Effective Strategies For Increasing The Bottom Line

by Warren Forest

Building any successful business takes countless hours of hard work, dedication and sometimes just plain old good luck. But, like the old adage says, more often than not, luck has little to do with your success, because you make your own luck.

The basic cues for building a successful brokerage operation are the same as other businesses. But, the brokerage industry, like other highly regulated businesses, have additional hurdles that must be overcome. Regulation has a price, and it is a price that is often hidden, but, one that directly affects the bottom line in many ways.

Of course, the direct costs of regulation are easy to identify. More expensive audits, higher priced fidelity bonds, increased SIPC assessments and generally higher expenditures to pay all around. But, there are also unknown outlays associated with additional regulation that are harder to identify.

One of the major unseen expenses, is the opportunity cost of more regulation. As the regulatory burden gets larger on a company, the individuals responsible for overseeing it have less time to devote to other areas, specifically selling securities.

The less time that one has to devote to sales and marketing, the less money one will be able to earn. The equation to solve this dilemma then is relatively simple. As your time to sell, as a managing producer, decreases, you must find effective ways to increase your sales and marketing efforts.

NASD Rule 2200 deals with Communications with Customers and the Public. This rule basically governs what you can say and how you say it. In depth knowledge of this rule is important, because one of the effective internal ways to grow is to advertise, and if you do not understand the provisions of NASD Rule 2200, you may be subject to large fines, as well as, sanctions.

Advertising has always been an effective way to increase sales. As the old saying goes, if you want people to ignore you, then do nothing. Getting the word out about products and services has always been a timeless way to increase interest in your business.

Because of NASD Rule 2200, advertising in the securities business presents challenges unique and quite different than advertising for any other business. It can be costly, and carries both direct costs and hidden costs, that are difficult to assess. While it is something to seriously consider, advertising by itself, should never be viewed as the primary way to develop a brokerage business.

Another time-tested way to enhance your bottom line is to develop and conduct seminars, which can both educate and cultivate new business prospects. Holding seminars establishes credibility, and is an excellent way to build a lasting rapport with customers.

Seminars also are subject to the requirements covered in NASD Rule 2200, as they are considered communications with the public. Again, rules and regulations must be followed so that you do not end up spending your time answering regulatory requests, and therefore, not selling, or in a worst case scenario, paying more in fines than you made through increased sales efforts.

Many companies have expanded their business opportunities by developing new product lines and offering additional services. For example, one may want to add the ability to sell options to their product mix, or, add a service such as investment banking.

FINRA Rule 1017 deals specifically with changes in ownership, control and business operations. This rule generally requires that if a product, or service, that is going to be added to the business mix will have a material effect on earnings, the specific product, or service, will need to be approved by FINRA before it can be added. The approval process for adding products and services can be especially complex and time consuming.

In general, one must demonstrate adequate systems and procedures, experienced and qualified personnel, and necessary capital to conduct the proposed business, before FINRA will approve it. Adding a product or service, will generally take approximately ninety days to get approved by FINRA.

Advertising, seminars and other methods of sales development such as direct mailers, or cold calling, as well as, adding additional products and services, are all internal “business building” methods that can effectively increase the bottom line.

Sometimes, however, rather than building internally and starting something from scratch, it makes more sense to look externally for growth which means that instead of building it, you are could buy it. They say that everything has its price, and certainly the brokerage business is no different than any other business in this respect.

When it comes to buying to increase your business, there are several options. You can buy an existing business. That’s right, many have grown through the acquisition of other brokerage houses. Purchasing can offer a relatively quick solution to business doldrums, but it is never instantaneous business gratification. Again, that is due to FINRA Rule 1017 which requires thirty days pre-notification before any sale can occur. Once pre-notification is made, it could take up to six months for the transaction to be approved by FINRA.

One other time-tested way to increase brokerage business is to acquire branch offices. These are often referred to as “franchise branches,” and are usually considered Offices of Supervisory Jurisdiction, or OSJ branches.

Because the branch owner/OSJ principal is responsible for a greater portion of the compliance burden, OSJ offices receive extremely large payouts. Depending on the number of branches permitted to be added, the size of the branch acquisition and business mix involved, adding a branch office may or may not require FINRA approval. If the addition of the branch falls under the provisions of FINRA Rule 1017, the approval process can take up to six months.

The least involved way to add business, is to take on additional individual registered representatives. Typically, as long as a brokerage house has the ability to add on a number of new individuals, and the new individuals are not introducing new products or services, prior regulatory approval is not required.

Of course, verifying prior earnings and background checks to review for disciplinary and employment history need to be conducted at a minimum. Many times, signing bonuses, or “up-front’ money is paid to experienced producers.

More often than not, the return on investment, for “up-front” money paid is not realized, and is a strategy that we do not usually recommend. There are other options to induce a producer to join a firm that can have just as good an effect as a cash payment, without costing nearly as much.

Building any successful business takes logic, determination and proper planning. Because of the nature of a regulated business, all of the above is true, plus the additional task of satisfying regulatory officials.

When building your business, whether or not it requires FINRA approval to do so, first impressions are critical. Regulators want to be certain beyond any doubt that the managers of the business, have what it takes to operate any new ventures successfully. This industry imposed requirement is certainly crucial, because knowledge and expertise are often the only difference between success and failure.

No one can be expected to do it all alone. If you have any questions, we at Broker Dealer Place, Inc. (407-774-2000), along with our sister company, Forest Brokerage Advisers, Inc. (407-696-9600) are here to help!

by Warren A. Forest

Two of the areas that the regulators are increasingly focusing on are ‘Outside Business Activities’ and ‘Private Securities Transactions.’  Not only are Outside Business Activities and Private Securities Transactions common in our industry,
but they are two situations frequently prone to abuse.

