Tag Archives: Compliance

SEC Adopts Rule to Disqualify Felons and other “Bad Actors” from Using Rule 506 of Regulation D in Connection with Private Placement Offerings.

 Bad-Boys, Bad-Boys What You Going to Do? In lieu of doing a public offering of securities, funds issuing securities can rely on an exemption from registration.  Regulation D is one of those exemptions. In 2010, Congress passed the Dodd-Frank Act.  That law specifically ordered the SEC to prohibit felons and other bad actors from utilizing Rule 506 of Reg. D to issue securities pursuant to the before-mentioned “safe harbor.” Persons who are subject to the ban include promoters, directors, investment managers or those owning more than twenty percent (20%) of the issuer’s securities. The “bad boy” behavior that would prevent one from using Rule 506 of Reg D includes:

i)                   criminal convictions;

ii)                 injunctions and restraining orders related to securities;

iii)              final orders from other securities regulators, banking regulators and the CFTC;

iv)               SEC disciplinary orders, SEC “cease and desist” orders, and SEC “stop orders;”

v)                 suspension or expulsion of broker-dealers (B-Ds) or registered representatives from the NASD, FINRA, NYSE; and

vi)                U.S. Postal Service “false representation orders.”

The length of time for the bar on events listed above is either within five (5) or ten (10) years. While the disqualification events listed above would have to occur after the effective date of the amended Rule 506, matters previously existing and that would otherwise fall under the rule, are subject to mandatory disclosure to investors. The amended Rule 506 becomes effective in mid-September.


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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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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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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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