Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY 10003 www.law360.com Phone: +1 646 783 7100 Fax: +1 646 783 7161 customerservice@law360.com Alternative Investments: What Regulators Are After Law360, New York (June 19, 2013, 2:18 PM ET) -- Regulators continue to pursue investigations and enforcement actions involving alternative investments. At thefinancial Industry Regulatory Authority's annual conference in May 2013, FINRA representatives described the new FINRA Corporate Finance Department program to review filings of offering materials pursuant to FINRA Rule 5123 and make referrals to FINRA's Member Regulation and Enforcement regarding perceived due diligence failures for private placement offerings. FINRA also plans to issue a report in early summer on conflict management practices, which will include a particular focus on the controls firms have built around the sale of structured products both to their own private wealth divisions and to other firms. [1] In its 2013 Regulatory and Examination Priorities Letter, FINRA asserted its continued focus on alternative investments, including structured products, exchange-traded funds (ETFs) and others. At the U.S. Securities and Exchange Commission's The SEC Speaks 2013" conference held on Feb. 22 and 23, and in the agency's Examination Priorities for 2013 outline, SEC staff reiterated their continued focus on investigating and enforcing broker-dealers recommendation and sale of alternative investments.[2] The SEC has extended its areas of concern regarding alternative investments beyond Regulation D offerings and nontraded real estate investment trusts (REITs) to include alternative investment strategies in open-end funds, ETFs and variable annuities. Yet, alternative investments remain attractive to retail investors who seek to diversify their portfolio and obtain higher returns. Accordingly, firms and representatives recommending alternative investments should mind the focus from regulators. This article discusses the consistent and growing trend of regulators attention to alternative investments, gives an overview of recent enforcement actions, and discusses certain regulatory rules and guidance applicable to alternative investments. What Constitutes an Alternative Investment? As an initial matter, firms must define what is considered an alternative investment as regulators expect them to draft written supervisory procedures that specifically address alternatives and define what is included. Because regulators apply different standards and have different expectations with respect to investments considered complex or alternative, it is necessary to understand what falls under the term alternative investment.
Although FINRA acknowledges that there is no legal definition of alternative investment, FINRA CEO Richard Ketchum has said that a product might be considered complex if the average retail investor probably will not understand how its features will interact under different market conditions, and how that interaction may affect potential risk and return. [3] Whether a product is alternative is a fact-specific analysis that is determined by considering the unique aspects of the product at issue: Is it complicated? Consider if an average investor would understand how the product functions. Is it non-traditional? Taken to an extreme, anything other than cash, mutual funds, stocks or bonds could be viewed as alternative investments. Is it exchange-traded? If not, it is more likely considered an alternative. But, if it is traded on an exchange, this does not necessarily mean that it is not an alternative. Is there limited performance data, high cost of investment and limited regulation? If so, the product is more likely to be considered an alternative investment. Investors are attracted to alternative investments for a variety of reasons, but first and foremost, for the higher returns. Alternative investments can also provide diversification in strategy and investment sectors, tax benefits, reduced portfolio volatility through hedging strategies, lower correlation to traditional investments, and access to talented managers. On the other hand, alternative investments may incorporate complex strategies that are hard to understand. Regulators have raised issues where registered representatives cannot explain how a product works in a way a customer can appreciate. Alternative investments may also have limited performance information, low liquidity and sometimes, unproven strategies with unknown risks. From a firm or registered representative standpoint, the unknown is a primary concern when dealing with alternative investments that have not been tested in the marketplace for a sufficient period of time. It can take time to fully appreciate certain unique characteristics that may be associated with a product. We have been engaged to represent firms in a variety of regulatory investigations and enforcement actions involving alternative investments, including secured notes, inverse/leveraged ETFs, nontraded REITs, and oil and gas leases, among others, where regulators have alleged that the firms and their representatives did not fully understand the risks associated with the investments and inaccurately communicated the associated risks to their customers. What Rules and Regulations Apply to Alternative Investments? Firms and registered individuals involved in the recommendation of alternative investments should be aware of the relevant rules, regulations and oversight requirements. The following regulatory notices explain some, but not all, of the regulatory requirements and nonmandatory guidance covering alternative investments. FINRA Regulatory Notice 13-18 Communications with the Public, Unlisted Real Estate Investment Programs (May 2013).[4] Notice 13-18 provides guidance on communications with the public concerning unlisted real estate investment programs, including unlisted REITs and unlisted direct participation programs. In connection with FINRA Rule 2210, which requires that
