Introduction to Complex Products

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

Panelists

o Speakers• Marc Freeman, Principal Risk Specialist, FINRA Member Supervision

• Andrea Seidt, Commissioner, Ohio Division of Securities

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 1

Introduction to Complex Products

Wednesday, January 27, 2021 4:55 p.m. – 5:25 p.m. Investment products abound that offer alternatives to conventional stock and bond investments. These products are sometimes referred to as structured products or non-conventional investments. They tend to be both more complex—and riskier—than traditional investments, and often tempt investors with special features and higher returns than offered by basic investments. During this session, we’ll discuss what makes a product complex, general characteristics of complex products, and the special risks involved in investing in them. Learning Objectives:

• Define what is considered to be a complex product.

• Review complex product characteristics.

• Review the risks of chasing yields when investing in complex products.

Speakers: Marc Freeman Principal Risk Specialist FINRA Member Supervision Andrea Seidt Commissioner Ohio Division of Securities Introduction to Complex Products Panelist Bios: Speakers:

Marc Freeman is Principal Risk Specialist with FINRA’s Member Supervision. He is a member of the Fixed Income Specialist Program responsible for examining member firms’ sales, trading, underwriting, supervisory and organizational practices to determine compliance with MSRB rules, Federal securities laws, and FINRA rules and regulations. Mr. Freeman entered the securities industry at Merrill Lynch where he obtained his Series 7 and 63 licenses and was Vice President of Fixed Income Sales. He later obtained his Series 53 license and served as Municipal Principal at a small broker-dealer before joining FINRA in 2015. He received his M.B.A. degree in Finance from Fordham University Graduate School of Business Administration and his B.S.

degree in Economics from the Pennsylvania State University.

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 2

Andrea Seidt is the Ohio Securities Commissioner with the Ohio Department of Commerce, Division of Securities. The Division regulates the sale of securities in Ohio and more than 200,000 securities firms and professionals. Commissioner Seidt actively represents the Department and investors throughout the state of Ohio through her service with the North American Securities Administrators Association (NASAA). Commissioner Seidt is a former President of NASAA and has served multiple terms on NASAA’s Board of Directors as well as other leadership positions. She currently serves as the Chair of NASAA’s Regulation Best Interest Implementation Committee. Prior to her appointment as Commissioner in 2008, she worked at the Jones Day

law firm and also served as Deputy Chief Counsel for the Office of the Ohio Attorney General. Commissioner Seidt received both her undergraduate and law degrees from The Ohio State University. Resources:

• SEC Charges Investment Advisory Firms and Broker-Dealers in Connection with Sales of Complex Exchange-Traded Products (November 2020)

www.sec.gov/news/press-release/2020-282

• SEC Joint Statement Regarding Complex Financial Products and Retail Investors (October 2020)

www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28

• NASAA Regulation Best Interest Implementation Phase I Report (September 2020)

www.nasaa.org/wp-content/uploads/2020/09/Reg-BI-Phase-1-Report.pdf

• FINRA Regulatory Notice 12-03 – Complex Products, Heightened Supervision of Complex Products (January 2012)

Website: www.finra.org/rules-guidance/notices/12-03 PDF: www.finra.org/sites/default/files/NoticeDocument/p125397.pdf

• Notice to Members 05-59 – NASD Provides Guidance Concerning the Sale of Structured Products (September 2005)

Website: www.finra.org/rules-guidance/notices/05-59 PDF: www.finra.org/sites/default/files/NoticeDocument/p014997.pdf

• Variable Annuities Overview including links to Rules, Notices, Guidance, News Releases and Investor Education

www.finra.org/rules-guidance/key-topics/variable-annuities

• Public Non-Traded REITs – Perform a Careful Review Before Investing

www.finra.org/investors/alerts/public-non-traded-reits-perform-careful-review-investing

• SEC Investor Bulletin: Publicly Traded REITs

www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-65

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved.

