Supervisor’s Negligence Results in Substantial FINRA Fine

Recent FINRA enforcement actions illustrate how a supervisor’s negligence can result in substantial fines. Advisory firms and the Financial Industry Regulatory Authority (FINRA) have rules in place meant to act as a barrier between investors and irresponsible brokers. This includes firms’ “duty to supervise” their registered representatives, as well as their duty to maintain systems designed to catch unsuitable, red-flag strategies. When supervisors let those red flags go unchecked, they risk sanctions from FINRA, as well as arbitration proceedings with securities attorneys.

What Happens When a Firm Ignores Red Flags?

Recently, an advisory firm called Worden Capital Management entered into an Acceptance, Waiver, and Consent agreement (AWC) with FINRA, in which they consented to the findings that their supervisor’s negligence allowed representatives to employ risky strategies. Supervisors should know how to catch red flags, which in this case included excessive trading, unsuitable use of margin, and account churning. As part of the terms of his AWC, the Worden Capital supervisor had to pay a $5,000 fine and complete 20 hours of continuing education on supervisory responsibilities.

Obvious Red Flags:

Here’s a breakdown of the red flags listed in the AWC and identified by FINRA as supervisory negligence.

1. Excessive Trading

Excessive trading, aka churning, is a type of sales practice violation. When a broker executes a trade, it should be part of a consistent, well thought-out strategy. Executing lots of trades is often a red flag for securities attorneys, because it could mean that the broker is only interested in generating commissions for themselves.

FINRA does not have an exact definition of what constitutes excessive trading, but the “cost-to-equity” ratio plays a key role. This ratio measures the equity of the account versus how much the transactions cost the customer. Equity refers to the account’s total value, minus any debts associated with the account. There is not a hard-and-fast percentage, but generally, if the cost amounts to more than 20% of the account’s equity, the costs may be too high and the trades may be excessive.

2. Short-Term Trading

Short-term trading, or “in-and-out trading,” describes a strategy of buying and selling shares the same day, to take advantage of minor price fluctuations throughout the day. This strategy involves a high degree of risk.

3. Unsuitable Use of Margin

The supervisor’s AWC states that the supervisor should have limited the brokers’ use of margin. A margin account allows the investor to borrow money from the brokerage firm to purchase securities. Utilizing margin is quite risky. If the margin account falls below the maintenance amount, the broker might make a “margin call” — a call to the investor letting them know they need to put more money in their margin account. If the investor can’t supply the funds, the broker may have to liquidate securities in order to meet the “maintenance margin.”

4. High Turnover Rates

In addition to the high commissions, the Worden Capital supervisor should have noticed the high turnover rates in certain investors’ accounts. The turnover refers to how long the broker holds shares. The higher the turnover, the higher the fund expenses. High turnover rates make it more difficult for the portfolio to earn the investor a good return. These high rates also increase the possibility that the client will have negative tax consequences.

Supervisor’s Negligence Leads to Losses

AWC with Worden Capital Management states that the firm had already placed the allegedly unsupervised brokers on heightened supervision because they each had three or more customer complaints in the past year. Both representatives that the firm had placed on heightened supervision charged steep commissions, all while engaging in trading strategies that lost their customers’ money.

· Representative 1 churned and excessively traded 7 customers’ accounts, resulting in alleged losses of $1,834,834 and $529,056 in commissions.

· Representative 2 allegedly churned and excessively traded four customers’ accounts. The customers realized a collective loss of $1,170,635 while they paid their representative $940,705 in commissions.

What Should Supervisors Do When They Spot Red Flags?

As part of the heightened supervision plan, the supervisor should have completed the following tasks:

· Notify customers when the advisers open new accounts;

· Conduct monthly reviews of the representatives’ sales practices

The AWC states that the supervisor did suggest that the representatives should reduce their commissions in the future, but he did not otherwise limit their trading and did not discipline the representatives.

Was the Supervisor Negligent?

According to the FINRA AWC, the Worden Capital supervisor simply assumed that the trading practices were reasonable for the clients, who were high net-worth individuals with speculative investment objectives. No matter what the customers’ objectives, however, investors should still have protection from unsuitable strategies.

In the AWC with Worden Capital’s Chief Compliance Officer, the CCO consented to the findings that he failed to train the supervisor to review customer accounts for red flags. His sanctions included a $15,000 fine. The firm also had to pay a fine of $350,000.

What Can Investors Do if Their Advisory Firm Ignored Red Flags?

Customers who have suffered losses because of red-flag trading strategies should contact a securities attorney. If you believe you may have lost money through churning or unsuitable use of a margin account, contact an experienced securities attorney to review your case for free. Reach out to the attorneys at Fitapelli Kurta by calling (877) 238–4175 or emailing info@fkesq.com.