Anti-Money Laundering Compliance: Regulators Focus on Manipulation By Bruce M. Bettigole and Christopher W. Hammond Bruce M. Bettigole is a member of Sutherland s Litigation Practice Group. He represents clients involved in Financial Industry Regulatory Authority (FINRA), the U.S. Securities and Exchange Commission (SEC), Public Company Accounting Oversight Board (PCAOB), and the U.S. Department of Justice (DOJ) investigations and litigation, as well as in FINRA arbitrations and private securities class actions. Christopher W. Hammond is a member of Sutherland s Litigation Practice Group. In the wake of the Madoff and Stanford Financial scandals, increased scrutiny has been placed on the Securities and Exchange Commission (SEC) and its examination program. Though less in the public eye, one area that is likely to be a continuing priority for the SEC is anti-money laundering (AML) compliance. The SEC s Office of Compliance Inspections and Examinations (OCIE) has made AML one of its Top Ten examination priorities since 2002, 1 and recent regulatory pronouncements and AML enforcement actions by both the SEC and the Financial Industry Regulatory Authority (FINRA) reveal an expanding regulatory effort to enlist the industry in screening for securities manipulation and similar offenses. Firms should be careful to recognize this regulatory trend and consider adapting their AML procedures accordingly. Absence of Guidance on Detection of Market Manipulation in AML Regulation Anti-money laundering has traditionally been understood to be focused on the movement of funds that were illegally obtained, rather than on the underlying offenses that generated the illicit proceeds. Money laundering is broadly defined as engaging in a financial transaction, whether with cash, check, wire, securities, insurance instruments, insurance proceeds or other means, that involves property derived from or used for criminal activity. 2 The law covers most financial transactions and includes money derived from securities fraud. 3 There are three stages to money laundering. Placement, when money derived from illegal activities is fi rst introduced into the financial system; layering, when the money is transferred to conceal its origin; and integration, when the money is reintroduced into the economy in a way that makes it look legitimate. 4 The Bank Secrecy Act of 1970 (BSA) established the basic anti-money laundering requirements such as keeping records and filing reports on certain financial transactions. 5 In the wake of the September 11, 2001 terrorist attacks, in an effort to combat ter- 2009, Sutherland Asbill & Brennan LLP PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER 2009 9
rorist financing and money-laundering, the USA PATRIOT Act of 2001 amended the BSA and imposed a number of obligations on all brokerdealers, including: Establishing anti-money laundering compliance programs, including development of internal policies, procedures and controls, designating an AML compliance officer, establishing an ongoing employee training program, and establishing an independent audit function; Customer identification programs; Monitoring, detecting and fi ling reports of suspicious activity; Due diligence on foreign correspondent accounts; and Due diligence on private banking accounts. NASD (now FINRA) adopted Rule 3011 in the immediate aftermath of the PATRIOT Act, incorporating these requirements in FINRA s own rules. The New York Stock Exchange adopted a parallel rule, Rule 445. FINRA was active in educating broker-dealers regarding their responsibilities, creating a Small Firm Template to assist firms in drafting their new AML procedures and issuing Notice to Members (NTM) 02-21, which provided a long list of potential red flags of suspicious activity. But the Small Firm Template did not contain any proposed procedures specifying reviews to detect market manipulation, and only one of the 25 red flags in NTM 02-21 appeared to reference market manipulation: the customer, for no apparent reason or in conjunction with other red flags, engages in transactions involving certain types of securities, such as penny stocks, Regulation S (Reg S) stocks, and bearer bonds, which although legitimate, have been used in connection with fraudulent schemes and money laundering activity. The Suspicious Activity Report (SAR) form for the securities industry, SAR-SF, was created in 2002. Like the SAR form that preceded it, the SAR-SF provides 20 checkboxes for different types of suspicious activity, including mail fraud, wire fraud, securities fraud, check fraud, market manipulation, money laundering/structuring/significant wire or other transactions without economic purpose, and wash or other fictitious trading. The checkboxes, however, overlap considerably, as every securities fraud is also wire and mail fraud if the telephones and mail are utilized, and securities fraud, market manipulation, and wash or fictitious trading are often overlapping descriptions of the same illegal activity. There is nothing in the SAR-SF form to indicate