An Economist's View of Structured...

MORRISON & FOERSTER LLP

An Economist’s View of Structured Products

1.0 CLE Credit

March 28, 2013, 6:30PM-7:30PM

Speakers: Bradley Berman, Morrison & Foerster Daniel Nathan, Morrison & Foerster

Stewart Mayhew, Cornerstone Research Adel Turki, Cornerstone Research

1. Presentation

2. Structured Thoughts, Volume 3, Issue 14




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An Economist’s View of Structured Products

March 28, 2013Presented By

Bradley BermanDaniel Nathan

Stewart MayhewAdel Turki

NY2‐716631.v3

1

IntroductionMorrison & Foerster LLP is one of the leading New York firms, and specializes in structured products. In the structured products area, we work with a number of leading financial institutions (in the United States, Canada, Europe and Asia) in connection with their new and ongoing offerings of structured products. Clients come to us for our experience with structured products offerings in multiple jurisdictions.

Daniel Nathan is a partner in Morrison & Foerster’s Securities Litigation, Enforcement and White Collar Defense practice, where he counsels financial institutions and others on examination and regulatory issues, and represents them before regulatory agencies. Before joining the firm, he was FINRA’s Vice President and Director of Regional Enforcement, and previously held senior enforcement positions at the SEC and CFTC.

Bradley Berman is of counsel in the Capital Markets Group of Morrison & Foerster LLP. Mr. Berman advises domestic and non-U.S. issuers on domestic and international securities offerings of structured products linked to equities, commodities and currencies. He also advises issuers on shelf registration statements, medium term note programs and exempt transactions.

2

Introduction (cont’d)Cornerstone Research is a consulting firm that provides economic and financial analysis in all phases of commercial litigation and regulatory proceedings. Lassaad Adel Turki is Senior Vice President in Cornerstone's Washington DC Office, and heads Cornerstone's finance practice. He has more than twenty years of experience consulting on complex litigation and regulatory matters.Stewart Mayhew is a Principal in Cornerstone's Washington DC Office. Formerly, he was Deputy Chief Economist at the Securities and Exchange Commission, where he worked on a wide range issues related to rulemaking, trading and markets, compliance, and investment management, including the review process for new products.

3

Today’s Presentation

• Overview of regulatory climate for structured products• Trends in economic analysis of structured products• Application of economic tools to structured products• How economists can assist structured products issuers

4

The Regulatory ClimateFINRA and the SEC are highly focused on structured products. Why?

• Wide retail distribution• “Complex” security

Recent FINRA guidance relating to structured products:• FINRA Regulatory Notice 12-03, “Heightened Supervision of Complex Products”:

o Firms must review and assess the adequacy of their controls with respect to complex products;

o In this regard, firms must discharge their suitability obligations;o Firms must perform diligence on the features of complex products, including

potential risks and rewards;o Firms must consider specialized training for representatives charged with

selling complex products;o Firms must consider whether less complex and costly products might be a

better fit for the customer; ando Firms’ internal controls should include periodic reassessments of structured

products.

5

The Regulatory Climate (cont’d)FINRA focus on suitability – New Rule 2111

• A broker’s recommendation of a security must be consistent with the customer’s best interests.

• A member must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the facts known by the member or disclosed by the customer in response to the member’s reasonable efforts to obtain information concerning the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the member considers to be reasonable in making recommendations.

6

The Regulatory Climate (cont’d)There are three main suitability obligations under Rule 2111:

• “Reasonable-basis obligation” requires a member to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.

• “Customer-specific obligation” requires that a member have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile.

• “Quantitative suitability” requires a member to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together in light of the customer’s profile.

7

The Regulatory Climate (cont’d)FINRA Annual Examination Priorities Letter for 2013:

• A focus on suitability and complex products;• Suitability compliance concerns:

o Must be a reasonable basis to believe that a recommendation is suitable for any customer;

o Representatives must fully understand the products that they recommend;o Failures to fully explain the risk versus reward profile of the product; ando Disconnect between customer expectation and risk tolerance.

• Particular products:o Structured products; ando Leveraged ETFs and ETNs, particularly those linked to newly-created

indices with no track record, and those linked to volatility, emerging markets and foreign currencies.

8

The Regulatory Climate (cont’d)SEC sweep letter to issuers of structured products (April 2012)

• Focus -- increased disclosure about the issuer’s “estimated initial value” of a structured product, including disclosure as to why that value is less than the initial public offering price of the structured product

• In other words, why is the investor paying one amount for the newly-issued structured product when its market value is somewhat less than the initial public offering price?

• Some issuers now include “estimated initial value” disclosure;• Other issuers are working on their disclosure.

Issue: Explaining, in plain English, the economic factors that go into valuing a structured product. Issuers don’t all necessarily think alike on this; there is no “one size fits all” answer.

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Concerns Raised in Recent SEC and FINRA Cases

Suitability:• Liquidity and holding periods. For example:

o Closed-end funds – they typically lose value after the initial offering; rarely profitable unless held to maturity.

o Leveraged ETFs and ETNs – these may not be suitable for investors with conservative objectives to hold for extended periods.

• Representative cases: Four FINRA AWCs from April 2012.• Investor sophistication – including the ability to follow the market in real time• Investor wealth and income – the ability to afford substantial losses.

Disclosure – Are the risks clearly explained?Supervision:

• Are the firm’s systems adequate to look for concentration and suitability in sales of these types of instruments?

• Are the firm’s registered representatives adequately trained in the features of these products? Do they understand the products such that they could sketch out their features on a single sheet of paper (the Ketchum test)?

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How Leveraged ETFs Achieve Leverage

Simplified Example:• Double Long ETF on Stock Index

– Receive $100 cash from investors– Use $50 to purchase the stocks in the index– Use $50 as collateral for entering $150 notional of total return swaps on

the index• Can also use index futures

– Total exposure to index is $200• Leverage ratio (200/100) = 2• If the index return is 1%, your return is 2%

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How Leveraged ETFs Achieve Leverage (cont’d)

What’s the Fuss?• The stated objective of a 2X long leveraged ETF is to match 2 times

the return of the reference index, on a daily basis.• Suppose the fund perfectly achieves this stated objective

– Return on NAV equals exactly 2 times the index return each day– Assume the fund is able to achieve perfect tracking with zero error and

zero expenses• The return on the ETF for a period of two days or longer will almost

certainly NOT equal two times the return of the reference index over the period.

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Illustrative Example:(using larger than life numbers)• Initial Index level = 100• Each period, the index either increases by 25% or decreases by 20%

– If the index increases by 25%, the double long ETF increases by 50%– If the index decreases by 20%, the double long ETF decreases by 40%

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After one period…

• Stock Index

• Double Long ETF

100

125

80

Index return = 25%

Index return = ‐20%

100

150

60

ETF return = 50%

ETF return = ‐40%

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After Two Periods . . .

100150

60

36

225

90

100

125

80

64

156.25

100

Two-period return = 56.25%2X Two period return = 112.50%

Two-period return = 0%2X Two period return = 0%

Two-period return = -36%2X Two period return = -72%

ETF return = 125%

ETF return = -64%

ETF return = -10%

Stock Index

Double Long ETF

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Leveraged ETF Returns vs. (Inappropriate) Benchmark

• If the market is strongly up or down, the Leveraged ETF does better than two times the index

• If the market is flat, the Leveraged ETF does worse• These effects are magnified if market volatility is high

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Backtested Returns: In Some Market ConditionsLeveraged ETF Tracks Long Term Target Leverage Ratio Reasonably Well

Nasdaq 100 Index: July 2006 – September 2007

$75

$100

$125

$150

$175

Jul-06 Aug-06 Oct-06 Nov-06 Dec-06 Feb-07 Apr-07 May-07 Jul-07 Aug-07 Sep-07

2X Index Return

ETF 2X Long

Source: Bloomberg

Notes: The green line shows the value of a $100 investment in the Nasdaq 100 index with an initial 2-to-1 leverage ratio July 3, 2006, assuming no subsequent rebalancing. The blue line shows the value of a $100 investment in the Nasdaq 100 index, where the position is adjusted at the close of each trading day to maintain a constant 2-to-1 leverage ratio each day (the strategy followed by leveraged ETFs).

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Backtested Returns: Example of DivergenceNasdaq 100 Index: September 2008 – December 2009

$0

$25

$50

$75

$100

$125

Sep-08 Oct-08 Dec-08 Jan-09 Mar-09 May-09 Jun-09 Aug-09 Sep-09 Nov-09 Dec-09

2X Index Return

ETF 2X Long

Source: Bloomberg

Notes: The green line shows the value of a $100 investment in the Nasdaq 100 index with an initial 2-to-1 leverage ratio on September 2, 2008, assuming no subsequent rebalancing. The blue line shows the value of a $100 investment in the Nasdaq 100 index, where the position is adjusted at the close of each trading day to maintain a constant 2-to-1 leverage ratio each day (the strategy followed by leveraged ETFs).

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Prospectus Disclosure• ProShares Ultra S&P 500• Guggenheim 2X S&P 500• Direxion Daily S&P 500 Bull

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What is the role of economicanalysis in structured products?

• Designing the product;• Testing the product;• Drafting/reviewing disclosure;• Monitoring actual performance; and• Defending the issuer or dealer in enforcement proceedings or private

actions.

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Hands-On EconomicsRoles of the Economist:

• Evaluating a structure to determine if there is a unique payoff that cannot be achieved directly through other products;

• Estimating the cost of embedded fees; and• Evaluating whether hypotheticals in the disclosure describe a full range of possible

scenarios.

Example: Responding to the SEC’s sweep letter request to fully disclose the estimated initial value of a typical structured product.

One of FINRA’s concerns is that the embedded fees are so high that the product may be unsuitable for an investor with a quick turnaround in mind; i.e., with no desire to hold the note to maturity. How to craft the disclosure?

