In May 2015, Amy Starr, the Chief of the SEC’s Office of Capital Markets Trends, spoke before an industry conference.7 She addressed a variety of issues that are of interest to market participants, which we summarize in this article.8

Estimated Initial Value

Ms. Starr reviewed the 2012-2013 process that led to the SEC’s guidance on the disclosure of estimated values for structured notes. She expressed satisfaction that issuers have been providing the required disclosures, and that other non-U.S. regulators have taken a similar position as to these disclosures.

Disclosures Regarding Underlying Assets

Ms. Starr encouraged the market to focus on disclosure requirements for linked assets, such as securities and indices. She reminded the audience about the disclosure obligations set forth in the so-called “Morgan Stanley” or “reading room” letter.9

Issuer Concentration. Ms. Starr discussed the issue of concentration of a particular issuer or security in an index or basket. The concentration impacts the degree of exposure that the particular structured product has to the relevant structure issuer or component security. Ms. Starr indicated that the SEC would request relevant disclosures along the lines of the Morgan Stanley letter where there are concentrated exposures of 20% or more to particular issuers or their securities.10 This position would remove a degree of uncertainty, as well as inconsistent market practices as to a variety of indices, particularly ones that track non-U.S. markets, and that have a significant concentration of a particular issuer that is not a U.S. public company.

Post-Issuance Information Relating to Underlying Assets. Ms. Starr noted that structured note offering documents included historical and current information relating to the relevant reference assets. However, she asked whether issuers or others were making this type of information available to investors post-issuance in order to enable investors to evaluate their investment, and whether investors know where they can obtain this information.

Exchange Traded Notes

Ms. Starr referenced the SEC’s 2014 “sweep letter” relating to ETNs, in particular the focus on providing “intraday indicative values as to a third-party index,” and ensuring that the relevant disclosures were adjusted to help investors understand what relevance these figures have to the value of their ETNs. She also noted that the SEC Staff has observed improvements in the disclosures for those ETNs that use a VWAP calculation of the index components for their notes, as opposed to an end of day index value.

Proprietary Indices

Ms. Starr noted the growth in the use of these indices, and raised a number of questions relating to proprietary indices as well that should be considered by market participants:

  • Is the disclosure of the key features of the index, including embedded fees and costs, understandable to retail investors?
  • Do the brokers and advisors selling these products understand the nature of the products, and their risks?
  • Are broker-dealer policies relating to sales and supervision being properly implemented to ensure that these products are being properly sold?

Know Your Distributor

Ms. Starr raised a variety of concerns about the use of third-party distributors:11

  • If third-party distributors are being used, do the product manufacturers know how the products are being sold?
  • Do these distributors provide any incentives to their sales force that raise concerns about the potential for unsuitable recommendations?
  • Are distributors considering the financial sophistication of the customer when selling complex structured products?
  • Are distributors considering any limitations on the type of investors to whom these notes may be sold, or employing investment concentration limitations?

Product Development and Suitability

While the SEC principally regulates prospectus disclosures, Ms. Starr encouraged product manufacturers to consider a variety of related questions in connection with new product development:

  • Does the new product “make sense” for retail investors?
  • Can the new product be readily explained to investors who are not sophisticated?
  • Should the new product be made eligible for sale for retail investors in the first place?
  • In designing new products, are product manufacturers considering the relevant economic studies as to the value of these instruments, some of which may suggest that they are being mis-priced?
  • Are other products potentially available that involve lower costs, or that are more transparent?

Non-Registered Offerings

Ms. Starr also focused on structured products that are sold in a “wrapper” other than registered notes, such as “bank notes” and certificates of deposit. She indicated her concern that these products may be similar to those for registered offerings, but may be providing less disclosure, both about the product, and the relevant issuer and its finances.

Conclusion

Ms. Starr reminded the audience that both the Office of Capital Markets Trends and the SEC Enforcement Division are paying careful attention to these products, complaints about them, and possible securities law violations. We expect this regulatory attention to continue.