regulatory update for retail representatives - 32002408

FINRA

Page ID: 517218

FINRA

The SEC approved the consolidation of NASD and the NewYork Stock Exchange (NYSE) member regulation functionsinto a single, self-regulatory organization (SRO) known asFinancial Industry Regulatory Authority (FINRA). Theconsolidation plan set forth a more sensible and less complexregulatory system that made securities regulation moreefficient and effective. This merger also eliminated duplicateregulation by the then NASD and NYSE, which continues tostrengthen investor protection and increase thecompetitiveness of the US markets.

The merger of the NYSE and NASD’s regulatory groupsgenerates several advantages. The primary advantage isincreased efficiency and lower costs due to less duplication ofeffort. This continues to enable firms to operate moreefficiently, which allows them to serve their customers at alower cost. It also makes it harder for unscrupulous people toevade the law, because there will no longer be any gap inoversight.

Page ID: 517219

Consolidated Rulebook

Regulatory Update for Retail Representatives - 32002408

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As noted on FINRA's website:

FINRA is establishing a consolidated FINRA rulebook that will consistsolely of FINRA Rules. Until the completion of the rulebookconsolidation process, the FINRA rulebook includes NASD Rules andIncorporated NYSE Rules (together referred to as the "TransitionalRulebook"), in addition to the new consolidated FINRA Rules. As the newFINRA Rules are approved and become effective, the rules in theTransitional Rulebook that address the same subject matter of regulationwill be eliminated. When the consolidated rulebook is completed, theTransitional Rulebook will have been eliminated in its entirety.

While the NASD Rules generally apply to all FINRA members, theIncorporated NYSE Rules apply only to those members of FINRA that arealso members of NYSE. FINRA Rules apply to all members, unless suchrules have a more limited application by their terms.1

Further evidence of the combining of the two regulatory entities into onewas on February 24, 2009 when the Board of Governors of FINRAannounced that Richard G. (Rick) Ketchum was appointed FINRA's ChiefExecutive Officer. Ketchum served as CEO of New York Stock Exchange(NYSE) Regulation and as Chairman of FINRA's Board of Governors, aposition he has had since FINRA was created in 2007.

1 FINRA. "FINRA Rules." Accessed June 29, 2012. http://www.finra.org/Industry/Regulation/FINRARules/.

New Developments and FINRA Areas of Focus

Page ID: 517221

Introduction

While persons of all ages can be vulnerable to consumer and securitiesfraud, the North American Securities Administrators Association(NASAA) warns that as baby boomers approach retirement, investmentfraud among seniors could increase. They report that more than 40% of allinvestor complaints received by state securities regulators are made byseniors, and nearly one-third of all enforcement action by securities


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regulators in the state involved senior investment fraud.

According to the Federal Trade Commission (FTC), in 2011, consumersreported fraud losses of more than $1.5 billion, and of the total fraudcomplaints filed in the 2011 calendar year, 45% of complaints were filedby people age 50 or older. The SEC brought 51 enforcement actions in the2008 fiscal year against frauds targeting retirees and other older investors.

Due to the Madoff scandal, the enforcement chief at the SEC reported adramatic rise in enforcement actions. The numbers of investigations andrestraining orders have approximately doubled as well as the number ofrestitution orders.

Page ID: 517222

Suitability

In FINRA Notice to Members 07-43, released in September 2007, FINRAreminded firms of their obligations relating to senior investors andhighlighted industry practices to serve these customers. The purpose of theNotice was to urge member firms to review and, where warranted,enhance their policies and procedures for complying with FINRA salespractice rules, as well as other applicable laws, regulations, and ethicalprinciples, in light of the special issues that are common to many seniorinvestors.


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FINRA Rule 2111, the suitability rule, requires that "A member or anassociated person must have a reasonable basis to believe that arecommended transaction or investment strategy involving a security orsecurities is suitable for the customer, based on the information obtainedthrough the reasonable diligence of the member or associated person toascertain the customer's investment profile."

It goes on to say "A customer's investment profile includes, but is notlimited to, the customer's age, other investments, financial situation andneeds, tax status, investment objectives, investment experience,investment time horizon, liquidity needs, risk tolerance, and any otherinformation the customer may disclose to the member or associated personin connection with such recommendation."

Page ID: 517223

Suitability (cont.)

As investors age, their investment time horizons, goals, risk tolerance, andtax status may change. Liquidity often takes on added importance.Depending on their particular circumstances, seniors and retirees mayhave less tolerance for certain types of risk than other investors. Forexample, retirees living solely on fixed incomes may be more vulnerableto inflation risk than those who are still in the workforce, depending on thenumber of years those retirees are likely to rely on fixed incomes.Likewise, investors whose investment time horizons afford less time oropportunity to recover investment losses may be disproportionatelyaffected by market fluctuations.

Therefore, firms cannot adequately assess the suitability of a product or


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transaction for a particular customer without making reasonable efforts toobtain information about the customer's age, life stage, and liquidity needs.Other questions to consider follow.

Is the customer currently employed? If so, how much longer does heplan to work?What are the customer's primary expenses? For example, does thecustomer still have a mortgage?What are the customer's sources of income? Is the customer livingon a fixed income or anticipate doing so in the future?How much income does the customer need to meet fixed oranticipated expenses?How much has the customer saved for retirement? How are thoseassets invested?How important is the liquidity of income-generating assets to thecustomer?What are the customer's financial and investment goals? Forexample, how important is generating income, preserving capital, oraccumulating assets for heirs?What health care insurance does the customer have? Will thecustomer be relying on investment assets for anticipated andunanticipated health costs?

