Financial Services Alert - January 31, 2012

Section 603 of the Dodd-Frank Act required the Government Accountability Office (“GAO”) to conduct a study (the “Study”) of those institutions that are exempt from the definition of “bank” under the Bank Holding Company Act (the “BHCA”).  In general, the types of institutions exempt from the definition of “bank” under Section 2 of the BHCA (even though their deposits are FDIC-insured) are industrial loan corporations, limited purpose credit card banks, limited purpose trust banks, and savings and loans (whose parent savings and loan holding companies are, after the Dodd-Frank Act, subject to supervision by the FRB).  The GAO was directed to consider, among other things, the implications of subjecting companies that control such exempt institutions to the restrictions and requirements of the BHCA. 

In the Study, the GAO concluded that removing the BHCA exemption “would likely have a limited impact on the overall credit markets.”  The GAO said that its interviews of representatives of exempt institutions and bank regulators left it unclear whether removal of the exemption would lead to improved safety and soundness or strengthened regulatory oversight.  The GAO further noted in the Study that representatives from limited purpose credit card banks and industrial loan corporations stated that the parent companies of those institutions would be likely to divest the exempt institution if the BHCA exemption were removed.

            The Study provides as an appendix comments from the Department of the Treasury (“Treasury”) on the Study.  In Treasury’s comments, Treasury states:

FINRA filed with the SEC an amendment (“Partial Amendment No. 1”) and letter in response to comments received regarding proposed FINRA Rule 5123 (Private Placements of Securities), which was filed with the SEC on October 5, 2011 (see “FINRA Proposes New Rule 5123 Governing Private Placements of Securities by Member Firms” in the October 18, 2011 Financial Services Alert).  Rule 5123 creates a separate rule for private placements other than member private offerings, which are governed by FINRA Rule 5122 (Member Private Offerings), and imposes disclosure and filing requirements similar to, but less restrictive than, those applicable to member private offerings.  Comments received on FINRA’s October 2011 filing included comments concerning the definition of “private placement” and opposing the requirement that members provide disclosure documents to each investor in a private placement.  Partial Amendment No. 1 reflects revisions made by FINRA in response to those comments.

Proposed Rule Change

The major revisions Partial Amendment No. 1 makes to Rule 5123 include the following:

• “Private Placement.”  The term “private placement” in Rule 5123 would be clarified to mean a non-public offering of securities conducted in reliance on an available exemption from registration under the Securities Act of 1933, as amended (the “Securities Act”).  The definition as amended would be consistent with the definition of “private placement” in Rule 5122.  In its response to comments, FINRA stated that the term “private placement” would not apply to securities offered pursuant to:
• Securities Act Sections 4(1), 4(3) and 4(4) (which generally exempt secondary transactions);
• Securities Act Sections 3(a)(2) (offerings by banks), 3(a)(9) (exchange transactions with an existing holder, where no one is paid to solicit the exchange), 3(a)(10) (securities subject to a fairness hearing), or 3(a)(12) (securities issued by a bank or bank holding company pursuant to reorganization or similar transactions); or
• Section 1145 of the Bankruptcy Code (securities issued in a court-approved reorganization plan that are not otherwise entitled to the exemption from registration afforded by Securities Act Section 3(a)(10)).
• Disclosure.  Rule 5123’s disclosure requirements would apply only to private placements in which a disclosure document drafted by or on behalf of the issuer is used.
• Filing.  The requirement that every participating member file the disclosure document would be replaced by a requirement that a disclosure document be filed by either the participating member or by a member designated to make the filing on behalf of members identified in the filing.
• Notice Filing.  In private placements in which no disclosure document is used, the member making the filing would make a notice filing identifying the private placement and that no disclosure document was used.
• Exemptions.  Partial Amendment No. 1 would add or clarify the following exemptions from the Rule 5123:
• sales to knowledgeable employees (as defined in Investment Company Act Rule 3c-5);
• sales to eligible contract participants (as defined in Section 3(a)(65) of the Securities Exchange Act of 1933, as amended);
• sales to accredited investors described in Securities Act Rule 501(a)(1), (2), (3) or (7) (these are categories of entities, not individuals);
• sales of short-term debt securities offered by members pursuant to Section (4)(2) of the Securities Act so long as the maturity does not exceed 397 days and the securities are issued in minimum denominations of $150,000 (or the equivalent thereof in another currency);
• business combination transactions as defined in Securities Act Rule 165(f);
• offerings of registered investment companies;
• standardized options (as defined in Securities Act Rule 238); and
• offerings exempt, in accordance with Rule 5110(b)(7), from filing with FINRA under Rules 2310, 5110, 5121 and 5122 (added to the exemption for offerings filed under one of these rules).

