Retail sales of complex investments

Selling complex or illiquid investments to retail customers in the US

Complex and/or illiquid investments (including hedge funds, real estate funds, structured products and asset-backed securities) are not new, but sales of these products to retail investors is a fairly recent and growing trend. And to put it mildly, US securities regulatory authorities are not entirely comfortable with the trend. Their concerns range from inherent structural complexities, to the supervision of operations and distribution-related matters.

This article will focus on the sales practice issues that those selling or planning to sell these investments to retail investors face. Specifically, it will cover four main areas: marketing, training, suitability and supervision. These are the four areas FINRA and the SEC appear to be focusing on, both from a guidance and an enforcement standpoint.

Marketing

As securities, complex or illiquid investments are subject to the same broad rules regarding communications with the public that apply to any other security. Marketing materials:

(a) must be fair and balanced, and provide a sound basis for evaluating the benefits, costs and risks of the security;

(b) cannot omit any material facts if the omission would cause the communication to be misleading; and

(c) cannot be cured of deficient disclosures by risk disclosure in the offering documents.

Neither the SEC nor FINRA have not been shy about interpreting these standards in the context of complex or illiquid investment and have insisted that marketing material should explain, in plain English, how the investment works. If an investment cannot be adequately described in simple narrative terms, the regulators take the position that it should not be sold to retail investors.

Communications should explain that principal is not guaranteed (unless specified) and that the product price and liquidity will be affected by the lack of a secondary market. The name of the investment should not be misleading, and marketing materials should include detailed, accurate and complete disclosure of the risks associated with the investment. Marketing material may not predict or project the expected performance of the investment or overstate the likelihood that an investor will get all of his or her money back.

Training

Before a firm allows its sales force to market and recommend a particular complex or illiquid investment the firm must provide adequate training. The training should be both general and more specific. The training must give the sales force an in-depth understanding of the complexities of the investment and should include explanations of the payout features, fees and costs, liquidity and valuation. Furthermore, sales representatives should be able to explain the investment fairly and accurately and in sufficient detail to a retail investor. Most importantly representatives must understand and appreciate that the average retail investor is unlikely to understand the investment on his or her own, augmenting the responsibility of representatives to the customer.

Sales teams should receive training on the structural conflicts of interest inherent in some complex investment products. In particular, sales teams should be aware of the ways the issuer, the manager, the distributor, and their affiliates earn their compensation. In addition, they should understand which expenses are borne by the various service providers, and which are passed on to the investors, and if there is any leeway in the way such expenses are allocated.

The training materials should be consistent with all the materials relating to the investment provided to prospective investors. In a recent SEC order involving a large financial institution selling complex investments in the retail market (in this case, structured notes), a significant part of the SEC’s case was based on the fact that some information provided to potential investors was not part of the firm’s training materials. The SEC used the existence of this inconsistency as evidence of inadequate supervision of the training process.

What this suggests is that firms should strive for consistency in all of their descriptions of an investment, including offering documents, training materials and materials provided to third parties, and should also be able to explain and justify any inconsistencies between such materials. Justifiable inconsistencies could include different audiences, different purposes and different modes of communication, for example, a registration statement versus a one-pager.

FINRA has also indicated that firms should have a specific process in place for ensuring that sales representatives cannot sell these types of investment products until they have been trained and not just a policy limiting sales to those trained. Firms should train supervisors as well as sales staff, and should make the training available for as long as the investment is offered.

Suitability

To meet its obligation to ensure that recommendations of complex or illiquid products are suitable, a firm should engage in the following three-step process:

Perform due diligence on the product
Firms must analyse the costs and risks of the specific offering including the restrictions on redemptions and transfers, payout structure, valuation methodology, volatility and liquidity of underlying assets, and any other associated risks. Additionally, firms should conduct an analysis of likely investment performance in a wide range of normal and extreme market conditions. Finally firms should not rely solely on issuer or third party information, which may be incomplete or inaccurate.

Establish a process for determining eligible investors
FINRA suggests limiting the pool of customers who are eligible to consider the investment to those who have been approved for options trading. Firms that choose not to follow this recommendation should (i) develop other comparable procedures (such as restrictions based on age, assets, and trading experience), and (ii) be prepared to defend the decision not to limit eligible investors to those with options accounts.

Establish a process for determining customer-specific suitability
Before recommending a complex or illiquid investment to a retail customer, sales teams must consider the nature of the investment and the objectives and trading experience of the customer, as well as whether a less complex or costly investment could achieve the same objectives. Sales personnel should not assume that if investing in the underlying asset class is suitable, then investing in a pool, fund or other structure consisting of or linked to that asset class must also be suitable.

Firms must consider concentration limits and monitor for excess concentration. Monitoring should be dynamic, taking into account changing market conditions and the issuer’s financial condition.

Supervision

FINRA has explicitly stated that it requires heightened supervision with respect to marketing and selling complex or illiquid products to retail investors. This includes heightened policies and procedures for: product approval; approval of marketing materials; developing and implementing a training programme; and determining and documenting suitability analyses. Firms must analyse, test and verify the effectiveness of controls they have established.

In 2015, the SEC Office of Compliance Inspections and Examinations (“OCIE”) conducted and reported on a sweep examination programme related to retail sales of non-traditional products. Although the examination and report addressed only sales of structured notes, the findings are relevant to firms selling any sort of complex securities product in the retail market. OCIE indicated that it found significant weaknesses in the firms’ effective implementation of supervision-related policies and procedures. OCIE in particular noted that in all of the firms examined:

• all had policies and procedures in place with respect to suitability, the processes for product approval, and the training of sales teams; but
• none of them maintained or enforced controls relating to suitability determinations; and
• none of them conducted compliance and supervisory reviews of sales persons’ suitability determinations.

In addition, OCIE found evidence of the following kind of interactions with a view to identifying financial exploitation:

• sales to elderly customers;
• sales to customers without age information;
• sales to non-English speakers;
• sales in excess of internal concentration limits; and
• sales representatives retroactively

Both the SEC and FINRA have stopped short of saying that retail sales of complex or illiquid products are unsuitable per se, but both have demonstrated uneasiness about this activity and indicated that investment firms engaging in it have heightened and specific disclosure, training, suitability and supervisory obligations. In summary, although investment firms can sell these products in the retail market, they should do so with thought, preparation and caution, because the regulatory agencies are watching.