The Securities Litigation Expert Blog

Understanding FINRA Suitability Rule 2111 - The Three Components of Suitability

Posted by Jack Duval

Dec 12, 2013 8:03:00 AM

This blog post is part of a series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In particular, customer-specific and reasonable-basis suitability will be examined.

In this post we examine the three components of suitability obligations due under FINRA Rule 2111.

Components of Suitability Obligations

Under FINRA Suitability Rule 2111, there are three components to the suitability obligation: reasonable-basis suitability; customer-specific suitability; and quantitative suitability. Each will be discussed in turn.

As discussed in previous blog posts, the concept of suitability can be succinctly stated as appropriately matching investments to the investor. With Rule 2111, FINRA has now made both ends of this task explicit.

Customer-Specific Suitability

FINRA Rule 2310 clearly dealt with the customer and required that for each recommendation to a customer, “a member have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.”[1]

The “basis of the facts, if any” language was essentially voided for retail clients under NTM 90-52, which imposed an affirmative duty upon the broker to profile the client.[2] This modification was addressed originally in Article III, Sections 2 and 21 (c) of the Rules of Fair Practice[3], and later in Rule 2310(b), which added the explicit requirements for the broker to gather basic information about non-institutional clients.

FINRA Rule 2111 continues the client profiling requirement (and incorporates the phrase “customer’s investment profile”) of Rule 2310(b) and adds more specific areas of inquiry.  Most important among the new profiling questions are: the customer’s needs; the customer’s investment time horizon; the customer’s liquidity needs; and the customer’s risk tolerance.[4]

While explicitly listing the new profiling questions in the Rule is helpful, they have been part of industry profiling practices for decades, if not longer.  Indeed, most member firm New Account Forms have required the broker to inquire about the customer’s time horizon and risk tolerance as well as other aspects of their financial life.

Lastly, it is worth noting that FINRA has also incorporated the New York Stock Exchange (“NYSE”) Rule 405 into FINRA Rule 2090 (Know Your Customer).  As with NYSE Rule 405, FINRA Rule 2090 is a due diligence based rule.  Rule 2090 states:

Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.[5]

Instead of approaching suitability by focusing on what is required for broker recommendations (as does Rule 2111), Rule 2090 approaches suitability by concentrating on the due diligence required for every customer relationship.  Under Rule 2090, suitability is ensured by knowing and understanding the customer prior to account opening, and maintaining the account in accord with what is known.

Importantly, the “maintenance” language in Rule 2090 creates an ongoing requirement to know the customer.  That is to say, the broker must continue to conduct her due diligence on the customer’s particular facts and circumstances during the lifetime of the relationship.

This is an important element of profiling as a customer’s life situation can change and thus require changes in her investments or strategies.  As with the new profiling questions of Rule 2111, these have been an industry practice for decades, if not longer.

Reasonable-Basis Suitability

The reasonable-basis suitability component addresses how broker-dealers and their associated persons must perform due diligence on investments before they recommend them.  The first level of due diligence is performed at the firm level and requires the member firm to first determine that the investment is at least suitable for some of its investors.[6]

Methods employed by firms to determine this first level of suitability will “vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy.”[7]

The second reasonable basis suitability determination is carried out by the broker when she educates herself about the investment. This is how the broker comes to “know the investment”.

One of the primary goals of the reasonable basis suitability obligation is that:

A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.[8]

As mentioned above, a failure to “know the investment” makes the recommendation unsuitable.  FINRA clearly states this in the Supplementary Material to Rule 2111:

The lack of such an understanding (about the potential risks and rewards of the recommending security or strategy) when recommending a security or strategy violates the suitability rule.[9]

Quantitative Suitability

The explicit quantitative suitability component highlights the potential for abuse in instances where accounts are “churned” by frequent purchases and sales of securities in order to generate excess commissions. As mentioned above, there can be instances where one trade, viewed in isolation could be suitable, but if made repeatedly, would change all the trades to unsuitable transactions. FINRA Rule 2111 addresses this potential head on, stating:

Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile, as delineated in Rule 2111(a). [10] (Emphasis added)

The Rule also addresses common metrics used to evaluate churning:

No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.[11]

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The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.

