FINRA Issues Guidance on the Heightened Supervision of Complex Products

January 25, 2012

On Jan. 17, 2012, FINRA issued Regulatory Notice 12-03 (“Notice”) regarding a member firm’s obligation to impose heightened supervision of retail sales of complex products. The Notice does not attempt to define what a complex product is; it merely identifies some of the characteristics that may cause a product to be deemed complex and thus subject to heightened supervision. While the Notice provides guidance about what might make a product complex, FINRA notes that even some “relatively simple products” might impose substantial risk to investors resulting in the need for heightened supervision and compliance. FINRA seems to be putting members on notice that all products — not just those falling within the available guidance set forth below — must be evaluated for any level of risk and treated accordingly.

Consistent with existing guidance on suitability requirements, the Notice provides non-exhaustive recommendations and “suggestions” for assessing the risks associated with potentially complex products whether the sale of those products to retail investors is appropriate. Ultimately, in FINRA’s view, a firm should assess the products it offers to determine if there is a level of complexity not likely to be understood by many investors, and should err on the side of applying enhanced supervisory and compliance procedures.

Identifying a Complex Product

According to FINRA, “[a]ny product with multiple features that affect its investment returns differently under various scenarios is potentially complex.”

In providing examples of potentially complex products, FINRA notes that a product is more likely to be deemed complex if it would be “unreasonable to expect an average retail investor to discern the existence” of the many features and comprehend how the features interact to result in a return on investment. According to FINRA, examples of complex products include:

  • Asset-backed securities secured by a pool of collateral
  • Investments with an embedded derivative component
  • Products with contingencies in gains or losses (e.g., FINRA gives the example of a range accrual note where the return on the investment can depend on the values of multiple reference assets on certain dates)
  • Structured notes with “worst of” features
  • Investments linked to the performance of markets that may not be understood by investors.

Despite providing guidance on how to identify complex products, FINRA notes that even seemingly simple products (including some exchange-traded funds) may present special or heightened risks to investors. As a result, such products may be considered “complex” and thus subject to heightened supervision and enhanced compliance. Every firm must make such determinations with regard to products it offers to retail investors.

Employing Heightened Supervision

NASD Rule 2310 requires that member firms have a reasonable basis for believing a particular recommendation is suitable for each retail customer (“customer-specific suitability”). A member must consider certain information about and characteristics of the particular customer in determining if the investment is indeed suitable for that customer. As codified in FINRA Rule 2111, which will become effective in July 2012, a member also must make a reasonable basis suitability determination to ensure an investment is appropriate or suitable for at least some investors (“reasonable basis suitability”). To perform a reasonable basis suitability determination, FINRA notes, a member firm must undertake “reasonable diligence” regarding the investment — though that reasonable diligence may vary with the product being reviewed. The diligence should include consideration of “the complexity and risks associated with the security or investment strategy and the familiarity of the firm or the registered representative with the security or investment strategy.” See FINRA Regulatory Notices 11-02 and 11-25.

The Notice indicates that member firms should have formal written procedures to ensure complex products have been reviewed and thoroughly vetted before they are recommended to retail investors. FINRA suggests a firm’s procedures require that representatives obtain answers to a number of questions before a recommendation is made. The Notice sets forth at least 10 questions FINRA believes should be considered before recommending a complex product, including:

  • For whom is this product intended? Is the product proposed for limited or general retail distribution, and, if limited, how will it be controlled?
  • To whom should this product not be offered?
  • What is the investment objective of the product and is the objective reasonable in relation to the product’s characteristics?
  • What assumptions underlie the product and how sound are they? How is the product anticipated to perform in a wide variety of market or economic scenarios? What market or performance factors determine the investor’s returns?
  • What are the risks for investors? If the product was designed mainly to generate yield, does the yield justify the risks to principal?
  • How will the firm and representatives be compensated for offering the product? Will offering the product create conflicts of interest between the customer and the firm or its affiliates? How will any conflicts be addressed?
  • Does the product present novel legal, tax, market, investment or credit risks?
  • Does the complexity of the product impair understanding and transparency thereof?
  • How does the complexity of the product affect suitability determinations or training requirements associated with the product?
  • How liquid is the product? Is there an active secondary market for the product?

Post-Approval Review of Complex Products and Training of Personnel

In addition to pre-sale reviews, FINRA indicates that member firms should have in place an internal control to periodically reevaluate complex products being offered. Such a process will ensure the products’ “performance and risk profile remain consistent with the manner in which the firm is selling them.” Although FINRA previously has identified this product reevaluation process as a “best practice,” FINRA now appears to be incorporating this process as a mandatory element of the “reasonable basis suitability” requirement.

FINRA notes that representatives recommending complex products should be adequately trained to be aware of the underlying features of the product and understand its performance characteristics. In addition, representatives recommending complex products should understand not only the risks associated with the products, but also should be able to “develop a payoff diagram” of the particular products to assist in their analysis. In addition, firms should periodically review their sales processes to ensure that only persons authorized to sell complex products to retail investors are in fact selling them.

Customer Sophistication

In employing a suitability analysis for recommending complex products, FINRA urges firms to look to the approach currently mandated for options trading accounts. This approach requires that representatives “‘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 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.” FINRA suggests that firms limit recommendations and sales of complex products (at least those with options or other derivative components) to only those retail investors whose accounts have been approved for options trading. Where complex products are recommended to retail investors whose accounts have not been approved for options trading, FINRA suggests that firms put in place procedures similar to those for options trading accounts to ensure complex products are only recommended to those accounts for which they are suitable. In addition, FINRA suggests that firms require the involvement of a “specially qualified supervisor” in each recommended transaction.

Finally, FINRA notes that representatives intending to recommend complex products should discuss the products with the retail investors in a manner that will assist in the investors’ understanding of the products’ features, risks and possible benefits. After the discussion, the representative should assess whether the customer understands the basics of the product. At all times, representatives should be considering whether there are alternative investments available that might be less complex and achieve the same goals. FINRA’s suggestion appears to be that if the investor cannot understand the product, it can never be suitable for that investor.


In this Notice, FINRA has stated its view that firms that recommend complex products should properly train their representatives to understand and explain the potential risks and rewards of such products. In addition, the representatives should consider whether the retail investors to whom the products are being offered understand the products and whether complex products are suitable for the particular accounts. Only after a firm has put in place heightened supervisory and compliance procedures related to complex products should it make those products available to its retail clients. Although the Notice does not explicitly require this, FINRA’s expectation appears to be that a firm will establish a separate suitability requirement for each complex product and not allow the sale of that product to any investor who does not meet that requirement. The most challenging part of the Notice is FINRA’s view that once a firm begins offering complex products to retail accounts, it should continue to monitor and assess those products to test whether they remain suitable for retail investors and, if so, for which ones. Firms must accomplish all this without any single definition of what a complex product is or how it should be assessed. As FINRA states in the Notice, even seemingly simple products may have associated risks so that they could be deemed complex and thus subject to heightened supervisory and compliance procedures.

*This alert was co-authored by W. Hardy Callcott, Michael Wolk and Margaret Blake. 



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This article was originally published by Bingham McCutchen LLP.