Monthly Archives: July 2012

Exchange-traded notes (ETNs) can be tricky, convoluted investments – and one that often spells a financial nightmare for the novice investor.

By definition, an ETN is an unsecured debt security in which the issuer – typically a bank or another financial institution – promises to pay a distribution based on terms laid out in the ETN’s prospectus. But, as many ETN investors discover, those terms can be highly complex.

ETNs are usually linked to indexes tracking commodities, foreign currencies, stocks, emerging markets, volatility, or other benchmarks selected by the issuer. Much like stocks or exchange-traded funds (ETFs), ETNs are traded throughout the market day. Finally, although investors may come across materials that reference ETNs as shares, they are, in fact, unsecured debt obligations.

The Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert on ETNs. Among other things, FINRA warned investors about some of the dangers associated with products. They can be illiquid, subject to early redemption at the issuer’s discretion, trade at a higher price than their underlying index, and contain conflicts of interests, FINRA says.

The conflict of interest warning poses particular concern for novice investors. That’s because the bank responsible for issuing shares of the ETN could very well be betting that it moves in the opposite direction of your ETN.

The bottom line: When it comes to investing in ETNs, proceed with caution. While not all ETNs are bad investments, of course, it’s what you don’t know that can hurt financially. Beyond their inherent complexity, ETNs are market-linked products. That means the value of the ETN is largely influenced by the value of the index it tracks. As the value of the index changes with market forces, so too will the value of the ETN. And that can result in a loss of principal to investors.

The cash-beleaguered city of Miami is facing civil charges by the Securities and Exchange Commission (SEC) for allegedly manipulating its books to deceive bond investors. On July 23, the SEC sent a Well Notice to Miami city officials, outlining the SEC’s intention to recommend civil charges of securities fraud and other disclosure violations against the city.

A Wells Notice informs a person or entity that it is being pursued by the regulator for potential violations.

The letter did not specify that the allegations were related to bond issues but, according to a story in the Miami Herald, city officials confirmed that in fact the SEC has been investigating its disclosure of budget manipulation to municipal bond investors for the past two-and-half years.

According to the Miami Herald story, the SEC’s investigation began in 2009 when regulators started asking for information regarding transfers of millions of dollars in capital that had been set aside for building projects and were instead put into the general fund. The SEC contends that the move misled investors by giving the appearance that the city had more cash on hand than it actually did during the sale of tax-free bonds at the height of the housing crisis.

The city has until Aug. 6 to present testimony that it did not mislead bond buyers during the sale.

Recently introduced legislation could allow the Securities and Exchange Commission (SEC) to impose fines on individuals of up to $1 million per securities violation and up to $10 million per violation for financial firms.

As reported July 23 by Investment News, the bill would enable the SEC to impose the fines or charge three times the amount of ill-gotten gains or investor losses, whichever is greater. In addition, the SEC could triple the penalty for violators who had been convicted of fraud or received an SEC administrative sanction within the previous five years.

Under current law, SEC civil penalties are capped at $150,000 per offense for individuals and $725,000 per offense for firms.

“If a fine is just decimal dust for a Wall Street firm, that’s not a deterrent,” said the bill’s co-sponsor Iowa Republican Chuck Grassley in a statement. “A penalty should mean something.

In a recent SEC settlement cited by Grassley and the bill’s other co-sponsor, Rhode Island Democrat Jack Reed, former Bear Stears hedge fund managers were forced to pay civil penalties totaling about $1 million, following their indictment of defrauding investors out of $1.6 billion.

Exchange-traded notes (ETNs) are complicated investments that come with a number of hidden and not-so-hidden risks for investors. On July 10, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on the products, following an investigation sparked by sudden swings of the Credit Suisse and Barclays ETNs earlier this year.

“ETNs are complex products and can carry a raft of risks,” said Gerri Walsh, FINRA vice president for investor education, in the notice. “Investors considering ETNs should only invest if they are confident the ETN can help them meet their investment objectives, and they fully understand and are comfortable with the risks.”

ETNs are a type of debt security that trade on exchanges and promise a return linked to a market index or other benchmark. Unlike exchange-traded funds (ETFs), however, ETNs do not buy or hold assets to replicate or approximate the performance of the underlying index. In addition, some of the indexes and investment strategies used by ETNs can be quite sophisticated and may not have much performance history.

Moreover, some leveraged, inverse and inverse leveraged ETNs are designed to be short-term trading tools; in other words, the performance of these types of ETNs over long periods can differ dramatically from the stated multiple of the performance (or inverse of the performance) of the underlying index or benchmark during the same period.

The return on an ETN generally depends on price changes if the ETN is sold prior to maturity (as with stocks or ETFs) – or on the payment, if any, of a distribution if the ETN is held to maturity (as with some other structured products).

As reported July 10 by Investment News, other problems with ETNs can occur when a bank is forced to stop issuing new shares. That happens in instances where the maximum number of shares has been reached or the bank itself is no longer able to hedge effectively against the index. When no new shares are issued, the ETN then functions like a closed-end fund and continued demand can drive shares to a premium over the net asset value.