Notes

Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

[1]                 See supra Note 33.

[2]                 FINRA NTM 90-52; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1514&element_id=1273&highlight=90-52#r1514; accessed July 31, 2013.

[3]                 The Rules of Fair Practice was what the original NASD Manual was called.  The numbering system was changed in May 1996.

[4]                 See supra Note 34 and accompanying text.

[5]                 FINRA Rule 2090 (Know Your Customer); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=13389&element_id=9858&highlight=2090#r13389; accessed August 1, 2013.

[6]                 See supra Note 34.  FINRA Rule 2111 Supplementary Material .05 Components of Suitability Obligations.

[7]                 Id.  See also FINRA NTM 05-26 for suggested best practices for vetting new products.

[8]                 Id.

[9]                 Id.

[10]               Id.

[11]               Id.

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Topics: reasonable basis suitability, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Quantitative Suitability, Customer-specific Suitability

FINRA Rule 2111 - Reasonable-Basis Suitability

Posted by Jack Duval

Dec 2, 2013 6:34:00 AM

FINRA Rule 2111 (Suitability) has made explicit the reasonable-bais suitability requirement that existed in Notices to Members and Regulatory Notices for well over a decade.

The reasonable-basis suitability component of Rule 2111 addresses how broker-dealers and their associated persons must perform due diligence on investments (as opposed to customers) before they recommend them. The first level of due diligence is performed at the firm level and requires the member firm to determine that the investment is at least suitable for some of its investors.[1]

Methods employed by firms to determine this first level of suitability will “vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy.”[2]

The second reasonable basis suitability determination is carried out by the broker when she educates herself about the investment. This is how the broker comes to “know the investment”.

One of the primary goals of the reasonable basis suitability obligation is that:

A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.[3]

A failure to “know the investment” makes the recommendation unsuitable. FINRA clearly states this in the Supplementary Material to Rule 2111:

The lack of such an understanding (about the potential risks and rewards of the recommending security or strategy) when recommending a security or strategy violates the suitability rule.[4]

Due diligence expert Tom Brakke and CEO Jack Duval will be publishing a white paper on the reasonable-basis suitability requirement and due diligence standards of broker-dealers.

 

Get Updates on Reasonable- Basis Suitability

Notes:

[1]              See supra Note 34. FINRA Rule 2111 Supplementary Material .05 Components of Suitability Obligations.

[2]              Id. See also FINRA NTM 05-26 for suggested best practices for vetting new products.

[3]              Id.

[4]              Id.

 

 

 

 

 

 

 

 

 

 

 

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Topics: reasonable basis suitability, FINRA Rule 2111

FINRA Issues Regulatory Notice 13-31 Suitability

Posted by Jack Duval

Oct 23, 2013 7:36:07 AM

FINRA has issued RN 13-31 to highlight effective practices for member firms when complying with Suitability Rule 2111.  (RN 13-31)

A number of highlights are worth noting, including:



  •  The manner in which the firm supervises explicit hold recommendations, including the method of documentation the firm uses when documentation occurs, as well as the information the firm considers in conducting the review...

  • Transaction red flags such as: those that appear to deviate from the firm’s internal suitability guidelines for a particular security; a long-term investment for an investor with a short-term horizon; a speculative investment or strategy held in the account of an investor with a conservative investment objective; and the same security held in the account or strategy implemented for...



The RN also emphasized compliance with the reasonable-basis component of Rule 2111:
As referenced above, reasonable-basis suitability requires a firm or associated person to perform reasonable diligence to understand the nature of a recommended security or investment strategy involving a security, as well as its potential risks and rewards, and to determine whether the recommendation is suitable for at least some investors based on that understanding. FINRA observed during examinations that many firms have in place a new product vetting process that assists them in executing reasonable diligence obligations. While many large firms have extensive frameworks for assessing products, even smaller firms established investment committees to vet complex or risky products to determine whether the product met the reasonable-basis suitability standard for retail customers, and if so, the type of customer profile for which the product would be suitable if recommended.

