopting Release at 69797-98. The required controls and procedures would need to adapt as regulatory 

requirements applicable to market access change. Id. 

Currency and Foreign Transactions Reporting Act of 1970, (commonly referred to as the Bank Secrecy 

Act), 12 U.S.C. § 1829b, 12 U.S.C. §§ 1951-1959, and 31 U.S.C. § 5311-5330. 

31 C.F.R. § 1000-1099. 

The BSA requires that broker-dealers establish AML programs that include, at a minimum, (1) the 

development of internal policies, procedures, and controls; (2) the designation of a compliance officer; (3) 

an ongoing employee training program; and (4) an independent audit function to test programs. 31 U.S.C. § 

5318(h). A broker-dealer is deemed to have complied with this AML program requirement if the brokerdealer 

adopts an AML program pursuant to the rules of a self-regulatory organization. See 31 C.F.R. § 

1023.210(b)(2). FINRA Rule 3310, as well as other SRO rules, requires broker-dealers to establish such a 

program. 

31 C.F.R. §1023.220. 

31 C.F.R. § 1023.320. 

17 C.F.R. §240.17a-8. 

See In the Matter of: Pinnacle Capital Markets, LLC, FinCEN Matter No. 2010-4 (Sept. 1, 2010). 

3

failing to document accurately its customer verification procedures. 16 Pinnacle held master 

omnibus accounts for foreign entities, which in turn were subdivided into sub-accounts for other 

foreign entities. The holders of these sub-accounts were then able to conduct transactions 

directly in the US securities markets. The Commission found that Pinnacle treated these subaccount 

holders in the same manner as it did its regular account holders, allowing them to use 

direct market access software to enter securities trades directly and instantly through their own 

computers. The Commission concluded that the sub-account holders were Pinnacle's customers 

for purposes of the CIP rule because the sub-account holders effected securities transactions 

directly and without the intermediation of the master account holders. The Commission found 

that Pinnacle did not accurately document its CIP as required by the CIP rule, because Pinnacle 

had not identified the customer sub-account holders or verified their identities. As a result of this 

and other conduct, Pinnacle was found to have willfully violated Section 17(a) of the Exchange 

Act and Rule 17a-8 thereunder. 

Risk: If money laundering, terrorist financing or other suspicious activity (such as the 

activity detailed below) is occurring through a customer’s master/sub-account, it may be difficult 

for the broker-dealer to identify who is responsible for such activity or whether suspicious 

activity is the result of one person or many persons who have authority to trade in the accounts. 

As a result, these relationships may make it difficult for a broker-dealer to adequately monitor 

for suspicious activity, and therefore to comply with the SAR Requirement. 

A broker-dealer must remain cognizant of its obligations under the CIP rule with respect 

to master/sub-account arrangements, as there are instances when the CIP rule may require 

identification and verification of sub-account holders. 17 Where a sub-account holder is the 

broker-dealer’s “customer” for purposes of the CIP rule, the broker-dealer must treat the subaccount 

accordingly. 18 For example, as in Pinnacle, where a broker-dealer has treated a sub- 

16 

17 

18 

In the Matter of Pinnacle Capital Markets LLC and Michael A. Paciorek, Exchange Act Release No. 62811 

(Sept. 1, 2010) (settled administrative proceeding); In the Matter of: Pinnacle Capital Markets,LLC, 

FinCEN Matter No. 2010-4 (Sept. 1, 2010)(concurrent FinCen action). The Commission has brought a 

number of other actions to enforce compliance by brokers and dealers with regulations under the BSA 

pursuant to Section 17(a) of the Exchange Act and Rule 17a-8 thereunder. See e.g., In the Matter of 

E*Trade Clearing LLC and E*Trade Securities LLC, Exchange Act Release No. 58250 (Jul. 30, 2008); In 

the Matter of Crowell, Weedon & Co., Exchange Act Release No. 53847 (May 22, 2006). 

This alert is not intended to be a comprehensive review of a broker-dealer’s AML obligations generally, or 

specifically with respect to master/sub-account relationships. Other AML obligations may require a 

broker-dealer to obtain information regarding sub-account holders, including, among other things, the due 

diligence obligations for private banking accounts and for correspondent accounts for foreign financial 

institutions, and requirements relating to the prohibition on correspondent accounts for foreign shell banks. 

See, e.g., 31 C.F.R. 1010.610, 1010.620, and 1010.630. See, also, Guidance on Obtaining and Retaining 

Beneficial Ownership Information, Exchange Act Release No. 61651 (Mar. 5, 2010). 

See, e.g., 31 C.F.R. §1023.100(d) (defining a “customer” for purposes of the CIP rule as a person who 

opens a new account); 31 C.F.R. §1023.220(a)(2)(ii)(C) (additional verification requirements for certain 

customers (i.e., customers that are not individuals); Question and Answer Regarding the Broker-Dealer 

Customer Identification Program Rule (31 CFR 103.122) (Oct. 1, 2003) available at 

http://sec.gov/divisions/marketreg/qa-bdidprogram.htm (Question and Answer (“Q&A”) that addressed the 

non-exclusive circumstances under which a broker-dealer could treat an omnibus account holder as the 

only customer for the purposes of the CIP rule and would not also be required to treat the underlying 

beneficial owner as a customer. Among other things, the Q&A contemplated a scenario in which all 

securities transactions in the omnibus account or sub-account would be initiated by the financial 

4

account owner as its own customer (i.e., sub-account owner effects transactions directly with the 

broker-dealer and without the intermediation of the master account owner), the broker-dealer 

has an obligation to identify and verify the identities of such sub-account holders as required by 

the CIP rule. 

Furthermore, a broker-dealer’s CIP must address situations where, based on the brokerdealer's 

risk assessment of a new account opened by a customer that is not an individual, the 

broker-dealer will obtain information about individuals with authority or control over such 

account. 19 This verification method applies when the broker-dealer cannot verify the customer's 

true identity using the documentary or non-documentary verification methods described in the 

CIP rule. 20 This may require a broker-dealer to obtain information about and verify the identity 

of a sub-account holder where the broker-dealer cannot otherwise verify the identity of the 

master account holder. 

Even absent a CIP obligation, a broker-dealer’s other AML obligations still apply, 

including the SAR Requirement. Among other things, a broker-dealer’s AML program should 

evaluate the risks that may be presented by such master/sub-accounts. Specifically, as part of a 

broker-dealer’s AML Program, a broker-dealer should establish and maintain customer due 

diligence procedures that are reasonably designed to identify and verify the identity of subaccount 

holders, as appropriate, based on the broker-dealer’s evaluation of risks presented by 

21 

such a master account. A broker-dealer’s acceptance of master/sub-account business may be 

higher risk for the reasons detailed above. 

Insider Trading – Illegal insider trading refers generally to buying or selling a security, in 

breach of a fiduciary duty or other relationship of trust and confidence, while in possession of 

22 

material, nonpublic information about the security. Insider trading violations may also include 

“tipping” such information, securities trading by the person “tipped,” and securities trading by 

those who misappropriate such information. The Commission staff is concerned that customers 

with master/sub-account arrangements may seek to use them as vehicles for insider trading 

schemes. 

The regulatory requirements provisions of the Market Access Rule include a requirement 

that a broker-dealer’s risk management controls and supervisory procedures are reasonably 

designed to “prevent the entry of orders for securities that the broker-dealer, customer, or other 


person …is restricted from trading.” 

19 

20 

21 

22 


intermediary holding the omnibus account, and the beneficial owner of the omnibus account or sub-account 

would have no direct control of the transactions effected in the account.). 

31 C.F.R. §1023.220(a)(2)(ii)(C). As discussed infra note 32 and accompanying text, SRO rules have 

independent due diligence and “know your customer” obligations that may apply. 

Id. 

See, e.g., Guidance on Obtaining and Retaining Beneficial Ownership Information, Exchange Act Release 

No. 61651 (Mar. 5, 2010). 

See, e.g., United States v. O’Hagan, 521 U.S. 642, 652-53 (1997). 

17 C.F.R. §240.15c3-5(c)(2)(ii). 

5

Risk: Insider trading may be conducted through a sub-account to try to avoid detection. 

The master account owner (if not a registered broker-dealer) may not be subject to supervisory 

obligations under the securities laws for the activities of the sub-accounts for compliance with 

insider trading rules. However, the registered broker-dealer carrying the master account does 

have certain obligations. 24 While these accounts may be visible to investigators after the 

occurrence of possible insider trading through information requests by self-regulatory 

organizations or the Commission under Exchange Act Rule 17a-25, 25 any weaknesses in frontline 

monitoring by a broker-dealer may create opportunities for abuse. 

If a broker-dealer offering its customers master accounts does not have reasonablydesigned 

controls and procedures to prevent unlawful trading, there may be significant legal and 

reputational risk for the broker-dealer. Reasonable controls and procedures should be designed 

to address factors such as the high volume of transactions flowing through these accounts and 

the lack of knowledge as to who is actually doing the trading. For example, broker-dealers may 

need to design procedures to identify patterns of trading that may indicate potential misuse of 

nonpublic information, and consider whether further due diligence as to the identity of the trader 

is necessary. Broker-dealers offering master accounts should consider surveilling the trading 

activity in master accounts and sub-accounts against their “grey list” and/or “restricted list,” 

and for the purpose of identifying unusual trading ahead of major market announcements or of 

highly profitable trading. Such activity could indicate the possibility of misuse of inside 

information. Broker-dealers should also consider the kind of appropriate due diligence needed 

to identify when the ultimate customer is an insider of a corporation and may be subject to 

trading restrictions in that corporation. 

Market Manipulation – Market manipulation refers to intentional conduct designed to 

deceive investors by controlling or artificially affecting the price of a security. 26 Manipulation 

may involve a number of techniques to affect the supply of, or demand for, a security. They 

include: spreading false or misleading information about a company, improperly limiting the 

number of publicly-available shares, rigging quotes, or pricing trades to create a false or 

deceptive picture of the demand for a security. Those who engage in manipulation are subject to 

various civil and criminal sanctions. As with insider trading, the Commission staff is concerned 

that master/sub-accounts arrangements could be vehicles for market manipulation schemes. 

Risk: A sub-account trader may open multiple accounts under a single master account 

or accounts under different master accounts and at different broker-dealers. The trader could 

effect trades on both sides of the market to manipulate a stock by entering orders to drive the 

price up, mark the close, or engage in other manipulative activity with minimal chance of 

detection. Such conduct may create the false appearance of activity or volume and can 

24 

25 

26 

See, e.g., Rule 15(g), 17 C.F.R. §240.15(g)(policies and procedures reasonably designed to prevent misuse 

of material, nonpublic information by the broker-dealer or associated persons); NASD Rule 3010 

(supervision generally); 31 C.F.R. § 1023.320 (obligation to monitor, detect and file reports of suspicious 

activity). 

17 C.F.R. §240.17a-25. The information provided under Rule 17a-25 is commonly referred to as the 

Bluesheets. While Bluesheets may not directly reveal which sub-accounts were responsible for individual 

trades, that information should be obtainable by inquiry or subpoena to the master account owner. 

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976). 

6

therefore fraudulently influence the price of a security. In addition, some bad actors may be 

engaged in account intrusions to further their manipulative conduct. Broker-dealers offering 

customers master accounts should apply their market manipulation surveillance parameters to 

trading activity at both the master account and sub-account levels. 

Information Security – Information security means protecting information and 

information systems from unauthorized access, use, disclosure, disruption, modification, perusal, 

inspection, recording or destruction. The Commission staff has observed that broker-dealers, 

master account owners and sub-account traders could be vulnerable to breaches of information 

security due to weak controls. This vulnerability implicates the Market Access Rule requirement 

that broker-dealers “establish, document, and maintain a system of risk management controls and 

supervisory procedures reasonably designed to manage the financial, regulatory, and other risks” 

of providing market access to any other person. 27 

Risk: If a broker-dealer does not have appropriate controls over access to a master 

account, the broker-dealer may lack means to protect itself, the master account/sub-account 

owners, and its other customers from unauthorized access and use. Although hacking is a 

potential risk for any broker-dealer, a master/sub account structure poses a greater risk of 

hacking based on the risk that a larger population of persons with access to a broker-dealer’s 

trading systems is more likely to include either bad actors or persons who are careless about 

information security. 

Under a scenario in which the master account owner is the beneficial owner of not only the 

master account but also the various sub-accounts, the broker-dealer only knows the master 

account owner as its customer. As illustrated by a number of Commission enforcement actions, 

various forms of electronic account intrusion are a serious risk for broker-dealers and their 

customers, 28 and broker-dealers that permit master/sub-account arrangements must take 

reasonable measures to address this risk. 

Master/sub-account relationships could also present a risk to informational national 

security if multiple sub-accounts, held through one or many different customers’ master 

accounts, are used to conduct a single or multi-source cyberattack on a systemically important 

financial institution, such as the broker-dealer carrying the master account, a market utility 

linked to the broker-dealer or to the master account, such as a clearance or settlement system, or 

a counterparty of the broker-dealer or master account. While the NEP staff has not observed 

indications of such an attack, the consequences of such an attack could be severe, for the host 

broker-dealer as well as for the securities markets generally. 

27 

28 

Rule 15c3-5(b), 17 C.F.R. § 15c3-5(b). This vulnerability could also implicate Rule 15c3-5(c)(2)(iii), 17 

C.F.R. § 15c3-5(c)(2)(iii), which specifies that the required risk management controls and supervisory 

procedures should be reasonably designed to, inter alia, “restrict access to trading systems and technology 

that provide market access to persons and accounts pre-approved and authorized by the broker or dealer.” 

See, e.g., SEC v. Dorozhko, Litigation Release No. 21465 (Mar. 29, 2010)(summary judgment against 

computer hacker for insider trading); SEC v. Marimuthu, et al., Litigation Release No. 20037 (Mar. 12, 

2007)(offshore hackers charged with account intrusion into online accounts and market manipulation); SEC 

v. Dinh, Litigation Release No. 18401 (Oct. 9, 2003)(allegations that hacker broke into investor’s online 

account and placed unauthorized buy orders). 

7

Broker-dealers offering customers master accounts may consider applying information 

security parameters and triggers to ensure that the trading activity and volume flowing through 

the master account do not result in undue added operational risk to the broker-dealer. In 

addition, the broker-dealers may require master account owners to implement controls to 

prevent the use of technology for inappropriate purposes. 

Unregistered Broker-Dealer Activity – Section 15(a) of the Exchange Act makes it 

unlawful for any broker or dealer to effect any transaction in, or induce or attempt to induce the 

purchase or sale of, any security unless such broker or dealer is registered with the Commission. 

The staff is concerned that broker-dealers offering master/sub-account arrangements may 

provide an avenue for unregistered broker-dealer activity, in which an LLC, LLP or other entity 

solicits customers to trade through the unregistered broker-dealer’s master account while taking 

trading commissions or other compensation from the sub-account traders. Indeed, the 

Commission has recently brought actions against persons opening master accounts through a 

registered broker-dealer and then giving day traders access to the securities markets through subaccounts. 

29 

Risks: As illustrated in actions against Tuco Trading, LLC and Warrior Fund, LLC, 

many master/sub-account arrangements may permit the master account owner, and possibly a 

sub-account owner, to act as unregistered broker-dealers in violation of Section 15(a) of the 

Exchange Act. In addition, the registered broker-dealer with which an unregistered broker 

opens an account may also have liability for aiding and abetting in the activities of the 

unregistered broker-dealer’s registration violations. 

In exercising its “know your customer” reasonable diligence, 30 a broker-dealer offering 

customers master accounts should understand the relationship that exists between the master 

account and the sub-account traders. For example, if the master account is identified by the 

broker-dealer’s customer as a proprietary account, the broker-dealer should endeavor to obtain 

and review valid partnership or employment agreements to evidence that the relationship 

between the master account customer and the sub-account is an employee or partnership 

relationship rather than a customer relationship. 

Excessive Leverage and Others Risks – In addition to the risks identified above, market 

participants and sub-account traders are also exposed to a number of other risks as a result of 

abusive practices facilitated by the master/sub-account trading model, including being 

inappropriately used to offer excessive leverage. 

Risks: In addition to unregistered broker-dealer activity, Tuco Trading, LLC and Warrior 

Fund, LLC, illustrate that master/sub-account arrangements also can be inappropriately used to 

offer excessive leverage to pattern day-traders who may have inadequate equity balances for 

such leverage. Additionally, staff continues to have a concern that the master/sub-account 

29 

30 

See In the Matter of Tuco Trading, LLC and Douglas G. Frederic, Litigation Release No. 20500 (Mar. 18, 

2008); In the Matter of Warrior Fund, LLC, Exchange Act Release No. 61625 (Mar. 2, 2010). 

The “know your customer rule” has long applied to most broker-dealers under New York Stock Exchange 

Rule 405(1). That rule, now enforced by FINRA, will soon be supplanted by FINRA Rule 2090, which 

takes effect July 9, 2012. See Securities Exchange Act Release No. 63325 (Nov. 17, 2010), 75 FR 71479 

(Nov. 23, 2010) (Order Approving Proposed Rule Change; File No. SR-FINRA-2010-039). FINRA Rule 

2090 is substantially the same as NYSE Rule 405(1). See FINRA NTM 11-25 (May 2011) at 2. 

8

trading model may be used by master account owners as a means to defraud traders who 

contribute money in order to obtain market access to trade. 31 

II. 

The National Exam Program will examine for compliance with the Market 

Access Rule as a means to combat violative activity in the master/sub-account 

trading model. 

With the adoption of the Market Access Rule, broker-dealers that provide market access are 

required to establish, document, and maintain a system of risk management controls and 

supervisory procedures that, among other things, is reasonably designed to systematically limit 

the financial, regulatory and other risks to the broker or dealer that could arise as a result of 

market access to an exchange or ATS, and ensure compliance with all regulatory requirements 

that are applicable in connection with market access. 32 In examining for compliance with the 

Market Access Rule, the staff intends to scrutinize 

(1) the system of risk management controls and supervisory procedures that addresses 

master account customers to which a broker-dealer offers market access, as defined in the 

Market Access Rule, and 

(2) whether, in accordance with such controls and procedures, a subject broker-dealer is 

appropriately vetting the master account customer and sub-accounts identified as 

customers engaged in the trading business, or proprietary accounts, and individual traders 

with access to the broker-dealer’s MPID, trading system and technology providing 

market access. 

The following are examples of effective practices to evidence due diligence that the staff has 

observed when examining for reasonable controls and procedures in similar contexts, 33 as well as 

illustrations of types of controls that firms might apply in order to comply with the controls and 

procedures requirements of the Market Access Rule: 34 

31 

32 

33 

34 

For example, in the Tuco Trading case, the Commission successfully sought a federal court permanent 

injunction from future violations of the federal securities laws, based on its allegation that the firm 

inaccurately reported equity balances to the traders and had used millions of dollars of the traders’ equity to 

pay for the firm’s expenses, which was not disclosed to the traders. These unregistered broker-dealers 

offering master-sub-account arrangements, even with adequate disclosure, still expose the traders to the risk 

of losing all of their capital contributions and profits based on the actions of the LLC, LLP or other entity 

or the actions/losses of fellow traders. 

Rule 15c3-5(b) and (c)(2), 17 C.F.R. § 15c3-5(b) and (c)(2). 

E.g., compliance with Exchange Act 15(g)’s requirement that broker-dealers have controls and procedures 

reasonably designed to prevent insider trading; compliance with supervisory obligations under the federal 

securities laws. 

These examples are not intended to be exclusive. Firms may demonstrate to the examination staff that they 

have acceptable alternative ways to comply with the Market Access Rule. 

