United States: Broker-Dealer Sanctioned for Encouraging Early Resales of Structured Notes

REVERSEinquiries: Volume 1, Issue 4, Structured and market-linked product news

On June 25, 2018, the Securities and Exchange Commission, or the SEC, announced that a broker-dealer settled charges relating to recommended resales of structured notes and certificates of deposit to retail investors between January 2009 and June 2013. According to the SEC's order (the "Order"),1 the SEC found that the broker-dealer generated substantial fees by improperly encouraging retail customers to trade structured notes prior to their maturity dates, even though the structured notes were intended to be held to maturity. Representatives of the broker-dealer recommended that customers sell their outstanding notes before maturity and invest the proceeds in new notes, generating fees for the broker-dealer and reducing the customers' returns.2

The SEC determined that the broker-dealer's representatives did not reasonably investigate or understand the significant costs of their recommendations and that their supervisors routinely approved these transactions despite internal policies prohibiting short-term trading of the notes. The Order recognizes that the broker-dealer took remedial steps to address the allegedly improper sales practices.


Structured notes are priced with embedded costs, or "mark-ups," including selling commissions and structuring and hedging costs. These costs, disclosed in each offering document, result in the estimated initial value of each note being less than its purchase price on the pricing date. There are also costs associated with redeeming notes prior to maturity. Prior to September 2011, the broker-dealer's representatives could charge a sales commission on early redemptions, with supervisor approval. Furthermore, the price at which the broker-dealer was willing to buy back the notes was typically lower than the current value of the note. This "mark-down" was typically between 2% and 3%. The mark-downs on sales of outstanding notes prior to maturity coupled with the mark-ups on purchasing new notes ate away at the customer's potential gains.


Churning. For the last several years, the SEC's Enforcement Division has been focused on churning, (i.e., multiple transactions switching between products within a short period of time), and the potential costs to investors. In many of the cases described in the Order, a substantial number of the broker-dealer's exchanges involved notes linked to similar or identical referenced assets. For example, a note linked to the S&P 500® was resold and the proceeds were used to purchase a note linked to the Dow Jones Industrial Average®.

Offering Documents versus Recommendations. According to the offering documents, these notes were not suitable for short-term trading due to their limited liquidity. The disclosure stated that these products were "buy-and-hold" products and should be held until maturity. This stated strategy was inconsistent with recommendations by the broker-dealer's representatives.

"Locking in Gains." Certain representatives justified the exchanges by claiming that that customers were "locking in gains" on their original notes, capturing gains rather than risking a decline in the performance of the reference asset. In many instances, there was limited value in locking in gains. Due to principal protection and the note's appreciation, the only amount reasonably at risk in the original note was the gain to date. In addition, due to mark-downs on early redemptions, the customer had to sacrifice a significant portion of the gain. Further, because principal protection only applied if the note was held to maturity, a new note would only be expected to outperform the original note if held to maturity.

Supervision. The Order points out that a certain representative's supervisors and regional compliance managers approved these transaction without understanding the economics of the transaction and strategy. The broker-dealer's compliance personnel were aware of the representative's recommendations, but failed to limit the practice. The representative never received any guidance from supervisors or compliance personnel regarding the practice of soliciting customers to exchange their notes.

Two-in-a-million? The SEC focused its Order on the practices of two individual representatives of the brokerdealer and noted that most of the broker-dealer's representatives only infrequently engaged in soliciting these exchanges.

Changes in Procedure. The trades in question occurred prior to June 2013, demonstrating the broker-dealer's efforts to prevent these types of trades. Generally, broker-dealers have been working over the past several years to improve their compliance and supervision procedures.

Bad behavior results in CDs being treated as securities? CDs are generally treated as bank deposits that are not subject to the securities laws under Marine Bank v. Weaver, 102 S.Ct. 1220 (1982). However, at least one court has characterized CDs as securities subject to the requirements of the federal securities laws due to the particular facts of that case, which resulted in the instruments being considered "investment contracts." In

Gary Plastic Packaging Corporation v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985), the CDs in question were determined to be investment contracts due to the fact that their value largely depended upon the efforts of others (i.e., the court considered that the dealer in Gary Plastics promised to, and did, maintain a secondary market in the CDs). In footnote 4 to the Order, which was placed at the end of a sentence noting that the representatives "engaged in a systematic practice of soliciting customers to engage in [structured notes and CDs] exchanges on hundreds of occasions," the SEC appears to reference Gary Plastics in stating that the CDs described in the Order were "investment contracts, and therefore securities." The SEC explained that the activities of the representatives, working with the dealer, constituted making and maintaining a market for the CDs, resulting, under a Gary Plastics analysis, in the CDs being treated as investment contracts, which are securities. This would be an unusual outcome, and it is not clear whether the footnote resulted from a thorough analysis of the circumstances.


The Order serves as a reminder to broker-dealers to review existing policies and practices regarding early redemption of structured products. Policies should indicate the circumstances under which trades prior to maturity may be appropriate and representatives should be trained accordingly. Compliance personnel should also be trained and review whether these transactions are appropriate under the circumstances.

Broker-dealers should ensure that their oversight and surveillance procedures track the occurrence of these transactions and the incidence of such transactions with respect to individual representatives.

Originally published in REVERSEinquiries: Volume 1, Issue 4.
Click here to read further articles from this latest edition

1 The Order may be found at https://goo.gl/tKmvWv.

2 The Order relates to activities relating to sales of structured notes and certificates of deposit ("CDs"), but for the sake of brevity, we only refer to structured notes in this article.

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