The Financial Industry Regulatory Authority released its 2018 Examination Report, showing the areas in which the regulator has taken some form of enforcement action against brokerage firms to prevent them from taking advantage of their customers, and to “better protect investors and maintain the integrity of the markets.”
The Recommendation of Unsuitable Investments
First, on this year’s list of abuses is “suitability,” or the lack of suitability, in connection with recommendations to investors or retail customers. FINRA Rule 2111 (Suitability) establishes a fundamental responsibility for firms and associated persons to deal with customers fairly and is composed of three main obligations: (1) reasonable basis suitability; (2) customer-specific suitability; and (3) quantitative suitability.
“Reasonable basis suitability” means that the broker or broker-dealer has conducted reasonable diligence, and understands the risks and characteristics of a security before recommending it to customers. “Customer-specific suitability” means that once there is a reasonable basis to recommend any particular security, the broker or broker-dealer has to determine if the security is suitable for that particular customer, based upon a variety of factors including their age, income, tolerance for risk, and investment objectives. Finally,“quantitative suitability,” means that the cost, or transaction costs are suitable for that customer. Examples of “quantitative suitability” include churning or excessive activity, or the short term trading of bonds, unit investment trusts, or even mutual funds, and includes any case where the customer is charged a fee, commission or mark-up, and the transaction or costs exceed any reasonable benefit to the customer.
Interestingly enough, firms that fail to evaluate whether a customer is better off in a fee-based or transaction based accounts, may be in violation of quantitative suitability. Notice to Members 03-68, states that broker dealers are required to evaluate customer accounts, based upon costs and commissions, “at least annually” to determine whether “the type of account is appropriate in light of the services provided,” or if “alternative fee structures” are available. Notice to Members 03-68 (“It generally is inconsistent with just and equitable principles of trade—and therefore a violation of Rule 2110—to place a customer in an account with a fee structure that reasonably can be expected to result in a greater cost than an alternative account offered by the member that provides the same services and benefits to the customer.”); See also, NASD Dept. of Enforcement v. Morgan Stanley DW, Inc., Action No. EAF 030116001 (July 27, 2005)($1.5 million fine and $4.6 order of restitution to customers for “failure to establish and maintain an adequate system of supervision, including written procedures, reasonably designed to review and monitor fee based vs. commission based business”).
However as part of its 2018 Examination Results, FINRA reports that it continues “to observe unsuitable recommendations by associated persons to retail investors as well as deficiencies in some firms’ supervisory systems for registered representatives’ activities.”
According to its Report, FINRA observed “situations where registered representatives did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations; in others, they failed to take into account the cumulative fees, sales charges or commissions.
In some cases, FINRA found that unsuitable recommendations involved complex products (such as leveraged and inverse exchange-traded products. In other cases, FINRA observed that they involved the over concentration in illiquid securities, such as non-traded Real Estate Investment Truss, variable annuities,, and sophisticated or risky investment strategies.
Failure to Conduct Due Diligence
FINRA also found in part as a general matter, “[i]nadequate product due diligence across product classes,” including failure to understand the specific features and terms of products recommended to customers.
FINRA also found that “some firms maintained customer accounts that were concentrated in complex structured notes or sector-specific investments, as well as illiquid securities, such as non-traded real estate investment trust (REITs), which were unsuitable for customers and
resulted in significant customer losses.”
Some registered representatives recommended structured notes or sector-specific investment strategies to customers who may not have had the sophistication to understand their features and without considering the customer’s individual financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors.
In “some instances,” firms did not have procedures or systems reasonably designed to identify and supervise the concentration of such products in customers’ accounts.
Churning or Excessive Activity
Churning or excessive activity also appear to be prevalent according to FINRA’s Report. According to FINRA, [s]ome firms failed to establish and enforce an adequate supervisory system reasonably designed to identify and prevent potentially excessive trading in customer accounts.”
One would think that with the various and generally custom-made exception reports that are available to broker-dealers in 2018 (generally from their clearing firms), that supervisory personnel would be able to quickly detect and prevent excessive activity or churning.
