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Practice Management

New and pending regulations amid tightened regulatory scrutiny have advisors wondering how best to comply.

This Practice Management article is intended for financial advisors only (registered representatives of broker/dealers or associated persons of Registered Investment Advisors)


Keith Laterrade knows a thing or two about floods. When Hurricane Katrina swept ashore in 2005, his office in New Orleans' Gulf Coast Bank ended up underwater. Laterrade weathered that storm but now faces another flood—not from Mother Nature this time but one that is more widespread: paperwork.

"My associate and I have to look around piles of paper just to see each other sometimes," he says. "Suitability and alternatives; FINRA's focus on those issues has us doing a lot of paperwork."

Indeed, FINRA has tightened regulation and compliance monitoring of broker-dealers over the past year or so, making sure that the investments being recommended to clients are suitable.

Of particular concern are 401(k) rollovers, which are becoming increasingly common as the 76 million baby boomers begin to hit retirement age. Also closely watched are alternative investments, the documenting of all "hold" recommendations, and conflict-of-interest issues.

There also is widespread concern in the industry over a new proposal for a comprehensive automated risk data system, or CARDS. If adopted by FINRA and approved by the SEC, it would require broker-dealers to "collect, on a standardized automated and regular basis, account information, account activity and security identification information that a firm maintains as part of its books and records."

Standardizing Suitability
FINRA says that policing the 401(k) rollover recommendations of advisors will be a priority in compliance examinations of broker-dealers this year, in the wake of a 2013 Government Accounting Office (GAO) report that, with the aid of "mystery shopper" sampling, found that clients often weren't being given the best options by their advisors. At issue are the 401(k) funds that clients have from previous jobs, sometimes years earlier.

Should they leave the money in the old employer's hands, if permitted, or should they move it into a new 401(k) offered by a current employer? Or should they roll it over into an IRA?

According to FINRA's December notice: "A broker-dealer's recommendation that an investor roll over retirement plan assets to an IRA typically involves securities recommendations subject to FINRA rules... Any recommendation to sell, purchase or hold securities must be suitable for the customer and the information that investors receive must be fair, balanced and not misleading." Specifically, FINRA says, in making recommendations about old 401(k) rollovers, advisors should consider tax consequences, the range of available tax-advantaged investment options and comparable fees and expenses, among other things.

The GAO study found that many advisors will push the idea of an in-house IRA product without explaining the costs to the client or comparing them with the costs of the 401(k) options. That's not to say that even a higher-cost IRA couldn't be a better choice. It may, for example, have a better performance record and offer the kind of risk profile that a client wants.

But it needs to be discussed and documented. FINRA's big concern is that clients get all the information about fees and risk. And, as Laterrade will attest, that means maintaining documentation that shows what information was provided.

FINRA notes that some broker-dealers offer their own in-house IRA plans and pay a commission to advisors who sell them to clients, and/or pay a bonus to advisors who sell the most IRAs.

The agency says potential conflicts of interest like this need to be explained to a client with any recommendation. Specifically, the guidance says broker-dealers must ensure that "conflicts of interest do not impair the judgment of a registered representative or another associated person about what is in the customer's interest and that they neither confuse investors nor interfere with important educational efforts."

Raymond James Chief Compliance Officer Don Runkle says that while he understands FINRA's concerns about suitability, the new rule is a challenge. "Rollovers of 401(k)s to IRAs are still kind of a new issue," he explains. "There are still problems with transparency of's not the easiest information to find." He adds, "You set up a broker-dealer for failure if you suggest that the client would have been better off leaving money in an old 401(k). How do we know? Now if you were to say: 'Once the client makes a decision to roll over the money to an IRA, then it's up to the broker-dealer to make sure the investment makes sense for that person,' that would work. But right now, as the rule is written, it's a little murky. There are more questions than answers."

Ahead of the Curve
The murkiness of it all is a major concern among compliance officers. "Sometimes the fees in a 401(k) plan are not terribly transparent," says Doug Preveza, chief compliance officer at Infinex. A former FINRA examiner, Preveza notes, "Giving good advice about the relative costs and other issues in a 401(k) rollover to an IRA is a valid concern for FINRA."

He doesn't expect FINRA compliance examiners to "come down hard" this year, in part because of the difficulty in evaluating the real costs of many 401(k) plans.

"I think this is a case of FINRA trying to get ahead of the curve," he says. "Even though 401(k) rollovers to IRAs have been going on for a while, now you've got all these baby boomers coming along, so FINRA is letting us know they're going to be looking at how we're doing this—both going forward, and retroactively. They're saying you cannot just take money because someone left their employer and the money's sitting in that old 401(k)."

At Infinex, he says, advisors are told that in making that recommendation regarding tax-advantaged retirement savings vehicles, they have to "consider internal and external options," look at the fees "to the best of their ability," find out whether there is an option to leave the money with the old employer's plan and if so whether that's advisable.

And if the client is moving to a new job and not retiring, another consideration is whether it might be better to roll the money into the new job's 401(k). The key thing is that there needs to be a record of all these issues having been discussed with the client, he says.

"It will be interesting to see what comes of this new FINRA focus," Preveza says. "The notice implies that practices out there are bad, and that clients aren't really being given a choice, but I don't know that in my world, there are that many abuses."

He notes that Infinex has turned down some IRA rollover advertising being offered to advisors for their clients, sending them off to FINRA for an opinion. "Just the word 401(k) in an ad is a red flag for us," he says. "Our view is that such ads must include the disclosure that the client may not need to move their money, and that there may be other options than an IRA.

