ETF News

COMPLY-FINRA to brokers: know your high-yield securities

Jan 16 (Reuters) - 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 the case.

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.


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 exchange-traded funds.

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, has 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.