For example, the Credit Suisse VelocityShares Daily 2X VIX Short-Term ETN stopped issuing new shares in early 2012. As a result, the shares quickly doubled in value because of high demand. But when Credit Suisse Group AG began issuing shares one month later, the share price of the ETN suddenly collapsed back to the NAV and wiped out $172 million in one trading day.

Another ETN, Barclays’ iPath Dow Jones-UBS Natural Gas Total Return Sub-Index, saw the premium of its share price go to as high as 134% of its NAV in March. In that case, investors were paying more than $2 for $1 of the ETN’s exposure. Today it’s at a 32% premium.

Tenants-in-Common (TICs) are an arrangement whereby two or more parties own a fractional interest in a real estate property. In the early 2000s, TICs surged in popularity with investors, partly due to a tax-code change that enabled TIC owners to defer capital gains on real estate transactions involving property exchanges.

The newfound popularity slowly began to dissipate, however, following the real estate crash of 2008. As a result, many TICs began to see a significant decline in their value. Investors meanwhile quickly learned that their supposed “safe” investments were not so safe after all, as dividends from the TICs were cut or stopped altogether. Other TICs, including one of the largest TIC firms, DBSI Inc., filed for Chapter 11 bankruptcy protection.

A number of investors found out about the problems surrounding their TIC investments after the fact, as many came forth with claims that certain characteristics – including risk and liquidity issues – of the TICs had been misrepresented to them.

The structure of TICs can be complex – and highly risky. The fractional interests of a TIC generally are not liquid investments. That means it’s difficult, if not impossible, for investors to sell their interests should they need quick access to immediate cash. Moreover, investors are often charged exorbitant fees to participate in a TIC.

The bottom line: TIC ownership is not for everyone. TIC investments are especially not for investors who have little prior investing knowledge. As with any investment, it’s important to do your own due diligence. What is the background and history of the TIC sponsor? Are the tenants in the property stable and financially sound?  What are the vacancy rates in the surrounding area of the TIC?

All of this information should be disclosed in the offering memorandum of a TIC investment, as well as provided by the broker recommending the TIC. Too often, however, these material facts are misrepresented, and the investor pays the ultimate price.

Investors, especially less-sophisticated ones, may be better protected from unscrupulous stockbrokers who put their interests ahead of their customers. Effective today, federal regulations require stockbrokers to make sure that the investments they recommend to clients are indeed suitable for an investor’s age, financial situation, risk tolerance, investment objectives and other factors.

The rule was written by the Financial Industry Regulatory (FINRA), and is called the Know-Your-Customer Rule, or FINRA Rule 2090; a companion piece to the rule is FINRA Rule 2111. In short, the rule provides another layer of protection to investors, and could give those who’ve lost money because of a bad investment strategy or advice a better chance of financial recovery.

As reported July 8 by Investment News, the new rule has some B-Ds concerned about the broader obligations to oversee customer accounts and investment strategies. In particular is a provision in the new rule requiring brokers to perform reasonable diligence on products, understand those investments and have a reasonable basis to think that a security or investment strategy is “suitable.”

In addition, the new rule goes a step a further to include discussions of investment strategies, not just recommendations for the purchase of a particular security.

The new rule is intended to help investors like Rhonda Waksman. As reported July 1 by the Pittsburgh Tribune, Waksman lost $123,301 in 2009, after her investments tanked. She faulted her investment broker/adviser and filed a claim against CCO Investment Services. In her claim, she alleged that her investment firm advised her to invest in an “aggressive high-risk” municipal bond fund that was “contrary to her investment objectives.”

As a result, Waksman lost $123,301, which she claims was due to the firm’s breach of fiduciary duty, misrepresentations, suitability of the investment and other conduct.

Maddox Hargett & Caruso, P.C. currently is investigating investor losses related to the 1861 Capital Management Funds and allegations that the funds were marketed and sold by UBS and various broker/dealers as safe, secure, and low-risk when in reality they were highly leveraged municipal arbitrage funds.

The 1861 Capital Management Funds focused on municipal arbitrage, which attempts to take advantage of the differences between municipal bonds and other types of debt, including Treasury securities and corporate bonds. Municipal arbitrage funds like the 1861 Funds also can be highly leveraged. That leverage, in turn, creates added risk for the investor and the potential for extreme financial losses.

It is believed that UBS and other broker/dealers sold the following 1861 arbitrage funds: 1861 Capital Municipal Enterprise Domestic Fund, LP, 1861 Capital Municipal Enterprise Offshore Fund, Ltd., 1861 Capital Discovery Domestic Fund, LP, and 1861 Capital Discovery Offshore Fund, Ltd.

The funds themselves were targeted to individual investors, many of whom were elderly and retirees and who took a conservative approach to investing. Many of these investors were looking for low-risk investments that provided safety and security.

What they got, however, was something entirely different. The investing strategies behind the 1861 Funds were highly risky, exposing investors to 100% or more to a loss of their principal investment.

If you’ve suffered financial losses from the 1861 Capital Management Municipal Bond Arbitrage Funds, contact us to tell your story.