RIA Compliance Blog
In a move that signals the need for heightened due diligence and supervision among financial advisory firms, the Financial Industry Regulatory Authority (FINRA) released Regulatory Notice 12-03 in relation to complex products last month. It is intended to guide firms to increase their supervision of activity involving complex products such as structured notes, reverse convertibles, inverse or leveraged exchange traded funds, hedge funds and securitized products. FINRA has already brought a number of enforcement actions against firms relating to complex products, charging inadequate supervision, unsuitable recommendations and misleading price sales.
Among the problems noted by FINRA is the uncertainty of how these products will behave in the market, as opposed to theoretical projections. The notice states, “Regulators have expressed concern about complex products because the intricacy of these products can impair the ability of registered representatives or their customers to understand how the product will perform in a variety of time periods and market environments, and can lead to inappropriate recommendations and sales.”
FINRA chose not to define a complex product in the notice due to the ever changing innovation in the marketplace; however, the notice states that “any product with multiple features that affect its investment returns differently under various scenarios is potentially complex.” The notice goes on to give a non-exhaustive list of examples of complex products. FINRA advises firms that are unsure whether a product is complex to err on the side of applying their procedures for enhanced oversight to the product.
The notice also discusses supervisory and compliance procedures that may help firms when they are dealing with complex products. A firm or registered representative must perform a reasonable basis suitability determination before recommending it to investors. The notice claims that the proper due diligence should allow the firm or registered representative to gauge performance in a wide range of market conditions. “Firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted,” says FINRA.
Even after the due diligence is initially performed, FINRA recommends that firms engage in post-approval review. This includes periodically reviewing the complex products to determine the consistency of its performance and risk. Some firms have chosen to review the complex products formally for a specified period of time while others have decided to conduct periodic reviews.
FINRA also makes it clear that registered representatives who are recommending complex products should have a sophisticated understanding of the payoff structure, any limit on upside potential, and the risks to investors that payoff structure presents. This includes not only knowing how the product will perform in normal market conditions, but also all the risks associated with it.
Finally, the notice discusses the importance of customer financial sophistication. When representatives decide what recommendations to give investors, they need to take into account the customer’s “investment experience” and “risk tolerance.” The notices states, “In recommending complex products, firms are encourages to adopt the approach mandated for options trading accounts, which requires that a registered representative have a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the complex product.”
A firms should not recommend complex products until it has created adequate supervisory and compliance procedures. The notice also tries to encourage firms and registered representatives to consider whether less complex products could achieve the same objectives for the investor. FINRA also discussed this issue again in its Regulatory Examination Priority Letter.
Parker MacIntyre provides legal and compliance services to registered investment advisers and broker dealers. Among other things, the firm advises financial industry firms regarding due diligence and suitability procedures.