Self-regulator Finra’s newly-released 2018 examinations report highlights what the organization often discovers when it places brokers under a suitability microscope.
The highlights in the 15-page report potentially offer some guidance on how Finra would enforce the SEC’s pending Regulation Best Interest. In May, Finra CEO Robert Cook said the self-regulator will have exam oversight over the best interest rule.
In October, Cook said Finra will evaluate if it’s necessary to keep its own suitability rule when Reg BI is adopted.
Finra’s Suitability Rule 2111 establishes a “fundamental responsibility” for firms and associated persons to deal with customers fairly and is composed of three main obligations: reasonable-basis suitability; customer-specific suitability; and quantitative suitability.
Finra’s exam report points out the following common suitability failures of registered representatives of broker-dealer firms:
- They did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity and other investment profile factors when making recommendations.
- They failed to take into account cumulative fees, sales charges or commissions.
- They made unsuitable recommendations involving complex products, such as leveraged and inverse exchange-traded products, including ETFs and exchange-traded notes.
- They were overconcentrated in illiquid securities and variable annuities, switched between share classes, and had sophisticated or risky investment strategies.
- They recommended unsuitable mutual fund share classes and Unit Investment Trusts.
- They had inadequate product due diligence across product classes, including failure to understand the specific features and terms of products recommended to customers.
Finra also observed some broker-dealer firms facing quantitative suitability challenges with their supervisory systems and other operational issues.
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 relation to the customer’s investment profile, according to Finra.
Finra says setting parameters for trading volume and cost, and restrictions on frequency or patterns of clustered or single product exchanges have helped broker-dealer firms deal with quantitative suitability issues. 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, according to Finra.
On the flip side, Finra said broker-dealer 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.
Such controls included restricting or prohibiting recommendations of products for certain investors, and establishing systems-based controls – or “hard blocks” – for recommendations of certain products to retail investors to prevent registered representatives from going rogue.
Some firms also implemented methods to verify the source of funds for variable annuity transactions. Some required registered representatives – including principals with supervisory responsibilities – to receive training on specific complex or high-risk products before the representatives recommended them.
Other exam findings highlighted in the recent report are related to fixed income markup disclosure, reasonable diligence for private placements and abuse of authority.
The latest report is a follow-up to Finra’s first-ever Examinations Findings Report released in December 2017. The key topics in last year’s report were best execution, product suitability, outside business activities and private securities transactions, cybersecurity, anti-money laundering and market access controls. Finra plans to release an exam findings report annually.