Structured Products – Complexity and Disclosure – Do Retail Investors Really Understand What They Are Buying and What the Risks Are?
Amy M. Starr, Chief, Office of Capital Market Trends
May 14, 2015
Standard Disclaimer: The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are my own and do not necessarily reflect the views of the Commission or of my colleagues on the staff of the Commission.
To begin, I’d like to provide some background on my office - the Office of Capital Markets Trends – and what we have been involved in since we were formed in 2010.
The Division of Corporation Finance’s Office of Capital Markets Trends was created to focus on micro and macro capital market trends, be the point of contact in the Division for new or novel securities and derivatives issues, look at takedowns off of shelf registration statements, and be a resource for disclosure operations and other offices.
In addition to the regular issuer reviews conducted by the Division’s Disclosure Operations group, the office selectively reviews prospectus supplements filed under Rule 424 in order to monitor and evaluate offering activities and trends, and to identify potential ways to improve disclosures. These 424 prospectus supplements reflect takedowns off of shelf registration statements of seasoned and well-known seasoned issuers. To provide a sense of the scope of offerings being conducted on 424’s, during the month of March, 2015 financial institution registrants filed 931 unique 424 takedowns; about 870 of these were structured note takedowns. By comparison, operating companies filed 310 takedowns during the month of March.
- The office began its product focused evaluations of prospectus supplements with a review of structured notes in 2011 and followed with a review of exchange traded notes, among other trends.
As most of you know, the Office’s key disclosure focus in structured note offerings concerned disclosures about the pricing and value of the notes
- Pricing and value of structured notes – As the staff identified, the issue price of the notes may be significantly higher than the issuer’s valuation of the notes. Our 2013 comment letters (now on our website) stated that investors should be able to understand the difference between the issuer’s estimated value of the notes at the time of issuance and the purchase price at issuance that investors are paying for the structured note. We advised issuers that the offering price and the issuer’s valuation of the structured note should be on the cover page of the prospectus.
These disclosure positions are relevant to all issuers of structured notes, regardless of whether they received the initial comment letter. I am pleased to note that structured note issuers have been providing that disclosure and we have been monitoring issuers’ response to the staff’s comments. I am also pleased that issuers have been using similar disclosure in other products and other international regulators have taken similar positions.
As part of our structured note review, we also reminded issuers about how to comply with disclosure requirements for the referenced securities, indices, and other assets. This is an area that I believe there should be continued focus on. For purposes of linked securities, such as structured notes that are offered on a registered basis disclosure is needed about the referenced security, index or other asset. The disclosure issues raised by these products generally relate to the adequacy of publicly available information and transparency of valuation of the particular referenced index or instrument. This arises from the need of investors to understand the terms of their securities and the dependence of the payment obligations, including the amount of such payment, on other entities or events.
The disclosure requirements for debt securities, such as structured notes, include disclosure about maturity, interest, conversion, redemption, amortization, sinking fund, or retirement. We view payments on structured notes as within the scope of these disclosure requirements and therefore information about the amounts due under the products and how that’s calculated are needed.
In evaluating particular linked securities, the staff has assessed whether the disclosures provide the investors with sufficient information about the terms of the security in order to make informed investment decisions, both at issuance and on an ongoing basis through the life of the linked security. The requisite disclosure regarding the terms of the security must be included directly in the prospectus unless the conditions in the staff no-action letter allowing reference to publicly available information are satisfied.
To determine what disclosure is necessary about a particular issuer or security that is a component of an index, basket or pool of securities to which an offering of securities is linked, the staff historically has analyzed the concentration of a single issuer, security or group of affiliated issuers or securities. Concentration relates to the level of exposure that the value of the linked security has to components of the linked reference or to the relative weight or dependence of any one component of the index to the value of the index.
Where there is concentration in an asset, security or issuer, such as a structured note linked to an individual security, or where there is an index in which there is concentrated exposure to a limited number of securities or issuers or other assets, the Division staff has taken the view that disclosure, including financial information, is needed for investors to be able to evaluate the risks and payments relating to investments linked to those securities, issuers, or assets. The type of information and how to provide it will depend on the level of concentration. For example, where a note is linked to the performance of the common stock of XYZ Corporation staff has advised that full audited financial statements and other information about XYZ Corporation should be provided. This disclosure obligation can be satisfied in many cases through a cross reference to XYZ’s Exchange Act periodic reports (assuming XYZ meets the conditions for using a shelf registration statement).
