Humpty Dumpty, FINRA, Sharing, Guarantee, and Losses
November 15, 2017
Many laws, rules, and regulations were apparently drafted by folks with a warped sense of humor and a penchant for irony. I say that because much of what guides our conduct on Wall Street comes down to sternly worded proscriptions against engaging in conduct that is wrongful, improper, unfair, or unreasonable -- which is all well and fine except when you believe with every fiber in your body that your conduct was right, proper, fair, or reasonable. All of which is exacerbated by the the reality that those with influence and money who do what you did get a pass while you're being charged and prosecuted. A recent Financial Industry Regulatory Authority regulatory settlement challenges us on many levels. First, we're not quite sure what the self-regulatory-organization is implying or what we should infer given the holes in the fact pattern. Second, assuming that respondent did what we think he did, FINRA appears to have jammed a size 10 foot into a size 8 shoe in order to make the underlying conduct fall under one of its rules.
Case In Point
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Jeffrey L. Slothower submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Jeffrey L. Slothower, Respondent (AWC 2016049080901, November 9, 2017).
The AWC asserts that Slothower was first registered with a FINRA member firm in 2002; on April 7, 2010, he was registered with Merrill Lynch, Pierce, Fenner & Smith Inc.; and on January 4, 2016, he was registered with Private Client Services, LLC. The AWC asserts that Slothower "does not have any disciplinary history with the Securities and Exchange Commission, any state securities regulators, FINRA or any other self-regulatory organization."
FINRA Rule 2150
FINRA Rule 2150 admonishes that you can't make "improper" use of a customer's securities or funds. Wow, that's a big help: don't do anything improper. On top of that prohibition, the Rule prohibits any "guarantee" against a customer's loss or sharing in a customer's account.
FINRA Rule 2150: Improper Use of Customers' Securities or Funds; Prohibition Against Guarantees and Sharing in Accounts
(a) Improper Use
No member or person associated with a member shall make improper use of a customer's securities or funds.
(b) Prohibition Against Guarantees
No member or person associated with a member shall guarantee a customer against loss in connection with any securities transaction or in any securities account of such customer.
(c) Sharing in Accounts; Extent Permissible
(1)(A) Except as provided in paragraph (c)(2), no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member; provided, however, that a member or person associated with a member may share in the profits or losses in such an account if:
(i) such person associated with a member obtains prior written authorization from the member employing the associated person;
(ii) such member or person associated with a member obtains prior written authorization from the customer; and
(iii) such member or person associated with a member shares in the profits or losses in any account of such customer only in direct proportion to the financial contributions made to such account by either the member or person associated with a member.
(B) Exempt from the direct proportionate share limitation of paragraph (c)(1)(A)(iii) are accounts of the immediate family of such member or person associated with a member. For purposes of this Rule, the term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, children or any relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.
(2) Notwithstanding the prohibition of paragraph (c)(1), a member or person associated with a member that is acting as an investment adviser may receive compensation based on a share in profits or gains in an account if:
(A) such person associated with a member seeking such compensation obtains prior written authorization from the member employing the associated person;
(B) such member or person associated with a member seeking such compensation obtains prior written authorization from the customer; and
(C) all of the conditions in Rule 205-3 of the Investment Advisers Act (as the same may be amended from time to time) are satisfied.
*** Supplementary Material ***
.01 Inapplicability of Rule to Certain Guarantees. For purposes of paragraph (b) of this Rule, a "guarantee" that is extended to all holders of a particular security by an issuer as part of that security generally would not be subject to the prohibition against guarantees.
.02 Permissible Reimbursement by Member of Certain Losses. Nothing in this Rule shall preclude a member, but not an associated person of the member, from determining on an after-the-fact basis, to reimburse a customer for transaction losses; provided, however, that the member shall comply with all reporting requirements that may be applicable to such payment. For example, if the payment can reasonably be construed as a settlement, the member shall report the payment as a settlement under the applicable reporting requirement(s). In addition, nothing in this Rule shall preclude a member, but not an associated person of the member, from correcting a bona fide error. This Supplementary Material .02 does not apply to an associated person of a member because of the concern that any such payment may conceal individual misconduct.
.03 Record Retention. For purposes of paragraph (c) of this Rule, members shall preserve the required written authorization(s) for at least six years after the date the account is closed.
.04 Applicability of Other Rules to Sharing Arrangements. Members and associated persons should be aware that participation in a sharing arrangement permitted under paragraph (c) of this Rule does not affect the applicability of other FINRA rules, including paragraph (b) of this Rule, FINRA Rules 3210, 3270 and 3280 to such sharing arrangement.
After-The-Fact
Among my favorite bits of regulatory nonsense is this lovely tidbit from the above "Supplementary Material .02":
Nothing in this Rule shall preclude a member, but not an associated person of the member, from determining on an after-the-fact basis, to reimburse a customer for transaction losses . . .
So, the Rule 2150 Supplementary Material .02 says that nothing precludes a member firm from reimbursing a customer's losses on an after-the-fact basis but regardless of that exception for the firm there is no exception for the firm's associated persons if they determine to reimburse a customer on that same after-the-fact basis. Which prompts me to ask how a company or individual would determine before-the-fact to reimburse a customer who had not yet sustained any losses? Sure, okay, you could come up with a before-the-fact policy of reimbursing a customer for any losses they may sustain in the future but is that a big problem on Wall Street? Not to be too snarky here but perhaps FINRA might help out the public and prepare a list of its member firms who have a loss reimbursement policy in place prior to a customer sustaining any losses. Boy would I open an account there tomorrow!
