As the popularity of structured products linked to the performance of proprietary indices continues to grow, we receive more frequent questions regarding the legal and compliance issues arising in connection with these products. Below we summarize a number of the principal issues which arise under the securities laws and stock exchange rules, together with additional key considerations.

Discretion: consider whether the index is in any way discretionary. Are the index rules sufficiently detailed such that the index sponsor and the calculation agent can follow the rules without making judgments? If the index is discretionary, the elements of discretion may present compliance issues. For example, decisions made by the index sponsor or by the calculation agent that are deemed discretionary may be questioned in hindsight. There may be reason to consider whether, in making such decisions or determinations, the index sponsor or the calculation agent had conflicts of interest or was in possession of material non-public information. If an index is discretionary, it may present Investment Company Act issues, because the discretion may make the instrument seem like a “managed” investment or make the product seem like a “managed” fund (with the fund being the “pool” of referenced assets that comprise the index).

Index rules: the index rules will have to be set out in a detailed fashion, particularly in the context of a registered offering. This will be essential in order to be able to provide investors with complete disclosure regarding the index, including any risks that arise from these rules. The index sponsor itself also will want to have a detailed description of the index. If there is ever a need to transfer the index to another sponsor, this will become important. Similarly, if the structured product is listed on a securities exchange, a detailed description will be needed for the exchange, so that the exchange can review the eligibility of the structured product for listing.

Information walls: from a compliance perspective, the index provider, issuer and underwriter each should confirm for itself that the index is created by a separate group at the investment bank, separate from the product structurers and marketers. Indices are often created by special research teams. The product marketers should be walled off from those responsible for index creation, so that the marketers cannot influence the index features or its components.

Window cleaning: some proprietary indices with an equity component may from time to time represent a concentrated position in one or more equity securities. Where this occurs, it may be appropriate for the issuer and the underwriter to perform “window cleaning” procedures that are comparable to those that it uses when issuing a structured product linked to a small number of stocks, or when linking to a non-proprietary index that has a high concentration in a particular security.

Leverage/roll features: we are seeing more indices that incorporate leverage or “roll” features, as well as indices that incorporate algorithmic trading models or “black box” features. Particularly for indices that incorporate leverage features, it will be important to describe accurately the index, the leverage factor and the risks associated with a product linked to such an index. Commodity indices that incorporate roll features may exacerbate certain risks. Regulators have cautioned that investors should be forewarned of the risks associated with products incorporating leverage as well as the risks associated with commodity-linked products.

Disclosure: as with any structured product that is offered to investors, crafting complete, useful disclosure is essential. It may be more challenging to describe accurately and completely a structured product linked to an innovative proprietary index. Oftentimes, we see indices that incorporate financial modeling or complex equations, and it may be challenging to describe the index methodology in plain English or to do so effectively without sacrificing accuracy. For products that are intended to be marketed and sold to retail investors, the parties should consider whether it is preferable to include the plain English description or whether it is helpful to include the formulas or other tables in the offering document. Particular care should be given in preparing the “historical” index levels to make clear that historical results are not actual, and if necessary, the nature of any assumptions used to create the historical information.

New product review: linking to a proprietary index may constitute a “new product.” In such case, broker-dealers will need to adhere to relevant regulatory guidance, such as NASD Notice 05-26 (April 2005) relating to reviewing new products.

Suitability: as in the case of any new financial product, the relevant underwriters will have to verify the suitability of the proposed product. In addition to ensuring that the product is suitable to a particular investor before making an investment recommendation as to the product, the underwriters will need to make a “reasonable basis” determination – are the economics of the product suitable to at least some investors?

Comparable indices: it is always helpful to be able to compare the proposed proprietary index to other existing indices and to identify the differences between them. Although these comparisons need not always be included in the offering document, these comparisons will facilitate creating useful and informative index disclosure. These comparisons will also provide a useful perspective in thinking about listing the structured products—an index’s similarity to an existing index that has been the subject of a different listed structured product may facilitate the new listing.

Licenses: once a proprietary index is created, the index creator may want to provide licenses for its use. It will be helpful to have a form of license agreement and form disclosure regarding the license that may be used in a disclosure document.

Third parties: the index creator may contract with a third-party index sponsor who will be responsible for publication and dissemination of the index information, as well as with a calculation agent.

Securities exchange: if the issuer would like to list a structured product linked to the proprietary index on a securities exchange, it will be necessary to review the index and determine whether the index meets the criteria discussed in the relevant exchange’s generic listing criteria for structured products. Alternatively, if the index is novel, listing will require a 19b-4 rule filing. The rule filing process may be quite time-consuming. In fact, it may require several months.

Additional documents discussing the index: the index sponsor may seek to create additional materials that describe the index. These may include brochures that explain the index to potential licensees, as well as documents that are intended to help market the relevant structured product. In each case, it will be necessary to ensure whether the disclosure is accurate, and whether, in the case of registered structured products, any of these materials need to be treated as a “free writing prospectus” under applicable SEC rules.

Broad-based/narrow-based index: the index creator also may focus on whether the proprietary index constitutes a broad-based index, which will be important to many investors.