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FINRA: 2012 Regulatory and Examination Priorities Letter (Jan 2012)

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FINRA: 2012 Regulatory and Examination Priorities Letter (Jan 2012)

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  1. IFLR Webinar: Structured Products: An Update of Recent US and EU Regulatory DevelopmentsRobert Dilworth, Bank of America Merrill LynchPeter Green, Partner, Morrison & Foerster LLPTimothy Hailes, Chairman Joint Associations Committee, LondonLloyd Harmetz, Partner, Morrison & Foerster LLPApril 4, 2012

  2. FINRA: 2012 Regulatory and ExaminationPriorities Letter (Jan 2012) Continued Focus on Structured Products • Summarizes the Themes of Regulatory Notice 12-03 (discussed below) • Principal concerns include: • Yield chasing. • Liquidity. • Cash flow characteristics – are they in line with investor expectations? • Transparency of cash flows. • Pricing of structured products in the secondary market. • Conflicts of interest in the sale and marketing of complex products.

  3. FINRA Regulatory Notice 12-03, January 2012 • Heightened Supervision of Complex Products • What is 12-03? • Guidance to firms about supervision. • An attempt to identify characteristics that render a product “complex” – largely focused on structured products.

  4. FINRA Regulatory Notice 12-03, January 2012 - Background • The notice continues to address many of the themes of prior regulatory action. • Notice to Members 03-71 (Nov. 2003): Selling Non-Conventional Investments • Notice to Members 05-26 (April 2005): Reviewing New Products • Notice to Members 05-59 (Sept. 2005): Sales of Structured Products • Regulatory Notice 09-31 (June 2009): Leveraged and Inverse Exchange-Traded Funds • Regulatory Notice 09-73 (Dec. 2009): Principal-Protected Notes • Regulatory Notice 10-09 (Feb. 2010): Reverse Exchangeable Securities • Regulatory Notice 10-51 (Oct. 2010): Commodity Futures

  5. FINRA Regulatory Notice 12-03, January 2012 - Background • 12-03 Focuses on Activities of Other Regulators • SEC (U.S.) • European and Asian Regulators

  6. FINRA Regulatory Notice 12-03, January 2012What Is Complex? • 12-03 doesn’t attempt to definitively answer that question. • “Any 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.”

  7. FINRA Regulatory Notice 12-03, January 2012Examples of Complex Products • Products that include an embedded derivative component “that may be difficult to understand”: • Reference asset, the performance of which is not readily available to investors. (the CMS rate) • Notes that provide for different stated returns throughout the lifetime of the product. (Steepener notes with a high teaser rate) • Range accrual notes. • Notes where loss is possible, but no participation in gains. (RevCons) • Notes with a “knock in” or “knock out” feature, where a change in the performance of the reference asset can have a disproportionate impact on the repayment of capital or on the payment of return. • Products with contingencies in gains or losses, particularly those that depend upon multiple mechanisms, such a range accrual notes with two or more reference assets.

  8. FINRA Regulatory Notice 12-03, January 2012Examples of Complex Products (cont.) • Notes with “worst-of” features. • Investments tied to the performance of markets that may not be well understood by many investors, such as volatility. • Products with principal protection that is conditional or partial, or that can be withdrawn under certain circumstances. • Product structures that can lead to performance that is significantly different from what an investor may expect, such as products with leveraged returns that are reset daily (e.g., leveraged ETFs) • Products with complicated limits or formulas for the calculation of investor gains.

  9. FINRA Regulatory Notice 12-03, January 2012Approval Requirements for Complex Products • Firm must perform a “reasonable basis” suitability determination: a transaction or investment strategy is suitable for at least some investors. • To do so, 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 actions. The lack of such an understanding when making the recommendation could violate the suitability rule. • Firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted. The procedures should ensure that the right questions are answered before a complex product is recommended to retail investors.

  10. FINRA Regulatory Notice 12-03, January 2012Questions for the New Product • For whom is this product intended? Limited or general retail distribution, and, if limited, how will it be controlled? • To whom 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 wide variety of market or economic scenarios? What market or performance factors determine the investor’s return? Under what scenarios would 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?

  11. FINRA Regulatory Notice 12-03, January 2012Questions for the New Product (cont.) • How will the firm and registered representatives be compensated? 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?

  12. FINRA Regulatory Notice 12-03, January 2012Post-Approval Review • Firm should periodically reassess complex products a firm offers to determine whether their performance and risk profile remain consistent with the manner in which the firm is selling them. • Firms also should consider developing procedures to monitor how the products performed after the firm approved them. • Firms also should conduct periodic reviews to ensure that only associated persons who are authorized to recommend complex products to retail customers are doing so.

