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FINRA to Brokerage Firms: Heightened Supervision Required for Complex Products

Last week, the Financial Industry Regulatory Authorized (“FINRA”) issued Notice to Members 12-03 (“Notice”) informing its members of the traits which may make an investment “complex,” requiring heightened supervision and compliance procedures.

FINRA stated that any investment with multiple features that impact its returns under different scenarios is potentially complex. This is especially true if an average, retail investor could not reasonably be expected to discern the existence of these features and to understand the basic way in which the features interact to provide a return on the investment.

In its list of potentially complex products, FINRA included the following: asset backed securities such as collateralized mortgage and debt obligations (“CMOs” and “CDOs”); unlisted real estate investment trusts (“REITs”); structured notes; inverse or leveraged exchange-traded funds (“ETFs”); and hedge funds.

The Notice indicated that firms recommending complex products should have formal written procedures addressing everything from the initial due diligence to post-sale performance. In addition, brokers who recommend complex products must understand all of the features and risks associated with the products. A broker’s analysis of a complex product should include the likely performance of the investment in a wide range of normal to extreme market conditions. A lack of product understanding by a broker recommending the product could violate the broker’s suitability obligations. The Notice also indicated that brokers should consider whether less complex products would achieve the same objectives.

FINRA cautioned that a firm should not recommend complex products to retail investors until the firm has implemented heightened supervisory and compliance procedures. The extent to which these procedures address concerns raised by the recommendation of complex products to retail investors should be closely monitored. Firms should also scrutinize the sale of complex investments to ensure that the products are only recommended to customers who understand the essential features of the products and for whom the products are suitable.

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