Staff Summary Report on Issues Identified in Examinations of Certain Structured 

Securities Products Sold to Retail Investors

By the staff of the Office of Compliance Inspections and Examinations

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

July 27, 2011

The SEC, as a matter of policy, disclaims any responsibility for any publication or 

statement by any of its employees. The views expressed herein are those of the staff of 

the Office of Compliance Inspections and Examinations and do not reflect the views of 

the Commission or of others at the SEC.
2

Staff Summary Report on Issues Identified in Examination of Certain Structured 

Securities Products Sold to Retail Investors

SUMMARY

Broker-dealers have long offered a range of structured securities to institutions and wealthy 

individuals. Certain structured securities products have been increasingly marketed to retail 

investors in recent years (referred to here as “SSPs” or “retail SSPs”).1Total U.S. sales of SSPs 

(to both retail and institutional investors) had risen from approximately $32 billion in 2004 to in 

excess of $100 billion in 2007. The demise of Lehman Brothers Holding Co. and its associated 

default on many SSPs it had issued and distributed, as well as its default on other of its structured 

products had a sobering effect across the SSP market in 2008. Nonetheless, SSPs seem to have 

resumed an overall upward sales trend in 2009 and 2010, and SSP sales to retail investors have, 

on an estimated basis, risen from $34 billion in 2009 to $45 billion in 2010.2

Starting in 2007, but predominantly in 2008 and 2009, Inspection staff from the Commission‟s 

Office of Compliance Inspections and Examinations (“OCIE”) reviewed the retail SSPs business 

of eleven broker-dealers: three large firms affiliated with bank holding companies that issue 

SSPs through such firms (which may be referred to here as “originating firms”); one wholesaler 

selling SSPs of an unrelated third party issuer through other broker-dealers; and seven smaller 

retail firms that also distribute such third-party SSPs. This report, which discusses the staff’s 

observations during these examinations, reflects the views of the staff and does not represent 

findings or conclusions of the Commission. This document should not be considered legal 

advice. The staff is considering what additional steps may be appropriate relating to SSPs.

Examination observations of note include evidence of broker-dealers recommending unsuitable 

SSPs to retail investors and engaging in secondary market purchases from and sales to retail 

investors at disadvantageous prices. Various examinations of the broker-dealers affiliated with 

the issuer, as well as the other retail broker-dealers, have identified deficiencies in the firms‟ 

supervisory and compliance structures as they relate to retail SSPs, including a tendency not to 

recognize SSPs as a distinct product class with special supervisory challenges – including 

surveillance for sales practice abuses as well as the need for specialized training for sales and 

supervisory personnel. 

The following OCIE staff worked on the examinations underlying this report: 

New York Regional Office: John M. Nee, Rosanne R. Smith, Linda Lettieri, Sonam Varghese,

 

1

See “An Arcane Investment Hits Main Street,” Wall Street Journal (June 21, 2006), “Twice Shy on 

Structured Products,” Wall Street Journal (May 28, 2009) and “Policy Issues Raised By Structured Products,” 

Jennifer Bethel & Allen Ferrell, Discussion Paper No. 56010/2006 John M. Olin Center For Law, Economics And 

Business (Harvard). Broker-dealer examinations conducted by staff from the United States Securities and Exchange 

Commission and from the Financial Industry Regulatory Authority (“FINRA”) have served to confirm this trend.

2

Financial services consulting firm Greenwich Associates indicated, according to Risk.net, that the global 

retail structured products market made a strong comeback at the end of 2009, and is poised to return to previous 

levels or may even grow in the near future. An article in Derivatives Week (February 3, 2010) contained similar 

findings. “Structured Notes: Not as Safe as They Seem,” Wall Street Journal (November 13, 2010).
3

Lourdes Caballes, Ethan J. Allfree, Ellen N. Hersh, Jennifer Fournier, Susan Castillo, Kathleen 

Kuzmen, Dee-Ann DiSalvo, Christy Wolanski, Tamara R. Heller, Sarah J. Curran and Savitri 

Singh.

