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Related Attorneys: Alan Wolper and Martin Jaszczuk

Related Practice: Securities Litigation

Law360, New York (March 21, 2011) -- Around 10 years ago, when I was the director of the National Association of Securities Dealers' Atlanta District Office, I found myself the subject of a rather uncomplimentary article in a trade publication.

In short, the article complained that I had abused NASD’s powers under Rule 8210 because I had compelled a young registered rep from a New York boiler room (who had made the rather unfortunate decision to cold-call one of my examiners — in the NASD office — and then make any number of obvious and material misrepresentations) to travel to Atlanta to appear and provide sworn testimony as part of the examination.

I thought then, as I do now, that my decision was proper under the language of the rule, and certainly justified under the circumstances. Ironically, however, now that I am on the other side of the table, representing registered reps and broker-dealers who regularly receive lengthy and oftentimes redundant 8210 requests, it is evident that FINRA is having trouble coming to grips with the fact that 8210 does, indeed, have boundaries.

While examples of FINRA’s seemingly casual view of the scope of Rule 8210 are rampant, the problem is most often manifested in the following manner: Parent Company (Parent) has two subsidiaries: a broker-dealer FINRA member (Member), and an affiliate of Member (Affiliate) that is not subject to FINRA regulation and has nothing to do with Member’s business. It is indisputable that FINRA has the authority to inspect Member’s books and records. Arguably, and depending on the relationship between Parent and Member, FINRA may also have the authority to inspect Parent’s books and records.[1]

But what about Affiliate? Does FINRA have the authority, under Rule 8210, to inspect the records of a non-FINRA member that has no other relation to Member aside from also being a subsidiary of Parent? No — Rule 8210 does not extend to such nonmember companies beyond FINRA’s jurisdiction.

But, with increasing frequency, FINRA has sought to circumvent the limits of its 8210 jurisdiction, to obtain Affiliate’s records by requesting them through certain of Member’s associated persons. The way this works, since an 8210 letter sent directly to Affiliate can safely be ignored, FINRA sends Member a request for the identity of those individuals who are both registered with Member and also associated with Affiliate.

If their position with Affiliate is sufficiently important, say, an officer or part of the management team, FINRA follows up with an 8210 request directed to the individual, who, in theory, has the legal ability to compel Associate to produce the documents to FINRA — even though Associate is not subject to FINRA jurisdiction. And that is a problem, because Rule 8210 does not allow for such clever maneuvering.[2]

Current Limits of Rule 8210

Rule 8210, as written and interpreted by the U.S. Securities and Exchange Commission, does not provide FINRA with the authority to compel anyone other than a member firm or persons associated with a member firm to produce documents. Rule 8210, titled “Provision of Information and Testimony and Inspection and Copying of Books,” governs what materials FINRA may seek, and from whom. The rule provides as follows, in pertinent part:

"a) Authority of Adjudicator and FINRA Staff — For the purpose of an investigation, complaint, examination, or proceeding authorized by the FINRA bylaws or rules, an adjudicator or FINRA staff shall have the right to:

"1) require a member, person associated with a member, or person subject to FINRA’s jurisdiction to provide information orally, in writing or electronically … and to testify at a location specified by FINRA staff, under oath or affirmation … with respect to any matter involved in the investigation, complaint, examination, or proceeding; and
2) inspect and copy the books, records and accounts of such member or person with respect to any matter involved in the investigation, complaint, examination, or proceeding ...

"(c) Requirement to Comply — No member or person shall fail to provide information or testimony or to permit an inspection and copying of books, records, or accounts pursuant to this rule."

The operative words of Section (a)(2), as highlighted above, which FINRA chooses to disregard, are “of such member or person.” More than simply implying a limit to FINRA’s jurisdiction, these terms indicate that FINRA is entitled only to request Member’s — or its associated person’s — documents, but not Affiliate’s documents, even if the associated person happens to be Affiliate’s president.

FINRA has attempted to go beyond this limit, however, and has even employed its most severe sanction (a permanent bar) in furtherance of that objective.[3] Fortunately, the SEC has pushed back.

In In re Jay Alan Ochanpaugh, Securities Exchange Act Release No. 54363 (Aug. 25, 2006), the SEC heard an appeal of an NASD enforcement action resulting in a bar where NASD had requested that respondent, Ochanpaugh, produce copies of checks drawn on the account of a church with which Ochanpaugh was associated.

Although Ochanpaugh was the president of the church, he had refused NASD’s demands to turn over the documents, arguing that the church was not a member firm. NASD, however, took the position that the checks were within the scope of its Rule 8210 request because the church was Ochanpaugh’s alter ego, and therefore the checks were within his possession and control.

As a result, based on his refusal to turn over the documents, NASD brought an enforcement complaint against Ochanpaugh and, following a hearing, barred him from associating with any NASD member in any capacity.

