By Suzanne Barlyn
Jan 16 Securities brokers who want to avoid
raising the hackles of regulators better get up to speed quickly
on the risks and features of certain high-yield, hard-to-explain
securities - a top priority for 2013 regulatory exams.
It sounds simple enough. Brokers, after all, should know the
inner-workings of securities they recommend to investors. And
they should be able to explain them in a way investors can
understand, say compliance professionals. But that's not always
Limited knowledge on the part of brokers, in some cases,
keeps investors in the dark about everything from how soon they
can get their money out to how market conditions may amplify
risks, compliance professionals say.
That concerns the Financial Industry Regulatory Authority
(FINRA), Wall Street's industry funded watchdog, which plans to
home in on what brokers know - and do not know - during its 2013
brokerage examinations. FINRA, which routinely examines the
630,000 brokers and 4,300 brokerages it oversees to gauge their
compliance with securities industry rules, published its annual
list of "examination priorities" late Friday.
The regulator, which pores through compliance and
supervision procedures, branch office records, and other
materials during the process, is particularly concerned about
whether brokers fully understand what they are selling.
Low interest rates have led to sales of a range of risky
products, including complex and high-yield products, FINRA said.
Among them: business development companies (BDCs), a type of
private equity vehicle that can be hard to exit but promises
dividend returns as high as 11 percent.
FINRA's focus on what brokers know expands on a theme it
pushed in 2012 and comes at the same time FINRA will be
examining brokerages for compliance with a suitability rule that
took effect in July. The rule requires securities to be suitable
for investors at all times, not just when they buy them.
That means brokers have a greater chance of facing questions
from regulators taking a broad look at their firms, said
Salvatore Faia, president of Vigilant Compliance LLC, a
consultancy in Chadds Ford, Pennsylvania. Securities regulators
have been contacting different levels of organizations,
including brokers, to ask about their understanding of certain
products, Faia said.
IN THE DETAILS
Investigators and examiners determine how much brokers know
about the securities by asking them to explain how a product
works and what its risks are to investors, said Bradley Bennett,
FINRA's enforcement head, during a fall industry conference.
The conversation can reveal knowledge gaps quickly,
especially when potential returns are tied to complex features,
such as futures contracts. Dancing around the fine points or not
being able to answer can lead to fines and suspensions for
brokers who are found to push unsuitable products on investors.
Brokers can attract the regulator's attention when they
least expect. FINRA may, for instance, be looking into broader
concerns at a brokerages, such as whether the firms are properly
supervising their sales force, or running adequate training
programs. Questioning individual brokers is sometimes part of
that process - and examiners don't have to limit questions to
just the original topics.
Not having a deep enough understanding of a product has
triggered enforcement cases in the past. In 2012, FINRA required
Citigroup Inc, Morgan Stanley, UBS AG and
Wells Fargo & Co to pay more than $9.1 million in fines
and restitution for sales of leveraged and inverse
The companies did not properly supervise brokers who sold
the securities, which are designed to amplify short-term returns
by using debt and derivatives and are more suitable for
professional traders than for long-term retail investors. One
reason why brokers did not understand: the companies themselves
did not study the risks and features well enough before telling
their brokers to push those products to investors.
FINRA's chairman and chief executive, Richard Ketchum, said
on Wednesday that brokers should include a written explanation
in clients' files about why transactions they recommend and
complete are appropriate. It should include specific reasons for
those decisions, said Ketchum, speaking to reporters after a
luncheon for compliance professionals.
Ketchum has also said publicly that brokers should be able
to develop a "payoff diagram" for clients, showing how
underlying components, such as bonds and derivatives, can affect
returns and liquidity.
While many brokerages have training programs to help brokers
get to that point, there are always opportunities for brokers to
improve their knowledge, said Vigilant's Faia.
Software programs at brokerages that quiz brokers on product
features, such as when investors can redeem shares of certain
non-traded securities, are just the start, Faia said. Brokers
must take the initiative to revisit training materials, such as
video presentations, to master the details, Faia said.
The challenge increases with each product's complexity, said
Francis Curran, a New York-based securities lawyer. Brokers who
still do not fully understand a product should not recommend it
to clients, despite the lure of a big commission, said Curran.