This staff would request this disclosure for concentrated exposures of 20% or more to particular issuers or their securities – which could arise with basket products, custom indices or even narrow published indices, based on staff and Commission disclosure positions. Disclosure issues for concentrated exposures and returns are not unique to linked securities such as structured notes – the same analysis applies in asset-backed securities offerings, real estate investments, and other financings or products where a payment or return is dependent on a single or small group of issuers, securities or income streams.
Where there are indices without concentrations in securities or issuers, the staff has focused its evaluation on whether information on the index as well as the underlying components of the index is publicly available and transparent to the market.
These disclosure issues arise for both security and non-security assets such as futures, swaps, and physical assets. The staff believes it is essential that transparency of the value of those assets is publicly available so that investors are able to evaluate their structured products.
We have seen most structured note issuers adopt these disclosure positions in the initial offerings of the structured notes. While not required to be included in periodic reports of the issuers after initial issuance, I wonder how much information investors are provided on their specific notes an ongoing basis. I am curious as to how much information is being provided or made available to investors by issuers or others about how the referenced securities, indices, or assets are performing and whether investors know where they can get information that will enable them to evaluate their investments in these structured notes.
In the related area of Exchange Traded Notes, (ETNs), as most of you know my office has looked at ETN disclosures which has resulted in improved disclosures for these ongoing offerings. Some of our identified concerns related to providing intraday indicative values about a third party index that is one component of an ETN’s value – we were concerned that without more context, this disclosure would not provide investors with meaningful information about the actual value of their notes. While I recognize that disclosure of intraday indicative value is required by the applicable listing standards, probably as a carryover from the ETF world, we are encouraging ETN issuers to tune their disclosures so that investors can understand what relevance, if any, the intraday indicative value may have about the value of the ETN.
The staff has seen improvement in disclosures in ETNs in these areas as well as for ETNs that use a VWAP calculation of the index components for their notes rather than the disclosed end of day index value. The disclosure now enables investors to more easily understand the differences in the values and the effect on the value of their ETNs.
The data the staff has seen shows continued flows to ETNs – based on Bloomberg, there are 205 tickers currently available and nearly $28 billion in market cap. We understand from these data sources that the ETN market is highly concentrated with a small number of issuers.
So where are we now? What does the current structured product environment look like and are there more areas for improvement?
At 2+ years after issuers began including the issuer’s estimated value disclosures, we are seeing greater numbers of increasingly complex notes being sold:
- In 2014: 8,733 distinct structured notes were sold totaling $41.1billion, approximately the same as the $41 billion sold in 2013.
- In 2015(YTD): 2,474 distinct structured notes were sold totaling $14.0 billion through April 17, 2015
- According to StructuredRetailProducts.com, there are nearly 25,000 structured notes currently outstanding, totaling just over $400 billion in the United States.
- Both Bloomberg and SRP report increased sales volumes of notes linked to equities, either single shares, equity indexes, or baskets of indexes from 2013 to 2015. Equity linkages have grown to about 80% of all structured note offerings.
What does this increasing issuance mean? And what new trends are there in structured offerings? Is the increased issuance a function of issuer’s liquidity needs, or of expanded broker-dealer networks? How will structured note sales activity change should interest rates begin to climb?
One significant development we have observed is the increasing use of complex or proprietary indices or non-security assets
The use of complex or proprietary indices in structured notes raises some interesting questions – what type of retail investor are these sold to and how can they understand the disclosure? We have seen many structured notes with payouts and indices that use highly complex formulas to determine how the index is valued, including fees and costs that are embedded into the index performance and therefore impact what an investor may realize on the notes – I’ve heard even learned counsel say that they find certain indices or notes hard to describe narratively and counsel thinks that the formula disclosure provides sufficient information about how investors will be paid on the notes.
I don’t know how many of you are mathematicians who may be able to figure out complex formulas but I can assure you that the retail investor is not – with that – I wonder how disclosure alone of such formulas could provide the retail investor, or even other “reasonable investors” the information they need to make informed investment decisions.
I also wonder how many brokers and advisors who sell these products to retail investors actually understand what they are selling; both how the notes will pay out and what the related risks are in these notes. In light of the increasing complexity of the products, a question I’ve heard is whether the brokers and advisors have looked at not only their written policies and procedures regarding the sales practices and supervision of these products, but how their policies and procedures are being implemented across their firms. These are very important issues and concerns and I would suggest that market participants consider these when they are determining what next best product they may want to create.
