DISCLOSURES AND SALES PRACTICES CONCERNING MARKET INDEXED/LINKED CERTIFICATES OF DEPOSIT
 

Information Memo  06-12  is available for viewing or printing with Adobe Acrobat
   
Number 06-12 03/17/2006
 
ATTENTION:   CHIEF EXECUTIVE OFFICER, MANAGING PARTNERS, COMPLIANCE AND LEGAL DEPARTMENTS
 
TO:   ALL MEMBER ORGANIZATIONS
 
SUBJECT:   DISCLOSURES AND SALES PRACTICES CONCERNING MARKET INDEXED/LINKED CERTIFICATES OF DEPOSIT
 



Introduction

Recent sales practice reviews have raised regulatory concerns relating to the marketing of certificates of deposit (“CDs”) that are linked to market indices. Of particular concern is the adequacy of disclosure materials used in connection with the sale of these instruments to customers and whether registered representatives and customers fully understand the product and how it differs from conventional CDs. This Information Memo provides member organizations with guidance regarding the sale of these products pursuant to NYSE Rules 401 (“Business Conduct”) and 405 (“Diligence as to Accounts”).1

While this Information Memo deals specifically with market-linked CDs, many of the responsibilities discussed are generally applicable to other products. Where new products are brought to market, member organizations have a responsibility to make certain that the product is well understood, both by its originators and by its sales force. Member organizations must identify the customer criteria that will define the appropriate market for the product generally, and provide training to their registered representatives to assure that they can identify customers for whom it may be suitable. This will entail education for the registered representatives and development of disclosure materials for the intended customers. Lastly, member organizations should devise internal procedures to monitor and supervise the new product sales and identify any problems that may arise from its novelty or complexity.
General Product Description

Market Indexed/Linked CDs (“MCDs”) are hybrid investments often marketed to customers as providing the ability to participate in the gains of a market index, such as the S&P 500, while guaranteeing the return of principal at maturity. MCDs usually combine zero-coupon bonds with stock options on the underlying market index. When held to maturity, MCDs are intended to offer a return of their initial investment with potential upside gain, based on the performance of the underlying index. MCDs are also often purported to provide account diversification because of the instrument’s relationship to the underlying index, thus increasing the breadth of a portfolio by participation in the index. MCDs are insured by the FDIC for up to $100,000 per account held at each institution. Immediate redemption of the MCD in case of the beneficial owner’s death may be permitted.

Disclosures Related to Market Indexed and Market Linked CDs

When marketing MCDs, certain disclosures should be made to customers due to the unique nature of the instruments. Customers can easily confuse MCDs with CDs traditionally issued by banks, particularly if they are sold by registered individuals located within banks.2 Member organizations should assure that the risks associated with MCDs are clearly explained and that appropriate disclosures are provided to customers prior to or at the point of sale. Such disclosures may be conveyed through an oral review of the applicable risks in conjunction with the provision of a written disclosure document. Some of the risks and features that should be clearly disclosed to customers are listed below.

Market Risk

Unlike traditional bank CDs, MCDs are subject to market risk if they are sold prior to maturity, which is typically 5 – 7 years. As with negotiable fixed rate CDs, if an MCD is liquidated prior to maturity, it may be worth less than the purchase amount or face value as its value is dependent upon fluctuations in interest rates and the performance of the specified index.

Liquidity Risk

Customers may have limited opportunities to redeem MCDs prior to maturity; a secondary market is not guaranteed and may not exist. In most instances, MCDs can be redeemed only on pre-specified liquidation dates. Therefore, customers may not be able to redeem the MCD on the exact date that they may want or need their money to be available.

Call Risk

Some MCDs may have call features that allow the issuing organization to call the MCD prior to its maturity with prior written notification to the customer. If called, the MCD will be redeemed at the call price and the customer may not realize the same return as he or she would have had the MCD not been called or if it had been called at a later date. In addition, the customer may not be able to reinvest the proceeds in a similar instrument since interest rates and index levels may have changed since the MCD was initially purchased. It is important that customers understand that an MCD is only callable by the issuing institution and that the customer does not have the right to put the MCD back to the issuing institution.

Tax Implications

The tax implications to the customer must also be clearly disclosed, including an explanation of the differences in tax treatment between MCDs and traditional CDs. As with zero coupon bonds, even though the actual interest is not received until maturity, the customer will be required to pay tax on the increase in the accreted value of the MCD on a yearly basis, where it is held in a taxable account.

Valuation

MCDs are typically priced based on an average of the value of the linked index on pre-specified valuation dates less the value of the linked index on the initial purchase date. Customers should be advised, preferably in writing, of the method used to derive valuation and, if applicable, that the price may not be based on the actual closing value of the linked index on the final maturity date.

Where practicable, MCDs should be priced at market value on customer account statements, not at the purchase amount or at par unless that is the actual market price.3 By pricing the MCDs at par or at the initial purchase amount, customers may be led to believe that the value of the MCD is greater than the actual market price and may expect a greater return if they try to sell it prior to maturity. Where the member organization is unable to price MCDs at market value, disclosure should be made as to the limitations of the stated price. Such disclosure may be made on the statement itself or the statement could refer the customer to where additional information is available.

It is also important to disclose to customers that the market value of an MCD may not correspond directly to increases or decreases in the underlying linked index. For example, a 15% increase in the underlying index may not result in a corresponding 15% increase in the value of the MCD’s index component. An MCD may cap the potential return on the underlying index at, for example, 6%. Any limitation or cap on the potential upside return must be clearly disclosed to customers in a readily understandable, plain English, format.
Training

All registered individuals who sell this product should receive proper training and should fully understand the product prior to soliciting customers. Such training, which may be incorporated into the Firm Element of the member organization’s Continuing Education program,4 should fully reflect the details, characteristics and risks of the product and the ways in which it differs from conventional CDs. A mere acknowledgement by a registered individual that he or she is familiar with MCDs may not be sufficient to ensure that the individual fully understands and is qualified to sell them.
Summary

As always, the proper disclosure of risks associated with all investment products is necessary. However, a higher level of caution should be exercised with MCDs as they may not be fully understood by investors and thus could be easily mistaken for a traditional bank issued CD. Member organizations should carefully consider the use of a brief disclosure document, clearly outlining all the features and risks of the MCD. Any disclosure document should be written in plain English and should be tailored to the needs of the expected class of persons to whom the MCDs will be marketed.

Disclosures may be made orally in the course of recommending a purchase in conjunction with the provision of a written disclosure document. Member organizations are urged to use the most effective means at their disposal to assure fair and adequate disclosure on a timely basis.

If there are any questions regarding this Information Memo, please contact Gregory Taylor at 212-656-2920 or William Jannace at 212-656-2744.

_______________________________________
Grace B. Vogel
Executive Vice President
Member Firm Regulation


_______________________________________
1 See also NYSE Information Memos Nos. 01-05 and 01-19 for related guidance.
2 While banking and securities regulators have detailed rules prescribing the separation of bank and brokerage activities on bank premises, the sale of these products requires especial care, since their terminology could easily lend itself to misunderstanding. See also Information Memo 05-74, announcing the approval of a new branch office definition and exceptions for “offices of convenience.”
3 See Information Memo 01-05 for guidance on this point.
4 See NYSE Rule 345A(b).