The Securities and Exchange Commission is pressing large banks to provide investors with more accurate information about structured notes, complex securities that are often sold to wealthy individuals. The SEC's Office of Capital Market Trends, created in 2010 to monitor disclosures by financial institutions, is requesting that Citigroup, Bank of America, JPMorgan Chase, and other issuers improve their disclosure about the risks and pricing of the securities, according to the banks' correspondence with the regulator.
Sales of structured notes have surged in the current low-yield environment. The products generate fees for banks and can sometimes offer a cheap source of funding. Citigroup reported in the correspondence that more than 8% of its outstanding long-term debt, around $26 billion, was in the form of structured notes as of March 31, 2012.
In correspondence beginning in April 2012 and continuing through March 2013, the SEC asked issuers to better explain the pricing and risks of the products, according to documents released last month. Of particular concern is how banks value the products, which are illiquid and sometimes composed of hard-to-value assets. Issuers provide their customers with valuations for the notes that are higher than their own internal valuations, the SEC said in an April 2012 letter to the banks.
Banks are not required to provide a market for the securities, but they must disclose to customers the difference between the sale price of the securities, which may include broker fees and a markup, and their value. Issuers estimate the value based on the prices of similar bonds and derivatives that are traded more often, estimates that are called the "mid-market inputs."
But in a February 2013 letter, the SEC expressed concern that issuers may be massaging these estimates without disclosing their rationales. "For structured notes, issuers generally make adjustments to the mid-market inputs to estimate the value of an embedded derivative," Office of Capital Markets Chief Amy Starr wrote to JPMorgan Chase in February. "If you do not use mid-market inputs, we believe you should disclose this fact, describe what you use, and the risk that the embedded derivative is being valued differently than other similar derivatives."
JPMorgan Chase did not respond to a request for comment. Bank of America and Citigroup declined to comment.
The office was also concerned that the banks had been calling the securities "principal-protected" investments, and asked that they include more balanced information about the products' risks. That phrase has already led to some lawsuits, with investors arguing that the risks of the product were hidden. The SEC also asked that the banks tell buyers prominently that the products are subject to the credit risk of the issuer.
Some of the SEC's questioning appears to be consistent with previous criticism of structured products' valuation and sale. Banks agreed to address many of the SEC's concerns through better disclosure, although some of the product's critics questioned the utility of that approach.
"Structured notes are so formidably opaque that adding additional disclosure is not going to be very helpful," says Ted Siedle, a forensic accountant and critic of the products. Banks and their affiliates "have plenty of motivation to inflate the value, and the lack of a liquid secondary market allows them to do that."
The SEC's scrutiny of banks' disclosure is the just the latest sign that regulators are taking a closer look at the marketing of structured products. The Financial Industry Regulatory Authority released a notice last year indicating that it was heightening its supervision of derivatives-based products that are marketed to retail investors. The SEC and FINRA jointly issued a notice in 2011 asking that issuers do more to educate investors about the risks of structured notes and other products claiming to offer principal protection.
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