Troubling FINRA Regulatory Case: Quis custodiet ipsos custodes?

A. Overview of the Complaint

FINRA's Department of Enforcement filed a six-cause Complaint against Respondents. Cause one charges Glendale Securities, Inc. ("Glendale" or the "Firm"), acting through its President and head trader George Alberto Castillo ("Castillo"), with manipulating the price of NuGene International, Inc. ("NUGN"), to benefit two Firm customers who owned the stock. For this, Glendale and Castillo are charged with violating Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), Exchange Act Rule 10b-5 thereunder, and FINRA Rules 2020 and 2010. 

Cause two charges Glendale, Paul Eric Flesche ("Flesche"), the Firm's Chief Compliance Officer ("CCO"), and Jose Miguel Abadin ("Abadin"), a registered representative and trader, with reselling unregistered or non-exempt shares of NUGN on behalf of two customers, in violation of Section 5 of the Securities Act of 1933 ("Securities Act"), which is a violation of FINRA Rule 2010. The Complaint alleges that a portion of the NUGN shares the two customers sold were bought from affiliates of the issuer and accordingly could not be re-sold within six months of acquiring them pursuant to the Securities Act and SEC Rule 144. 

Cause three charges each of the Respondents with committing anti-money laundering ("AML") violations of FINRA Rules 3310 and 2010 relating to customer deposits and liquidations of shares of NUGN and two other securities in 2015 and 2016: Broke Out, Inc. ("BRKO") and Vitaxel Group Limited ("VXEL"). It charges Respondents with failing to establish a reasonable AML system to detect and report suspicious activities associated with Firm customers' sales of NUGN, BRKO, and VXEL. Cause three also charges the Firm, Flesche, Laubenstein, and Huang with failing to comply with their obligations under the customer identification program ("CIP") in connection with customers who deposited VXEL shares. Cause three further charges the Firm and Albert Raymond Laubenstein ("Laubenstein"), the Firm's AML Compliance Officer ("AMLCO"), with AML violations for failing to establish and maintain an adequate due diligence program for customer correspondent accounts introduced to the Firm from 2007 to approximately 2011 by a bank based in Belize ("Belize Bank"). Belize Bank did not disclose the identities of approximately 18 customers who opened accounts at Glendale through the bank. 

Cause four charges the Firm, Castillo, Flesche, and Laubenstein with supervisory failures in two distinct areas. It charges that Glendale, Castillo, and Flesche failed to establish and maintain a supervisory system, including written supervisory procedures ("WSPs"), reasonably designed to ensure the Firm's compliance with Section 5 of the Securities Act for sales of unregistered, non-exempt securities. Cause four further charges the Firm, Flesche, and Laubenstein with failing to reasonably supervise Respondent Huanwei Huang's ("Huang") activities, specifically with respect to his Asian customers who deposited and sold BRKO and VXEL shares. 

Causes five and six contain allegations only against Huang. Cause five charges Huang with improperly providing nonpublic personal information to third parties about his customers who deposited VXEL in their accounts, in violation of Securities and Exchange Commission ("SEC") Regulation S-P, which constitutes a violation of FINRA Rule 2010. Cause six charges Huang with communicating about VXEL with a customer and another person in Asia via a cell phone text messaging service not approved by Glendale, in violation of FINRA Rules 4511 and 2010. The Complaint charges that Huang's use of the unapproved text messaging service prevented Glendale from being able to preserve securities-related communications among its books and records. 

Respondents filed Answers1 denying the allegations and requesting a hearing. In their Answer, Glendale, Castillo, Flesche, Laubenstein, and Abadin stated that Glendale "occupies a unique niche" in the securities industry because "[f]ew introducing brokers or clearing firms are willing to service the needs of early round investors and founders of microcap companies because of the intense regulatory scrutiny and labor-intensive processes that are required." Glendale "believes that its experience in this type of trading has gotten the firm to the point where it can conduct this business without rule violations."

B. Summary of the Hearing Panel's Findings and Sanctions

After a careful review of the evidence presented at the hearing and the arguments of the parties, the Extended Hearing Panel ("Panel") concludes that Enforcement failed to prove that Glendale and Castillo engaged in a fraudulent manipulation of NUGN, as alleged in cause one. Enforcement alleges that Castillo's NUGN market making activities and his transactions in NUGN on behalf of two customers were calculated to increase the stock's share price so that two other customers would be released from the terms of a lock-up/leak-out agreement ("Lock-Up Agreement"). Specifically, the Panel finds that Enforcement failed to prove that Castillo acted  with scienter when he entered quotations and engaged in market making in NUGN and executed trades on behalf of two customers. The Panel accordingly dismisses this cause of action. 

