by Brian Mahany
The Financial Industry Regulatory Authority issued a formal notice to stockbrokers earlier this week. The notice (12-03) advises of “heightened supervision” of complex financial products and echoes what we have said for years; don’t buy something if your broker can’t explain or you don’t understand it!
FINRA defines a complex product as a financial instrument or investment with “novel, complicated or intricate derivative-like features, such as structured notes, inverse or leveraged exchange-traded funds, hedge funds and securitized products, such as asset-backed securities.” Common examples of complex instruments include:
- Asset-backed securities that are secured by a pool of collateral such as mortgages,
- illiquid Real Estate Invest Trusts (REITs) with no ready secondary market,
- “structured notes with an embedded derivative for which the reference asset is a constant maturity swap rate”, [Editor’s Note – even we are having difficulty understanding this one!]
- reverse convertible notes, and
- futures on the CBOE volatility index (VIX),
In today’s marketplace, the list of complex financial products is virtually endless. The important thing to remember is that a broker shouldn’t recommend something that he or she doesn’t understand. And obviously, if you can’t understand it and explain to someone else, you probably should not be purchasing it. While complex derivatives do offer the opportunity to enjoy above market returns, it is equally possible to lose all or most of your money in the blink of an eye.
Many of these derivative products are also illiquid meaning there is no secondary market to sell the investment if you need money in a hurry. While it is easy to sell GM or Apple stock, try to find a buyer for some hedge fund shares or REITs. It could take months to sell IF you can even find a buyer. Sometimes you are stuck with the investment until its maturity.
FINRA’s notice doesn’t prohibit the sale of these products but it does warn brokers of increased scrutiny. That means regulators will take a dim view if a customer loses money from one of these products if the product was recommended by the broker and was not suitable for that customer.
Investment advisers, stockbrokers and brokerage firms must recommend investments suitable for their customers. What is suitable for a sophisticated investor may not be suitable for an elderly couple with little education and no investment experience.
For example, we have seen several cases of people nearing retirement who need access to their money yet are stuck with an illiquid REIT that can’t be sold. These REITs might otherwise be a great investment for folks… if they live to be 105!
Although FINRA’s formal notice was issued on Wednesday, the warnings are not new. In May 2010, SEC Commissioner Mary Shapiro warned brokers that the SEC would closely watch how complex products are marketed. Some foreign countries have even outright banned overly complex instruments (Belgium) or require brokers to give customers an opt out or cooling off period (Hong Kong.)
FINRA hasn’t banned these products but now says that brokers should have written policies on the sale of these products that require a case by case determination of customers to whom these products are offered and training for those selling them.
If you have lost money through a complex financial transaction or security recommended to you by a broker or investment advisor, you may be able to recoup your losses. Sometimes you can even get attorney’s fees and punitive damages, although the latter are reserved for particularly flagrant or outrageous cases.
Claims against stockbrokers are usually handled by binding arbitration through FINRA. Most cases can be handled on a contingent fee basis meaning you do not have to pay legal fees unless you win. For more information, contact attorney Brian Mahany at (414) 704-6731 (direct) or by email at Our investment fraud attorneys include two certified civil trial attorneys one of whom is a former FINRA arbitrator.
Mahany & Ertl – America’s Fraud Lawyers. Offices in Milwaukee, Wisconsin; Detroit, Michigan; Portland, Maine & Minneapolis, Minnesota.Services available in most jurisdictions.