My office is concerned that for some complex indices or referenced assets or issuers there may be a lack of transparency about the index, asset or issuer at the time of issuance and on an ongoing basis. This raises the potential that there may not be full and fair disclosure to the investor about the structured product that they own or will be purchasing.
In addition to complex and proprietary indices, the staff has been asked on many occasions about linking structured notes to assets or securities that may not be fully transparent or that may fall outside the scope of our disclosure position allowing for cross references to periodic reports to satisfy disclosure about the linked entity or security. For example, we were asked if an issuer could link a structured note to an ETF and cross reference to the ETF’s investment company reports. Division staff agreed that the use of a cross reference to such reports would be permissible.
Prior to the establishment of my office (and prior to the financial crisis), the Division of Corporation Finance considered new linked securities in the context of our new and novel securities review. And there were a number of products that Division staff did not believe would be able to satisfy the disclosure requirements of the Securities Act with respect to the terms of the securities and objected to registered structured notes linked to certain types of indexes or products. For example, the staff would not view that credit linked notes – notes linked to credit events -- could be offered on a registered basis because disclosure about when, how, and if payments would be made under the notes would not be available to investors through the life of the notes. Similarly, the staff would not view notes linked to hedge funds or hedge fund indices as being able to satisfy the disclosure requirements due to the lack of transparency about the hedge funds.
A couple of weeks ago I saw that Sweden’s Nasdaq Exchange approved a bitcoin-based ETN that is expected to launch in a few days (May 18th). If a similar product is planned for offering in the U.S, we would be interested in how the product would be structured and how the valuations would be made, both initially and on an ongoing basis. As with other types of assets or indices that may not be fully transparent and verifiable as to values, some interesting questions would arise – such as would the Bitcoin be valued based on trading on an exchange – such as the recently defunct Mt. Gox? Or would the valuation be based on a formula or calculation using other unregulated exchanges? How would the information and valuation be verified and be publicly available? This is a good example of a novel asset that would raise important disclosure questions for us.
I am sure that folks may be considering products today that may raise similar disclosure concerns. I would encourage you all to consider speaking with us before introducing new products – we have a process for that. I like to think that it’s better to talk to my office before a product is offered and sold than to enforcement afterwards.
In looking at the issues from the vantage point of the investor a common view, as many of you know, is that these products are “sold” not “bought”. How many retail investors cry out to their brokers or advisers that they have to buy an incredibly complex product that they don’t understand that will provide them exposure to an esoteric, customized or proprietary index that they don’t understand. I would suggest few if any.
We have heard the rationale for the sales of many of these products: that they provide investors:
- The opportunity to gain exposure to more esoteric indexes/commodities/strategies typically limited to hedge funds or professional traders.
- Or that investors want a customized risk/reward tradeoff for a particular investment thesis (e.g. child will attend college next year, I am seeking to protect principal prior to a tuition payment).
There are significant questions, however, about the financial literacy of many retail investors – and that’s for plain vanilla products. Given these questions, do you know your distributors and how they are selling these products? Do any incentives to their sales force raise concerns about the potential for unsuitable recommendations? I know that many who have looked at structured products view these as highly complex in many cases, including due to the use of option strategies that a retail investor may not otherwise be eligible to purchase. Have your distributors considered the financial sophistication of the customer when selling these structured notes? For instance, have they considered any sort of limitations on the type of investors to whom the notes may be sold or considered using investment concentration limitations?
- As an example, cover page disclosure on certain ETNs indicates that the products are intended to be trading tools for a sophisticated investor managing daily trading risk. These disclosures note that the performance of these ETNs over periods longer than one day can differ significantly from their daily objectives –meaning that investors should be actively monitoring their investments on a daily, if not intra-day basis.
Separate from the legal question of have you satisfied your disclosure obligations under the federal securities laws (including compliance with the antifraud provisions) – there are other questions one could ask: – have you really created an instrument that makes sense for retail investors? If you were trying to sell a structured note to your spouse, your parents, or your children, could you explain to them in plain English exactly what they were buying and what the risks were that they would lose their money? And a more important question may be whether you would even consider selling these products to them in the first place. The SEC as you all know is not a merit regulator – the Commission’s mandate is full and fair disclosure, fair and orderly markets, and capital formation. So with that focus – to me disclosure for these products is of highest importance. While we know that structured products are an important source of capital and in some cases liquidity for the financial institution issuers, I wonder if disclosure (and suitability some may argue) may be taking a backseat in some cases to the capital needs of these issuers.
