Business Conduct and Sales practice Examination Priorities from FINRA

As we all know the business and regulatory environments are constantly changing, FINRA changes its regulatory priorities each year accordingly to assess new risks and integrates them into the scope of its programs.

Currently retail investors are facing the challenge of finding satisfactory return over their risk tolerances. Fundamentally the challenge is caused by few reasons: first is the slow growth, low-interest-rate environment which leaves retail investors particularly vulnerable. Second is due to central bank and investors’ efforts to lower balance sheet risk and shift assets to safer investments that contributed to an unprecedented compression of credit risk premiums and yields in the U.S. Lastly, investor appetite for yield caused the rise of market prices on investment –grade and high yield debt, putting pressure on upside growth and generating downside risks. To prevent sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices, FINRA will focus its examination on the suitability of recommendations, the brokers level of product-specific knowledge, the level of due diligence in assessing the risk tolerance and liquidity needs of the customer, the disclosure of material risk and the impact of other competing investment on broker compensation.

FINRA’s recently revised suitability rule focuses on proper disclosure of risk-return and high-yield complex to customer. More specifically are market risk exposures associated with interest-rate-sensitive investment, credit risk exposures and liquidity risk exposures.

Business Development Companies (BDCs) offer attractive yields through high credit risk exposures. Investors of BDCs are not only exposed to significant market, credit and liquidity risks, but also the risk from non-traded BDC funds. Investors who are in the funds, their exit opportunities are limited only to periodic share repurchases by the BDC at high discount.

Leverage loan products, or adjustable-rate loans, are issued by financial institutions to companies with low credit quality and high debt-to-equity ratio. Due to the fact that floating-rate loans do not trade on an organized exchange, they are relatively illiquid and difficult to value. Although these products are less vulnerable to interest rate fluctuations and offer inflation protection, the underlying loans in the fund are still subject to significant credit, valuation and liquidity risks that are hard to detect by investors.  Commercial mortgage-backed securities are also concerned by FINRA as the firms are not fully disclosing its considerable risk in today’s low-interest-rate, low-yield environment. High-yield debt instruments, given the inverse relationship between price and yield, increased prices and put downward pressure on yields. Its risk premiums have compressed across the sector, resulting significant market risk exposure. While more diversely ranged companies engaged in high-yield underwritings, some of these companies have very high-level cash flow demands that raise significant credit risks.

Structured products are often complex and have cash-flow characteristics and risk-adjusted rates of
return that are uncertain or hard to estimate.

Some investors may not fully understand the risk associated with exchange-traded funds and notes, which sometimes lack of established track records for volatility performance, emerging markets and foreign currencies.

The non-traded REITs might confuse investors with its sales costs deducted from the offering price and the repayment of principle amounts as dividend payments in its early stage.

Closed-end funds attract investors with its high distribution rates. Some investors may not understand
that some funds are returning capital to maintain high distribution rates, causing the funds to trade at high premiums compared to their Net-Asset-Value.

In all, the changes in the business and regulatory environments are continuous. Assessing risk and integrating them into the scope of its programs is a FINRA constant.