9

To evidence that the subject broker dealer has performed 35 appropriate suitability, knowyour-customer 

and other due diligence on the master account holder and traders to whom 

market access (with an MPID or similar arrangements) has been provided based on the 

broker-dealer’s risk assessment of the business activity: (i) obtaining and maintaining 

the names of all traders authorized to trade with the broker-dealer’s MPID in each subaccount; 

(ii) verifying through documentation the identities of all such traders, including 

fingerprints if appropriate, background checks and interviews; and (iii) periodically 

checking the names of all such traders through criminal and other data bases such as, in 

the case of foreign nationals, the Special Designated Nationals List of the Office of 

Foreign Assets Control of the United States Treasury Department; 

Monitoring trading patterns in both the master account and sub-account levels for 

indications of insider trading, market manipulation, or other suspicious activity; 

Physically securing information of customer or client systems and technology; 

Establishing trader validation requirements (e.g., minimum procedures for effective 

password management, IP address identification, and other mechanisms that validate the 

trader’s identity); 

Tracking and logging incidents of penetration-of-system attempts by outside parties 

without authority; 

Determining that traders who have access to the broker-dealer’s trading system and 

technology have received training in areas relevant to their activity, including market 

trading rules and credit; 

Regularly reviewing the effectiveness of all controls and procedures around sub-account 

due diligence and monitoring; and 

Creating written descriptions of all controls and procedures around sub-account due 

diligence and monitoring, including frequency of reviews, identity of who is responsible 

for conducting such reviews, and a description of the review process. 

In the course of these examinations, the broker-dealer providing access will be asked to supply 

information regarding the nature of its risk assessment and to support its conclusions. The staff 

may request records evidencing whether persons associated with the master account customer, 

who are provided access to the market through the broker-dealer’s trading systems or other 

technology, are not themselves customers for purposes of Exchange Act Rule 15c3-3. For 

example, the subject broker-dealer may supply (i) partnership or shareholder agreements signed 

by the person at the sub-account level to whom market access is provided, or (ii) documentary 

evidence among the various persons to whom access or technology is provided that sufficiently 

demonstrates that the relationship between the customer and the sub-account traders is an 

employment or trading relationship rather than a customer relationship. 

III. 

Conclusion. 

While master/sub-account arrangements may be used for legitimate business purposes, the NEP 

has also identified a number of serious abusive practices that this account structure can facilitate. 

Broker-dealers offering master/sub-accounts have an obligation under the Market Access Rule to 

35 

The Market Access Rule provides that broker-dealers may have a reasonable, written allocation 

arrangement under certain circumstances with a customer that is a registered broker-dealer for specific 

controls and procedures Rule 15c3-5(d)(1), 17 C.F.R. § 15c3-5(d)(1). 

10

establish, document and maintain a system of risk management controls and supervisory 

procedures that are reasonably designed, among other things, to ensure compliance with all 

regulatory requirements that are applicable in connection with market access. In this Alert we 

have described certain risks that broker-dealers that offer the master/sub-account trading model 

to customers should consider in designing such controls and procedures. We have also 

highlighted certain practices that we believe could be helpful to firms in meeting their 

obligations under the Market Access Rule. 

11



10:30 a.m. – 11:45 a.m. 

Resources 

Disciplinary Actions 

FINRA Actions: 

• Department of Enforcement v. Pinnacle Capital Markets, LLC, (Case No. 2006006637101) 

(December 17, 2009) 

FINRA Press Release: www.finra.org/Newsroom/NewsReleases/2010/P120859 

Pinnacle operates as an online business providing primarily foreign customers direct access to the 

U.S. securities markets. Direct online access allows customers to electronically execute trades with 

virtually no intervention by the firm. Nearly all of the firm's customers, including foreign financial 

institutions, reside in overseas jurisdictions known for a high degree of money-laundering risk, as 

classified by the U.S. Department of State. These foreign financial institutions opened sub-accounts 

for foreign customers who could then direct activity without fully disclosing their identity. From 

January 2006 to September 2009, Pinnacle failed to adopt risk-based procedures to verify the identity 

of sub-account holders, even though these customers lived overseas in high-risk jurisdictions and 

could freely execute trades for their own profit. 

Pinnacle also failed to adopt effective procedures for detecting suspicious activity. Instead, the firm 

used a "manual" system, which involved a daily review of its trade blotter. This approach failed to 

uncover highly suspicious trading patterns, including abrupt and inexplicable changes in investment 

strategy, the rapid accumulation and liquidation of penny stocks for profit, and other indications of 

potential market manipulation. In one particularly egregious case, the firm failed to detect irregular 

trading patterns in customer accounts used as part of an international online "pump-and-dump" 

scheme involving a Latvian bank. 

• Department of Market Regulation v. Trillium Brokerage Services, IXC, f/k/a Trillium Trading 

LLC, et al., (Case No. 2007007678201) (August 5, 2010) 

www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p122044.pdf 

FINRA Press Release: www.finra.org/Newsroom/NewsReleases/2010/P121951 

The Financial Industry Regulatory Authority (FINRA) today announced that it has censured and fined 

New York-based Trillium Brokerage Services, LLC, $1 million for using an illicit high frequency trading 

strategy and related supervisory failures. Trillium, through nine proprietary traders, entered numerous 


layered, non-bona fide market moving orders to generate selling or buying interest in specific stocks. 

By entering the non-bona fide orders, often in substantial size relative to a stock's overall legitimate 

pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure. 

This trading strategy induced other market participants to enter orders to execute against limit orders 

previously entered by the Trillium traders. Once their orders were filled, the Trillium traders would 

then immediately cancel orders that had only been designed to create the false appearance of market 

activity. As a result of this improper high frequency trading strategy, Trillium's traders obtained 

advantageous prices that otherwise would not have been available to them on 46,000 occasions. 

Other market participants were unaware that they were acting on the layered, illegitimate orders 

entered by Trillium traders. 

• Department of Enforcement v. Zulina Visram (Case No. 2010021162201) (May 27, 2011) 

http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=17092 

In 2008 and 2009, Respondent, as the Firm's CCO, was the designated principal responsible for 

compliance with NASD Rule 3012(a)(1). Although Respondent was aware that the Firm's business 

was limited to executing transactions on behalf of foreign day traders, Respondent never tested and 

verified whether Biremis' procedures were reasonably designed to detect and prevent manipulative 

and fraudulent trading activity, nor did she detail Biremis system of supervisory controls in the report 

that she prepared and submitted to senior management as required by the rule. 

In 2008 and 2009, Biremis received and handled a significant volume of orders originating from day 

traders located outside the United States, and executed the majority of those orders on U.S. markets. 

During the period from January 1,2009 through June 30, 2010, for example, Biremis received an 

average of over one million orders per day and executed, on average, over 400,000 transactions 

involving, in the aggregate, more than 310 million shares. On average, 83% of the transactions 

executed by Biremis during this time period were executed on U.S. markets. 

• Department of Enforcement v. TradeStation Securities, Inc. (Case No. 2010023934201) 

(Dec. 19, 2011) 

http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=27310 

The firm submitted an Acceptance, Waiver and Consent in which the firm was censured and fined 

$200,000. Without admitting or denying the findings, the firm consented to the described sanctions 

and to the entry of findings that it failed to implement policies and procedures reasonably designed to 

detect and cause the reporting of suspicious activity in customer accounts as required by 31 U.S.C. 

5318(g) and the implementing regulations thereunder. In particular, the firm failed to tailor its AMLCP 

to its business, which is to provide direct market access to equities, futures and foreign exchange 

market (forex) customers using a proprietary online trading platform. The findings also stated that the 

firm’s written AML procedures did not contain adequate provisions for the monitoring of trades to 

detect suspicious activity. In practice, the firm’s automated surveillance of trades was limited to two 

daily exception reports, a wash sales report and an odd/partial round lot report. Apart from these two 

exception reports, the firm did not utilize other automated surveillance modules to monitor trades for 

suspicious activity so that the firm may have failed to detect and report red flags concerning irregular 

patterns of trading activity, including evidence of market manipulation and other suspicious 

transactions. The findings also included that for monitoring flow of funds, the firm relied on a manual, 

transaction-by-transaction approach, conducted by the firm’s cashiers; each cashier was assigned a 

specific type of money movement to monitor (e.g., one would review outgoing wires and another 

would review incoming wires). The cashiers were instructed to notify the firm’s AMLCO by email when 

the flow of funds in an account looked suspicious. Additionally, the AMLCO selected one day a month 

at random and reviewed all wires for that particular day. The AMLCO recorded this information on a 

log, but did not begin recording this information until recently. The firm’s approach to monitoring flow 

of funds made it difficult to detect patterns of suspicious activity over time. 


SEC Actions: 

• In the Matter of Pinnacle Capital Markets LLC and Michael A. Paciorek, Exchange Act Rel. 

No. 62811 (September 1, 2010) 

www.sec.gov/litigation/admin/2010/34-62811.pdf 

SEC Press Release: www.sec.gov/news/press/2010/2010-161.htm 

Pinnacle is a broker-dealer based in Raleigh, N.C., with more than 99 percent of its customers 

residing outside the United States. Pinnacle's business primarily involves order processing with direct 

market access (DMA) software for foreign institutions comprised mostly of banks and brokerage firms 

and foreign individuals. 

The SEC found that Pinnacle established, documented and maintained a customer identification 

program (CIP) that specified it would identify and verify the identities of all of its customers. However, 

during a six-year period, Pinnacle failed to follow the identification and verification procedures set 

forth in its CIP. 

Financial Crimes Enforcement Network (FinCEN) 

• In the Matter of Pinnancle Capital Markets, LLC, Number 2010-4 – Assessment of Civil 

Money Penalty (August 26, 2010) 

www.fincen.gov/news_room/ea/files/Final%20Pinnacle%20Assessment%20for%20FinCEN% 

20Internet%20with%20Date%20and%20No%20Signature.pdf 

FinCEN Press Release: www.fincen.gov/news_room/nr/html/20100831.html 

FinCEN determined that Pinnacle failed to establish and implement an adequate anti-money 

laundering program, establish an adequate due diligence program for foreign correspondent 

accounts, obtain and verify required customer identification program information for account holders, 

and establish and implement adequate procedures for monitoring suspicious transactions that led to 

the failure to file suspicious activity reports. 

"Of particular relevance in this case was the firm's failure to conduct adequate due diligence under its 

customer identification program when dealing with non-U.S. persons that were subaccount holders 

with direct access to U.S. securities markets. The evidence revealed that Pinnacle could not form a 

reasonable belief that it knew the identity of thousands of customers. This action serves to emphasize 

that all broker-dealers, regardless of size, must implement systems and controls to comply with the 

Bank Secrecy Act" said FinCEN Director James H. Freis, Jr. "Any firm operating without effective 

anti-money laundering and customer identification programs is vulnerable to misuse by clients and 

sanctions by government authorities." 

Regulatory Notices and Other Guidance 

• SEC National Examination Program Risk Alert – Master/Sub-accounts (September 29, 2011) 

http://sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf 

The Securities and Exchange Commission’s National Exam Program has identified the master/subaccount 

trading model as a vehicle that could be used to further violations of the federal securities 

laws as well as other laws and regulations. In particular, misuse of the account structure raises 

significant regulatory concerns with respect to: (i) money laundering, (ii) insider trading, (iii) market 


manipulation, (iv) account intrusions, (v) information security, (vi) unregistered broker-dealer activity, 

and (vii) and excessive leverage (e.g., inadequate minimum equity for pattern day traders). 

• FINRA Regulatory Notice 10-18, Master Accounts and Sub Accounts: FINRA Issues 

Guidance on Master and Sub-Account Arrangements (April 2010) 


The application of many FINRA rules, federal securities laws and other applicable federal laws 

depends on the nature of the account and the identity of its beneficial owners. At times, an account 

may take the form of a master/sub-account arrangement where the beneficial ownership interests in 

the various sub-accounts may or may not be identified to the firm. FINRA recognizes there are bona 

fide reasons to establish master/sub-account arrangements whereby the same beneficial owner 

maintains multiple sub-accounts (for example, to employ different trading strategies or to trade in 

different asset classes). However, certain master/sub-account arrangements raise questions 

regarding whether the master account and all sub-accounts have the same beneficial owner and, 

therefore, whether they can legitimately be viewed as one customer account for purposes of FINRA 

rules, the federal securities laws and other applicable federal laws. 

• SEC -- Policy Statement on Obtaining and Retaining Beneficial Ownership Information for 

Anti-Money Laundering Purposes, Exchange Act Release No. 61651 (Mar. 5, 2010). 

www.sec.gov/rules/other/2010/34-61651.pdf 

The Securities and Exchange Commission is issuing a policy statement that provides guidance on 

obtaining and retaining beneficial ownership information for anti-money laundering purposes. This 

guidance is being issued jointly with the Financial Crimes Enforcement Network, the Board of 

Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of 

the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union 

Administration, and in consultation with the staff of the Commodity Futures Trading Commission. The 

guidance provided in this policy statement clarifies and consolidates existing regulatory expectations 

for obtaining beneficial ownership information for certain accounts and customer relationships. 


Qualifications and Continuing Education 


10:30 a.m. – 11:45 a.m.

Qualifications and Continuing Education 


10:30 a.m. – 11:45 a.m. 


• Explain the differences between the legacy and the redesigned S201 programs. 

• Summarize the changes to the Series 7 qualification exam. 

• Discuss changes to other qualification examination content outlines. 

• Discuss the latest information about the Operations Professional Program. 

Moderator: 

Speakers: 

John Kalohn 


FINRA Testing and Continuing Education 

Joseph McDonald 

Senior Director 

FINRA Qualifications and Exams 

Roni Meikle 

Director of Continuing Education 

FINRA Testing and Continuing Education 

Outline 

Overview of the redesigned S201 Program 

• Focus on the educational value of the program 

• Changes to the program workflow 

• Preparation tools for candidates and metrics / reports for firms 

Overview of changes to the Series 7 Exam 

• Overview of the Series 7 Exam update project 

• Description of changes made to the Series 7 exam 

Various registration categories and updated qualification exams 

• Job analysis / focus groups 

• Upcoming exam revisions: Series 6, 16, 24 and 26 

• Other updated exams: Series 17, 37 and 38 

Update on the Operations Professional Program 

• Update on the Series 99 Operations Professional Exam 

• Update on the S901 Continuing Education Program 



John Kalohn is Vice President of FINRA’s Testing and Continuing Education Department. He leads 

FINRA’s efforts in the development, maintenance and delivery of the securities industry qualification 

examinations and continuing education programs. He has more than 20 years of experience in 

educational measurement and assessments, with more than 17 years of experience developing, 

implementing and managing assessment programs for professional licensure and university 

admissions. Dr. Kalohn’s prior experiences include service with one of the nation’s largest providers 

of educational and workplace measurement and research services. He holds a bachelor’s degree 

from State University of New York, a master’s degree from Wake Forest University and a doctorate 

from the University of Wisconsin, Madison. 

Joseph McDonald is the Senior Director of Qualifications and Registration within FINRA’s Testing 

and Continuing Education Department, where he manages FINRA qualification examinations and 

examination waiver matters. Mr. McDonald began his career with FINRA (then NASD) 14 years ago. 

Previously, he worked as counsel in the Office of Compliance and Inspections and the Division of 

Market Regulation at the Securities and Exchange Commission and as a clerk for an administrative 

law judge at the Commodity Futures Trading Commission. He received a bachelor’s degree in 

psychology from the State University of New York at Stony Brook and a law degree from the 

American University’s Washington College of Law. 

Roni Meikle is the Director of Continuing Education in FINRA’s Registration and Disclosure 

Department, where she manages the development and administration of the Continuing Education 

Regulatory Element Programs and provides tools and guidance for the Firm Element Programs. In 

addition, Ms. Meikle serves as the administrator of the Securities Industry/Regulatory Council on 

Continuing Education (CE Council) and oversees the operations of the CE Council’s website, 

www.cecouncil.com. She served in similar roles during her tenure with NYSE Regulation. Before 

joining the NYSE as the manager of broker and specialist training in 1998, Ms. Meikle held positions 

in training, technical writing and systems analysis/management with Dow Jones Markets, Computer 

Applications Learning Center, Amerada Hess Corporation, Merrill Lynch and Mutual Benefit Life 

Insurance. Ms. Meikle graduated from Montclair State University with a bachelor’s degree in business 

administration with a concentration in systems management. 


Qualifications and Continuing 

Education 



Panel Members 

• John C. Kalohn (Moderator) 

Vice President – FINRA Registration and Disclosure / 

Testing and Continuing ing Education 

• Joseph McDonald (Presenter) 

Senior Director – FINRA Qualifications and Testing 

• Roni Meikle (Presenter) 

Senior Director – FINRA Continuing Education 


1

Agenda 

• Redesigned S201 Continuing Education Program 

• Revision of the Series 7 Examination 

• Qualification Examination Revisions 

• Operations Professional Qualification Examination 

and Continuing Education Programs 


Redesigned S201 Continuing Education 

Program 

2

CE Program Redesign – Project Overview 

• A multi-year, multi-phased project to redesign the 

Regulatory Element of the Continuing Education (CE) 

Program 

• Incorporates updated technologies and state-of-the-art 

instructional design methodologies 

• CE Redesign project phases: 

• Phase I – Update the technology infrastructure and instructional 

design methodologies to support state-of-the art content 

development for the S101 and S106 Programs. (Completed 

January 2010) 

• Phase II – Leverage infrastructure and instructional design 

updates to redesign the S201 Program. (Completed January 2012) 

• Phase III – Expand the S101 to provide more personalized CE 

programs to align with functional responsibilities and explore 

feasibility of Web delivery. (In progress) 


4 

Redesigned S201 Program – What’s Changed? 

• The interface has been updated – No more “Click on 

the Lighted Building” to access the modules / cases. 

– Click on the module selection screen to access the cases. 

• Four modules integrate common topics in contextual storylines. 

• Participants may select the order in which the modules are presented. 

• Lengthy module-specific tutorials have been replaced with contextual 

extensions of the storylines. 

• Interface is the same as that used in the S101 / S106 Programs. 

• Audio and video have been eliminated 

– Self-paced text addresses the varying speeds at which candidates read 

and retain information. 

– Media treatments used to supplement the educational value. 

– Supports faster replacement / rollouts in the event of a rule change. 


5 

3

Redesigned S201 Program – Updated Interface 


Redesigned S201 Program – Structure 

• Redesigned structure reinforces the educational 

aspect of the Regulatory Element Program 

• Learning objectives are presented at the beginning of each 

case to focus the participant’s attention on the required topics 

and set expectations for proficiency. 

• Cases are presented in story format with realistic characters 

whose descriptions remain available throughout the scenes in 

the case. 

• Educational elements are available throughout the case to 

support the learning objectives. 

– Rollovers are short definitions of terms used in the case. 

– Resources are longer definitions and artifacts such as account 

statements that support the storyline and the learning objectives. 


7 

4

Redesigned S201 Program – Education Elements 


Redesigned S201 Program – Sample Scene 


5

Redesigned S201 Program – Activities 

• Activities appear at the end of each scene to assess 

proficiency 

• Activities directly relate to the learning objectives and educational 

elements. 

• A variety of activity types are used throughout the case. 

• Instructive feedback appears for each activity to enhance 

knowledge or correct misconceptions that led to incorrect 

responses. 

• A story wrap-up appears if the participant shows proficiency with 

subject matter. 

• If proficiency of the subject mater was not demonstrated, 

the storyline continues into extra scenes, called vignettes, 

to provide additional learning opportunities. 

• A variety of activities directly relate to the learning objectives and 

educational elements. 

• Instructive feedback appears for each activity. 


10 

CE Redesigned Program – Proficiency 

• Two cases per module are randomly selected for 

participants. 

• If proficiency of the content was demonstrated in the first case 

– A story wrap up appears to provide closure to the storyline. 