INTRODUCTION TO COMPLEX PRODUCTS COURSE OUTLINE

What is a complex product or complex strategy?

“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.” (FINRA Regulatory Notice 12-03). Alternative or non-conventional products are also viewed as complex by regulators and firms because they have special features that make them more complex and riskier than traditional investments. Investors may be attracted to these products due to the prospect of higher returns. Complex products may utilize futures and options as part of a complicated trading strategy to achieve specific investment objectives.

First time you’ve come across a certain complex product? Check out FINRA

investor alerts for product basics and key risks:

• The Grass Isn’t Always Greener: Chasing Return in a Challenging Investment Environment

• Structured Notes With Principal Protection: Note the Terms of Your Investment

• Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors

• Alternative Funds Are Not Your Typical Mutual Funds • Reverse Convertibles: Complex Investment Vehicles • Catastrophe Bonds and Other Event-Linked Securities • Slow Down When You See High Yield • Equity-Indexed Annuities: A Complex Choice

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 2

• Public Non-Traded REITs – Perform A Careful Review Before Investing, https://www.finra.org/investors/alerts/public-non-traded-reits-perform-careful-review-investing

The product or strategy is definitely complex. Now what?

Increase your scrutiny over the firm’s due diligence, mitigation,

recordkeeping, and supervision policies, procedures, and practices.

Due diligence – the firm and rep’s knowledge of both their customers and

their products will need to increase commensurate with the level of

complexity and risk of the product and strategy used.

SEC Reg BI Release: “What would constitute reasonable diligence, care,

and skill under Paragraph (a)(2)(ii)(A) [standard of care obligation] will vary

depending on, among other things, the complexity of and risks associated

with the recommended security or investment strategy and the broker-

dealer’s familiarity with the recommended security or investment strategy.”

Release at 2621 (citing FINRA Rule 2111.05(a)); see also Release at 75 n.

148 (“Complex products may be more costly – require more due diligence.”).

This ‘reasonable-basis’ component of the Care Obligation is

especially important when broker-dealers recommend securities

and investment strategies that are complex or risky. For

example, in recent years, the Commission staff and FINRA have

addressed broker-dealer sales practice obligations under

existing law relating to complex products, such as inverse or

leveraged exchange-traded products. These products, which

may be useful for some sophisticated trading strategies, are

highly complex financial instruments and are typically designed

to achieve their stated objectives on a daily basis.

Release at 263 (citing FINRA Rule 2111 (Suitability) FAQ at Q5.1 (“The

reasonable-basis obligation is critically important because, in recent years,

securities and investment strategies that brokers recommend to customers,

1 Regulation Best Interest: The Broker-Dealer Standard of Conduct , SEC Release No. 34-86031, 17 CFR Part 240 (June 4, 2019), https://www.sec.gov/rules/final/2019/34-

86031.pdf

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 3

including retail investors, have become increasingly complex and, in some

cases, risky.); SEC v. Hallas, No. 17-cv-02999 (S.D.N.Y. filed Apr. 25,

2017)).

How do I assess the firm’s due diligence, mitigation, recordkeeping,

and supervision?

Examine the who, what, when, why, and how of the transaction.

WHO

To whom is this product or strategy being recommended and how well does

the rep know that client and understand the client’s needs?

• Pore over the investor profile questionnaire. What does it tell you about

the investor? Does the form provide all of the details needed to justify

the sale of a complex product?

o Limited financial assets, inability to withstand loss

o Liquidity needs

o Age and/or retirement status

o Time horizon

• What is this client’s investment objective – what are they looking for?

Short-term or long-term? Preservation or yield?

• Which client bucket does the investor fall in with respect to income and

wealth – retail, accredited, qualified?

• What is their risk tolerance? Are they willing to lose it all in the hopes

of generating higher returns?

• How sophisticated is the investor when it comes to complex products?

Education level? Uneducated novice or experienced veteran with

investments?

