August 25, 2015
By Melanie Waddell, ThinkAdvisor
Violations included heavy sales to customers who were elderly, didn’t speak English or had a conservative investment objective
A recent exam by the Securities and Exchange Commission of 10 broker-dealers’ branch offices revealed “significant deficiencies” in the BDs’ suitability and supervision of sales of structured securities products to investors.
Violations included an over-concentration of sales to customers who were non-English speaking, elderly or had a conservative investment objective. One firm had even retroactively changed customers’ stated investment objectives in order to sell them more structured products.
The SEC’s Office of Compliance Inspections and Examinations released Tuesday a risk alert detailing the findings of exams conducted on 10 branch offices of registered broker-dealers that distribute SSPs issued by their parents or affiliates or by unaffiliated third parties.
While significant deficiencies were found in the suitability and supervision of such sales, BDs also failed to maintain and/or enforce adequate controls relating to determining the suitability of SSP recommendations, and failed to review reps’ determinations of customer suitability in the SSPs.
The SEC notes that SSPs have been increasingly marketed to retail investors as they search for income in the persistently low-yield interest-rate environment. SSPs also may offer “attractive attributes” such as partial or full principal protection or exposure to a particular asset class.
SSPs derive their value from, and provide exposure to, a variety of underlying asset classes such as a single security, baskets of securities, indexes, options, commodities, and/or foreign currencies. The products, which may or may not be listed on an exchange, typically have some form of embedded derivatives and may supply, among other things, principal protection, interest payments, or leveraged exposure to the referenced assets, the SEC explains.
The products “may be more complex than a simple debt instrument with a stated interest rate,” the SEC states.
Indeed, Jon Henschen of the broker-dealer recruiting firm Henschen & Associates says that advisors and broker-dealers “need to step up education and due diligence on more complex products in general, especially when they are intermixed with embedded derivatives that make it difficult to measure levels of additional risk.”
Cipperman Compliance Services notes that “firms should ask whether they should ever sell structured notes to retail investors. If they do, they need to significantly increase rep supervision, testing and ongoing monitoring.”
The SEC found during its exams of one BD branch that its reps were “aggressively recommending” SSPs to customers while appearing to “mischaracterize the underlying attributes of the products in light of the goals of the investors, particularly to non-English speaking investors.”
Another exam found significant SSP activity in the accounts of elderly customers at two BDs, and in the accounts of customers for whom the firm did not have any age information.
“Data from one of these firms revealed that the firm often did not collect, and therefore representatives could not consider, information about customers’ age when making suitability determinations,” the SEC states.
The agency notes that while “the absence of certain customer specific factors, such as age, does not necessarily render a transaction unsuitable, together with other factors, such lack of consideration may warrant further inquiry.”
The SEC’s analysis identified, on an aggregate basis, the predominant types of customers that had purchased SSPs at each firm and branch office, and it allowed the OCIE staff to further scrutinize branch offices and reps that had made high numbers of sales that merited further review.
Another review of all SSP trading at four branch offices of one firm revealed that the firm sold more SSPs to customers in its most conservative investment objective (“income”) than it did to customers in its most aggressive investment objective (“speculation”): approximately $96 million versus $11 million.
“While such observations did not necessarily indicate that there were unsuitable transactions, the staff used this high-level information to identify and request further information from those branches and representatives that had conducted the highest numbers of such sales,” the SEC said.
For instance, upon further review of “documentation” and emails, the SEC found that reps at one firm had retroactively changed customers’ investment objectives in their account documentation, without the customers’ approval, in order to justify concentrated positions of SSPs in the portfolios.