CSG Law Alert: Is a Recent FINRA Case an Example of “Regulation by Enforcement?”
Let’s start with what we hope is an obvious proposition: FINRA is a rules-based organization. What does that mean? Among other things, it means that FINRA can only bring disciplinary actions against members (or associated persons of members) who violate a federal law or regulation or a FINRA rule. Indeed, FINRA’s By-Laws state that any determination by FINRA to discipline a member shall include a statement setting forth “the rule, regulation, or statutory provision” deemed to have been violated.
A number of truisms flow from this proposition.
First, if FINRA can only enforce rules, regulations, and statutes, it cannot enforce things that are not rules, regulations, and statutes. FINRA Regulatory Notices and Notices to Members, for example, are not rules, regulations, or statutes and, therefore, cannot serve as the basis for a disciplinary action. The same goes for statements made by FINRA staff in exam reports, cautionary action letters, and similar documents.
Second, any FINRA charging document, whether a complaint or, more commonly, a Letter of Acceptance, Waiver, and Consent (AWC), must cite the specific rule, regulation, or statute alleged to have been violated. If it doesn’t, one can reasonably question whether the action is “regulation by enforcement”—a term to describe an enforcement-created regulation, which, of course, would be improper.
That brings us to a case FINRA issued last month in which FINRA fined a firm $850,000 for, among other things, failing to abide by its obligation to “monitor transmittals of customer funds.” The heading in the first section of the AWC, which describes the legal basis for the charges, states unequivocally: “Member firms are required to monitor transmittals of customer funds.” So, what is the rule, regulation, or statute that creates this obligation?
In the AWC, FINRA does not cite to any statute or regulation, so we’re left only with the possibility that a FINRA rule creates this obligation. So which FINRA rule is it? The AWC offers up a number of possibilities.
First, the AWC cites to FINRA Rule 3110(a), the general supervision rule. But that rule states, in pertinent part, that a member firm must establish “a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with … applicable FINRA rules.” In other words, FINRA Rule 3110(a) itself does not create an obligation to monitor transmittals of customer funds; it only requires that a firm create a system to comply with other “applicable FINRA rules.” So, we’re back to where we started—what is the FINRA rule that obligates a firm to monitor transmittals of customer funds?
FINRA next cites NASD Rule 3012(a)(2)(B)(i), which it states “specifically required” firms to monitor the transmittal of funds from customers to third parties. Does it really?
Not exactly. NASD Rule 3012(a)(1) requires firms to designate one or more principals who shall establish, maintain, and enforce a “system of supervisory control policies and procedures” to (1) test and verify that the firm’s supervisory procedures are reasonably designed, and (2) create additional or amended procedures where the need is identified by that testing and verification. NASD Rule 3012(a)(2)(B)(i) states that the written supervisory control policies and procedures mandated by subsection (a)(1) shall include procedures that are reasonably designed to review and monitor “all transmittals of funds … or securities from customers to third party accounts.”
In other words, NASD Rule 3012 requires firms to appoint one or more principals, who must establish controls to test the firm’s procedures, including procedures to monitor the transmittal of customer funds. Suffice it to say, nowhere does the rule itself explicitly require a firm to monitor the transmittal of customer funds. Is it implicit? Perhaps it is. But the point is moot because NASD Rule 3012 is no longer in effect. It was replaced in December 2014 by FINRA Rule 3120. FINRA Rule 3120 does not include any requirement—explicit, implicit, or otherwise—that a firm monitor the transmittal of customer funds.
So, after December 2014, what rule requires a firm to monitor transmittals of customer funds? The AWC next quotes from a 2009 FINRA Notice to Members, which states that FINRA firms “must have and enforce policies and procedures governing the withdrawal or transmittal of funds or other assets from customer accounts.” This statement does seem unequivocal. However, there are two problems with it. First, as we know, FINRA notices are not rules, regulations, or statutes and, therefore, cannot be the basis for a disciplinary action. Second, the authority the Notice cites in support of this proposition is NASD Rule 3012, which no longer exists.
Where does that leave us? FINRA does not cite to any other rule in the body of the AWC itself. However, in a footnote, FINRA writes that NASD Rule 3012’s requirements regarding the monitoring of transmittals of funds “were relocated” to FINRA Rule 3110(c)(2). Query if that were true—if this requirement was set forth in FINRA Rule 3110(c)(2)—then why doesn’t the AWC lead with that? Why take us meandering through a defunct NASD Rule and a fifteen-year-old Notice to Members? And why only cite to 3110(c)(2) in a footnote instead of in the section of the AWC that lists the rules alleged to have been violated?
The likely answer to those questions is that FINRA Rule 3110(c)(2) does not actually require a firm to monitor transmittals of funds from customer accounts. Rule 3110(c)—entitled “Internal Inspections”—provides that firms shall review the “activities of each office” which shall include “periodic examinations of customer accounts” to detect irregularities or abuses. Subsection (c)(2) states that, after conducting an internal inspection required by subsection (c)(1), the firm should document the results in a written report. Subsection (c)(2)(A) further describes what information must be included in that written inspection report and lists, among other things, the “testing and verification of the member’s policies and procedures” related to transmittals of funds from customer accounts.
Is it really fair to say that a description of what must be included in an internal inspection report of a branch office creates a more general obligation for all member firms to monitor transmittals of funds from customer accounts?
More fundamentally, even if FINRA could make this argument, should it? To return to where we started, FINRA is a rules-based organization. To be effective, its rules should be clear, unambiguous, and easily understood. FINRA seems to have fallen far short of that standard here.