Remarks from the National Compliance Outreach Program for Broker-Dealers

As prepared for delivery.

Good morning and thank you Carlo [di Florio] for that introduction.

I'm honored to be with you today, particularly because the conversation we're having here about the role of compliance and effective controls is more important than ever. Our financial markets are changing quickly, and your commitment to continually assess risk, exposure and how your brokers interact with customers is key to ensuring investors are treated fairly. Events like this give us an opportunity to talk about how we can achieve our mutual goal of investor protection while ensuring that firms are able to provide innovative products that meet investor demand and generate revenue.

Let me start by acknowledging the improvements in compliance that have taken place over the last few years. For example, we're seeing better conflict-management processes and improved coordination among firms' compliance, risk-management and legal functions. In firms with multiple affiliates—including federally regulated banks—we're seeing improved controls within the broker-dealer and better communication among the affiliates. It's also good to hear that compliance is more frequently being invited to participate in a more meaningful way in the risk-management functions of the broker-dealer.

Firms are also reporting that they have enhanced their processes for conducting due diligence on new products, as well as made enhancements in the technology they're using in automated surveillance of customer activity. In addition, more firms are taking proactive steps to improve data security—something they will need to continue to focus on as these risks evolve and grow over time.

When conducting exams or assessing risk, FINRA evaluates a firm's "culture of compliance," and we have found that many firms have done an excellent job of fostering a compliance culture that permeates throughout the organization. It's no surprise that firms with the right "tone at the top" generally have better results in this area.

All of these are meaningful improvements in supervision and compliance, but we still have more work to do to ensure investors are protected. It's especially important in this zero-yield environment, where investors are more willing to take on risk they either don't understand or can't afford. We're also concerned that investment professionals may not always understand the features of the products they recommend or whether the products are suitable for a particular investor. So this morning I want to talk to you about one area where we believe heightened supervision is necessary: complex products. I also want to update you on our risk-based exam program.

Complex Products

Our concerns regarding complex products are not new. We've discussed them in our annual Exam Priorities Letter, and we've issued guidance in Regulatory Notices reminding firms that these products may need additional supervision. But we continue to see problems with suitability and supervisory violations. So I want to share with you some of our concerns.

Let's start with structured products. We consider these products to be complex because they typically involve unsecured debt and involve derivative strategies featuring pay-outs that are linked to a variety of underlying assets—which are sometimes highly volatile—such as a narrow or proprietary index or some other obscure benchmark. Though firms may market these products to retail customers based on attractive initial yields and, in some cases, on the promise of some level of principal protection, they often have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, these products generally do not have an active secondary market, which means investors must be willing to assume considerable liquidity risk in addition to market risk and the credit risk associated with the issuer of the product. These features can make the products unsuitable for some retail investors.

As we noted in our Exam Priorities Letter, firms must consider an investor's tolerance for risk, investment horizon and level of sophistication when assessing whether the product is suitable for that investor.

Closed-end funds are another example of complex products that require enhanced supervision. Retail investors may find them attractive because they typically pay income regularly in the form of dividends, interest income, capital gains and/or return of capital. FINRA is concerned that retail investors may not understand that some funds are returning capital to maintain the high distribution rates, causing the closed-end funds to trade at high premiums compared to their net asset value.

You may have also heard me talk about your responsibilities regarding the sale and marketing of private placement securities. We've reminded firms that the scarcity of independent financial information and the uncertainty surrounding the market- and credit-risk exposures associated with many private placements means they must conduct reasonable due diligence on prospective issuers. Due diligence should focus on the issuer's creditworthiness, the validity and integrity of their business model, and the plausibility of expected rates of return as compared to industry benchmarks. Our primary concern is that inadequate due diligence regarding private placements could expose customers to harm and result in insufficient disclosure.

When we examine firms, we focus on due diligence policies and procedures, as well as valuation processes. We also place special emphasis on the integrity and independence of third-party valuation services, and the timely disclosure of material risks.

To help us better understand these offerings, we now require firms that sell an issuer's securities in a private placement to file a copy of the offering document with us. We use the information it provides to better identify and assess higher-risk transactions.

What should your firm be doing? If you are selling these products, you must consider the potential pitfalls, and develop a way to address those potential problems.

Before recommending a complex product to a retail customer, financial advisers at your firm should discuss the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. Reps. should describe the circumstances under which the customer could lose money—and not just those under which the customer would earn money. Finally, reps should also explain carefully the direct and imputed costs clients will incur.

Conflicts of Interest

In addition to assessing the potential risks of the individual products, you should assess and disclose your firm's conflicts of interest. Susan will cover our ongoing conflicts review in detail later today, but let me underline one fundamental message. Conflicts reviews must be a continuing focus of your firms. To use the language of enterprise risk management, history suggests that for major integrated firms, improper management of conflicts is your greatest risk. I cannot think of either an industrywide failure or significant individual firm regulatory or financial failure in the last twenty years that does not have a conflicts issue imbedded in it.

Start by looking at whether your business practices place your firm's—or its employees'—interests ahead of customers. You should also make sure that the products your firm sells are appropriate for each investor, and assess the potential risks associated with products that raise specific investor-protection concerns. And where applicable, you should disclose any conflicts of interest.

More broadly, we want to better understand how firms identify and manage conflicts. To get a better sense of industry practices, and to identify both good policies and potential problem areas, we initiated conversations with a number of firms last year. Knowing what firms do to address conflicts and the challenges they face also helps us determine whether we should issue guidance to the industry or consider other steps. In some cases, the selling challenges firms face point out where the culture of the industry has gone wrong. What is clear is that the culture has to evolve with respect to firms being able to document that their recommendations are in the best interest of investors.

One example of the type of conflict that FINRA believes should be disclosed to customers is recruitment compensation packages. When a broker moves to a new firm and calls a customer to say, "You should move your account with me because it will be good for you," the customer needs to know all of the broker's motivations for moving. In some instances, recommendations to customers can be driven by direct and indirect compensation incentives to the financial adviser and the firm itself.

So in January, we proposed a rule that would require a broker-dealer that recruits representatives using enhanced recruitment compensation to disclose that compensation to customers solicited to transfer with the representative. We are reviewing comments we received on the proposal and will soon decide how to proceed.

Exam Program

Whether we are talking about complex products or high-frequency trading, FINRA's goal is to address problems early and prevent harm to investors. This means we have to monitor emerging trends like the ones I just described and be prepared to respond quickly. To assure we meet this challenge, we shifted our examination program to a more risk-based approach that would strengthen our ability to identify high-risk firms, brokers, activities and products. We developed new technology to support and streamline the process of examining firms, which is critical to identifying and prioritizing areas of risk exposure.

Ongoing data collection and analysis—most of which occurs before we start an exam—is a main focus of our program. One way in which we are collecting more data before an exam is through the Risk Control Assessment Survey. Since we introduced the RCA last year, we've heard from firms that their subsequent sales practice cycle examinations were more streamlined and that examiners arrived on site with a better understanding of the firm's business. We made a number of adjustments to the survey and to the exam program based on your feedback, and we welcome your thoughts on how we can continue to streamline the examination process.

Close

I want to close with one thought: Strong supervisory systems are the most effective way to prevent and detect improper activities. To make sure our supervisory programs keep up with the changing marketplace, we have to continually assess the way we operate, and work together to make sure we are doing all we can to protect investors.

Thanks for listening.