In a joint public statement, SEC Chair Jay Clayton, Division of Investment Management Director Dalia Blass, Division of Corporation Finance William Hinman and Division of Trading and Markets Brett Redfearn (collectively, "SEC Officials") directed staff "to review the effectiveness of the existing regulatory requirements in protecting investors ... who invest in leveraged/inverse products and other complex products."

In their statement, the SEC Officials did not define the phrase "complex products," instead stating that complex products are "more complex than conventional stock and bond investments," and include products that provide leverage or inverse leverage to an underlying index. The SEC Officials noted that retail investors (and some financial professionals) may not understand the "unique risks" that complex products may present, particularly during times of market stress and increased volatility, including COVID-19 volatility.

Legal Structures and the Delivery of Complex Financial Products

The SEC Officials described risks associated with legal structures and for delivery of complex financial products. They included:

  • Registered investment companies, including exchange-traded funds;
  • Exchange-traded notes;
  • Structured notes; and
  • Public commodity pools.

According to the SEC Officials, even when the economic behavior of different products may be similar, products delivered under differing legal structures also may have differing regulatory and economic nuances. The Officials stated that retail investors (as well as professionals) may not appreciate these differences.

Self Directed Accounts

The SEC Officials also expressed concern over investors with self-directed accounts who have the ability to purchase complex products "without the assistance of a financial professional." They noted that financial technology has vastly expanded retail investors' direct access to all investment products, complex or otherwise. They stated that the fiduciary obligations of investment advisers and the best interest standard of conduct and suitability analysis (where Regulation Best Interest is not applicable) apply only for broker-dealers making "recommendations." Accordingly, the Officials pointed out the risks to retail investors that unilaterally decide to invest in complex products through self-directed accounts.

In light of those concerns, the SEC Officials directed staffs of the Divisions of Investment Management, Corporation Finance, and Trading and Markets to review the effectiveness of existing regulatory requirements in protecting investors, particularly those with self-directed accounts. As part of its review, the staffs will consider whether the adoption of additional disclosure requirements, additional obligations for broker-dealers and investment advisers, and point-of-sale disclosures, policies or procedures could increase awareness of complex products' unique risks.

Notably, the SEC determined, on the same day the SEC Officials made the statement, not to adopt a rule requiring broker-dealers and investment advisers to comply with "due diligence and approval" requirements prior to approving an order to buy and sell shares of leveraged investment vehicles (see related coverage here).

Commentary

The statement, while providing examples of complex products, intentionally does not define them. Certainly "more complex than conventional stock and bond investments" is overbroad and the definition of complex products is no easy task. FINRA has issued notices to members discussing complex products, each of which describes "characteristics" of such products, but avoids a definition, in part because even "relatively simple products" can present "significant risks" meriting "enhanced compliance and supervisory procedures."

In reality, the risk of even simple common stock may present extraordinary risks (e.g., retail investors purchasing large amounts of Hertz common stock after the company filed for bankruptcy). This demonstrates the difficulty of regulating based on a subjective analysis of complexity, particularly when used as a proxy for financial risk.

In addition, the legal structures for the delivery of financial products (and their inherent differences) are largely architecturally mandated as a statutory matter and exist irrespective of the complexity of a product.

Restricting accessibility of self-directed investors to products based on an SEC-imposed categorization of complexity would fetter investor choice as it uses the subjective notion of complexity as a proxy for financial risk (and therefore, by necessity, potential return). Certainly, in some cases complexity may translate to more financial risk, but that is certainly not a necessity, and even simple products may pose great financial risk. Conversely, many complex products are engineered to reduce specific types of financial risk. Thus the staffs may wish to consider a risk-based approach to investor education rather than trying to attempting to define complexity and using it as a proxy for risk and disclosure.

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