The Financial Industry Regulatory Authority – FINRA – outlined its 2014 enforcement priorities. Each January, the securities regulator publishes its list of priorities to highlight significant risks that could hurt investors and securities markets.
Topping the list this year is suitability, something that has long concerned us. Stockbrokers and other financial professionals have a legal duty to fully understand their clients’ investment needs, risk tolerance and financial situation. Once that is understood, brokers have a further duty to only recommend investments that are suitable for that particular client. What makes sense for some folks would be completely unsuitable for others.
Unfortunately, we frequently see brokers recommend investments that are only “suitable” for the broker. That is, they recommend investments that pay high commissions even though they may be much too risky or inappropriate for their clients. Nowhere is this more evident than in illiquid or thinly traded investments.
In recent years, there has been a spike in investments in TICs (tenant-in-common real estate projects), REITs and “baby bonds.” While these investments might be appropriate for younger investors with no immediate need for their capital, they are inappropriate for retirees, people who have a low risk tolerance or investors needing access to their cash.
The spike in suitability claims has caused FINRA to also separately identify private REITs as an enforcement priority. A REIT is a real estate investment trust. They allow ordinary investors to pool their money and buy into large shopping center, hotel and other real estate projects. REITs pay dividends and have some tax advantages too.
While some REITs are listed on major exchanges and can easily be bought and sold like stocks, others are private and very thinly traded. That means once you invest you may be stuck holding the investment for 8 years or longer. That’s not good if you need access to your money.
This is what FINRA says about private REITs for 2014:
“These products do not trade on a national securities exchange and are generally illiquid—meaning that the early redemption of shares is often very limited. Fees associated with the sale of non-traded REITs can be high and erode total return. The periodic distributions that help make these products so appealing to income- seeking investors can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal. The valuation of non-traded REITs is complex, which also makes understanding the performance of the product difficult.”
New on FINRA’s hit list this year are baby bonds.
Baby bonds are bonds issued in small denominations, typically $5000, making them attractive to small investors. Although often issued by municipalities and state governments, the baby bonds that concern FINRA are those issued by Business Development Companies. BDCs are closed-end investment companies that are operated to make investments in troubled companies and emerging businesses. They are quite risky and often illiquid as there is no secondary market.
FINRA says this about baby bonds in 2014:
“Although the market is in its infancy, FINRA is concerned that retail investors may not understand the liquidity risks they assume when gaining exposure to business development companies (BDCs) through baby bonds. The secondary market for these instruments is thin and investors forced to sell prior to maturity may be harmed.”
Another topic that has received extensive media coverage thanks to the Wall Street Journal is “cockroaching” which is the phenomena of brokers going from one bad firm to another. Like real life cockroaches that stay one step ahead of the exterminator, there is a small but identifiable group of stockbrokers that seem to migrate from one troubled brokrage firm to another, always leaving just before the firm is shut down.
We applaud FINRA’s decision to tackle the problem of serial bad brokers. We also remind readers that investment adviser and stockbroker compliance information is available on-line and free of charge. Check out your broker before you invest by logging on to FINRA’s brokercheck system.
While FINRA, the SEC and state securities regulators work hard to police the industry, there will always be bad brokers. If you have lost money because of an unsuitable investment, thinly traded REIT, Ponzi scheme or other scam, contact us. Most investment fraud cases can be handled through arbitration and without legal fees unless there is a recovery.
For more information, contact the author at or by telephone at (414) 704-6731 (direct). All inquiries are kept in confidence. Cases can be handled in most jurisdictions. Our minimum loss is generally $100,000 but contact us anyway if you need more information.