FINRA focus on “worst-of” structured notes: Heightened scrutiny of concentrations and Reg BI compliance

Scope of FINRA’s Review

Per its sweep letter, FINRA’s review will cover the period of January 1, 2022 through December 31, 2025. The review will focus on how firms supervise customer concentrations in higher-risk structured notes, particularly those with worst-of features and no principal protection.

The inquiry centers on firms’ compliance with Reg BI, including the Care Obligation, encompassing both reasonable-basis and customer-specific suitability determinations, and the Conflict of Interest Obligation, particularly the identification and mitigation of incentives associated with product recommendations. FINRA is also assessing compliance with applicable supervisory rules, with a focus on the adequacy and effectiveness of written supervisory procedures (WSPs) and surveillance systems.

Key Areas of Regulatory Focus

Based on FINRA’s enumerated information requests, firms should expect scrutiny across several core areas of their structured products frameworks:

• Written Supervisory Procedures. FINRA is focusing on firms’ WSPs and how firms classify structured notes by risk, including distinctions tied to principal protection, payoff structures, and worst-of or multi-underlying features. 
• Restrictions and Limitations. FINRA is also examining the extent to which firms impose and enforce concentration controls, such as account-level or portfolio thresholds and eligibility restrictions based on customer profile or sophistication. 
• Supervision and Surveillance. Firms’ surveillance systems and exception reporting will be reviewed closely, including how firms identify concentrated positions, high-risk recommendation patterns, and potential Reg BI concerns, as well as the trigger criteria and supervisory follow-up associated with those alerts. 
• Training. Training and oversight of registered representatives is another key area, with attention to whether firms require product-specific training prior to authorization and provide ongoing education. 
• Compensation and Potential Conflicts. FINRA is also focused on compensation structures and related conflicts of interest, including how representatives are paid for structured note sales and what controls are in place to mitigate incentive-driven conflicts. 
• Customer Disclosures. Firms should expect review of customer disclosures and communications, including the use of offering materials and how firms convey product risks—particularly downside exposure and lack of principal protection—as well as compensation-related information.

Focus on Firms’ Actual Practices

FINRA’s review is expected to extend beyond firms’ written policies and focus closely on how those policies operate in practice. In particular, FINRA is likely to assess whether firms are actively monitoring and enforcing concentration limits, maintaining adequate documentation to support Reg BI determinations, and ensuring alignment between product risk, customer profiles, and recommendations. 

FINRA is also expected to examine the effectiveness and timeliness of supervisory responses to alerts, as well as whether compensation structures create incentives that are appropriately identified and mitigated.

Implications for Firms

Consistent with our observations in representing broker-dealers in FINRA investigations involving recommendations and supervision of structured products, including under Reg BI, this initiative underscores FINRA’s continued concern with the risks associated with complex products and the heightened expectations for supervision under Reg BI. Firms that permit recommendations of non-principal-protected structured notes, particularly those with worst-of features, should expect increased regulatory scrutiny.

In our experience, areas of potential regulatory exposure often include:

• Unsuitable recommendations and misalignment with client profiles, including sales of structured notes and alternative investments to conservative or income-focused investors, or recommendations that are inconsistent with stated investment objectives
• Excessive concentration in higher-risk or illiquid products, including in senior or retirement accounts, without adequate justification or mitigation controls
• Product diligence and understanding gaps, including failure to conduct or document adequate due diligence, insufficient independent risk analysis, inadequate vetting of issuers or underlying assets, and lack of consideration of worst-case scenarios
• Failure to conduct ongoing product diligence and performance monitoring, including not tracking post-sale performance or reassessing continued appropriateness in light of changing market conditions or client circumstances
• Insufficient training for registered representatives and supervisors, including limited or overly generic training programs (“check the box”) that do not adequately cover product structure, risks, and appropriate use cases or test product knowledge 
• Insufficient product knowledge among representatives and supervisors, including situations where products are recommended without a full understanding of structure, risks, or liquidity
• Supervisory framework deficiencies, such as weak or outdated WSPs, overly generic policies, and supervisors’ lack of product-specific expertise
• Surveillance and escalation failures, including ignored or inadequately addressed alerts, exception reports, and red flags, as well as weak tracking and escalation of potentially problematic activity
• Reg BI documentation and process weaknesses, including insufficient support for recommendations and gaps between policy and practice
• Compensation-driven conflicts of interest that are not adequately identified, mitigated, or supervised
• Customer communication concerns, including overstated yield or return potential, understated risks, or disclosures that are technically accurate but not presented in a clear, understandable manner
• Inconsistent or poorly enforced concentration controls, including lack of clear thresholds or failure to apply them consistently across accounts and customer segments

Taken together, these issues reflect recurring themes in regulatory inquiries: a disconnect between policy and practice, insufficient focus on product risk in the context of the customer profile, and inadequate supervisory oversight and documentation.

Recommended Next Steps

Firms may consider conducting a proactive review of their structured products frameworks. This includes reviewing and, where appropriate, enhancing written supervisory procedures and product classification methodologies, as well as assessing current product due diligence protocols. 

Firms can consider evaluating the adequacy of concentration limits and related supervisory controls, along with the effectiveness of surveillance systems, exception reports, and escalation practices. In addition, firms can test the robustness of documentation supporting Reg BI compliance, review compensation practices and related conflict mitigation measures, and assess the sufficiency of training programs and customer-facing disclosures.

Proactive review can help identify and address potential issues early and position firms effectively in the event of a FINRA sweep or examination.

For additional information or to discuss how this development may affect your firm, please contact any member of our team.