Firms must undertake thorough review of supervisory process

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In January, the Financial Industry Regulatory Authority (FINRA) published its annual letter identifying its regulatory and examination priorities for 2013, a document intended to “represent [FINRA’s] current assessment of the key investor protection and market integrity issues on which [FINRA] will focus in the coming year.”

Although numerous such issues were identified by FINRA in its letter, including issues relating to the sale of private placement securities, anti-money laundering compliance, insider trading, margin lending practices, and algorithmic trading, a substantial focus for 2013 relates to suitability concerns and the sale of complex products to retail investors.

Economic Environment Sharpens FINRA’s Concern

FINRA specified in its letter a number of current general economic factors giving rise to concerns about retail investors purchasing complex products:

  • FINRA believes the “slow growth, low-interest rate environment…” has challenged retail customers to seek returns outside their stated risk tolerance;
  • “[A]n unprecedented compression of credit risk premiums and yields…;”
  • The fact that retail investors are, therefore, increasingly transferring funds from equity to debt markets;
  • Retail investor “appetite for yield…” has increased prices on investment-grade and high-yield debt issues, limiting substantially upside growth while exacerbating risk of loss.

In light of the above factors, FINRA expressed its particular concern “about sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices.”

3 Complex Products Earn Particular FINRA Scrutiny

While FINRA’s assessment again identifies numerous complex products in previous annual reviews, including non-traded REITs and leveraged and inverse ETFs, FINRA singled-out the following three “recently surfaced…” products as potentially unsuitable for retail investors in the current economic environment, given their underlying market, credit and liquidity risk factors:

  • Business Development Companies (BDCs): BDCs, typically closed-end investment companies, are highlighted due to, among other things, their investment in the corporate debt and equity of private companies;
  • Leveraged Loan Products: These adjustable-rate loans are extended by financial institutions to companies with low credit quality;
  • Commercial Mortgage-Backed Securities: FINRA is concerned retail investors are not being advised by their registered representatives of the “considerable risks given today’s low-interest-rate, low-yield environment.”

FINRA’s Recommended Supervisory Points of Emphasis

Supervisory policies and procedures regarding the sale of complex products to retail investors will be subject to particular scrutiny in 2013. FINRA’s Regulatory Notice 12-03 (“Complex Products-Heightened Supervision of Complex Products”), offers substantial guidance regarding heightened supervisory procedures that may be appropriate. In brief, some of these supervisory procedures may include:

  • Suitability: Is there a process to ensure the mandatory suitability analyses have been undertaken, particularly in light of FINRA’s revised suitability rule (FINRA Rule 2111)?
  • Post-Approval Review: Is there a supervisory process in place to reassess – post-sale – the performance and risk profile of existing complex products? Does this process also capture any complaints received from customers relating to a particular complex product?
  • Training: Registered representatives who recommend complex products must have a thorough understanding of all features and risks of a given product to enable them to articulate such features and risks to retail clients. Have sufficient resources been allocated to such training, and is there a process in place to ensure this training was utilized and effective?
  • Financial Sophistication of Clients: FINRA recommends that firms adopt the approach mandated for options trading accounts – that financial advisors must have a reasonable basis to believe that a retail client is sufficiently knowledgeable in financial matters, that he or she is capable of evaluating the risks of a recommended transaction and that the client can bear the associated financial risks.
  • Discussions with the Client: In recommending a complex product, a registered representative should thoroughly discuss all features of the product, how the product is expected to perform under different market conditions, the risks of the product and potential returns and the costs of the product. Fundamentally this should be undertaken in a manner most likely to facilitate the client’s understanding of the product.

In sum, as advised in its letter, FINRA is “particularly concerned about firms’ and registered representatives’ full understanding of complex or high-yield products, potential failures to adequately explain the risk-versus-return profile of certain products, as well as a disconnect between customer expectations and risk tolerances.”

For these reasons, supervisory procedures regarding sales of complex products to retail investors in large part must be designed – and enforced – with the intent to give financial advisors the ability to provide credible, substantive responses to the regulatory inquiry, “How did you educate yourself regarding the particular features and risk factors of this product?” and “How did you effectively communicate that information to your (suitable) client?”.