In recent years, the Financial Industry Regulatory Authority, Inc. has been scrutinizing its member broker-dealers' sales, recommendations and procedures relating to investments in unit investment trusts (UITs). Its 2017 Regulatory and Examination Priorities Letter reaffirmed its committment to doing so. Because of the ongoing focus on UIT transactions, Finra-registered firms and brokers must be aware of the potential liability that could arise from inadequate supervision and the failure to give clients the appropriate UIT-related discount.
But first, a quick refresher on these instruments. UITs are registered investment companies that offer redeemable units of a portfolio of securities with specified termination dates. Typically, a UIT is organized by investment banks or broker-dealers who sponsor and create its portfolio. The portfolios are generally fixed: UITs employ a buy-and-hold strategy and are not actively managed. Units of UITs, which represent undivided interests in the portfolio, are first issued at an initial public offering. Though they are designed to be bought and retained until termination, investors can redeem the units at any time for a proportionate share of the UIT's net asset value (NAV). Often, the sponsor will maintain a secondary market to facilitate the buying and selling of units without causing depletion of the UIT's NAV.
The key distinctive feature of UITs is their predetermined termination dates. UIT sponsors typically offer a series of UITs, in which the offering period of a new UIT begins with the termination of a prior one. At the end of a UIT's fixed term, investors typically are given the option of rolling their money into a new UIT.
UIT sponsors generally offer price break discounts, which are sales charge discounts that increase depending on the dollar amount of a purchase. Similarly, sponsors often offer discounts to incentivize investors to roll money from a terminating UIT into a new one.
In the past, Finra has focused on the proper application of these discounts. In its March 2004 Regulatory Notice, for example, the authority reminded member broker-dealers of their duty to maintain procedures to ensure that investors receive the correct discounts.
Failure to do so could be a violation of Finra Rule 2010, relating to members' obligations to "observe high standards of commercial honor and just and equitable principles of trade," or Rule 3110, relating to proper supervision and establishing written procedures. In October 2015, Finra ordered twelve firms to pay restitution totaling over $4 million and fines totaling over $2.6 million for failing to apply appropriate sales charge discounts, failing to properly supervise investment advisors, and failing to establish adequate written procedures. The individual liabilities ranged from roughly $135,000 to over $1 million.
Finra has also focused on members' recommending early rollovers to increase their sales credits. Early rollovers of UIT investments, which are designed for longer terms, may increase investor costs and cause losses. Finra has suspended investment advisers who recommend early rollovers that hurt investors from association with member broker-dealers. In October 2016, one firm entered into a settlement to pay over $1 million in restitution and fines without admitting or denying the allegations that it, among other things, recommended unsuitable short-term UIT rollovers.
In September 2016, Finra conducted an inquiry into UIT rollover practices from January 1, 2014, through June 30, 3016, at select firms. The targeted exam letter sent by Finra requested firms' written supervisory procedures with respect to UITs, a list and description of exception reports, a list of the top twenty-five registered representatives who generated the highest early rollover revenue and had the highest number of early rollovers, and other information relating to transaction blotters and customer lists. Finra defined "early rollover" as one that occurs 100 or more days before the UIT's termination.
As stated in this year's Regulatory and Examination Priorities Letter, Finra will continue to focus on members' application of price break discounts, rollover recommendations, and supervision of UIT transactions. In light of this declared aim, it is important for Finra-registered brokers and firms that sell UITs to review their written procedures to ensure that customers receive applicable discounts for new purchases, as well as for rollovers. Firms may also consider looking into whether their representatives recommend early rollovers and confirm that such recommendation is made only to the appropriate clients.
Perrie Michael Weiner and Kirby Hsu are attorneys at law firm DLA Piper.