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Monthly Archives: August 2011

New FINRA rule for reporting requirements

FINRA’s Rule 4530, modeled after NASD Rule 3070 and NYSE Rule 351, went into effect on July 1, 2011. The rule requires all member firms to:

  • report to FINRA certain specified events and quarterly statistical and summary information regarding written customer complaints, and
  • file with FINRA documents of certain criminal actions, civil complaints and arbitration claims.

A member firm has 30 calendar days to report to FINRA violations of any securities, insurance, commodities, financial or investment laws, rules, regulations or standards of conduct committed by the firm or its associated persons.  The 30-day period begins when the firm has concluded, or reasonably should have concluded, that a violation has occurred. Below is a summary of the provision.

  • Firms are not required to report every instance of non-compliant conduct, but they must report conduct that has widespread or potential widespread impact to the firm, its customers or the markets, or conduct that arises from a material failure of the firm’s systems, policies or practices involving numerous customers, multiple errors or significant dollar amounts.
  • Violative conduct by an associated person must be reported only when it has widespread or potential widespread impact to the firm, its customers or the markets; conduct that has a significant monetary result on a member firm(s), customer(s) or market(s); or multiple instances of any violative conduct.
  • The “reasonably should have concluded” standard is applied on a good faith basis (by the firm) if a reasonable person would have concluded that a violation has occurred; if a reasonable person would not have concluded that a violation occurred, then the matter is not reportable. Firms must establish who, within the firm, is responsible for making such determinations. Stating that a violation was of a nature that did not merit consideration by the responsible person is not a defense to a failure to report such conduct.
  • The reporting obligation and internal review processes set forth under other rules – eg., FINRA Rule 3130 – are mutually exclusive.
  • While internal review processes may point to a firm’s determination that a specific violation has occurred, they do not by themselves lead to the conclusion that the matter is reportable – e.g., FINRA would not view a discussion in an internal audit report regarding the need for enhanced controls in a particular area, standing alone, as determinative of a reportable violation.  An internal audit finding would serve only as one factor, among others, that a firm should consider in determining whether a reportable violation occurred.
  • Certain disciplinary actions taken by a firm against an associated person must be reported under a separate provision, rather than under the internal conclusion provision.

In addition to the above “internal conclusions” obligations, the new rules for “other reportable events” as per NASD Rule 3070 and NYSE Rule 351, have been modified somewhat in Rule 4530. For example, more customer disputes may have to be reported, as the new rule will now include attorney’s fees and interest penalties in customer settlements or awards with damages against a broker of $15,000 or more and against a firm of $25,000 or more, thus lowering the calculations threshold for reporting requirements.

August 16th, 2011|Legislation|

Rudiments of a Ponzi scheme

The scheme is named after Charles Ponzi, who duped thousands of New England residents into investing in postage stamp speculation in the 1920s. But Ponzi is not the original mastermind behind the scheme; various reports show that there were several similar scams before he was born. (Charles Dickens’ 1857 novel “Little Dorrit,” for example, described such a scheme whereby the fraudulent dealings of Mr. Merdle led to the collapse of his bank.) Ponzi’s operation, however, took in so much money that it was the first to become widely known in the United States. Ponzi promised investors that he could provide a 50% return in just 90 days, at a time when the annual interest rate for bank accounts was 5%. Based on the arbitrage of international reply coupons for postage stamps, Ponzi quickly diverted investors’ money to support payments to earlier investors and to himself.

As originally designed, a Ponzi scheme remains a fraudulent operation that pays returns to separate investors, not from an actual profit earned but from the investors’ own money or money paid by subsequent investors. The scheme typically entices new investors by offering returns that other investments cannot guarantee, in the form of short-term yields that are either extraordinarily high or unusually consistent.
The main reason why the scheme initially works is that the early investors, those who actually got paid the large returns (from the investments of new entrants) reinvest their money in the scheme. Meanwhile, the fraudsters gain the investors’ confidence, maintaining the deception of high profits. Claims of a “proprietary” investment strategy, which must be kept secret to ensure a competitive edge, frequently is touted to hide the fraudulent operation.

The fraudsters also try to minimize withdrawals by offering new plans to investors, often freezing their money for a long time in exchange for higher returns. If a few investors do wish to withdraw their money in accordance with the strict terms, the requests are usually promptly processed, giving the illusion to other investors that the fund is solvent.

