SRP Americas 2024: 'complex products' definition still pending

Both lawyers noted that SEC's recent statements emphasised the importance of dealers' and RIA's understanding of complex products although some of the enforcement actions related to structured products included cases involving back-testing and material non-public information.

Social media and digital engagement practices (DEPs) were also discussed with a focus on fairness, supervision, and record-keeping in the context of the SEC's Alternative Trading System (ATS) proposed changes which could impact platforms using communication protocols.

"The regulatory guidance and enforcement actions around complex products indicate an ongoing concern about retail investor understanding and protection, leading to the potential for future rulemaking, particularly if there is a change in the political landscape," said Breman (below).

In 2022, the US Finra introduced Regulatory Notice 22-08, one of the most comprehensive notices on structured products since 2012 when Regulatory Notice 12-03 was introduced.

"That [12-03 notice] was a really big one," said Breman. "They talked about complex products, but they never defined them. We know they're talking about structured products, but they wanted to kind of keep it wide open."

The update in 2022 came with a statement on sales of complex structured products as well as a focus on options – it reminded members of their obligations with respect to complex products and options.

This update coincided with a big increase in the number of accounts trading in complex products and options with the regulator noting that 'investors may be trading in such products without understanding the unique characteristics'.

"Structured products are very much on their radar," Bradley Berman.

"The notice also raised concerns that retail investors accessing complex products through self-directed platforms, without the assistance of a financial professional," said Breman.

"That doesn't happen. Retail Investors can't go on Simon or Halo and buy structured products. There's really no way for a retail investor to buy a structured product without using a broker dealer or RIA."

However, Finra raised that question and said that they were going to cooperate with the response to the notice, with the SEC but the issue about the complex products definition remains unresolved.

"There's no universally accepted definition," Berman. "In Finra speak it is a product with features that may make it difficult for retail investor to understand the essential characteristics of the product, its risks and pay out structure. They want to keep it flexible, possibly because products are changing all the time."

According to Berman, over the years both regulators have put out a number of publications and warnings, and although they don't want to be trapped within a particular definition, "they've identified some products considered complex including steepeners, geared and volatility linked ETNs as well as ETF with structured payoffs and daily reset".

"Those are notes they're registered, which unfortunately sometimes find their way into retirement accounts often with bad results," he said. "The good news is that the proposed rulemaking on complex products mentioned two years ago seems to have faded and there is nothing on the horizon."

Reg BI

On the SEC side, there has also been a few developments since 2019 including the introduction of Reg Best Interest (Reg BI) which emphasises the importance of dealers and RIAs understanding of terms as well as the risks of complex products.

In October 2020, the SEC launched a review looking at the effectiveness of the current regulatory requirements in relation to investor protection, particularly self-directed accounts investing in complex products; and in 2021, Gary Geinsler directed the SEC staff to study the risks of complex exchange traded products (ETPs) and to present recommendations for rulemaking to address those risks.

In 2023, there was a staff bulletin that discussed the application of Reg BI for broker dealers and the fiduciary standards with new recommendations.

Also, in 2023, the Finra examinations program looked at members communications and disclosures made to customers in relation to complex products and retail customers investment profile and highlighted that advisors should consider reasonably available alternatives to high risk and complex products when making recommendations to retail customers.

Finra's head of enforcement stated in April that the regulator has brought cases involving complex products and that there are more in the pipeline as they currently have a comprehensive framework of rules to address products and options.

"There's been a cadence of statements about structured products from the SEC and Finra. They've but There haven't been any new rules, but they have talked about this for a number of years. So I would say structured products are very much on their radar," said Breman.

Index focus

Another recent move from the regulator relevant to the structured products industry involved a request for comment from information providers and pricing services involved in indexing in 2022.

"They were wondering if, perhaps, by the nature of the business, some of these information providers were acting as investment advisors, but not being registered under the advisors act of 1940 and also whether there was potential misuse of what they called the publishers exclusion.

According to Breman, the potential impact of rulemaking from the SEC regarding indices includes conflict with existing regulatory frameworks as well as increased compliance burden.

"The SEC's potential rulemaking on indices may conflict with existing regulatory frameworks, such as the Iosco principles that index providers already follow," he said. "This could create compliance challenges and regulatory uncertainty for index providers.

"Given the global nature of the index industry, new SEC rules may overlap or conflict with regulations in other jurisdictions, such as the EU's Benchmark Regulation (BMR). This could create compliance challenges for index providers that operate across multiple markets."

Breman also noted that new SEC rules on indices could impose additional compliance requirements on index providers, such as increased disclosure, oversight, and record-keeping obligations which could "increase the operational and legal costs for index providers, particularly smaller or independent firms".

Any new rules on indexing could also bring potential restrictions to investor choice as if the SEC rules limit the discretion or flexibility in index methodologies, it could constrain index providers' ability to adapt to market changes and innovate.

"This could reduce the diversity of indices available and potentially impact the products and services that can be offered to investors," concluded Breman. "Overly prescriptive or restrictive SEC rules on indices could have unintended consequences, such as reducing market efficiency, liquidity, or innovation in index-linked products."

To mitigate these potential impacts, according to Breman, the SEC should engage in extensive industry consultation, consider existing regulatory frameworks, and aim to strike a balance between investor protection and fostering a vibrant and innovative index industry.

Digital platforms

Looking at social media and the use of digital trading platforms to invest, Steffen Hemmerich (pictured), partner at Mayer Brown in New York shed light on the key concerns regarding the SEC's proposed changes to Exchange Act Rule 3b-16 which doubles down on DeFi and digital asset regulation and expands the definition of what it means to be an exchange.

"The proposed rule would broaden the definition of an exchange and ATS to include communication protocols used to bring together buyers and sellers of securities," said Hemmerich.

"This could impact digital platforms that currently operate as broker-dealers, as the SEC has not clearly defined what constitutes a 'communication protocol system' under the proposed rule."

Hemmerich noted that to address these industry concerns, the SEC could provide some clarifications such as clearly defining what types of communication protocols would be considered within the scope of the proposed rule.

"Providing specific examples would help platforms understand if they would be impacted," he said.

Other areas that require guidance and definitions from the SEC include the criteria or thresholds that would determine whether a digital platform's communication protocols would require it to register as an ATS, versus continuing to operate as a broker-dealer; and how the proposed changes would apply to different business models and platform types, such as structured product platforms, to give the industry more certainty on the rule's impact.

"Considering a phased or tiered implementation approach to give platforms time to assess their status and make any necessary changes to comply as well as providing clear guidance and definitions would help address the industry's concerns about the broad applicability of the proposed changes to Rule 3b-16 and how they may impact various digital platforms," said Hemmerich.