Numerous Registered Representatives today wear several hats.  In addition to serving as a securities salesperson, individuals may sell non-securities products such as real estate, or fixed insurance products.  Many licensed persons may also be working with Registered Investment Advisors (“RIA”).  Certainly in economic slowdowns, it becomes more common for people to seek several sources of income.

In other businesses, it does not matter if individuals have two or more jobs.  For the most part, as long as you perform competently in each position you hold, companies you provide a service for do not care what you do outside of company time.

However, the same does not hold true when it comes to the securities industry.  Not only do individuals have to notify their Broker/Dealer (“B/D”) about all of the business activities they are involved in separate from their securities work, but the B/D must conduct an investigation to confirm the outside activity does not impede, or give the perception of impropriety to customers.

Likewise, all registered persons must notify their B/D in advance, if they are engaging in private securities transactions.  That is, if they are representing, not just selling, securities through anyone other than the B/D that they are registered with.

FINRA Rule 3270 deals specifically with Outside Business Activities of Registered Persons.  The rule requires any registered individual to provide prior written notice of the activity to their member firm.

The rule goes further by requiring the member B/D, once they have received the written notice to evaluate the outside activity, and determine whether it will interfere with, or compromise, a registered person’s responsibilities with the
member Broker/Dealer.  It also requires the member firm to determine whether the Outside Business Activity will be viewed by the public as part of the member firm’s business.

Many times the distinction between a Registered Representative’s job at a brokerage firm is clear cut from their duties at another outside job.  However, there are times when the difference is not easy to discern, especially when the Outside Business Activity involves an RIA.

B/D’s and RIA’s are conceptually different in their operating methods.  Typically, B/D’s offer securities, and are transaction based.  They sell various products and charge a commission or markup/markdown for each transaction.  RIA’s offer advice or manage money for their clients.  They charge a fee based upon the amount of time spent offering their advice, or as a percentage of the assets they are managing.

B/D representatives are responsible for ensuring that their recommendations are suitable for their customers.  RIA representatives are held to a higher standard, since they are considered fiduciaries, which require them to operate considering their client’s best interests, based upon all of the information they know about their customer.

Now that all sounds good in practice, but when you are wearing different hats, you better be sure your customers know which hat you are wearing when you are offering various products and services.  The problem becomes quite challenging because many times, even relatively sophisticated customers, simply don’t see, or understand, the difference between a B/D or an RIA.

After all both B/D’s and RIA’s deal in securities, and the representative that the customer deals with is often offering investment advice in both situations.  While there is a duty for a registered person to inform their B/D whenever they have an outside business activity, it is critical that the customers involved also know the difference whenever two regulated entities, for example, when a B/D and an RIA, are involved.

The reason is simple, to establish responsibility, and limit potential liability.  If customers don’t know exactly which hat their representative is wearing, innocent parties may be held liable for another entity’s transgressions.

FINRA Rule 3040 deals with private securities transactions of an associated person.  Similar to FINRA Rule 3270, it requires an individual to notify their B/D of any security activities that they are involved in, outside of the direct jurisdiction of the B/D  they are registered with.

One important aspect of FINRA Rule 3040 is if the B/D approves of the private security transaction, they must record the transaction on their books and records, and supervise the associated person’s participation in the transaction, as if the transaction were executed on behalf of the member. Clearly, when a B/D can be held liable for the activities which occur outside of their direct control, the stakes can become quite high, quickly.

So what should firm’s and the persons associated with them do?  The answer is relatively simple; communicate clearly with all parties involved.   Make sure you memorialize all of your communications regarding any Outside Business Activities, and/or, Private Securities Transactions, in writing.

The communication regarding Outside Business Activities and Private Securities Transactions must occur at the beginning of the relationship between a registered person and a company, anytime there is a change in a registered person’s situation, and at least annually thereafter.  Registered persons/firms should notify their customers at least at the establishment of the relationship, and whenever there is a change in a registered person’s situation.

When companies and their respective customers clearly understand which hat their representative is wearing, and when the representative is wearing it, the potential for misunderstandings and miscommunications will be significantly
reduced.  In place of those pitfalls, there will be more satisfied customers that clearly know the products and services being offered to them, together with companies and representatives that definitely know the roles they play in their customers’ lives.

As our new year freshly unfolds before us, it is a perfect time to assess the past and plan for the future.  By any measure, we have experienced a challenging year.  The economy has taken its toll on virtually every business enterprise.  Broker/Dealers and Investment Advisors certainly have seen their share of adversities.

Not only have business opportunities lessened as investors have fewer resources at their disposal, but the regulatory landscape has gotten bleaker.  Both state and federal regulators are imposing more and more requirements such that the
“regulatory burden” is a very heavy load for financial service firms to carry.

One of the first things to do is decide whether to stay in the game, or not.  Do we continue to suffer the slings and arrows of outrageous fortune, or take aim against the sea of troubles, and by opposing, end them?

Many times owners of financial service firms especially small companies, are surprised to learn their companies have value.  All financial service firms, even dormant inactive ones have value.  If you are contemplating closing your company, you may want to explore selling it first.

We have spoken to many people who were not aware that their Broker/Dealer had value, and was saleable, and filed a BDW (Broker/Dealer Withdrawal request.)  And, while a BDW is a  request to withdraw from FINRA membership, once it is submitted it CANNOT be withdrawn.  We at Broker Dealer Place, Inc. are specialists at selling financial service companies.  Before you decide to close your business, you may want to talk to us about assessing other options available to you.

If you decide to “take aim against a sea of troubles,” and persevere with your efforts, now is the best time to start the year off right with Broker/Dealer house cleaning.  Annual audits for most companies will be due very soon.  Make sure that you have a qualified PCAOB CPA firm preparing your audited financial statements.

