finra

Richard G. Ketchum

Chairman and Chief Executive Officer

SIFMA Complex Products Forum

 

New York, NY
September 27, 2012

As prepared for delivery.

 

Good morning, and thank you, John [Maurello], for the introduction and invitation to join you here today.

 

I'm pleased to have this opportunity to talk to you about complex products in the retail market. Complex products have grown in importance as retail customers search for yield and firms look for innovative products to meet this demand and generate revenue. Firms and regulators have had a long and, pardon the pun, complex relationship with these products. We've been talking about the evolution and regulation of complex products for many years. While our discussions may have intensified recently in the current low-yield environment, I recall similar conversations as early as the 1970s, when I was at the SEC.

 

At the time, the options market had grown substantially. The volume of listed options trades grew from 2.6 percent of the NYSE's total share volume in 1973, to almost 75 percent five years later. As the market grew, so did the investor protection concerns. An SEC study found numerous instances of sales practices abuse: inadequate risk disclosure, poor training of reps and lack of adequate supervision. The SROs subsequently adopted new requirements for listed options that still remain in place.

 

Today, we're dealing with a wide array of new and complicated products that are being offered to retail investors. The issues that they present are similar to those we encountered nearly 40 years ago, although the rules adopted for listed options do not apply. As you know, in the United States we do not engage in "merit" regulation. Federal regulators do not deny retail investors the opportunity to invest in risky or complicated products. Instead, the federal securities laws require that issuers and intermediaries disclose the risks associated with securities products. Of course, FINRA requires that broker-dealers supervise the recommendation of securities products by their registered representatives.

 

Other countries have recently taken a different approach. Some countries have implemented a form of merit regulation, in which they prohibit certain speculative products from reaching the retail market. This approach would be a significant departure from the product disclosure model on which the federal securities laws are based. However, the possible benefits and disadvantages of a product approval model will generate debate, as retail investors seek the higher yield and lower volatility promised by some complex instruments. In the simplest terms, it's up to us collectively to get it right for investors. If the industry and regulators are unable to demonstrate their ability to control sales practice abuses relating to complex products through appropriate supervisory controls and oversight, then some forms of product approval may become inevitable.

 

The Meaning of "Complexity"

 

What do we mean by the term "complex product"? Of course, there is no legal definition. I suggest that a basic guide might be the following: A product might be considered complex if the average retail investor probably will not understand how its features will interact under different market conditions, and how that interaction may affect potential risk and return. These types of products merit heightened supervision.

 

While there are numerous products that fit these criteria, here are a few of my favorite examples:

  • Range accrual notes track multiple assets, such as a stock index and an interest rate. These notes may offer an attractive return if both reference assets behave in a certain way, but may also result in a low or zero yield if those conditions are not met.
  • Products with "worst-of" payoffs are also linked to the performance of multiple reference assets, but in this case the worst-performing asset determines investors' return.
  • Dual-directional notes promise positive returns in both bull and bear markets—subject to strict conditions that can limit an investor's upside while placing principal at risk.
  • Products with reference assets may not be well understood. For example, market volatility products can be misperceived. Instead of tracking actual price fluctuation, these products may invest in volatility index futures that reflect the market's expectation of future volatility.

As one benchmark, if you are embedding imputed derivative exposure, leverage or tracking, an asset class or index with limited liquidity combined with issuer credit exposure, don't think twice—it meets our definition of complex.

 

Supervision, From Beginning to End

 

To be blunt, if you are going to offer these types of products to retail investors, then you must supervise them at every stage. In the words of the great American philosopher, Casey Stengel: "Most ball games are lost, not won." A baseball game is more likely lost through unforced errors, poor judgment and boneheaded play. Often, the team's management will properly be held accountable.

 

A broker-dealer might desire to win market share. But business is lost, more often than it is won. As we have seen in recent years, a firm that becomes unduly aggressive about the products it sells will forfeit its reputation, its customers and, ultimately, its market share.

