Regulator Issues Caution Regarding New Products
he NASD (National Association of Securities Dealers) recently expressed its concern regarding new products that seek higher returns or higher yield. According to NASD Notice to Members 05-26, such products are so unique and complex that investors and even their financial advisers may not understand them. Likewise, NASD cautions that these new products may not be suitable for investors and may involve potential conflicts of interest.
Let's consider what investors, brokerage firms and financial advisers should consider in evaluating these new products. First, what are they? The NASD identifies these new products seeking higher returns or yields as including asset-backed securities, distressed debt, structured notes and derivative products. The NASD previously issued similar warnings regarding hedge funds and deferred variable annuities.
Second, what due diligence must be conducted? The NASD sets forth a series of questions that every firm should ask, at a minimum, as part of its "vetting process". These questions include:
For whom is the new product intended? Will it be offered to all retail investors?
What is the investment objective of the product? Can less costly, complex or risky products achieve the same objective?
What assumptions underlie the product? Are they sound? What market or performance factors determine the investor's return?
What are the risks to investors? If the product is designed mainly to generate yield, does the yield justify the risk to principal?
What are the costs and fees associated with the product, and are they justified and transparent? How do the costs and fees compare to those of similar products offered by the brokerage firm or by its competitors?
How will the brokerage firm and its financial advisers be compensated for offering the product? Will conflicts of interest be created and, if so, how will they be addressed? As an example, if there is a revenue sharing arrangement, the NASD notes that the brokerage firm may have an obligation to disclose that conflict to the investor, even if the product is otherwise suitable for that investor.
Does the product present any novel legal, tax, market investment or credit risks?
What is the complexity of the product in structure, function and description? Is the product too complex to understand? Does the complexity make it difficult to ensure that it is suitable for a particular customer?
How will the product be marketed? What sales materials will be used? What risks must be disclosed, and how will those risks be disclosed?
How liquid is the product? Is there a secondary market for the product?
The remainder of the NASD's notice to members highlights prudent practices that the NASD observed at some brokerage firms. One such practice is to require that a committee formally approve any new product for sale. In that regard, the NASD suggests several interesting procedures to better ensure that a new product is suitable for a customer. First, there may be a sales restriction, whereby new products are sold only to customers who have a "speculative" investment objective, or a minimum net worth, or a certain (high) risk tolerance level. Of course, the NASD notes and has noted that wealth alone is not an indicator of either sophistication or suitability for a particular product. Likewise, the NASD suggests that brokerage firms may want to consider limiting the purchase of a new product to some reasonable percentage of the customer's net worth.
In conclusion, investors and their financial advisers carefully should examine the new, complex high return and high yield products before they invest.
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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