Page ID: 517224

Suitability (cont.)

Firms should carefully consider the risk of a product with the age andretirement status of the customer in mind, including its market, inflation,and issuer credit risk. Investment involves varying degrees of risk andreward. For many investors who are at or nearing retirement, there can bea temptation to reach for yield to maximize retirement income without theappreciation of the associated risk. Moreover, it can be difficult for someinvestors to fully appreciate the risks of certain products or strategies,particularly if they are concerned about running out of money. Yet,especially when investments involve retirement accounts or lump-sumpension plan payments, taking undue risks with funds needed to last alifetime can be financially disastrous.


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Page ID: 517225

Suitability (cont.)

Firms do not have an obligation to shield their customers from risks thatcustomers want to take, but they are required to fully understand theproducts recommended by their registered representatives; to give theircustomers a fair and balanced picture of the risks, costs, and benefitsassociated with the products or transactions they recommend; and torecommend only those products that are suitable in light of the customer'sfinancial goals and needs.

In many cases the situation arises in which a client qualifies as anaccredited investor under Regulation D of the Securities Act of 1933.Effective February 27, 2012, through the provisions of the Dodd-FrankAct, one can qualify with a net worth in excess of $1 million, excludingthe equity in one's primary residence. An important phrase to remember,however, is "eligibility does not equal suitability."

This does not mean that all seniors are, or should be, risk-averse or thatany particular product, per se, is unsuitable for older investors. However,certain products or strategies pose risks that may be unsuitable for manyseniors because of time horizon considerations, liquidity, volatility, orinflation risk.

Therefore, the regulatory bodies are focusing on recommendations to


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seniors, particularly those that involve:

products that have withdrawal penalties or otherwise lack liquidity,such as deferred variable annuities, equity indexed annuities, somereal estate investments, and limited partnerships;variable life settlements;complex structured products, such as collateralized debt obligations;mortgaging home equity for investment purposes; andusing retirement savings, including early withdrawals fromindividual retirement accounts (IRAs), to invest in high-riskinvestments.

Page ID: 517226

Certifications and Designations

The use of certain designations or a certification by salespersons, whetherregistered or not, confers an impression with the general public andspecifically senior citizens or retirees that the salesperson has specialqualifications or specialized education in particular areas of finance,financial planning, estate planning, or investing. The requirements toobtain designations and certifications vary greatly, as can the processes formonitoring compliance with a code of conduct or ethics, if any, adoptedby the organization that awards the designation or certification.

Investors often have insufficient information about the designation orcertification when trying to determine which designation or certificationrepresents meaningful educational achievement by the salesperson orwhich designation or certification merely represents a marketing tool. Thisproblem has been particularly pronounced in the area of seniordesignations. Certain segments of the financial services industry have


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aggressively used designations and certifications that incorrectly implyexpertise in the financial needs of seniors. Such aggressive use oftenresults in unsuitable investments being sold to unsuspecting seniors byapparent experts who are little more than salespersons with little or noexpertise in the individual specific needs of the senior client orunderstanding of the product they are selling.

Accordingly, a NASAA task force was formed to study what approach, ifany, NASAA members should consider in addressing this problem. In thecourse of their study, the members of the task force considered a numberof potential methodologies, including the regulatory initiatives undertakenby the securities regulators in Massachusetts, Nebraska, and Washington.

A proposed model rule incorporates aspects of the various regulations thatare already in place or under consideration in other jurisdictions. Theproposed rule prohibits the misleading use of senior and retireedesignations by any person. The proposed rule also provides a means bywhich an administrator may recognize the use of certain designations thathave been accredited. Violations of the rule may be prosecuted againstany person under the administrator's antifraud authority or againstregistrants under the statutory prohibitions against dishonest and unethicalbusiness practices.

Page ID: 517227

Certifications and Designations (cont.)

As with other senior issues, more than one regulatory body is involved.According to FINRA, communications with the public are currentlygoverned by NASD Rule 2210 and by incorporated NYSE Rule 472. Bothrules prohibit firms and registered representatives from making false,exaggerated, unwarranted, or misleading statements or claims incommunications with the public. These two rules are set to beconsolidated into FINRA Rule 2210 and 2212 through 2216 effectiveFebruary 4, 2013 and will significantly change the structure ofcommunications. However, one will never be able to make false ormisleading statements.

FINRA does not prohibit or endorse the use of any particular designation.However, it is noted that the criteria used by the organizations that grantprofessional designations for investment professionals vary greatly. Somedesignations require formal certification and mandatory professionaleducation, while others can be obtained simply by paying membership


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dues. Some seniors may be led to believe that these individuals areparticularly qualified to assist them on the basis of such designations. Theuse of any title or designation that conveys an expertise in seniorinvestments or retirement planning where such expertise does not existwould be a violation of FINRA rules.

Obviously, the use of these designations is an attempt to imply a level ofability where none exists. A variation of this is the use of ghostwrittenbooks available from third-party vendors. These publications deal withsenior issues and are printed with the registered representative's name insuch manner as to make it appear that the book was actually written bythat representative. Holding oneself out as the author of one of thesebooks on senior investing, and therefore an expert, could violate a numberof rules, including FINRA Rules 2110 and 2120, NASD Rule 2210, andNYSE Rule 472.

Understand a firm's policies and check with a supervisor or complianceofficer before using designations or other credentials.

Page ID: 517228

Selling Seminars


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There is probably no other area of abuse directed at seniors that hasreceived the attention of the free-lunch seminars.

