The State of Indiana recently imposed a $450,000 civil penaltyagainst LPL Financial for failing to supervise the company’s financial advisors on a state-wide basis. The fine was based on two material deficiencies in LPL’s supervisory system. First, due to an alleged software glitch, LPL supervisors were not monitoring or supervising an undisclosed number of emails. There is an obligation for LPL to supervise all incoming and outgoing correspondence with firm clients. This obligation is rooted in FINRA Rule 3110(b)(4), which provides:
The supervisory procedures required by this paragraph (b) shall include procedures for the review of incoming and outgoing written (including electronic) correspondence and internal communications relating to the member’s investment banking or securities business. The supervisory procedures must be appropriate for the member’s business, size, structure, and customers. The supervisory procedures must require the member’s review of:
(A) incoming and outgoing written (including electronic) correspondence to properly identify and handle in accordance with firm procedures, customer complaints, instructions, funds and securities, and communications that are of a subject matter that require review under FINRA rules and federal securities laws.
(B) internal communications to properly identify those communications that are of a subject matter that require review under FINRA rules and federal securities laws.
Reviews of correspondence and internal communications must be conducted by a registered principal and must be evidenced in writing, either electronically or on paper.
By failing to have a system in place to adequately review email correspondence, LPL clearly operated in violation of FINRA Rule 3110.
The second material compliance gaffe identified by the State of Indiana involved LPL’s failure to perform required annual audits of the offices located in the state. This is a substantial problem endemic to the supervisory style of independent brokerage firms like LPL, which pride themselves on providing their financial advisors with freedom and independence to run their businesses as they see fit with as little interference from the mothership as possible. Although LPL can strive to provide this sort of freedom to its advisors, it is obligated, pursuant to FINRA Rule 3110(c)to at least annually perform an on-sight examination of all branch office locations that self-supervise and must audit each non-supervisory branch office at least once every three years. These rules also require the examinations to be documented. This examination process goes to the core of a brokerage firm’s supervisory responsibilities.
For years the SEC has instructed brokerage firms like LPL on best practices for branch examinations or audits. In March 2004, the SEC published Staff Bulletin No. 17. This bulletin highlighted numerous best practices, including the recommendation that these examinations be performed on a surprise-no-notice basis. Typically, firms like LPL will send their offices a notice which typically includes a pre-audit questionnaire and to-do list. If a financial advisor is up to no good and perhaps running an outside business or even a fraudulent scheme out of his office, receiving this notice is the difference between getting caught and not. Although firms are not required to perform these audits on an unauthorized basis, the SEC has fine firms substantially for not performing unannounced audits when it determined performing them would have been reasonable under the circumstances. See Fidelity Brokerage Services, LLC, Rel. No. 34-50138 (Aug. 3, 2004) (pre-announced inspections resulted in, among other things, employees altering and destroying documents; sanctions included a $1,000,000 fine payable to the SEC, plus a $1,000,000 fine payable to the NYSE). According to the State of Indiana, LPL failed to perform these required inspections on a statewide basis.
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