Broker-Dealer Settles Charges for Excessive Trading
Commentary by Glen Barrentine
A broker-dealer settled FINRA charges for supervisory failures on trading "that appeared to be potentially excessive and unsuitable."
According to the AWC, the firm was involved in the trading of approximately one hundred customer accounts "by four registered representatives that produced an average cost-to-equity ratio of 30%, an average turnover rate of 8, and caused those customers to pay total trading costs of more than $2.5 million."
FINRA found that the firm's supervisory system was not reasonably designed to detect and reasonably respond to potential excessive trading. FINRA found that the firm's WSPs did not provide reasonable guidance on how principals should identify or investigate potentially excessive trading and did not require any review of trading over longer periods, which could identify patterns of unsuitable trades over time.
FINRA also found that the firm's use of exception reports to supervise for excessive trading was not reasonable. FINRA said that the exception reports, reviewed by compliance staff for the vast majority of the firm's accounts did not include cost-to-equity ratios, turnover rates or any other useful indicators of potentially excessive trading. Further, FINRA found that the firm had created new exception reports that included cost-to-equity ratios and turnover rates, but did not provide it to supervisors. Finally, FINRA found that the firm failed to consistently enforce its activity letter procedures.
As a result, FINRA found that the firm violated FINRA Rules 3110 ("Supervision") and 2010 ("Standards of Commercial Honor and Principles of Trade").
To settle the charges, the firm agreed to (i) a censure, (ii) pay a $475,000 fine, (iii) pay restitution of $1,057,632.70 plus interest and (iv) an undertaking to review and revise the firm's WSPs.
Commentary
This AWC provides an interesting analysis of a member firm's reliance on so-called "activity letters" to allow continued trading in an active account. Specifically, in response to indications of excessive trading, the firm's compliance staff would send letters to affected clients stating that the firm had recently reviewed the customer's account and noted the account had been actively traded and asking the client to indicate whether the client was in agreement with the activity by signing and returning a copy of the letter. In the event the client signed and returned the letter, the firm's practice was to cease any further action based upon the excess activity in the client's account for six months.
FINRA did not think that the activity letter process provided a "reasonable basis to believe that customers fully understood the risks presented by the active trading, that customers had knowingly accepted those risks, and that the trading was otherwise suitable for them ..."
The takeaway here seems to be that FINRA believes that the determination of whether activity in an account is excessive should generally be made by the firm based upon objective factors. In such a context, a customer's agreement to, and acceptance of, the trading activity should count for little, unless the firm can demonstrate that the customer fully understood and appreciated the trading activity.