The St. Louis Broker-Dealer: June 2010

To the St. Louis region small broker-dealers, compliance officers, legal officers and banks with securities related activities: We present the twelfth issue of our newsletter.

Social Media – Linked In, Facebook, Twitter, etc. have become a major method of communicating not only personal information, but also business information. And with so many possible clients utilizing it, small broker-dealers must consider using it in their business in order to just keep up with their competition.

But the characteristics of social media which are so positive – quickness and freedom of the user and of responses of third parties – cause difficulty in this industry, which requires control and supervision of all communications with the public. The Financial Industry Regulatory Authority (“FINRA”), in its January 2010 Regulatory Notice 10-06, guides – and restricts – broker-dealers in their use of social media.

I have asked a “guest writer” to advise on these issues: Cliff Campeau, a Partner with Evolutionize, LLC. Cliff’s statements and opinions in this piece are his, and are not necessarily mine or those of Danna McKitrick, P.C.

The “Business Memo” part of this newsletter continues the discussion of theories of, and avoidance of, liability of broker-dealers (“BDs”) and registered representatives (“RRs”). This time we analyze “unauthorized trading.”

If you would like copies of past issues or have any questions arising from the contents of this or past issues, please call or e-mail me, Joe Soraghan, at (314) 726-1000 or jsoraghan@dmfirm.com at no charge.

A Social Media Perspective for Financial Advisors

Deferred Variable Annuities: The New Requirements and Some Problems, Solutions and Considerations

By: Cliff Campeau (cliffc@evolutionizemypractice.com)

Is your practice currently enjoying double-digit annual revenue increases? Are you profitably expanding your client base? Have you reduced the time required to convert prospects to clients? If you answered “yes” to any of these questions, read no further.

On the other hand, if you’re wrestling with how you are going to grow your practice, increasing assets under management and boosting profit margins, consider “Social Media Marketing.” But be aware of its risks.

Social media is here to stay. Consider that consumer activity on social media and blogging sites comprised 17% of all time on the internet in August, 2009, up from 6% the prior year, according to Nielsen.

Take a look at usage levels and you can begin to sense the impact social networking can have on extending your firm’s reach:

• 30 million LinkedIn users in the U.S. source: LinkedIn, February, 2010)
• 400 million Facebook users globally, with the average user spending 55 minutes per day (source: Facebook, January, 2010)
• 50 million Tweets per day (source: Twitter, February, 2010)

Perhaps at this point we can agree that leveraging the power of social media has the potential to dramatically impact your business development efforts. . . with minimal investment of time and money.

So what are you waiting for? Perhaps it is the fact that your compliance partner has not provided a clear path forward for incorporating social media into your firm’s marketing efforts. Clearly, there are guidelines that we must follow and grey areas that we must navigate as we manage our businesses on a daily basis. The same is true for social networking.

FINRA to the Rescue

The good news is that in January, 2010 FINRA issued Regulatory Notice 10-06, providing guidance on the use of blogs and social networking sites. Their guidance provides welcome clarity around the compliant use of social media.

Framework for Social Media Success

It is our goal to provide you with basic advice for advancing your consideration of social media to enhance communications with your investors, increase the number of leads you generate and convert more prospects into clients.

All communication on social networks and blog sites should be treated the same as personal or written communications. Therefore, the following rules apply:

• E-mail messages sent to 25 or more prospects is considered to be “sales literature.” E-mail to fewer than 25 prospects or customers should be considered “correspondence.”
• Publicly available websites, such as Twitter or YouTube are considered “advertisements,” while password protected sites such as LinkedIn, Facebook or MySpace are considered “sales literature.”
• Chat room discussions and/or posts on LinkedIn, Facebook for example, are considered “public appearances.”

With these guidelines established by FINRA, your compliance partner will be able to guide you on the need for pre-approval or not to allow your firm to remain compliant with FINRA’s Communications Rule 13. in conjunction with your compliance partner, it is recommended that you develop policies and procedures that suit your risk profile and ability to pre-approve or post-review your firm=s social media activity.

