FINRA Resolutions: Key Sales Practices

By Patricia Uceda, Spring 2015 Graduate Research Assistant

As we mentioned yesterday, FINRA has published its 2015 priorities.  Today we will focus on key sales practices.  FINRA concerns regarding sales practice include features of the product itself as well as the sales or distribution methods used to sell those products. FINRA’s 2015 surveillance activities will focus on whether firms and registered representatives are performing due diligence and making sound suitability decisions when recommending products to investors, as well as whether they are remaining attentive to changing circumstances that can affect suitability decisions or risk descriptions. FINRA will specifically focus on the following types of products:

  • Interest Rate-Sensitive Fixed Income Securities: FINRA examiners plan on taking a closer look at concentrated positions in products that are very sensitive to interest rates and testing for suitability and adequate disclosures. This includes long-duration fixed income securities, high yield bonds, mortgage-backed securities, or bond funds composed of interest rate-sensitive securities. They will also make sure that firms have adequate systems in place to educate registered representatives and customers about those products. While the U.S. has been in a sustained period of unusually low interest rates, shifts in the environment could change this and cause drastic harm to costumers holding these types of products.
  • Variable Annuities: FINRA plans on focusing on sales practice issues with variable annuities, and will assess suitability of recommendations, compensation structures, statements made by representatives about those products, and the adequacy of disclosures. Many times the compensation structure can improperly incentivize the sale of variable annuities, which is something they are hoping to cut down on. They will also ensure that the training procedures implemented by firms adequately prepare the brokers with knowledge of these types of product in order to prevent problematic sales practices.
  • Alternative Mutual Funds: Alternative mutual funds are funds that involve non-traditional asset classes and non-traditional strategies, as opposed to long-only equity and fixed-income conventional mutual funds. The sale of these alternative mutual funds has increased rapidly over the past several years, and FINRA is concerned about how these products are being marketed to customers. They recommend that firms refer to them based on their specific strategies, as opposed to bundling them under an umbrella category of “alternative mutual funds.” This year they will be taking a closer look at sales strategies and ensuring that recommendations adequately disclose how the funds work and how they will respond to various market conditions.
  • Non-Traded Real Estate Investment Trusts (REITs): Non-traded REITs carry various unique risks, including general lack of liquidity, high fees, and valuation difficulties. FINRA intends to monitor firms to ensure that they are fulfilling suitability obligations when recommending non-traded REITs to clients, as well as performing ongoing due diligence on REITs that they have recommended. FINRA has also amended the Customer Account Statement Rule to require broker-dealers to provide a more accurate per share estimated value on customer account statements, which is often a problem with non-traded REITs.
  • Exchange-Traded Products (ETPs) Tracking Alternatively Weighed Indices: Market indexes are very useful indicators of an exchange-traded product’s price and changes in market values over time. However, recently indexes have expanded beyond traditional market capitalization-weighted indexes to alternatively weighted strategies which provide exposure to specific investment risk factors or strategies. Products tracking these alternatively weighted indices are being sold increasingly, however they can be very complex and unfamiliar to investors. This year FINRA intends to have a closer look at these products and their sales practices, making sure that they are being recommended after a thorough suitability determination and after full disclosure of all risks.
  • Structured Retail Products (SRPs): SRPs consist of structured notes that typically have complex payout structures, long maturities, and linkages to new and less well-understood proprietary indices. Because of these complex features, SRPs can often bring new and unfamiliar risks to investors. In addition, they are often sold through distribution channels that do not have adequate controls to protect investor interests, such as retail distributors with insufficient expertise. FINRA will focus on these sales practices this year to ensure that sound suitability determinations are being made when these products are recommended, as well as ensuring that there are no conflict issues where the distributor and the wholesalers of these products are affiliated companies.
  • Floating-Rate Bank Loan Funds: Products which primarily invest in floating-rate bank loans are called floating-rate bank loan funds. Despite the promise of lessened exposure to interest-rate risk, these loans carry a large amount of credit risk. In addition, they can be very difficult to valuate and are relatively illiquid. While these loans are typically geared to institutional investors, FINRA has noticed that retail investors have been increasing their exposure to these products and they intend to closely monitor them throughout the year.
  • Securities-Backed Lines of Credit (SBLOCs): Investors can borrow money from lending institutions using their fully paid-for securities in brokerage accounts as collateral; these are called SBLOCs. FINRA has observed that the number of firms offering these SBLOCs has greatly increased, and they are concerned about how these products are being marketed. Broker-dealers offering SBLOCs need to have proper supervision controls in place to ensure that customers are being fully informed about how changing market conditions may affect their SBLOCs, as well as operational procedures to be able to monitor the customer’s account.

In short, all of these concerns boil down to suitability and disclosure issues. Many of these products are very complex and subject to substantial market, credit, liquidity or operational risks. Thus, firms and registered representatives have to be sure they have procedures in place to make sound suitability decisions and describe product risks in a balanced manner that investors can understand.