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News January 14, 2008 Issue

Broker Sued For Failing to Have Adequate Procedures, Leading to Improper Soft Dollar Payout

For the first time, FINRA has sued a broker-dealer for failing to have adequate procedures in place to supervise its soft dollar payments.

Last week, Houston-based SMH Capital agreed to pay $450,000 to settle FINRA’s charges that it failed to adopt adequate supervisory procedures and systems to address its prime brokerage and soft dollar services to hedge funds. Because it did not have adequate procedures in place, alleged FINRA , the brokerage firm made improper soft dollar payments of $325,000 to hedge fund manager FCM.

Specifically, FINRA alleged that SMH made two improper soft dollar payments, totaling $325,000, to FCM after the manager had submitted an invoice that was "suspect on its face." One of the items was $75,000 for "consulting services." The other was for $249,640 for "research expense reimbursement."

According to FINRA, the invoice should have raised red flags, because "[i]t requested that SMH pay the hedge fund manager directly for expenses that had purportedly been provided by a third party; it did not describe what research had been provided to the manager or who had provided the research; and it failed to describe the ‘consulting services’ the individual provided." And, noted FINRA, the hedge fund manager did not provide any backup documentation from the consultant or research provider to support its soft dollar invoice.

FINRA faulted SMH for failing to determine whether the manager was relying on Section 28(e) and, if not, whether the manager had disclosed to its clients that it was operating outside the safe harbor. "Had SMH taken such steps, it would have revealed the invoice should not have been paid," said the regulator.

Brokers, of course, have been on notice that regulators would be looking at their soft dollar activities. In April 2004, FINRA (then the NASD) said it was examining brokerage firms’ soft dollar activities to determine, among other things, "compliance with the requirements necessary to take advantage of the Section 28(e) safe harbor" as well as "abuses in the use of soft dollars by broker-dealers." In its 2006 soft dollar interpretive release, the SEC reminded broker-dealers that they could be subject to liability if they aid and abet another person’s violation of the securities laws. "For example," said the SEC, "if a broker-dealer knows that a money manager has represented to its clients that he will operate solely within Section 28(e), and the adviser asks the broker-dealer to pay for office furniture and computer terminals, which under this release are not eligible under the safe harbor, the broker-dealer may risk aiding and abetting liability."

FINRA also asserted a number of other violations against SMH and three of its registered reps. Among other things, FINRA alleged that the firm drafted and distributed hedge fund sales material that did not adequately disclose material investment risks to potential hedge fund investors. It also alleged that SMH entered into an improper compensation arrangement with two SMH brokers who also managed hedge funds, whereby they were compensated based on the funds’ trading, something that was explicitly disavowed in the funds’ offering documentation.

In addition to agreeing to a censure and the $450,000 fine, the firm agreed to retain an independent consultant to review the firm’s systems, procedures, and training with regard to its hedge fund operations.