a broker-dealer s communications be fair, balanced and not misleading, the notice provides guidance concerning communications involving distribution rates, stability/volatility claims, redemption features and liquidity events, performance of prior related real estate programs, use of indices and comparisons, pictures of specific properties, and capitalization rates. Because unlisted real estate investment programs may be structured and function differently than more typical investments, firms should discuss a product's features and risks in a factual and balanced manner. FINRA Regulatory Notice 12-03 Heightened Supervision of Complex Products (January 2012).[5] Among other things, Notice 12-03 explains that because a product is complex, what constitutes a reasonable basis suitability obligation is increased. The firm, according to the notice, should seek to ensure that the registered representative and customer understand the potential risks associated with the recommended security or strategy. Firms should also reassess the suitability of complex products over time and provide appropriate training to its sales team on the characteristics of the product; this is typically done through training in the class of securities at issue, as FINRA representatives have acknowledged at a number of industry conferences. FINRA Regulatory Notice 10-22 Regulation D Offerings, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings (April 2010).[6] Although limited to Regulation D offerings, the notice discusses best practices regarding due diligence or a reasonable investigation of an offering and is also applicable to complex products. At the recent FINRA annual conference, FINRA s head of corporate finance conceded that FINRA had not been able to find any prior written standard for how a broker-dealer might perform reasonable basis suitability analysis, and that FINRA had gathered a two-foot stack of cases and distilled them into Notice 10-22. He added that this notice really amounted to a facts and circumstances guidance for broker-dealers. FINRA Notice to Members 05-59 Structured Products, NASD provides Guidance Concerning the Sale of Structured Products (September 2005).[7] NASD expressed concerns about the manner in which structured products were marketed to retail investors and the types of investors purchasing structured products, which offer interest or coupon rates substantially above the prevailing market rate and may be thinly traded. The notice covers obligations to provide balanced disclosure in promotional efforts, ascertain accounts eligible to purchase structured products, deal fairly with customers with regard to derivative products, perform a reasonable-basis suitability determination, perform a customer-specific suitability determination, supervise and maintain a supervisory control system, and train associated people. FINRA Notice to Members 05-26 New Products, NASD Recommends Best Practices for Reviewing New Products (April 2005).[8] A precursor to Notice 12-03, this notice explains that a firm s written supervisory procedures (WSPs) should include clear guidelines for determining what constitutes a new product that would trigger a firm s vetting process. FINRA also has a number of product-specific releases that discuss product-specific concerns and requirements: Regulatory Notice 09-31, Nontraditional ETFs (June 2009); Regulatory Notice 09-09, Unlisted REITs and DPPs (February 2009); Regulatory Notice 08-35, DPPs and REITs (July 2008); and NTM 03-07, Hedge Funds (February 2003).
FINRA Corporate Finance Department Review of Rule 5123 Filings. As discussed by the head of FINRA s corporate financing department at the annual FINRA conference, FINRA has received approximately 1,100 filings of private placement memoranda (PPMs) by broker-dealers since December 2012, when such filings commenced under the new FINRA Rule 5123. FINRA has assigned a team of 32 staff members to review these filings for potential issues regarding the firms product due diligence in having approved these products for sale to retail customers. For each filing, FINRA calculates a triage score, which is a function of information concerning the issuers, the broker-dealers and the offering. FINRA then closely reviews the PPMs that are identified through this triage process, looking for issues such as internally inconsistent representations, regulatory or criminal background issues concerning the principals of the issuer, unreasonable or unsupported forecasts of potential returns, inadequate escrow procedures, misleading descriptions of an issuer s prior performance, or apparent attempts by the broker-dealer to disclaim any consideration or review of the issuers financial statements. FINRA Corporate Finance then frequently consults with Member Regulation and Enforcement to determine whether to initiate an investigation, and which FINRA department should issue a request for information to a given broker-dealer pursuant to FINRA Rule 8210. FINRA is currently issuing such 8210 requests frequently and has already made eight referrals to its enforcement department for further investigation. Recent Enforcement Matters Regulatory enforcement efforts relating to alternative investments generally follow a formula: due diligence (the vetting process), training, suitability (both reasonable-basis and customer-specific suitability) and supervision (what systems the firm had in place to oversee the sale of alternative investments). The SEC and FINRA s recent investigations and enforcement actions, as well as recent actions by the Massachusetts Securities Division, are illustrative of the continued regulatory interest in alternative investments: Massachusetts Securities Division Fines Firm for Sales of REITs (2013). Massachusetts brought a settled action against a firm for alleged violations of the prospectus limits for net worth and income