The Securities Litigation Expert Blog

FINRA Moves Closer to Fiduciary Standard with Conflicts Report

Posted by Jack Duval

Oct 22, 2013 10:54:25 AM

According to a release by FINRA CEO Richard G. Ketchum, the regulator is stepping up it's focus on conflicts of interest at Broker-Dealer firms.  (Release)  This increase in focus is significant because it takes a step closer to a fiduciary standard for Registered Representatives.  The full, 44 page report can be found here.

Some areas for BD focus include:



  • identifying and managing conflicts on an ongoing basis through an enterprise-level approach that is scaled to the size and complexity of a firm's business and that starts with a "tone from the top" that carries through to the organization's structures, policies, processes, training and culture;

  • establishing new product review processes that include perspectives independent from the business proposing products, that identify potential conflicts raised by new products, that restrict distribution of products that may pose conflicts that cannot be effectively mitigated and that periodically re-assesses products through post-launch reviews;

  • making independent decisions in the wealth management business about the products they offer without pressure to favor proprietary products or products for which the firm has revenue-sharing agreements;

  • minimizing conflicts in compensation structures between customer and broker or firm interests where possible and including heightened supervision when conflicts remain; for example, around thresholds in a firm's compensation structure;

  • mitigating conflicts of interest through disclosures and other information that enables customers to understand the factors that may affect a product's financial outcome—such as the use of scenarios and graphics for a particular product; and

  • including "best-interest-of-the-customer" standards in codes of conduct that apply to brokers' personalized recommendations to retail customers in order to maintain and increase investor trust.



Broker-Dealer compliance departments will need to establish a framework of policies and procedures to address actual and potential conflicts of interest.

 

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Topics: FINRA, Richard G. Ketchum, litigation, Conflicts of Interest, investments, report, SEC, Compliance, Dodd-Frank Act, regulation.

Finra Scales Back RIA Oversight Bid

Posted by Jack Duval

Feb 8, 2013 1:45:46 AM

Finra CEO Richard G. Ketchum is quoted in an InvestmentNews article saying the regulator will pare back it's lobbying efforts to take over Investment Advisor regulation from the SEC.  (IA)  Despite the lack of political momentum, Ketchum said the need for more resources for RIAs remains.

“We haven't changed our view,” Mr. Ketchum said. “We've been at this for four years now. The SRO approach is the most effective, least duplicative way to oversee [advisers]. If an SRO is not approved, the SEC should be given more resources to oversee [advisers]. If an SRO is not approved, the SEC should be given more resources to address a significant investor exposure. Any way you look at it, the SEC needs more resources.

A 2011 SEC study mandated by the Dodd-Frank financial reform law indicated that the SEC could conduct annual examinations of only 8% of the approximately 12,000 advisers under its aegis at the time. After some adjustments ushered in by Dodd-Frank, the SEC now oversees about 11,000 advisers.

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Topics: FINRA, RIA, Richard G. Ketchum, Investment Advisors, SEC, Compliance, Dodd-Frank Act, regulation.

Finra Focus Areas

Posted by Jack Duval

Jan 10, 2013 4:04:00 AM

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

In an interview with The New York Times, Finra CEO Richard G. Ketchum gave insights into the regulators areas of focus.  (NYT)  These include:


    • High Frequency Trading

    • Complex Products

    • Leveraged Loans

    • Collateralized Loan Obligations

    • Brokerage Conflicts with Proprietary Products


You can find our previous coverage of Richard G. Ketchum here and here.
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Topics: collateralized loan obligations, FINRA, complex, high frequency trading, Richard G. Ketchum, complex products, leveraged loans, investments, Compliance, regulation., Complexity

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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