With complex products, it is very important to think about investor

sophistication and how capable the investor alone is to understand the

unique features and risks of the complex product. The less sophisticated the

investor is, the more the investor will be relying on the rep to unpack those

features and assess the risks.

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 4

The SEC Reg BI Release notes:

Studies in this strand of academic literature find that higher levels

of trust increase investors’ propensity to seek investment advice

and hire financial professionals, increase levels of stock market

participation, and increase willingness to take on higher-risk

investments. Regarding the importance of trust in established

advice relationships, some studies find that trust in financial

professionals is greater when investors have lower financial

literacy or when purchasing complex products, such as

insurance products. Further, as trust in financial professionals

grows, investors may be more likely to delegate all investment

decisions to the financial professional, irrespective of their level

of financial education.

Release at 497-98 (citing Brian Scholl, et al., SEC Office of the Investor

Advocate and RAND Corporation, The Retail Market for Investment Advice

(2018), available at https://www.sec.gov/comments /s7-07-18/s70718-

4513005-176009.pdf (investors most likely in need of investor protection

(e.g., financially unsophisticated) are most likely to place their trust in

financial professionals).

Remember, “disclosures may be ineffective, particularly if the intended

audience does not read the disclosure documents or does not understand

the material presented to them.” (insert page number, cite at 1146).

Research suggests that as the length and complexity of the disclosure

document increases, so does the time that it takes for investors to read and

understand the material contained within; therefore, investors are more likely

to prefer shorter, simpler, and more straightforward language in disclosures.

Release at 505 & n. 1146 (citing Tamar Frankel, The Failure of Investor

Protection by Disclosure, 81 U. CIN. L. REV. 421 (2013). Omri Ben-Shahar

& Carl E. Schneider, The Failure of Mandated Disclosure, 159 U. PA. L. REV.

647 (2011)).

WHAT

What product or strategy is being recommended and how well does the rep

understand that product?

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 5

• What are the main and unusual features of the product? What are the

risks? Can the rep explain all of those in simple lay terms?

• Does the product’s investment objective (check prospectus) match the

investor’s objective (check investor profile questionnaire)?

o Is this the type of client for whom the product is intended?

Conversely, is this the type of client to whom this product should

not be offered?

o Check the prospectus and any applicable suitability

questionnaires specifying firm limitations on use, particularly

retail restrictions. For example, if product is limited to accredited

investors, verify accredited status.

• Does the investor benefit outweigh the expected product risk? Is

investor really willing and able to withstand loss of principal in hopes of

generating greater yield?

• Are there any legal, tax, market, investment or credit risks that could

adversely impact the investor? How are those disclosed? Would

investor be better off with a product that does not pose those risks?

• Does the product provide the investor with sufficient liquidity given

existing assets and investments? Is there an active secondary market

for the product that will not result in a “fire sale” loss should investor

need to liquidate?

• What are the fees and costs embedded in this product and how will

those affect investment performance over the life of the investment?

Would the investor be better off with a less expensive product?

• Can less complex, costly, or risky products achieve the same

objectives of the product?

The SEC Reg BI Release points to helpful FINRA guidance and tips on

assessing product due diligence. Release at 264-65 & n. 598. “The level of

reasonable diligence that is required will rise with the complexity and risks

associated with the security or strategy. With regard to a complex product

such as a volatility-linked ETP, an associated person should be capable of

explaining, at a minimum, the product’s main features and associated risks.”

FINRA Regulatory Notice 17-32, Volatility-Linked Exchange Traded

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 6

Products – FINRA Reminds Firms of Sales Practice Obligations for Volatility-

Linked Exchange-Traded Products (Oct. 2017).2

The SEC Reg BI Release also cites variable insurance products and

leveraged- and inverse- ETFs as specific examples of complex products

requiring elevated scrutiny. “[V]ariable insurance products are often unique

and have different features depending on the company providing the

product, as well as depending on the chosen investment options, benefits,

fees and expenses, liquidity restrictions, and other considerations.” Release

at 265. As such, the products have “generated special attention from

regulators and their staff” and “require careful attention and a specific

understanding of certain factors, such as whether the product provides tax-

deferred growth, or a death or living benefit, before a broker-dealer could

establish an understanding of the product, and apply that understanding to

a retail customer’s investment profile in making a recommendation.”

