MIAMI - The Financial Industry Regulatory Authority is monitoring broker-dealers' retail sales of municipal and corporate auction-rate securities, as well as collateralized mortgage obligations, to ensure compliance with suitability and other rules in light of the turmoil in the ARS markets, Malcolm Northam, FINRA's director of fixed-income securities regulation, said Friday.
Speaking at a Securities Industry and Financial Markets Association regional capital markets conference here, Northam said that such an examination "should not come as any surprise" in light of market conditions.
"If you're engaged in municipal or otherwise auction-rate securities, selling them to retail customers, it's fair to assume that we'll be making inquiries on what it is you did and the procedures that you have in place," he said during a panel on fixed-income regulation. "If you sold collateralized mortgage obligations or [collateralized debt obligations] retail ... it's fair to assume that we'll be taking a look at that and what you did and what the disclosures were."
Northam said broker dealers could be notified of the examinations in several ways, including through "survey letters of inquiry."
He also noted that FINRA recently increased its margin requirements for auction-rate securities and suggested that broker-dealers should no longer consider them to be the equivalent of cash or short-term securities.
FINRA raised the margin requirements to 25% from either 10% or 20%, depending on whether the securities are investment grade or lower.
In referencing the margin increases, Northam cited an example of a now-defunct firm that he did not identify that sold highly leveraged mortgage-backed securities to retail investors who did not understand the products they were purchasing, and ultimately lost all of their investment when the market nosedived last year and brokers made margin calls on the securities, which some retail investors could not fulfill.
"We've seen suitability forms ... for an elderly person who is investing $50,000 into some sort of mortgage-backed product, and the suitability form says, 'He understands CMOs,' " Northam said. "Well, maybe he does, but my guess is that he probably doesn't. And so, our inquiry is, what is the process when you are selling retail?"
Meanwhile, Northam also warned about "unsavory" practices between broker-dealers and brokers' brokers that appear to revolve around questionable relationships. Though he didn't name any specific firms while addressing the SIFMA panel, he generally referred to a recent $100,000 fine FINRA assessed against a Dallas-based broker's broker for municipal securities rule violations, including unauthorized bid changes during multiple transactions in 2002 and 2003 that kept other broker-dealers from receiving a higher sale price. He also cited two separate Securities and Exchange Commission enforcement actions against brokers' brokers.
Without referring to the specifics of those particular enforcement actions, Northam said: "Too often I think we've found that sometimes the selection of the broker's broker was made ... based upon the personal relationship and entertainment or food provided by the broker's broker That may be a perfectly accessibly way for the selection of a counterparty, [but] I'm not sure that from a compliance and a risk management perspective that's the best way."
Brokers' brokers act as agents exclusively for other broker-dealers, matching their buy and sell orders of muni bonds and typically, a selling broker-dealer will enlist the services of a broker's broker to obtain bids for municipal securities it wishes to sell.