21

Valuing a Structured Product

Use of Market Prices• Is the structured product traded on an exchange? If so, is

the aftermarket price informative about value?• Example: Exchange Traded Structured Note

– Issued in 2002– McCann and Luo analysis claims the fair value was $880 per

$1000 of face value suggesting an implicit fee of 12%– But market prices the first week of trading indicated a value

between $950 and $980.

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Valuing a Structured Product (cont’d)Example: Exchange Traded Structured Note Closing Prices: Aug. 30, 2002 – Sept. 20, 2002

$800

$825

$850

$875

$900

$925

$950

$975

$1,000

$1,025

$1,050

$1,075

$1,100

8/30/02 9/3/02 9/7/02 9/11/02 9/15/02 9/20/02

Price

Valuation reported by McCann and Luo

Source: Bloomberg; McCann, Craig and Dengpan Luo, "Are Structured Products Suitable for Retail Investors?" White paper, 2006.

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Valuing a Structured Product (cont’d)Valuation Example (using approximate values)Structured Notes Linked to the S&P 500 Index• Initial valuation date: 9/28/2011

(S&P 500: ~1150)• Payoff linked to S&P 500 on 9/28/2017• Offering price = 1000• Terminal payoff:

S&P 500 < ~1150: 1000~1150 < S&P 500 < ~2070: 1000 X Index Return~2070 < S&P 500: 1800

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Valuing a Structured Product (cont’d)Payoff Diagram

~1150 ~2070

1000

1800

S&P 500 Level

Payoff

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Valuing a Structured Product (cont’d)Decomposition• This Structured Note is economically equivalent to a

portfolio consisting of:• Zero coupon bond with face value 1000• Purchased “ATM” call option with strike price of ~1150• Written “OTM” call option with strike price of ~ 2070

• Estimated value depends on what model is used to price these options

• It also depend on the inputs to these models (especially volatility)

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Valuing a Structured Product (cont’d)Valuation Can Be Sensitive toChoice of Models and Inputs• In pricing the option components of the structured

product, there are various possible models• A common, simple choice is to use the Black-Scholes

model (but there are other choices)• The volatility of the underlying asset is an unobserved

input—choosing an appropriate value is not always straightforward

– Historical volatility– Implied volatility

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Valuing a Structured Product (cont’d)Historical Volatility• Historical volatility is typically estimated by computing the

(annualized) standard deviation of daily returns on the underlying stock or index

• This is generally used if the underlying stock or index does not have exchange-traded options available

• There is no universally accepted standard for how much past data to use

• Different choices can lead to quite difference values– Using two months of data to estimate volatility results in a

volatility of 33.5%– Using one year of data results in a volatility of 19.9%

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Valuing a Structured Product (cont’d)Implied Volatility• Implied volatility is backed out from the prices of traded

options• If the structured product has two embedded options,

should one use the same volatility to price both?• Probably not—it is well known that the implied volatilities

for traded options vary depending on the strike price and time to expiration

– The Implied volatility for a long term At-the-Money S&P 500 option was 28.8%

– The implied volatility for an option with strike price at 180% of the current stock price was 22.5%

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Valuing a Structured Product (cont’d)Implied Volatility for S&P 500 Options Expiring in Dec. 2017Extrapolated from Exchange Traded Option Prices Sept. 28, 2011

0

5

10

15

20

25

30

35

40

60% 80% 100% 120% 140% 160% 180% 200%

Impli

ed Vo

latilit

y (%)

Moneyness (Strike / Index)

ATM Volatility

180% OTM Volatility

Source: Bloomberg

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Valuation• Black-Scholes model using reasonable assumptions

gives a range of values– Two implied volatilities: Note value = $965.45– Single implied volatility: Note value = $932.93– Historical (Two months): Note value = $935.35– Historical (One year): Note value = $917.05

• Value reported in SLCG Report: $921.17

Valuing a Structured Product (cont’d)

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In summary• If the structured product cannot be perfectly replicated

using exchange traded bonds and options, there is no single methodology universally accepted as the best

• In our example, the “implicit” fee paid by investors ranged from 3.5% to 8.3% depending on assumptions.

• Regulators and plaintiffs may focus on certain assumptions that make the fee look high

• Economic analysis based on a reasonable range of assumptions can provide a more balanced view

Valuing a Structured Product (cont’d)

32

Cost of Non-Compliance with FINRA Rules

FINRA’s 2012 Enforcement action results:• 2012 was the fourth straight year of growth in the number of disciplinary

actions;• An increase of 15.6% in the number of suspended individuals, as compared

to 2011;• An increase of 15.6% in the amount of fines imposed; • Suitability cases were the top enforcement issue for 2012; $19.4 million in

fines assessed; the four ETF cases were a significant component; $22.5 million in restitution ordered in connection with suitability cases;

• Due diligence cases were the second highest number of assessed fines; due diligence cases included those involving complex products;

• Nine ETF cases in 2012; $7.6 million in fines assessed; the four ETF cases involved leveraged and inverse ETFs that FINRA alleged were unsuitable for conservative investors.

1 Attorney Advertising

Volume 3, Issue 14 December 18, 2012

Dividend Adjustments on the Way To help shareholders benefit in the event that Congress does not retain the lower rates for dividends in connection with the ongoing “fiscal cliff” negotiations, a variety of companies have increased their fourth quarter dividends in 2012. Some companies have accelerated the payment dates of their planned dividends to ensure that they are paid before the end of the year. Some have increased their planned dividend payments above prior quarterly levels. Other companies may pay a special dividend payment. In some cases, the fourth quarter increase will be offset by a decrease in the subsequent first quarter's dividend. In each case, these dividend payments may trigger the dividend adjustment provisions of structured notes linked to the relevant underlying stocks.

Most stock-linked notes have provisions that adjust the price of the stock, and therefore, the return on the notes, when the linked stock pays a special or extraordinary dividend. After the applicable “ex date”, a special dividend may reduce the stock price, in order to account for the smaller amount of cash held by the company. Consequently, for typical stock-linked notes, which are bullish on the linked stock, a special dividend would usually reduce the note’s return if protections are not built into the note terms. And of course, holders of structured notes usually don’t benefit from the dividend on the linked stock. Dividend adjustment provisions protect the investors’ interests by, under certain circumstances, adjusting upwards the price of the linked stock for purposes of the notes, offsetting the negative impact of the special dividend.

Various dividend adjustment provisions exist:

• A special dividend must exceed a certain size threshold to be triggered.

• A special dividend must be deemed “material” by the calculation agent in order to be triggered.

IN THIS ISSUE:

Dividend Adjustments on the Way…page 1

Federal Court Decision Supports Use of “Big-Boy Letters”…………….page 2

FINRA Updates Its Suitability Questions and Answers…….……....page 3

FINRA Rule 5123 Excludes Some, But Not All, Options………………….page 4

Commodity Pool Issues……………..page 5

Indices: GFMA’s Framework of Principles...………………..…..……...page 5

Division of Investment Management Lifts ETF Ban, But Not for Leveraged ETFs……………………..page 6

Here Comes 2013…………………...page 6

MoFo Capital Markets Introduces Structured Products Resource Page…………………………………..page 9

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Attorney Advertising

• Mainly in the case of single-stock linked notes purchased by institutional investors, a provision that is automatically triggered whenever the dividend exceeds, or is less than, a “base dividend” agreed to at the time of pricing. This type of provision can differ from the other two types. Instead of providing only “investor protection,” this type of provision can also work “adversely” to an investor when the linked stock reduces its dividend, because the provision will cause the stock price, for purposes of the notes, to decrease.

As a result, depending upon the terms of a structured note, the planned dividend increases may cause an upward adjustment of the stock price. For a smaller set of notes, mainly notes for institutional investors described in the third bullet above, a potential Q1 dividend decrease after the Q4 increase may then decrease the stock price after the initial upward adjustment.

Depending on the circumstances of the relevant company, stockholders may receive the same total amount of cash with or without the special dividend. They could simply receive it sooner and at a lower average income tax rate. In contrast, depending on the terms of a structured note, some notes may have increased returns due to the increased dividend, and then, may or may not have a decreased return due to the Q1 decreased dividend. In this regard, calculation agents for structured notes may wish to review the adjustment provisions for notes subject to a special dividend, and the extent to which they have discretion to require an adjustment, or to modulate the extent of the required adjustment.

Federal Court Decision Supports Use of “Big-Boy Letters”

Introduction

“Big-Boy Letters” are often used as a tool to limit an issuer’s or broker-dealer’s potential liability in connection with a private sale of securities. In these letters, the investor represents that, as a “big boy,” it is a sophisticated party that can fend for itself. Often, these letters also contain an explicit waiver of all claims against the inside party arising from the nondisclosure of non-public information, including violations of Rule 10b-5 under the Securities Act of 1933.

“Big Boy Letters” serve several useful purposes for both the inside and outside parties as they can:

• increase the execution speed of time-sensitive transactions;

• reduce the costs and risks of potential claims and liability from frustrated counterparties; and

• facilitate the contractual allocation of risks between sophisticated parties.

These letters can be particularly useful in connection with private sales of sophisticated structured products to institutional investors. For example, the security may have particularly complex terms, and/or an affiliate of the issuer may possess material non-public information that relates to the security, such as business or financial information about the stock linked to the structured note.

Are They Enforceable?

The enforceability of “Big-Boy Letters” has been the subject of dispute.1 This uncertainty stems from tension between the “sanctity of a contract,” on the one hand, and Section 29(a) of the Securities Exchange Act of 1934, which states that waivers of liability for securities fraud are void as a matter of public policy. However, a recent U.S. District Court decision has articulated a means to honor the contractual relationship created by “Big-Boy Letters” without characterizing their effect as a waiver of securities fraud liability and thus as void as a matter of public policy.

