The U.S. Financial Industry Regulatory Authority wants broker-dealers to take a closer look at their procedures for selling "complex products" to retail investors which could spell a lot more work for compliance executives.

In a recent notice to member firms, the self-regulatory agency for broker-dealers, doesn't appear to be creating any new standards or rules. However, it is following in the footsteps of some foreign regulators in characterizing some financial products as complex and subject to further scrutiny. The U.K.'s Financial Services Authority recently said it will place heightened focus on the design, development and management of products. The U.K.'s regulatory watchdog also published for comment guidance to product providers regarding the sale of structured products. France's Autorite des marches financieres (AMF) has reminded firms of their marketing and disclosure obligations to investors dealing with complex products and established criteria to identify highly complex products.

FINRA is urging broker-dealers to review and document how they determine which products they should sell, train registered representatives to know what to sell to whom; and how they follow-up on the sale to determine whether the performance and risk profile of the product is consistent with how it was sold. "While a firm's procedures for approving specific complex products will help ensure that the solicitation of investors is properly supervised, firms also should consider developing procedures to monitor how the products performed after the firm approved them," writes Finra. "Every product presents risks that may cause the product to perform differently than anticipated, particularly when market conditions have changed." Although FINRA doesn't define the term "complex product" it cites structured notes, inverse or leveraged exchange-traded funds, hedge funds and asset-backed securities in that category.

"If a firm engages in selling complex securities, FINRA's notice should cause it to more closely look at its supervisory procedures and controls," says Joel Beck, principal at the Beck Law Firm in Atlanta.

A dozen compliance executives at US brokerages contacted by ISS Magazine's online edition say they aren't predicting any change to the current industry practice of following customer suitability rules. However, they do expect to be thoroughly reviewing their firm's documentation to ensure nothing is left to chance. "The key is in proving we have sufficient written guidelines to monitor that our registered representatives have the proper training to understand just what they are selling and keep track of how the products have performed," says one compliance manager at a New York-based brokerage firm.

For starters, that means reviewing all of the products sold by the firm to determine which ones fall into the category of "complex product". Of even greater concern is ensuring a solid post-trade follow up because that is where some mistakes could be made. The executive would not comment on his firm's policies but says that like many brokerages "more attention is paid to the pre-sale due diligence rather than post-sale analysis."

FINRA encourages broker-dealers and their registered representatives to thoroughly understand the risks and rewards of products before recommending them to customers. Among the questions registered representatives should ask are: for whom is the product intended; for whom should the product not be offered; what are the risks for the investor; what assumptions underlie the product and how sound are they; how is the product expected to perform in a wide variety of market or economic scenarios.

"Registered representatives who recommend structured products with embedded options and derivatives shoudl possess a sophisticated understanding of the pay off or structure, any limit on upside potential and the risks to investors that the payoff structure presents," writes FINRA. The regulatory agency cites the following example: if a structured product promises a 100 percent return of capital at maturity plus 150 percent of any rise in an underying index over the investment period, the registered representative should know the product is similar to a bond that matures with a 100 percent return of capital and an embedded call with 150 percent participation.

As with previous notices, FINRA reiterates that firms should consider whether less complex products can achieve the same objective for investors . "Registered representatives should compare a structured product with embedded options to the same strategy through multiple financial instruments on the open market even with any possible advantages of purchasing a single product," says Finra in the regulatory notice. A full copy of the notice can be found at http://www.finra.org/industry/regulation/notices 2102/p125398.

Written by Chris Kentouris, Editor-in-chief (Chris can be reached through Chris.Kentouris@hotmail.com).

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