FINRA Rule 2111 states that a “member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.” In addition, FINRA Rule 3110 obligates firms to establish and maintain a system to supervise the activities of associated persons that is reasonably designed to achieve compliance with applicable securities laws and regulations and FINRA rules.
The concerns that FINRA had during the course of examinations with regard to the suitability of certain products and their supervision did not vary materially by firm size, but did occur more frequently in connection with certain product classes, specifically unit investment trusts (UITs) and certain multi-share class and complex products, such as leveraged and inverse exchange-traded funds (ETFs). FINRA observed firms that implemented a variety of effective practices in recommending the purchase or sale of these products, which included thoroughly training registered representatives on products’ performance and risk characteristics, as well as establishing criteria to consider in determining whether a product was suitable for a specific customer; communicating product risks to customers in a way those customers could understand; and tailoring supervisory systems to products’ features and sources of risk to customers. For example, with respect to UITs, FINRA observed firms that alerted customers to the consequences of selling and reinvesting in a new UIT prior to the initial UIT’s maturity using negative or positive consent letters. Some firms implemented surveillance patterns to identify early UIT rollovers under a variety of scenarios. In addition, some firms required registered representatives to enter a rationale into firm systems for each short-term UIT transaction and coupled the entry with documented supervisory review.
Selected Examination Findings
UITs are generally structured portfolios with maturities aligned to meet the objective of the strategy. Typically, the vast majority of UITs purchased are not traded or redeemed significantly in advance of maturity without a customer-specific need for liquidation or specific changes in the economic environment. Given that registered representatives earn most of the fees associated with UITs at or shortly following the initial offering period, there is a risk that they may recommend early rollovers or exchanges to increase their sales credits.
FINRA identified instances in which customers were advised to roll their UIT investments over early, and firms did not have appropriate supervisory mechanisms in place to identify and review the suitability of the recommendation.8 This practice causes investors to incur additional sales charges, including both creation and development fees and deferred sales charges.
Some firms FINRA reviewed failed to adequately identify short-term UIT trading activity as an area of potential abuse by registered representatives, and did not implement adequate internal controls to identify potentially problematic UIT trading activity. For example, some firms’ systems and processes looked at individual short-term UIT trades in isolation, but did not have processes to capture patterns of short-term UIT trades across customer accounts, registered representatives, branch office location, or to look for patterns of series-to-series UIT trading, excessive early liquidations followed by subsequent purchases, or cross-product trading partially involving UITs.
FINRA observed that the quality of a firm’s supervision for potentially problematic short-term trading of UITs was often correlated with the degree of specificity in a firm’s definition of such trading. Some firms defined a UIT short-term trade to include multiple scenarios (e.g., rollovers, early rollovers, exchanges, series-to-series transactions prior to an approaching maturity). By contrast, other firms had more limited definitions (e.g., excluding early rollovers). This more limited definition reduced the efficacy of the firm’s supervision and surveillance.
Multi-Share Class and Complex Products
FINRA found that some firms failed to meet their suitability obligations with respect to individual customers when recommending multi-share class or complex products. For example, FINRA observed situations where firms: (1) recommended a higher-fee share class without a reasonable basis to believe that the recommendation was suitable; or (2) recommended a complex product without a reasonable basis to believe the product was suitable in light of the customer’s risk tolerance and investment time horizon. In some instances, firms also failed to seek to obtain key pieces of investor profile information, without providing a reasonable basis for failing to do so.
In addition, FINRA observed that some firms failed to establish and implement adequate supervisory systems and written supervisory procedures with regard to multi-share class and complex products. At one firm, for example, FINRA observed that in a sample of short-term surrender variable annuity transactions, over 50 percent of customers had a long-term investment time horizon. Despite this appearance of a conflict with the recommendation to purchase the short-term surrender annuity, FINRA found no evidence in most of the transactions that the firm had performed a supervisory review addressing these concerns. At other firms, FINRA found that the suitability of recommendations for the purchase of leveraged or inverse ETFs had not been subject to adequate supervisory reviews.9
Some firms failed to provide adequate training for registered representatives with respect to suitability issues, particularly regarding the products described above. Consequently, they were neither sufficiently knowledgeable to make customer-specific suitability determinations nor to advise customers effectively on the risks those products entailed. In the case of UITs, for example, firms that relied on written supervisory procedures and compliance bulletins to inform their registered representatives and principals about UITs encountered more sales practice problems than firms that implemented UIT-focused training for registered representatives.
8 FINRA bases its observations here on findings from our cycle examination program as well as a sweep FINRA conducted. The information request for the sweep can be found here.
9 Most recently, FINRA reminded firms of sales practice obligations for volatility-linked exchange-traded products in Regulatory Notice 17-32.