A new report highlighting examination findings explains that the self-governing body continues to observe unsuitable recommendations to retail investors, as well as deficiencies in some firms’ supervisory systems for registered representatives’ activities.
The organization’s second annual report – “2018 Report on FINRA Examination Findings” – focuses on selected observations from recent examinations that FINRA considers worth highlighting because of their “potential significance, frequency and impact on investors and the markets.”
As part of the organization’s FINRA360 initiative, the report focuses on, among other things, suitability for retail customers, fixed income mark-up disclosure, reasonable diligence for private placements and abuse of authority.
“We hope the observations within the Exam Findings Report enable firms to strengthen their own control environments and address potential deficiencies before their next exam,” notes FINRA CEO Robert Cook.
In reviewing FINRA Rule 2111 on suitability, the organization suggests that firms should also consider the guidance in FINRA Regulatory Notice 18-15 to determine whether certain representatives engaging in repeated misconduct should be subject to special supervisory procedures, such as a heightened supervision plan.
“FINRA observed situations where registered representatives did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations; in others, they failed to take into account the cumulative fees, sales charges or commissions,” the report states.
In some cases unsuitable recommendations involved complex products such as leveraged and inverse exchange-traded products, including ETFs and ETNs, the report further explains. Other cases involved overconcentration in illiquid securities, recommendations of variable annuities, switches between share classes, and sophisticated or risky investment strategies, FINRA notes.
The organization also said it remains concerned about recommendations of unsuitable mutual fund share classes and Unit Investment Trusts (UITs), as discussed in its 2017 report. Inadequate product due diligence across product classes — including failure to understand the specific features and terms of products recommended to customers — was a common contributor to the challenges, FINRA observed.
An additional observation is that some firms failed to establish and enforce an “adequate supervisory system” to identify and prevent potentially excessive trading in customer accounts. For example, some firms failed to review account alerts from their clearing firm or use other available compliance tools to detect excessive trading, commissions or trading losses in customer accounts, the report notes.
Another area of supervisory failure involved representatives’ recommendations of variable annuities. For example, FINRA notes that it observed “unsuitable and largely unsupervised representative driven recommendations” to retail customers to exchange one annuity product for another. “In many instances FINRA reviewed, the recommended exchange was inconsistent with the customer’s objectives and time horizon, and resulted in — among other consequences — increased fees to the customer or the loss of material, paid-for accrued benefits,” the report states.
Other observations included the failure to conduct reasonable diligence on private placements and failure to meet their supervisory requirements under FINRA Rule 3110 (Supervision) with respect to suitability obligations.
In some instances, firms performed no additional research about new offerings because they relied on their experience with the same issuer in previous offerings, according to the report. In other instances, firms reviewed the offering memorandum and other relevant documentation, but did not discuss the offering in greater detail with the issuer or independently verify aspects of the offerings, it noted.
The organization further observed that some firms “did not investigate red flags” identified during the reasonable diligence process. In other examples, some firms reviewed due diligence reports provided by consultants, experts or other third-party vendors, but they did not independently evaluate the third parties’ conclusions or respond to concerns noted in the reports.
The organization reminds firms conducting diligence required by the reasonable-basis suitability obligation to document both the “process and results” of such reasonable diligence analysis. “Although firms may use a risk-based approach to documenting compliance with the suitability rule, even when using such an approach, firms ordinarily would be expected to document their diligence efforts regarding recommendations of private placements,” the report explains.