FINRA Requests Information from Member Firms Related to the Sale of Complex Products by May 9, 2022

What is a "Complex Product" and Why is FINRA Focused on Them

FINRA’s notice unequivocally states that: “There is currently no standard definition of a complex product.” Akin to Justice Potter Stewart’s stance on pornography in the famed Supreme Court case of Jacobellis v. Ohio,[i] FINRA articulates an “I will know it when I see it” standard by stating that: “FINRA has construed the phrase “complex product” flexibly to avoid a static definition that may not address the evolution of financial products and technology.” This fluid and undefined definition makes it difficult for industry practitioners when it comes to counselling clients, but thankfully there are some relevant materials for consideration. 

Previously released FINRA Regulatory Notice 12-03 is a good place to start. Some examples of common complex products described in that regulatory notice include: equity-indexed annuities, structured products, leveraged and inverse-leveraged exchange traded funds, principal protected notes, reverse convertibles, commodity futures-linked securities, hedge funds, REITs, DPPs, and securitized products, such as asset-backed securities, mortgage-backed securities, and collateralized debt obligations. Perhaps one may conclude conversely that it’s easier to define what is not a complex product, rather than arriving at a clear definition. For example, the regulatory notices do not describe common or preferred stocks, bonds, treasuries, CDs, or mutual funds as complex investments. However, it’s not that simple as all products may have unique features that require extra attention. The safe view is that the term complex product refers any investment that may be difficult for a retail investor to understand in terms of both structure and related risks. 

Continued Regulatory Concerns Related To Complex Products

1. A Fundamental Lack of Understanding by Registered Representatives and Retail Investors. The most frequent and reoccurring concern expressed by regulators is the fundamental lack of understanding that registered representatives and retail customers alike have regarding complex investments in terms of both structure and risk. That concern is heightened in self-directed accounts. 
2. Inadequate Suitability Considerations. Another reoccurring concern expressed by regulators is whether certain retail customers possess the intelligence, investment experience and propensity to understand investments before the sale of a complex product is completed. Further dovetailing off that concept is the concern that registered representatives are selling complex products to customers without fulfilling adequate suitability analyses and ensuring best interests of customers as required by Reg BI. 
3. Inadequate Advertising, Supervision and Training. The final reoccurring concern raised by regulators involves concerns over inadequate customer communications, advertising, training and supervision by member firms. 

Continued Regulatory Focus on Complex Products and Options

A. FINRA’s Continued Focus on Complex Products. The topic of “complex products”[ii] is not a novel one as the concept appears in every Annual Regulatory and Exam Priorities Letter released by FINRA going back to at least 2006[iii], and it is the subject of countless FINRA enforcement actions. In Regulatory Notice 22-08, FINRA notes a few emerging examination observations:

Account Opening. Member firms are not ensuring customers have the requisite investment experience to trade in certain products and options commensurate with their written policies. 

Disclosure Practices. Member firms are not preparing and distributing comprehensive risk disclosures that address, among other risks, the mechanics of options expirations.

Options Exercise Procedures. Member firms are not clearly communicating cut-off times for customers to submit options exercise instructions.

B. SEC’s Continued Focus on Complex Products. Chair Gary Gensler directed SEC staff at the end of last year to study the risks of complex ETPs and to present recommendations for potential SEC rulemaking to address those risks . Similarly, in 2015, the SEC solicited comments regarding, among other things, the ways in which broker-dealers market ETPs and the extent to which individual investors understand the nature and operation of ETPs. In 2019, the SEC proposed sales practices rules that would require broker-dealers and SEC-registered investment advisers to exercise due diligence in approving a retail customer’s account to buy or sell shares of certain “leveraged/inverse investment vehicles.” Subsequent to that proposal, the SEC published a Joint Statement Regarding Complex Financial Products and Retail Investors. The joint statement noted the SEC staff’s concern that retail investors are independently selecting complex products for which they may not fully appreciate the unique characteristics and risks. It stated that the SEC staff would review the effectiveness of the existing regulatory requirements in protecting investors, particularly those with self-directed accounts, and recommend potential new rulemakings, guidance or other policy actions, where appropriate. 

C. Non-Domestic Regulatory Focus. Regulators outside of the U.S. have also sought to strengthen investor protections surrounding the sale of complex products. For example, regulations and guidelines under the European Union’s (EU) Markets in Financial Instruments Directive (MiFID II) provide that firms should adopt procedures to ensure that an investor’s profile is commensurate with his/her trading activity, especially when complex products are involved in the strategy. For “non-advised” accounts trading complex products, MiFID II regulations require firms to assess the appropriateness of the investment and to issue a warning if the investor does not have the necessary knowledge and experience to understand the risks. Canadian securities regulators recently enhanced their know-your-product suitability obligations and product due diligence guidance in order to ensure that customers understand complex products. Similarly, Hong Kong SAR’s regulators explicitly define complex products and provide minimum information and types of warning statements that must be provided to investors. Hong Kong SAR’’s regulators also recently issued a circular to remind intermediaries of the requirements governing selling practices for insurance-linked securities, including suitability rules for complex products. A growing number of other financial regulators, including in the EU, Australia and the United Kingdom, have introduced product governance obligations to ensure product development is client focused and distribution is consistent with an identified target market for the product.

Conclusion

Domestic regulators and those abroad seem intently focused on the subject of complex products and options and this subject matter will likely remain in focus for years to come. Understandably, the most commonly articulated regulatory concern is that some member firms and registered representatives do not fully understand the intricacies and risks of complex products and options before selling those products to retail investors. In turn, retail customers who do not understand or want the inherent risks associated with those products are buying them and are being exposed to unintended risks, including the potential loss of principal. In order to safeguard from these concerns, and in order to meet regulatory expectations, member firms must ensure adequate training and the design and implementation of supervision and compliance programs that protect customers from the related risks. If you have questions on this topic, or need assistance with broker/dealer regulatory enforcement matters, litigation, arbitration, internal investigations or compliance consulting, please reach out to us as we would be delighted to help with your legal needs.

1. See Justice Stewart’s concurring opinion in Jacobellis v. Ohio, 378 U.S. 184, 197 (1964), in which he states: “I shall not today attempt to further define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligently doing so.  But I know when I see it, and the motion picture involved in this case is not that.” 

2. The Annual Regulatory and Examination Priorities Letters describe this concept in multiple ways including the use of the phrase “complex products” or the concept that a registered representatives does not understand the product that he/she is selling.

3. FINRA’s website posts prior Annual Regulatory and Exam Priorities Letters going back to 2006.