On October 13, 2015, the SEC announced a settlement with an issuer related to alleged material misstatements and omissions in the issuer's offering documents for certain registered structured notes.1 The structured notes were sold to "retail investors" (it is not clear from the publicly available information whether these were high net worth investors) and linked to a proprietary index that tracked G10 currency foreign exchange forward rates.

According to the settlement documents, the index was described as being a “transparent” and “systematic” trading strategy, and the index was calculated using “market prices.” The SEC’s order focused on undisclosed hedging activities by the issuer that negatively affected, or had the potential to affect negatively, the level of the index. The order alleges that the hedging activities distorted the pricing inputs used by the index.2 These activities allegedly included the addition of markups to hedging transactions, which led to index pricing inputs that were inconsistent with market prices, and the addition of spreads to internal hedging trades, the prices of which (including the added spreads) were used to calculate the index.

In various issuer free writing prospectuses filed with the SEC, the issuer reported on the performance of the index, attributing changes in the index level to macroeconomic events. Those free writing prospectuses did not disclose the issuer’s hedging activities, some of which appear to have contributed to a drop in the index level.

The order focused on the issuer’s lack of an effective policy, procedure or process by which individuals within the issuer with primary responsibility for drafting disclosure documents relating to the index and the structured notes linked to the index would be aware of the activities of other employees that had, or potentially could have had, a negative effect on the index level. According to the SEC, because the individuals drafting the disclosure documents had no way to make informed decisions about the index disclosure, the issuer negligently breached its duty to disclose all material information necessary to make the statements in the offering documents, in light of the circumstances under which they were made, not misleading.

Due to the allegedly negligent conduct and the materially misleading statements and omissions, the SEC claimed that the issuer violated Section 17(a)(2) of the Securities Act. Without admitting or denying the SEC’s findings, the issuer agreed to cease and desist from committing or causing any violations or future violations of Section 17(a)(2), and to pay disgorgement and prejudgment interest. The SEC noted the issuer’s cooperation in investigating this incident and the issuer’s centralization and improvement of its internal controls.

Conclusion

The SEC continues its focus on structured products with this action, the first, according to the SEC, against an issuer of structured notes. The SEC is focused on sales of structured products to "retail investors" and also with respect to the accuracy of disclosures.

Besides ensuring that an issuer has processes in place to inform investors of all activities by its employees that may have an effect on the materiality of its disclosures, an issuer should also check its risk factors and descriptions of hedging and other activities to determine if they are broad enough to disclose all material transactions.

Reminders for Index Linked Notes

In light of the settlement, other regulatory guidance and “best practices,” market participants should consider (and often reconsider for improvement) a variety of issues when linking notes to complex underliers, including many proprietary indices. Understanding these factors will help the working group consider what disclosures and/or risk factors are appropriate.

  • Index Disclosures
    • Ownership: is the index owned, sponsored or calculated by the issuer or an affiliate?
    • Rules: have index governance rules, and/or a process for index governance, been put in place? When and why, if applicable, are any index rules changed or superseded?
    • Transparency: are the index descriptions and index methodologies transparent?
    • Fees and Costs: are there any fees, charges or other factors that could reduce the level of the index at any time? How are they calculated, and who does the calculating?
    • Third Party Providers: are they regulated by any governmental agency? Do they comply with the index standards articulated by IOSCO and ESMA? What types of compliance policies and procedures do these entities maintain?
  • Hedging Activities
    • What types of hedging activities will be conducted? Who is responsible for supervising them? Are any unusual hedging activities going to be conducted?
    • Do the offering documents adequately disclose any known (and especially, unusual) hedging activities?
    • Are there any spreads built into the hedging activities that could affect the level of the index and/or the payments on the notes?