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This Blog breaks down the mysteries of FINRA’s Conduct Rules, and its investigative and disciplinary process as well as firm practices so that those of you who are facing scrutiny by the regulator are better prepared to defend yourself. In each posting, we explore a rule or small piece of the process and explain how it impacts FINRA and you. If you want a topic covered on #finraFridays, feel free to contact Gary Carleton at gary@carletonlaw.net.
This Week:
FINRA Should Alter its Use of Cautionary Action Letters
Not all FINRA formal investigations of potential rule violations end in FINRA’s bringing of formal Complaints or settlements in the form of a Letter of Acceptance, Waiver and Consent (“AWC”). Three other ways that FINRA concludes and closes a formal investigation is simply by closing an investigation with no action taken, by issuing a Cause Examination Disposition Letter (“Disposition Letter”), or issuing a Cautionary Action Letter (“CAL”). This blog focuses on why FINRA’s current method of issuing CALs needs to change to provide fundamental fairness to the recipients.
FINRA’s closing of an investigation or issuance of a Disposition Letter makes no findings of fact or violation and essentially clears the subject of the investigation or examination. The Disposition Letter reads in part:
This is to inform you that FINRA has completed a review into the circumstances in the above-mentioned matter. Based on our inquiry, we have determined to close our file pertaining to this matter. This determination is based on the facts known to us at this time. In this regard, new or additional facts could lead to a new inquiry.
A CAL issued by FINRA’s Department of Enforcement is quite different from a Disposition Letter. It is fraught with questions of its legal legitimacy due to its imposition of non-negotiated, unadjudicated, unappealable findings of violation with potential future sanctions to brokers who find themselves subject to these letters.
According to FINRA’s then Deputy Head of Enforcement, the Department issues “hundreds of cautionary action letters [each year] for violations that don’t rise to the level of a formal action.”[1] He stated on FINRA’s Unscripted podcast, that, “[m]any times, what we do is, instead of issuing a formal action, we’ll issue what we call a cautionary action letter, which is essentially a written warning, putting the broker or the firm on notice of the violation. There’s no bright line rule for when we might bring a formal action versus an informal action, such as a cautionary action letter.”[2]
As the Deputy Head of Enforcement points out, as opposed to the Disposition Letter, which makes no findings of wrongful conduct, FINRA does make a finding of violation in a CAL.
The typical language of a CAL includes the following language:
FINRA’s Department of Enforcement has concluded its investigation of your conduct in connection with the above referenced matter. Enforcement is issuing this Cautionary Action to advise you that your participation in [description of alleged violative acts] violated FINRA Rules [Numbers]. [Emphasis Added.]
However, that language where FINRA Staff identifies specific acts that it says constitutes a violation, differs from the guidance FINRA gives elsewhere to describe what a Cautionary Action actually represents.
According to FINRA’s Regulatory Notice 09-17, the Cautionary Action is supposed to be issued after a Sufficiency of Evidence Review process. It notes:
At the conclusion of the investigation, the staff analyzes the evidence and applicable law and makes a preliminary determination of whether or not a violation appears to have occurred. This process is called a Sufficiency of Evidence review and is conducted under the supervision of the senior manager responsible for the investigation. If it appears that rules have been violated, the senior manager will determine whether the conduct merits a recommendation of formal disciplinary action. If the violation is of a minor nature and there is an absence of customer harm or detrimental market impact, the matter may be resolved with an informal disciplinary action, such as the issuance of a Cautionary Action.
So FINRA’s Department of Enforcement conducts an internal review and makes what is admittedly a preliminary determination of whether a violation has occurred. When it appears to a senior manager in the Department that a rule has been violated based on that preliminary determination, the Department issues a definitive, final, unappealable determination on behalf of FINRA that a violation as specifically described in the Cautionary Action did in fact occur.
These “findings” of violation are not fact-checked or reviewed for legal sufficiency outside of the Department, unlike all other actions by the Department seeking to formally charge a broker with a rule violation.
These CALs are unadjudicated, so the recipient has no way to dispute FINRA’s factual or legal predicate of a violation before a neutral adjudicator. Whether accurate or inaccurate, and they do sometimes contain inaccurate factual descriptions, these findings become part of a broker’s unpublished record within FINRA.
Despite the fact that FINRA does not include the findings of violations on the Central Registration Depository (“CRD”) or Brokercheck, FINRA nonetheless can and does use these unadjudicated findings against a broker in subsequent matters. As FINRA warns in its CAL:
A Cautionary Action by FINRA is not included in the Central Registration Depository, nor does it need to be reported on your Form U4. However, you should be aware that FINRA staff will consider repeat violations in any future matter. [Emphasis Added.]
Also, although the CAL is not publicly available, a broker’s firm may also take adverse action against the broker for what FINRA claims was a violation of its rules. This unadjudicated finding of violation can also have an adverse effect on a pending arbitration proceeding that has the same factual underpinnings of as the FINRA investigation.
The manner in which CALs are currently administered and issued by FINRA violates multiple fundamental principles upon which FINRA is supposed to operate. As described above, these supposed factual findings and legal conclusions of violation, unlike even mere allegations, are not reviewed by FINRA’s independent Office of Disciplinary Affairs (“ODA”) prior to issuance. According to Regulatory Notice 09-17, ODA was established and serves to “provide an independent review of the legal and evidentiary sufficiency of the charges proposed by the staff.”
As FINRA Enforcement’s then Head described, the only review of them is by “two senior managers” within Enforcement.
