No More Mr. Nice BI: Reg BI Violation Leads to Expulsion for FINRA Member Firm
The Financial Industry Regulatory Authority (“FINRA”) has acted on its promise to bring Reg BI to life, announcing last week that it has expelled member firm SW Financial, as well as disciplined its CEO and majority-owner, Thomas Diamante. See FINRA Press Release.
Melville, New York-based SW Financial is charged with several FINRA rule violations, as well as violations of Regulation Best Interest (“Reg BI”), and specifically the Disclosure and Care Obligations created thereunder. The Disclosure Obligation requires that, before or at the time a recommendation is made, retail customers be given complete and fair written disclosure of all material facts related to conflicts of interest associated with that recommendation. The Care Obligation requires broker-dealers and registered representatives to exercise reasonable care, diligence, and skill to understand the pros and cons of a recommendation and to have a reasonable basis to believe that the recommendation could be in the best interest of at least some customers.
The Charges Against SW Financial
SW Financial is charged with, among other things, negligently misrepresenting and omitting material facts in disclosures to its investors, cloaking a conflict of interest the firm had with the securities at issue. Specifically, FINRA alleges that, from March 2018 through December 2021, SW Financial and its principal told investors that the firm would receive a 10% commission on the sales of certain private placement offerings; however, in reality, Mr. Diamante, on behalf of the firm, entered into an additional agreement with the issuer granting SW Financial another 5% commission, as well as half of the carried interest. Interestingly, Mr. Diamante did not even inform others at the firm (including the firm’s Chief Compliance Officer (“CCO”)) about this agreement, and they therefore could not correct this information in the firm’s disclosures. However, the CCO and others at the firm did receive additional compensation as a result of that secret agreement, and the firm itself still faces liability for its negligent misrepresentation and/or omission of these material facts. In SW Financial’s Letter of Acceptance, Waiver, and Consent (“AWC”), FINRA points out that, in addition to the firm indicating as much in the disclosures to investors, the CCO also made four different filings with FINRA falsely indicating that the firm was receiving only the 10% compensation.
FINRA alleges that, from March 2018 through December 2021, the securities were sold to 171 SW Financial customers, and the firm made approximately $2 million in undisclosed compensation between the additional 5% and the firm’s share of the carried interest. Mr. Diamante is alleged to have directed those funds to the company’s general fund, from which he drew his compensation.
This conduct, which FINRA contends is a violation of the Disclosure Obligation of Reg BI, seems to be the primary focus of FINRA’s attention regarding SW Financial. FINRA chastised the firm for these “material misstatements or omissions,” which Acting Head of FINRA’s Enforcement Department, Christopher Kelly, said “exposed customers to significant risk of harm,” which “necessitated expulsion.” Mr. Kelly also highlighted in his comments the firm’s “significant disciplinary history.” In fact, SW Financial has entered into AWCs with FINRA on three other occasions, as well as a Consent Order with the State of Connecticut. These prior disciplinary matters identified misconduct by SW Financial including failure to establish and maintain adequate supervisory systems and written supervisory procedures reasonably designed to prevent misconduct by its representatives, including relating to mutual fund recommendations, non-traditional exchange-traded fund transactions, and complying with the do-not-call list, as well as failure to provide adequate training and to perform adequate diligence. The Connecticut action and one FINRA AWC also dealt with improper imposition of a “handling fee.” Each matter is detailed in this week’s AWC, available here.
In addition, in the present action, SW Financial is also charged with violating the Care Obligation because FINRA contends that it had no reasonable basis to recommend these particular securities to its customers at all (also constituting a violation of the longer-standing suitability rule). SW Financial was also charged with failing to conduct adequate due diligence, including because it allegedly failed to ascertain whether the issuer actually even possessed or had access to the shares to sell.
Finally, SW Financial is also charged with churning in nine customer accounts by two former representatives between January 2016 and May 2019, costing the investors $350,000 in trading costs and causing more than $465,000 in realized losses. The firm also faces FINRA violations for failure to supervise, as FINRA requires firms to have reasonable procedures to detect and investigate red flags for practices like churning and, FINRA contends, SW Financial failed to do so.
In total, SW Financial is charged with violations of: FINRA Rules 2010, 2011, 2020, and 3110; Sections 17(a)(2) and (3) of the Securities Act of 1933; and the Disclosure and Care Obligations of Reg BI (Rules 15l-1(a)(2)(i)(A) and (B) under the Exchange Act).
Mr. Diamante’s Individual Charges
SW Financial’s CEO and majority owner also faced charges. Individually, Mr. Diamante was charged with some of the same conduct as the firm – in particular, making negligent misrepresentations and material omissions to investors concerning the amount of compensation the firm was to receive from the sale of these securities. Mr. Diamante was also charged individually with failure to reasonably supervise the offerings, specifically in his failure to perform reasonable due diligence, failure to complete required diligence checklists, and failure to ensure that the offering documents were complete and accurate. Mr. Diamante was suspended for nine months in all capacities and for another three months in any principal capacities, as well as fined $50,000. In addition, Mr. Diamante must sit for the necessary exams and requalify to be a principal or an investment banking representative before he may resume working in these capacities, should he choose (and find an opportunity) to do so. In total, Mr. Diamante was charged with violations of FINRA Rules 2010 and 3110, as well as violations of Sections 17(a)(2) and (3) of the Securities Act of 1933. Interestingly, although individuals are bound by Reg BI’s Disclosure and Care Obligations, just as are firms, FINRA made no mention of Reg BI in Mr. Diamante’s AWC.
Mr. Diamante seems to be no stranger to FINRA investigations, having worked at three other firms that were ultimately expelled from FINRA membership. In fact, Mr. Diamante was associated with nine different member firms from 1987 (when he first registered) to 2006, establishing SW Financial in 2007 (which, as noted above, itself has been party to multiple AWCs with FINRA). Mr. Diamante was voluntarily terminated from SW Financial on April 17, 2023.
FINRA’s Commitment to Enforcing Reg BI
This is not FINRA’s first enforcement action involved Reg BI, but it is its first expulsion. Although Reg BI has been on the books for quite some time – since June 2020 – regulators have only recently started to give life to the rule. The SEC brought its first Reg BI enforcement action in June of last year, and FINRA followed suit in October 2022. See Mintz Insight, “High Risk, No Reward: SEC’s First Reg BI Enforcement Action” for more information on the SEC’s action, and Mintz Insight, “It Gets BIgger: FINRA Joins the SEC In Bringing Reg BI Enforcement Actions” for more information on the October 2022 FINRA action.
In March, however, FINRA announced that it would conduct Reg BI compliance examinations of 1000 broker-dealers – or just under one-third of FINRA’s member firms – by the end of the year. See Mintz Insight, “It’s Going to Be a Big Year for FINRA” for more information on FINRA’s announcement. If FINRA is to be believed, SW Financial and Mr. Diamante may be the first in a tidal wave of similar enforcement actions. Broker-dealers and registered representatives should be on high alert and would be wise to pay particular attention to the completeness, sufficiency, and accuracy of their compliance policies, training programs, and, perhaps most importantly, marketing and disclosure materials.