  13. FINRA Regulatory Notice 12-03, January 2012Training • Registered representatives who recommend complex products must understand their features and risks. • Registered representatives who recommend structured products should possess a “sophisticated understanding” of the payoff structure and risks. • The registered representative should be able to develop a payoff diagram of a structured product to facilitate the analysis of its embedded features and recognize that such a product typically consists of a bond and derivative parts. • The registered representative also should understand such features as the characteristics of the reference asset, including its historic performance and volatility and its correlation with specific asset classes, any interrelationship between multiple reference assets, the likelihood that the complex product may be called, and the extent and limitations of any principal protection. • The registered representative should be adequately trained to understand not only the manner in which a complex product is expected to perform in normal market conditions, but the risks associated with the product.

  14. FINRA Regulatory Notice 12-03, January 2012Consideration of a Customer’s Financial Sophistication • 12-03 encourages firms to adopt the approach mandated for options trading accounts: would require that a registered representative have “a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the” complex product. • Firms also should consider prohibiting their sales force from recommending the purchase of some complex products to retail investors whose accounts have not been approved for options trading, particularly the recommendation of complex products with embedded options or derivatives. • Similar text to 05-59.

  15. FINRA Regulatory Notice 12-03, January 2012Consideration of a Customer’s Financial Sophistication (cont.) • Firms that permit the recommendation of complex products to retail investors whose accounts have not been approved for options trading should: • Develop other comparable procedures designed to ensure that their sales force does not solicit retail customers for whom complex products are unsuitable • Be prepared to demonstrate the basis for allowing their sales force to recommend complex products to retail investors with accounts not approved for options trading. • Approving an account for the purchase of complex products is not a substitute for a thorough suitability analysis.

  16. FINRA Regulatory Notice 12-03, January 2012Discussions with the Customer • The registered representative who intends to recommend a complex product should discuss with the customer: • the features of the product • how it is expected to perform under different market conditions • the risks and the possible benefits, the costs of the product • the scenarios in which the product may perform poorly. • The registered representative should consider whether, after this discussion, the retail customer seems to understand the basic features of the product.

  17. FINRA Regulatory Notice 12-03, January 2012 • Consideration of Whether Less Complex or Costly Products Could Achieve the Same Objectives for the Customer • Registered representatives should consider whether less complex or costly products could achieve the same objectives for their customers. • For example, 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.

  18. FINRA: December 2011 Consent reReverse Convertible Notes • Fined Wells Fargo $2 million, plus restitution. • Unsuitable sales by a registered representative. • Consent agreement continues many of FINRA’s prior themes. • Relevant activities took place between 2006 and 2009.

  19. FINRA: December 2011 Consent reReverse Convertible Notes (cont.) • Adequate Written Supervisory Procedures and an Effective Supervisory System • Close attention should be paid to customer profiles and investment history. • Transactions should be approved upon adequate inquiry into the suitability of the purchases and concentrations in the accounts. • Firms should provide supervisors with reports that demonstrate customer investment concentrations to assist in suitability identification. • Although there was a required training program, there was no system in place to ensure compliance; many registered representatives placed trades without completing the training program.

  20. FINRA: December 2011 Consent reReverse Convertible Notes (cont.) • A Firm’s Sales Representatives Must Be Adequately Supervised • Broker dealer did not investigate the suitability of the reverse convertibles being sold to elderly customers. • To facilitate these transactions, the broker changed the investment objectives of some customers – red flags that went without investigation, despite compliance reports showing large concentrations of reverse convertibles.

  21. EU Developments - Themes • Harmonization of provisions across different products / level playing field • Move towards single market / single rule book • One size fits all? • More intervention and through the cycle intervention • Increased regulatory capture • More centralisation (more legislation in the form of EU regulation) • Greater role for ESMA • Focus on enforcement and supervision

  22. EU Developments – Overview of Legislative Developments • Packaged retail investment products (PRIPs) • Markets in Financial Instruments Directive (MiFID) and MiFID II draft legislation • Prospectus Directive amendments • Huge raft of other relevant EU and national legislation including: • Alternative Fund Managers Directive (AIFMD) • UCITS IV / UCITS V • European Market Infrastructure Regulation (EMIR) • Recast Market Abuse Directive / Regulation • CRD IV • Retail Distribution Review (UK)

  23. PRIPs - Background • Proposal is a more consistent approach for regulation of packaged retail investment products irrespective of how packaged • It is envisaged the PRIPs legislation will cover at least : • Investment funds • Structured securities • Certain life insurance policies • Structured deposits • Process began with EU Commission Call for Evidence in October 2007 • EU Commission Consultation on PRIPs – 26 November 2010 • EU Commission draft legislation on MiFID II / MiFIR – October 2011 • Draft PRIPs legislation awaited

