Another Reminder of FINRA’s Expectations (Regulatory Notice 22-11)

FINRA issued Regulatory Notice 22-11 in April to remind broker-dealers of their obligations in the sale of alternative mutual funds to their clients.  FINRA explained that it published this guidance because of a number of recent enforcement actions it took against firms selling this product.  However, upon closer inspection, 22-11 is simply FINRA’s latest iteration of its expectations of the industry.

Santayana Was Correct

Philosopher George Santayana once remarked that those who do not remember history are doomed to repeat it.  Santayana was not referring to the broker-dealer industry.  But he could have been.  Consider this statement from FINRA:

In the current investment environment, investors and brokers are increasingly turning to alternatives to conventional equity and fixed-income investments in search of higher returns or yields.

This is not in 22-11.  This actually appears in FINRA’s (then NASD Regulation, Inc.) guidance to the broker-dealer community for reviewing new securities products.  In 2005,¹  this came on the heels of FINRA’s Notice to Members 03-71 concerning non-conventional investments in which the regulator noted “[i]n the aftermath of the recent downturn in the equity markets, NASD reviewed the services and products offered by members and observed that retail investors were being offered an array of different investments as alternatives to conventional equity and fixed-income investments.”²

Does this sound familiar?  

FINRA could have issued these statements – and, more importantly, its related guidance – at any point in the past twenty years.  This is not a criticism.  Rather, it is a reminder that FINRA has certain expectations of the broker-dealer community.   These include:

Written Supervisory Procedures Remain a Cornerstone of an Effective Compliance Program

FINRA observed in 22-11 that it cited firms that failed to have detailed written supervisory procedures (WSPs) for selling, or reviewing the sale of, alternative mutual funds or did not have WSPs for this product at all.³ This should come as no surprise.  FINRA has made similar statements throughout the years, including:

• “Members must ensure that their written procedures for supervisory and compliance personnel require that (1) the appropriate due diligence/reasonable-basis suitability is completed before products are offered for sale; (2) associated persons perform appropriate customer-specific suitability analysis; (3) all promotional materials are accurate and balanced; and (4) all NASD and SEC rules are followed. In addition to establishing written procedures, members also must document the steps they have taken to ensure adherence to these procedures.”⁴
• “As part of the supervisory responsibilities imposed by NASD Rule 3010, all firms that sell new products should have formal written procedures to ensure that no new product is introduced to the marketplace before it has been thoroughly vetted from a regulatory as well as a business perspective.”⁵
• “Among other things, if a firm promotes or allows its registered representatives to recommend such funds, the firm must ensure that its written supervisory procedures require that: the appropriate reasonable-basis suitability analysis is completed; associated persons perform appropriate customer-specific suitability analysis; all promotional materials are accurate and balanced; and all FINRA and SEC rules are followed.  In addition to establishing written procedures, such firms must document the steps they have taken to ensure adherence to these procedures.”⁶
• “Firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted.  Those procedures should ensure that the right questions are answered before a complex product is recommended to retail investors.”⁷

Action Item:  It is not enough that broker-dealers have WSPs.  As I noted recently, firms must craft actionable procedures.  A WSP that only explains the applicable law (and I saw those in my time as a regulator) does not create a system that is “reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.”⁸  A firm’s WSPs should describe what actions must be taken, who is responsible for taking them, when he or she must complete these tasks and how they are memorialized.

Broker-Dealers Must Marry Reasonable WSPs With Reasonable Oversight 

A broker-dealer can craft the strongest WSPs known to the industry, but with all due respect to the late Ron Popeil, an effective compliance program cannot be “set it and forget it”.  FINRA expects broker-dealers to continue to monitor its associates’ activities for compliance with its WSPs.  FINRA has not wavered on this point.  It noted this in 22-11 (“Firms did not implement effective oversight of registered representatives’ recommendations of Alt Funds.”⁹).  It also raised this in the 2010s (see e.g., “A well-designed system of internal controls should include a process to periodically reassess complex products a firm offers to determine whether their performance and risk profile remain consistent with the manner in which the firm is selling them.”) and the 2000s (see, e.g., “Some firms require that complex products, those approved on a contingent or limited basis, or those based on critical market assumptions, be formally reviewed for a specific period of time, often six months or a year.”).¹⁰

Action Items: Have reasonable procedures, but also do not forget to create a process to review compliance with them.  Also keep records of the broker-dealer’s surveillance efforts.  Process matters here.

Broker-Dealers Also Need to Train Their Associated Persons

FINRA stated in 22-11 that firms that effectively addressed alternative mutual funds “notified appropriate staff regarding regulatory guidance and investor alerts addressing Alt Funds and included training on Alt Funds in their annual compliance meetings”.¹¹ This is part and parcel with its guidance over the years concerning new products (“Members must train registered persons about the characteristics, risks, and rewards of each product before they allow registered persons to sell that product to investors”); exchange-traded funds (“Firms must train registered persons about the terms, features and risks of all ETFs that they sell, as well as the factors that would make such products either suitable or unsuitable for certain investors.”); and complex products (“The registered representative should be adequately trained to understand not only the manner in which a complex product is expected to perform in normal market conditions, but the risks associated with the product.”), among other notices.¹²

Action Items: Create reasonable procedures with reasonable oversight, but also do not forget to “coach up” your associates on how to meet those standards.

Broker-Dealers Need to Watch Communications

FINRA prominently states on the “About” page of its site that it “is dedicated to protecting investors. . .” and “work[s] every day to ensure that everyone can participate in the market with confidence.”  To that end, FINRA takes broker-dealers’ communications with investors very seriously.  In 22-11, FINRA noted that certain firms “did not review whether retail communications they used to market Alt Funds provided a sound basis for evaluating the facts with respect to these products”.¹³ This yet another in a long line of reminders that communications must be, among other requirements in FINRA Rule 2210, fair and balanced and cannot include false or misleading statements or claims.¹⁴

Action Items: Remember that the content standards in FINRA Rule 2210 apply to any communication with the public – even if the broker-dealer is not required to file it with FINRA’s Advertising Regulation Department – and review those communications accordingly.

Thank you for reading this article.  Please know that I wrote it for informational purposes only (some may consider it ADVERTISING MATERIAL) and did not intend for it to be legal advice or to form an attorney-client relationship with you – especially in jurisdictions where I am not licensed to practice law.  I encourage you to seek your own counsel to help you with your specific situation.  To that end, I invite you to contact me if you would like to discuss my services.

I enable broker-dealers, registered investment advisers and their associates to spend more time growing their business by helping them address a wide range of legal and compliance responsibilities with clear and detailed advice.