Introduction 

Structured products are sold by broker-dealers, many of which are affiliates of large investment banks. The equity research group of the same investment bank may have useful research reports that help explain why a strategy of investing in a certain stock, index or sector could be an excellent investment. That research could also help explain to an investor the types of risks that such an investment may pose. In some cases, it’s even possible that a structured note may be designed around one of the themes set forth in the research.

In all of these cases, it would seem that the structured product and the equity research would make great partners, and the research reports would constitute useful materials to be shared with an investor in the structured note.

But not so fast. A variety of SEC and FINRA rules limit the manner in which research reports can be used in connection with an offering, particularly in the context of a registered debt offering. This article examines some of these issues.

FINRA Rules

NASD Rule 2711 regulates research reports and their preparation. Rule 2711(b)(2) generally prohibits personnel outside of the research group from reviewing the research prior to its publication. As a result, the rule bars structured note developers and marketers from gaining pre-publication access to research reports, whether for the purpose of structuring new notes, or for planning the disclosures that will be made in the new offering documents.

Information Walls

Rule 2711(b)(1) also prohibits research analysts from being subject to the supervision or control of personnel in the investment banking department. Any such control, or any influence over research analyst compensation, would call into question the integrity of the research.

For these reasons, and due to the prohibition on pre-public review of the research reports, investment banks will establish information walls and separations between the research group and the structurers and marketers of a variety of  investment products, including structured products. These walls are designed to ensure that the research and banking groups remain separate, that the research group will not be consulted or involved in the structuring of any product, and that the research group will not provide advance notice to the product structurers of any anticipated research reports, research views, or changes to research-based indices.

Free Writing Prospectuses

A knotty issue can arise when a broker wishes to provide copies of a research report to potential investors in a structured note.

The SEC historically has broadly defined the terms “offer” and “prospectus.” If a research report is used in connection with a securities offering, whether to tout the reasons why the investment is a promising one, or even to disclose the risks that may arise from such an investment, the research report could be viewed as a prospectus.

This characterization would have a variety of negative consequences.

First, the accuracy of the research report, or the basis for any recommendations made in the research report, could be challenged in litigation for any poorly performing structured note. Because research reports are not prepared with a view  to the liability provisions of the 1933 Act (for example, they typically include a variety of estimates and forecasts that issuers and underwriters would be quite reluctant to include, and may not be appropriate to include, in a prospectus), few parties would want to take the risk of liability for their contents. In addition, if they are in fact deemed to be prospectuses,  if they do not comply with the SEC’s legending and filing requirements for free writing prospectuses under Rule 433, they could potentially create a rescission or damages claim from investors, even if the information therein is not, in and of itself, actionable.

The “Rule 433 considerations” do not apply in the context of unregistered offerings, such as structured certificates of deposit, unregistered bank notes and Rule 144A offerings. However, many broker-dealers apply their policies consistently, particularly as to offerings involving retail investors and high net worth investors, due to liability considerations and other related factors. In addition, we note that the Rule 433 considerations apply not only to underwriters, but also to other “offering participants,” such as distributors that are party to an MSDA or similar agreement with the underwriter

A Few Practical Considerations

How do brokers address these limitations?

First, most brokers have a standing policy not to send research reports to investors that have been offered, or are expected to be offered, a structured note that may reference a security or index that is the subject of research. (These types of policies do not bar brokers from sending research reports in the ordinary course, in accordance with their standard policies.)

Oral communications between a broker and customers relating to research can be more complicated to police. On the one hand, a broker can presumably orally advise a customer that the “thesis” of a note is supported by, or is not inconsistent with a recent research report. On the other hand, doing so will often generate a request from the investor to receive a copy of that report. Sending that report would be problematic once the specific offering is discussed, as discussed above. A response such as “our lawyers do not allow us to send the research report now that we have discussed the note” is not likely to help the sales process. Accordingly, many broker-dealers will bar their representatives from discussing the research with customers.

Some structured notes are based around a particular strategy recommended by research, such that it is may be helpful to indicate in the offering documents the nature of the research. In these cases, the offering document may discuss the research in summary, while also noting (in the risk factors section, and/or other parts of the prospectus) that:

  • the relevant underlying stocks or other assets are based on research recommendations, which are only opinions as of a particular time, and may change;
  • the research views are generated without regard to any specific investor’s overall holdings, circumstances and investment needs, and the related investment may not be suitable for all investors; and
  • the research views are separate from the offering of the structured product.