Securities Law & Corporate Counsel Blog

Many opine the financial crisis was hastened by the financial industry’s use of byzantine and risky securities. FINRA recently released more specific guidance concerning supervision by broker dealers over the sale of complex products:  Regulatory Notice 12-03, Complex Products: Heightened Supervision of Complex Products.The Notice provides helpful guidance for determining whether products require heightened supervision, as well as specific supervisory and compliance procedures firms should have in place. Characteristics of Complex Products FINRA notes that “any product with multiple features that affect its investment returns differently under various scenarios is potentially complex” and provides a non-exclusive list of characteristics to consider, including:

• Asset-backed securities secured by a pool of collateral (i.e. mortgages or consumer credit card payments) whose risks are not readily apparent;
• Any product with an embedded derivate component that is difficult to understand (i.e. structured notes with an embedded derivative); and
• Investments tied to the performance of markets not readily understood (i.e. an exchange traded product with exposure to futures on the CBOE Volatility Index).

If there is any question firms are cautioned to “err on side of applying their procedures for enhanced oversight to the product.” Best Practices for Heightened Supervision Broker-dealers and their registered representatives (RRs) must perform a reasonable basis suitability determination before recommending complex securities, which provides "an understanding of the potential risks and rewards associated with the recommended security or strategy.” Further, firms should have formal written procedures to ensure that reps do not recommend a complex product before it has been thoroughly vetted.Broker-dealers also should ensure that their RRs are adequately knowledgeable about the complex products they offer. Ideally the RR “should be competent to develop a payoff diagram of a structured product to facilitate his or her analysis of its embedded features and recognize that such a product typically can be decomposed into bond and derivative parts.” The RR must also be fully knowledgeable on the risks associated with each part of the complex product. Importantly, “[r]egistered representatives should consider whether less complex or costly products could achieve the same objectives for their customers” as the contemplated complex product.For additional information on FINRA Regulatory Notice 12-03, please contact us at (619)298-2880.