  24. Proposed Definition of PRIPs • “A product where the amount payable to the investor is exposed to fluctuations in the market value of assets or payouts from assets, through a combination or wrapping of those assets, or other mechanisms than a direct holding” • Consideration of “white list” of PRIPs • Proposed definition does not embed retail element but it is intended that disclosure and selling rules should only apply to sales to retail investors

  25. PRIPs – Disclosure Requirements • EU Commission proposes development of new disclosure framework applicable to PRIPs generally – “Key investor information disclosure” • UCITS “KII” regarded as benchmark • Objective is harmonisation and standardisation of key disclosures: • Product disclosures and any associated marketing communications should be fair, clear and not misleading • Information necessary to allow investor to take an informed investment decision • Allowing for comparison between products • Some tailoring permitted • Issue as to whether KIID should be a document separate from any other prospectus or background document • Interaction of PD summary section and KIID not yet clear

  26. PRIPs – Disclosure Requirements –Issues for further consideration • Risk considerations – inclusion of simple risk indicator? • Costs – aim is to enable easy comparison between different products • Approach in relation to information on performance • Information to enable comparability between guarantees or capital protection for PRIPs • Responsibility for KIID preparation – likely to be product manufacturer in most cases • Obligation to update KIID? • Development of KIID template: • Template produced for UCITS KIID is very prescriptive • JAC submissions and proforma template

  27. PRIPs – Selling Practices • Key elements identified by the Commission are: • Conduct of business rules • Inducements • Conflicts of interest • MiFID regarded as benchmark • Now being dealt with as part of MiFID II legislative package • Insurance Mediation Directive to be recast to be consistent with MiFID rules on selling practices

  28. MiFID II - Background • MiFID came into force in November 2007 • Review highlighted for some time • EU Consultation Paper published on 8 December 2010 • Draft legislative proposals published in October 2011 • Conduct of business and conflicts of interest rules to be extended to: • Advised and non-advised sales of structured deposits • Firms selling their own securities to clients even on a non-advised basis • Client classifications largely unchanged • Some exceptions regarding “complex” instruments

  29. MiFID II - Investor Protection • Scope of MiFID broadened to include sales of / advice on structured deposits, as well as firms dealing on own account by executing client orders • Client classification largely unchanged – eligible counterparty, professional client, retail client – except as to local authorities • Duties to determine suitability / appropriateness of product / service largely unchanged • If providing investment advice, must state whether it is provided on an independent basis and, for independent advice, firms must assess “sufficiently large” number of instruments available on the market • Firms providing investment advice / portfolio management will not be permitted to receive fees / inducements from any third party

  30. MiFID II - Investor Protection (cont.) • Exemption remains for sale of non-complex instruments on execution only basis – structured UCITS will not be non-complex, nor any instrument embedding a derivative or “structure which makes it difficult to understand the risk involved” • Firms must provide clients with details of their “best execution” policy in sufficient detail and in easily understandable form • Tied agents prohibited from handling client money and / or financial instruments

  31. MiFID II - Transparency • Existing MiFID pre and post trade transparency regime for equity markets to be extended to all bonds and structured products which are • Admitted to trading on a regulated market or • Traded on an MTF / OTF in respect of which a prospectus is published • Organised Trading Facility (OTF) is a new MiFID II concept being “any facility or system (other than a regulated market or MTF) operated by an investment firm or market operator that brings together multiple buy and sell orders in relation to financial instruments on an organised basis in order to form a binding financial contract” • Transparency rules will apply to OTC derivatives entered into by a systematic internaliser which are clearing eligible under EMIR and those traded on a regulated market MTF or OTF • Transparency rules to be calibrated for different products / transactions through use of waivers by competent authorities

  32. MiFID II - Product Intervention • MiFID consultation paper set out EU Commission intention to introduce power to ban certain investment services and activities • MiFIR provides that ESMA can take action to prohibit or restrict marketing, distribution or sale of a financial activity or practice if: • Addressing a threat to investor protection OR • The orderly functioning and integrity of financial markets OR • The stability of all or part of the EU’s financial system AND • Existing regulatory obligations are not sufficient and the relevant competent authorities have not taken appropriate action to deal with the threat • ESMA must take into account any detrimental effect on the efficiency of markets that such action may have and the possibility of regulatory arbitrage

  33. MiFID II - Product Intervention (cont.) • Competent Authorities will also have power to restrict marketing or sale of financial instruments in their member state on the same grounds as ESMA • Action must be proportionate taking into account: • Nature of risks identified • Level of sophistication of investors or market participants • Likely effect of action on investors or market participants • Relevant authority must consult with other authorities likely to be effected by such action • Action must not have a discriminatory effect on services or activities provided from another member state • At least one month’s notice must be given and details must be published on authority's website • ESMA must seek to coordinate such action taken by competent authorities

