Just two weeks after Standard and Poor’s (S&P) downgraded the U.S. government’s credit rating to AA+, the New York Times reported that the Justice Department is investigating S&P’s ratings of mortgage securities in the lead up to the recent mortgage crisis.

Despite the timing of the news, we know that the investigation isn’t retribution for the downgrade since the investigation precedes the downgrade by months. But the rating agency’s downgrade of US treasuries certainly didn’t help its case, and is construed by many as an effort at establishing S&P independence.

The investigation began with the Securities and Exchange Commission (SEC) looking into whether S&P and Moody’s Investors Service turned a blind eye to problems with sub-prime mortgage bonds that it rated prior to the recent financial crisis. The Justice Department joined the SEC’s investigation in recent months.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the debt crisis and U.S. downgrade in Advisor’s Journal, see What Does the U.S. Downgrade Mean for Clients? (CC 11-159), Debt Limit Deal Leaves Unfinished Business (CC 11-154), & Democrats Call Debt Limit Unconstitutional (CC 11-134).

Structured security products (SSPs) encompass a range of financial instruments, such as securities that derive their value from, and provide exposure to, various asset classes, including, among other things, a single security, baskets of securities, indices, options, commodities, debt issuances and/or foreign currencies.

SSPs are a subset of such securities products and are generally registered under the Securities Act of 1933 (“Securities Act”) in order to facilitate their offerings to retail investors.

These registered securities are generally offered to retail investors in the form of medium-term or short-term corporate debt with exposure to a variety of asset classes issued by an affiliate of a broker-dealer, and then distributed by that broker-dealer.    The issuer of the obligation is typically the parent public company of the affiliated broker-dealer underwriter.

SSPs intended for retail distribution, which are sometimes listed on an exchange, typically have some form of option or other embedded financial derivative exposure.   They may be described as offering, among other things, partial or full “principal protection,” higher interest payments, or leveraged and/or asymmetrical exposure to the underlying asset class. SSPs are often quite complex and can present wide-ranging risks and regulatory issues, including suitability and disclosure concerns, limited liquidity, comparatively opaque and often expensive fee structures, paucity of secondary market activity, and difficulty in pricing. They also pose supervisory, compliance and sales training challenges.

Total U.S. sales of SSPs (to both retail and institutional investors) had risen from approximately $32 billion in 2004 to in excess of $100 billion in 2007.  The demise of Lehman Brothers Holding Co. and its associated default on many SSPs it had issued and distributed, as well as its default on other of its structured products had a sobering effect across the SSP market in 2008.  Nonetheless, SSPs seem to have resumed an overall upward sales trend in 2009 and 2010, and SSP sales to retail investors have, on an estimated basis, risen from $34 billion in 2009 to $45 billion in 2010.

SSPs can generally be classified into five basic categories with varying payouts and risks:

The most basic category has been referred to as partial or full “principal protected” notes. Such notes typically have returns linked to broad-based equity indices, such as the S&P 500, Nikkei 225, and Nasdaq.  The basic “principal protected” SSPs might have maturities of five years or more, but they usually have a duration of 6 months to 2 years.

The next category – enhanced-income notes – typically pays a higher coupon base and has capped returns tied to the value/performance of the underlying asset and may include at least some level of “principal protection.”  The underlying assets for enhanced income notes typically include single stocks, baskets of stocks, and indices.  Enhanced-income notes with indices as the underlying reference are typically coupled with increased principal protection and have longer maturities and lower yields than others. Enhanced income notes typically have maturities of 5 years or less with the majority having maturities of 1.5-2 years.

Another category, performance/market participation notes are linked to underlying assets such as gold, or investment strategies, such as long-short strategies, that are not  otherwise easily accessed by small investors.

The fourth category is leveraged/enhanced participation notes that offer  a leveraged upside (with a leveraged risk of loss). (For example, the notes may  pay a return two to three times the return on the underlying,  usually with a cap on the return and no principal protection.

In the fifth category, these basic forms are often adjusted and/or combined with each other to form numerous other types of SSPs, most notably reverse convertible notes (“Reverse Convertibles” or “RCNs”).  With Reverse Convertibles investors are, in essence, purchasing a security with the sale of a put option embedded in it (some call option-SSPs are also offered).  The payout for a typical equity-linked reverse convertible note is a high-level interest rate plus a return of principal at maturity if the equity increases in value (or stays the same) over the term of the note.

Tomorrow’s blogticle will contain a discussion relating to life insurance.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

The Financial Industry Regulatory Authority (FINRA) is targeting structured products over concerns about unsuitable sales to retail customers. In an exclusive interview with AdvisorOne (a Summit Business Media product) Bradley Bennett, enforcement chief at FINRA, said that the agency’s caseload relating to the recent financial crisis has eased up, and the agency is ready to renew its focus on structured products.

