Preparing for and Enduring a FINRA...

MORRISON & FOERSTER LLP

Preparing for and Enduring a FINRA Exam

1.0 CLE Credits

September 25, 2013, 9:00AM – 10:00AM

Speakers: Daniel Nathan, Morrison & Foerster LLP

Justin Kletter, Bank of America Merrill Lynch

1. Presentation Outline

2. Structured Thoughts: Volume 4, Issue 11



5. FINRA Issues Sweep Letter Regarding Use of Social Media

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Outline: Preparing for and Enduring a FINRA Exam

I. Introduction

II. General themes

A. FINRA’s focus is a moving target

B. “Gotcha” – FINRA will look for gaps in procedures as low-hanging fruit to

be the basis of informal or formal action. It’s rare that an exam doesn’t find

some violations; the question is how serious.

C. It is never too late to adopt new procedures or make other changes before an

exam.

D. In preparing for an exam, try to mirror what FINRA’s examiners are doing in

their preparation.

E. Make sure you document everything; all tests, training, changes in procedures,

etc.

III. Specific subject matter areas

A. As a general matter, exam will cover:

1. Financial condition

2. Supervisory procedures

3. Internal controls

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4. AML

5. Sales practice

6. Business continuity planning

B. In preparing for an exam, you should inform yourself about the likely areas of

focus.

C. Current areas of focus

1. Annual Priorities

2. FINRA Dedicated Municipal Exam Team

3. Real-time priorities

4. Review SIFMA materials on current priorities

IV. Getting your house in order

A. Specific review

1. Prior year’s exam report

2. Formal Disciplinary Actions involving the firm over the last several

years

3. Nature of the firm’s business

B. Procedures

1. Are WSPs up-to-date?

2. Have WSPs been tested?

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C. Training -- Make sure all training for compliance staff and other associated

persons is up to date, and that the training is documented.

D. Identify risk areas

V. Cooperating with the exam

A. Prior to the exam

B. Assemble requested materials

VI. During the Exam

A. Hold an introductory conference with the exam staff, and with senior firm

personnel

B. Designate a primary contact for the examiners.

C. Nuts and bolts

D. Interviews

E. Maintain close contact – schedule a regular – preferably daily -- meeting with

exam staff or supervisors.

F. Keep your eyes and ears open – nip possible concerns in the bud.

G. Problems with examiners – how to handle

VII. Following the exam

A. Exit meeting and receipt of exit meeting report – at end of exam

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B. Report of examination

C. Respond to the report

D. Examination Disposition Letter – indicates actions taken

VIII. TMMS

A. When is the exam?

1. After documentation is provided there is an on-site exam. Usually

discusses documents/other questions provided and a view of trading

facilities.

2. After on-site exam, the examiners will start sending individual

questions which will now give the firm the understanding of what the

target areas are.

B. Topics that appear to be of interest this year

C. After the exam is completed, there will be a preliminary finding letter sent to

the firm. The firm has the opportunity to discuss and respond.

D. The final letter is received and the findings will be disclosed

E. New to TMMS

1. Next year the Equities and Options TMMS will be combined at

FINRA.

2. Still separate TMMS for BATS/CBOE and FINRA

F. Considerations

1. As discussed prior – continue to update WSP – Dates are important

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2. Need to make sure Trading Systems are defined

3. Need to know how sales dates uses trading desks and systems

G. Being an informed Compliance/Legal representative is most important to

these exams.

H. Sweeps

IX. Other Specialized Areas

A. AML

B. Other NY focusses

1. Centralized Supervision model

2. Undisclosed judgments and liens

3. Long duration Fixed income investments

a. Present a high risk of losing value as interest rates increase

b. Looking at training of RRs

c. Looking at suitability

1 Attorney Advertising

Volume 4, Issue 11 August 12, 2013

Complex Products and Conducting a Reasonable Basis Suitability Review In the past several years, FINRA has paid substantial attention to the suitability of structured products for particular investors, issuing a variety of new rules and regulatory notices. These include, but are not limited to, FINRA’s revised suitability rule, Rule 2111, and its guidance for complex securities set forth in Regulatory Notice 12-03.

In addition to customer-specific suitability, FINRA expects members to make a “reasonable basis” suitability determination: a product must be suitable for at least some investors. For example, issuers cannot sell products for which “the house always wins,” or that are too complex to be understood by any retail investor. In order to make this determination, the firm must perform reasonable diligence to understand the nature of the transaction, as well as the potential risks and rewards. This understanding should be informed by an analysis of likely product performance in a wide range of normal and extreme market conditions.

In practice, how do market participants implement these guidelines? Much of the guidance is principles-based, and it is not necessarily obvious how it should be applied in a given situation.

Commencing the Review

FINRA Regulatory Notice 12-03 sets forth a variety of questions that product manufacturers need to ask prior to introducing a new complex product:

• For whom is the product intended? Is it intended for limited or general retail distribution, and, if limited, how will it control its distribution?

IN THIS ISSUE: Complex Products and Conducting a Reasonable Basis Suitability Review……………….……………..….Page 1

Guidelines for Presenting Backtested Performance Data….….Page 6

IOSCO Final Report on Principles for Financial Benchmarks……………

Protect Your Elders, Part II...............Page 9

“Retailisation” of Structured Products in the EU……………………Page 9

FINRA FAQ on TRACE Reporting and Variable Price Reofferings…….Page 10

FINRA Postpones Rule Requiring Disclosure of Enhanced Compensation………………………...Page 10

iShares Changes Names of Widely Used ETFs…………………………….Page 11

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Attorney Advertising

• To what types of customers should this product not be offered?

• What is the investment objective and is that objective reasonable in relation to the product’s characteristics? How does the product add to or improve the firm’s current offerings? Can less complex products achieve the same objectives?

• What assumptions underlie the product, and how sound are they? How is the product expected to perform in a variety of market or economic scenarios? What market or performance factors determine the investor’s return? Under what scenarios would the product’s planned principal protection, enhanced yield, or other benefits not occur?

• What are the risks for investors? If the product was designed mainly to generate yield, does the yield justify the risks?

• How will the firm and registered representatives be compensated for sales of this product? Will the offering of the product create any conflicts of interest between the customer and any part of the firm? If so, how will those conflicts be addressed?

• Are there novel legal, tax, market, investment or credit risks?

• Does the product’s complexity impair understanding and transparency of the product?

• How does this complexity affect suitability considerations or the training requirements for the product?

• How liquid is the product? Is there an active secondary market?

In addition, a broker may consider a number of additional factors:

• Do any competitors already offer a similar product? Of course, when our children use the behavior of other kids as a justification for bad acts, we may say to them: “If your friend jumped off the Empire State Building, would you do so too?” However, market practice may in some cases provide some degree of information as to potential risks.

• Is the payout formula particularly complex? Is the payout formula unsuitable for certain types of investors?

• To what extent does the product incorporate leverage?

• Is the linked asset class capable of being understood by a typical investor?

• Does the product reference a new asset class, or a proprietary index?

• Does the product create any unusual disclosure concerns?

• What is the format, or “wrapper”, in which the product will be packaged?

Some market participants categorize or “group” products based on particular attributes, and may subject certain products to heightened scrutiny. Other market participants have formulated a “matrix” approach and identified various characteristics that a committee should consider in connection with a suitability review. Some “benchmark” their products against other products offered by competitors.

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Factors to Consider

The following table sets forth some considerations that may inform a committee’s analysis as it reviews a potential new product.

Characteristics of Product Impact of Product Features

General product description, including the maximum term to maturity.

Products with a longer term to maturity may be perceived as riskier, less liquid, and more difficult for a potential investor to evaluate.

Consider the potential performance of the product under current market conditions. What assumptions underlie the product? How is the product expected to perform in different economic scenarios?

The committee should consider the likely pay-out under normal scenarios, as well as under stress scenarios. FINRA will consider whether the product is “designed to fail,” or whether it offers a value proposition only under certain limited scenarios.

What is the product’s investment objective? Is that investment objective reasonable in relation to the product’s characteristics? Does the product provide market access, or exposure to a particular investment strategy, or otherwise add to the firm’s current product offerings?

