FINRA’s 2013 Examination Priorities
The Financial Industry Regulatory Authority (“FINRA”) has published its list of investor protection priorities for the coming year. FINRA expressed particular concern with sales practice abuses and yield-chasing behaviors given the current slow growth and low-interest rate environment.
Brokers are required to have a reasonable basis to believe a recommendation is suitable for his or her customer. FINRA is concerned that brokers may not have a full understanding of complex products and as such, may fail to fully explain the risk-vs-return of the product or fail to correct inconsistencies between the investor’s expectations and his or her risk tolerance.
Some of the complex products cited by FINRA as the focal points for its 2013 examinations are:
Business Development Companies – A business development company (“BDC”) is a closed-end investment company that pools investors’ money for the purpose of making investments in small and developing businesses and financially troubled businesses. Investors in BDCs are exposed to significant risks including market, liquidity and credit risks which may be amplified by the use of leverage. Brokers may not sufficiently warn investors that they may have substantial difficulty liquidating the investment and may be limited to periodic share repurchases by the BDC at a deep discount.
Leveraged Loan Funds – Floating-rate loan funds, also called Leveraged Loan Funds, invest in adjustable rate loans extended by financial institutions to companies, of below investment-grade credit quality, that have a significant level of debt-to-equity. Unlike traditional bond funds, Leveraged Loan Funds do not trade on an organized exchange. Leveraged Loan Funds are illiquid and hard to value. The potential for high returns is attractive to some investors, but the underlying loans are subject to tremendous credit, valuation and liquidity risks that may not be adequately explained to investors.
Commercial Mortgage-Backed Securities (“CMBS”) – Mortgage-backed securities are bonds secured by real estate loans. They are created when a number of loans, usually with similar characteristics, are pooled together. CMBS are comprised of loans secured by commercial real estate, rather than residential mortgages. Brokers may not be adequately disclosing that CMBS carry considerable risk in the current low-interest rate, low-yield environment.
Exchange-Traded Funds and Notes – An exchange-traded fund (“ETF”) is a basket of investments that tracks the performance of an underlying index or sector. Leveraged ETFs use financial derivatives and debt to multiply the returns of an underlying index. Exchange-traded notes (“ETNs”) are promissory notes made by an issuer that promise a return linked to the performance of an underlying index, but unlike ETFs, ETNs do not hold a basket of stocks or bonds to replicate the performance of the underlying index. The differences and substantial risks of ETFs and ETNs may not be transparent to investors. FINRA previously issued Investor Alerts regarding both ETFs and ETNs.
Non-Traded REITs – Real estate investment trusts (“REITs”) engage in the acquisition, development, and management of real estate properties. Non-traded REITs do not trade on any securities exchange and have a limited secondary market. Non-traded REITs are attractive to investors because they distribute at least 90% of their taxable income to investors, but they carry substantial risk: no ready market – limited redemption programs; high fees and commissions; and sporadic valuation. Brokers may not sufficiently disclose, and investors may not clearly understand, the costs and risks associated with non-traded REITs.
Closed-End Funds – Closed-end funds are mutual funds that raise money only once in a single offering, similar to a stock’s initial public offering. Future growth in the size of the fund is dependent on the return on its investments, rather than on new investment dollars. Distributions to investors may include dividends, interest income, capital gains and/or the return of capital. Closed-end funds may be attractive to investors because of their high distribution rates. Investors may not be fully advised that some closed-end funds return capital to maintain high distribution rates, resulting in the funds trading at high-premiums compared to their net asset value.
Variable Annuities – In addition to the basic features of mutual funds, variable annuities may also provide tax-deferred treatment of earnings, a death benefit and guaranteed income for life. However, the risks associated with variable annuities – liquidity, surrender charges, fees and market risk – may not be transparent to investors.
In addition to targeting firms’ business conduct and sales practices, FINRA announced that its examiners will focus on determining whether brokerage firms have adequate policies and procedures in place regarding: 1) the cyber-security of sensitive customer data; 2) supervisory efforts to guard against microcap fraud; 3) due diligence concerning the sale of private placement securities; 4) anti-money laundering efforts; 5) use of software to provide automated investment advice; and 6) efforts to prevent insider trading.
The full FINRA 2013 Regulatory and Examination Priorities Letter can be read here.
