On August 24, 2015, the SEC’s Office of Compliance Inspections and Examinations (OCIE), issued its National Exam Program Risk Alert entitled “Broker-Dealer Controls Regarding Retail Sales of Structured Securities Products.” While not directly related to broker-dealer sales of Direct Participation Programs (DPPs), the Alert’s findings are illustrative and the warnings should be heeded by broker-dealers selling DPP securities.
The SEC assessed the broker-dealers’ compliance with suitability and supervision requirements in the Securities Exchange Act of 1934. In its review, the SEC was able to gather information from customers’ account documentation about the types of customers who purchased the structured securities products (SSPs). The SEC staff found “significant deficiencies in the areas of suitability and supervision with respect to … sales of SSPs to retail investors.” The SEC staff found that firms:
- Failed to maintain and/or enforce adequate controls relating to determining the suitability of SSP recommendations; and
- Failed to conduct both compliance and supervisory reviews of registered representatives’ determinations of customer suitability for the SSPs, as required by their internal controls.
FINRA Rule 2111 requires a registered representative to have a reasonable basis to believe that “the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position.” Broker-dealers selling DPP securities pursuant to FINRA Rule 2310(b)(2)(B) must:
- have reasonable grounds to believe, on the basis of information obtained from the participant concerning his investment objectives, other investments, financial situation and needs, and any other information known by the member or associated person, that a. the participant is or will be in a financial position appropriate to enable him to realize to a significant extent the benefits described in the prospectus, including the tax benefits where they are a significant aspect of the program; b. the participant has a fair market net worth sufficient to sustain the risks inherent in the program, including loss of investment and lack of liquidity; and c. the program is otherwise suitable for the participant; and
- maintain in the files of the member documents disclosing the basis upon which the determination of suitability was reached as to each participant.
The Alert’s findings included inadequate and inconsistent implementation of the controls around determinations of suitability, including significant SSP activity in accounts of elderly customers and/or customers for whom there was no age information. In one firm, representatives retroactively changed customers’ investment objectives, without customer approval, to justify concentrated positions in SSPs.
Those broker-dealers selling DPP securities would be well advised to continue to make certain their files contain all of the necessary documentation and information showing that they have reviewed the suitability requirements and their customers’ investment objectives and information before selling DPP securities.
The Alert also noted that all of the firms examined “failed to enforce their written supervisory procedures relating to review of representatives’ determinations of suitability with regard to SSPs.” In addition, review procedures varied across different branches within the same firm. Like DPPs, there were concentration guidelines regarding the percentage of a client’s liquid net worth that should be held in SSPs. When exceeding those guidelines, supervisory review, approval and documentation was required. Within one firm, some branches provided “lengthy and specific descriptions of their reviews and the reasons for the overrides.” Other branches used generic language not geared either to the investor or the transaction and did not provide an explanation of the override. Broker-dealers who sell DPP securities would be well advised to make certain they are tracking and monitoring the varying concentration guidelines and providing adequate documentation if and when those guidelines are exceeded.
The need for comprehensive documented suitability and concentration determinations as well as supervisory procedures that are well defined and consistently applied should be the biggest takeaway from this Alert for DPP broker-dealers. Branches within the same firm should enforce the suitability and concentration guidelines with a consistent focus and sufficient documentation. Supervisors should be certain to make clear in their documentation the nature of the client and the reasons for any overrides with respect to any product, but DPPs in particular.