Introduction

Market participants in a number of jurisdictions outside of the U.S. use different types of electronic systems to offer structured products. In these countries, brokers and investment advisers use these types of programs to show investors the pricing and terms for different types of offerings. In some cases, the systems can also be used to effect actual sales.

The features of current systems, and any future systems, may vary. Depending upon the service in question, it may:

  • show investors the current trading values of previously issued structured notes, with or without enabling investors to purchase them; or
  • show investors a broker’s current offerings, again with an opportunity to place an order for the product.

More elaborate systems could show the investor the potential pricing of a newly-issued product with different parameters. For example, imagine a simple structured note linked to a particular stock, which provides a buffer against losses on the downside, together with a multiple of the participation in the upside, subject to a cap. In such a system, if, for example, the investor sought to increase the upside participation rate, the system would show the extent to which the cap on the upside may decrease, or the buffer on the downside may decrease.3 Such a system could show investors preliminary terms that could be accepted within a specified period of time, possibly by entering an order on the system. Depending on the capabilities of such a system, the system may automatically generate final term sheets and simple final pricing supplements.

In this article, we examine the federal securities regulations that would apply to systems of this nature if used in the U.S., and describe a number of other related practical issues to address in the U.S. market.4

Prospectuses and Free Writing Prospectuses

User Interface/Website. In the case of registered structured notes, the system interface itself would likely be deemed a "free writing prospectus" under the SEC rules. Accordingly, depending on its use, and which securities were offered on it, the relevant screens viewed by investors may be required to be filed with the SEC under Rule 433 by one or more of the relevant issuers, and/or the broker-dealer that operated the system. Depending on its use, and which party files it with the SEC, the document may also be subject to filing with FINRA under Rule 2210(c)(3)(E).

Product Supplements. In the case of registered structured notes, a robust prospectus should be made available to the investor prior to the investor’s investment decision. In the case of an electronic system, this would likely be accomplished through a hyperlink on the website to a "product supplement" or similar document that describes the key terms and risks of the relevant product in which the investor sought to invest. The system could also have functionality to e-mail a .pdf version of that document to the investor. That document, together with the issuer’s base prospectus and any "MTN prospectus supplement," would typically be filed with the SEC prior to its use under Rule 424(b).

Brokers would likely want to ensure not only that investors had access to this key document, but also that the investor has an appropriate amount of time in which to read it. Accordingly, a system may operate such that, for an investor that has not recently purchased a similar product, the investor’s agreement to purchase the product could only be entered following the passage of a certain amount of time after these documents had been made available to the investor.

Preliminary Term Sheets. In the case of a system that enables an investor to customize a product around certain parameters, the system would produce preliminary term sheets that set forth to the investor the potential terms of the offering, which would only be available for purchase during a particular period of time. After that period, the pricing and economic terms of that instrument may change, due to changes in market conditions. Such a term sheet would typically constitute a free writing prospectus, which would be required to contain the legend required by SEC Rule 433. However, such documents would not be required filings on the EDGAR system, under Rule 433(d)(5)(i), since they are preliminary in nature. (This feature would avoid the need to publicly file the preliminary term sheet for every iteration of the structure requested to be viewed by the investor, the majority of which did not result in an actual sale.5) In addition, since these documents are customized for each individual investor, and not broadly disseminated, they would not constitute "retail communications" under the FINRA Rule 2210(a)(5). Instead, they would typically constitute "correspondence" under FINRA Rule 2210(a)(2).

A new challenge for issuers: under the SEC’s recent guidance, the estimated value of the notes, or a range of estimated values, needs to be provided to the investor before it makes an investment decision. That information could be set forth in the preliminary term sheet presented by the system. However, in order to do so, the operator of the system would have to ensure that the system is capable of accurately employing its pricing models on a rapid basis so as to properly include this information.

