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Appeals Court Disregards FINRA Rule in CCO Case

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In a recent review of a disciplinary action charging a chief compliance officer (CCO) with committing “should have known” liability, the DC Circuit Court of Appeals, in a per curium opinion, ignored the FINRA rule that the CCO allegedly violated.

In this case, Thaddeus North had been found liable by FINRA for failing to comply with a FINRA rule that requires reporting to FINRA certain conduct within a specified number of days after the firm “knows or should have known” about the conduct.

The SEC affirmed FINRA’s decision, albeit applying different standards.

The DC Circuit ruled that the SEC’s decision was “supported by substantial evidence.” However, the Court failed to analyze what the FINRA rule meant when it used the phrase, “should have known.”

Instead, the DC Circuit simply noted that the “Commission found a series of ‘clear red flags’ that ‘should have led North to inquire’ about such a relationship, but he failed to do so.”

Unfortunately for firms and CCOs, inquiring about red flags is only part of the analysis to determine whether a firm or individual “should have known” about certain facts. In effect, the DC Circuit established a strict liability standard for failing to investigate red flags.

Case Against Thaddeus North

In July 2013, FINRA brought an enforcement action against a registered representative of a broker-dealer, the firm’s chief executive officer (the CEO), and North, who was the CCO.

The registered rep was charged with enabling a statutorily disqualified person (SDP) to operate as an unregistered person, and the CEO was charged with failing to supervise the registered rep’s relationship with the SDP.

FINRA charged North with, among other things, failing to report to FINRA the rep’s relationship with the SDP because North allegedly “should have known” about the relationship. After a hearing, FINRA found him liable and the SEC sustained FINRA’s finding.

‘Should Have Known Liability’

The DC Circuit ignored the language of the rule and the legal standards to be applied, possibly because the SEC also ignored the standard of care.

While the court affirmed the SEC’s decision that the red flags “should have led North to inquire,” it did not review (nor did the SEC) what North would have known had he inquired.

They apparently assumed that if North had followed up on the red flags and inquired about the relationship, he would have learned that an SDP was associated with the firm. But that is effectively a strict liability standard and contradictory to precedent.

The DC Circuit requires analyzing what “knowledge [the] inquiry would have produced.”

It is easy to see why. Sometimes following up on a red flag will yield information and sometimes it will not.

For example, suppose that the red flags were emails between the RR and the SDP with the subject “our secret deal” and that those emails discussed their secret relationship. If North had followed up and reviewed those red flag emails, then he would have learned about the relationship.

In that hypothetical, he “should have known” about their relationship. In contrast, the facts in this matter are substantially different. FINRA presented no evidence showing that if North had followed up, he would have learned anything sufficient for him to determine that he should notify FINRA about the issue.

Indeed, the Hearing Panel analyzed the facts and found that if North had investigated the relationship between the SDP’s business and the RR, he “likely would have learned” about the relationship.

“Likely would have learned” falls far short of “would have produced” knowledge. At most, FINRA established that North could possibly have learned about the relationship, and such a finding is insufficient to support a “should have known” charge.

The DC Circuit also ignored the specific standard of care for the rule that North allegedly violated. During the rulemaking process, a question arose about whether the “should have known standard” was “too demanding.”

In response, in the Notice of Filing for FINRA Rule 4530, the SEC stated, “[t]he purpose of the ‘should have known’ standard is to ensure that members do not intentionally avoid becoming aware of a reportable event.”

If the court or the SEC had analyzed this issue, they would have found that North did not intentionally avoid becoming aware of the underlying facts.

Rather, at the hearing, North contended that he did not view the relevant facts as red flags that needed to be followed up:

“I don’t think I would ever look at a company — if [the registered rep] hired a cleaning service, I wouldn’t look at the cleaning service and try to find out who owns it and who operates it and things like that,”  North said.

Consistent with that interpretation, the Hearing Panel noted that “there was nothing on the face of the [agreement] that struck [North] as illegal or immoral.” Moreover, there was no evidence to show that North was motivated to “look the other way.”

For example, there was no evidence that he received kickbacks from the RR or the SDP, or that he would have suffered repercussions from his firm had he become aware of the relationship.

Going Forward

The DC Circuit’s decision leaves open several questions that impact how FINRA will charge firms and CCOs in the future for “should have known” violations:

  • Will FINRA treat this issue as a strict liability offense?
  • Will FINRA analyze what knowledge would have been produced if red flags were reviewed?
  • Will FINRA review whether the respondent intentionally avoided becoming aware of a reportable event?

The bottom line for firms and CCOs is that if they are confronted with a red flag (or even a pink one), they may be found liable if they fail to follow up, regardless of precedent or the statutory basis for the charge.


Brian Rubin is partner and Adam Pollet is counsel at Eversheds Sutherland (US) LLP.