Every year, the Financial Industry Regulatory Authority (FINRA) takes note of key regulatory and examination issues that it plans to prioritize in the new year. In 2013, those priorities include a number of hot-button – and familiar – financial products, from structured investments, to non-traded REITs, to business development companies, or BDCs.
In a recent notice to investors, FINRA highlighted the following products and issues, along with an explanation as to why they merit top placement on FINRA’s 2013 watch list.
Structured Products: These products may be marketed to retail customers based on attractive initial yields and, in many cases, on the promise of some level of principal protection, according to FINRA. Moreover, structured products are often complex, and have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, structured products generally do not have an active secondary market.
Suitability and Complex Products: FINRA’s recently revised suitability rule (FINRA Rule 2111) requires broker/dealers and associated persons to have a reasonable basis to believe a recommendation is suitable for a customer. FINRA says it is particularly concerned about firms’ and registered representatives’ understanding of complex or high-yield products, potential failures to adequately explain the risk-versus-return profile of certain products, as well as a disconnect between customer expectations and risk tolerances.
Business Development Companies (BDCs): BDCs are typically closed-end investment companies. Some BDCs primarily invest in the corporate debt and equity of private companies and may offer attractive yields generated through high credit risk exposures amplified through leverage. As with other high-yield investments – such as floating rate/leveraged loan funds, private REITs and limited partnerships – investors are exposed to significant market, credit and liquidity risks. In addition, fueled by the availability of low-cost financing, BDCs run the risk of over-leveraging their relatively illiquid portfolios, FINRA says.
Exchange-Traded Funds and Notes: In many instances, retail investors may not fully understand the differences among exchange-traded index products (i.e., funds, grantor trusts, commodity pools and notes) and the risks associated with these investments, particularly those that employ leverage to amplify returns. FINRA says it also is concerned about the proliferation of newly created index products that lack an established track record. Examples include products with valuations and performance tied to volatility, emerging markets and foreign currencies.
Non-Traded REITs: FINRA’s interest in non-traded REITs centers on the fact that many customers of non-traded REITs are unaware of the sales costs deducted from the offering price and the repayment of principal amounts as dividend payments in the early stages of a REIT program.
Private Placement Securities: Private placements will continue to be a key focus of FINRA’s investor protection efforts in 2013, with particular emphasis on sales and marketing efforts by broker/dealers. To improve its understanding of private placements, FINRA implemented Rule 5123, which requires member firms that sell an issuer’s securities in a private placement to individuals to file a copy of the offering document with FINRA.
FINRA also reminds member firms that the relative scarcity of independent financial information and the uncertainty surrounding the market- and credit-risk exposures associated with many private placements necessitates reasonable due diligence on prospective issuers. FINRA notes that 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, particularly in light of the complex fee structures associated with many of these investments.