Ochanpaugh appealed the result to the SEC. In considering NASD’s document request, the SEC stated that “the scope of Rule 8210, while necessarily broad, does have limits.” The SEC held that NASD was wrong in requiring an associated person of a member firm to provide records of a nonmember religious organization, and set aside the bar.

The SEC further explained that NASD cited no authority for its argument that Ochanpaugh was required to turn over the documents of a nonmember firm simply because he happened to have possession and control over them. Moreover, while declining to delineate the boundaries of Rule 8210 as currently written, the SEC held that even under FINRA’s proposed possession, custody or control test, the documents still would not have been within the scope of the rule. The SEC also directed NASD to undertake an analysis of the proper scope of Rule 8210.

Accordingly, the SEC case law already in existence amply demonstrates that FINRA exceeds the limits of its Rule 8210 authority when it seeks Affiliate’s records through a request made to an individual who happens simultaneously to be associated with both Member and Affiliate.[4] But there is more evidence leading to the same conclusion — FINRA’s recent request to amend Rule 8210.

Proposed Changes to Rule 8210

In November 2007, FINRA fined the Stanford Group Co. $10,000 for distributing marketing material that “failed to present fair and balanced treatment” of the risks associated with certain products it offered to customers. Just over a year later, the SEC filed a complaint against Stanford in U.S. District Court in Dallas, alleging that the company had perpetuated a massive, $8 billion fraud — based on the same allegations that warranted a mere $10,000 fine from FINRA.

Needless to say, the failure of FINRA to perceive and appropriately address such a massive fraud, particularly when coupled with similar issues relating to FINRA’s failure to uncover Bernie Madoff’s even bigger scheme, raised questions about the efficacy of FINRA’s examination process.

In an effort to answer those questions, on April 13, 2009, FINRA’s board of governors established a Special Review Committee “to review FINRA’s examination program, with particular emphasis on the examinations of” Stanford and Madoff.

In September 2009, the Special Review Committee issued its report, and recommended, among other things, that
FINRA should also amend its bylaws or rules to enable it to obtain information from or investigate affiliates of member firms to enforce such firms’ compliance with the Exchange Act and FINRA rules.

This authority is particularly important to enable FINRA to pursue enforcement actions against member firms or registered persons when it believes there is evidence of fraud or potential serious harm to investors. This recommendation will require SEC approval to expand FINRA’s jurisdiction.[5]

Shortly thereafter, on Oct. 16, 2009, FINRA filed a proposal to amend Rule 8210.[6] Strangely, the proposed amendment does not echo the recommendation of the Special Review Committee. Instead, the proposal is more modest; it seeks merely to revise 8210(a)(2) to allow FINRA to “inspect and copy the books, records and accounts of such member or person with respect to any matter involved in the investigation, complaint, examination or proceeding that is in such member’s or person’s possession, custody or control."

No explanation is given for FINRA’s decision not to expressly seek to expand 8210 to affiliates of members, as the Special Review Committee recommended. Rather, as the SEC notice states, FINRA’s proposed language parallels the Federal Rules of Civil Procedure (FRCP) regarding document requests and subpoenas for documents.[7]

The language also mirrors FINRA’s argument in Ochanpaugh that the document request was proper under Rule 8210 because Ochanpaugh had control over the requested records.

As with any proposed rule change, the SEC invited comments. In this instance, various entities and individuals responded, some of whom voiced their concerns over what they saw as an improper expansion of FINRA’s authority into areas it was never intended to govern.[8]

Responding to these concerns, FINRA argued that the proposed rule change is not an attempt to expand the jurisdiction of FINRA, but merely a much-needed clarification.[9] Under FINRA’s interpretation of its investigatory powers, even though documents are technically third-party documents, if they are nevertheless within the possession, custody and control of a FINRA member or associated person and they relate to the pending investigation, they should be produced pursuant to Rule 8210.

According to FINRA, the additional language is, therefore, merely a clarification and explanation of FINRA’s existing powers and jurisdiction. Significantly, however, FINRA does not address the fact that simply because a document is within someone’s “possession, custody or control” does not necessarily also mean that the document is among the “books, records and accounts of [the] member or [associated] person,” as required by 8210(a)(2).

An inability by FINRA to satisfy the latter requirement would seem to render moot the question whether a document is, in fact, within the “possession, custody or control” of the recipient of an 8210 letter.

There are several other concerns with the language of the proposed rule change. The first, and most significant, is procedural. FINRA suggests that the amendment is benign, as the language of the proposed rule change essentially mirrors FRCP Rules 34 and 35.

The problem with this explanation, however, is that the FRCP affords parties to litigation certain procedural protections, including the ability to have a judge hear and resolve discovery disputes. If a party to a litigated matter feels that it has received objectionably broad document requests, it can seek the court’s intervention to prevent production.

FINRA’s Code of Procedure, by comparison, includes no similar process; the broker-dealer or registered rep who receives an objectionable 8210 request does not have the opportunity to have its argument heard by someone independent of the party requesting the documents.[10] Rather, the only means available to the recipient of an 8210 letter to challenge the request is to endure the enforcement process, and risk a permanent bar, in the case of an individual, or an expulsion, in the case of a member firm.

