An Economist s View of Structured Products

Transcription

1 An Economist s View of Structured Products 1.0 CLE Credit March 28, 2013, 6:30PM-7:30PM Speakers: Bradley Berman, Morrison & Foerster Daniel Nathan, Morrison & Foerster Stewart Mayhew, Cornerstone Research Adel Turki, Cornerstone Research 1. Presentation 2. Structured Thoughts, Volume 3, Issue Structured Thoughts, Volume 3, Issue 8 4. Structured Thoughts, Volume 3, Issue 7 5. Structured Thoughts, Volume 3, Issue 1 MORRISON & FOERSTER LLP

2 NY v3 An Economist s View of Structured Products March 28, 2013 Presented By Bradley Berman Daniel Nathan Stewart Mayhew Adel Turki 2013 Morrison & Foerster LLP All Rights Reserved mofo.com

3 Introduction Morrison & Foerster LLP is one of the leading New York firms, and specializes in structured products. In the structured products area, we work with a number of leading financial institutions (in the United States, Canada, Europe and Asia) in connection with their new and ongoing offerings of structured products. Clients come to us for our experience with structured products offerings in multiple jurisdictions. Daniel Nathan is a partner in Morrison & Foerster s Securities Litigation, Enforcement and White Collar Defense practice, where he counsels financial institutions and others on examination and regulatory issues, and represents them before regulatory agencies. Before joining the firm, he was FINRA s Vice President and Director of Regional Enforcement, and previously held senior enforcement positions at the SEC and CFTC. Bradley Berman is of counsel in the Capital Markets Group of Morrison & Foerster LLP. Mr. Berman advises domestic and non-u.s. issuers on domestic and international securities offerings of structured products linked to equities, commodities and currencies. He also advises issuers on shelf registration statements, medium term note programs and exempt transactions. 1

4 Introduction (cont d) Cornerstone Research is a consulting firm that provides economic and financial analysis in all phases of commercial litigation and regulatory proceedings. Lassaad Adel Turki is Senior Vice President in Cornerstone's Washington DC Office, and heads Cornerstone's finance practice. He has more than twenty years of experience consulting on complex litigation and regulatory matters. Stewart Mayhew is a Principal in Cornerstone's Washington DC Office. Formerly, he was Deputy Chief Economist at the Securities and Exchange Commission, where he worked on a wide range issues related to rulemaking, trading and markets, compliance, and investment management, including the review process for new products. 2

5 Today s Presentation Overview of regulatory climate for structured products Trends in economic analysis of structured products Application of economic tools to structured products How economists can assist structured products issuers 3

6 The Regulatory Climate FINRA and the SEC are highly focused on structured products. Why? Wide retail distribution Complex security Recent FINRA guidance relating to structured products: FINRA Regulatory Notice 12-03, Heightened Supervision of Complex Products : o Firms must review and assess the adequacy of their controls with respect to complex products; o In this regard, firms must discharge their suitability obligations; o Firms must perform diligence on the features of complex products, including potential risks and rewards; o Firms must consider specialized training for representatives charged with selling complex products; o Firms must consider whether less complex and costly products might be a better fit for the customer; and o Firms internal controls should include periodic reassessments of structured products. 4

7 The Regulatory Climate (cont d) FINRA focus on suitability New Rule 2111 A broker s recommendation of a security must be consistent with the customer s best interests. A member must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the facts known by the member or disclosed by the customer in response to the member s reasonable efforts to obtain information concerning the customer s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the member considers to be reasonable in making recommendations. 5

8 The Regulatory Climate (cont d) There are three main suitability obligations under Rule 2111: Reasonable-basis obligation requires a member to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. Customer-specific obligation requires that a member have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer s investment profile. Quantitative suitability requires a member to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together in light of the customer s profile. 6

9 The Regulatory Climate (cont d) FINRA Annual Examination Priorities Letter for 2013: A focus on suitability and complex products; Suitability compliance concerns: o Must be a reasonable basis to believe that a recommendation is suitable for any customer; o Representatives must fully understand the products that they recommend; o Failures to fully explain the risk versus reward profile of the product; and o Disconnect between customer expectation and risk tolerance. Particular products: o Structured products; and o Leveraged ETFs and ETNs, particularly those linked to newly-created indices with no track record, and those linked to volatility, emerging markets and foreign currencies. 7

10 The Regulatory Climate (cont d) SEC sweep letter to issuers of structured products (April 2012) Focus -- increased disclosure about the issuer s estimated initial value of a structured product, including disclosure as to why that value is less than the initial public offering price of the structured product In other words, why is the investor paying one amount for the newly-issued structured product when its market value is somewhat less than the initial public offering price? Some issuers now include estimated initial value disclosure; Other issuers are working on their disclosure. Issue: Explaining, in plain English, the economic factors that go into valuing a structured product. Issuers don t all necessarily think alike on this; there is no one size fits all answer. 8

