With FINRA and other regulators focused on conflicts of interest in the broker-dealer industry, market participants are working diligently to identify and disclose, and where possible, mitigate, potential or actual conflicts of interest. In this article, we summarize the types of conflicts of interest that may present themselves. We encourage broker-dealers to consider these relationships and arrangements, and any others that might apply, in connection with their offerings of structured products and the formulation of conflicts of interest policies. As we discuss in more detail below, some conflicts of interest are inherent given the nature of the product and the distribution channel. Other conflicts may arise due to the specific nature of the transaction.
Roles in Structured Product Offerings
In connection with an offering, the broker-dealer or its affiliates are likely to play several roles. Of course, this may involve the broker-dealer acting as underwriter for the securities of a parent or affiliated corporation. (As a result, many structured products offerings are subject to FINRA's specific rules relating to offerings involving conflicts of interest.) In addition, the broker-dealer may play additional roles, such as serving as calculation agent. In that role, it will calculate the payments due to holders of the product, and potentially make significant determinations upon the occurrence of a market disruption event, merger of a reference stock or index constituent, discontinuance of an index, or similar extraordinary event. The underwriter or its affiliate is frequently the issuer's hedge counterparty. As a result of this arrangement, the hedge counterparty will have a significant role in structuring the transaction terms. The hedge counterparty will typically price the hedging arrangements with a view to making a profit; if successful, the hedge counterparty will typically receive such a profit regardless of whether the investors in the related structured note have achieved a positive or a negative return. In connection with offerings referencing a proprietary index, the broker-dealer or its affiliate may be the sponsor of the index, or may be the "index calculation agent," determining the levels of the relevant index. Broker-dealers involved in such a manner will typically "wall off" the individuals or teams responsible for the index from the team responsible for structuring and selling the related structured note.
After the issuance of the product, the broker-dealer is likely to play a continuing role. It is likely to be a market-maker (perhaps the only market-maker) in the relevant structured product, as well as other securities of an affiliated issuer.
In rendering the services described in the prior section, the broker-dealer expects to receive a variety of potential fees. And this is where the "rubber hits the road" in terms of addressing whether the conflict has been addressed appropriately, and whether compensation is reasonable.
In acting as underwriter for the product, the broker-dealer will receive an underwriting commission or similar compensation. A portion of these fees, or potentially an additional fee, may be paid as a structuring fee or similar fee for arranging the transaction. For some offerings, the broker-dealer may be entitled to a "trailing fee," which enables the broker-dealer to receive additional compensation based on the amount of time that the investors continue to hold the instrument.
In connection with proprietary indices or other similar arrangements, the broker-dealer may receive a license fee for granting the issuer the right to use the index. Many proprietary indices involve an ongoing index fee, in which the return profile of the index is reduced to reflect the broker-dealer's hedging costs or similar actual expenses incurred over the life of the security.
Additional fees may be received by broker-dealers in connection with their role in the transaction. For some types of securities, distributors charge so-called "shelf space fees," for making their distribution platforms available to different issuers or product manufacturers. In any potential future environment in which the new Department of Labor fiduciary duty rules or other similar fiduciary duties apply, these brokers will need to consider carefully whether these and other arrangements are permitted and appropriate.
Trading and Other Commercial Activities by the Broker-Dealer
A broker-dealer, particularly a full service one, is likely to conduct a variety of ongoing trading activities relating to the underlying assets. Some of this activity will be for its own account, and some will be for the benefit of its customers. This trading activity may or not be in the same direction as the "thesis" of the structured note, and could cause or contribute to price movements that may adversely impact holders of the structured product.
Broker-dealers not only are underwriters of securities and other structured products, but often serve as underwriters, financial advisers, or lenders to companies the securities of which may be included in the relevant underlying asset. Broker-dealers may or may not acquire information that relates to the value of these securities, which they are not obligated to disclose to investors in the structured product. As a result, broker-dealers will rely on their "control room" process to determine whether the firm is in a position to link a proposed product to specific securities. Whether or not any material non-public information would be attributed to the structuring desk, market participants are concerned about the reputational issues and potential impact on customer relations that could arise from offering a structured product while in possession of material non-public information about the relevant issuer or issuers.
Research departments of broker-dealers will publish reports about indices, sectors, individual stocks, or other assets. These reports may in many cases express a view that is adverse to the thesis of a structured product, and can be a factor that influences the direction of the underlying asset and, as a result, the value of securities linked to that underlying asset.