Alert

FINRA Sanctions E*Trade Brokerage Firm for Failing to Comply with

Requirements for Reporting Suspicious Activity
February 9, 2009
On Dec. 31, 2008, the Financial Industry Regulatory Authority (“FINRA”) accepted a Letter of Acceptance,
Waiver and Consent (“AWC”) submitted by E*Trade Securities, LLC and E*Trade Clearing, LLC (collectively,
“E*Trade” or the “Firm”), both of which are registered broker-dealers. The AWC alleged that E*Trade violated
NASD Conduct Rules 3011(a) and (b) and 2110, and MSRB Rule G-41, which require that broker-dealers
establish and implement: (i) policies and procedures that could reasonably be expected to detect and cause
the reporting of transactions required under 31 U.S.C. § 5318(g) (the Suspicious Activity Reporting statute);
and (ii) policies, procedures, and internal controls reasonably designed to achieve compliance with the Bank
Secrecy Act (“BSA”) and the implementing regulations thereunder. Each of the E*Trade entities consented to
these allegations by FINRA without admitting or denying FINRA’s findings.

The AWC focuses primarily on the need for a securities firm to monitor for suspicious trading activity. In
particular, FINRA points to language in Special Notice to Members (“NTM 02-21”) which provides that a firm’s
AML procedures are required to address, among other things, the monitoring of account activities, including
but not limited to, trading and the flow of money into and out of accounts. In connection with a firm’s obligation
to file with Treasury’s Financial Crimes Enforcement Network (“FinCEN”) “a report of any suspicious
transaction relevant to a possible violation of law or regulation,” FINRA asserts that FinCEN’s SAR-SF
identifies, among other activities, suspicious securities trading activity that is required to be reported, including
“market manipulation,” “pre-arranged or other non-competitive trading,” and “wash or other fictitious trading.”

Firms should be aware that this AWC set forth a new standard with respect to the monitoring of suspicious
securities transactions.

E*Trade’s Automated AML System Was Inadequate Because It Focused Primarily on Money
Movement

According to the AWC, between Jan. 2003 and May 2007 (the “review period”), E*Trade primarily relied on an
automated proprietary filter-based AML system to review accounts for money laundering activity. If an alert
was generated by the AML system, Firm personnel then manually accessed a variety of sources (e.g.,
Internet resources, FinCEN reports, and OFAC alerts from CDC) and systems to review the account activity
for, among other things, suspicious trading activity. Because the AML system alerts were triggered by money
movements, FINRA alleged that it was unlikely that Firm personnel reviewed the alerts for suspicious trading
activity, such as wash or matched trades, in the absence of any money movement. Because the Firm’s AML
system did not flag and cause the review of accounts for suspicious trading activity unless accompanied by
money movement, FINRA determined that it was not reasonably designed to achieve compliance with the
BSA and implementing regulations thereunder, in contravention of NASD Conduct Rule 3011(b).
 Referring to the principle that each financial institution should tailor its AML program to fit its business, FINRA
alleged that E*Trade also failed to tailor its suspicious activity monitoring program to its business of facilitating
investors’ self-directed electronic access to the market, through which the Firm processed on average, more
than 110,000 customer orders daily with little or no human intervention. Thus, the Firm did not conduct
computerized surveillance of customer account activity to monitor for matched or washed trading. Instead, the
Firm relied on its System analysts, discussed above, and its employees to manually monitor for and detect
suspicious trading activity without providing them with sufficient automated tools necessary to monitor for
such activity. FINRA determined that such an approach to suspicious activity detection was unreasonable
given E*Trade’s business model. FINRA cited, by way of example, 85,029 matched transactions, which were
executed at E*Trade during a ten month period. While matched trading is not illegal in and of itself, FINRA
pointed out that they are expressly prohibited by SEC rules when effectuated “for purposes of creating a false
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or misleading appearance of active trading in any security.” Accordingly, a matched trade could be an
indication of suspicious activity requiring further review.

Although NTM 02-21 states that on-line firms should “consider conducting computerized surveillance of
account activity to detect suspicious transactions and activity,” the AWC goes beyond this guidance stating
that “on-line trading firms, such as E*Trade, are required to design and implement systems reasonably
designed to detect trading activity in customer accounts that may be manipulative and thus reportable.”
(emphasis added). Because E*Trade’s approach to suspicious activity detection was unreasonable given
E*Trade’s business model, the Firm violated NASD Conduct Rule 3011(b).

E*Trade’s AML Policies and Procedures Violated NASD Conduct Rule 3011(a)

With respect to the Firm’s AML procedures, E*Trade’s employees were required to view transactions in the
context of other account activity to determine whether a transaction was suspicious. E*Trade’s AML
procedures defined “transactions” to include “deposits, withdrawals, wire transfers, securities trading, and
investments.” As described above, during the review period, the Firm’s AML filter-based system triggered the
review of potentially suspicious trading activity primarily when accompanied by money movement activity.
Because the Firm did not have “separate and distinct monitoring procedures for suspicious trading activity in
the absence of money movement,” FINRA determined that E*Trade’s AML procedures could not reasonably
be expected to detect and cause the reporting of suspicious securities transactions, constituting a violation of
NASD Conduct Rule 3011(a).

Sanctions

Under the AWC, each of the E*Trade entities consented to a censure and paid a civil monetary penalty
of $500,000, for a total penalty amount of $1 million. These sanctions took into account E*Trade’s prompt
corrective action to remediate its AML system and procedures after the initiation of FINRA’s investigation, but
without prompting by FINRA, including the implementation of automated monitoring systems specifically
designed to detect suspicious trading during the review period and the expansion of staff along with the
retention of third party vendors dedicated to the monitoring function.

Authored by Betty Santangelo and William Friedman.

If you have any questions concerning this Alert, please contact:

Betty Santangelo +1 212.756.2587 betty.santangelo@srz.com
William Friedman +1 212.756.2406 william.friedman@srz.com
Ana P. Kang +1 212.756.2092 ana.kang@srz.com
Atul K. Sood +1 212.756.2073 atul.sood@srz.com
Amber Stokes +1 212.756.2705 amber.stokes@srz.com
Stephanie I. Valentin +1 212.756.2415 stephanie.valentin@srz.com

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Securities Exchange Act of 1934 § 9(a)(1) (2002).

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