Wall Street

Tough economic times call for investors to be wary, as financial professionals are tempted toward riskier behaviors, according to the Financial Industry Regulatory Industry’s (FINRA) 2012 report on regulatory and examination priorities, released Jan. 31.

The report first lists a few investment characteristics that demand close attention, and then provides a detailed list of products FINRA believes require heightened regulatory, supervisory and investor attention.

The economic climate since 2008 has resulted in a surge of aggressive yield chasing, inappropriate sales practices, unsuitable product offerings, misappropriation and fraud, the report says.

Investor themselves, worried about their financial future, may be more prone to jump in without fully understanding the risks involved with the esoteric products finding their way into retail portfolios these days.

FINRA notes that firms under economic pressure may be more likely to engage in faulty disclosure of material risks, overcharging and the recommendation of unsuitable of products.

Four characteristics of investments call for special attention, according to the report:

  • Yield Chasing — With yields on Treasuries at all-time lows, FINRA is concerned that investors may take risks they don’t understand or that are inadequately disclosed.
  • Liquidity — Certain investments have little prospect of trading on the secondary market, making them unsuitable for every-day investors with strong liquidity needs.
  • Cash Flow Characteristics — Projected cash flows should be in line with investors” goals.
  • Transparency of Cash Flows and Financial Condition — Complete, transparent and accurate financial data should be disclosed to investors so they can make an informed decision. The classification if cash flow is particularly important. Investors need to know whether returns are paid from principal or from capital raised in later offerings.

The FINRA report then turned to the meat of the matter: A list of products that illustrate its heightened concerns relating to business conduct and suitability. The list is not meant to be all-inclusive, but more a kind of warning label for compliance officers regarding certain products.

Church Bonds

Sales of these bonds are often based in the affinity the purchaser, which makes them ripe for fraud. The credit quality of the issuing church is often not easy to discover. Ditto for the financial condition and sources of revenue, and investors may be unaware of the risk.

Complex Exchange-Traded Products

Not surprisingly, exchange-traded products that use complex strategies or enter exotic markets may expose investors to impossible-to-predict risks. For example, consider exchange-traded funds (ETFs) that use synthetic derivatives, which are basically bets in the form of contracts between parties based on the performance of a measurable, observable underlying asset that none of the parties owns.

The risk of tracking errors is significant with these arrangements because the performance of the ETF may differ unpredictably from that of the underlying asset during any time of economic stress or market volatility. The risks are worse when the ETFs are highly leveraged.

Life Settlements

Life settlements are existing life insurance policies sold to third parties. Although there was some discussion as to whether these are securities, FINRA consider them such, and has expressed regulatory concerns about their extremely high commissions. In addition, recent decisions by the Delaware Supreme Court have pointed out the risk that the validity of a life settlement contract may be challenged based on the lack of an insurable interest.

Mortgage-Backed Securities: Residential and Commercial

The underlying collateral of mortgage-backed securities may be difficult to ascertain, and some lack a robust secondary market. Also, the embedded pre-payment option associated with mortgage-backed securities creates re-investment risk, which can significantly affect yield.

In addition, collateralized mortgage obligations (CMOs) are often separated into tranches, or smaller portions that are sliced off and sold to different investors. These investors need to be ware that some CMO tranches, such as interest-only strips or inverse floaters, carry much higher levels of risk than others.

Municipal Securities

Stockbrokers often fail to make timely disclosures and provide complete financials when it comes to municipal securities, which makes it harder for retail investors to make informed decisions.

In its report FINRA reminded member firms that they have an obligation to make suitable recommendations to their customers regarding trading in the secondary markets. This obligation includes gathering enough information about the issuer to have a reasonable basis as to the suitability of the recommendation.

Along with the suitability obligation, firms must follow Municipal Securities Rulemaking Board (MSRB) Rule G-17, which requires disclosure of all material facts about a security known to the broker-dealer firm, as well as all the material facts that are reasonably known to the market.

The firms need to make sure that their stockbrokers have access to the proper municipal issuer information, which can be accessed through MSRB’s Electronic Municipal Market Access (EMMA) system and other sources.

