Third Time Is a Harm

A NASD proposal to require that reps with three or more formal complaints against them receive extra supervision from their firms elicited a hue and cry from major broker/dealers when it was first announced in late 2003. Both reps and their firms said the rule would be unfair because it's too easy for clients to lodge complaints and too difficult for reps to expunge baseless charges. Currently, the

A NASD proposal to require that reps with three or more formal complaints against them receive extra supervision from their firms elicited a hue and cry from major broker/dealers when it was first announced in late 2003.

Both reps and their firms said the rule would be unfair because it's too easy for clients to lodge complaints and too difficult for reps to expunge baseless charges. Currently, the proposed rule is lying dormant — some expect the SEC to eventually pass it, while others think it will sit for a while longer. But in an ironic twist, most major b/ds are already operating as if the rule were in place.

Just as the mere announcements of investigations into 529 plans and fee-based arrangements sent b/ds scurrying to root out problems before the regulators found them, firms now are stepping up their due diligence on recruits, shying away from those with multiple complaints. In addition, current employees with multiple complaints face rising insurance fees and closer scrutiny of trades and of client-related paperwork. It's all part of an effort to head off unwanted regulatory attention.

“It has developed as a matter of self-protection. A smart office is going to say, ‘We'll protect ourselves,’” says Aegis Frumento, an attorney with Duane Morris in New York. “Frankly, among major firms, if you have three strikes, you can't get a job.”

Firms tend not to comment on proposed regulations, but last year, Don Runkle, head of compliance for Raymond James Financial, said that at his firm, reps with two complaints most likely wouldn't be hired anyway — and even those with one complaint would be subject to a series of extensive reviews.

Richard Nummi, head of compliance for GunnAllen Financial, an independent b/d with 900 reps, says his firm won't hire those reps either, and that existing reps will be forced to pay for the increased compliance costs out of their pocket.

NASD officials initially were surprised at the pushback — in part because the measure would apply to a very small number of reps. Fewer than 3,000, or less than 0.5 percent of the nation's 650,000 registered reps, have three or more complaints against them in the NASD's Central Registration Depository.

However, the adoption of a formal rule raises an interesting issue: Could it have an effect on reps with fewer than three complaints? More specifically, might firms tread more carefully in their hiring of a rep with just one complaint? About 29,500 reps, or almost 5 percent, fall into that category.

In the wake of the great market bust of a few years back, the number of complaints against reps skyrocketed. Experts believe many of these complaints lack merit, so holding a lone black mark against a rep would now seem unjust.

“With anybody who lost money filing, the concept of having nothing on your U4 has gone by the boards,” says Anthony Paduano, a New York-based attorney who believes the proposed three-strikes rules will not go anywhere. (One area where the SEC has stepped up: offices with producing branch managers are subject to more supervision as of the end of January.)

Complicating matters further, the NASD recently made the process of expunging fraudulent complaints more difficult. In short, a single complaint is probably not a great indicator of whether or not a rep is an ethical advisor.

When discussing the proposed rule earlier this year, NASD general counsel Marc Menchel said, “I would have thought firms would have been glad to have some certainty around who they should look at in terms of heightened supervision.”

Some securities attorneys are concerned about codifying the number of complaints it takes for greater supervision to kick in. They think that by setting a line that must first be crossed, firms will be too lax in their supervision until that threshold is reached.

“It's always been the rule that supervision is something applied on a variable basis, based on numbers of red flags and rep profiling,” says attorney Steve Insel of Jeffer Mangels Butler & Marmaro in Los Angeles. “It can't hurt to have specific guidance, as long as it's not an excuse to replace a prudent evaluation of supervisory needs and risk management.”

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