Finra launches exam sweep of business development companies

One area the regulator is focusing on is brokers who have selling agreements with each BDC

Aug 4, 2016 @ 1:46 pm

By Mark Schoeff Jr.

Finra has launched an examination sweep of nontraded business development companies, the latest alternative investment product to receive increased scrutiny from the broker-dealer regulator.

In an exam letter posted on its website Thursday, the Financial Industry Regulatory Authority Inc. said it is requesting a list of BDCs offered by Finra members as well as a list of the brokers who have selling agreements with each BDC. 

The organization also is seeking a copy of the firms' due diligence procedures for evaluating the BDC and participating brokers.

The information request covers the period from Jan. 1, 2015, through June 30, 2016, and is due by Sept. 9. Finra has not yet determined how many firms will be included in the sweep, according to spokeswoman Michelle Ong.

A BDC, similar to a closed-end fund, invests in emerging small- and medium-size companies. The product can provide investors with a way to increase returns, but it also can be risky and expensive.

The ascetic Finra exam letter didn't elaborate on the reason for the BDC probe.

But Ms. Ong explained that the regulator is targeting the increasingly popular BDCs to assess how they're marketed and sold.

“Given the complexity and high-risk nature of this product, there is concern that retail customers may not fully understand the risks and the potential impact on their portfolios,” Ms. Ong said in a statement.

Previously, the regulator has expressed concern about suitability and supervision related to nontraded real estate investment trusts, leveraged exchange-traded funds, structured products and mortgage-backed securities.

Finra has noticed that “many of the firms that distributed nontraded REITs are now turning to nontraded BDCs,” Ms. Ong said.

The BDCs “have emerged as the flavor of the month,” said Daniel Nathan, a partner at law firm Morvillo. “Each year, we're seeing another alternative product show cracks around the edges.”

In its annual examination priorities list, Finra cited “high commissions and fees, illiquidity risks and uncertainty regarding the time period BDCs will hold funds before they are invested” as concerns related to them.

But the products were only mentioned briefly in the document. The exam sweep is an indication that Finra is digging in more deeply.

“They're expanding their interests,” said Mr. Nathan, a former Finra vice president and director of regional enforcement. “It feels like a mid-year course alteration.”

Firms that promote BDCs tout them both as a vehicle for raising capital for small companies that will create jobs and as a way to diversify portfolios.

Franklin Square, an alternative asset manager, is one of the leading proponents of BDCs. Spokesman Marc Yaklofsky said the firm never comments on information requests from regulators.

BDCs have been the subject of Finra enforcement this year. In addition, a Wall Street Journal analysis in March showed that investors have been pulling money out of the vehicles as their value has declined.

Finra is paying particular attention to the point at which retail investors can become involved with BDCs by assessing the brokers who sell them.

“That's where the rubber meets the road,” Mr. Nathan said. “They're the ones that have direct contact with the purchaser.”


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