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.
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.