A firm’s vetting of new products does not, standing alone, satisfy the need for associated persons to understand the securities and investment strategies they recommend to customers.  In this regard, some firms post due diligence on products (and accompanying documents) to an internal website that associated persons can access when recommending a product. Such information includes audited financial statements, notes of interviews with key individuals of the product sponsor or issuer, and other information relevant to understanding the product and its features. Some firms use the vetting process to aid in product-focused training of their associated persons, supervisors and compliance staff.


Compliance with the reasonable-basis suitability requirement will be an important issue in the next securities litigation cycle.  Chief Compliance Officers are right to focus on this issue before the next cycle is upon them.
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Topics: reasonable basis suitability, FINRA, RN 13-31, litigation, investments, supervision, Due Diligence, SEC, Compliance, regulation.

Finra Reflects on the SRO Model

Posted by Jack Duval

Nov 20, 2012 3:50:52 AM

Finra Executive Vice President, Thomas M. Selman, spoke at the Investment Program Association Fall Conference on November 15, 2012 and made some interesting comments.  (IPAFC)  I have extracted some of the better parts below.

Here's another pitch for Finra (and not the SEC) to regulate Investment Advisors:

Despite the longstanding faith in the SRO model, it became a point of discussion in the recent debate about how to improve the oversight of investment advisers. As you are aware, investment advisers are not required to join an SRO. The SEC examined only 8 percent of SEC-registered investment advisers in 2011. By contrast, the SEC and FINRA examine about 55 percent of all broker-dealers every year. Almost 40 percent of all SEC-registered advisers have never been examined. The absence of regular examinations of investment advisers poses a threat to their customers. This is a fact upon which virtually everybody agrees, including the SEC staff, FINRA and even the investment adviser industry. The only disagreement has been the manner in which this problem should be solved. The investment adviser industry supported a user fee to fund SEC examinations. FINRA supported statutory authority for the SEC to designate one or more SROs for the investment adviser industry. The principal responsibility of these SROs would be to examine investment advisers for compliance with their statutory requirements and to enforce those requirements.

On the valuation of unlisted REIT and DPP securities:
With these thoughts in mind, I commend the Investment Program Association for the steps it's taken to improve business practices in your industry. I commend the IPA's commitment to establish guidelines for the valuation of unlisted REIT and DPP securities. As you know, the valuation of these securities has been the subject of concern at FINRA. In Regulatory Notice 12-14, we requested comment on a proposal to amend Rule 2340 to address the per share estimated values at which unlisted REIT and DPP securities are reported on customer account statements. Industry commenters generally supported our proposal, and we are considering these comments as we prepare a rule filing with the SEC.

As you are undoubtedly aware, the manner in which unlisted REITs are marketed and sold to retail investors was the subject of our recent enforcement action in the David Lerner case. FINRA will not tolerate abusive marketing practices by broker-dealers in the distribution of any security. Your support for new approaches to the regulation of the unlisted REIT and DPP market, such as vigorous standards for valuing, marketing and selling those securities, is the type of support that will improve the public perception of your industry.


Regarding the reasonable basis suitability determinations of private placements offered by broker-dealers:
Of similar concern is the private placement market. On December 3rd, new FINRA Rule 5123 goes into effect. This rule requires a notice filing requirement for some types of private placements. It will enable us to better police the private placement market, which has been the source of many instances of abuse. In our administration of this rule, we will be particularly interested in the extent to which a broker-dealer selling a private placement has undertaken a reasonable inquiry concerning the security and the issuer.

Lastly, of note is this last bit: "We have posted a position for a Chief Economist who will build economic analysis into our significant rulemaking."

Readers of this blog know that we have been following the REIT/DPP valuation issue for some time.  A previous post can be found here.

Likewise, our previous coverage of the reasonable basis suitability standard can be found here, here, and here.

 

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Topics: reasonable basis suitability, FINRA, SRO, valuation, Investment Program Association, Investment Advisors, investments, REIT, DPP, SEC, Compliance, Thomas M. Selman, regulation.

Finra EVP Susan Axelrod on Complex Products and Suitability

Posted by Jack Duval

Oct 31, 2012 3:18:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

Speaking at a PLI Seminar on Broker-Dealer Regulation and Enforcement on October 24, 2012, Finra EVP Susan F. Axelrod had some interesting comments on Complex Investments, the new Suitability Rule 2111, and Know Your Customer Rule 2090.  (Axelrod)  You can also see our previous coverage on Complex Products here.  Below are some extracts.

