More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.
The Financial Industry Regulatory Authority (FINRA) just released its watch list for 2013, highlighting its top 10 products and regulatory areas that will be priorities during its exam schedule this year.
FINRA notes that retail investors have been challenged to find attractive returns within their risk tolerance, while increasingly shifting funds from equity to debt markets. “Investor appetite for yield, among other factors, has bid up market prices on investment-grade and high-yield debt, putting pressure on upside growth potential and creating significant downside risks,”it said in a statement.
In this environment, FINRA says that it is particularly concerned about “sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices.”
Against this background, FINRA said the following on the 10 areas in its exam efforts this year:
1) Suitability and Complex Products—FINRA’s recently revised suitability rule (FINRA Rule 2111) requires broker-dealers and associated persons to have a reasonable basis to believe a recommendation is suitable for a customer. Given the market conditions discussed above, we are particularly concerned about firms’ and registered representatives’ full understanding of complex or high-yield products, potential failures to adequately explain the risk-versus-return profile of certain products, as well as a disconnect between customer expectations and risk tolerances. More specifically, we are concerned about:
-- the market risk exposures associated with interest-rate-sensitive investments and the corresponding alignment with customer risk tolerances given today’s low-yield environment;
-- credit risk exposures associated with investments where the creditworthiness of counterparties may not necessarily be transparent to or align with the risk tolerance of customers; and
-- liquidity risk exposures associated with investments where the timing of cash flows or the ability to quickly liquidate positions may not align with customer cash flow needs.
2) Leveraged Loan Products—Leveraged loans are adjustable-rate loans extended by financial institutions to companies of low credit quality that have a high amount of debt relative to equity. Funds that invest in leveraged loans have seen relatively heavy inflows during 2012. Unlike traditional fixed-income bonds, floating-rate loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, but the underlying loans held in the fund are subject to significant credit, valuation and liquidity risks that may not be transparent to investors.
3) Commercial Mortgage-Backed Securities (MBS)—As noted above, FINRA has concerns about yield compression, and those concerns apply to agency MBS as a fixed-income instrument. But not all CMOs are alike. FINRA has heightened concerns about the sale and marketing of commercial mortgage-backed securities to retail investors. Specifically, we are concerned that firms are not fully disclosing in a transparent manner the considerable risks given today’s low-interest-rate, low-yield environment. The commercial mortgage-backed securities space, in particular, has seen a significant compression in risk premium in 2012 as investors have bid up prices and driven down yields while default rates remain high as compared to historical norms.
4) High-Yield Debt Instruments—Since the domestic financial crisis, the high-yield debt market has been viewed as an attractive alternative to other financial products. Given the inverse relationship between price and yield, this influx of cash into the high-yield market has increased prices and put downward pressure on yields. In September 2012 alone, investors put an estimated $8.8 billion in high-yield-bond funds, bringing the 2012 total as of October 5 to a record $64.5 billion—more than double the previous high of $31.8 billion in 2009, according to EPFR Global. Risk premiums have compressed across the sector, resulting in significant market risk exposures. In addition, an increasingly diverse range of companies have recently engaged in high-yield underwritings, and some of these companies have very high-level cash flow or funding demands that raise significant credit risks.
5) Structured Products—These products may be marketed to retail customers based on attractive initial yields and in some cases on the promise of some level of principal protection. These products are often complex, and have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, these products generally do not have an active secondary market.
6) Exchange-Traded Funds and Notes—Retail investors may not understand the differences among exchange-traded index products (e.g., funds, grantor trusts, commodity pools and notes) and the risks associated with these investments, particularly those that employ leverage to amplify returns. We are also concerned about the proliferation of newly created index products lacking an established track record, such as those with valuations and performance tied to volatility, emerging markets and foreign currencies.
7) Non-Traded REITs—FINRA says it’s concerned that customers of non-traded REITs may not fully understand the sales costs deducted from the offering price and the repayment of principal amounts as dividend payments in the early stages of a REIT program.
8) Closed-End Funds—In today’s low-interest-rate environment, retail investors find the high distribution rates associated with many closed-end funds attractive. Distributions may be composed of dividends, interest income, capital gains and/or return of capital. We are concerned that retail investors may not understand that some funds are returning capital to maintain high distribution rates, causing the closed-end funds to trade at high premiums compared to their NAV.
9) Municipal Securities—Rated municipal securities, on the aggregate, have demonstrated relatively strong repayment patterns as compared to similarly rated corporate bonds. General obligation bond default rates typically hover around 0.1 percent. However, market sectors dependent upon private profit-making or nonprofit performance, for example, experienced significantly higher default rates.4 We are concerned that brokers may fail to disclose the material risks associated with these kinds of higher risk bonds, and that customers searching for safe-harbor investments may assume that these instruments share the same risk-versus-reward profile of general obligation municipal securities.
Moreover, consolidation in insurance companies offering variable annuities may provide an inappropriate incentive for brokers to recommend exchanges. Where the insurance company offers to buy back the product or increase the account value to forgo product guarantees, it may also present both brokers and investors with a less-than-clear picture of the financial benefit to the investor as well as the challenge of finding a similar product with the features included in the prior product.