– Participants are returned to the Module Selection Screen to choose the next 

module. 

• If proficiency of the content was not demonstrated, the 

storyline continues into vignette1 to provide additional 

opportunities to show proficiency. 

• If proficiency was not demonstrated at the end of the first 

case: 

• Transitional messages appear warning that the participant may 

not complete the module. 

• The second case is presented to the participant. 


11 

6

CE Redesigned Program – Proficiency 

• If proficiency was not demonstrated in the second 

case: 

• A story wrap up appears to provide closure to the storyline. 

• Transitional messages appear warning that the participant will 

not complete the module. 

• Participants are returned to the Module Selection Screen where 

an incomplete status will be indicated for that module. 

• Participants who do not demonstrate proficiency in 

any one module will not complete the Regulatory 

Element requirement within that t session. 

• The participant may continue viewing the remaining modules 

for their educational benefit. 

• The participant will have to schedule another CE session. 


12 

CE Redesign Program – Information 

• Tools are available at cedemo.finra.org and 

cecouncil.com to become familiar with the 

Redesigned Programs: 

– Content outlines describing the topics covered in the Redesigned S201 

as well as the S101/S106 Programs. 

– An animated orientation that highlights the interactive functions of the 

programs. 

– An abbreviated sample case that demonstrates the new presentation 

format of the Regulatory Element Programs, complete with each type of 

activity. 

• Quarterly reports have been redesigned as well. 

• Reports are available through Report Center on FINRA.org. 

• Quarterly reports now include the S201 results. 


13 

7

CE Redesign Program – What’s Next? 

• Phase III: Personalization and Web delivery 

• Explore possibility of Web delivery of the Regulatory Element 

Programs. 

– Have explored a number of alternatives, but no winners yet. 

• Develop new required Continuing Education Programs as 

needed. 

– S901 for Operations Professionals is underway. Expected launch is 

November 2013 to coincide with candidate’s two-year anniversaries. 

– S501 for Prop Traders is underway. Expected launch is June 2013 to 

coincide with candidate’s two-year anniversaries. 

• Develop modules of S101 Program to address specific job 

functions. 

– Investigating feasibility of this approach. 


14 

Revision of the Series 7 Exam 

8

Series 7 Exam Revision 

• The Series 7 exam was revised effective November 7, 2011. 

(See FINRA Regulatory Notice 11-45) 

• The revision was based on a job analysis study that 

involved committees of industry and SRO representatives 

reviewing the examination program and data collected on 

the current activities performed by a general securities 

registered representative and the underlying knowledge 

required to perform those activities (e.g., product 

knowledge and rule knowledge). 

• The eSeries es 17, ,37 and d38e exam poga programs have easobee also been 

similarly revised. 

• The content outline describes five major job functions, 28 

tasks and the underlying knowledge required to perform 

the functions and tasks. 


16 

Five Major Job Functions of the Series 7 Exam 

F1 

F2 

F3 

F4 

F5 

Major Job Functions of the Series 7 

Seeks Business for the Broker-Dealer through Customers 

and Potential Customers 

Evaluates Customers’ Other Security Holdings, Financial 

Situation and Needs, Financial Status, Tax Status, and 

Investment Objectives 

Opens Accounts, Transfers Assets, and Maintains 

Appropriate Account Records 

Provides Customers with Information on Investments and 

Makes Suitable Recommendations 

Obtains and Verifies Customer’s Purchase and Sales 

Instructions, Enters Orders, and Follows Up 

Percentage of 

Test Questions 

Number of 

Questions 

27% 68 

11% 27 

11% 27 

28% 70 

23% 58 

TOTAL 100% 250 


17 

9

What has changed? 

• Some new topics have been added / emphasized and 

a few have been removed / de-emphasized. 

• The number of questions assessing various product 

knowledge covered on the exam has changed. 

• Decrease in the number of municipal securities questions 

• Decrease in the number of options questions 

• Increased in the number of questions addressing other 

products (e.g., equities, packaged securities and other fixed 

income products) 

• The scaled score required to pass the exam has been 

increased from 70 percent to 72 percent. 


18 

Municipal Securities Activities and the Revised 

Series 7 Exam 

• To engage in municipal securities sales activities an 

individual must pass either the Series 7 exam or the Series 

52 exam. 

• The Series 7 exam will qualify an individual as a “municipal 

securities sales limited representative.” This is a subcategory of 

municipal securities representative. An individual in this category 

is limited exclusively to sales to and purchases from customers of 

municipal securities. 

• To engage in municipal securities underwriting activities 

and other municipal securities activities that are beyond 

the scope of sales activities, individuals must pass the 

Series 52 exam. 

• The Series 52 exam qualifies an individual as a “municipal 

securities representative.” An individual in this category is 

qualified to engage in municipals securities underwriting 

activities, and sales to and purchases from customers of 

municipal securities. 


19 

10

Municipal Securities Activities and the Revised 

Series 7 Exam 

• Individuals who passed the Series 7 PRIOR to 

November 7, 2011 and have maintained this 

registration will qualify as full municipal securities 

representatives. 

• These individuals will have met the pre-requisite for the Series 

53 Exam. 

• The revised Series 7 exam will not be accepted as a 

prerequisite for the Series 53 (Municipal Securities 

Principal) exam. Such person will need to pass the 

Series 52 exam prior to taking the Series 53 exam. 


20 

Qualification Examinations Revisions 

11

Qualification Examinations Revisions 

• FINRA has scheduled routine maintenance activities 

to update the content outlines for all qualification 

exams. 

• The purpose of these activities is to align the exams 

and their associated content outlines with current job 

functions and knowledge requirements. 

• A job analysis study will be conducted for each exam 

program. 

• Industry input is a major component of each job 

analysis study, including the use of committees of 

industry representatives, focus panels, one-on-one 

interviews and industry-wide surveys of registrants. 


22 

Qualification Exam Revisions – Current Efforts 

• FINRA is nearing completion of revisions to the 

Series 6, 16, 23, 24 and 26 exam programs. 

• Surveys of active registrants were conducted for each 

of these exam programs in 2011. 

• Updated content outlines for each exam program are 

likely to be filed with the SEC in the second half of 

2012. 

• Topic areas and rule coverage will be similar to 

current content outlines, however, relative weightings 

of each content area are updated to reflect changes in 

rules and the industry. 



12

Qualification Exam Revisions – Current Efforts 

• FINRA has started job analysis studies of the Series 

55 (Equity Trader) and Series 27 / 28 (FINOP) exam 

programs. 

• Focus panels and one-on-one interviews were 

conducted in late 2011 and early 2012. 

• Surveys were sent to registrants in April and May 


• Revisions to the exam programs should be completed 

in early 2013, followed by filings of the revised 

content outlines with the SEC. 


24 

Operations Professional Examination 

and Continuing Education Programs 

13

Overview – Operations Professional Registration 

• FINRA Rule 1230(b)(6) establishes a new representative 

registration category and qualification examination for 

certain operations personnel (Operations Professionals). 

• As announced in FINRA Regulatory Notice 11-33, Rule 

1230(b)(6) went into effect on October 17th, 2011. 

• The rule is intended to enhance the regulatory structure 

surrounding a member’s operations functions and 

increase awareness and knowledge that Operations 

Professionals are operating in a regulated environment 

designed ed to protect investors’ s interests ests and the integrity ty of 

the operations of a broker-dealer. 

• Operations Professionals are subject to both Regulatory 

and Firm Element Programs. 


11 

Operations Professional Examination (Series 99) 

• The Operations Professional examination (Series 99) was 

developed by a committee comprised of individuals from a 

broad cross-section of FINRA members including firms of 

different sizes, geographic location and business model. 

• The Series 99 key content themes are: 

• Professional conduct and ethical considerations 

• Essential product and market knowledge for an operations 

professional 

• Knowledge associated with operations activities 

• The exam provides reasonable assurance that individuals 

understand the importance of identifying and escalating 

red flags that may harm a member, a customer, the 

integrity of the marketplace, or the public. 


27 

14

Operations Professional Roll Out 

• Firms were required to identify those persons required to 

register as an operations professional as of October 17, 2011 

(day-one professionals) and request registration via Form U4 in 

the CRD system on or before December 16, 2011. 

• Day-one professionals with an eligible registration (such as the 

Series 7) were automatically exempted from taking the Series 99. 

• Day-one professionals who must pass the Series 99 (or another 

eligible exam) to qualify must pass such exam on or before 

October 17, 2012, during which time, day-one professionals may 

function in the capacity of an operations professional. 

• If aday-one professional does not pass an acceptable 

examination on or before October 17, 2012, the individual must 

cease functioning as an operations professional on October 17, 



28 

Operations Professional Roll Out 

• Non-day-one professionals must request registration as 

an operations professional via Form U4 in the CRD system 

prior to engaging g g in any activities that require such 

registration. 

• Non-day-one professionals who must pass the Series 99 

(or another eligible exam) to qualify for operations 

professional registration will have 120 days beginning on 

the date such person requests operations professional 

registration via Form U4 in the CRD system to pass an 

exam, during which time such person may function as an 

operations professional. 

• The CRD system will automatically opt-in non-day-one 

professionals with an eligible registration when a request 

for operations professional registration is made. 


14 

15

Results of the Initial Rollout Period 

• Approximately 35,000 individuals were identified as 

day-one professionals. 

• Of these, about 27,000 were automatically opted-in 

with an eligible registration. 

• About 8,000 individuals need to take and pass the 

Series 99 (or pass another acceptable exam, such as 

the Series 7) by October 17, 2012. 

• Nearly 1,000 administrations of the Series 99 Exam 

have been given. 


30 

Continuing Education – Regulatory and Firm 

Element 

• The Operations Professional Regulatory Element 

(S901) will include four modules and focuses on 

instruction to: 

• Maintain and improve understanding of the regulatory and 

ethical aspects associated with the covered functions; 

• Identify suspicious activities and / or red flags that could harm 

a customer, a firm, issuers of securities or the integrity of the 

marketplace; 

• Maintain and improve knowledge and understanding of the 

covered functions; and, 

• Assist the operations professional in keeping up with changes 

in the industry and regulations that impact their work. 


16 

16

Continuing Education – Regulatory and Firm 

Element 

• The S901 is being developed and will be ready by the 

4th Quarter 2013 (CE is required on second 

anniversary of registration and every er three years 

thereafter). 

• Operations professionals that register with an eligible 

registration (i.e., Series 6, 7, 24) will be subject to that 

registration category’s corresponding Regulatory 

Element CE session (i.e., Series 106, 101, 201). 

• Firm Element will enable the firms to deliver targeted 

training, as needed, taking into account a firm’s 

business model and the operations professionals’ 

specific tasks. 


32 

17

Suitability Rule Implementation (Small Firm Focus) 


12:00 p.m. – 1:15 p.m.



12:00 p.m. – 1:15 p.m. 


• Understand the new suitability rule requirements. 

• Assess the impact of the new rule requirements on your firm. 

• Implement changes to your supervisory and compliance programs to address the new suitability 

requirements. 

Moderator: 

Speakers: 

Michael Rufino 

Senior Vice President, Chief Operating Officer 

FINRA Member Regulation, Sales Practice 

Tina Maloney 

Chairman 

Winslow, Evans & Crocker, Inc. 

Joseph Romano 

President 

Romano Brothers & Co. 

James Wrona 

Vice President and Associate General Counsel 


Outline 

New rule requirements 

• Know Your Customer (FINRA Rule 2090) 

• Suitability (FINRA Rule 2111) 

• Strategies and hold recommendations 

• Three main suitability obligations 

• Information gathering 

• Institutional exemption 

• Risk-based approach to documentation 

Challenges facing small firms 

• Updating policies and procedures 

• Gathering new information from customers 

• Implementing institutional exemption 

• Manual vs. automated 

• Systems enhancements 

• Education and training 

• Clearing firm challenges 


• Cost 

• Timing 

Approaches small firms are taking 

• New account profile 

• Triggering events 

• Documentation 

Examples / cases 

Senior investor challenges 

• Products 

• Diminished capacity 


Tina B. Maloney is the Chairman and majority owner of Winslow, Evans & Crocker, Inc., a dually 

licensed full-service broker-dealer and SEC-registered investment advisor headquartered in Boston, 

Massachusetts. Ms. Maloney manages the firm’s financial operations and compliance areas. Since 

joining Winslow in January 1994, Ms. Maloney has served the firm in the capacities of a chief operating 

officer, chief financial officer and president. Ms. Maloney’s career in the securities industry began in 1979. 

Her experience in management, sales, compliance and administration includes work for both small and 

large firms, namely Winslow, Merrill Lynch, Lawrence Energy Associates, Putnam Financial Services, 

Dean Witter, Moseley, Hallgarten, Estabrook & Weeden, and Drexel Burnham Lambert. Ms. Maloney is a 

General Securities Principal, Financial Operations Principal and a Registered Investment Advisor 

Representative (Series 24, 27, 7, 63 and 65). She currently serves on the FINRA Small Firm Advisory 

Board as the elected North Region Representative and is a director of the National Association of 

Independent Broker/Dealers. Past committees include FINRA District 11 Committee Member (2006- 

2010), Committee Chair (2009-2010_and FINRA Advisory Council member (2009-2010). Ms. Maloney 

has also participated on numerous FINRA disciplinary hearing panels and is a frequent speaker at 

conferences on topics of current importance to the broker-dealer community. She attended Suffolk and 

Northeastern Universities in Boston. 

Joseph Romano is President of Romano Brothers & Co., a dually registered RIAIBD, founded by his 

father Richard Romano in 1962, which now manages $1 billion in client assets. In addition to 

administering the firm, Mr. Romano also acts as a portfolio manager creating customized portfolios for 

private clients using individual stocks and bonds. Mr. Romano began his career in 1995 earning his 

Series 7 General Securities and Series 55 Equity Trading licenses. He later obtained the Series 24 

General Securities Principal and Series 4 Registered Options Principal licenses. He served for several 

years until 2007 as a chief compliance officer for Romano Brothers. Mr. Romano is a past president of the 

Illinois Securities Industry Association and currently serves on the FINRA District 8 (Midwest) Committee 

since 2009, and the Small Firm Advisory Board since 2011. He graduated with honors in economics from 

Wesleyan University, in Middletown, CT, in 1992. 

Michael Rufino is presently Chief Operating Officer in Sales Practice in Member Regulation at 

FINRA and has been in regulation for over 23 years. Mr. Rufino has extensive knowledge in key 

aspects of a broker-dealer’s operation, spending the first 10 years of his career working on financial 

and operational regulation and the last 13 years on sales practice regulation. He is presently a 

representative on FINRA’s Compliance Advisory Committee and is chairman of the Options Self 

Regulatory Council. Mr. Rufino has taken part in many regulatory initiatives, including FINRA’s Social 

Media Task Force, and has spoken on many topics including ones on supervision, branch offices, 

electronic communications and anti-money laundering (AML). Mr. Rufino is one of FINRA’s 

representatives on the Bank Secrecy Act Advisory Group (BSAAG) and is an active participant in the 

BSAAG Securities/Futures, BSAAG SAR and BSAAG SAR Review subcommittees. Mr. Rufino 

played a key role in setting up the AML examination program at the NYSE. He has also participated 

in the Financial Action Task Force’s (FATF) initiative on creating guidance on the risk-based 

approach to the prevention of money laundering and terrorist financing as part of the working group 

undertaking this initiative as well as the FATF Typology on the Securities Industry. Mr. Rufino 


graduated Magna Cum Laude from Iona College with a degree in finance. In addition, he received his 

master’s of business administration with honors in management information systems from Iona. 

James S. Wrona is Vice President and Associate General Counsel for FINRA in Washington, DC. In 

this role, he assists with policy initiatives, rule changes and litigation regarding the securities industry. 

He was formerly associated with the law firm of K&L Gates LLP, where his practice focused on 

complex federal litigation. He also previously served as a federal law clerk for the Honorable A. 

Andrew Hauk of the United States District Court for the Central District of California (Los Angeles). 

Mr. Wrona is a frequent speaker at securities and litigation conferences and author of numerous law 

review articles, including The Securities Industry and the Internet: A Suitable Match?, 2001 Colum. 

Bus. L. Rev. 601 (2001). 




12:00 p.m. – 1:15 p.m. 

Resources 

SEC Studies 

• SEC Study on Investment Advisers and Broker-Dealers (January 2011) (discussing the 

obligations of investment advisers and broker-dealers, as required by Section 913 of the Dodd- 

Frank Wall Street Reform and Consumer Protection Act) 

www.sec.gov/news/studies/2011/913studyfinal.pdf 

• SEC Special Study of Securities Markets, H.R. Doc. No. 88-95, pt. 1 (1st Sess. 1963) 

(discussing, inter alia, various suitability issues regarding low-priced securities) 

http://c0403731.cdn.cloudfiles.rackspacecloud.com/collection/papers/1960/1963_SSMkt_Chapter 

_01_1.pdf 

FINRA Regulatory Notices 

• FINRA Regulatory Notice 12-03, Heightened Supervision of Complex Products (January 2012) 

www.finra.org/Industry/Regulation/Notices/2012/P125398 

• FINRA Regulatory Notice 11-25, New Implementation Date for and Additional Guidance on the 

Consolidated FINRA Rules Governing Know-Your-Customer and Suitability Obligations (May 

2011) 

www.finra.org/Industry/Regulation/Notices/2011/P123702 

• FINRA Regulatory Notice 11-02, SEC Approves Consolidated FINRA Rules Governing Know- 

Your-Customer and Suitability Obligations (January 2011) 


• FINRA Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable 

Investigations in Regulation D Offerings (April 2010) 


• FINRA Regulatory Notice 09-42, FINRA Reminds Firms of Their Obligations With Variable Life 

Settlement Activities (July 2009) 



• FINRA Regulatory Notice 09-32, SEC Approves Amendments to NASD Rule 2821 Governing 

Purchases and Exchanges of Deferred Variable Annuities; Effective Date: February 8, 2010 

(June 2009) 


• FINRA Regulatory Notice 09-31, FINRA Reminds Firms of Sales Practice Obligations Relating to 

Leveraged and Inverse Exchange-Traded Funds (June 2009) 


• FINRA Regulatory Notice 09-25, Proposed Consolidated FINRA Rules Governing Suitability and 

Know-Your-Customer Obligations; Comment Period Expired: June 29, 2009 (May 2009) 


• FINRA Regulatory Notice 07-53, Deferred Variable Annuities (November 2007) 

www.finra.org/RulesRegulation/NoticestoMembers/2007NoticestoMembers/P037403 

• FINRA Regulatory Notice 07-43, FINRA Reminds Firms of Their Obligations Relating to Senior 

Investors and Highlights Industry Practices to Serve these Customers (September 2007) 


NASD Notices to Members 

• NASD Notice to Members 07-06, Supervision of Recommendations after a Registered 

Representative Changes Firms (February 2007) 


• NASD Notice to Members 05-59, NASD Provides Guidance Concerning the Sale of Structured 

Products (September 2005) 


• NASD Notice to Members 03-71, NASD Reminds Members of Obligations When 

Selling Non-Conventional Investments (November 2003) 


• NASD Notice to Members 01-23, Suitability Rule and Online Communications (April 2001) 


• NASD Notice to Members 99-35, NASD Reminds Members of Their Responsibilities Regarding 

the Sales of Variable Annuities (May 1999) 


• NASD Notice to Members 96-86, NASD Regulation Reminds Members and Associated Persons 

that Sales of Variable Contracts are Subject to NASD Suitability Requirements (December 1996) 


• NASD Notice to Members 96-60, Clarification of Members' Suitability Responsibilities under 

NASD Rules with Special Emphasis on Member Activities in Speculative and Low-Priced 

Securities (March 1997) 



• NASD Notice to Members 95-80, NASD Further Explains Members Obligations and 

Responsibilities Regarding Mutual Funds Sales Practices (September 1995) 

http://nasd.complinet.com/nasd/display/display.html?rbid=1189&record_id=1159003811&element 

_id=1159003637&highlight=95-80#r1159003811 

• NASD Notice to Members 94-16, NASD Reminds Members Of Mutual Fund Sales Practice 

Obligations (March 1994) 

http://nasd.complinet.com/nasd/display/display.html?rbid=1189&record_id=1159003811&element 

_id=1159003637&highlight=95-80#r1159003811 

FINRA Regulatory & Compliance Alerts 

• Reminder—Suitability of Variable Annuity Sales, Regulatory & Compliance Alert (2002) 

www.nasd.com/RulesRegulation/PublicationsGuidance/MemberUpdates/RegulatoryandComplian 

ceAlerts/NASDW_015299 

• Online Brokerage Services and the Suitability Rule, Regulatory & Compliance Alert (Summer 

2000) 

www.nasd.com/web/groups/rules_regs/documents/rca/nasdw_002377.pdf 

• Suitability Issues for Multi-Class Mutual Funds, Regulatory & Compliance Alert (Summer 2000) 

www.nasd.com/web/groups/rules_regs/documents/rca/nasdw_002377.pdf 

Law Review Articles 

• Nancy C. Libin & James S. Wrona, The Securities Industry and the Internet: A Suitable Match? 

