The Financial Industry Regulatory Authority or “FINRA” is conducting a review of firm practices related to supervision of concentrations in non-principal protected “worst-of” structured notes, a higher risk structured product. FINRA is examining how firms ensure compliance with Regulation Best Interest (Reg BI)—including Reg BI’s care and conflict of interest obligations—and with FINRA rules when they permit their registered representatives to recommend those products to their customers.
The term structured notes or “structured note with principal protection” refers to any structured product that combines a bond with a derivative component and that offers a full or partial return of principal at maturity. financial industry regulatory authorityStructured products in general do not represent ownership of any portfolio of assets but rather are promises to pay made by the product issuers. Structured notes with principal protection typically reflect the combination of a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. The investor is entitled to participate in a return that is linked to a specified change in the value of the underlying asset.
“Structured notes” are “complex,” often high risk, investment products.” According to FINRA, “structured notes” or “structured products” are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency. Most structured products pay an interest or coupon rate substantially above the prevailing market rate. However, structured products also frequently cap or limit the upside participation in the referenced or “Linked” security or basket of securities, but if the underlying “Linked” securities decline in value, the Note may be redeemed or called by the Issuer at a predetermined rate, or often a fraction of the Note’s offering price, which can result in the substantial loss of principal.
The retail market for structured notes with principal protection has been growing in recent years. While these products often have reassuring names that include some variant of “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms, they are not risk-free. Any promise to repay some or all of the money invested will depend on the creditworthiness of the issuer of the note and investors could lose all of their money if the issuer of the Note goes bankrupt.
Notice to Members 05-09 (“despite the derivative component of a structured product, they are often marketed to investors as debt securities.”); See also, Staff Summary Report on Issues Identified in Examinations of Certain Structured Securities Products, U.S. Securities & Exchange Commission (July 27, 2011)(“Structured Security Products are often quite complex and can present wide-ranging risks and regulatory issues, including suitability and disclosure concerns, limited liquidity, comparatively opaque and often expensive fee structures, and difficulty in pricing. They also pose supervisory, compliance and sales training challenges.”).
With respect to Structured Products, FINRA has cautioned that:
a member has an obligation to perform a reasonable basis suitability determination before recommending a product to investors. A reasonable basis suitability determination is necessary to ensure that a security—in this case a structured product—is suitable for some investors (as opposed to the customer-specific suitability determination, which is made on an investor-by-investor basis). To discharge its reasonable basis suitability obligation, a member must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards.
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Members should consider whether an investment in a structured product meets the reasonable basis suitability standard if the instrument is priced such that the potential yield is not an appropriate rate of return in relation to the volatility of the reference asset based upon comparable or similar investments, in terms of structure, volatility, and risk in the market as determined at the time the structured product is issued.
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Under Rule 2310, members must ensure that a recommendation is suitable for a specific customer by examining (1) the customer’s financial status, (2) the customer’s tax status, (3) the customer’s investment objectives, and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
FINRA Notice to Members 05-59 (September 2005).
Many Structured Notes Offer Only Partial Protection
Moreover, many of these products are loaded upon with conditions as to the protection, or which only offer partial protection. In these cases, investors will lose their principal investment even if the issuer does not go bankrupt. Of those notes where investors will receive some principal protection from the issuer, investors are required to hold these investments until maturity.
Also, any guarantee that the principal will be protected, is only as good as the financial strength of the company that makes that promise.
In other words, the principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. In the event the issuer goes bankrupt, investors who hold these notes are considered unsecured creditors and might recover little, if anything, of their original investment.
Investors needing cash before maturity, need to know that no secondary market often exists for them to sell these notes and there is no obligation for the issuer to repurchase them. Even where a secondary market exists, investors can only expect to receive pennies on the dollar.
According to FINRA’s survey, unless otherwise noted, the relevant period for each request is January 1, 2022, through December 31, 2025 (the “Relevant Period”). In addition, if your response varies over the Relevant Period, please explain the differences in your response.
Provide copies of the firm’s written supervisory procedures (WSPs) related to structured notes and complex products.
Describe how the firm categorized structured notes for supervision purposes, including classifications, if any, based on product risk such as principal protection or “worst-of” features.
