FINRA Issues Guidance on Suitability Rule Concerning Definition of "Customer" and "Investment Strategy"

By way of background, FINRA Rule 2111 requires that a broker-dealer or registered representative “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 customer’s investment profile.”

Recently-issued FINRA Regulatory Notice 12-55 provides additional guidance related to FINRA Rule 2111. Specifically, Notice 12-55 addresses the scope of the terms  “customer” and “investment strategy.”

According to Notice 12-55, “the term customer includes a person who is not a broker or dealer who either 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 even though the security is held at an issuer, the issuer’s affiliate or a custodial agent . . . or using another similar arrangement” (i.e. even though the security is not held by the broker-dealer).

Notice 12-55 also addresses the application of the suitability rule in the context of a recommendation made by a broker-dealer or registered representative to a potential investor. In such a case, suitability obligations do not apply unless the potential investor executes the transaction through the broker-dealer or if the broker-dealer receives compensation. If and when a transaction occurs, suitability obligations immediately commence. However, the suitability of the recommendation is evaluated based on circumstances at the time of the recommendation.

Notice 12-55 also addresses the term “investment strategy.” Under 12-55, the term “investment strategy” is to be broadly construed, focusing on whether the recommendation was suitable when made. The “investment strategy” language would  “apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the ‘Dogs of the Dow,’ or in a market sector, regardless of whether the recommendations identify particular securities.” This language would also apply to general recommendations to customers to use a bond ladder, day trading, “liquefied home equity,” or margin strategy involving securities even if the recommendations do not reference particular securities. In addition, “the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.”

It is worth emphasizing that, under Notice 12-55, the suitability rule encompasses a broker-dealers’ recommendation of an investment strategy involving both security and non-security components.

Although Notice 12-55 appears to offer some helpful clarifications, it is interesting to note the inconsistent treatment between customers and potential customers. Moreover, despite various illustrations, the limit of Notice 12-55’s broad reach with regard to investment strategy is far from clear. Outside of the specific illustrations in Notice 12-55, it seems that it would be safe to assume that most investment advice would constitute “investment strategy,” particularly given that this term is to be broadly construed. Time will tell how Notice 12-55 will play out in practice.

Regulatory Notice 12-55, Guidance on FINRA's Suitability Rule

Davis Polk. Guidance on FINRA's Suitability Rule

FINRA Clarifies Customer and Investment Strategy Terms Under the Suitability Rule

FINRA Suitability Overview

 

 

Former New Hampshire Stockbroker Convicted in Maine Theft and Securities Fraud Case

On November 2, 2012, Maine Securities Administrator Judith M. Shaw and Attorney General William J. Schneider that former New Hampshire stockbroker James A. Philbrook was found guilty by an Aroostook County jury of two felony charges stemming from an investment scheme that duped a St. Agatha couple out of $195,000.

Philbrook initially convinced the couple to invest $145,000 in developing a pay-per-view cable television production featuring Carmen Electra. The couple relied on Philbrook’s assurances that the production would net a substantial return. Unbeknownst to the couple, Philbrook used a substantial portion of the money for his personal gain.

Following that incident, Philbrook obtained another $50,000 investment from the couple which he used for his personal benefit.  

The jury rejected Philbrook’s claim that the funds provided by the couple were personal loans to be used at his discretion.

Philbrook is expected to be sentenced in October. The New Hampshire Bureau of Securities Regulation took administrative action against Philbrook on September 7, 2012, for the same conduct.

http://www.mainebiz.biz/apps/pbcs.dll/article?AID=/20121106/NEWS0101/121109984/1092&utm_source=enews&utm_medium=Daily%2BReport&utm_campaign=Tuesday

http://www.unionleader.com/article/20120919/NEWS02/709199979/0/News07

SEC Shows Much Progress to Be Made in Educating the Average Retail Investor

On August 30, 2012, The Securities and Exchange Commission (SEC) released a “Study Regarding Financial Literacy Among Investors.” The Study is mandated by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.  The results of the Study are based upon multiple sources, including online surveys, focus group research, public comments to the SEC and a Library of Congress review of studies of financial literacy among U.S. retail investors. 

The SEC concludes that “U.S. retail investors lack basic financial literacy . . . have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.” According to the Study: "[I]nvestors do not understand the most elementary financial concepts, such as compound interest and inflation,” nor do they understanding “the differences between stocks and bonds, and are not fully aware of investment costs and the impact on investment returns." 

Aside from shedding light on the general lack of knowledge in the retail investment population, a primary goal of the Study was to provide solutions. Most of these solutions centered on providing more transparency as well as more relevant and understandable information to the average investor.

