Articles Posted in Problems at Broker Dealers

The Securities and Exchange Commission governs private placements exemption from registration of securities on an exchange that are still sold to the investing public via Regulation D (Reg D). Reg D offerings are attempted by private companies or entrepreneurs because funding is faster at a lower cost than in a heavily reviewed and documented public offering. The problem many investors face are illiquidity, company failure and the end of promised distribution income.

Studies show that in the past 14 years, there have been $20 trillion in Reg D offerings, $7.7 trillion sold by brokers; $4.8 trillion of that has happened since 2016. Reg D Fraud Lawyers in New York at Malecki Law know the losses these investments can cause investors.

Studies estimate that close to 10% of Reg D offerings fail, meaning likely in excess of $5 trillion sold by brokers in the past 6 years may have failed.  Approximately one-third of Reg D offerings reportedly fail within the first six years and approximately 25% are sold by high-risk brokerage firms.

Securities Industry Background

The securities industry is one of the most regulated industries in the United States. Statutes, common law, and federal regulations all govern the conduct of securities firms and their representatives. Securities firms must register with the Financial Industry Regulatory Authority (FINRA). FINRA is a self-regulated organization (SRO) that protects investors by ensuring that the securities industry operates honestly and fairly. An SRO is an organization that has power to create and enforce industry regulations on its own. This means that FINRA has the authority to create and enforce its rules on securities firms that register with FINRA. A broker-dealer is a securities firm that must register with FINRA. Broker-dealers engage in the business of buying and selling securities. Broker-dealers also offer services such as trade execution, selling securities out of inventory, and lending. Since all broker-dealers and its registered representatives (its individual brokers) must register with FINRA, FINRA’s rules and regulations apply to broker-dealers. If you notice all your investments declined at the same time, it may be a clue that your broker engaged in misconduct. Your brokerage firm has a duty to supervise its brokers to detect and prevent misconduct. You may have a failure to supervise claim. You need a New York Failure to Supervise Lawyer like the lawyers at Malecki Law to review your portfolio, at no cost.

Failure to Supervise Broker Misconduct

Yesterday, Malecki Law filed its official response to FINRA’s proposed changes to FINRA Rule 3240, in which FINRA seeks to modify the five current exceptions to the general rule that prohibits any “registered person” with a brokerage firm, from borrowing or lending to their customers. The rule applies to registered persons, which is most typically the account’s stockbroker, but applies to any licensed person with the firm. While FINRA has proposed this rule to “narrow the scope” of certain exceptions to the rule, Malecki Law filed its comment because of concerns that some of the modifications do not go far enough and still leaves room for possible abuse of the customer.

The five existing exceptions that currently permit borrowing or lending arrangements with a customer under Rule 3240 are if the customer is (1) a member of the registered person’s immediate family; (2) if the customer is a financial institution; (3) if the customer is also a registered person with the same firm; (4) if the lending arrangement is based on a personal relationship with the customer such that the arrangement would not exist had the personal relationship not existed in the first place; and (5) if the lending arrangements is based on a business relationship external to the broker-customer relationship.

Malecki Law is in favor of Rule 3240’s general prohibition against borrowing or lending to customers, because, as noted in Malecki Law’s filed comment, “there are thousands of brokers and advisors in America,” and therefore plenty “available to take over the debtor or lender’s investment account until the loan is repaid.” So while we support any proposal that narrows the rule, we believe that the inherent conflicts of interest in allowing such arrangements, even with a narrowed set of exceptions, could be entirely avoided in the first place.

Few would dispute that Cryptocurrency – whether Bitcoin, Ethereum, or the thousands of other smaller coins – is a speculative and risky investment. The volatility alone in these coins was showcased this past weekend, with Bitcoin suddenly plunging over 25% from nearly $57,000 to just over $42,000 per unit. This is mere weeks after Bitcoin had dropped from its all-time high of roughly $69,000 in early November. Needless to say, investing in crypto is not for the faint of heart and certainly not the type of investment you would see in the portfolio of a risk-averse retiree. Yet it is possible that retirees and conservative investors who rely on financial advisors to manage their retirement assets are receiving exposure to Bitcoin and other cryptocurrencies without even realizing it.