Structured products are often marketed to retail customers without an adequate explanation of their associated risks.  “They purport to provide the alchemy of lowering risk while increasing yield,” Bennett said, “but the risk needs to be explained” both to the broker-dealer’s “sales force and customers, and be suitable given the customer’s financial circumstances.”

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of structured products in Advisor’s Journal, see SEC Warns Investors about Principal Protected Notes (CC 11-117).

For in-depth analysis of structured products, see Advisor’s Main Library: 7774. What is a structured product? How are structured products taxed?

In a low interest rate world, high-yield investments offering principal protection are enticing to investors. But the complexity of some high-end investment products has the Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission’s (SEC) warning investors to look before they leap.

In an alert titled Structured Notes with Principal Protection: Note the Terms of Your Investment, the regulators warn investors that these structured products may not be what they seem. Although they are marketed under a variety of names with a “principal protection” component—e.g. “absolute return” and “minimum return”—the true extent of their safety is never obvious at first glance. Investors need to read the fine print to determine whether they are suitable for their investing needs and risk tolerance.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

Brokers’ disciplinary histories are now prominently displayed for the web savvy public; they’re no longer filed away at the Financial Industry Regulatory Authority (FINRA), where only the most diligent investors will find them. FINRA has made your disciplinary history freely and easily available to the public by launching a web-accessible discipline database.

Whether the easy accessibility of the information is a positive or negative will depend on a broker’s history. Those with a clean record will undoubtedly benefit from the easy accessibility of the information and the ease with which clients and prospects can canvass their record and compare it to others. Those with a negative history, whether deserved or not, may now find themselves on the defensive with prospects more often.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of FINRA complaint and disciplinary procedure in Advisor’s Journal, see FINRA Rule 45-30: Expansive New Complaint Report Requirements (CC 11-96) & Broker Bonus Arbitration Bottleneck Forces FINRA to Reconsider Arbitrator Qualification Standards (CC 11-08).

Dodd-Frank’s whistleblower provisions may be more effective than originally anticipated, but will they lead to increased corporate compliance?

Opponents of the whistleblower rules believe the rules are more likely to inhibit compliance procedures than to improve them. The generous Whistleblower provisions have also raised concerns about the already overcommitted SEC being overwhelmed by frivolous claims by employees who view the program as a lottery with multi-million dollar payouts.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of Dodd-Frank updates in Advisor’s Journal, see Is Barney Frank’s Resolve to Implement Dodd-Frank Weakening? (CC 11-95).

The Financial Industry Regulatory Authority (“FINRA”) has issued a regulatory notice addressing price volatility concerns associated with low-priced equity securities in customer margin and firm proprietary accounts. The notice advises that close attention be paid to low-priced equity securities; price volatility is usually associated with low-priced equities because they are inherently volatile. But what does FINRA consider a “low-price equity,” and what does it mean for you and your clients?

FINRA advises firms to weigh the risks that come with low-priced equity securities before extending credit in strategy-based or portfolio margin accounts. FINRA cautions firms to consider “volatility and concentrated positions in a single customer account and across all customer accounts, as well as the daily volume and market capitalization of each security when imposing ‘house’ maintenance margin requirements.”

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of FINRA-issued guidance in Advisor’s Journal, see Getting Your Feet Wet in the Social Media Market (CC 11-79) & SEC Says “Not So Fast” to Advisor Social Media Marketing (CC 11-40).

Why is this Topic Important to Wealth Managers? This blogticle presents discussion on proposed rules that would affect wealth managers who charge performance fees in association with asset management. Given the proposed rule some clients may become exempt from the performance fee structures allowed, thus staying informed on the subject is critical for some wealth managers.

Earlier this week the Securities and Exchange Commission provided a public notice of its plan to raise certain dollar thresholds that would need to be met before investment advisers can charge their clients performance fees.

Generally, section 205(a)(1) of the Investment Advisers Act generally prohibits an investment  adviser from entering into, extending, renewing, or performing any investment advisory contract  that provides for compensation to the adviser based on a share of capital gains on, or capital  appreciation of, the funds of a client. [1]

Congress prohibited these compensation arrangements (also known as performance compensation or performance fees) in 1940 to protect advisory clients from arrangements it believed might encourage advisers to take undue risks with client funds to increase advisory fees.

By 1970 however, Congress provided an exception from the prohibition for advisory contracts relating to the investment of assets in excess of $1,000,000, if an appropriate “fulcrum fee” is used. [2]

Congress subsequently authorized the SEC to exempt any advisory contract from the performance fee prohibition if the contract is with persons that the SEC determines do not need the protections of that prohibition. [3]

The SEC thus adopted rule 205-3 in 1985 to exempt an investment adviser from the prohibition against charging a client performance fees in certain circumstances.

