November 2014 – Mitch Atkins FINRA Consultant

Mitch Atkins, FINRA’s former South Region Director who is now Principal of FirstMark Regulatory Solutions, recently had the opportunity to participate on a panel at FINRA’s South Region Compliance Seminar. The panel, which also included a member-firm representative and two FINRA representatives covered the topic of suitability, and focused in particular on two products, non-traded REITs and L-Share Variable Annuities.

The FINRA panelists expressed concern regarding what they are seeing as improper or unsuitable sales of L-Share classes of variable annuities. Several issues of note mentioned by the FINRA panelists included the time horizon of the customer and the fee structure of the product. Before we get into that here, a primer on L-Shares may be worthwhile.

L-Shares, like any other share class, are designed with a specific purpose in mind. First, an L-Share typically has a surrender period of 3 to 5 years, compared to a typical B-Share variable annuity which has a surrender period of 7 years. Typically, deferred sales charge variable annuities have a declining surrender charge. In the instance of a B-Share, this surrender fee schedule might be: 7%, 7%, 6%, 5%, 4%, 3%, 2%, 0%. Meaning if the product is surrendered in year one, the fee is 7%, year two, the fee is 7%, year three, the fee is 6% and so on. But in an L-Share situation, the surrender fee schedule looks more like this: 8%, 7%, 6%, 5%, 0%. So clearly the L-Share recoups a higher percentage if surrendered earlier. In exchange for this early termination of the surrender period, the products have higher M&E fees (Mortality and Expense). For example, a typical B-Share may have an ongoing M&E expense of 1.25% which is charged to the contract holder each year. However in a typical L-Share product, this ongoing fee is 1.65%. As a result, the higher ongoing fees over time can be substantial.

The FINRA staff’s point in this scenario is that broker-dealers and their associated persons must have a reasonable basis to believe that a recommended transaction in a variable annuity is suitable for a customer based on the information obtained from that customer about their investment profile. If a customer has a long term time horizon, an L-Share may not be the most appropriate share class to recommend.

Here are several key points were made during the presentation about monitoring transactions in L-Share variable annuities. First, broker-dealers must conduct an effective due diligence process such that they understand the products being sold, as well as the features of those products and for which of their clients that product may be appropriate. Second, broker-dealers must have written procedures that are designed to address the specific features of the products they sell, including in this instance, L-Shares. Some broker-dealers do not have specific procedures addressing these products. Third, firm training programs must address the unique features of these products, and that also means training the principals reviewing the transactions, not just the representatives selling them. Fourth, firms are required to monitor the sales of the product and the riders selected. In some instances, long-term riders are inappropriately being recommended with the shorter-term L-Share. Finally, questions regarding the suitability of the product should be confirmed directly with the customer when appropriate.

Broker-dealers should ensure that their supervisory systems are adequate to match customer time horizons with recommendations in L-Shares. These share class issues are not new. However, just like the days of the A vs. B share mutual fund, FINRA is now seeing issues with variable annuity share classes. As with any other recommendation, documenting the rationale for the recommendation is a critical aspect of a good recordkeeping system.

If you have questions regarding this aspect of suitability or any other issue, contact Mitch Atkins, Principal of FirstMark Regulatory Solutions at 561-948-6511.

Non-Traded REITS

Non-Traded REITS have been the subject of quite a bit of controversy over the past few years, not the least of which has been the recent announcement by one large organization about accounting concerns. In recent years, FINRA has focused both its examination and rule making resources on the sellers of these products. Earlier this year, FINRA announced significant enforcement actions against two large sellers of non-traded REIT products. Additionally, FINRA has proposed changes to the requirements affecting how positions in non-traded REITS are valued on customer statements. Mitch Atkins, FINRA’s former South Region Director, has extensive experience with the compliance issues that are unique to these products. Here, he discusses some of the key issues he has observed both as a regulator and a consultant to broker-dealers.
Non-Traded REITS are not inherently bad products. Unfortunately, there are some sellers of the products that have recommended the products to clients who, under FINRA rules, were unsuitable purchasers. Further, there have been instances in which sellers have misrepresented the products in their advertising and sales literature, or in direct communications with clients. This may have prompted FINRA to conduct its spot-check of non-traded REIT advertising and to issue a Regulatory Notice addressing the issue of REIT advertising.
Whatever the issue, it seems that sales of these products is continuing to grow, with many broker-dealers seeing significant increases in revenues over the last few years. This has a lot to do with the current market environment, interest rates and customer desire for higher returns.
There are several practices which seem to make a difference in the success or failure of a non-traded REIT compliance program. The first is an effective due diligence approach. Prior to permitting the sale of a non-traded REIT product, broker-dealers should conduct thorough due diligence. And following approval, ongoing due diligence is a must. Material events that could change the initial due diligence decision should be addressed by the broker-dealer and appropriate actions taken. The second key to an effective non-traded REIT compliance program is a supervisory system covering the suitability of sales of the product to customers. Most firms (and states for that matter) limit the amount of a client’s liquid net worth that may be invested in non-traded REITs. This threshold varies, as does the suitability standard imposed by each state on a particular product. But generally, firms and states limit the percentage of a client’s liquid net worth that may be invested in a single non-traded REIT to 10 percent.

An effective suitability review process is critical to preventing inappropriate sales to clients. The third key to compliance when selling these products is a thorough and effective advertising and sales literature review process. A simple review of the recent FINRA disciplinary actions yields plenty of information on what not to do in this space. The most important of which seems to be adequacy of disclosure and taking care not to misrepresent the illiquidity of the product. Finally, an effective training program for these products is a must. Many broker-dealers require their salespersons to complete an online training module for each product sold as well as general modules about the features of non-traded REITs. These online modules are easy to administer and cost-effective. It is important to note that broker-dealers must also train the principals who are responsible for supervising the sales staff in the features of the products it sells.

Mitch Atkins, FINRA’s former Senior Vice President and Regional Director, has extensive experience in non-traded REIT compliance. To speak with Mitch Atkins, call FirstMark Regulatory Solutions at 561-948-6511.