Smith v. Finger
Stockbroker pleads guilty to taking millions from investors. FINRA arbitration filed.
Regulators may have missed securities fraud by Kirkland firm
Puget Sound Business Journal by Kelly Gilblom, Staff Writer
Date: Friday, October 21, 2011, 3:00am PDT – Last Modified: Thursday, October 20, 2011, 6:51pm PDT
On Aug. 18,Jon-Michael Smith called the Kirkland Police Department to report an unusual theft.
Smith, a distraught investor, had been trying to reach his broker for several days because his July statement hadn’t arrived. Finally, Smith phoned a company that handles trading for his account.
What he heard made him sick. Instead of the $1.56 million he was supposed to have, the clearing broker said Smith’s balance was just $27,000.
The account statements Smith had received were false, part of a fraud allegedly conducted by Kirkland broker Richard Finger Jr. to conceal the fact that he had lost nearly $7 million that his 25 clients had trusted him to manage, according to police reports and court documents.
By the end of that week, Smith had given statements to the FBI, the Justice Department and the Securities and Exchange Commission. On Sept. 8, the federal entities went to court to arrest Finger and freeze the assets of his firms, Black Diamond Securities and Black Diamond Capital.
What makes the story unusual is that just three weeks before Smith called the police, regulators had audited Black Diamond Securities and did not report finding any fraud.
Finger, 32, quickly admitted his misdeeds. In a statement issued two weeks after Smith went to the police, he “acknowledged deceiving some of his customers” and said he had “met or spoken to each of the customers whom he deceived and apologized for his behavior.”
The auditors’ failure to uncover the alleged fraud points to a glaring hole in financial oversight — one experts say would be easy to close.
A simple procedural change might root out far more fraud, safeguard investors and prevent the industry from suffering the loss of trust that comes when long-running schemes are revealed. Investment manager Bernard Madoff’s fraud, which totaled nearly $65 billion when exposed in 2008, might have been caught earlier had regulators contacted clients to see if statements provided by Madoff to the SEC matched reality, experts said. Instead, Madoff’s Ponzi scheme grew for 20 years to become one of the largest frauds in U.S. history.
“Everyone is incredulous about Madoff, and given what they (regulators) look at, it doesn’t surprise (me),” said Anita Krug, a securities lawyer and assistant professor at the University of Washington. “They need to come up with better techniques to detect fraudulent activity. It’s inquiring of third parties one way or another that would be helpful.”
The Financial Industry Regulatory Authority and the Securities and Exchange Commission usually don’t interview clients when they audit investment firms, Krug said. They rely on the firms to provide client information. Though this saves clients from facing intrusive questions, it can cause regulators to miss fraud, Krug said. FINRA is a nongovernmental securities industry regulator, funded by the industry.
FINRA examiners who looked at the Black Diamond Securities books noticed the firm’s losses, according to people familiar with the matter. But they didn’t compare those with the allegedly doctored statements being sent to clients, meaning they missed seeing the discrepancy that Smith reported to the police, these people said. One client who said he received doctored statements told the Puget Sound Business Journal that he was never contacted by FINRA to verify whether his statements matched those provided to FINRA by Black Diamond Securities.
It’s unclear whether Finger provided fake documents to FINRA or how extensive was the scope of the exam. It was part of a regular audit that occurs every two years — meaning the FINRA representatives were not looking for a specific type of fraud or investigating an investor complaint, according to someone close to the investigation.
Krug said regulators “are so worried about technicalities, fraud could happen right under their nose. What they’re doing isn’t getting to the gut of the problem.”
FINRA officials declined to discuss the case.
To be sure, FINRA exams usually include on-site and off-site portions. W. Hardy Callcott, a securities lawyer and FINRA expert at San Francisco firm Bingham McCutcheon, said it’s possible FINRA was still gathering documents and investigating Black Diamond Securities when Smith called the police. The missed fraud could have been a one-off incident, rather than a systemic problem with regulation, he said.
