FINRA has announced a review of member firms’ supervision of concentrations in non-principal protected “worst-of” structured notes, given the unique risks the regulator says these products present to investors. “Worst-of” notes generally tie key terms, such as interest payments and/or return of principal at maturity, to the worst-performing asset within a group of reference assets. While FINRA has acknowledged the benefits that such products may deliver to retail investors, it suggests the instruments’ heightened complexity warrants additional compliance scrutiny.
The sweep letter issued by FINRA asks firms to demonstrate that they have reasonably designed written supervisory procedures, controls, surveillance and training related to these products. Among other things, FINRA is requesting information about how firms classify structured notes by risk feature (including principal protection and worst-of characteristics), whether they impose concentration limits or other restrictions on recommendations, how supervisory alerts are generated and resolved, what training is required before personnel can sell the products, how representatives are compensated for structured note sales and how firms identify and mitigate product-related conflicts of interest.
The sweep reflects FINRA’s continued focus on the intersection of complex products, retail recommendations, concentration risk and Regulation Best Interest, and it aligns with broader trends among other financial regulators, such as the Securities and Exchange Commission, to focus enforcement priorities on investor protection. FINRA’s announcement also arrives against the backdrop of significant customer arbitration activity involving structured notes, including at least one nine-figure FINRA award issued last year against a broker-dealer arising from allegations of over-concentration in complex structured products. The sweep is not limited to firms involved in those matters, but the timing signals that FINRA is closely scrutinizing whether firms that approve these types of products for sale can affirmatively demonstrate that their supervisory systems actually detect and respond to concentration risk while appropriately aligning compensation incentives and ensuring adequate customer disclosures.
Although firms that offer or recommend structured products are the focus of this FINRA review, all member firms should use this sweep as a reminder to critically examine their compliance programs, and the sweep letter offers a useful checklist for identifying potential gaps and enhancing supervisory practices.