11 Suitability: Concerns Raised in Recent SEC and FINRA Cases Liquidity and holding periods. For example: o Closed-end funds they typically lose value after the initial offering; rarely profitable unless held to maturity. o Leveraged ETFs and ETNs these may not be suitable for investors with conservative objectives to hold for extended periods. Representative cases: Four FINRA AWCs from April Investor sophistication including the ability to follow the market in real time Investor wealth and income the ability to afford substantial losses. Disclosure Are the risks clearly explained? Supervision: Are the firm s systems adequate to look for concentration and suitability in sales of these types of instruments? Are the firm s registered representatives adequately trained in the features of these products? Do they understand the products such that they could sketch out their features on a single sheet of paper (the Ketchum test)? 9

12 How Leveraged ETFs Achieve Leverage Simplified Example: Double Long ETF on Stock Index Receive $100 cash from investors Use $50 to purchase the stocks in the index Use $50 as collateral for entering $150 notional of total return swaps on the index Can also use index futures Total exposure to index is $200 Leverage ratio (200/100) = 2 If the index return is 1%, your return is 2% 10

13 What s the Fuss? How Leveraged ETFs Achieve Leverage (cont d) The stated objective of a 2X long leveraged ETF is to match 2 times the return of the reference index, on a daily basis. Suppose the fund perfectly achieves this stated objective Return on NAV equals exactly 2 times the index return each day Assume the fund is able to achieve perfect tracking with zero error and zero expenses The return on the ETF for a period of two days or longer will almost certainly NOT equal two times the return of the reference index over the period. 11

14 How Leveraged ETFs Achieve Leverage (cont d) Illustrative Example: (using larger than life numbers) Initial Index level = 100 Each period, the index either increases by 25% or decreases by 20% If the index increases by 25%, the double long ETF increases by 50% If the index decreases by 20%, the double long ETF decreases by 40% 12

15 How Leveraged ETFs Achieve Leverage (cont d) After one period 125 Index return = 25% Stock Index Index return = 20% Double Long ETF ETF return = 50% 60 ETF return = 40% 13

16 After Two Periods... Stock Index 100 How Leveraged ETFs Achieve Leverage (cont d) Two-period return = 56.25% 2X Two period return = % Two-period return = 0% 2X Two period return = 0% Two-period return = -36% 2X Two period return = -72% Double Long ETF 225 ETF return = 125% ETF return = -10% ETF return = -64% 14

17 How Leveraged ETFs Achieve Leverage (cont d) Leveraged ETF Returns vs. (Inappropriate) Benchmark If the market is strongly up or down, the Leveraged ETF does better than two times the index If the market is flat, the Leveraged ETF does worse These effects are magnified if market volatility is high 15

18 Backtested Returns: In Some Market Conditions Leveraged ETF Tracks Long Term Target Leverage Ratio Reasonably Well Nasdaq 100 Index: July 2006 September 2007 $175 $150 $125 $100 2X Index Return ETF 2X Long $75 Jul-06 Aug-06 Oct-06 Nov-06 Dec-06 Feb-07 Apr-07 May-07 Jul-07 Aug-07 Sep-07 Source: Bloomberg Notes: The green line shows the value of a $100 investment in the Nasdaq 100 index with an initial 2-to-1 leverage ratio July 3, 2006, assuming no subsequent rebalancing. The blue line shows the value of a $100 investment in the Nasdaq 100 index, where the position is adjusted at the close of each trading day to maintain a constant 2-to-1 leverage ratio each day (the strategy followed by leveraged ETFs). 16

19 Backtested Returns: Example of Divergence Nasdaq 100 Index: September 2008 December 2009 $125 $100 $75 $50 $25 2X Index Return ETF 2X Long $0 Sep-08 Oct-08 Dec-08 Jan-09 Mar-09 May-09 Jun-09 Aug-09 Sep-09 Nov-09 Dec-09 Source: Bloomberg Notes: The green line shows the value of a $100 investment in the Nasdaq 100 index with an initial 2-to-1 leverage ratio on September 2, 2008, assuming no subsequent rebalancing. The blue line shows the value of a $100 investment in the Nasdaq 100 index, where the position is adjusted at the close of each trading day to maintain a constant 2-to-1 leverage ratio each day (the strategy followed by leveraged ETFs). 17

20 How Leveraged ETFs Achieve Leverage (cont d) Prospectus Disclosure ProShares Ultra S&P 500 Guggenheim 2X S&P 500 Direxion Daily S&P 500 Bull 18

21 What is the role of economic analysis in structured products? Designing the product; Testing the product; Drafting/reviewing disclosure; Monitoring actual performance; and Defending the issuer or dealer in enforcement proceedings or private actions. 19

22 Hands-On Economics Roles of the Economist: Evaluating a structure to determine if there is a unique payoff that cannot be achieved directly through other products; Estimating the cost of embedded fees; and Evaluating whether hypotheticals in the disclosure describe a full range of possible scenarios. Example: Responding to the SEC s sweep letter request to fully disclose the estimated initial value of a typical structured product. One of FINRA s concerns is that the embedded fees are so high that the product may be unsuitable for an investor with a quick turnaround in mind; i.e., with no desire to hold the note to maturity. How to craft the disclosure? 20

