FINRA Addresses Light Bulb and Coffee Cake Abuses

November 15, 2019

Over the years, I have received numerous telephone calls from the family members of deceased individuals complaining that the departed had been victimized by an unscrupulous stockbroker. More often than not, the story is of a variety that I've come to call the "light bulb and coffee cake" tale. As that scenario goes, a brokerage firm customer (often a widow) is befriended by the stockbroker who had handled her former husband's transactions. The widow regaled her family and friends with stories about how the charming, young stockbroker came to her home and changed the light bulbs she could not reach, brought her a coffee cake, and picked up the brokerage statements that he told her not to worry about and leave for him to review when he dropped by.

After the widow's death, when an accountant reviews the estate assets, a lot of curious trading is disclosed. At times, the trades seem excessive with no apparent purposes beyond churning to generate commissions; and at other times, there are staggering loses in overly speculative investments or unexplained outbound wire transfers to some unknown destination. As if those revelations were not distressing enough, it often gets worse when it turns out that the stockbroker was listed in a recently revised will as the deceased's sole beneficiary -- or the stockbroker's spouse was so listed.

When I was a regulatory lawyer, I investigated and prosecuted "light bulb and coffee cake" frauds perpetrated by unethical stockbrokers upon unsuspecting customers. And, yes, in private practice, I have also represented customers victimized by such practices, and I have defended stockbrokers so charged. During my four decades on Wall Street, the overwhelming majority of allegations involving stockbrokers ripping off the elderly and unsophisticated tend to prove out; however, there are exceptions. In some cases, an elderly individual was truly and sincerely befriended by an honest and caring stockbroker. That investment professional may have known the senior citizen for many years, may have been a long-time family friend, may be a parishioner at the same church, may be part of a regular Saturday four-some. In such cases, a stockbroker may be exercising a genuine act of goodness by changing light bulbs. In such cases, a stockbroker may, indeed, bring the proverbial coffee cake with good intentions. Many an elderly brokerage customer feels abandoned by family and friends, and will come to look upon the stockbroker as a trusted resource -- which may explain the naming of that party as a beneficiary.

On the other hand -- I have seen far too much pernicious fraud masquerading as the purported pure intentions of stockbrokers when it comes to vulnerable customers. Far too often, the stockbroker defrauds the customer by engaging in excessive trading, making unsuitable investments, and simply victimizing an otherwise trusting soul. As if the monthly commissions and fees reaped from such fraud were not enough, some stockbrokers pressure, cajole, or otherwise persuade a vulnerable customer into making loans or gifts of cash, and, further, to agree to name the stockbroker as a beneficiary of a brokerage/bank account or Will.

Given what I've outlined above, I applaud FINRA's recent foray into addressing the conflicts of interest inherent in the relationships that I've described: FINRA Requests Comment on a Proposed Rule to Limit a Registered Person from Being Named a Customer's Beneficiary or Holding a Position of Trust for or on Behalf of a Customer / Comment Period Expires: January 10, 2020 (FINRA Regulatory Notice 19-36)

https://www.finra.org/rules-guidance/notices/19-36. As set forth in part under the "Summary" portion of the FINRA Regulatory Notice:

Investment professionals often develop close and trusted relationships with their customers, which in some instances have resulted in the investment professional being named the customer's beneficiary, executor or trustee, or holding a power of attorney or a similar position for the customer. Being a customer's beneficiary or holding a position of trust may present significant conflicts of interest, and FINRA has previously taken steps to address misconduct in this area.

To further address potential conflicts of interest, FINRA is proposing a new rule to limit any associated person of a member firm who is registered with FINRA (each a "registered person") from being named a beneficiary, executor or trustee, or to have a power of attorney or similar position of trust for or on behalf of a customer. The proposed rule would protect investors by requiring all member firms to affirmatively address registered persons being named beneficiaries or holding positions of trusts for customers. The proposed rule would require the member firm with which the registered person is associated, upon receiving written notice from the registered person, to review and approve the registered person assuming such status or acting in such capacity. The proposed rule would not apply where the customer is a member of the registered person's "immediate family."¹

Recognizing that a registered person and customer may have a close and longstanding friendship or relationship that may be akin to, but not actually, a familial relationship, the proposed rule would not prohibit a registered person being named a beneficiary of or receiving a bequest from a customer's estate. However, given the potential conflicts of interest, FINRA would expect a member firm to employ heightened scrutiny in assessing a registered person's request to be named a beneficiary of or receive a bequest from a customer's estate. Approval should be given only when the member firm has made a reasonable determination that the registered person assuming such status does not present a risk of financial exploitation that the proposed rule is designed to address.

