Abuses involving the sale of complex financial products to unsophisticated investors will continue to be an enforcement hot button in 2018, SEC Commissioner Kara M. Stein warned securities attorneys at the PLI’s SEC Speaks conference in Washington D.C. on Friday.
Despite SEC enforcement actions, “the commission continues to see abuses relating to the purchase and sales of complex products,” said Stein.
“Investors can lose money, or even a lot of money, but that’s not the issue,” Stein said. “What concerns me is the disconnect between what investors actually understand and what they really need to understand in order to have a fighting chance at using these products the way they are designed to be used.”
What would the SEC consider “complex” from a product sales perspective? Exchange-traded products and over-the-counter structured notes linked to indices could both be overly complex for retail investors, Stein said.
“The index methodologies on which these products are based often involve some form of calculus or advanced math. The embedded fees can be mind-numbingly complicated. Notably, the underlying investments can include instruments that would not be available to a retail investor directly. Despite this, these products are often sold to retail investors by financial professionals who make a lot of money by selling complex products. What’s more, it’s not even clear that all of these financial professionals fully understand the products they are selling,” Stein said.
Among Stein’s cautionary examples of complex product sales that ran afoul of the SEC was UBS paying $15 million to settle SEC charges it failed to supervise the sale of reverse convertible notes to retail investors in 2016. Merrill Lynch paid $10 million for using misleading statements to sell structured notes in 2017. Both the SEC and Finra have also brought a number of enforcement actions regarding sales practices of inverse and leveraged ETFs, Stein said.
While a big part of the SEC’s mission is to protect investors, even after issuers improve disclosure it is difficult to know if investors really understand what they are buying, Stein said, adding that disclosure may only be one piece of the puzzle.
Deciding if a product is a suitable or the best available option for an investor comes down to the person recommending or selling it—the rep or investment advisor—whom Stein called “gatekeepers on the front lines.”
Advisors and brokers “are charged with advising clients on their investments or how to comply with the law. All gatekeepers need to remember that there are real people behind each account number who are saving for college, retirement or any number of financial goals. Gatekeepers should be part of the solution, not part of the problem,” Stein warned.
The fact that many retail investors lack basic financial literacy makes the sale of increasingly complex products even more critical, Stein said. While financial education can have some impact, other studies have shown that attempting to improve general financial literacy often does not work to improve outcomes or subsequent behavior. “This is an area we should continue to understand and strengthen,” Stein said.