FINRA set guidelines for the first time for how banks in the U.S. should perform due diligence on brokers who sell their structured notes.

Issuers should conduct background checks on distributors as well as relevant employees, according to a report on conflicts of interest the industry watchdog released on Oct. 14.

FINRA summarized practices on managing conflicts of interest among brokerage firms, including having brokers explain complex securities, according to the report. The regulator doesn’t set any new rules, but expects brokers to “implement an appropriate conflict management framework.”

The approach is “carrot and stick” rather than rulemaking, said Bradley Berman, a lawyer at Morrison & Foerster in New York. “They’re going to look at what people are doing over time and they’re saying ‘we could, if necessary, go to rulemaking if we don’t see conflicts-of-interest procedures being implemented and investors being informed about conflicts.’”

FINRA asked brokers to detail their most significant conflicts and how they manage them in a July 2012 letter.


“While many firms have made progress in improving the way they manage conflicts, our review reveals that firms should do more,” Richard Ketchum, FINRA’s chief executive officer, said in a statement.

The know-your-distributor guidelines in the report can be applied whenever third-party distributors, like brokerages that aren’t owned by banks, are used to sell structured notes, Berman said.

Banks creating structured notes should conduct background checks on individual brokers, including looking for complaints and litigation, according to the report. The issuer should also review the financial health of the firm, require distributors to complete questionnaires on sales practices, conduct interviews on its “compliance culture,” obtain information on compensation and customers, and review sub-distributors.

“There needs to be supervision and management to prevent conflicts,” said Jacob Zamansky, a lawyer who has represented investors over soured structured notes. “Otherwise, you get these firms that are pushing products that investors don’t want or are not suitable.”


Before the report was released, security issuers were expected to perform due diligence on distributors and evaluate their compliance culture, but there wasn’t “a large amount of specific regulatory guidance,” according to a March 2012 report from Morrison & Foerster, which tracks the industry.

“FINRA has done something new here,” Berman said. “They’ve summarized information on know-your-distributor practices gathered from firms, describing them as ‘effective processes’ for assessing potential distributors for a product manufacturer’s products.”

Banks have sold $31.5 billion of structured notes this year, about the same as during the same period in 2012, according to data compiled by Bloomberg.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.



Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access