In September 2016, the SEC instituted administrative proceedings against a broker-dealer, alleging that the broker's internal training materials used for certain structured notes were insufficient.3 The action principally relates to the broker's training of its registered representatives as to "reverse convertible notes" and similar securities linked to single stocks.
In evaluating the broker's training materials, the SEC noted that many of the securities in question were recommended by the broker to retail investors who had limited investing experience, only modest income and net worth, and moderate or conservative investment objectives. These investors included a number of retirees. Accordingly, the retail nature of these offerings appears to have contributed to the degree of scrutiny that the SEC applied.
In connection with the order, the SEC did not identify any issues with the prospectuses or other offering documents provided to investors; rather, the action challenged the broker's education and training. The SEC concluded that certain registered representatives did not properly understand certain aspects of the notes and, therefore, did not always form a reasonable basis to determine whether they were suitable for certain customers.
The action rests largely on Section 17(a)(3) of the Securities Act's prohibition on engaging in a course of business that operates or would operate as a fraud or deceit upon the purchaser in the offer or sale; in this type of action, simple negligence may be sufficient to seek damages against a defendant, even without scienter.4
Describing the Options and Volatility
Like other structured notes, the pricing of reverse convertible notes depends upon one or more derivatives. The SEC pointed out that, when the broker-dealer's desk solicited competitive bids from issuers to issue these notes, it described the derivative from what it characterized as "the investor's perspective," in order to avoid confusion on the part of the issuer as to the product on which it was bidding.5 In the action, the SEC also focused on the manner in which a stock's implied volatility played a role in the broker's policies and practices of selecting underlying stocks. The broker selected underlying stocks that had sufficient volatility to generate attractive coupons for its investors, and appropriate downside market protection levels.
Inadequate Education and Training? The SEC pointed out that the broker's internal education and training primarily focused on describing the notes' payouts and other terms. However, the SEC alleged that these materials did not describe the option from the investor's perspective in the same manner as the summary information provided to issuers in the correspondence described above. In addition, the broker's educational materials did not describe sufficiently the role of volatility and the potential for breach of the notes' barrier in the broker's selection of the underlying stocks. Accordingly, the SEC concluded that the broker's registered representatives were not adequately educated and trained to understand the risk and characteristics of the product and, therefore, not necessarily positioned to make appropriate representations of these products.
This action is largely rooted in the discrepancy in how the broker described the relevant products in some communications, but not in its training materials. That is, the concepts of "optionality" and "volatility" were addressed in some of the broker's materials, but not the training materials. In this regard, the SEC has shown a readiness to identify these types of discrepancies, and to consider them as evidence of inadequacies. Accordingly, brokers are encouraged to have another look at their own training materials to consider whether, among other things, they reflect the key aspects of their products that may appear in their other materials. Needless to say, to the extent that they played a role in the
SEC's action, the concepts of option pricing and volatility are useful places to start; however, they are certainly not the end of the inquiry.
Once information is set forth in a broker's training materials, the question will of course arise whether that information is sufficiently material to also belong in the relevant offering documents for a structured product. Otherwise, a regulator can make an argument that is similar to that of this reverse convertible note action: "If the information is in the training materials, why wasn't it provided to investors as well?" Of course, further loading offering documents with additional information may further complicate otherwise lengthy materials, rendering them less useful for investors at the end of the day, and perhaps less likely to be read. However, to the extent that a regulator views differing descriptions as evidence of an inadequacy, some market participants may be willing to make those types of additions or revisions.