1 Compare Harsco v. Segui, 91 F.3d 337 (2d Cir. 1996) (indicating that waivers that are the result of sophisticated business entities negotiating at arm’s length should be enforced), with AES Corp v. The Down Chemical Co., 325 F.3d 174 (3d Cir. 2003) (rejecting the Harsco court’s view that sophisticated parties can contract out of duties imposed by federal securities laws).

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Pharos Capital

In Pharos Capital Partners, L.P. v. Deloitte & Touche, LLP, plaintiff Pharos Capital Partners (“Pharos”) filed suit alleging fraud in connection with its $12 million equity investment in National Century Financial Enterprise, Inc. (“NCEF”)—an investment that lost its full value when NCEF proceeded to file for bankruptcy.2 Pharos claimed that defendant Credit Suisse Securities, LLC (“Credit Suisse”), acting as co-placement agent in connection with the offering, failed to disclose material information while also materially misrepresenting NCEF’s business operations. Credit Suisse’s defense rested primarily on the existence of a “Big-Boy Letter,” in which Pharos acknowledged that it was a “sophisticated institutional investor” who was “relying exclusively” on its own due diligence and would bear the risk of an “entire loss” of its investment.3

Rather than treating the “Big-Boy Letter” as a waiver of liability, the court focused on its effect on a crucial element of successful fraud claims. In granting summary judgment in favor of defendant Credit Suisse, the court noted that common law claims for fraud and negligent misrepresentation require the aggrieved party to have justifiably relied upon the alleged misrepresentation or omission. The court then went on to cite the clear language of the “Big-Boy Letter” to hold that any reliance on the part of Pharos was unjustifiable and thus does not support a claim for fraud or negligent misrepresentation.4 In other words, the existence of a well-crafted “Big-Boy Letter” does not waive liability for securities fraud; rather, it may eviscerate the underpinnings of such a claim.

Pharos demonstrates the value to underwriters of furnishing “Big-Boy Letters” in connection with the offering of complex structured products. However, the existence of such a letter, on its own, may not be sufficient to shield underwriters from liability. Underwriters should also have reason to believe that the investor can in fact protect itself. Obtaining this level of comfort requires reasonable know-your-customer procedures, providing access to any relevant requested materials upon which the investor can rely, and negotiating the content of the “Big-Boy Letter” to evidence an arm’s length transaction between two sophisticated parties.

FINRA Updates Its Suitability Questions and Answers

On December 10, 2012, FINRA issued Regulatory Notice 12-55, in which FINRA expanded on its earlier suitability guidance, in Regulatory Notice 12-25, of the terms “customer” and “investment strategy”, as used in FINRA Rule 2111. FINRA also provided a link to its new “suitability Web page”, containing questions and answers about FINRA Rule 2111.

Regulatory Notice 12-55 can be found at:

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p197435.pdf

The suitability web page can be found at:

http://www.finra.org/Industry/Issues/Suitability/

The updated guidance is relevant to sales practices in the structured products industry.5

Definition of “Customer” as it Relates to Potential Investors

FINRA clarified that the suitability rule applies to a potential investor who then becomes a customer, and the point at which suitability obligations attach. The rule applies where a registered representative makes a recommendation to purchase a security to a potential investor if that individual executes the transaction through the broker-dealer with which

2 2012 WL 5334027 (S.D. Oh. Oct. 26, 2012). 3 Id. at *1. 4 Id. at *9. 5 We most recently described FINRA Rule 2111 and Regulatory Notice 12-25 in Volume 3, Issue 8 of Structured Thoughts (available at http://www.mofo.com/files/Uploads/Images/120530-Structured-Thoughts.pdf).


http://www.finra.org/Industry/Issues/Suitability/

http://www.mofo.com/files/Uploads/Images/120530-Structured-Thoughts.pdf

4



the representative is associated or the broker-dealer will receive, directly or indirectly, compensation as a result of the recommended transaction. The suitability obligation would not apply, however, if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.

FINRA noted that, with respect to a recommendation made to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on circumstances that existed at the time that the recommendation was made. When a broker-dealer or registered representative makes a recommendation to a customer (as opposed to a potential investor), suitability obligations attach at the time that the recommendation is made, irrespective of whether a transaction occurs.

Investment Strategies

FINRA expanded on its examples of what would or would not be considered an “investment strategy”. Recommended investment strategies must be suitable. Recommendations of some specific types of securities, such as high dividend companies or types of securities in a particular market sector would constitute an investment strategy, regardless of whether the recommendation identified particular securities. The notice does not indicate whether recommending “structured notes” generally is sufficiently specific to constitute an investment strategy.6

Recommendations that do not refer to a security or securities do not fall under the suitability rule. For example, the rule would not apply to a registered representative’s recommendation of a non-security investment as part of a customer’s outside business activity, where that customer separately decides on its own to liquidate securities positions and apply the proceeds toward the recommended non-security investment. In contrast, if a customer, absent a recommendation by a registered representative, decides on its own to purchase a non-security investment and then asks the registered representative to recommend which securities the customer should sell to fund the purchase of the non-security investment, the suitability rule would apply to the recommendation regarding which securities to sell, but not to the customer’s decision to purchase the non-security investment.

The notice raises the question about a broker-dealer’s supervisory responsibilities for a registered representative’s recommendation of an investment strategy involving a security and a non-security investment. While stating that its supervisory rules do not provide an exact method, the notice indicated that a broker-dealer could use a risk-based approach. A firm could focus on the detection, investigation and follow-up of “red flags” indicating that a recommendation may have been made for an unsuitable investment strategy with both a security and a non-security component. The suitability obligations would apply to the security component of the recommended investment strategy, but the suitability analysis must also be informed by a general understanding of the non-security component of the recommended investment strategy. These concerns would apply to an investment strategy that involves structured certificates of deposits, even though they are typically not “securities”, and other structured products. FINRA reminded broker-dealers of their other regulatory obligations to investigate unusual activity.

FINRA Rule 5123 Excludes Some, But Not All, Options

Option issuers may be surprised to learn that sales of some over-the-counter options are within the filing requirements of FINRA Rule 5123 (Private Placements of Securities). Rule 5123 requires members selling securities issued by non-members in a private placement to file the private placement memorandum, term sheet or other offering documents with FINRA within 15 days of the first sale of the securities, or indicate that there were no offering documents used.7

6 As a practical matter, a general recommendation of “structured notes” would most likely be followed by the investor asking “which ones?” The suitability determination would apply to the registered representative’s response. 7 FINRA Rule 5123 is available on FINRA’s website at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=10753. We have issued two News Bulletins on Rule 5123. “SEC Adopts New FINRA Rule 5123 on Private Placements” can be found at http://www.mofo.com/files/Uploads/Images/120615-FINRA-Rule-5123.pdf and “FINRA Issues Guidance for Private Placement Filings” can be found at http://www.mofo.com/files/Uploads/Images/121210-FINRA-Issues-Guidance-Private-Placements.pdf.

http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=10753

http://www.mofo.com/files/Uploads/Images/120615-FINRA-Rule-5123.pdf

http://www.mofo.com/files/Uploads/Images/121210-FINRA-Issues-Guidance-Private-Placements.pdf

5



A sale of an OTC equity option to an individual accredited investor would require the member to make the filing required by the rule. Rule 5123(b)(1) exempts private placements to certain classes of investors, including accredited investors described in Rule 501(a)(1), (2), (3) or (7) under the Securities Act of 1933 (institutional accredited investors) and eligible contract participants, as defined in Section 3(a)(65) of the Securities Exchange Act of 1934.

The rule also exempts private placements of standardized options, as defined in Rule 238 under the Securities Act. Standardized options must be traded on a national securities exchange or on a national securities association registered pursuant to Section 15A(a) of the Securities Exchange Act. Consequently, a private placement of OTC options to an individual accredited investor, or to any other investor not within the classes of exempted investors enumerated in Rule 5123(b)(1), would require a member to file the private offering documents. This seems to be an incongruous result since options trading can only be undertaken with customers that have been cleared for options trading and who receive options disclosures.8 Commodity Pool Issues

As many are aware, the Dodd-Frank Act amended the definition of “commodity pool”, making it broader by including any enterprise operated for the purpose of trading in swaps. Trading in swaps may seem like a high bar, but there is little guidance as to the type of entity that constitutes a “commodity pool.” Some of that guidance suggests that entering into a single swap may be sufficient to trigger the registration requirement. The CFTC has issued various interpretative letters clarifying that certain entities (such as business development companies, family offices, equity REITs, etc.) that might inadvertently be included within the “commodity pool” definition should not be considered commodity pools to the extent that these entities satisfy the specified CFTC conditions for relief. Institutions that use repackaging vehicles or that use trust vehicles to issue structured products should consider whether any of these vehicles may be considered a commodity pool. In CFTC Letter No. 12-45 issued on December 7, 2012, the CFTC provides further relief for certain legacy and other securitization vehicles.9 However, the CFTC also notes in that letter that certain vehicles may be deemed commodity pools, including, for example “a repackaging vehicle that issues credit-linked or equity-linked notes where the repackaging vehicle owns high quality financial assets, but sells credit protection on a broad based index or obtains exposure to a broad based stock index through a swap. The vehicle finances its acquisition of the high quality assets by issuing notes to investors that are linked to credit risks or price changes in the stock index.” The CFTC notes that this type of vehicle may be a commodity pool. Further, the CFTC also points to another example: “a repackaging vehicle that acquired a three year bond, issued a tranche of notes, and used swaps to extend the investment experience of the bond (and thus the tranche of notes) to four years may be deemed to be a commodity pool, as would a repackaging vehicle that paired the three year bond with a swap to provide inflation rate protection.” In light of this commentary and the over broad definition of “commodity pool,” any structured product that relies on the use of a trust or other collective investment vehicle should be analyzed closely. Indices: GFMA’s Framework of Principles

Following on from the publication of its proposals in September 2012, the Global Financial Markets Association (“GFMA”) has now released its final framework of principles in respect of conducting benchmark price assessment. The principles focus on enhancing market integrity and transparency through sponsors (i.e., entities or groups which develop and direct the determination, publication and licensing of a benchmark) meeting three primary obligations when designing, operating and publishing benchmarks:

1) governance – ensuring that there is a single point of accountability and that roles and responsibilities are clearly defined;

8 FINRA Rule 0180, which precludes the application of Rule 5123 and other FINRA rules to security-based swaps, does not apply to a private placement of an OTC equity option, as such an option does not fall within the definition of a “Security-Based Swap”, as defined in Section 3(a)(68) of the Securities Exchange Act and the rules and guidance of the SEC or its staff. 9 The letter may be found at the following link: http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-45.pdf.

http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-45.pdf

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2) design and methodology – ensuring that, amongst other things, the benchmark has a robust design which provides an accurate measure of the market and incorporates (where possible) real transaction data; and

3) control infrastructure – ensuring that a resilient infrastructure is in place by requiring periodic review and the maintenance of mechanisms which provide continuity of the benchmark under duress.

