Compliance July 7, 2023

FINRA Expels Brokerage Firm Monmouth for Violating Reg BI

Monmouth is the second firm to be expelled by FINRA for failing to supervise its representatives’ trading.

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Monmouth Capital Management LLC has been expelled by the Financial Industry Regulatory Authority for alleged churning and excessive trading of customer accounts; violating Regulation Best Interest; failing to supervise its representatives; and providing false and misleading disclosures on its client relationship summary, Form CRS.

“Monmouth abdicated its responsibility to reasonably supervise its representatives’ trading, resulting in substantial harm to customers, including Gold Star families,” Christopher Kelly, senior vice president and acting head of FINRA’s department of enforcement, said in a statement on Friday. “The egregiousness of the firm’s sales practice and supervisory violations necessitated expulsion of the firm from FINRA membership.”

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Reg BI was implemented by the Securities and Exchange Commission in 2019 to address key obligations of advisers when providing investment advice to clients. The SEC issued additional guidance in April, which included an FAQ document emphasizing that advisers must have a comprehensive understanding of recommended investments. Monmouth is the second firm expelled for allegations that include violations of Reg BI; Salomon Whitney Financial LLC was expelled in May.

Point Pleasant Beach, New Jersey-based Monmouth has accepted and consented to FINRA’s findings but has not admitted or denied them in the settlement.

According to FINRA’s report, between August 2020 and February 2023, Monmouth, acting through six representatives, excessively traded 110 accounts, 42 of which were churned. Customers allegedly incurred about $3.9 million in commissions and trading costs, leading to significant losses. FINRA cited Monmouth for its violations of the Care Obligation of Reg BI; Section 10(b) of the Securities Exchange Act of 1934; and SEC Rule 10b-5.

In one case, a customer’s account had an annualized cost-to-equity ratio exceeding 103%, meaning the account had to grow more than 103% to cover commissions and trading costs, according to FINRA. One customer allegedly experienced a loss of $158,078 due to a cost-to-equity ratio of over 72%. FINRA’s Christopher Kelly, senior vice president and acting head of enforcement, has said that FINRA and other regulators view cost equity ratios of 20% or more as suggestive of excessive trading.

Monmouth failed to reasonably supervise the trading in these accounts despite clear indicators of churning, according to FINRA. Numerous red flags, including 24 consecutive monthly exception reports indicating potential churning, were ignored by the firm.

Notably, some of the impacted accounts belonged to Gold Star Families, meaning they have lost an immediate family member in military service, who had funded their accounts with military death gratuity or Servicemembers’ Group Life Insurance payments. Monmouth representatives excessively purchased securities in these accounts, generating significant commissions and trading costs. In one example, Monmouth allegedly opened an account for a 13-year-old child, funded by SGLI payments, according to FINRA. Despite the account having an average equity of $150,000, Monmouth purchased more than $1.9 million in securities in the account over a 20-month period, generating nearly $80,000 in commissions and trading costs.

Additionally, FINRA found that Monmouth made false and misleading statements on its Form CRS between November 2020 and February 2023. The firm falsely claimed to monitor customer accounts through daily exception reports, despite never utilizing such reports.

Compliance July 7, 2023

Supreme Court Accepts Case Challenging Legitimacy of SEC’s Adjudication System

The court has agreed to hear a case next session which could dramatically reduce the authority of in-house adjudication process for the SEC and other federal agencies.

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The U.S. Supreme Court will hear a challenge to the legitimacy of the Securities and Exchange Commission’s administrative law judges, brought by George Jarkesy, a hedge fund manager. The court will likely hear the case during its next session and rule by June 2024.

The case dates back to 2011, when the SEC began investigating Jarkesy for securities fraud. Jarkesy was managing two hedge funds with more than 100 customers and more than $24 million in assets. Patriot28 LLC was the fund’s adviser and was also charged by the SEC.

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The SEC alleged Jarkesy and Patriot28 defrauded investors by misrepresenting who the prime broker and auditor were; mispresenting the parameters and safeguards of the hedge fund; and overvaluing the funds’ assets in order to justify higher fees.

Jarkesy asked the district and appeals courts in the District of Columbia to review the case, and both responded that they did not have jurisdiction, because Congress empowers the SEC to choose whether to bring a case to federal courts (established via Article III of the U.S. Constitution) or to adjudicate it within the agency.

The SEC adjudicated the case and ultimately fined Jarkesy and Patriot28 $300,000 in civil fines and ordered them to repay $685,000 in ill-gotten gains. Jarkesy was also barred “from various securities industry activities: associating with brokers, dealers, and advisers; offering penny stocks; and serving as an officer or director of an advisory board or as an investment adviser,” according to the appeals court’s decision.

Jarkesy appealed to the 5th U.S. Circuit Court of Appeals, based in New Orleans. The appellate court ruled in his favor and found that the SEC’s in-house adjudication system violated the Seventh Amendment guarantee to a jury trial in federal civil matters in which the amount in dispute exceeds $25. The appeals court also found that Congress improperly delegated legislative authority to the SEC by permitting the commission to bring a case before a court or the agency’s own administrative law judges. Lastly, the appeals court ruled that administrative law judges’ protection to not be removed except “for cause” violates Article II of the U.S. Constitution by improperly shielding them from presidential removal.

The appeals court’s decision stated, “Petitioners had the right for a jury to adjudicate the facts underlying any potential fraud liability that justifies penalties” and “Congress unconstitutionally delegated legislative power to the SEC when it gave the SEC the unfettered authority to choose whether to bring enforcement actions in Article III courts or within the agency.”

The SEC then appealed to the Supreme Court, seeking a reversal of the 5th Circuit’s decision.

The case could have profound consequences for the authority and administration of the SEC and other federal agencies, depending on which legal theories the Supreme Court upholds or reverses. In addition to the SEC, at least 20 other federal agencies employ administrative law judges.

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