FINRA will consider the fundamental objective of the product. Is the new product priced such that the potential yield represents an appropriate rate of return in relation to the volatility of the reference asset based on comparable and similar investments, in terms of structure, volatility and risk? For example, similar structured products based on reference assets that possess substantially similar volatility characteristics, but which offer materially different rates of return, could call into question whether the instrument with the lower yield meets the reasonable basis suitability standard.

What is the target market for the product? Are there particular types of accounts/investors for which the product may not be appropriate?

Is it a retail product? High net worth/private bank client product? What are the minimum denominations? Is there a minimum purchase requirement? Is it intended for investors that seek higher yield? For investors that do not need current income?

Is the economic exposure provided by the product appropriate for the relevant class of investor, both in terms of risk and “type” of exposure?

• For example, a product providing heavily leveraged downside exposure to a particular reference asset may not be suitable for retail investors. In addition, exposure to certain types of complex “hidden assets” (for example, “skew” and “smile”) may also not be appropriate for retail investors, even if the risk of the product is not particularly high.

• When selling a product into the retail market, consider the types of investments typically held by retail investors and whether the proposed new

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product would be an appropriate component of such an investor’s investment mix.

Can the new product be explained in a manner that can be reasonably expected to be understood by the relevant class of investor? Can investors in that class be reasonably expected to be capable of evaluating the risks?

Could interests in the reference asset be sold directly to the relevant class of investor?1 As a general rule, if the reference asset could not be sold directly, a structured product on such reference asset may be problematic.

Does the product incorporate leverage? Incorporate any algorithmic models, or quantitative strategies? What are the elements, if any, of the product that might be deemed “complex”? Could a less complex structured product be developed that could achieve the same objective?

FINRA assumes that products that incorporate leverage are “riskier” and more difficult for a retail investor to understand and evaluate. Leverage may magnify losses in unpredictable ways. Similarly, FINRA assumes that products that incorporate a proprietary model or quantitative strategies are more complex, even if the payout is simple.

Does the product involve a new or unusual index? The committee may consider asking additional questions or formulating an additional questionnaire for products that reference an index, which may include several considerations: Does the index use a complex strategy (e.g., market-neutral, momentum, carry, negative serial correlation, etc.)? Does the index have high embedded leverage? Is there frequent rebalancing?

Are there multiple indexing levels? Is the index actively managed? Does the index track a broad asset class? Does the index have a volatility control? Does the note have downside leverage? Does the product have a low minimum purchase amount (<$1,000)?

What market or performance factors determine the investor’s return? Under what scenarios would principal protection, enhanced yield, contingent protection or other presumed benefits not be realized?

FINRA views products that incorporate “contingencies” (such as a “knock-out level” that is monitored during substantially the entire term of a note) as more challenging for retail investors to understand. Retail investors may not understand how contingencies will affect their potential investment or their return. Products with contingencies will require more detailed disclosures; the disclosures, of course, must be clear. There is also a higher risk that distributors may not understand or be able to explain the contingencies.

1 For example, if an index tracks a strategy linked to equity options, would the investor be eligible for purchases of the underlying options?

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How will the distributor be compensated for offering the product (i.e., what are the associated fees paid to third parties)? Is there anything different about the fees that will be paid in connection with the distribution of this product compared to other products?

FINRA is concerned that a “structured product” contains embedded fees and that the “packaging” may obscure inappropriate fees or mark-ups. In addition, FINRA is concerned that the compensation paid to product manufacturers or distributors may motivate them to sell a structured product in favor of a simpler product.

Will the offering of the product create any conflicts of interest between the investor and any part of the firm or its affiliates? If so, how will those conflicts be addressed?

FINRA has conducted a “conflicts of interest” sweep and has noted that structured products may involve conflicts of interest (whether in connection with the product being manufactured by the issuer’s affiliated broker-dealer; the hedging arrangements between the affiliated broker-dealer and the issuer; the index creation; any calculation agent function; or distribution through private banking or advisory channels.

What Can Be Done Where Suitability Concerns Exist

Once a product has been identified as involving suitability issues, a variety of tools exist to address the relevant issues.

• Requiring higher minimum denominations and/or minimum purchase amounts, to help screen out less sophisticated investors.

• Imposing restrictions on the types of potential investors.

• Limiting sales to advised channels.

• Only selling the product through particular distributors that are better suited to handle complex products, and have demonstrated their ability to do so.

• Providing additional training to the distributors as to the particular product, including which product risks and features need to be most carefully explained to purchasers.2

• Requiring special training for the broker’s own personnel.

• Granting only conditional approval for a limited period of time, subject to certain requirements.

• Mandating post-approval review within a specified period of time, to determine whether sales were made through the proper channels, and to assess product performance.

2 Needless to say, whether or not a structured product is complex, the relevant offering documents must have robust disclosures of the product features and relevant risk factors.

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Guidelines for Presenting Backtested Performance Data Issuers that link structured products to a new index with limited, or no, performance history typically present hypothetical historical performance, or backtested, data to show how the index would have performed prior to the inception of the index.

In this article, we present guidelines for backtested data disclosure and also discuss any guidance from U.S. regulators on the subject.

Some common sense disclosure principles:

• Backtested data must be objective and capable of reproduction;

• Backtested data must cover a time period long enough to include a variety of market conditions, including stressed periods;

• Appropriate disclosure about the backtesting methodology and appropriate risk factors highlighting the difference from historical data must be included.

Objective and replicable data. Backtested data must be based on objective formulae and models applied to past historical data. The methodology used to create the backtested data should be the same methodology used to calculate the index, with appropriate disclosure as to any differences in the application. An independent third party, or a skilled investor, should be able to independently reproduce the backtested data. Necessarily, this excludes presenting backtested data for indices that are “managed”; i.e., where discretion is used in calculating the level of the index. That discretion could not be reproduced by an independent third party. Understandably, some discretion might be required to create the backtested data. The required discretion should be minimal and fully disclosed to investors.

Representative time periods. Backtested data should be presented for a time period long enough to encompass different market conditions. Including stressed periods, such as the recent financial crisis, is particularly important.

Currently, presenting a five-year period would show how an index would have performed during and after the financial crisis. However, as time goes on, a five-year period will not include the period from 2008 - 2010. Issuers should consider using longer periods, when necessary, to include periods representing different market conditions in order to show investors how the index might perform in similar future periods. Issuers should avoid “cherry picking,” or presenting backtested data that shows only periods when the index would have performed optimally.

Full disclosure. Backtested data should be accompanied by additional disclosure that explains how the data was derived (including any assumptions and the impact of fees), that the data is hypothetical and not actual, was created with the benefit of hindsight and that the backtested data cannot accurately predict future results. Issuers should also include risk factor disclosures that explain that backtested data is not necessarily accurate and is not predictive of future performance. Issuers should disclose that there may be conditions (e.g., very high or low interest rate environments) for which the backtested data may not be effective. If the index has actual historical performance results, the backtested data may be presented alongside the historical data, with an explanation of the two time periods and any differences in the data.

Regulatory Guidance

As many readers know, there are no specific Securities and Exchange Commission or Financial Industry Regulatory Authority, Inc. regulations that address the use of backtested data. Accordingly, market participants look to general disclosure principles, and other statements and materials from the regulators, in order to guide their practices.

In the SEC’s April 2012 sweep letter sent to structured products issuers (question 12), the SEC asked issuers whether they use backtested data and, if so, whether the information was provided to investors and how it was presented.3 After

3 The SEC’s April 2012 sweep letter can be found at http://www.sec.gov/divisions/corpfin/guidance/structurednote0412.htm.

http://www.sec.gov/divisions/corpfin/guidance/structurednote0412.htm

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receiving detailed responses from a variety of major issuers, the SEC did not object to the inclusion of such data. Absent specific guidance from the SEC, the key test remains whether the data is presented in a manner that is not misleading.

