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Introduction to Structured Products Regulation (Mastering the Law of Structured Products in 30

Minutes or Less)

November 12, 2014

Lloyd Harmetz Remmelt Reigersman

Morrison & Foerster LLP

NY2 741349

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Topics to Be Covered •Registered Notes, Bank Notes and CDs – What’s the Difference? •Understanding the Morgan Stanley Letter: What Common Stocks are Suitable for Reverse Inquiry Transactions in a Registered Program?

•Introduction to U.S. Tax Issues in Structured Products •Sales Outside the U.S. and Selling Restrictions

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Registered Notes •Perhaps the most important type of structured product. •Offered under a registration statement that has been filed with the SEC – usually a “shelf.”

•Misstatements and/omissions are actionable under Rule 10b-5, as well as the “strict liability” provisions of Section 11 and Section 12 of the Securities Act of 1933 (the “1933 Act”).

•This is the area that is most closely monitored by the SEC and FINRA.

•All prospectuses, and most marketing materials, are publicly filed.

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Bank Notes •Bank securities that are exempt from registration under the 1933 Act – Section 3(a)(2).

• In the U.S., typically issued or guaranteed by the U.S. branch of a non-U.S. bank.

•Bank holding companies and other entities don’t obtain the benefit of the exemption.

•Not registered with the SEC, but documents are subject to the anti-fraud provisions of the federal securities laws, such as Rule 10b-5.

•Generally may be sold to “retail investors,” and accordingly, remains an area of scrutiny by FINRA and other regulators.

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Structured Certificates of Deposit •Not a “security” (if structured correctly) under the federal securities laws.

•Benefits from FDIC insurance. • Must be a “principal protected” instrument in order to have FDIC insurance. • Key difference from structured notes: may not pay less than principal at maturity.

Otherwise, the FDIC would take the position that they are not “deposits”, and not subject to FDIC insurance.

• But: may sell for less than principal if sold prior to maturity. • That is, “principal protection” applies only at maturity.

•Subject to “truth-in-lending” disclosures. •Offering documents are subject to FINRA regulations on retail communications.

• FINRA does review marketing materials, and does comment on them if not satisfied with their content.

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Securities Law Issues “Certificates of deposit” are included in the 1933 Act’s definition of a

“security.” However, under relevant case law, FDIC insured CDs are typically

not treated as a “security”. Guaranteed payment of principal. Other regulatory protections provided to holders under applicable banking laws. Similar concept of exemption from OCC registration for national banks.

When is a certificate of deposit a security? See “Gary Plastics”, a 1985 Second Circuit decision. Bad facts: Broker marketed CDs that it had obtained from other banks. Broker promised to maintain a secondary market to guarantee liquidity. Broker represented to investors that it had reviewed the financial soundness of

the issuing banks. Today’s structured CD offering documents are drafted with these concerns in mind.

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FDIC Insurance Current limit is $250,000 Application may vary, depending upon type of investment account. Guidance is available to the public on the FDIC’s website.

Not all payments are guaranteed: Principal and guaranteed interest payments are covered. The FDIC has taken the position that contingent payments at maturity, and any

indexed interest payments, are not insured until determined. Impact: if bank fails before a “determination date,” that payment will not be

covered by FDIC insurance. FDIC insurance will not cover any amount paid in excess of principal, such as the

payment of a premium in a secondary market transaction. e.g., investor pays $1,001 for a CD with a face amount of $1,000. That

additional dollar is not insured.

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Truth in Savings Act Bureau of Consumer Financial Protection Regulation DD implements

the Truth-in-Savings Act. Provisions are applicable to the issuing banks, as well as to deposit

brokers. Banks may not advertise deposits in any way that is inaccurate or

misleading, and the regulation provides examples. Required disclosures of “annual percentage yield,” “penalty fees” that

may be imposed for early withdrawals, and any other fees. In addition, the Federal Trade Commission Act prohibits unfair or

deceptive acts or practices. Applies to all aspects of a depository institution's consumer products and services,

including advertisements.

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Disclosure Documents for CDs No specific form requirements. (In contrast, registered securities are

subject to the form requirements of S-3/F-3 and Regulation S-K.) Truth-in-Savings Act, FINRA communication rules, and “best

practices” require full and accurate disclosure. Often quite similar to the offering documents for registered notes –

similar set of brokers, similar set of investors. Estimated Value Disclosures: CDs are not subject to the 2012 SEC “sweep letter.” However, many regard it as a good disclosure, any many distributors request its

disclosure.

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The Morgan Stanley Letter and Stock-Linked Structured Notes

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An SEC Scorecard •Number of SEC No-Action Letters Setting Forth the Requirements for Linking to an Underlying Asset:

Underlying Asset Number of No-Action Letters

Equity Indices 0

Commodity Indices 0

Single Commodities 0

Exchange Rates 0

Single Stocks 1

Total 1

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The Structured Products Market •Billions of dollars of notes, but only one source of law that was really designed for it: the Morgan Stanley No-Action Letter.

