Gino Ercolino is a Director in Treliant’s Securities & Investment Management Compliance, Corporate & Regulatory Investigations, and Global Financial Crimes Compliance service areas. He has 25 years of experience as an attorney and financial regulator, serving in various leadership roles. Gino assists broker-dealers and registered investment advisors with satisfying their…
As a former enforcement attorney with the New York Stock Exchange (NYSE) and Director of Enforcement with the Financial Industry Regulatory Authority (FINRA), I have come to anticipate an uptick in investor complaints after a sharp market downturn or period of market volatility. However, the timing of these complaints, whether to a financial professional, securities firm, or regulator, can vary greatly during such periods. Understanding the risks that can lead to investor complaints, and recognizing the warning signs in relationships between investors and investment professionals, are essential first steps for your firm to be prepared. What you then do with this knowledge is critical to limiting the impact of investor complaints and possible regulatory intervention. Monitoring transactions, reviewing communications, performing testing in key areas, as well as ongoing education, will help your firm to stay ahead of the curve.
How Complaints Come to Light in Turbulent Times
Investor complaints do not always come to light immediately following a turbulent market. While some investors are quick to blame their broker or investment adviser for market woes, often it takes months before an investor’s concerns about the underlying investments in their account find their way to the financial institution or regulator.
In the current environment, we have seen months of volatility along with some market recovery. Now that investors and securities firms have had some time to take a closer look at investment performance (after dealing with all of the other personal and business disruptions of the past several months), firms and regulators can expect to see an uptick in investor complaints.
The timing for when an investor’s initial complaint or inquiry about the performance of their account might ultimately turn into an arbitration complaint or enforcement action varies based on a number of factors. Brokerage customers, for example, might initially inquire directly to their financial representative and no one else from the broker dealer’s local branch office, office of supervisory jurisdiction, or home office. In this instance, a series of back and forth verbal discussions with the financial professional may delay the customer from taking the next step in the complaint process.
Additionally, from the financial professional’s perspective, there may be a question as to whether the customer is “complaining” or just asking questions about the investments in their account. This subjective determination can further draw out the complaint process. Most firm’s written supervisory procedures, as well as regulatory rules, provide guidance on what investor actions or communications should be considered a “complaint” that requires further disclosure.
From an investigative standpoint, any substantive evidence available from communications between the investor and the financial representative will ultimately go a long way to determining the validity of the investor’s complaint and the representative’s responsibility in any alleged wrongdoing. Therefore, complaints initiated directly by the investor to the financial representative, while taking more time to develop, may help the firm, attorneys, and the regulators get a clearer understanding of the facts and make more informed culpability determinations.
What You Can Expect to Happen
I would venture to say that over the past couple of months, hundreds if not thousands of investors across the country have raised concerns directly to their financial representatives, verbally and in writing, about their account performance. Some of these inquiries will inevitably be escalated and result in formal complaints soon, particularly if the stock market continues to improve, but the investor’s account
performance does not.
In other instances, investors may reach out directly to the financial institution where their account is held to raise their concerns, or contact investor hotlines at regulators such as the Securities and Exchange Commission (SEC), FINRA, or state securities regulators. Upon learning facts about a potential investor complaint, the clock begins to run for firms to investigate and potentially disclose their conclusions.
For broker-dealers, FINRA Rule 4530 requires member firms to report certain specified events to FINRA, including internal firm conclusions of violations of various securities and investment-related laws and rules.1 These internal conclusions of violations may ultimately result in disclosures to regulators and spark regulatory investigations. Many of these disclosures originate from customer inquiries or increased or unusual activity in the customer account during volatile market conditions.
Under Rule 4530, member firms must “promptly” report their conclusions no more than 30 calendar days after the member “knows or should have known” of the existence of the disclosable events. Therefore, once a firm investigates a possible complaint and concludes the information must be disclosed under Rule 4530, disclosure to the regulator is ostensibly forthcoming.
In addition to the requirements of Rule 4530, brokers, investment adviser representatives, and their firms share a continuing obligation to update their Uniform Application for Securities Industry Registration or Transfer (Form U4) no later than 30 days after learning of facts and circumstances that prompt an update. Such events prompting an update include certain customer complaints and investment-related,
customer-initiated arbitration claims and civil litigation.2 Once this information gets to a regulator like FINRA, a preliminary investigation will usually begin in order to triage the facts and circumstances of the disclosure to determine if a more formal enforcement investigation should occur.
Often, at the same time the regulatory disclosure process is occurring, investors may have contacted a civil litigation attorney to determine what claims they might have against the firm or individual investment professional regarding the handling of their account or investments. Hiring an attorney might move the initial complaint process along faster than the time it takes for an investor to go at it alone. However, it still requires the customer to recognize a few things, prior to contacting an attorney, including:
- that market volatility has occurred;
- that his or her investments were negatively affected (or more greatly affected)
during the period of volatility;
- that any market recovery has not improved the investor’s position(s); and/or
- that there is some actionable causal link between their investment professional
and their investment woes.
Scenarios Where Misconduct May Be Revealed
As many regulators and compliance officers will tell you, just because an investor’s holdings perform poorly or react negatively to market volatility does not mean that their financial professional has violated a securities law or rule, or is liable for the losses. Suitable3 investments that are consistent with an investor’s objectives and risk tolerance can still go down in value regardless of volatility in the markets.4 However, periods of market volatility do often uncover:
- fraud or investment scams occurring in investor accounts;
- spikes in trading activity, sometimes to limit losses for investments that were questionable for a particular investor; and
- disputes about previous investment representations made to the customer.