Finra has noticed the hunt for yield that we have been observing in junk bonds here and MLPs here:

Let me now turn to complex products. This is an area that warrants our attention because of the continuous and rapid evolution of these types of products, and more importantly, because these products are now more frequently being offered to retail investors. There is no doubt that customers are seeking higher returns. The industry has responded by creating products that offer the potential for greater yields. But the greater yields provided through complex products can expose customers to increased risk. Firms and registered representatives must ensure that these products are only sold after a careful evaluation, through which all parties fully understand the intricacies of each product. Effective product vetting is critical if your firm is going to sell complex products.

The reasonable basis suitability requirement gets a lot of attention as well, including comprehensive due diligence, written supervisory procedures, and training:
FINRA examiners have been focused on several product types, including principal-protected notes, non-traded REITs, reverse-convertible notes, structured notes, and leveraged and inverse ETFs. FINRA recently issued Regulatory Notice 12-03 highlighting our concerns about complex products and offering guidance to firms on developing adequate supervisory systems for these products. In that guidance, FINRA notes that complex products often necessitate more scrutiny and supervision by a firm. More specifically, the guidance calls for a comprehensive process that includes due diligence prior to approval of the product for sale to clients. Also, this due diligence process must inform the firm's written supervisory procedures and training programs. Brokers should be trained on the features of the product as well as the firm's own suitability guidelines for that product. And these guidelines should be specific enough to identify those to whom the product should and should not be offered. The decision to offer complex products to retail investors is one that should be carefully considered and made only after a thorough assessment of a product's features, a comprehensive training effort and a full evaluation of firm supervisory systems related to that product.

The recent AWC and fine of David Lerner Associates was cited as an example of improper due diligence:
Earlier this week, FINRA announced a significant action involving David Lerner Associates wherein the firm agreed to pay approximately $11.7 million in restitution to customers who purchased Apple REIT Ten, a publicly registered, non-traded REIT. The sanctions, which also include a suspension of the firm's President, David Lerner, as well as a $250,000 fine, stem from the firm's recommendations and sales of Apple REIT Ten without performing adequate due diligence in violation of its suitability obligations. Also, the firm marketed the product using misleading marketing materials, including the presentation of performance results for closed Apple REIT issues, which did not disclose that income from those REITs was insufficient to support the distributions. David Lerner consented to findings that he made false, exaggerated and misleading claims regarding the investment returns, market values, prospects and performance of the closed Apple REIT issues through investment seminars and in letters to customers. As FINRA has repeatedly stated, inadequate due diligence in the complex product space is a recipe for significant problems. FINRA will take appropriate action when it finds that a firm has failed to take reasonable steps in this area.

Finally, Axelrod highlighted how some firms are now documenting hold recommendations:
In addition to understanding the products they sell, every firm must take steps to ensure that the products they sell are suitable for the specific customer. FINRA Rule 2111 (the Suitability Rule) and FINRA Rule 2090 (Know Your Customer Rule) became effective in July. The results of the examinations of this area, while preliminary at this stage, are very encouraging. With very few exceptions, FINRA examiners have observed that firms are demonstrating awareness of the requirements of the rules and have updated their supervisory procedures accordingly. Firms have updated their new account forms to include questions about the information that is required in the new know your customer rule. Although not a specific requirement of the rule, some firms have implemented a process whereby they create a "hold" ticket when brokers make an explicit hold recommendation. Others prefer to document the recommendation in customer relationship management systems. As we have said previously, not a one-size-fits-all approach to compliance with these rule changes.

 

 

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Topics: reasonable basis suitability, Rule 2111, FINRA, complex, Susan Axelrod, hold recommendations, complex products, investments, Rule 2090, Complex Investments, Compliance, David Lerner, regulation.