• Issued by the SEC in 1996. • As will be discussed below, life has changed since 1996. • Especially: how we access information.

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Some General Points About the Letter •The letter relates to notes exchangeable into the publicly-traded common stock of an unrelated issuer.

•The letter only applies to registered public offerings, and does not technically apply to CDs, bank notes, Rule 144A offerings and other private placements.

•On its face, it does not address stock baskets, equity indices, currencies or commodities.

•But that’s about all that practitioners have, so the market has adapted its principles to some extent for these different types of assets.

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The SEC’s Starting Point: Materiality •The concept: if the return on a security depends upon the performance of a stock, then information about the relevant issuer of the underlying stock and that issuer’s finances are material information to an investor.

• In the absence of the Morgan Stanley letter, an issuer of a structured note would theoretically need to include in a prospectus substantial information about the underlying issuer, including financial statements.

• Presumably copy from the underlying issuer’s SEC reports, and “staple” onto offering document.

•Problem: issuer and underwriter would have liability for any misstatements or omissions in those documents.

• No due diligence defense for issuer of the structured note. • Underwriter of the structured note has a due diligence defense, but due diligence is

(a) expensive and time consuming and (b) not practical in the case of an unaffiliated issuer.

• Offering documents wouldn’t be very attractive if you included all of this information.

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Requirements and Benefits •The letter consists of two parts:

• Requirements: the criteria that an underlying stock must satisfy. • Benefits: if the stock satisfies the criteria, only limited information about the underlying stock and its issuer needs to be disclosed.

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Criteria •The issuer of the underlying stock is an SEC-reporting company – equity securities registered under Section 12.

• ADRs traded in the OTC market without 1934 Act registration don’t qualify. AND

•That issuer is eligible to use Form S-3 or Form F-3 for primary offerings of noninvestment grade securities or it meets the relevant listing standards for equity-linked securities.

• S-3/F-3 Eligibility: at least one year of public trading, market capitalization of at least $75 million held by non-affiliates.

• Key listing standards, Rule 107.B of NYSE MKT. • Available at:

http://wallstreet.cch.com/MKTtools/PlatformViewer.asp?SelectedNode=chp_1_1_1&manual=/MKT/CompanyGuide/mkt-company-guide/

• Key: market capitalization/liquidity criteria.

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Benefit: Limited Disclosure •“Brief discussion” of the business of the underlying issuer.

• Often adapted from issuer’s SEC filings or Bloomberg.

•A reference to the availability of information about the underlying issuer.

• The SEC website and “reading room.”

• Information regarding the market price of the underlying securities. • Technically, only two years plus a stub period are required, but virtually all issuers

show more than that. • Practices differ.

•Some offer additional information: • Dividend history, CIK number, etc.

•Should not be liable for any misstatements by the relevant issuer in its public documents.

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Limitations of the Morgan Stanley Letter •1934 Act Registrants Only:

• Doesn’t help for large foreign stocks, even if their financials are easily obtained and the foreign issuer would satisfy the 12g3-2(b) requirements.

• Doesn’t help for mutual funds or closed end funds that are registered only under the 1940 Act.

• Is the level of information that is publicly available “comparable” to the type of information that would be available for an MS eligible stock?

•Doesn’t address debt securities, credit-linked notes, or commodity-linked notes.

•One year of trading history – Form S-3/F-3.

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Structured Products and U.S. Federal Income Taxes

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Structured Notes – Tax Categorization Principal Protected?

“Type 1” Note Bears a Periodic Coupon?

“Type 2” Note “Type 3” Note

(Debt)

(Open Transaction) (Alternative Characterizations)

Yes

No

No

Yes

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Tax Categorization •Special Considerations

• Foreign currencies; Rev. Rul. 2008-1 • Expectations vs. legal entitlements

•Type 1 Notes • Fixed rate debt, variable rate debt, contingent payment debt • OID

•Type 2 Notes • Open transaction • Notice 2008-2

•Type 3 Notes • Unit consisting of components (debt/deposit plus a derivative) • Single instrument

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A Word About Non-U.S. Law

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Non-U.S. Distribution and Non-U.S. Distributors

•Just like the U.S. has a variety of offering requirements, so do many or most non-U.S. jurisdictions.

•Registration requirements, filing requirements, investor qualifications, product intervention, required selling legends.

•Potential different regulatory regime for “securities” vs. “bank certificates of deposit.”

•Many broker-dealers have “vetted” a variety of jurisdictions, and placed any required selling restriction language into their offering documents.

•Agreements with broker-dealers are likely to address, and in some cases, restrict, international sales.

• In a nutshell: consider where sales are being made before selling.