Chicago Regional Office: Thomas F. Murphy, Daniel R. Gregus, James J. Malo, Marianne E. 

Neidhart, Joshua M. Herbst, Stephen G. Vilim, John G. Haworth, Edward W. Holland, Ambar 

Freyre, David W. Kinsella, Christopher Caprio, Anna M. Mieszaniec, Thomas P. Conroy and 

John T. Brodersen.

I. Background

Structured products encompass a range of financial instruments, such as securities that derive 

their value from, and provide exposure to, various asset classes, including, among other things, a 

single security, baskets of securities, indices, options, commodities, debt issuances and/or foreign 

currencies.3 SSPs are a subset of such securities products and are generally registered under the 

Securities Act of 1933 (“Securities Act”) in order to facilitate their offerings to retail investors. 

These registered securities are generally offered to retail investors in the form of medium-term or 

short-term corporate debt with exposure to a variety of asset classes issued by an affiliate of a 

broker-dealer, and then distributed by that broker-dealer. The issuer of the obligation is 

typically the parent public company of the affiliated broker-dealer underwriter. 

SSPs intended for retail distribution, which are sometimes listed on an exchange, typically have 

some form of option or other embedded financial derivative exposure. They may be described 

as offering, among other things, partial or full “principal protection,” higher interest payments, or 

leveraged and/or asymmetrical exposure to the underlying asset class. SSPs are often quite 

complex and can present wide-ranging risks and regulatory issues, including suitability and 

disclosure concerns, limited liquidity, comparatively opaque and often expensive fee structures, 

paucity of secondary market activity, and difficulty in pricing. They also pose supervisory, 

compliance and sales training challenges.

Based on the review conducted by OCIE, SSPs are issued and offered in five basic categories 

with varying payouts and risks.4 

The most basic category has been referred to as partial or full “principal protected” 

notes.5 Such notes typically have returns linked to broad-based equity indices, such as 

the S&P 500, Nikkei 225, and Nasdaq. The underlying assets for the majority of the 

notes described as principal protected notes that we reviewed are typically widely 

 

3

Structured securities products are not currently defined in the federal securities laws. Former Rule 434 

under the Securities Act (Prospectus Delivery Requirements in Firm Commitment Underwritten Offerings of

Securities for Cash) defined structured securities as “securities whose cash flow characteristics depend upon one or 

more indices or that have embedded forwards or options or securities where an investor‟s investment return and the

issuer‟s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, 

indices, interest rates or cash flows.” FINRA Notice to Members 05-59 defines them as “securities derived from or 

based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or foreign security.” 

4 These basic forms are often adjusted and/or combined with each other to form numerous types of SSPs.

5 As noted later in this report, these notes are “principal protected” only if held to maturity and, of course, are 

also subject to the creditworthiness of the issuer.
4

recognized indices such as the S&P or the Russell 2000, although some of the underlying 

assets could be more esoteric indices or defined baskets. SSPs described as principal 

protected with full protection tend to have the lowest yields of the SSPs, due to their 

principal protection component. The basic “principal protected” SSPs might have 

maturities of five years or more, but they usually have a duration of 6 months to 2 years.

The next category – enhanced-income notes – typically pays a higher coupon base and 

has capped returns tied to the value/performance of the underlying asset and may include 

at least some level of “principal protection.” The underlying assets for enhanced income 

notes typically include single stocks, baskets of stocks, and indices. Enhanced-income 

notes with indices as the underlying reference are typically coupled with increased 

principal protection and have longer maturities and lower yields than others. Enhancedincome notes typically have maturities of 5 years or less with the majority having 

maturities of 1.5-2 years. (The basic “principal protected” notes might have maturities of 

five years or more, but they usually have a duration of 6 months to 2 years.) 

Another category, performance/market participation notes are linked to underlying assets 

such as gold, or investment strategies, such as long-short strategies,6that are not 

otherwise easily accessed by small investors. 