2001 Colum. Bus. L. Rev. 601 (2001). 

http://cblr.columbia.edu/archives/10789 

Other FINRA Publications Discussing Suitability-Type Issues 

• NASD Notice to Members 05-50, Member Responsibilities for Supervising Sales of Unregistered 

Equity-Indexed Annuities (August 2005) 


• NASD Notice to Members 05-48, Members' Responsibilities When Outsourcing Activities to 

Third-Party Service Providers (July 2005) 


• NASD Notice to Members 05-26, NASD Recommends Best Practices for Reviewing New 

Products (April 2005) 


• NASD Notice to Members 04-89, NASD Alerts Members to Concerns When Recommending or 

Facilitating Investments of Liquefied Home Equity (December 2004) 



• NASD Notice to Members 03-68, NASD Reminds Members That Fee-Based Compensation 

Programs Must Be Appropriate (November 2003) 


Significant Suitability Cases 

• Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 (7th Cir. 1983) (discussing various factors 

that courts and regulators consider in determining whether the trading was excessive) 

• Richard G. Cody, Exchange Act Rel. No. 64565, 2011 SEC LEXIS 1862, *30-32 (May 27, 2011) 

(explaining, among other things, that a broker can violate reasonable-basis suitability by failing to 

perform a reasonable investigation of a recommended product and to understand the risks of the 

recommendation notwithstanding that the recommendation could be suitable for some investors) 

• Michael Frederick Siegel, Exchange Act Rel. No.58737, 2008 SEC LEXIS 2459 (Oct. 6, 2008) 

(discussing various factors to consider in determining whether a communication is a 

recommendation and reviewing elements of reasonable-basis and customer-specific suitability), 

aff’d in relevant part, 592 F.3d 147 (D.C. Cir. Jan. 12, 2010), cert. denied, 2010 U.S. LEXIS 4340 

(May 24, 2010) 

• Raghavan Sathianathan, Exchange Act Rel. No. 54722, 2006 SEC LEXIS 2572, at *21-33 (Nov. 

8, 2006) (discussing suitability obligations in the context of different mutual fund share classes, as 

well as the use of margin) 

• Dane S. Faber, Exchange Act Rel. No. 49216, 2004 SEC LEXIS 277, at *23-24 (Feb. 10, 2004) 

(stating that, under the suitability rule, a “broker’s recommendations must be consistent with his 

customer’s best interests” and are “not suitable merely because the customer acquiesces in 

[them]”); id. at *26 ("We have repeatedly found that high concentration of investments in one or a 

limited number of speculative securities is not suitable for investors seeking limited risk.") 

• Wendell D. Belden, Exchange Act Rel. No. 47859, 2003 SEC LEXIS 1154, at *14 (May 14, 2003) 

(finding unsuitable recommendations where motivation for recommending Class B shares over 

Class A shares was the significantly greater commissions that the broker received from the 

former shares) 

• James B. Chase, Exchange Act Rel. No. 47476, 2003 SEC LEXIS 566, at *12-21 (March 10, 

2003) (upholding suitability violation and noting that high concentration in a speculative security 

was inappropriate and that the customer’s college education does not mean that she was a 

sophisticated investor who fully understood the risky investment) 

• Jack H. Stein, Exchange Act Rel. No. 47335, 2003 SEC LEXIS 338, at *8 (Feb. 10, 2003) (“Even 

in cases in which a customer affirmatively seeks to engage in highly speculative or otherwise 

aggressive trading, a representative is under a duty to refrain from making recommendations that 

are incompatible with the customer’s financial profile.”); id. at *11 (stating that it was improper for 

a broker to make recommendations “on the basis of guesswork” regarding a customer’s net worth 

where a customer refused to provide broker with any information regarding other assets not listed 

on her new account form) 

• Rafael Pinchas, 54 S.E.C. 331, 341 n.22 & 342 (1999) (holding that "[t]ransactions that were not 

specifically authorized by a client but were executed on the client's behalf are considered to have 

been implicitly recommended within the meaning of the NASD rules" and "excessive trading, by 

itself, can violate NASD suitability standards by representing an unsuitable frequency of trading") 

• Clinton Hugh Holland, Jr., 52 S.E.C. 562, 565-66 (1995) (emphasizing, in the suitability context, 

the inappropriateness of the shift in the customer’s portfolio from conservative to speculative 

securities), aff'd, 105 F.3d 665 (9th Cir. 1996) 


• David Joseph Dambro, 51 S.E.C. 513, 517 & n.14 (1993) ("[The respondent] was obligated to 

make his recommendation only on the basis of concrete information about [his customer's] 

financial situation . . . [and] [w]ithout knowing [the customer's] other securities holdings and 

financial situation, [the respondent] could not make the requisite customer-specific evaluation 

necessary for a suitable recommendation.") 

• F.J. Kaufman and Co., 50 S.E.C. 164, 168 (1989) (explaining the “reasonable basis” suitability 

obligation) 

• Dep’t of Enforcement v. Medeck, No. E9B2003033701, 2009 FINRA Discip. LEXIS 7 (NAC July 

30, 2009) (discussing various elements of churning and excessive trading) 

• Dep’t of Enforcement v. Frankfort, No. C02040032 (NAC May 24, 2007) (finding a violation of the 

suitability rule and noting that a broker can, under certain limited circumstances, violate the 

suitability rule by failing to disclose material information that, if not disclosed, also could amount 

to a violation of the anti-fraud provisions, especially where disclosure of such information would 

be necessary for the broker to properly asses the customer’s risk tolerance and investment 

objectives) 

• Dep’t of Enforcement v. Siegel, No. C05020055 (NAC May 11, 2007) (discussing the relevant 

factors for determining whether a broker has make a “recommendation” triggering application of 

the rule and finding that the broker violated the “reasonable basis” suitability obligation) 

• Dep’t of Enforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC 

Aug. 9, 2004) (“[A] broker’s recommendations must serve his client’s best interests and the test 

for whether a broker’s recommendation is suitable is not whether the client acquiesced in them, 

but whether the broker’s recommendations were consistent with the client’s financial situation and 

needs.”) 

• Dep't of Enforcement v. Howard, No. C11970032, 2000 NASD Discip. LEXIS 16, at *19 (NAC 

Nov. 16, 2000) (holding that the broker's recommendations "also led to an undue concentration of 

these speculative securities, making the recommendations particularly unsuitable"), aff'd, 

Exchange Act Rel. No 46269, 2002 SEC LEXIS 1909 (July 26, 2002), aff'd, No. 02-1939, 2003 

U.S. App. LEXIS 19454 (1st Cir. Sept. 19, 2003) 

• Dist. Bus. Conduct Comm. v. Kunz, Complaint No. C3A960029, 1999 NASD Discip. LEXIS 20, 

*62-63 & n.29 (NAC July 7, 1999) (implicitly holding that respondent's distribution of an issuer's 

offering document in connection with a rescission offer, without more, did not constitute a 

recommendation of the subject security), aff'd, Exchange Act Rel. No. 45290, 2002 SEC LEXIS 

104 (Jan. 16, 2002) 

• Dist. Bus. Conduct Comm. v. Nickles, Complaint No. C8A910051, 1992 NASD Discip. LEXIS 28, 

*18 (NBCC Oct. 19, 1992) (holding that suitability rule "applies not only to transactions that 

registered persons effect for their clients, but also to any recommendations that a registered 

person makes to his or her client") 


Communications With the Public 


12:00 p.m. – 1:15 p.m.



12:00 p.m. – 1:15 p.m. 


• Explain the recently approved rules for Communications With the Public. 

• Apply the advertising rules to areas of regulatory concern regarding exchange-traded products, 

fixed income products and non-traded real estate investment trust (REITs). 

• Highlight current advertising compliance issues through a hands-on review of sample ads. 

Moderator: 

Panelists: 

Thomas Pappas 

Vice President and Director 

FINRA Advertising Regulation 

Wallace W. Kunzman, Jr. 

President 

Kunzman & Bollinger, Inc. 

Anthony Maher 

Supervisor 


Gregory Riviello 

Director 


Outline 

Rule updates 

• Advertising modernization 

o New categories 

o Filing requirements 

o Content standards 

• Communications With the Public about Variable Insurance Products 

• FINRA Regulatory Notices 12-02 and 11-49 

Exchange-traded products 

Fixed income 

• Yield chasing 

• Liquidity 

• Risks 

Non-traded REITs 

• Product characteristics 

• Wells Investment Services, Inc. case study analysis 


Working with FINRA staff 

• Filing process 

• Appeals of comments 

Advertising review workshop – sample ads: 

• Blutarsky Capital retail REIT brochure 

• Buckle-Up market-linked CD brochure 

• Trek exchange-traded fund (ETF) handout 

• Retirement investment strategies invitation 


Wallace Kunzman has been actively involved in the securities area as a lawyer for over 30 years. He 

has drafted offering documents and performed all aspects of securities compliance in over 250 offerings 

over this period, including both registered offerings and Regulation D offerings. These offerings have 

been primarily in the direct investment area. Also, he has represented numerous broker-dealers in 

various aspects of their business, such as underwriting activities, and FINRA and state regulatory and 

compliance matters. Mr. Kunzman was an adjunct professor, Oklahoma City University School of Law in 

1982, and has lectured in the securities and corporate areas for the University of Tulsa Continuing Legal 

Education Division, Oklahoma City University Continuing Legal Education Division, the Investment 

Program Association and the Oklahoma Society of Certified Public Accountants and in 2007, 2009 and 

2011 the NASAA Corporate Finance Training Seminar. He serves as a FINRA arbitrator and has served 

on committees to the Oklahoma Securities Department, been an expert witness for the Securities 

Department of the State of Kansas in securities cases and worked with the states of Texas, Louisiana 

and New Mexico concerning the enactment of securities exemptions for the oil and gas industry. Mr. 

Kunzman has been a member of the Legal and Regulatory Affairs Committee for the Investment Program 

Association since 2001 and has been a member of the FINRA Series 22/39 Item Writing and Review 

Committee since 2008. 

Anthony T. Maher is Supervisor in FINRA’s Advertising Regulation Department. His chief responsibility is 

managing staff members dedicated to the routine review of member advertisements. Mr. Maher also 

frequently speaks at FINRA educational programs. Prior to joining FINRA in 1995, he was a registered 

principal and a compliance analyst for a broker-dealer subsidiary of a life insurance company. Mr. Maher 

holds a law degree from George Mason University School of Law, a master’s degree from Georgetown 

University and a bachelor’s degree from George Mason University. 

Thomas A. Pappas is Vice President of the FINRA Advertising Regulation Department, which regulates 

the advertisements, sales literature and correspondence FINRA member firms use. His responsibilities 

include rule development, management of the filing and surveillance programs and related enforcement 

activities. He served in the same role at NASD before its 2007 consolidation with NYSE Member 

Regulation, which resulted in the formation of FINRA. He was previously registered with Davenport & 

Company LLC. He received a bachelor’s degree from The University of Richmond and a master’s 

business administration from Virginia Commonwealth University. 

Gregory Riviello is Director in FINRA’s Advertising Regulation Department. The department is 

responsible for the regulation of FINRA member firms’ communications with the public. His daily 

responsibilities include supervising the activities of staff devoted to the review of communications 

routinely filed with the department by FINRA member firms. Mr. Riviello has been with the Advertising 

Regulation Department since 1990 and has more than 30 years of experience in the securities industry. 

He is a graduate of West Chester State University in West Chester, Pennsylvania, and holds an MBA 

from the University of Maryland. 


New Rules – Effective Early 2013 




• Change in rule structure 

• Revised communication categories: 

• Institutional communication 

• Retail communication 

• Correspondence 

• Approval, review and recordkeeping requirements: 

• Principal approval of retail communications 

– Exception for communications that do not include a financial or 

investment recommendation or otherwise promote a product or service 

• Correspondence and institutional communications 

• Recordkeeping requirements 


1 



• Revised filing requirements: 

• New member filing requirements for retail communications 

– Based on date of effectiveness 

• Retail structured product communications 

– Excludes issuer prepared free-writing prospectuses 

• Closed-end fund retail communications 

– Includes all IPO and secondary market offerings 

• Codifies current Interpretive Letter regarding templates 

• Filing exception 

– Communications that do not include a financial or investment 

recommendation or otherwise promote a product or service 

• Revised content standards: 

• Codifies current policy regarding promissory statements 

• New section for comparative illustrations of tax-deferred 

compounding 

• Amended disclosure requirements for recommendations 

• New section for public appearances with supervisory 

implications 


2 


1

Regulatory Notices 

• FINRA Regulatory Notice 12-02, FINRA Provides 

Guidance on Application of Communications Rules to 

Disclosures Required by Department of Labor 

(January 2012): 

• Dept. of Labor performance disclosures for retirement plans 

• SEC No-Action Letter 

• Application of NASD Rules 2210 and 2211 

• FINRA Regulatory Notice 11-49, FINRA Provides 

Guidance on Advertising Regulation Issues (October 

2011): 

• Treasury Inflation-Protected Securities funds 

• Use of FINRA in firm trademarks 

• Filing requirements for certain exchange-traded products 

Exchange-Traded Products 

• FINRA Regulatory Notice 11-49 (October 2011) 

• Exchange-traded funds subject to NASD Rule 2210 

filing requirements: 

• ETFs structured as an open-end investment company 

• ETFs structured as a UIT 

• ETFs organized as grantor trusts and meet the definition of a 

direct participation program 

• Performance and risk standards 



Fixed Income and Structured Products 

• FINRA Investor Alert: “The Grass Isn’t Always 

Greener…” 

• Cautions investors considering esoteric products that promise 

higher yields and returns than traditional investments 

• Examples cited include principal-protected notes, steepeners, 

high yield bonds, leveraged ETFs and floating rate funds 

• Issues to consider before investing in such products: 

– Does the higher return from the investment come with increased risk? 

– Do I understand how the investment operates? 

– What are the costs and fees associated with the new investment? 

– Is the product callable? 

Fixed Income and Structured Products 

• FINRA concerns: 

• Yield and return “chasing” 

• Liquidity 

• Risks 

• Communications promoting structured products 

must: 

• Provide a fair and balanced discussion; 

• Not make any false exaggerated unwarranted or misleading 

claims; and, 

• Explain how the product works. 


6 


7 

2

Non-Traded Real Estate Investment Trusts (REITs) 

• Product characteristics 

• Wells Investment Securities, Inc. case analysis 

• Wells Timberland REIT marketing materials 


• FINRA concerns: 

• Distributions 

• Claims regarding stability and volatility 

• Redemption programs and liquidity event 

• Risk disclosure 

• Use of indices and comparisons 

• SEC Rule 134 



Working With FINRA Staff 

Advertising Workshop 

• Call before filing 

• Review process 

• Appeal of comments 

• Consistency of comments 

• Red flags 

• Different levels of review 

• Length of disclosure 

Advertising Review Workshop 

Sample Ads 


10 


11 

3

COMMUNICATION # 1 

Blutarsky Capital Retail 

Real Estate Investment Trust (REIT)

THE BLUTARSKY CAPITAL RETAIL 

REAL ESTATE INVESTMENT TRUST 

Managed by Blutarsky Capital Advisors, LLC. 

A Perfect Storm of Opportunity, Income and Growth 

Blutarsky Capital Advisors focuses on 

investors and strives to provide: 

Wealth Preservation 

Predictable Income 

Potential Growth 

Inflation Protection

Blutarsky Capital Advisors, LLC. is acknowledged for its expertise 

and exceptional track record spanning more than 25 years: 

John Blutarsky is the founder of Blutarsky Capital Advisors, and has been a figure in 

the real estate industry for more than 25 years. He has raised more than $150 

million in a number of investment programs, and looks forward to continued 

success with the Blutarsky Capital Retail Real Estate Investment Trust. 

Kent Dorfman is a long-time associate of John Blutarsky’s and has a similarly 

lengthy investment track record. 

E. Otter Stratton serves as marketing genius at Blutarsky Capital. 

Archer Hoover and Larry Kroger are the financial sleuths that discover the retail 

shopping center gems that provide consistent income and the potential for longterm 

growth. 

Collectively, Blutarsky Capital Advisors has participated p in more than 28 investment 

programs with assets totaling more than $6 billion. 

Predictable income + Potential growth + Preservation of capital = Success 

A Word About Risk 

The REIT may not be suitable for all investors. A complete discussion of the risks involved with an investment in the 

REIT is in the prospectus. Some of these risks include: 

o The is an illiquid investment. There is no public secondary market on which shares are traded. 

o The REIT Share Redemption program is very limited, and subject to change termination or suspension by the Board 

of Directors at any time. 

o The REIT has a limited operating history and owns few properties. Consequently, its performance is hard to 

predict. 

o There is no guarantee that the REIT’s investment objectives will be met. 

o The distribution rate is not guaranteed and can be changed by the Board at any time. 

o There is no guarantee that the REIT will pay distributions given the inherent risks associated with the market. 

o The REIT is dependent on Blutarsky Capital Advisors to identify properties with solid investment potential. Poorly 

performing properties could negatively impact the REIT’s ability to pay distributions. 

o Distributions may not be paid from FFO; if not, then distributions will be paid from offering proceeds and debt. 

o The REIT intends to use a significant amount of leverage to acquire target properties. 

o The REIT may fail to qualify as a REIT as defined in the tax Code, which could affect operations and negatively 

impact the ability to make distributions.

The Blutarsky Capital Retail Real Estate Investment Trust 

is a fixed income investment alternative with greater 

stability and superior monthly income. 

7.0% 

Distribution 

Paid Monthly 

The Blutarsky Capital Retail REIT strives to produce predictable 

monthly income for its investors. In fact, over the past 4 years, 

distributions have always been paid and on time. 

In addition to steady income, Blutarsky Capital Advisors is 

committed to preserving the wealth of its investors.

BLUTARSKY CAPITAL RETAIL REIT OFFERING SUMMARY 

SPONSOR 

NAME 

STRUCTURE 

OBJECTIVE 

STRATEGY 

OFFERING 

SHARE PRICE 

Blutarsky Capital Corporation, Inc. 

Blutarsky Capital Retail REIT 

Registered, non-traded REIT 

Preserve and return shareholder 

contributions, pay regular distributions 

and realize capital appreciation 

Diversified portfolio of retail properties 

anchored by national retail chains 

350,000,000 shares 

$10/share 

DISTRIBUTION 7.0% 

MINIMUM INVESTMENT $10,000 

SHARE REDEMPTION 

Limited, but no guarantees 

SUITABILITY STANDARDS 

Investors must have a net worth of at least 

$250,000, excluding the investor's 

residence and personal property, or a gross 

income of $100,000 and a net worth of $75,000. 