 

It would be foolish for any firm, including yours, to distribute complex products to retail investors without ensuring that products are vetted, reps are trained and supervised, and risks are disclosed in a way that the average investor can understand. Many complex products are distributed by broker-dealer wholesalers. In reviewing the activities of these wholesalers, FINRA is focusing on their level of understanding of complex products, how they are compensated for promoting them to retail broker-dealers, what they advertise about the products, and how they inform the distributing dealer about the complexities and risks of these products.

 

We recognize that the complexity of these products does not make them inherently unsuitable. The higher yield that they offer or principal protection that they might afford could make them suitable for some investors. However, at each step in the process selling such a product, you must consider the potential pitfalls of selling these products, and develop a way to address those potential problems.

 

Let's begin with the approval of a complex product. Suppose that your marketing team approaches you with a new type of structured note. The note incorporates embedded options that allow for some principal protection and higher return. The marketing team believes that this note could satisfy demand by your financial advisers and their customers.

 

What steps will you take to consider whether the firm should sell this note? Many firms have a committee to consider new investment products. The committee may include people with the expertise to dissect the note, to analyze the credit risk of the issuing bank and to analyze how the note will operate under different market conditions. You should consider how to ensure that the committee or group has the right range of experience to fully evaluate a wide range of products and has independent authority to reject a product or to recommend its rejection at the highest level of the firm—even when the product might provide a short-term financial benefit to the firm.

 

For many firms, the new products committee is especially focused on the question of whether this is the type of product that should be offered to retail customers. Is it the type of product with basic features that a retail investor could be expected to understand? What types of conflicts of interest does this product present to the firm? The committee or group might consider whether the product adds to the firm's current offerings, and whether the same investment strategy could be achieved more cheaply on the open market. Can the firm reasonably expect its financial advisers to understand the product, its risks, its real and imputed costs, and how it will perform under various market scenarios?

 

In a recent case, a registered rep, Richard Cody, sold asset-backed securities collateralized by installment sales contracts and installment loans for mobile homes, to retail investors with low-to-moderate risk tolerance. The ABS was issued from the eighth of 11 tranches, and thus bore the fourth-highest risk of loss from default of the underlying collateral. For this recommendation, Cody relied on the recommendation of a colleague at his firm. It does not appear that the firm itself vetted the product, and the only documentation that Cody obtained was a printout of basic information from Bloomberg. The investors lost 55 to 66 percent of their investment over 15 months.

 

In other recent cases, FINRA sanctioned four firms for selling leveraged and inverse ETFs without reasonable supervision and without having a reasonable basis for recommending the securities. We found that the firms had failed to conduct adequate due diligence regarding the risks and features of the ETFs. Reps made unsuitable recommendations to customers with conservative investment objectives or risk profiles. Some of these customers held the securities for months while the markets were volatile. These cases illustrate the harm that can occur if a firm does not properly vet the sale of complex products.

 

Assume now that your firm has vetted the structured note, and determined that it may be offered by your financial advisers to the retail market. How will you control distribution to retail customers? Some firms place various limitations on the distribution of a complex product. Distribution might be restricted to certain financial advisers, or might require some form of investor proficiency. Some firms limit the concentration of a customer's liquid net worth in a particular product. Others limit product ownership based on a client's age or investment time horizon. Firms also adopt procedures to ensure that as market conditions change, performance of the product is reviewed. Will your firm have a process to notify the financial advisers when conditions have changed to such a degree that the product presents "tail risks" to your customers?

 

A fundamental characteristic of many structured products is that it offers upside risk to an asset class that has become the "flavor of the month." It is natural that your customers want to enhance their yield by taking advantage of a hedged investment in an asset that is benefitting from present economic conditions. It is your job to make sure that customers understand the downsides of that investment. It is equally important that you respond quickly if your own firm's analyses of the likely performance of that asset turn out to be too optimistic. No firm's analysis of market movements will be infallible, but it is your responsibility to get your new forecasts quickly to your users and your customers.