The GFMA principles are only a first step towards improving market confidence in benchmarks. Next steps include ensuring the broadest possible agreement from all stakeholders through promoting awareness and understanding of the principles in meetings and calls and attempting to encourage stakeholders to hold each other accountable by refusing to do business with each other in the event of breaches of the principles. Further discussion and consultation with regulators, government entities and industry bodies is required in order to review the principles and generate feedback. It is hoped that the principles will be incorporated by regulators and governments as they take further strides to co-ordinate an international approach. Such efforts to date include:

1) consultation on the functioning and oversight of oil price reporting agencies by IOSCO in March 2012;

2) review of the framework for setting and governing LIBOR by the designated new chief executive of the Financial Conduct Authority, Martin Wheatley (August 2012);

3) European Commission consultation seeking views on possible new regulations governing the creation and use of indices which serve as benchmarks (September 2012);

4) IOSCO are also currently looking at benchmarks generally and it is expected that a consultation will be released in January 2013; and

5) ESMA are preparing some interim principles for issuance at the EU level in respect of benchmarks generally. Again, these are expected to be published in early 2013.

The Division of Investment Management Lifts ETF Ban, But Not for Leveraged ETFs In remarks made on December 6, 2012 to the ALI CLE 2012 Conference on Investment Adviser Regulation.10 Norm Champ, the Director of the Division of Investment Management, said that the Division will partially lift the two-year old moratorium on considering exemptive requests under the Investment Company Act of 1940 relating to actively-managed exchange-traded funds that make use of derivative products, subject to certain representations to be made in any future exemptive request. However, due to the Division’s concerns about leveraged ETFs, Director Champ said that the Division will “continue not to support new exemptive relief for such ETFs.”

Please see the full discussion of Director Champ’s remarks in the December 2012 Morrison & Foerster Investment Management Legal + Regulatory Update, which can be found at http://www.mofo.com/files/Uploads/Images/121214-Investment-Management-Update.pdf.

Here Comes 2013… This is our last issue of Structured Thoughts for 2012. We wish our readers happy and healthy holidays, and a wonderful new year.

The business and regulatory environment for structured products continues to evolve, sometimes in ways that surprise all of us. In this final article, we identify a few items to look out for in 2013.

10 Director Champ’s remarks can be found at http://www.sec.gov/news/speech/2012/spchl20612nc.htm.

http://www.mofo.com/files/Uploads/Images/121214-Investment-Management-Update.pdf

http://www.mofo.com/files/Uploads/Images/121214-Investment-Management-Update.pdf

http://www.sec.gov/news/speech/2012/spchl20612nc.htm

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Estimated Value. Market participants will probably remember 2012 most for the SEC’s April 2012 sweep letter, and its focus on the disclosure of estimated values of structured notes. As of the end of 2012, most market participants have not revised their structured note offering documents, as they continue their discussions with the SEC staff, await additional guidance from the SEC, and/or complete their internal valuation procedures. If the SEC does in fact provide any additional guidance, and as issuers have the opportunity to consider best practices in connection with the new disclosures, we may see further evolution in these disclosures.

New FINRA Communications Rules. On February 4, 2013, FINRA’s new communication rules, 2210 and 2211, will become effective. Market participants will be furnishing a greater number of free writing prospectuses and similar documents relating to structured products to FINRA, and obtaining principal review for a variety of offering documents. Based on the new submissions, it is possible that the FINRA staff will reach out to specific broker-dealers, or to the market generally, as to any disclosure practices that it deems insufficient.

Amendments to Regulation M. The SEC has not yet issued final rules with respect to its proposal to remove the references to investment grade securities from Regulation M.11 Any revisions to Regulation M may impact the manner in which structured notes are offered, and the manner in which broker-dealers create a secondary market for them.

Conflicts of interest. The SEC issued proposed rules to implement the Dodd-Frank Act Section 621 prohibition on material conflicts of interest relating to certain securitizations some time ago, and has not finalized these rules. The conflicts of interest proposals may affect certain structured products that are issued in reliance on a special purpose vehicle or trust. The conflicts of interest rules are expected to be finalized toward the end of the first quarter of 2013, in conjunction with final action on the Volcker Rule. Volcker Rule. The Volcker Rule also may have an effect on the structured products market, especially on the type of secondary market activity that will be permissible for underwriters of structured products. Based on recent statements by regulators, we anticipate that the Volcker Rule will be finalized by March 2013. FINRA and Conflicts of Interest. In July 2012, FINRA commenced a street sweep, soliciting information as to how participants in the structured products market identified and managed conflicts of interest.12 Once FINRA has evaluated and digested the information obtained by the sweep, it may take additional actions, including the identification of best practices for industry participants, or sanctioning broker-dealers that have not made proper disclosures or maintained proper procedures.

Role of Third Party Distributors. Both the SEC and FINRA have taken an interest in the role that third-party dealers (i.e., distributors other than the lead underwriter, such as selling group members) play in the distribution of structured products. At times, questions have arisen as to how these distributors are selected and screened by the lead underwriter, and whether these distributors have adequate sophistication and training to offer structured products for their customers. The “know your dealer” regime remains largely unregulated in the U.S., with different market participants following different procedures, and making different decisions as to which entities they will permit to participate in their offerings. 2013 may see additional scrutiny, and perhaps additional guidance, as to the role that these distributors play.

Reverse Inquiry Transactions. Both the SEC and FINRA have raised questions to market participants relating to reverse inquiry transactions. This process in part reflects the process by which these regulators are becoming more educated as to the role of reverse inquiry transactions from registered investment advisors and other sophisticated investors in the offering process. Questions have arisen as to whether the existing disclosure and pricing practices, including the new estimated value disclosures, remain as relevant for these types of investors, and whether differences in the offering process and offering documents are appropriate in these cases.

Proprietary Indices and Related Guidance. Broker-dealers continue to seek to enhance their range of offerings, and to provide useful investment tools for investors, by developing a range of proprietary indices. Of course, due to potential uncertainties under existing legislation, including the Investment Company Act and the Investment Advisers Act, many

11 We discussed the proposals in Volume 2, Issue 10 of Structured Thoughts: http://www.mofo.com/files/Uploads/Images/110620-Structured-Thoughts.pdf. 12 We discussed the street sweep in our August 2012 client alert: http://www.mofo.com/files/Uploads/Images/120814-FINRA-Conflicts-of-Interest.pdf.



http://www.mofo.com/files/Uploads/Images/120814-FINRA-Conflicts-of-Interest.pdf

http://www.mofo.com/files/Uploads/Images/120814-FINRA-Conflicts-of-Interest.pdf

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issuers and underwriters have taken a cautious approach to some proposed products. Whether in 2013, or at some later point, market participants will hope to obtain more clarity as to the rules of the road, and the extent to which their affiliated broker’s investment recommendations and/or discretion can play a role in developing these indices. Efforts by industry organizations, such as the Global Financial Markets Association,13 to identify standards relating to new market measures may also gain traction as best practices in the market.