FINRA recently provided written guidance in the context of broker-prepared materials for exchange-listed products provided to institutional investors.4 FINRA’s approval of the use of backtested data in these materials is limited to a narrow set of circumstances. In its guidance, FINRA reiterated its historic position that the presentation of backtested data to retail investors does not comply with its disclosure standards. FINRA also warned that the backtested data should not be given excess weight in a recommendation to an investor.

It is possible that backtested data aimed solely at educating investors about product risks, together with providing a balanced perspective without over-emphasizing a product’s positive features, can be differentiated from the use of backtested data to which FINRA objects.

In private discussions, FINRA has recently reiterated its position against the use of backtested data in “retail communications,” as that term is defined in FINRA Rule 2210(a)(5), relating to structured products (not just exchange-listed products). In “institutional communications,” as that term is defined in FINRA Rule 2210(a)(3), relating to structured products, FINRA indicated that its application of the content standards of Rule 2210(d) to backtested data would not be applicable in the same manner as it is to retail communications. Consequently, the use of backtested data may be appropriate in institutional communications relating to structured products, in the discretion of the broker-dealer.

Conclusion

Backtested performance data may be used in issuer-prepared offering documents for structured products. The data itself should be objective and reproducible, and cover a sufficient time period so as not to be misleading. The presentation must contain appropriate disclosure as to the methodology used to create the backtested data and appropriate risk factors. Broker-dealers preparing materials relating to structured products containing backtested data should consider FINRA’s guidance, and not include such data in any retail communications.

IOSCO Final Report on Principles for Financial Benchmarks We have previously reported on the consultation on financial benchmarks by the International Organization of Securities Commissions (“IOSCO”)5, and its follow-up consultation report (the “Consultation Report”)6 setting out draft principles (the “Principles”) regarding inter alia benchmark calculation, determination, related governance issues and transparency processes. IOSCO has now released its final report (the “Final Report”) on the Principles on 17 July 2013.7

The Final Report makes certain amendments and clarifications to the draft Principles and the scope of their application, in response to consultation feedback. The Final Report states that in general, there was a good level of support for the Principles, with the majority of comments on the technical detail rather than the substantive approach. The key amendments are analysed below.

4 A full discussion of FINRA’s interpretive guidance can be found in Structured Thoughts, Volume 4, Issue 6 (April 26, 2013), at: http://www.mofo.com/files/Uploads/Images/130426-Structured-Thoughts.pdf. The FINRA guidance is available at: http://www.finra.org/Industry/Regulation/Guidance/InterpretiveLetters/P246651. 5 The consultation materials may be found at: link: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD399.pdf. Please see our client alert in relation to this consultation—Structured Thoughts: Volume 4, Issue 3 February 6, 2013—http://www.mofo.com/files/Uploads/Images/130206-Structured-Thoughts.pdf. 6 The Consultation Report may be found at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD409.pdf. Please see our client alert in relation to the Consultation Report—IOSCO Consultation Report on Financial Benchmarks, May 6, 2013—http://www.mofo.com/files/Uploads/Images/130506-IOSCO-Consultation-Report-on-Financial-Benchmarks.pdf. 7 The Final Report may be found at: http://www.fsa.go.jp/inter/ios/20130718-1/03.pdf.

http://www.mofo.com/files/Uploads/Images/130426-Structured-Thoughts.pdf

http://www.finra.org/Industry/Regulation/Guidance/InterpretiveLetters/P246651

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD399.pdf




http://www.mofo.com/files/Uploads/Images/130506-IOSCO-Consultation-Report-on-Financial-Benchmarks.pdf

http://www.mofo.com/files/Uploads/Images/130506-IOSCO-Consultation-Report-on-Financial-Benchmarks.pdf

http://www.fsa.go.jp/inter/ios/20130718-1/03.pdf

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Scope

In relation to submission-based benchmarks, where information is provided by third party submitters to the administrator (the entity which calculates, determines and disseminates the benchmark) to determine the benchmark, the definition of “Submission(s)” now explicitly excludes data sourced from regulated markets or exchanges with mandatory post-trade transparency requirements. This amendment was made in response to concerns that certain Principles were less relevant for benchmarks based on prices that are made public. Further, the Final Report amends Principle 14(g)(xi) to clarify that submissions from front office staff are allowed (under the draft Principles they were prohibited) but only if there are adequate internal oversight and verification procedures, including to address potential conflicts of interest. The potential for conflicts of interest and manipulation is considered to be increased when front office staff are involved with benchmark determination, but this amendment reflects the fact that smaller organisations may not be able to segregate staff accordingly and thus valuable market information may be lost by applying such an outright prohibition.

Principles 4 (Control Framework for Administrators), 5 (Internal Oversight) and 12 (Changes to the Methodology) now allow for summary information and key features to be disclosed to stakeholders (those who use or rely on benchmark determination services), rather than full disclosure being required. This amendment was made in response to a concern from benchmark providers that certain transparency practices should not apply to them as they have a strong incentive to disclose to stakeholders, with IOSCO’s response being that a proportional application of such transparency Principles would be appropriate.

Principles 2 (Oversight of Third Parties) and 18 (Audit Trail) also relax certain requirements relating to benchmarks based on transactions in securities on regulated markets and exchanges in line with IOSCO’s desire for a proportional application of the Principles. IOSCO reiterates in the Final Report that these Principles have been designed as a set of recommended practices and it does not expect a “one-size-fits-all” method of implementation. IOSCO highlights that there is an overarching theme of proportional application of the Principles depending on the size and risk posed by each benchmark and/or administrator and the benchmark-setting process.

The Final Report also excludes central counterparty risk management and settlement prices from the application of the Principles, since such central counterparties that are regulated already have to comply with stringent risk management and governance requirements.

Use of Transaction Data

IOSCO highlights that a benchmark should be underpinned by an observable market consisting of bona fide, arms-length transactions, but introduces a clarification in the Final Report that a benchmark does not need to be constructed solely of transaction data, nor does transaction data carry more significance in the determination of a benchmark than non-transaction data. The Final Report recognises that in certain circumstances, such as in a low liquidity market, confirmed bids or offers may carry more meaning than an outlier transaction. Further, the Final Report states that non-transactional data can be used to determine benchmarks in relation to certain indices which are not designed to represent transactions, as long as data is derived from, and thus “anchored” in, a transparent, active market.

Transparency of Benchmark Determination and Expert Judgment

The final Principles include a new Principle 9 (Transparency of Benchmark Determinations) which recommends that benchmark administrators should provide a concise explanation of how a benchmark has been determined, including certain minimum information such as the size and liquidity of the market being assessed, the pricing methodology and the extent to which any “expert judgment” (discretion in data selection and modification) was used.

Annex C of the Final Report provides further guidance on Principle 9, stating that its focus is to provide stakeholders with sufficient information to understand how a benchmark is determined. The guidance highlights that benchmarks that regularly publish their methodologies would comply with this Principle when they are derived from data sourced from regulated markets or exchanges with mandatory post-trade transparency requirements. Further, a benchmark that is based exclusively on executable quotes would not need to explain in each determination why it has not used transaction data, provided that it includes the requisite disclosure in its published rules and procedures.

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Next Steps

IOSCO has called on benchmark administrators to publicly disclose their compliance with the Principles within 12 months, and stated that it intends to review the extent to which the principles have been implemented within 18 months. IOSCO will also consider the need in due course for any modification of the Principles for Oil Price Reporting Agencies8, which it adopted in October 20129 and took into consideration when developing the Principles.

