1

By the Office of Compliance Inspections and Examinations (“OCIE”)1

Volume IV, Issue 7 August 24, 2015 

 

BROKER-DEALER CONTROLS REGARDING RETAIL

SALES OF STRUCTURED SECURITIES PRODUCTS

I. Introduction

OCIE’s National Examination Program staff (the “Staff”) examined ten

branch offices of registered broker-dealers (the “broker-dealers” or 

“firms”) that distribute structured securities products (“SSPs”) issued 

by their parents or affiliates or issued by unaffiliated third parties.

2

 

Using data analytics, the Staff assessed these firms’ compliance with 

suitability and supervision requirements in the Securities Exchange Act 

of 1934 (“Exchange Act”) and evaluated whether the firms effectively 

supervised and monitored activities and risks associated with sales of 

SSPs to retail investors. The Staff’s analysis of the implementation of 

controls across the branch offices of each firm revealed discrepancies 

in the practices within each firm and discrepancies in the effectiveness 

of the controls. Firms should note the importance of the 

implementation of controls as well as their design on the effectiveness 

of such controls.

 

SSPs are securities, often issued as corporate obligations of an affiliate of the underwriting 

broker-dealer. They derive their value from, and provide exposure to, a variety of underlying 

asset classes such as a single security, baskets of securities, indices, options, commodities, and/or 

foreign currencies. SSPs, which may or may not be listed on an exchange, typically have some 

form of embedded derivatives and may supply, among other things, principal protection, interest 

payments, or leveraged exposure to the referenced assets. This Risk Alert focuses on structured 

notes in particular.3

 

 1

 The views expressed herein are those of the staff of OCIE, in coordination with other staff of the Securities and 

Exchange Commission (“SEC” or “Commission”), including the Division of Trading and Markets. The 

Commission has expressed no view on the contents of this Risk Alert. This document was prepared by the SEC 

staff and is not legal advice.

2 The examinations described in this Risk Alert did not cover exchange-traded products. 

3 Structured notes are structured products that are comprised of a debt obligation and at least one embedded 

derivative. 

This Risk Alert summarizes 

deficiencies that OCIE staff 

observed in the controls that 

certain broker-dealers put in 

place to comply with 

obligations related to sales 

of structured securities 

products (“SSPs”) to retail 

investors, including

1) controls related to 

determining suitability of 

SSP recommendations and 

2) written supervisory 

procedures related to 

reviews of representatives’ 

suitability determinations 

with regard to SSPs.
2

During these examinations, the Staff analyzed, in aggregate, over 26,600 sales of SSPs, totaling 

over $1.25 billion in principal transactions.

4

 By reviewing the account documentation of 

customers engaged in these transactions, including data on risk tolerance and investment 

objective, age, and any approval for options trading, the Staff was able to identify, on an 

aggregate basis, the predominant types of customers that had purchased SSPs at each firm and 

branch office. The Staff also reviewed resales of SSPs in these accounts in order to gauge the 

frequency and price at which SSPs were resold prior to maturity. Finally, the Staff analyzed the 

frequency with which each firm’s transactions exceeded internal policies and procedures 

governing suitability of recommendations to brokerage customers as well as supervisors’ 

documentation approving overrides of internal suitability guidelines with respect to suitability of 

recommendations. 

Among other things, the examinations revealed several significant deficiencies in the areas of 

suitability and supervision with respect to all of the examined firms’ sales of SSPs to retail 

investors. Specifically, all of the examined firms:

• Failed to maintain and/or enforce adequate controls relating to determining the 

suitability of SSP recommendations; and

• Failed to conduct both compliance and supervisory reviews of registered

representatives’ (“representatives”) determinations of customer suitability in the 

SSPs, as required by their internal controls.

II. Overview of Broker-Dealer Obligations Regarding Sales of SSPs

A. SSPs

SSPs have been increasingly marketed to retail investors, who have been interested in generating

income in the low-yield interest-rate environment that has persisted since the financial crisis. 

Additionally, SSPs may offer attractive attributes such as partial or full “principal protection” or 

exposure to a particular asset class. SSPs often provide for payments determined by reference to 

other assets or indices and may be more complex than a simple debt instrument with a stated 

interest rate.5

B. Suitability and Supervision Requirements

A central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which 

generally requires a broker-dealer to make recommendations that are consistent with the best 

interests of its customer.6

 The concept of suitability has been interpreted as an obligation under 

 4 The review period for these examinations included the period of January 1, 2011 to December 31, 2012, unless 

indicated otherwise herein. 