The SEC and NASAA announced a coordinated national initiativedesigned to protect seniors from investment fraud and sales of unsuitablesecurities. Working together with FINRA, the SEC and NASAA initiativeincludes three components: active investor education and outreach toseniors and those nearing retirement age; targeted examinations to detectabusive sales tactics aimed at seniors; and aggressive enforcement ofsecurities laws in cases of fraud against seniors. This joint andcollaborative initiative by securities regulators was designed to build onthe existing efforts that each regulator had underway toward a sharedmission to protect senior investors. This initiative is active and ongoing.

As part of this effort to protect senior investors, regulators initiated aseries of coordinated on-site examinations of broker/dealers, investmentadvisers, and other financial services firms that offer free-lunch salesseminars. These seminars are widely offered by financial services firmsseeking to sell financial products, and they often include a free meal forattendees. Sales seminars are often advertised in local newspapers,through mass-mailed invitations, mass email, and on Websites. Whilespecific data is not available regarding the actual number of sales seminarsbeing conducted, regulators believe that the number of sales seminars hasincreased in recent years, as financial services firms are increasinglyseeking to provide advice to seniors and those approaching retirement.

Page ID: 517229

Selling Seminars (cont.)

The purpose of the examinations was to review firms that offer salesseminars targeted to seniors and retirees for compliance with securitieslaws and rules (federal, state, and SRO rules) designed to protectinvestors. Specifically, the examinations reviewed:

advertisements, seminar materials, and sales literature for anymisrepresentations, exaggerations, or omissions of materialinformation;customer transactions engendered by these seminars to evaluate thesuitability of investment recommendations that were made; andsupervisory systems, policies, and procedures used to detect andprevent violations of the securities laws for adequacy.


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Page ID: 517230

Selling Seminars (cont.)

The regulators conducted 110 examinations and while each of the findingsis described in greater detail in their report, in sum, they found thefollowing information.

Please reference the online course to view this activity.

The results of these examinations led regulators to conclude that financialservices firms should take steps to supervise sales seminars more closelyand specifically take steps to review and approve all advertisements andsales materials for accuracy. In addition, firms should redouble efforts toensure that the investment recommendations they make to seniors aresuitable in light of the particular customer’s investment objectives.

Page ID: 517231

Annuity Products

FINRA Rule 2330 did not spring up unexpectedly or without considerablebackground rationale. For the past several years, FINRA and the SEC


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have been studying sales and supervision practices of variousbroker/dealers and registered representatives in the sale of variableannuities.

After several years in the making and following the lead of earlier FINRAefforts, the rule was approved by the SEC on September 7, 2007. The firsttwo parts of the rule became effective May 5, 2008 and the final effectivedate was July 9, 2012. Rule 2330, which applies to recommendedpurchases and exchanges of deferred variable annuities and recommendedinitial subaccount allocations, imposes requirements in four main areas:

Registered representative requirements for recommendedtransactionsPrincipal review and approval obligations for all transactionsFirm supervisory proceduresFirm training program

Each of these requirements will be examined individually regarding therule and FINRA's guidance.

Page ID: 517232

Registered Representative Requirements for RecommendedTransactions

Although Rule 2330 does not apply to reallocations among subaccounts orto funds paid after the initial purchase or exchange of a deferred variableannuity, it imposes a number of specific requirements for ascertaining thesuitability of variable annuity recommendations. The rule requires thatregistered representatives '…must have a reasonable basis to believe thatthe customer has been informed, in general terms, of the material features


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of a deferred variable annuity…' and requires that the representative alsomake 'a reasonable effort to obtain and consider various types ofcustomer-specific information….' Specific guidance from FINRA includesrequirements such as:

Age-Is the prospect too young or too old for the annuity to be asuitable investment?Income-Can the prospect reasonably afford to purchase theproposed annuity?Investment experience-This is particularly critical when theregistered representative is recommending investments in particularsubaccounts that may entail aggressive risk portfolios. Is the clientsophisticated regarding the risk/reward concepts posed by certaininvestments?Intended uses of the variable annuity-The representative should askspecific questions on this subject and listen closely to the answersbefore recommending variable annuities.Investment time horizon-If there is an immediate, or near-term,requirement for liquidity, the registered representative must lookclosely at the contract. If there is a surrender charge, for instance,that lasts 5 to 7 years, recommending a deferred variable annuity toan elderly person may not be the best choice.Tax status-Deferred annuities offer the advantage of tax-deferredgrowth. This advantage may not be useful to all investors.

Page ID: 517261

Registered Representative Requirements for Recommended Transactions (cont.)

The features that customers should be informed of include:

Surrender charges—Many annuities impose declining surrender charges over a period that canbe from 5 to 7 years.


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Potential tax penalty—An investor's withdrawal of funds from an annuity might be subject totaxation on the growth at the investor's ordinary income rate plus a 10% penalty if youngerthan age 59½.

Page ID: 517233

Registered Representative Requirements for RecommendedTransactions (cont.)

The suitability determination of the particular annuity should includeevaluation of:

Investments in the underlying subaccounts-Age, financial status,attitude, and investor sophistication are primary touchstones to testa recommendation for its suitability to a specific client.All riders and other product enhancements-A clear, in-depthunderstanding of variable annuities and the company-specificproducts to be recommended to a customer are vital to registeredrepresentatives.

