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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Eight Things You Need to Know about FINRA’s New Suitability Rule – 2111

Eight Things You Need to Know about FINRA's New Suitability Rule – 2111.

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Last July 9th, FINRA’s updated suitability rule became effective. That rule, FINRA Rule 2111, had a number of terms that were far from clear. To assist them, FINRA issued Notice to Members (“NTM”) 12-25 in May 2012. Securities Law and Compliance covered this in depth in prior posts on June 24, 2012 (Eight Things You Need to Know about FINRA’s New Suitability Rule – 2111) and November 27, 2012 (Suitability Requirements Concerning Leveraged and Inverse Exchange-Traded Funds). Now, FINRA has issued NTM 12-55 in November 2012 to clear up additional terms defined in FINRA Rule 2111.

Who is a “Customer” Under FINRA Rule 2111?

The suitability rules only apply to customers. However, if a broker-dealer or registered representative makes a recommendation to a potential customer who later, in fact, becomes a customer then the suitability rule does apply. The suitability rule does not apply if the potential customer does not become a customer of the firm or representative. Indeed, even if the potential customer acts on the advice given, but not through the broker-dealer or registered representative and neither receives any compensation, then the suitability rule also does not apply.

What is an “Investment Strategy” under FINRA Rule 2111?

The more specific the recommendation as to securities or sectors, the more likely it is to be an “investment strategy.”While the term investment strategy is to be considered broadly under FINRA Rule 2111.03, it does not apply to recommendations in “equity” or “fixed income” securities or asset allocation plans based upon generally accepted investment theory. However, the following strategies are “investment strategies” subject to the rule:

1) “Dogs of the Dow”;
2) high dividend paying stocks; or
3) a particular market sector, i.e., health care, regardless of whether a particular security is mentioned.

Despite not Referring to a Particular Security, the Following Strategies are “Investment Strategies” under FINRA Rule 2111:

i) day trading;
ii) utilizing margin;
iii) constructing a bond ladder; and
iv) investing home equity in the securities markets.

The Elusive “Hold” Recommendation.

An explicit recommendation to hold a security or securities or to continue to utilize an investment strategy of the same is subject to the suitability rule, FINRA Rule 2111. Therefore, an implicit hold recommendation does not trigger FINRA Rule 2111. Perhaps FINRA will issue additional guidance on this seemingly vague and easy to argue distinction.

However, FINRA continued to explain that FINRA Rule 2111 is not meant to change the existing law that any recommendation of a security or maintaining an investment strategy does not normally create an ongoing duty to monitor that position, and that the suitability of a “hold” recommendation or investment strategy for that matter is judged when it is made.

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Private Placement Filing Requirement for Broker-Dealers – New FINRA Rule 5123

As of December 3, 2012, some broker-dealers now have to file certain documents with FINRA relating to the sale of private placements. Among the documents that must be filed, if no exception is applicable, are private placement memoranda, term sheets and other offering documents concerning non-publicly offered investments. Thankfully, a number of exceptions apply including sales to:

1)      Certain but not all “accredited investors; “

2)      “Institutional Accounts;” and

3)       “Qualified Institutional Buyers.”

Firms that sell such privately offered securities to those type investors need not file anything with FINRA. If required, such filings must be filed through the “Firm Gateway.” Among the more salient points of FINRA Rule 5123 and the accompanying release are:

  • The required filings are so called “notice filings,” which do not trigger any clearance type correspondence;
  • Required filings must be made within fifteen (15) calendar days of the first sale of the privately offered securities;
  • The .pdf documents filed must be “in a searchable format;”
  • Only one firm need make the filing even if multiple firms are selling the offering;
  • If material amendments are made to the documents enumerated above, then those must be submitted to FINRA as well; and
  • Confidential treatment of the filings is available but must be requested in advance.

Are you unclear about how to comply with the new rule? Need guidance on the exemptions to the new rule’s application? We are here to assist you with the foregoing.

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Suitability Requirements Concerning Leveraged and Inverse Exchange-Traded Funds

FINRA declares that inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them longer than one trading session, particularly in volatile markets!

