Are FINRA’s Threatened Enforcement Actions on Structured Products Fact or Window Dressing?


While financial advisers are selling the daylights out of high-yield structured products to investors who complain about low interest rates, the Financial Industry Regulatory Authority (FINRA) is warning them of the perils of such securities, according to Bruce Kelly’s InvestmentNews article entitled “Ketchum warns that FINRA is focusing on ‘hot’ investment.”

Last year, sales of structured products to retail investors reached a record $55 billion, up 61% from $34 billion in 2009, according to the article, citing industry database With double-digit yields, the attraction is understandable, but structured products carry serious risks that are all too often not understood by investors or their individual brokers.

In fact, Richard Ketchum, FINRA’s chairman and chief executive, warned some 900 attendees at the FINRA’s recent annual meeting that broker-dealers that sell structured products will be a major focus of FINRA’s enforcement activities. The investments “have been a hot product and continue to be a hot product,” Ketchum was quoted as saying, adding: “They are a major focus of our exam program [of broker-dealers] at the present time.”

“Our special concerns relate to the ones that are levered, that track indexes using futures and other things that can create risk, that involve credit risks that are significant without effective disclosure, or are very complex in one way or another,” Mr. Ketchum was quoted as saying.

Were the attendees equally concerned? Don’t bet on it. FINRA has said all of this before, but broker-dealers just ignore it, apparently with impunity. FINRA “warned” its member firms in 2010 (in FINRA Notice to Members 10-09) that reverse convertibles “often involve terms, features and risk that can be difficult for individual investors and investment professionals alike to evaluate,” and that given the put option component of reverse convertibles, firms that do not limit reverse convertibles to accounts approved for options trading “should be prepared to demonstrate the basis for allowing investors with accounts not approved for options trading to purchase reverse convertibles.” According to FINRA, NTM 10-09 was issued because FINRA had found that firms failed to heed that warning, which first appeared in NASD NTM 05-57, five years earlier.

Reverse convertibles are short-term high-yield notes that are linked to a reference asset like a stock or a basket of stocks, bonds or currencies. Unbeknownst to most investors, if the value of the reference asset falls below a certain pre-determined value, the investor receives the depressed asset instead of his principal at maturity. This happens as a result of an imbedded put option that is part of the deal.

“Some firms require retail customers who are interested in purchasing these complex products to complete an option account approval process,” Mr. Ketchum was quoted as saying. The problem with that is FINRA ought to REQUIRE ALL firms to limit sales to customers who are properly qualified to buy and sell options, because structured products contain options.

“Brokers cannot rely on firm approval alone to satisfy their suitability obligations. This is particularly important with the proliferation of increasingly complex financial products and at a time when certain investors are tempted to chase yield in today’s low-interest-rate environment,” Mr. Ketchum was quoted as saying.

Brokers need proper training in the product, Mr. Ketchum said. “Effective supervision is rooted in a thorough understanding of the product risks, coupled with robust broker training regarding the clients for whom the product is appropriate,” he added.

Is this just meaningless blather coming from a captive regulator or is FINRA serious? The idea that registered representatives, who are securities promoters and salesmen, will ever thoroughly understand complex, option-based structured products and only sell them to the very few customers for whom they might be suitable is the stuff of dreams. FINRA needs to get real and address these issues before another disaster devastates unwary investors.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving principal protected notes, reverse convertibles and other structured products. For further information, please contact us.