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Regulatory and risk issues for 2014

January 8, 2014

In late December 2013 and early January 2014, both FINRA and the SEC announced regulatory priorities and programs aimed toward more robust regulation of broker-dealers. Moreover, in 2014, broker-dealers may face risk management concerns regarding products that, in the past, were considered by many as relatively safe and conservative. The following provides a brief overview of these developments.

FINRA Establishes Its 2014 Regulatory and Examination Priorities

On January 2, 2014, FINRA issued its regulatory and examination priorities  for 2014. The purpose of that letter is to provide guidance to member firms on FINRA's specific regulatory concerns which will be priorities in its examinations of firms and for its enforcement agenda for 2014. While FINRA identifies certain specialized areas of risk, such as private placements and crowd funding, some of FINRA's concerns apply broadly to most broker-dealers. For example, FINRA highlighted potential suitability issues regarding securities that are sensitive to interest rate changes. FINRA does not limit this risk simply to recommendations to retail investors for complex products (see Regulatory Notice 13-31), but FINRA's suitability apprehension includes the "potential downside risks to interest rate sensitive fixed income products, and a possible adverse impact to equities markets, that could arise from an unanticipated, rapid or uncontrolled shift in the interest rate environment precipitated by changes in monetary policy."

Consequently, in 2014, FINRA examiners will be focusing on "concentrations in longer duration instruments, including bond funds with longer average durations, and high yield securities recommended to retail investors, especially if those investors have near-term liquidity needs or have a conservative or defensive investment profile." In addition to long duration bond funds, FINRA also identified as investments of concern to include mortgage-backed securities, long duration bond ETFs, long duration corporate bonds (particularly zero coupon or bullet bonds), emerging market debt, and municipal securities. Accordingly, broker-dealers should expect heightened scrutiny by FINRA of recommendations for various long-term income products to retail customers whose investment objectives were income and risk tolerance was conservative, despite disclosure to the customer of interest rate risks and the customer's desire for higher yields. 1  

Additionally, FINRA's priorities included expending its High Risk Broker program by creating a "dedicated" enforcement team to prosecute "recidivist brokers." The team will focus on brokers who have been identified as high-risk and thus subject to expedited regulatory actions. Moreover, FINRA indicated that its examiners will focus on firms that hire "these high risk brokers" and "will review the firm's due diligence conducted in the hiring process, review for the adequacy of supervision of higher risk brokers – including whether the brokers have been placed under heightened supervision – based on the patterns of past conduct." Of particular emphasis for the examiners’ review of a firm’s sales practices will be the client accounts of such brokers. 

Two other priorities FINRA identified concerned senior or older investors. First, during 2013, FINRA warned member firms not to make claims of "free IRA's" or "no-fee IRAs" with respect to a retiring employee’s decision on whether to roll over assets from a 401(k) plan to an IRA. (See Regulatory Notice 13-23 and also Regulatory Notice 13-45) In 2014, an examination priority will be to review firms' roll over practices, including firms' marketing materials and supervision. FINRA examiners also will evaluate securities recommendations made in rollover scenarios to determine if they comply with suitability standards. The second priority concerning older investors focuses upon suitability. According to FINRA, in "2014, FINRA examiners will continue to focus on how firms engage with senior investors, especially with respect to suitability determinations as well as disclosures and communications." FINRA examiners also will review firms' policies and procedures to identify and address situations where issues of diminished capacity may be present. 

SEC Creates a New Enforcement Task Force Focused on Broker-Dealers  

On December 23, 2013, the SEC announced that its Enforcement Division created a new task force to scrutinize broker-dealer practices. The task force is developing "national initiatives for potential investigations." The task force "will coordinate these broker-dealer related initiatives across the [Commission], and centralize information and expertise regarding ongoing investigations and examinations, industry practices and trends, to generate quality referrals and investigations." The task force will liaise with the SEC national examination program and FINRA "as appropriate" as well as the Commission's regional offices. The broker-dealer task force appears modeled after the Enforcement Division’s Asset Management Unit, formed in 2010 to focus on investment advisors, investment companies, and private funds. The Commission expects that, similar to the significant increase in cases against investment advisors and companies due to the efforts of the Asset Management Unit, the new broker-dealer task force will lead to a significant increase in enforcement actions against broker-dealers. 

Credit Risk Uncertainties of Municipal Bonds  

While some sort of credit risk has always existed with municipal bonds, 2014 may produce, for many, an unexpected realization concerning the degree of that risk. As our firm previously communicated, prior to filing for bankruptcy, the City of Detroit's Emergency Manager proposed that most bondholders not be afforded preferential treatment and offered them the same pennies on the dollar other unsecured creditors were being offered. The Emergency Manager has taken the same position in the bankruptcy proceedings. The City of Detroit's position is contrary to the understanding of many as to the appropriate treatment of municipal bonds. Municipal bonds typically were considered relatively safe investments because they are backed by the “faith and credit” of the municipality. The prevailing assumption has been that when a city is in fiscal distress, holders of municipal bonds will receive most of their money back. In the case of the City of Detroit, those long-standing assumptions are no longer reliable. 

Among the issues for bondholders in Chapter 9 bankruptcy will be whether their municipal bonds are considered “special revenue” bonds or “general revenue” bonds. Special revenue bonds receive payments from the revenue generated by the project that is the subject of the bonds, such as the Detroit sewer system or the Cobo Hall renovations. To the extent that the revenues generated by the project do not meet the commitment of the special revenue bond offering, the difference is to be made up by general revenue funds. Under 11 USC § 902, general revenue bondholders may be treated as unsecured claims capable of being discharged, while special revenue bonds cannot be discharged and the bondholder is entitled to payments based upon the revenue of the subject project (although the City will no longer be required to make up the difference with general revenue funds). 

Given these circumstances, brokerage firms may have customers raising questions concerning the prospects of the potential treatment of their City of Detroit bond or the appropriateness of this investment in their portfolio. Moreover, should the City of Detroit succeed in its position that general obligation bonds should not be treated deferentially, many other municipalities which are facing financial difficulties may take a similar position. Consequently, broker-dealers could be facing the risk of customer complaints and litigation concerning the disclosures and suitability of municipal bond positions. 

We have substantial experience concerning municipal debt obligations and bond offerings and are highly capable of advising brokerage firms regarding the risks these situations present and in defending against any customer claims. For more information regarding these or any other broker-dealer related issues, please contact any of the attorneys in Honigman's Broker-Dealers and Investment Advisors Industry Group.   

1 FINRA's focus on the suitability of long-term fixed income and other interest-rate sensitive instruments reflects the recent concern of risk conscious broker-dealers. Years of low interest rates, risk aversion due to the volatility of the markets, and the desire to earn significant yield, has set the stage for many disappointed investors when interest rates increase. Our firm has been preparing for this possibility and has developed approaches for minimizing this risk with respect to litigation and other strategies.