[T]here’s actually such a thing as an informal disciplinary action. And these responses, usually cautionary action letters, are what we use for the less egregious violations. It’s basically a warning of what’s not right or what’s a violation and gives firms an opportunity to fix what’s wrong. Unlike formal actions, these are not public.[3]
If the attorney recommends … a cautionary action and the two senior managers agree, then …[w]e let the respondent, or the firm or individual know by sending the cautionary action letter, it gives them some understanding of the fact there is an issue to be corrected.[4]
FINRA’s use of the CAL process to make factual and legal findings of rule violations is fundamentally unfair to the broker, even in this informal disciplinary context. Brokers are given no due process or rights that they would otherwise have to review the evidence that Enforcement used in making its determination of violation. The broker has no recourse when he finds the facts that led to the legal conclusion to be inaccurate.
FINRA should consider amending its procedures for issuing CALs and only issue them when the broker has been advised of the alleged finding of violation, been given an opportunity to respond, and ultimately agrees to have the CAL issued rather than facing the possibility of more serious outcomes. This at least gives the broker the right to test the merits of Enforcement’s accusations and legal conclusions of wrongdoing where Enforcement acts as the prosecutor and adjudicator in these findings of violations.
Conclusion
FINRA’s current method of issuing Cautionary Action Letters lacks fundamental fairness to brokers who, without fundamental due process are accused of violative conduct, can be subject to internal disciplinary action, and can face elevated disciplinary action by FINRA in the future. FINRA should amend its procedures for issuing CALs by engaging the subject broker and obtain his or her consent to its issuance. Otherwise, if FINRA does not believe that it has sufficient evidence to charge a broker after the preliminary determination, it should either conduct a further review or close the investigation. But making a finding of violation that cannot be disputed or reviewed and does not have the broker’s consent is unfair and needs to stop.
Gary Carleton focuses his practice representing individuals and firms facing FINRA investigations, disciplinary proceedings and appeals, and statutory disqualifications. He also serves as co-counsel with attorneys who have clients facing a FINRA investigation or disciplinary proceedings Contact Gary Carleton at 202.744.6297 or gary@carletonlaw.net to set up an initial consultation.
In Case You Missed It – You can find prior blogs on the FINRA investigative and disciplinary process at www.carletonlaw.net and go to the Blog tab. #finraFlashback blogs in which we discuss notorious FINRA disciplinary proceedings can also be found at www.carletonlaw.net.
The prior topics include:
* SEC’s Seemingly Endless Delays in Ruling on FINRA Disciplinary Appeals – Justice Delayed Means Justice Denied
* FINRA’s Disciplinary Hearings Disappearing Act
https://carletonlaw.net/finras-disciplinary-hearings-disappearing-act/
* Guarding Against Excessive Trading in a Customer’s Account
* Keeping Stockbrokers Out of Trouble by Updating Their FINRA Form U4 Filings
https://carletonlaw.net/keeping-stockbrokers-out-of-trouble-by-updating-their-finra-form-u4-filings/
* Why FINRA’s Disciplinary Decisions are so “Appealing”
https://carletonlaw.net/why-finras-disciplinary-decisions-are-so-appealing/
* FINRA Flashback – FINRA’s Investigation Uncovers Stock Manipulation
https://carletonlaw.net/finra-flashback-finras-investigation-uncovers-stock-manipulation/
* FINRA Flashback to Stratton Oakmont
htps://carletonlaw.net/finra-flashback-to-stratton-oakmont/
* Where have all the FINRA Members (and disciplinary actions) gone?
https://carletonlaw.net/where-have-all-the-finra-members-and-disciplinary-actions-gone/
* Special Considerations for Small Firms when Negotiating Settlements with FINRA https://carletonlaw.net/special-considerations-for-small-firms-when-negotiating-settlements-with-finra/
* Receiving that First Request for Information (a Rule 8210 Request) https://carletonlaw.net/receiving-that-first-request-for-information-a-rule-8210-request/
* Pre-Wells Notices – An Early Opportunity to Discover FINRA’s Evidence and Present Your Case
* Understanding the Significance of FINRA’s Limited Jurisdiction; https://carletonlaw.net/315-2/ and
* How Old is Too Old for a FINRA Disciplinary Action
https://carletonlaw.net/how-old-is-too-old-for-a-finra-disciplinary-action/
About Carleton Law PLLC
Getting a call from FINRA or SEC Enforcement telling you that your work as a securities broker is under investigation could be the worst day of your life. You have worked hard for years building your business. Now, with one wrongful allegation you can see it all swept away. But with expert counsel, it does not have to end that way.
For more than 30 years, Gary Carleton was the attorney conducting those investigations at FINRA and SEC and now his firm, Carleton Law PLLC, brings that savvy experience to bear to advocate for brokers and FINRA firms who find themselves in that dreaded position. Carleton Law focuses on the individual needs of each client to guide them through the maze of the investigative and disciplinary process.
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The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information is for general informational purposes only. Readers of this article should contact their attorney to obtain advice with respect to any particular legal matter. No reader should act or refrain from acting on the basis of information contained herein without first seeking legal advice from counsel in the relevant jurisdiction. Only your individual attorney can provide assurances that the information contained herein – and your interpretation of it – is applicable or appropriate to your particular situation. Use of, and access to, this article does not create an attorney-client relationship between the reader or user and the article author or law firm.
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[1] Interview of FINRA Former Department of Enforcement Deputy Head Chris Kelly at https://www.finra.org/media-center/finra-unscripted/enforcement-individual-brokers#:~:text=Chris%20Kelly:%20I%20can’t%20emphasize%20enough%20how%20important%20it%20is
[2] Id.
[3] Interview of FINRA Former Department of Enforcement Head Jessica Hopper https://www.finra.org/media-center/finra-unscripted/enforcement-process
[4] Id.