2018 EXAMINATION FINDINGS REPORT

December, 2018

Suitability for Retail Customers

FINRA Rule 2111 (Suitability) establishes a fundamental responsibility for firms and associated persons to deal with customers fairly1 and is composed of three main obligations: (1) reasonable-basis suitability; (2) customer-specific suitability; and (3) quantitative suitability. FINRA continues to observe unsuitable recommendations by associated persons to retail investors as well as deficiencies in some firms’ supervisory systems for registered representatives’ activities. Firms should also consider the guidance in FINRA Regulatory Notice 18-15 to determine whether certain representatives engaging in repeated misconduct should be subject to special supervisory procedures, such as a heightened supervision plan.

FINRA observed situations where registered representatives did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations; in others, they failed to take into account the cumulative fees, sales charges or commissions. In some cases, unsuitable recommendations involved complex products (such as leveraged and inverse exchange-traded products (ETPs), including exchange-traded funds (ETFs) and notes (ETNs)). In other cases, they involved overconcentration in illiquid securities, variable annuities, switches between share classes, and sophisticated or risky investment strategies. FINRA also remains concerned about recommendations of unsuitable mutual fund share classes and Unit Investment Trusts (UITs), as discussed in the 2017 Report on Examination Findings. Inadequate product due diligence across product classes, including failure to understand the specific features and terms of products recommended to customers, was a common contributor to the challenges FINRA observed.

FINRA observed that firms with sound supervisory practices for suitability generally identified risks, developed policies, and implemented controls tailored to the specific features of the products they offered and their customer base.2 These controls included, for example, restricting or prohibiting recommendations of products for certain investors, as well as establishing systems-based controls (or “hard blocks”) for recommendations of certain products to retail investors to ensure that registered representatives adhered to those restrictions or prohibitions. Some firms also implemented methods to verify the source of funds for variable annuity transactions. In addition, certain firms required registered representatives, including principals with supervisory responsibilities, to receive training on specific complex or high-risk products before the representatives recommended them so the representatives understood the products’ risks and performance characteristics, as well as the types of investors for whom the product might be suitable.

FINRA also observed some firms facing challenges with their supervisory systems and other operational issues relating to quantitative suitability. When a broker-dealer or associated person has “actual or de facto control” over a customer’s account, there must be a reasonable basis that a series of recommended securities transactions are not excessive and unsuitable in light of the customer’s investment profile.3 Some firms developed parameters for trading volume and cost to identify and prevent excessive trading, as well as restrictions on frequency or patterns of clustered or single product exchanges. In some cases, customers whose accounts breached the firm’s thresholds received telephone calls from principals or detailed activity letters setting forth the frequency and cost of trading over specific periods.

Selected Examination Findings

FINRA addressed product suitability in our 2017 Report on Examination Findings, but we supplement those observations with the following additional insights from recent FINRA examinations, as well as our targeted examination (sweep) of volatility-linked products.

  • Overconcentration – Some firms maintained customer accounts that were concentrated in complex structured notes or sector-specific investments, as well as illiquid securities, such as non-traded real estate investment trust (REITs), which were unsuitable for customers and resulted in significant customer losses. Some registered representatives recommended structured notes or sector-specific investment strategies to customers who may not have had the sophistication to understand their features and without considering the customer’s individual financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors. Some recommendations involved illiquid securities with limited price transparency, which made it difficult for investors to know the true value of their investment and led them to believe that their investments would not fluctuate in value. In some instances, firms did not have procedures or systems reasonably designed to identify and supervise the concentration of such products in customers’ accounts.
  • Excessive Trading – Some firms failed to establish and enforce an adequate supervisory system reasonably designed to identify and prevent potentially excessive trading in customer accounts. For example, some firms failed to review account alerts from their clearing firm or use other available compliance tools designed to detect excessive trading, commissions or trading losses in customer accounts. Some firms did not take into consideration the use of joint representative codes by combining all of the activity in each associated person’s customer accounts when looking for problematic activity at a customer account level.

    Some firms maintained inadequate written supervisory procedures (WSPs) that, for example, identified key indicators of excessive account activity, but did not establish related specific threshold values or parameters for these indicators. In other instances, the indicators did not allow firms to identify potential quantitative suitability concerns (e.g., identifying active accounts based solely on the quantity of trades executed while failing to consider other pertinent criteria, such as turnover ratio, cost-to-equity ratios, margin balances, total commissions, total fees paid, and profit and loss).

    In certain cases, firms had an “active account” letter (sometimes also referred to as an “activity letter”)4 process, but did not adequately supervise that process, resulting in letters that were overly general and failed to include meaningful information regarding the relevant account activity. For example, the letters did not provide specific trading details, such as number of trades, commissions, cost- or commission-to-equity ratios, margin balances and account losses. Other firms provided such details, but failed to share plain language definitions of the data categories or explain why they were issuing the letters. Some firms were inconsistent in their usage of letters, sometimes not issuing active account letters for customer accounts engaged in similar, or even more active trading than accounts receiving such letters. Finally, in some cases, when customers did not return a signed letter, firms failed to follow their own procedures and restrict account activity.
  • Unsuitable Variable Annuity Recommendations – FINRA observed that some firms failed to establish, maintain and enforce supervisory systems and WSPs reasonably designed to ensure that representatives’ recommendations of variable annuities complied with suitability obligations. For example, FINRA observed unsuitable and largely unsupervised representative-driven recommendations to retail customers to exchange one annuity product for another. In many instances FINRA reviewed, the recommended exchange was inconsistent with the customer’s objectives and time horizon, and resulted in—among other consequences—increased fees to the customer or the loss of material, paid-for accrued benefits. This occurred, for instance, when a registered representative effected transactions directly with the insurance company. Moreover, some representatives concealed the source of funds used to purchase new variable annuities by having customers take direct receipt of monies from existing securities or annuities, which created the appearance of un-invested cash being used to purchase a new variable annuity and, in some instances, may have resulted in unfavorable tax consequences for the customer.