Particular Features of Leveraged and Inverse Exchange Traded Funds (ETFs)

1) Typically designed to achieve stated results on a daily basis, which can lead to significantly different performance from the index or benchmark over extended periods of time due to compounding;

2) Seek to deliver multiples of performance of the index or benchmark they track. Some of these ETFs are “short” or seek to deliver the inverse or opposite performance of the index or branch they track.

3) Use swaps, futures contracts and other derivatives to produce multiple rates of return.

Two Separate Parts to Suitability Analysis under NASD Rule 2310

Before recommending the purchase, sale or exchange of a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer to whom it is recommended.

A) Product Suitability;

i) Is the leveraged exchange traded fund (ETF) suitable for any customer?

ii) Does the broker dealer (BD) understand the leveraged exchange traded fund (ETF) terms and features, etc?

iii) Does the registered representative (RR) understand the leveraged exchange traded fund (ETF) features and terms, etc?

iv) For both ii) and iii) is the how the fund is designed to perform, how it achieves those objectives, the impact on performance of market volatility, the use of leverage and the appropriate holding period for the exchange traded fund (ETF)

B) Customer Suitability.

i) Is the leveraged exchange traded fund (ETF) suitable for the customer to whom it is recommended?

ii) To determine this suitability, look at the customer’s:

a) Tax status;

b) Financial status;

c) Investment objectives; and

d) risk tolerance.

Supervision under NASD Rule 3010’s requirements

● SEC and FINRA rules are followed by broker-dealers (BD) and registered representatives (RR)

● Promotional materials are fair and balanced and not inaccurate

● Broker-dealer (BD) conducts the product suitability analysis

● Registered representative (RR) conducts the client specific suitability analysis

May Law, PC is a securities and commodities boutique firm that has a an extensive knowledge of FINRA related rules and assists registered broker-dealers (BDs) and associated persons (APs) in responding to FINRA investigations, disciplinary matters and routine one the record interviews (OTRs). The firm’s website is located at www.maylawpc.net, and the main number is 847-675-1052. Andrew May has been practicing law for 17 years and can be contacted at amay@maylawpc.net.

© 2012 May Law, PC

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Are we set to expunge like its 1999? Do ancient CRD entries have “regulatory value?”

A California state appellate court, in Liss v. FINRA, recently held that the earlier trial court’s earlier decision — that FINRA’s Rule 2080 was the only path to expungement of material from the CRD — was wrongfully decided.  Importantly, the information in the CRD record need not be erroneous to seek expungement. It could be still true but arguably no longer relevant due to the amount of time between the events in question and the present day.

FINRA Rule 2080 requires the person seeking expungement to include FINRA as a party to any expungement case brought in state or federal court. FINRA’s Rule 2080 requires proving two additional items. First, the fact finder – court or arbitration panel – must make an affirmative finding. Courts routinely do this but arbitrators do not. Indeed, FINRA arbitration panels will not provide an explanation unless all parties unanimously agree by certain case milestones. Second, that finding must demonstrate one of the following occurred: (i) the claim, allegation or information is factually impossible or clearly erroneous; (ii) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (iii) the claim, allegation or information is false. Those are high hurdles for FINRA arbitration where discovery is more limited, no written opinion generally need be given and often no explanation for a decision is given.

In Liss v. FINRA, registered representative Mr. Liss requested the court use its inherent equitable powers to affect the expungement.  Equitable powers essentially means invoking the Court’s conscience to obtain relief aside from an award of money. In the case of expungement, the court must weigh the hardship to the individual with the protection afforded to society by the information being in the records.

Mr. Liss, believed the following factors warranted expungement.   All complaints on his CRD record were related to only one security. Every complaint was more than fifteen (15) years old, and he has had an unblemished record since the incidents in question. Importantly, Mr. Liss filed an affidavit that he suffered professional and financial hardship due to current and potential clients using the Internet to obtain his Broker Check history.

The Liss court latched onto something mentioned in the SEC Release approving FINRA Rule 2080: whether or not continued inclusion of the allegation(s) in the CRD have “regulatory value.”  That standard has been utilized by two other federal courts.

Why is the Liss decision so important? It demonstrates that this court believes that FINRA’s requirements in Rule 2080 are not the exclusive way to get materials erased from the CRD system despite FINRA’s arguments to the contrary. While the Liss decision is helpful to those seeking expungement, the downside to court based expungement includes its expense and the lack of privacy.

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