Protect Your Elders, Part II In recent years, the SEC and FINRA have been focusing on market practices related to the sale of complex products to senior citizens.10 Some state securities regulators have also expressed similar concerns. On July 10, 2013, the Massachusetts Securities Division issued a press release indicating that it had issued subpoenas to 14 broker dealers.11 The subpoenas requested information concerning the firms’ sales of alternative investment products to seniors in Massachusetts. These investment products include “REITs, oil and gas partnerships, [Rule] 506 private placements, structured products, tenancy-in-common” and other non-traditional securities. In the press release, Secretary of the Commonwealth William F. Galvin indicated that these products are not unsuitable in and of themselves. However, he expressed his concern over their sale to inexperienced investors by untrained agents who are eager to make the sales, and to obtain the higher commissions that may be associated with these products. This is not the first time that Secretary Galvin’s office has focused on the sale of complex products. In 2012, his office issued guidance in connection with retail sales of structured products.12 In addition to fair and balanced disclosures, the guidance requires that the sale must meet customer-specific suitability requirements. The guidance is at least in part a result of concern over “a large number of transactions to elderly customers.” In addition, in previous settlements with five broker-dealers for improper sales of REITs to seniors, his office enabled Massachusetts investors to receive compensation of over $11 million.13 In 2011, his office obtained a consent agreement regarding improper sales of non-traditional ETFs to certain Massachusetts investors, which required a broker-dealer to reimburse those investors for their losses and to pay a fine of $250,000.14 Suitability is a principal issue associated with the sale of complex products. Market participants, of course, should be aware that a variety of regulators may scrutinize their recommendations when structured and other products are sold to senior citizens.

“Retailisation” of Structured Products in the EU In early July, the European Securities and Markets Authority (ESMA) published an Economic Report discussing the sale of complex financial products, including UCITs focused on alternative investment strategies and structured products, to retail investors. The report analyzes whether unexpected losses in relation to these products could reasonably be expected to lead to complaints, reputational damage, or a loss of confidence in the integrity of the financial markets. 8 FR06/12 Principles for Oil Price Reporting Agencies, Report of the Board of IOSCO, October 2012, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD391.pdf. 9 IOSCO developed the Principles for Oil Price Reporting Agencies in collaboration with the International Energy Agency, the International Energy Forum and the Organization of Petroleum Exporting Countries. 10 We have addressed this development in a prior issue of Structured Thoughts. See http://www.mofo.com/files/Uploads/Images/130515-Structured-Thoughts.pdf. 11 For full text of the press release, see http://www.mofo.com/files/Uploads/Images/130710-Secretary-Galvin-Begins-Investigatory-Sweep-of-the-Sales-of-High-Risk-Alternative-Investments-to-Seniors.pdf. 12 See http://www.sec.state.ma.us/sct/sctguidance/guidance.pdf. 13 See the press release, at 11. 14 See http://www.mofo.com/files/Uploads/Images/120530-Structured-Thoughts.pdf.




http://www.mofo.com/files/Uploads/Images/130710-Secretary-Galvin-Begins-Investigatory-Sweep-of-the-Sales-of-High-Risk-Alternative-Investments-to-Seniors.pdf

http://www.mofo.com/files/Uploads/Images/130710-Secretary-Galvin-Begins-Investigatory-Sweep-of-the-Sales-of-High-Risk-Alternative-Investments-to-Seniors.pdf

http://www.sec.state.ma.us/sct/sctguidance/guidance.pdf


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The report recommends that, given the complexity of certain products, disclosures be improved to include a higher degree of transparency regarding the total costs, including embedded costs, and more detailed information regarding specific product risks, with quantification. The study provides useful survey information on market trends, including market size, growth, and type of product offered. The study assesses the intrinsic value of a sampling of structured products using various pricing models. The study also analyzes the returns on a sampling of nearly 3,000 principal-protected structured products.

FINRA FAQ on TRACE Reporting and Variable Price Reofferings On August 1, 2013, FINRA issued a new set of FAQs relating to its TRACE system.15 In one question, FINRA stated that a firm commitment from a broker-dealer or a customer to purchase a new issue debt security when it is issued, prior to a final pricing or determination of the final material terms of the new issue, does not constitute a transaction that must be reported to TRACE. Citing FINRA Rule 6710(d), FINRA stated that, for purposes of TRACE trade reporting, the “time of execution” for a TRACE-eligible security occurs when the parties have a “meeting of the minds” regarding the material terms of the transaction. Material terms include price, coupon and quantity of the security, without which there can be no time of execution and, therefore, no requirement to report the firm commitment to TRACE. FINRA’s advice appears to apply in the context of a variable price reoffering, where a dealer receives various firm commitments to purchase a security at varying prices within a range of public offering prices and underwriting discounts previously disclosed to investors. In these offerings, the aggregate principal amount of the offering is typically not known until the end of the marketing period. Accordingly, a TRACE report would not have to be filed until all of the commitments in the variable price reoffering have been made, and the aggregate principal amount has been determined. The FAQ also reminds underwriters of these offerings that they should be clear in their communications regarding the final terms of the trade and how those terms will be conveyed between the parties.

FINRA Postpones Rule Requiring Disclosure of Enhanced Compensation FINRA has postponed finalizing its Proposed Rule requiring disclosure of enhanced compensation relating to recruitment of investment advisors, which had been scheduled for discussion on July 11, 2013.16 The Proposed Rule seeks to inform customers about investment advisors’ conflicts of interest when the advisors receive compensation in connection with their recruitment to new member firms.17 According to FINRA spokesperson Nancy Condon, FINRA postponed consideration of the Proposed Rule due to scheduling issues.18 Given FINRA’s recent focus on conflicts of interest in the financial services industry, it appears likely that the regulator will eventually consider the Proposed Rule, perhaps with some revisions.19

15 The new FAQ can be found at http://www.finra.org/Industry/Regulation/Notices/2013/P314035. 16 See http://www.finra.org/Industry/Regulation/Guidance/CommunicationstoFirms/P292644. 17 For our summary of the Proposed Rule, see http://www.mofo.com/files/Uploads/Images/130116-Structured-Thoughts.pdf. The Proposed Rule is available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/industry/p197601.pdf. 18 See http://m.investmentnews.com/article/20130708/FREE/130709950?template=mobileart. 19 See http://www.mofo.com/files/Uploads/Images/120814-FINRA-Conflicts-of-Interest.pdf.

http://www.finra.org/Industry/Regulation/Notices/2013/P314035

http://www.finra.org/Industry/Regulation/Guidance/CommunicationstoFirms/P292644


http://m.investmentnews.com/article/20130708/FREE/130709950?template=mobileart

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iShares Changes Names of Widely Used ETFs BlackRock has changed the names of many of its iShares Exchange Traded Funds (“ETFs”) effective July 1, 2013. A complete list of the iShares name changes is available at: http://investwithanedge.com/ishares-name-changes. However, BlackRock did not change the applicable ticker symbols, and the holdings and investment strategies of these ETFs will not change as a result of the name change. Some of the name changes seek conformity between the iShares ETFs (such as changing the words “Index Fund” and “Fund” to “ETF”). Other name changes create future flexibility for iShares by removing the index provider identifiers (such as “Dow Jones,” “S&P” and “FTSE”). Generally, the changes result in shorter and simpler names for the ETFs. It remains to be seen whether removing the name of the underlying index from an ETF’s name may obfuscate a bit the basis for an ETF’s investment strategy. The following are examples of the iShares ETF name changes: Ticker Old Name New Name EEM iShares MSCI Emerging Markets Index Fund iShares MSCI Emerging Markets ETF

EFA iShares MSCI EAFE Index Fund iShares MSCI EAFE ETF

FXI iShares FTSE China 25 Index Fund iShares China Large-Cap ETF

IWM iShares Russell 2000 Index Fund iShares Russell 2000 ETF

IYR iShares Dow Jones U.S. Real Estate Index Fund iShares U.S. Real Estate ETF

Providers of structured notes, structured CDs, derivatives and other instruments linked to these ETFs will wish to review their documentation to ensure that they reflect the new names. Contacts Bradley Berman New York (212) 336-4177 [email protected]

Nimesh Christie New York +44 20 7920 4175 [email protected]

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

Justin B. Kamen New York (212) 336-4222 [email protected]

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

Helen Shouhua Yu New York (212) 336-4049 [email protected]

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 eight years. See the write up at http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf. Morrison & Foerster named Best Law Firm in the Americas, 2012, 2013 by StructuredRetailProducts.com. Morrison & Foerster named Legal Leader, 2013 by mtn-i at their Americas Awards. Two of our 2012 transactions were also granted awards of their own as a result of their innovation.

http://investwithanedge.com/ishares-name-changes

mailto:[email protected]






http://www.twitter.com/Thinkingcapmkts

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


Volume 4, Issue 10 July 9, 2013

Chasing Return, Reprise Two years ago, in the summer of 2011, FINRA released its investor alert “The Grass Isn’t Always Greener—Chasing Return in a Challenging Investment Environment.”1 The alert focused on how investors, in the then-existing low interest rate environment, were purchasing structured products and other more complex investments in an effort to increase their returns.

