The country’s largest independent regulator of securities firms doing business in the United States recently came to the rescue of "unsophisticated investors" who incurred thousands of dollars in losses deriving from unsuitable transactions.
USA HSBC Securities Inc. paid $320,000 to its retail customers to compensate losses on grounds of unsuitable sales and supervisory failure allegations brought on by the Financial Industry Regulatory Authority.
HSBC neither admitted nor denied the charges—yet it consented to FINRA settlement findings and restitutions $55,000 short of the initial amount. FINRA had originally fined HSBC $375,000 “for recommending unsuitable sales” of inverse floating-rate CDOs, or collateralized mortgage obligations, to its retail customers.
CMOs are fixed-income securities that pool mortgages and issue tranches featuring various risk levels. And one of the riskiest CMO tranches is the inverse floater whose adjustable interest rate moves in the opposite direction from movements of an interest rate index, such as LIBOR. And that is why FINRA said since 1993 it has been advising these CMOs would be suitable only for “sophisticated investors with a high-risk profile.”
Allegations included failure “to adequately supervise” brokers on the suitability of these sales and failure to “fully explain the risks” of such transactions.
The complexity of these tranches requires sufficient broker training on all products they sell, says FINRA executive vice president and acting chief of enforcement James S. Shorris, along with reasonable supervision “to ensure that every security recommended is suitable for the particular customer."
FINRA said six HSBC brokers made 43 unsuitable sales of inverse floaters to “unsophisticated investors and not suited for high-risk investments.”
Shorris says losses incurred by HSBC’s customers could have been avoided had the firm “sufficiently trained its brokers on the suitability and risks of inverse floating rate CMOs and reasonably supervised their brokers to ensure that they were making suitable recommendations."
For example, even though HSBC’s procedures require a supervisor’s pre-approval on sales exceeding $100,000, 25 of the 43 CMO sales were within that range and in five of these instances, customers lost money in their inverse floating rate CMO investments. HSBC has paid these customers.
FINRA found that HSBC did not provide its brokers with sufficient guidance and training regarding the risks and suitability of CMOs. In particular, the firm did not inform its registered representatives that inverse floaters were only suitable for sophisticated investors with a high-risk profile. In addition, the firm did not provide its registered representatives with information regarding the risks associated with the specific inverse floaters that were available to be sold.
FINRA also found that HSBC failed to comply with a FINRA rule, adopted in November 2003, which requires firms to offer certain educational materials before the sale of a CMO to any person, other than an institutional investor. The educational materials must include, among other things, the characteristics and risks of CMOs, in general, and the specific characteristics and risks associated with the different tranches of a CMO.
During the relevant time period, HSBC did not advise its registered persons that they were required to offer written educational material to their customers before they sold them CMOs.
FINRA alleges that although HSBC provided its brokers with a CMO brochure, the brokers did not offer the brochure to every CMO investor, nor did they know that they were required to give the materials to all potential CMO investors before selling them a CMO. Moreover, the brochures did not comply with FINRA’s content standards, failed to discuss inverse floaters and did not include a section on risks associated with purchasing CMOs.