Securities Industry Publication Identifies Current Investor Protection Issues

by James J. Eccleston, Esq.

ecurities firms are required to train their advisers. To assist firms in doing so, the Securities Industry/Regulatory Council on Continuing Education (the "Council") publishes its annual Firm Element Advisory (the "FEA"). The FEA serves "to identify current regulatory and sales practice issues" for possible use in training advisers. The FEA also serves as a helpful listing of topics for attorneys in counseling their clients - whether they are securities firms, financial advisers or aggrieved customers. Let's examine the more important areas of the 2007 FEA.

This year's FEA focuses, first, upon "alternative investments". Among those discussed are structured products, new products, hedge funds, and exchange-traded funds. Regarding structured products, the FEA cautions that due to their complexity, "the risks may not be readily apparent." Similarly, the complex nature of new products is cause for concern. The regulators have issued several communications "that discuss the proactive approach firms should take to review and improve their procedures for developing and vetting these new products." Additionally, many hedge funds utilize "investment practices that may increase the risk of investment loss." Hence, firms must ensure that they comply with their sales practice obligations when selling hedge funds. Finally, the number of exchange-traded funds being offered has "significantly increased." The FEA warns that the number of retail investors exposed to these alternative investments has significantly increased as well.

Another important focus of this year's FEA is insurance and annuities. The Council has identified three notable areas: life settlements, market indexed/linked certificates of deposit, and sales of unregistered equity-indexed annuities. Life settlements are sales of existing life insurance policies to third parties. The National Association of Securities Dealers (NASD), a securities regulator, has reminded firms that life settlements involving variable insurance policies are securities transactions. One should expect to see more regulatory activity in this area as life settlements have "grown exponentially", and that trend appears likely to continue. Similarly, regulators have expressed concerns regarding market indexed/linked certificates of deposit. Specifically, "[o]f particular concern is the adequacy of disclosure materials used in connection with the sale of these instruments to customers and whether registered representatives and customers fully understand the product and how it differs from conventional CDs." By the same token, the NASD has reminded securities firms that they have responsibilities to supervise their employees with respect to sales of unregistered equity-indexed annuities.

The 2007 FEA specifically highlights supervision. Two areas are most important: individual retirement accounts, and supervising recommendations of newly hired financial advisers. Regarding the latter, the Council especially is concerned with new hires who replace existing mutual funds or variable annuities with new ones. The FEA warns, "Any recommendation by the firm or its [financial adviser] to sell a product and replace it with another may be made only after fully assessing the suitability of the transaction for the customer and determining that the transaction is in the best interests in view of all considerations."

The most striking caution in the 2007 FEA was prompted by an Information Memo that the New York Stock Exchange (NYSE) issued in November, 2006, entitled, "Reminder Concerning Supervisory Obligations With Respect to Rollover Individual Retirement Accounts." After noticing "an increase in customer complaints concerning investments in rollover IRAs", the NYSE, a securities regulator, issued a reminder to firms regarding their supervisory obligations and also suggested examples of sound practices for monitoring and reviewing such accounts. The Information Memo notes that the "customer protections of suitability, due diligence, and supervision are critically important for rollover investors" for several reasons, including the need to fund several decades of retirement, little or no investment experience, and limited financial resources. Such customers are "particularly vulnerable" because there likely is no sufficient opportunity for them to replace money that they have lost in their investments. As a result, the NYSE suggests, among other things, that firms consider imposing enhanced supervision and careful review of marketing materials, presentations and sales pitches. Additionally, the NYSE recommends that firms specially tag or code rollover IRA accounts in order to better prevent unsuitable investment activity. Finally, the NYSE suggests that firms impose more stringent surveillance screening to better detect red flags such as significant decreases in account value, on a dollar or percentage basis.

This year's FEA has a great deal of helpful information. Let's hope that securities firms and financial advisers put it to good use!

_______________________________________________________________________
James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.