Structured products are a type of derivatives-based securities. While structured products may provide a rate of return above the prevailing market rate, their risk and complexity make them unsuitable for most investors.
Financial advisers may have additional obligations when recommending structured products. Investors who lost money on structured products may be able to file a claim and recover their losses.
WHAT ARE STRUCTURED PRODUCTS?
The basic characteristics of structured products include:
- They are based on a traditional security, such as a bond, but have a non-traditional payoff.
- The payoff is based on the performance of underlying assets (i.e. a derivatives).
- Performance-based payoffs are contingent (if the underlying assets pay out “x,” amount the investor receives “y” amount).
- If the underlying assets do not perform at sufficient levels, there is no payout to the investor.
Beyond these traits, structured products are highly-customizable and can vary widely. For example, some (but not all) structured products are listed on a national securities exchange, they may or may not have principle protection (and protection levels are variable), and payout structures depend on the individual product.
These are just a few of the factors that make structured products difficult to understand—and inappropriate for—the typical investor.
FINRA HAS WARNED ABOUT STRUCTURED PRODUCTS
Structured product sales began in the 1980s, but it wasn’t until the 2000s that they were targeted at retail investors as a way to easily access derivatives that previously were popular with institutional investors.
Investment professionals were eager to sell structured products to retail investors and earn commissions, but the Financial Regulatory Authority (FINRA) in 2005 warned brokers and brokerages about the way they were selling structured products. Many investors suffered heavy losses from structured products in the 2008 financial crisis.
In 2011, FINRA and the SEC directly warned investors about structured product risks. FINRA also began cracking down on brokerage firms for improperly selling structured products.
Despite numerous warnings and sanctions, firms continue selling structured products without adequately explaining how they work or what their risks are. In fact, the complexity and obscure features of these securities makes them difficult to fully understand even for investment professionals.
When a broker sells securities that are not offered by the brokerage firm, this is called “selling away.”
Selling away is a violation of securities regulations. If an investor suffers losses in a selling away situation, the broker—and ultimately, the brokerage firm—may be liable.
SELLING AWAY SCHEMES CAN BE DANGEROUS FOR INVESTORS
Brokerage firms keep a list of products that its brokers may sell to investors. Products on the list have been approved based on the firm’s due diligence process, which is designed to filter out disreputable and risky investments. Investment products not approved for sale by the firm are more likely to be high-risk or fraudulent.
A broker may sell away in order to earn a commission on an investment the client is willing to buy, or in order to not have to share the commission with the brokerage firm. Brokers may steer clients towards unregistered investments in which the broker has a personal financial interest. Selling away can also conceal more deliberate fraudulent activities, such as Ponzi schemes.
SELLING AWAY CAN BE LEGAL, BUT FIRMS MUST APPROVE AND SUPERVISE
Although brokers may sell securities that are not offered by their firm, the firm must be given written notice and sign off on any such transaction. If a brokerage firm approves an unregistered transaction, the firm is then responsible for supervising the transaction.
Brokerage firms may try to avoid liability in a selling away case by denying that they knew about the outside transaction. But firms are required to have reasonable supervisory procedures in place that can detect selling away and other violations.
Perhaps more importantly, firms must implement their supervisory procedures in a reasonable manner, including investigating possible red flags such as broker irregularities. There may be a heightened duty to supervise a broker who has a history of disciplinary actions, customer complaints, or other legal issues.
SELLING AWAY RED FLAGS
Investors often are not aware when a broker sells investments without the approval of the brokerage firm. There may be certain red flags, however, that indicate possible selling away.
For starters, you should always perform a background check on your broker. FINRA offers free background checks through its BrokerCheck service.
Research shows that broker misconduct is more prevalent among repeat offenders, so prior complaints or disciplinary action for selling away (or any securities violation) is a red flag.
Investors should also be wary of:
- Non-public investments such as private placements.
- Investment offers that sound too good to be true (such as “special,” “secret,” or “limited time” offers).
- Documents (including a transaction “confirmation” document) given to you by the broker that do not have the brokerage firm’s name on them.
- Requests for payments or communications outside of the firm’s official channels.
Selling away often occurs in conjunction with other securities violations, such as recommending unsuitable investments and misrepresentation.
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