 

In the Cody case, the ABS security was downgraded several times during the year following the recommendations, declining from an A rating to triple-C. Apparently, there was no discussion with the customers concerning the downgrade, nor was any action taken until the market price had dropped from $104 to $41 in 15 months. This case illustrates the problems of selling a complex product without monitoring developments after the sale. In another case, FINRA found that a broker-dealer had sold reverse convertibles to unsophisticated investors, leaving them with highly concentrated positions, in some cases greater than 90 percent.

 

Before the structured note is sold, your firm needs to ensure that the financial advisers who offer the product are properly trained and supervised. What steps will you take to ensure that this is the case? What proficiency will you require of the financial adviser or their supervisors? In Regulatory Notice 12-03, we stated that a financial adviser should be expected to develop a payoff diagram of the structured note, so as to demonstrate an understanding of how the embedded options will work. How will the firm be sure that the adviser understands the characteristics of the reference asset and the limitations of promised principal protection? Will the supervisor have the knowledge to detect any shortcomings?

 

In the leveraged and inverse ETF cases, the firms failed to establish adequate formal training, and some registered representatives did not have an adequate understanding of these ETFs before recommending them to retail customers. In the Cody case, the rep relied only on a Bloomberg printout of basic information concerning the ABS security. The rep was even unaware that the security had already been downgraded four months before the recommendations. As the Court of Appeals stated:

 

"Cody did not know that the security's credit rating had been recently downgraded, he did not know that the security was one of the riskiest tranches of securities collateralized by the same pool of assets, and by his own admission, he did not understand that securities collateralized by housing assets have fundamentally different risks than traditional bonds that are backed by the credit of a government or a corporation."

 

The need to ensure that a financial adviser is qualified to sell a complex product is one that may require reassessment. The adviser may have little proficiency concerning a recently issued product. The adviser's knowledge about existing products might grow stale. Some form of continuing education concerning the various products sold by a firm may be needed to make sure that advisers remain qualified to sell these products.

 

In addition, you need to look closely at any special incentives that your advisers are provided that may influence their recommendations or selling methods regarding a structured investment. I refer you to a terrific recent speech by Martin Wheatley announcing a FSA initiative on incentives. I can guarantee we also will be looking closely at firm incentives in this area, both from the effectiveness of your disclosure and the effectiveness of your controls. Stated simply, you should not address the misuse of incentives on an ad hoc basis. You should document your process to ensure that they don't encourage improper selling activity and, frankly, I would recommend that you take the time to clearly articulate how these incentives operate in the interests of your customers.

 

Finally, it is necessary to ensure that customers who purchase the product understand its basic features. Some firms only permit the sale of these products to customers who are qualified to trade options. The sale of complex products through discretionary accounts is a particular issue. As we have repeatedly stated, financial advisers should discuss the basic features of these products with retail customers, and include in the discussion the potential risks of those products under different market scenarios. Other additional steps might be needed to ensure that the recommendation of the structured note is consistent with the investment objectives and risk tolerance of particular customers.

 

In a case earlier this year, FINRA sanctioned a securities firm, its owner and one of its brokers for making fraudulent sales of CMOs to unsophisticated, elderly and retired investors. The respondents made fraudulent misrepresentations and omissions regarding the risks associated with the CMOs, and preyed on the fears of their elderly customers, such as the fear of losing their assets to nursing homes. Even after interest rates increased, causing the value of the CMOs to decline, the respondents did not explain the changing conditions to their customers.

 

This is but one example of the types of problems that can arise if complex products are distributed to retail investors. I recognize that some of these products can provide income and some principal protection to investors, and that they may be suitable for some of these investors. Neither FINRA nor the SEC engages in "merit" regulation of complex products. But we will do whatever is necessary to ensure that our members supervise the sale of complex products to the retail public. I hope that I have provided you with some ideas to consider before your firm decides to distribute such a product to your retail customers.