What has changed in the past two years?

The rate environment hasn’t necessarily changed much. (See graph below.) But product offerings have evolved, and some of them raise issues that make the investor alert still relevant today.

The 2011 alert was issued not long after several FINRA actions involving unsuitable sales of “reverse convertible securities.” Since that time, many broker-dealers have enhanced their supervision of sales of that particular product, and the investing public has developed a greater awareness of how it works, and for whom it is designed. (And we also believe that the disclosure documents relating to these products remain robust, with prominent disclosure of the key risks.)

The 2011 alert also focused on “curve steepeners,” which can be used in some markets to increase yields. However, here in the summer of 2013, the effectiveness of these products is threatened by a narrowing gap between short-term and long-term rates.2

1 The alert may be found at: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P123947. Our summary of the alert may be found at: http://www.mofo.com/files/Uploads/Images/110727-Structured-Thoughts.pdf. 2 See, for example, “Narrowing of Swap-Rate Spread Endangers U.S. ‘Steepener’ Notes”, available at http://www.bloomberg.com/news/2013-06-21/narrowing-of-swap-rate-spread-endangers-u-s-steepener-notes.html.

IN THIS ISSUE:

Chasing Return, Reprise.………....…Page 1

IOSCO: Uniform Regulation and More Transparency for ETFs.…..………….Page 2

FINRA Removes Proposal to Require Supervision of Non-Securities Business...………..............................Page 4

In Case You Missed It..............…......Page 4

http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P123947


http://www.bloomberg.com/news/2013-06-21/narrowing-of-swap-rate-spread-endangers-u-s-steepener-notes.html

http://www.bloomberg.com/news/2013-06-21/narrowing-of-swap-rate-spread-endangers-u-s-steepener-notes.html

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Of course, the key retail structured product types that remain from the 2011 alert are non-principal protected notes. And since 2011, product manufacturers have increasingly offered different products that are designed to enhance yield, in a manner that is consistent with an investor’s market outlook and risk tolerance. Various types of conditional coupon notes, autocallable notes, and “non-principal protected” range accrual notes all can be used to enhance returns. But of course, these products may result in losses, or lower returns, under different market scenarios.

These types of products may not have generated the type of specific regulatory focus of “reverse convertible notes.” (And again, we believe the terms and risk factors of this class of products are the subject of many very carefully written disclosure documents.) However, brokerages must be careful to ensure that, like any other product, they are recommended only to appropriate investors, who understand their risks. Sales pitches about their above-market coupons need to be carefully balanced with a proper explanation of the downside. Brokerages also will want to know that any distributors to whom they are sold can market them in an appropriate manner.

IOSCO: Uniform Regulation and More Transparency for ETFs Introduction

The International Organization of Securities Commissions (IOSCO) has published a report calling for financial regulators to encourage greater transparency on the differences between exchange traded funds (ETFs) and other exchange traded products (ETPs) and more uniform regulation.

IOSCO’s June 2013 report, “Principles for Regulation of Exchange Traded Funds,” found that globally, ETFs amount to $1.9 trillion in assets, representing roughly 7 percent of the global mutual fund market, which, in turn, is estimated at approximately $26.8 trillion.

Global Trends

The report noted several global trends of which regulators should be mindful. Among other things, the report stated:

• The ETF industry is consolidated and dominated by a few large players;

• Investor appetite for exposure to equity indices has grown in light of the low interest rate environment;


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• ETF providers in some jurisdictions have substantially enhanced their disclosures;

• Synthetic ETF providers have taken significant steps to increase transparency and minimize counterparty risk.

Overview of the Principles

The report enumerates nine principles, which fall primarily into two categories. The first section concerns ETF classification and disclosures, including principles intended to clearly differentiate ETFs from other types of investments. The second section concerns structuring issues, including management of inherent conflicts of interest and counterparty risk arising from the two main types of index replication methods: physical and synthetic.

Investors in the U.S. should not be surprised by the nature of the recommendations, which are consistent with U.S. regulation of ETFs. Similarly, it would come as no surprise if the SEC were to propose regulations or issue guidance that would enhance the existing regulatory scheme, particularly with respect to disclosures, conflicts of interest or securities lending, which have been popular areas of focus for the SEC’s enforcement division.

IOSCO accompanied each principle with recommended means of implementation.

The Nine Principles

The nine IOSCO principles for ETFs are:

Principle 1: Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other ETPs.

Principle 2: Regulators should seek to ensure a clear differentiation between ETFs and other collective investment schemes (CIS), as well as appropriate disclosure for index-based and non-index-based ETFs.

Principle 3: Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references. (This approach is already typical in prospectuses for U.S. ETFs.)

Principle 4: Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio and/or other appropriate measures in order to provide adequate information concerning (i) any index referenced and its composition, and (ii) the operation of performance tracking.

Principle 5: Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.

Principle 6: Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., on related costs).

Principal 7: Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with the ETF’s strategies.

Principle 8: Regulators should assess whether the securities laws and rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interest raised by ETFs.

Principle 9: Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.

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The SEC and IOSCO

IOSCO consists of 32 securities regulators of different countries, including the Securities and Exchange Commission. The SEC served as co-chair of the working group that authored the report. In the past, the SEC has disavowed reports when it found the recommendations inconsistent with its goals. For example, in 2012, the SEC publicly stated that it disagreed with IOSCO recommendations for regulation of money market funds. It appears, however, that the SEC would be amenable to the IOSCO recommendations, which it may incorporate into future rulemaking or regulatory guidance.

FINRA Removes Proposal to Require Supervision of Non-Securities Business For the past several years, FINRA has engaged in a process to revise and consolidate its supervision rules. In a June 2013 filing,3 FINRA abandoned its prior proposal to require broker-dealers to supervise under proposed Rule 3110(a) its lines of business outside of the securities industry. The proposed rules, which were originally filed with the SEC in 2011, had initially included supplemental material providing that for a member’s supervisory system required by proposed FINRA Rule 3110(a) to achieve compliance with FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), it must include supervision for all of the member’s business lines regardless of whether they require broker-dealer registration.

Proposed FINRA Rule 3110 is based primarily on existing requirements in NASD Rule 3010 and Incorporated NYSE Rule 342 relating to, for example, supervisory systems, written procedures, internal inspections, and review of correspondence. Proposed FINRA Rule 3110 also incorporates provisions in other NASD rules relating to supervision, such as NASD Rule 3012. Proposed FINRA Rule 3110(a) requires a member to have a supervisory system for the activities of its associated persons that is reasonably designed to achieve compliance with the applicable securities laws and regulations and FINRA and Municipal Securities Rulemaking Board rules.

According to the June 2013 filing, FINRA has decided that the best course is to eliminate the proposed supplementary material relating to other business lines from the proposed rule. Instead, FINRA will continue to apply FINRA Rule 2010’s standards to non-securities activities, consistent with existing case law. Rule 2010 is FINRA’s general requirement of broker-dealers: “a member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”

In the structured product market, many broker-dealers market structured CDs, which are not securities, using a manufacturing and distribution methodology that is similar to that used for structured notes, which are subject to FINRA’s supervision rules. Often, the personnel and processes involved in the structured CDs overlap with the personnel and processes for structured securities. Accordingly, as a practical matter, while the proposed FINRA rules would not require a supervision system for the structured CD line of business, most broker-dealers manage and monitor that business in a manner that is consistent with their structured CDs. And in light of continuing regulatory attention from FINRA and other regulators to these products, that degree of careful supervision remains appropriate.

