by Bianca Olivadoti
Last year, FINRA assessed $78.2 million in fines—a 15% increase from 2011, according to a recent study released by Sutherland Asbill & Brennan LLP.
With a total of 1,541 cases filed, 2012 was the fourth consecutive year of growth in FINRA disciplinary actions. Suitability and due diligence violations earned clear spots as number one and number two on the list of allegations.
Suitability violations alone accounted for $19.4 million in fines. In particular, FINRA has focused these suitability cases on complex products, such as real estate investment trusts (REITs), unit investment trusts (UITs), and collateralized mortgage obligations (CMOs).
The increase in these actions has emphasized the need for firms to conduct a thorough suitability analysis before selling products to their customers. Brokers must make sure to disclose all risks at the point of sale, especially with complex alternative investments.
Likewise, FINRA’s growing emphasis on complex products has caused an explosion in the number of due diligence cases during the past two years. In 2012, 62 due diligence actions generated $12.8 million in fines.
As long as interest rates stay low, firms will continue to put together alternative investment products with high potential yields. This may result in suitability and due diligence violations remaining at the top of the list.
by Eric Malloff
The Jumpstart Our Business Startups Act or “JOBS” was signed into law on April 5, 2012. Contained in the JOBS Act are several mandates that liberalize Securities and Exchange Commission (“SEC”) rules governing when and how a “small business” may raise capital through the issuance of securities.
Among the new mandates, the JOBS Act requires the SEC to loosen rules governing private placements, or Regulation D (“Reg. D”) offerings. One of the more notable liberalizations is the rescission of the prohibition against general solicitation for private placements relying on the safe harbor provided in ’33 Act § 4(a)(3), or Rule 506 offerings, contained in ’33 Act Rule 502(c). However, under JOBS a Rule 506 offering is still prohibited from general solicitation when any non-accredited investor purchases such offerings. Furthermore, the JOBS act requires the “issuer take reasonable steps to verify that the purchasers of the securities are accredited investors.”
While this change represents only a small part of the changes under JOBS it is nonetheless significant. Prior to JOBS, Rule 506 issuers had to rely upon their own network of interested parties. Conversely, JOBS allows these same issuers to advertise and seek public interest in their securities so long as they reasonably believe the purchaser to be an accredited investor. This begs the question whether we will soon start seeing various securities touted across the television smashed between an ad for our favorite cereal and those kid’s toys that seems extraordinary but always disappoint.
While freeing market cash flows and encouraging capital investment in new ventures is essential to continued economic growth, I am not convinced that a conditional rescission of Rule 502(c) is the best methodology for accomplishing that goal. I am generally concerned that these changes may result in private equities markets rife with fraud. The question remains, will this tactic create capital fluidity or stifle unaware investors with junk equity.
One possible safeguard is the inclusion of a provision prohibiting non-registered parties from profiting from the sale of securities or ancillary services associated with a Rule 506 issue. Nevertheless, this does not place any prohibition on registered broker-dealers.
The key to JOBS’s success will be the post review and comment regulation and enforcement by the SEC. As always, it is worthwhile to take a close look when considering any private placement offering: especially with the anticipated increased prevalence of Rule 506 issues in the marketplace.
By Amber Eanes
President Obama signed the JOBS Act bill in April 2012, but it has yet to take full effect as we wait for the SEC to develop regulations. The purpose of the JOBS Act is to enable small businesses and startups to raise capital and gather investors through crowd-funding: selling small amounts of equity to many investors in order to fund a company.
The idea behind the legislation is to increase the American emerging markets sector. This sector in the United States officially includes “emerging growth companies,” which is defined by the SEC as a company with less than $1 billion in total gross revenue on a yearly basis. If you consider participating in crowd-funding, it is important to remember that extra risk is associated with these emerging growth companies. While you may be investing smaller amounts of capital in these startups it is highly likely that if you lose, you will lose everything. For instance, 85% of small businesses will fail within the first year, showing the higher risk of a total loss when putting equity into these small startups.
The JOBS Act is pioneering legislation because it is the first time individual investors in the United States will actually be able to purchase equity in startup companies that have not gone through the expense of SEC registration. The novelty of the act increases the need for the SEC to regulate in a way that balances investor protection with the interests of small business owners seeking to raise capital, as we do not know how either will be affected. Without appropriate regulation, the legislation could end badly with possible scams and exploitation of unsophisticated investors. The SEC is supposed to have its regulations for implementation in place by December 2013, but until this time investors should invest cautiously, taking into consideration the risk of total investment loss.
The Investor Rights Clinic (“IRC”) today submitted a comment letter to the Financial Industry Regulatory Authority (“FINRA”) supporting a proposed rule to require FINRA member firms that have recruited a broker from another firm to disclose the financial incentives that broker received before a retail customer from the broker’s previous firm makes a final determination to transfer an account to the new firm. The IRC’s comment letter, drafted by IRC student intern James Schlosser, is available here.
by Jacqueline Smith
Many securities firms offer brokers enhanced compensation packages to transfer from one firm to another. Enhanced compensation packages, which currently are not disclosed to customers, provide an additional amount of compensation, over and above commissions, that often include some combination of upfront bonuses, forgivable loans, transaction assistance, and back-end bonuses. These financial incentives and increased commission targets create the concern that brokers may be motivated to engage in conduct that would violate their obligations to investors.
To address these conflicts of interest relating to compensation practices, FINRA is considering a new rule focused on protecting customers. The proposed rule would require a firm that provides a recruited broker enhanced compensation related to transferring firms to provide the details of the enhanced compensation for one year to any former customer of the broker who either (1) is contacted by the broker regarding the transfer of the broker’s employment to the firm, or (2) seeks to transfer an account from the previous firm to an account assigned to the broker. The proposed rule would also require that the details of the enhanced compensation be made at the time of first individualized contact by the firm or broker after the broker has terminated association with the previous firm. If the disclosure is made orally, or if a customer seeks to transfer an account when no individualized contact occurred, written disclosure would be required with the account transfer approval documentation. A general disclosure would not be sufficient; rather, the rule proposes that the written disclosure be clear, prominent, and include information regarding the timing, amount, and nature of the enhanced compensation. As a result, this disclosure would provide customers with transparency regarding the true motivation behind a broker’s decision to transfer firms, and would allow customers to ascertain whether to transfer their business to the new firm. The proposed rule would not apply to institutional accounts, and firms would not be required to disclose enhanced compensation that is less than $50,000.
FINRA is requesting comments on the proposed rule until March 5, 2013.
FINRA Regulatory Notice 13-02