that separate procedures are necessary to detect suspicious activity for each checkbox, so the existence of a checkbox for market manipulation provided no guidance that regulators expected firms to affirmatively seek to detect such activity, as opposed to just reporting it if it was observed. Nor was there any other form of regulatory guidance as to how fi rms might detect market manipulation or other fraudulent securities transactions. It was generally understood that each broker-dealer only had access to its own customers trading data and thus could not be expected to detect manipulations that customers engaged in through accounts at multiple firms. Recent Emphasis on AML Detection of Market Manipulation Recently, however, there have been a series of regulatory pronouncements and enforcement actions that have clearly demonstrated SEC and FINRA expectations that firms will actively monitor for market manipulation, despite any limitations on their ability to see the entire market. This represents a signifi cant trend in SEC and FINRA enforcement the use of AML obligations to force fi rms to assist the regulators in detecting stock manipulation and other suspicious trading that might otherwise elude the regulators themselves. This trend, though understandably desirable from the regulators perspective, appears to impose obligations not clearly provided for in the AML rules themselves, at potentially great cost to member firms. Firms should be aware that this is an area of increasing attention by regulators and consider adopting procedures that demonstrate efforts to identify and report manipulative trading patterns, such as matched or wash trades or marking the close in thinly traded stocks. Enforcement Actions In June 2009, FINRA fined three broker-dealers for failing to implement reasonable AML compliance programs. The deficiencies included failing to detect, investigate and report potentially suspicious transactions in low-priced stocks. 6 J.P. Turner & Co. 10 SEPTEMBER OCTOBER 2009 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY
was fined $525,000; Park Financial Group, Inc., was fined $400,000; and Legent Clearing, LLC, was fined $350,000. Legent Clearing, LLC FINRA accused Legent Clearing, LLC (Legent) of implementing an AML program that was not reasonably designed to achieve and monitor compliance with the BSA. The program did not adequately consider that some of its introducing firms were conducting high risk AML activities, such as penny-stock liquidations. Legent also did not provide adequate resources to its AML program during a period in which the company experienced rapid growth. The Letter of Acceptance, Waiver and Consent detailed many of the alleged violations where Legent cleared penny-stock transactions that required further investigation, many of which also required a SAR filing. To the extent that Legent did investigate, such investigation was not documented. Legent failed to file a SAR relating to a suspicious transaction involving the stock of Solucorp Industries, Ltd. Solucorp stock was journaled among numerous accounts with no apparent relationship, one of which was held by a former Solucorp insider with a securities disciplinary history. Legent did not investigate the relationship between the accounts or the business purpose for the transactions. In October 2005, a former Solucorp insider, J.K., received 41,000 shares of Solucorp one day after Solucorp issued a press release regarding an agreement with a new manufacturer. This transaction should have been given heightened scrutiny, as J.K. had previously been identified as an executive who falsified press releases and financial statements. This, and other similar transactions, were red flags for which Legent should have filed a SAR. The red flags included: The customer engages in excessive journal entries between related accounts without any apparent business purpose, or, the customer, for no apparent reason or in conjunction with other red flags, engages in transactions involving certain types of securities, such as penny stocks. J.P. Turner & Co. FINRA accused J.P. Turner & Co. (JPT) of implementing defi cient AML procedures, failing to follow those procedures, and conducting inadequate AML tests. Due to the deficient AML procedures and implementation thereof, JPT failed to detect, investigate and/or report numerous red flags. The red flags included customers who maintained multiple accounts for no apparent reason; transactions where large blocks of low-priced stock of issuers with questionable operating and financial histories were transferred into accounts, and then sold and the proceeds wired from the accounts ; unexplained SEC s Office of Compliance Inspections and Examinations (OCIE) has made AML one of its Top Ten examination priorities since 2002 or questionable stock journals; indications of unregistered stock sales; indications of stock manipulation through the involvement of known stock promoters; and customers with securitiesrelated histories delivering and liquidating low-priced stocks. Park