The fourth category is leveraged/enhanced participation notes that offer a leveraged 

upside (with a leveraged risk of loss). (For example, the notes may pay a return two to 

three times the return on the underlying, usually with a cap on the return and no principal 

protection. 

In the fifth category, these basic forms are often adjusted and/or combined with each 

other to form numerous other types of SSPs, most notably reverse convertible notes 

(“Reverse Convertibles” or “RCNs”). Reverse Convertibles linked to a single entity are 

perhaps the riskiest SSPs available to retail investors. Investors are, in essence, 

purchasing a security with the sale of a put option embedded in it (some call option-SSPs 

are also offered). The payout for a typical equity-linked reverse convertible note is a 

high-level interest rate plus a return of principal at maturity if the equity increases in 

value (or stays the same) over the term of the note. However, if the underlying equity 

decreases below a set “trigger/knock-in” price at any time during the life of the note 

(even intraday for some issues) or if the equity closes below the initial level on the 

valuation date, instead of receiving the principal at maturity, the customer/investor will 

have “put” to him by the issuer a predetermined number of depreciated shares whose 

value on the date of maturity is less than the principal amount - while still receiving the 

coupon payments over the life of the note.7 These equity-linked Reverse Convertibles are 

 

6 A long-short SSP allows investors to participate in the performance of a leveraged long position of a basket of 

securities or indices and a short position of a different basket of securities or indices.

7 The “trigger/knock-in” price is typically 70–80% of the initial reference level; the initial reference level is typically 

the closing price of the reference shares on the day the SSPs are priced for initial sale to the public; the valuation 

date occurs a few business days before the maturity date of notes; and the predetermined number of shares delivered

to the investor is equal to 1,000 divided by the initial reference level per $1,000 principal amount. Some reverse 
5

equivalent to the investor writing/selling a put option on the underlying equity. Such 

notes lend themselves to being improperly marketed as conservative fixed-income 

investments when in fact they may be very susceptible to volatile or falling equity prices 

and may carry considerable risk of loss. 

The distribution fees on SSP instruments are upfront sales concessions embedded in the offering 

price. These vary depending on the complexity of the structure and term of the note. The typical 

SSP, which might have a maturity ranging from 3 months to three years, might have a fee of one 

and a half to three percent of the price. (Some longer term-structured products similar to SSPs, 

such as asset-linked certificates of deposit with maturity dates of five years or longer and the 

benefit of FDIC insurance may have distribution fees as high as 5% or more.) 

II. Current Literature and Resources

In September 2005, the National Association of Securities Dealers (“NASD”), now FINRA, 

issued Notice to Members 05-59, which provides guidance to member broker-dealers 

concerning the sale of retail SSPs.8 The notice was issued because of concern that members 

may not be fulfilling their sales practice obligations when selling SSPs, especially to retail 

customers. Notice to Members 05-59 provides guidance to members concerning their 

obligations when selling structured products, including the requirements to: (1) provide balanced 

disclosure in promotional efforts; (2) ascertain accounts eligible to purchase structured products; 

(3) deal fairly with customers with regard to derivative products; (4) perform a reasonable-basis 

suitability determination; (5) perform a customer specific suitability determination; (6) supervise 

and maintain a supervisory control system; and (7) train associated persons. The Notice 

highlights the FINRA rules that apply to activities involving SSPs, including NASD Rule 2210, 

which prohibits exaggerated statements and the omission of any material fact or qualification

that would cause a communication to be misleading. In addition, the applicable FINRA rules 

require that materials present a fair and balanced picture regarding both the risks and benefits of 

the offered product. NASD Notice to Members 05-59 can be found on FINRA‟s website at 

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p014997.pdf

More recently, in February 2010, FINRA issued Regulatory Notice 10-09, Reverse 

Convertibles, reminding member broker-dealers of their sales practice obligations with respect 

to these popular though complex SSPs that feature a high level of risk. In this Regulatory Notice, 

FINRA reminded firms that sell reverse convertibles to ensure that their promotional materials or 

communications to the public regarding these products are fair and balanced, and do not 

understate the risks associated with them. Firms are also reminded to ensure that their registered 

representatives understand the risks, terms and costs associated with these products, and that they 

perform an adequate suitability analysis before recommending them to any customer.

