Finra issues notice about heightened supervision of complex products

By Angela McDaniels

Tacoma, Wash., Jan. 17 - The Financial Industry Regulatory Authority issued a regulatory notice to help firms identify whether a product is "complex" and merits heightened supervisory and compliance procedures.

Finra noted that regulators have expressed concern about complex products because their intricacy can impair the ability of registered representatives or their customers to understand how the product will perform and can lead to inappropriate recommendations and sales.

The notice provides guidance about the characteristics of many complex products, but it does not define a "complex product."

"Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex," the notice said.

"This is particularly true if 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."

Examples of complex products include the following:

• Asset-backed securities;

• Products that include an embedded derivative component such as those in which repayment of principal or payment of yield depends on a reference asset, steepener notes, reverse convertibles and knock-out notes;

• Products with contingencies in gains or losses, particularly those that depend on multiple mechanisms. Range accrual notes are an example;

• Structured notes with "worst-of" features;

• Investments tied to the performance of markets that may not be well understood by many investors, for example exchange-traded products that offer exposure to stock market volatility;

• Products with principal protection that is conditional or partial;

• 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 set daily; and

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

This list is not exhaustive. "The fundamental point for firms is that if a product has similar features of complexity [...] then firms should err on the side of applying their procedures for enhanced oversight to the product," Finra said.

Heightened supervision

Finra said firms should have formal written procedures to ensure that their representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted.

According to Finra, these questions should be answered prior to a recommendation:

• For whom is this product intended?

• Conversely, to whom should this product not be offered?

• What is the product's investment objective and is that investment objective reasonable in relation to the product's characteristics?

• What assumptions underlie the product, and how sound are they?

• What are the risks for investors? If the product was designed mainly to generate yield, does the yield justify the risks to principal?

• How will the firm and registered representatives be compensated for offering the product?

• Does the product present any novel legal, tax, market, investment or credit risks?

• Does the product's complexity impair understanding and transparency of the product?

• How does this complexity affect suitability considerations or the training requirements

associated with the product? and

• How liquid is the product?

In addition, Finra wants representatives to consider whether less complex or less costly products could achieve the same objectives for their customers.

Finra also suggested that firms periodically reassess the complex products they offer to determine whether their performance and risk profile remain consistent with the manner in which they are being sold.

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