23 Use of Market Prices Valuing a Structured Product Is the structured product traded on an exchange? If so, is the aftermarket price informative about value? Example: Exchange Traded Structured Note Issued in 2002 McCann and Luo analysis claims the fair value was $880 per $1000 of face value suggesting an implicit fee of 12% But market prices the first week of trading indicated a value between $950 and $

24 Valuing a Structured Product (cont d) Example: Exchange Traded Structured Note Closing Prices: Aug. 30, 2002 Sept. 20, 2002 Price $1,100 $1,075 $1,050 $1,025 $1,000 $975 $950 $925 $900 $875 $850 Valuation reported by McCann and Luo $825 $800 8/30/02 9/3/02 9/7/02 9/11/02 9/15/02 9/20/02 Source: Bloomberg; McCann, Craig and Dengpan Luo, "Are Structured Products Suitable for Retail Investors?" White paper,

25 Valuing a Structured Product (cont d) Valuation Example (using approximate values) Structured Notes Linked to the S&P 500 Index Initial valuation date: 9/28/2011 (S&P 500: ~1150) Payoff linked to S&P 500 on 9/28/2017 Offering price = 1000 Terminal payoff: S&P 500 < ~1150: 1000 ~1150 < S&P 500 < ~2070: 1000 X Index Return ~2070 < S&P 500:

26 Valuing a Structured Product (cont d) Payoff Diagram Payoff ~1150 ~2070 S&P 500 Level 24

27 Valuing a Structured Product (cont d) Decomposition This Structured Note is economically equivalent to a portfolio consisting of: Zero coupon bond with face value 1000 Purchased ATM call option with strike price of ~1150 Written OTM call option with strike price of ~ 2070 Estimated value depends on what model is used to price these options It also depend on the inputs to these models (especially volatility) 25

28 Valuing a Structured Product (cont d) Valuation Can Be Sensitive to Choice of Models and Inputs In pricing the option components of the structured product, there are various possible models A common, simple choice is to use the Black-Scholes model (but there are other choices) The volatility of the underlying asset is an unobserved input choosing an appropriate value is not always straightforward Historical volatility Implied volatility 26

29 Valuing a Structured Product (cont d) Historical Volatility Historical volatility is typically estimated by computing the (annualized) standard deviation of daily returns on the underlying stock or index This is generally used if the underlying stock or index does not have exchange-traded options available There is no universally accepted standard for how much past data to use Different choices can lead to quite difference values Using two months of data to estimate volatility results in a volatility of 33.5% Using one year of data results in a volatility of 19.9% 27

30 Valuing a Structured Product (cont d) Implied Volatility Implied volatility is backed out from the prices of traded options If the structured product has two embedded options, should one use the same volatility to price both? Probably not it is well known that the implied volatilities for traded options vary depending on the strike price and time to expiration The Implied volatility for a long term At-the-Money S&P 500 option was 28.8% The implied volatility for an option with strike price at 180% of the current stock price was 22.5% 28

31 Valuing a Structured Product (cont d) Implied Volatility for S&P 500 Options Expiring in Dec Extrapolated from Exchange Traded Option Prices Sept. 28, ATM Volatility Implied Volatility (%) % OTM Volatility % 80% 100% 120% 140% 160% 180% 200% Moneyness (Strike / Index) Source: Bloomberg 29

32 Valuing a Structured Product (cont d) Valuation Black-Scholes model using reasonable assumptions gives a range of values Two implied volatilities: Note value = $ Single implied volatility: Note value = $ Historical (Two months): Note value = $ Historical (One year): Note value = $ Value reported in SLCG Report: $

33 Valuing a Structured Product (cont d) In summary If the structured product cannot be perfectly replicated using exchange traded bonds and options, there is no single methodology universally accepted as the best In our example, the implicit fee paid by investors ranged from 3.5% to 8.3% depending on assumptions. Regulators and plaintiffs may focus on certain assumptions that make the fee look high Economic analysis based on a reasonable range of assumptions can provide a more balanced view 31

34 Cost of Non-Compliance with FINRA Rules FINRA s 2012 Enforcement action results: 2012 was the fourth straight year of growth in the number of disciplinary actions; An increase of 15.6% in the number of suspended individuals, as compared to 2011; An increase of 15.6% in the amount of fines imposed; Suitability cases were the top enforcement issue for 2012; $19.4 million in fines assessed; the four ETF cases were a significant component; $22.5 million in restitution ordered in connection with suitability cases; Due diligence cases were the second highest number of assessed fines; due diligence cases included those involving complex products; Nine ETF cases in 2012; $7.6 million in fines assessed; the four ETF cases involved leveraged and inverse ETFs that FINRA alleged were unsuitable for conservative investors. 32