5

 For additional information on structured products and trends indicating increased sales to retail investors, see

OCIE’s “Staff Summary Report on Issues Identified in Examinations of Certain Structured Securities Products 

Sold to Retail Investors” (July 27, 2011).

6

 See, e.g., In the Matter of the Application of Raghavan Sathianathan, Exchange Act Release No. 54722 at 21 

(Nov. 8, 2006) (“NASD Conduct Rule 2310 requires that, in recommending a transaction to a customer, a 
3

the antifraud provisions of the federal securities laws7 and also appears in specific SRO rules.8 

As part of its suitability obligations for complex products, FINRA encourages firms to require 

that a registered representative has a reasonable basis to believe that “the customer has such 

knowledge and experience in financial matters that he may reasonably be expected to be capable 

of evaluating the risks of the recommended transaction, and is financially able to bear the risks of 

the recommended position.”9 

The FINRA rules also require broker-dealers to supervise their associated persons, and the 

Exchange Act permits the Commission to sanction broker-dealers who fail reasonably to 

supervise, with a view to preventing violations of the federal securities laws by a person subject 

to their supervision.

10 In addition, FINRA has released guidance to help assess the adequacy of 

controls with respect to SSPs and complex products that members should include in their 

supervisory and compliance procedures, such as provisions relating to a reasonable basis 

 

registered representative ‘shall have reasonable grounds for believing that the recommendation is suitable for 

such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings 

and as to his financial situation and needs.’ As we have frequently stated, a broker’s recommendations must be 

consistent with his customers’ best interests.”) (citations omitted). See also In the Matter of the Application of 

Dane S. Faber, Exchange Act Release No. 49216 at 23-24 (Feb. 10, 2004) (“Before recommending a 

transaction, NASD Conduct Rule 2310 requires that a registered representative have reasonable grounds for 

believing, on the basis of information furnished by the customer, and after reasonable inquiry concerning the 

customer’s investment objectives, financial situation, and needs, that the recommended transaction is not 

unsuitable for the customer. A broker’s recommendations must be consistent with his customer’s best interests, 

and he or she must abstain from making recommendations that are inconsistent with the customer’s financial 

situation.”); In the Matters of Powell & McGowan, Inc., Exchange Act Release No. 7302 (Apr. 24, 1964) (a 

broker has “an obligation not to recommend a course of action clearly contrary to the best interests of the 

customer”); see also FINRA Regulatory Notice 12-25 (“Additional Guidance on FINRA’s New Suitability 

Rule”).

7 See Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969). See also SEC Division of Trading and Markets, “Guide to 

Broker-Dealer Registration” (April 2008).

8 FINRA members’ general suitability obligations are set out in FINRA Rule 2111 (“Suitability”) and the 

accompanying Supplementary Materials. See also FINRA Regulatory Notice 11-25 (“New Implementation 

Date for and Additional Guidance on the Consolidated FINRA Rules Governing Know-Your-Customer and 

Suitability Obligations”), FINRA Regulatory Notice 12-25 (“Additional Guidance on FINRA’s New Suitability 

Rule”), and FINRA Regulatory Notice 12-55 (“Guidance on FINRA’s Suitability Rule”). From January 1, 2011 

until July 8, 2012 during the review period, FINRA suitability obligations were set out in NASD Rule 2310

(“Recommendations to Customers (Suitability)”) and NASD Interpretive Materials, specifically IM 2310-1

(“Possible Application of SEC Rules 15g-1 through 15g-9”), IM 2310-2 (“Fair Dealing with Customers”), and 

IM 2310-3 (“Suitability Obligations to Institutional Customers”), as applicable. Broker-dealers have additional 

specific suitability guidance with respect to certain types of products or transactions. See, e.g., NASD Notice to 

Members 05-59 (“NASD Provides Guidance Concerning the Sale of Structured Products”) and FINRA 

Regulatory Notice 12-03 (“Heightened Supervision of Complex Products”). 

9 FINRA Regulatory Notice 12-03 (“Heightened Supervision of Complex Products”) (citing Rule 

2360(b)(19)(B)). 