Suitability of an annuity investment should, among other factors, include:

Whether the customer would incur a surrender charge or be subjectto a new surrender charge. If an exchange would incur surrendercharges, would the new annuity subject the client to yet anotherseries of years with surrender charges?Will the client lose existing benefits or be subject to increased feesor charges? In all cases involving exchanges, the registeredrepresentative must consider the benefits already purchased by theclient.Has the client had another annuity exchange in the past 36 months?If so, the client's costs for the exchange have probably not yet beenrecovered.

Page ID: 517234

Principal Review and Approval Obligations for AllTransactions


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Rule 2330 has added a unique requirement: With regard to timing, the rulerequires review and approval 'prior to transmitting a customer's applicationfor a deferred variable annuity to the issuing insurance company forprocessing, but no later than seven business days after an office ofsupervisory jurisdiction of the member receives a complete and correctapplication package.'

FINRA rules generally require a member firm to promptly forward fundsto the insurance company who actually owns the VA. However, this ruleprovides an exception. Without this exemption, smaller broker/dealerswould have been subjected to higher net capital requirements, and if theydid not promptly transmit customer's checks to the insurance company,they could have been found to be in violation of the rule. Without theseexemptions, compliance with the rule would have shortened the time inwhich the principal would be able to review the transactions.

Regarding the approach that the principal must take in evaluating aproposed transaction, he must view the issue at hand based on all thefactors that a registered representative must consider when making arecommendation to a customer. The principal must consider alltransactions as if they had been recommended for purposes of his review.

Page ID: 517235

Firm Supervisory Procedures


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The rule requires that broker/dealers establish surveillance programs todetect patterns that may indicate unsuitable transactions, such asinappropriate or too-frequent exchanges. The requirement places anobligation on firms to put in place programs that would indicate the needfor further review of the transactions themselves and/or the registeredrepresentative submitting the applications for potential misconduct.Appropriate corrective measures to be undertaken by the firm are requiredby the rule.

FINRA's rule does not preclude the use of automated supervisory systemsand states that a combination of automated and manual systems forsupervision is also acceptable. The rule does, however, stress that theprincipal's responsibility is not diminished by the use of automated systemsand states that a principal is obligated to ensure that the system used isadequate for the purposes of supervision as required by the rule. Theguidance also holds the principal responsible for '…any deficiency in thesystem's criteria that would result in the system not being reasonablydesigned to comply with Rule 2330.' In very simple terms, a principal mayuse computer systems as a tool for supervision and surveillance, butultimately the principal is responsible.

Page ID: 517236

Firm Training Program

The rule requires that broker/dealers establish training programs on


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variable annuities for both registered representatives who sell theseproducts and for the principals who review the transactions.

The requirement for these training programs is meant to addressweaknesses in the system, such as those that were identified in thepreviously mentioned Joint Report, which found the following:

Training programs of broker/dealers often did not address the sale orsupervision of variable annuities.Firms provided only general training to registered representativesand did not cover special features of the annuities or specificsuitability issues.Principals reviewing variable annuity transactions were often notsufficiently trained or experienced to recognize abusive salespractices.The annual compliance meetings and firm element continuingeducation programs did not include information on the sale andsupervision of variable annuity products.

Broker/dealers involved in the sale of variable annuities must now ensurethat their training programs address these weaknesses.

Page ID: 517237

Equity-Indexed Products

Equity-indexed annuities (EIA) sales have grown dramatically in recentyears. Although the sales literature of at least one insurance companydescribes them as simple, they are anything but easy to understand,


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particularly by potential investors. They have characteristics of both fixedand variable annuities. They offer a greater potential for growth thantraditional fixed annuities but carry a higher risk. At the same time, EIAspresent a risk that is lower than the potential risk from variable annuitiesbut also have a lower potential for return. An individual selling theseproducts must understand the products clearly in order to effectivelycommunicate the nature of the contracts to customers.

EIAs offer a guaranteed minimum return in combination with an interestrate that is linked to one of the stock market indices, such as the S&P 500Index. Because of the guaranteed interest rate, EIAs have a lower marketrisk than traditional variable annuities, along with the potential for higherreturns when the market is rising. The guaranteed minimum return from anEIA is (in part because of changes to state insurance laws), typically atleast 87.5% of the premium paid at 1 to 3% interest. This compares to afixed annuity’s guaranteed interest rate, except that the fixed annuity’srate is based on the total of premiums paid into the account.

The index-linked portion of the contract is most frequently linked to themovement of the S&P 500 Index. There are, however, other indices towhich the annuity may be linked; some insurance companies allow EIAinvestors to select one or more.

One of the more complex features of EIAs is the method by which theindex-linked interest rate is calculated. Three of the more commonmethods of computing the interest rate gain are participation rate, ratecaps, and administration fee.


Page ID: 517238

Selling New Products to Customers

Since the registered representative is the first point of contact with acustomer and is the party who possesses the greatest personal knowledgeabout the situation, Rule 2330 imposes a number of specific requirementsfor ascertaining the suitability of variable annuity recommendations. Therule requires that registered representatives '…must have a reasonablebasis to believe that the customer has been informed, in general terms, ofthe material features of a deferred variable annuity…' and requires thatthe representative also make 'a reasonable effort to obtain and consider


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various types of customer-specific information…' Specific guidance fromFINRA lists these requirements as:

