Alert January 31, 2012

FINRA Issues Guidance on Heightened Supervision of Complex Products

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.