    In addition, some firms experienced challenges training registered representatives, including those responsible for supervising variable annuity transactions, regarding how to assess fees, surrender charges and long-term income riders to determine whether an exchange was beneficial to a customer. FINRA observed, for example, some registered representatives who used guaranteed income riders5 to persuade customers to sell or exchange their existing variable annuities, even though the surrender costs or loss of benefits did not support the purchase of or exchange to a new variable annuity. FINRA also observed representatives misrepresenting the cost of variable annuity riders through disclosure forms.6 In some instances, firm supervision appeared to focus on exchange form completion, as opposed to the substantive factors involved in the decision.

    Finally, FINRA remains concerned about the accuracy and completeness of certain firms’ data for annuity products, including general product information, share class, riders and exchange-based activity.

Findings From Targeted Examination of Volatility-Linked Products

During the two trading sessions covering February 5 and 6, 2018, the Dow Jones Industrial Average experienced roughly a 4 percent decline while the VIX rose over 100 percent. Volatility-linked products and, especially, products offering inverse or “short” volatility exposure experienced severe declines in value, with several products in the latter category suffering losses of 80 percent or more.7 In response, FINRA conducted a sweep to assess the adequacy of firms’ supervisory systems and controls to meet their suitability obligations in connection with recommendations to retail customers regarding volatility-linked products.8

Many of the firms FINRA examined had comprehensive WSPs and controls regarding such products. Several firms prohibited or restricted representatives’ recommendations to retail clients for either all or some volatility-linked products, such as inverse or leveraged ETPs or other products. Controls to enforce such restrictions included system-based controls, stringent net worth conditions or other pre-qualification criteria; required signed risk acknowledgement forms; and completed written certifications attesting to customers’ product knowledge. Some firms also required registered representatives who made recommendations regarding volatility-linked products to participate in training that addressed these products’ specific performance and risk characteristics (e.g., the risks of holding the product over an extended period).

Selected Examination Findings

While the observations below focus on volatility-linked products, FINRA urges firms that recommend any complex or risky products, such as leveraged and inverse ETPs, to consider the applicability of the following concerns to their activities. FINRA notes that the supervision of complex products was discussed in previous Regulatory and Examination Priorities Letters and FINRA Regulatory Notices, such as FINRA Regulatory Notices 12-03 and 17-32.

  • Unsuitable Recommendations – Despite prospectuses and other materials that included risk disclosures, including explicit warnings about sales to retail customers, some firms nevertheless marketed volatility-linked products to retail customers who did not understand those products’ unique risks and made recommendations that were inconsistent with the investors’ investment profile, including risk tolerance and investment time horizon (e.g., in many of those instances, customers held the securities far longer than the holding periods—frequently one trading day—recommended in the prospectus).
  • Inadequate Due Diligence – In some cases, firms’ due diligence did not address volatility-linked products’ unique characteristics and risks, such as the potentially magnified impact volatility in the VIX index and VIX futures, as well as operational features of the volatility-linked products themselves, which could affect the products’ performance. As a result, some firms were not aware—either through their own testing and analysis or through reliance on a third party—that volatility-linked products, in particular those offering short-volatility exposure, could be susceptible to steep losses in value within a very short timeframe, even while equity markets experienced relatively moderate declines.
  • Insufficient Systems and Controls – Some firms did not address the risks of offering complex leveraged, inverse and volatile products, including volatility-linked products, to retail customers. Other firms identified these risks, but lacked the operational capacity to enforce the limited conditions under which they permitted the sale of such products to retail investors. Further, some firms’ controls for volatility-linked products did not comply with the firms’ own WSP restrictions for such products. Other firms did not recognize when a new product on their platform was a volatility-linked product and, as a consequence, did not implement appropriate controls.

End Notes

1 FINRA Rule 2111.01 (“Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing.”)

2 See NASD Notice to Members 05-26 for a discussion of best practices for reviewing new products.

3 FINRA Rule 2111.05(c) (Suitability); FINRA Regulatory Notice 18-13 requested comment regarding revising the quantitative suitability obligation and removing the control element.

4 Active account or activity letters are a communication from the broker-dealer to notify the customer of the level of trading activity in the customer’s account.

5 Many variable annuities offer riders with unique insurance-backed benefits and guarantees providing for predictable income, which can be purchased at an added percentage cost. Variable annuities generally require that the investment be subjected to a surrender period where the customer incurs a penalty for certain withdrawals made over time.

6 FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities) requires firms to factor the costs and features of the existing and recommended variable annuities into their recommendation and approval of the transaction.

7 The one-day decline in value for one ETN tracking the inverse of VIX futures prices triggered an automatic liquidation of the product and a mutual fund with a short-volatility strategy also was liquidated as a result of the event. In addition, two VIX futures-tracking ETPs subsequently reduced the degree of their leveraged or inverse exposure, which led to the termination of other ETPs that incorporated them as part of their strategies.

8 The targeted examination letter regarding that review is available here.