FINRA Finds Firm's Securities Lending Program Unsuitable
Commentary by Glen Barrentine
A broker settled FINRA charges for failing to ensure its fully paid securities lending program ("FPLP") was appropriate for customers.
According to the AWC, during the relevant period, the firm "entered into securities loans with certain introduced customers without having reasonable grounds to believe the loans were appropriate for those customers because those customers did not receive a loan fee for lending their shares." FINRA found that other customers that enrolled through introducing broker-dealers received nearly $18,000,000 in cash payments in lieu of dividends, exposing them to adverse tax consequences.
FINRA found that the firm distributed misleading documents to introducing broker-dealers, who in turn sent them to over five million retail customers. FINRA said the documents falsely stated that customers would "receive a loan fee" for securities lent under the program. FINRA found that many customers received no compensation. FINRA also found communications misleadingly suggesting that participation would result in reduced management fees, despite the fact that the relevant broker-dealers did not charge management fees to any customers.
Further, FINRA found that the firm failed to provide customers with the required written disclosures explaining the risks and financial implications of lending their securities. FINRA said the firm omitted the standalone risk disclosure document from enrollment materials, meaning many customers did not receive details about SIPC protection limitations, loss of voting rights, tax consequences and compensation terms.
FINRA found that the firm failed to establish a supervisory system to ensure compliance with customer protection rules. FINRA said the firm did not have procedures to verify the appropriateness of loans or ensure required disclosures were provided.
As a result, FINRA determined that the firm violated FINRA Rules 4330 ("Customer Protection — Permissible Use of Customers' Securities"), 2210 ("Communications with the Public"), 3110 ("Supervision") and 2010 ("Standards of Commercial Honor and Principles of Trade"). FINRA noted this is the first time it has charged a firm with violating FINRA Rule 4330.
To settle the charges the firm agreed to (i) a censure, (ii) pay a $3.2 million fine and (iii) an undertaking to remediate the identified issues within 180 days.
Commentary
In this case, the borrowing firm entered into securities loans with customers of introducing brokers who cleared through the borrowing firm. FINRA found that the borrowing firm failed to comply with two provisions of Rule 4330 ("Customer Protection — Permissible Use of Customers' Securities") and also caused inaccurate statements to be made to lending customers.
First, the AWC stated that the borrowing firm entered into securities loans with customers of introducing brokers without having reasonable grounds to believe the loans were appropriate, as is required by Rule 4330. The basis for FINRA charging the borrowing firm with this failure, however, is not immediately obvious as Supplementary Material .04 of Rule 4330 allows an introducing broker to rely on the representations of the introducing broker that has a customer relationship with the lending customer rather than make this determination itself. While the AWC is not as clear as it could be, it seems to say that certain of the introducing broker-dealers did not share loan fees generated by the participation of their customers in the securities lending program with some or all of their borrowing customers. In other words, participation in the loan program could not be appropriate for these customers given that the customers received no benefit from such participation but still faced certain risks and possible adverse financial consequences. What is not clear, at least from the AWC, is whether the lending firm was aware of the fact that certain introducing brokers were not passing along a share of the lending fee to their customers. If not, it is not clear why the lending firm would not have been entitled to rely upon the representation of the introducing brokers.
Second, for more than two years, the borrowing firm failed to provide a stand-alone Risk Disclosure Document to customers who enrolled in the lending program, which Document set forth certain disclosures required by Rule 4330, including a limited set of disclosures that were not otherwise provided elsewhere. Historically, the borrowing firm provided the Risk Disclosure Document together with a securities lending agreement, but, after making changes to the securities lending agreement, the borrowing firm failed to continue to include the Risk Disclosure Document with the updated securities lending agreement. Ideally, the firm's WSPs would have provided that the Risk Disclosure Document would be provided with the securities lending agreement, and, as part of the change control process related to the updating of the securities lending agreement, someone at the firm would have had the responsibility to ensure that the Risk Disclosure Document was still being provided. This was not done, however, and the mistake was not caught for more than two years.
Third, the borrowing firm caused its introducing brokers to distribute to their customers a brochure that described the securities lending program in a manner that was not accurate as to all customers who received it. The inaccuracies included a statement that customers would receive a loan fee and that customers would be compensated via reduced management fees. As stated above, not all customers received a loan fee, though it is unclear whether this was actually known to the borrowing firm, and none of the relevant broker-dealers charged management fees with the result that customers would not receive compensation via reduced management fees. Obviously, FINRA members are responsible for ensuring that any statements they make to customers are accurate and are not misleading. Here, the statement regarding receipt of loan fees, should have been backed up by a representation and agreement by the introducing brokers to the effect that they would share the loan fees received with participating customers. As to reduced management fees, this language could have been saved if it was written in a manner to make it clear that this only applied to customers who paid management fees in the first place—though that clarification probably seemed implied to the borrowing firm when it drafted the brochure.