Financial Group, Inc. FINRA similarly accused Park Financial Group, Inc. (Park) of implementing AML policies and procedures that were not tailored to the firm s business activities. Park had previously been charged by the SEC with AML violations. FINRA found that the firm s AML program did not contain a provision regarding penny-stock activity even though many of the firm s customers traded penny stocks. Park also failed to adequately enforce its procedures by investigating and/or reporting red flags such as the trading in penny stocks by customers with histories of securities misconduct; customers who maintained multiple accounts for no apparent reason; numerous transactions in which large blocks of penny stocks were transferred into accounts at Park, sold, and the proceeds immediately wired from the account; indications of unregistered stock sales and possible manipulations with the involvement of known stock promoters; and customers with inflows of funds that were beyond their known resources. FINRA also noted that there were numerous instances where individuals or entities PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER 2009 11
who had been found liable for securities-related violations received from several hundred thousand to millions of shares of penny stock. Each time, the stock was immediately sold and the proceeds were wired out of the accounts. The 2007 SEC case alleged that Park Financial Group, Inc., and its president and owner, Gordon Cantley, aided and abetted a pump-and-dump scheme perpetrated by Spear & Jackson, Inc. Recently, there have been a series of regulatory pronouncements and enforcement actions that have clearly demonstrated SEC and FINRA expectations that firms will actively monitor for market manipulation, despite any limitations on their ability to see the entire market. Park executed approximately 100 trades in Spear securities, which generated more than $2 million in proceeds for three British Virgin Islands-based accounts. Those accounts also transferred large amounts of shares to a stock promoter (IMS) whom Park and Cantley knew was promoting Spears securities. The order alleged that Park executed all of these orders despite the following red flags: Park maintained very few foreign-based accounts; Spear s CEO provided the sell orders on behalf of the British Virgin Islands-based accounts despite the fact that the account documents did not provide him with trading authority; the British Virgin Island-based accounts traded only Spear securities, frequently on a daily basis and in unusually high volumes; and Park and Cantley were aware that IMS was actively promoting Spear securities and that Spear had made several large transfers of shares to IMS. According to the SEC, these red flags necessitated the filing of SARs. Park was ordered to cease and desist from violations and was censured, ordered to disgorge $29,775.24 and fined $50,000. 7 Ferris, Baker, Watts In February 2009, the SEC sanctioned Ferris, Baker, Watts, Inc. (FBW) for failures involving a stock manipulation scheme engaged in by a registered representative of FBW. Information about the manipulative scheme was provided to senior executives at FBW in memorandums from a compliance officer recommending a SAR. FBW allegedly did not follow the recommendations of the compliance officer and chose not to file a SAR. 8 The SEC found a violation, despite the regulators frequent statements that they will not second-guess decisions made by firms that follow reasonable SAR procedures. 9 Recent Regulatory Pronouncements Regarding Market Manipulation The May 2009 SAR Activity Review, published by FinCen in close collaboration with the SEC and FINRA, 10 further demonstrates the increased regulatory attention to detection by AML programs of market manipulation and similar offenses. This detailed FinCen report, which was focused on the securities industry, set forth a number of common exam findings that relate to market manipulation: Substantial deposit, transfer or journal of very low-priced and thinly traded securities. Journaling of those shares between related and unrelated accounts. Systematic sale of those low-priced securities shortly after being deposited, transferred or journaled into the account. Multiple wire transfers out of the accounts usually to third parties and many times to offshore tax havens. Little to no other activity in the accounts other than the deposit of low-priced securities, liquidation of shares and the wiring out of funds. The SAR Activity Review also reported, as a common exam finding, the failure to obtain information regarding the source of stock certificates, the registration status of those shares, the length of time the customer has owned the shares, and whether the shares were freely tradable. All of these factors are typically associated with potential market manipulation. On March 9, 2009, FINRA issued a letter stating: FINRA examiners continue to focus on anti-money laundering (AML) requirements. Firms should ensure that their AML policies and procedures are appropriately tailored to 12 SEPTEMBER OCTOBER 2009 PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY
