San Leandro, CA

Sunday, June 28, 2009

FINRA is changing its suitability rules and requested commentary:

June 27, 2009

Marcia E. Asquith

Office of the Corporate Secretary FINRA 1735 K Street, NW Washington, DC 20006-1506

RE: Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations

I have the unique background of teaching almost all the securities licensing courses in the past (4, 6, 7, 86, 22, 24, 27, 63, etc) as well as acting as an securities arbitrator, expert witness and more. A resume is attached for validation. Beyond that I am almost assuredly the only one who replies who definitively defines suitability on a real world application, not just with words.

I have also approached the NASD/FINRA for over 15 years in regards to investor protection via broker knowledge. Without such fundamental training, suitability cannot be determined.

I note that the material states, "NASD Rule 2310, addressing suitability obligations, and Incorporated NYSE Rule 405,4 addressing know-your-customer obligations, are critical to protecting investors."

While an acceptable plaudit, it has no meaning. None of the brokers via a series 7 (the most common broker license) have ever been taught the fundamentals of investing. I have independently taught that such fundamentals include alpha, beta, standard deviation, diversification (by the numbers), correlation, risk of loss and more. I estimate that over 85% of RIAs are equally dumbstruck by even the most rudimentary elements of risk and reward. In such regard, how is one to "know thy customer???" The agent can get all types of info from a naive and unsophisticated investor and then what?- protect them from what? Unknowledgeable competitor advisers? Well, you won't have anyone left.

FINRA also seeks comment on whether it should propose expanding suitability obligations to all recommendations of investment products, services and strategies made in connection with a firm's business, regardless of whether the recommendations involve securities.

That goes without saying. Effectively all the investment plans, retirement analyses and certainly any variable life and annuity illustrations I have seen to date, regardless of the size of the B/D, are deceptive at best and fraudulent at worst. The prime example involves the use of the term and numbers of standard deviation that is used to supposedly indicate something reflective of what risk is (wrong). Almost all the computerized plans are incorrect and deceptive. AIGs index life policy is backtested to use a 17.53% annualized return each year for the next 50 years. FINRA will now demand that indexed products be suitable? And no broker is trained on the use of a financial calculator? Well this will be interesting.

As far as I am concerned, such activity, which invariably includes any type of retirement income plan, budgeting and so on, has always fallen under the purview of suitability since the selection for the investments to be used requires scrutiny of not only how it works for the intended purpose, but whether they will work at all. So why not expand the suitability limits? It will make my job easier overall in showing the limited to nil competence of the brokerage community. But you need to realize that it will further denigrate the status of FINRA for refusing to instruct licensees on the fundamentals.

Information Gathering Regarding the Proposed Suitability Rule

Proposed FINRA Rule 2111 contains a number of minor changes regarding the gathering and use of information as part of the suitability analysis. For instance, the information that must be analyzed in determining whether a recommendation is suitable would include not only information disclosed by the customer in response to the member firm's or associated person's reasonable efforts to obtain it, but also information about the customer that is "known by the member or associated person." The proposal also requires members or associated persons to make reasonable efforts to obtain more information than is explicitly required by NASD Rule 2310 (e.g., age, investment experience, investment time horizon, liquidity needs and risk tolerance).

The words are nice but investment experience is a wasted request when put into the real world. As stated to Shapiro years ago, consumers may have bought various investments over the years but generally without any true insight to what was going on or what they should have done. I repeat the fact that there is literally no consumer who knows what diversification is by the numbers. If you cannot determine diversification you cannot determine risk. If you cannot determine risk, you cannot even remotely identify suitability. Of course I took liberty with the comments about the knowledge of diversification by consumers but not by more than 0.0005%. That said, the understanding to risk is nil.

Investment experience CANNOT be used as a guide to what they should have done over the same period. To have uneducated brokers use this as a rationale or crutch is a breach of duty.

It is within this same commentary that 'risk tolerance' is a joke. I have NEVER seen any type of investment plan that has defined risk properly. A recent major B/D firm- as with effectively all others- has no clue to risk tolerance and to suggest that they can use they can transfer the risk tolerance to an individual who cannot properly spell it is ludicrous.

Further: Whether the firm or associated person has a reasonable basis to believe that the institutional customer is capable of analyzing the risks of investments independently, both in general and with regard to particular transactions and investment strategies involving a security or securities;

And how do you propose to determine such capability?

Because the "FINRA Institute at Wharton provides an understanding of the foundation, theory and practical application of securities laws and regulation. Participants learn from Wharton faculty, senior regulators and industry practitioners, and earn the distinct designation of Certified Regulatory and Compliance Professional (CRCP) upon successful completion of the program"?

And the point is what? There is no practical application of use of product. There is nothing on a financial calculator. After all, you would have all know about the fraud of a 17.53% projection and would have curtailed it, right??

No matter, Professors Herring and Diebold of Wharton noted this recently when asked if risk can be measured accurately: Dick Herring: "I think the last year shows that we can't, that there are lots of things we can't quantify very successfully and that we became overconfident in the things we could quantify. We've made great strides in risk analysis, risk measurement, and aggregating risk. But we've tended to focus most of those efforts on things that are relatively easy to manage. And even some of those relations broke down. We simply didn't have enough data. Our techniques were not good enough. We weren't using enough forward information and, unfortunately, this crisis has blame that can be shared across the entire spectrum of participants, from regulators to participants in securitizations and even to risk managers themselves.

Francis Diebold: I think that's right. That reminds me of our project on the known, the unknown, and the unknowable that we've done here at Wharton at the Financial Institutions Center in conjunction with the Sloan Foundation. What we focused on and really came to realize more intensely was that there's a whole spectrum of risks ranging from market risk to credit risk to operational risk to legal and reputational risk and things beyond that. Some are comparatively easy to model, which isn't to say they are easy, but they're comparatively easy. Others are really challenging and basically we're not good at at all."

But the fundamentals of risk analysis can be taught. However not to brokers since one needs a financial calculator. Such capability has never been required for licensees.

Supposedly, 'The proposed FINRA know-your-customer obligation, proposed FINRA Rule 2090, captures the main ethical standard of NYSE Rule 405(1). Firms would be required to use due diligence, in regard to the opening and maintenance of every account, to know the essential facts concerning every customer (including the customer's financial profile and investment objectives or policy'.

I will agree that the words are acceptable. But the whole emphasis on know the customer is a fraud due to the continuation of a severely bankrupt knowledge base to any licensee from the time I started instruction in the 1980s to now. The position taken in the mid 90s by NASD that increased knowledge would slow sales and would never be allowed remains. Shapiro's statements that FINRA is a procedural entity and not a substantive one (2004) continues to reflect the dearth of ethical responsibility to consumers. Brokers do not even know what diversification is.

Finra has provided nice words. The theory is valid. But it cannot back them up with any industry elements since it refuses to even expose licensees to any of the fundamentals of investing. Add any credentials from Wharton or Harvard or whatever. Compliance over entities that are effectively clueless to the proper use of product is absurd. Unless and until the necessary knowledge is mandated, changes in a rule like this per se will provide little, if any, benefits to the consumer.

Why bother??

Errold Moody

Errold F. Moody, Jr.

PhD LLB MBA MSFP BSCE CFP

Life and Disability Insurance Analyst

San Leandro, CA

510-352-4127