The Financial Industry Regulatory Authority (“FINRA”) recently initiated a sweep examination concerning collateralized mortgage obligations (“CMOs”). FINRA appears to be focusing on sales practices issues as well supervision. While not directly concerning sales to seniors and retirees, the sweep examination highlights FINRA’s continued regulatory emphasis on issues that could relate to seniors and retirees.1


CMOs are a type of mortgage-backed security that could provide investors with cash flows from large pools of home mortgages.2 Each CMO is made up of pools of securities, referred to as tranches. Each tranche can have a different interest rate, expected average life, and cash flow structure. There can also be significant variations in risk because of the actual payments made on the underlying mortgages. Interest only (IO) strips may be carved off of collateral securities to pay investors only the interest and not principal, while principal only (PO) strips may be carved off to pay investors principal only. An inverse floater (IF) is a CMO tranche that pays an adjustable rate of interest that moves in the opposite direction from movements in a representative interest rate index. Although there is an active secondary market for CMOs, the degree of liquidity can vary widely based on a variety of factors.

FINRA has stated that CMOs are reserved for sophisticated investors and should be considered by investors only after considerable research.3 Accordingly, FINRA has instituted this sweep stating that certain brokers may attempt to push these products on seniors.4 The SEC has also issued warnings, stating that CMOs are highly sensitive to changes in interest rates and changes in the rate at which homeowners sell their properties, refinance, or otherwise pre-pay loans.5 The troubles plaguing the mortgage industry, particularly with regard to subprime mortgages, has also cast a shadow of concern on mortgage-backed securities.6

FINRA’s Sweep Examination

FINRA’s sweep letter requests, among other things, for the relevant period of June 30, 2006 through July 31, 2007, information concerning:

  • Transaction details (including account names, account numbers, amount of transactions, and registered representative identification numbers) for sales of principal only (PO), interest only (IO), and inverse floater (IF) CMO transactions;
  • Documents providing rating information and tranche information for each type of PO, IO, or IF CMOs purchased; 
  • A listing of firm exception reports relating to PO, IO, or IF CMOs; 
  • All customer complaints and arbitration/litigation claims relating to PO, IO, or IF CMOs; 
  • Written Supervisory Procedures addressing the suitability review process for PO, IO, and IF CMOs; 
  • Registered representative holding pages for the 5 registered representatives who generated the largest amount of commissions for PO, IO, and IF CMOs; 
  • Presentation and marketing materials relating to PO, IO, and IF CMOs; and 
  • A description of how PO, IO, and IF CMOs were priced for account statement purposes.

Potential Violations

It is too early in FINRA’s sweep examination to speculate as to whether any formal investigations or disciplinary proceedings will result. However, FINRA’s interest in CMOs is consistent with its continued regulatory scrutiny of what it perceives as abusive sales practices directed at seniors or retirees. Among the rules that could possibly be implicated by FINRA’s sweep examinations are:

  • Conduct Rule 2110 (misleading statements or omissions); 
  • Conduct Rule 2120 (use of manipulative, deceptive or other fraudulent devices); 
  • Conduct Rule 2310 (unsuitable recommendations to customers); 
  • Conduct Rule 2320 (best execution); 
  • Conduct Rule 3010 (failure to reasonably supervise representatives, and/or failure to establish, maintain or enforce written procedures);
  • Conduct Rule 3030 (outside business activities); and
  • Conduct Rule 3040 (selling away).


Based on prior sweep examinations, if FINRA staff uncovers any concerns relating to CMOs, it is likely that certain firms and registered representatives will be referred to FINRA’s Enforcement Department for formal investigations, which will probably involve requests for additional documents and on-the-record testimony. Enforcement may then determine to bring a formal disciplinary action against one or more firms and individuals.

Even if a firm did not receive the sweep letter, it may want to consider reviewing its policies, procedures and practices relating to CMOs.