Misrepresentation claims may stem from verbal representations or written marketing materials provided at the time of purchase about the risks associated with a particular investment. While there are various other scenarios that trigger investor complaints, these examples provide a glimpse as to why it can take time for the complaint process to develop.
Underlying account fraud, for instance, often comes to light when markets drop. A frequent example involves an investment professional who has been creating fictitious account statements for a customer that show a relatively steady increase in account value.5 However, when there is a precipitous market drop, the investments in the fictitious statements may not actually follow the market, prompting questions
from the investor and exposing the fraud. Similarly, during periods of volatility, some customers seek to liquidate investments in their accounts and move to a cash position. Here, customers often learn about the fraud when they request that their broker sell a particular security they believe was previously bought for their account.
In these scenarios, the customer inevitably learns, either from the investment professional or from some digging by the financial institution, that the security was never purchased in the first place and the account statements are a sham. Uncovering this fraud can take time for a few reasons. For one, the investment professional who is engaged in fraud may attempt to stall the sale suggesting that the time is not right to liquidate the security and that the investor should wait until the market recovers. Since this can be a valid reason to hold off on a particular sale, this fraud may take more time to ultimately reveal itself. Also, in the case of false account statements, it takes time, and often a change in market conditions, for a firm to identify and investigate the fraud and determine how the real statements were intercepted and recreated.
Another area that will trigger complaints and that is also a frequent byproduct of a volatile market involves brokers recommending securities products (either before or during a period of volatility) that may be inconsistent with the customer’s investment objectives and risk tolerance. This often occurs when a broker is feeling pressure, from the customer or otherwise, for the account to perform. Similarly, representations
allegedly made to the customer about the risks associated with an investment are often challenged after periods of volatility. This discussion (or claim) becomes less subjective if the representations were in writing. However, a misleading representation on mass distributed marketing materials regarding performance or risk can trigger a large number of investor complaints related to the product at issue.6
The challenge for both of these scenarios is determining whether the recommended investments were appropriate for that investor’s particular objectives and needs and simply fell victim to unfortunate market fluctuations, or if the representative’s conduct in recommending the investment(s) forms the basis for a viable customer complaint to the firm, a regulator, and/or for monetary damages. This analysis has become even more critical in the broker-dealer world now that Regulation Best Interest (Reg BI) is in effect and the standard for recommendations to retail customers is one of “best interests” instead of only general suitability.
Steps to Help You Stay Ahead of the Curve
While there are other ways in which a complaint may get raised to a regulator or reviewed by a civil litigation attorney, these methods provide a sense of the time it takes for a complaint to develop and ultimately turn into an investigation or litigation. What’s important for firms to understand is that any regulatory or civil litigation attorney investigating an investor complaint is going to look at the reasonableness of the firm’s systems and procedures and for possible supervisory missteps. Therefore, it is critical that firms stay ahead of the curve, particularly during periods of market volatility. This should include performing robust transaction monitoring focusing on the above-mentioned patterns of conduct and other risks that are relevant to the firm’s particular business model.
In an environment where surveillance teams are monitoring transactions remotely, firms must be vigilant to ensure that they have adequate resources and capabilities to timely and appropriately monitor transactions. Additionally, it is critical that systems that will trigger active account reviews and exception reports are properly tuned to identify relevant anomalous activity.
Further, a robust review of your investment professionals’ electronic communications will not only facilitate the prompt identification of problematic activity, but also help ensure that your firm is satisfying its regulatory obligations for performing a reasonable review of such communications. Also, conducting risk-based testing is critical to help your firm more promptly identify and address undisclosed procedural and supervisory deficiencies. Failure to do so will likely allow customer complaints to linger and expose the firm to greater responsibility. Testing will also help your firm prepare for its next sales practice examination, which, given the recent implementation of Reg BI, is likely to occur soon anyway. Showing that you are staying ahead of the curve will go a long way to help set the right tone with the regulators’ exam teams.
Lastly, providing additional training to compliance and supervisory staff on each of these areas, and reminding staff that communications between investors and representatives are often heightened during periods of market volatility, will help prepare firm personnel to identify potentially problematic activity at the earliest stage possible. Each of these steps will also help your firm prepare for, and possibly reduce
or assuage, the inevitable investor complaints still to come.
1 Additionally, firms must disclose written customer complaints of theft, misappropriation, or forgery, among other things. FINRA uses the information for a variety of regulatory purposes, including to initiate investigations of firms, offices, and associated persons.
2 See, Form U4 Question 14I, Customer Complaint/Arbitration/Civil Litigation Disclosure. When learning of a
“statutory disqualifying” event, the Form U4 must be updated within 10 days.
3 For retail broker-dealer customers, see, FINRA Rule 2111 (Suitability) May 1, 2014 – June 29, 2020. FINRA Rule 2111(a) requires, in relevant part, that a broker-dealer or associated person “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 [broker-dealer] or associated person to ascertain the customer’s investment profile.” A customer’s investment profile includes the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance, among other things.
4 With the implementation of Regulation Best Interest (Reg BI) on June 30, 2020, the standard for retail
customer recommendations has changed. Broker-dealers and their associated persons, when making a
recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer or associated person making the recommendation ahead of the interest of the retail customer.
5 Fictitious account statements might be created for a number of reasons, including outright fraud or theft of funds, attempts to hide account losses, to cover up a failure to purchase a particular security for a customer’s account as was requested, or a combination of these or other reasons.
6 For broker-dealer communications, see, FINRA Rule 2210, Communications with the Public.