In Case You Missed It… FINRA Issues Sweep Letter Regarding the Use of Social Media

FINRA has followed up on its recent communications rules that reference electronic communications, and its recent regulatory notices providing guidance to the securities industry on social media. FINRA is now conducting a sweep of

3 The proposal may be found at: http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p286229.pdf.

http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p286229.pdf

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broker-dealers to determine their compliance with its communications rules. FINRA has posted on its website a targeted examination letter that seeks, among other things:

• an explanation of how the firm is using social media at the corporate level in the conduct of its business;

• an explanation of how the firm’s brokers generally use social media in conducting the firm’s business;

• the firm’s written supervisory procedures concerning production, approval and distribution of social media communications; and

• an explanation of how the firm monitors compliance with its social media policies.

For additional information, please see our client alert: http://www.mofo.com/files/Uploads/Images/130619-FINRA.pdf.

UK Private Placement Regime and Non-EU Fund Managers

On June 28, 2013, the UK’s Financial Conduct Authority (the FCA) published its Policy Statement on the Implementation of the Alternative Investment Fund Managers Directive in the UK. This Policy Statement sets forth the FCA’s final rules for implementing the EU’s Alternative Investment Fund Managers Directive (the AIFMD) (which must be adopted by July 22, 2013), as well as responding to the feedback it received from its earlier consultation papers. The UK’s HM Treasury has recently clarified how AIFMD will affect alternative investment fund managers, including those based outside the EU, with respect to UK private placements and UK marketing activities.

For additional information, please see our client alert: http://www.mofo.com/files/Uploads/Images/130702-UK-IAFMD.pdf.

Basel Committee Proposes Leverage Capital Framework for Banking Organizations

On June 26, 2013, the Basel Committee on Banking Supervision published a Consultative Document that proposed specific leverage capital requirements, and related disclosure requirements. The proposal would more fully implement the leverage capital provision of the 2010-2011 revised regulatory capital accord (“Basel III”), which was adopted in the wake of the financial crisis. The proposal specifies the elements of the “Exposure Measure” for calculating leverage capital requirements, including detailed provisions relating to derivatives exposures, and credit derivatives in particular.

For additional information, including our observations as to the proposals, please see our client alert: http://www.mofo.com/files/Uploads/Images/130701-Basel-Capital-Framework.pdf.

Contacts Jay G. Baris New York (212) 468-8053 [email protected]

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

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

http://www.mofo.com/files/Uploads/Images/130619-FINRA.pdf

http://www.mofo.com/files/Uploads/Images/130702-UK-IAFMD.pdf

http://www.mofo.com/files/Uploads/Images/130701-Basel-Capital-Framework.pdf





Volume 4, Issue 9 June 17, 2013

UK’s FCA Restricts Marketing of Unregulated Collective Investment Schemes and Similar Products to Retail Investors Following a public consultation conducted by its predecessor, the Financial Services Authority (FSA), the Financial Conduct Authority (FCA) of the UK has published new, final rules1 restricting the distribution of unregulated collective investment schemes and “close substitutes” to certain retail investors.

Unregulated collective investment schemes (UCIS) are collective investment schemes (as defined in Section 235 of the Financial Services and Markets Act 2000), the operator of which has not applied for or obtained authorised or recognised scheme status from the FCA. These CIS are not generally subject to the FCA rules on the operation of collective investment schemes, such as in relation to a CIS’ investment and borrowing powers, its management of risk, information to investors and provisions regarding fees and other investor protection measures.

In addition to UCIS, the new rules focus also on schemes that the FCA regards as close substitutes to UCIS and that, together with UCIS, it terms “non-mainstream pooled investments” (NMPIs). Expressly within the scope of the NMPI definition are units in qualified investor schemes (QIS), non-excluded securities issued by special purpose vehicles (SPVs) and traded life policy investments (TLPIs).

Background. The FSA had previously concluded that most retail promotions and sales of UCIS that they had reviewed were inappropriate and exposed ordinary retail investors to significant risk of detriment. The rules are intended to

1 Appendix 1 to Policy Statement 13/3 of the Financial Conduct Authority, http://www.fca.org.uk/static/documents/policy-statements/ps13-03.pdf.

IN THIS ISSUE:

UK’s FCA Restricts Marketing of Unregulated Collective Investment Schemes and Similar Products to Retail Investors…………Page 1

Electronic Structured Note Systems and U.S. Securities Regulation…………………………….Page 3

Reminders from the SEC and FINRA…….….……………….............Page 6

http://www.fca.org.uk/static/documents/policy-statements/ps13-03.pdf

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enhance consumer protection by restricting the promotion of NMPIs to those consumers for whom these products are likely to be unsuitable.

Ban on marketing NMPIs to certain investors. The FCA distinguishes between three different types of retail investor: sophisticated investors, high net worth individuals and “other retail investors.” The FCA’s rules are designed to protect the “other retail investors,” who are the vast majority of the UK retail market, by a complete ban on promoting NMPIs to them, except in very limited circumstances.

Beginning 1 January 2014, firms must comply with this new communications ban. The means that a firm must not communicate or approve an invitation or inducement to participate in, acquire or underwrite a non-mainstream pooled investment when that communication is likely to be received by a retail client, unless the relevant promotion falls within one of a number of exemptions, such as a promotion to a sophisticated investor or to a high net worth individual.

The FCA is particularly concerned about a number of different investment types, including traded life policy investments (investments in second-hand life insurance policies of US citizens—sometimes known as traded life settlements or senior life settlements). The FCA has found these TLPIs to be “higher risk, complex and opaque products, yet often marketed as low risk on the basis of being uncorrelated with mainstream investments, and many of these products have failed and caused significant consumer detriment.” Also of concern to the FCA are schemes based on investments in land, overseas forestry and crops, property/hotel developments and wine.

The FSA’s consultation paper made clear that, despite the reference to securities issued by SPVs, structured products were not the focus of its intervention action. However, since the FSA had encountered securities issued by SPVs that were used to facilitate retail investment in TLPIs, the FCA’s final rules provide that securities issued by SPVs should not automatically be excluded from the definition of NMPI. When the SPV invests in non-mainstream assets, it could be subject to the NMPI restrictions.

Therefore the final rules generally include securities issued by an SPV in the restrictions, subject to a list of exclusions. Among other things, covered bonds, investment trusts, venture capital trusts and REITs and exchange traded products are excluded. Also excluded are securities “wholly or predominantly linked to, contingent on, highly sensitive to or dependent on, the performance of or changes in the value of shares, debentures or government and public securities, whether or not such performance or changes in value are measured directly or via a market index or indices, and provided the relevant shares and debentures are not themselves issued by SPVs.”

Of particular interest to US persons resident in the UK: funds registered under the US Investment Company Act of 1940 are excluded from the prohibition. That is, broker-dealers may promote US registered investment companies in the UK to any person who is classified as a United States person for tax purposes under US legislation, or who owns a US qualified retirement plan. This exemption was crafted by the FCA in response to comments that, in the case of US citizens temporarily resident in the UK and expecting to return to the USA, regulated US mutual funds are likely to be more suitable than EEA-regulated funds, and therefore should not be subject to marketing restrictions to which the EEA funds were not.

The FCA has also provided further guidance to firms wishing to rely on the exemptions for promotions to certified high net worth investors, self-certified sophisticated investors and for non-recognised UCITs (i.e. funds which have been approved by an EEA regulator in accordance with the UCITS legislation, but where the fund manager has not applied for the fund to be recognised in the UK). It notes that a preliminary assessment of suitability is required before the promotion of NMPIs to clients, although this preliminary assessment does not extend to a full suitability assessment, unless the NMPI is being promoted on an advised basis. However, it states that the preliminary assessment of suitability requires the firm to take reasonable steps to acquaint itself with the client’s profile and objectives in order to ascertain whether the particular NMPI is likely to be suitable for that client.

One more item of interest in the FCA’s policy statement that contained the final rules is an indication that the FCA is planning to consult on other possible new marketing restrictions. In particular, it is concerned that the new Basel III and (in Europe) CRD4 requirements for banks and building societies to raise loss-absorbing capital will lead to firms offering

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these types of regulatory capital instruments, and similar instruments such as contingent capital securities (CoCos), to retail consumers who do not have the necessary experience and understanding to evaluate them. It therefore plans to consult on a new restriction for the marketing of these products only to sophisticated or high net worth retail investors, as well as professional investors. In the meantime, it expects issuers to distribute these sorts of instruments in a way that prevents ordinary retail investors from buying them, and it does not rule out using its temporary product intervention powers2 to address these risks in the short term if necessary.