Release at 265.3

With respect to leveraged- and inverse- ETFs, the Release indicates

recommendations should be limited to sophisticated trading strategies where

investor is seeking to achieve a trading objective on a daily basis. Release

at 263. “However, because of the effects of compounding, the performance

of these products over longer periods of time can differ significantly from their

stated daily objectives. Thus, broker-dealers recommending such products

should understand that inverse and leveraged exchange-traded products

2 See also FINRA Regulatory Notice 12-03, Complex Products – Heightened Supervision of Complex Products (Jan. 2012) (stating that “Reasonable diligence must provide the firm or registered representative ‘with an understanding of the potential risks and rewards associated with the recommended security or strategy.’ This understanding

should be informed by an analysis of likely product performance in a wide range of normal and extreme market actions.”) (internal citations omitted). 3 See id. at nn. 599-601 (citing FINRA Rule 2330, Members Responsibilities

Regarding Deferred Variable Annuities; FINRA Rule2320, Variable Contracts of

Insurance Companies; FINRA Regulatory Notice 10-05, Deferred Variable Annuities –

FINRA Reminds Firms of Their Responsibilities Under FINRA Rule 2330 for

Recommended Purchases or Exchange of Deferred Variable Annuities (Jan. 2010); SEC

Updated Investor Bulletin: Variable Annuities (Oct. 30, 2018); SEC Investor Bulletin:

Variable Life Insurance (Oct. 30, 2018); Updated Disclosure Requirements and Summary

Prospectus for Variable Annuity and Variable Life Insurance Contracts, Investment

Advisers Act Release No.10569 (Oct. 30, 2018) [83 FR 61730 (Nov. 30, 2018)].

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 7

that are reset daily may not be suitable for, and as a consequence also not

in the best interest of, retail customers who plan to hold them for longer than

one trading session, particularly in volatile markets.” Id. at 263-64. Review

the investor profile questionnaire and other documentation to probe for the

existence (or absence) of this trading objective.

WHEN

When is this product being sold (in terms of the investor’s age and

investment cycle) and when is it being traded (in terms of the product’s own

trading guidelines)? With complex products, the product or strategy may

require extended hold periods, e.g., private placements, annuities, non-

traded REITs, that would not make sense for most investors near or at

retirement age. On the flip side, there are complex products with very short

hold periods, e.g., leveraged- and inverse-ETFs that reset daily, that require

closer sales data review.

• What assumptions underlie the product and how do they mesh with the

investor’s current financial needs and investment objectives? Has the

product been managed consistent with stated trading objectives?

• How is the product expected to perform in a wide variety of market or

economic scenarios and are there any specific market or performance

factors that are outcome-determinative of the investor’s return?

• Under what circumstances would redemption, principal protection,

yield, or other touted benefits not occur, especially if those benefits

were the driving force behind the investment decision?

• Have all of these timing dynamics been adequately explained to the

investor to prevent confusion and surprise?

WHY

Why is the rep recommending this complex product as opposed to a

traditional product or other reasonably available alternatives? You want to

be sure that neither the firm’s nor the rep’s self-interest is tainting the

recommendation. For this, you need to dig into compensation and conflicts

of interest.

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 8

What is a conflict of interest?

A conflict of interest is an “incentive to a broker-dealer [or a rep] to seek to

increase its own compensation or other financial interests at the expense of

the customer to whom it is making investment recommendations.” Release

at 8.

