Finra's notice on complex products causes perplexity, sources say

By Emma Trincal

New York, Feb. 21 - A recent notice on "complex products" from the Financial Industry Regulatory Authority has left market participants in U.S. structured products "confused," some sources said.

"In our industry, we need all the help that we can get. It's really not helping when Finra comes out with a notice requiring our industry to do things that are not clear to us, leaving everyone pretty confused," a New York structurer said.

"It may not impact issuance volume yet, but the uncertainty is not good for business, especially in this very difficult market."

Finra issued Notice 12-03 in January in an effort to provide guidance to firms about the supervision of complex products. The initiative was a result of concerns expressed by regulators over the idea that registered representatives may not always understand themselves what they sold to their customers.

Finra said in the notice that the products may include securities or investment strategies 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.

Vague definition

Part of the challenge sources said the notice has created for the market is that the nine-page document fails to fully explain what a complex product really is.

"Don't get me wrong," the structurer said. "We think disclosure is important. We think that you have to educate and explain more what the product is. We're already doing a good job at it.

"But asking the industry to judge what's complex, what's not? That's a little bit of a stretch."

Finra said in its notice that "any product with multiple features that affect its investment returns differently under various scenarios is potentially complex."

"The level of vagueness from Finra leads to the level of paranoia on the Street," a market participant said.

"It's the kind of thing where people call each other and ask 'Jeez, do you think it's complex?' If I need to call three people in the industry to find out what you guys think, it creates a difficult climate to operate."

Anna Pinedo, partner at New York law firm Morrison & Foerster, said that while the notice "gives examples" of complex products, "it doesn't provide a definition."

"Market participants are a little perplexed. They are wondering whether the notice signals a new direction or if it's just the compilation of previously issued guidance," she said.

Even when understood, the notion of "complexity" remains too broad for some.

"Their definition of complexity is interesting. To me, a point-to-point CD tied to an index is not all that complex, and it probably falls into the definition of complex security. A range accrual note would be, yes," the market participant said.

"It's too vague and too broad. By drafting their notice the way they drafted it, a simple callable bond would be a complex product as you have interest rate derivatives embedded into it," the structurer said.

Business consequences

The structurer said that the notice left a lot of questions unanswered for a lot of people.

"Even lawyers don't have the answers. It's putting the compliance departments of banks or broker-dealers in a very difficult position. They're being asked by management or by their sales operations to explain the notice and they have no idea. I have no idea," he said.

"The confusion is pretty widespread within law firms and investment banks.

"But the biggest impact is at the compliance department level of distributors. I sympathize with them. They ask questions to lawyers: What does that mean? But the lawyers don't know. Nobody knows.

"To protect themselves, compliance officers may take the safest route, which may just be 'You know what? Let's not do this!'

"And that's why it may have a negative impact going forward. Everybody shares this concern in the market."

The market participant said that Finra's ultimate goal was to send a warning to the sales force.

"There is certainly a lack of clarity on the part of Finra. I think it's intentionally vague. It's probably in their best interest not to be too specific because all of this comes down to sales practices, and the notice is designed to keep brokers on their toes," this market participant said.

"But meanwhile, the confusion is such that I have broker-dealers calling me about plain vanilla bonds and asking me if it's complex. Everybody is very confused."

Pinedo was skeptical about the potential negative impact of the notice on sales.

"I don't think it rises to that level. I don't think this is why the market is sluggish. There are many, many other factors, like Europe," she said. "I wouldn't blame the slow issuance volume on this."

Heightened supervision

The notice, Pinedo said, was straightforward in its supervisory and compliance procedure recommendations.

"Clearly, once a product is identified as complex, you need to take additional steps," she said.

"You have to provide additional training for registered persons selling complex products.

"You have to put in place additional suitability procedures or processes to make sure that investors purchasing complex products truly understand the products.

"And you must make sure you have some post-sale process to see how the product performs and how it's trading in the secondary market.

"Generally, the notice is consistent with prior guidance."

Comparing costs

One specific part of the notice related to costs was seen as particularly challenging.

The structurer pointed to a paragraph called "consideration of whether less complex or costly products could achieve the same objectives for the customer."

"They expect a registered rep to compare a structured product with an equivalent product and determine whether it's cheaper to use the structured product," he said.

"When you compare a structured product with the package of embedded options, even the most seasoned structurer would be hard pressed to say which one is cheaper.

"After 20 years of practice, I cannot definitely tell you with certainty that the options package is cheaper. Do they expect the rep to know that?"

Pinedo said that she spoke with representatives of Finra about the cost comparison part of the notice and asked them for clarification.

"It seems like Finra is not looking for banks to deconstruct a structured product and price out the option-like feature and the zero-coupon bond feature. It seems like Finra is asking the banks to look at similar structured products. For instance, you would compare the cost of an equity-linked note with another equity-linked note, both having a similar underlying and return profile," she said.

But the structurer said that he remained perplexed.

"They talk about similar products rather than identical products. It's still unclear to me. How do they define similar? Nobody knows what they mean. It's a real source of confusion in the market," he said.

A Finra representative declined to comment.

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