However, according to the FINRA Report, “[s]ome firms maintained inadequate written supervisory procedures” that “identified key indicators of excessive account activity, but did not establish related specific threshold values or parameters for these indicators”
In other instances, FINRA found the firms picked the wrong indicators or exception reports, including , “indicators did not allow firms to identify potential quantitative suitability concerns (e.g., 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).”
FINRA also found that some firms even lacked adequate supervisory procedures concerning the generation of exculpatory “happy letters,” or “activity letters” sent to customers whom are generally the victims of churning. FINRA found that “[i]n certain cases, firms had an “active account” but did not adequately supervise that process, resulting in letters that were overly general and failed to include meaningful information regarding the relevant account activity.”
Fixed Income Compensation Disclosure
Another topic or abuse highlighted in FINRA’s 2018 Report is the disclosure of mark-ups or mark-downs in connection with the sale of fixed income securities.
FINRA points out that on May 14, 2018, it and the Municipal Securities Rulemaking Board implemented amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G-15, which requires firms to provide additional transaction-related information to retail customers for certain trades in corporate, agency and municipal debt securities (other than municipal fund securities).
This information includes the mark-up or mark-down for principal trades with retail customers that a firm offsets on the same day with other principal trades in the same security. Disclosed markups and mark-downs must be expressed as both a total dollar amount for the transaction and a percentage of “prevailing market price.”
However, once again, if the broker-dealer offsets these transactions the following day, or has the securities in inventory overnight, the broker-dealer has no obligation to disclose these mark-ups or mark-downs, and perhaps more importantly, if these securities are thinly traded or there is a large spread between the “bid price” and “ask price,” the broker-dealer is only obligated to disclose the mark-up or mark-down from the prevailing “bid price” or “ask price,” not their actual cost (the difference being their profits or “trading profits”).
Private Placements
Private Placements also appear to be a problem for investors.
FINRA has observed instances where some firms that have suitability obligations under FINRA Rule 2111 failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110.
FINRA Regulatory Notice 10-22 describes the circumstances under which firms have an obligation to conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.” It is 2018 Report, FINRA reminds firms conducting diligence required by the reasonable-basis suitability obligation to document both the “process and results” of such reasonable diligence analysis.
Nonetheless, FINRA found that “some firms failed to perform reasonable diligence on private placement offerings prior to recommending the offerings to retail investors.”
In many cases where some firms obtained and reviewed due diligence reports by third party due diligence consultants, they sometimes did not independently evaluate the third parties’ conclusions, respond to red flags or significant concerns noted in the reports. In other cases, in connection with obtaining these third party due diligence reports, often if not always paid for by the issuer, FINRA found that firms “did not consider the related conflicts of interest in their evaluation and assessment of the reports’ conclusions and recommendations.”
Unauthorized Trading
FINRA 2018 Exam Findings also appears to be a continuing issue. In its Report, FINRA observed situations where registered representatives exercised discretion in customer accounts without the customers’ prior written authorization or the firm’s approval of the discretionary account.
As is typical, and as ought to be detected by adequate supervisory procedure, FINRA found that “[i]n some instances, this occurred when a registered representative executed transactions in a single security across multiple customer accounts in a short period of time.” In addition, “[s]ome registered representatives mismarked order tickets to obscure unauthorized discretionary trading by indicating that trades were executed in an unsolicited capacity, when, in fact, customers did not initiate the transactions and were unaware of the trading occurring in their accounts.”
FINRA also found problems with customer confirmations. In particular, FINRA observed that some firms did not maintain adequate supervisory programs relating to confirmations or comply with certain confirmation disclosure requirements for transactions with customers in equity securities.
Some firms inaccurately disclosed their trading capacity (such as agent, dual agent, principal or riskless principal, as necessary), including whether they served in multiple capacities, and “ [in some instances, firms mislabeled theircompensation because they did not list it as commission, mark-up or mark-down, or commission equivalent, as appropriate.”
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