The REIT entails a high level of risk and investors should be 

able to bear the potential loss of their entire investment. 

(1) There is no assurance that the investment objectives will be met. 

(2) Distributions, which are set by the Board of Directors, are not guaranteed. Economic or market conditions may cause a temporary halt 

to distributions. Until the REIT realizes sufficient income to produce distributions based on funds from operations, distributions maybe 

paid from other sources, including offering proceeds and debt. 

(3) The share redemption program has limitations. 

Securities distributed by Blutarsky Capital Markets, Inc.

ADDITIONAL INFORMATION 

Source of Material: 

• Submitted to the Advertising Regulation Department prior to use with the public. 

Offering Document info for The Blutarsky Capital Retail Real Estate Investment Trust info: 

• Primary investment objectives are: 

•To preserve and return investor’s capital contribution; and 

•To provide investors with attractive cash distributions 

• Secondary objective is to seek growth. 

• Risks of the REIT: 

• An investment in the REIT entails a high level of risk. 

• The REIT is an illiquid investment. There is no public secondary market on which shares are 

traded. 

• Share Redemption program is very limited, and subject to change termination or 

suspension by the Board of Directors at any time. 

• The REIT has a limited operating history and owns few properties. Consequently, its 

performance is hard to predict. 

• There is no guarantee that the REIT’s investment objectives will be met. 

• The distribution rate is not guaranteed and can be changed by the Board at any time. 

• There is no guarantee that the REIT will pay distributions given the inherent risks associated 

with the market. 

• The REIT is dependent on Blutarsky Capital Advisors to identify properties with solid 

investment potential. Poorly performing properties could negatively impact the REIT’s 

ability to pay distributions. 

ib ti 

• Distributions may not be paid from FFO; if not, then distributions will be paid from offering 

proceeds and debt. 

• The REIT intends to use a significant amount of leverage to acquire target properties. 

• The REIT may fail to qualify as a REIT as defined in the tax code, which could affect 

operations and negatively impact the ability to make distributions.


Buckle-Up Market-Linked CD Brochure

Buckle-Up Market-Linked 

CDs 

Does the bull have you 

feeling down? 

The best way to ride the up & down swings 

of the market 

Call today to learn more at 

1555UPNDOWN 

1.555.UP.N.DOWN 

Buckle-Up CDs are linked to the performance of specific underlying assets and are not 

equivalent to investing directly in the asset ∙ There is currently no secondary market 

for the CDs ∙ Investors may be subject to redemption charges if the CD is redeemed 

before maturity ∙ The CDs may be subject to certain limitations and restrictions. ∙ See 

the specific term sheet for details. 

Forget the aspirin, buy some 

protection. 

Introducing an investment combining 

market returns with the protection of 

FDIC Insurance – the solution for 

today’s turbulent market. 

Buckle-Up 

Market-Linked Certificates of 

Deposit (CDs) 

Coaster 

Securities, LLC 

Member SIPC 

BACK 

COVER 

Coaster 

Securities, LLC 

Member SIPC 

FRONT 

COVER

Our clients ask, “How do I 

take advantage of market 

upswings without the fear 

of losing my principal 

investment?” 

The answer is simple. 

Market-linked k CDs offer 

investors enhanced 

returns compared to 

traditional deposit 

products and without the 

risk of losing money in 

most securities products 

like mutual funds. 

Market-linked CDs are 

structured investments 

that give you the peace of 

mind dof FDIC insurance 

and market-linked 

returns. Isn’t it time you 

give up the wild ride of 

investing and consider a 

market-linked CD? 

While your fellow 

investors try to time the 

market with stocks, 

bonds, mutual funds and 

ETFs, you can take a 

smarter and safer 

approach that offers a 

minimum 3% guaranteed 

rate of return and the 

potential for even more. 

Buckle-Up 500 Market 

Linked CD 

Benefits and 

Features 

• The Buckle-Up 500 CD is 

issued by Coaster Bank USA. 

• The CD is 100 percent 

principal protected and is 

FDIC Insured up to federal 

statutory limits. 

• 6-Year Term. 

• The rate of return rn is linked 

to the positive difference 

between the average 

closing levels of the S&P 

500 Index on 12 semiannual 

observation dates. 

Investor 

Profile 

• The Buckle-Up 500 CD is 

designed for all investors 

seeking a buy and hold 

investment strategy such 

as retirees, baby boomers 

and families saving for 

college expenses. 

• Investors with an 

investment time horizon 

of 6 years. 

• Investors who want to 

invest in securities like 

those companies in the 

S&P 500 Index but also 

want protection of their 

principal. 

Unlimited 

Opportunities 

Our Buckle-Up CD Series 

provides clients access to 

a wide range of CDs that 

offer investment exposure 

to various markets in 

addition to the S&P 500. 

If your investment 

perspective leads you to 

believe that international 

equities, commodities or 

currencies are a fit for 

your portfolio, why not 

consider other 

alternatives. 

• Buckle-Up NASDAQ 

100 

• Buckle-Up Nikkei 25 

• Buckle-Up Hang Seng 

China 

• Buckle-Up Foreign 

Currencies 

About Coaster 

Bank, USA 

• Coaster Bank USA holds 

$102 billion in assets (as 

of December 21, 2010). 

• Coaster Bank USA is 

rated AAA. 

• Coaster Bank USA rated 

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• The Buckle-Up CD Series 

is offered by Coaster 

Securities, LLC , a 

subsidiary of Coaster 

Bank USA. 

Securities are not FDIC Insured No Bank Guarantee May Lose Value 

INSIDE 

CONTENT

FIRM SUBMISSION DETAILS INFORMATION 

• Filed with Advertising Regulation Department for review on October 21, 2011. 

• Date of first use was October 3, 2011. 

• Date of registered principal approval October 5, 2011. 

OFFERING DOCUMENT & TERM SHEET INFORMATION 

• The Buckle-Up Market-Linked CDs are issued by Coaster Bank USA and distributed by 

Coaster Securities, LLC , which is a subsidiary of Coaster Bank USA. 

• The Buckle-Up Marked-Linked CD series offers investors the opportunity to choose from 5 

CDs, each with a six-year term linked to a particular securities index (S&P 500 Index, 

NASDAQ 100, Nikkei 225, Hang Seng China and the CSI Foreign Currency Index). 

• Each CD provides principal protection if the CDs are held until the maturity date. 

• Investors can benefit by receiving market gains but are limited to a specified cap or limit of 

the gains in the corresponding index. An investor does not receive the full percentage gain 

of the index. Thus, during favorable market conditions investors must be willing to forfeit 

some of the index appreciation in exchange for the protection feature. 

• Investors are subject to a surrender charge if a withdrawal is made prior to the maturity 

date: in years 1-6 as follows: 10%, 10%, 10%, 8%, 8%, and 8%. An investor will also not earn 

any interest ton the CDifth the CDi is surrendered dbefore maturity since any interest tis only 

paid on the maturity date. 

• The Buckle-Up Market-Linked CDs provides a minimum interest guarantee of 2%. 

• The minimum investment is $5,000.00. 

ADDITIONAL INFORMATION FROM ANALYST RESEARCH 

• In the event of bank failure, the deposited principal amount invested in the Buckle-Up 

Market-Linked CD is insured up to $250,000 per depositor. 

• Coaster Bank USA is rated by three major rating agencies: 

– AA by Cobra Rating Services 

– Aa1 1by Space Mountain Associates 

– AA- by ThunderMountain Ratings Inc.


Trek Exchange-Traded Funds Handout

Trek Exchange-Traded Funds 

Seeking to boldly go where no ETF has gone before® 

Trek Exchange-Traded Funds (ETFs) are designed for investors who seek new frontiers in 

investing. Our funds explore new investment sectors and seek out new worlds of 

investment opportunities. It is the continuing mission of Trek ETFs to boldly go where no 

ETF has gone before. 

Trek ETFs allow investors to simply pyand easily obtain a desired 

market or benchmark exposure for their portfolio by trading just 

a single ETF. Offering intra-day liquidity and continuous, realtime 

trading and pricing, Trek ETFs help investors better navigate 

the galaxy between profit and loss while monitoring risk. 

With Trek ETFs, each portfolio seeks 

to provide investment results, 

before expenses and fees, that 

correspond generally to the price 

and yield performance of the 

securities in the corresponding 

Enterprise Indexes. The Enterprise 

Indexes are designed to track the 

performance of a particular sector. 

The selection of securities for the 

Enterprise Indexes is determined 

using Transporter analysis - a 

proprietary methodology developed 

by Kirk Advisors, LLC. 

The Enterprise Indexes and daily 

prices of the Trek ETFs are listed on 

the Vulcan Exchange. 

i d i l i f i 

Enterprise Indexes use a proprietary Transporter analysis for security 

selection. 

Investing is subject to risk and potential loss of principal. 

Trek ETFs are distributed by Starfleet Investment Services, LLC. The Advisor to the Trek ETFs is Kirk Advisors, LLC. 

Member NASD/SIPC

Trek Exchange-Traded Funds 

Seeking to boldly go where no ETF has gone before® 

Name of Trek ETF 

Scott Energy Fund 

Uhura Communications Fund 

The Fund seeks performance that corresponds to 

the performance of the following Indexes: 

Enterprise Energy Index 

Enterprise Communications Index 

Chekov Security Fund 

Enterprise Security Index 

McCoy Healthcare Fund 

Enterprise Healthcare Index 

Spock Biotechnology Fund 

Enterprise Biotechnology Index 

Data Technology Fund 

Enterprise Modern Technology Index 

Picard Industrial Fund 

Enterprise Industrial Index 

Klingon Commodities Fund 

Enterprise All Commodities Index 

Total Returns 

(as of September 30, 2011) 

Name of Trek ETF One-Year Three - 

Year 

Since Inception 

Scott Energy Fund 1.90% 7.06% 9.56% 1 

Uhura Communications Fund .80% 5.43% 8.10% 1 

Chekov Security Fund -.55% 3.02% 5.44% 1 

McCoy Healthcare Fund 2.23% 4.01% 5.07% 1 

Spock kBiotechnology Fund 6.69% 69% 7.87% 9.59% 1 

Data Technology Fund 4.23% 5.02% 7.12% 1 

Picard Industrial Fund 2.55% 3.98% 4.21% 1 

Klingon Commodities Fund 28.07% -13.02% 4.56% 2 

1 Inception date: 12/01/07 

2 

Inception date: 03/01/08 

Past performance may not be a guarantee of future results. The performance quoted represents past performance. 

Shares when redeemed may be worth more or less than their original cost. 

For more information, call for a prospectus at 1.555.USA.TREK . The prospectus 

must be read carefully before investing. 

Trek ETFs are distributed by Starfleet Investment Services, LLC. The Advisor to the Trek ETFs is Kirk Advisors, LLC. 

Member NASD/SIPC

FIRM SUBMISSION DETAILS INFORMATION 

• Filed with Advertising Regulation Department for review on October 5, 2011. 

• Date of first use was October 10, 2011. 

• Date of registered principal approval was October 4, 2011. 

PROSPECTUS INFORMATION 

• The Trek ETFs (the “Funds”) listed in the handout are structured as open-end end registered 

investment companies (with one exception) and trade on the Vulcan Exchange (VEX). 

• The Klingon Commodities Fund is organized as a Delaware statutory trust and is classified as 

a partnership for U.S. federal income tax purposes. The Fund is registered under the 

Securities Act of 1933 but is not a registered investment company under the Investment 

Company Act of 1940. The Klingon Commodities Fund has a prospectus separate from the 

remaining Trek Funds. 

• The Funds are subject to the specialized risks associated with their specific sectors. The 

prospectuses describe each of the Funds as non-diversified and typically have a limited 

number of holdings. The prospectuses also explain that Trek Funds are subject to significant 

volatility. 

• The Funds (structured as registered investment companies) are subject to gross total annual 

operating expenses of 0.60%. The Klingon Commodities Fund is subject to a management 

fee of 0.95% in addition to other fund expenses listed in the prospectus. Investors are 

subject to the commission costs associated with executing each securities trade. 

ADDITIONAL INFORMATION FROM ANALYST RESEARCH 

• The Fund performance shown in the handout is computed at net asset value (NAV). 

• With respect to the Klingon Commodities Fund, the handout is not intended to be preceded 

or accompanied by the prospectus. Consequently, the analyst must apply SEC Rule 134 in 

her review.


Retirement Investment Strategies Invitation

If you have money in CDs, IRAs, Annuities, Stocks, Bonds, Mutual 

Funds or Real Estate, it’s taken you a lifetime of hard work to 

accumulate those assets. Learn how to protect them from risk, 

erosion, and taxation . . . 

You are invited to attend a FREE 

Workshop and Luncheon: 

Retirement Investment Strategies 

Wednesday, August 31, 2011 

6:00 p.m. – 8:30 p.m. 

Marx Bros. Chophouse in Chicago 

55 West Monroe Street, Chicago, IL 60603 

Please join us for dinner and learn to: 

• Keep more of your social security income tax-free 

• Convert your IRA from taxable to tax-free 

• Eliminate income taxes on interest income forever 

• Invest in the Stock market with no possibility of loss 

• Lock in Stock market gains and never pay capital gains or 

income taxes again 

• Differentiate between fixed, variable, and indexed annuities 

• Lower or eliminate investment fees 

• Avoid costs and delays of PROBATE through trusts 

• Earn 6% safely with 6 different methods 

• Protect your assets from TAXES and INFLATION 

• Provide custodial care at home or in a private facility at no cost 

to your estate 

This is a rare opportunity to hear from the nationally recognized and respected financial guru, Otis 

P. Driftwood. Mr. Driftwood has authored several best-selling books on personal finance and has 

lectured extensively on overcoming the most critical financial challenges facing investors today. 

Make sure your dollars will last longer than your years. 

Call for reservations! 555-867-5309 

Cocoanuts Investment Brokers. Inc 

Member, FINRA/SIPC

ADDITIONAL INFORMATION 

Source of Material: 

• Submitted to the Advertising Regulation Department as a misleading advertising complaint. 

Due Diligence by FINRA Analyst: 

• Firm has no evidence of principal i approval; compliance principal i ldoes not recall seeing the 

invitation in question. 

• The advertised seminar took place on August 31, 2011, as advertised. An audience of 47 

prospective investors was confirmed. 

• Mr. Driftwood received a Cautionary Action in 2010 by the Advertising Regulation 

Department for using misleading seminar sales materials and related advertisements. The 

Cautionary Action also cited Mr. Driftwood for using sales materials without principal 

approval. 

• Mr. Driftwood first became a registered representative in May, 2006. 

• The results of a Web search of Mr. Driftwood did not indicate that he had a national 

reputation or was otherwise considered a financial guru. The search also showed that he 

authored one book; however, he only wrote the foreword, not any of the chapters offering 

information and advice. The substance of the book was ghostwritten.

Advertising Review Workshop 

Answers for 

Hands-On Sample Communications

Communication #1: Blutarsky Capital Retail Real Estate Investment Trust (REIT) Brochure 

Main Concerns: 

• Omissions of material information: 

– Fails to disclose that the REIT should be considered as a high risk investment. 

– Fails to disclose the basis for the claim that Blutarsky Capital Advisors has an exceptional track 

record. 

– Fails to disclose the potential impact of the REIT’s use of significant leverage. 

– Fails to fully explain the consequences of the REIT’s potential failure to qualify as a REIT. 

– Fails to disclose that the distribution rate touted is annualized, but paid on a monthly basis. 

• Exaggerated, unwarranted or misleading statements or claims: 

– “A perfect storm of . . .” 

– Claims that Blutarsky Capital Advisors strives to provide wealth preservation and inflation protection 

are not supported by the prospectus. 

– “Predictable income + Potential growth + Preservation of capital = Success” strongly implies the 

certainty of success with the Blutarsky REIT. 

– Referring to the REIT’s distributions as “superior monthly income” is unwarranted given the inherent 

and significant risks associated with an investment in the REIT. 

– The implication that the REIT offers “greater stability” appears exaggerated. 

– The display of the “7.0%” distribution rate is exaggerated. 

– Disclosure beneath the “7.0%” implies that investors will receive 7.0% each month. 

– Implies that, because distributions have been paid over the last four years, future distributions will 

similarly be paid. This implication is unwarranted given the risks of the REIT as well as the fact that 

distributions are not guaranteed. 

– Blutarsky is committed to preserving the “wealth of its investors.” 

• Presentation of disclosure: 

– Materially important disclosures are relegated to footnotes, which are very hard to read. Placing 

information in small font size which is difficult to read marginalizes the importance of that 

information. 


Communication #2: Buckle-Up Market-Linked CD Brochure 


• Omission of material information: 

– Fails to explain that principal protection is only offered if the Buckle-Up CDs are held until the maturity 

date. Thus, it is possible to lose money when investing in the Buckle-Up CD. 

– Fails to explain how the Buckle-Up CD works including the existence of market caps and the fact that 

during favorable market conditions, investors must be willing to forfeit some gains. 

– Fails to disclose the existence of surrender charges during the six-year term. 

– Risks which are explained are relegated to the last page and given less prominence than the 

discussion of the benefits of investing in the Buckle-Up CDs. 

– Brochure refers readers to see the term sheet for details. However, the brochure must provide a 

balanced discussion as a stand-alone communication. Providing risk disclosure in a term sheet does 

not cure otherwise deficient disclosure in a sales communication. 

• Exaggerated, unwarranted and misleading statements: 

– The statement “…an investment combining market returns with the protection of FDIC insurance” 

exaggerates and oversimplifies how the Buckle-Up CDs work. 

– The phrase “… the solution for today’s turbulent market” is exaggerated and unwarranted. 

– The statement “The best way to ride the up & down swings of the market” is unwarranted and without 

basis. 

– References to “market-linked returns” inaccurately describe how the CD works. 

– Comparison to other investment products in the statement “While your fellow investors try to time the 

market with stocks, bonds, mutual funds and ETFs, you can take a smarter approach…” is exaggerated 

and incomplete. 

– The reference to a minimum 3% guaranteed rate of return is inaccurate. The minimum guaranteed 

return disclosed in the offering document is 2%. 

– The Coaster Bank USA rating in the brochure is inaccurate. 


Communication #3: Trek Exchange-Traded Funds Handout 



– Fails to explain the various risks associated with the Trek Exchange-Traded Funds. 

– Fails to explain the greater risks associated with the Klingon Commodities Fund because it is not a 

registered investment company. 

– Fails to disclose the gross total operating expenses of the Trek Exchange-Traded Funds registered as 

investment companies. 

– Fails to disclose the fees and expenses associated with an investment in the Klingon Commodities 

Fund. 

– Fails to disclose the returns for each of the ETFs at “market price” in addition to the existing returns at 

net asset value for the same time periods. As explained in the fall 2001 NASD Regulatory & 

Compliance Alert, performance material for ETFs structured as open-end registered investment 

companies must provide equally prominent performance based on the closing market price when 

returns at NAV are included. 

• Exaggerated, unwarranted and misleading statements: 

– The statement “Trek ETFs help investors better navigate the galaxy between profit and loss while 

monitoring risk” is exaggerated and unwarranted. 

– References to “easily” and “simply” in the statement “Trek ETFs allow investors to simply and easily 

obtain a desired market or benchmark exposure…” mitigates the risks associated with an investment in 

any of the ETFs. 

• SEC Rule 482: 

– Fails to disclose the complete prospectus offer. 

– Fails to provide the complete performance disclosure legend. 

• SEC Rule 134: 

– With respect to the Klingon Commodities Fund, the handout exceeds the limited information permitted 

by the rule. Therefore, the handout fails to comply with SEC Rule 134. 