35 Volume 3, Issue 14 December 18, 2012 IN THIS ISSUE: Dividend Adjustments on the Way Dividend Adjustments on the Way page 1 Federal Court Decision Supports Use of Big-Boy Letters.page 2 FINRA Updates Its Suitability Questions and Answers....page 3 FINRA Rule 5123 Excludes Some, But Not All, Options.page 4 Commodity Pool Issues..page 5 Indices: GFMA s Framework of Principles page 5 Division of Investment Management Lifts ETF Ban, But Not for Leveraged ETFs..page 6 Here Comes page 6 MoFo Capital Markets Introduces Structured Products Resource Page..page 9 To help shareholders benefit in the event that Congress does not retain the lower rates for dividends in connection with the ongoing fiscal cliff negotiations, a variety of companies have increased their fourth quarter dividends in Some companies have accelerated the payment dates of their planned dividends to ensure that they are paid before the end of the year. Some have increased their planned dividend payments above prior quarterly levels. Other companies may pay a special dividend payment. In some cases, the fourth quarter increase will be offset by a decrease in the subsequent first quarter's dividend. In each case, these dividend payments may trigger the dividend adjustment provisions of structured notes linked to the relevant underlying stocks. Most stock-linked notes have provisions that adjust the price of the stock, and therefore, the return on the notes, when the linked stock pays a special or extraordinary dividend. After the applicable ex date, a special dividend may reduce the stock price, in order to account for the smaller amount of cash held by the company. Consequently, for typical stocklinked notes, which are bullish on the linked stock, a special dividend would usually reduce the note s return if protections are not built into the note terms. And of course, holders of structured notes usually don t benefit from the dividend on the linked stock. Dividend adjustment provisions protect the investors interests by, under certain circumstances, adjusting upwards the price of the linked stock for purposes of the notes, offsetting the negative impact of the special dividend. Various dividend adjustment provisions exist: A special dividend must exceed a certain size threshold to be triggered. A special dividend must be deemed material by the calculation agent in order to be triggered. 1 Attorney Advertising

36 Volume 3, Issue 14 December 18, 2012 Mainly in the case of single-stock linked notes purchased by institutional investors, a provision that is automatically triggered whenever the dividend exceeds, or is less than, a base dividend agreed to at the time of pricing. This type of provision can differ from the other two types. Instead of providing only investor protection, this type of provision can also work adversely to an investor when the linked stock reduces its dividend, because the provision will cause the stock price, for purposes of the notes, to decrease. As a result, depending upon the terms of a structured note, the planned dividend increases may cause an upward adjustment of the stock price. For a smaller set of notes, mainly notes for institutional investors described in the third bullet above, a potential Q1 dividend decrease after the Q4 increase may then decrease the stock price after the initial upward adjustment. Depending on the circumstances of the relevant company, stockholders may receive the same total amount of cash with or without the special dividend. They could simply receive it sooner and at a lower average income tax rate. In contrast, depending on the terms of a structured note, some notes may have increased returns due to the increased dividend, and then, may or may not have a decreased return due to the Q1 decreased dividend. In this regard, calculation agents for structured notes may wish to review the adjustment provisions for notes subject to a special dividend, and the extent to which they have discretion to require an adjustment, or to modulate the extent of the required adjustment. Federal Court Decision Supports Use of Big-Boy Letters Introduction Big-Boy Letters are often used as a tool to limit an issuer s or broker-dealer s potential liability in connection with a private sale of securities. In these letters, the investor represents that, as a big boy, it is a sophisticated party that can fend for itself. Often, these letters also contain an explicit waiver of all claims against the inside party arising from the nondisclosure of non-public information, including violations of Rule 10b-5 under the Securities Act of Big Boy Letters serve several useful purposes for both the inside and outside parties as they can: increase the execution speed of time-sensitive transactions; reduce the costs and risks of potential claims and liability from frustrated counterparties; and facilitate the contractual allocation of risks between sophisticated parties. These letters can be particularly useful in connection with private sales of sophisticated structured products to institutional investors. For example, the security may have particularly complex terms, and/or an affiliate of the issuer may possess material non-public information that relates to the security, such as business or financial information about the stock linked to the structured note. Are They Enforceable? The enforceability of Big-Boy Letters has been the subject of dispute. 1 This uncertainty stems from tension between the sanctity of a contract, on the one hand, and Section 29(a) of the Securities Exchange Act of 1934, which states that waivers of liability for securities fraud are void as a matter of public policy. However, a recent U.S. District Court decision has articulated a means to honor the contractual relationship created by Big-Boy Letters without characterizing their effect as a waiver of securities fraud liability and thus as void as a matter of public policy. 1 Compare Harsco v. Segui, 91 F.3d 337 (2d Cir. 1996) (indicating that waivers that are the result of sophisticated business entities negotiating at arm s length should be enforced), with AES Corp v. The Down Chemical Co., 325 F.3d 174 (3d Cir. 2003) (rejecting the Harsco court s view that sophisticated parties can contract out of duties imposed by federal securities laws). 2 Attorney Advertising

