Last week's order that Next Financial Group Inc. stop violating privacy regulations when recruiting brokers upended a key tenet of independent-contractor broker-dealers: that independent representatives — and not broker-dealers — are at the center of the relationship with the clients.
In the closely watched dispute over the recruitment of brokers and protecting client information, a Securities and Exchange Commission administrative law judge implied that firms, not reps, are the responsible parties, and ordered Next Financial of Houston last Wednesday to pay a $125,000 penalty as well as cease and desist from any recruiting tactics that violate privacy laws, known in the industry as Regulation S-P.
"According to Next, the registered representatives believe they, not the brokerage firms, have the primary relationship with customers under the independent-contractor business model," Judge James T. Kelly wrote in his decision. "In this setting the registered representatives treat customers' non-public personal information as if it were their responsibility and not the firm's."
The SEC alleged last year that Next Financial violated Reg S-P by disclosing non-public personal information about its customers to outside parties, that brokers who left the firm took clients' private information to other broker-dealers and that the company failed to safeguard customer records and information.
The company also came under scrutiny for using "reckless" tactics to obtain personal information of potential clients from broker-dealers from which Next was recruiting rep candidates.
Next Financial argued that the reps don't "take" private client information when recruited to a new firm but simply "keep" the information that is already in their possession.
Mr. Kelly contended that that line of argument is nonsense.
"There is no merit to this metaphysical distinction, as it is applied to Regulation S-P," he wrote. "The departing representative has no property right to a customer's non-public personal information."
The decision "makes it more difficult to transfer client accounts," said Lee Pickard, a former SEC commissioner who was an expert witness for Next Financial in the case.
Meanwhile, the industry and regulators are trying to figure out how to comply with Reg S-P.
Last month, the SEC closed a comment period on proposed changes to Reg S-P.
The proposed updates to the SEC's privacy regulations would allow individual representatives to take basic customer contact information such as names, phone numbers, and e-mail and street addresses, without violating Reg S-P.
Some critics argue that the changes would give firms the power to veto sharing client information when a rep leaves to join a new -broker-dealer because the firm would have to give the rep its approval to take the information. (
InvestmentNews, May 26)
In his decision, Mr. Kelly scolded Next Financial for some of its past recruiting tactics that involved private information of clients.
For example, the firm asked recruits to provide their user identifications and passwords so the firm could access the computer systems of the recruits' brokerage firms and take non-public personal information of clients, he wrote.
"Both of Next's expert witnesses conceded that using recruits' user identifications and passwords in this fashion was not consistent with industry practice and that they did not know of any brokerage firms, other than Next, that had done so," Mr. Kelly wrote. "I conclude that Next's conduct was extremely reckless and that Next must have known that its conduct was highly improper."
In the decision, Mr. Kelly also said that the SEC presented no evidence that "substantial harm or inconvenience" was caused to recruits' clients.
The SEC originally wanted a $325,000 penalty against the firm.
"We're obviously disappointed and will review the decision and consider our options," said Brian Rubin, a partner in Sutherland Asbill & Brennan LLP of Atlanta and Washington and one of the attorneys for Next Financial.
He noted that Mr. Kelly acknowledged confusion and uncertainty in the industry about Reg S-P and that he significantly reduced the SEC's original penalty.
Reg S-P is the securities industry's implementation of stricter privacy laws under the Gramm- Leach-Bliley Act of 2000.
The SEC has been focusing on Next Financial since 2005, when examiners from its Salt Lake City office began an audit.
Last August, the SEC slapped the firm with an administrative complaint over the potential violations, the first step in a cease-and-desist proceeding.
Next Financial has been one of the fastest-growing independent broker-dealer during this decade, with staff and revenue increasing 40% to 50% a year between 1999 and 2007. Last year, the firm re-ported $114.3 million in gross revenue, and it has about 880 affiliated reps.
E-mail Bruce Kelly at [email protected].
