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FINRA Promises 2015 Will Be a Year of Scrutiny for Brokerage Firms

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A few days ago, the Financial Industry Regulatory Authority (FINRA) released its 2015 Regulatory and Examination Priorities letter highlighting significant risks and issues that, if not properly addressed, could affect investors and market integrity. Although it comes in a bit long at seventeen pages, we found it quite interesting and informative.

This opening paragraph is a shot fired across the bows of brokerage firms:

"A central failing FINRA has observed is firms not putting customers’ interests first. The harm caused by this may be compounded when it involves vulnerable investors (e.g., senior investors) or a major liquidity or wealth event in an investor’s life (e.g., an inheritance or Individual Retirement Account rollover). Poor advice and investments in these situations can have especially devastating and lasting consequences for the investor. Irrespective of whether a firm must meet a suitability or fiduciary standard, FINRA believes that firms best serve their customers—and reduce their regulatory risk—by putting customers’ interests first. This requires the firm to align its interests with those of its customers."

As we have pointed out so many times, commissions create conflict, and wise investors avoid situations where their advisor is paid by somebody other than themselves. FINRA goes to the heart of the matter in identifying the source of the problem:

"Many of the problems we have observed in the financial services industry have their roots in firm culture. A poor culture may arise, for example, if firm management places undue emphasis on short-term profits or pursues rapid growth without a concomitant concern for controls."

In several past articles such as this one, we have noted the role played by company culture in the illegal or unethical activities of rogue employees. FINRA correctly places the responsibility for culture at the highest levels of the company.

FINRA identified several areas of focus for 2015 that we believe will aid in the areas of investor protection and market integrity:

  • Variable Annuities: Certain compensation structures may improperly incent the sale of variable annuities which may be unsuitable for some clients.
  • Alternative Mutual Funds: Sales of alternative mutual funds have rapidly escalated and now have over $300 billion as of November 2014. They are often marketed as a way for retail investors to access hedge fund strategies even if they don’t qualify for the real thing. Last year, we evaluated the performance of alternative mutual funds and found that they have failed to deliver on their purported claims of reducing volatility, increasing diversification, and producing non-correlated return and higher yields compared to long-only equity and fixed income portfolios. FINRA raised concerns that brokers and customers will not understand how the funds will respond to various market conditions. FINRA has also found that some firms are not properly reviewing these funds before allowing their brokers to sell them.
  • Non-Traded Real Estate Investment Trusts (REITs): We have long cautioned investors to steer clear of these illiquid, expensive, and opaque securities.  We are glad that FINRA is giving them the attention that is long overdue. This Investor Alert from FINRA provides an excellent overview of the problems with these securities. 
  • Structured Retail Products: We have also cautioned investors to stay away from these complicated products which are one more way for Wall Street to pick investor’s pockets. FINRA has expressed concerns that both brokers and clients may be overwhelmed by their complexity. Furthermore, FINRA has identified potential conflicts of interest where the distributor and the provider of the structured product are either the same company or affiliated companies. 
  • Floating-Rate Bank Loan Funds: Although these have primarily been geared towards institutional investors, retail investors have increased their exposure through mutual funds and exchange-traded funds to hedge against a possible increase in interest rates. FINRA notes that these loans can carry significant credit and call risk. Also, they are difficult to value and are relatively illiquid.
  • Securities-Backed Lines of Credit (SBLOCs): These are loans that allow investors to borrow money for purposes other than buying more securities.  Richard Ketchum, FINRA’s chairman and chief executive was quoted in this Wall Street Journal article as saying, “Any time you see leverage increase in a variety of ways…that increases risk for investors.” FINRA has raised concerns about how these loans are marketed and the risks they pose to individual investors as well as the systemic risk to the overall market.

The FINRA letter identified many other issues that will receive increased attention such as excessive trading and exposing investors to concentration risk. Cybersecurity is now a front-burner issue, especially after the recent data breach at Morgan Stanley that was attributed to a rogue employee. FINRA has made clear that it will hold companies to a high standard of supervision and risk management. No longer will they be able to hire “high-risk and recidivist” brokers and claim ignorance as an excuse.

We at Index Fund Advisors welcome this FINRA letter, and we hope it moves the entire industry closer to the fiduciary standard, which all investors deserve.