There are also confidentiality concerns raised by the proposed amendment. FINRA is not required to maintain the confidentiality of any documents that it receives pursuant to a Rule 8210 request. In fact, FINRA often cautions members that it may provide documents to other parties in response to subpoenas and will not endeavor to give notice to members whose documents have been sought by way of subpoena.

Accordingly, in our example, Affiliate’s confidential documents might very well become public if they are produced by Parent or Member and FINRA subsequently provides them to other parties pursuant to subpoena.

Conclusion

FINRA’s decision not to pursue the Special Review Committee’s recommended amendment to Rule 8210 is a telling indication of FINRA’s recognition that it lacks the ability to compel Affiliate to produce documents in response to an 8210 request. The plain language of Rule 8210(a)(2) simply does not grant FINRA the authority to obtain Affiliate’s documents, even from someone who works in a managerial role with Affiliate and is also an associated person of a broker-dealer.

Yet, because FINRA has the power to sanction members and registered reps who refuse to provide documents in response to 8210 requests, and because those sanctions are severe, the risk of these sanctions typically leaves members and their reps little choice but to capitulate and provide the requested documents.

Someday, a respondent will take the risk of challenging FINRA’s view of its 8210 powers by pursuing its rights under the enforcement process, and requiring FINRA to prove that, contrary to the rules, it can, indeed, obtain documents from entities that are not member firms.

Until then, we can expect that FINRA will continue to push the scope of Rule 8210 to limits that, while perhaps not to infinity, go well beyond what the drafters contemplated, or the board approved.

--By Alan M. Wolper and Martin W. Jaszczuk, Locke Lord Bissell & Liddell LLP

Alan Wolper and Martin Jaszczuk are partners in Locke Lord's Chicago office in the firm's securities practice. Wolper is a former director of NASD's Atlanta district office. Associate Nathan Lamb assisted in the preparation of this article.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] The most obvious example of a situation where FINRA can inspect the parent’s books is when the parent is listed on Schedule A of Form BD as a direct owner of the firm. Any direct owner of a broker-dealer is, by definition in FINRA’s bylaws, deemed to be an associated person for the purposes of Rule 8210. FINRA Bylaws, Article I(rr). Another example is when the parent, even if not a Schedule A direct owner, assumes responsibility for the payment of some or all of the member firm’s financial obligations, pursuant to an expense sharing arrangement. See FINRA Notice to Members 03-63.

[2] This is not the sole example of tricky maneuvering by FINRA. In one enforcement case handled by this office, we listed as one of our potential witnesses an individual who, strictly in the capacity of a paid consultant, not as a registered or even associated person, had provided some compliance advice to the respondent firm. Because that individual happened to be registered with a completely different broker-dealer, however, wholly unrelated to the respondent, FINRA sent him a request under 8210 to appear and provide sworn testimony about the advice he had rendered to the respondent. Efforts to dissuade FINRA from proceeding were unsuccessful.

[3] FINRA has recently amended the Sanction Guideline pertinent to Rule 8210 violations, increasing the high end of the range of possible fines for an “incomplete” response from $25,000 to $50,000. In addition, FINRA has indicated that if a respondent does not respond to an information request until after FINRA files a complaint, a bar is the “presumptive sanction.” Regulatory Notice 11-07.

[4] While there are other reported cases generally describing FINRA’s 8210 power over members and associated persons, In re Jay Alan Ochanpaugh appears to be the sole reported decision discussing FINRA’s 8210 power as it relates to affiliates.

[5] The Special Review Committee’s report is available at: http://www.finra.org/web/groups/corporate/@corp/documents/corporate/p120078.pdf.

[6] SEC Release No. 34-60836, File No. SR-FINRA-2009-060. Although the proposed rule change also addresses issues with regard to service of requests made pursuant to Rule 8210, this article discusses only those amendments that essentially broaden the scope of the rule.

[7] Recently, FINRA again appeared to recognize its inability to compel non-members to produce documents in Regulatory Notice 10-61, in which it proposed new Rule 4160, regarding independent verification of assets. In that Notice, FINRA urges members to enter into contracts with non-member institutions which hold customer assets that include provisions obligating them to cooperate with requests from FINRA examiners. Obviously, such contracts would not be necessary if FINRA could compel those institutions to produce documents under 8210.

[8] These comments are available at http://www.sec.gov/comments/sr-finra-2009-060/finra2009060.shtml.

[9] Letter from Stan Macel, Assistant General Counsel, Regulatory Policy and Oversight, submitted on Dec. 22, 2009, available at http://www.sec.gov/comments/sr-finra-2009-060/finra2009060-8.pdf.

[10] A point the SEC recognized and discussed in In re Jay Alan Ochanpaugh, Securities Exchange Act Release No. 54363 (Aug. 25, 2006).