The Real Lesson From FINRA’s 2018 Exam Findings Report

From Ulmer’s Broker-Dealer Law Corner Blog
By Alan M. Wolper

On Friday last week, FINRA released a report discussing the findings from its 2018 exams, providing what it described as “selected observations” that were deemed to have “potential significance.” Even with that tepid introduction, in theory, this is still a great idea, since anyone in the industry, even so-called “good” or “clean” firms, should welcome the chance to learn lessons from all those other firms who have managed to find themselves on FINRA’s radar screen. Unfortunately, as is often the case, in reality, there’s really not much to see here, as the results are entirely predictable. I mean, would it surprise even one person to read that FINRA encountered issues in its 2018 exams with suitability, supervision, net capital and AML? Likely not, given the frequency with which these subjects are the subject of Enforcement actions, and not just this past year, but going back seemingly forever.

So, since the principal purpose of the report is pretty pointless (because it simply tells us what we already know), the question becomes whether there is anything else of value in there. On close reading, I think there is, as the report serves to highlight FINRA’s fairly black-and-white view of what’s ok and what’s not. And, once you know that, you can at least try to stay out of trouble.

First, it is interesting, but not at all shocking, to observe that most of what bothers FINRA relates to products other than bread-and-butter stocks and bonds. A large majority of FINRA’s discussion of the things that got firms into regulatory difficulty this year involve less mainstream products. The list includes products that FINRA describes only generally, like “complex” and “high-risk” products, but also more specific things, such as leveraged and inverse ETFs and ETNs, variable annuities, UITs, REITs, volatility-linked products, and private placements. This just serves to reinforce something I have long espoused, which is that the further one gets away from vanilla buy-and-hold strategies involving blue chip stocks or index mutual funds, the less comfortable FINRA becomes. Even products as mundane as municipal bonds or certain managed mutual funds become, in FINRA’s eyes, fraught with danger for unwary investors.

Second, even I was surprised to read, both explicitly as well as between the lines, that FINRA’s recommended approach to these “risky” products seems not to manage whatever risks they supposedly present, but, more simply, less elegantly, to eliminate them, by not selling them in the first place. Throughout the report, FINRA highlights – and not unfavorably – instances in which exams revealed that certain BDs have, apparently, just thrown in the towel and said they’ve decided it’s not worth it to sell or do something that FINRA has concluded, rightly or wrongly, is risky. Consider the following examples from the report:

  • In its discussion of suitability issues, FINRA complimented “firms with sound supervisory practices for suitability” not only because they “implemented controls tailored to the specific features of the products they offered and their customer base,” but because those controls “included, for example, restricting or prohibiting recommendations of products for certain investors, as well as establishing systems based controls (or “hard blocks”) for recommendations of certain products to retail investors.”
  • Regarding volatility-linked products, the report notes that “[s]everal firms prohibited or restricted representatives’ recommendations to retail clients for either all or some volatility-linked products, such as inverse or leveraged ETPs or other products.”
  • Similarly, the report begins the section relating to claimed abuses of discretionary trading authority by noting that “FINRA has observed that some firms prohibit the use of all discretionary customer accounts.” In that same part of the report, which discusses registered reps who happen to get named by customers as trustees, FINRA “also observed that certain firms prohibited registered representatives from acting in some positions of trust, such as trustees or co-trustees, Powers of Attorney, executors or beneficiaries.”

I don’t want to oversell this view by suggesting that FINRA is actually pushing BDs away from these products or strategies; indeed, the report contains plenty of examples of firms that somehow manage to implement supervisory procedures that FINRA deigns to call “reasonable” even though they pertain to products or strategies that other firms have deemed verboten. But, it is still very clear to me that FINRA would be happy if BDs simply steered completely away from the kinds of products or trading strategies that it has determined are risky, or too complex to be easily understood by the average investor, or, frankly, which result in high commissions. Knowing this about your securities regulator is valuable. Once you know where the landmines are buried, navigating the minefield becomes that much less challenging.

But, that assumes that you are still willing to enter the minefield. Just because you have a map doesn’t ensure that it is 100% accurate, and messy errors can still happen. And that is the message that FINRA is espousing here. Sure, you can sell ETFs or ETNs. You can recommend an aggressive trading strategy that entails frequent in-and-out trading. You can sell private placements replete with nasty risk disclosures. Just know that if you do, FINRA will be watching you, and watching closely, ready to second-guess your supervisory efforts. That’s no way to live, at least professionally, constantly looking over your shoulder.