Securities Regulators Set High Standards for Firms Selling Complex Investments


The Financial Industry Regulatory Authority has issued a Regulatory Notice (12-03, Jan. 2012) to “remind” its member firms of their sales practice obligations with regard to complex products, and to provide them “guidance” in exercising heightened scrutiny and supervision over marketing and sales of complex products. Complex products are not defined in the Notice, but are described as including a host of alternative investments, such as derivative-based products, nontraded REITs, structured notes, inverse or leveraged exchange traded funds, hedge funds, and securitized products like mortgage-backed securities and asset-backed securities.

First, the Notice states, brokerage firm must perform a reasonable investigation (due diligence) concerning any security that the firm recommends. A firm cannot just blindly accept the issuer’s representations about the product; it must take reasonable steps to verify such representations and discover material problems and risks associated with the investment. The firm must obtain an understanding of the risks and “[t]his understanding should be informed by an analysis of likely product performance in a wide range of normal and extreme market actions.” In addition, “[f]irms 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.” A failure by the firm to comply with this duty “can constitute a violation of the antifraud provisions of the federal securities laws and FINRA Rule 2010, requiring adherence to just and equitable principles of trade, and FINRA Rule 2020, prohibiting manipulative and fraudulent devices.”

Second, FINRA states that the very complexity of these products adds additional risks “beyond the fundamentals of market forces,” and that this holds true even when the complexity arises from purported risk-reduction features of the product.

Third, the Notice sets out a number of questions that must be addressed by the firm before recommending or selling a complex product. Among them are: “Can less complex products achieve the objectives of the product?” The answer, according to experts, is almost invariably, “Yes.” So why are these complex products being sold? The answer is, “Because they generate outsized commissions and fees for the sellers.”

The experts’ answers to other questions posed by FINRA ought to prevent firms from selling complex products: “Does the product’s complexity impair understanding and transparency of the product”? Of course it does. “How liquid is the product? [Most if not all of these complex products are illiquid.] Is there an active secondary market for the product? [Even if there is, investors invariably receive only pennies on the dollar.]

Complex products are unsuitable for most investors. The SEC and FINRA have expressed concerns about complex products. The risks, lack of transparency, and lack of liquidity are too great. Most investors do not understand them. Most brokers do not understand them, and so cannot explain them to investors. Firms will not be able to meet FINRA’s guidelines with respect to complex products, and are, therefore, putting their interests ahead of their customers if they continue to sell them.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.