Age: Is the prospect's too young or too old for the annuity to be asuitable investment?Income: Can the prospect reasonably afford to purchase theproposed annuity?Financial situation and needs: What are the client's needs regardingthe preservation of principal and liquidity?Investment experience: This is particularly critical when theregistered representative is recommending investments in particularsub accounts which may entail aggressive risk portfolios. Is theclient sophisticated regarding the risk/reward concepts posed bycertain investments?Investment objectives: Here, based on the registered representative'sknowledge of the client, it is quite possible that the representativemay be required to assist the customer in defining primary andsecondary objectives. It is also at this point that an ethical registeredrepresentative will be determining whether variable annuities are theoptimum solution for a specific client.Intended uses of the variable annuity: From some of the terribleexamples mentioned earlier, it is obvious that the representativeshould ask specific questions on this subject and listen closely to theanswers before recommending variable annuities.Investment time horizon: If there is an immediate, or near-term,requirement for liquidity, the registered representative must lookclosely at the contract. If there is a surrender charge, for instance,that lasts 5-7 years, recommending a deferred variable annuity to anelderly person may not be the best choice.Tax status: Deferred annuities offer the advantage of tax-deferredgrowth. This advantage may not be useful to all investors.

Page ID: 517239

Selling New Products to Customers

FINRA's guidance for registered representatives requires the registeredrepresentative to 'have a reasonable basis to believe that the customer hasbeen informed of the material features of a deferred variable annuity.'



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Page ID: 517240

Selling New Products to Customers (cont.)

A registered representative must also, under Rule 2330, 'have a reasonablebasis to believe that the customer would benefit from certain features ofdeferred annuities.'


Page ID: 517241


Under the provisions of FINRA Rule 2330, the registered representativemust '…make a suitability determination as to the investment in thedeferred variable annuity at the time of purchase or exchange.' Thisincludes careful evaluation by the registered representative of:

Investments in the underlying subaccounts-The investmentsthemselves must be treated with the same scrutiny for suitability asany other securities recommendations for clients. Age, financialstatus, attitude, and investor sophistication are primary touchstonesto test a recommendation for its suitability to a specific client.All riders and other product enhancements-A clear, in-depthunderstanding of variable annuities and the company-specificproducts to be recommended to a customer are vital to registeredrepresentatives. As noted above, in one enforcement action byFINRA, a registered representative sold riders-at an additional cost,of course-to clients who were not eligible to use the rider because ofage.

Page ID: 517242


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Registered representatives must, under the rule, “have a reasonable basisto believe that a deferred annuity exchange transaction is suitable for theparticular customer, considering, among other factors”:

Whether the customer would incur a surrender charge or be subjectto a new surrender charge-As already noted, surrender chargescommonly last for as many as 7 years. Among the first factors that aregistered representative should consider when determining whetheran exchange should be recommended is whether an exchange willbe costly to the customer. If the exchange would incur surrendercharges, would the new annuity subject the client to yet anotherseries of years with surrender charges?Will the client lose existing benefits or be subject to increased feesor charges? -In all cases involving exchanges, the registeredrepresentative must consider the benefits already purchased by theclient. The question of increased fees-due, among other things, tonew sales charges, administrative costs, and management fees, mustbe carefully considered-with full disclosure-in close consultationwith the customer, before any exchange may ethically beconsidered.Has the client had another annuity exchange in the past 36months?-If so, the client's costs for the exchange have probably notyet been recovered. Numerous exchanges in relatively short periodsare akin to churning a client's account.

As a unique item, Rule 2330 establishes a documentation requirement forthe registered representative: 'Finally, a registered representative whorecommends the purchase or exchange of a deferred variable annuity mustdocument and sign the determinations discussed above. This signeddocument must provide reviewing principals with enough information toadequately assess whether the registered representative has complied withthe requirements of Rule 2330.' This is a requirement that does not usuallyexist for other securities sales.

Other Updates on Key Topics


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Page ID: 517244

Mutual Fund Disclosure Requirement

On January 13, 2009, the SEC adopted an improved mutual funddisclosure framework that it had originally proposed in November 2007.This improved disclosure framework is intended to provide investors withinformation that is easier to use and more readily accessible, whileretaining the comprehensive quality of the information that is availabletoday. The foundation of the improved disclosure framework is theprovision to all investors of streamlined and user-friendly information thatis key to an investment decision.

To implement the disclosure framework, the SEC adopted amendments toForm N-1A (used to register investment companies) that requires everyprospectus to include a summary section at the front of the prospectus,consisting of key information about the fund, including investmentobjectives and strategies, risks, costs, and performance.

Fund prospectuses, which have been criticized by investor advocates,representatives of the fund industry, and others as being too long andcomplicated, often prove difficult for investors to use efficiently incomparing their many choices.

Previous SEC rules required mutual fund prospectuses to contain keyinformation about investment objectives, risks, and expenses that, whileimportant to investors, was difficult for some to extract. Prospectuses areoften long, both because they contain a wealth of detailed information,which their rules require, and because prospectuses for multiple funds areoften combined in a single document. Too frequently, the language ofprospectuses is complex and legalistic, and the presentation formats makelittle use of graphic design techniques that would contribute to readability.

In November 2007, the Commission proposed an improved mutual funddisclosure framework that was intended to address the concerns that havebeen raised about mutual fund prospectuses and to make use oftechnological advances to enhance the provision of information to mutualfund investors.


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Page ID: 517245

Mutual Fund Disclosure Requirement (cont.)

This rule, effective March 31, 2009, created amendments to Form N-1Athat requires every prospectus to include a summary section at the front ofthe prospectus, consisting of key information about the fund, includinginvestment objectives and strategies, risks, costs, and performance. Thiskey information is required to be presented in plain English in astandardized order. The intent was that this information be presentedsuccinctly, in three or four pages, at the front of the prospectus.