37 Volume 3, Issue 14 December 18, 2012 Pharos Capital In Pharos Capital Partners, L.P. v. Deloitte & Touche, LLP, plaintiff Pharos Capital Partners ( Pharos ) filed suit alleging fraud in connection with its $12 million equity investment in National Century Financial Enterprise, Inc. ( NCEF ) an investment that lost its full value when NCEF proceeded to file for bankruptcy. 2 Pharos claimed that defendant Credit Suisse Securities, LLC ( Credit Suisse ), acting as co-placement agent in connection with the offering, failed to disclose material information while also materially misrepresenting NCEF s business operations. Credit Suisse s defense rested primarily on the existence of a Big-Boy Letter, in which Pharos acknowledged that it was a sophisticated institutional investor who was relying exclusively on its own due diligence and would bear the risk of an entire loss of its investment. 3 Rather than treating the Big-Boy Letter as a waiver of liability, the court focused on its effect on a crucial element of successful fraud claims. In granting summary judgment in favor of defendant Credit Suisse, the court noted that common law claims for fraud and negligent misrepresentation require the aggrieved party to have justifiably relied upon the alleged misrepresentation or omission. The court then went on to cite the clear language of the Big-Boy Letter to hold that any reliance on the part of Pharos was unjustifiable and thus does not support a claim for fraud or negligent misrepresentation. 4 In other words, the existence of a well-crafted Big-Boy Letter does not waive liability for securities fraud; rather, it may eviscerate the underpinnings of such a claim. Pharos demonstrates the value to underwriters of furnishing Big-Boy Letters in connection with the offering of complex structured products. However, the existence of such a letter, on its own, may not be sufficient to shield underwriters from liability. Underwriters should also have reason to believe that the investor can in fact protect itself. Obtaining this level of comfort requires reasonable know-your-customer procedures, providing access to any relevant requested materials upon which the investor can rely, and negotiating the content of the Big-Boy Letter to evidence an arm s length transaction between two sophisticated parties. FINRA Updates Its Suitability Questions and Answers On December 10, 2012, FINRA issued Regulatory Notice 12-55, in which FINRA expanded on its earlier suitability guidance, in Regulatory Notice 12-25, of the terms customer and investment strategy, as used in FINRA Rule FINRA also provided a link to its new suitability Web page, containing questions and answers about FINRA Rule Regulatory Notice can be found at: The suitability web page can be found at: The updated guidance is relevant to sales practices in the structured products industry. 5 Definition of Customer as it Relates to Potential Investors FINRA clarified that the suitability rule applies to a potential investor who then becomes a customer, and the point at which suitability obligations attach. The rule applies where a registered representative makes a recommendation to purchase a security to a potential investor if that individual executes the transaction through the broker-dealer with which WL (S.D. Oh. Oct. 26, 2012). 3 Id. at *1. 4 Id. at *9. 5 We most recently described FINRA Rule 2111 and Regulatory Notice in Volume 3, Issue 8 of Structured Thoughts (available at 3 Attorney Advertising

38 Volume 3, Issue 14 December 18, 2012 the representative is associated or the broker-dealer will receive, directly or indirectly, compensation as a result of the recommended transaction. The suitability obligation would not apply, however, if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction. FINRA noted that, with respect to a recommendation made to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on circumstances that existed at the time that the recommendation was made. When a broker-dealer or registered representative makes a recommendation to a customer (as opposed to a potential investor), suitability obligations attach at the time that the recommendation is made, irrespective of whether a transaction occurs. Investment Strategies FINRA expanded on its examples of what would or would not be considered an investment strategy. Recommended investment strategies must be suitable. Recommendations of some specific types of securities, such as high dividend companies or types of securities in a particular market sector would constitute an investment strategy, regardless of whether the recommendation identified particular securities. The notice does not indicate whether recommending structured notes generally is sufficiently specific to constitute an investment strategy. 6 Recommendations that do not refer to a security or securities do not fall under the suitability rule. For example, the rule would not apply to a registered representative s recommendation of a non-security investment as part of a customer s outside business activity, where that customer separately decides on its own to liquidate securities positions and apply the proceeds toward the recommended non-security investment. In contrast, if a customer, absent a recommendation by a registered representative, decides on its own to purchase a non-security investment and then asks the registered representative to recommend which securities the customer should sell to fund the purchase of the non-security investment, the suitability rule would apply to the recommendation regarding which securities to sell, but not to the customer s decision to purchase the non-security investment. The notice raises the question about a broker-dealer s supervisory responsibilities for a registered representative s recommendation of an investment strategy involving a security and a non-security investment. While stating that its supervisory rules do not provide an exact method, the notice indicated that a broker-dealer could use a risk-based approach. A firm could focus on the detection, investigation and follow-up of red flags indicating that a recommendation may have been made for an unsuitable investment strategy with both a security and a non-security component. The suitability obligations would apply to the security component of the recommended investment strategy, but the suitability analysis must also be informed by a general understanding of the non-security component of the recommended investment strategy. These concerns would apply to an investment strategy that involves structured certificates of deposits, even though they are typically not securities, and other structured products. FINRA reminded broker-dealers of their other regulatory obligations to investigate unusual activity. FINRA Rule 5123 Excludes Some, But Not All, Options Option issuers may be surprised to learn that sales of some over-the-counter options are within the filing requirements of FINRA Rule 5123 (Private Placements of Securities). Rule 5123 requires members selling securities issued by nonmembers in a private placement to file the private placement memorandum, term sheet or other offering documents with FINRA within 15 days of the first sale of the securities, or indicate that there were no offering documents used. 7 6 As a practical matter, a general recommendation of structured notes would most likely be followed by the investor asking which ones? The suitability determination would apply to the registered representative s response. 7 FINRA Rule 5123 is available on FINRA s website at We have issued two News Bulletins on Rule SEC Adopts New FINRA Rule 5123 on Private Placements can be found at and FINRA Issues Guidance for Private Placement Filings can be found at 4 Attorney Advertising

