by Howard Haykin

In July 2014, NYLife Securities (“NYLS”) began offering 3 mutual funds that focused on the exploration, production, storage, transportation, processing, and use of energy and natural resources. The funds’ prospectuses warned that the funds were not diversified and thus subject to additional risk – and that the funds' holdings may be affected by the prices of oil and natural gas, which were expected to be volatile.

From October 2014 to July 2015, a Missouri-based broker recommended one or more of the 3 non-diversified mutual funds to 90 of his customers, primarily based on his belief that the funds’ yield would exceed 10%. The broker effected around 250 transactions totaling $4.5 million, and he earned $34,500 in commissions. The broker even recommended concentrated investments in the funds to approximately half of those customers, even though their expressed investment objectives and tolerances for risk were conservative or moderate.

• At least 6 of those customers invested 35% or more of their liquid net worth in the funds;
• 2 customers invested more than 80% of their liquid net worth in the funds.

In late 2014, the funds' prices began to drop, and they lost between 49% and 80% of their value over the next 18 months. Starting in late 2015, about 2 dozen customers filed complaints with NYLS, which precipitated FINRA's investigation.

FINRA’S TAKE ON THE TRANSACTIONS.    The broker understood that the funds were different from stocks, bonds, and other mutual funds, and that the funds were not diversified. However, he did not understand the complexity of the funds or the magnitude of their potential risks – particularly since he had no prior experience selling securities focused on the energy or natural resources industries.

Rather than conducting reasonable due diligence, the broker basically relied on cursory reviews of available documentation. He acquainted himself with the funds by listening to a 45-minute presentation on the funds – which covered the features but not the risks. He reviewed the funds’ sales literature, which did not explain in detail how the funds worked. And he spent less than an hour reviewing the funds’ prospectus - where he might have paid closer attention to detailed discussion of attendant risks. And so, when he began recommending the funds, he did so without having a reasonable basis for suitability.

Furthermore, when loading certain customers with concentrated positions in the funds, the broker knew that those recommendations exceeded NYLS's limits on concentrations in risky securities by customers with conservative or moderate investment objectives and tolerances for risk. However, (FINRA notes that) he was aware that NYLS changed some of his customers' investment objectives and tolerances for risk from “conservative” or “moderate” to ‘more aggressive levels’ so they would conform to the customers' purchases of the funds. [Is FINRA accusing NYLS of being duplicitous? Perhaps, but there’s nothing in the CRD to indicate that FINRA assigned any responsibility to the firm for such violative conduct. ]

FINANCIALISH TAKE AWAYS.    First off, it’s worth noting that, in addition to the 18-month suspension, the broker was disgorged of his $34.5K in earned commissions. However, as I note above, it doesn't appear as though the broker contributed anything to the settlements with 17 of his customers, who complained that the broker had not communicated the risks of the non-diversified mutual funds. All told, the customers settled their complaints for a sum total of $1.1 million – and I'm presuming that the firm, NYLS, footed the bill.