Wednesday, November 5, 2014

New Confidentiality Requirement in Customer Discovery and Settlement Agreements

Experienced securities law attorneys know that it is a violation of FINRA rules to include a confidentiality provision in a settlement agreement with a customer that prohibits the customer from discussing the case with a regulator. While we do incorporate confidentiality provisions into our settlement agreements, we are careful to exclude discussions with regulators.

FINRA has now released Regulatory Notice 14-40, which contains something of a trap for the unsuspecting firm, and imposing a new requirement in discovery confidentiality agreements. And they have done it all without following the rule making requirements set by Congress.

In its notice FINRA says that it is simply reminding firms of the violation of FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade) to include confidentiality that prohibit or restrict a customer or any other person from communicating with the Securities and Exchange Commission (SEC), FINRA, or any federal or state regulatory authority regarding a possible securities law violation.

Given the fact that most General Counsels and Compliance Officers are inundated with notices and paperwork, most might stop at the executive summary. However, the Notice makes a substantive change in how these agreements are handled, and includes a requirement that discovery confidentiality agreements must be modified.

Settlement Agreements


The Notice now requires that confidentiality provisions in settlement agreements should be written to expressly authorize, without restriction or condition, a customer or other person to initiate direct communications with, or respond to any inquiry from, FINRA or other regulatory authorities.

FINRA had never required an express authorization in a settlement agreement, but rather simply an exclusion. from the confidentiality provisions.

FINRA has offered the following  an example of an acceptable confidentiality provision in a settlement agreement:

Any non-disclosure provision in this agreement does not prohibit or restrict you (or your attorney) from initiating communications directly with, or responding to any inquiry from, or providing testimony before, the SEC, FINRA, any other self-regulatory organization or any other state or federal regulatory authority, regarding this
settlement or its underlying facts or circumstances.
While some will argue that this is not a dramatic change, many view this as forcing firms to encourage customers to contact regulators.

Discovery Agreements


FINRA has now decided to insert itself in the discovery process and this notice includes a requirement that discovery confidentiality agreements and orders cannot include FINRA or other regulators. FINRA has once again decided that it knows better than its own arbitrators, and that it is going to violate the property rights and constitutional rights of its own members, once again.

Much of what is produced in discovery is confidential. Information regarding other customers is often included. Federal and state law, as well as Regulation S-P prevent the disclosure of such information, without a confidentiality order. Once FINRA mandates that it, the SEC, and the 52 other securities regulators are excepted from the confidentiality provision, they have introduced a huge hole in the protections afforded to customers and third parties by federal and state law.

In addition, some discovery material is proprietary. Compliance manuals, which cost tens of thousands of dollars to prepare and maintain are proprietary. Many surveillance tools are proprietary and confidential - and the public disclosure of such information - such as the parameters which trigger an exception report, could materially harm a firm's ability to detect wrongful conduct.

By forcing an exemption for regulators, FINRA has opened a door to unfettered disclosure of proprietary information. When we deal with FINRA Staff in a regulatory examination, and produce such material, we can rely on the process, and the integrity of the Staff, to protect the confidentiality of that information.

Once you allow customers to send these documents to any person at any regulatory body, the firm has lost control of its proprietary information and the confidentiality of that information is gone, causing material harm to the firm. In addition, this Regulatory Notice allows customers, and their attorneys, to freely distribute information regarding other customer to any regulatory body, for any reason, or no reason.

These new requirements will cause a violation of federal and state law, as well as a violation of the constitutional rights of the parties. It also violates the rule making requirements that Congress set forth in the Exchange Act, and circumvents the entire purpose of the amendment to FINRA Rule 12300(g)(1) as a customer can now take the documents he obtained in discovery and simply forward them, unredacted to any regulatory office he chooses.

FINRA needs to correct this, and needs to do so immediately.
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