Request for Comments

Due to issues raised by FINRA’s proposed rule change, the SEC has determined to institute proceedings pursuant to Section 19(b)(2) of the Exchange Act to determine whether to approve or disapprove the proposed rule change.  The SEC has requested that comments on the proposed rule, as modified by Partial Amendment No. 1, including comments regarding whether the proposed rule change should be approved or disapproved, be submitted to the SEC by February 27, 2012.  Rebuttal comments by any person, with respect to the comments of any other person, should be submitted by March 12, 2012.

FINRA has published Regulatory Notice 12-03 (the “Notice”) providing guidance to its member broker-dealers about the supervision of complex products, which may contain features that make it difficult for a retail investor to understand the essential characteristics of the product and its risks.  The Notice does not provide a definition of complex products; however, it identifies characteristics that may render a product “complex” for purposes of determining whether the product should be subject to heightened supervisory and compliance procedures and provides examples of heightened procedures that may be appropriate.  Such complex products may include a security or investment strategy with novel, complicated or intricate derivative-like features, such as structured notes, inverse or leveraged exchange-traded funds, hedge funds and securitized products, such as asset-backed securities (collectively, “Complex Products”).

Prior Guidance on Complex Products 

FINRA has previously issued several notices that remind member firms of their obligation to assess the potential risks associated with products that raise specific investor protection concerns.  In recent years FINRA has issued notices discussing the risks associated with certain complex product and advising members to adopt procedures for vetting products and supervising the sale and marketing of Complex Products to retail investors (collectively, the “Prior Notices”), including Notice to Members 03-07 (hedge funds), Notice to Members 03‑71 (non-conventional investments), Notice to Members 05-26 (recommending best practices for reviewing new products), Notice to Members 05-50 (unregistered equity-indexed annuities), Notice to Members 05-59 (structured products), Regulatory Notice 09‑31 (leveraged and inverse exchange traded funds), Regulatory Notice 09-73 (principal protected notes), Regulatory Notice 10-09 (reverse convertibles), and Regulatory Notice 10‑51 (commodity futures-linked securities). 

Characteristics of Complex Products 

The Notice states that any product with multiple features that affect its investment returns differently under various scenarios is potentially a Complex Product, and that this is particularly true in circumstances where it would be unreasonable to expect an average retail investor to discern the existence of these features and to understand the basic manner in which these features interact to produce an investment return.

Some examples of Complex Products identified in the Notice are:

Asset Backed Securities.  Securities that are secured by a pool of collateral such as mortgages, payments from consumer credit cards or future royalty payments on popular music may contain risks related to the creditworthiness of the underlying borrowers, prepayment, liquidity or valuation that may not be readily apparent to retail investors.

Embedded Derivatives.  Products that include an embedded derivative component may be difficult to understand, such as those:

• in which repayment of principal or payment of yield depends upon a reference asset, when information about the performance of the reference asset is not readily available to investors (for example, structured notes with an embedded derivative for which the reference asset is a constant maturity swap rate);
• that provide for different stated returns throughout the lifetime of the product;
• under which a capital loss might be incurred as a result of a fall in the value of the reference asset although the investor is unable, or becomes unable, to participate in an increase in its value; and
• in which a change in the performance of the reference asset can have a disproportionate impact on the repayment of capital or on the payment of return.

