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FINRA Torches Small Brokerage Firm Over Due Diligence Procedures
May 10, 2022
On Wall Street, the regulated and the regulators each have a role to play in the regulatory scheme. The regulated need to follow the rules. The regulators need to ensure that the rules are followed. Unfortunately, the industry's rulebook isn't so much a single volume as it is a massive encyclopedia with annual yearbook updates -- a reference for those old folks among us who still remember the hard-copy likes of an Encyclopedia Britannica. For regulation to work, there needs to be a sensitivity to the difference between willful and inadvertent noncompliance. Beyond merely imposing fines, Wall Street regulators have an obligation to timely flag oversights and misunderstandings. Unfortunately, on modern day Wall Street, too much of the art of regulation seems mired in gotcha.Case In PointFor 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, Torch Securities, LLC submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Torch Securities, LLC , Respondent (FINRA AWC 2019062311702)https://www.finra.org/sites/default/files/fda_documents/2019062311702%20Torch%20Securities%20LLC%20%20CRD%20133642%20AWC%20lp.pdfThe AWC asserts that Torch Securities LLC has been a FINRA member firm since 2005 with only one registered representative. In accordance with the terms of the AWC, FINRA imposed upon the firm a Censure, $17,500 fine, and an undertaking to certify compliance with the cited due diligence issues. As alleged in part in the AWC [Ed: footnotes omitted]:
Between January 2019 and November 2019, Torch Securities' written supervisory procedures required that the firm, before it recommended a private offering to any customer, conduct an investigation and complete a due diligence checklist related to several areas of review, including the issuer's management, business prospects and plan, assets, and use of offering proceeds. The firm's procedures, however, did not include any discussion of red flags that might arise in the due diligence process or how the firm would address red flags. Nor did the procedures provide any guidance on how to perform reasonable due diligence when investigating private placements before offering and recommending them to customers. As a result, the firm's procedures were not reasonable.Between January 2019 and November 2019, Torch Securities approved and recommended three private placement offerings for sale to customers. The firm failed to conduct and document reasonable investigations of the offerings before recommending these securities to customers. Customers of the firm invested in two of the offerings. The firm, rather than conducting an independent investigation, relied almost exclusively on documentation and information the issuers provided. For example, the firm failed to detect that the managers of the offerings had included multiple third-party debts of other entities on the issuers' balance sheets and used investor funds to satisfy third-party debts. The firm failed to detect that, for several of the offerings, the issuers' required state business licenses were expired and/or nontransferable and in the name of other entities. The firm also failed to detect that the offering documentation contained multiple contradictory claims related to the current and projected revenue of the projects, as well as valuation estimates.
Therefore, Torch Securities violated FINRA Rules 3110 and 2010.
Bill Singer's Comment
Among the regulatory underpinnings for this AWC is the 12-page/32-footnotes "Regulation D Offerings / Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings" (FINRA Regulatory Notice 10-22 / April 2010)
https://www.finra.org/sites/default/files/NoticeDocument/p121304.pdf, FINRA Regulatory Notice 10-22 offers this brief over-view [Ed: footnote omitted]:
https://www.finra.org/sites/default/files/NoticeDocument/p121304.pdf, FINRA Regulatory Notice 10-22 offers this brief over-view [Ed: footnote omitted]:
Part I of this Notice describes Regulation D. Part II describes broker-dealers' regulatory responsibilities to engage in a reasonable investigation of a Regulation D offering, enforceable under the antifraud provisions of the federal securities laws and FINRA rules. Part II also describes specific issues that pertain to a broker-dealer's (BD's) responsibilities and how the scope of a BD's responsibility to conduct a reasonable investigation will necessarily depend upon its affiliation with the issuer, its role in the transaction, and other facts and circumstances of the offering, including whether the offerees are retail investors or more sophisticated institutional investors.Part III describes practices that some broker-dealers have adopted to help them discharge their reasonable investigation obligations. These practices are especially relevant to Regulation D offerings of securities of companies that are non-reporting under the Securities Exchange Act of 1934. BDs, however, may find that many of the practices are appropriate for other types of offerings.