A majority of the Panel finds that Enforcement failed to prove the allegations in cause two that Glendale, Flesche, and Abadin violated Section 5 of the Securities Act by participating in the unlawful distribution of unregistered or non-exempt shares of NUGN. The shares were sold by two Firm customers who had recently acquired their shares from persons the Complaint alleges were affiliates of the issuer. A majority of the Panel finds that Glendale, Flesche, and Abadin performed adequate due diligence and engaged in a reasonable inquiry into whether the customers had acquired their shares of NUGN from affiliates of the issuer. Accordingly, cause two is dismissed. 

With respect to cause three, alleging that all Respondents committed AML violations relating to customer deposits and sales of NUGN, BRKO, and VXEL, the Panel finds that the Firm, acting through Laubenstein, failed to establish a reasonable system to detect and report suspicious activities. The Panel also finds that, as alleged in cause three, Glendale and Laubenstein failed to comply with their AML-related obligations associated with verifying the identifications of Asia-based customers who deposited VXEL shares. The Panel censures Glendale and fines it $125,000 for the AML violations of FINRA Rules 3310 and 2010. The Panel suspends Laubenstein for 18 months years from associating with any member firm in any capacity and fine him $20,000. The Panel dismisses the AML-related charges contained in cause three against the other four individual Respondents-Castillo, Flesche, Abadin, and Huang because Enforcement failed to meet its burden of proof that their conduct violated FINRA's AML rules. 

The Panel also finds that, as alleged in cause three, Glendale and Laubenstein failed to establish an adequate due diligence program to monitor the activities of certain customer accounts introduced to the Firm by Belize Bank. Given the totality of the circumstances- particularly the limited number of customer accounts in question and the absence of evidence of potentially suspicious financial transactions or securities-related activity in the accounts-the Panel finds it appropriate for this Decision to serve as a Letter of Caution to Glendale and Laubenstein concerning the allegations in cause three about Belize Bank's introduction of customer accounts. 

A majority of the Panel also finds that Enforcement did not prove that Glendale, Castillo, and Flesche failed to establish and maintain a supervisory system and WSPs reasonably designed to achieve compliance with Section 5 of the Securities Act, as alleged in cause four. Accordingly, this portion of cause four is dismissed. 

The Panel finds that, as also alleged in cause four, Glendale, Flesche, and Laubenstein failed to reasonably supervise Huang and his dealings with his customers, including communications with the customers. For this violation, Glendale is censured. It is also fined $30,000 jointly and severally with Flesche. Flesche is also suspended from associating with any member firm in any capacity for 30 business days. Laubenstein is fined $5,000 and suspended from associating with any member firm in any capacity for 15 business days. 

The Panel determines that, as alleged in cause five, Huang improperly shared personal information belonging to his customers who resided in Asia with third parties without first obtaining the customers' consent, in violation of SEC Regulation S-P, which constitutes a violation of FINRA Rule 2010. Huang provided customer transaction information concerning VXEL and financial information to third parties. After considering all the circumstances, including the nature of the customer information provided and the limited number of violations, the Panel determines that it is appropriate for this Decision to serve as a Letter of Caution to Huang. 

Last, the Panel finds that, as alleged in cause six, for about a month, Huang used a text messaging cell phone application popular in Asia to communicate with two persons about securities-related matters, instead of using the Firm's approved email system, in violation of FINRA Rules 4511 and 2010. The two persons acted as representatives of customers they introduced to Glendale and Huang to deposit and sell VXEL shares. One of the two persons was also a customer who deposited VXEL in his Glendale account and sold shares through Huang. For this misconduct, the Panel suspends Huang from associating with any member firm in all capacities for 10 business days and fines him $5,000.

Federal Rules of Civil Procedure Rule 26: Duty to Disclose; General Provisions Governing Discovery

(a) Required Disclosures.

. . .

(5) Claiming Privilege or Protecting Trial-Preparation Materials.

(A) Information Withheld. When a party withholds information otherwise discoverable by claiming that the information is privileged or subject to protection as trial-preparation material, the party must:

(i) expressly make the claim; and

(ii) describe the nature of the documents, communications, or tangible things not produced or disclosed-and do so in a manner that, without revealing information itself privileged or protected, will enable other parties to assess the claim.

(B) Information Produced. If information produced in discovery is subject to a claim of privilege or of protection as trial-preparation material, the party making the claim may notify any party that received the information of the claim and the basis for it. After being notified, a party must promptly return, sequester, or destroy the specified information and any copies it has; must not use or disclose the information until the claim is resolved; must take reasonable steps to retrieve the information if the party disclosed it before being notified; and may promptly present the information to the court under seal for a determination of the claim. The producing party must preserve the information until the claim is resolved.

• FINRA
• Glendale
• OHO
• NAC
• Outside Counsel
• Information
• Rule 144
• AML
• Rule 3310
• WSP
• Reg SP
• Rule 4511
• BrokeAndBroker
• Bill Singer