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Regulation and Compliance > Federal Regulation > FINRA

FINRA Exam Report: 5 Big Problem Areas for Brokers in 2018

By Janet Levaux

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The Financial Industry Regulatory Authority released its annual exam findings on Friday, zooming in on improper activity that it wants to stop.

The report lists the areas in which industry players need to do better, based on what FINRA staff has been seeing out in the advisory field: advisors working on accounts and transactions for which they do not have authorization or the authorization had expired, as well as cases of mismarked order tickets, false statements, blank forms and the abuse of trustee status.

The summary also discusses investor suitability, fixed income markup disclosure and due diligence for private placements, as well as findings from a targeted exam (or sweep) tied to with volatility-linked products.

“One of our core priorities is to provide firms with information that will help them more easily comply with rules and regulations, and this report aims to do just that,” according to FINRA CEO Robert Cook. “We hope the observations within the Exam Findings Report enable firms to strengthen their own control environments and address potential deficiencies before their next exam.”

Separately, the group shares report cards for specific firms, so they can look at how their compliance controls are doing in comparison with the rest of the industry’s. In addition, FINRA publishes an yearly Regulatory and Examination Priorities Letter each January.

1. Suitability for Retail Clients

FINRA says it continues to see unsuitable recommendations and deficiencies in supervisory systems for registered representatives’ activities. “Firms should also consider the guidance in FINRA Regulatory Notice 18-15 to determine whether certain representatives engaging in repeated misconduct should be subject to special supervisory procedures, such as a heightened supervision plan,” it states.

For example, some reps are not adequately considering a client’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives or liquidity needs when when making recommendations.

In other cases, the advisors are not taking into account the cumulative fees, sales charges or commissions. Plus, some are making unsuitable recommendations that include complex products (such as leveraged and inverse exchange-traded products) or an overconcentration in illiquid securities, variable annuities, switches between share classes, and sophisticated or risky investment strategies.

FINRA also is concerned about the unsuitability of some mutual fund share classes and unit  investment trusts (UITs), which were also discussed in last year’s exam report.

In addition, inadequate product due diligence, such as failing to understand specific features and terms of products, was “a common contributor to the challenges FINRA observed.”

Proper controls entail measures such as restricting or prohibiting the recommendations of products for certain investors, as well as establishing systems-based controls (or “hard blocks”).

2. Overconcentration

Some firms have allowed clients to keep concentrated positions in complex structured notes or sector-specific investments, as well as illiquid securities, such as nontraded real estate investment trust (REITs), “which were unsuitable for customers and resulted in significant customer losses,” FINRA explains.

In these cases, advisors recommended structured notes or sector-specific investment strategies to clients who lacked “the sophistication to understand their features,” for instance. Certain recommendations involved illiquid securities with limited price transparency, “which made

it difficult for investors to know the true value of their investment and led them to believe that their investments would not fluctuate in value.”

3. Excessive Trading

FINRA observed a failure to set up and enforce adequate supervisory systems for identifying and preventing potentially excessive trading. It points out that some firms have not reviewed account alerts from their clearing firm or used other available compliance tools that can detect excessive trading, commissions or trading losses.

There also are problems with indicators that did not adequately identify potential quantitative suitability concerns, like “identifying active accounts based solely on the quantity of trades executed while failing to consider other pertinent criteria, such as turnover ratio, cost-to-equity ratios, margin balances, total commissions, total fees paid, and profit and loss.”

In addition, some firms failed to use plain-language definitions of data categories or explain why they were issuing the letters to clients and have been inconsistent in their use of letters — i.e., they did not issue active account letters for clients engaged in similar or more active trading than clients  receiving such letters.

Furthermore, when clients did not return a signed letter, some firms neglected to follow procedures and restrict account activity.

4. Unsuitable Variable Annuities

FINRA says that some firms have failed to set up, keep and enforce supervisory systems and written supervisory procedures to ensure that advisors’ recommendations of variable annuities complied with suitability obligations. Specifically, some advisors have been exchanging one annuity product for another, which amounted to “unsuitable and largely unsupervised representative-driven recommendations.”

According to the regulator, the recommended exchange was inconsistent with the client’s “objectives and time horizon, and resulted in … increased fees to the customer or the loss of material, paid-for accrued benefits” in many instances.

Moreover, some advisors are executing transactions directly with the insurance company and have “concealed the source of funds used to purchase new variable annuities by having customers take direct receipt of monies from existing securities or annuities.” This creates the appearance of uninvested cash being used to buy a new VA and can create unfavorable tax consequences.

Firms also have problems training reps, “including those responsible for supervising variable annuity transactions, regarding how to assess fees, surrender charges and long-term income riders to determine whether an exchange was beneficial to a customer,” FINRA says.

Some advisors are using guaranteed income riders to persuade clients to sell or exchange existing VAs, even when the surrender costs or loss of benefits does not justify the purchase of or exchange to a new product.

In addition, some advisors misrepresent the cost of VA riders in disclosure forms, and some firms seem to be misfocused: looking more at the completion of exchange forms than at “substantive factors involved in the decision” to switch products, the exam report states.

Overall, FINRA says it “remains concerned about the accuracy and completeness of certain firms’ data for annuity products, including general product information, share class, riders and exchange-based activity.”

5. Volatility-Linked Products

FINRA looked at trading on Feb. 5 and 6, when the Dow Jones industrial average dropped about 4% and the VIX soared 100%. During this period, volatility-linked products and products with inverse or “short” volatility exposure experienced sharp declines in value, and some had losses of 80% or more.

Some firms were found to have comprehensive procedures and controls tied to such products, such as system-based controls, stringent net worth conditions and other pre-qualification criteria. Certain firms also required advisors recommending these products to go through training about their performance and risk characteristics.

FINRA says that overall, marketing to clients who do not understand these products’ unique risks and who may have an inappropriate risk tolerance and or investment time horizon continues. Some firms do not have proper due diligence for these products and thus fail to grasp that the products’ short-volatility exposure makes them vulnerable to steep losses in short timeframes “while equity markets experienced relatively moderate declines.”

The examiners also point out that in some cases such risks are not discussed with clients, that some firms do not have the ability to enforce the limited conditions under which they permit sales of such products, and that policies and procedures regarding the sales and use of such products do not fully comply with firms’ written restrictions.

In fact, some firms have failed to “recognize when a new product on their platform was a volatility-linked product and, as a consequence, did not implement appropriate controls.”

— Related on ThinkAdvisor:

Janet Levaux

@Think_JanetL

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