levels of investors in various nontraded REITs. This settlement included more than $2 million in restitution and a $500,000 fine. Massachusetts subsequently brought an additional series of similar settled actions against numerous other broker-dealers. FINRA Sanctions Four Firms $9.1 Million for Sales of Leveraged and Inverse Exchange-Traded Funds (2012). FINRA first released NTM 09-31 in June 2009, identifying its concerns about the sale of inverse and leveraged ETFs. Shortly after, FINRA commenced a sweep examination that ultimately resulted in sanctions against more than five firms for failing to detect problems associated with ETFs before FINRA did. Notably, FINRA ultimately determined the sanctions by requiring firms to submit detailed customer and transaction data and applying a complex formula to identify those customers and transactions to be included in its penalty analysis. SEC Charges Firm for Selling Complex Investments Without Disclosing Risks (2012). The SEC charged a firm and a former vice president for selling investments tied to mortgage-backed
securities without sufficiently understanding the complexity of the products or disclosing the associated risks to investors. According to the SEC, the firm was at least negligent when recommending the products without understanding the relevant risks. FINRA Orders Firm to Reimburse Customers $1.9 Million for Unsuitable Sales of Unit Investment Trusts (UITs) and Floating-Rate Loan Funds (2012). FINRA instituted this action alleging that the firm allowed its brokers to sell these risky products without providing registered representatives with the training, guidance and supervision necessary to make sure the products were suitable for their customers. Here, FINRA did not argue that the products were not suitable for anyone, just not for conservative investors. FINRA expressed concerns about whether the firm s sales force sufficiently understood the products to explain the unique features to customers. FINRA Hearing Panel Fines Securities Firm $1 Million for Fraudulent Sales of Collateralized Mortgage Obligations (CMOs) to Elderly (2012). The hearing panel fined a firm, ordered it to pay restitution in full to customers and barred its registered representatives for making unsuitable recommendations of CMOs to unsophisticated and elderly investors. The hearing panel found that all of the firm s customers in this matter were unsophisticated investors who had always relied on brokers to assist them with their investment needs. Customers were allegedly looking for safer alternatives to equity investments. The panel determined that in reality, the CMOs were high-risk investments whose returns were not assured, but because of interest rate changes, were subject to dramatic changes in maturity, cash flow and value. The hearing panel noted that even assuming all of the customers wanted aggressive income, a customer s stated investment objective is only one fact a broker must consider when assessing suitability. FINRA Sanctions Firm $14 Million for Unfair Practices in Sale of REIT and for Charging Excessive Markups on Municipal Bonds and CMOs (2012). According to FINRA, the firm sold in a one-year period in 2011 more than $442 million of a $2 billion nontraded REIT without performing adequate due diligence and in violation of its suitability obligations. FINRA claimed that the marketing materials were misleading in that they presented performance results for the closed REITs without disclosing that the income was not sufficient to support the distribution to unit owners. In a letter to customers, the president of the firm characterized the investments as a fabulous cash cow or a gold mine. Conclusion In light of the unique risks and a regulatory system focused on investigating and commencing enforcement actions related to alternative investments, firms and registered individuals should consider and plan for the additional regulatory hurdles associated with selling these products. Firms and associated individuals should examine the approval process behind alternative investments, including committee review and due diligence procedures; implement post-approval review; develop appropriate training; and consider implementing specific suitability requirements to address features or concerns associated with alternative investments. By Bruce Bettigole, Cheryl L. Haas and Michael K. Freedman, Sutherland Asbill & Brennan LLP Bruce Bettigole is a partner in Sutherland's Washington, D.C., office. Cheryl Haas is a partner in the firm's
Atlanta office. Michael Freedman is an associate in the firm's Atlanta office. The opinions expressed are those of the authors and do not necessarily reflect the views of the United States or Portfolio Media Inc. or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] Richard G. Ketchum, Chairman and CEO, FINRA, FINRA Annual Conference (May 21, 2013), available at http://www.finra.org/newsroom/speeches/ketchum/p264525, at 3. [2] See Legal Alert Summary of Selected Sessions From The SEC Speaks in 2013, Sutherland Asbill & Brennan LLP (March 12, 2013), available at http://www.sutherland.com/files/upload/legalalert- LITSummaryofSelectedSessionsFromTheSECSpeaksin2013(March2013).pdf, at 6, 9, 13-15; SEC Examination Priorities for 2013, Office of Compliance Inspections and Examinations (Feb. 21, 2013), available at http://www.sec.gov/news/press/2013/2013-26.htm, at 5. [3] Richard G. Ketchum, Chairman and CEO, FINRA, SIFMA Complex Products Forum (Sept. 27, 2012), available at http://www.finra.org/newsroom/speeches/ketchum/p180112, at 1. [4] http://www.finra.org/industry/regulation/notices/2013/p253837 [5] http://www.finra.org/industry/regulation/notices/2012/p125398 [6] http://www.finra.org/industry/regulation/notices/2010/p121299 [7] http://www.finra.org/industry/regulation/notices/2005/p014998 [8] http://www.finra.org/industry/regulation/notices/2005/p013756 All Content 2003-2013, Portfolio Media, Inc.