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FINRA Warns BDs of Reg BI Obligations on Complex Products

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What You Need to Know

  • FINRA wants feedback by May 9.
  • BDs are asked to weigh in on effective practices they’ve developed for complex products and options.
  • FINRA also wants to know if the current regulatory structure is working.

The Financial Industry Regulatory Authority is reminding broker-dealers of their obligations under Regulation Best Interest as they relate to complex products.

In a just-released Regulatory Notice, FINRA also seeks feedback from broker-dealers on how they’re handling complex products as the regulator weighs changes to its rules.

Robert Cook, FINRA’s CEO, said last October that FINRA was mulling an update to its rules around complex products.

The broker-dealer self-regulator is “looking closely at the offering of complex products by our member firms,” Cook said during an event held by the New York Law School.

FINRA said in its notice that the availability of complex products and options “can potentially expand the investment opportunities for retail investors and, if properly understood, offer favorable investment outcomes (e.g., enhancing returns, limiting losses or improving diversification).”

However, “important regulatory concerns arise when investors trade complex products without understanding their unique characteristics and risks,” FINRA said.

Reg BI Obligations, Potential Violations

FINRA explains in that notice that when adopting Reg BI, the SEC “emphasized the importance of understanding the terms, features and risks of complex products, such as inverse and leveraged ETPs, in order to establish a reasonable basis to recommend these products to retail customers.”

The reasonable basis portion of Reg BI’s Care Obligation, FINRA states, “requires the broker-dealer or associated person to use reasonable diligence, care, and skill to understand the nature of the recommended security or investment strategy involving a security, as well as the potential risks, rewards and costs of the recommended security or investment strategy.”

The rule also requires “a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers based on that understanding,” FINRA said.

Similar to FINRA’s suitability rule, ”a broker-dealer could violate the reasonable basis portion of Reg BI’s Care Obligation by not fully understanding the recommended security or investment strategy, even if the security or investment strategy could have been in the best interest of at least some retail customers,” the notice states.

Reg BI and the fiduciary obligation of investment advisors as described in the 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers “suggest that firms apply heightened scrutiny when assessing whether recommendations of potentially high-risk products are in a retail customer’s best interest,” FINRA said.

Complex Product Definition

FINRA notes that there’s currently no standard definition of a “complex product,” as new products and strategies “are constantly introduced.”

However, FINRA has described a complex product one “with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks (including the payout structure and how the product may perform in different market and economic conditions).”

For instance, complex products include leveraged or inverse exchange-traded products; structured products with embedded optionality; interval funds; and nontraded REITs.

FINRA asks BDs to weigh in by May 9 on the effective practices they’ve developed for complex products and options, particularly when retail investors are involved, and whether the current regulatory framework is appropriately tailored to address current concerns raised by complex products and options.

Securities and Exchange Commission Chairman Gary Gensler launched in October a review of the potential risks of complex financial products that are listed and traded on exchanges.

“I also asked [SEC staff] to present recommendations for the Commission’s consideration on potential rulemaking proposals to address those risks, as part of a broader look at exchange-traded products,” Gensler said then.


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