But once the required continuous stream of investors slows down, the scheme begins to collapse as the fraudsters start to have problems paying the promised returns (the higher the returns, the greater the risk of collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run. (A bank run, also known as a “run on the bank” occurs when a large number of customers withdraw deposits because they believe the bank is, or might become, insolvent.)

External market forces, such as the global economy decline in 2008, also cause many investors to withdraw part or all of their funds, not necessarily because of fraud suspicions, but simply due to underlying market conditions. (In Madoff’s case, the fund could no longer appear legitimate after investors attempted to withdraw $7 billion in late 2008.)

And of course, there is rarely a happy ending to this story as fraudsters attempt to vanish, taking the remaining investment money with them.

August 10th, 2011|Educational Series, Fraud|

Controversy abounds in employment decisions based on social media searches

In May 2011, the Federal Trade Commission (FTC) ruled that companies providing social media information to employers – and employers who use the reports – must follow the same Fair Credit Reporting Act (FCRA) regulations that apply to more traditional sources. The FTC also stated that postings on any social media site can be saved by on-line background screening companies for up to seven years.

According to the FTC’s letter dated May 9, 2011 to a company that sells information from social networking sites for employment purposes, such a company is considered a Consumer Reporting Agency (CRA) and thus must take reasonable steps to ensure the accuracy of the information obtained from online social networks (as well as other sources) and positively identify it with the subject. It also must comply with other FCRA provisions, such as providing a copy of the report to the subject and maintaining an established protocol if the subject disputes the reported information. As with “traditional” background investigations, employers who use a report prepared by a CRA must certify to the CRA that the report will not be used in violations of federal or state equal employment opportunity laws or regulations. Additionally, both the CRA and the employer have a legal obligation to keep and dispose of the reports securely and properly. (For more information, see the FTC blog, “The Fair Credit Reporting Act & Social Media: What Businesses Should Know.”)

Social media legal experts and various literature point to a multitude of issues and risks faced by both the CRA and the employer who uses social media checks, which include, but are not limited to:

  • Problems under FCRA section 607(b) in exercising “reasonable procedures to assure maximum possible accuracy” of the information.
    Since the information on social media sites is self-reported and can be changed at any time, it is often difficult if not impossible to ascertain that the information is accurate, authentic and belongs to the subject. Online identity theft is not uncommon, as are postings under another person’s name for the purpose of “cyber–slamming” (which refers to online defamation, slander, bullying, harassment, etc.)
  • Information may be discriminatory to job candidates or employees, or in violation of anti-retaliation laws.
    Social sites and postings may reveal protected concerted activity under the National Labor Relations Act (NLRA,) and protected class information under Title VII of the Civil Rights Act and other federal laws, such as race, age, creed, nationality, ancestry, medical condition, disability, marital status, gender, sexual preference, labor union affiliations, certain social interests, or political associations. And while the information may have no impact on the employment decision, the fact that the information was accessed may support claims for discrimination, retaliation or harassment.
  • Accessing the information may be in violation of the federal Stored Communications Act (SCA).
    To the extent that an employer requests or requires an employee’s login or password information, searches of social networking sites may implicate the SCA (18 U.S.C. § 2701) and comparable state laws which prohibit access to stored electronic communications without valid authorization. A California court recently ruled that the SCA also may protect an employee’s private information on social networking sites from discovery in civil litigation.
  • Assessing the information may violate terms of use agreements and privacy rights.
    While certain social media sites have stricter privacy controls than others, most if not all limit the use of their content. The terms of use agreements typically state that the information is for “personal use only” and not for “commercial” purposes. Although the definition of “commercial” in connection with employment purposes is interpretive, most legal experts indicate that employment screening fits that scope.
  • Information may be subjective and irrelevant to the employment decision.
    Blogs, photos and similar postings often do not provide an objective depiction of the subject or predict job performance. The California Labor Code, for example, specifically provides that an employer is prevented from making employment-related decisions based on an employee’s legal off-duty conduct. Employers may use such information only if the off-duty conduct is illegal, if it presents a conflict of interest to the business or if it adversely affects the employee’s ability to do his/her job. And the evidence of such activities must be clear.

The popularity of employment-related background checks that include social media searches is growing rapidly. But the unreliable and unverifiable information from these sources is a potential landmine of legal liabilities.

August 8th, 2011|Employment Decisions|
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