Crypto is a polarizing topic, with some insisting that it is the future, others distrusting it as a Ponzi-type pump and dump, and many more who have no understanding of what it is at all. World governments have traditionally been reluctant to adopt crypto because they see it as a threat to their central banks and control over their fiat currencies, but approaches to regulation vary.  China has outright banned crypto, El Salvador has fully adopted Bitcoin to allow its citizens to shop and pay taxes with, and most other countries (including the United States) are still figuring out how to regulate it.

Financial institutions have been even slower at the notion of adoption because the nature of blockchain transactions poses a threat to the “middleman” place of these institutions in brokering everyday global transactions. Jamie Dimon, the CEO of JPMorgan Chase, has been famously on record for nearly a decade, repeatedly calling Bitcoin “worthless,” “fool’s gold,” and a “fraud.” Yet now it is becoming commonplace for retailers to accept certain cryptocurrencies as payment directly from their customers, with no more hassle than it is to process a credit card or any other electronic payment.

Malecki Law filed an expedited FINRA arbitration complaint today on behalf of a retired couple from New York alleging that their brokerage firm Henley & Company LLC failed to supervise its recently deceased, registered representative Philip Incorvia and the Henley branch office he worked out of.  The complaint claims losses of approximately $2.5 million and that Henley essentially allowed Mr. Incorvia’s Ponzi scheme to flourish since about the time he joined Henley in 2006.  Through these alleged supervisory failures and extreme negligence, the complaint alleges that Henley effectively promoted Mr. Incorvia’s fraudulent practices, including allowing him to freely run his own business, Jefferson Resources, Inc., out of the satellite branch office of Henley’s affiliate, SEC-registered investment advisory firm, Henley & Company Wealth Management, LLC, located at 10 Beatty Road, Shoreham, New York.  Mr. Incorvia operated his Ponzi scheme out of this Jefferson entity housed right inside a Henley office, soliciting investor funds away from investor accounts at Henley to be invested directly into private “alternative” (i.e., fictitious) investments with Jefferson.  Mr. Incorvia’s recent passing is what caused the Ponzi scheme to unravel.  A Henley executive named in the complaint has further admitted to the existence of numerous other Henley customers who are only just discovering that they have been victimized as well.

The complaint alleges that Henley knew about the existence of Jefferson being run out of its own office but failed to follow industry rules to both report and supervise the activity. According to Henley’s BrokerCheck Report published by the Financial Industry Regulatory Authority (FINRA), the defendant brokerage arm of the firm (Henley & Company LLC) apparently failed to disclose the existence of its10 Beatty Road satellite office to FINRA.  However, Henley’s advisory arm (Henley & Company Wealth Management, regulated by the SEC) did disclose it as an operational branch office in a public ADV filing to the SEC.  The ADV filing further disclosed Henley’s awareness of Jefferson by reporting Mr. Incorvia’s association with Jefferson as its “President.” According to BrokerCheck, both Henley firms are under common supervisory control, have the same main office address in Uniondale, New York, and are owned by the same CEO, Francis P. Gemino, with common oversight by their managing director, Michael J. Laderer.  Both Gemino and Laderer are named in the lawsuit as liable control persons.

FINRA’s supervisory rules require all brokerage firms to disclose and report all outside business activities of its registered representatives, further requiring firms to audit and supervise those businesses, especially if they are small branch offices. Both FINRA and the SEC have made clear that supervision of small, satellite branch offices require the same level of supervision as a main office.  The SEC, for instance, takes the position that geographically dispersed offices staffed by only a few people are more at risk of fraud because “[t]heir distance from compliance and supervisory personnel can make it easier for registered representatives [like Mr. Incorvia] to carry out and conceal violations of the securities laws.”

It is usually a bad sign when a retiree or the typical conservative investor suffers investment losses and brings a case to us where their broker was trading options.  In such instances, it at least bodes well for a customer’s legal case when the investor has limited investing knowledge yet has somehow been approved by their brokerage firm for options trading.  It is a sign that the investor may have been misled by a broker who was not properly supervised by the firm, as firms have a duty to know their customers and recommend investment strategies that are suitable to each investor’s risk tolerance and objectives. Very generally, options are not considered safe for conservative investors, but there are circumstances where they could be.

