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Structured Products: Still on FINRA’s Radar

Every January, the Financial Industry Regulatory Authority puts out its annual priorities letter. The letter is a list of the things the agency will be watching for the year…in other words, it’s a cautionary heads up for the broker-dealer industry.

This year, FINRA is “particularly concerned about sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices”. There are several items on the watch list for this year: business development companies, non-traded REITs, variable annuities, etc.

And among the “troublesome” things that FINRA will be keeping an eye on: structured products. According to the letter: “(Structured Products) may be marketed to retail customers based on attractive initial yields and in some cases on the promise of some level of principal protection. These products are often complex, and have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, these products generally do not have an active secondary market.”

In other words, structured products are often marketed to investors who don’t fully understand them because they are pretty complex (they are securities tied to derivatives). And once you are in, you are stuck – there is little liquidity because the secondary market is thin. Not to mention there is no price-transparency.

Yet, they are sold to investors anyway.

Last year Morgan Stanley was fined $600,000 by FINRA for failing to supervise brokers who were selling structured products to clients. The firm didn’t have a firm-wide structured product suitability policy – only guidelines posted on their site…but even those rules weren’t followed.

The result: between 2006 and 2008, a total of 14 unsuitable products were sold to 8 clients that were inappropriate given their investment objectives (and within those two years, over 30,000 structured product sales were made outside the posted guidelines).

The irony: all of this happened after FINRA sent out a notice in 2005 saying that broker-dealers needed a system in place for structured product sales to make sure they matched clients’ risk tolerance.


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