Currently, Rule 205-3 under the Investment Advisers Act allows an adviser to charge its clients performance fees in certain circumstances. Two of the circumstances are:

1. The client has at least $750,000 under management with the adviser.
2. The adviser reasonably believes the client has a net worth of more than $1.5 million.

Section 418 of the Dodd-Frank Act requires the SEC to issue an order to adjust for inflation these dollar amount thresholds by July 21, 2011, and every five years thereafter. As a result, the SEC issued its recent notice that it intends to issue an order to revise the dollar amount tests to $1 million for assets under management and $2 million for net worth.

The SEC also proposed related amendments to Rule 205-3 that would:

• Provide the method for calculating future inflation adjustments of the dollar amount tests.
• Exclude the value of a person’s primary residence from the determination of whether a person meets the net worth standard.
• Modify the transition provisions of the rule to take into account performance fee arrangements that were permissible at the time the adviser and client entered into their advisory contract.

The SEC is now seeking public comment on these proposed related rule amendments.

For previous coverage of recent SEC rulemaking in Advisor’s Journal, see SEC Unprepared to Implement a Fiduciary Standard for Broker-Dealers (CC 11-33), SEC Fiduciary Standard Study Answers Few Questions (CC 11-25), Study Finds that Universal Fiduciary Standard Will Hurt Investors (CC 10-97) & What You Don’t Know Yet Might Hurt You: A Broker’s Duties under the Financial Reform Act (CC 10-40).

Next week’s blogticles will discuss current wealth management issues.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] A fulcrum fee generally involves averaging the adviser’s fee over a specified  period and increasing or decreasing the fee proportionately with the investment performance of  the company or fund in relation to the investment record of an appropriate index of securities  prices.  See rule 205-2 under the Advisers Act.

[3] Section 205(e) of the Advisers Act.

When advisors hear the term “social media marketing,” the usual list of suspects comes to mind: LinkedIn, Facebook, and Twitter. Could Advisor Pages, a new advisor search engine, be the next business boosting social media site like LinkedIn, or will its cost to advisors outweigh any marketing benefits?

The hype surrounding social media marketing has yet to die down, and advisors’ use of online marketing techniques continues to grow. Adding to the panoply of sites relevant to advisors, BrightScope recently launched Advisor Pages, a free online service that allows consumers to search for financial advisors. Advisor Pages compiles data from public sources, including the Financial Industry Regulatory Authority (“FINRA”) and the Securities and Exchange Commission (“SEC”). Search results can be tailored based upon advisors’ names, locations, amounts and types of assets under management (“AUM”), employers, formal complaints, legal disputes and more.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber)

For previous coverage of social media in Advisor’s Journal, see Getting Your Feet Wet in the Social Media Market (CC 11-79) & It’s Not Facebook That’s Making Microsoft Obsolete: Advisor Technology Trends (CC 11-49).

Why is this Topic Important to Wealth Managers? This blogticle presents discussion on trades made based on inside information. We have all heard about Enron and the fraudulent practices, but liability can actually extend well beyond insiders. It is thus important to realize sensitive information shared with wealth managers could be subject to federal regulation to prevent trading based on manipulative or deceptive devices.

What is the liability imposed by federal law with regards to trading based on inside information?

Generally trading based on inside information is legislated under Section 10(b) of the 1934 Securities Exchange Act, [1] and SEC Rule 10b-5 promulgated thereunder. [2]

As the law is currently stated, it is unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange:

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Generally liability can occur for civil and criminal penalties when an insider or temporary insider tips or trades based on material non-public information. Not only are tippors liable though, tippees may be as well. When an individual trades on material non-public information which was given to him by a tippor, he may be held liable if he knew or had reason to know the tippor was breaching a fiduciary duty (owed to the corporation) by tipping.  A breach of fiduciary duty generally occurs if there is a personal financial gain, increase in reputation or quid pro quo.

Moreover, there may be investor and SEC liability for those who are considered “misappropriatiors”. Under the misappropriation theory an individual may be held criminally or civilly liable based on the purchase or sale of securities on the basis of, or the communication of, material non-public information misappropriated in breach of a duty of trust or confidence.

A duty of trust or confidence generally exists when:

(1) Whenever a person agrees to maintain information in confidence;

(2) Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or

(3) Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling. Provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information. [3]

Tomorrow’s blogticle will continue to discuss issues related to the practice of wealth management.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] 17 C.F.R. § 240.10b-5.

[3] 17 C.F.R. § 240.10b5-2.