The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a recent “Risk Alert” noting observed deficiencies in broker-dealer supervision and compliance controls over retail sales of structured products – especially structured notes.

Structured Securities Products (“SSP’s”) often are principal obligations of BD affiliates, offering exposure to particular underlying asset classes and typically having fixed-income characteristics with embedded derivatives. Examples include principal-protected notes and reverse-convertible notes.

SSP’s have been near the top of regulators’ “hot topics” lists for years. See “SEC Exam Priorities (Jan. 15, 2015). They have garnered extra scrutiny with greater “retail-ization” as retail investors hunt for yield during prolonged low-interest-rate environments. See Heightened Supervision of Complex Products, FINRA Reg. Notice 12-03 (Jan. 2012).

The deficiencies cited by OCIE included poor implementation of written supervisory procedures on SSPs and failure to adhere to stated controls. For example, OCIE found that account concentration limits often were exceeded, as were liquid net worth guidelines. OCIE also noted instances in which limit over-rides contained only vague or general explanations by supervisors who granted them, lacking account or transactions specifics.

FINRA Suitability Rules

FINRA upgraded its suitability rules effective July, 2012, partly in response to greater retail sales of more complex products. The new suitability rules clarified and expanded the suitability duties to three levels:

  1. Reasonable-Basis Suitability – which requires both firm and individual broker, due diligence, understanding of a given product or strategy, and reasonable belief that it is suitable for some investors;
  2. Customer-Specific Suitability – the long-standing requirement that a recommended product or strategy be suitable for the specific customer to whom it is recommended, though the new Rule is preoccupied with the required documented customer risk profile; and,
  3. Quantitative Suitability – which requires that the amount or position size recommended also be appropriate (it used be a “churning” analysis).

New Rule 2111 also extended beyond products to encompass “investment strategies” and “hold” recommendations (though with considerable discussion).See FINRA Rule 2111 (eff. July 9, 2012). See also FINRA Reg. Notice 12-25 (May 2012) and 12-55 (Dec. 2012).

OCIE’s Ex-Post Point of View

OCIE’s Risk Alert smacks a bit of after-the-fact “gotcha.” Its review period was calendar years 2011-2012, so three-quarters of that was before the effective date of the newer FINRA suitability rules. The older rules and guidance arguably covered the points made, but the newer guidance has been much more specific on SSPs.

The Alert offers insight into examiners’ thinking and what observations trigger further scrutiny or escalation during an exam. Each of these three examples taken from the alert demonstrates correlation fallacies, but prompted “further review” even as OCIE disclaimed unsuitability per se:

  • Sales to customers stating “conservative investment objectives” triggered deeper review [reps will say you might expect that an “Income” objective in a low-yield environment might turn to alternative products when more standard fixed-income vehicles don’t yield much “income”];
  • Sales to elderly customers triggered heightened scrutiny [although one could posit that elders dependent upon income from investments (not jobs) might need higher-yielding products when they no longer can count on income from traditional investments];
  • Liquidations of positions at a substantial loss provoked greater examination [though customers aren’t as likely to sell well-performing investments].

OCIE noted that its deficiency findings often involved higher-yield, shorter-term SSP’s with no guaranteed periodic payments, potential underwater equity conversions at term and greater illiquidity.


The Alert offers a few take-aways for broker-dealer compliance:

First, use this opportunity to double-check your supervisory and compliance procedures for suitability generally and especially for complex or structured products sold to retail customers, to ensure they encompass the more recent guidance and particulars of Rule 2111.

Second, use random spot-checks to ensure your organization is complying with your own rules. Nothing is worse in an examination (or worse yet, in customer or enforcement disputes) than “paper-tiger” rules or procedures that aren’t followed.

Third, educate your supervisory personnel on the OCIE triggers and prepare for them ahead of time. For example: (A) Regulators view SSPs as “not conservative,”; (B) Regulators reflexively view complex products as presumptively unsuitable for older investors; and (C) Hind-sight review is apt to liquidation at a material loss as having been unsuitable when purchased. So if your sales force ventures into these “trigger zones,” educate your supervisors to document the disclosures, economic justifications and customer approvals with extra depth and care.