Finra Sanctions David Lerner Associates $12 million for Apple REIT Ten Sales

Posted by Jack Duval

Oct 23, 2012 3:49:36 AM

A Finra news release yesterday reported the regulator fined David Lerner Associates $12 million for sales of Apple REIT 10.  (Finra)  The funds will go towards restitution for the Apple REIT 10 customers.  The release quoted Brad Bennett, Executive Vice President and Chief of Enforcement:

David Lerner and his firm targeted unsophisticated and elderly customers, grossly failing to comply with basic standards of suitability in selling Apple REIT 10 to thousands of customers.  Firms must conduct a thorough suitability analysis before selling products, and make accurate disclosures of risks and features at the point of sale, especially with alternative investments such as non-traded REITs.

Finra seems to be more focused on reasonable basis suitability these days, which ties in to the new Suitability Rule 2111.

The Order Accepting Offer of Settlement directly addressed the reasonable suitability issue (Order):

93. In addition to its customer-specific suitability obligation, DLA and its registered representatives have a duty to perform reasonable due diligence ot understand the potential risks and rewards associated with a security it recommends to customers, and to determine whether the recommendation is suitable for at least some investors based upon that understanding.

94.  Based upon sales and account maintenace of all issued Apple REITs, DLA management was or should have been aware of red flags indicating that management of Apple REIT Ten may adopt improper valuation practices and may unreasonably leverage the REIT in order to continue to issue returns unsupported by the REITs performance.

95.  Especially in light of these red flags, and DLA's role as sole underwriter, DLA personnel did not conduct reasonable due diligence to understand the potential risks and rewards of Apple REIT Ten before recommending the security to customers.  As a result, DLA was not in a position to determine whether Apple REIT Ten would be suitable for any investor prior to recommending it to customers.

96.  By failing to conduct adequate due diligence to fulfill its reasonable-basis suitability obligation, which also violated its duty to observe high standards of commercial honor and just and equitable principals of trade, DLA violated NASD Rule 2310 and Finra Rules 2310(b) and 2010.


See our coverage of suitability here.

The May 27, 2011 Finra Complaint against DLA can be found here.

Finra also fined David Lerner personally $250,000 and suspended him for one year from the securities industry and for two years after that from acting as a principal.

 

 

 

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Topics: reasonable basis suitability, FINRA, Brad Bennett, David Lerner Associates, Apple REIT 10, investments, DLA, Compliance, regulation.

Complex Products Speech by Finra Chairman and CEO Richard G. Ketchum

Posted by Jack Duval

Oct 1, 2012 4:25:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

Finra Chairman and CEO Richard G. Ketchum delivered some enlightening remarks at the SIFMA Complex Products Forum on September 27, 2012.  (Speech).  The speech is well worth the read.  There are many items of note in Ketchum's remarks.  Some are highlighted below (with useful links at the end):

An attempt at a definition of complex products:

What do we mean by the term "complex product"? Of course, there is no legal definition. I suggest that a basic guide might be the following: A product might be considered complex if the average retail investor probably will not understand how its features will interact under different market conditions, and how that interaction may affect potential risk and return. These types of products merit heightened supervision.

While there are numerous products that fit these criteria, here are a few of my favorite examples:


    • Range accrual notes track multiple assets, such as a stock index and an interest rate. These notes may offer an attractive return if both reference assets behave in a certain way, but may also result in a low or zero yield if those conditions are not met.

    • Products with "worst-of" payoffs are also linked to the performance of multiple reference assets, but in this case theworst-performing asset determines investors' return.

    • Dual-directional notes promise positive returns in both bull and bear markets—subject to strict conditions that can limit an investor's upside while placing principal at risk.

    • Products with reference assets may not be well understood. For example, market volatility products can be misperceived. Instead of tracking actual price fluctuation, these products may invest in volatility index futures that reflect the market's expectation of future volatility.


As one benchmark, if you are embedding imputed derivative exposure, leverage or tracking, an asset class or index with limited liquidity combined with issuer credit exposure, don't think twice—it meets our definition of complex.

How complex products should be supervised:
To be blunt, if you are going to offer these types of products to retail investors, then you must supervise them at every stage. In the words of the great American philosopher, Casey Stengel: "Most ball games are lost, not won." A baseball game is more likely lost through unforced errors, poor judgment and boneheaded play. Often, the team's management will properly be held accountable...

