Financial Adviser Continuing Education Program Provides Helpful Roadmap of Significant Regulatory Developments Affecting Investors and Their Advisers

Posted on April 26th, 2011 at 2:02 PM

Twice each year the Securities Industry Regulatory Council on Continuing Education publishes guidance for financial services firms to assist them in formulating their continuing education programs.  The Spring 2011 “Firm Element Advisory” (FEA) highlights current regulatory and sales practice topics based upon a review of publications and announcements of significant events, as issued by regulators such as the Securities and Exchange Commission (SEC) and self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA).  Let’s highlight the more important investor protection topics.

            First, FEA focuses on alternative investments.  In particular, FEA calls attention to two alternative investments: reverse exchangeable securities (reverse convertibles) and commodity futures-linked securities.  Regarding reverse convertibles, the FEA cites to FINRA Regulatory Notice 10-09.  In that notice FINRA states: 

Reverse exchangeable securities, commonly called "reverse convertibles," are popular structured products with retail investors, due in large part to the high yields they offer. However, reverse convertibles are complex investments that often involve terms, features and risks that can be difficult for retail investors and registered representatives to evaluate. Firms that sell reverse convertibles are reminded to ensure that their promotional materials or communications to the public regarding these products are fair and balanced, and do not understate the risks associated with them. Firms are also reminded to ensure that their registered representatives understand the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to any customer.

Similarly, commodity futures-linked securities also are of concern.  FEA likewise cites to FINRA Regulatory Notice 10-51.  In that notice, FINRA states:

Securities that offer exposure to commodities have become increasingly popular and accessible to retail investors in recent years. Given the practical difficulties that can be associated with investing directly in many commodities, commodity-linked securities often use futures contracts to track an underlying commodity or commodity index. Commodity futures linked securities can be an effective tool for gaining exposure to an asset class that in some cases can be difficult for retail investors to access. However, firms should be aware that, in some cases, the performance of the commodity futures-linked security can deviate significantly from the performance of the referenced commodity, especially over longer periods. The deviation could be either positive or negative, depending on market conditions and the product’s investment strategy. This deviation can produce unexpected results for investors who are not familiar with futures markets, or who mistakenly believe that commodity futures-linked securities are designed to track commodity spot prices.


FINRA is issuing this Notice to remind firms that offer commodity futures linked securities that they must ensure that communications with the public about these securities are fair and balanced, that recommendations to customers are suitable, and that their registered representatives adequately understand and are able to inform their customers about these securities before they recommend them. To meet these obligations, firms must train registered personnel about the characteristics, risks, and rewards of each product before they allow registered persons to sell that product to investors. Firms must also have adequate written supervisory procedures and supervisory controls that are reasonably designed to ensure that sales of commodity futures-linked securities comply with the federal securities laws and applicable FINRA rules.


            Second, FEA points out the new Know Your Customer and suitability obligations that FINRA proposed and that the SEC approved.  In a previous article, I addressed those important rule changes, including noting that the new Know Your Customer rule continues throughout the life of the account relationship with the customer, and that FINRA will require firms to “verify” the essential facts “at intervals reasonably calculated to prevent and detect any mishandling of a customer’s account that might result from the customer’s change in circumstances.”  Likewise, I noted that the new suitability rule applies to recommended investment strategies involving a security or securities, and that “the term ‘strategy’ would capture a broker’s explicit recommendation to hold a security or securities.” 

            Third, FEA highlights municipal securities sales practice and supervisory requirements, stating, “Brokers, dealers and municipal securities dealers must fully understand the bonds that they sell in order to meet their disclosure, suitability and pricing obligations under the rules of the MSRB [Municipal Securities Rulemaking Board] and the federal securities laws.”  FEA cites several pronouncements by both MSRB and FINRA.  For instance, FEA cites a FINRA publication entitled Municipal Bond Sales in the Secondary Market: Checklist for Customer Disclosure.  FINRA states, “Among other things, the checklist reminds firms to disclose material information about a bond to customers such as terms and features, ratings and ratings changes, the existence of bond insurance or credit or liquidity enhancements, the bond's price and yield, interest payments, tax implications, call provisions and other material risks, including risk of default.” 


            Fourth, FEA focuses on amendments relating to BrokerCheck, which is a free tool to help investors research the professional backgrounds of current and former FINRA-registered financial advisers and their firms.  BrokerCheck has been expanded to lengthen the disclosure period to ten years and to make certain information permanently available, such as arbitration awards or civil judgments against an adviser based upon allegations that the person was involved in a sales practice violation.  Similarly, FEA discusses the obligation on the part of financial services firms to provide FINRA with timely, complete and accurate disclosure information related to a host of inquiries including reasons for employment termination, regulatory inquiries and complaints.

            Fifth, FEA points out the new rules relating to both the initial purchase and the exchange of deferred variable annuities.  The new rules impose more stringent recommendation requirements, disclosure obligations, in addition to requirements for principal review and approval, supervisory procedures and training.

            Sixth, FEA emphasizes FINRA’s continuing priority to ensure that firms and their advisers maintain adequate business continuity and contingency plans.  In addition, firms must ensure that their advisers are aware of and understand those plans.

            Seventh and finally, FEA alerts firms to developments relating to securities arbitration rules.  For example, the rules now allow a non-party witness attorney to attend an arbitration hearing while the witness is testifying.  This is an important protection for those not named in a proceeding yet called upon to provide testimony under oath.  Unless otherwise authorized by the arbitrators, the attorney’s role will be limited to asserting recognized privileges, such as the attorney-client and work-product privileges, as well as the privilege against self-incrimination.  Another significant development is the new customer option to choose an all public arbitration panel.  For years, investor advocates have criticized FINRA’s rule requiring the inclusion of one securities industry arbitrator on three-person arbitration panels.  Effective February 1, 2011, customers in FINRA arbitration now have the option of choosing three public arbitrators – those not affiliated with the securities industry.  In announcing the rule change, FINRA stated that it “believes that providing customers with the right to exclude a non-public arbitrator from the panel deciding their case will enhance customers’ perception of the fairness of FINRA’s rules and the securities arbitration process.”


            As one can see, the Securities Industry Regulatory Council’s FEA nicely summarizes the current regulatory landscape.  Hopefully, firms will take the guidance to heart, by implementing effective continuing education programs, and as a result better protect investors.



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