As part of FINRA’s continuing focus on member firms’ communications with retail investors about more complex structured products and structures,1 it recently released regulatory notice 10-512 reminding firms of their sales practice obligations for commodity futures-linked securities. The notice is likely to impact the sales process for a variety of commodity-linked structured products, including “principal protected” and “non-principal protected” notes, certificates of deposit, exchange-traded notes and exchange-traded funds.
Consistent with prior FINRA guidance, communications with the public about commodity futures-linked securities must be fair and balanced, and must provide a sound basis for evaluating the facts in regards to those securities. In addition, in recommending commodity futures-linked products to its customers, firms must have reasonable grounds for believing that the recommendation is suitable, and firms must train and supervise their registered representatives to ensure they understand these products.
While recognizing the growth of products designed to provide retail investors exposure to commodities and the value commodities may offer these investors, the notice concerns securities that use commodity futures contracts as their investment strategy and highlights the differences between the prices and price movements of a commodity’s futures contracts as compared to its spot price. In doing so, FINRA notes that the security’s use of commodity futures contracts, as opposed to spot prices, can lead to unexpected results for investors or registered representatives who do not understand the security or who mistakenly believe that the security will track the performance of the spot price. In addition, the notice points out that commodity futures-linked securities have varying methodologies for managing roll yield, and cautions firms that the appropriateness of the security’s particular strategy will depend on the customer’s situation and preferences.
The notice principally discusses issues raised in the context of securities directly linked to one or more futures contracts. However, the price differences and futures market forces outlined in the notice would appear to apply to products that track certain types of commodity indices, particularly those with strategies or methodologies that attempt to optimize roll yield. In addition, although not specifically mentioned in the notice, many of the concerns raised by FINRA would apply to commodity futures-linked certificates of deposit, even though certificates of deposit are generally not considered “securities” under federal securities laws.3
Sales Practice Obligations
As mentioned above, firms have an obligation to ensure that their communications with the public4 about commodity futures-linked securities are fair and balanced. In addition, NASD Rule 2210 requires that the communications provide customers with a sound basis for evaluating the facts regarding the securities, and the communications may not omit any material fact or qualification if omitting it would cause the communication to be misleading. Firms that sell commodity futures-linked securities may want to consider reviewing the forms of prospectuses and pricing supplements that they use, and/or augmenting their advertising materials and literature, in light of FINRA’s guidance. The notice cautions against including any suggestion that a commodity futures-linked product offers a direct exposure to the commodity’s spot price or any overstatement regarding the degree of correlation between the product’s return and the spot price. The mere fact that the prospectus for the product indicates that the product uses futures contracts to track the price of the commodity or index, or discloses that there is a potential difference between the futures and spot prices, may not be sufficient to fulfill the firm’s obligation to ensure that the information it provides is fair, balanced and not misleading.
Firms should consider including discussions of the risks associated with a product’s investment strategy in using commodity futures, as well as the impact of rolling the positions held or tracked by the product and roll yield on the product’s performance. Firms may also want to describe any strategies or methodologies used by the product to maximize the benefit or minimize the impact of contango or backwardation.5 FINRA also warns firms not to overstate the hedging value of the commodity futures-linked product, or imply that the product’s performance is always negatively correlated with equities or other assets.
In addition, under NASD Rule 2310, before recommending commodity futures-linked securities to a retail customer, the firm must have reasonable grounds for believing that the recommendation is suitable for the customer based on any facts provided by the customer about that customer’s other investments and financial situation and needs. In addition, before executing the recommended transaction, the firm must make reasonable efforts to obtain information about the customer’s financial status and investment objectives, as well as the customer’s tax status and other information used or considered to be reasonable by the firm or the registered representative in making the recommendation. The notice references FINRA’s IM-2310-2(e), which emphasizes firms’ obligations for fair dealing with customers when making recommendations or accepting orders for new financial products. With the introduction of new products, firms should make every effort to familiarize themselves with each customer’s financial situation, trading experience and ability to accept the risks involved with the product. Firms should also make every effort to make customers aware of the relevant information about the product. FINRA advises that for commodity futures-linked securities, registered representatives and their retail customers discuss, among other things:
- the commodity, basket of commodities or commodity index that the product tracks;
- the product’s goals, strategy and structure;
- that commodities prices, and the performance of commodity futures-linked securities, can be volatile;
- that the use of futures contracts can affect the performance of the product as compared to the performance of the underlying commodity or commodity index;
- the product’s methodology, including its strategy, if any, for managing roll yield and other factors that may affect its performance; and
- the product’s tax implications. (Commodity pools have different tax implications than mutual funds or exchange-traded notes.)
Firms may want to consider for which of their customers commodity futures-linked securities may be suitable before introducing these new products, or to combine the introduction of these and other new products with a review of their customers’ financial situations and goals.
Training and Supervision
Finally, the notice reminds firms that under NASD Rules 3101 and 3012, they must properly supervise their registered persons to ensure that they understand the commodity futures-linked securities they recommend and can describe them to retail investors in a manner that is fair, balanced and not misleading. FINRA requires firms to train registered persons about the characteristics, risks and goals of each product before they allow them to sell the product to its customers. The training should include instruction on how to make customers aware of the relevant information about the product as well as a presentation of factors that would make the product suitable or unsuitable for certain customers, and should not be limited only to representatives selling the products. Firms are also required to provide appropriate training to supervisors of registered persons selling commodity futures-linked products and to develop, maintain and enforce procedures and controls reasonably designed to ensure that the sales of these products will comply with federal securities laws and FINRA rules. Firms selling commodity futures-linked products may want to review their existing training materials and methods to ensure that these topics are included and should consider reviewing registered persons’ correspondence and other communications with customers after the introduction of new products to ensure that they are adequately training and supervising their registered persons.6
Other Types of Commodity-Linked Securities
By its terms, the notice does not cover certain commodity-linked instruments that are not based on futures contracts, such as securities linked to the spot price of a particular commodity. However, it is likely that many of the concepts included in notice 10-51 would apply in that context as well, such as investor suitability, training and supervision, and many of the disclosure principles. Accordingly, firms should exercise appropriate caution and implement appropriate procedures with respect to these types of instruments as well.