One new development concerning audits is that FINRA is now requiring them to be submitted electronically.  If you send a hard copy audit report to FINRA, it will not count as being submitted.
Take the time now to make sure you are set up for the electronic filing.

Review all of your documents such as Form BD, Form U-4′s, and FINRA contact information, and update your records as needed.  Check your Customer New Account Forms for accuracy, and reach out to your customers.  This can be a great marketing opportunity, and also ensure your customer records are all up-to-date, which is a regulatory requirement.

Your 3012 Certification, annual review of operations, branch office examinations, and AML audits should be completed, or in the process, for the prior year. Make sure you have updated all of your FINRA contact information electronically on Web CRD.  If you are a small firm, you should make the “limited size and resource” notification to limit your heightened supervision obligations.

Minimum Fidelity Bond coverage increases this year.  All B/D’s now must have at least a $100,000 Fidelity Bond in place.  There is a hidden “kicker” as well.  If you do not structure your deductable properly, you may find yourself surprised
with a charge to your net capital!

As the brokerage business becomes increasingly complex, your oversight is paramount.  And, the beginning of the new year is a perfect time to start your house cleaning.

No one can be expected to do it all alone.  If you have any questions, we at Broker Dealer Place, Inc. (407-774-2000), along with our sister company, Forest Brokerage Advisers, Inc. (407-696-9600) are here to help!

You only have one month left! That’s right, there are just thirty days for you to complete your “Firm Element” continuing education (CE) sessions.

BD University, located at http://brokerdealerplace.com/bdp/continuing-ed, can help you accomplish this. Our CE platform has recently been upgraded to provide hundreds of relevant classes. It is affordable, user-friendly, customizable, and FINRA compliant.

Ongoing education is vital to every profession. Due to the complexities of the brokerage industry, CE is particularly involved. One of the reasons is that member firms face at least three layers of regulation, the U.S. Securities & Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the individual state securities administrators, and all of these regulators required a uniform standard that was acceptable to all parties.

A second reason is that while there exists situations common to all registered representatives and Broker/Dealers, each Broker/Dealer is unique unto its own, and has specific needs that must be satisfied. In 1995, the NASD, now known as FINRA, initiated Conduct Rule 1120, which made CE mandatory. The regulators and member firms took the cue and created a uniform standard applicable to all registered members of the profession, known as the Regulatory Element. However, they also created another CE system which required each firm to develop and design a unique specific training program, known as the Firm Element.

The Regulatory Element is administered by FINRA, and affects only registered persons. Firms need only insure that their reps participate in computer generated Regulatory Element sessions at the required time intervals.

The Firm Element, however, is designed and administered by each FINRA Member Firm. What makes the Firm Element daunting is that FINRA does not inform its members just how they should design a Firm Element Program, nor do they let them know how frequently they must hold their sessions.

But rest assured, if the Firm Element is not done properly, or as often as the regulators deem fit, a member firm may be subject to adverse regulatory actions. This could translate into fines, sanctions, or even suspensions from the business.

A Firm Element Program must be designed to take into account the specific educational needs of each broker/dealer. In order to accomplish this management must annually complete a ‘Needs Analysis’ that serves to outline the Firm Element Program for the current year.

The Firm Element introduced a new concept called a ‘covered person’. This is any person, whether they are registered or not, that has contact with the investing public. All covered persons must attend Firm Element training sessions. Therefore, a non-registered receptionist has to participate in these sessions, while a registered trader, who has no public contact, is Firm Element CE exempt, and does not have to attend any sessions.

Registered Representatives may view the Firm and Regulatory Elements as a necessary evil, or just another compliance burden. CE is mandatory, but every registered rep should view this requirement in a positive light. After all, you would not want to entrust your physical health to a professional who had out-of-date skills. Your clients’ financial health is equally as important as their physical health. By staying informed and educated with current knowledge, as a financial professional, you will keep your clients financially healthy, which should lead to increased sales, production, and professional satisfaction for you.

If you have not done anything about your Firm Element CE, it is not too late. Simply contact Broker Dealer Place at 407-774-2000, to set up your CE program, and stay compliant. BD University offers a comprehensive product that lifts the Firm Element burden entirely. Member firms and registered reps can utilize BD University’s tools to create a ‘Needs Analysis’ and Firm Element program that will both satisfy the regulators and effectively educate covered persons.

As a securities industry panelist, I recently heard an arbitration which involved two middle-aged claimants, a husband and wife, both retired.  They submitted their claim against a large bank Broker/Dealer and the two registered representatives that handled their account.

The claimants, in their Statement of Claim, alleged all of the usual wrongdoings against the company and their reps.  Fraud, misrepresentation, unsuitability, and negligent supervision were asserted.  At first glance, this case seemed unremarkable, but it quickly became apparent that there was more to it than met the eye.

The first indication that this case differed from most was the types of investments that were involved.  Many cases that I have heard involve highly speculative investments.  Often, there are illiquid investments involved, and, frequently, the accounts have a very high rate of turnover.

This case exhibited none of those traits.  Because the claimant lost a significant amount of money when he attempted to day trade tech stocks years earlier, he changed his investment strategy.  After that humbling and costly experience, he only invested in brokered CD’s and conservative mutual fund investments.

The portfolio he brought to the bank brokerage was about as vanilla of a portfolio that one would find, and the pattern of investing that occurred continued to be extremely conservative.  The broker continued to recommended CD’s and mutual funds only.  At the time that the recommendations were made, the investments carried Morningstar ratings of at least four, if not five stars.

At the beginning of their testimony, the claimant made a very emotional statement that influenced the panel.  They shared that they were suffering from a terminal condition, and had but a very short time to live.

