BROKER-DEALER CONTROLS REGARDING RETAIL SALES OF STRUCTURED SECURITIES PRODUCTS

From the Desk of Jim Eccleston at Eccleston Law LLC:

The SEC has issued a Risk Alert relating tobroker-dealer controls on retail sales of Structured Securities Products (“SSP”).

SSPs are securities issued as corporate obligations of an affiliate of the underwriting broker-dealer. They have been marketed to retail investors due to their attractive interest payment, and other attributes such as principal protection or exposure to a particular asset class. SSPs may not be listed on an exchange, and typically have some form of embedded derivatives. Therefore, the sales of those products may become a potential risk issue for broker-dealer firms.

The SEC, through OCIE’s National Examination Program staff (“Staff”), examined several registered broker-dealers, which in total sold 26,600 SSPs, or $1.25 billion in principal transactions. The SEC assessed those firms’ compliance, suitability and supervision requirements and evaluated whether the firms effectively supervised and monitored activities and risks associated with sales of SSPs to retail investors.

The examinations revealed several significant deficiencies in the areas of suitability and supervision with respect to all of the examined firms’ sales of SSPs to retail investors. Specifically, all of the examined firms:

• Failed to maintain and/or enforce adequate controls relating to determining the suitability of SSP recommendations; and
• Failed to conduct both compliance and supervisory reviews of registered representatives’ determinations of customer suitability in the SSPs, as required by their internal controls.

In the examinations, on an aggregate basis, the analysis revealed several observations of broker-dealer’s failing to maintain and enforce policies and procedures relating to determining the suitability of recommendations of SSPs:

• Firms sold more SSPs to customers in its most conservative investment objective (“Income”) than it did to customers in its most aggressive investment objective (“Speculation”): approximately $96 million versus $11 million.
• Representatives were aggressively recommending SSPs to customers while appearing to mischaracterize the underlying attributes of the products in light of the goals of the investors, particularly to non-English speaking investors.
• At two of the examined firms there was significant SSP activity in the accounts of elderly customers and in the accounts of customers for whom the firm did not have any age information.
• Representatives at one firm had retroactively changed customers’ investment objectives in their account documentation, without the customers’ approval, in order to justify concentrated positions of SSPs in the portfolios.
• Various account types – including, but not limited to, trusts, individuals, and at least one employee benefits plan – had a large number of SSP purchases during the two-year review period (from January 2011 through December 2012), and many of those SSPs thereafter were liquidated at well below face value of the SSP.

The examinations also revealed that some of the examined firms failed to enforce their written supervisory procedures relating to reviews of representatives’ determinations of suitability with regard to SSPs.One firm’swritten supervisory procedures stated that all SSP holdings should not exceed a certain percentage of the client’s stated liquid net worth.   Yet, more than 1,800 of the over 3,000 SSP transactions (approximately 60%) exceeded the firm’s concentration guidelines. In almost 10% of those transactions, the SSPs exceeded twice the total liquid net worth guideline (with some as high as 100% of liquid net worth). At this particular firm, all of those transactions had been approved by the branch manager or complex risk officer with little or no documented explanation to support their approvals.

FINRA requires a registered representative have a reasonable basis to believe that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and be financially able to bear the risks of the recommended position.FINRA also requires broker-dealers to supervise their associated persons, and the Exchange Act permits the SEC to sanction broker-dealers who fail reasonably to supervise, with a view to preventing violations of the federal securities laws. In addition, FINRA has released guidance to help assess the adequacy of controls with respect to SSPs and complex products.That guidance includes provisions relating to a reasonable basis suitability determination; customer-specific suitability analysis; and training for registered representatives regarding the characteristics, risks, and rewards of SSPs.

Broker-dealer firms should utilizethe SEC Risk Alert as a guide to self-assess their internal control system in order to ensure that sales practices and supervision of SSPs passes muster. 

The attorneys of Eccleston Law LLC represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 65 years in delivering the highest quality legal services.

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