10 See Exchange Act Section 15(b)(4)(E), NASD Rule 3010 (“Supervision”), and NASD Rule 3012 (“Supervisory 

Control System”). On December 1, 2014, FINRA’s new consolidated rules governing supervision went into 

effect. The new Rules 3110 (“Supervision”), 3120 (“Supervisory Control System”), 3150 (“Holding of 

Customer Mail”), and 3170 (“Tape Recording of Registered Persons by Certain Firms”) replace NASD Rules 

3010 (“Supervision”), 3012 (“Supervisory Control System”), 3110(i) (“Holding of Customer Mail”), and 

3010(b)(2) (often referred to as the “Taping Rule”) and other corresponding NYSE rule provisions. See FINRA 

Regulatory Notice 14-10 (“SEC Approves New Supervision Rules”).
4

suitability determination; customer-specific suitability analysis; and training for registered 

representatives regarding the characteristics, risks, and rewards of SSPs.11

III. Examination Observations

A. Controls over Suitability Determinations

The Staff cited all of the examined firms for deficiencies in failing to maintain and enforce 

policies and procedures relating to determining the suitability of recommendations of SSPs. All 

of the examined firms had policies and procedures governing suitability, processes for product 

development and approval, and training of representatives. Leaving aside the question of the 

adequacy of the written policies and procedures, the Staff found instances in which such controls 

were inadequately or inconsistently implemented.

The Staff began its analysis by using data analytics to conduct a review of all SSP sales at the 

examined firms during the review period. This analysis identified, on an aggregate basis, the 

predominant types of customers that had purchased SSPs at each firm and branch office, and it 

allowed the Staff to further scrutinize branch offices and representatives that had made high 

numbers of sales that merited further review. For example, the Staff’s review of all SSP trading 

at four branch offices of one firm12 revealed that the firm sold more SSPs to customers in its 

most conservative investment objective (“Income”) than it did to customers in its most 

aggressive investment objective (“Speculation”): approximately $96 million versus $11

million. While such observations did not necessarily indicate that there were unsuitable 

transactions, the Staff used this high-level information to identify and request further information 

from those branches and representatives that had conducted the highest numbers of such sales. 

 11 See FINRA Regulatory Notice 12-03 (“Heightened Supervision of Complex Products”) and NASD Notice to 

Members 05-59 (“NASD Provides Guidance Concerning the Sale of Structured Products”), supra note 8.

12 The Staff observed that the SSPs most frequently sold were higher yield, short-term SSPs with maturities 

ranging from three months to two years. These SSPs provided investors with an opportunity to receive 

contingent periodic payments of stated amounts of principal or interest if certain criteria were met. Upon 

maturity, investors would receive either cash in the original amount of the investment or a predetermined 

number of shares in an underlying company. Depending on market conditions, investors may receive no 

contingent periodic payments of principal or interest and may not recover the principal amount of their 

investment at maturity (e.g., receiving shares of an underlying company with a value below that of their original 

investment). In addition, neither the issuer nor distributor was obligated to repurchase these securities. Further, 

these SSPs generally were not listed on an exchange. As a result, these SSPs were often illiquid securities.
5

In this deeper review, the Staff reviewed e-mails indicating that representatives within one 

branch in particular were aggressively recommending SSPs to customers while appearing to 

mischaracterize the underlying attributes of the products in light of the goals of the investors,

particularly to non-English speaking investors. 

The Staff’s analysis also revealed that at two of the examined firms there was significant SSP 

activity in the accounts of elderly customers and in the accounts of customers for whom the firm 

did not have any age information. Data from one of these firms revealed that the firm often did 

not collect, and therefore representatives could not consider, information about customers’ age 

when making suitability determinations. While the absence of certain customer specific factors, 

such as age, does not necessarily render a transaction unsuitable, together with other factors, 

such lack of consideration may warrant further inquiry.13 The Staff discovered such additional 

factors when it also reviewed further documentation at these firms and reviewed e-mails. The 

documentation and emails indicated that representatives at one firm had retroactively changed 

customers’ investment objectives in their account documentation, without the customers’ 

approval, in order to justify concentrated positions of SSPs in the portfolios.

For each firm, the Staff also reviewed the volume and prices of repurchases of SSPs, often by 

broker-dealers affiliated with the issuer. While observations related to such reviews did not 

necessarily indicate that there were unsuitable transactions based on either the original 

recommendation for the customer to purchase or the subsequent recommendation for the 

customer to sell, the Staff used this high-level information to identify and request further 

information from those branch offices and representatives that had conducted liquidation 

transactions at well below face value (i.e., initial issuance price) of the SSPs. The Staff’s review 

of trade blotters indicated that various account types – including, but not limited to, trusts, 

individuals, and at least one employee benefits plan – had a large number of SSP purchases 

 13 See FINRA Regulatory Notice 12-25 at Q.17 (providing that the suitability rule “would not prohibit a brokerdealer from making a recommendation in the absence of certain customer-specific factors as long as the firm 

has enough information about the customer to have a reasonable basis to believe the recommendation is 

suitable. The significance of specific types of customer information will depend on the facts and circumstances 

of the particular case.”).

