FINRA board member's firm settles cases without disclosure of conflicts

Regulators pressing hundreds of cases in recent years ordering firms to explain their conflicts of interests to clients omitted any mention of a particularly glaring one in two recent enforcement actions.

FINRA and the SEC settled cases late last month against Kovack Financial, whose CEO sat on FINRA's Board of Governors for most of the time at issue in the two matters. Neither regulator disclosed that their handling of the cases could present a conflict of interest to FINRA or the agency overseeing it.

Fort Lauderdale-based Kovack Financial and subsidiaries Kovack Securities and Kovack Advisors agreed on Aug. 23 and Aug. 26 to pay a combined $1.1 million in restitution and penalties to resolve the separate investigations, which began around the time that CEO Brian J. Kovack started serving on FINRA's board for six years as a midsize firm representative.

He completed the second of two terms in August 2021, eventually earning about $90,000 per year from FINRA for an average workload of four hours a week, according to FINRA's latest available nonprofit disclosure to the IRS. Neither FINRA's supervisory case against Kovack's firm over mutual fund recommendations nor the action by the SEC involving wrap advisory accounts includes mention of the CEO's seat on the board. Kovack's board tenure overlapped with the respective time periods that the regulators say the firm was violating the rules.

At a minimum, FINRA should have followed the same standards as most publicly traded firms in sharing the existence of its investigation and the steps taken by its board to remove Kovack's CEO from any discussions involving either case, according to Bill Singer, an attorney and former regulator who writes the "Broke and Broker" compliance blog. 

"It really presents a laboratory experiment with FINRA," Singer said. "What do you do when you begin investigating a firm that has somebody sitting on the board? Here, it appears they did nothing."

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Singer added that he's not accusing Kovack personally of any wrongdoing, but rather raising the same questions that Singer has asked when other FINRA governors' firms had cases. In the most infamous example, convicted fraudster Bernie Madoff once acted as the vice chairman of FINRA predecessor the National Association of Securities Dealers and was a member of its board and chairman of its New York region, in addition to several roles overseeing NASDAQ.

Representatives for the SEC didn't immediately respond to requests for comment. 

FINRA spokesman Ray Pellecchia noted that the regulator's website discloses the member firm affiliations of each person on the Board of Governors and that the regulator and FINRA personnel abide by a code of conduct that includes addressing conflicts of interest. Board members and FINRA staff receive annual training on the topic as well.

"The Board of Governors receives no information about and has zero involvement in pending enforcement matters," Pellecchia said. "If a decision in an enforcement action is appealed to the board, any governor for whom that would present a conflict would be recused."

Representatives for Kovack Financial, which didn't admit or deny the regulators' allegations in settling the cases, referred any questions about FINRA policies to the regulator.

"The two matters you have asked about are two separate and distinct regulatory settlements that are completely unrelated to each other. We recognize that our industry has always been heavily regulated, our regulatory and compliance team is among the best in the industry, and when regulatory issues arise, we address them as expeditiously and completely as possible," spokesman Donald Cutler said in a statement. "We reached a definitive conclusion to both of these matters, so all parties can move forward."

In a 2018 press release on the launch of Kovack's "re-election campaign" to the board of governors, Kovack said had "helped guide FINRA toward greater transparency, efficiency and more open communication on behalf of the firms and advisors I represent."

"As the leader of an independent broker-dealer that I helped build from scratch, and as someone who has devoted most of my working life to the financial advisory space, I am dedicated to doing the heavy lifting on behalf of midsize firms across America," he said. "That's why I'm committed to pushing forward with the mission of establishing a regulatory landscape that will both protect and empower firms, advisors, and investors as they pursue their goals in the years ahead."

Kovack's firm generates more than $100 million in revenue annually with more than 400 producing financial advisors, as the No. 30 company on Financial Planning's IBD Elite rankings of independent wealth managers. In the settlement with FINRA, it agreed to a censure and a fine of $210,000; to resolve the SEC case, it agreed to pay $899,000 including restitution and interest of $199,000 and a civil penalty of $700,000. 

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FINRA alleges the firm failed between March 2015 and May 2017 to enforce a system of supervising the sales of certain mutual fund shares whose upfront charges make short-term trades unsuitable for some clients. The firm also missed the red flags of a barred former Kovack broker identified only by the initials "M.K." who recommended $2.1 million worth of such trades to eight clients, five of them seniors, according to investigators. FINRA didn't divulge the former broker's name but said it barred the representative in 2017 for failure to cooperate with its investigation. The firm fired the broker and paid restitution to harmed clients who paid "unnecessary sales charges" during its eventual investigation, according to FINRA.

Kovack Securities "relied primarily on one person to conduct daily, manual reviews of trading activity in the accounts for all its registered representatives, which at the time numbered over 300," according to FINRA's letter of acceptance, waiver and consent.

In the other case, the SEC accused Kovack's RIA of failing between 2015 and August 2018 to review its wrap fee accounts on a regular basis to ensure they were still suitable for clients and to state some of the charges paid by the customers adequately. Such "wrap fee" programs cost clients a single asset-based fee across many investment management services. The firm shut down its program in 2018. The SEC has subsequently warned all firms about conflicts of interest with wrap fee accounts, such as those without much trading activity warranting the expenses, outright mis-billing and transactions that reduce costs to RIAs while increasing them for clients.

The SEC credited Kovack with "remedial actions promptly undertaken" during the investigation, but it took the firm to task for botching some basic compliance steps. Between 2012 and 2015, the firm didn't complete its required annual compliance review, and, from 2015 to 2017, it didn't even conduct any reviews of client accounts, according to the settlement order.

"After the Commission's Division of Examinations began an examination of [the RIA] in 2017, [it] conducted account reviews for the first time in almost two years," the order states.

The allegations and the lack of discussion from either regulator about how to handle enforcement matters involving firms with executives on FINRA's board "doesn't meet the smell test" for Singer, he said. He acknowledged the presumption of innocence for Kovack's firm but said that FINRA still needed to disclose at least its investigation.

"How is it that they were investigating a governor in 2018 and nobody knew anything about it until 2022? This is going to pose significant problems going forward," Singer said. "Why is it that FINRA always seems to be the dog that's chasing after the car?"