Financial Services: Examination priorities to protect investors

By James J. Eccleston
Shaheen, Novoselsky, Staat, Filipowski & Eccleston

FINRA (the Financial Industry Regulatory Authority) has issued its publication, ”Improving Examination Results” to highlight ”examination priorities.” Many of the examination priorities relate to investor protection issues, including guidance regarding the recommendation of, and required risk disclosures for, purchases of auction rate securities. Let’s examine three of the more important investor protection issues.

1. Senior Issues. FINRA’s efforts to educate investors, advisers, and financial services firms have focused on sales seminars. Specifically, FINRA is concerned about ‘’sales pitches masquerading as educational seminars, misleading advertising and sales materials, poor supervision, product suitability and outright fraud.” FINRA references its ”cogent summary” of its concerns in Regulatory Notice 07-43. In its examinations of firms, the regulator will ”focus on sales to seniors and other investors approaching requirement.”

Among other things, FINRA will scrutinize advertisements and sales material to ensure that they are fair and accurate, will be suspicious of ‘’self-conferred designations or other unwarranted claims of senior specialty,” and will ensure that investment recommendations are suitable, given current investment objectives and age.

2. Deferred Variable Annuities. Since May 5, 2008, FINRA has begun examining for compliance with the new provisions of Rule 2821, which the SEC approved over the strong objections of the financial services industry.

Firms now have responsibilities both in terms of the suitability and supervision of recommendations to purchase or exchange deferred variable annuities (which are life insurance annuity contracts whose value fluctuates over time, and whose income is delayed).

In terms of suitability of recommendations, financial advisers must take into consideration whether: (1) the customer will incur a surrender charge, be subject to a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements); (2) the customer will benefit from product enhancements and improvements; and (3) the customer’s account has had another deferred variable annuity exchange within the preceding 36 months.

Financial advisers not only must gather personal and financial information from the investor, but also must make reasonable efforts to determine the investor’s ”intended use of the deferred variable annuity.”

Finally, in the SEC’s release approving the changes to Rule 2821, a footnote highlights an additional, ongoing duty: ”The general suitability obligation requires a [financial services firm] to consider its customer’s ability to understand the security being recommended, including changes in the customer’s ability to understand, monitor, and make further decisions regarding securities over time.”

3. Sales of New or Non-Conventional Products, Including Auction Rate Securities. FINRA is concerned with the features and characteristics of new or non-conventional products.

Among other things, firms must ”conduct adequate due diligence to understand the features of a product,” and firms should not recommend a product to investors if their advisers do not understand it. There must be ”a balanced disclosure of the risks and potential awards associated with the particular product.”

In particular, FINRA is focused on the suitability of recommendations to purchase hedge funds, CMOs (collateralized mortgage obligations) and CDOs (collateralized debt obligations), REITs, auction rate securities, and other products. FINRA emphasizes, ”Many of these products are not suitable for all customers.”

Auction rate securities recently have been in focus, as investors have come to learn that these investments are neither safe nor liquid.

FINRA references MSRB Notice 2008-09, which the Municipal Securities Rulemaking Board published on February 19, 2008. The MSRB notice observes that auction rate securities ”historically have been sold to investors seeking short-term, liquid investments.”

It highlights MSRB’s rules on disclosure and suitability, specifically noting that, ”The duty to disclose material facts to a customer in an auction rate securities transaction includes the duty to give a complete description of the security, including features of the auction process that likely would be considered significant by a reasonable investor.”

The MSRB notice provides several examples, including: the duration of the interest rate reset period, information on how the ”all hold” and maximum rates are determined, and that an auction rate security recently was subject to a failed auction. Likewise, in terms of suitability of recommendations to purchase auction rate securities, the MSRB notice requires firms and their advisers to consider the investor’s need for a liquid investment.

These three examination priorities give a sense of FINRA’s agenda as it seeks to protect investors. Given the state of the markets — a host of senior issues, sales abuses with deferred variable annuities, and challenging new or non-conventional products — no doubt FINRA will be quite busy enforcing its examination priorities for years to come.