The evidence seemed to indicate that the brokers and the brokerage house did everything and more, that I advise my consulting clients to do in order to prevent and successfully defend themselves against adverse arbitration actions.  The rep stayed in close and frequent contact with his clients, and he kept fastidious notes about the client meetings and telephone conversations they had. The recommendations that were made based upon the evidence presented appeared to be entirely suitable given the claimants’ investment objectives, risk tolerances and time horizons.

When we looked at the holding period of the account, it seemed clear as to what happened to cause the portfolio to lose value.   It was not that the recommendations were flawed when they were made.  It was not that the broker had a greedy objective, and wanted to maximize his commissions.  Simply stated the market crashed.  Only the investments that lost money were unsuitable, the other investments in the portfolio that retained or increased value were perfectly fine.

It is not a requirement that public panelists have any industry knowledge or experience.  Yet, this is currently balanced out by the fact that the third panelist is an individual with in-depth industry experience.  However, since FINRA recently made a rule change allowing all public panels, hearings will be decided by panels that may have absolutely no understanding of the specific investments involved in the case.

During the course of the hearing it quickly became apparent that the two public arbitrators had absolutely no knowledge or understanding of even the most basic investments, let alone the investments involved in this case.  They did not know the difference between a Broker/Dealer and a Registered Investment Advisor, or a discretionary and non-discretionary account.  Indeed, on their individual Arbitrator Disclosure Reports, it indicated that both public panelists have “no skill” in Security information.

Many times during the hearing we needed to break in order to discuss the nature of the recommendations, the types of  investments and the role of Broker/Dealers and registered representatives versus investment advisors and their agents.  Without this critical understanding the public panelists would be hard pressed to render an effective decision.

At the conclusion of the hearing, and as deliberations began, it was evident that there was dissension amongst us.  The public panelists wanted to render a large award in favor of the claimants, and wanted to hold the broker fully responsible.  It seemed that the full consensus needed to render a unanimous decision would be impossible to achieve.

To the credit of my public panelists, they felt as bad about this outcome as did I.  We decided that more discussion would be helpful to see if we could come up with an award that all would be comfortable with.  At the end of our second deliberation session we did just that.   Our final decision is not one that we individually would have made, but by agreeing to disagree, we have an award that addresses the arbitrators concerns.  The claimant will receive something to mitigate the loss, and the registered representative will be held faultless.

While we did not render the award I alone would have given, our joint decision restored my faith in the process.  We all had the chance to fully explain our positions, and heard what we each had to say.  This communication enabled us to craft a difficult award that addresses many issues to our collective satisfaction.

This case, from the very beginning, was all about communication; the communication that occurs between a registered representative and their customer, as well as with the arbitrators.  As the evidence was presented, it was clear that while they talked to each other they were not really hearing.  And at the deliberation table, it was clear that members of the panel heard or understood things differently.

Arbitration is a process fraught with hazard and peril.  Even when one thinks their case is perfect and cannot fail, you will need to guess again, because fail it certainly can.  If you can resolve your case without it going to an arbitration hearing, then make every possible effort to do so.  If resolution is impossible, then do everything that you can to make sure you effectively communicate your case.

by Warren Forest

As anyone who has been in the securities business for any length of time knows, there is nothing simple about this industry.  In
fact, some have gone on to say that simplicity and the brokerage business are mutually exclusive terms.  One good example of this is how branch offices are defined.

Branch locations, or offices, are often essential in building a vibrant and flourishing business enterprise.  McDonalds certainly could not advertise that it has sold billions and billions of hamburgers if it had to rely on just one store.  In much the same way, brokerage companies often find it advantageous to have multiple locations.

Multiple offices can do many things for a company.  By providing geographic dispersity they allow one to reach many more prospects.  Decentralization also allows for sales persons to be physically available to clients that they service.  Branding and marketing efforts are enhanced through branch operations.  Regional and national presences can be made.  Various business models can be employed through branch operations, such as franchising.

Now in every other type of business, a branch office is a branch office, plain and simple.  Not so in the world of broker/dealers.  For, in this world, there are three distinct types of branch offices.  Each type has permitted activities, levels of supervision and required duties attached to it.

The first type of branch office is an Office of Supervisory Jurisdiction, or OSJ.  OSJ’s are the highest level of branch office, and therefore, many high level functions are permitted to occur at an OSJ.

There are seven distinct functions that must happen at an OSJ branch:  1) Order Execution and Market Making; 2) Structuring
of Public Offerings or Private Placements; 3) Maintaining Custody of Customer Funds and/or Securities; 4) Final  Acceptance/Approval of New Accounts on Behalf of the Member; 5) Review and Endorsement of Customer Orders; 6) Final Approval of Advertising or Sales Literature; and,  7) Responsibility for Supervising the Activities of Persons Associated with the Member.  Not every member firm will conduct business in each of these functions, but if you are doing any of them, the location
better be registered as an OSJ.

The second type of office location is simply known as a Branch Office, or non-OSJ.  A non-OSJ branch office is defined as any
location where one or more associated persons of a member regularly conducts the business of effecting any transactions in, or inducing, or attempting, to induce the purchase or sale of any security, or is held out as such, and does not conduct any of the seven activities permitted to happen at an OSJ.

If you are selling securities, or are trying to do so, and you are not doing any of the functions that are permitted to occur at an OSJ, then your location is simply a branch office.  A little different from the norm, it is a location where sales functions are allowed, and a location where certain activities can never happen.

Now here is where things start to get a little more complicated.  The third type of branch location is known as the “Non Branch” location, or NBL.