If the proposed rule is approved, FINRA would assess registered persons' and firms' conduct pursuant to the rule to determine the effectiveness of the rule in addressing potential conflicts of interest and evaluate whether additional rulemaking or other action is appropriate. . .
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Footnote 1: The proposal would define the term "immediate family" to include "parents, grandparents, mother-in-law or father-in-law, spouse or domestic partner, brother or sister, brother-in-law or sister-in-law, son-in law or daughter-in-law, children, grandchildren, cousin, aunt or uncle, or niece or nephew, and any other person whom the registered person financially supports, directly or indirectly, to a material extent. The term includes step and adoptive relationships." See proposed Rule 3241(c).

READ the full-text Proposed Rule 3241
https://www.finra.org/sites/default/files/2019-11/Regulatory-Notice-19-36_Attachment-A.pdf

In developing its updated approach to the issues set forth in the Regulatory Notice:

FINRA requests comment on all aspects of the proposal. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. FINRA specifically requests comment concerning the following questions:

Are there approaches other than the proposed rule that FINRA should consider?
Should the scope of the proposed rule be expanded to encompass other requirements?
What are member firms' current practices regarding a registered person being named a beneficiary or to a position of trust for or on behalf of a customer? Would the proposed rule change firms' current practices?
If your firm currently has procedures regarding a registered person being named a beneficiary or to a position of trust for or on behalf of a customer, on an annual basis, how many requests are made by registered persons to be named beneficiaries or to positions of trust for a: (i) non-immediate family member; or (ii) for an immediate family member?
If your firm currently has procedures regarding a registered person being named a beneficiary or to a position of trust for or on behalf of a customer, has a registered person failed to provide notice to the firm or otherwise comply with the procedures? If so, how prevalent is the problem and how has your firm addressed the non-compliance with firm procedures?
Do dually-registered firms have comparable procedures for broker-dealer registered persons and investment adviser representatives regarding being named a beneficiary or to a position of trust for or on behalf of a customer?
Is the time period in the definition of "customer" for purposes of the proposed rule (i.e., a customer who in the previous six months had a securities account assigned to the registered person) a sufficient period to mitigate potential conflicts of interest and to deter circumvention of the rule?
Should the proposed rule apply to beneficiary status and positions of trust that were entered into prior to the existence of a broker-customer relationship?
Should the proposed rule require a specific form of written notice for requesting approval by a registered person to be named a beneficiary or to a position of trust?
What other economic impacts, including costs and benefits, might be associated with the proposal? Who might be affected and how?
Would the proposal impose any other competitive impacts that FINRA has not considered?

FINRA's Proposed Rule 3241 sets forth a fairly direct approach based upon the premise that absent certain compelling conditions, a "registered person shall decline":

being named as a beneficiary of a customer's estate; or
receiving a bequest from a customer's estate; or
being named as an executor or trustee or holding a power of attorney or similar position for or on behalf of a customer.

Among the most prominent conditions contemplated in the proposed rule is that the "customer is a member of the registered person's immediate family." In the alternative to that family status, the other condition requires the registered person to provide written notice to the employer member firm describing the beneficiary/bequest/trust status. Upon receipt of such notice, the proposed rule imposes obligations upon the employer member firm to provide written approval or, in the alternative, the firm may disapprove or imposed pre-conditions. Inherent in the proposed rule's terms, are various full-disclosure requirement by which the registered person must present such factors as financial gain and compensation.

In a section titled "Supplementary Material," FINRA sets out six enumerated items for the proposed rule:

.01 Customer. For purposes of this Rule, a "customer" would include any customer that has, or in the previous six months had, a securities account assigned to the registered person at any member.

.02 Estate. For purposes of this Rule, a customer's estate would include any cash and securities, real estate, insurance, trusts, annuities, business interests and other assets that the customer owns or has an interest in at the time of death.

.03 Record Retention. For purposes of paragraph (b) of this Rule, members shall preserve the written notice and approval for at least three years after the date that the beneficiary status or position of trust has terminated or the bequest received or for at least three years, whichever is earlier, after the registered person's association with the member has terminated.

.04 Position Prior to Association With Member. If a registered person was named as a beneficiary or to a position of trust prior to the registered person's association with the member, the registered person, within 30 calendar days of becoming so associated, shall provide notice to and receive approval from the member consistent with this Rule to maintain the beneficiary status or position of trust.

