Firm’s Failure to Act on Numerous Compliance “Red Flags” Results in $250,000 Penalty and Censure by SEC

A recent settled SEC Order with Wedbush Securities, Inc., a dually-registered investment adviser and broker-dealer, has resulted in a censure and $250,000 fine against that firm. The genesis of this rather harsh result is what the SEC alleges to be the firm’s lack of an ability to follow-up on obvious compliance “red flags” that, in this case, pointed to an extensive and long-running “pump and dump” scheme involving one of the firm’s registered representatives. Indeed, as noted by Marc P. Berger, Director of the SEC’s New York Regional Office, “Wedbush abandoned important responsibilities to its customers by looking the other way in the face of mounting evidence of manipulative conduct.”

The SEC’s regulatory requirements compel broker-dealers to adopt policies and procedures that are sufficiently tailored to determine whether their associated persons are violating the securities laws and to prevent them from violating the securities laws. Broker-dealers are also compelled to ensure that these policies and procedures are sufficiently implemented to discover and prevent securities law violations.

The SEC’s Order alleges that from about 2008 to 2014, a now-barred former registered representative of Wedbush was a member of an elaborate pump and dump scheme involving penny stocks orchestrated by a now-convicted felon. As part of this scheme, the registered representative purchased certain stocks in her customers’ accounts or urged her customers to purchase the stocks, in exchange for compensation including shares and cash, which was not disclosed to her customers. She also participated in manipulative trading with the intent of increasing the price of certain securities and creating an inflated appearance of the volume traded.

The crux of the SEC’s Order alleges that Wedbush early-on became aware of certain aspects of the registered representative’s securities law violations, but that “its supervisory policies and implementation systems failed reasonably to guide staff on how to investigate the activity.” The SEC identifies several key “red flags” that the firm became aware of involving the registered representative’s conduct, but which it failed to act upon. Specifically, the registered representative’s supervisor reviewed an email from the registered representative to one of her customers detailing the customer’s involvement in inflating the price of penny stocks, most of which were held in Wedbush accounts. Notably, that email was escalated internally up to the president of Wedbush and was also reviewed by legal and compliance personnel. At about the same time, Wedbush and the registered representative were listed as respondents in two FINRA arbitration claims brought by customers of the representative. Both of the arbitration claims—which were passed along to legal/compliance staff as well as the president of Wedbush—revealed material aspects of the pump and dump scheme. Wedbush also received an inquiry from FINRA regarding trading in a specified penny stock by three Wedbush accounts that the registered representative and her husband held. Wedbush subsequently received a second FINRA inquiry requesting information about the allegations made in the afore-mentioned FINRA customer disputes.

Despite this wealth of warning signs, Wedbush’s response, as alleged by the SEC, was wholly inadequate. According to the SEC, Wedbush conducted two “flawed” investigations into this specific matter which notably failed to document or otherwise clarify the scope of either investigation. Furthermore, the SEC found a lack of process as to how the results of the investigations were to be documented or reported. As a result, no coherent response emerged vis-à-vis the specific red flags outlined above. As determined by the SEC, “Wedbush lacked reasonable procedures regarding the investigation and handling of red flags.” This lack of reasonable policies and procedures, therefore, resulted in Wedbush failing to supervise.

While the particular facts of this case involved misbehavior arising on the broker-dealer side of Wedbush’s business, the implications for all SEC-registered entities should be clear. That is, firms must have reasonably designed policies and procedures to act upon—and not just identify—these so-called red flags. While the red flags arising in various contexts and at different firms will be of an infinite variety, firms must be singular in purpose as to having well-thought and actionable procedures for dealing with them.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including compliance with federal and state laws and rules. Please visit our website for more information.

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