In the past several years, FINRA has paid substantial attention to the suitability of structured products for particular investors, issuing a variety of new rules and regulatory notices. These include, but are not limited to, FINRA’s revised suitability rule, Rule 2111, and its guidance for complex securities set forth in Regulatory Notice 12-03.
In addition to customer-specific suitability, FINRA expects members to make a "reasonable basis" suitability determination: a product must be suitable for at least some investors. For example, issuers cannot sell products for which "the house always wins," or that are too complex to be understood by any retail investor. In order to make this determination, the firm must perform reasonable diligence to understand the nature of the transaction, as well as the potential risks and rewards. This understanding should be informed by an analysis of likely product performance in a wide range of normal and extreme market conditions.
In practice, how do market participants implement these guidelines? Much of the guidance is principles-based, and it is not necessarily obvious how it should be applied in a given situation.
Commencing the Review
FINRA Regulatory Notice 12-03 sets forth a variety of questions that product manufacturers need to ask prior to introducing a new complex product:
- For whom is the product intended? Is it intended for limited or general retail distribution, and, if limited, how will it control its distribution?
- To what types of customers should this product not be offered?
- What is the investment objective and is that objective reasonable in relation to the product’s characteristics? How does the product add to or improve the firm’s current offerings? Can less complex products achieve the same objectives?
- What assumptions underlie the product, and how sound are they? How is the product expected to perform in a variety of market or economic scenarios? What market or performance factors determine the investor’s return? Under what scenarios would the product’s planned principal protection, enhanced yield, or other benefits not occur?
- What are the risks for investors? If the product was designed mainly to generate yield, does the yield justify the risks?
- How will the firm and registered representatives be compensated for sales of this product? Will the offering of the product create any conflicts of interest between the customer and any part of the firm? If so, how will those conflicts be addressed?
- Are there novel legal, tax, market, investment or credit risks?
- Does the product’s complexity impair understanding and transparency of the product?
- How does this complexity affect suitability considerations or the training requirements for the product?
- How liquid is the product? Is there an active secondary market?
In addition, a broker may consider a number of additional factors:
- Do any competitors already offer a similar product? Of course, when our children use the behavior of other kids as a justification for bad acts, we may say to them: "If your friend jumped off the Empire State Building, would you do so too?" However, market practice may in some cases provide some degree of information as to potential risks.
- Is the payout formula particularly complex? Is the payout formula unsuitable for certain types of investors?
- To what extent does the product incorporate leverage?
- Is the linked asset class capable of being understood by a typical investor?
- Does the product reference a new asset class, or a proprietary index?
- Does the product create any unusual disclosure concerns?
- What is the format, or "wrapper", in which the product will be packaged?
Some market participants categorize or "group" products based on particular attributes, and may subject certain products to heightened scrutiny. Other market participants have formulated a "matrix" approach and identified various characteristics that a committee should consider in connection with a suitability review. Some "benchmark" their products against other products offered by competitors.
Factors to Consider
The following table sets forth some considerations that may inform a committee’s analysis as it reviews a potential new product.
Click here to view table.
What Can Be Done Where Suitability Concerns Exist
Once a product has been identified as involving suitability issues, a variety of tools exist to address the relevant issues.
- Requiring higher minimum denominations and/or minimum purchase amounts, to help screen out less sophisticated investors.
- Imposing restrictions on the types of potential investors.
- Limiting sales to advised channels.
- Only selling the product through particular distributors that are better suited to handle complex products, and have demonstrated their ability to do so.
- Providing additional training to the distributors as to the particular product, including which product risks and features need to be most carefully explained to purchasers.2
- Requiring special training for the broker’s own personnel.
- Granting only conditional approval for a limited period of time, subject to certain requirements.
- Mandating post-approval review within a specified period of time, to determine whether sales were made through the proper channels, and to assess product performance.