As Financial Industry Regulatory Authority fines soared 15 percent in 2012, the watchdog that oversees securities firms paid particular attention to the suitability of investment products, and to the due diligence performed by firms on those products, according to the latest analysis from Sutherland Asbill & Brennan.
Sutherland’s annual report on FINRA disciplinary actions finds that the regulator brought an increased number of cases for the fourth year in a row—filing 1,541 actions in 2012, up 3.6 percent from the 1,488 cases in 2011.
But while the increase in enforcement actions was small, overall fines grew from $68 million in 2011 to $78.2 million in 2012, a nearly 15 percent jump.
Alleged suitability violations in 117 cases accounted for the largest portion of these fines, to the tune of $19.4 million. Due diligence cases followed with the second highest fines: 62 such cases generated $12.8 million in fines, up from 44 cases and $1.6 million in fines in 2011.
“Suitability has always been a focus of FINRA, and firms have to be careful about how they train their reps and whether the products they’re selling meet the needs of their clients,” says Sutherland partner Brian Rubin, who authored the report with colleagues Deborah Heilizer and Andrew McCormick, all of them based in the firm’s Washington, D.C., office.
Yet the number of suitability cases the regulator has pursued has doubled in the past two years. “More recently, FINRA has been focused on products that are arguably complex,” says Rubin. Those products include real estate investment trusts (REITs), unit investment trusts (UITs), and collateralized mortgage obligations (CMOs).
For example, in one suitability case last year a firm, “was fined $2.3 million for its allegedly unsuitable sales of a non-traded REIT to thousands of elderly investors,” according to Sutherland. “FINRA also ordered the firm to pay $12 million of restitution to investors.”
In commenting on the case, FINRA’s chief of enforcement Brad Bennett said, “Firms must conduct a thorough suitability analysis before selling products, and make accurate disclosure of risks and features at the point of sale, especially with alternative investments such as non-traded REITs.”
The 2012 figures marked the first time that due diligence cracked Sutherland’s list of top FINRA enforcement issues, with the dollar amount of fines in this area having increased 700 percent since 2008.
“It appears this issue caught FINRA’s attention in the wake of the financial crisis, which has resulted in an explosion in the number of due diligence cases during the past two years,” Sutherland reports. “As FINRA continues placing a growing emphasis on complex products, it seems likely that due diligence issues will remain a key priority for the regulator.”
Most of the increase in due diligence fines in 2012 stemmed from four cases involving leveraged and inverse exchange-traded funds (ETFs). The firms involved were ordered to pay $7.35 million in fines and $1.8 million in restitution.
“FINRA found that over a 17-month period these firms failed to conduct sufficient due diligence about the risks and features of these ETFs,” the report states. “Thus, FINRA alleged that the firms did not have a reasonable basis for recommending these securities and that the firms did not adequately supervise the sale of these ETFs.”
Rubin says that securities firms can curb their due diligence risk by reviewing their policies and procedures to make sure their sales force understands the products being sold to customers.
As for dealing with the reality of what Sutherland calls “supersized fines,” Rubin adds: “A big way for firms to mitigate the sanctions is to self-report and to correct problems when they become aware of the problems—and to hire a good lawyer.”