The Study lists some common traits of retail investors. The Study found investors prefer to receive investment disclosures before investing (rather than afterwards, which often occurs). In reviewing disclosures, most investors preferred a visual format, using charts, bullets and graphs. The Study also identified information that most investors find useful and relevant in helping them make informed investment decisions. This includes information on fees, investment objective, performance strategy, and risks of an investment product. The Study also found that with regard to financial professionals, most investors care about professional background, disciplinary history and conflicts of interest.

It is anticipated that the SEC will act on this information to at least implement steps to give retail investors the tools they need to invest safely and successfully.
 
Click here for a link to the study.

Sources:http://www.sec.gov/news/press/2012/2012-172.htm
http://nymag.com/daily/intel/2012/08/sec-study-nobody-knows-anything.html?mid=googlehttp://www.minyanville.com/business-news/markets/articles/retail-retail-investors-how-to-invest/8/31/2012/id/43648

 

On the Taxation of Annuities Held by a Trust (or other non-natural person) . . . .

Beware!  When selling (or buying) an annuity, keep in mind that annuities are not always tax deferred no matter who the investor might be.  An annuity sold to a corporation or a trust is a case in point.  Under section 72(u) of the Internal Revenue Code, an annuity held by a trust may not be tax deferred.    

The consequences can be dire.  From the perspective of the investor (the corporation or trust buying the annuity) the IRS will be looking for payment of taxes on phantom income.  The Trust may not have liquidity to make those payments.  At a bare minimum those payments are unexpected and significantly erode the performance of the annuity. 

From the perspective of the representative involved in the sale, the buyer may have legal recourse on a theory of fraud, misrepresentation, suitability, or otherwise based on representations at the time of sale that the annuity would be tax deferred, when the opposite might actually be true, or for failure to disclose that income is not deferred.   The purchase of an annuity by a non-natural person should be a compliance red flag.  The customer should be provided a complete disclosure and should be given adequate and correct information on the anticipated after-tax performance of the annuity.

There are a number of exceptions and complexities to tax treatment of annuities that are not held by a natural person.  A qualified accountant or financial services lawyer should be consulted to determine – before the annuity is in place – how the annuity will be treated by the IRS.

 

For more information, contact Sigmund Schutz or click here for more about Preti Flaherty's Financial Services Group.

Attorney Richard Ploss Discusses New Financial Planner Sanctions with Dow Jones Advisor Reporter

Preti Flaherty’s Trusts and Estates Practice Group Chair, Richard Ploss, was recently quoted by the Dow Jones Advisor on the new sanctions for financial planners. Wall Street Journal and Dow Jones Advisor reporter Arden Dale discussed the Certified Financial Planner Board of Standards Inc.'s new rules, which now address personal bankruptcy, borrowing from clients, breach of contract, criminal convictions, forgery and inappropriate relationships with clients. Read the article here.

Richard is a Certified Financial Planner (CFP), a Certified Public Accountant (CPA) and an attorney with Preti Flaherty. Richard holds a Trusts & Estates Practitioner (TEP) designation, granted by the Society of Trusts & Estates Practitioners in London.

Richard practices in the firm's Bedminster, New Jersey, Portland, Maine, Boston, Mass and Concord, NH offices. Learn more about his practice here.

An Employment Lawyer's Take on Disgruntled Financial Industry Professionals

The tell-all Op-Ed published by Greg Smith in the New York Times on March 14, 2012, accusing Goldman Sachs of having a rotten corporate culture, reverberated across Wall Street and beyond.  Damage to the reputation of Goldman Sachs and the reputation of the Street as a whole?  Yes.  One of many related issues is what employers – including brokerage firms and others in the financial industry -- can do to avoid or mitigate a similar reputational and public relations disaster.  I spoke with Betty Olivier, a partner in Preti Flaherty’s employment law group to explore the topic.

Sig:      What are the legal considerations for an employer when faced with a potentially disgruntled employee’s departure?

Betty:  If the employer has any control over the exit itself, it may have the ability to enter into a separation agreement with the employee that can address post-employment conduct.  This type of arrangement typically would involve the employer having to pay the employee severance in exchange for the employee’s agreement to do or refrain from doing certain things.  This type of agreement often includes non-disparagement language.  However, it is most typically used with involuntary separations, and may not provide a viable option when the employee just walks out the door. 

Sig:      So when an employee just walks out the door, up and quits, are there options available to an employer in addressing that kind of situation?