There are seven exclusions that define an NBL: 1) Any location established solely for customer service and/or back office
functions; 2) Any location that is the associated person’s primary residence; 3) Any location that is used for securities business less than 30 business days per calendar year; 4) Any office of convenience where associated persons occasionally, and exclusively, meet with customers by appointment; 5) Any location from which an associated person effects no more than 25 securities transactions in one calendar year; 6) The Floor of a registered national securities exchange; and, 7) A temporary location established in response to the implementation of a business continuity plan. * Business days are considered to be working at the NBL for four hours or more.

Any office that supervises the activities of associated persons conducting business as an NBL is considered to be a branch office.  And each and every branch location must undergo a self inspection by the Member Firm.  Exactly how often does the internal inspection have to occur?  Well, that depends on how the office location is defined.

OSJ branches and non-OSJ offices that supervise one or more NBL’s must undergo an internal inspection at least once a year.  Non-OSJ offices that are not responsible for supervising associated persons must be physically inspected at least every three years.  And, NBL’s need to be inspected on a regular periodic schedule with no particular time-frame required.

Opening a branch office is not an automatic event, as firms that desire to have multiple locations must be approved by FINRA to do so.  While the rules allow very limited flexibility in this area, typically increasing branch locations, as well as, the number of  permitted personnel to staff the locations, is handled pursuant to a Continuing Member Application.

A formal request must be made, and the firm must evidence its ability to implement the changes.  This is done by demonstrating
the supervisory system that will be in place, furnishing the procedural changes that will be made and designating specific  individuals that can show experience in managing branch office locations.

FINRA also likes to see a minimum level of supervision in place.  That minimum level is one designated principal, usually a Series 24 General Securities Principal, for every ten registered representatives that require supervision.  Sometimes firms may need a higher level of supervision, such as, one designated principal supervising less than ten individuals.

As the complexities of branch office rules, requirements and regulations indicate, FINRA does not take these activities lightly.  Many firms have made the mistake in the past to grow rapidly through geographic dispersion, and neglect to oversee the actions that occur at remote locations.

Firms that make sure that they have qualified experienced branch managers in place, and clearly establish the lines of  responsibility, will do much to deflect the adverse actions that could otherwise occur.  Coupling the people with quality procedures can do much to ensure that branch office operations will be a successful part of a firm’s business model.

*Please note that these exclusions are highlighted from the FINRA Rule 3010.  To ensure that your location meets one of the
standards of an NBL, please seek professional advice.

Virtually all security industry disputes are decided through an arbitration process rather than through litigation.  Instead of having a judge hear a grievance and render a decision, customers and firms elect to have arbitrators listen to their dispute and grant an award to one party or the other.

Historically, most arbitration panels are composed of three members.   Two of the panelists are “public” arbitrators meaning that they derive no income from, and have no direct ties to the security industry.

The third panel member is an “industry” arbitrator, and this person is tied to, and derives a significant portion of their income from the securities industry.  More importantly, the industry arbitrator is familiar with industry rules, laws and regulation, and can lend considerable insight into often complicated issues that arise during the course of an arbitration hearing.

Unanimous decisions are strongly encouraged in arbitration proceedings.  However, a majority decision will prevail, and is enough to render an arbitration award.

On February 1, 2011, FINRA announced that the SEC approved its proposed rule change to allow customers in all FINRA arbitrations the option to have an all-public arbitration panel.  The amended rule will apply to all customer cases in which a list of potential arbitrators has not yet been sent to the parties.

According to Mr. Frank Ketchum, FINRA Chairman and Chief Executive Officer, “this change will give investors an additional choice in selecting their arbitrators when they file claims. We believe that giving investors the ability to have an all-public panel will increase public confidence in the fairness of our dispute resolution process.”

FINRA sought the rule change shortly after the arbitration results were tabulated for 2007, which was the worst year for investors that had their disputes decided by arbitration over the last six years.  Securities firms prevailed in their cases nearly 60% of the time in 2007.  Coincidentally, during the pilot program that soon ensued, customers chose all public panels nearly 60% of the time.

There are over five thousand arbitration cases filed every year.  Yet, the pilot program to effect this rule change included the participation of only fourteen member firms, which is less than half-a-percent of the firms involved in an arbitration in any given year.

In the subsequent years, investors increasingly prevailed.  In 2009, customers won almost 45% of their cases, and in 2010 the odds of a customer winning an arbitration case was just shy of 50%.  FINRA was still concerned about perceptions, and claimed that “investors regularly accepted a non-public (industry) arbitrator, but the ability to have an all-public panel will increase public
confidence in the fairness of our dispute resolution process.”

Securities arbitration has a long history in the United States.  Disputes between member firms, and between member firms and registered persons, must be decided through arbitration.

Grievances between member firms and customers can be resolved through arbitration as long as both parties use a pre-dispute
arbitration agreement where both sides voluntarily agree to arbitrate any dispute before any dispute actually arises.   The use and validity of Pre-dispute Arbitration Agreements was upheld by the United States Supreme Court in Shearson v. MacMahon, 482 U.S. 220 (1987).

Arbitration is a preferred method for dispute resolution because it is typically faster, simpler and less expensive than litigation, most certainly for the claimants.  Since almost all customer cases are handled on a contingency basis, the customer usually pays nothing until their case is decided.

The downside to arbitration is that you only get one shot at having your case heard.  Since arbitration is binding, the grounds for
vacating an award are extremely few, therefore, virtually all awards rendered are final, and cannot be appealed.

The vast majority of customer initiated disputes against member firms involve only a few allegations.  These allegations are suitability, excessive transactions, excessive commissions, negligence, and failures to supervise.

While the allegations are the same, customers historically make these allegations only when there is a monetary loss.  In falling markets, arbitration cases soar, in rising markets they diminish.  It becomes even more important during times of increasing arbitration cases that panels be as knowledgeable and  informed as possible.