.05 Pre-Existing Positions. With respect to agreements to assume such status or act in such capacity that were entered into prior to the existence of a broker-customer relationship, such as where the customer was not a customer of the registered person at the time at which the registered person was named beneficiary or to a position of trust, these agreements raise similar conflict of interest concerns as agreements to assume such status or act in such capacity entered into subsequent to the existence of a broker-customer relationship. Therefore, the registered person must act consistent with paragraph (a) of this Rule for any existing beneficiary status or position of trust prior to the initiation of the broker customer relationship. Moreover, upon receipt of notice of such a position, the member should evaluate the beneficiary status or position of trust consistent with paragraph (b) of this Rule.

.06 Naming Other Persons. A registered person instructing or asking a customer to name another person to be a beneficiary of the customer's estate or to receive a bequest from the customer's estate would present similar conflict of interest concerns as the registered person being so named. Accordingly, a registered person instructing or asking a customer to name another person, such as the registered person's spouse or child, to be a beneficiary of the customer's estate or to receive a bequest from the customer's estate would not be consistent with paragraph (a)(1) of the Rule.

Right off the bat, I see a potential flaw in Supplementary Material .06 [Ed: emphasis supplied]:

a registered person instructing or asking a customer to name another person, such as the registered person's spouse or child, to be a beneficiary of the customer's estate or to receive a bequest from the customer's estate would not be consistent with paragraph (a)(1) of the Rule.

As contemplated in (a)(1) above, a registered person shall decline being named a beneficiary of a customer's estate or receiving a bequest from a customer's estate upon learning of such status . . ." As such, the Supplementary Material extends that obligation of declination to a scenario whereby the registered person instructs or asks a customer to, in effect, name a third-party as a beneficiary or recipient of a bequest. Unfortunately, I can easily imagine a clever stockbroker having a conversation which might sound something like:

I wish that I could do more for you and I know that you would love to show me all your appreciation for all the free light bulbs and coffee cake that I bought for you over the years, but it would be improper for me to instruct you to name me or another person as your beneficiary and, similarly, it would be improper for me to ask you to name me or another person as the recipient of any kind of bequest. And you know I would never, ever do anything improper. I mean, you know, sure, if you decided on your own to name me or my wife or kids as a beneficiary, well, I would always be grateful, eternally so, but, that would be up to you and, like I said, I would never, ever instruct or ask you to take such a thoughtful step. By the way, let me leave a photo of my kids with you -- we're hoping to send Jack to college this year, and, in another two years, to send Jill. I only hope that I can afford the killer costs of college. By the way, before I go, my wife Jane baked you a coffee cake from her mother's recipe.

As you can see, notwithstanding the best of intentions, Supplementary Material .06 still leaves the door wide open. Similarly, another glaring loophole is that an unscrupulous stockbroker could simply arrange to have his wife or other third-party ask the customer to undertake the bequest -- and then, the stockbroker could argue (and with some effect) that he was not named as a beneficiary and he did not instruct or ask the customer to name the third party at issue. Moreover, since the third party would likely not be an associated person of a FINRA member firm, FINRA might find it difficult to compel that individual's testimony during its investigation and any subsequent hearing.

I have been involved with many situations where an estate bequest or transfer-on-death ("TOD") is at issue. When faced with the consequences of such a scenario, the stockbroker's calculation often entails the somewhat pragmatic weighing of the value of the gift versus the financial detriment arising from being fired -- versus any potential suspension or fine that FINRA may impose. If the bequest is in the millions, that often prompts an easy albeit mercenary decision to keep the gift and pay what comes off as a freight charge. In the end, it may well be that FINRA's best intentions can only be extended so far. And when we arrive at the end of that self-regulatory tether, it may be that state and federal laws will need to be revised to best (or better) address the consequences of financial professionals taking advantage of their elderly or vulnerable customers.

For those of you who may think FINRA's concerns are overly esoteric, I would urge you to read some of the BrokeAndBroker.com Blogs that covered the bequest/gift concerns raised in the proposed rule:

Two Deceased Customers,Their Stockbroker, A POA, A TOD Account, And a Bar (BrokeAndBroker.com Blog December 3, 2018)

The Stockbroker, His Wife, 3 Customers, 3 Healthcare Proxies, 1 Trust, and 1 IRA
(BrokeAndBroker.com Blog October 5, 2018)

Where There's A Will, FINRA Says No Way!
(BrokeAndBroker.com Blog August 9, 2018)

97 Year Old Client Names Stockbroker Executor and Beneficiary
(BrokeAndBroker.com Blog November 10, 2017)

FINRA Fines And Suspends Husband For Adding His Wife As Customer's Annuity Beneficiary (BrokeAndBroker.com Blog June 20, 2017)

The Elderly Edward Jones Client, His Account, His Will, His Stockbroker, and The Broker's Wife (BrokeAndBroker.com Blog May 15, 2017)