Much has been written about the concept of suitability as it pertains to investments.
In essence, the “suitability rule” mandates that all licensed financial professionals have an obligation to make appropriate (suitable) investment recommendations to their clients, given their clients’ needs and objectives.
The rule has a long history and is codified as Rule 2111 in the FINRA manual.
Investors will sometimes get pitched an investment by their financial advisor that doesn’t clear through normal channels. These types of transactions are considered to be outside business activities, and are also referred to as “selling away.”
Licensed financial advisors are required to transmit all of their business through the broker dealer with whom they are licensed, unless they have written permission to do otherwise. For a variety of reasons, financial advisors may choose to get involved with a startup company, whose investments aren’t approved for sale, and whose securities aren’t traded on a public market.
In a typical situation the financial advisor will approach an existing (or prospective client) touting the investment. If the client is interested he or she will write a check directly to the new company, bypassing the broker dealer. The investor will then receive the shares from the financial advisor or from the company.
A promissory note is a contract whereby the borrower – usually a business- promises to repay the lender at a specific time in the future. Sometimes the contract calls for the payment of periodic interest; oftentimes the interest is paid upon maturity, along with principal.
Promissory notes with maturities longer than nine months are generally considered to be securities, and as a result they must be registered for sale, or exempt from registration. Usually this entails a filing with either the SEC or with a state securities regulator.
In addition strict rules govern who can sell the promissory notes; generally, they can be sold only by employees of the business, and only to people with whom an existing relationship exists. These restrictions are why these types of investments are rarely sold through traditional brokerage firms.
Made infamous by Charles ponzi in the 20th century, and again by Bernie Madoff in the 21st century ponzi schemes have taken numerous forms over the years. But they all employ the same fundamental scam; new investor money is used to pay “dividends” to older investors. Rather than investing into a profitable, money making business, investors are investing in the fund raising prowess of the promoter. This is the fundamental fraud underlying all ponzi schemes; the lack of disclosure, and the misrepresentation of where and how dividend payments are generated.
Not all programs start out as ponzi type schemes. Oftentimes, a bad quarter or year, or a series of setbacks leads the promoter to turn to new investor funds to make dividend payments, rather than coming clean or suspending dividend payments for a time.
Investors can avoid getting involved in ponzi type schemes by asking for and reviewing a company’s financial statements prior to investing. If the amount of income being generated by the business is insufficient to pay expenses and make the promised dividend payments, it is likely that the company is using investor funds to pay some or all of the dividends.
The term “penny stock” generally refers to stocks that trade below five dollars per share, or that were issued by small companies with limited revenue. The trading market for penny stocks is thin, and is usually dominated by one or two brokerage firms who have an interest in the companies’ stock.
Penny stocks are considered speculative, and the SEC requires that brokerage firms document a customer’s “suitability”, and obtain a signed written agreement prior to engaging in penny stock transactions. Broker dealers are also required to provide customers with a risk disclosure document concerning the risk of the penny stock market.
Penny stocks are frequent the targets of “pump and dump” schemes where a brokerage firm with a large position, or a favored client, aggressively tout the stock, which causes a dramatic rise in price, during which the brokerage firm or its preferred client, sell their shares into the market. When the selling is concluded, and the firm moves on to their next target stock, there is little to support the price of the penny stock, and it gradually (sometimes violently) drops in price.
Most investments purchased by customers can be easily sold with just a phone call. Stocks, bonds and mutual funds trade on transparent exchanges where brokerage firms are obligated to get the best price for their customers.
But some investments don’t trade on an exchange, leaving investors at the mercy of the companies’ redemption program, or third party auction houses.
Over the past ten years many advisors pitched non traded real estate investment trusts, or REITs, promissory note type investments, oil and gas private placements, equipment leasing deals and a variety of other non-traded, illiquid investments. These were often described as income generating investments, not subject to stock market risk.
FIRNA is an acronym for the financial industry regulatory authority.
FINRA is a not for profit organization, authorized by congress to oversee the regulation of investment professionals. FINRA writes and enforces rules of conduct governing brokerage firms and registered representatives. They oversee the licensing of investment professionals, and conduct audits and investigations to ensure that the firms and individuals remain in compliance with the securities laws.
FINRA also operates the largest arbitration forum in the country, where investment related disputes are heard and decided.
Every broker dealer has a duty to establish and enforce an effective supervisory system designed to prevent violations of the securities laws. FINRA Rule 3110 sets out the requirements for establishing and implementing a supervisory system.
The branch manager and the chief compliance officer have a multitude of duties and responsibilities to make sure that the firm’s registered representatives are observing “high standards of commercial honor” in dealing with customers. Among their duties are ensuring that a client’s opening account documents are properly completed; approving the daily transactions, periodically reviewing transactions for suitability and following up on “red flags” or indications of wrongdoing.
Failure to supervise is one of the most commonly brought claims in FINRA arbitrations. On the regulatory side FINRA referred more than 700 fraud cases for prosecution in 2014 and levied more than $166 million in fines. Most of these cases involved a breakdown in the supervision chain at the broker dealer level.
Before an investment can be offered to investors a licensed FINRA broker dealer has an affirmative obligation to investigate the product being sold. For large cap publicly traded stocks the investigation might simply be insuring the company is current in its SEC filings. For private placement investments, the due diligence requirement is more substantial.
On private placement investments like REITs, oil and gas programs and other “con conventional investments, broker dealers have an affirmative duty to challenge the assumptions in the offering documents provided by the sponsor of the investments. This might entail hiring an independent company to review the financials, visiting the company’s headquarters or place of business site to “eyeball” the operations, and a reviewing credit reports, the track record of the sponsor, and any other documents to help gain a better understanding of whether the company is on sound financial footing.
It is not sufficient for a broker dealer to simply rely on the representations and written materials provided by the sponsor, which clearly has a conflict of interest in providing the materials to a broker dealer. A broker dealer must conduct a thorough and independent investigation prior to offering a private placement to investors. FINRA Notices to Members NTM 03-71, NTM 05-18 and NTM 10-22 all discuss the duties of broker dealers to undertake a vigorous investigation into the investments they approve for sale.
Excessive trading, sometimes called churning occurs when a financial advisor, exercising control over an investor’s account engages in transactions which are excessive in size and scope to the needs and objectives of the client for the purpose of generating commissions.
Churning generally occurs in accounts where the financial advisor has discretionary authority, or authorization to make transactions without first consulting with the client. Excessive trading also occurs in accounts where a client does not follow the trading closely. This gives unethical financial advisors the opportunity to make unnecessary and inappropriate transactions.
A rule of thumb to measure churning is the generally accepted “Six Times Turnover” Rule. If an account’s equity has been turned over six times in the course of a year, with the financial advisor making all or most of the transactions, there is a presumption the account has been churned. Put plainly, if an account is worth, on average, $100,000 over the course of the year, and $600,000 in purchases were made on that $100,000 net equity (not counting margin) then the account turnover rate would be 6X: $600,000 /$100,000.
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