Also on the FCA’s radar are the criteria used to determine when a retail client qualifies as a “high net worth individual.” Currently the criteria are that the person must have an annual income of more than £100,000 or investable net assets of £250,000. These criteria were determined back in 2001, and the FCA plans to consult on whether they are still set at an appropriate level, or whether they should be raised.

Electronic Structured Note Systems and U.S. Securities Regulation Introduction

Market participants in a number of jurisdictions outside of the U.S. use different types of electronic systems to offer structured products. In these countries, brokers and investment advisers use these types of programs to show investors the pricing and terms for different types of offerings. In some cases, the systems can also be used to effect actual sales.

The features of current systems, and any future systems, may vary. Depending upon the service in question, it may:

• show investors the current trading values of previously issued structured notes, with or without enabling investors to purchase them; or

• show investors a broker’s current offerings, again with an opportunity to place an order for the product.

More elaborate systems could show the investor the potential pricing of a newly-issued product with different parameters. For example, imagine a simple structured note linked to a particular stock, which provides a buffer against losses on the downside, together with a multiple of the participation in the upside, subject to a cap. In such a system, if, for example, the investor sought to increase the upside participation rate, the system would show the extent to which the cap on the upside may decrease, or the buffer on the downside may decrease.3 Such a system could show investors preliminary terms that could be accepted within a specified period of time, possibly by entering an order on the system. Depending on the capabilities of such a system, the system may automatically generate final term sheets and simple final pricing supplements.

In this article, we examine the federal securities regulations that would apply to systems of this nature if used in the U.S., and describe a number of other related practical issues to address in the U.S. market.4

Prospectuses and Free Writing Prospectuses

User Interface/Website. In the case of registered structured notes, the system interface itself would likely be deemed a “free writing prospectus” under the SEC rules. Accordingly, depending on its use, and which securities were offered on it, the relevant screens viewed by investors may be required to be filed with the SEC under Rule 433 by one or more of the relevant issuers, and/or the broker-dealer that operated the system. Depending on its use, and which party files it with the SEC, the document may also be subject to filing with FINRA under Rule 2210(c)(3)(E).

2 See Morrison & Foerster’s Structured Thoughts Vol. 4 Issue 5, “FCA Temporary Product Intervention Rules: Nipping It In The Bud”, http://www.mofo.com/files/Uploads/Images/130412-Structured-Thoughts.pdf. 3 Because there is no such thing as a free lunch. 4 Many brokers maintain internal pricing systems, which they use to help set the terms for structured products. These systems are not accessed directly by the investor, and we do not address them in this article.


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Product Supplements. In the case of registered structured notes, a robust prospectus should be made available to the investor prior to the investor’s investment decision. In the case of an electronic system, this would likely be accomplished through a hyperlink on the website to a “product supplement” or similar document that describes the key terms and risks of the relevant product in which the investor sought to invest. The system could also have functionality to e-mail a .pdf version of that document to the investor. That document, together with the issuer’s base prospectus and any “MTN prospectus supplement,” would typically be filed with the SEC prior to its use under Rule 424(b).

Brokers would likely want to ensure not only that investors had access to this key document, but also that the investor has an appropriate amount of time in which to read it. Accordingly, a system may operate such that, for an investor that has not recently purchased a similar product, the investor’s agreement to purchase the product could only be entered following the passage of a certain amount of time after these documents had been made available to the investor.

Preliminary Term Sheets. In the case of a system that enables an investor to customize a product around certain parameters, the system would produce preliminary term sheets that set forth to the investor the potential terms of the offering, which would only be available for purchase during a particular period of time. After that period, the pricing and economic terms of that instrument may change, due to changes in market conditions. Such a term sheet would typically constitute a free writing prospectus, which would be required to contain the legend required by SEC Rule 433. However, such documents would not be required filings on the EDGAR system, under Rule 433(d)(5)(i), since they are preliminary in nature. (This feature would avoid the need to publicly file the preliminary term sheet for every iteration of the structure requested to be viewed by the investor, the majority of which did not result in an actual sale.5) In addition, since these documents are customized for each individual investor, and not broadly disseminated, they would not constitute “retail communications” under the FINRA Rule 2210(a)(5). Instead, they would typically constitute “correspondence” under FINRA Rule 2210(a)(2).

A new challenge for issuers: under the SEC’s recent guidance, the estimated value of the notes, or a range of estimated values, needs to be provided to the investor before it makes an investment decision. That information could be set forth in the preliminary term sheet presented by the system. However, in order to do so, the operator of the system would have to ensure that the system is capable of accurately employing its pricing models on a rapid basis so as to properly include this information.

Pricing and Final Pricing Supplements. For an investor that elects to act on a set of offering terms, and decides to purchase the product, a system of this kind may generate a final pricing supplement (and perhaps a final term sheet) in a specified form. Such a final pricing supplement must be filed with the SEC under Rule 424(b) within two days of the agreement. Similarly, a final term sheet would be filed with the SEC under Rule 433 on the same timeframe. The broker-dealer may seek to act on the “access equals delivery” model established under SEC Rules 172 and Rule 173. Using these rules, by filing the final pricing supplement and entering an appropriate note on the investor’s purchase confirmation, the broker would avoid the need to print a copy of the issuer’s full suite of offering documents: base prospectus, MTN prospectus, product supplement and final pricing supplement.

Exempt Offerings and Private Placements. Needless to say, the above paragraphs assume that, like for most structured notes, the issuer is effecting the sales using a shelf registration statement. But that need not be the case. Issuers could consider establishing systems that offer exempt bank notes or bank certificates of deposit, or even that are limited to private placements. These types of offerings are outside the scope of the Rule 424(b) filing requirements and the rules relating to free writing prospectuses.6 A Regulation D private placement system, in which the notes may only be sold to “accredited investors,” may seem appealing, in that it would avoid any SEC filing requirements (other than a notice filing on Form D), and perhaps avoid the SEC’s insistence on the inclusion of estimated value disclosures. A private system may also be used to help support the “suitability” analysis discussed below. However, such a program would need to be carefully vetted, for example, to ensure that the private offerings would not be integrated with the issuer’s registered offerings of similar structured securities.7

5 For example, in a service like the one described above that enables an investor to vary one or more terms, the investor may review multiple versions of the same product, with different economic parameters. 6 Depending upon the context, these offerings are subject to relevant securities or banking anti-fraud or truth-in-disclosure rules. 7 Under the 2012 “JOBS Act,” the SEC is required to adopt rules that will liberalize to some extent the degree of permitted communications in Regulation D offerings.

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FINRA Issues

FINRA Communications Rules. FINRA rules and guidance would need to be considered in connection with the establishment of an electronic system. Among other things, the materials and interface prepared by any broker for such a system could be subject to the approval, content and filing provisions of FINRA Rule 2210. In light of FINRA’s ongoing concerns relating to structured products, it may be difficult to implement a system through which retail investors may make purchases, without some sort of direct advice from a registered representative during the process.

Recommendations and Suitability. To the extent that any offer under the system is deemed a “recommendation,” which it could be in the case of a retail investor, a variety of FINRA provisions would apply, including FINRA’s rules relating to reasonable basis suitability and customer-specific suitability.

FINRA Notice 11-028 describes FINRA’s considerations for determining whether a recommendation has occurred, applying a “facts and circumstances” test. A system in which investors made their own independent decisions as to whether to purchase a product, or how to customize a product, would not appear to be a “recommendation” of a security. However, to the extent that a broker is setting the parameters for the products that may be purchased, and advertising the flexibility of such a system, there may be a question as to whether some sort of “recommendation” occurs at the time of sale. FINRA may have concerns that individual investors do not have the ability to properly evaluate these parameters and options without professional advice.

