SEC reveals fraud and abuse after Finra warns greedy investors

Triggering alarm bells

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Sales of structured products in the US increased from $33 billion in 2009 to $54 billion in 2010, according to the Financial Industry Regulatory Authority (Finra), which was enough to prompt the regulator to issue a warning to investors chasing yields. Lumping structured products in with high-yield bonds and floating-rate loan funds, Finra published its thoughts on the inherent dangers in an investor alert entitled The grass isn't always greener - chasing return in a challenging investment environment, on July 25.

Before the ink was dry, the US Securities and Exchange Commission (SEC) issued its own report, on July 27, identifying the common weaknesses it has seen in the sale of structured products, from fraud to abusive sales practices.

"The SEC release was potentially a little confusing for the market because it refers to findings principally from 2008 and 2009," says Anna Pinedo, partner at Morrison & Foerster (Mofo) in New York. "This is odd, as so much has happened between then and now. Finra has put out lots of guidance and has had a number of actions since 2008 and 2009: the consent with UBS, for example, where a lot of the issues the SEC points out have already been brought to light by Finra.

"Many things it mentions clients already are quite focused on. If it did the same review today, it would probably not find many of these issues. For example, the SEC notes possible confusion resulting from the use of the term ‘principal protected product'. The industry is now well aware of these issues, and about using product names that could potentially be confusing to clients."

David Krein, senior director, product development and analytics at Dow Jones Indexes in New York, offers another explanation. "Finra is attempting to fire another warning shot across the bows - it is non-binding and is really background research; it does not reflect the official view of the commission"

The notion of misselling is complicated because there are an awful lot of moving parts within these structured products... even the simple ones

According to a New York-based structured products professional, "there is a lot of opacity and not a whole lot of transparency on fees, structures, liquidity, who the buyers are, and suitability. It is a broker's market and not a fiduciary market, which is an important distinction. On some level it is more of the same, and possibly until the SEC takes a much more proactive rule, warnings haven't done much."

Comments in the SEC document about underwriting fee disclosure were a surprise, although overlooked by most bankers. "It looked pretty egregious the way I read it. If there was really a 2% distribution fee in a deal and it was disclosed as zero, I am surprised a bigger deal wasn't made of it at the time," says a New York-based structured products banker. "The way it was written, it said there was nothing disclosed, that there was no fee, and if that's a payment to a distributor that looks odd to me."


Sweeping giant

The SEC report summarises the results of a sweep examination of the retail structured securities products business of 11 broker-dealers, covering a cross-section of the industry, states the US Structured Products Association (SPA) in a release posted on its website. "Structured securities products generally do not represent ownership of a particular asset (such as stock in a manufacturing company); instead, the products promise returns to investors based on the performance of one or more underlying assets," notes the SPA.

"It is interesting that the sweep was concluded in 2009, and only came back in July 2011," says one head of structured products at a New York-based bank. "Perhaps an indication of how backed up the SEC is currently."

Alice Yurke, a partner at Ashurst in New York, adds: "The ‘sweep' was not a surprise, nor was the resulting report. There has been a co-ordinated effort between the SEC and Finra for some time regarding greater scrutiny of, and enforcement actions with respect to, broker-dealers that sell structured products, particularly in the retail space."

There is also another explanation for the release of the regulator statements. "It is particularly strapped; it needs to be seen as active, involved and informed," says the New York-based structured products professional. "This might have been the nearest utensil, so it picked it up. The SEC is an organisation trying to save face with a declining set of resources and influence."

Of more concern for some bankers was the number and status of the firms included in the investigation. "We knew it was going on - there's not that much in it that is too surprising," says the New York-based structured products banker. "But it still worries me when some of the product descriptions are so weak."

The result has been the informal creation of an issuers committee within the Securities Industry and Financial Markets Association (Sifma) to address some of the areas of concern from the issuer side. "There have been a couple of calls and a couple of preliminary working group meetings," according to the banker. "The idea is that a smaller group of big-boy issuers that know the issues and can work in a more focused way would be a good influence. Our biggest issue is when the regulator calls up a few firms and says ‘do this or do that' without doing anything consistently across the industry. Rule-making by phone call.

"Whether the banks were the major ones or not, there is a lot of similarity in the messaging, paperwork and disclosures that go into these documents, and so 11 is quite possibly an appropriate snapshot of the market for it to make its point."


Warning shots

The most alarming conclusions of the SEC's investigation suggest broker-dealers might have: recommended unsuitable structured securities products to retail investors; traded at prices disadvantageous to retail investors; omitted material facts about structured securities products offered to retail investors; and engaged in questionable sales practices with customers.