Income 

(17%)

Aggressive 

Income (4%)

Cap 

Appreciation 

(76%)

Speculation 

(2%)

Blank

(1%)

SSP Activity by Investment Objective –

Four Examined Branch Offices of Firm A

Income

Aggressive Income

Cap Appreciation

Speculation

Blank
6

during the two-year review period (from January 2011 through December 2012), and many of 

these SSPs were thereafter liquidated at well below face value of the SSP. Focusing on reverse 

convertible notes, the Staff found that the branch offices examined liquidated almost 25% of the 

purchases that representatives had sold to their customers. Over 35% of these liquidations were 

at prices below 80% of face value of the note, as shown in the table below.

RCN Liquidation Prices14 # of Liquidations

Less Than 70 27

Between 70 and 80 45

Between 80 and 100 57

Greater than 100 72

Total Sales 201

% of Sales Below 80 35.8%

B. Supervision of Suitability Controls

The examinations revealed that all of the examined firms failed to enforce their written 

supervisory procedures relating to reviews of representatives’ determinations of suitability with 

regard to SSPs. Additionally, the implementation of the firms’ review procedures varied across 

branches of the same firm.

For example, one firm’s written supervisory procedures stated that all SSP holdings should not 

exceed a certain percentage of the client’s stated liquid net worth. The Staff’s analysis, however,

uncovered that, at one branch, more than 1,800 of the over 3,000 SSP transactions 

(approximately 60%) exceeded the firm’s concentration guidelines. In almost 10% of these

transactions, the SSPs exceeded twice the total liquid net worth guideline (with some as high as 

100% of liquid net worth). This rate was significantly higher than the firm’s other branch 

offices, where less than 15% of SSP transactions exceeded the concentration guidelines. 

Moreover, this firm had a system in place to alert representatives and supervisors of breaches of 

concentration guidelines. This system required, in part, a review and documentation of reasons 

for an override of the firm’s guidelines. At this particular branch, all of these transactions had 

been approved by the branch manager or complex risk officer with little or no documented 

explanation to support their approvals. For example, the branch manager and complex risk 

officer would use generic language that the transactions were approved by the branch, but the 

language was not specific to either the investor or the transaction and did not explain the basis 

for the override, contrary to the firm’s internal guidelines and observed practices at other 

branches. In contrast, branch managers and complex risk officers in the firm’s other branches 

who had approved overrides to transactions that breached the concentration guidelines typically 

documented lengthy and specific descriptions of their reviews and the reasons for the overrides. 

 14 For this table of liquidation prices, the face value of the note was 100.
7

IV. Conclusion

In these examinations, the Staff observed not only indications that the examined firms’ suitability 

controls may be weak, but also significant weaknesses in supervision and implementation of 

internal suitability and supervisory procedures across branches of the same firm. This Risk Alert 

is intended to raise awareness of these types of weaknesses in order for registrants to consider 

them in their own compliance programs.

The Staff welcomes comments and suggestions about how the Commission’s examination 

program can better fulfill its mission to promote compliance, prevent fraud, monitor risk, and 

inform SEC policy. If you suspect or observe activity that may violate the federal securities 

laws or otherwise operates to harm investors, please notify us 

at http://www.sec.gov/complaint/info_tipscomplaint.shtml.

This Risk Alert is intended to highlight for firms risks and issues that the Staff has identified. In addition, 

this Risk Alert describes factors that firms may consider to (i) assess their supervisory, compliance and/or 

other risk management systems related to these risks, and (ii) make any changes, as may be appropriate, 

to address or strengthen such systems. These factors are not exhaustive, nor will they constitute a safe 

harbor. Other factors besides those described in this Risk Alert may be appropriate to consider, and 

some of the factors may not be applicable to a particular firm’s business. While some of the factors 

discussed in this Risk Alert reflect existing regulatory requirements, they are not intended to alter such 

requirements. Moreover, future changes in laws or regulations may supersede some of the factors or 

issues raised here. The adequacy of supervisory, compliance and other risk management systems can be 

determined only with reference to the profile of each specific firm and other facts and circumstances.