FINRA may limit self-directed investments in complex products

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On March 8, 2022, the Financial Industry Regulatory Authority, Inc. (FINRA) issued Notice to Members No. 22-08 (NtM 22-08) to “remind members of their sales practice obligations” for complex products and options and to “solicit feedback” on effective practices and “rule improvements” related to complex products.1

For the purposes of NtM 22-08, what constitutes a “complex product” is of crucial importance. Unfortunately, as FINRA acknowledges in the NtM, “[t]There is currently no standard definition of a “complex product”. Instead, provides a description based on FINRA’s previous discussions of products it perceived to be complex. Specifically, “FINRA has described a complex product as one whose characteristics may make it difficult for a retail investor to understand the essential characteristics of the product and its risks.”

In previous versions, FINRA described each of the following product types as complex:

Closed funds Target Date Funds Emerging Markets Funds
ESG funds Smart beta index funds Cryptocurrency Futures Fund
High Yield Bond Funds Funds using derivatives for hedging purposes Cryptocurrency trusts
Multi-strategy funds Funds using derivatives for leverage Commodity funds
business development companies Leveraged funds (leveraged or inverse) Currency Funds
Variable annuities Funds Sold Short Insurance titles
Market-linked certificates of deposit Absolute Return Funds Asset-backed securities
Bond funds without constraints Distressed Debt Fund Non-Traded Real Estate Investment Trusts
Floating Rate Loan Fund Volatility funds Global real estate funds
Funds at intervals Defined outcome funds Reverse Convertible Notes
Fund of hedge funds Principal Protected Notes Exchange Traded Notes

Indeed, according to this description, only vanilla index funds and certain long-only US or developed markets funds escape categorization as “complex”. Accordingly, almost all brokers selling or making available exchange-traded funds, mutual funds and closed-end funds and sponsors of these fund products in the country should have an interest in the potential regulation of the FINRA on complex products.

To be clear, NtM 22-08 does not propose a new rule for complex products. Rather, it outlines FINRA’s historical approach to overseeing broker-dealer sales practices with respect to complex products and asks a series of questions about potential “improvements” to this approach. The questions relate to reconsidering the unlimited ability of do-it-yourself investors to invest in any “complex” registered securities they wish and whether FINRA members should impose certain limits and controls on “complex” registered securities. ‘complex investment’.

The potential improvements proposed by FINRA for comment in NtM 22-08 vary widely and are discussed here (in order from protections that may be familiar to FINRA members to proposals that are entirely unprecedented).

  1. Require brokers to provide investors with additional “plain language” information, including possibly at the point of sale, that highlights the features and/or risks of the particular complex product being purchased, or to obtain certifications investors that they understand the complex product they are buying. Although such measures are not currently required, they are used voluntarily by some brokers.

  2. Require that brokers, at the time of opening an investor’s account, approve the account to trade complex products based on the information provided in the account opening documents. In this scheme, the broker-dealer should determine that trading complex products might be in the best interest of an investor providing such information. Brokers must follow an analogous process when opening options accounts which is substantially similar to the scheme discussed by FINRA in NtM 22-08. The options regulatory regime, however, was enacted following an extensive review of the options market commissioned by the United States Securities and Exchange Commission (SEC). The study documented widespread abuses in the options market, which culminated in a Congressional directive to the SEC to apply options-specific rules. On the other hand, NtM 22-08 does not indicate that FINRA has discovered widespread abuse by brokers in complex products,2 let alone the abuses that are likely to inspire a directive for action from Congress.

  3. Require investors to pass a test to trade a complex product and possibly retest from time to time to ensure the investor’s continued understanding. Although NtM 22-08 does not say precisely how the tests would work, an investor would apparently have to answer a certain percentage of test questions correctly to be allowed to trade a complex product. This approach has no analog in securities regulation and can be administratively burdensome for FINRA, broker-dealers and investors.

FINRA, of course, characterizes its review of potential improvements to complex product regulation as grounded in investor protection concerns. However, given that NtM 22-08 appears to be focused on crafting a rule that will reach do-it-yourself investors, this raises the question of who FINRA is seeking to protect such investors from. Unlike past FINRA rules, which were largely designed to protect investors from broker-dealer sales practices that could harm the investing public, FINRA in this case appears to be considering a rule that will protect investors from themselves.

All comments in response to NtM 22-08 should be submitted to FINRA by May 9, 2022. Please contact one of the authors or another K&L Gates attorney if you have any questions about the scope of NtM 22- 08.

FOOTNOTES

1 NtM 22-08 also formulates certain proposals for changes to the regulatory regime for options. This alert focuses only on the discussion of NtM 22-08 on complex products.

2 NtM 22-08 cites a handful of enforcement cases brought against registered representatives or their supervisors due to inappropriate complex product recommendations.

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