In a recent issue of this newsletter,5 we noted that FINRA representatives were focused on conflicts of interest in relation to the structuring and sales of structured products. In the period since that speech by Susan Axelrod, Executive Vice President, Member Regulation Sales Practice, of FINRA, the focus on conflicts seems to have intensified. In a more recent speech delivered at the end of October,6 Axelrod emphasized that, in connection with the FINRA examination process, FINRA would continue to devote substantial attention to complex products offered to retail investors. She cited as examples principal-protected notes, non-traded REITs, reverse convertible notes, and other structured notes. In relation to complex products she advised that “Firms should also consider whether they have any conflicts—particularly where they maintain affiliations with the product issuer or where there is a compensation arrangement that creates a conflict.” She also noted that firms should “identify potential conflicts and document their process for ensuring that they do not place their interest—or that of their brokers—before the clients.”
Many of these same issues were raised in a presentation given by Carlo di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations.7 Di Florio highlighted conflicts of interest as a key area in connection with OCIE examinations. Di Florio identified a number of types of conflicts that are high priorities in connection with examinations. In this list, he included: “retail customers’ interests potentially taking a back seat to various financial incentives of a broker-dealer or its representatives in recommendations and sales practices for new or risky products. This includes, for example, the retailization of complex instruments such as structured securities products….”
Structured product offering documents and marketing materials generally disclose the role of any affiliated parties in the transaction, and highlight the risk of potential or actual conflicts of interest as a result of these relationships. Likewise, the disclosures generally alert potential investors that the issuer’s affiliated broker-dealer may be providing hedging arrangements to the issuer in connection with the note and/or engaging in hedging activities for its own account or in connection with other business activities. Participants in the structured products market may consider reviewing whether their internal sales and training materials also highlight these potential conflicts of interest. In connection with reviewing their policies and procedures to address FINRA Notice 12-03 on Complex Products, market participants also may want to ensure that their new product committees are charged with considering any actual or potential conflicts of interest that may arise in connection with “manufacturing” the product, entering into hedging arrangements related to the products, or distributing the products. Market participants also may want to evaluate whether it is appropriate to evaluate the terms of their various distributor arrangements, to the extent that these are significant, in connection with a review of potential conflicts of interest. As we highlighted in another recent issue, firms also may want to review their “window-cleaning” and other internal wall or information handling policies in relation to the manufacturing of structured products.