United States: Regulation Best Interest: Can Structured Products Conflicts Be Resolved?

Of the three new obligations included in proposed Regulation Best Interest (the "Regulation"), perhaps the most challenging for brokers and dealers of structured products will be the conflict of interest obligation.1 With respect to that obligation, the Regulation states that a broker or dealer's best interest obligation will be satisfied if the broker or dealer establishes, maintains and enforces written policies and procedures reasonably designed to:

  • identify and at a minimum disclose, or eliminate, all material conflicts of interest associated with making recommendations of any securities transaction or investment strategy involving securities to a retail customer; and
  • identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

(Emphasis added.)

Material conflicts of interest arising from financial incentives are treated differently under the Regulation, as those conflicts must be mitigated or eliminated, whereas other material conflicts of interest may be resolved with disclosure only.

A "material conflict of interest" is defined as a "conflict of interest that a reasonable person would expect might incline a broker-dealer – consciously or unconsciously – to make a recommendation that is not disinterested."2 "Financial incentives" associated with a recommendation include, but are not limited to:

  • compensation practices established by the broker-dealer, including fees and other charges for the services provided and products sold;
  • employee compensation or employment initiatives;
  • compensation practices involving third parties, including both sales compensation and compensation that does not result from sales activity, such as compensation for services provided to third parties;
  • receipt of commissions or sales charges, or other fees or financial incentives, or differential or variable compensation, whether paid by the retail customer or a third party;
  • sales of proprietary products or services, or products of affiliates; and
  • transactions that would be effected by the broker-dealer (or an affiliate thereof) in a principal capacity.3

Some of these financial incentives are less prevalent in recommendations of an equity security or a fixed-rate debt security. Structured notes, however, are complex securities, and distributions of structured products may often involve certain of these financial incentives.

For example, let's imagine a structured note issued by BankHoldCo, as issuer ("BHC"). The structured note's payoff is linked to a proprietary index created by BHC's affiliated broker-dealer, BankHoldCo Junior ("BHCJ"). BHC pays a licensing fee to BHCJ for BHC's use of the proprietary index as a reference asset for the note. The determination of whether a market disruption event exists and whether other payoff events are triggered (such as whether a contingent coupon will be paid if an autocall occurs or if a barrier is breached on the final valuation date) will be made by the calculation agent, which happens to be an affiliate of BHC. BHCJ recommends this structured note to certain financially sophisticated retail investors. All of these features are fully disclosed in the offering document for the structured note, including associated risk factors. BHCJ's associated persons receive slightly higher compensation for selling the BHC structured note, as opposed to selling an equivalent security (or securities) of another issuer.4

Regulators have focused on the types of conflicts of interest that arise in selling structured products. In its Report on Conflicts of Interest (Oct. 2013) (the "FINRA Report"), the Financial Industry Regulatory Authority, Inc. ("FINRA") identified a number of potential "embedded" conflicts of interest that may exist in the context of offerings of structured products. These embedded conflicts usually exist when issuers or their affiliates play multiple roles in determining a structured product's economic outcome and also may make critical and potentially subjective decisions that affect the value of the structured product.5 These decisions are usually made by the calculation agent or index calculation agent, each of which may be an affiliate of the issuer (and possibly the member firm):

  • an index calculation agent's discretion in determining an index closing level;
  • an index calculation agent's discretion to adjust an index methodology;
  • a calculation agent's various valuation functions;
  • a calculation agent's ability to cause the issuer to call the note if there is a hedging disruption event (an event that makes it difficult for the issuer or its affiliates to initiate, unwind or maintain hedges relating to the structured product);
  • the use of a proprietary index, particularly one created and maintained by the issuer or its affiliates;
  • the fees associated with proprietary indices, which may be difficult to assess; and
  • a call provision in an exchange traded note whereby the issuer has the ability to call the note when it is significantly undervalued.6

The FINRA Report also highlighted potential conflicts of interest that may arise when a member firm distributes proprietary products for which that firm receives revenue sharing payments. The FINRA Report noted that proprietary products may involve significant financial incentives for firms to favor these products over others.7 An additional conflict may arise if, in response to a reverse inquiry, a member firm solicits and/or works with only one issuer in creating the structured product, as opposed to bidding the request out among multiple issuers. If the former, there is an incentive for the member firm, as a "co-manufacturer," to build in or incorporate high selling concessions or potentially higher returns at the cost of a riskier product structure.8

Returning to our note, how would a broker-dealer's policies and procedures address the conflict of interest obligation's requirements to identify and at a minimum disclose, or eliminate, all material conflicts of interest, and disclose and mitigate, or eliminate, conflicts of interest arising from financial incentives, in each case associated with making recommendations of any securities transaction or investment strategy involving the note to a retail customer?