Arbitration is a forum of equity not a court of law.  In recognition of this, the perception of equity is equally important as is the actuality of equity.  That is why there have historically been two public arbitrators instead of two industry arbitrators on three member arbitration panels.

Security arbitrations often involve complex issues that an industry panelist can shed light on and explain to the public members of the panel.  Without this important input, the process, let alone the perception of the process can be critically flawed.

While it is still extremely early to  determine the outcome of this amendment on all of the parties involved, member firms, and customers alike, should be extremely wary of the change.  Arbitration cases that are not adequately heard and understood by panels will have an adverse effect on all participants involved.

Member firms have never had equal representation on arbitration panels. To deny them of any representation at all has at least the perception of defeating any chance of equity for them.  Since arbitration is a voluntary process, firms may want to consider litigation in lieu of arbitration until the perception of equity is restored for them.

Anyone that has been in the securities business for any length of time learns two essential elements very early in their career.  These two elements go hand-in-hand in building a successful foundation to support all sales efforts directed toward customers.

First, a registered representative needs to “know” their customer. Second, all transactions that a registered representative recommends to a customer must be suitable for them.

These concepts have been generally understood to be critical for ensuring your customers’ financial interests are protected, the customers are treated fairly by the security professionals they are relying on, and the highest standard of ethical treatment is in place.  While these two provisions have been required for some time now, recently FINRA has put in place additional definitions and requirements to better identify responsibilities and strengthen the present rules.

The new provisions are effective on October 7, 2011, and it is extremely important that registered individuals and brokerage houses become familiar with the new rules.  These enhanced rules will require changes in procedures for dealing with customers, documenting changes to meet the additional information needed, and more recordkeeping of documentation evidencing compliance with the new rules.

The first element is a requirement that brokers “know” their customers.  Now FINRA is not suggesting that brokers “know” their customers in a biblical sense.  Instead, firms and registered representatives must use “reasonable diligence” and attempt to know the “essential facts” affecting each and every customer.

Reasonable diligence means that one must demonstrate that they have made a professional attempt to gather the information.  In other words, if clients do not make information available, or thwart the information gathering attempt, Herculean efforts to otherwise get the information do not need to be made.

Essential facts are “those required to effectively service the account, act in accordance with any special handling of the account, understand the authority of each person acting on behalf of the customer, and comply with applicable laws, regulations and rules.  In other words, you must have enough information about your customer to both support and defend the recommendations that you make to them.

When do you need to “know” your customer?  A broker must know their customer at the very beginning of the relationship, and the requirement has to continue throughout the relationship.  It does not end after the account is opened.  Many things will change over time, and these factors need to be constantly updated if they will affect financial recommendations made to a customer.

A broker’s obligation to know their customer is independent of whether or not a broker makes a recommendation.  Firms and brokers need to demonstrate that they have enough information on hand regarding their customers to support any sales to them, even if they never make a sale.

The second element is suitability of recommendations.  Or, to paraphrase the FINRA suitability rule, “a firm or associated person is required to have a reasonable basis to believe that a recommended transaction or investment strategy involving a security, or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”  The customer’s investment profile “includes, but is not limited to the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information the customer may disclose to the member or associated person in connection with such recommendation.”

It is important to understand exactly what a recommendation is.  Specifically, a recommendation is any information communicated to a customer that could result in a triggering event happening, such as a purchase, or sale, of a security.  Like the requirement to “know” your customer even if a purchase or sale never occurs, with respect to suitability, it does not matter whether an actual triggering event ever occurs.  Even if a purchase or sale never happens, both firms and brokers must make sure that the recommendation itself is suitable.

The new rule requires that even more information be captured and documented concerning the customer.  In addition to financial situation, financial needs, tax status, other investments and investment objectives, other factors such as age investment experience, risk tolerance, time horizons and liquidity needs must be added.

But, that is not all as there is the ubiquitous “catch all” category, any other information the customer may disclose to the firm or associated person in regards to the recommendation.  As FINRA believes that each required information is essential for a determination of suitability, each firm and their associated persons must document their basis for not including, or capturing, a required piece of information.

The new suitability rule also reflects three main suitability obligations.  These are reasonable basis suitability, customer specific suitability and quantitative suitability.

Reasonable basis suitability basically means that a broker, after doing their homework concerning an investment vehicle, also known as “reasonable diligence” would have a reason to believe that the investment is suitable for at least some investors.  At the very least, in order to demonstrate reasonable basis, one should understand the particular risks and rewards associated with the recommended strategy or investment.

Customer specific suitability means that a broker must have enough information to insure that a specific recommendation is suitable for the specific customer based upon that customer’s investment profile.  Firms and brokers must, therefore, insure that they capture all of the required informational fields that now must be documented in order to demonstrate compliance with the rule.

Quantitative suitability or “more is not necessarily better” suitability, requires a broker to demonstrate that a series of recommended transactions is still suitable, even if an isolated transaction is appropriate.  If you have a number of transactions involving the same security, and the same customer, you need to show that the transactions in total are not excessive, and, therefore, unsuitable for the customer.

Clearly, the sales process is going to be more involved than ever before under the new rules.  While requirements can appear to be burdensome and a nuisance, the enhanced definitions and additional information needs should be viewed as marketing opportunities.  For the know your customer and suitability rules will give registered representatives ample chances to stay in close touch with their customers, and closer communications with customers invariably leads to increased sales.

Although a firm may receive an Arbitration Notice unexpectedly, without any advance warning or knowledge, this is rare.  In all likelihood, there is usually something that will indicate a customer’s dissatisfaction with their investment.  Typically a number of phone calls and complaint letters precede an Arbitration Action.  All too often, firms take inadequate steps to mitigate and, or resolve the situation, or they just simply choose to ignore things, and mistakenly hope that the problem will somehow disappear.