Prices must be fair and reasonable, including markups and markdowns, and this admonition has some bite. In October 2011, Morgan Stanley & Co. Inc. and its subsidiary Morgan Stanley Smith Barney LLC were fined $1 million by FINRA for excessive markups and markdowns in corporate and municipal bond transactions. Morgan Stanley was also ordered to $371,475 in restitution plus interest to customers.

Non-Traded Real Estate Investment Trusts (REITs)

These unlisted products do not have an active secondary market and therefore offer little in the way of liquidity. The pricing often lacks transparency and the remaining financial information may be murky, which makes the actual risk and actual value difficult to ascertain.

Many of these products have questionable valuations, and in some cases distributions are paid with borrowed money. Distributions may also take many years to pay out. Sometimes, distributions are paid from just-raised capital, or are actually a return of principal rather than a return on investment. To cap it off, the sources of distributions may be hidden.

In short, although non-traded REITs can offer diversification benefits, they come with certain risks that may make them unsuitable for investors who need liquidity, or who want to protect principal, or who can’t afford to wait many years for a return.

Promissory Notes

Stockbrokers — or entities associated with stockbrokers– sometimes write these notes without the knowledge of the broker-dealer firm who employs them. Or stockbrokers may offer and sell promissory notes issued by entities or people not associated with their firm. These instruments may be used to defraud customers who may think the note has received a judgment as to suitability from the firm. Watch out for stockbrokers fraudulently trading on the good name of their employers.

Private Placements

Sometimes companies seek to raise capital by selling unregistered securities in private placements. The Securities and Exchange Commission (SEC) adopted Regulation D to allow broker-dealer firms to offer private placement securities to accredited investors, defined as those having a net worth, alone or with a spouse, of at least $1 million, excluding the value of the person’s primary residence.

In addition to making sure a person is a proper accredited investor, firms must conduct a reasonable investigation of the issuer in order to comply with anti-fraud provisions such as FINRA rules regarding suitability.

The FINRA rules are designed to ensure that firms and stockbrokers disclose all relevant information to each investor in a private placement. In addition, the private placement memorandum, term sheet or similar document must be filed with FINRA.

Structured Products

While these products might promise high yields or some kind of principal protection, they are often extremely complex, and their cash flow and rates of return may be unpredictable or difficult to estimate. Usually, structured products do not have a secondary market, which means investors must assume high liquidity risk, as well as market risk and the credit risk associated with the issuer.

The above can make these products unsuitable for some investors. For example, reverse convertibles are debt obligations tied to the performance of an underlying security or basket of securities. While they can offer a high return, they may also feature complicated pay-out structures.

Reverse convertible pay outs are often tied to what is called a “knock-in” level: if the value of the underlying asset falls below this level, investors might lose most of their principle. As such, reverse convertibles have elements of options trading. They not only expose investors to the normal financial risks associated with debt, the risks associated with the underlying securities as well.

Unregistered Securities

The state of the markets over the past few years, especially the sluggish market for initial public offerings, means that quite a few marquis companies have chosen to remain private. Naturally, their securities are traded on the secondary markets.

Although many of these companies are well known, they can be difficult to value because they do not have to file public financial statements. Moreover, buying these securities through a single security fund or a pooled investment fund imposes another round of costs on investors, and exposes them to the risks that come with entrusting you money to any fund manager.

Variable Annuities

For investors seeking predictable income streams, tax advantages and flexibility, variable annuities can be a useful product, but they do carry risks that make them unsuitable for some investors.

They often have long holding periods and high fees in the event of surrender, making them a bad investment for investors who require liquidity. High fees and expenses may also cut into performance, and high commissions make the product a target for switching.

Variable annuities come with enhanced responsibilities for broker-dealer firms per FINRA Rule 2330. The firm or stockbroker must have a reasonable basis to believe that a customer would benefit from tax-deferred growth, annuitization, or a death or living benefit, among other things. A firm must also ensure that any riders or other policy enhancements are suitable for that particular customer.

The rule also requires the firm or stockbroker to have a reasonable basis to believe that a customer is generally informed as to the various features of deferred variable annuities. Firms need to set up a system that can quickly detect anyone engaging in variable annuity exchanges at a pace that could indicate the person is breaking the securities laws. Firms also need to establish procedures for corrective measures.

Guiliano Law Group

If you have been the victim of securities fraud and you have a complaint, you should consult with an attorney. The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Group, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.

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