More On Legal & Compliancefrom The Advisor's Professional Library
- Updating Form ADV and Form U4 When it comes to disclosure on Form ADV, RIAs should assume information would be material to investors. When in doubt, RIAs should disclose information rather than arguing later with securities regulators that it was not material.
- Suitability and Fiduciary Duty Recommending suitable investments is more than just a regulatory obligation. Many investors bring cases claiming lack of suitability, so RIAs must continuously put the onus on clients to notify the advisor of changes in their financial situation.
Richard Ketchum, CEO of the Financial Industry Regulatory Authority, told broker-dealer compliance officers on Tuesday that while the regulator has noticed improvements among firms’ supervision and compliance programs, “heightened supervision” is still necessary when it comes to complex products.
During the Securities and Exchange Commission’s National Compliance Outreach Program for Broker-Dealers, held at SEC headquarters in Washington, Ketchum pointed to three areas that FINRA is focusing on—complex products, conflicts of interest and exams.
He also told BDs that the next step in FINRA’s “continuing efforts to integrate and merge surveillance with exams” was to increase the amount of data that FINRA gets from its member firms. Said Ketchum: “We are looking to download significant transactional information” from member firms. Ketchum also said he hoped guidance would be coming from FINRA by early summer on conflicts of interest.
As to conflicts, Ketchum noted that FINRA is now reviewing the comments it received on its controversial proposal under Regulatory Notice 13-02 to require that brokers’ recruitment compensation be disclosed when they switch firms, and “will soon decide on how to proceed.”
Said Ketchum: “When a broker moves to a new firm and calls a customer to say, ‘You should move your account with me because it will be good for you,’ the customer needs to know all of the broker’s motivations for moving. In some instances, recommendations to customers can be driven by direct and indirect compensation incentives to the financial advisor and the firm itself.”
Noting that FINRA’s concerns about complex products aren't new, Ketchum said that FINRA continued to “see problems” with suitability and supervisory violations.
Ketchum first pointed to structured products, which he said were complex because they typically involve “unsecured debt and involve derivative strategies featuring payouts that are linked to a variety of underlying assets—which are sometimes highly volatile—such as a narrow or proprietary index or some other obscure benchmark.” He added that though firms “may market these products to retail customers based on attractive initial yields and, in some cases, on the promise of some level of principal protection, they often have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate.”
Other complex products include closed-end funds, private REITs, private placement securities and “exotic” ETFs that “have driven way too many enforcement cases,” Ketchum told BD compliance officers.
Retail investors may find closed-end funds “attractive,” Ketchum said, “because they typically pay income regularly in the form of dividends, interest income, capital gains and/or return of capital.” However, closed-end funds require “enhanced supervision because retail investors may not understand that some funds are returning capital to maintain the high distribution rates, causing the closed-end funds to trade at high premiums compared to their net asset value,” he said.
The “scarcity of independent financial information and the uncertainty surrounding the private placement securities market and credit-risk exposures associated with many private placements” means firms must conduct reasonable due diligence on prospective issuers, Ketchum said.
Due diligence, he continued, “should focus on the issuer’s creditworthiness, the validity and integrity of their business model, and the plausibility of expected rates of return as compared to industry benchmarks. Our primary concern is that inadequate due diligence regarding private placements could expose customers to harm and result in insufficient disclosure.”
Ketchum also told BD compliance officials that in addition to assessing the potential risks of the individual products, they “should assess and disclose” their firm's conflicts of interest.
“Start by looking at whether your business practices place your firm's—or its employees'—interests ahead of customers,” Ketchum advised. “You should also make sure that the products your firm sells are appropriate for each investor, and assess the potential risks associated with products that raise specific investor-protection concerns. And where applicable, you should disclose any conflicts of interest.”
More broadly, he continued, FINRA wants “to better understand how firms identify and manage conflicts.”
---Read Ketchum’s Big SRO Omission on AdvisorOne.