When the dollar amounts of the losses are large, as they typically are in the vast majority of cases, ignoring the problem will not make it go away.  The end result is the receipt of the Arbitration Claim.  One of the first things that need to occur is preparing an Answer to the Statement of Claim.

Before you respond to the claimant and FINRA Dispute Resolution, you must make sure that all required notifications pertaining to the arbitration are made to FINRA Regulation.  That means that Form U-4 amendments are created disclosing the matters.  It is important to note that even if a Registered Representative is not named as a claimant to the dispute, their Form U-4, or Form U-5 if they were terminated within the last twenty four (24) months, is updated to reflect the complaint or arbitration.

Depending on the nature of the dispute, the firm’s Form BD may need to be amended as well.  While most customer initiated disputes do not result in situations that require disclosure at the company level, management should always take the initiative and verify whether a Form BD amendment is needed or not.

Another area that must be considered is the notifications required pursuant to FINRA Rule 3070.  Rule 3070 requires that notifications pertaining to certain events, including complaints and arbitrations, be electronically transmitted to FINRA.  Many times, in the heat of the moment, the required regulatory notifications are made late or forgotten entirely, and this can result in fines and sanctions against the firm, in addition to any adverse awards rendered directly as a result of the actual arbitration.

Now that the housekeeping efforts have been completed, all required filings have been properly submitted to FINRA, and have been reviewed by designated principals and retained as part of the firm’s records, it is time to move on to answering the claimant’s Statement of Claim.  The Statement of Answer is a required response, but when creating it you should never lose sight of your intended audience.  That audience is the Arbitration Panel.

Arbitration Panels can be composed of one panel member, or three panelists.  Usually the monetary losses realized by a customer that initiate the dispute are large enough to warrant that the matter will be heard by a three- member panel.  When a dispute involves a customer and a FINRA member, the three-member panel will be comprised of two non-industry panelists and one industry panelist.

Invariably one will hire an attorney to represent them for the arbitration.  Unlike a court of law, however, where you must have legal counsel, unless the court action involves a small claim, you do not need an attorney to represent you in an arbitration hearing.  You can be a “pro se” respondent, and answer on your own behalf. In most cases this is not recommended, but in some instances it can be an effective strategy as arbitration panels usually will give more leeway to a pro se respondent than to an attorney.

As the arbitration process is a forum of equity, and not a court of law, all documents, representations, verbal and written communications, in other words everything you present on your behalf should be directed to that fact.  You should do away with presenting endless citations of case law, legal precedents and legalese.  Instead, all information should be presented in plain easy to understand English.

Another mistake is made in the amount of documents presented and the amount of time estimated to present the case.  Many times numerous voluminous binders are compiled that panelists must repeatedly juggle as they refer to various papers during the course of the hearing.  Often, there is a veritable overkill of information presented.  Although one or the other side will object to documents or testimony given as evidence, due to the nature of the arbitration process almost everything presented will be accepted by the panel, and they will give evidence the “weight that it merits.”  Burdening arbitration panels with too much unneeded information can be worse than not giving them enough.

Many cases can be decided in two-thirds to half-the-time they are given.  All too often, the parties will schedule four or five day hearings.  The vast majority of customer claims allege the same infractions, such as unsuitable transactions, unauthorized trading, churning and failures to supervise.  If the claim has merit, or if the defense of the claim is valid, it typically becomes apparent to arbitration panels early on in the process.  The best approach to an effective presentation to an arbitration panel is to follow the kiss principal and “keep it simple and straightforward.”

We are visual creatures.  A much more effective use of cornerstone evidence is to display it in front of a panel at all times rather than have it buried within a binder.  By cornerstone evidence we are talking about such things as New Account Forms, Disclosure Letters, Speculative Trading Authorizations, etc.  To the extent that will bolster the case, use them largely.  Largely means just that, have the documents maximized to three foot by five foot displays.  And, let them sit in the hearing room for the entire length of the arbitration.  Refer to them often when making your case, or defending against allegations.

The effect on panels can be dramatic.  Since the displays will be ever present, they can do work for you even when you are not talking.  If the client established risk tolerances and time horizons that coincide with the investments in dispute, or if we have documents, or letters that bolster your side of the disagreement, it makes sense to let the panelists see that information in a large format.

Panelists, unlike juries, will begin talking about the case amongst themselves at the first opportunity to do so.  How effective one is in establishing the strength of your position early on often means the difference between success and failure.  Due to the binding non-appealable nature of arbitration, giving written reason explaining the basis behind an award is discouraged, and rare to see.  Awards can be paid out over time, but have to be booked in their entirety on a Broker/Dealers financial statements.  The unknown aspect, the binding nature of the award, and the immediate requirement to record the whole amount of the award makes it even more important to establish the strongest position you can as quickly as you can.

Due to these conditions of arbitration, another option to consider is litigation.  Litigation is more costly for firms, but it is also more costly for claimants.  While most arbitrations are handled on a contingent basis by claimant’s counsel, litigations typically are not.  Lastly, litigation is appealable so that you can effectively get more than one day “in court” if you do not initially prevail.  Claimants that jump at the chance to arbitrate may think twice if they have to litigate.

By the time a dispute escalates into an arbitration hearing, it is apparent that neither side has “clean hands”.  If they did, the matter would have been settled long before the hearing.  When questioned, both parties will conveniently suffer from SLOM Syndrome, or Selective Loss Of Memory.  But, the fact will remain that both sides are remiss.  The best chance of prevailing goes to the party that can establish a more credible position sooner than the other side does.   The key to succeeding in arbitration is simple.  Convince the panel that your position is right using clear, easy to understand evidence is all one needs to do.