What we would like to focus on for this article are the following operational considerations for implementing a compliant social media program:

1. Record Keeping
2. 3rd Party Posts
3. Recommendations and Testimonials

Record Keeping

FINRA requires that advertisements and sales literature be retained for a period of three years. This includes advisor e-mails, posts or instant messaging activity related to the firm’s business, whether sent from the office, home or elsewhere. Status updates, Tweets and comparable social networking activity would fall under the advertisement and or sales literature guidelines. Sending an e-mail or instant message via a social network would be considered correspondence. Both of these scenarios, in conjunction with any network profile updates, must be captured and maintained.

Therefore, your firm will need to implement a social networking monitoring and archiving service. There are a range of software or freeware solutions providers that serve the Broker-Dealer/RIA market, providing a range of social network access control, monitoring and archiving services.

3rd Party Posts

FINRA does not generally consider 3rd party posts by customers as the firm’s communication, unless the firm was involved in producing, approving or endorsing the content. Hence, 3rd party posts can become attributable to the firm if they are republished or re-Tweeted. Commenting on a LinkedIn post or “Favoriting” a post on Twitter, for example, may be considered an endorsement and therefore attributable to the firm. This area is best addressed by 1) Limiting the advisers in the firm who are authorized to participate in the development of content and/or to post, comment or re-Tweet; 2) Training the firm’s advisers on the appropriate guidelines established by the firm related to this area; and 3) Working with your compliance partner to identify pre/post review parameters for posts and re-Tweets.

Recommendations & Testimonials

FINRA Notice 10-06 recognizes that it is beyond the reach of your firm to control or monitor all communication on the various social networks, and as a result acknowledges the fact that the 3rd party posts are generally not attributable to your firm’s communications. We do, however, want to address one particular social network. . .LinkedIn. LinkedIn provides its members the opportunity to solicit and approve endorsements from one’s contact network. FINRA has consistently advised against any form of direct or indirect testimonial “of any kind” concerning the adviser, their advice, analysis, reports or service proffered. Hence we would counsel your firm to develop a policy that prohibits advisers from soliciting or exhibiting any testimonials of any kind on LinkedIn or any of its social networks.

Conclusion

According to the Financial Planning Association, 43% of advisors surveyed are now using networking or social media sites.  Further, 60% of those advisors indicate that they have generated at least 16 leads per year form their activity on these sites.

Converting one lead to a client can offset the time and money invested in formulation, implementing, and monitoring a compliant social media marketing program.

Business Memo– Other Claims Against You: Unauthorized Trading

by Joseph R. Soraghan (jsoraghan@dmfirm.com)

I continue here the theme of the past few issues studying the claims most frequently brought against BDs and RRs in courts and arbitration. In past issues we have discussed common law fraud, negligence and breach of fiduciary duty. Yet to be discussed are Respondeat Superior, Unauthorized Trading and Failure to Supervise. In this issue I will discuss unauthorized trading.

Notwithstanding the offense and the concept of “unauthorized trading” are so important and commonplace, it is not defined in any statute or in any regulation of the Financial Industry Regulatory Authority (FINRA) or any other securities enforcement body. Rather, the Securities and Exchange Commission has simply declared that “unauthorized trading” (without defining it) constitutes a violation of the FINRA and NYSE Rules requiring members to “observe high standards of commercial honor and just and equitable principles of trade” (the “Fair Dealing Rule”). And FINRA then interpreted its Fair Dealing Rule in IM-23-2(4)(A)(iii) to include “causing the execution of transactions which are unauthorized by customers or the sending of confirmations in order to cause customers to accept transactions not actually agreed upon.”

The Easy Cases. There are scenarios in which the fact of a transaction being unauthorized is clear. In these are situations the client/customer alleges that no communication concerning the contested transaction occurred between himself and his broker. Typical evidence of this is telephone records showing

No telephone calls between them on or near the date of the trade, the customer being out of town and out of reach, etc.

