Remarks from the SIFMA Complex Products Forum

Susan F. Axelrod

Executive Vice President, Member Regulation Sales Practice

New York, NY
September 27, 2012

As prepared for delivery.


Good afternoon, and thank you for inviting me to spend some time with you discussing complex products. I'm sure you know that this has been a priority for FINRA examiners. I would like to share some of what we have learned so far.

Today, we find ourselves in a challenging economic environment—one in which current yields on money market funds are near zero and mid-range fixed income investments yield too little to satisfy customer income needs. Today, customers demonstrate a willingness to consider products they would not have several years ago. And firms eager to satisfy customer demand demonstrate a willingness to sell them. These products often contain features—generally designed to offer the possibility of increased yields—that introduce customers to possible loss of income and in some cases, their principal. Also, firms without sufficient experience in selling these products have run into unexpected issues that can have devastating reputational and financial effects.

Complex products—often discussed in compliance forums with great concern—serve a very legitimate purpose. But they also pose very legitimate risks that can harm retail investors. This morning, Rick Ketchum discussed FINRA's concerns about complex products. He outlined the steps a firm should consider taking when adding a complex product to its retail sales platform. He focused on several areas, including: supervision, due diligence, and suitability of recommendations.

Today, I want to share what we're seeing in some of our recent examinations of firms selling complex products to retail investors. I will touch on FINRA's review of firm conflict management practices. And lastly, I will discuss an examination finding that continues to trouble me—the unreported sale of securities by brokers away from their firms.

While there are many products that can be defined as complex, I will focus on two that we have noted during our examinations: non-traded REITs and reverse convertibles. Virtually all of the concerns FINRA examiners have noted during their examinations of firms selling these products stem from a failure in one of the areas Rick outlined earlier today. I'll start with non-traded REITs.

Non-Traded REITs

These are publicly registered products that are not traded on a national securities exchange. For this reason, there is a very limited or no secondary market for shares. Thus, investors in these products have very few alternatives should they decide they need to liquidate their positions. These products own (and sometimes manage) real estate. REIT offerings normally last several years, and during the offering period, broker-dealers selling them reflect an estimated per-share price on customer statements—typically the public offering price. This is sometimes the case for years after the customer's initial purchase. Unfortunately, we have recently seen several high-profile instances of REITs re-pricing their per-share estimated values at substantially less than the offering price—with little or no advance notice to investors.

NASD Rule 2340 governs customer account statements and requires broker-dealers to provide estimated valuations of certain non-traded REIT positions on customer statements. These values may come from appraisals, the annual report of the REIT, an independent valuation service or any other source, and the value must be based on data that is less than 18 months old. In 2011, FINRA proposed amendments to this rule that would change the manner in which firms report these per-share estimated values. Specifically, FINRA proposed to limit the time period that the offering price may be used as the basis for the per-share value.

Further, FINRA proposed that per-share estimated valuations must exclude organization and offering expenses, which will provide investors with greater transparency into the fee and expense deductions from their initial investment. And these fees can be substantial. FINRA is currently drafting a rule filing which takes into account the public comments received on this proposal. To ensure that estimated share prices are not misleading, firms should include this as an area of focus when conducting ongoing due diligence. Firms should also take this into account when conducting reviews of correspondence, advertising and sales literature.

FINRA examiners have found in some cases that investors in REITs have been confused about the product's features, fees and liquidity. Investors who are attracted to the product are often interested in high initial distribution rates as well as the possibility of a gain upon liquidation of the REIT. Brokers must ensure that investors understand there is no guarantee the distributions will continue in the same amount, or at all, and that distributions may exceed cash flow from operations.

Non-traded REITs may also borrow funds to make distributions if operating cash flow is insufficient. And excessive borrowing may increase the risk of default or devaluation. In addition, non-traded REIT distributions may actually be a return of principal. For these reasons, brokers must use caution when discussing distributions with investors, particularly when making comparisons to other dividend-paying investments. With respect to liquidity, non-traded REITs are rarely suitable for investors with short time horizons. Brokers should consider investors' need for short-term liquidity before recommending that they purchase a non-traded REIT.

During 2011 and 2012, FINRA examiners have been conducting examinations of numerous retail sellers of non-traded REITs. In several instances, FINRA examiners have found that firms selling these products failed to conduct reasonable diligence before selling a product, and failed to make a determination that the product was suitable for investors. FINRA examiners have noted that—in the instances of REITs that have experienced financial difficulties—red flags existed and should have been considered by firms prior to the product being offered to firm clients.

Additionally, some firms have failed to conduct adequate training for brokers selling the products to investors. FINRA examiners are also reviewing advertising, sales literature and correspondence between brokers and investors and, in some instances, have found misrepresentations of product features, such as distributions and share values. All of these issues raise investor protection concerns.

In 2011, FINRA commenced an enforcement action against one seller of non-traded REIT products in the Northeast. In this action, FINRA charged that the firm engaged in unsuitable sales of a non-traded REIT, failed to conduct adequate due diligence, and made misleading statements and omitted material facts in connection with communications about the non-traded REIT. FINRA has a number of open investigations related to the sale of these products, and we will provide more information as it becomes available. Now, let me turn to a different product—reverse exchangeable securities, otherwise referred to as reverse convertibles.

