Securities Regulator Issues Timely Guidance Regarding Cash Alternatives and High Yield Securities

By James Eccleston

nvestors have searched for high yield securities as well as "cash equivalents" that will protect their principal. Financial services firms have responded, but in too many instances have mischaracterized the benefits and the risks of both kinds of investments. Recently, FINRA (the Financial Industry Regulatory Authority) issued regulatory notices to firms to guide them in how to market and sell such investments. Let's examine FINRA's guidance.

Regarding high yield securities (such as bonds, bond funds, structured products and non-conventional investments), FINRA issued Regulatory Notice 08-81. The notice observes that, in 2008, the yield on many high yield investments reached "unusually high levels." Given that investors may be attracted to such high yields, FINRA issued the guidance to financial firms in order to ensure that they balance the discussion of high yield with an appropriate discussion of the features of those investments as well as their risks.

Specifically, financial services firms must conduct due diligence to understand the "terms, conditions, risks and rewards" of the high yield investment, and then must determine that the high yield investment is suitable for each particular customer before the firm recommends it to that customer. Additionally, all sales materials and oral presentations must present a "fair and balanced picture" of the risks and rewards. As an example with bonds, FINRA states that there must be a discussion of "any applicable credit risk or risk of default associated with the issuer, and how that risk might affect the safety of the invested principal." As an example with bond funds, FINRA states that there must be a discussion of "credit risk associated with the fund's portfolio and the risk that the fund's net asset value could decline." FINRA also cautions that the discussion should address interest rate risk (that is, that a change in interest rates may affect the market value of the investment prior to its call or maturity date), as well as liquidity risk. FINRA states that the liquidity risk associated with many bonds and unconventional products, which trade infrequently or irregularly, can affect the ability to execute a sell order as well as the price that the investor obtains when placing that sell order.

Regarding "cash alternatives", FINRA has issued Regulatory Notice 08-82. While recognizing that cash alternatives can represent an important component of an investment portfolio, FINRA issued the notice to ensure that financial services firms "avoid overstating a product's similarities to a cash holding and provide balanced disclosure of the risks and returns associated with a particular product."

Examples of cash alternatives include: auction rate securities, bank certificates of deposit, bank money market accounts, commercial paper, floating rate funds, guaranteed investment contracts, money market mutual funds, repos and swaps, structured investment vehicles, Treasury bills, ultra-short bond mutual funds, and variable rate demand notes. FINRA notes that while many of those investments are well-known, others are not. Recent experience with auction rate securities is an example. According to FINRA, "many investors who believed their auction rate securities holdings to be almost as conservative and liquid as cash found themselves with illiquid holdings of uncertain value."

As another example, FINRA reports that some investors do not understand the differences between ultra-short bond funds and money market mutual funds. Although both invest in bonds with short maturities, the similarities likely end there. FINRA cautions that ultra-short bond funds are not subject to the high quality, strict diversification and maturity standards that are imposed upon money market mutual funds. As a result, ultra-short bond funds "typically pursue strategies aimed at producing higher yields by investing in securities with higher risks."

As a result of the uncertainty associated with that and other cash alternatives, FINRA outlines several disclosure points designed to ensure that financial services firms present a fair and balanced picture of the risks and benefits to investors. For example, there needs to be communication (if applicable) that the cash alternative is not federally insured and that it is possible to lose money. Likewise, there needs to be a description of "the factors that could reasonably be anticipated to affect the liquidity or price stability of the investment, as well as the ability of the issuer to repay its obligation in full." FINRA warns firms that "a statement to retail investors that an investment is a 'cash equivalent', that it is as 'safe as cash' or that it carries no market or credit risk would raise serious questions under FINRA advertising rules."

Importantly, should market or economic developments affect the accuracy of such communications, FINRA notes that financial services firms have a duty "to promptly review their promotional materials and promptly make the necessary changes to ensure that investors are not misled." Moreover, FINRA reminds firms that "simply providing a prospectus or offering memorandum does not cure unfair or unbalanced sales or promotional materials."

FINRA's guidance comes at a critical time for investors. Let's hope financial services firms appreciate the urgency of its guidance.

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.