The rule also includes an option for satisfying prospectus deliveryobligations with respect to mutual fund securities under the Securities Actof 1933. Under the option, key information is sent or given to investors inthe form of a Summary (profile) Prospectus, and the statutory prospectuswill be provided on an Internet Web site. Upon an investor's request, fundsare also required to send the statutory prospectus to the investor. Theintent behind providing this option is that funds take full advantage of theInternet's search and retrieval capabilities in order to enhance theprovision of information to mutual fund investors.

In recent years, access to the Internet has greatly expanded, andsignificant strides have been made in the speed and quality of Internetconnections. As a result, on February 11, 2009, the SEC proposed rulesthat would require mutual funds to provide the risk/return summarysection of their prospectuses, and companies to provide their financialstatements, to the Commission in interactive data format. This is just


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another example of using the power of modern technology.

Page ID: 517246

Structured Products

Structured investment vehicles (SIVs) are similar to an index-linked annuity inthat they offer capital protection with upside potential. Some structuredproducts offer full protection of the investment, while others offer limited orno protection of the investment. The greater the capital protection, the lessupside potential there is.

A SIV is a product wherein the issuer secures most of the principal investedand invests the remainder in other products. For example, an issuer has $1million principal. The manager buys a zero-coupon bond for $900,000 thatwill mature to $1 million in 5 years. The remaining $100,000 will be used topurchase whatever (other fixed-income products, equities, currencies,options, and commodities, etc.) is needed to fulfill the investment strategy. Atthe end of 5 years, the investors should receive no less than their originalinvestment which was secured with the purchase of the zero-coupon bond.


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According to the Structured Products Association, for the entire 2010 year,the US structured products market sold more than $53 billion of productsacross just over 8,000 structured notes and market-linked certificates ofdeposit. If this current pace continues until the end of 2012, sales could top$60 billion.

Page ID: 517247

Structured Products (cont.)

Notice to Members 05-59 provides guidance regarding obligations whenselling structured products.


Page ID: 517248

The Role of Brokers Versus Fiduciaries

Brokers and advisers have different obligations to their clients. Brokershave a suitability obligation, and investment advisers have a fiduciaryobligation.


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Fiduciary obligations include the duty to render disinterested and impartialadvice; to make suitable recommendations to clients in light of their needs,financial circumstances, and investment objectives; to exercise a highdegree of care to ensure that adequate and accurate representations andother information about securities are represented to clients; and to havean adequate basis in fact for its recommendations.

The SEC has said that an adviser has a duty to:

make reasonable investment recommendations independent ofoutside influences;select broker/dealers on the basis of their ability to provide the bestexecution of trades for accounts where the adviser has authority toselect the broker/dealer; andmake recommendations on the basis of a reasonable inquiry into aclient's investment objectives, financial situation, and other factors.

To fulfill its suitability obligation, a broker must make a reasonabledetermination that the investment advice provided is suitable for the clientbased on the client's financial situation and investment objectives.

Page ID: 517249

Fee-Based Versus Commission-Based Accounts


Page ID: 517250


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Suitability

Fee-based accounts are appropriate only for investors who engage in atleast a moderate level of trading activity. Accounts with a low level oftrading activity may be better off with commission-based charges. Beforeopening a fee-based account, investors should be given a disclosuredocument describing the services to be provided and the cost.

In the event that a fee-based account is suitable for a client, the firmshould conduct periodic reviews to determine whether the accountremains appropriate. In doing the reviews, firms should consider whetherassumptions upon which the member based its initial determination ofappropriateness have changed, as well as other changes in customerobjectives or financial circumstances.

Page ID: 517251

Gifts and Entertainment

Under FINRA Rule 3220, Influencing or Rewarding Employees of Others,FINRA limited spending on gifts to employees of clients to $100 perperson per year. In 2006, FINRA clarified the difference between businessentertainment and gifts. Specifically, business entertainment meansproviding entertainment to an employee in the form of any social event,hospitality event, charitable event, sporting event, entertainment event,meal, leisure activity or event of like nature or purpose, as well as anytransportation and/or lodging accompanying or related to such activity orevent, including such business entertainment offered in connection with an


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educational event or business conference, in which a person associatedwith a member accompanies and participates with such employeeirrespective of whether any business is conducted during, or is consideredattendant to, such event. Anything of value given to an employee that isnot defined as entertainment is a gift under Rule 3220.

Page ID: 517252

Common Questions About Gifts


Page ID: 517253

Business Continuation

A critical lesson learned from the events of September 11, 2001, is theneed for more rigorous business continuity planning in the financial sectorto address problems of wider geographic scope and longer duration thanthose previously addressed. Firms must create a plan for how they willrespond to events that significantly disrupt their business. Plans should be


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designed to permit firms to resume operations as quickly as possible and toprovide clients access to their funds.

This plan must, at a minimum, address the following.

Data backup and recovery (hard copy and electronic)All mission critical systemsFinancial and operational assessmentsAlternate communications between customers and the memberAlternate communications between the member and its employeesAlternate physical location of employeesCritical business constituent, bank, and counterparty impactRegulatory reportingCommunications with regulatorsHow the member will assure customers’ prompt access to theirfunds and securities in the event that the member determines that itis unable to continue its business

Each member must disclose to its customers how it plans to address thepossibility of a future significant business disruption and how it plans torespond to events of varying scope. Disclosure of the plan must be madein writing to customers at account opening, posted on the member'sWebsite, and mailed to customers upon request.

