During the Securities Industry and Financial Markets Association (“SIFMA”) Complex Products Forum, held on September 27, 2012, Susan F. Axelrod explained the risks complex products pose to investors and outlined several steps brokerage firms should take in order to minimize those risks. Her speech focused on two products: non-traded real estate investment trusts (“REITs”) and reverse convertibles.
Non-traded REITs are “publicly registered products that are not traded on a national securities exchange.” There is a limited secondary market, creating difficulty for investors who wish to liquidate. The offerings extend over a period of years and are reflected in customer statements based on the broker’s estimated per-share price. A significant problem occurs when brokers re-price the REITs at a value much lower than the offering price without notice to investors.
The Financial Industry Regulatory Authority (“FINRA”) suggested several amendments to National Association of Securities Dealers (“NASD”) Rule 2340, which governs customer statements. First, FINRA proposed limiting how long the offering price may be used as the per-share price. Second, FINRA proposed excluding organization and offering expenses from the estimated value in order to provide greater transparency to investors.
Reverse convertibles are notes that pay “a high initial fixed coupon - sometimes ranging up to 30 percent per year.” Such a high coupon rate is possible due to the volatility of the underlying assets, which determine how much of the capital an investor will get back. The volatility of the assets causes investors to risk losing a large portion of this capital. FINRA frequently encounters portfolios with a dangerously heavy concentration of reverse convertibles due to brokerage firms’ failure to offer appropriate recommendations to investors.
Ms. Axelrod also pointed out that several conflicts can arise with complex products such as non-traded REITs and reverse convertibles. One such conflict occurs when firms sell complex products created by an affiliate. Compensation arrangements with the product’s manufacturer also give rise to conflicts. Another issue occurs when brokers make undisclosed investments that directly conflict with investments sold to their own clients.
Additionally, investors are often confused about a product’s features and do not realize that there is a chance they will not receive distributions or a return of the full principal. Brokers frequently do not understand which products are best for different investor goals and make improper recommendations.
Axelrod suggested four techniques brokerage firms should utilize in order to protect investors from the dangers of complex products. First, firms should properly research a product prior to offering it to investors. With appropriate research, a firm can determine if the product can be monitored effectively given the firm’s current supervisory procedures. Second, “supervisory procedures should have clear and specific guidelines on how brokers and their supervisors are to assess suitability of recommendations.” Third, firms should implement training programs for each new product in order to educate brokers on how to make appropriate recommendations to investors. Fourth, firms should have ongoing monitoring in order to adjust training or supervising when necessary.