Communication #4: Driftwood Retirement Investment Strategies Invitation 



– Fails to identify the strategies and methods alluded to, and their corresponding risks, costs, conditions, 

limitations, and restrictions. 

– Fails to balance the claim of avoiding probate costs through trusts with disclosure of the costs, 

conditions, limitations, and restrictions applicable to trust instruments. 

– Fails to set forth the address and telephone number of the location from which Mr. Driftwood is directly 

supervised (the Office of Supervisory Jurisdiction). 

• Exaggerated, unwarranted, promissory or misleading statements or images: 

– The claims that Mr. Driftwood is a “nationally recognized and respected financial guru” and that he 

“authored several best-selling books” lack an adequate factual basis and misrepresent his reputation. 

– The following references are exaggerated: claims regarding eliminating or never paying income or 

capital gains taxes, “[p]rovide custodial care . . . At no cost to your estate”. 

– The following references are unwarranted: “[l]earn how to protect [assets] from risk”, “[i]nvest . . . with 

no possibility of loss”, “[e]arn 6% safely”, “[p]rotect your assets from TAXES and INFLATION”; “[m]ake 

sure your dollars will last longer than your years”. 

• Other issues: 

– Principal approval not obtained and/or record-keeping requirements applicable to approval not 

observed. 

– Member firm failed to adequately supervise Mr. Driftwood’s business activities. 




12:00 p.m. – 1:15 p.m. 

Resources 

New Rules 

• SEC Release No. 34-66681; File No. SR-FINRA-2011-035: Notice of Filing of Amendment No. 3 

and Order Granting Accelerated Approval of a Proposed Rule Change, as modified by 

Amendments Nos. 1, 2 and 3, to Adopt FINRA Rules 2210 (Communications with the Public), 

2212 (Use of Investment Companies Rankings in Retail Communications), 2213 (Requirements 

for the Use of Bond Mutual Fund Volatility Ratings), 2214 (Requirements for the Use of 

Investment Analysis Tools), 2215 (Communications with the Public Regarding Security Futures), 

and 2216 (Communications with the Public About Collateralized Mortgage Obligations (CMOs)) in 

the Consolidated FINRA Rulebook 

http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p125940.pdf 

FINRA Regulatory Notices 

• FINRA Regulatory Notice 12-02, FINRA Provides Guidance on Application of Communications 

Rules to Disclosures Required by Department of Labor (January 2012) 

www.finra.org/Industry/Regulation/Notices/2012/P125394 

• FINRA Regulatory Notice 11-49, FINRA Provides Guidance on Advertising Regulation Issues 

(October 2011) 


Fixed Income 

• FINRA Investor Alert: The Grass Isn’t Always Greener – Chasing Return in a Challenging 

Investment Environment 

www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P123947 


• Securities Exchange Commission CF Disclosure Guidance: Topic No. 3: Staff Observations in the 

Review of Promotional and Sales Material Submitted Pursuant to Securities Act Industry Guide 5 

www.sec.gov/divisions/corpfin/guidance/cfguidance-topic3.htm 


• FINRA Investor Alert: Public Non-Traded REITs – Perform a Careful Review Before Investing 

www.finra.org/Investors/ProtectYourself/InvestorAlerts/REITS/P124232 


Managing Risk in a Volatile Market 


12:00 p.m. – 1:15 p.m.



12:00 p.m. – 1:15 p.m. 


• Examine for deficiencies in your firm’s risk-management structure. 

• Identify factors that may pose the greatest risk in volatile markets. 

• Identify red flags that may signal a firm’s risk exposure is too great. 

• Understand how actions of others (employees, customers, counterparties, etc.) can adversely 

affect broker-dealers business in normal and stressed times. 

Moderator: 

William Wollman 


FINRA Member Regulation, Office of Risk Oversight and Operational Regulation 

Marshall Levinson 



Anand Ramtahal 



Patrick Tominey 



Outline 

Examine the types of risks firms face 

• Credit 

• Liquidity 

• Operational 

• Market 

Identifying and measuring factors contributing to risk 

• Risk-appetite 

o The role of business lines in affecting the company-wide views of risk 

o Understanding the underlying complexity and characteristics of risk 

• Risk-taking activity 

o High-risk complex financial transactions and products 

o Use of special purpose vehicles and entities (SPVs and SPEs) 

Risk monitoring and risk management 

• Sound corporate governance 


• Relationship between liquidity, leverage and capital adequacy and mitigating the 

compounding risks 

• Red flags signaling an over exposure to risk 

• Controls over the business 

Case study: Examination of MF Global 

• Off-balance sheet transactions 

• Use of customer funds 

• SEC Customer Protection Rule 


Marshall J. Levinson is Vice President, Member Regulation at FINRA. He is currently assisting in 

the implementation of Dodd-Frank regulations, solving complex issues, developing new examination 

scopes and staff education. Along with other FINRA staff, he works with the SEC in developing 

interpretive guidance on issues impacting the industry. Mr. Levinson joined FINRA from the Securities 

and Exchange Commission, where he was an accounting fellow in the Division of Trading and 

Markets, Office of Broker-Dealer Finances. He worked with other division staff on crafting new 

regulations and revising existing regulations, and along with FINRA, on current interpretations and 

other issues. Prior to joining the SEC, he was a chief liquidating officer of Lehman Brothers Inc. 

working with the SIPA Trustee. From 1987 to 2008, Mr. Levinson was a senior managing director with 

The Bear Stearns Companies Inc. where he held several financial positions including senior vice 

president-finance, corporate controller, general auditor and chief financial officer and chief 

administrative officer of Bear, Stearns International Limited (a UK-registered broker-dealer, in 

London). He was also a member of the Bear Stearns’ Operations Committee and the New Business 

and Structured Products Committee. Prior to joining Bear Stearns, Mr. Levinson was an audit partner 

with Arthur Young & Company (now Ernst & Young), where he was the designated industry expert for 

the securities industry. He has served as chairman of the SIFMA Capital Committee and as president 

of both the Internal Auditors Society and the Financial Management Society of SIFMA. He also 

served as a member of the AICPA’s Stockbrokerage and Investment Banking Committee. He holds a 

bachelor’s degree in business administration from Lehigh University and is a CPA. 

Anand Ramtahal is Senior Vice President and Regional Director in the Office of Risk Oversight and 

Operational Regulation, within Member Regulation, at FINRA. Mr. Ramtahal is responsible for the 

Financial and Operational Examination and Surveillance Programs for approximately 234 FINRA 

members that conduct a public customer business. Mr. Ramtahal joined NYSE Regulation in May 

1984, and held various positions in the division of Member Firm Regulation, most recently as a vice 

president. He became associated with FINRA in July 2007, after the consolidation of NASD and 

certain divisions of NYSE Regulation. Prior to joining NYSE Regulation, Mr. Ramtahal spent four 

years in the securities industry as an accountant, with The Wilsher Group and Paine Webber Inc. Mr. 

Ramtahal graduated from Pace University with a bachelor’s of business administration in public 

accounting and earned an M.B.A. in finance from Long Island University. 

Patrick Tominey is Vice President in the FINRA Member Regulation department. In his current role, 

Mr. Tominey is responsible for managing a group that conducts financial and operational 

examinations and surveillance of FINRA member firms and members of other self-regulatory 

organizations, including NYSE, NYSE AMEX, NYSE Arca and NASDAQ OMX PHLX. The 

examinations and surveillance group reviews include determination of compliance with rules, 

regulations and practices in a multitude of areas, including net capital, customer protection, 

operations, designated market maker, floor brokerage and internal controls, among others. Mr. 

Tominey began his career in 1988 in the Controllers Department of the New York Stock Exchange. 

He spent four years in that area, assisting in the preparation of the NYSE’s books and records and 

financial statements. In 1992, he became an examiner in the Member Firm Regulation Department of 

the NYSE, and served as Examination Director from 2001 through 2008, first at NYSE Regulation, 

and subsequently at FINRA. Mr. Tominey graduated in 1988 with a bachelor’s degree in finance from 

St. John’s University and was awarded a master’s in business administration in tax accounting from 

Hofstra University in 1991. 


William Wollman is Senior Vice President in FINRA Member Regulation. As a senior member of the 

Risk Oversight and Operational Regulation group at FINRA, he is responsible for financial and 

operational examinations for 170 of the most complex FINRA firms. He also has responsibility for the 

coordinator program that oversees 170 firms’ compliance with financial, operational and sales 

practices rules. Mr. Wollman has been with FINRA since its inception and was previously with the 

New York Stock Exchange for more than 18 years. 


Testimony of 

Stephen Luparello 

Vice Chairman 

Financial Industry Regulatory Authority 

Before the Committee on Agriculture 

U.S. House of Representatives 

December 8, 2011 

Chairman Lucas, Ranking Member Peterson and Members of the Committee: 

I am Steve Luparello, Vice Chairman of the Financial Industry Regulatory Authority, or FINRA. 

On behalf of FINRA, I would like to thank you for the opportunity to testify today. 

When a firm like MF Global fails, there is always value in reviewing the events leading to that 

failure and examining where rules and processes might be improved. I commend the 

Committee for having this hearing to do just that. Clearly the continued impact of MF Global’s 

failure on customers who cannot access their funds is of great concern, and every possible step 

should be taken to transfer and restore those accounts as quickly as possible. 

Like many other financial firms today, MF Global’s operations included multiple business lines, 

engaging multiple regulatory schemes and crossing national boundaries. We and the other 

regulators here today will explain our roles in overseeing the various parts of the firm. We all 

share the goal of restoring funds to customers. While FINRA’s role in that process is limited at 

this stage, we are committed to continuing to provide assistance wherever we can. 

FINRA 

FINRA is the largest independent regulator for all securities firms doing business in the United 

States, and, through its comprehensive regulatory oversight programs, regulates both the firms 

and professionals that sell securities in the United States and the U.S. securities markets. 

FINRA oversees approximately 4,500 brokerage firms, 163,000 branch offices and 636,000 

registered securities representatives. FINRA touches virtually every aspect of the securities 

business—from registering industry participants to examining securities firms; writing rules and 

enforcing those rules and the federal securities laws; informing and educating the investing 

public; providing trade reporting and other industry utilities and administering the largest dispute 

resolution forum for investors and registered firms.

In 2010, FINRA brought 1,310 disciplinary actions, collected fines totaling $42.2 million and 

ordered the payment of almost $6.2 million in restitution to harmed investors. FINRA expelled 

14 firms from the securities industry, barred 288 individuals and suspended 428 from 

association with FINRA-regulated firms. Last year, FINRA conducted approximately 2,600 cycle 

examinations and 7,300 cause examinations. 

One of our regulatory programs that is particularly relevant to today’s hearing is our financial 

and operational surveillance. Through this program, FINRA reviews FOCUS (Financial and 

Operational Combined Uniform Single) reports that broker-dealers file on a monthly basis as 

required by the Securities and Exchange Commission (SEC). These reports detail a firm’s 

financial and operational conditions and allow FINRA to closely monitor a firm’s net capital 

position and profitability for signs of potential problems. 

FINRA's activities are overseen by the SEC, which approves all FINRA rules and has oversight 

authority over FINRA operations. 

Oversight of MF Global 

Like many financial firms today that operate simultaneously in multiple channels, MF Global was 

not solely a broker-dealer, but also a futures commission merchant or FCM. As such, multiple 

government regulators and self-regulatory organizations (SROs), including FINRA, had a role in 

overseeing various parts of the firm’s operations. 

With respect to oversight of MF Global’s financial and operational compliance, which is most 

relevant to today’s hearing, FINRA shares oversight responsibilities with the Chicago Board 

Options Exchange (CBOE) and the SEC, especially in terms of the firm’s compliance with the 

net capital rule. For broker-dealers that are members of multiple SROs, the SEC assigns a 

Designated Examining Authority, or DEA, to examine the firm’s financial and operational 

programs, including the firm’s compliance with the Commission’s net capital and customer 

protection rules. For MF Global, that DEA is the CBOE. As such, CBOE conducted the regular 

examinations of the firm for capital compliance. 

There are two primary SEC rules for which financial examinations evaluate compliance, the net 

capital and customer protection rules. The primary purpose of the SEC's net capital rule, 15c3- 

1, is to protect customers and creditors of a registered broker-dealer from monetary losses and 

delays that can occur if that broker-dealer fails. It requires firms to maintain sufficient liquid 

assets to satisfy customer and creditor claims. It accomplishes this by requiring brokerage firms 

to maintain net capital in excess of certain minimum amounts. A firm’s net capital takes into 

account net worth, reduced by illiquid assets and various deductions to account for market and 

credit risk. This amount is measured against the minimum amount of net capital a firm is 

required to maintain, which depends on its size and business. The net capital rule is intended to 

provide an extra buffer of protection, beyond rules requiring segregation of customer funds, so 

that if a firm cannot continue business and needs to liquidate, resources will be available for 

them to do so. 

The SEC’s customer protection rule, 15c3-3, has two components, reserve formula computation 

and possession or control, and was designed to ensure the safety of customers’ assets. The 

objective of the reserve formula computation is to protect the customer funds in the event the 

2

oker-dealer becomes financially insolvent. Possession or control requires that the brokerdealer 

obtain prompt possession or control of customers’ fully paid for and excess margin 

securities, ensure that customers’ assets held by a broker-dealer are properly safeguarded 

against unauthorized use and separate firm and customer related business. 

Fewer than 20 FINRA-regulated broker-dealers have a DEA other than FINRA, but in those 

cases, we work closely and cooperatively with the DEA when questions or issues arise. Even 

when we are not the DEA for one of our regulated broker-dealers, FINRA monitors and 

analyzes the firm’s FOCUS report filings and annual audited financial statements as part of our 

ongoing oversight of the firm. That was the case with MF Global. 

While that monitoring focuses on a broad range of issues, it is particularly relevant to note that 

our financial surveillance team placed a heightened focus on exposure to European sovereign 

debt beginning in spring 2010. During April and May, our staff began surveying firms as to their 

positions in European sovereign debt as part of our ongoing monitoring of regulated firms. 

In response to our outreach on this issue, MF Global indicated in late September 2010 that the 

firm did not have any such positions. We later learned that the firm began entering into 

transactions that carried European debt exposure in mid-September 2010. While the firm’s 

response was consistent with GAAP accounting rules that repo-to-maturity (RTM) transactions 

are treated as a sale for accounting purposes, the lack of a complete response delayed us in 

detecting the firm’s exposure. 

MF Global’s Exposure to European Sovereign Debt 

In a routine review of MF Global’s audited financial statements filed with FINRA on May 31 of 

this year, our staff raised questions about a footnote disclosure regarding the firm’s RTM 

portfolio. RTMs are essentially transactions whereby the maturity date of a firm’s bond position 

held in its inventory matches the maturity date of the repo. During the course of discussions 

with the firm, FINRA learned that a significant portion of that portfolio was collateralized by 

approximately $7.6 billion in European sovereign debt. According to U.S. GAAP, RTMs are 

afforded sale treatment and therefore not recognized on the balance sheet. Notwithstanding that 

accounting position, the firm remained subject to market and credit risk throughout the life of the 

repo. 

Beginning in mid-June, FINRA had detailed discussions with the firm, in which CBOE also 

participated, regarding the proper treatment of the RTM portfolio and we asserted that not 

enough capital was reserved against the RTM. While the SEC has issued guidance clarifying 

that RTMs collateralized by U.S. Treasury debt do not require capital to be reserved, there is no 

such relief for RTMs collateralized by debt of non-U.S. governments. We researched whether 

the firm retained default risk on the positions, and concluded that it did. Our view was that while 

recording the RTMs as sales was consistent with GAAP, they should not be treated as such for 

purposes of the capital rule given the market and credit risk those positions carried. As a result, 

we asserted that capital needed to be reserved against the RTM. 

FINRA and CBOE also had discussions with the SEC about our concerns that the firm was not 

holding capital against its RTM portfolio. The SEC agreed with our assertion that the firm 

should be holding capital against the positions. The firm fought this interpretation throughout 

the summer, appealing directly to the SEC, before eventually conceding in late August. 

3

The firm infused additional capital and filed an amended July FOCUS report on August 31 to 

report a $150 million capital deficiency in July. The firm also provided notification, pursuant to 

SEC Rule 17a-11, of its capital deficiency to the SEC, CBOE and FINRA as well as to the 

Commodity Futures Trading Commission (CFTC), pursuant to CFTC Rule 1.12. The net capital 

deficiency in the amended July FOCUS report was reported on the CFTC’s website. In addition, 

on September 1, the firm amended its Form 10-Q filing with the SEC to identify the change in 

net capital treatment of the RTM portfolio. 

In September, FINRA added MF Global to “alert reporting,” a heightened monitoring process 

whereby we require firms to provide weekly information on net capital, inventory, profit and loss 

as well as reserve formula computations. 

On October 19, the Intermarket Financial Surveillance Group (IFSG), which is comprised of 

securities and futures regulators and self-regulatory organizations, had its annual meeting. The 

IFSG was established in 1989 in order to enhance the coordination and monitoring efforts of 

both securities and commodities regulators. Through an information sharing agreement, SROs 

provide each other with financial surveillance data and related information on an as-needed 

basis. In addition, SRO representatives meet annually to discuss relevant capital and customer 

protection issues. Exposure to European sovereign debt was one of the topics at the October 

meeting and FINRA raised MF Global’s positions during the discussions. 

During the week of October 24, as MF Global’s equity price declined and its credit rating was 

cut, FINRA increased the level of surveillance over the firm. We requested detailed information 

about the firm’s balance sheet and liquidity; we received updates about the loss of lending 

counterparties and customers; and we spoke to clearing organizations about the margin 

required to settle trades. At the end of that week, FINRA was on site at the firm, with the SEC, 

as it became clear that MF Global was unlikely to continue to be a viable standalone business. 

Our primary goal was to gain an understanding of the custodial locations for customer securities 

and to work closely with potential acquirers in hopes of avoiding SIPC liquidation. As has been 

widely reported, the discrepancy discovered in the segregated funds on the futures side of the 

firm ended those discussions. 

MF Global Bankruptcy and Liquidation Proceeding 

On October 31, 2011, MF Global Holdings, Ltd. and MF Global, Inc. filed for bankruptcy and 

entered into SIPC liquidation. Since that time, FINRA has provided assistance as requested by 

the SEC and the trustee. 

On November 4, 2011, FINRA assisted the trustee in alerting broker-dealer firms via email that 

the trustee was accepting proposals for the transfer of approximately 450 customer securities 

accounts of MF Global to another member of SIPC. 

We have also assisted the trustee by providing information about other broker-dealers to which 

MF Global securities customer accounts may be transferred. 

4

Proposed Rules to Enhance Financial Surveillance and Expedite the Return of Customer 

Funds and Securities in the Event of Liquidation 

While FINRA believes that financial oversight rules of the SEC, combined with SIPC, create a 

good structure for protecting customer funds, firm failures provide opportunities for review and 

analysis of where improvements may be warranted. FINRA has proposed two rules that we 

believe would assist us in our work to monitor the financial status of firms. One of the 

proposals, approved by FINRA’s Board in September of this year, would expedite the liquidation 

of a firm and most importantly, the transfer of customer assets. This rule is focused on enabling 

a more orderly resolution when a firm must cease operations. Specifically, it would require firms 

to contractually require their clearing banks and custodians to continue providing transaction 

feeds to the firm after the commencement of liquidation avoiding the recent reconciliation 

problems experienced by MF Global in its final days of business. 

The rule would require the clearing agencies and custodians to provide read-only access to the 

firm's records to the regulators and SIPC, with the goal of providing a more timely transfer of 

customer assets. The rule would also require carrying or clearing firms regulated by FINRA to 

maintain and keep current certain records in a central location to facilitate a more rapid and 

orderly transfer of customer accounts to another broker-dealer as well as a more orderly 

liquidation in the event the firm can no longer continue to operate. 