 

convertibles may be structured such that any breach of the trigger or knock-in level may result in the 

investor receiving less than the original principal regardless of share price at maturity.

8 Also, in November 2003 the NASD (FINRA‟s predecessor) issued Notice To Members 03-71, concerning member 

firm obligations when selling “non-conventional investments.” The NASD also issued Notice To Members 05-26 in 

April 2005, with best practices for reviewing new products, including complex products.
6

Also in February 2010 FINRA published an investor alert on reverse convertibles, which is 

available at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P120883.

In July of 2007, five trade associations jointly released a set of non-binding principles relating to 

retail structured products (the „RSP Principles‟) to guide their members (such as banks, 

investment banks, broker-dealers and other derivative dealers) in their dealings with each other. 

The RSP Principles focus primarily on the relationship between firms which are “providers” and 

“distributors” of SSPs for retail customers. These providers and distributors are the issuers, 

manufacturers and sellers of retail SSPs.9 The RSP Principles are available at 

http://www.sifma.org/regulatory/pdf/RSPrinciples0707.pdf. 

III. EXAMINATION OBSERVATIONS 

GENERAL OBSERVATIONS

At the larger broker-dealers which underwrite SSPs issued by an affiliate, certain deficiencies

and weaknesses were observed during the examinations in the areas of supervision of secondary 

market trading, disclosures to customers, and training. Based on instances of weaknesses 

observed at such large broker-dealers, firms should focus on issues such as:

having adequate procedures and controls in place to prevent and detect possible abuses in 

the secondary market for SSPs;

disclosing material facts regarding the SSPs being offered;

requiring that Registered Representatives (“RR”s) and their supervisors complete 

specialized training in SSPs prior to selling these products to customers; 

accurately listing SSPs on customer statements;

having controls to independently review their desk prices of SSPs in the secondary 

market; 

having controls to adequately review customer suitability;

having controls to review customer concentrations in the SSPs it sold;

pre-reviewing transactions in SSPs issued by an affiliate for purchases in ERISA 

accounts to prevent transactions that may be prohibited transactions. 

 

9 The RSP Principles are the product of a working group of their members, taking in the views of both distributors 

and providers and supported by a coalition of trade associations: European Securitization Forum (ESF), International 

Capital Market Association (ICMA), International Swaps and Derivatives Association (ISDA), London Investment 

Banking Association (LIBA) and Securities Industry and Financial Markets Association (SIFMA).
7

At the smaller, retail broker-dealers the most common area of concern was suitability, especially 

with respect to the sale of Reverse Convertibles. Training deficiencies were also common.

Based on weaknesses seen in these examinations, firms should focus on these issues: 

the suitability of SSP recommendations to retail customers;

establishing, maintaining and/or enforcing proper supervisory procedures relating to 

suitability determination for purchasers of SSPs;

having adequate training for the supervisors and RRs selling SSPs.

DETAILS REGARDING OBSERVATIONS

1. Customer Suitability 

Customer Specific Suitability 

The most significant SSP-related observations made during examinations of retail firms related 

to suitability with respect to the sale of Reverse Convertibles. There were numerous instances at 

these firms where the sale of RCNs did not appear to coincide with the customers‟ stated 

investment objectives and financial profile. In addition, the firms solicited the purchase of 

RCNs

10 without adequately disclosing to customers the material risks associated with investing 

in RCNs. Many of the customers experienced significant losses in these securities as the value 

of the underlying equity securities diminished. Staff interviews with some of these customers

highlighted their apparent lack of understanding of RCNs. Various firms were cited by the staff 

for violating NASD Rule 2310(a) when they made apparently unsuitable recommendations to 

purchase RCNs. In connection with those unsuitable recommendations, it also appears that some 

of the firms failed to conduct any sort of supervisory review of the suitability of these 

recommendations. In particular, it appeared that firms‟ written supervisory procedures often did not 

ensure that RCNs were only recommended to persons for whom the risk of such products is 

appropriate, and that all promotional materials were accurate and balanced as required by NASD 

Rule 2210. 