Most broker-dealer conflicts of interest center around financial incentives,

which includes obvious items like up-front sales commissions but can also

include other less transparent forms of compensation, e.g., advisor fees,

management fees, service fees, trailing commissions, and other forms of

deferred sales compensation. Compensation is often one of the more

complex features of complex products.

• How will the firm and registered representatives be compensated for

offering the product? What do they take up front and what other types

of compensation is deferred? What is the total compensation package

and what impact does that have on the investor’s returns?

• What other types of incentives is the product sponsor or affiliate

providing to the broker-dealer? Think about both cash and non-cash

compensation?

• Will the offering of the product create any other conflicts of interest

between the customer and any part of the firm or its affiliates? If so,

how will those conflicts be addressed?

• Are these conflicts disclosed in a transparent way that is easy for the

investor to understand? Check the Form CRS, the prospectus,

advertising, and any sales communications to determine where there

is full and fair disclosure of the down-side risk in proceeding with the

conflict.

Complex products offer lucrative compensation, creating strong financial

sales incentives. The SEC’s Reg BI Release noted how this compensation

can result in adverse recommendations:

Beyond mutual funds, a nascent literature is emerging on other

securities that may be prone to conflicts of interest by financial

professionals. Recent studies have examined potential conflicts

of interest in markets for more complex investments, including

reverse convertible corporate bonds and non-traded REITs. One

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 9

study uses a sample of reverse convertible corporate bonds that

differ only in the financial incentives provided to financial

professionals and the coupon rate, and finds that investors are

more likely to purchase—based on the advice given—the inferior

bond (lower coupon, all else equal) with the higher “kick-back” to

the broker-dealer, which appears to be driven by conflicts of

interest between the financial professional and the investors. In

an examination of non-traded REITs, one study documents that

retail investors in non-traded REITs underperformed by over $45

billion relative to a portfolio of traded REITs, and that nearly one-

third of that underperformance was driven by upfront fees used

to compensate broker-dealers.

Release at 493-94 & nn. 1108-1112) (citing Mark Egan, Brokers vs. Retail

Investors: Conflicting Interests and Dominated Products, J. FIN. (2019);

Craig McCann, Fiduciary Duty and Non-Traded REITs, INVESTMENTS &

WEALTH MONITOR, July/Aug. 2015, at 39, available at

https://www.slcg.com/pdf/workingpapers/Fiduciary%20duty%20and%20No

n-traded%20REITs.pdf ). The SEC also highlights a wealth of FINRA

guidance on best practices regarding suitability as a starting point for

compliance with Regulation Best Interest.4

4 NASD Notice to Members 94-16, NASD Reminds Members Of Mutual Fund Sales Practice Obligations (Mar. 1994) and NASD Notice to Members 95-80, NASD Further

Explains Members Obligations and Responsibilities Regarding Mutual Funds Sales Practices (Sep. 1995) (mutual fund suitability and sales practices); NASD Notice to Members 96-86, NASD Regulation Reminds Members and Associated Persons that

Sales of Variable Contracts are Subject to NASD Suitability Requirements (Dec. 1996) and NASD 99-35, NASD Reminds Members of Their Responsibilities Regarding Sales of Variable Annuities (May 1999) (suitability and sales practices of variable contracts and

variable annuities); NASD Notice to Members 05-59, NASD Provides Guidance Concerning the Sale of Structure Products; and FINRA Regulatory Notice 12-03, Complex Products – Heightened Supervision of Complex Products (Jan. 2012);

(suitability and sales practices of structured and complex products); FINRA Regulatory Notice 09-31, FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009) (sales practices of leveraged and

inverse ETFs); and FINRA Regulatory Notice 13-45, Rollovers to Individual Retirement Accounts – FINRA Reminds Firms of Their Responsibilities Concerning IRA Rollovers (Dec. 2013) (obligations when recommending a rollover or transfer of assets from a

sponsored retirement plan to an IRA).