European Regulatory Developments

PRIPs Initiative Developments. Regulatory initiatives with respect to Packaged Retail Investment Products (or PRIPs) gained momentum this year, with the publication of draft regulations in July 2012 and first EU presidency compromise proposal on November 27, 2012. The regulations require that in circumstances where an investment product is sold to retail investors, a Key Investor Document (KID) must be prepared by the product ‘manufacturer’. It is expected that further consideration will be given by the European Parliament and the Counsel of the EU to the legislative proposals during 2013, with a vote by the European Parliament’s Economic and Monetary Affairs Committee scheduled for March 20, 2013. It is not expected, however, that the regulations will apply until mid-2015. EMIR Reporting Requirements. Transaction reporting requirements in respect of derivatives transactions in the European Union will be phased in from 2013 onwards. Where there is a registered trade repository available, transaction reporting of credit and interest rate contracts will be required from July 1, 2013. This is the earliest possible date from which transaction reporting under the European Market Infrastructure Regulation (EMIR) shall be required. If there is no registered trade repository available on or before April 1, 2013, reporting must take place within 90 days after registration of such trade repository. If there is no registered trade repository available on or before July 1, 2015, reporting commences on July 1, 2015, directly to the European Securities and Markets Authority (ESMA). Transaction reporting in respect of all other types of derivatives contracts shall not be required until 2014 at the earliest. UCITS V. In July 2012, the European Commission published a legislative proposal focusing on amendments with respect to the duties of depositories (safe-keeping, oversight and delegation), the remuneration of UCITS managers and the ways in which the relevant rules could be better harmonized. It is expected that the proposal will be further considered by the European Parliament during 2013, although it is also widely believed that member states will be given around 2 years to transpose the amendments to the existing directive into their national laws. Accordingly, it is unlikely that any changes will come into effect until the end of 2014 at the earliest. MiFID II. Legislative proposals intended to replace and recast the Markets in Financial Instruments Directive are slated to be considered by the European Parliament in its plenary session on October 24 / 25, 2013. Such scheduling comes a full year after the proposals were originally intended to be considered. Financial Conduct Authority (UK only). On April 1, 2013, the Financial Services Authority (FSA) will finally be replaced as the UK’s single financial services regulator. The Financial Conduct Authority (FCA) will assume its new role as regulator of wholesale, retail and financial markets, the infrastructure which supports those markets and as prudential regulator of firms which do not fall under the scope of the new Prudential Regulation Authority (PRA). These changes are likely to result in new powers of the FCA to utilize temporary product intervention rules. A consultation on these issues is currently underway and it is intended that a final statement of policy will be published in advance of the legal cutover to the FCA in April 2013. Retail Distribution Review (UK only). Efforts have been made in the UK to ensure that there is greater clarity with respect to advice provided by investment advisers. Measures which come into force in 2013 include: (1) a requirement that firms state whether they offer “independent advice” (i.e., personal, unbiased recommendations based on a comprehensive and fair analysis of the relevant market) or “restricted advice” (i.e., where an advisor is tied to specific products), (2) stricter requirements regarding minimum qualification levels for advisers and in respect of their continuing professional development (CPD); and (3) a ban on traditional forms of commission (paid by product providers to investment advisers) in respect of advised sales relating to investment products. Instead, consumers will pay an agreed investment adviser charge, either in the form of a fee or as part of the product.

We look forward to continuing the conversation in 2013…. 13 The GFMA’s proposed principles may be found at: http://www.gfma.org/correspondence/item.aspx?id=350.

http://www.gfma.org/correspondence/item.aspx?id=350

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MoFo Capital Markets Introduces Structured Product Resource Page

By popular demand of our clients and other market participants, our capital markets website now includes a page containing links to key legal resources relating to structured products.

The page may be found at the following link: http://www.mofo.com/resources/structured-products/.

The page includes links to a wide variety of frequently-used reference materials, including:

• FINRA’s releases relating to structured products.

• FINRA’s enforcement proceedings relating to structured products.

• SEC materials relating to structured products.

• Back-issues of this venerable publication.

• And more.

We hope these materials will help you navigate the evolving legal landscape for structured products.

Contacts Bradley Berman New York (212) 336-4177 [email protected]

Peter Green London 4420 7920 [email protected]

Lloyd Harmetz New York (212) 468-8061 [email protected]

Jeremy Jennings-Mares London 4420 7920 4072 [email protected]

Lewis Lee London 4420 7920 4071 [email protected]

Anna Pinedo New York (212) 468-8179 [email protected]

Ryan Williams New York (212) 336-4227 [email protected]

FAQs at Your Fingertips Knowledge is power, and now, with the eBook version of MoFo’s FAQs, you can be even more powerful. We’ve taken our popular FAQs containing questions and answers about securities offerings, securities filings, etc. and created an eBook that you can download on your iOS or Kindle device and readily access and search. Imagine that—MoFo magic at your fingertips. Download our FAQs to your iPhone or iPad here, and to your Kindle here. For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts. Morrison & Foerster named Structured Products Firm of the Year, Americas, 2012 by Structured Products magazine for the fifth time in the last seven years. See the write up at http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf. Morrison & Foerster named Best Law Firm of the Americas, 2012 by StructuredRetailProducts.com. About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology, and life sciences companies. We’ve been included on The American Lawyer’s A-List for nine straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2012 Morrison & Foerster LLP. All rights reserved. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

http://www.mofo.com/resources/structured-products/

mailto:[email protected]







https://itunes.apple.com/us/book/capital-markets-securities/id585629137?mt=11

http://www.amazon.com/Capital-Markets-Securities-FAQs-ebook/dp/B00AJ2CWW8

http://www.twitter.com/Thinkingcapmkts

http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf

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Volume 3, Issue 8 May 30, 2012

FINRA’s New Guidance Relating to Suitability – Potential Impact on Structured Products On May 21, 2012, FINRA issued Regulatory Notice 12-25, in which FINRA provided additional guidance on its new suitability rule, FINRA Rule 2111. The notice may be found at:

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf.

The additional guidance responds to industry questions about Rule 2111. Some of the additional guidance applies to sales practices in the structured products industry; we discuss that guidance below.1 The new notice reminds the industry that many of the obligations under the new suitability rules are the same as under the predecessor rules. However, the new Q&A’s provide some useful indications of FINRA’s views on a variety of questions that brokers frequently must address.

1 We previously described the provisions of FINRA Rule 2111 in Volume 1, Issue 13 of Structured Thoughts (available at: http://www.mofo.com/files/Uploads/Images/101004-Structured-Thoughts-Issue-13.pdf), as well as FINRA’s announcement of the original effective date of the rule in Volume 2, Issue 1 of Structured Thoughts (available at: http://www.mofo.com/files/Uploads/Images/110120-Structured-Thoughts.pdf). We have also discussed FINRA Regulatory Notice 11-25, which contained answers to frequently asked questions about FINRA Rule 2111, in Volume 2, Issue 7 of Structured Thoughts (available at http://www.mofo.com/files/Uploads/Images/110620-Structured-Thoughts.pdf).

IN THIS ISSUE: FINRA’s New Guidance Relating to Suitability – Potential Impact on Structured Products ….......................page 1 FINRA’s Consent Agreements Target Supervisory Systems and Procedures in the Sale of Non-Traditional ETFs…page 4 Massachusetts Fines Broker Dealer for Sales of Non-Traditional ETFs............page 6


http://www.mofo.com/files/Uploads/Images/101004-Structured-Thoughts-Issue-13.pdf





Acting in a Customer’s Best Interests

A broker’s recommendation of a security must be consistent with his or her customer’s best interests.2 The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing the broker’s interests ahead of the customer’s interests.3 In answer to a question about the meaning of acting “in a customer’s best interests,” FINRA provided examples where brokers had violated the suitability rule by placing their interests ahead of the customer’s.

One example, which would apply to structured products and any other type of security, was a broker whose motivation for recommending one product over another was to receive larger commissions.4 FINRA noted that the cost associated with a recommendation is only one of many important factors to consider when determining whether the subject security or investment strategy involving a security or securities is suitable.5 Steering an investor to an investment solely due to its profitability for the firm or the broker would be problematic under the suitability rules. If the recommendation is suitable for the customer and the broker is not placing the broker’s interests ahead of the customer’s, then the broker would not be obligated to recommend a product with the lowest commission.

When assessing whether a recommendation is in the customer’s best interests, in addition to the customer’s investment profile, product or strategy-related factors must also be considered. One product-related characteristic is “special or unusual features,” which are present in many structured products.6

Recommendations

In answer to a request to enumerate factors to consider in determining whether a recommendation has been made for purposes of Rule 2111, FINRA pointed to existing FINRA and SEC guidance as to particular communications that could be viewed as recommendations. FINRA highlighted that “a broker-dealer’s use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a ‘recommendation’ for purposes of the suitability rule.”7 Accordingly, consistent with the understanding of practitioners, the brochures and marketing materials used by many broker-dealers relating to structured products would typically not on their own (in the absence of other communications) be deemed to be “recommendations.”

Investment Strategies

In response to a request for a description of a suitable investment strategy, FINRA responded by explaining that a broker’s recommendation that a customer generally invest in equities or fixed income securities would not be an investment strategy covered by Rule 2111, unless that recommendation was part of an asset allocation plan not eligible for the safe harbor provisions of Rule 2111.03. However, FINRA pointed out that the rule would apply to recommendations to “invest in more specific types of securities, such as high dividend companies or ‘Dogs of the Dow’ ….”8 The “Dogs of the Dow” strategy is premised on investing “equal dollar amounts in the ten constituents of the Dow Jones industrial average with the highest dividend yields, hold[ing] them for twelve months and then switch[ing] to a new group of dogs.”9

As a result, a recommendation to invest in many types of structured products could trigger the requirement that the investment strategy be suitable under Rule 2111. A recommendation as to a structured product could fall into two categories of the suitability requirements – the security itself and the strategy that the security reflects.

2 Regulatory Notice 12-25, page 3, and footnote 15. 3 Regulatory Notice 12-25, page 3, and footnote 16. 4 Regulatory Notice 12-25, page 3, and footnote 17. 5 Regulatory Notice 12-25, page 4. 6 Regulatory Notice 12-25, page 4. 7 Regulatory Notice 12-25, page 4 and footnote 25. 8 Regulatory Notice 12-25, page 6. 9 Regulatory Notice 12-25, footnote 35.



The “investment strategy” language also covers broker’s recommendations for investing in both a security and a non-security.10 Consequently, a recommendation as to an investment strategy that involved purchases of structured certificates of deposit as part of an investment portfolio would be subject to the rule, even though structured certificates of deposit are typically not “securities.”

Risk-Based Approach to Documenting Compliance With Suitability Obligations

In order to make an appropriate determination of suitability, a member or associated person must ascertain the customer’s investment profile. Rule 2111.04 provides that a member or associated person must use reasonable diligence to obtain and analyze all of the investment profile factors included in Rule 2111(a), unless the member or associated person has a reasonable basis to believe, documented with specificity, that one or more of those factors are not relevant components of a customer’s investment profile in light of the particular facts and circumstances.

