Overview
FINRA arbitration rules require broker-dealers to supervise transactions and the conduct of their personnel. Failure to supervise most often relates to one or both of the following:
(1) The quality of the broker-dealer’s supervision over the financial advisor(s) responsible for making investment recommendations.
(2) The brokerage firm’s supervision over the specific transactions in an investor’s account(s).
The FINRA rules provide extensive guidance and regulatory framework to help ensure broker-dealers are properly supervised. Preliminarily, firms must create a hierarchy that designates managers with the appropriate supervisory licenses responsible for overseeing the activity of the financial advisors beneath them. Typically, firms create this management hierarchy based on location.
For example, a firm might designate a branch manager responsible for overseeing the activities of 5 brokers in one branch. The firm might then designate a regional manager responsible for overseeing 5 branches in a particular region. And a national manager responsible for supervising 5 regions.
Some of the most important supervisory responsibilities that FINRA imposes are summarized below.
Broker-Dealers must Perform Pre-Hire Due Diligence on the Brokers they Hire
Before hiring a broker, the firm must perform pre-hiring due diligence to ensure that broker does not have any issues from their past that might suggest a propensity for future misconduct. Pre-hire due diligence is an important function of a broker-dealer’s duty to supervise. Broker-dealers have extensive resources that enable them to review a prospective broker’s background. Background information at broker-dealer’s disposal includes (among other things):
- Education
- Work history
- Past complaints investors made about thee prospective broker’s conduct
- The circumstances behind past terminations from previous employing broker-dealers
- Criminal history
- Bankruptcies
A failure to perform robust pre-hire due diligence could expose a broker-dealer to liability.
Broker-Dealers must Monitor Transactions in Investor Accounts
Brokerage firms should implement electronic supervisory systems that monitor transactions in investor accounts. These systems should flag anything that falls outside of a specific investor’s investment objective and risk tolerance. That way, the firm can try to ensure that the recommended transaction is suitable for the investor. This should not only apply to individual transactions. But it should also apply as it relates to ensuring proper asset allocation.
Example:
Suppose an investor has a conservative risk tolerance. And a broker attempts to place more than 20% of the investor’s assets in speculative stocks. This allocation in speculative stock does not comport with the investor’s risk tolerance. A functioning supervisory system would automatically flag, and potentially halt those transactions until a manager discusses issue with both the broker and the investor.
Example:
Suppose an investor has a commission-based account. And the broker collects a commission on every trade he makes in a customer’s account. The broker then places dozens of trades in a week, generating exorbitant commissions. A compliant supervisory system ought to flag that trade volume and potentially halt the transaction until after a supervisor speaks to both the broker and the investor.
Broker-Dealers must Monitor Correspondence
Firms also have an obligation to monitor correspondence as a function of their duty to supervise. Correspondence, including email, letters, and text messages, often provide important representations about the investor’s accounts, investment objective and risk tolerance. To help ensure these representations are accurate, compliant brokerage firms have complex systems that monitor correspondence that automatically flags certain key words that might suggest nefarious representations. Once flagged, a supervisor reviews the flagged correspondence.
Example:
Suppose a broker states to an investor in an email that a notoriously risky investment is actually a conservative/safe investment. A compliant supervisory system would flag that email sent over the broker-dealer’s server to review and potentially prevent the customer from purchasing something with false information. Failure to identify such an email could constitute a breach of the firm’s supervisory duties.
Broker-Dealers must Inspect and Audit their Brokers
FINRA rules require broker-dealers to regularly inspect all the securities businesses. The firm must design these inspections so that they detect and prevent potential securities violations. In practice, broker-dealers should (at least annually) audit and inspect the business practices of their brokers.
Example:
Suppose a financial advisor convinces and investor to sign account forms while they are blank. After the forms are signed, the financial advisor fills in information sufficient to purchase an investment for the customer that generates a substantial fee. Meanwhile, the investor does not know about the transaction because he signed the form while blank. The financial advisor keeps these blank, but signed forms in a folder on his desk.
The broker-dealer then conducts an inspection of the financial advisor’s branch but does not bother inspecting the financial advisor’s desk sufficient to locate these blank, signed forms. Later, the investments lose value.
In this example, the broker-dealer might be found liable in a FINRA arbitration for failing to supervise because it did not perform an adequate inspection.
*The Law Offices of Patrick R. Mahoney is a full service law firm with extensive experience litigating cases involving a host of securities-related issues. This page is for information purposes only and does not constitute legal or investment advice; nor is it a comprehensive explanation of all supervisory issues. If you believe you have a claim, you should speak to competent counsel to better understand your options. Or, contact us.*