Contingent Gains or Losses.  Products with contingencies in gains or losses, particularly those that depend upon multiple mechanisms, such as the simultaneous occurrence of several conditions across different asset classes.

Certain Structured Notes.  Structured notes with “worst-of” features, which provide payoffs that depend upon the worst performing reference index in a pre-specified group.

Complex Markets.  Investments tied to the performance of markets that may not be well understood by many investors, such as exchange-traded products that offer retail investors exposure to stock market volatility in the form of futures on the CBOE Volatility Index (VIX) that reflect the market’s expectation of volatility.

Principal Protection.  Products with principal protection that is conditional or partial, or that can be withdrawn by the product sponsor upon the occurrence of certain events.

Unexpected Performance.  Product structures that can lead to performance that is significantly different from what an investor may expect, such as products with leveraged returns that are reset daily.

Complicated Formulas.  Products with complicated limits or formulas for the calculation of investor gains.

In providing these examples, the Notice states that the general characteristics of these Complex Products should assist member firms in establishing policies and procedures to identify products that are sufficiently complex to warrant enhanced oversight; and noted that many products that do not possess the same characteristics may also require heightened compliance and supervisory procedures due to the risks they present.  Moreover, the Notice states that if a product has similar features of complexity, member firms should err on the side of applying their procedures for enhanced oversight to the product.

Heightened Supervision

The Notice states that Complex Products should only be recommended after the member firm has performed heightened supervisory and compliance procedures, to address the various investor protection concerns raised by the recommendation of a Complex Product to a retail investor.  The Notice also suggests that member firms should rigorously monitor the sale of Complex Products in a manner that is reasonably designed to ensure that each product is recommended only to customers who understand the essential features of the product and for whom the product is suitable.  The Notice provides examples of, and a discussion of the basis for, certain heightened supervisory procedures that may be appropriate for a member firm to institute in connection with Complex Products.

Approval of Sale of Complex Products.  Under NASD Rule 2310 (the “Suitability Rule”), member firms must make a reasonable basis suitability determination to understand the nature of the transaction or investment strategy, as well as the potential risks and rewards before a transaction or investment strategy involving a security is recommended.  The Notice states that member firms should have formal written procedures designed to ensure that Complex Products are not recommended to a retail investor before such due diligence is conducted and appropriate questions have been asked.  The Notice provides examples of questions that should be asked, including: the type of investor for whom the product is intended; whether the assumptions underlying the product are sound; whether the yield on the product justifies the risks; and how the member firm and its registered representatives will be compensated and whether that compensation will present conflicts of interest with the investor.

Post-Approval Review.  The Notice states that heightened supervisory procedures should include a process for periodic reassessments of Complex Products to determine whether the Complex Product’s performance and risk is consistent with the manner in which it is being sold.

Training of Registered Representatives.  Registered representatives that sell Complex Products must understand the risks associated with those products and should be adequately trained to understand not only the manner in which a Complex Product is expected to perform in normal market conditions, but the risks associated with the product.

Consideration of a Customer’s Financial Sophistication.   The customer-specific element of the Suitability Rule requires a member firm to consider, among other things, a customer’s “investment experience” and “risk tolerance” when recommending a securities transaction or investment strategy.  In recommending Complex Products, the Notice encourages member firms to adopt the approach mandated for options trading accounts, which requires “a reasonable basis for believing, at the time of making the recommendation, 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, or other comparable procedures.

Discussion with the Customer.   The Notice states that before a Complex Product is recommended to a retail investor, the member firm should discuss the features of the product, how it is expected to perform under different market conditions, the risks and the possible benefits, and the costs of the product.

Consideration of Whether Less Complex or Costly Products Could Achieve the Same Objectives for the Customer.  Member firms and their representatives should consider whether less complex or costly products could achieve the same objectives.