It would be foolish for any firm, including yours, to distribute complex products to retail investors without ensuring that products are vetted, reps are trained and supervised, and risks are disclosed in a way that the average investor can understand. Many complex products are distributed by broker-dealer wholesalers. In reviewing the activities of these wholesalers, FINRA is focusing on their level of understanding of complex products, how they are compensated for promoting them to retail broker-dealers, what they advertise about the products, and how they inform the distributing dealer about the complexities and risks of these products.


Ketchum gives two examples of where there was no reasonable basis suitability determination of different complex products:
In a recent case, a registered rep, Richard Cody, sold asset-backed securities collateralized by installment sales contracts and installment loans for mobile homes, to retail investors with low-to-moderate risk tolerance. The ABS was issued from the eighth of 11 tranches, and thus bore the fourth-highest risk of loss from default of the underlying collateral. For this recommendation, Cody relied on the recommendation of a colleague at his firm. It does not appear that the firm itself vetted the product, and the only documentation that Cody obtained was a printout of basic information from Bloomberg. The investors lost 55 to 66 percent of their investment over 15 months.

In other recent cases, FINRA sanctioned four firms for selling leveraged and inverse ETFs without reasonable supervision and without having a reasonable basis for recommending the securities. We found that the firms had failed to conduct adequate due diligence regarding the risks and features of the ETFs. Reps made unsuitable recommendations to customers with conservative investment objectives or risk profiles. Some of these customers held the securities for months while the markets were volatile. These cases illustrate the harm that can occur if a firm does not properly vet the sale of complex products.


As many of you know, the reasonable basis suitability requirement has been formally incorporated into the new Finra Suitability Rule 2111.

Remarkably, Ketchum discusses a furtherance of the diligence requirement after the complex product is sold:

Assume now that your firm has vetted the structured note, and determined that it may be offered by your financial advisers to the retail market. How will you control distribution to retail customers? Some firms place various limitations on the distribution of a complex product. Distribution might be restricted to certain financial advisers, or might require some form of investor proficiency. Some firms limit the concentration of a customer's liquid net worth in a particular product. Others limit product ownership based on a client's age or investment time horizon. Firms also adopt procedures to ensure that as market conditions change, performance of the product is reviewed. Will your firm have a process to notify the financial advisers when conditions have changed to such a degree that the product presents "tail risks" to your customers?

A fundamental characteristic of many structured products is that it offers upside risk to an asset class that has become the "flavor of the month." It is natural that your customers want to enhance their yield by taking advantage of a hedged investment in an asset that is benefitting from present economic conditions. It is your job to make sure that customers understand the downsides of that investment. It is equally important that you respond quickly if your own firm's analyses of the likely performance of that asset turn out to be too optimistic. No firm's analysis of market movements will be infallible, but it is your responsibility to get your new forecasts quickly to your users and your customers.

In the Cody case, the ABS security was downgraded several times during the year following the recommendations, declining from an A rating to triple-C. Apparently, there was no discussion with the customers concerning the downgrade, nor was any action taken until the market price had dropped from $104 to $41 in 15 months. This case illustrates the problems of selling a complex product without monitoring developments after the sale. In another case, FINRA found that a broker-dealer had sold reverse convertibles to unsophisticated investors, leaving them with highly concentrated positions, in some cases greater than 90 percent.  (Emphasis added.)


Disclosure and risk discussions were also highlighted:
Finally, it is necessary to ensure that customers who purchase the product understand its basic features. Some firms only permit the sale of these products to customers who are qualified to trade options. The sale of complex products through discretionary accounts is a particular issue. As we have repeatedly stated, financial advisers should discuss the basic features of these products with retail customers, and include in the discussion the potential risks of those products under different market scenarios. Other additional steps might be needed to ensure that the recommendation of the structured note is consistent with the investment objectives and risk tolerance of particular customers.  (Emphasis added.)

It is clear from this speech and recent NTMs that there is increased regulatory scrutiny of complex products.  While complex products can certainly be appropriate, broker-dealers face higher compliance, supervisory, and suitability hurdles with them.

Some useful links relating to complex products:


    • Reuters article on Ketchum's speech (Reuters)







 

 

 

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Topics: reasonable basis suitability, Rule 2111, FINRA, Richard G. Ketchum, Reverse Convertible, suitability, supervision, ETF, Complex Investments, Compliance, Complexity

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