FINRA provided examples of complex securities or investment strategies that would require documentation under Rule 2111.04. While large-cap, value–oriented equity securities would usually not require documentation, a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation.11 FINRA cited earlier Regulatory Notices and cases relating to complex and/or potentially risky securities or investment strategies involving a security or securities; those notices and cases related to, among others, commodity futures-linked securities, reverse exchangeable or reverse convertible securities, principal-protected notes, leveraged and inverse exchange-traded funds and structured products.12

With respect to an investment strategy involving an explicit recommendation to hold a security, firms should consider documenting recommendations to hold securities “that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product’s character over time ….”13 Examples include leveraged exchange-traded funds, due to daily reset features causing their performance over long periods to differ significantly from the performance of the underlying index or benchmark over the same period.14 The same concern would most likely apply to exchange-traded notes with similar features.

Consequently, firms not currently doing so may wish to plan to document their recommended securities and investment strategies involving structured products.

Reasonable-Basis Suitability

The Rule 2111.05(a) reasonable-basis obligation contains two components, diligence on the nature of the recommended security and a determination of whether the recommendation is suitable for at least some investors. What happens if the broker does not understand the risks associated with a recommendation, even if that recommendation is suitable for some investors?

FINRA stated that “[b]rokers cannot fulfill their suitability responsibilities … when they fail to understand the securities and investment strategies they recommend.”15 Given that FINRA views most structured products as potentially complex, firms’ supervisory policies and procedures must be reasonably designed to ensure that brokers understand the structured products that they recommend so that brokers can comply with their reasonable-basis obligation.

10 Regulatory Notice 12-25, page 8. 11 Regulatory Notice 12-25, page 9. 12 Regulatory Notice 12-25, page 9 and footnotes 50 and 51. 13 Regulatory Notice 12-25, page 9 and footnote 52. 14 Regulatory Notice 12-25, page 10. 15 Regulatory Notice 12-25, page 14.



Institutional Investor Exemption

Rule 2111(b) provides an exemption from the customer-specific suitability obligation for certain institutional accounts, which focuses on two factors: “(1) whether a broker ‘has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities’ … and (2) whether ‘the institutional customer affirmatively indicates that it is exercising independent judgment’ …. A broker-dealer fulfills its customer-specific suitability obligation if all of these conditions are satisfied.”16

FINRA noted that some institutional customers may not, in some cases, be capable of understanding a particular type of instrument or its risk. “If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product or investment strategy that is the subject of the recommendation, the scope of a broker’s customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer.”17

Consequently, when brokers are selling structured products, which FINRA generally views as complex, to institutional customers, they should take extra care in ensuring that they are in compliance with the exception provided by Rule 2111(b).

In Regulatory Notice 12-25, FINRA confirmed that (1) it has not approved or endorsed any third-party institutional suitability certificates, (2) it has not contracted with any vendors to create such certificates on FINRA’s behalf and (3) the use of such certificates does not constitute a safe harbor from Rule 2111.18 FINRA also said that “broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption.”19

In particular, if a broker is selling structured products to institutional customers, the broker should ensure that the conditions of the Rule 2111(b) exceptions are met rather than relying solely on the customer completing an institutional suitability certificate. If a broker is relying on an oral affirmation, as opposed to a written one, it should consider having procedures in place to document the fact that it has received the affirmation.

FINRA’s Consent Agreements Target Supervisory Systems and Procedures in the Sale of Non-Traditional ETFs Introduction

On May 1, 2012, the Financial Industry Regulatory Authority, Inc. (“FINRA”) announced that it had fined four major investment banks for a total of more than $9.1 million dollars for the sale of leveraged and inverse exchange-traded funds (“Non-Traditional ETFs) without reasonable supervision and for not having a reasonable basis for recommending the sales. 20 Prior to the announcement, FINRA had entered into Letters of Acceptance, Waiver and

16 Regulatory Notice 12-25, page 15. 17 Regulatory Notice 12-25, page 16. 18 Regulatory Notice 12-25, pages 15-16. 19 Regulatory Notice 12-25, page 15. In Volume 3, Issue 6 of Structured Thoughts (available at http://www.mofo.com/files/Uploads/Images/120411-Structured-Thoughts.pdf), we discussed a certificate provided by SIFMA to facilitate the use of this exemption. 20 A copy of FINRA’s press release relating to these actions may be found at: http://www.finra.org/Newsroom/NewsReleases/2012/P126123.


http://www.finra.org/Newsroom/NewsReleases/2012/P126123



Consent with each of the broker-dealers that were fined (the “Consent Agreements”).21 The Consent Agreements outlined disciplinary actions which include censures, fines and restitution.

In its press release dated May 1, 2012 and the Consent Agreements, FINRA points out that leveraged and inverse ETFs often contain features such as daily reset, leveraging and compounding, which results in very different performance as compared to the performance of the related underlying indices, especially when held over longer periods. Because of these features and the complexity of these instruments, FINRA has carefully scrutinized whether FINRA members are satisfying their duties with respect to investor suitability and broker supervision. FINRA previously indicated that it was reviewing Non-Traditional ETFs, in its Regulatory Notice 09-31 (June 2009).22

We note that FINRA’s actions in connection to these four firms focus on sales and supervision activities that occurred between January 2008 and June 2009, prior to FINRA’s Regulatory Notice 09-31.

1. A Firm Must Establish a Reasonable Supervisory System

FINRA criticized each of the firms for failing to establish reasonable supervisory systems in connection with the sale of Non-Traditional ETFs. FINRA found that the firms’ standard supervisory procedures that apply to ETFs in general were not sufficient for Non-Traditional ETFs. In order to be considered reasonable, supervisory procedures need to be tailored specifically to address the unique features and risks associated with Non-Traditional ETFs, such as the differences in performance expectations when these instruments are held over longer periods.

2. A Firm Must Provide Adequate Training

FINRA also criticized the firms for failing to provide adequate training for its representatives and supervisors on the features of Non-Traditional ETFs. FINRA requires that guidance and tools to educate representatives and supervisors about Non-Traditional ETFs must also be specifically tailored to the product.

3. A Firm Must Not Make Unsuitable Recommendations

The Consent Agreements indicated that the firms violated NASD Rule 2310, as well as NASD 2110 and FINRA Rule 2010, by recommending Non-Traditional ETFs to customers with conservative investment objectives and to customers with a primary objective of income investment. FINRA cited the firms for not performing reasonable diligence so as to understand the nature of the security recommended for purchase, as well as its risks and rewards. Furthermore, firms must understand each customer’s tolerance for risk, performance expectations and intended holding periods.

Conclusion

The circumstances surrounding the alleged violations are particular to the facts described in the various Consent Agreements. There is, however, a common theme in many of FINRA’s recent decisions with regards to establishing adequate supervisory policies and procedures specific to the behavior and risks of the structured product offered to retail customers, including Non-Traditional ETFs. Because some exchange-traded notes (“ETNs”) have the same characteristics as Non-Traditional ETFs, the same concerns relating to supervision, training and investor suitability should also apply to sales of ETNs with leverage and/or inverse returns. It has been reported that FINRA is looking into ETN sales practices in the wake of the recent VelocityShares Daily 2x VIX Short Term ETN (TVIX) trading price

21 The Consent Agreements may be found at: http://disciplinaryactions.finra.org/viewDocument.aspx?DocNb=31714, http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=31713, http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=31712, and http://disciplinaryactions.finra.org/viewDocument.aspx?DocNb=31711. 22 FINRA’s Regulatory Notice 09-31 may be found at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p118952.pdf.

http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=31713

http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=31712

http://disciplinaryactions.finra.org/viewDocument.aspx?DocNb=31711




crash. Many firms may need to carefully devise and review supervisory policies and procedures to suit different types of risks associated with various types of structured products.

Massachusetts Fines Broker Dealer for Sales of Non-Traditional ETFs FINRA and the SEC are not the only U.S. regulators who are paying careful attention to the structured products market. In recent years, state regulators have taken a more active role in regulating structured product sales in their respective states. Several significant ones have been conducting a review of the market, and soliciting information from issuers and broker-dealers about their activities.

At about the same time as FINRA announced the consent agreements described in the previous article, the Massachusetts Securities Division (the “Division”) announced that it had entered into a consent order with a broker-dealer relating to its sales of leveraged ETFs in the state.23 The proceeding had been initially announced in July 2011.

The Division’s findings and concerns are quite similar to those discussed in the FINRA consent agreements, and the Division brought the proceeding under the authority of relevant Massachusetts laws.24 The sales at issue took place during the period from October 2007 to December 2009. The sales and practices described in the Massachusetts consent order raise somewhat similar concerns as to suitability, supervision and training as those of the FINRA consent agreements

The consent agreement required the broker-dealer to reimburse the relevant Massachusetts investors for their losses, and to pay an administrative fine of $250,000. The market may see similar actions, as Massachusetts and other regulators continue their efforts.

Contacts Anna Pinedo (212) 468-8179 [email protected]

Lloyd Harmetz (212) 468-8061 [email protected]

Bradley Berman (212) 336-4177 [email protected]

Morrison & Foerster named Structured Products Firm of the Year, Americas, 2012 by Structured Products magazine for the fifth time in the last seven years. See the write up at http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf. About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology, and life science companies. We’ve been included on The American Lawyer’s A-List for seven straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2012 Morrison & Foerster LLP. All rights reserved. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

23 The consent order may be found at the following link: http://www.sec.state.ma.us/sct/sctrbc/rbc_consent_order.pdf. 24 In this regard, Massachusetts permits the Division to sanction broker dealers that do not comply with the FINRA rules relating to fair practices.




http://www.mofo.com/files/Uploads/Images/110500-SP-award-2011.pdf

http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf

http://www.mofo.com/

http://www.sec.state.ma.us/sct/sctrbc/rbc_consent_order.pdf


Volume 3, Issue 7 April 19, 2012

SEC Announces Sweep Relating to Structured Products In April 2012, the SEC’s Division of Corporate Finance announced that it had sent a letter to certain financial institutions relating to their structured note offerings. The text of the letter may be found on the SEC website at the following link: http://www.sec.gov/divisions/corpfin/guidance/cfostructurednote0412.htm.