On the plus side, Preveza says, "The 401(k) suitability rule has been an opportunity for us here to revisit our overall suitability documentation. Do we want to set up more criteria in that space? But that's a process we go through with every new regulation. We look to see whether we need to make any adjustments.

It's not just the TPMs that are concerned about the new focus on rollovers. The banks are watching this too. "Seventy percent of my business is qualified retirement accounts," says Corey Quattlebaum, a producing program manager responsible for all the advisors of the 70-branch regional Southern Bank and Trust based in North Carolina. "Any responsible, ethical advisor will clarify the issues for a client in a rollover situation, but when it comes to the difference in expenses between the two I don't know how the heck I'm supposed to get it. And I'm not sure how we document it, but I guess with the new rules, we will have to start doing that."

He adds, "I assume when FINRA comes in here for an exam, they'll want to have some kind of disclosure, but I don't know of any broker-dealer that's requiring it yet. I don't know how FINRA can expect us to do this without a disclosure document, and they haven't provided one."

No More Unofficial "Holds"
Last October, FINRA offered new guidance on "hold" recommendations. It was decided that it was not good enough for advisors to record just their "buy" and "sell" recommendations. In reviewing a client portfolio, all holdings that are not official "buys" or "sells" must be designated as a "hold" recommendation, and explained as such.

In FINRA's view, silence is no longer an implied "hold." Going forward, it has to be explicit. And for compliance purposes, the advisor must maintain records to show that this was done.

"That wasn't out there before," says Preveza. "It used to be your longtime advisor, in a portfolio review, might tell you: 'This asset isn't likely to perform well this year, so let's sell it, and these four look promising so let's buy some more shares. But these other assets all look fine so let's hold on to them.' Now those others have to all be officially hold recommendations, so for each one the advisor has to be clear with the client that it's a hold."

Preveza says FINRA is "not being very explicit" about how we document them, but requiring documentation could help firms avoid problems later in arbitration cases, where "it can just be he said/she said, which is an awful situation to be in."

LPL's Laterrade says his broker-dealer has things set up so that "as we go through a discussion of the portfolio, I can say to the client, 'Okay, this asset is a hold," and then check a 'hold' button on the screen, which saves me having to write a conversation down."

FINRA said its compliance examiners found firms using a variety of methods to document hold recommendations, ranging from "hold tickets," like LPL's, to keeping notes of discussions with clients in files.

Noting that the new guidance on hold recommendations is part of the overall Suitability Rule 2111, it adds: "The type or form of documentation that may be needed is dependent on the facts and circumstances of the investment strategy or hold recommendation, including the complexity and risks associated with the security or investment strategy at the time of the recommendation. Irrespective of the method a firm uses to capture hold and other strategy recommendations when necessary, the firm must have a supervisory system in place to adequately review investment strategies."

Too Much Information
The FINRA notice that really had the broker-dealer industry sitting up and paying attention was Regulatory Notice 13-42, the CARDS proposal issued last December, which several critics joked seemed to be attempting to make FINRA into the "National Security Agency for client financial data."

As originally drawn up, this proposal would have FINRA sweeping up, on an automated basis as often as weekly, "account information, as well as account activity and security identification information that a firm maintains as part of its books and records."

As broker-dealers quickly pointed out, this raises enormous questions about the security of that client data, all in FINRA's hands, from inadvertent or even deliberate data breaches.

As Raymond James' compliance head Runkle put it, "Do we really want to be shipping personally identifiable information to FINRA? It's a little unnerving what they're requesting. And also, what are they going to be doing with it?"

Preveza, agrees, saying, "Does FINRA really want to collect and own all of this information?" A former FINRA examiner, he noted: "The training I had at FINRA was that it's not a matter of if you have a data breach, it's when. And if I were a criminal—or an attorney—my mouth would be watering at all that data. That's one of the risks of consolidating all that information in one place."

Comment letters poured in on the proposal, from both investors and firms. Typical of the individual letters was one from an investor who told FINRA if the rule was adopted, he would be "closing all domestic brokerage accounts and investing elsewhere."

He went on to cite the public outcry over the revelations of NSA surveillance and wondered if this is an appropriate time for securities regulators to tell the investing public that they will be collecting their account information in a large regulatory database? He concludes: "While I don't necessarily doubt that FINRA's intent is to better protect the investing public, I am not convinced that the investing public will be so understanding."

In the end, FINRA modified its CARDS proposal, saying: "After considering the written comments on the CARDS concept proposal and the views expressed in FINRA staff discussions with industry participants regarding investor privacy, FINRA has concluded that the CARDS proposal will not require the submission of information that would identify to FINRA the individual account owner, particularly, account name, account address or tax identification number."

It remains to be seen what the final proposal will look like.

Preveza worries that even with client identification removed from the data provided to FINRA, such a project would entail huge costs for clearing firms, which would then raise costs for broker-dealers, "which there's probably no way for me to pass on to my customers, since we're pretty locked in where we are on the fees we charge."

He also worries about the impact of such a sweeping data requirement on smaller firms.

Concerns are also being raised about whether so much company activity data in outside hands could lead to breaches that could hurt individual firms competitively, or open them to unwanted takeover bids.

On the costs issue, FINRA says the proposal will be vetted by the regulator's new chief economist, who has been tasked with running a cost-benefit analysis on all new rules, including how they may impact smaller firms.

—Dave Lindorff 



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