“Reverse inquiry transactions” take a variety of forms. In the classic example of a reverse inquiry, a particular investor or its representative reaches out to a structured note manufacturer to request a note of a particular type, underlying asset, and other pricing terms.
In addition, a variety of transaction types, and types of relationships among the parties, fall within this rubric. A prior course of dealing may exist between the investor, on the one hand, and the product manufacturer on the other hand. The parties may engage in ongoing discussions as to a particular transaction type. In addition, an investor may reach out to a variety of manufacturers about the same investment idea, and select the one that reverts with the most favorable pricing terms.
A reverse inquiry transaction can often be effected on a private placement basis, due to the limited number of investors, and (in general) their relative sophistication. And in fact, some institutional investors prefer Rule 144A transactions, in order to maintain the confidentiality of their investment idea as to a particular underlying asset, especially if that underlying asset consists of an individual equity security. However, many (or most) reverse transactions that occur today are effected on a registered basis, since that is often the most convenient “wrapper” for the parties to use for the product. And the registered basis for the offering is one of the key factors (but not the only factor!) that makes these offerings subject to regulation by the SEC and FINRA.
In recent months, a variety of issuers and broker-dealers have received questions from these regulators about these transactions. The aim of these inquiries has been obscure to some extent, and many market participants have been curious about the nature of the review – the investors who make reverse inquiries are often the investors who are most expert in the relevant products, and they are often in a position to negotiate the best economic terms with product manufacturers. As a result, these transactions might at first glance appear to be the ones that would be of reduced interest to securities regulators.
Of course, a variety of “garden variety” securities law and related concerns may be relevant to many reverse inquiry transactions:
- Is the broker-dealer applying its proper approval and other procedures before effecting a reverse inquiry transaction? For example, is it considering whether a security issued in a reverse inquiry transaction should be treated as a “new product”, subject to its standard new product approval procedures?
- Has the broker-dealer properly discharged its duty to make a suitability determination for that investor? (Under FINRA’s guidance, an “institutional account” may be deemed to be able to look out for itself. (FINRA Rule 2111(b).)
- Does the broker-dealer have a contrary research recommendation relating to the stock or other asset that is the subject of the reverse inquiry transaction? Is the investment thesis of the reverse inquiry transaction inconsistent with the firm’s overall recommendations? If either is the case, has the broker-dealer disclosed this to the investor?
- Is the investor making its investment decision based on the improper use of material non-public information about the underlying asset? If so, does any representative of the product manufacturer have any responsibility for that improper use?
- How do the pricing and economic terms afforded in the reverse inquiry transaction compare to the pricing and economic terms in broader offerings? Are there any superior economic terms that call into question the appropriateness of the terms of similar offerings made to retail investors? How do the profits of the broker-dealer compare in each case, and are they disclosed in each case in an appropriate manner?
- Has appropriate conveyance of information about the issuer and the offering been made available to the investor in the reverse inquiry transaction prior the investor’s investment decision?
In addition to these issues, it is possible that in some reverse inquiry transactions, a “stub” piece of a reverse inquiry transaction could be sold to investors other than the investor that initially made the reverse inquiry. This could occur, for example, if a structured note was designed around a “lead order” made on a reverse inquiry basis, and the product manufacturer sought to sell the offering to additional investors. In such a case, a variety of additional concerns may arise. For example, does the reverse inquiry transaction consist of a product that is too complex for certain other investors who might purchase it? In addition, the investment goal of the lead investor (for example, to hedge a different position) may be inconsistent with the investment needs of the additional investors added to the offering.
The ongoing investigation of reverse inquiry transactions is yet another factor in today’s environment that should encourage market participants to carefully consider how they offer and price these transactions. During 2013, we may see from the SEC and FINRA the results of their review, and whether they have identified practices that they deem to be inappropriate.