Bates Research - 01-10-14

Complex Product Suitability

Guest Post by Expert Bruce Cramer

On January 2, FINRA published its regulatory and examination priorities, highlighting what it sees as significant risks and issues in today’s market environment.  In the area of suitability, FINRA specifically identified complex products and interest-rate-sensitive fixed income products as a focus for scrutiny.  While the ongoing risks with these products have not changed with the New Year, any market disruptions resulting in a realization of those risks will be viewed in the light of FINRA’s new suitability rule, 2111.

FINRA focuses its primary concern on ineffective disclosure practices, specifically related to the sale of complex products.  A truly balanced discussion of the risks and potentially negative scenarios that could cause those risks to be realized is demanded, assuming that the broker making the recommendation is actually informed and able to make such disclosures.  Under the reasonable basis suitability duty, a broker must understand the products they are recommending, or they must refrain from making a recommendation.  This creates a responsibility for broker-dealers to adequately train brokers and monitor their understanding of the unique and varied risks embedded in many complex products.  A broker’s observation of a product’s success in a benign market environment may enhance its marketability; however, supervisors and brokers must be particularly wary of historical performance benchmarks when disclosing risks and observing suitability standards.  The risks of capital loss and potential liquidity issues that arise during market disruptions must be understood and disclosed, and a broker must make a reasonable effort to ensure that the client has an understanding of those risks. 

Relative to interest-rate-sensitive products, concern is focused on concentrations of such products in accounts as well as the disclosures or omissions of material facts at the time the products are recommended.  Over the last 30 years, owners of long-duration products have been generally well rewarded as long term interest rates have declined.  The decline of money market fund yields from 15% in 1980 to .15% in today’s environment has compelled investors to seek out longer maturities and new products in their search for yield on their fixed income investments.  The reasonable basis suitability standard described above requires brokers and broker-dealers to employ a full and balanced discussion of the risks and rewards of long-duration products, whether purchased as individual bonds or through products such as bond mutual funds and Exchange Traded Funds (ETFs).  Interest rate risk must be considered for all bonds across different credit ratings or tax treatments (tax free or taxable bonds).  The customer-specific suitability standard requires brokers and broker dealers to be aware of their clients’ other investments when making a buy, sell, or hold recommendation.  As such, when members make recommendations of long-duration products, they must be aware of the duration of a client's other holdings irrespective of its credit rating or tax status.  FINRA notes that this inquiry by brokers is particularly relevant to accounts where the client has near-term liquidity needs or a conservative investment profile.

When considering the impact that today’s low interest rates have on savers’ and investors’ ability to generate income from their investments, along with demographic trends showing a pronounced increase in the population of retirees that typically demand income generation from their investments, FINRA’s concerns appear to be well placed.


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