39 Volume 3, Issue 14 December 18, 2012 A sale of an OTC equity option to an individual accredited investor would require the member to make the filing required by the rule. Rule 5123(b)(1) exempts private placements to certain classes of investors, including accredited investors described in Rule 501(a)(1), (2), (3) or (7) under the Securities Act of 1933 (institutional accredited investors) and eligible contract participants, as defined in Section 3(a)(65) of the Securities Exchange Act of The rule also exempts private placements of standardized options, as defined in Rule 238 under the Securities Act. Standardized options must be traded on a national securities exchange or on a national securities association registered pursuant to Section 15A(a) of the Securities Exchange Act. Consequently, a private placement of OTC options to an individual accredited investor, or to any other investor not within the classes of exempted investors enumerated in Rule 5123(b)(1), would require a member to file the private offering documents. This seems to be an incongruous result since options trading can only be undertaken with customers that have been cleared for options trading and who receive options disclosures. 8 Commodity Pool Issues As many are aware, the Dodd-Frank Act amended the definition of commodity pool, making it broader by including any enterprise operated for the purpose of trading in swaps. Trading in swaps may seem like a high bar, but there is little guidance as to the type of entity that constitutes a commodity pool. Some of that guidance suggests that entering into a single swap may be sufficient to trigger the registration requirement. The CFTC has issued various interpretative letters clarifying that certain entities (such as business development companies, family offices, equity REITs, etc.) that might inadvertently be included within the commodity pool definition should not be considered commodity pools to the extent that these entities satisfy the specified CFTC conditions for relief. Institutions that use repackaging vehicles or that use trust vehicles to issue structured products should consider whether any of these vehicles may be considered a commodity pool. In CFTC Letter No issued on December 7, 2012, the CFTC provides further relief for certain legacy and other securitization vehicles. 9 However, the CFTC also notes in that letter that certain vehicles may be deemed commodity pools, including, for example a repackaging vehicle that issues credit-linked or equity-linked notes where the repackaging vehicle owns high quality financial assets, but sells credit protection on a broad based index or obtains exposure to a broad based stock index through a swap. The vehicle finances its acquisition of the high quality assets by issuing notes to investors that are linked to credit risks or price changes in the stock index. The CFTC notes that this type of vehicle may be a commodity pool. Further, the CFTC also points to another example: a repackaging vehicle that acquired a three year bond, issued a tranche of notes, and used swaps to extend the investment experience of the bond (and thus the tranche of notes) to four years may be deemed to be a commodity pool, as would a repackaging vehicle that paired the three year bond with a swap to provide inflation rate protection. In light of this commentary and the over broad definition of commodity pool, any structured product that relies on the use of a trust or other collective investment vehicle should be analyzed closely. Indices: GFMA s Framework of Principles Following on from the publication of its proposals in September 2012, the Global Financial Markets Association ( GFMA ) has now released its final framework of principles in respect of conducting benchmark price assessment. The principles focus on enhancing market integrity and transparency through sponsors (i.e., entities or groups which develop and direct the determination, publication and licensing of a benchmark) meeting three primary obligations when designing, operating and publishing benchmarks: 1) governance ensuring that there is a single point of accountability and that roles and responsibilities are clearly defined; 8 FINRA Rule 0180, which precludes the application of Rule 5123 and other FINRA rules to security-based swaps, does not apply to a private placement of an OTC equity option, as such an option does not fall within the definition of a Security-Based Swap, as defined in Section 3(a)(68) of the Securities Exchange Act and the rules and guidance of the SEC or its staff. 9 The letter may be found at the following link: 5 Attorney Advertising

