Business Conduct and Sales Practice Priorities

[ by Howard Haykin ]

Economic pressures challenge retail investors to find attractive returns within their risk tolerance.  Investors often seek out investments offering higher returns, but such strategies - when pursued by so many investors - are accompanied by increased risk and higher prices.   FINRA is particularly concerned about: (i) sales practice abuses;  (ii) yield-chasing behaviors;  and, (iii) the potential impact of any market correction, external stress event or market dislocation on market prices.

Accordingly, FINRA's 2013 Letter begins with Customer Suitability as it pertains to various types of Complex Products. 

                _{^{******************************************************************}}

Suitability and Complex Products.   FINRA's recently revised suitability rule (Rule 2111) requires broker-dealers ("B/D's) and associated persons ("RRs") to have a reasonable basis to believe a recommendation is suitable for a customer.  FINRA is particularly concerned about how well firms and RRs understand complex or high-yield products they recommend and sell to customers - e.g., risk-versus-return, and disconnect between customer expectations and risk tolerances.  More specific concerns include:

• market risk exposures associated with interest-rate-sensitive investments, and corresponding alignment with customer risk tolerances given today’s low-yield environment;
• credit risk exposures associated with investments where the creditworthiness of counterparties may not necessarily be transparent to or align with the risk tolerance of customers; and,
• liquidity risk exposures associated with investments where the timing of cash flows or the ability to quickly liquidate positions may not align with customer cash flow needs.

Examples of products that sometimes are complex, and can be problematic and inappropriate for retail customers:

Business Development Companies (BDCs).   These typically are closed-end investment companies.

• Some primarily invest in the corporate debt and equity of private companies.
• May offer attractive yields generated through high credit risk exposures amplified through leverage.
• Investors can be exposed to significant market, credit and liquidity risks.
• Some BDCs run risk of over-leveraging their relatively illiquid portfolios.
• There's been an increasing issuance of non-traded BDC funds - limited opportunities to exit the fund, and the only option is to sell at a steep discount.

Leveraged Loan Products.   Are adjustable-rate loans extended by financial institutions to companies of low credit quality that have a high amount of debt relative to equity. 

• In 2012, investors invested heavily in funds that invest in leveraged loans.
• Unlike traditional fixed income bonds, floating-rate loans don't trade on an organized exchange, making them relatively illiquid and difficult to value.
• Marketing of such funds can be misleading: 
• selling points: they're less vulnerable to interest rate fluctuations and offer inflation protection. 
• not mentioned:  underlying loans carry significant credit, valuation and liquidity risks - not apparent to investors.

Commercial Mortgage-Backed  Securities (MBS).   Not all CMOs are alike, leading FINRA to heightened concerns about the sale and marketing of commercial mortgage-backed securities to retail investors.

• Failure to fully transparently disclose considerable risks in today’s low-interest-rate, low-yield environment.
• Commercial mortgage-backed securities space, has seen a significant compression in risk premium in 2012, leading to higher prices and lower yields, while default rates remain high.

High-Yield Debt Instruments.    Given the inverse relationship between price and yield, the recent influx of cash into the high-yield market has increased prices and lowered yields. 

• In September 2012 alone, nearly $9 billion was invested in high-yield-bond funds;
• As of 10/5/12, nearly $65 billion had been invested in such funds.
• Compared to previous high of $32 billion in 2009.
• Risk premiums have compressed, resulting in significant market risk exposures.
• A more diverse range of companies have issued high-yield bonds - some with high-level cash flow or funding demands that raise significant credit risks.

Structured Products.   May be marketed to retail customers based on attractive initial yields and in some cases on the promise of some level of principal protection.

• They're often complex.
• Their cash-flow characteristics and risk-adjusted rates of return are uncertain or hard to estimate.
• Generally do not have an active secondary market.

Exchange-Traded Funds and Notes.   Investors may not understand differences among exchange-traded index products - e.g., funds, grantor trusts, commodity pools and notes.

• Different risks associated with different products.
• Risks higher for products using leverage to amplify returns. 
• There's been a proliferation of newly created index products lacking an established track record - e.g., those with valuations and performance tied to volatility, emerging markets and foreign currencies.

Non-Traded REITs.   Customers who purchase non-traded REITs may not fully understand that sales costs are deducted from the offering price and the repayment of principal amounts as dividend payments in the early stages of a REIT program.

Closed-End Funds.   The high distribution rates offered by many CE Funds are appealing to retail investors. 

• Distributions, however, may include capital gains and/or return of capital - in addition to dividends and interest income.
• Retail investors may not understand that some funds are returning capital in order to maintain high distribution rates.
• This treatment can cause closed-end funds to trade at high premiums compared to their NAV.

Municipal Securities.   Rated municipal securities, on the aggregate, have demonstrated relatively strong repayment patterns as compared to similarly rated corporate bonds.  General obligation bond default rates typically hover around 0.1%.

• Default rates are significantly higher for those market sectors dependent upon private profit-making or nonprofit performance.
• Brokers may fail to disclose material risks associated with these kinds of higher risk bonds.
• Customers searching for safe-harbor investments may mistakenly presume these instruments share a risk-reward profile with general obligation (G.O.) municipal securities.

Variable Annuities.   These products can offer valuable benefits to investors seeking predictable income streams, tax deferral for investment gains and flexible investment choices.

• Long holding periods in conjunction with significant surrender charges be be unsuitable for investors who have near-term liquidity needs.
• High fees and expenses above typical sub-account fees reduce the performance of variable annuities.
• High commissions make the product a target for switching.
• Consolidation in insurance companies offering variable annuities may provide an inappropriate incentive for brokers to recommend exchanges.
• Where an insurance company offers to buy back the product or increase the account value to forgo product guarantees, it may also present both brokers and investors with a less-than-clear picture of the financial benefit to the investor as well as the challenge of finding a similar product with the features included in the prior product.
   

_{^{******************************************************************}}

Concluding Notes:   FINRA encourages firms to use the information in this letter to enhance their supervisory and compliance programs to mitigate risk and better protect investors. As always, firms may contact their Regulatory Coordinator with specific questions or comments.  Firms may also contact Daniel Sibears, FINRA EVP, Member Regulations Programs, with their general comments or suggestions on how the letter can be improved. 

To access a copy of the letter, go to:   [FINRA Regulatory and Examination Priorities for 2013, 1/11/13].