Welcome to Compliance Matters, the first entry in the securities industry segment of our blog. We hope you enjoy it. We start with topics involving FINRA Examination Priorities — the things that keep compliance people up at night.
The headlines are plentiful. In 2014, FINRA is going to “keep the pressure on,” “bear down on,” “focus on,” and even “target” complex products, especially those that are interest rate sensitive. Although many people focus on the fact that complex products will have a special place in regulatory examinations again, little is being said about what exactly is a “complex product.” Most industry veterans can identify complex products at the end of the spectrum, with derivative-based investments leading the charge. But where is the line drawn?
You may be surprised by the answer. Given the continuous development of investment products, regulators understandably have found it difficult to produce an all-purpose definition of complex products. In previous regulatory notices, however, FINRA has given examples. They include many commonly unfamiliar things, such as collateralized debt obligations, packaged products with hedge fund-type returns, and commodity-based products, which involve various risks. Others types include leveraged exchange traded funds (ETFs), variable annuities and structured products.
Although the term sounds complicated, “structured products” turn out to include incredibly common asset types, such as certificates of deposit (CDs) or notes, with a payout based on a variety of underlying reference assets, such as equities. You would not expect a simple CD to have such potential risk.
Complex products need to be pre-approved by a broker-dealer who must conduct a reasonable-basis suitability assessment before placing the item on its sales platform. The assessment must be done with a procedure to ensure that representatives do not recommend a product to investors before vetting its suitability.
Vetting should include questions to determine for whom the product is intended, the need for a retail distribution limit and how this would be controlled, and the types of investors to whom the product would be sold.
Internal procedures also need to figure out whether product performance and risk profiles remain consistent after their initial sale. This requires training staff to understand the expected product performance and underlying market risks so that they sell the product properly, and explain these things to their customers.
After a product is approved, FINRA’s suitability rule then requires a customer-based suitability review. This has been the topic of much discussion and debate, which our practice has addressed in other publications.
The bottom line for compliance personnel is that FINRA intends to continue watching the approval process of complex products and, despite the lack of a specific definition, the industry must be careful to fully understand the underlying investment components of everything they sell. We urge this careful approach even if a product seems to present a straightforward investment structure.