But it is More Complicated Than That: Unauthorized Trading When There IS Communication. But unauthorized trading does occur (and customers can recover for it) even when it is clear that communications concerning the contested transactions DID occur. This can occur when (i) it is not clear whether an order was actually placed, or (ii) an order was placed but the customer did not understand the recommended transaction.

Most frequently, in a telephone conference the RR discusses a recommendation with the client, the client says yes to the trade, and the RR hangs up and executes the trade. Another but less frequent scenario is a meeting between the RR and customer in which the RR makes his recommendation. Industry rules do not require written authorization from the customer. And most clients, because they trust their broker and they are often in a hurry, prefer this to spending time “with the paperwork.”

Unclear Orders

But suppose the RR makes his recommendation and the customer simply says, “That’s a good idea.” Is that an order? Successful claims against brokers have occurred even in scenarios with more definiteness than this. The RR should be trained to require the customer to use clear language in ordering, and even better, to also note his or her wording briefly in writing, particularly for large or unusual orders.

Trades not Fully Understood by Clients

Courts generally hold that a customer can authorize only trades which he or she understands. Of course, that means that the customer must be explained the type of trade (buy or sell, etc.), the specific security being purchased, how many shares/units are to be purchased and the price. It is probable that a court or an arbitration panel would also require that the RR be certain that the customer understands the nature of the security (e.g., a complicated derivative versus common stock), any recent news, particularly negative, about the issuer of the security, whether the broker-dealer is a market maker or a consultant to the issuer, etc.

The theory of these cases is that an order made without knowledge and an understanding of all necessary information about the trade is one made without authority. Of course, the more exotic and complicated the security or the transaction, the less likely an arbitration panel is to find the client understood and thus authorized the trade. Essentially, securities law requires that any investor, sophisticated or not, be informed of, and understand, prior to a trade all facts concerning the trade and the issuer involved which a reasonable investor would want to know in deciding whether to make the trade. If an investor, on the stand in a hearing when asked “would you have made this trade had you known this fact (e.g., that the company is in a dying industry) might answer “no,” the RR should be certain to inform the investor of that fact.

Supervision: Indications of Unauthorized Trading

The broker-dealer has available various “red flags” which should be the basis of its computer-based supervisory system. That system should monitor for the following, based on the customer’s financial status, objectives and risk profile:

• Evidence of excessive activity;
• In and out trading (buying and selling the same or similar securities in short periods of time);
• Trading beyond the customer’s resources;
• Consistent and similar trading patterns in most of the bro- ker’s accounts;
• Large and suspicious margin balances;
• One or a few account’s commissions constituting a large portion of the broker’s total production; and
• Unusual trading.

The last item, requiring a bit of explanation, is perhaps the most trustworthy indication. By “unusual trading” I mean trades which do not fall within the parameters set by the customer’s net worth, risk tolerance, objectives, and expertise, and particularly his past investment history.

Some other warning signs for the supervisor are knowledge of an RR’s past unauthorized trading violations at prior brokerage firms, the broker’s unwarranted confidence in his own recommendations, or his or her gambling or other financial problems. Acting upon these latter signs may prevent unauthorized trading before it occurs.

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The Genesis of this Newsletter

I have represented large and small St. Louis region broker-dealers, their registered representatives and investment advisors for many years. I have wondered why there is no organization of, or publications dedicated to, the community of small broker-dealers and small banks with securities activities in that region. It also seems to me, based upon that experience, that questions arise of particular interest to that community, coverage of which benefits both that community and its clients.

Therefore, I publish this informal letter to that community, on an occasional and not necessarily periodic basis, noting and discussing (1) questions and events of interest to the small broker-dealer community as they arise; and (2) business memos on topics of on-going interest. Also, if you know of topics or questions which you would like presented, and which are of general interest to small broker-dealers, please let me know.