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Failure to Supervise Brokers Leading to Investment Loss

FINRA is the Financial Industry Regulatory Authority and is the regulatory body that oversees all brokerage firms. A cornerstone of FINRA regulation is the mandate that firms must develop supervisory procedures to ensure consumer protection. Branch managers and compliance personnel are required to review a multitude of reports, usually computer-generated, to determine and pinpoint any irregularities in their offices. This process is in place to protect clients from their own financial advisors.

One standard check and balance is the exception report which is supposed to "red flag" any troubling occurrences. Though these reports exist, they are routinely ignored by management. In a particular situation, a client's account was being churned by the broker. Churning means that the broker was making recommendations to continuously buy and sell securities which are rarely, if ever, in the best interest of the client. The computerized supervisory system concluded that the account had a very high turnover rate, which is a technical term indicating the account was being churned. Though compliance had the red flag alerts, they did nothing to supervise the broker. Besides suing the firm for churning and unsuitability, the client also had a case for failure to supervise.

In another matter, the broker was recommending the same product for almost all his clients. Compliance personnel can run reports assessing the type of products/securities a financial advisor was recommending for all his clients. Generally, an advisor will have different clients with different needs and risk tolerances. As such, the advisor's "book of business" would naturally be varied, with different portfolios for different clients who naturally fall into diverse categories. In this instance, the advisor had almost all his clients in the exact same product, regardless of age, objective and risk tolerance. That pattern should have been a red flag for the compliance department. However, it was neglected and they did nothing about it. The product in question resembled that of a Ponzi Scheme and all the clients ended up with considerable losses.

FINRA has many rules regarding the supervision of client accounts and financial advisors. A prime example is Rule 3110 which mandates that financial firms, that are FINRA members, establish and maintain a system that ensures proper supervision of all financial advisor/broker activities. Moreover, the established system must ensure that advisors/brokers follow all financially related laws, securities regulations, and FINRA rules. The main tenet of 3110 is the mandate that financial entities have written supervisory procedures ("WSPs"). This must include rules regarding the supervision of supervisors to ensure the supervisors are actually being supervised. 3110 also mandates the creation of a pyramided structure to ensure these ends. That way, there would be supervisors who themselves were supervised by someone who is also then supervised. Of course, all of this would have to have been written out with specificity to list all supervisory responsibilities in the hierarchy, and detail how the supervision is supposed to be carried out. The WSPs would also have to provide procedures involving systems tests to ensure compliance and appoint principals to carry out the tasks. A Chief Compliance Officer ("CCO") must be appointed.

3130's other important tenet is the yearly process that certifies the firm's compliance with its WSPs. The certification has to be in writing and also requires that the firm's CEO do the actual certification. Therein, the CEO would affirm that policies and procedures are in place to ensure the firm will continue to comply with applicable regulations and laws. The next step would be a formal reporting to the board of directors and any applicable committees. Furthermore, the CEO' must verify that he or she has held a formal meeting with the CCO and has discussed compliance and supervisory procedures. There must be an in-person meeting, not just a bunch of memos.

The next set of Finra rules that are of the utmost importance in the field of supervision are Rules 2090 (Know Your Customer Rule) and 2111 (the Suitability Rule). To paraphrase 2090, all financial advisors/brokers must be diligent when it comes to opening and maintaining every client account. He or she must also know and understand the important facts of every client. 2090 essentially ties into 2111, the Suitability Rule. 2111 mandates that before an advisor/broker makes a recommendation he or she must have a reasonable basis that the recommendation is a suitable transaction or strategy. This includes not only a recommendation to buy or sell, but also to hold a security or maintain a strategy.

Another import FINRA Rule involving supervision is 2210. It deals with public communications by the financial advisor/broker. In the electronic world we live in, diligence by supervisors over advisors' transmissions is of the utmost importance. All communications must be approved to ensure financial advisors/brokers are not making misrepresentations. Given the means of transmission range from emails and texts to Twitter and Facebook, supervisors have to be extra diligent.

Lastly, is Rule 3270 which deals with any Outside Business Activities by the advisor/broker. In sumation, this rule requires disclosure of all business activities of the advisor/broker that are unrelated to their employment. The reason this is so important is that in the past some unscrupulous financial professionals have set up side schemes in which they get unsuspecting customers to invest, by claiming its a private placement created by the firm, or that the firm has endorsed it in some fashion. This activity is referred to as "selling away" and all financial firms forbid such activity.

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