Just for fun, let's suppose that FINRA comes a knockin' and accuses a firm of determining on a before-the-fact basis to reimburse a customer for losses. Not to give any wannabe miscreants out there any clever ideas but, geez, you could simply cross your fingers behind your back, look some FINRA investigator right in her eyes and say with all apparent sincerity, "We didn't decide to reimburse before-the-fact. We decided to reimburse after-the-fact. That's our story and we're sticking to it and go ahead and try to prove otherwise!"
The Offset Payment
In pertinent part, the Slothower AWC alleges:
From August 2015 through January 2016, a Merrill customer lost money from options trading in his Merrill brokerage account while Slothower was his broker of record. On January 20, 2016, while associated with PCS, Slothower wired $355,000 to the customer's bank account to offset the customer's trading losses. Slothower and the customer are not related. At the time of the wire, the Merrill customer was not a customer of Slothower. Slothower did not obtain prior written authorization from Merrill, PCS or the customer. Nor had Slothower or his employing member firms financially contributed to the customer's brokerage account prior to the wire. Thus, Slothower improperly shared in the Merrill customer's losses.
Let's walk through that AWC fact pattern slowly . . . very slowly.
The Customer's Losses
During the five month span from August 2015 to January 2016, a customer of Merrill Lynch lost money from options trades in his Merrill account, for which Slothower was the servicing stockbroker. Missing from the presentation of facts is the dollar amount of those losses, which is an odd omission given that the whole case against Slothower is predicated on that fact. Also missing from the fact pattern is whether the alleged losses were sustained from solicited options trades or if there was even some allegation by the customer that the trades were unauthorized or if the client complained to the stockbroker or the firm about any aspect of what caused his losses. Is this simply a case where the market or the position(s) turned against the client (as is often the case) and there was no wrongdoing stockbroker? Slothower is owed such a clarification in the AWC.
Funds From Where?
After Slothower left Merrill and began employment at PCS, on January 20, 2016, he wired $355,000 to the customer's bank account as an "offset" for the alleged trading losses. Not explained in the AWC is the source of the $355,000 in wired funds. Did the funds come from a personal bank account of Slothower's or from an account (his or another individual's or entity's) at PCS? That's a bizarre omission given the nature of the charges.
Offset
The AWC characterizes the $355,000 in wired funds represents an "offset" of losses but it's not indicated whether the offset was partial or full, and, as previously noted, we still have no idea as to what the amount of the alleged losses were.
The AWC uses the term "offset" to describe the purpose of the $355,000 wire. I've carefully re-read Rule 2150, which uses lots and lots of words, but I can't find the term "offset" in its paragraphs, subparagraphs, enumerated sections, and supplementary material. So . . . what the hell does offset mean here -- in contradistinction to reimburse, guarantee, or share -- and why doesn't FINRA's in-house policies require it to track the language of its rules when charging their violation?
Permission for What?
The AWC goes to pains to note that there Slothower "did not obtain prior written authorization from Merrill, PCS or the customer." Ummm . . . prior written authorization for what? Since we are never told about the source of the funds constituting the $355,000 wire, we don't know who needed to give Slothower permission to transmit those same funds. If it came from his personal account, I don't think he needed to ask himself for permission.
Since Slothower allegedly wired funds to a Merrill customer for losses sustained in the customer's Merrill account before Slothower relocated to PCS, why would he need to get authorization from PCS? And since Slothower was no longer a Merrill associated person when he wired the subject funds, why would he need permission from Merrill? Not saying that Slothower didn't need to get permission from some firm but it's not such a clear-cut answer as to the mechanics given the issues noted.
Sharing?
Even if we concur that Slothower wired funds to a former client in order to "offset" that client's losses, how does that conduct constitute his sharing in the customer's account? Which again makes me wonder why Slothower wired funds to the customer and the source of those funds. I mean, you know, stockbrokers don't wake up every morning and say, gee, I feel sad that a former customer at my former firm lost money trading options and I think that I'm going to offset those losses by wiring him $355,000. Apparently, FINRA thinks that it's okay to publish a settlement that asks us to accept that absurd proposition.
In any event, FINRA deemed that Slothower had improperly shared in the customer's losses in violation of FINRA Rules 2150 (c) and 2010. In accordance with the terms of the AWC, FINRA imposed upon Slothower a $5,000 fine and a 15-business-day suspension from association with any FINRA member firm in any capacity.
Bill Singer's Comment
Sadly, the Slothower AWC is what passes for FINRA's discharge of its regulatory role: The public and the industry is supposed to fill in the blanks and use our imagination.
In case you haven't detected my ample doses of sarcasm in this article, of course I understand the issue here is to avoid "undisclosed settlements," which is likely what is intended by: "This Supplementary Material .02 does not apply to an associated person of a member because of the concern that any such payment may conceal individual misconduct."
At some point, trying to make sense of FINRA's work-product becomes tiring. FINRA must better appreciate that it has the power to fine and suspend men and women -- it has the power to destroy their careers and lives. This is not a role to be undertaken lightly. The industry and public have a vested interest in ensuring that FINRA remains a bulwark against fraud and misconduct. That role begins and ends with saying what you mean and meaning what you say. Otherwise, we're left with Alice looking up at an egg-shaped being who spouts nonsense that seems sensible but falls apart under scrutiny.
"When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean - neither more nor less."