Betty:  Often written employment agreements executed at the beginning of employment include language that can reduce the risk.  It will always be difficult for an employer to dictate what an employee does after the relationship ends, but there are provisions that can be included in employment agreements that address some types of post- employment conduct.  For example, many employers have written confidentiality and non-disclosure agreements with their employees, and the language in those agreements can regulate the kind of things an employee can say about a company on the way out the door. 

Sig:      Those agreements don’t typically restrict opinions about the company, do they?

Betty:  No, they are generally designed to protect confidential information, but may be of some use in limiting what an employee says about a company or in limiting the assertion of certain facts as supporting opinions.

Sig:      If ongoing compensation is owed, that would be potentially an incentive for the employee to abide by those terms or risk forfeiting compensation.

Betty:  Not necessarily. If the compensation owed is for services provided while the employee was employed, the employer can’t condition payment on an agreement to behave after the relationship ends. If there is an agreement to make a post-termination payment and that payment is conditioned on the employee abiding by confidentiality and nondisparagement obligations, among other things, that payment might provide the incentive.  Employers have to be careful about imposing certain types of restrictions on certain employees, and avoid claims of improper restrictions on those employee’s right to speak.  There has been a lot of activity with the National Labor Relations Board regarding employer policies that restrict employees from talking to each other about terms and conditions of employment.  One would have to look very closely at any restrictions proposed to make sure that language is not construed to be overly broad or violative of an employee’s right to engage in concerted activity.

Sig:      In this situation, presumably to convince the New York Times to publish his Op-Ed, Mr. Smith presumably took with him internal company emails and documentation to confirm the accuracy of the facts that he reports in his Op-Ed.  What’s your reaction to that?

Betty:  That, hopefully, is the kind of behavior most employers take action to protect against when they hire employees.  Email on an employer’s server is the property of the employer, not the employee.  Many e-mails may contain confidential proprietary information. Employers  should have some arrangement that prohibits employees from taking Company property with them when they leave employment. 

Sig:      The situation with Greg Smith is extreme both in terms of the highly public nature and content of the article is published.  The New York Times Op-Ed page is about as public as one could get.  The accusations themselves are harsh.  You get a call from the HR director or CEO of a client saying have you read this morning’s local paper, have you seen the article by my former Vice President?  It contains harsh accusations about the company’s culture or its treatment of clients.  What options are available to the company from an employment perspective.

Betty:  If the statements are false and defamatory, the employer may be able to pursue a defamation claim.  There can be downsides to that course of action, however.

Sig:      One of the issues there is whether a legal claim or response further risks damage to reputation by keeping the story in the news and creating a forum for more back and forth over what really happened.  What are your thoughts as to what should be done from a public relations standpoint?

Betty:  You raise a very important point. Companies should consider whether the commencement of a lawsuit might carry with it certain risks, and weigh those risks against the benefit of pursuing a claim. If a company is considering using the media to respond to a disgruntled former employee’s claims, it should consider the very issue you raise – that is, whether they will only draw more attention to a bad situation. There are firms that can help companies deal with this kind of public relations nightmare, and it may be worth a company’s while to retain professional assistance.  The point is that the response is not strictly or even primarily a "legal" one.
  

New Hampshire Ramps Up Efforts to Warn of Investment Scams

The New Hampshire Bureau of Securities Regulation (NHBSR) recently announced the launch of a television ad campaign in an effort to raise public awareness of con artists in the investment world, the cost of which will be funded by the Investor Protection Trust (IPT). The IPT, founded in 1993, is part of a multi-state settlement to resolve charges of misconduct and serves as an independent source of non-commercial investor education materials.


According to the NHBSR, would-be investors should approach any potential investment opportunity with caution, and proceed only after ample investigation. In particular, if nothing else, investors should check whether a seller is licensed and whether an investment product is registered.


Of course, investors are always encouraged to dig deeper when it comes to any potential investment. Investors are also encouraged to contact the NHBSR with any questions. According to Barry Glennon, Deputy Director of the Bureau, “Before you invest your hard-earned money, it is vitally important to call the Securities Bureau to investigate both the promoter and the investment.”


Glennon noted the risk associated with high-return investments: “Citizens should understand that ‘high return’ investments often carry high risk including the risk that the investment may yield no return, or, worse, a substantial loss to the investor.”


New Hampshire is unfortunately entirely too familiar with investment scams. In recent years, New Hampshire investors have been victims of various con-artists, resulting in significant losses to some investors.
http://www.chicagotribune.com/business/sns-mct-nh-securities-bureaus-ads-will-warn-about-con-20120508,0,3662775.story

http://www.sos.nh.gov/securities/Press_Releases/PRESSR_2012-05-04.pdf