Securities Lawyer Blog

The Financial Industry Regulatory Authority (FINRA) is going on the offensive to protect the investing public against email hacking attacks in which fraudulent transfers are being made. Issuing both a Regulatory Notice 12-05 and an Investor Alert that is aptly titled: Email Hack Attack? Be Sure to Notify Brokerage Firms and Other Financial Institutions, the agency has blanketed the subject due to what it says are increased reports of email and account invasion by hackers that are leading to investors' funds being stolen.

At first glance, the scenario is similar to other email scams, but these attacks differ in a significant way. In past instances, customers are sent emails asking for private information that is then used to fraudulently obtain information that allows outsiders to gain access to accounts.

As noted in the Regulatory Notice executive summary, the scheme has several steps that make it appear that the transfer requests are legitimate. But in fact the perpetrators have gained access to an investor's email and contact lists and that information is then used to instruct firms to make transfers into accounts controlled by third parties, not the investor. In some instances, these fraudulent "instructions" might include what are also fraudulent letters of authorization that attempt to pressure firms into releasing funds prior to a follow-up phone authorization.

The FINRA warning is intended to inform the public to avoid these circumstances by safeguarding assets. The Regulatory Notice is also intended to halt this trend by helping firms understand that allowing or accepting email instructions is fraught with risk. The hope is that firms will reassess their policies with regard to instructions, which should help protect against this fraudulent practice on the part of hackers.

Once an individual is aware of or suspects that email has been compromised, FINRA is asking that investors immediately inform their brokerage firms or financial institutions of this problem.

Referring generally to NASD Rule 3012 and NYSE Rule 401, RN12-05 reminds firms that they must establish, maintain and enforce written supervisory control policies and procedures that are reasonably designed to review and monitor the transmittal of funds or securities from customer accounts to third-party accounts. These requirements and their scope have been delineated in Regulatory Notice 09-64, which "highlighted a number of questions firms should consider in assessing the adequacy of their policies and procedures for verifying the validity of requests to withdraw or transfer customer funds."

This increase of fraudulent email activity serves as a reminder that firms should be vigilant in assessing and establishing policies and practices as to electronic communications with investors. Assessing the risks involved with the way in which investors are permitted to communicate instructions for the withdrawal or transfer of funds through electronic means, including verification and follow-up, are recommended.

The lawyers of Wall Street's Gusrae Kaplan Nusbaum PLLC are experienced advisors to firms and broker-dealers in all areas of compliance. Contact our law firm for more information on our wide range of services, including litigation and enforcement representation. We are a firm comprised of experienced former senior level regulators and securities and compliance litigators, providing advisory services to our clients in regulatory compliance.

The Securities Lawyer Blog has recently posted on rulemaking and regulatory enforcement matters that are related to conflicts of interest in several contexts. As we noted in discussing FINRA Regulatory Notice 10-54, Dodd-Frank and related SEC mandates are intended to address the underlying obligations of broker-dealers and investment advisers "to facilitate simple and clear disclosures of material conflicts by both broker-dealers and investment advisers."

Conflict of interest allegations can arise in various circumstances in the securities industry. Earlier this month, Citigroup Global Markets, Inc., settled conflict of interest allegations with the Financial Industry Regulatory Authority (FINRA) that arose in the context of research reports and research analyst's public appearances. The firm has agreed to pay $725,000 for the resolution of the allegations against it.

FINRA claimed that Citigroup did not disclose potential conflicts of interest that were relevant to business relationships that it maintained. At issue in the matter were research reports that the firm published from early 2007 through the first quarter of 2010. Part of the problem was alleged by FINRA to have been due to supervisory failures that otherwise might have caught the lack of required disclosures.

Additional allegations made by FINRA in this situation related to several issues. First, the firm did not disclose its management or co-management of public securities offerings; second, the firm did not disclose that it made a market in the securities of, and/or had a one percent or greater beneficial ownership in, covered companies from which it received revenues, and; third, the firm failed to disclose this in research reports.

Added to these allegations is the claim by FINRA that in public appearances, research analysts did not disclose potential conflicts when allegedly conflicted companies were discussed. According to FINRA's Executive Vice President and Chief of Enforcement, Brad Bennett, these alleged failures " 'prevented investors from being aware of potential biases in its research recommendations.' "

A major factor in the disclosure failures was stated by FINRA to be problematic databases that were used by the firm to manage and identify conflicts of interest. In this case, as in many others we have posted in the past, the databases were claimed to have been either inaccurate and/or incomplete. These database problems are alleged to have derived from what were deemed to be "technical deficiencies."

Wall Street's Gusrae Kaplan Nusbaum PLLC represents broker-dealers in regulatory and enforcement matters. We regularly advise clients and defend industry members before all regulatory entities in matters involving a broad spectrum of issues for broker-dealers and firms. These issues include maintaining adequate supervision and providing marketing materials that properly disclose potential conflicts of interest. Contact our law firm to consult with one of our attorneys and to learn more about our law practice.