The note checks the box on financial incentives, such as sales of products and services of affiliates and the receipt of differential compensation, in addition to raising many of the embedded conflicts of interest identified in the FINRA Report.

Disclosure alone is not the answer if there are material conflicts of interest arising from financial incentives. No matter how clearly the conflicts of interest could be disclosed to a retail customer, the Regulation requires that material conflicts of interest arising from financial incentives must be mitigated (or eliminated). In this case, according to the Securities and Exchange Commission (the "Commission"), retail investors need the enhanced protections not provided by disclosure alone.9 This is interesting given that this is a higher standard than the standard currently imposed on registered investment advisers by statute.

There may be material conflicts of interest other than those arising from financial incentives that may have to be eliminated, in addition to being disclosed. The Regulation would require that a member firm's policies and procedures be reasonably designed to "at a minimum disclose, or eliminate," all material conflicts. In a situation where the member firm determines that disclosure does not reasonably address the conflict, or the disclosure cannot be made in a clear manner or is not helpful to the retail customer's understanding of the conflict or the customer's capacity for informed decision making, the member firm would have to establish policies and procedures reasonably designed to either eliminate or both disclose and mitigate the conflict.

This issue could also arise if it becomes difficult for the member firm to determine that it is not putting its own interests ahead of the retail customer's.10

How does a member firm mitigate conflicts of interest arising from financial incentives? The Commission asserts that the Regulation does not mandate the absolute elimination of any particular conflicts, absent another requirement to do so, noting that it is not the Commission's intent to cause a broker-dealer not to receive compensation for its services. However, in the next sentence, the Commission gave three examples of how to eliminate a material conflict of interest:

  • removing incentives associated with a particular product or practice;
  • not offering products with special incentives; or
  • negating the effect of the conflict by crediting, for example, mutual fund advisory fees against other broker-dealer charges.11

The Release does acknowledge the difficulty of eliminating conflicts of interest, or mitigating conflicts arising from financial incentives, in certain situations. Differential compensation, used as an example by the Commission, "may appropriately recognize the time and expertise necessary to understand an investment, and in doing so promote investor choice and access to a range of products ...."12 Accordingly, the Release states that elimination of that conflict may not be appropriate or desirable.

The Regulation does not require a fixed approach or specific mitigation measures; rather, it uses a principles-based approach, providing broker-dealers with the flexibility to develop reasonably designed policies and procedures that include conflict mitigation measures, based on each firm's circumstances.13 Conflict mitigation measures may vary based on factors relating to the broker-dealer's business model, including the firm's size, retail customer base, the nature and significance of the compensation conflict and the complexity of the product. Heightened mitigation measures, including enhanced supervision, may be appropriate for less sophisticated retail customers in instances in which the compensation is less transparent (e.g., fees received from third parties), or depending on the complexity of the product.14 The Release also states that "more or less demanding mitigation measures" may be included in reasonably designed policies and procedures depending on a member firm's assessment of these factors as a whole.15

Here, the Release points to the Regulation's "Care Obligation," which keys off of the existing FINRA suitability requirements expressed in FINRA Rule 2111. In discharging FINRA's suitability requirements, a member firm would necessarily have to satisfy itself that the retail customer had sufficient knowledge to understand the recommendation. The Release also cites FINRA's recommendation to member firms that they employ certain heightened procedures in connection with making recommendations of complex products, including making those recommendations contingent upon specific limitations or conditions, and prohibiting sales to certain retail investors, citing FINRA Regulatory Notice 12-03, Heightened Supervision of Complex Products (Jan. 2012).16

At this point in the Release, the Commission seems to refer to existing FINRA rules and guidance as a starting point for reasonably designed policies and procedures that could, depending on the broker-dealer's business model, be sufficient to mitigate a material conflict of interest arising from financial incentives for sales to at least some retail investors. It would seem that a broker-dealer that has expertise in selling complex products similar to the proprietary note could satisfy the mitigation requirement of the conflicts of interest obligation in recommending that product to at least some financially sophisticated retail investors. The broker-dealer would have to satisfy its suitability requirements under FINRA Rule 2111, have in place and enforce the necessary policies and procedures and use supervised sales personnel sufficiently trained to understand and clearly explain the note. Given the Regulation's focus on this area, it is a good idea for the broker-dealer to document its efforts at mitigation when recommending complex products. This may include having financially sophisticated customers sign representation letters acknowledging that they are fully aware of any financial incentives relating to the complex product.