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 10

HOW

How are the firm and the rep managing the down-side risks of the complex

product for the investor? Those risks include the unique features of the

product itself as well as risks emanating from the firm’s business or

compensation models. You will need to examine individual account data,

exception reports, and supervisory policies and procedures to ensure all the

risks of the complex product have been fully and fairly disclosed to the

investor and properly mitigated.

Reasonably designed policies and procedures should include

mitigation measures that depend on the nature and significance

of the incentives provided to the associated person and a variety

of factors related to a broker-dealer’s business model (such as

the size of the broker-dealer, retail customer base (e.g., diversity

of investment experience and financial needs), and the

complexity of the security or investment strategy involving

securities that is being recommended), some of which may be

weighed more heavily than others.

For example, more stringent mitigation measures may be

appropriate in situations where the characteristics of the retail

customer base in general displays less understanding of the

incentives associated with particular securities or investment

strategies; where the compensation is less transparent (for

example, an incentive from a third-party or charge built into the

price of the product or a transaction versus a straight

commission); or in a situation involving a complex security or

investment strategy.

Release at 331-32.

The SEC Reg BI Release pointed to FINRA’s heightened suitability

requirements for options trading accounts as a best practice for firms seeking

to mitigate risk and conflicts arising in the sale of complex products. There,

registered representatives must 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

© 2021 Financial Industry Regulatory Authority, Inc. All rights reserved. 11

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.” Release at 332 & n. 747 (citing FINRA Rule

2360(b)(19)).

Confirming investor capacity is only the first step, however. Firms will not

meet the standard of care obligation without also giving due consideration to

less complex, costly, and risky alternatives. “[W]hen broker-dealers are

recommending complex or costly products, they should first consider

whether less complex or costly products could achieve the same objectives

for their retail customers. Release at 284. This affirmative requirement

expands beyond the body of suitability case law that was “generally limited

to certain circumstances, such as recommendations of mutual funds with

different share classes or recommendations of complex or costly products.”

Release at 284 n. 637 (citing In re Application of Raghavan Sathianathan,

Exchange Act Release No. 54722 at 21 (Nov. 8, 2006); In the Matter of

Wendell D. Belden, 56 S.E.C. 496 (2003)).

The comparative suitability framework remains a helpful framework for firms.

Release at 284 n. 638 (citing FINRA Regulatory Notice 12-03 (“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.”).

In many cases, firms will employ heightened supervision over complex

product sales, adjust compensation to neutralize conflict, or expressly limit

the types of retail customer to whom a complex product, transaction or

strategy may be recommended, a few of the mitigation methods noted in the

SEC Reg BI Release. Release at 336 & n. 760 (citing FINRA Regulatory

Notice 12-03, Heightened Supervision of Complex Products (Jan. 2012)).

Lastly, the SEC has stated its expectation that broker-dealers will record the

basis for their recommendations “for more complex, risky or expensive

products and significant investment decisions, such as rollovers and choice

of accounts” in order to demonstrate compliance with the Care Obligation.

Release at 192. Such explanation should be reviewed to assess whether

reasonably available alternatives were adequately considered prior to the

recommendation.

Introduction to Complex Products

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

Panelists

o Speakers• Marc Freeman, Principal Risk Specialist, FINRA Member Supervision

• Andrea Seidt, Commissioner, Ohio Division of Securities

What Is A Complex Product?

o Any product with multiple features that affect its investment returns differently under various scenarios (FINRA Reg. Notice 12-03)

o Alternative or non-conventional products that have special features that make them more complex and riskier than traditional products (https://www.nasaa.org/wp-content/uploads/2020/09/Reg-BI-Phase-1-Report.pdf).

o May utilize futures and options as part of trading strategy to achieve specific objective

