SEC Vacates $1.6 Million In FINRA Fines Against Broker-Dealer And Officers
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  • SEC Vacates $1.6 Million In FINRA Fines Against Broker-Dealer And Officers

    On September 17, 2021, the Securities and Exchange Commission (“SEC”) vacated $1.6 million in fines and penalties that the Financial Industry Regulatory Authority (“FINRA”) had previously levied against Scottsdale Capital Advisors Corp. (“Firm”) and three of its officers (“Applicants,” collectively).  In 2015, FINRA alleged that the Firm failed to maintain appropriate internal controls and executed sales of unregistered microcap securities for its foreign financial institution customers.  The next year, following a disciplinary hearing, FINRA imposed a $1.5 million fine on the Firm, a lifetime bar on one of the Firm’s officers, and a $50,000 fine and a two-year suspension on the two remaining Firm officers.  In reviewing FINRA’s findings on appeal by the Applicants, the SEC overturned the sanctions after determining that FINRA’s National Adjudicatory Council (“NAC”) applied incorrect legal standards, failed to adequately explain the basis of its conclusions, and conflated applicable regulations in its case against the Firm.

    The Firm is a registered broker-dealer whose main business is the deposit and liquidation of microcap securities, which involves companies with low capitalization and which the SEC has previously noted “present a risk of abuse.”  On May 15, 2015, FINRA brought a complaint against Firm alleging three causes of action:  First, FINRA alleged that the Firm and one of its officers (“Officer A”) violated FINRA Rule 2010, which requires members to observe “high standards of commercial honor and just and equitable principles of trade.”  FINRA alleged that Rule 2010 was violated because Scottsdale participated in the sale of unregistered and unexempted securities in contravention of Section 5 of the Securities Act, and that Officer A was “a necessary participant and substantial factor” in the sales of those securities.  Second, the complaint alleged that the Firm and a separate Officer (“Officer B”) violated NASD Rule 3010 (which requires member firms to establish supervisory compliance systems) and FINRA Rule 2010 by failing to establish and maintain a supervisory system reasonably designed to achieve compliance with Section 5 for sales of microcap stocks.  Third, the complaint alleged that the Firm and another officer (“Officer C”) violated NASD Rule 3010 and FINRA Rule 2010 by failing to conduct reasonable inquiries into the sales of the securities which allegedly violated Section 5.

    Following a 12-day hearing, a FINRA Hearing Panel found that the Applicants engaged in the violations alleged in the complaint and fined the Firm $1.5 million, barred Officer A from associating with any FINRA member firm, and fined Officers B and C each $50,000 while also imposing upon each a two-year suspension.  The Applicants appealed the Hearing Panel’s decision to FINRA’s NAC, which affirmed most of the Hearing Panel’s findings.  However, with respect to Officer A, the NAC departed from the Hearing Panel’s theory of liability, which, as explained above, was originally premised on Officer A having been “a necessary participant and substantial factor” to the Firm’s sale of allegedly unregistered and unexempted securities.  Instead, the NAC reasoned that Officer A had violated Rule 2010 because his conduct “was unethical, regardless of whether [Officer A] was a necessary participant and substantial factor[.]”

    The Applicants appealed to the SEC, which conducted an independent review of the record using a preponderance of the evidence standard in accordance with Section 19(d)(2) of the Exchange Act, which permits the SEC to review FINRA’s findings.  See also 17 CFR § 201.420.  With respect to the second and third causes of action, the SEC found that the record did not support FINRA’s findings of liability.  On the first cause of action, the SEC determined that FINRA’s finding of liability as to Officer A must be set aside because “the NAC’s theory of liability was fundamentally different than the one FINRA pursued throughout its proceedings.”  The SEC determined that the NAC’s alternate theory of liability deprived Officer A of a fair opportunity to defend himself, such as by building an appropriate factual record during the hearing.  The SEC additionally determined that FINRA’s finding of liability as to Scottsdale must be set aside because the NAC “failed to correctly state and apply the appropriate legal standards.”  According to the SEC, the NAC conflated two different sections of the Securities Act to require that Scottsdale conduct “a searching inquiry” under Securities Act Rule 144, which identifies when a person will be deemed not to be an “underwriter” for purposes of Section 4(a)(1), and therefore exempt from its requirements.  The SEC made clear that a “searching inquiry” was not relevant to the Rule 144 analysis, and the NAC’s failure to articulate and apply the appropriate legal standard rendered the SEC “unable to discern whether FINRA has discharged its obligation of establishing a violation for which it can impose sanctions.”  As a result, the SEC set aside FINRA’s findings without making any determination as to whether the Rule 144 exemption was satisfied.

    After vacating FINRA’s findings, the SEC declined to exercise its discretion to remand the case back to FINRA for further clarification, given the “significant flaws” they “identified in the application of legal standards and FINRA’s changing theories of liability in the case.”  Thus, the Applicants will not face further disciplinary proceedings by FINRA, and this action represents a rare example of the SEC overturning sanctions imposed by FINRA, including an industry bar, in exercising its oversight of the self-regulatory agency.