NASD Notice To Members 05-59 states, “Given the similar risk profile of many structured 

products and options, particularly those where principal invested is at risk from market 

movements in the reference security, it may be an appropriate investor safeguard to require that 

such structured products only be purchased in accounts approved for options trading." However, 

the staff observed that the originating firms examined and most of the retail firms did not have 

procedures in place consistent with this suggested guideline or take other appropriate steps prior 

to retail customers‟ investment in these products.11 

 

10 See section I for a detailed description of reverse convertible notes.

11 One of the retail firms examined had procedures which required option trading approval for customers who 

bought SSPs but it did not enforce those procedures.
8

Concentration Risk

Reports on customer concentrations in SSPs may be a beneficial practice, as the failure of 

Lehman Brothers and customer losses related to their heavy concentration in Lehman SSPs 

illustrates.12 Two of the three originating firms reviewed have monthly exception reports that 

review for customers‟ concentrations in SSPs. At both firms, the compliance department is 

responsible for reviewing these reports. The third firm does not have any customer 

concentration review procedure in place.

2. Disclosure Documents

For “principal protected” SSPs, the principal protection element only applies if the notes are held 

until maturity. However, at one firm, the prospectus, including a free-writing prospectus, that 

offered what was called a ten year 100% principally protected SSP did not disclose the risk that 

customers may receive less than the principal investment if these notes are redeemed before 

maturity. Nonetheless, the firm marketed the note as a “100% principally protected structured 

product.” Furthermore, the same firm‟s secondary market activity in the note revealed that 

customers who redeemed these products early sold below the principal value. All other SSP 

prospectuses reviewed for this firm included a disclosure that principal protection only applied if 

held to maturity. 

In the examination of one underwriting firm, the staff noted that the fixed income SSP disclosure 

documents listed the upfront sales fee (that was included in the offering price) for the 

underwriting broker-dealer from the affiliated issuer as zero percent. The actual fees paid to the 

firm on these deals ranged from one and a half to three percent of the deal‟s total purchase price. 

Per discussions with the firm, the free-writing prospectuses were updated in September 2007 to 

disclose these fees on the front cover; however, the final pricing supplement incorrectly still 

reflected a zero percent fee as late as March, 2008, inconsistent with the free-writing prospectus.

Additionally, there was no disclosure in this pricing supplement of the actual fee received by the 

firm. The staff cited the firm for a violation of NYSE Rule 472(i)(General Standards for All 

Communications). 

3. Customer Account Statement Classification

In its examinations of two other large firms, the staff noted that on customer account statements 

certain SSPs were inaccurately listed as “Preferred Securities.” At one of the firms, there were 

two SSPs that were inaccurately listed as preferred securities on customer statements. At the 

other firm, numerous equity-linked SSPs appeared inaccurately under the “preferred stocks” 

section of customer statements. The classification of SSPs as preferred securities did not 

accurately reflect the investment characteristics of the particular SSPs. At the first firm, the staff 

noted two complaints in which customers claimed they were sold SSPs by their RRs under the 

impression that these were actually preferred stock. 

 

12

 However, a firm may not be able to have a fully reliable way to determine the relative size of a specific 

customer‟s risk exposure to SSPs (or to other investments) if that customer has other accounts away from the firm.
9

4. Secondary Market Pricing 

SSPs are designed to be held until maturity and thus are not intended to be very active in the 

secondary market. The secondary market liquidity is often provided solely by the issuer 

affiliated broker-dealer that underwrote the SSPs. Examiners observed that trading in the SSPs 

is usually very thin regardless of whether the issue is listed or unlisted. At most firms, their 

trading desk prices are reviewed by an internal control group, independent of the trading 

business. However, the staff‟s review of one firm showed that its traders do not utilize models as 

a basis for their prices on SSPs and the traders‟ prices are not reviewed by risk management or 

any other independent control group. Since this firm is the only one to trade the SSP, a control 

to ensure that the prices are fair is warranted. The staff cited the lack of an independent review 

of the traders‟ prices as an internal control weakness.