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

Common Characteristics

o Costly

o Risky

o Hold periods that are not normal

o Geared toward wealthier, more sophisticated investors

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

Examples

o Leveraged and Inverse Exchange Traded Funds (ETFs)

o Principal Protected Notes

o Equity Linked Notes

o Leveraged Steepeners

o Market Linked CDs

o Alternative Mutual Funds

o Public Non-traded Real Estate Investment Trusts (REITs)

o Variable Annuities

o Private Placements*

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

o Illiquid – Limited secondary market

o Trade Over-the-Counter (OTC)

o Returns may be based on a complex formula and linked to the performance of an underlying benchmark, index, or individual or basket of securities

o Clear disclosures on features and risks

o Avoid over-concentration

o Limit to investors with a high-risk tolerance

o Training registered representatives on features and risks

Mitigation Tools IncludeUnique Features

Structured Products

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

o Most leveraged and inverse ETPs reset on a daily basis

o Holding period risk due to effect of compounding (tracking error)

o Early redemption and acceleration maturity risk

o May provide broad market exposure or target specific asset classes

o Actively monitor and rebalance as necessary

o Do not use for a ‘buy and hold’ strategy

o Use as a short-term trading tool such as for hedging strategy

o Avoid over-concentration

o Limit to investors with a high-risk tolerance

Mitigation Tools IncludeUnique Features

Non-Traditional Exchange-Traded Products

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

o Distributions from offering proceeds

o DRIPs

o Illiquid – limited redemption, no secondary market

o Uncertain valuations

o Tied to real estate market performance

o Complex comp - high up-front commission plus other deferred fees –large financial incentive

o Limit sales to accredited investors

o Limit sales to non-senior investors

o Limit investment concentration (10% LNW)

o Heightened supervision – adherence to investor and investment limitations

o Clear fee disclosure

o Compelling explanation as to why a listed REIT or cheaper, safer traditional real estate investment was not recommended

Mitigation Tools IncludeUnique Features

Non-Traded REITs

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

o Very expensive, loaded with fees beyond large commission

o Complicated riders, guarantees are conditional

o Long hold period

o Surrender charges and 10% tax penalties for early withdrawals

o Limit to investors that have maxed out 401(k)

o Limit to long-term investors

o Limit to accredited investors

o Limit to non-senior investors

o Clear disclosure re surrender charges, tax penalties, and other fees

o Heightened supervision – riders, sales communication/pitch material

Mitigation Tools IncludeUnique Features

Variable Annuities

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

o Advertising/solicitation restrictions

o Unregistered – no regulatory review

o Limited disclosure and no public financial reporting

o Illiquid – limited secondary sales

o High commissions – large financial incentive

o High fraud risk

o Already limited by statute to accredited investors

o Limit to non-senior investors

o Limit to friends and family only

o Extensive due diligence of principals, financials, and operations

o Heightened supervision –verification of investor accreditation, sales communications/pitches

Mitigation Tools IncludeUnique Features/Red Flags

Private Placements

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training

Resources

o NASAA Regulation Best Interest Implementation Phase I Report, • www.nasaa.org/wp-content/uploads/2020/09/Reg-BI-Phase-1-Report.pdf

o FINRA Regulatory Notice 12-03 – Heightened Supervision of Complex Products• www.finra.org/rules-guidance/notices/12-03

o SEC Joint Statement Regarding Complex Financial Products and Retail Investors• www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28

o SEC Charges Investment Advisory Firms and Broker-Dealers in Connection with Sales of Complex Exchange-Traded Products• www.sec.gov/news/press-release/2020-282

o Notice to Members 05-59 - Guidance Concerning the Sale of Structured Products• www.finra.org/rules-guidance/notices/05-59

o Variable Annuities Overview including links to Rules, Notices, Guidance, News Releases and Investor Education• www.finra.org/rules-guidance/key-topics/variable-annuities

o Public Non-Traded REITs – Perform a Careful Review Before Investing• www.finra.org/investors/alerts/public-non-traded-reits-perform-careful-review-investing

o SEC Investor Bulletin: Publicly Traded REITs• www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-65

Copyright 2021 FINRA | 2021 Get SET – State Examiner Training