“If someone is intentionally creating dual sets of books and is only showing FINRA the accurate set of books, it’s possible for an exam to miss things,” Callcott said. “But the fact this fraud was discovered within a couple-week period of that on-site exam doesn’t necessarily suggest this is a case where FINRA failed. They just may not have gotten there yet with their exam.”
Indeed, FINRA initiated an action against Black Diamond Securities on Aug. 29, seeking to punish it for failing to respond to a request seeking documents.
The action, however, came 11 days after Smith called the police and a week after Black Diamond Securities ceased operations. The companies were suspended from the industry on Sept. 22, several weeks after Finger’s arrest. Black Diamond Securities had been registered to operate in eight states, including Washington.
By the time FINRA’s action was initiated, criminal and civil investigations against Finger and both Black Diamond firms — headed by the SEC and Department of Justice — were under way, court records show.
FINRA spokesman Thomas Holloman declined to answer specific questions about Finger or Black Diamond. FINRA reports on each, however, list past regulatory problems.
FINRA and the SEC say they have stepped up efforts to expose fraud in recent years. However, the number of brokers and firms suspended or barred from the securities industry has remained steady or declined slightly since the financial crisis, according to FINRA and SEC tallies.
FINRA’s report on Finger showed he has been accused of impropriety by three separate clients between 2003 and 2008 while an employee at other firms. The accusations say Finger acted against the wishes of his clients when trading on their behalf, in one case transferring $40,000 from a customer account “for his own personal use.” Those allegations resulted in one suspension and more than $5 million worth of settlements assessed against Finger. Solomon Wisenberg, a Washington D.C.-based attorney with law firm Barnes & Thornburg who is an attorney for Finger, said the past incidents may look outwardly bad but each case was the fault of another party and Finger always acted properly.
Finger declined to comment for this article.
The allegations that resulted in the Black Diamond case brought last month by the Department of Justice suggest that Finger’s fraudulent activities date back to 2009, when he was working as a broker for Seattle investment advisory firm First Washington Corp. According to the criminal complaint filed in U.S. District Court for the Western District of Washington Sept. 8, Finger “induced” one investor — identified in the suit as “J.M.S.,” an apparent reference to Jon-Michael Smith;— to provide Finger with $670,000 to manage.
“Within months of soliciting J.M.S. to place money with him, Richard A. Finger, Jr. began to incur signficant trading losses in J.M.S.’s account,” said the court documents. “During the fall of 2009, Richard A. Finger, Jr. began telling J.M.S. that his account was doing well when, in fact, Richard A. Finger, Jr. was generating significant trading losses in the account.”
Smith could not be reached for comment, and the U.S. District Court would not comment on the suit. David Lewis, chairman of First Washington Corp., declined to comment on Finger’s time at the company.
The SEC complaint alleges that Finger “lost millions of dollars for customers in a matter of months through risky, undisclosed options trading and excessive, concealed commissions,” according to a summary later noted by FINRA. He also concealed losses by sending out “doctored statements,” the SEC complaint said.
For example, Finger told one investor his account balance was $796,234.53 when in fact the balance was just $62, according to the SEC.
The entities also allege that Finger continued to make trades because with each transaction he could take a sizable commission. However, most clients had not authorized the trades and Finger was forging documents that he gave to his clearing broker in order to execute the trades, the SEC and DOJ alleged. Ultimately the fraud extended to nearly all of Black Diamond Securities’ 25 clients, who held money in 40 separate accounts.
According to a Kirkland Police Department report from August, Finger lived lavishly off his earnings. In 2009 he purchased a home in Bellevue for $1.9 million; he also owns two luxury cars, two motorcycles, a ski-boat and a jet-ski, said the report. The SEC said that, since February, Finger had transferred more than $800,000 in funds derived from excessive commissions to his personal bank account.
Prosecutors have until Nov. 10 to file an indictment against Finger, who is currently out on bond. The separate SEC case could lead to civil penalties and if it prevails could ban Finger from working in the securities industry.
Kelly Gilblom covers banking & finance, wealth management for the Puget Sound Business Journal.