Options are considered high risk because they are derivatives of an underlying stock price, which gives investors a completely separate asset class of investment to speculate in.  The speculation is a bet that not only tries to predict whether the stock price will go up or down to a particular price (known as a “strike price”), but whether it will reach or exceed that level within a specified timeframe (i.e., by the option contract’s expiration date).  As the time frame gets closer and closer to expiration, the value of the options contract decays and becomes worth less and less over time, until it expires worthless, which is what happens with most options contracts. Moreover, when buying a stock, you simply pay the price of the stock.  When buying an option contract, you pay a premium in addition to the price of the stock (should you decide or have the ability to later exercise that option).  Therefore, buying shares in a specific stock is almost always a safer strategy than buying options for that same security.

Options differ from other asset classes in that they give the buyer (or seller) the right, but not the obligation, to buy (or sell) an underlying stock at a specific price on or before a specific date. It is the premium paid on an option that gives the purchaser the right (but not obligation) to later buy or sell, no different than placing a down payment on a home that you intend to later purchase at the agreed upon price. You could walk away from the purchase later and you only lose the premium.  So by granting an investor a right, rather than an obligation, to transact in a certain security, options provide investors with the opportunity to speculate on the future price movement of that security. Although options allow investors to hedge, add cash flow, and leverage returns, options are inherently risky product because they are complex products that are wholly based on price speculation. It is, therefore, highly critical that your broker discuss all applicable risks with you before having an options trading strategy deployed in your account.

Investors are still watching which way the market is ready to turn after yesterday’s 600-point drop in the Dow Jones Industrial average, the biggest one-day drop in over two months. While world markets appeared to be reacting to the prospect of loan defaults by the Evergrande Group – China’s second largest real estate company and the world’s largest property developer –retail investors, and retirees in particular, should keep in mind that this might be the beginning of something bigger. Given that U.S. equities remain at historic highs, portfolios still have a long way to fall.  It is still unclear what ripple effect Evergrande will have even within China, as the Chinese government has yet to formally decide on whether it will bail out Evergrande or let it fail.  But both scenarios are fueling fears of contagion within the U.S. and world markets. Some are calling this China’s “Lehman’s moment,” despite Evergrande’s debt only being about roughly half of the $600 billion in liabilities that Lehman had when it defaulted.  There are rumblings, however, that Evergrande is the canary in the coal mine for China’s numerous other property companies, representing an outsized portion in driving China’s economy and GDP.  The net effect on retail investors in the U.S., thus, depends to some degree on the level of Chinese investment and debt holdings by U.S. companies and financial institutions.

HSBC, BlackRock, and J.P. Morgan have been said to have significant exposure to the Chinese market generally, as do many individual U.S. companies, ranging from Wynn Resorts to Apple.  As always, retail investors who are overconcentrated in any single company or market sector face the biggest risk.  While the stock of many of these companies might seem relatively “safe” over the long term, not every investor can wait for the stock market to rebound.  Seniors and retirees are a prime example, as this is a group regularly identified by U.S. regulators (e.g., FINRA and the SEC) as being vulnerable because they are typically saddled with higher expenses (e.g., medical and age-related expenses) at a time when they need liquidity and are no longer working or earning an income. For this reason, stockbrokers and financial advisors have a legal duty to retirees to recommend investments and an investment strategy that is suitable for this stage of life and the possibility that the stock market will not just continue to rise in perpetuity.

For retirees, overconcentration of an investment portfolio is often the culprit of an investment strategy or recommendation gone wrong.  As we have written in this space before, brokers and financial advisors have long been required to have a reasonable basis for recommending an investment or strategy.  And as of June 30, 2020, brokerage firms have had to comply with a new SEC rule, Regulation Best Interest (Reg BI), which further requires every recommendation to be in a customer’s best interests.  Overconcentrating a retiree’s investment portfolio in largely equities (or worse, a single equity) is typically not in a retiree’s best interests and is what makes a portfolio most vulnerable to significant market events like Evergrande. Even though regulators do their best to raise the public’s awareness of this fact, retail enthusiasm during a bull market often drowns out the well-worn refrain to not put all your eggs in one basket.  FINRA’s “Concentrate on Concentration Risk” publication is just one such warning.

