By Julia Schroeder

If you are a millennial and anything like me, you didn’t have a financial literacy class at your high school. If you majored in a humanities subject in college, you likely didn’t take a finance class either. Finance is a particularly sensitive topic for many individuals to openly discuss, but the failure to talk about it has led to people incurring too much debt, or worse, losing their hard-earned savings to fraudsters, or through themselves engaging in a complicated trading strategy that they don’t understand.

The truth is, we are not provided with adequate financial education growing up, and it doesn’t get much better as we grow older. Interning with UM’s Investor Rights Clinic has shown me how many of our elderly clients could have avoided their losses if they only knew more about the types of investments they were agreeing to and how to monitor them when they signed on the dotted line. Instead, many overly relied on brokers or other financial professionals, often without learning anything about their backgrounds. Most of the public has no idea that they can check the backgrounds of their financial professionals by entering their name in “BrokerCheck” on the FINRA.org website.

As a result of schools failing to meet the need for financial literacy courses with enough speed, younger generations are feeling the consequences.  In 2018, just 17 states required high school students to take a course on personal finance. While the number of states that include education about personal finance has risen to 45, only 21 states require such a course in order to graduate from high school. In the meantime, the lack of financial literacy can lead to serious consequences. The fact that so many young people have overextended themselves with student loan debt is, at least in part, attributable to a lack of financial literacy. Moreover, there are now faster ways in which individuals can quickly get into deep financial trouble, and it involves the smartphone likely lying next to you right now.

Social media has promoted the ease by which people with all levels of investment experience can invest in the stock market. In its 2021 Examination Report, FINRA addressed the “surge” of retail investors trading through apps and announced steps to crack down on digital platforms to ensure that they are in compliance with FINRA communication and supervisory rules, and acting in a customer’s “best interest.” This came after findings that in the first half of 2020 alone, individual investors accounted for 19.5% of shares traded in the U.S. stock market, which was an increase from 14.9% in 2019 and almost double what it was in 2010.   Trading Apps such as Robinhood have enticed younger people to engage in high risk, often complex trading activity by advertising self-directed trading accounts that offer zero commissions per trade. Yet, critics have expressed concern that the app engages in “gamification” by releasing green confetti after users make a trade. After accusations that confetti distracts its users, and makes a game out of the trading of real money, Robinhood announced the discontinuation of this feature earlier this year.

The nightmare story of college student Alex Kearns’ suicide following a Robinhood app misunderstanding highlights the dangers of self-directed trading with less sophisticated investment experience. While there may have been other unfortunate factors at play, 20-year-old Kearns took his own life after believing he had racked up a negative $730,165 cash balance in his accounts. In a note he left to his family, he thought that his investment plan was well thought out, but in actuality, he had ““no clue” what he was doing.”

Securities clinics across the country, including UM’s, are seeing a major spike in calls for assistance, and more of them are involving self-directed accounts. This is a glaring sign that we must take the time to educate ourselves. Rather than wait for the state and federal governments to introduce more financial literacy programs, there are resources we can take advantage of right now. In addition to sites like MyMoney.Gov and Investor.com providing educational resources for individuals interested in investing, FINRA regularly hosts informational webinars. This upcoming April 13^th, FINRA, in collaboration with St. John’s University, will be hosting “Smart Investing in Today’s Environment” to discuss investor education issues and intelligent ways to approach these self-directed trading platforms that can get investors into trouble. Sign up by visiting www.finra.org/lawschoolforum.

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.

FINRA yesterday released Regulatory Notice 12-55 to provide guidance to broker-dealers on the implementation of FINRA Rule 2111 (Suitability).  Rule 2111 became effective on July 9, 2012.  In Regulatory Notice 12-25, released in May 2012, FINRA addressed the scope of the terms “customer” and “investment strategy” as used in Rule 2111.  Regulatory Notice 12-55 supersedes the guidance of Regulatory Notice 12-25 on the scope of those terms.

Among the most salient points raised by Regulatory Notice 12-55:

• Regulatory Notice 12-55 suggests that a broker-dealer may not be liable for violations of the suitability rule by one of its brokers who is “selling away.”
• FINRA affirmatively states that a broker-dealer or broker generally does not have an ongoing duty to monitor after making a recommendation to hold securities, to maintain an investment strategy, or to implement a new investment strategy in place of another.

