FINRA Outlines Investments They are Watching Closely in 2012

Monday, February 27th, 2012

The Financial Industry Regulatory Authority (FINRA) outlined a list of investment products that they will be watching closely in 2012 because they feel that “concerns relative to business conduct and suitability issues are heightened.” This list of investment products comes from FINRA’s January letter outlining the “2012 annual regulatory and examination priorities.”

The White Law Group is all too familiar with many of the investment products on the list this year. Our securities law firm is dedicated to securities fraud litigation and helping investors who have suffered investment losses as a result of the inappropriate recommendations or actions of their financial professional or brokerage firm. We have spoken with and represented investors who have struggled with investments in mortgage backed securities, non-traded REITs, municipal securities, ETF’s, variable annuities, structured products, private placements, promissory notes, and life settlements. All of these products are commented on in FINRA’s letter and are on their radar for 2012. FINRA’s comments on all the products in the letter can be found below:

Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities: Due to the embedded pre-payment option associated with mortgage-backed products, these securities carry significant re-investment risk, which can strongly affect the yield investors realize. Also, with collateralized mortgage obligations (CMOs), some tranches, such as interest-only strips or inverse floaters, carry much higher levels of risk than other tranches. Finally, the opaque nature of underlying collateral and the lack of a robust secondary market for some mortgage-backed securities should be considered when evaluating suitability.

Non-Traded REITs: Although non-traded REITs may offer diversification benefits as a part of a balanced portfolio, they do have certain underlying risk characteristics that can make them unsuitable for certain investors. As an unlisted product without an active secondary market, these products offer little price transparency to investors and little liquidity. The related financial information for these products may often be unclear to the investor, which makes the true associated risks and value difficult to ascertain. With many products, there are questions about valuation and concerns that in some cases distributions to investors are paid with borrowed money, over a lengthy period of time, with newly raised capital, or by a return of principal rather than a return on investment. The source of the distribution may not be transparent.

Municipal Securities: On the whole, municipal securities may offer significant benefits to many investors and can be an important component of a diversified portfolio. With some municipal securities, however, the lack of timely disclosures and complete financials often inhibit individual retail investors from making informed investment decisions, and may preclude associated persons from having a reasonable basis to recommend such a security. Member firms are reminded of their obligation to make suitable recommendations to their clients with respect to trading in the secondary markets. This includes obtaining sufficient information about the issuer to provide a reasonable basis that the recommendation is suitable. Separate and independent of the suitability obligation, member firms are also required, under MSRB Rule G-17, to disclose to their customers, at or prior to a sale of securities to a customer, all material facts about the transaction known by the dealer as well as all material facts about the security that are reasonably accessible to the market. Firms should ensure that representatives have access to this municipal issuer information (through MSRB’s Electronic Municipal Market Access (EMMA) system and/or other sources) to meet these requirements. Firms are also obligated to trade with their customers at prices that are fair and reasonable (including any markup or markdown).

Complex Exchange-Traded Products: Certain exchange-traded products that employ sophisticated strategies or access more exotic markets can expose investors to unexpected results or unforeseen risks. For example, exchange-traded funds (ETFs) that employ optimization strategies using synthetic derivatives can expose individual investors to the risk of significant tracking errors. In other words, the performance of the ETF may differ from that of the underlying benchmark during times of stress or volatility in unanticipated ways. These risks can be exacerbated when the ETFs employ significant leverage.

Variable Annuities: Although variable annuity products can offer valuable benefits to investors seeking predictable annuity streams, tax deferral for investment gains and flexible investment choices, they do have certain risk characteristics that can make them unsuitable for some investors. These products often have long holding periods and significant surrender fees, making them unsuitable for investors who have a need for liquidity. High fees and expenses may result in reduced performance in the underlying holdings, and high commissions make the product a target for switching. FINRA Rule 2330 imposes enhanced responsibilities on member firms with respect to variable annuities. Among other things, the rule requires that the firm or associated person have a reasonable basis to believe that a customer would benefit from certain features of a deferred variable annuity, such as tax-deferred growth, annuitization, or a death or living benefit, and that the particular recommended deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated, and any rider or similar policy enhancements accompanying it are suitable for the customer. The rule, moreover, requires that the firm or associated person have a reasonable basis to believe that the customer has been informed, in general terms, of various features of deferred variable annuities. Firms are also required to implement surveillance procedures to detect any registered persons who are effecting deferred variable annuity exchanges at a rate that could indicate non-compliance with securities laws and rules, and to have procedures for taking corrective action if such activity is detected. The rule has a training component as well.

