FINRA Considers Limiting Self-Directed Investors' Ability to Invest in Certain Exchange-Traded Funds, Mutual Funds and Closed-End Funds

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On 8 March 2022, the Financial Industry Regulatory Authority, Inc. (FINRA) issued Notice to Members No. 22-08 (NtM 22-08) to “remind members of their sales practice obligations” for complex products and options and to “solicit comment” on effective practices and “rule enhancements” related to complex products.1

For purposes of NtM 22-08, what constitutes a “complex product” is critically important. Unfortunately, as FINRA acknowledges in the NtM, “[t]here is currently no standard definition of a ‘complex product.’” Rather, provides only a description based on prior FINRA discussions of products it perceived to be complex. Specifically, “FINRA has described a complex product as a product with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks.”

In prior releases, FINRA has described each of the following types of products as complex:

Closed-end funds Target date funds Emerging market funds
ESG funds Smart beta index funds Cryptocurrency futures funds
High-yield bond funds Funds using derivatives for hedging Cryptocurrency trusts
Multi-strategy funds Funds using derivatives for leverage Commodity funds
Business development companies Geared (leveraged or inverse) funds Currency funds
Variable annuities Funds selling short Insurance-linked securities
Market-linked Certificates of Deposit Absolute return funds Asset-backed securities
Unconstrained bond funds Distressed debt funds Non-traded Real Estate Investment Trusts
Floating rate loan funds Volatility-linked funds Global real estate funds
Interval funds Defined outcome funds Reverse convertible notes
Funds of hedge funds Principal protected notes Exchange-traded notes

In effect, under this description only plain vanilla index funds and certain long-only U.S. or developed market funds escape categorization as “complex.” As a result, nearly every broker-dealer selling or making available exchange-traded funds, mutual funds, and closed-end funds and sponsors of such fund products in the country should have an interest in FINRA’s potential regulation of complex products.

To be clear, NtM 22-08 does not propose a new rule for complex products. Rather, it describes FINRA’s historical approach to overseeing broker-dealers’ sales practices with respect to complex products and poses a series of questions about potential “enhancements” to that approach. The questions focus on reconsidering the unconstrained ability of self-directed investors to invest in “complex” registered securities that they want and whether FINRA members should impose certain limits and controls on “complex investment products.”

The potential enhancements posited by FINRA for comment in NtM 22-08 vary widely and are discussed here (in order of protections that may be familiar to FINRA members to entirely unprecedented proposals).

  1. Require broker-dealers to make additional, “plain English” disclosures to investors, potentially including at the point of sale, which highlight the characteristics and/or risks of the particular complex product being purchased, or obtain attestations from investors that they understand the complex product that they are buying. Although such measures are not currently required, they are voluntarily being used by certain broker-dealers.
  2. Require broker-dealers, at the time of an investor’s account opening, to approve the account to trade complex products based on the information provided in the account opening paperwork. In this scheme, the broker-dealer would need to make a determination that trading complex products could be in the best interest of an investor who provides such information. Broker-dealers must follow an analogous process when opening options accounts that is substantially similar to the scheme discussed by FINRA in NtM 22-08. The regulatory regime for options, however, was adopted following an extensive study of the options market that was commissioned by the U.S. Securities and Exchange Commission (SEC). The study documented widespread abuses in the options market, which resulted in a congressional directive to the SEC to pursue options-specific rules. By contrast, NtM 22-08 provides no indication that FINRA has uncovered widespread abuses by broker-dealers with respect to complex products,2 much less abuses that are likely to inspire a congressional directive for action.
  3. Require investors to pass a test to trade a complex product and potentially undergo re-testing from time to time to ensure the investor’s continued understanding. Although NtM 22-08 does not say precisely how testing would work, an investor would seemingly need to correctly answer a certain percentage of test questions to be permitted to trade a complex product. This approach has no analogue in securities regulation and has the potential to be administratively burdensome for FINRA, broker-dealers and investors.

FINRA, of course, characterizes its consideration of potential enhancements to the regulation of complex products as grounded in investor protection concerns. However, because the focus of NtM 22-08 appears to be on developing a rule that will reach self-directed investors, it begs the question of who FINRA is seeking to protect such investors from. Unlike FINRA’s past rules, which have largely been designed to protect investors from sales practices by broker-dealers that could harm the investing public, FINRA appears in this case to be considering a rule that will protect investors from themselves.

All comments in response to NtM 22-08 must be submitted to FINRA no later than 9 May 2022.

1 NtM 22-08 also sets forth certain proposals for amendments to the regulatory regime for options. This Alert focuses solely on NtM 22-08’s discussion of complex products.

2 NtM 22-08 cites a handful of enforcement cases brought against registered representatives or their supervisors due to unsuitable recommendations of complex products.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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