40 Volume 3, Issue 14 December 18, ) design and methodology ensuring that, amongst other things, the benchmark has a robust design which provides an accurate measure of the market and incorporates (where possible) real transaction data; and 3) control infrastructure ensuring that a resilient infrastructure is in place by requiring periodic review and the maintenance of mechanisms which provide continuity of the benchmark under duress. The GFMA principles are only a first step towards improving market confidence in benchmarks. Next steps include ensuring the broadest possible agreement from all stakeholders through promoting awareness and understanding of the principles in meetings and calls and attempting to encourage stakeholders to hold each other accountable by refusing to do business with each other in the event of breaches of the principles. Further discussion and consultation with regulators, government entities and industry bodies is required in order to review the principles and generate feedback. It is hoped that the principles will be incorporated by regulators and governments as they take further strides to co-ordinate an international approach. Such efforts to date include: 1) consultation on the functioning and oversight of oil price reporting agencies by IOSCO in March 2012; 2) review of the framework for setting and governing LIBOR by the designated new chief executive of the Financial Conduct Authority, Martin Wheatley (August 2012); 3) European Commission consultation seeking views on possible new regulations governing the creation and use of indices which serve as benchmarks (September 2012); 4) IOSCO are also currently looking at benchmarks generally and it is expected that a consultation will be released in January 2013; and 5) ESMA are preparing some interim principles for issuance at the EU level in respect of benchmarks generally. Again, these are expected to be published in early The Division of Investment Management Lifts ETF Ban, But Not for Leveraged ETFs In remarks made on December 6, 2012 to the ALI CLE 2012 Conference on Investment Adviser Regulation. 10 Norm Champ, the Director of the Division of Investment Management, said that the Division will partially lift the two-year old moratorium on considering exemptive requests under the Investment Company Act of 1940 relating to actively-managed exchange-traded funds that make use of derivative products, subject to certain representations to be made in any future exemptive request. However, due to the Division s concerns about leveraged ETFs, Director Champ said that the Division will continue not to support new exemptive relief for such ETFs. Please see the full discussion of Director Champ s remarks in the December 2012 Morrison & Foerster Investment Management Legal + Regulatory Update, which can be found at Investment-Management-Update.pdf. Here Comes 2013 This is our last issue of Structured Thoughts for We wish our readers happy and healthy holidays, and a wonderful new year. The business and regulatory environment for structured products continues to evolve, sometimes in ways that surprise all of us. In this final article, we identify a few items to look out for in Director Champ s remarks can be found at 6 Attorney Advertising

41 Volume 3, Issue 14 December 18, 2012 Estimated Value. Market participants will probably remember 2012 most for the SEC s April 2012 sweep letter, and its focus on the disclosure of estimated values of structured notes. As of the end of 2012, most market participants have not revised their structured note offering documents, as they continue their discussions with the SEC staff, await additional guidance from the SEC, and/or complete their internal valuation procedures. If the SEC does in fact provide any additional guidance, and as issuers have the opportunity to consider best practices in connection with the new disclosures, we may see further evolution in these disclosures. New FINRA Communications Rules. On February 4, 2013, FINRA s new communication rules, 2210 and 2211, will become effective. Market participants will be furnishing a greater number of free writing prospectuses and similar documents relating to structured products to FINRA, and obtaining principal review for a variety of offering documents. Based on the new submissions, it is possible that the FINRA staff will reach out to specific broker-dealers, or to the market generally, as to any disclosure practices that it deems insufficient. Amendments to Regulation M. The SEC has not yet issued final rules with respect to its proposal to remove the references to investment grade securities from Regulation M. 11 Any revisions to Regulation M may impact the manner in which structured notes are offered, and the manner in which broker-dealers create a secondary market for them. Conflicts of interest. The SEC issued proposed rules to implement the Dodd-Frank Act Section 621 prohibition on material conflicts of interest relating to certain securitizations some time ago, and has not finalized these rules. The conflicts of interest proposals may affect certain structured products that are issued in reliance on a special purpose vehicle or trust. The conflicts of interest rules are expected to be finalized toward the end of the first quarter of 2013, in conjunction with final action on the Volcker Rule. Volcker Rule. The Volcker Rule also may have an effect on the structured products market, especially on the type of secondary market activity that will be permissible for underwriters of structured products. Based on recent statements by regulators, we anticipate that the Volcker Rule will be finalized by March FINRA and Conflicts of Interest. In July 2012, FINRA commenced a street sweep, soliciting information as to how participants in the structured products market identified and managed conflicts of interest. 12 Once FINRA has evaluated and digested the information obtained by the sweep, it may take additional actions, including the identification of best practices for industry participants, or sanctioning broker-dealers that have not made proper disclosures or maintained proper procedures. Role of Third Party Distributors. Both the SEC and FINRA have taken an interest in the role that third-party dealers (i.e., distributors other than the lead underwriter, such as selling group members) play in the distribution of structured products. At times, questions have arisen as to how these distributors are selected and screened by the lead underwriter, and whether these distributors have adequate sophistication and training to offer structured products for their customers. The know your dealer regime remains largely unregulated in the U.S., with different market participants following different procedures, and making different decisions as to which entities they will permit to participate in their offerings may see additional scrutiny, and perhaps additional guidance, as to the role that these distributors play. Reverse Inquiry Transactions. Both the SEC and FINRA have raised questions to market participants relating to reverse inquiry transactions. This process in part reflects the process by which these regulators are becoming more educated as to the role of reverse inquiry transactions from registered investment advisors and other sophisticated investors in the offering process. Questions have arisen as to whether the existing disclosure and pricing practices, including the new estimated value disclosures, remain as relevant for these types of investors, and whether differences in the offering process and offering documents are appropriate in these cases. Proprietary Indices and Related Guidance. Broker-dealers continue to seek to enhance their range of offerings, and to provide useful investment tools for investors, by developing a range of proprietary indices. Of course, due to potential uncertainties under existing legislation, including the Investment Company Act and the Investment Advisers Act, many 11 We discussed the proposals in Volume 2, Issue 10 of Structured Thoughts: Structured-Thoughts.pdf. 12 We discussed the street sweep in our August 2012 client alert: 7 Attorney Advertising