  34. Product Intervention – Individual Action by EU Member States • During last 18 months a number of EU member states have taken or consulted in relation to various product intervention measures which impact on structured products including: • UK • Belgium • Denmark • France • Italy

  35. UK – Product Intervention • January 2011 Discussion Paper • Previous approach of pre-contractual disclosure and “point of sale” regulation • New proposed interventionist stance “where resulting benefits to majority from not being mis-sold a product outweigh costs to the minority who might benefit from being able to access it” • Features more likely to provoke FSA intervention – complexity, cross-subsidy, conflicts of interest, layers of charging, teaser rates, exit charges, product names implying safety / return, difficult to assess performance risks. • Warning signals of possible consumer detriment if risks not managed through product governance processes

  36. UK – Product Intervention (cont.) • Additional intervention powers being considered by FSA: • Pre-approval / pre-notification of products • Banning products • Banning product features • Pricing interventions • Increased prudential requirements (incl. capital requirements) • Consumer warnings • “Wealth” warnings • Preventing non-advised sales • Limiting sales to certain classes of clients • Competence requirements for advisers

  37. UK Retail Distribution Review • Covers retail investment products – packaged products and structured investment products • As well as “any other designated investment which offers exposure to underlying financial assets in a packaged form which modifies that exposure when compared with a direct holding in the relevant asset” • Intended to cover same scope as PRIPS definition – structured deposits? • New, higher standards for independent advice, including new status of “independent” and “restricted” for advisers • For independent advice, firm must conduct “comprehensive and fair analysis” of alternative instruments • New, higher standards of qualification for retail investment advisers • Adviser charging – abolition of commission for advised sales of investment products (whether sold on independent / non-independent basis)

  38. FSAStructured Products Guidance • FSA Consultation in November 2011 • Finalised Guidance Published in March 2012 • Guidance to structured products providers on internal systems and controls relating to development, design marketing and distribution of structured products • Objective is to minimise risk of “poorly designed products” and mis-selling (or mis-buying) further down distribution chain • Eight main areas of guidance including: • Product approval process • Product development / design • Marketing and distribution • Information to distributors / consumers • Post-sale responsibilities

  39. Proposed Amendments to Prospectus Directive • Prospectus Directive sets out framework for prospectuses for EU securities offerings – amended in 2010 • Further amendments recently proposed by EU Commission in a delegated amending regulation including relating to format and content of final terms and prospectus summaries and other matters • ESMA provided technical advice to EU Commission in October 2011 • Provisions will impact on structured products transactions

  40. Proposed Amendment to Prospectus Directive (cont.) • Base prospectus and any supplement need to be approved by relevant competent authority but no approval needed for final terms • Market practices in relation to final terms vary • EU Commission proposes to limit and harmonize the approach to information that can be included in final terms • Draft amending regulation has categorised items required to be included in securities note by Prospectus Regulation as follows: • Category A – must be included in base prospectus – cannot be left in blank for insertion in final terms • Category B – general principles must be in base prospectus. Final terms can only include information not known at time of approval of base prospectus • Category C – base prospectus may reserve a space for later insertion of information not known at the time of approval of base prospectus • Certain “additional information” may be included but is linked to information set out in Annex XXI, including : • Examples of complex derivatives securities referred to in recital 18 of the Prospectus Regulation • Additional provisions, not required by the relevant securities note, relating to the underlying • Countries where the offer takes place on admission to trading is being sought

  41. Proposed Amendment to Prospectus Directive (cont.) • Issues of particular relevance for structured products: • A statement setting out the type of underlying must be contained in the base prospectus • For securities linked to an index composed by the issuer, the description shall not be included in the final terms • General principles of the manner of redemption and settlement procedure of the security should be in the base prospectus • Market adjustment and extraordinary events and consequential amendments should be set out in full in the base prospectus • Final terms may not amend or replace any information contained in the base prospectus

  42. Proposed Amendment to Prospectus Directive (cont.) • Requirements for content and style of summary include: • Should contain key information as set out in Annex XXII of amending Regulation • Length should not exceed longer of 7% of Prospectus length or 15 pages • Should be short, simple, clear and easy for target investors to understand • No “boilerplate” • Risk factors should highlight key risks relating to issuer, its industry and securities

  43. Proposed Amendment to Prospectus Directive (cont.) • Amending Regulation requires a summary of each individual issue to be appended to final terms: • Should provide key information of summary of base prospectus combined with relevant parts of final terms • Information of summary of base prospectus should be limited to that relevant to individual issue • Information in final terms blank in base prospectus • No word count limit • Interaction with PRIPs initiative • Proportionate disclosure regime for right issues and SMEs • To enter into force on 1 July 2012 • 2nd part of ESMA final advice published on 1 March 2012 to be subject of further amending Regulation

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