More complex securities | Series 10 Basic securities

Direct participation plans (DPPs)

The primary feature of a DPP is the passthrough of losses in addition to gains. Other investments, like REITs, pass through gains but not losses; DPPs pass through gains AND losses. There are several corporate structures DPPs can be, usually a limited partnership, but it could also be an S-corp, or a similar type of structure.

With all limited partnerships, there is at least one general partner. The general partner manages the business and is personally liable for its debts. Limited partners are passive investors: they are not involved in day-to-day management, and they usually vote only on major matters, such as a rollup or removing the general partner (FINRA Rule 2310). A limited partnership must have at least one limited partner as well: one whose partners are all general partners is a general partnership. For the general partner to raise money for the DPP, they could do it publicly or privately. To offer the securities publicly they must register with the SEC, and use an underwriter, a sponsor, or a syndicator in the case of DPPs. To offer the securities privately, the general partner would attempt to locate potential buyers, and most often conduct the offering under Regulation D, which would therefore make it exempt from registration.

Risks

DPPs carry numerous risks and are not suitable for most investors, so firms must make certain key disclosures before recommending them. One major risk is illiquidity: a limited partner usually needs the general partner’s permission to sell their interest. Member firms must also verify suitability, and must have reasonable grounds, after reasonable diligence, to believe that the investor is in a financial position to afford the investment, that the investor will benefit from the program’s tax benefits, and that the investor meets all other suitability standards. Member firms must keep records documenting how they verified the suitability and appropriateness of each DPP recommendation. None of this makes DPPs an institutional-only product. A firm may sell a public program only if the program has set suitability standards for its investors and disclosed them in the prospectus, and a retail investor who meets those standards can buy (FINRA Rule 2310).

Suitability

To determine the suitability, the issuer provides a subscription agreement, which would contain similar disclosures as a prospectus, but also is the application itself for the DPP. When someone wants to invest in a DPP, they are choosing to become a partner in the partnership, and make a capital contribution that establishes their basis in the partnership. The basis is basically the amount they have at risk and can lose in the event the DPP fails. Limited partners are a lot like shareholders of a corporation, in that they have limited liability. The new partner, like the others, has a capital account that represents the contribution that partner made to the partnership. Partners will only be liable for assessments that become part of their capital account, not anyone else’s. The capital account of each partner is reviewed and adjusted annually based on the results of operations of the partnership.

For a firm to participate in a DPP offering, the firm must determine that the organization and offering expenses are fair and reasonable. Under FINRA Rule 2310, underwriting compensation is capped at 10% of the gross dollar value of the securities sold, and, where a member or an affiliate of a member is the sponsor, total organization and offering expenses - including that 10% - are capped at 15% of the gross dollar value of the securities sold.

Rollups

Rollups regarding DPPs are transactions that involve the combination or reorganization of one or more limited partnerships, directly or indirectly. Often several smaller partnerships are merged into a new entity that could be a corporation, REIT, a new partnership, or similar. Under FINRA Rule 2310, the compensation paid for soliciting votes on a rollup can be no more than 2% of the exchange value of the newly created securities, and it must be paid in the same amount whether a given partner votes for or against the proposal, and paid even if the limited partners reject the rollup. A firm also may not take part in a rollup that is unfair or unreasonable. A rollup is presumed not to be unfair if dissenting limited partners, those who vote against it, have the right to compensation based on an independent appraisal of the partnership’s assets (in cash, debt instruments, or freely tradeable securities), to a security with substantially the same terms as the one they held, or to other comparable rights (FINRA Rule 2310).

Master limited partnerships (MLPs)

Master limited partnerships are a type of limited partnership that is actually publicly traded on an exchange, and is most often found in energy or resource industries and businesses in them. Most limited and general partnerships do not trade on any exchange, and therefore are illiquid, or at least have extreme liquidity concerns. MLPs combine the tax benefits of limited partnerships with the liquidity of publicly traded securities. The MLP must receive income from some qualifying source in order to qualify for the pass-through tax benefits. Examples of the qualifying sources, again most of these are energy and resource businesses, would include things like exploration, extraction, refining of oil and/or gas, mining, and similar examples. Interest, dividends, and real property rents are qualifying sources too. At least 90% of the income the MLP generates must be from these qualified sources, in order to qualify as an MLP and get the benefits. These are complicated and sophisticated securities, and the investor must carefully consider whether the tax complications are worth it.

Structured products

Structured products are complex, so this chapter covers only their outlines and the main suitability considerations. These products are generally most suitable for institutional investors, which are evaluated under FINRA’s institutional suitability standard (FINRA Rule 2111) rather than Regulation Best Interest, since Reg BI applies only to recommendations made to retail customers.

Structured products are a prepackaged, customizable, debt-based investment that combines a fixed income security and a derivative. It helps create specific risk-return profiles. One of the principal risks in these products, above the individual risks in their creation, is their complexity risk. These things are very complex.

A common example is the principal protected note, a PPN. It is a structured product, which is a fixed income security, combining a zero-coupon bond with an option linked to some other asset, index, or benchmark. The idea being that the investor is guaranteed their investment back, up to the creditworthiness of the issuer, and potential gain from the option as well. If the option was based on say, the S&P500, and the S&P500 went up 25%, they would gain the 25%. Principal protection, however, is only as strong as the creditworthiness of the issuer - if the issuer defaults, the promised protection may not be paid.

Exchange-traded notes are one of the more common structured products. ETNs look like ETFs and are often confused, but they are very different. ETNs are unsecured senior debt, and are even more likely to be suitable for institutional investors than other structured products. The return is linked to a market index, though it could instead be tied to a commodity, currency, or other benchmark. They do trade on exchanges and can be shorted.

Reverse convertible securities are a short-term structured product issued by brokerages and banks. Effectively, the investor will be paid a higher than typical interest rate, but they may be converted to stock to the investor instead of the cash they would expect from a traditional debt. Normal debt securities, at maturity, pay principal in cash. These could pay it in stock if the stock price drops to where it is advantageous for the issuer.