Describe any restrictions or limitations the firm placed on recommendations of structured notes (including non-principal protected, worst-of structured notes), including but not limited to concentration limitations.
Describe any supervisory alerts/exceptions the firm had in place for structured notes (including but not limited to any concentration alerts or Reg BI/suitability alerts) and the corresponding trigger criteria.
Did the firm provide structured product trainings? If so, please provide any materials and state whether the firm required representatives to complete the training prior to selling structured products.
State how registered representatives were compensated for sales of structured notes.
Describe how the firm identifies and mitigates product-related conflicts of interest associated with recommendations of structured notes.
Did the firm provide general information to customers concerning structured notes, including non-principal protected, worst-of structured notes, and/or information about the compensation received by the firm or representatives on sales of such notes? If so, please provide copies of documents reflecting that information and explain how it was used.
“Worst-of” structured notes refers to principal-at-risk structured notes that may result in a reduction or cessation in interest payments, and/or a reduced return of principal at maturity, based on the worst-performing asset in a group of two or more reference assets.
Firms whose brokers advise their clients on a certain type of complex investment product known as structured notes should be prepared to answer questions about how and why they recommend these securities. FINRA, the brokerage industry’s self-regulatory organization, is conducting a series of exams exploring how firms are handling structured notes where an investor’s principal is at risk. Regulators say these products have caused substantial client losses.
Key Areas for WSP Review
Member firms are on notice that their WSPs are going to be scrutinized. Of course, each firm’s review and potential enhancements will be unique depending on a firm’s product mix, business model, and existing compliance infrastructure, but all firms will need to pay close attention to several key areas:
WSP Completeness and Specificity. FINRA will ask to review WSPs with a focus on structured notes and complex products. Firms should ensure they have specific, standalone procedures addressing structured notes rather than relying on general complex-product language.
Product Risk Categorization. FINRA expects firms to have a tiered classification system that distinguishes among structured note types based on risk characteristics, including principal protection and worst-of features.
Concentration Limits and Restrictions. Clearly defined and enforceable concentration limits at both the individual account and portfolio level, with heightened restrictions for higher-risk sub-categories such as non-principal protected worst-of notes are a must.
Supervisory Alerts and Exception Monitoring. Firms must maintain surveillance mechanisms that flag concentration threshold breaches, risk-profile mismatches, and other red flags, with clearly specified trigger criteria.
Training Requirements. Firms should mandate and document product-specific training for all representatives before they are authorized to recommend or sell structured notes to customers.
Compensation Transparency. FINRA is specifically focused on how representatives are compensated for structured note sales, including commissions, markups, and selling concessions.
Compensation structures must be clearly documented because of the conflict-of-interest implications they carry.
Conflict of Interest Identification and Mitigation. Firms need a systematic process to identify and address conflicts arising from compensation, proprietary preferences, issuer relationships, and revenue-sharing. The WSPs should also clearly document mitigation measures. This ties directly to Reg BI’s conflict of interest obligation.
Customer Disclosure Practices. Firms should be prepared to demonstrate that they provide customers with clear information about structured note risks and compensation, including product fact sheets and risk disclosures delivered in a timely manner.
The bottom line for investors is that structured notes with principal protection can lose their entire investment or depending on how the note is structured, could tie up their principal for upwards of a decade with the possibility of no profit on your initial investment.
If you have lost money as the result of the recommendation and sale of structured products, you should consult with an attorney to determine your rights and obligations.
Nicholas J. Guiliano has more than thirty years experience representing investors. He is “AV Rated,” (Highest Rating in Both Legal Ability & Ethical Standards) by Martindale Hubbell, and has also been selected as a Martindale Hubbell Client Champion. Mr. Guiliano has an AVVO Rating of 10 (Superb), has received the AVVO Five Star Rated Client’s Choice Award, and for more than a decade, Nicholas J. Guiliano has also been honored as one of America’s Most Honored Lawyers (Top 10% Nationwide).
The Guiliano Law Group, P.C. National practice exclusively representing investors in claims against brokerage firms for securities fraud, the sale of unsuitable investments, defective financial products, breach of fiduciary duty, and the failure to supervise. FINRA Securities Arbitrations. Contingent fee. Free Consultation.