Page ID: 517254

Providing Advice to 401(k) Participants

The Pension Protection Act has a provision that allows fiduciary advisersto provide investment advice to plan participants. A fiduciary adviser isdefined by the Pension Protection Act to include banks, insurancecompanies, broker/dealers, and registered investment advisers. Theinvestment advice provided by the fiduciary adviser must be providedunder an eligible investment advice arrangement and must satisfy otherrequirements, including appropriate disclosure of the investment advice.

To qualify as an eligible investment advice arrangement, the investmentadvice must be one in which either of the following occurs.

The fees do not vary based on the investment options selected.The adviser uses a computer model that is certified and audited byan independent party.

The computer model must not be biased in favor of the investments


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offered by the adviser; must take into account all of the investmentsoffered under the plan; and must take into account the participant's age,life expectancy, risk tolerance, and other assets.

Page ID: 517255

FINRA Says Market Letters no Longer Sales Literature

Effective February 5, 2009, firms may supervise 'market letters' ascorrespondence rather than sales literature, unless the letters aredistributed to 25 or more existing retail customers within any 30-calendarday period and make a financial or investment recommendation orotherwise promote the firm's product or service. A 'market letter' isdefined as a communication that is excepted from the definition of'research report.'

NASD Rule 2210 requires a registered principal of a firm to approve, priorto first use, any item of sales literature (as a reminder, NASD Rule 2210and 2211 will become FINRA Rules 2210 and 2011 effective February 4,2013). Prior to this rule change, market letters were included in thedefinition of sales literature.

To address the concern that the pre-use approval requirements in somecircumstances may have inhibited the flow of information to traders andother investors who base their investment decisions on timely marketanalysis, FINRA has amended the definition of sales literature in NASDRule 2210 to exclude market letters that qualify as 'correspondence.'

FINRA also has correspondingly amended the definition ofcorrespondence in NASD Rule 2211 so that it now also includes marketletters distributed by a firm to one or more of its existing retail customersand fewer than 25 prospective retail customers within any


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30-calendar-day period. Remember, correspondence does not requireapproval by a registered principal prior to use, unless that correspondenceis distributed to 25 or more existing retail customers within any30-calendar-day period and makes a financial or investmentrecommendation or otherwise promotes a product or service of themember firm.

The effect of the rule change is that all FINRA member firms maydistribute, without prior approval by a registered principal, a market letterthat is sent only to existing retail customers and fewer than 25 prospectiveretail customers within a 30-calendar-day period. However, prior principalapproval is required if the market letter both:

is sent to 25 or more existing retail customers, and1.makes a financial or investment recommendation or otherwisepromotes a product or service of the firm.

2.

Page ID: 517256

Exchange-Traded Notes

Recent events involving exchange-traded notes (ETNs) have placed aspotlight on the market for these products and highlighted the importanceof understanding what ETNs are and how they work before yourecommend them. ETNs are a type of debt security that trade onexchanges and promise a return linked to a market index or otherbenchmark. ETNs can offer investors convenient and cost-effectiveexposure to everything from commodities to emerging markets, but theycan be complex and carry numerous risks, including the risk that the issuerwill default on the note or take other actions that may impact the price ofthe ETN.

ETNs are unsecured debt obligations of the issuer, typically a bank oranother financial institution. They are, however, different from traditionalbonds. For example, unlike traditional bonds, ETNs typically do not payany interest payments to investors. Instead, the issuer promises to pay theholder of the ETN an amount (referred to as a distribution) determined bythe performance of the underlying index or benchmark on the ETN’smaturity date (typically 10, 30, or in some cases, even 40 years fromissuance), minus any specified fees. In addition, unlike traditional bonds,ETNs trade on exchanges throughout the day at prices determined by themarket, similar to stocks or ETFs. Unlike ETFs, however, ETNs do notbuy or hold assets to replicate or approximate the performance of the


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underlying index.

Because of the risks you, as the registered representative, should have theanswers to the following questions:

Who is the issuer?What index or benchmark does the ETN track?Is the ETN callable by the issuer?What fees and costs are associated with the ETN?What are the tax consequences?

These questions should show that until you understand how they work andto what degree they will meet the client's objective, you should do yourhomework. However, if suitable, they may add an interesting product thatwill serve the client well.

Review Test - Not for Insurance CE Credit

1.QID: 441346The merger of the NYSE and NASD regulatory bodiesA) preempted a merger of the SEC and the Commodity Futures Trading CommissionB) was a response to the merger of the Chicago Board of Trade and Chicago Mercantile ExchangeC) brought together floor-based and electronic tradingD) combined licensing, regulatory enforcement, arbitration, and mediation functions

2.QID: 441347The benefits of FINRA includeA) increased efficiency and lower costsB) a $3,500 payment to every registered personC) electronic trading to improve executionD) decreased importance of licenses

3.QID: 441348FINRA Rule 2090, ''know your customer,'' requires every member toA) use reasonable diligence to know the essential facts concerning every customerB) have reasonable grounds for believing that the recommendation is not objectionable to thatcustomerC) believe, beyond a reasonable doubt, that the recommendation will preform as promisedD) produce, within acceptable variances based on the belief of a suitable recommendation, that thecustomer will retain any gains


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4.QID: 441349Equity-indexed annuitiesA) are suitable for all investors because of the insurance featureB) offer an insured return with some upside based on market performanceC) are futures valued on expectations for index performanceD) have to be registered with the SEC

5.QID: 441350One of FINRA's concerns about life settlements is thatA) they are not suitable for many of those involved with themB) NASAA has oversight, which cuts into FINRA's authorityC) registered representatives are preying on the terminally illD) the product is unregistered and therefore illegal