In a continuing investigation, the Securities and Exchange Commission (SEC) announced earlier this month that it has charged three executives, along with their financial services firm, with allegations of fraudulent disclosure in an accounting scheme involving life settlements. The company, Life Partners Holdings, Inc., is based in Texas and is traded on the Nasdaq. The core business of this company is in the brokering of life settlements. In fact, the SEC notes that all the company's revenues derive from life settlements.

Perhaps a lesser-known business model for most of the investing public, life settlements involve the buying and selling of fractional interests in life insurance policies. Key to the offering of this investment is the insured's life expectancy, as well as the terms and conditions of the insurance policy.

In this matter, the SEC complaint alleges that three of the company's executives - the chairman and CEO, the president and general counsel and the chief financial officer -- " 'misled shareholders by failing to disclose a significant risk to Life Partners' business: the company was systematically and materially underestimating the life expectancy estimates it used to price transactions.' " These estimates are significant because if they are consistently inaccurate, the company's revenues and profits are likely to be adversely impacted.

The SEC also alleges that the company and its executives engaged in disclosure violations. They are also alleged to have engaged in improper accounting practices, which resulted in an overvaluing of the company's assets while also making it seem to the public that the company had healthy earnings from brokering these life settlement transactions. The company's misrepresentations and disclosure failures in its SEC public filings are alleged by the agency to have constituted a material risk to the company's revenues, which was detrimental to its shareholders and the investing public.

A major factor in this was the use of an allegedly unqualified individual to perform the actuarial work needed to estimate life expectancies, which were consistently shorter than they should have been. According to the complaint filed by the SEC, the shortened life expectancy valuations resulted in the use of material non-public information that generated revenues to the public's detriment. The person performing this function was not an experienced life expectancy underwriter and was told simply to use methodologies that had been established by a former underwriter that had worked for the company. The use of unqualified experts in a core valuation that is critical to a company's health, presents a risk to the investing public.

New York City's Gusrae Kaplan Nusbaum PLLC, represents firms and broker-dealers before all regulatory agencies. Please contact our law firm for a confidential consultation with one of our lawyers regarding representation and our litigation and advisory practice. Our highly-respected lawyers have decades of experience and expertise representing firms and broker-dealers.

Last week, we posted the first part of our summary of FINRA's year-end review of its efforts in various areas of enforcement. This week we bring you part two of that review.

One major area of focus this past year for FINRA has been its securities firm examination program. Several key reforms were made to "better detect potential fraud and to focus on areas of risk." To this end, FINRA conducted more than 3,050 examinations in 2011 and deployed the resources needed to accomplish these examinations. For example, matters that pose the most risk to investors are now designated as urgent, with resources allocated to expedite the review of these matters. One area in which this has been evident is in the staffing of district offices, which has increased to manage the push for greater real-time monitoring.

As noted in our last post, branch-level examinations are increasing, as are point-of-sale examinations. The shift this past year included greater time in the branch offices for FINRA staff -- another way in which resources were allocated in a different way than they have been in the past. This is borne out by the numbers, as FINRA reported an increase of 350 more branch office exams than in the past year. This is a significant increase that is likely continue into 2012.

Another major area of significant expansion for FINRA was in equity markets regulation. FINRA took over the primary surveillance of the NYSE's equity and options markets, and according to the agency its collection of data is now accounting for 80 percent of volume across the NASDAQ and NYSE.

New developments for 2012 include the creation of comprehensive cross-market surveillance patterns which will be evaluating trading activity across these markets simultaneously. According to FINRA, the "consolidation of market data for integration into new cross-market surveillance patterns will help FINRA identify problematic trading activity more quickly." The intention is to "detect improper conduct" as soon as possible and then take steps to stop it from continuing. In addition, the NYSE's Order Tracking System is essentially being replaced as FINRA has now expanded its tracking systems to meet its cross-markets surveillance responsibilities.

Arbitration panel composition was another area of change for FINRA, with nearly 4.400 arbitration matters filed last year. As we posted last year, FINRA's new arbitration rule made it possible for customers with three panel arbitrations to have those panels comprised of only public members. This was intended to support the public's confidence in the arbitration process.

Finally, FINRA notes that its Investor Education Foundation issued investor alerts on a number of topics. We have posted information about some of these alerts this past year, which are intended to educate the public on various issues, including potential scams and high-risk investments.

The New York firm of Gusrae Kaplan Nusbaum PLLC represents firms and broker-dealers in regulatory and enforcement matters. Our lawyers advise our industry member clients in matters involving a broad spectrum of issues before all regulatory entities. Contact our law firm to consult with one of our attorneys.