SEC says crucial information being withheld from investors in structured notes

The US Securities and Exchange Commission (SEC) has warned banks in a letter sent last week that they will have to give investors more details about what the structured notes they buy from them are worth.

The banks must now “prominently” disclose an estimate of their notes’ fair market value to investors when they are making investment decisions. This should be “a single number” that represents the sum of the underlying bond and embedded derivative, the two components of a structured note. If banks do not value the embedded derivative using the most widely accepted method for valuing these instruments – the so-called mid-market inputs – they must describe what style they use instead. To price their debt, banks typically use a combination of internal funding rate and secondary market spreads, but if they choose to use internal funding rates rather than market spreads to value the bond component of the note, they must say how this affects the valuation, the letter says.

The new disclosure will have to appear in banks’ offering documents and be communicated to investors prior to the time of sale, says the SEC.

The difference between the price investors are charged for structured notes and their value on the secondary market has been a hot topic for the US regulator. The agency previously suggested that investors may not have enough information to adequately understand the reasons for the difference between these values. This latest guidance appears aimed at filling this gap.

The letter provides detailed instructions on how to arrive at “issuer’s valuation”, but as long as they disclose their inputs and assumptions, banks are given some leeway in how they calculate the figure. One bank contacted by Structured Products praised the agency “for giving [the banks] alternatives”, but it may make meaningful comparisons between issuers difficult for investors, as one commentator pointed out when the guidance was first made public.

The agency had reportedly been holding informal meetings with the major issuers of structured products in order to learn about their programmes. As a result, the letter reads like it was written by someone well informed about the banks’ current practices. One bank that participated in the meetings called them “constructive”, while another praised the “level of consultation” by the SEC’s staff.

Last week’s letter follows upon a sweep letter the agency sent to banks in April and increased global scrutiny of the structured products industry by national regulators – punctuated last month when the Financial Industry Regulatory Authority (Finra) called structured products “troublesome” and a continued source of concern in its annual examination priorities letter.

The SEC says on its website that it views the comment letter process as a “dialogue” with companies and that it “does not evaluate the merits of any transaction or determine whether an investment is appropriate for any investor”. A London-based lawyer who interacts regularly with the regulator describes the process as a “learning experience” through which the agency seeks to “better understand” the financial product in question.

In a speech delivered in 2012, Finra head Richard Ketchum argued for product approval as a possibility in the US should sales practice abuses relating to complex products continue. In Europe, the Belgian securities authority ordered a voluntary ban on distributing what it called “particularly complex” structured products to retail investors in 2011. That same year, the UK Financial Services Authority (FSA) endorsed product intervention for retail financial products in a discussion paper.

A New York-based lawyer says she doesn’t see this latest letter as a “clear end” to the issues raised in the April sweep letter because issuers may respond differently to its imperatives. “The SEC will continue to review particular banks’ disclosure from time to time,” she says. “I don’t think this is the end.”

The comment letter and response letters will become publicly available on the SEC’s online database, Edgar, no earlier than 20 business days following the completion of its review, according to the SEC’s website.

The SEC declined to comment.


This article was first published on Risk

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