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Learning Center Experience
By Jim Heitman, Instructor, Kaplan Professional and Continuing EducationPublished October 2014
In the early
1990s, it was not at all uncommon to turn to your favorite music station and,
after hearing some unfamiliar tunes, learn that they had changed their format
to alternative rock. At about the same time, financial advisers began
introducing their wealthy clients to alternative investments, now generally
referred to as alts. These included, among other products, hedge funds, private
equity, and new, highly sophisticated financial derivatives.
One thing that all
of these alternative investments had in common was that they were quite
difficult to understand, for both the investor and the person recommending the
investing can be complex, standard investments are fairly easy to comprehend. Even
neophyte investors understand that stocks have more risk but hold out the chance
of superior returns, while bonds generally have less risk with correspondingly
lower returns. The dream of investors is the miracle of high returns without
the bad stuff (negative returns).
In an effort to give investors exactly what
they want (a nice profit while minimizing negative results), the investment
marketplace has created an impressive array of products that try to mimic the
upside of equity investments (like stocks and real estate), while still providing
some protection on the downside. Over the years, these cobbled together
creations have become increasingly complex and unpredictable. For some time,
securities industry regulators, and more recently the public, have realized
that these alternative investments more closely resemble Frankenstein’s monster
than a miracle.
As early as
2003, the Financial Industry Regulatory Authority (FINRA) cautioned the securities
industry to uphold its obligation to thoroughly vet investments it planned to
offer the public (a process called due diligence). Even as FINRA published more
and more advisories on specific products, the industry continued to create and
sell ever more complex investments to the public. The financial crises of 2008
revealed the weaknesses in many of these investment structures and proved to be
an unpleasant surprise for investors, brokers, and regulators. FINRA concluded the
industry needed a more comprehensive approach to the sale of these investments
to the public.
In January 2012,
FINRA released Regulatory Notice 12-03: Heightened Supervision of Complex
Products. Notice 12-03 provides the most comprehensive guidance to date on the
approval and sale of complex investments. The Notice effectively created a new
classification for investments, the “Complex Product.”
notices regularly include background material to provide context for rules
being introduced. Notice 12-03 is more than 20 percent background. The
background section reminds the reader of a large number of existing rules
regarding different products, as well as regulatory activity, both here (the
SEC) and in several other countries on the issue.
of investment notices covered in the background material reminds the industry
that nothing here should be new; everything in the notice has been stated
before, just not as clearly or comprehensively. At certain points, the tone sounds
like an exasperated parent explaining that the prohibition against locking your
little brother in the hall closet applies to all closets, trunks, suitcases,
and other confined spaces wherever they may be. You can almost hear the
regulators sigh as they say, “Do I really need to explain this?”
One of the
most important points in the regulatory notice is something that is not in it:
a definition of what makes an investment product complex. Before launching into
a discussion of what characteristics may make a product “complex,” FINRA states:
this Notice provides guidance about
the characteristics of many complex products, it does not define a ‘complex
product’ or provide an exhaustive list of features that might render a product ‘complex.’
Moreover, some relatively simple products may also present significant risks to
investors that warrant heightened scrutiny or supervision.”
continues with a list of characteristics and includes specific examples of
products with those characteristics. However, at the end of this list, FINRA
writes, “The list above is not exhaustive.” It is clear that FINRA is not
interested in issuing guidance just to have the industry develop products that
are just different enough to avoid the category. FINRA does provide a general
principal in identifying a complex product:
product with multiple features that affect its investment returns differently
under various scenarios is potentially complex. This is particularly true if it
would be unreasonable to expect an average retail investor to discern the
existence of these features and to understand the basic manner in which these
features interact to produce an investment return.”
Put simply, if
an investment has multiple moving parts that would make it difficult for the
average investor to understand how it works, it may be considered “complex.” FINRA
gives us eight examples of investments that would be considered “complex” under
the Notice and identifies those characteristics that cause complexity.
the Notice by recommending that firms “err on the side of caution” when
deciding if they should apply the higher expectations recommended in the
Notice. As FINRA is a regulator, the guidelines laid out in Notice 12-03 apply
to member firms and representatives, but there are some things the investor can
learn from the Notice as well. Let’s take a look at all three.
The Notice is
aimed squarely at brokerage firms (also known as broker/dealers) that sell or
offer to sell these investment products. As mentioned above, the Notice
strongly cautions firms that they have an obligation to perform a reasonable
due diligence investigation into a product before it allows its representatives
to sell the investment to its customers. One of those determinations is that
the investment be suitable for at least some of its customers. Before a firm
includes a complex product on the approved list, it should answer a number of
FINRA makes it clear
that a brokerage firm and its representatives must understand how an investment
works, and whom it will work for, before they place it on the approved list. A
firm is said to have a “special relationship” with its customers and should
take the necessary care before approving a product.
In addition, FINRA
suggests that its member firms establish an approval process for those customer
accounts that seek to purchase complex products, similar to that used for derivative
investments, such as options. Product-specific training should be put into
place for representatives before they are allowed to recommend a complex
product to the firm’s customers.
has a number of guidelines for the representative. Most of the recommendations
are reminders to apply standard suitability expectations to the recommendation,
but there are a few higher expectations for complex products. The first is that
a rep should possess a “sophisticated understanding” of the investment. The
representative needs to be able to explain the investment and its associated
risks in a way that fortifies the customer’s understanding of the investment. A
deeper and thorough understanding of the product’s investment characteristics
would likely include how the payoff is structured and how the investment will
perform in a variety of market environments.
are cautioned that they may not rely on the product’s presence on the firm’s
approved list, or account approval for complex products, to determine
suitability. Suitability determinations need to be made on a case-by-case basis
considering each customer’s objectives, circumstances, and sophistication.
Representatives must take special care in recommending complex products to the
notices are aimed at the securities industry (the SEC produces alerts aimed at
investors), there is much for the investors to glean from Notice 12-03. First,
no investment is without risk. If an investment appears to have no downside,
something is missing. Furthermore, “complex” is an understatement for some
investment products; arcane is a more colorful and accurate description.
Investors should ask questions and try to develop an accurate and thorough
understanding of what they can reasonably expect, as well as what can cause the
investment to perform badly. No investment is perfect.
Why has FINRA
gone so far as to effectively create a new classification of securities for
are viewed by FINRA to fit the specific needs of certain sophisticated
investors. Through the Notice, FINRA put member firms and their representatives
“on notice.” The industry must take great care in recommending complex
investments to all its customers, and particularly the average investor. It’s
too easy to communicate a simple story and leave out the details needed to
fully understand the rewards, as well as the risks, associated with complex
investments. There are no magic tricks, sure things, or miracles in investing. Make
sure you fully understand all the characteristics of a “complex product” before
offering it to your customers.
Jim Heitman is an instructor
at Kaplan University
School of Professional and Continuing Education. The views expressed in this
article are solely those of the author and do not represent the view of Kaplan
The contents of this article are
presented for informational purposes only. Always check with a
professional regarding any questions you may have regarding financial services.
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