While the stock market and S&P 500 continue to hit all time highs, many investors still have the 2008 market collapse fresh in their memories and know that this historic bull run could, and likely will, come to an end.  There are many signs that the market is overheated, leading some to have speculated that a correction is inevitable, if not imminent.  One of many lessons from prior market collapses is that the investment portfolios most at risk are those which are not properly diversified and may be overly concentrated in either one security or one particular sector of the market.  For retirees, in particular, it is possible to sue and recover such investment losses when following the advice of a licensed financial advisor.

The cratering of an investment portfolio can come as a shock to most investors, particularly retirees who have increased medical and age-related expenses, and are thus unable to afford a long wait until the market bounces back.  In some instances, legal action may be necessary to recover the lost funds. While there is less legal recourse for investors who choose their own investments through a self-directed brokerage platform, the opposite is true for investors who still rely on licensed stockbrokers for financial advice.  Both financial advisors and their brokerage firms can be held liable for recommending investment decisions that are poorly suited to the investor’s needs.

The brokerage industry is regulated by the Financial Industry Regulatory Authority (FINRA), which, until recently, has long imposed FINRA Rule 2111, known as the “Suitability Rule” on all licensed stockbrokers and the brokerage firms that employ them.  Under Rule 2111, brokers were required to have a reasonable basis for recommending a transaction that reasonably considers a broad range of factors, which “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”

On July 20, 2020, the Securities and Exchange Commission brought investment advisor and former registered representative Michael “Barry” Carter up on multiple federal charges relating to the alleged misappropriation of over $6 million in funds.  Mr. Carter allegedly stole this money from his brokerage customers, including nearly $1 million from one elderly client, defrauding them in the process in an effort to remain undetected.  His alleged fraudulent acts occurred between the fall of 2007 and spring of 2019 while working at Morgan Stanley, with over 40% of the misappropriation occurring in the last five years, all to sustain his extravagant lifestyle.

Mr. Carter was reportedly fired from Morgan Stanley in the summer of 2019 for misappropriation of funds.  Later that fall, FINRA launched an investigation into his alleged crimes and he was then barred by FINRA for refusing to turn over documents relating to the alleged misappropriations.

Additionally, the state of Maryland reportedly brought criminal charges against Mr. Carter, to which he has already pled guilty to the investment advisory fraud charges and wire fraud; as part of his plea agreement he will, according to prosecutors, be required to pay back about $4.3 million, the total net proceeds of his illegal activities.

Can a Broker-Dealer Firm be Sued for Failure to Supervise a Broker?

Broker-dealers, also known as brokerage firms, are routinely sued for “failure to supervise” claims.  The Financial Industry Regulatory Authority (FINRA), the organization which regulates broker-dealers and their employees, has a series of rules requiring broker-dealers to establish and maintain a supervisory system to supervise its brokers and other employees, as well as to monitor all trading activity to ensure compliance with applicable securities laws and regulations.  In many of our clients’ cases, the brokerage firm’s lack of supervision and failure to properly supervise a broker’s misconduct has directly and indirectly impacted our clients’ accounts, causing losses.  Malecki Law’s FINRA arbitration attorneys have handled many cases against brokerage firms in New York (and across the country) for failure to supervise and have received favorable monetary awards and settlements for our clients.

A supervisory system that cannot reasonably surveil and detect trades that violate securities laws and deceptive trade practices does not meet FINRA’s minimum requirement of proper supervision.  Moreover, proper supervision also requires a firm supervisor to approve a broker’s daily trades, as well as to systematically review clients’ accounts for wrongful trading activity such as recommending unsuitable investments, trading without proper authority from the customer, or charging high commissions that make it virtually impossible for the customer to make any sort of profit.

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