The SEC’s letter consists of 14 numbered paragraphs. The letter contains several statements of the Staff’s positions relating to structured notes (some of which repeats, or elaborates on, prior guidance), and requests for additional information from issuers (some of which may lead to further issuer-specific comments). As discussed in more detail below, the letter may lead to a variety of changes in current offering practices, as well as additional regulatory actions by the SEC.

Reminders as to Certain Disclosure Practices Several of the items in the letter have been addressed in prior actions or statements by the SEC:



• A request that issuers evaluate the title of their notes to ensure that they do not use terms such as “principal protected” in a misleading manner.1 This request relates to all types of notes that an issuer may offer, whether or not they are “principal protected.”

• With respect to liquidity, the SEC’s letter requests information as to the circumstances under which the issuer or its affiliates repurchase notes from investors prior to maturity, suggesting that issuers provide more information in their offering documents.

• A request that the cover page of each prospectus disclose the fact that an investor faces “issuer credit risk” in a “clear, consistent and prominent manner.”

• Echoing its analysis in Staff Legal Bulletin No. 19 (October 2011),2 the SEC’s letter reminds issuers that the tax consequences of most structured products are “material” and requests information as to how issuers comply with the relevant requirement to file a tax opinion.

• The SEC’s letter reminds issuers that disclaimers of responsibility for information regarding an underlying asset is inconsistent with the issuer’s obligations under the securities laws, and that some disclaimers of this kind may need to be revised.3

Disclosure Format As readers of this article already know, structured note offering documents are typically constructed with a mix of term sheets, prospectus supplements and product supplements, depending on the relevant issuer and the nature of the offering. The potential complexity of this format is an issue that has arisen in a number of different contexts, including the UBS securities litigation relating to Lehman Brothers’ structured notes4 and the SEC’s releases relating to asset-backed securities.5 In addition, different underwriters make different uses of short-form, free-writing prospectuses and statutory prospectuses. The SEC’s letter requests additional information from each issuer as to the documents that they create and how information is divided between these documents. This particular question could lead to additional regulatory action from the SEC as to the appropriate format for offering documents.

Potential New Disclosures

The SEC’s letter highlights existing issuer disclosure indicating that a portion of an offering’s use of proceeds will be used for hedging transactions and suggests that such amounts be quantified. If there are no specific plans for a significant portion of an offering’s proceeds, the letter indicates that the issuer should note the reasons for the offering. This focus on hedging activity also relates to the SEC’s request for additional disclosure as to the estimated value of structured notes on the pricing date, as discussed below.

The SEC’s letter suggests that structured note programs may be relevant for disclosure in an issuer’s Exchange Act reports, potentially in the MD&A section. The letter seeks information about how an issuer’s structured notes fit into 1 In 2011, the SEC and FINRA issued a joint alert encouraging investors to pay close attention to securities referred to as “principal protected” and to note the limitations of the principal protection. (http://www.sec.gov/investor/alerts/structurednotes.htm) The alert followed calls from the Staff to certain issuers requesting that they revise their usage of the term “principal protected.” 2 Staff Legal Bulletin No. 19 may be found on the SEC’s website at the following page: http://www.sec.gov/interps/legal/cfslb19.htm. 3 The Staff also addressed “impermissible disclaimers” in free-writing prospectuses in connection with its 2005 Securities Offering Reform. (SEC Release 33-8591; 34-52056; IC-26993; and FR-75 (April 2010). 4 In re Lehman Bros. Sec. & ERISA Litig., 799 F. Supp.2d 258 (S.D.N.Y. 2011). 5 SEC Release Nos. 33-9117 and 34-61858; and File No. S7-08-10, page 97, “We are concerned that the base and supplement format has resulted in unwieldy documents with excessive and inapplicable disclosure that is not useful to investors.”



its overall financing and liquidity, and trends in their usage. The letter also requests quantitative information as to the outstanding amounts of an issuer’s structured notes.

Product Pricing and Value

In July 2011, the SEC’s Office of Compliance Inspections and Evaluations (“OCIE”) issued a report relating to its findings following its investigations of several broker-dealers.6 The OCIE report raised questions as to the pricing policies and practices of market participants, and the SEC’s letter reflects some of those concerns. In that regard, the SEC letter:

• indicates that market participants should consider prominently disclosing the difference between a structured note’s public offering price and the issuer’s estimate of its fair value (or discussing with the Staff the reasons why that disclosure should not be provided); and

• requests that issuers include risk-factor disclosure which indicates how an issuer’s valuations of structured notes are reflected in post-offering pricing, valuation and trading.

Plan of Distribution and Dissemination of Final Pricing Terms

The SEC’s letter seeks information as to the circumstances under which different investors may receive different prices for a security – such as in the case of a “variable price re-offer,” or sales that are made at a volume discount. In addition, for those issuers that may change the price of an offering after the initial offering, the SEC’s letter seeks additional information as to how and when this is done.

As a general matter, the SEC letter seeks information as to how pricing information is disclosed to investors, such as the point in the sales prices at which information that is “ranged” in the red herring (such as an interest rate or a capped return) is disclosed to investors, and how the range and the actual final terms are determined. This point is reminiscent of the issues that many market participants addressed when Rule 159 was enacted as part of “Securities Offering Reform” in December 2005.

Hypothetical Historical Performance The SEC has observed that a variety of indices used in structured note offerings, particularly proprietary indices, have limited historical information. The SEC’s letter requests that issuers explain what historical information they have presented in their offering documents for these types of underlying assets and what steps were taken to ensure that the information was presented in a “balanced manner.”

Required Exhibits In 2011, many structured note issuers revised their practices as to the filing of “validity opinions” following the SEC’s review of existing practices and Staff Legal Bulletin No. 19 described above. Continuing in that direction, the SEC’s letter requests information as to issuer practices relating to documents such as distribution agreements and forms of notes, and whether their practices are consistent with the SEC’s form requirements and Item 601 of Regulation S-K.

6 That report may be found at the following link: http://www.sec.gov/news/studies/2011/ssp-study.pdf. We discussed the OCIE report in our August 2, 2011 issue of Structured Thoughts (http://www.mofo.com/files/Uploads/Images/110802-Structured-Thoughts.pdf).



Due Date The SEC has requested written responses within 10 business days from the date of its letter. Some issuers may struggle to satisfy that deadline, particularly those with multiple channels of distribution, multiple product types, or different underwriters offering their structured products.

Public Availability of Response Letters We expect that the SEC will publicly post issuers’ responses to these letters, together with any follow-up correspondence, once the review process is completed. We expect that, consistent with the Staff’s typical practice in connection with the review of filings, all correspondence will need to be submitted to the Staff using the EDGAR System and will ultimately become public upon the conclusion of the Staff’s review. If a response includes confidential, competitively sensitive information, then it may be possible to submit that information under a request for confidential treatment pursuant to Rule 83.

Expected Impact It is quite possible that the written responses to the SEC’s letter will result in issuer-specific requests from the SEC to change their practices. Upon review of the industry’s responses, the SEC may also set forth its views on these topics to market participants, generally.

By its terms, the letter relates only to registered offerings of structured notes. However, any changes that are made to the prospectuses for registered offerings may also be adapted by market participants to the offering documents for unregistered offerings, such as structured bank notes and structured certificates of deposit.

Of course, the SEC’s letter itself sets forth the Staff’s current positions on a variety of issues that frequently arise. Accordingly, even before the SEC responds to the planned submissions, it is entirely possible that a number of issuers will plan to revise certain of their disclosures and other practices to conform to the principles in the SEC’s letter. Whether or not they received a letter from the SEC, we anticipate that issuers and underwriters will be carefully reviewing their current practices in light of the letter.

Contacts Anna Pinedo (212) 468-8179 [email protected]

Lloyd Harmetz (212) 468-8061 [email protected]

Bradley Berman (212) 336-4177 [email protected]

About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology, and life science companies. We’ve been included on The American Lawyer’s A-List for seven straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2012 Morrison & Foerster LLP. All rights reserved. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.


Volume 3, Issue 1 January 19, 2012

FINRA Notice Regarding Complex Products FINRA recently released Regulatory Notice 12-03 titled “Complex Products: Heightened Supervision of Complex Products.” The Notice identifies the types of products that may be considered “complex” and provides guidance to member firms regarding supervisory concerns associated with sales of complex products. Until now, in the United States we had avoided the debate ongoing for some time now in Europe regarding “complex” and non complex (simple?) products. It is interesting that FINRA is now headed in a direction similar to that taken by European regulators.

This Notice identifies as complex products those that include “complicated or intricate derivative-like features”, like structured notes, certain exchange-traded funds, hedge funds and asset-backed securities. The Notice references FINRA’s prior Notices to Members and Regulatory Notices regarding particular types of structured products. The Notice reminds member firms that the firms should review and assess the adequacy of their controls with respect to products that may be deemed complex. In this regard, the Notice reminds members that they must discharge their suitability obligation, which entails diligence regarding the features of the product, including potential risks and rewards. FINRA poses a number of suggested questions that should be considered during the diligence process. The Notice reminds firms that they should establish post-approval review processes in respect of new and complex products. Specialized training also may be appropriate for registered representatives charged with selling complex products. Member firms also should consider the financial sophistication of customers when recommending a complex product and should engage customers in a discussion of product features, risks, rewards and costs. Member firms also should consider whether less complex or costly products would achieve the customer’s goals. In sum, many of the same themes have been communicated in prior FINRA releases; however, we note that this Notice appears to be taking the dialogue regarding financial products in a new direction on this side of the Atlantic.