As such, more than a decade ago, in 2010, FINRA flagged its member firms' private placement due diligence as an important investor protection issue -- or, as the self-regulatory-organization phrased it, its members had an "obligation" to "conduct reasonable investigations" of private placement offerings. Without question, FINRA is on sound regulatory ground when it warns its member firms about the need to pursue due diligence on Reg D offerings. I take no issue with that oversight or the enforcement of failures to abide by the rules in place. When it comes to ensuring investor protection, few arrows in a brokerage firm's quiver will prove more effective than comprehensive due diligence of a proposed offering and the underlying fundamentals of the issuer. As such, the following criticism and critique is not against the merits of FINRA's role in furthering sound compliance policies in terms of its members' due diligence practices but, in contradistinction, in the "manner" in which FINRA discharges those investor protection mandates.
How did FINRA uncover the cited alleged violations against Torch Securities? According to the AWC:
This matter originated from FINRA's 2019 cycle exam of Torch Securities.
In May 2022, FINRA published its Acceptance, Waiver & Consent settlement with its member firm Torch Securities, and, in part, the findings in FINRA's investigations were that:
Between January 2019 and November 2019, Torch Securities failed to establish and maintain written supervisory procedures reasonably designed to ensure that the firm complied with its due diligence obligations and failed to conduct reasonable due diligence into three private placement offerings in violation of FINRA Rules 3110 and 2010.
A few preliminary observations -- according to FINRA's online BrokerCheck disclosures for Torch Securities, LLC as of May 10, 2022, the firm has no regulatory history, as in no disclosures, as in nada, as in zippo, as in clean as a whistle. As in what you'd likely expect from a FINRA member firm with one office and one rep. Torch has been around since 2005 and after 17 years in the industry, the firm has emerged squeaky clean. Truly, nice job!
So . . . lemme see here if I got some dates right:
- 2005: Torch Securities became a FINRA member;
- 2010: FINRA published Regulatory Notice 10-22;
- January 2019 - November 2019: Torch lacks reasonably designed WSPS;
- 2019: FINRA conducts Cycle Exam of Torch; and
- May 5, 2022: Torch AWC executed.
So . . . in 2019, FINRA conducted a Cycle Exam of Torch Securities. Not a so-called "Cause Exam" prompted by allegations of misconduct or by concerns but just a routine, cycle exam (sometimes referred to as a "Firm Exam").
Of course, FINRA likely should have and probably did conduct prior exams of Torch. As to how often FINRA examines its member firms, well, that's an interesting question. The answer sort of depends. Mind you, I don't think that an example cycle should "sort of depend," but that's how things often are when it comes to Wall Street regulation. As FINRA itself explains its examination schedules at
https://www.finra.org/rules-guidance/key-topics/finra-examination-risk-monitoring-programs:
https://www.finra.org/rules-guidance/key-topics/finra-examination-risk-monitoring-programs:
ExaminationsDepending on the type of firm and our assessment of the risk and impact a firm poses to investors or the markets, we generally examine firms on a one, two or four-year frequency; at a minimum, every firm is examined at least once every four years. These "Firm" exams are the foundation of our oversight program and ensure that we examine firms for compliance with FINRA rules, federal securities laws and regulations, and, when applicable, exchanges' rules, on a regular basis. The Firm exam teams may include specialist teams -- such as anti-money laundering, cybersecurity or fixed income -- when warranted, based on the particular risks associated with a firm or its business model.Beyond scheduled Firm exams, FINRA can initiate what are known as "Cause" exams based on customer complaints, regulatory tips or calls into FINRA's Securities Helpline for Seniors. These exams focus on specific issues at a firm or with specific registered representatives, with the intent to investigate and resolve concerns or problematic conduct as quickly as possible. This could be through firm-driven changes to their controls, supervisory oversight or compliance program, through the firm's termination or discipline of the involved employee(s), or through FINRA-imposed sanctions.If an exam -- either Firm or Cause -- identifies significant deficiencies, fraud or issues that are clear violations of FINRA or federal securities rules, the matter will be referred promptly to FINRA's Enforcement Department, other regulators and/or law enforcement agencies. For more on how FINRA's enforcement process works, visit the Enforcement page.
Okay, pens down and books closed. Time for a pop quiz: How often is a firm like Torch Securities examined by FINRA -- you know, a firm with one branch and one rep? And the answer is, according to FINRA's website: "we generally examine firms on a one, two or four-year frequency; at a minimum, every firm is examined every four years." You got that? 1 year or 2 years or 4 years. Apparently, this is a multiple choice exam.