The staff is keeping a close eye on disclosures in these products. We are continuing to review 424 takedowns for new types of products and trends and our enforcement division is also busy fielding complaints and analyzing products offerings for potential securities law violations. While there may have been less regulatory scrutiny of these products prior to 2008, the SEC and FINRA are now on the field and our eyeballs are on this.
So why are structured notes so popular and how have they performed as investment opportunities. I understand there is little published data on the historical performance of structured notes. I know that some academic articles have criticized the mispricing of credit risk and widespread use of price premiums in these products. I would be curious to know if issuers or broker dealers evaluate these questions when they are creating and selling structured notes. Are there other investment products that would provide similar exposures with lower costs? Or that would be more transparent during the life of the product?
Some have also asked what more can be done with disclosures about these structured products or other actions that will help investors better understand the risks and operation of these sometimes very complex products? What sources do investors use aside from the prospectus to understand the risks and complexities of these products? I’ve touched on several complexities here, but others may need disclosure focus as well: for example, the credit risk of the issuer or the lack of a secondary trading market for these structured notes making them a product that is best held to maturity.
Our Office of Investor Education and Advocacy recently issued an Investor Bulletin on Structured Notes in January, 2015, that presents a number of questions for investors to consider prior to investing in structured notes. I encourage you to take a look at the bulletin and consider if your disclosures can help investors better answer these questions.
I also understand that similar products may be offered and sold to investors other than in registered securities offerings. I have some questions about these - are there products being sold that provide the same or similar exposures but provide less disclosure than in registered offerings? Are these being sold by broker dealers or other financial advisers and, if so, why is less disclosure good for investors? Are the broker-dealers or other financial advisers able to understand the products and their appropriateness for various investors? What information do investors get about the issuer and their ability to pay? Do they get audited financial statements? For those of you selling these types of products I would suggest these may be questions you may want to ask as well?
Another important issue is what is the role of the broker or advisor, who is selling the structured note to the investor? Have they had an input in creating the product? Do they understand how the product works, including in different market scenarios? If not, I wonder how they can explain the product and risks to their client.
The staff is keenly interested in whether the disclosures would be consistent with the antifraud provisions and the professionals conduct would be consistent with their obligations.
I would like to close with some questions that those of you structuring and selling notes should continue to ask. Who is the note being created for? Do you understand how it works and how the payouts work? Can you explain it in plain English (assuming you are explaining it to your spouse, child, parents, etc.) and does the disclosure do that? Do they need to buy this note to achieve their investment objective? Is it really appropriate for them to buy? There are many other questions I’m sure you all ask and I encourage you to continue to ask – Central to the Commission’s mandate is the protection of investors. My office, as well as others on the staff, will continue to monitor this area in order to pursue that mandate.
 17 CFR 230. 424(b).
 See Staff Comment Letter sent to certain financial institutions by the Office of Capital Markets Trends on February 21, 2013, which can be located by searching for the term “pricing and value of structured notes” at the following link or via other search engines:
 See e.g., No Action Letter to Morgan Stanley & Co., Inc. (June 24, 1996)(“Morgan Stanley No Action Letter”);.
 17 CFR 229.202(b).
 See Morgan Stanley No Action Letter, note 3 supra.
 See Morgan Stanley No Action Letter, note 3 supra; Staff Comment Letter sent to certain financial institutions by the Office of Capital Markets Trends on February 21, 2013, which can be located by searching for the term “pricing and value of structured notes” at the following link or via other search engines:
http://searchwww.sec.gov/EDGARFSClient/jsp/EDGAR_MainAccess.jsp ; Securities and Exchange Commission, “Asset-Backed Securities,” Release No. 33-8518, (Jan. 7, 2005) 70 FR. 1506], pp. 1531-1554 (“Asset-Backed Securities Release”).
 See Morgan Stanley No Action Letter, note 3 supra.
 See e.g., Asset-Backed Securities Release, note 6 supra at 1547-48..
 See Asset Backed Securities Release, note 6 supra; The Division of Corporation Finance, “Financial Reporting Manual,” sections 2335-2345, 2705, and 2815-2820, available at http://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.pdf.
 See Staff Comment Letter sent to certain financial institutions by the Office of Capital Markets Trends in February, 2014, which can be located by searching for the term “selective review of prospectus supplements for ETN offerings” at the following link or via other search engines:
 See Morgan Stanley No Action Letter, note 3 supra.
 Securities and Exchange Commission, Office of Investor Education and Advocacy, Investor Alert “Structured Notes” (Jan. 12, 2015) http://www.sec.gov/oiea/investor-alerts-bulletins/ib_structurednotes.html .