As the poet Robert Burns so aptly put it, “the best laid plans of mice and men often go astray.”  Despite our good intentions, what we attempt to do does not always materialize.  Depending on the ultimate outcome of events, our failings may leave us with unforgiving results.

When these events involve brokerage customers and the loss of their monies, often security arbitration is the end result.  Since arbitration awards are binding, final and non-appealable, securities arbitration can certainly be considered to be an unforgiving process.

In prior newsletters, we have written extensively about the importance of keeping good records, of communicating effectively with customers and how to best handle customer complaints.  Firms that have effective compliance programs, and adopt the proactive systems needed to successfully defend themselves, will minimize the probability that a customer dispute will escalate into arbitration.

When a complaint evolves into an arbitration claim, firms that have these same effective compliance measures in place will also minimize the chance that an adverse arbitration award will be rendered against them.  In other words, proactive compliance will allow firms and associated persons to prevail in the arbitration forum.

The best arbitration is the one that never happens.  If you can avoid the arbitration process, ninety-nine times out of a hundred it is best to do so.  Often people get caught up in the process once it begins and get ensnared by the “principle” trap.  They might think they should fight because their principles are infracted upon.  As most attorneys will tell you, “principle” is the most expensive word in the English language.

If there is a way to resolve the dispute prior to arbitration, it is highly recommended that a resolution occur.  If the matter can be settled amicably, it is often far less costly to do so.  Unresolved disputes, as part of the arbitration process, can be directed to concurrent mediation, so that formal resolution efforts can take place even as the arbitration works its way forward in the system.

Unlike customers, arbitration will involve hard dollar costs for a broker/dealer and any associated persons named in a dispute.  Firms will have to pay forum fees and hearing costs, and sometimes these costs are assessed even if the firm wins the case.  Attorney representation, while not required for an arbitration case, is highly recommended.  If you do not already know this, you will quickly find out once you find yourself named in an arbitration, that attorneys can be very expensive.

Most claimants (customers) on the other hand, do not have to pay upfront fees or expenses.  Claimants are generally represented on a contingency basis by their lawyers.  This means that they do not have to pay anything to their attorneys unless they prevail and receive a monetary award.

Numerous customer actions are arbitrated simply because claimants lost money due to market conditions, and not because the recommendations were unsuitable, fraudulent, or the principals failed to supervise the registered representatives properly.  Unfortunately, all too often, firms do not have adequate resources or documentation in place to mount an adequate defense.

While arbitration on the surface may appear to be like litigation, or a court proceeding, there are huge differences in the process and philosophy of arbitration.  Both sides, claimants and respondents (broker/dealers and associated persons) are invariably represented by legal counsel.  There is a panel of arbitrators who effectively serve as judge and jury.  But, there the similarities end.

Arbitration is a forum for equity, and is not a court of law.  Many brokerage firms and their attorneys fail to note this.  The distinction between arbitration and litigation, which if not thoroughly understood, can end with disastrous results.  Legal counsel will often submit briefs which go into great detail citing case law.  Attorneys will raise repeated vehement objections during hearings as if they were posturing before a jury.  Many times neither side fully understands the nuances involved in the actual transaction that resulted in the hearing in the first place.

As a forum of equity, rules of evidence, and formal rules of the court do not apply.  While there is a discovery process involved in arbitration that is designed to uncover factual evidence, the strict rules of discovery that apply in court, do not apply to arbitrations.  Although there is an overall structure to the arbitration process, this structure is much less rigorous and controlled than a court proceeding.

If you are the unlucky recipient of a Notice of Hearing for an arbitration, take whatever steps you can to resolve it before the hearing.  When resolution is not possible, then become as knowledgeable about the process as you can, for knowledge is power.

The first step in the arbitration process involves filing the Statement of Claim.  The vast majority of customer’s Statement of Claims all cite the same infractions.  We call these infractions the three U’s.  That is the transactions were Unsuitable, Unauthorized, and Unsupervised.

When a customer makes these allegations they are basically saying that their broker sold them a security that was completely inappropriate for them.  Furthermore, the sale occurred without their knowledge and/or permission, and no one in management knew about the transaction.

Other allegations will often be made as well, such as negligence, fraud and breach of fiduciary responsibility.  Lack of fiduciary responsibility is a moot allegation since Broker/Dealers and their associated persons are legally not fiduciaries.  In any event, these other allegations are but window dressing as the cases will ultimately hinge on you successfully defending yourself against the three U’s.

The task at hand then is to prove all of these customer allegations to be wrong.  In order to do this one must first create a Statement of Answers and Defenses.  The Statement of Answers and Defenses must thoroughly discuss the claimant’s Claims and describe why they are groundless.  Proper account documentation and a good audit trail of the transactions are invaluable in building a credible defense.

One of the major faults with most Statements of Answers are they are written by attorneys for attorneys.  They tend to be quite long, address complicated legal theories and cite numerous case law findings.

The problem with this is that the ultimate readers will be members of the arbitration panel who are charged with hearing and deciding the case.  At least some of the panel, if not all of the panelists are not lawyers.

The best Statements of Answer are written in understandable English and are addressed to non-attorneys.  They will succinctly answer all of the allegations, and will not rely on a preponderance of legalese to do so.

After all of the initial paperwork has been created and distributed to the parties involved, the next step in the process will begin.  That is discussing the timetable for preparing and submitting evidence and scheduling dates for the hearing.

Our next newsletter will help you continue your knowledge base for arbitrations.  We will thoroughly discuss the entire hearing process and will elaborate upon panel selection, pre-hearing sessions and the hearing process itself.  Effective strategies for presenting a case will be reviewed, as well as alternatives to arbitration and the reasons why they should be considered.