SEC warns structured note issuers over proprietary indexes

A senior SEC official has warned US issuers that it is closely monitoring the current uptick in the sale of structured notes tied to proprietary indexes

Amy Starr: full and fair disclosure needed

A senior regulator at the Securities and Exchange Commission (SEC) has warned US banks that it is scrutinising the sale of structured notes tied to proprietary indexes, arguing that dealers' sales networks may not understand the payout profiles of the products they have been tasked with selling.

Giving the keynote address at the Structured Products Americas conference in Miami on May 14, Amy Starr, chief of the Office of Capital Markets Trends in the SEC's Division of Corporation Finance, warned issuers that her office was monitoring the recent uptick in issuance of notes tied to proprietary indexes closely, and voiced concerns as to whether investors understood what they were buying.

"I don't know how many of you are mathematicians who may be able to figure out complex formulas, but I can assure you the retail investor is not. I wonder how disclosure alone of such formulas could provide the retail investor or even other so-called reasonable investors with the information they need to make an informed investment decision. I also wonder how many brokers and advisers who sell these products to retail investors actually understand what they're selling: both how the notes will pay out and what the related risks are," said Starr.

Commenting on the buoyant issuance market for structured notes in the US despite regulatory headwinds, Starr suggested that the rise of notes tied to proprietary indexes – rules-based formulae that banks have developed in-house to give investors exposure to a certain market or investment style in a targeted manner – was one the SEC was keeping a close eye on. Many US banks already have large proprietary index businesses, while others are known to be scaling up their presence in the market.

"The use of complex or proprietary indexes in structured notes raises some interesting questions: what type of retail investor are these sold to, and how can they understand the disclosure? We've seen many structured notes with payouts and indexes that use highly complex formulas to determine how the note is valued, including fees and costs that are embedded into the index performance and therefore impact what an investor may realise on the note," Starr said.

I'd like to think that it's better to talk to my office before a product is offered and sold than it is to the department of enforcement afterwards

In light of the recent uptick, she added, the SEC was seeking to understand whether firms had been in touch with their investment adviser and broker-dealer networks to assess whether their sales procedures and polices took account of the added complexity inherent in such products.

"My office is also concerned that, for some complex indexes or referenced assets or issuers, there may be a lack of transparency about the index, asset or issuer, both at the time of issuance and on an ongoing basis. This raises the potential that there may not be full and fair disclosure to the investor about the structured product that they own or will be purchasing," she said.

Bitcoin concerns

Starr pointed to the pending launch of a bitcoin-based exchange-traded fund on Sweden's Nasdaq exchange as an example of a novel asset that would raise important disclosure questions for the SEC. "If a similar product is planned for launch in the US, we'd be interested in how the product would be structured and how the valuations would be made, both initially and on an ongoing basis. As with other types of asset or index that may not be as fully transparent and verifiable to value, some interesting questions would arise. Would the bitcoin be valued based on trading on an exchange such as the recently defunct Mt. Gox? Or would the valuation be based on a formula or calculation using other unregulated exchanges? How would the information be verified and made publicly available?"

In fact, a bitcoin trust backed by US investors the Winklevoss twins has filed a preliminary prospectus with the SEC to list exchange-traded funds on Nasdaq OMX.

According to the filing, "the net asset value (NAV) of the trust will be calculated daily and is the aggregate value of the trust's assets less its liabilities (which include estimated accrued but unpaid fees and expenses). In determining the NAV of the trust, the administrator will value the price of the bitcoins held by the trust as determined by the price of bitcoins at 4:00pm [New York time] on Winkdex [a pricing service backed by the twins which aggregates prices from across the most active US dollar-denominated bitcoin exchanges]."

"I'm sure that folks may be considering products today that may raise similar disclosure concerns. I would encourage you all to speak with us before introducing new products: we have a process for that. I'd like to think that it's better to talk to my office before a product is offered and sold than it is to the department of enforcement afterwards," Starr added.

She acknowledged that such products can offer retail investors the chance to diversify their exposure or gain access to bespoke strategies, without the need to invest in an actively managed alternatives fund. But she urged issuers to thoroughly vet the sales practices and incentives offered to their broker-dealer networks where sales of such products are concerned, as well as ensuring that sales staff understand what they are selling.

"How many retail investors cry out to their brokers or advisers for an incredibly complex product that will give them exposure to an esoteric, customised or proprietary index that they don't understand? I would suggest few, if any," she concluded.

It is not the first time that regulators have scrutinised dealers' development of products tied to proprietary indexes. Two years ago, lawyers in the US and Europe warned that dealers should be careful to describe to investors in detail the rules followed by rules-based indexes – not just so that investors have all the information they need, but also to cover a bank against prospective claims that the index was poorly designed or represented a conflict of interests – a distinction enshrined in the US Investment Advisers Act of 1940.