Rule 2111(a) provides:

A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.  (Emphasis added.)

In Regulatory Notice 12-55, FINRA defines a “customer” for purposes of Rule 2111 as “a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation … .”  Notably, under this definition, the term “customer” would not appear to include a person who purchases a security recommended by a broker when the broker’s employer does not receive compensation in connection with the transaction.  In other words, broker-dealers may not be liable for unsuitable recommendations made by its broker when the broker is “selling away” (i.e., when the broker recommends an investment that is not offered through the broker-dealer), even when the individual broker receives compensation.

Another significant piece of guidance provided in Regulatory Notice 12-55 deals with whether a broker has an ongoing duty to monitor after making a recommendation to hold a security or to maintain an investment strategy.  In this regard, Regulatory Notice 12-55 provides:

It is important to emphasize, moreover, that the [suitability] rule’s focus is on whether the recommendation was suitable when it was made. (Emphasis added.)

Thus, a recommendation to hold a security, to maintain an investment strategy, or to implement an investment strategy – as with a recommendation to buy or sell securities – “normally would not create an ongoing duty to monitor and make subsequent recommendations.”  The modifier “normally” arguably leaves room for application of the ongoing duty to monitor in certain circumstances, such as in fee-based accounts (i.e., where the broker receives a quarterly or annual fee for managing an account, instead of receiving commissions for each transaction) or where the broker affirmatively undertakes the duty to monitor a customer’s account.  However, FINRA’s guidance unequivocally establishes that, under normal circumstances, a broker has no obligation to monitor the suitability of a security or an investment strategy after the purchase is made or the investment strategy is implemented, regardless of changes in the market or economic environment.

With respect to the term “investment strategy,” FINRA states that a recommendation to invest generally in “equity” or “fixed income” would not constitute an investment strategy, while a recommendation to invest in specific types of securities or a market sector would constitute an investment strategy, thus triggering the suitability obligation.  Recommendations to customers to use a bond ladder, day trading, or margin trading also constitute the recommendation of an investment strategy.

When an investment strategy involves both a security and non-security investment (e.g., using a home equity loan to purchase securities), suitability obligations apply to a broker-dealer’s or broker’s recommendation.  The trickier question is whether suitability obligations apply when the customer, independent of any broker or broker-dealer recommendation, decides either side of the security and non-security “investment strategy.”  FINRA states that the suitability obligations do not not apply where, for example, a broker recommends a non-security investment (e.g., real estate) and the customer separately decides to liquidate securities to fund the purchase of non-security investment.  Conversely, where the customer independently decides to purchase a non-security investment and then asks the broker what securities to sell to fund the non-security investment, the suitability rule  would apply to the broker’s recommendation as to which securities to sell but would not apply to the decision to purchase the non-security investment.

In terms of supervision, when a broker recommends an investment strategy involving both a security and a non-security, the broker-dealer’s suitability obligations apply to the security component of the recommended investment strategy, but its suitability analysis also “must be informed by a general understanding of the business activity based on the information and considerations required by FINRA Rule 3270 [(Outside Business Activities of Registered Persons)].”

Did you know that national surveys have found that 15 percent of the adult population will be a victim of financial fraud during his or her lifetime?  In a white paper released last week, the Financial Fraud Research Center — a joint initiative of the Standford Center on Longevity and the FINRA Foundation — compiled a summary of research on consumer financial fraud titled “Scams, Schemes, and Swindles: A Review of Consumer Financial Fraud Research.”  Some of the collected data shows that fraud complaints increased to almost one million in 2011 and that Americans lose $40 to $50 billion every year to fraud.  However, given the reluctance of some victims to report fraud, the actual cost of fraud may dwarf that estimate.  In addition, the impact of fraud is far greater than its direct financial costs; significant amounts of time and money are spent each year to avoid and redress fraud, and victims of fraud often experience non-financial costs, including psychological consequences.  The Financial Fraud Research Center reviewed data collected through various surveys and studies to analyze the prevalence of reported incidents of fraud, variables in the profile of fraud victims, the characteristics of fraudsters, and the methods commonly used to commit fraud.  To read the full report, click here.