Accordingly, in connection with a system of this kind, a variety of steps could be taken to bolster the analysis. For example:

• The system could inform investors explicitly that the products sold on the system are not recommended for any and all investors.

• The system could require that investors seek the specific advice of their financial advisors before making an investment decision.

• The system could be limited to investors that satisfy specified parameters, such as institutional investors or those who satisfy a wealth test, or that have a given number of years of investing in structured products.

• A system that permitted investors to select different parameters for an investment, such as buffer levels, caps and participation rates, should vet the potential outputs with a “reasonable basis” analysis in mind.9 That is, can the various types of securities generated by the system be justified as suitable to at least some investors, based on their potential risks and rewards?

In short, creating a system that leaves product design all or partially in the hands of individual investors creates significant challenges in light of FINRA’s recent concerns.

Practice Pointers

In a service that enables investors to price and purchase new series of structured notes, a variety of additional practical considerations would also need to be addressed:

• Creating a system for obtaining and assigning CUSIP/ISIN numbers for the securities.

• Ensuring that the documents were converted to an EDGAR format, and filed with the SEC, on a timely basis.

8 Available at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf. 9 This type of functionality may require that all investors be institutional investors, due to the ability to create products viewed by FINRA as “complex,” and thus potentially not suitable for retail investors.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf

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• Ensuring that counsel had the opportunity to pass on the forms of the relevant documents to ensure that any required corporate and tax opinions can be rendered (and if needed, filed with the SEC) on a timely basis.10

• Ensuring that the securities are made DTC eligible.

• Ensuring that TRACE reports are filed on a timely basis.

• Ensuring that all necessary closing documents, forms and global notes, and other relevant documents are prepared.

Conclusion

Electronic systems potentially offer U.S. market participants a variety of desirable features and opportunities. However, these systems must be carefully planned in order to conform to the legal requirements of the U.S. market.

Reminders from the SEC and FINRA On June 12, 2013, Celia Moore, Assistant Director of the SEC’s Structured New Products Unit, Division of Enforcement, and Richard Vagnoni, Senior Economist of FINRA, spoke in a panel at the annual North American Structured Products Conference. The title of the panel discussion was: “Regulators Panel: What Are the Responsibilities of the Issuer and the Distributor?” The panel was organized to address continuing questions that arise in the structured products market as to the proper allocation of legal responsibilities among offering participants.

The speakers used the opportunity to provide some useful reminders about how the SEC and FINRA have analyzed a variety of issues, and the approach they take in regulating the market.

Continuing SEC Attention. First, Ms. Moore noted that structured products remain a significant focus of attention for the SEC. The SEC has established structured product working groups within the Office of Compliance Inspections and Examinations (OCIE), as well as in its recently renamed Division of Economic and Risk Analysis. These divisions are additional to the relatively new Office of Capital Markets Trends, which has significantly focused on this market. These divisions, together with other personnel from the Division of Corporate Finance and the Enforcement Division, communicate with one another in order to monitor market developments.

Know Your Distributor. Both speakers encouraged issuers and underwriters alike to take appropriate means to ensure the quality and experience of their distributors for structured products. In particular, appropriate review should be made of distributors who may be new to structured products.

Responsibility of Underwriters and Issuers for Downstream Distribution. Ms. Moore suggested that a party, such as an issuer, could not absolve itself entirely from an inappropriate sale by a downstream distributor, simply because that distributor was the entity which made the sale to the actual investor, and had a duty to make a suitability determination. Although many of the most important suitability determinations will rest upon such a downstream distributor, other parties to the transaction are likely to have duties as well. Ms. Moore pointed to the 2006 Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities.11 This statement sets forth a variety of recommended practices for issuers and product manufacturers to take, whether or not they are making sales of the product to a customer. These duties include, for example, adopting appropriate approval and review procedures. And of course, inappropriate sales by third-party distributors can create significant reputational risks for the issuer.

Areas of Regulatory Focus. Both speakers identified a few common themes as to areas and practice that are more likely to attract regulatory scrutiny:

10 See the SEC’s Staff Bulletin No. 19: http://www.sec.gov/interps/legal/cfslb19.htm. 11 The statement may be found at: http://www.sec.gov/rules/policy/2006/34-53773.pdf.

http://www.sec.gov/interps/legal/cfslb19.htm

http://www.sec.gov/rules/policy/2006/34-53773.pdf

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• Products and disclosure documents involving complexity, opacity or ambiguities that might make it easier to perpetuate fraud.

• Products characterized by a lack of liquidity.

• Products involving conflicts of interest.

Ease of Access. The panelists noted that many complex products were becoming more available to retail investors, including through self-directed accounts. Some brokers have been more willing than others to enable these types of accounts to elect to purchase these types of investments. Ms. Moore noted that in these situations, additional caution was recommended to ensure that appropriate disclosures of risks were provided to the relevant investors, in order to help strengthen their ability to make better investment decisions.

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

Jeremy Jennings-Mares London + 44 20 7920 4072 [email protected]

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 eight years. See the write up at http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf. Morrison & Foerster named Best Law Firm in the Americas, 2012, 2013 by StructuredRetailProducts.com. Morrison & Foerster named Legal Leader, 2013 by mtn-i at their Americas Awards. Two of our 2012 transactions were also granted awards of their own as a result of their innovation. 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. © 2013 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/files/Uploads/Images/120530-Americas-Awards.pdf

http://www.mofo.com/

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Client Alert June 19, 2013

FINRA Issues Sweep Letter Regarding Use of Social Media

FINRA, having enacted new communications rules that specifically reference electronic communications, having issued two Regulatory Notices (linked here and here) providing guidance to the securities industry on social media, and having made social media and electronic communications exam priorities in two of the last three years, is now taking the next logical step: conducting a sweep of broker-dealers to determine their compliance with the communications rules. In posting a Targeted Examination Letter—otherwise known as a sweep letter—on its website, FINRA invoked Rule 2210(c)(6), which provides for periodic spot checking by FINRA of firms’ written (including electronic) communications.

FINRA’s sweep letter seeks, among other things:

• An explanation of how the firm is using social media at the corporate level in the conduct of its business;

• An explanation of how the firm’s brokers generally use social media in conducting the firm’s business;

• The firm’s written supervisory procedures concerning production, approval and distribution of social media communications; and

• An explanation of how the firm monitors compliance with the firm’s social media policies.

If past experience is any guide, FINRA likely will review the information with an eye to both establishing a baseline of current industry adherence to the communications rules and guidance, and to developing individual informal or formal disciplinary responses to firms whose procedures are seriously deficient. The sweep letter includes a request for information about the firm’s top 20 producing brokers who used social media to interact with retail investors. FINRA probably believes that, in view of these brokers’ levels of activity, examiners are more likely to find that some of these brokers failed in some way to comply with FINRA rules—such as FINRA content standards, or approval, review, recordkeeping and filing requirements—with respect to their use of social media to communicate with customers. FINRA might well seek to develop formal disciplinary actions against some of these brokers.

As the firms that received this request gather responsive information, they should take a comprehensive look at their procedures for approval and review of communications using social media, and should determine whether these procedures are adequately documented, and whether their registered representatives, associated persons and compliance officers are adequately trained to apply these procedures. MoFo’s recent Guide to Social Media and the Securities Laws, and recent related presentation, are convenient places to start.



http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P282569

http://www.mofo.com/files/Uploads/Images/130528-Socia-Media-Securities-Laws.pdf

http://www.mofo.com/files/Uploads/Images/130528-Socia-Media-Securities-Laws.pdf

http://www.mofo.com/Use-of-Social-Media-for-Issuers-Broker-Dealers-and-Advisers-and-Investment-Companies-05-28-2013/

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Author

Daniel A. Nathan Washington, D.C. (202) 887-1500 [email protected] Contacts

Jay G. Baris New York (212) 468-8053 [email protected]

Hillel T. Cohn Los Angeles (213) 892-5251 [email protected]

David M. Lynn Washington, D.C. (202) 887-1563 [email protected]

Anna T. Pinedo New York (212) 468-8179 [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 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. © 2013 Morrison & Foerster LLP. All rights reserved.

For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts. 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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