Ketchum warns that Finra is focusing on 'hot' investment

May 29, 2011 @ 12:01 am

By Bruce Kelly

Just as financial advisers are embracing alternative investments as a way to generate income for clients, their chief regulator is warning them of the perils of one such type of offering: structured products.

Richard Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority Inc., warned an audience of more than 900 industry professionals at the regulator's annual meeting in Washington last week that the regulator is focusing on broker-dealers that sell structured products, which are being pitched to clients as a way to protect principal and generate income.

The investments “have been a hot product and continue to be a hot product,” he said. “They are a major focus of our exam program [of broker-dealers] at the present time.”

Finra has tracked more than 8,000 structured products in the market, Mr. Ketchum said.

They vary widely and returns can be pegged to individual stocks, commodities and stock indexes.

“Our special concerns relate to the ones that are levered, that track indexes using futures and other things that can create risk, that involve credit risks that are significant without effective disclosure, or are very complex in one way or another,” Mr. Ketchum said after his speech.

The market for such products among retail investors is booming. Last year, sales of retail structured products hit a record $55 billion, up 61% from $34 billion in 2009, according to industry database

Finra already has taken regulatory action against at least one firm for failing to supervise the sale of one type of structured product: reverse convertible notes. Last year, the self-regulator fined H&R Block Financial Advisors Inc. $200,000 and ordered it to pay $75,000 to clients who were sold the product.

“The firm did not have an adequate system or procedure in place to effectively monitor customer accounts for a potentially unsuitable level of concentration in reverse convertible notes” in “numerous” customer accounts, Finra said.

H&R Block, which is now part of the brokerage operations of Ameriprise Financial Inc., consented to the order without admitting to or denying Finra's allegations.


Returns on the products can move up or down, and investors can get caught flat-footed on the downside. Although the yield on a reverse convertible note, for example, is capped at an interest rate ranging from 11% to 22%, the catch is that investors can lose a significant amount of their principal if the note's underlying investment — a specific stock, for example — falls below a strike position.

The investment is attractive, particularly in a market with historically low interest rates, because the interest rates are attractive in the short term, industry observers said. Those who defend structured products said that in many cases, structured notes can carry less risk than the underlying stock or index.

Yet the risk to investors' principal is considerable, observers said.

With a reverse convertible note, “the catch is the trigger point, where you wind up owning the underlying asset, or underlying stock, the product is built around,” said Dean Rager, senior vice president and chief advisory compliance officer with Geneos Wealth Management Inc. “The hook is interest rates that vary from 11% to 22% over a six- to 18-month period.”

Investors potentially face problems when the value of the asset falls below the strike price, which, hypothetically, could be 15% below the initial investment price, Mr. Rager said.

“The investor then owns the stock at that price,” he said. “The investor collected the interest, but the original principal is not returned.”

Under that scenario, the investor winds up owning the stock at a lesser value than originally invested.

“They're unique and very complicated,” Mr. Rager said.

“To get that kind of a yield, you have to take on some serious risk,” he said. “In a rapidly falling market, you could wind up owning a security worth half of what it was at the strike price.”

Reverse convertible notes have a limited use for some investors, Mr. Rager said.


“It's just another product that looks shiny and new, and offers a high yield. But it comes with risk, already higher risk than just the underlying security itself,” Mr. Rager said.

“You believe that you're packaged or structured away from the risk, when in fact you're locked in and guaranteed the risk. They're riskier than a stock itself because of its complicated nature,” Mr. Rager said.

Big Wall Street firms are pushing independent broker-dealers to sell the products, industry professionals said.

“All the big guys build the structured products, and then they offer them out to other small broker-dealers,” Mr. Rager said.

During his speech, Mr. Ketchum warned broker-dealers to keep a close eye on structured products.

“The increasing availability of complex and sophisticated products to retail investors, while beneficial in some ways, can present challenges to a compliance department,” he said.

“The breathtaking pace of innovation and availability of these more sophisticated and complex products poses significant challenges to firms,” Mr. Ketchum said. “I am pleased to hear that many firms are taking this challenge extremely seriously and enhancing their product training programs.”

Mr. Ketchum said that some firms have set up committees to determine which products they will sell. Some have even established additional controls with respect to those complex products they do permit, he said.

“Some firms require retail customers who are interested in purchasing these complex products to complete an option account approval process,” Mr. Ketchum said. “Some firms also pre-qualify retail customers and require them to sign specialized investor qualification agreements.”

Brokers need proper training in the product, Mr. Ketchum said. “Effective supervision is rooted in a thorough understanding of the product risks, coupled with robust broker training regarding the clients for whom the product is appropriate,” he said.

“Brokers cannot rely on firm approval alone to satisfy their suitability obligations. This is particularly important with the proliferation of increasingly complex financial products and at a time when certain investors are tempted to chase yield in today's low-interest-rate environment,” Mr. Ketchum said.

E-mail Bruce Kelly at


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