Introduction

In connection with our examination of the Department of Labor's new fiduciary rules, and potential offerings conducted under the "BIC Exemption," we recently examined offerings of structured notes on an "agency basis."1

In this article, we discuss an alternative offering methodology that may be used under the BIC Exemption, "riskless principal" transactions.

The BIC Exemption is not available for use in a principal transaction, where the broker-dealer sells a product from its "inventory" and resells it to a retirement investor. However, the BIC Exemption contemplates the possibility of sales on a "riskless principal" basis. It defines a transaction of this type as "a transaction in which a [Financial Institution] purchases or sells [the notes] for [its] own account to offset the simultaneous transaction with the [Retirement Investor]."

Accordingly, this type of transaction seems suited for many types of offerings that are made to retirement investors. That is, in a typical structured note offering, the broker-dealer will purchase the notes from the applicable issuer based upon the amount of "indications of interest" received from its investors, including retail retirement investors that are subject to the DOL rules. In most offerings, the broker-dealer will not purchase the notes unless it has customer orders. (In contrast, in some offerings, a broker-dealer will base its purchase amount upon the amount that it expects to be able to sell, without necessarily tying that amount to the number of orders received.) At the time of settlement, the broker-dealer's settlement of its purchase of the notes occurs simultaneously with its sale of the notes to the end investors; the broker-dealer does not "own" the notes in its own account for a significant period of time.

In a sense, many transactions have already been conducted on this basis, although they have not necessarily been described in this manner. For example, most program agreements providing for the sale of structured notes discuss the possibility of a broker-dealer acting as "principal" or as "agent," but do not address riskless principal transactions as a separate category.

Broker-dealers who are considering fitting these types of transactions into the BIC Exemption may wish to consider a variety of issues, including:

  • Are any changes to their distribution agreements needed or appropriate to effect this manner of sale? For example, should any changes be made to address situations in which the ultimate purchaser cancels an order, or fails to settle on the closing date?
  • Since brokerage confirmations typically address only the "principal" and "agent" dichotomy, are changes appropriate to reflect these types of sales? If so, what modifications might be needed to a broker-dealer's technology systems to recognize these types of transactions?
  • How are these transactions accounted for in considering the broker-dealer's own regulatory capital requirements? Are there other transactions effected by broker-dealers, outside of the structured note context, that do or should have similar treatment?

Of course, the characterization of a transaction as a "riskless principal" transaction (or a permitted "agency" transaction) is one of many requirements that must be satisfied for the use of the BIC Exemption, and to protect against potential claims long after the transaction is completed. Brokers are currently working to evaluate the wide range of conditions that need to be satisfied, in order to determine the extent to which structured products and other complex instruments can be appropriately sold under this exemption.