Sometimes, even the biggest worry warts among us would like to let our guard down a bit. We’d like to think that there are some contingencies at to which we need not be that concerned. We’d also like to think that some documents are a less likely source of trouble than others.

Unfortunately, the world doesn’t always work that way. An August 2015 FINRA consent agreement, which resulted in a censure and fine of a broker-dealer, is a useful reminder that:

  • Contingencies that can result in an adverse outcome to investors must be properly disclosed, and registered representatives should be made aware of them in order to advise their clients properly.
  • Even “broker-dealer” only communications can turn raise concerns for a broker if the materials are not deemed fair and balanced or sufficiently robust.

Background – An Unexpected Redemption

The recent FINRA action arose from allegedly unsuitable recommendations made over a seven-year period in which the broker offered a trust security. The trust security represented an interest in (a) a capital security issued by an unaffiliated bank holding company and (b) a related interest rate swap contract. The trust security would pay a variable rate of interest that was subject to a minimum and a maximum rate.

The trust was subject to early termination under a variety of circumstances, including the redemption of the underlying capital security. Upon such a termination, the investors’ redemption proceeds could be reduced by a “swap termination fee.” At the time of issuance, the bank holding company wasn’t expected to be able to redeem the capital security. However, as regulatory capital rules laws changed following the 2010 adoption of the Dodd-Frank Act, many relevant rules changed. And during the term of these instruments, sure enough, the bank holding company did in fact redeem its capital security. The trusts were terminated, and investors received redemption proceeds that reflected the deduction of the (significant) swap termination fee. As a result, investors lost a portion of the principal amount invested.

Unsuitable Recommendations and Insufficient Training

FINRA alleged that the broker’s representatives were not properly educated as to the early redemption risk. Accordingly, they could not inform investors about the possibility of losses arising from the early termination. Under FINRA’s guidance, in order for a member to been deemed to have discharged its reasonable basis suitability obligation, the member must perform appropriate due diligence to ensure an understanding of the product’s potential risks and rewards, and must educate its registered representatives, about the characteristics and risks of each product before it allows registered persons to sell the product to investors.

FINRA also alleged that the broker failed to provide product specific training to its sales force, and that its internal-use only communications (discussed below) regarding the product failed to adequately describe the risks.

In light of the registered representatives’ limited comprehension of the termination provisions and associated risks, FINRA concluded that the member firm lacked a reasonable basis for recommending the product.

Internal Communications

FINRA also concluded that the broker’s internal-use only materials for the product were not fair and balanced, and that they failed to provide a sound basis for evaluating the risks of investing in the trust security. These materials were designed for broker-dealer use only, and did not disclose all of the risks of the security, including the risk of loss of principal arising in the case of an early redemption. Although these materials did include some key risk factors, they did not identify the risk relating to early redemption, which turned out to be the one that resulted in significant investor losses.

NASD Rule 2211(d), which was in effect prior to FINRA’s revisions to its communication rules in 2013, required that “institutional sales material,” which included internal-use only material, meet the content standards applicable to communications with the public under former NASD Rule 2210(d). NASD Rule 2210(d)(1), in turn, provided that subject communications “shall be based on principles of fair dealing and good faith, must be fair and balanced and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry or service.”

To the extent that the broker’s materials did not include adequate disclosures about the possible loss of principal upon an early redemption, FINRA concluded that these materials were inadequate.


Drafting risk factors always involves a degree of judgment. Practitioners consider a variety of factors in drafting risk factors, including materiality, the probability of occurrence, and the intended audience of the communication. FINRA’s recent action is a reminder to parties to err on the side of caution in this area.