5. Training 

NASD Notice To Members 05-59 states that firms “must train registered personnel about the 

characteristics, risks, and rewards of each structured product before they allow registered persons 

to sell that product to investors.” In addition, firms “should provide appropriate training to 

supervisors of registered persons selling structured products.” The review of the training 

materials available at all three firms examined showed that the training information included a 

description of the product, payout structures, underlying, investment strategy, key risks, and 

target investors. 

Two of the three originating firms examined do not have any training requirements for RRs 

regarding SSPs. Furthermore, none of the three firms examined have training requirements in 

place for the supervisors of RRs that market SSPs to their customers. Likewise, numerous retail 

firm and branch office examinations showed deficiencies in training at both the RR and 

supervisory level. At the two firms that did not have training requirements, the staff cited the 

lack of training requirements regarding SSPs as an internal control weakness.

6. Secondary Market Activity

Reviews of secondary market activity showed the following sales practice concerns: (1) 

customers selling SSPs soon after issuance; (2) customers purchasing SSPs soon after issuance 

and being charged a commission higher than the sales concessions included in the primary 

offering price; (3) customers selling (and thereby incurring a commission charge) a SSP near

payment/maturity date or likely automatic call date13 with some sales transactions that settled 

after the payout date; (4) customers “switching” SSPs, which are products designed to be held to 

maturity in most cases; and (5) purchases effected for customers at prices that exceeded the 

maximum return price of the SSP at call date. All of the reviews occurred at originating firms. 

The staff‟s review of secondary activity in SSPs raised concerns about the sufficiency of 

supervisory systems in this area at all originating firms examined. Specifically, the following 

weaknesses/inadequacies in the firms‟ controls and supervisory systems were noted:

 

13 Automatically callable notes are notes that are called if the underlying asset reaches a certain benchmark on select 

dates outlined in the prospectus. 
10

The firms do not review customer transactions soon after issuance;

The firms do not review customer sell transactions near maturity, especially those that 

settle on or after payment date;

The commission charges on secondary activity often greatly exceed sales charges on 

issuance and the firm‟s applicable guidelines; and

The firms do not review secondary activity in SSPs for possible switching, despite the 

high incentive for RRs to switch customers from one SSP to another.

IV. CONCLUSION

The level of SSPs being sold to retail customers has grown tremendously in recent years and 

today‟s low interest rate environment and reduced number of dividend paying stocks makes it 

more likely that this growth will continue. However, as this Report describes, SSPs present wideranging risks and regulatory issues, and they are becoming increasingly complex as evidenced by 

the large number of Reverse Convertibles being sold to retail customers. SSP sales to retail 

investors must be tempered by appropriate disclosures of relevant risks. And, as the collapse of 

Lehman Brothers – a significant issuer of SSPs - has shown, SSPs are also subject to the credit 

risk of the issuer.

Firms which sell SSPs to retail customers must: acknowledge the unique attributes and risks of 

these products; tailor their firm‟s disclosure, supervisory and surveillance functions to address 

those unique attributes, which include the secondary market concerns detailed in this Report; 

make a reasonable determination that SSPs are suitable for their customers generally, as well as 

for each specific customer; and supervise the manner in which SSPs may be marketed to 

conservative or other investors as suitable, when in fact they may not be suitable. OCIE staff 

and other regulators will continue to review this area for weaknesses in disclosure, supervision 

and sales practices, as well as other relevant areas such as are addressed in this Report, and to

detect and prevent improper or abusive practices and conduct.