The other proposed rule, approved by FINRA’s Board in July 2010, would require that FINRAregulated 

firms file additional financial or operational schedules or reports as we deem 

necessary to supplement the FOCUS report. The rule would provide FINRA with the framework 

to request more specific information regarding, among other things, the generation of revenues 

and allocation of expenses by business segment or product line, the sources of trading gains 

and losses, the types and amounts of fees earned and the nature and extent of participation in 

securities offerings. As part of the rule filing, we have proposed a supplemental statement of 

income to the FOCUS reports, in order to capture more granular detail of a firm’s revenue and 

expense information. 

We are also working to develop an off balance sheet schedule, which could highlight exposures 

to regulators on a more timely basis. 

We believe these proposals would enhance our ability to closely oversee the financial 

operations of firms we regulate and to more quickly and efficiently assist in transfers or 

liquidations when firms must close their doors. 

Conclusion 

FINRA will continue to work with our fellow regulators and Congress as the liquidation process 

for MF Global proceeds. We share your commitment to reviewing the events involved in the 

firm’s collapse, relevant rules and coordination with other regulators to identify the lessons 

learned and potential policy or procedural adjustments that may be warranted. 

We realize that it is critical to continually evaluate the customer protection regime to ensure that 

it is designed as well as it can be to ensure prompt restoration of customer funds in the event of 

5

a firm collapse. To that end, we would be glad to participate in a broader review, in coordination 

with the SEC, CFTC, self-regulatory organizations and others to provide an overall assessment 

of where current rules and processes may need enhancements. 

Again, I appreciate the opportunity to testify today. I would be happy to answer any questions 

you may have. 

6

Committee: 

STATEMENT OF JON S. CORZINE 

BEFORE THE UNITED STATES HOUSE OF REPRESENTATIVES 

COMMITTEE ON AGRICULTURE 

DECEMBER 8, 2011 

Chairman Lucas, Ranking Member Peterson and Distinguished Members of the 

Recognizing the enormous impact on many peoples’ lives resulting from the events 

surrounding the MF Global bankruptcy, I appear at today’s hearing with great sadness. My 

sadness, of course, pales in comparison to the losses and hardships that customers, employees 

and investors have suffered as a result of MF Global’s bankruptcy. Their plight weighs on my 

mind every day – every hour. And, as the chief executive officer of MF Global at the time of its 

bankruptcy, I apologize to all those affected. 

Before I address what happened, I must make clear that since my departure from MF 

Global on November 3, 2011, I have had limited access to many relevant documents, including 

internal communications and account statements, and even my own notes, all of which are 

essential to my being able to testify accurately about the chaotic, sleepless nights preceding the 

declaration of bankruptcy. Furthermore, even when I was at MF Global, my involvement in the 

firm’s clearing, settlement and payment mechanisms, and accounting was limited. 

The Members should also understand that the Committee turned down my request to 

testify voluntarily in January. I had hoped that, by that time, I would have obtained and 

reviewed relevant records so that I could be more helpful to the Committee. 

As a consequence of my situation, not every fact of which I am or may have been aware 

that may be relevant to your inquiry is contained in this statement. While I intend to be 

responsive to the best of my ability today, without adequate time and materials to prepare, I may 

be unable to respond to various questions members might pose. Other questions, given my 

1

specific role in the company, will be questions for which I simply have no personal knowledge. 

Many of your questions may well be ones I myself have. 

Considering the circumstances, many people in my situation would almost certainly 

invoke their constitutional right to remain silent – a fundamental right that exists for the purpose 

of protecting the innocent. Nonetheless, as a former United States Senator who recognizes the 

importance of congressional oversight, and recognizing my position as former chief executive 

officer in these terrible circumstances, I believe it is appropriate that I attempt to respond to your 

inquiries. 

My Background 

I was born in 1947 and raised in the rural community of Taylorville, Illinois. After high 

school graduation in 1965, I attended the University of Illinois, from which I graduated in 1969. 

In the summer of 1969, I joined the United States Marine Corps Reserve, in which I served until 

1975. In 1970, I enrolled in the University of Chicago Business School. I took classes at night 

while working at a bank during the day, and I and received my MBA in 1973. 

In 1975, after working for a short time for a regional bank in Ohio, I took a job as a bond 

trader at the investment banking firm Goldman Sachs in New York. I remained at Goldman 

Sachs until January 1999, rising to the position of Senior Partner. 

In 2000, I was elected to serve in the United States Senate representing New Jersey. I 

served in the Senate until January 2006, when I became the Governor of New Jersey. I was 

elected to one term as Governor, serving from January 2006 to January 2010. 

Approximately three months after I left the governorship, I was recruited to become the 

chief executive officer of MF Global, whose prior chief executive had resigned abruptly after 

serving for 17 months. Prior to being approached about this position, I had no involvement with 

MF Global, and my only financial tie to it was extremely remote – I was an investor in the 

2

private equity fund J.C. Flowers, which had an investment in MF Global and a seat on the board 

of directors. My connection to J.C. Flowers led to my introduction to MF Global. 

MF Global Before I Joined 

Before I joined the company in late March 2010, MF Global was primarily a brokerage 

which provided execution and clearing services for products traded in derivative markets on 

exchanges around the world. MF Global was primarily a voice-based broker, which means that 

it took and placed orders largely over the telephone and had not yet made significant use of 

electronic trading technology. As stated in MF Global’s annual Form 10-K filing for the fiscal 

year ended March 31, 2009, the company’s revenues derived principally from commission fees 

generated from execution and clearing services and from interest income on cash held in 

customer accounts. 1 

By 2010, however, online brokerages and high-frequency traders had begun exerting 

downward pressure on commissions. Interest rates were at historic lows and were expected to 

remain so for an “extended period,” according to Federal Reserve policy statements. As a 

consequence of these developments among others, revenues were in decline. MF Global was 

accordingly experiencing substantial losses. The firm had reported losses in five consecutive 

quarters before I arrived, including the final quarter of the fiscal year ended March 31, 2010 (just 

as I was arriving), 2 and it had lost money in each of the previous three years, including the fiscal 

year that ended on March 31, 2010, for which the company posted a net loss to common 

shareholders of $167.7 million. 3 

(MF Global’s fiscal year ran from April 1 to March 31; the 

fiscal year ended on March 31, 2010 was MF Global’s 2010 fiscal year.) 

I took the job at MF Global even though the company was in a weak financial position 

because it had several positive attributes such as memberships on multiple derivative exchanges 

around the globe, solid market shares on those exchanges, and an extensive set of client 

3

elationships. I saw the possibility of taking part in the transformation of a challenged company 

by restructuring existing businesses and capturing opportunities available in the post-2008 

financial environment. 

Upon my arrival at MF Global, management and the board initiated a strategic review of 

our business. We engaged an outside consultant, the Boston Consulting Group, to help the firm 

define a business strategy that would lead it to profitability. Management, the board of directors, 

and the consultant came to the common conclusion that MF Global had to change its business 

strategy and diversify its revenues. 

The new business plan provided, in substance, that MF Global would evolve into a 

broker-dealer, and ultimately into an investment bank, which would provide broker, dealer, 

underwriting, advisory and investment management services. The implementation of the plan 

was expected to take three to five years. This new strategic plan was communicated to the 

public. 4 During my tenure as chief executive officer, MF Global made both structural and 

personnel changes in an effort to implement the strategic plan. One of the first priorities was to 

reduce the level of compensation as a percentage of MF Global’s revenues. The company was 

paying over 60% of its revenues to its employees, and sought to reduce this figure. Many 

employment contracts were restructured to increase the amount of pay that was dependent on MF 

Global’s performance. My own pay was structured to include a substantial component 

determined by MF Global’s performance, as discussed below. 

Before my tenure at MF Global, Promontory Financial Group (“Promontory”), a 

prominent financial consulting firm run by Eugene Ludwig, the former United States 

Comptroller of the Currency, had been retained pursuant to a settlement with the CFTC to review 

4

and assess MF Global’s implementation of the settlement. 5 

During my tenure, we retained 

Promontory to review various of MF Global’s compliance systems. 

I was hopeful about the prospects for the company, and I invested in it personally. Much 

of my compensation was in the form of options to purchase stock, which would have value only 

if the company prospered. When the company made a public equity offering in June 2010, I 

purchased almost $2.5 million worth of stock. In 2011, I bought approximately $500,000 more 

stockinthecompany. 6 

MF Global’s Leverage 

One of the recurrent themes in the media has been that MF Global took on too much risk 

during my tenure, in particular the amount of leverage that MF Global bore at the time of its 

bankruptcy. In fact, MF Global reduced leverage. In the quarter ended March 31, 2010, MF 

Global’s leverage was 37.3. During my tenure, it was consistently around 30. 7 

The RTMs 

A. Description of RTMs 

There has been extensive comment about a series of positions entered into by MF Global 

that involved “repurchase transactions to maturity,” known colloquially as “RTMs.” I would 

like to address those here. 

As relevant here, repurchase transactions (also known as “repos”) worked roughly as 

follows: MF Global would purchase a debt security (such as sovereign debt) from a seller and 

would sell the same security to another party (the “Counterparty”), with an agreement to 

repurchase the security from the Counterparty at a later date. The agreement between MF Global 

and the Counterparty to sell and buy back the debt security was the repurchase agreement, and it 

served, in effect, as a loan from the Counterparty to MF Global. The Counterparty would hold 

the debt security as collateral for the loan. 

5

An RTM is a particular kind of repurchase transaction in which the purchaser (MF 

Global) agrees to buy back the underlying debt security on its maturity date. 

The economic benefit of RTMs to MF Global was the difference (or “spread”) between 

(a) the interest rate paid by the issuer of the debt security to MF Global, and (b) the repurchase 

rate (referred to as the “financing rate”) paid by MF Global to the Counterparty. It is my 

understanding – and I do not claim to be an accountant – that under the applicable accounting 

principles, MF Global was required to recognize its profit immediately in RTMs, and the asset 

(the debt security) and the liability (the money owed to the Counterparty) must be “derecognized,” 

i.e., removed from MF Global’s balance sheet. I want to note here that I believe 

that accounting issues with respect to the RTMs would have been reviewed by MF Global’s 

internal auditors, outside auditors (PricewaterhouseCoopers), and its audit committee. 

B. Risks Related to RTMs 

Financing the purchase of debt with RTMs allowed MF Global to reduce certain kinds of 

risk. Because RTMs financed MF Global’s purchase of the debt security to the security’s 

maturity, the RTMs eliminated the risk (referred to as “financing risk”) that at some point during 

the life of the security MF Global would not be able to find additional financing for the security, 

and would therefore be forced to sell the security, potentially at a loss. Elimination of the 

financing risk meant that MF Global’s market risk (arising from the fluctuation of the price of 

the underlying debt security) was significantly reduced. 

MF Global retained, however, the risk that the debt securities might default or be 

restructured. If the debt securities defaulted or were restructured, then MF Global would not be 

paid in full at their maturity, even though MF Global would still have the obligation to buy back 

the debt securities from the Counterparty in full (at par). 

6

Also, the clearing house through which the repurchase transaction was executed 

(typically, the London Clearing House, or “LCH”) could demand that MF Global increase its 

margin. It might do so for at least two reasons: (a) if it determined that MF Global itself was not 

credit-worthy, or (b) if it determined that the underlying debt security – which was the collateral 

for the loan from the Counterparty to MF Global – decreased in value. The possibility of such 

margin calls from LCH meant that MF Global retained liquidity risk. 8 

To mitigate some of the risk of the RTMs, on some occasions MF Global took short 

positions in the underlying debt securities or in similar securities. 9 

C. The Decision To Engage In RTMs Involving European Sovereign Debt 

Even before I joined MF Global, the firm traded European sovereign debt securities. For 

instance, for the year ending March 31, 2010, the company reported that it was carrying over $9 

billion in foreign government securities, including both foreign securities owned outright and 

those sold to counterparties under repurchase agreements. 10 

The company also reported that it 

had used RTM agreements to purchase some securities, although not specifically foreign 

government debt. 11 

In the summer of 2010, I met with MF Global’s senior traders to discuss ways to improve 

the company’s profitability. One of the ideas discussed was for MF Global to purchase 

European sovereign debt using RTMs. Such transactions were attractive for the reasons stated 

above – the reduction of finance risk and market risk – and the spread on the European sovereign 

debt securities appeared to be favorable. MF Global could engage in RTMs with these securities 

much as it had already done with other securities. Through these discussions, I became an 

advocate of purchasing European sovereign debt using RTMs. 

At the time that MF Global entered into the transactions, I believed that its investments in 

short-term European debt securities were prudent. MF Global invested in RTMs with respect to 

7

the debt of Belgium, Italy, Spain, Ireland and Portugal. The first three of these – Italy, Spain and 

Belgium – were rated AA or better when MF Global invested in them. Even today, they are all 

at least A rated, and some of them are AA rated. 12 

All of the sovereign debt of these three 

countries that MF Global held in RTMs matured no later than December 2012. Ireland and 

Portugal were lower rated, but for most of the time that MF Global held these securities they 

were backed by financing offered through the European Financial Stability Facility (EFSF) and 

the IMF, which made it highly likely that Ireland and Portugal would be able to roll over their 

outstanding debt before June 2013, when the funding facility expired. All of the sovereign Irish 

and Portuguese debt that MF Global held in RTMs matured no later than June 2012. 

Furthermore, because the European debt instruments that MF Global purchased did not all 

mature at the same time, there was an additional level of risk mitigation. As time went on and as 

the instruments matured, MF Global’s risk would decrease. 

D. Participants In The Decision To Engage In RTMs Involving European 

Sovereign Debt 

MF Global’s involvement in RTMs involving European sovereign debt securities was the 

subject of internal discussions with the company’s traders, senior managers, and the board of 

directors. 

The RTM transactions were reported to the board of directors. There were discussions at 

board meetings, at which the transactions were described, analyzed and debated. Although some 

people complain that boards of directors are “rubber stamps” for the decisions of company 

management, MF Global’s board was not a rubber stamp. The members of the board of directors 

were independent and sophisticated, and they asked hard questions and raised concerns about the 

RTMs. All of the members had been on the board of directors before I joined MF Global. The 

8

oard met without management on some occasions, and it is my understanding that the RTM 

portfolio was a topic of discussion during at least some of those meetings. 

The directors approved sovereign risk limits up to which MF Global could invest in the 

RTM trades. Ultimately, the limits were specified on a country-by-country basis. MF Global 

attempted to adhere to those limits, and generally did so. On a few occasions, however, the chief 

risk officer reported that the firm had exceeded its limits with respect to a particular country. I 

recall, for example, one occasion on which the limit was exceeded because the Euro gained value 

against the dollar, and the risk limits were set in dollars. On the occasions on which the firm 

exceeded the country limits, it nonetheless remained within the overall limit and took appropriate 

steps (such as entering a reverse-RTM or shorting the same security) to bring its level of 

exposure back within the country limits. At the time of the bankruptcy, MF Global was within 

the risk limits set by the board of directors. 

I accept responsibility for the RTM trades that MF Global engaged in from the time that I 

arrived at MF Global until my departure, on November 3, 2011, and I strongly advocated the 

trading strategy that I have described here. It is important to recognize, however, that MF 

Global’s involvement in RTM trades was disclosed to the board of directors, the senior officers 

of the company, the company’s accountants and numerous outsiders. 

E. The Public Disclosures Of The RTMs 

The RTM trades were also publicly disclosed, both in the periodic financial statements 

and in other public statements, including press releases and earnings calls. 

MF Global’s annual filing (Form 10-K), dated May 20, 2011, for the fiscal year ended 

March 31, 2011, stated that MF Global invested in the sovereign debt of Italy, Spain, Belgium, 

Portugal and Ireland, and that the final maturity for any of these securities was no later than 

December 2012, which, it noted, was “prior to the expiration of the European Financial Stability 

9

Facility.” 13 

The filing also reported that “[a]t March 31, 2011 securities . . . sold under 

agreements to repurchase of $14,520,341[,000] at contract value, were de-recognized, of which 

52.6% were collateralized with European sovereign debt.” 14 

On July 28, 2011, the company announced its results for the first quarter of fiscal year 

2012 (which ended on June 30, 2011), and its disclosures about the RTMs were again extensive. 

Its filing (Form 10-Q) stated that as of June 30, 2011, “securities purchased under agreements to 

repurchase of $16,548,450[,000] ...werede-recognized,ofwhich69.3% . . . were collateralized 

with European sovereign debt, consisting of Italy, Spain, Belgium, Portugal and Ireland.” 15 

The 

Form 10-Q also stated that the net notional value of the Italian, Spanish, Belgian, Irish and 

Portuguese sovereign debt securities that MF Global held was $6.4 billion. 16 

In a conference call 

that MF Global held on July 28 to announce its results, the RTMs collateralized with European 

sovereign debt were discussed. 17 

F. The Fate Of The RTMs 

As of today, none of the foreign debt securities that MF Global used in the RTM trades 

has defaulted or been restructured. All of those securities that reached maturity while they were 

part of the RTM position paid in full. 

Communications With Regulators 

A. FINRA’s Position Regarding The Capital Treatment Of The RTMs 

Involving European Sovereign Debt Securities 

In approximately the first week of August 2011, I recall becoming aware that officials 

from FINRA were considering whether to require that MF Global modify its capital treatment 

under SEC Rule 15c3-1 of the RTMs involving European sovereign debt instruments. I believe 

that FINRA officials may have raised this issue with others at MF Global earlier than August 

2011, but to the best of my recollection, I did not focus on the issue until approximately early 

10

August. I had not met with FINRA officials, to the best of my recollection, although I spoke 

briefly at a meeting at MF Global’s offices on or about June 14, 2011, that was attended by 

officials from the SEC, the CFTC, FINRA and perhaps other regulators. I believe that I spoke 

about RTMs at that meeting. I believe that other members of the management of MF Global 

spoke at that meeting about several topics, although I did not attend those others members’ 

presentations. 

On or about August 15, 2011, I went with others from MF Global to the SEC in 

Washington to question FINRA’s interpretation of SEC Rule 15c3-1. We met with Michael 

Macchiaroli, the Associate Director in the Division of Trading and Markets, and others from the 

SEC, and presented our argument that the capital treatment of the RTMs involving European 

sovereign debt securities should not be changed in the way that FINRA proposed. Some days 

after the meeting, MF Global was apprised by FINRA that FINRA would not change its position. 

I thereafter made a telephone call to Mr. Macchiaroli who told me, in substance, that there was 

no further appeal and that MF Global had to comply with FINRA’s direction. He noted, 

however, that other companies in similar positions had sent letters of objection to the SEC, 

although he was clear that such a letter would make no difference to FINRA’s or the SEC’s 

position. 

Although MF Global disagreed with FINRA’s position, the firm promptly complied with 

the demand that its United States subsidiary increase its net capital. On September 1, 2011, we 

made a Form 10-Q/A public filing disclosing FINRA’s ruling. It stated: 

As previously disclosed, the Company is required to maintain specific minimum levels of 

regulatory capital in its operating subsidiaries that conduct its futures and securities 

business, which levels its regulators monitor closely. The Company was recently 

informed by the Financial Industry Regulatory Authority, or FINRA, that its regulated 

U.S. operating subsidiary, MF Global Inc., is required to modify its capital treatment of 

certain repurchase transactions to maturity collateralized with European sovereign debt 

11

and thus increase its required net capital pursuant to SEC Rule 15c3-1. MF Global Inc. 

has increased its net capital and currently has net capital sufficient to exceed both the 

required minimum level and FINRA’s early-warning notification level. … 18 

B. My Communications Regarding Proposed CFTC Rules Changes 

Sometime in late 2010 or early 2011, the CFTC proposed certain changes in 17 C.F.R. 

