As many readers know, on July 27, 2011, the SEC Office of Compliance Inspections and Examinations (OCIE) issued a summary report identifying common weaknesses that it observed in sales of retail structured products during its sweep examination in 2008 and 2009.1 The report describes measures that broker-dealers may take to better protect retail investors from fraud and abusive sales practices. In this article, we provide an analysis and some observations about the report.
Background and Summary Findings and Recommendations
The report summarizes the results of the SEC’s sweep examination of the retail structured products business of 11 different broker-dealers, which cover a cross-section of the industry.
Among other things, the staff observed that, during the relevant period, broker-dealers might have:
- Recommended unsuitable structured products to retail investors;
- Traded structured products at prices that were disadvantageous to retail investors;
- Omitted material facts about structured products offered to retail investors;
- Engaged in questionable sales practices with customers; and
- Did not maintain adequate supervisory and training requirements.
The report recommends that larger broker-dealers should focus on the following issues:
- Having adequate procedures and controls to prevent and detect possible abuses in the secondary market for structured products;
- Appropriately disclosing material facts regarding structured products;
- Requiring registered representatives and their supervisors to complete specialized training in these instruments before selling them to customers;
- Accurately listing structured products on customer statements;
- Establishing controls to independently review their desk prices of structured products in the secondary market;
- Having controls to adequately review the suitability of these products for customers; and
- Having controls to review customer concentrations in the structured products it sold.
The staff report states that smaller retail broker-dealers should focus on:
- The suitability of structured products recommended to retail customers;
- Establishing, maintaining and enforcing proper supervisory procedures relating to suitability determinations for purchasers of structured products; and
- Having adequate training for registered representatives who sell structured products and for their supervisors.
As we note above, the report was issued by the staff of the OCIE, which regularly conducts examinations of brokerdealers. The OCIE’s examinations are principally intended to test the broker-dealer’s compliance with the federal securities laws and regulations. The OCIE frequently consults with other staff within the SEC and with other divisions concerning matters that arise during its field examinations. From time to time, when the OCIE identifies compliance or internal control issues of a serious nature, the OCIE may refer the matter to the Division of Enforcement. The OCIE may also raise issues with the Division of Trading and Markets or the Division of Corporation Finance. The OCIE is one of several groups within the SEC that has been focused on the structured products market.
Given the growth of the retail structured products market that are in the United States, the OCIE reviewed the retail business of 11 broker-dealers, including three that are affiliated with bank holding companies that are structured products issuers, a wholesaler that sells structured product through other broker-dealers, and seven smaller retail firms that also distribute third-party structured products. The examinations were conducted principally in 2008 and 2009 and included participation by the OCIE’s regional offices in New York and Chicago.
In large measure, many of the issues noted in the report are issues with which market participants are quite familiar, given that there has been significant activity by FINRA and by other regulators during recent years related to structured products. In fact, the report cites various FINRA notices or alerts, including the 2005 NASD Notice to Members (05-59) on structured products, as well as prior guidance relating to “non-conventional investments” (Notice to Members 03-71) and new products (Notice to Members 05-26). The report also cites the more recent FINRA guidance on reverse convertibles (Regulatory Notice 10-09).
In recounting the observations made during the examinations, the report tracks closely the requirements that were included in Notice 05-59. The report notes that the most significant weaknesses observed related to suitability issues in connection with the sale of reverse convertibles. In its comments on suitability, the report appears to adopt the procedure originally highlighted in Notice 05-59 of requiring option trading approval for customers purchasing structured products. However, the report does not track the significant caveat made in the original Notice to Members, which included an observation that options trading approval was but one possible approach to addressing suitability determinations. If a firm does adopt the options trading approval process, then, of course, it must take care to implement appropriate procedures.
Consistent with various FINRA actions, the report notes that concentration issues require close attention and suggests that reports on customer concentration in structured products “may be a beneficial practice.” The report appears to note favorably the fact that two of the reviewed originating firms have monthly exception reports that review for customer concentration. Market participants should focus on their policies and procedures and technology for monitoring concentration issues.
The focus on an investor’s concentration in structured products is reminiscent of the concerns raised by FINRA in its February 2010 fine of H&R Block for sales of reverse convertible notes.2 There, FINRA recommended that brokers maintain procedures to monitor customer accounts for concentration of these products.
Neither FINRA nor the SEC have defined what would constitute appropriate levels of concentration in structured products, or in different kinds of structured products. However, for purposes of evaluating account concentration, both of them seem interested in the possibility of treating structured products (or different types of structured products) as an asset class. Such treatment would raise a variety of issues for brokers, including:
To what extent does a concentration in structured products interact with related concentration issues (which may offset to some extent the concentration in structured products), such as concentration of a portfolio in a small number of issuers, concentration in a small number of asset classes or exposure to a limited number of stocks?3
- To what extent is concentration an issue, if an investor’s structured product investments are not concentrated in particular structured product issuers (and their credit risk) or in the same asset class?
- If an investor has a high concentration even in a particular type of product, such as reverse convertibles, to what extent is it problematic if the instruments are issued by a variety of issuers, and with a set of underlying stocks that reflects the investor’s investment view?
- What systems or other procedures are needed to monitor concentrations in structured products?
The report raises concerns regarding disclosures relating to “principal protection.” Given the extraordinary attention that this issue has attracted in the aftermath of the failure of Lehman Brothers, we believe that it is well understood by market participants. Due to concerns that have arisen over this issue, most market participants have attempted during the past few years to enhance and improve the disclosures in their offering documents as to issuer credit risk. The staff also notes disclosure concerns related to fees.
As compared to, for example, the SEC’s Division of Corporate Finance, the OCIE has been less active in reviewing the content of disclosure documents. We would anticipate that other groups at the SEC could express in the future a view or preference as to other disclosures in structured product offering documents that market participants consider important, including risk factors, conflict of interests, and related items.4
Secondary Market Concerns
The report devotes substantial attention to secondary market issues, while acknowledging that structured products are designed as buy-and-hold investments, and that there is limited secondary market trading. Examiners noted that at most firms, trading desk prices are reviewed by an internal control group that is independent of the trading desk. Specifically, the staff notes that there should be a control to ensure fair pricing.5 At another firm, the lack of an independent review of the trading desk’s prices was identified as an internal control weakness. The staff also noted a number of other weaknesses or inadequacies related to secondary trading, including that:
- Firms do not review customer trades that occur soon after issuance;6
- Firms do not review customer sales near maturity;7
- The commissions charged on secondary activity often greatly exceed the charge at issuance and exceed the firm’s applicable guidelines; and
- Firms do not review secondary activity for “possible switching, despite the high incentive for registered representatives to switch customers from one [structured product] to another.”
Again, consistent with recent FINRA actions, the report noted that a few of the firms did not have specific training requirements in place for registered representatives active in structured products, and none had training requirements in place for the supervisors of the registered representatives that market structured products. For those firms that did have training programs, there were deficiencies cited relating to structured product sales.
Given the growth in the market, we anticipate that regulatory scrutiny is likely to intensify. Although there are only a handful of new issues raised in the OCIE report, the report is another indication of the level of attention being paid to this segment of the market. The report also provides important reminders for broker-dealers regarding the need to revisit their policies and procedures, especially as these relate to retail structured products. Carlo di Florio, Director of the OCIE, notes, “This report could help companies strengthen their compliance programs to better address the issues [the OCIE] observed during [the] sweep and in subsequent exams.”
And as a “heads up” that more may be to come, Mr. di Florio added, “Beyond this report, we are monitoring the way in which these products evolve, and are considering additional steps in the near future relating to structured securities products that may further bolster investor protection.”