6.QID: 441351As FINRA considers firm supervision, it looks at howA) private investments disrupt trading activitiesB) mutual fund companies structure feesC) firms monitor unscripted comments at seminarsD) seminar producers bribe attendees with free lunch

7.QID: 441352The SEC's program to protect senior citizens includesA) removal of the state regulators' oversight authorityB) examination of the suitability of investment recommendations to seniorsC) requirements that firms establish Websites to educate seniorsD) prohibitions on the sale of variable annuity products

8.QID: 441353Firms may give employees of customer firms gifts as long as the total value isA) not in excess of $100 per year, excluding the value of decorative items to commemorate dealsB) not in excess of $100 per quarterC) not in excess of $100 per year, including the value of pens and trinketsD) not in excess of $100 per year, excluding expensive silver items engraved with the firm logo

9.QID: 441354An acceptable gift to commemorate a deal might beA) an engraved handcrafted pen from a luxury accessories company, which would be excluded fromthe $100 gift limitB) a Lucite tombstone, which would be included in the $100 gift limitC) a mountain bike, because the gift limit could be prorated over several years


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D) a purely decorative Lucite tombstone, which would be excluded from the $100 gift limit

10.QID: 441355A wedding present to an employee of a customer firm would beA) allowed, but a present for the birth of a new baby would not beB) exempted from the $100 limit if the recipient is a good customerC) exempted from the $100 limit if the registered representative paid for it personally and not inrelation to business receivedD) allowed under a onetime exclusion from the $100 limit

11.QID: 441356Money spent on client entertainment is permittedA) if the business was conducted during, or attendant to, the entertainmentB) as long as a person associated with a member firm accompanies the customer's employee andparticipates in the eventC) if the total amount spent on entertainment per client per year is less than $100D) if the total amount spent on entertainment and gifts per client per year is less than $100

12.QID: 441357When a client solicits a charitable donation from a registered representative or member firmA) the firm may make the donation as long as it fits the firm's policy on charitable donations, whichshould not take into consideration the actual or anticipated level of business from the person makingthe solicitationB) the firm must refuse to donate to avoid a conflict of interestC) the firm may make a donation but must count it against the $100 annual gift limitD) the firm does not need to worry about FINRA regulations as long as the charity is bona fide

13.QID: 441358A new Model Rule dealing with Certifications and Designations relating to implied expertise dealingwith the senior market was proposed byA) NASAAB) FINRAC) SECD) NYSE

14.QID: 441359Until the NYSE and NASD rulebooks are consolidated, all firms are subject to FINRA's rulebook.A) FalseB) True

15.QID: 441360According to the North American Securities Administrators Association (NASAA), what percentage


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of investor complaints received by state securities regulators are made by seniors?A) 25%B) 40%C) 55%D) 10%

16.QID: 441361Generally speaking, seniors and retirees have less tolerance for certain types of risk than otherinvestors.A) FalseB) True

17.QID: 441362Firms do NOT have an obligation to shield their customers from risks that the customers want totake.A) TrueB) False

18.QID: 441363An individual can qualify as an accredited investor with a net worth in excess of $1 million.A) TrueB) False

19.QID: 441364When determining net worth to become an accredited investor, the equity in a home is included.A) FalseB) True

20.QID: 441365Although FINRA Rule 2310 dealing with customer suitability does not specify unique requirementsfor seniors, it is generally accepted that registered representatives will give greater consideration towhich of the following when making recommendations to their senior clients?

Marital statusI.Life stageII.Retirement savingsIII.Disability insurance coverageIV.

A) II and IIIB) I and IIC) III and IVD) I and IV


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21.QID: 441366Certain products or strategies pose risks that may be unsuitable for many seniors because of theirtime horizon, liquidity, volatility, or inflation risk. Among those products or strategies are

noninvestment grade bondsI.deferred variable annuitiesII.mortgaging home equity for investment purposesIII.making early withdrawals from IRAs pursuant to Section 72(t) of the Internal Revenue CodeIV.

A) I, II, III and IVB) II and IIIC) I and IID) I, III and IV

22.QID: 441367One of the most prevalent schemes abusing seniors is one in which the individual or couple receivesan invitation to attend an educational seminar held at an upscale location. This scheme is commonlyreferred to asA) free lunchB) lunch and learnC) wealth preservation sessionD) senior seminar

23.QID: 441368A 74-year-old widower has been your client since his early 50s. He is a well-informed investor andhas always seemed capable of understanding most investment concepts presented. At least twice ayear, the two of you meet to evaluate his current financial situation and objectives. In the lastmeeting, it seemed that he was distracted and somewhat forgetful. It would be appropriate to do allof the following, EXCEPTA) inform your supervisor of your concerns about his memory lossB) ask him to invite a friend or family member to accompany him to appointments with youC) wait to see if there are further causes for concern about his capabilitiesD) take detailed notes on future conversations and meetings with him

24.QID: 441369SEC rules require that, all mutual funds must make their statutory prospectus availableA) only upon investor request if preceded by a summary prospectusB) on an Internet websiteC) prior to or concurrent with the saleD) upon approval by the SEC

25.QID: 441370Exchange-traded notes are securities that differ from traditional bonds in which of the following


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ways?A) ETNs are not callableB) ETNs are not subject to taxesC) It is necessary to know the issuer of ETNsD) ETNs pay a distribution while bonds pay interest

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Page ID: 517259

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regulatory update for retail representatives - 32002408

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