FINRA’s Focus on DVP Accounts Highlights Rise in ‘Free-Riding’ Scam
The nation’s largest nongovernmental regulator of securities is signaling it wants executing brokers to know their customers better, even when the clients come from larger firms.
In a letter outlining its 2014 examination priorities, the Washington, D.C.-based Financial Industry Regulatory Authority (FINRA) said it will focus on penalizing executing broker-dealers that help delivery-versus-payment/receipt-versus-payment (DVP/RVP) clients liquidate large volumes of low-priced securities without sufficient anti-money laundering (AML) controls.
The organization, which regulates on behalf of the U.S. Securities and Exchange Commission, cited a “misconception” among some brokers that the relationships do not require them to collect customer information as part of an AML program. But “absent a formal reliance agreement with the prime broker,” executing brokers must implement customer identification program (CIP) controls for DVP/RVP clients, FINRA said.
The settlements “fly under the suspicious activity monitoring radars of larger financial institutions because it may be a small component of a much larger client relationship,” said Nick Hartofilis, a director with Kaufman Rossin. who examined the compliance programs of broker-dealers while at FINRA.
DVP settlements, which require verification of payments before or at the time of the delivery of securities, allow investors to place orders through executing brokers at locked prices but pay days later. RVP settlements view the same settlements from the viewpoint of sellers.
But because buyers can pay after the values of the securities fluctuate, fraudsters can choose to renege on their orders if it benefits them to do so, a scheme known as “free riding.” The scam allows individuals, who often pose as wealthier investors than they are, to profit if the securities rise in value ahead of the settlement and not lose money if the securities drop before they pay for them.
Several prosecutions in the past year have “highlighted the potential for abuse in DVP accounts, particularly with unregistered securities” and registered penny stocks, said Brian Neville, a partner in New York-based Lax & Neville LLP.
In September, the SEC accused Ronald Feldstein of perpetrating a free-riding scheme that caused $2 million in losses and bilked investors out of $450,000 between 2008 and 2011.
In a complaint, the agency said that Feldstein created two fictitious investment funds and accounts at three broker-dealers and then made large stock purchases through the funds even though he couldn’t pay for them. He used the DVP procedure because it did not require that he have money in his account, the SEC said.
In October 2011, the U.S. Justice Department, Manhattan District Attorney’s Office and the SEC charged Scott Kupersmith and five of his companies for their role in the illegal trade of $60 million in stocks that caused six brokers to lose more than $830,000. Kupersmith, who was sentenced in March to 33 months in prison, used DVP accounts at 36 broker-dealers held for shell companies.
When conducting due diligence on DVP/RVP accounts, executing brokers should determine who owns or controls the relevant funds and whether they have been sanctioned or banned by industry regulators, according to Alma Angotti, a director in the global investigations and compliance practice at Navigant.
The brokers should also inquire about recent changes to the accountholders’ trading strategies, she said, adding that one indication of fraud is when a low-value stock has had a recent spike in trade volume.
“In some cases, FINRA has barred individuals from being brokers due to microcap fraud, so they come back and act as stock promoters,” Angotti said.