Structured Products: These products may be marketed to retail customers based on attractive headline yields or the promise of some level of principal protection. However, they can be complex, and have cash flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. These products generally lack any active secondary market, which means investors must be willing to assume considerable liquidity risk in addition to market risk and the credit risk associated with the issuer of the product. These features can make the products unsuitable for some retail investors. For example, reverse convertibles are debt obligations that are typically tied to the performance of a security or basket of securities. These securities, which may offer a high rate of return, have complex pay-out structures often tied to a “knock-in” level, and involve elements of options trading. In addition, reverse convertibles not only expose investors to the financial risks associated with the debt obligation, but also to those risks associated with the underlying basket of securities.

Securities Offered Through Private Placements: Certain issuers seek to raise capital by offering unregistered securities in private placements. Many firms also offer securities in private placements to accredited investors under SEC’s Regulation D. Firms conducting private placements under Regulation D or any other applicable exemption from registration must conduct a reasonable investigation of the issuer, based upon the facts and circumstances, with careful attention to any “red flags,” to comply with the anti-fraud provisions and other FINRA rules, such as suitability. Proposed FINRA Rule 5123 (Private Placements of Securities) would help ensure that member firms and associated persons that sell applicable private placements provide relevant disclosures to each investor, and would also require that the private placement memorandum, term sheet or other disclosure document be filed with FINRA to help inform FINRA’s regulatory programs. In addition, firms are reminded that the definition of accredited investor has changed.

Unregistered Securities Acquired in Secondary Markets: As many high-profile companies have elected to remain private, secondary trading markets have emerged for their securities. However, despite their profile, many of these companies are difficult to value, as the issuers may not make financial statements publicly available. Acquiring interests in such securities through a pooled investment or single security “fund” introduces another layer of costs to the investor as well as risk associated with the fund manager.

Church Bonds: The credit quality of the underlying issuer and its true financial condition are often not transparent. Investors may be unaware of the substantial credit and market risk they are assuming with such investments. The source and nature of the underlying revenue streams of the issuer that are required to service the instruments are often less than clear. Further, as sales are frequently made on an affinity basis, these securities can be vehicles for fraud.

Promissory Notes: When investing in promissory notes, investors could assume substantial credit and market risk exposures that may not be transparent to them. Such notes may potentially be written by registered persons or by entities associated with registered persons, with or without their employing broker-dealer’s knowledge. Similarly, registered persons may offer and sell promissory notes issued by persons and entities not associated with a broker-dealer, again without their employing broker-dealer’s knowledge. At worst, such instruments are principally a vehicle to defraud clients who may believe that a broker-dealer is knowledgeable about the product and is recommending it as a suitable investment.

Life Settlements: Sales of existing life insurance policies to third parties—referred to as life settlements—have raised regulatory concerns, as these products generally have very high commissions. In 2009, FINRA published Regulatory Notice 09-42 about member firms’ responsibilities in marketing variable life settlements, as these are securities under FINRA jurisdiction. Recent decisions issued by the Delaware Supreme Court highlight the risk that insurers may challenge the validity of a contract based on a lack of insurable interest.

The full text of FINRA’s letter including the investment products they are watching for 2012 can be found at The foregoing information, which is publicly available on FINRA’s website, is being provided by The White Law Group.

If you have suffered losses or believe you have been the victim of securities fraud due to your investment in mortgage backed securities, non-traded REITs, municipal securities, ETF’s, variable annuities, structured products, private placements, promissory notes, and/or life settlements The White Law Group may be able to assist you in pursuing recovery through the FINRA dispute resolution process. If you would like to speak to a securities attorney please call our Chicago office at 312-238-9650.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.

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