The Securities Litigation Expert Blog

3 Dangerous Trends for Senior Investors

Posted by Jack Duval

Jun 6, 2013 2:39:24 AM

After 13 years of volatile markets that have left many retirees with their assets depleted, some of them are taking desperate measures to make ends meet.  Recent articles have highlighted three of these methods:


  • Reverse Mortgages.  Allow a homeowner to monetize their home while living in it. (CNBC)

  • Early IRA Withdrawals.  Allow an IRA holder to make withdrawals before age 59 1/2 or before Required Minimum Distributions start. (Forbes)

  • Pension Loans.  Allow a pensioner to monetize their income stream. (NYT)


None of these are sustainable and they all put the retirees at risk of running out of money.  If utilized, they should be used to fund living expenses and not investments.

Under the FINRA Suitability Rules (2111), "investment strategies" are covered, so a recommendation by a Registered Representative for a client to use one of these strategies would come under the rule.  This is similar to the "Liquified Home Equity" strategy that became common during the housing bubble.  (NTM 04-89)

Compliance and supervisory personnel should monitor accounts for deposits from these strategies and insure that they are not going into securities - a sequence that would almost certainly involve fees and/or penalties from the liquidity source and fees from the subsequent reinvestment.

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Topics: Rule 2111, FINRA, Pension Loans, Investment Advisors, early IRA withdrawals, reverse mortgages, Senior Investors, investments, SEC, Compliance, NTM 04-89, regulation.

Finra Clarifies Suitability Rule 2111

Posted by Jack Duval

Jan 3, 2013 3:48:21 AM

Finra has released NTM 12-55 to further clarify the recently updated suitability Rule 2111.  (Finra)  Some key takeaways:


  1. The term "customers" does not include other broker-dealers;

  2. The suitability rule applies to recommendations made to potential clients who become clients and execute the recommended trade or strategy at the recommending firm;

  3. The suitability rule applies to recommended strategies, such as the general use of margin, even if there is no specific investment recommendation made;

  4. The suitability rule applies to explicit recommendations to hold securities or to continue with an investment strategy (Finra uses an example of a quarterly review meeting with a client where the Registered Representative explicitly advises the client not to sell any securities or to continue their existing investment strategy.);

  5. The suitability rule applies to recommendations to sell securities in order to raise funds to purchase non-securities.


See our previous coverage of suitability Rule 2111 here.

Compliance departments need to update their policies and procedures to reflect these clarifications and to monitor RR activity regarding: investment strategies, hold recommendations, and sell recommendations to purchase non-securities.

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Topics: Rule 2111, FINRA, client, hold recommendations, supervision, NTM 12-55, SEC, Compliance, regulation., investment strategies

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.

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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