42 Volume 3, Issue 14 December 18, 2012 issuers and underwriters have taken a cautious approach to some proposed products. Whether in 2013, or at some later point, market participants will hope to obtain more clarity as to the rules of the road, and the extent to which their affiliated broker s investment recommendations and/or discretion can play a role in developing these indices. Efforts by industry organizations, such as the Global Financial Markets Association, 13 to identify standards relating to new market measures may also gain traction as best practices in the market. European Regulatory Developments PRIPs Initiative Developments. Regulatory initiatives with respect to Packaged Retail Investment Products (or PRIPs) gained momentum this year, with the publication of draft regulations in July 2012 and first EU presidency compromise proposal on November 27, The regulations require that in circumstances where an investment product is sold to retail investors, a Key Investor Document (KID) must be prepared by the product manufacturer. It is expected that further consideration will be given by the European Parliament and the Counsel of the EU to the legislative proposals during 2013, with a vote by the European Parliament s Economic and Monetary Affairs Committee scheduled for March 20, It is not expected, however, that the regulations will apply until mid EMIR Reporting Requirements. Transaction reporting requirements in respect of derivatives transactions in the European Union will be phased in from 2013 onwards. Where there is a registered trade repository available, transaction reporting of credit and interest rate contracts will be required from July 1, This is the earliest possible date from which transaction reporting under the European Market Infrastructure Regulation (EMIR) shall be required. If there is no registered trade repository available on or before April 1, 2013, reporting must take place within 90 days after registration of such trade repository. If there is no registered trade repository available on or before July 1, 2015, reporting commences on July 1, 2015, directly to the European Securities and Markets Authority (ESMA). Transaction reporting in respect of all other types of derivatives contracts shall not be required until 2014 at the earliest. UCITS V. In July 2012, the European Commission published a legislative proposal focusing on amendments with respect to the duties of depositories (safe-keeping, oversight and delegation), the remuneration of UCITS managers and the ways in which the relevant rules could be better harmonized. It is expected that the proposal will be further considered by the European Parliament during 2013, although it is also widely believed that member states will be given around 2 years to transpose the amendments to the existing directive into their national laws. Accordingly, it is unlikely that any changes will come into effect until the end of 2014 at the earliest. MiFID II. Legislative proposals intended to replace and recast the Markets in Financial Instruments Directive are slated to be considered by the European Parliament in its plenary session on October 24 / 25, Such scheduling comes a full year after the proposals were originally intended to be considered. Financial Conduct Authority (UK only). On April 1, 2013, the Financial Services Authority (FSA) will finally be replaced as the UK s single financial services regulator. The Financial Conduct Authority (FCA) will assume its new role as regulator of wholesale, retail and financial markets, the infrastructure which supports those markets and as prudential regulator of firms which do not fall under the scope of the new Prudential Regulation Authority (PRA). These changes are likely to result in new powers of the FCA to utilize temporary product intervention rules. A consultation on these issues is currently underway and it is intended that a final statement of policy will be published in advance of the legal cutover to the FCA in April Retail Distribution Review (UK only). Efforts have been made in the UK to ensure that there is greater clarity with respect to advice provided by investment advisers. Measures which come into force in 2013 include: (1) a requirement that firms state whether they offer independent advice (i.e., personal, unbiased recommendations based on a comprehensive and fair analysis of the relevant market) or restricted advice (i.e., where an advisor is tied to specific products), (2) stricter requirements regarding minimum qualification levels for advisers and in respect of their continuing professional development (CPD); and (3) a ban on traditional forms of commission (paid by product providers to investment advisers) in respect of advised sales relating to investment products. Instead, consumers will pay an agreed investment adviser charge, either in the form of a fee or as part of the product. We look forward to continuing the conversation in The GFMA s proposed principles may be found at: 8 Attorney Advertising