the fi rm s business model, risk profi le and volume of transactions, particularly with regard to monitoring, detecting and reporting suspicious activity. Procedures and systems that focus solely on money movements and do not address potentially suspicious activities related to securities transactions may not be appropriate. 11 This admonition appears to add emphasis to FINRA s recent enforcement activities regarding procedures for detecting potentially improper trading. 12 In a January 2009 Notice, FINRA noted that recent investigations revealed instances where firms failed to recognize red flags that signaled the possibility of an illegal, unregistered distribution. 13 Again, this Notice appears to be geared toward detection of market manipulations and other penny stock frauds. Recommendations The recent regulatory pronouncements and enforcement cases demonstrate that SEC and FINRA examiners will continue to scrutinize AML programs for procedures to detect and report market manipulation, as well as effective implementation of those procedures. Specific emphasis has been placed on the sale of penny stocks and firms with customers who have a securities-related disciplinary record. Regardless of any doubt as to whether a particular firm is able to effectively detect manipulations, or whether its client base would likely include those with regulatory histories, firms would be well advised to adopt and follow such procedures in their AML programs to demonstrate their awareness of the issues raised by the regulators, especially concerning the journaling of large amounts of thinly priced stocks into accounts and subsequent sales, and the documentation of decisions as to whether to file SARs. ENDNOTES 1 Lori Richards was the Director of the SEC s Office of Compliance Inspections and Examinations (OCIE) from the creation of OCIE in May 1995 until August 7, 2009. Ms. Richards set the priorities for SEC investigations over the past fourteen years, including a well established emphasis on anti-money laundering. OCIE Associate Director-Chief Counsel John Walsh is now serving as Acting Director, and is likely to continue OCIE s focus on AML. Walsh has been with the SEC for 20 years, and has been a member of OCIE s staff since its creation in 1995. 2 Sutherland, Overview of the USA Patriot Act and of Title III (Money Laundering Abatement), available at http://saber/files/28cb4d26-7763 -45d2-9e66-7ee323d7bc87/patriotfinancial4- pdf.pdf. 3 Estes, Sarah B., Securities Broker-Dealers and Money Laundering: The Obligations of Broker-Dealers Under Money Laundering Laws, Sutherland, available at http:// saber/files/5b6e5378-e04a-4a68-acd2- b07d843752e7/secpatriot.pdf. 4 Id. 5 Securities and Exchange Commission, Anti- Money Laundering (AML) Source Tool for Broker-Dealers, available at http://www.sec.gov/ about/offices/ocie/amlsourcetool.htm#1. 6 Press Release, FINRA, FINRA Fines Three Firms Over $1.25 Million for Failing to Detect, Investigate and Report Suspicious Transactions in Penny Stocks, June 4, 2009, available at http://www. finra.org/newsroom/newsreleases/2009/ P118831. 7 In the Matter of Park Financial Group, Inc. and Gordon C. Cantley, Securities and Exchange Act Release No. 55614, April 11, 2007, available at http://www.sec.gov/litigation/ admin/2007/34-55614.pdf. 8 In the Matter of Ferris, Baker, Watts, Inc., Securities and Exchange Act Release No. 59372, February 10, 2009, available at http://www. sec.gov/litigation/admin/2009/34-59372. pdf. 9 See, e.g., FinCEN, The SAR Activity Review, Trends Tips & Issues, May 2009, available at http://www.fincen.gov/news_room/rp/ sar_tti.html. [E]xaminers will accept a firm s decision not to file a SAR-SF as long as the firm demonstrates that it had reasonable, risk-based controls and a reasonable decision-making process, and the examiners must find that the firm s decision not to file a particular SAR-SF was reasonable under the facts and circumstances. Id. at 23. 10 Id. 11 Letter from FINRA to Executive Representatives, March 9, 2009, available at http://www. finra.org/web/groups/industry/@ip/@reg/@ guide/documents/industry/p118113.pdf. 12 See Press Release, FINRA, E*Trade Units Fined $1 Million for Inadequate Anti-Money Laundering Program, January 2, 2009, available at http://www.finra.org/newsroom/ newsreleases/2009/p117667. 13 FINRA Regulatory Notice 09-05, Unregistered Resales of Restricted Securities, January 2009, available at http://www.finra.org/industry/ Regulation/Notices/2009/P117713. This article is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc. This article may not be further re-published without permission from Wolters Kluwer Financial Services, Inc. For more information on this journal or to order a subscription to Practical Compliance and Risk Management for the Securities Industry, go to onlinestore.cch.com and search keywords practical compliance PRACTICAL COMPLIANCE & RISK MANAGEMENT FOR THE SECURITIES INDUSTRY SEPTEMBER OCTOBER 2009 13