§1.25 (“Rule 1.25”). As far as I understand, roughly speaking, Rule 1.25 outlines the 

permissible investments and uses for customer funds, as that term is defined in the CFTC Rules 

and Regulations, held by a Futures Commission Merchant (“FCM”). 

The proposed rule change was the topic of substantial discussion among regulated 

entities, industry organizations, associations, committees and even designated self-regulatory 

organizations. I understand that there were numerous letters received by the CFTC opposing 

various aspects of the proposed rule change. 19 

MF Global submitted a letter, along with 

Newedge, which was one of the largest FCMs in the United States, opposing the proposed 

amendments to the rule. 

The proposed rule change was also the topic of the conference call in which I took part 

on July 20, 2011, in which CFTC Chairman Gary Gensler participated. As best as I can recall, 

there were others from MF Global who took part in the conference call, and the CFTC’s own 

records state that in addition to CFTC Chairman Gensler, four other officials from the CFTC 

were on the call. According to the CFTC’s records, I was not the only representative of the 

industry that had calls with members of the CFTC, including Chairman Gensler, regarding the 

proposed changes. 

The principal topic of discussion was whether Rule 1.25 should be changed to prevent 

FCMs from engaging in repurchase transactions with related broker-dealers. As I understood it, 

the then-current version of Rule 1.25 permitted such transactions but the proposed version would 

not, or would somehow limit such transactions. Consistent with the letter that we had submitted 

12

with Newedge, I argued, in substance, that such transactions should continue to be permitted 

because such transactions could be beneficial to the FCMs. 

On the same afternoon, I spoke with another CFTC commissioner, Mr. Bart Chilton, to 

discuss the same matter. Mr. Chilton, who, according to the CFTC’s records was accompanied 

by another CFTC official, listened to the arguments. I was joined on the phone by the general 

counsel for MF Global. 

Later, I came to understand that the CFTC deferred consideration of the new rule. 

C. Further Contacts 

From the time that I joined MF Global through October 30, 2011, to the best of my 

recollection, I spoke with Chairman Gensler on only limited occasions. In addition to those 

contacts set forth above, I had a meeting with him in or about May 5, 2010, and I also met with 

him in or about December 2010. Those meetings were at the CFTC in Washington, and on those 

occasions there were other officials from the CFTC present. 

In addition, Chairman Gensler and I had a few brief interactions at which there was, to 

the best of my recollection, no private discussions about the CFTC’s regulation or oversight of 

MF Global. For example: 

(a) 

He was a guest lecturer on government regulation at my class at Princeton on or 

about November 22, 2010. When he spoke at Princeton, there was another person from the 

CFTC present, and we did not discuss professional matters, except in the context of the class. 

(b) 

I also attended a conference that was sponsored by the investment firm of Sandler 

& O’Neill on or about June 9, 2011. Chairman Gensler was there, as were others from the 

CFTC. I gave a presentation about MF Global at the conference, and Chairman Gensler gave the 

luncheon speech. I do not recall that I discussed any business with Chairman Gensler other than 

a question that I put to him before the full audience during a question and answer session 

13

following his presentation. To the best of my recollection, the question was about proposed 

changes to Rule 1.25. 

(c) 

In addition, on or about September 14, 2011, Chairman Gensler and I attended the 

wedding celebration of mutual friends. On that occasion, Chairman Gensler was not 

accompanied by anyone from the CFTC, but, again, we did not discuss business or regulatory 

matters so far as I recall. 

On various occasions during my tenure at MF Global, I met or communicated with others 

at the CFTC about a variety of issues. 

During my tenure at MF Global, to the best of my recollection I never spoke about 

business with Chairwoman Shapiro of the SEC, another of our regulators, or any other SEC 

commissioner. (I may have greeted Chairwoman Shapiro at a conference.) During my tenure at 

MF Global, to the best of my recollection, I never communicated with Secretary of the Treasury, 

Timothy Geithner. 

During my tenure at MF Global, to the best of my recollection, I never spoke with the 

President of the New York Federal Reserve William Dudley until approximately the week 

preceding the bankruptcy of MF Global, other than on one occasion (on or about April 13, 2011) 

when he and I attended a speech at Princeton by Chairman Bernanke of the Federal Reserve. To 

the best of my recollection, Mr. Dudley and I greeted each other on that occasion, but did not 

engage in substantive conversation. During my tenure at MF Global, to the best of my 

recollection, I did not speak with any governor of the Federal Reserve other than to greet 

Chairman Bernanke after his presentation at Princeton. 

The Events Of October 2011 

The late summer and fall of 2011 were extraordinarily difficult times in the financial 

markets for almost all market participants. Like many comparable firms, MF Global was 

14

experiencing poor earnings principally on account of diminished revenues, and highly correlated 

volatility in many markets. 

On October 17, 2011, the Wall Street Journal published an article that described the 

FINRA ruling that MF Global had disclosed on September 1. Other news stories followed, and 

some of MF Global’s counterparties decided to reduce their exposure to the company, requiring 

some adjustment in our financing. MF Global’s stock began to perform relatively poorly. 

On or about October 21 and 22, 2011 – in anticipation of a disappointing earnings 

announcement, and concerned that the ratings agencies would downgrade MF Global – I and 

several of my colleagues made presentations to the ratings agencies to put the earnings 

announcement in context. The firm customarily made presentations to the ratings agencies 

shortly before the firm’s quarterly earnings announcements. 

On Monday, October 24, 2011, Moody’s cut MF Global’s rating from Baa2 to Baa3, 

followed by another downgrade to Ba2, on October 27. Fitch followed suit, cutting the 

company’s rating from BBB to BB+. On October 26, S&P placed MF Global on its “credit 

watch negative” list, although it did not downgrade its rating below investment grade. 

MF Global announced its quarterly earnings on October 25, 2011. The announcement 

was made two days ahead of schedule so that the firm could get full information to the public in 

light of Moody’s downgrade. The announcement revealed that MF Global had lost $191.6 

million in the quarter that ended September 30, 2011. 

In light of the attention that has been given to RTMs, and the press reports that attributed 

MF Global’s loss to RTMs involving European debt securities, it is important to make clear here 

that the loss was not related to those positions. The lion’s share of the quarterly loss was a writeoff 

of approximately $119.4 million that reflected a valuation adjustment against a deferred tax 

15

asset. That asset had been created by years of (non-RTM) tax losses cumulated (mostly before I 

arrived at MF Global) in the firm’s United States and Japanese subsidiaries, which had allowed 

MF Global to recognize as an asset potential tax benefits – equal to $119.4 million – in future 

years. Under applicable accounting rules, by the second quarter of MF Global’s 2011 fiscal year 

(i.e., the quarter ending September 30, 2011) the firm was no longer permitted to recognize those 

tax benefits as assets, and therefore, with the advice and knowledge of its external auditor, it 

recognized a loss in that amount. 

In addition, approximately $16.1 million of the quarterly loss resulted from the retirement 

of debt arising out of MF Global’s purchase of certain of its 9% senior notes due 2038. Another 

approximately $10.0 million was for “restructuring charges,” which included the closure of our 

Japanese securities business. The remainder was miscellaneous matters including reserves for 

litigation, much of it arising out of events before I arrived at MF Global. Approximately $18 

million was operating losses (again, not related to the RTMs). 

Shortly following the earnings announcement and the ratings downgrades, some clients 

and counterparties withdrew their business from the firm; others required increased margins. 

The firm’s stock traded at sharply higher volumes and lower prices. 

During the week of October 24-28, 2011, MF Global undertook extraordinary steps to 

ensure that it was able to honor customers’ requests to withdraw funds or collateral. To the best 

of my recollection, during that week the firm unwound hundreds of millions of dollars worth of 

RTMs, and sold the underlying sovereign debt instruments; it also sought to draw down its 

revolver loans from a consortium of banks led by J.P. Morgan. On October 27, MF Global sold, 

to the best of my recollection, $1.3 billion in commercial paper instruments for same-day 

settlement, and over $300 million in corporate securities, also for same-day settlement. The next 

16

day, I believe that MF Global sold approximately $4.5 billion in United States agency securities. 

Over the course of the week, MF Global reduced the size of its match book by, to the best of my 

recollection, approximately $10 billion. Despite our best efforts to sell assets and generate 

liquidity, the marketplace lost confidence in the firm. 

The firm was in regular contact with its regulators, including the CFTC, the Federal 

Reserve Bank of New York, the SEC and the U.K’s Financial Services Authority, and the 

Chicago Mercantile Exchange (CME), the firm’s designated self-regulatory organization. 

The firm was also engaged in efforts to sell the FCM part of its business. It had been 

contemplating, for some time prior to the week of October 24, a strategic partnership involving 

the FCM business. On or about Tuesday, October 25, the firm retained an investment bank, 

Evercore, to explore selling that business. By the next day, MF Global instructed Evercore also 

to explore selling the entire firm. MF Global was in negotiations to sell the firm through the 

weekend of October 29-30. The sale did not take place when it was discovered that customer 

accounts could not be reconciled at that time. 

The Unreconciled Accounts 

Obviously on the forefront of everyone’s mind – including mine – are the varying reports 

that customer accounts have not been reconciled. I was stunned when I was told on Sunday, 

October 30, 2011, that MF Global could not account for many hundreds of millions of dollars of 

client money. I remain deeply concerned about the impact that the unreconciled and frozen 

funds have had on MF Global’s customers and others. 

As the chief executive officer of MF Global, I ultimately had overall responsibility for 

the firm. I did not, however, generally involve myself in the mechanics of the clearing and 

settlement of trades, or in the movement of cash and collateral. Nor was I an expert on the 

complicated rules and regulations governing the various different operating businesses that 

17

comprised MF Global. I had little expertise or experience in those operational aspects of the 

business. 

Again, I want to emphasize that, since my resignation from MF Global on November 3, 

2011, I have not had access to the information that I would need to understand what happened. It 

is extremely difficult for me to reconstruct the events that occurred during the chaotic days and 

the last hours leading up to the bankruptcy filing. 

I simply do not know where the money is, or why the accounts have not been reconciled 

to date. I do not know which accounts are unreconciled or whether the unreconciled accounts 

were or were not subject to the segregation rules. Moreover, there were an extraordinary number 

of transactions during MF Global’s last few days, and I do not know, for example, whether there 

were operational errors at MF Global or elsewhere, or whether banks and counterparties have 

held onto funds that should rightfully have been returned to MF Global. I am sure that the 

trustee in bankruptcy, the SIPC receiver, and the regulators are working to answer these 

questions and to understand precisely what happened during the firm’s last days and hours. 

As the chief executive officer of MF Global, I tried to exercise my best judgment on 

behalf of MF Global’s customers, employees and shareholders. Once again, let me go back to 

where I started: I sincerely apologize, both personally and on behalf of the company, to our 

customers, our employees and our investors, who are bearing the brunt of the impact of the 

firm’s bankruptcy. 

That concludes my prepared statement. I am willing to answer the Committee’s 

questions. 

18

1 

2 

See FY 2009 Form 10-K (for fiscal year ended March 31, 2009) (filed on June 10, 2009), at 

pp. 3-4 (“Description of Business”). 

Quarter Profit/(Loss) Source 

4Q 2010 ($96.5 million) News Release, “MF Global Reports Fourth Quarter 

and Fiscal Year 2010 Results,” May 20, 2010, at p. 

1 (filed with Form 8-K on May 20, 2010) 

3Q 2010 ($22.3 million) News Release, “MF Global Reports Third Quarter 

2010 Results,” Feb. 4, 2010, at p. 1 (filed with 

Form 8-K on Feb. 4, 2010). 

2Q 2010 ($16.0 million) News Release, “MF Global Reports Second 

Quarter 2010 Results,” Nov. 5, 2009, at p. 1 (filed 

with Form 8-K on Nov. 5, 2009). 

1Q 2010 ($32.8 million) News Release, “MF Global Reports First Quarter 

2010 Results,” Aug. 6, 2009, at p. 1 (filed with 

Form 8-K on Aug. 6, 2009). 

4Q 2009 ($119.4 million) News Release, “MF Global Reports Fourth Quarter 


7 (Consolidated & Combined Statements of 

Operations) (filed with Form 8-K on May 21, 

2009). 

3 

Quarter Profit/(Loss) Source 

FY 2010 ($167.7 million) News Release, “MF Global Reports Fourth Quarter 


1 (filed with Form 8-K on May 20, 2010). 

FY 2009 ($69.2 million) News Release, “MF Global Reports Fourth Quarter 


7 (Consolidated & Combined Statements of 

Operations) (filed with Form 8-K on May 21, 

2009). 

FY 2008 ($71.1 million) News Release, “MF Global Reports Record Fourth 

Quarter and Fiscal Year 2008 Results,” May 20, 

2008, at p. 1 (filed with Form 8-K on May 20, 

2008) 

4 

5 

See, e.g., FY 2011 Form 10-K filing (for fiscal year ended March 31, 2011) (filed May 20, 2011), 

at p. 6 (“Growth Strategy”); id. at 15. 

In February 2008, MF Global suffered a loss of $141.0 million, following an unauthorized trading 

incident involving wheat futures (“Dooley Trading Incident”). Criminal charges were brought 

against the trader, Evan Dooley. MF Global, among other things, entered into a settlement with 

the CFTC, under which the company agreed to specific undertakings relating to risk management, 

including the engagement of an independent outside consultant (Promontory). See FY 2010 

Form 10-K (for fiscal year ended Mar. 31, 2010) (filed May 28, 2010), at p. 35. 

19

6 

7 

8 

9 

10 

11 

My Equity Acquisitions in MF Global 

04/07/2010 Granted 2,500,000 stock options (granted as part of my initial compensation) 

06/03/2010 Bought 352,100 common shares at $7.10, in a public offering 

05/20/2011 Granted 1,600,000 stock options (granted at the time of my contract extension) 

06/09-11/2011 Bought 36,100 common shares at between $6.85 and $6.92, on the market 

08/08/2011 Bought 33,960 common shares at $5.71 and $5.91, on the market 

08/10/2011 Bought 1,000 common shares at $5.41, on the market 

08/18/2011 Bought 18,800 common shares at $5.25, on the market 

I never sold any shares or options. 

Leverage is calculated by dividing (a) the reported total assets, by the sum of (b) total equity and 

(c) preferred shares. The relevant data can be found in MF Global’s consolidated balance sheets, 

which are contained in the firm’s quarterly (Form 10-Q) or annual (Form 10-K) financial 

statements. 

These risks were described in, for example, MF Global’s Form 10-Q for the period ending June 

30, 2011 (filed August 3, 2011), at p. 76: 

Under the Company’s repurchase agreements, including those repurchase agreements 

accounted for as sales, its counterparties may require the Company to post additional 

margin at any time, as a means for securing its ability to repurchase the underlying 

collateral during the term of the repurchase agreement. Accordingly, repurchase 

agreements create liquidity risk for the Company because if the value of the collateral 

underlying the repurchase agreement decreases, whether because of market 

conditions or because there are issuer-specific concerns with respect to the collateral, 

the Company will be required to post additional margin, which the Company may not 

readily have. If the value of the collateral were permanently impaired (for example, if 

the issuer of the collateral defaults on its obligations), the Company would be 

required to repurchase the collateral at the contracted-for purchase price upon the 

expiration of the repurchase agreement, causing the Company to recognize a loss. 

Also, margin funds that are posted by the Company cannot be used by it for other 

purposes, which may limit the Company’s ability to deploy its capital in an optimal 

manner or to effectively implement its growth strategy. For information about these 

exposures and forward purchase commitments, see “—Off Balance Sheet 

Arrangements and Risk” and “Item 3. Quantitative and Qualitative Disclosures about 

Market Risk—Disclosures about Market Risk—Risk Management.” 

See, e.g., FY 2011 Form 10-K, at p. 78 (“From time to time, and in addition to short positions in 

our non-trading book, we also take short positions in our trading book to mitigate our issuer credit 

risk further.”). 

See Notes 5 & 7 to Consolidated & Combined Financial Statements, FY 2010 Form 10-K, at p. 

112-13. 

See id. at pp. 100, 112 (describing accounting treatment of RTMs). 

20

12 

13 

14 

15 

16 

17 

18 

19 

The current ratings are as follows: 

Belgium: AA negative (S&P) AA+ negative 

(Fitch) 

Aa1possible downgrade 

(Moody’s) 

Italy: A negative (S&P) A+ negative (Fitch) A2 negative (Moody’s) 

Spain: AA- negative (S&P) AA- negative A1 negative (Moody’s). 

(Fitch) 

The credit ratings above were obtained from the websites of the three major credit rating agencies 

on December 6, 2011. See http://www.standardandpoors.com/ratings/en/us/; 

www.fitchratings.com; www.moodys.com. 

FY 2011 Form 10-K, at pp. 77-78; see also id. at pp. 99-100. 

Id. at p. 100. 

Note 3, to Consolidated & Combined Financial Statements, 1Q FY 2012 Form 10-Q, at pp. 13-14 

(filed Aug. 3, 2011). 

Id. at p. 90 (table). 

Earnings call, “MF Global Holdings’ CEO Discusses F1Q2012 Results,” July 28, 2011, at p. 4. 

“Additional Information,” Q1 FY 2012 Form 10-Q/A, at p. 2. 

The CFTC received over 30 comment letters related to topics covered by the proposed changes. 

Many of these letters commented on the same proposed changes on which MF Global 

commented. As examples, both the CME and the Futures Industry Association (“FIA”) in 

conjunction with the International Swaps and Derivatives Association (“ISDA”), Inc. challenged, 

among other things, the proposed amendments regarding permissible investments and internal 

repurchase transactions. The comments provided by the CME, FIA and ISDA advocated that an 

FCM should be permitted to invest in certain types of foreign sovereign debt and also advocated 

that FCMs should be able to engage in repurchase transactions and reverse repurchase 

transactions with affiliates and to engage in in-house transactions. Both JP Morgan Futures, Inc. 

and Morgan Stanley took similar positions. 

21



12:00 p.m. – 1:15 p.m. 

Resources 

• FINRA Regulatory Notice 10-57, Funding and Liquidity Risk Management Practices 

(November 2010) 

www.finra.org/Industry/Regulation/Notices/2010/P122389 

• Containing Systemic Risk: The Road to Reform; The Report of the CRMPG III (August 6, 

2008) 

www.crmpolicygroup.org/docs/CRMPG-III.pdf 

• Senior Supervisors Group Observations on Risk Management Practices During the Recent 

Market Turbulence (March 2008) 

www.newyorkfed.org/newsevents/news/banking/2008/ssg_risk_mgt_doc_final.pdf 

• Senior Supervisors Group Risk Management Lessons from the Global Banking Crisis of 2008 

(October 21, 2009) 

www.sec.gov/news/press/2009/report102109.pdf 

• Committee of European Bank Supervisors’ High Level Principles for Risk Management 

(February 16, 2010) 

www.c-ebs.org/documents/Publications/Standards---Guidelines/2010/Riskmanagement/HighLevelprinciplesonriskmanagement.aspx 

• FSA Strengthening Liquidity Standards (October 2009) 

www.fsa.gov.uk/pubs/policy/ps09_16.pdf 

• Policy Perspectives on OTC Derivatives Market Infrastructure (January 2010) (March 2010 

Revised) 

www.newyorkfed.org/research/staff_reports/sr424.pdf 

• FSA Assessing Possible Sources of Systemic Risk from Hedge Funds 

(February 2010) 

www.fsa.gov.uk/pubs/other/hedge_funds.pdf 

© 2012 Financial Industry Regulatory Authority, Inc. All rights reserved.

2012 FINRA Annual Conference Materials - May 23 Session

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