IN THIS ISSUE: FINRA Notice Regarding Complex Products …………………………..…page 1 FINRA’s Recent Consent Agreement: A Continued Focus on Adequate Supervisory Systems and Procedures in the Sale of Reverse Convertible Notes…………page 2 FINRA Revises Proposal re Communications with the Public …..page 3 SEC Announces Second Extension of Comment Period for Conflict of Interest Rules…..….………….......page 4



FINRA’s Consent Agreement: A Continued Focus on Adequate Supervisory Systems and Procedures in the Sale of Reverse Convertible Notes Introduction

In December 2011, the Financial Industry Regulatory Authority (“FINRA”) announced that it had fined Wells Fargo Investments, LLC $2 million, and required the broker-dealer to pay restitution to investors. These penalties arose from alleged unsuitable sales of reverse convertible securities by a former registered representative affiliated with the company, Alfred Chi Chen, and for failing to provide sales charge discounts on Unit Investment Trust (“UIT”) transactions to eligible customers.1

Prior to FINRA’s announcement, FINRA entered into a Letter of Acceptance, Waiver and Consent with the broker-dealer (the “Consent Agreement”).2 The Consent Agreement sets forth the factors that led to FINRA imposing these penalties.

Some of the actions described in the Consent Agreement were not unique and have been attributed to other institutions,3 as FINRA has carefully scrutinized in recent years the appropriateness of the sale and suitability of reverse convertible notes and the adequate supervision of employees, particularly those that have offered structured products. We note that FINRA’s actions focus on activities that occurred between 2006 and 2009, prior to the time that reverse convertible sales became as highly publicized as they are today, and before many institutions began to more carefully scrutinize their procedures in the area.

1. A Firm Must Establish Adequate Written Supervisory Procedures and an Effective Supervisory System for Sales of Reverse Convertibles

FINRA has emphasized the importance of adequate supervisory systems and written procedures pertaining to reverse convertible sales. One particular focus has been customer suitability. FINRA criticized the broker-dealer, through Chen, for recommending hundreds of unsuitable reverse convertible transactions to customers, most of whom were elderly,4 and who had conservative investment objectives and limited experience investing in options and in equities.

Accordingly, close attention should be paid to customer profiles and investment history when recommending financial products such as reverse convertibles. Transactions should be approved upon adequate inquiry into the suitability of the purchases and concentrations in the accounts of these customers. FINRA suggests that firms should provide supervisors with reports that demonstrate customer investment concentrations to assist in suitability identification.

In addition, the Consent Agreement focuses on the establishment of protocols pertaining to the sales of reverse convertibles, which must be carefully monitored for compliance. During the relevant period, the broker-dealer implemented a required training program for each registered representative who sold the reverse convertibles.

1 A copy of FINRA’s press release relating to these actions may be found at: http://www.finra.org/Newsroom/NewsReleases/2011/P125262. 2 The Consent Agreement may be found at: http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p125264.pdf. 3 See, for example, the [April 2011] UBS consent (the “UBS Consent”), which may be found at: http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p123478.pdf. Our summary of the UBS Consent may be found in Structured Thoughts, Volume 2, Issue 4: http://www.mofo.com/files/Uploads/Images/110414-Structured-Thoughts.pdf. The Santander consent (the “Santander Consent”) may be found at: http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p123490.pdf. 4 According to FINRA’s complaint, except for one exception, all of Mr. Chen’s accounts that invested in reverse convertible notes belonged to persons who were at least 65 years old, many of whom were in their 80s and 90s.



However, as there was no system in place to ensure compliance, many registered representatives placed trades without completing the training program.

2. A Firm’s Sales Representatives Must be Adequately Supervised

In the Consent Agreement, FINRA emphasized the importance of the reasonable supervision of sales representatives. FINRA criticized the broker-dealer for not investigating the suitability concerns of the reverse convertibles being sold to elderly customers. During the last two years of Chen’s employment, he had derived 75% of his total commissions from reverse convertible sales, was the firm-wide top producer of reverse convertible commissions and was promoted to a senior position. To facilitate these transactions, Chen allegedly changed the investment objectives of some customers. These changes were red flags which went without investigation by his supervisors, despite compliance reports showing unreasonable concentrations of reverse convertibles in the accounts that he advised.5

3. A Firm Must Establish and Effect Adequate Supervisory Procedures for Sales of Unit Investment Trusts

FINRA criticized the broker-dealer for failing to apply discounts to customers who qualified for breakpoint discounts or rollover or exchange discounts, which resulted in additional sales charges to those customers. The firm had relied upon its sales force and their respective supervisors to monitor accounts for the appropriate discounts, but did not implement a formal procedure to ensure compliance.

In the Consent Agreement, FINRA emphasized the importance of establishing, maintaining and enforcing effective supervisory systems and written supervisory procedures to prevent customers from incurring unnecessary sales charges. These systems and procedures should be designed to ensure that qualified customer accounts receive their proper breakpoint discounts or rollover and exchange discounts.

Conclusion

The circumstances surrounding these alleged violations are particular to the facts described in the Consent Agreement. However, a common theme in many of FINRA’s recent decisions relates to the establishment of adequate sales supervisory policies and procedures and ensuring investment suitability. The Consent Agreement demonstrates the need for firms to perform a careful review of their supervisory procedures and systems with respect to sales of structured products. We may not have seen the last of FINRA’s investigation of improper sales practices.

FINRA Revises Proposal re Communications with the Public In July 2011, FINRA proposed to amend several of its rules relating to broker-dealers’ communications with the public.6 These rules relate to a number of areas, and potentially impact a wide variety of securities offerings.7 In December 2011, FINRA further revised its proposal.8

5 FINRA’s complaint against Mr. Chen (available at: http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p125266.pdf) indicates a variety of unauthorized trades by Mr. Chen, including placing orders for securities for the accounts of holders who had passed away, and explicitly contravening a client’s request not to make any purchases from her account. 6 The text of the proposed rules may be found at the following web page: http://www.finra.org/Industry/Regulation/RuleFilings/2011/P123894. 7 For example, the proposals impact Rule 2210 (Communications with the Public), Rule 2212 (Use of Investment Companies Rankings in Retail Communications), Rule 2213 (Requirements for the Use of Bond Mutual Fund Volatility Ratings), Rule 2214 (Requirements for the Use of Investment Analysis Tools), Rule 2215 (Communications with the Public Regarding Security Futures), and Rule 2216 (Communications with the Public About Collateralized Mortgage Obligations (CMOs)). We discussed a variety of these provisions in



The December 2011 revisions remove an aspect of the July 2011 proposed rules that had generated significant controversy. Proposed supplementary material “.01” to Rule 2210, proposed in July 2011, would have applied certain FINRA guidance to internal-use only materials. The supplemental material would have provided that a member’s internal written communications that are intended to educate or train registered persons about the member’s products or services would be considered “institutional communications” under paragraph (a)(3) of FINRA Rule 2210. As a result, these internal communications would have been subject to both the provisions of proposed FINRA Rule 2210 and NASD Rule 3010(d). Among the potential effects would have been a requirement for each member to establish appropriate written procedures for review of these written materials by an appropriately qualified registered principal.

In the December 2011 revisions, FINRA has removed this supplemental material from the proposal, and has also explicitly provided that “institutional communications” do not include internal-use only materials. That being said, caution is still advisable in connection with the preparation and dissemination of internal-use only materials. Prior FINRA investigations have focused upon the adequacy of these types of materials, and whether they were sufficient to properly educate the sales force about the nature and risks of the products that they offered.

FINRA itself takes the position that these types of materials are governed by the supervisory provisions of NASD Rule 3010.

FINRA’s proposal is subject to a comment period that will end on January 18, 2012.

SEC Announces Second Extension of Comment Period for Conflict of Interest Rules In September 2011, the SEC proposed new Rule 127B, which is intended to address the conflicts of interest provisions of Section 621 of the Dodd-Frank Act. Proposed Rule 127B would generally prohibit certain persons involved in the structuring, creation and distribution of an asset-backed security (“ABS”) from engaging in certain transactions that would result in a material conflict of interest with respect to any investor in that ABS. We discussed the proposal and its potential impact on structured products in a prior issue of Structured Thoughts, which may be accessed at the following link: http://www.mofo.com/files/Uploads/Images/111108-Structured-Thoughts.pdf.

In December 2011, the SEC announced that it would extend the comment period for the proposal until February 13, 2012. The comment period had previously been extended through January 13, 2012. The new extension will provide market participants with additional time to prepare and submit their comments on the proposal.9 In providing the extensions, the SEC noted that the comment period for the “Volcker Rule Proposal” relating to proprietary trading and other matters will end on February 13, 2012. Accordingly, the SEC believes that the extended comment period will enable market participants to focus on, together with any other comments, the interplay between proposed Rule 127B and the Volcker Rule Proposal, and will benefit the SEC in its preparation of the final rules.

our July 26, 2011 client alert, which is available at: http://www.mofo.com/files/Uploads/Images/110726-FINRA-Proposed-Rules-2210-2211.pdf. In Volume 2, Issue 10 of Structured Thoughts, we addressed the potential impact of these rules on the structured products market in particular. 8 The text of the December 2011 revisions may be found at: http://www.sec.gov/rules/sro/finra/2011/34-66049.pdf. 9 The SEC’s release concerning the extension may be found at the following link: http://www.sec.gov/rules/proposed/2011/34-66058.pdf.



For questions, please contact: Lloyd Harmetz, [email protected], 212-468-8061

Vernicka Shaw, [email protected], 212-336-4142

Anna Pinedo, [email protected], 212-468-8179

Morrison & Foerster named Structured Products Firm of the Year, Americas, 2011 by Structured Products magazine. About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology, and life science companies. We’ve been included on The American Lawyer’s A-List for eight straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2011 Morrison & Foerster LLP. All rights reserved. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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