Regulator's First Enforcement Action Relating to Mortgage-Backed Securities Is Just the Beginning

By James Eccleston

he recent enforcement action by FINRA (the Financial Industry Regulatory Authority) against two brokers from a now defunct small brokerage firm normally might have come and gone with little fanfare. But this action, which FINRA itself headlined, "First Enforcement Action Arising from FINRA's Ongoing Investigations Into Abuses in Marketing and Sales of Mortgage-Backed Securities" surely promises more to come. In addition to barring two brokers from the industry and suspending another at SAMCO Financial Services, Inc. — the opening act — FINRA clearly is unveiling the fruits of its labors associated with a targeted examination request sent to brokerage firms nationwide. Let's examine what the fuss is — and will be — about.

Veteran observers will recall that mortgage-backed securities made the news in 1996, when FINRA (then known as the NASD) fined Piper Jaffray $1.25 million for inadequate disclosures and improper sales practices associated with its mutual fund called the "Piper Jaffray Institutional Government Income Portfolio." The regulator found that the fund had become a lot less "government income" and a lot more "interest rate-sensitive mortgage-backed derivatives." These included "interest only" securities ("IOs"), inverse IOs, "principal only" securities ("POs"), "inverse floaters", and accrual or Z-bonds. The regulator determined that, with regard to these derivative investments, Piper Jaffray "failed to adequately disclose that the fund's increased holdings in volatile mortgage-backed derivatives and use of leverage significantly increased risk, as well as potential return." When interest rates rose in early 1994 and there were market disruptions, customers sustained "significant, unanticipated losses."

In 1997, Mary Shapiro, then-president of the NASD, spoke before The Bond Market Association, and told the audience, "[T]his is not your grandfather's bond market." She cautioned the audience that while "otherwise ordinary-looking bonds have been transformed by adding a little (or in some cases, a lot) of spice in the form of inverse bets on [interest] rate movements..., a little spice makes things interesting; a lot can lead to headaches and nausea."

It then was quiet for a while, as investors and regulators were distracted by the Bull Market in technology and Internet stocks. However, when those markets suffered, investors searched for alternative investments, and Wall Street delivered. The NASD responded by issuing several notices to brokerage firms. Included among them was a 2003 notice, Notice to Members 03-71, entitled, "Non-Conventional Investments - NASD Reminds Members of Obligations When Selling Non-Conventional Investments."

Notice to Members 03-71 set the stage for what regulators would expect, and continue to expect, brokerage firms to do as part of their product due diligence, suitability and disclosure obligations. In summary, NTM 03-71 requires firms to: (1) conduct adequate due diligence to understand the features of the product; (2) determine that the product is suitable for at least some customers; (3) perform a customer-specific suitability analysis in connection with any recommended transaction; (4) provide a balanced disclosure of risks and rewards; (5) implement appropriate internal controls; and (6) train brokers regarding the features, risks and suitability of the products.

Fast forward to December, 2007. FINRA issued a "targeted examination request" to brokerage firms nationwide, stating, "FINRA is conducting an inquiry regarding sales of principal only ("PO"), interest only ("IO") and inverse floater ("IF") tranches of collateralized mortgage obligations" -- one form of mortgage-backed securities. The comprehensive nature of this recent regulatory examination cannot be underestimated. FINRA requested 15 broad categories of documents and information. Among those requests, FINRA asked for Excel spreadsheets showing the details of all customer transactions in PO, IO and IF tranches of collateralized mortgage obligations. Additionally, FINRA requested copies of all marketing materials and sales literature provided to customers, as well as presentation materials, marketing materials and training materials provided to brokers. FINRA also requested copies of each type of customer communication that disclosed the risks of the products. FINRA likewise was interested in reviewing customer complaints and arbitration claims, as well as the brokerage firm responses to them.

No doubt, FINRA's press release relates to what SAMCO Financial Services revealed to regulators during that examination. Susan Merrill, FINRA Executive Vice President and Chief of Enforcement, states in the press release, "These are FINRA's first enforcement actions arising from our ongoing investigations into abuses in the marketing and sales of mortgage-backed securities such as CMOs to retail customers." In describing suitability, Ms. Merrill remarked that these securities are suitable only for "sophisticated investors with a high-risk profile" and "willing to take on high levels of risk."

In the weeks and months - and perhaps years -- ahead, we will see additional chapters in this continuing story of customer abuse associated with the marketing and sale of mortgage-backed securities.

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.