Pricing and Final Pricing Supplements. For an investor that elects to act on a set of offering terms, and decides to purchase the product, a system of this kind may generate a final pricing supplement (and perhaps a final term sheet) in a specified form. Such a final pricing supplement must be filed with the SEC under Rule 424(b) within two days of the agreement. Similarly, a final term sheet would be filed with the SEC under Rule 433 on the same timeframe. The broker-dealer may seek to act on the "access equals delivery" model established under SEC Rules 172 and Rule 173. Using these rules, by filing the final pricing supplement and entering an appropriate note on the investor’s purchase confirmation, the broker would avoid the need to print a copy of the issuer’s full suite of offering documents: base prospectus, MTN prospectus, product supplement and final pricing supplement.

Exempt Offerings and Private Placements. Needless to say, the above paragraphs assume that, like for most structured notes, the issuer is effecting the sales using a shelf registration statement. But that need not be the case. Issuers could consider establishing systems that offer exempt bank notes or bank certificates of deposit, or even that are limited to private placements. These types of offerings are outside the scope of the Rule 424(b) filing requirements and the rules relating to free writing prospectuses.6 A Regulation D private placement system, in which the notes may only be sold to "accredited investors," may seem appealing, in that it would avoid any SEC filing requirements (other than a notice filing on Form D), and perhaps avoid the SEC’s insistence on the inclusion of estimated value disclosures. A private system may also be used to help support the "suitability" analysis discussed below. However, such a program would need to be carefully vetted, for example, to ensure that the private offerings would not be integrated with the issuer’s registered offerings of similar structured securities7

FINRA Issues

FINRA Communications Rules. FINRA rules and guidance would need to be considered in connection with the establishment of an electronic system. Among other things, the materials and interface prepared by any broker for such a system could be subject to the approval, content and filing provisions of FINRA Rule 2210. In light of FINRA’s ongoing concerns relating to structured products, it may be difficult to implement a system through which retail investors may make purchases, without some sort of direct advice from a registered representative during the process.

Recommendations and Suitability. To the extent that any offer under the system is deemed a "recommendation," which it could be in the case of a retail investor, a variety of FINRA provisions would apply, including FINRA’s rules relating to reasonable basis suitability and customer-specific suitability.

FINRA Notice 11-028 describes FINRA’s considerations for determining whether a recommendation has occurred, applying a "facts and circumstances" test. A system in which investors made their own independent decisions as to whether to purchase a product, or how to customize a product, would not appear to be a "recommendation" of a security. However, to the extent that a broker is setting the parameters for the products that may be purchased, and advertising the flexibility of such a system, there may be a question as to whether some sort of "recommendation" occurs at the time of sale. FINRA may have concerns that individual investors do not have the ability to properly evaluate these parameters and options without professional advice.

Accordingly, in connection with a system of this kind, a variety of steps could be taken to bolster the analysis. For example:

  • The system could inform investors explicitly that the products sold on the system are not recommended for any and all investors.
  • The system could require that investors seek the specific advice of their financial advisors before making an investment decision.
  • The system could be limited to investors that satisfy specified parameters, such as institutional investors or those who satisfy a wealth test, or that have a given number of years of investing in structured products.
  • A system that permitted investors to select different parameters for an investment, such as buffer levels, caps and participation rates, should vet the potential outputs with a "reasonable basis" analysis in mind.9 That is, can the various types of securities generated by the system be justified as suitable to at least some investors, based on their potential risks and rewards?

In short, creating a system that leaves product design all or partially in the hands of individual investors creates significant challenges in light of FINRA’s recent concerns.

Practice Pointers

In a service that enables investors to price and purchase new series of structured notes, a variety of additional practical considerations would also need to be addressed:

  • Creating a system for obtaining and assigning CUSIP/ISIN numbers for the securities.
  • Ensuring that the documents were converted to an EDGAR format, and filed with the SEC, on a timely basis.
  • Ensuring that counsel had the opportunity to pass on the forms of the relevant documents to ensure that any required corporate and tax opinions can be rendered (and if needed, filed with the SEC) on a timely basis.10
  • Ensuring that the securities are made DTC eligible.
  • Ensuring that TRACE reports are filed on a timely basis.
  • Ensuring that all necessary closing documents, forms and global notes, and other relevant documents are prepared.

Conclusion

Electronic systems potentially offer U.S. market participants a variety of desirable features and opportunities. However, these systems must be carefully planned in order to conform to the legal requirements of the U.S. market.