FINRA (the Financial Industry Regulatory Authority) has issued a warning to financial services firms that they need to heighten their supervision of and compliance procedures associated with complex products. Complex products include any security or investment strategy with “novel, complicated or intricate derivative-like features.” The basic rationale for heightened supervision is the fact that FINRA is concerned that retail investors may not understand the characteristics of the product or appreciate its risks.
As background, Regulatory Notice 12-03 is not the first notification that FINRA has provided to financial services firms. As early as 2003 FINRA sounded the alarm. In Notice to Members 03-07, FINRA reminded members of their obligations with respect to selling hedge funds, and in Notice to Members 03-71, they did the same with respect to selling “non-conventional” investments. Similarly in 2005, Notice to Members 05-26 recommended best practices with respect to reviewing new products. Thereafter, the securities regulator issued numerous notices related to equity-indexed annuities,
structured products, leveraged and inverse exchange-traded funds, principal protected notes, reverse convertibles, commodity futures-linked securities and Regulation D offerings.
The Securities and Exchange Commission (SEC) likewise has expressed concern about complex products, has devoted more resources to the issues presented by complex products, and, in recent years, has brought a number of enforcement cases.
Let’s examine the key points contained in Regulatory Notice 12-03, focusing first on what constitutes
complexity, broadly speaking, and, second, what constitutes effective, heightened supervision.
First, what constitutes complexity? FINRA answers that question simply by stating that, “Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex.” FINRA includes the following as some examples of complex products:
- Asset-backed securities.
- Unlisted REITs (real estate investment trusts).
- Products that include an embedded derivative component.
- Products with contingencies in gains or losses.
- Structured notes.
- Exchange-traded products and especially leveraged or inverse
exchange-traded funds (ETFs).
- Products with principal protection that is conditional or partial,
or that can be withdrawn.
Second, what constitutes heightened supervision? Preliminarily, firms must satisfy two levels of suitability. As with any investment, the first obligation is to determine that the complex product is suitable for at least some investors (known as “reasonable basis suitability”); the second is to determine that the complex product is suitable for each particular investor to whom the firm recommends the investment (known as “customer specific suitability”).
To satisfy each level of suitability, firms must conduct adequate due diligence, so that the firm at least understands “the potential risks and rewards associated with the recommended security or strategy.” Regulatory Notice 12-03 requires that a complex product be “thoroughly vetted”, through firms asking questions such as:
- For whom is the product intended, and to whom should the product
not be offered?
- What is the product’s investment objective, is that objective
reasonable in light of the product’s characteristics, and can less complex
products achieve the objectives of the product?
- What assumptions underlie the product, and how sound are they?
- How is the product expected to perform in a wide variety of market
or economic scenarios, and under what scenarios would principal protection,
enhanced yield or other presumed benefits not occur?
- What are the risks for investors, and if the product was designed
mainly to generate yield, does the yield justify the risks to the principal?
- How liquid is the product, and is there an active secondary market
for the product?
Moreover, FINRA imposes additional requirements by way of a post-approval review. That is, firms are required to “include a process to periodically reassess complex products a firm offers to determine
whether their performance and risk profile remain consistent with the manner in which the firm is selling them.” Likewise, firms should develop procedures to “monitor how the products performed after the firm approved them”, recognizing that “[e]very product presents risks that may cause the product to perform differently than anticipated, particularly when market conditions have changed.”
Finally, the regulatory notice encourages firms to adopt heightened customer account approval procedures. Specifically in recommending complex products, FINRA encourages firms to “adopt the approach mandated for options trading accounts, which requires that a registered representative havea reasonable basis for believing, at the time of making therecommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to
bear the risks of the recommended position in the complex product.” In addition, FINRA observes that some firms have imposed specific limitations, such as investment concentration limitations, or “specialized investor qualification agreements that may explain the products features and risk in plain English” with a customerattestation. FINRA reminds firms, however, that “the agreement cannot mitigate the responsibility of the firm and the registered representative to conduct a thorough, customer-specific suitability analysis.”
In conclusion, Regulatory Notice 12-03 is a game-changer! Investors, who have suffered losses, due to
unsuitable recommendations and inadequate risk disclosures related to complex products, now can rejoice that FINRA has reminded firms of their sales practice obligations.