CHARACTERISTICS AND RISKS

FINRA guidance requires a broker-dealer to assure that retail investors understand the unique characteristics and risks of a complex product recommended by the broker.

The fact that a product is “complex” indicates that it presents an additional risk to retail investors because its complexity adds a further dimension to the investment decision process beyond the fundamentals of market forces.

A non-exclusive list of complex products includes:

—> Asset-backed securities that are secured by a pool of collateral such as mortgages, payments from consumer credit cards or rent payments.

—> Products that include an embedded derivative component that may be difficult to understand.

—> Products whose repayment of principal or payment of yield depends upon an OTC reference asset, such that information about the performance of the reference asset is not readily available.

—> Products that have different stated returns throughout the lifetime of the product.

—> Products under which the investor might incur a capital loss as a result of the fall in the value of the reference asset without being able to participate in an increase in its value.

—> Products in which a change in the performance of the reference asset can have a disproportionate impact on the repayment of capital or on the payment of return.

—> Products with contingencies in gains or losses, particularly those that depend upon multiple mechanisms, such as the simultaneous occurrence of several conditions across different asset classes.

—> Structured notes.

—> Investments tied to the performance of markets that may not be well understood by many investors.

—> Products with principal protection that is conditional or partial, or that can be withdrawn by the product sponsor upon the occurrence of certain events.

—> Product structures that can lead to performance that is significantly different from what an investor may expect, such as products with leveraged returns that are reset daily.

—> Products with complicated limits or formulas for the calculation of investor gains.

All of the above investment types are considered complex products by FINRA because it would be unreasonable to expect an average retail investor to discern the existence of these features and to understand the basic manner in which these features interact to produce an investment return.

The same test logically applies to ERISA fiduciaries who safeguard the investments of plan participants. Because plan participants (typically) are not sophisticated investors, they must rely on the plan fiduciaries to exercise sound management over plan assets. In a very real sense, plan participants are the equivalent of indirect “retail investors.”

It is therefore essential that an ERISA investment manager evaluates the characteristics and risks of complex products that are placed into a pension plan through the manager’s discretion, or are recommended to individual 401(k) participants through the menu of investing options.

If an average plan participant would not discern the existence of these complex products in his or her pension plan; and would not understand the basic manner in which these complex features interact to produce an investment return, the ERISA fiduciary has a duty to explain these features and risks and give the participant a choice of whether to invest, or not invest, in a complex product.

Under ERISA, an investment fiduciary must invest plan funds:

“with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use.”

There is no specific “prudent man (person)” standard spelled out in ERISA.  However, prudent person standards for investing in complex products are set out in FINRA guidance directives, and should guide ERISA fiduciaries.

Otherwise stated, if a FINRA broker has a duty of care to investigate and discuss the unique characteristics and risks of complex investments concerning a retail securities investor, then, ipso facto, a similar and analogous duty of care extends to a pension fiduciary to act with the same level of care, skill, prudence and diligence, in adding a complex product to a pension plan or a 401(k) menu of investing options.

This is the level of fiduciary duty we strive to impose on plan fiduciaries who invest our clients’ funds in any complex product.