"The item I question in any of these regulatory reports is, how many examples of misleading information in terms of marketing documents are there: it could be one case or 1,000 - those points are never clear in these reports," says one Washington, DC-based structured products professional.

Potential supervisory deficiencies were also noted, including a lack of training requirements for supervisors and registered representatives that market structured products. "What has been reported has been discussed many times over," he says. "One of the biggest challenges is that many reps cannot effectively communicate what they are selling. I've spoken to plenty of reps over the years who cannot communicatethe risk profiles of the product or the elements of the embedded derivatives.

"But there are always two sides to the story - the SEC report suggests the market will continue to grow due to investor search for yield given the market environment. So, given the risk tolerance of the individual, they should have access to the product - given that the risks are understood. This is not dissimilar to the activities in the mortgage-backed securities market. Prior to 2002, the lowest-rated tranche would be at the BBB level - the yields were so thin, investors wanted lower-rated tranches and the issuers accommodated the requests. Collateralised debt obligations and hedge funds became the natural buyers, as they were trying to maximise returns."

One of the stated intents of the SEC report is to help companies strengthen compliance programmes and better address "the issues we observed during our sweep and in subsequent exams", says Carlo di Florio, director of the SEC's Office of Compliance Inspections and Examinations. "Beyond this report, we are monitoring the way these products evolve, and considering additional steps in the near future relating to structured securities products that might further bolster investor protection."

Mofo's Pinedo adds: "The value of this is most clients will go back, look at this, look at their policies and procedures, and see what they might need to change or improve."

The SEC report mentions concerns over suitability, disclosure and broker-dealer education, all of which are concerns addressed in Finra's notices to members and arbitrations. "It dovetails with what Finra has been dealing with for some time, and reflects the co-ordination and consistency between the two entities and their respective policies," says Yurke.

Pinedo agrees. "The mention of the need for disclosure is a little easier to understand. Frequent issuers have made a lot of progress in crafting disclosure that is more straightforward and more plain English. The SEC mentions concentration - an issue Finra has been quite focused on with the H&R Block and Santander actions."

On the retail and high-net-worth side, the challenge is how to value the characteristics and attributes of a structured product once it has been purchased.

"For instance, you can't really value the statement in a document where the bank states it has no obligation to make a market to buy it back: how does a buyer value that when the note has one, three or five years to maturity? They really can't, so the challenge is that, given there are probably dozens of similar examples in an offering document, any one of these could trip up a buyer after the purchase has been made," says the New York-based professional. "Structured products are the perfect vehicle for catching buyers on some kind of hook. Reps often cannot communicate the risks, because they are often far more numerous than the market exposure."


The qualification question

Beyond the call for disclosure, the call from product makers and distributors is for certain types of retail structured products to be sold only to qualified investors; the availability of standardised products for all other investors (similar to the approach taken by the Hong Kong regulator, whereby products are registered before sale); and the development of an active secondary market. "The most interesting part was on secondary trading and monitoring aftersales," says Pinedo. "That was new, in the sense that Finra has not focused on this and neither have any of the other actions."

But not everyone agrees about the need for professional investors to be differentiated. "I am not inclined to restrict the market to qualified investors, or limit it in some way," says the professional. "One simplifying approach might be a standardised term sheet from the core issuers, and simplified terms, and the issuers taking on some of the risk themselves for market-making."

The Finra investor alert cautioned: "[Structured] products can seem attractive to investors because they can offer higher returns and might even feature a level of principal protection, subject to the credit-worthiness of the issuer. However, these products can also have significant drawbacks such as credit risk, market risk, lack of liquidity and high hidden costs."

The Washington, DC-based professional acknowledges the basic complexity and adds: "Modelling these products is complicated, with bespoke transactions requiring significant financial engineering and expertise. The models include the probability of payout - to demonstrate transparency in the market - and something like this should be shown and explained to potential investors. But, if it was, maybe no-one would invest."

The New York-based professional offers an answer. "The solution is to have this stuff listed on an exchange, although the issues are often too small to be listed. It is a complicated market - there are a lot of issuer and security types - but then that's one of the beauties of this market: there is an awful lot of customisation, you can express your views a number of different ways with a number of different issuers in reasonably small size.

"Maybe the market is happy with $50 billion, but if they are looking for $500 billion - the next order of magnitude - maybe it does require this kind of synchronisation or more disciplined policing. With $50 billion sold, the brokers are happy, the banks are happy, the margins are good and everybody gets paid. And that might be reason enough for the market not to grow at some other hypothetical rate and compromise the margins or the business overall."

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