If, in fact, Torch was examined every four years since its 2005 entry onto FINRA's member roll, then by the time of the 2019 Cycle Exam, the firm had been in business for 14 years, and 14 divided by 4 is 3.5. Giving FINRA the benefit of the doubt by rounding down 3.5 to 3, the self regulator should have examined Torch 3 times over the 14 years between 2005 and 2019. If the exam cycle was every two years, then FINRA should have examined Torch 7 times between 2005 and 2019; and if it was an annual exam, then Torch should have had 14 examinations during the cited period. Depending upon the math, we have a range of FINRA exams of Torch numbering no less than 3 and as many as 14 from 2005 through 2019.
Again, let me put FINRA's words back into the regulator's mouth:
Between January 2019 and November 2019, Torch Securities failed to establish and maintain written supervisory procedures reasonably designed to ensure that the firm complied with its due diligence obligations and failed to conduct reasonable due diligence into three private placement offerings in violation of FINRA Rules 3110 and 2010.
Putting things a different way and looking at the very same facts but from another perspective:
Between 2005 and November 2019, FINRA examiners failed to confirm that Torch Securities had established and maintained written supervisory procedures reasonably designed to ensure that the firm complied with its due diligence obligations and failed to conduct reasonable due diligence into three private placement offerings in violation of FINRA Rules 3110 and 2010.
In imposing a Censure, fine, and certification upon Torch, FINRA clarified the latter per this:
Certification Regarding Implementation of Reasonably Designed Procedures. Within no later than 120 days of the date this AWC is accepted, a senior officer and principal of the firm shall certify in writing to FINRA that the firm has implemented supervisory systems and written supervisory procedures reasonably designed to address the deficiencies regarding the firm's due diligence obligations in connection with private offerings. This certification shall be submitted by letter addressed to Albert A. Starkus III, Senior Counsel, FINRA Department of Enforcement . . .
Being as dickish about this as I often am (and, no, I'm not going to apologize about my snarky demeanor), I would like to urge FINRA's lackluster Board of Governors to request the following from FINRA's examination staff:
Certification Regarding Implementation of Reasonably Designed Procedures. Within no later than 120 days of the date this AWC is accepted, a senior officer and principal of FINRA's Department of Enforcement shall certify in writing to the FINRA Board of Governors that Enforcement has implemented supervisory systems and written supervisory procedures reasonably designed to address the deficiencies regarding the FINRA's due diligence obligations in connection with conducting cycle examinations of member firms and reviewing said firms' supervisory systems and written supervisory procedures regarding the firm's due diligence obligations in connection with private offerings. This certification shall be submitted by letter addressed to Eileen K. Murray, Chair of FINRA Board of Governors . . .
Could this AWC be any more hypocritical?
FINRA has censured, fined, and imposed a certification upon Torch Securities, a small member firm, which, frankly, is the very essence of a small firm -- it's hard to get much smaller than one office with one rep, right? And for what?
- Assuming that the firm lacked adequate WSPs, the lack of due diligence procedures should have been apparent from the very first WSPs submitted to FINRA as part of Torch's 2005 admission to membership.
- The lack of due dilly references were also on display, as it were, through 2019, when, apparently, some examiner awoke the self regulator from some 15 years' of its own failed supervision of Torch Securities and, lo and behold, Torch's WSPs were cited for not disclosing something that hadn't been disclosed for each of the preceding 14 years.
- During Torch Securities' 14 years of FINRA membership, during cycle exams, FINRA examiners should have eyeballed those same now-deficient WSPs no less than three times and as many as 14 times.
According to FINRA's timeline in the AWC, the self regulator had determined by the end of 2019 that Torch's supervisory systems/procedures were allegedly deficient. What further "proof" was needed by FINRA throughout 2020, 2021, and the first five months of 2022 to build a case? Even in the most favorable light, FINRA twiddled its thumbs for some 29 months, and for what? For a one-branch-one-rep member firm's seemingly aberrant failure to include a paragraph (or two or three) in its WSPs? You know, the same WSPs that apparently no FINRA examiner bothered to read over a 14 year period.
Which brings me, at long last, to the point of this rant.
And my point is that there is no point.
The Torch AWC is a joke.
The Torch AWC is not effective oversight of Wall Street. It is half-assed regulation that serves no meaningful investor protection purpose because FINRA has waited until 2022 to sanction misconduct that, at it's best, arose three years ago in 2019, and, at it's worst, was obvious to any diligent FINRA examiner for 14 years from 2005 until its belated discovery in 2019.