How would a broker-dealer resolve the material conflict of interest arising from an increased sales fee paid to personnel who recommend particular structured products, such as those of an affiliated issuer? This goes to the heart of the vague definition of "material conflict of interest." A reasonable person would expect that an increased sales fee would influence a broker-dealer to make a recommendation that is not disinterested.

As mentioned above, differential compensation may be appropriate. For complex products, time and effort is spent structuring the products and creating the appropriate hedge, among other tasks, and the Commission recognizes that it is not unreasonable for the broker-dealer to be compensated for those efforts. It would be a reasonable approach to mitigation if a broker-dealer offered a customer a choice between an equivalent structured product of a non-affiliated issuer, without an increased sales fee, and a note similar to that which we have described with a fully disclosed increased sales fee. If an informed, sophisticated retail investor chose the proprietary note instead of the competitor's equivalent note in that situation, the broker-dealer should document that.

The same broker-dealer may also determine that, at least for less sophisticated retail investors, the material conflicts of interest arising from the financial incentives in the proprietary note could not be mitigated and, accordingly, the proprietary note should not be recommended to those investors.17 This decision may be made despite good disclosure, strong policies and procedures and an educated sales force.

The Commission enumerated a non-inclusive list of potential practices that, if incorporated into written policies and procedures, may reasonably mitigate conflicts of interest arising from financial incentives, including the following:

  • minimizing compensation incentives for employees to favor one type of product over another, such as a proprietary or preferred provider product (firms should consider establishing differential compensation based on neutral factors, such as time and complexity of work involved);
  • implementing supervisory procedures to monitor recommendations that involve higher compensating products or proprietary products; and
  • limiting the types of retail customers to whom a product, transaction or strategy may be recommended (e.g., certain products that give rise to conflicts of interest associated with complex compensation structures).

The Commission noted that whether a recommended securities transaction or investment strategy complies with the Regulation will turn on the facts and circumstances of the particular recommendation and the particular retail customer and whether the broker-dealer has complied with the Regulation's Disclosure and Care Obligations.18

CONCLUSION

If adopted, the Regulation will enhance scrutiny of a broker-dealer's recommendation of complex products, such as structured notes, that may involve material conflicts of interest arising from financial incentives. In any event, broker-dealers should review their policies and procedures to ensure that, to the extent possible, they are disclosing or eliminating material conflicts of interest and also disclosing and mitigating, or eliminating, material conflicts of interest arising from financial incentives. Broker-dealers that onsell complex products downstream should review their know-your-dealer policies to ensure that the downstream dealers

have in place the necessary policies and procedures. Maintaining documentation of a broker-dealer's analysis of how and why a material conflict of interest was disclosed, mitigated or eliminated will be helpful in protecting against regulatory scrutiny in the future.

Footnotes

1 This article discusses only the conflict of interest obligations of a broker or dealer. It does not address the disclosure a proposed by the Regulation.

2 Exchange Act Release No. 34-83062 (Apr. 18, 2018) (the "Release") at II.D.3.a (page 169). The Release is available at: goo.gl/GcYM6k.

3 Id.

4 See Release at n.303, p. 177: "Conflicts of interest may arise from compensation other than sales compensation" using an example of a mutual fund for which the member firm provides various administrative services. The compensation received by the member firm for these services is an incentive to not offer a fund or other products for which it does not receive compensation.

5 The FINRA Report on Conflicts of Interest (Oct. 2013) can be found at: goo.gl/76Fpdx.

6 See FINRA Report at 21-23.

7 Id. at 24.

8 Id. at 25.

9 See Release at p. 168.

10 See id. at p. 175-176.

11 See id. at p. 175.

12 Id. at p. 177-178.

13 See id. at p. 179.

14 See id. at p. 179-180.

15 Id at p. 179.

16 See id. at n.313, p. 180. FINRA Regulatory Notice 12-03 is available at: goo.gl/Gd2sLC.

17 See the Release at p. 181.

18 See id. at pp. 181-183 and n.317.


Originally published in REVERSEinquiries: Volume 1, Issue 5.
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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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