Reverse Convertibles

Reverse convertibles are often attractive to customers because of the high initial yields they offer. Investors and brokers may misunderstand this complex product—and its downside. A reverse convertible is a note that pays a high initial fixed coupon—sometimes ranging up to 30 percent per year. The return of principal is tied to the performance of a basket of stocks or, sometimes, the performance of a specific security. I will call these the "underlying assets," or just "the assets," for our discussion today. The performance of the assets determines whether, at a specified date or performance level, the investor will receive the assets—essentially giving the issuer a "put" option should their value decline. The investor typically does not benefit if the underlying assets increase in value. And, it is generally true that the higher the coupon rate, the higher the volatility of the underlying asset. This can increase the chance that the investor will receive less than a full return of principal. Now, believe it or not, this is a simplified discussion of the product.

FINRA examiners have noted that some investor portfolios are over-concentrated in these products, generally due to unsuitable recommendations. FINRA has brought a number of enforcement actions against firms for failing to ensure that their supervisory systems were adequate. These cases involved failures to establish and implement adequate systems and written procedures for the supervision of sales of reverse convertible notes. They also found failures to detect and respond to indications of potential over-concentration in reverse convertible notes in customer accounts. There are also many examples of enforcement actions against brokers who made unsuitable recommendations for clients to purchase these products.

There are more complex products that warrant attention, and certainly there is not enough time to discuss them all. Instead, I would like to turn away from specific products and discuss a few issues that are particularly important when dealing with any complex product.


As you may know, FINRA recently initiated discussions with several firms to better understand the processes they have in place to identify, manage, mitigate or eliminate conflicts. One area of concern has been the conflict that is created when a firm sells complex products created by affiliates. Another is compensation arrangements with product manufacturers that create conflicts of interest. Firms should have written procedures outlining how these conflicts are managed, including what information must be disclosed to investors and how that disclosure is made.

Additionally, as we discussed in our 2012 Exam Priorities Letter, we are concerned about allegations that some broker-dealers may be making undisclosed investments in deals that directly conflict with positions these firms sold to their own clients. FINRA expects to learn more about these conflicts and how firms intend to manage them in the future. By knowing what firms do to address conflicts and the challenges they face, FINRA hopes to develop guidance for the industry.

Selling Away

Let's turn to a problem we are seeing more of recently—brokers improperly selling securities or otherwise engaging in problematic outside activities away from their firm.

Along with the rise in popularity of alternative and complex products, FINRA has seen an uptick in the number of matters involving unapproved private securities transactions. In this challenging economic environment, it is not surprising that brokers may be looking to supplement their income with outside activities. All too often, however, these activities are not reported to employing firms. There are many examples of FINRA enforcement actions against brokers who have engaged in unapproved private securities transactions. Unfortunately, in many of these cases, there is significant investor harm, and often significant financial liability for the broker's employer.

Firm compliance programs must be designed to prevent and detect violations like this. Let me share some of the sound practices FINRA exam staff has noted during examinations.

Some firms employ staff (or use vendors) to search public records, the Internet and/or social media for outside activities of registered representatives. Others have developed more robust branch office inspection programs. For example, some firms require representatives to turn over personal banking and financial records for review. Some conduct inspections of registered representative's computers and portable devices. And many firms require brokers to sign periodic certifications about outside activities. Also, firms have implemented training programs to ensure that brokers understand regulatory requirements and firm policies. Robust supervisory systems in this area are the most effective way to prevent and detect improper activities.

Recap and Guidance

From today's discussion, several themes arise—and I will recap those for you now. First, a critical factor in supervising the sale of complex products is the new product vetting process. With an effective process in place for vetting new products, including conducting appropriate due diligence related to the issuer and the product's features, firms can avoid many of the problems FINRA exams have uncovered in this area. This initial due diligence process should take into account whether the firm's existing supervisory procedures and systems are sufficient given the new product's features. Also, this process should inform the firm's formal training program for registered persons selling the product.

Second, supervisory procedures should have clear and specific guidelines on how brokers and their supervisors are to assess suitability of recommendations—including how the firm monitors for potential problems unique to that product, like over-concentration. The more effective supervisory procedures we have seen establish customer eligibility requirements for complex products.

Third, a very important area of focus should be firm training programs. It is critically important that brokers selling complex products (and their supervisors) understand the product, its features and the firm's supervisory procedures related to customer specific suitability. Brokers should understand which clients should be or should not be considered for a particular product.

And finally, our examiners have noted that firms conducting robust and ongoing due diligence on the complex products they sell were able to quickly adjust supervisory systems and training programs if needed—or, in some cases, even limit or discontinue the sale of a product. FINRA has issued guidance in this regard, and you can find it on our website.


Complex products present a number of challenges to firms, brokers and clients. And, they will continue to remain a priority for FINRA examiners. As products evolve, additional risks can be mitigated through solid compliance and supervisory systems, effective training programs and through fair and accurate disclosures to clients. Lastly, and at the risk of over-simplifying this, my hope is that in making the determination about whether to sell a complex product—or, at the broker's level, whether to recommend a complex product to a client—that firms and brokers consider whether the same objectives could be achieved through a less complex or less costly product.

Again, I want to thank you for inviting me to join you this afternoon. I would love to hear your questions.