A FRESH TAKE ON FINRA’s 2013 ON-SITE EXAMINATION and REGULATORY PRIORITIES

With First Quarter in the books, what more do we know?
As you may recall, on January 13, 2013, FINRA came out with its letter listing its concerns. In counseling several clients and participating in a fair number of “On the Record” (“OTR”) interviews, this post will provide greater insight than simply relisting the priorities.

A) Suitability of Complex Products

Perhaps the prevalence of these products has to do with the extraordinary low interest rate environment that we find ourselves. FINRA believes that if you cannot effectively communicate the requisite information to them about such products upon request then you cannot hope to explain this to the customers. While that may not be the case, it certainly is a widely shared view at FINRA.

B) Exchanged Traded Funds and Products

Do you know the difference between an exchange traded fund (“ETF”) and an exchange traded note (“ETN”)? What about a commodity pool or grantor trust? You may not have cared before the collapse of Lehman Brothers, but now you should be able to explain the difference and the risk that certain products may not track the index that they are designed to follow.

C) Non-Traded REITs and Closed End Funds

On non-traded REITs, is the money paid from operations/investment or just return of principal? Are those stated prices accurate? For closed end funds, what sort of risk is taken on to juice returns and are distributions from investment return? All of the foregoing is fair game in an OTR!

D) Private Placements

FINRA now has Rule 5123; Securities Law and Compliance, previously covered this on December 12, 2012, and will be examining “due diligence procedures,” whether they are followed and documented and the disclosures of material risks of the offering. How are conflicts resolved between say investment banking and the end purchasers/customers?

E) The Not so “New” Suitability Rule and Customer Identification Procedures

This was covered in depth previously by Securities Law and Compliance in posts from February 10, 2013 and post from June 24, 2012.

My take away from the first quarter and the 2013 priority letter are:

  1. Can the registered representative fully explain the products features and risks? You sold the product to a customer so now you need to explain to FINRA how it works, and “no” you are generally not allowed to take the prospectus into this examination.
  2. Due diligence on private placements must be done even if one is not an underwriter and effective due diligence means asking questions and not simply accepting answers given.
  3. More and more suitability is being morphed into a test of understanding products’ features.

How do your firm’s practices, procedures and compliance program deal with the above insights and criteria? The time to act is now and not after FINRA shows up on your threshold unannounced and planning to stay for a several week “visit!”

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