Category Archives: Principal Protected Notes

Every year, the Financial Industry Regulatory Authority (FINRA) takes note of key regulatory and examination issues that it plans to prioritize in the new year. In 2013, those priorities include a number of hot-button – and familiar – financial products, from structured investments, to non-traded REITs, to business development companies, or BDCs.

In a recent notice to investors, FINRA highlighted the following products and issues, along with an explanation as to why they merit top placement on FINRA’s 2013 watch list.

Structured Products: These products may be marketed to retail customers based on attractive initial yields and, in many cases, on the promise of some level of principal protection, according to FINRA. Moreover, structured products are often complex, and have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, structured products generally do not have an active secondary market.

Suitability and Complex Products: FINRA’s recently revised suitability rule (FINRA Rule 2111) requires broker/dealers and associated persons to have a reasonable basis to believe a recommendation is suitable for a customer. FINRA says it is particularly concerned about firms’ and registered representatives’ understanding of complex or high-yield products, potential failures to adequately explain the risk-versus-return profile of certain products, as well as a disconnect between customer expectations and risk tolerances.

Business Development Companies (BDCs): BDCs are typically closed-end investment companies. Some BDCs primarily invest in the corporate debt and equity of private companies and may offer attractive yields generated through high credit risk exposures amplified through leverage. As with other high-yield investments – such as floating rate/leveraged loan funds, private REITs and limited partnerships – investors are exposed to significant market, credit and liquidity risks. In addition, fueled by the availability of low-cost financing, BDCs run the risk of over-leveraging their relatively illiquid portfolios, FINRA says.

Exchange-Traded Funds and Notes: In many instances, retail investors may not fully understand the differences among exchange-traded index products (i.e., funds, grantor trusts, commodity pools and notes) and the risks associated with these investments, particularly those that employ leverage to amplify returns. FINRA says it also is concerned about the proliferation of newly created index products that lack an established track record. Examples include products with valuations and performance tied to volatility, emerging markets and foreign currencies.

Non-Traded REITs: FINRA’s interest in non-traded REITs centers on the fact that many customers of non-traded REITs are unaware of the sales costs deducted from the offering price and the repayment of principal amounts as dividend payments in the early stages of a REIT program.

Private Placement Securities: Private placements will continue to be a key focus of FINRA’s investor protection efforts in 2013, with particular emphasis on sales and marketing efforts by broker/dealers. To improve its understanding of private placements, FINRA implemented Rule 5123, which requires member firms that sell an issuer’s securities in a private placement to individuals to file a copy of the offering document with FINRA.

FINRA also reminds member firms that the relative scarcity of independent financial information and the uncertainty surrounding the market- and credit-risk exposures associated with many private placements necessitates reasonable due diligence on prospective issuers. FINRA notes that due diligence should focus on the issuer’s creditworthiness, the validity and integrity of their business model, and the plausibility of expected rates of return as compared to industry benchmarks, particularly in light of the complex fee structures associated with many of these investments.

The words “due diligence” and “suitability” have taken on a whole new meaning following Greg Smith’s very public condemnation of his former employer, Goldman Sachs. Smith, an executive at Goldman, lambasted his firm via an Op-ed in the New York Times last week. Among other things, Smith called the environment at Goldman “toxic” and that the interests of clients are now “sidelined in the way the firm operates and thinks about making money.”

Smith’s characterization of Goldman may hit a nerve with investors and brokers alike. For investors, the diatribe against Goldman could very well spur them to rethink the quality of investment service and advice they’re receiving. Meanwhile, brokers may be prompted to re-examine and reaffirm the due diligence duties they owe to clients.

No investment is without risk. But financial professionals and their brokerage firms are bound by certain duties to clients – and that includes making investment recommendations based on a client’s suitability, as well fully and accurately explaining an investment.

In the past year, countless examples have come to light in which these duties have fallen by the wayside. Medical Capital Holdings, Provident Royalties, MAT/ASTA, Lehman Brothers principal-protected notes, Behringer Harvard REIT. While each of these cases and the financial products they represent may be different, a common theme ultimately prevails: In one way or another, investors found themselves on the losing end of their investment because the concept of “client-first” was all but forgotten by the brokers and firms they trusted.

Structured investments have rendered a countless number of investors financially ruined – many of whom would never have been invested in the exotic products if not for the recommendations of their financial advisor.  The 2008 financial crisis cast a new light on the potential problems of structured products, from so-called principal-protected investments issued by Lehman Brothers to reverse convertible notes from Morgan Stanley. The result was the same: Investors lost big.

Jargon-laden literature, illiquidity, counter-party risk and lack of transparency all make structured products a complex and often unsuitable investment for the average investor. Despite these characterizations, many financial advisors continue to sell structured products because of the large mark-ups and commissions they bring – not because they are in the best interests of a client.

In the case of Morgan Stanley, a review by the Financial Industry Regulatory Authority (FINRA) into sales of the firm’s structured products – which included principal-protected investments, leveraged exposure, yield enhancement, and access investments – revealed that in many instances the true risks of the structured products were never disclosed to clients.

FINRA’s findings were officially documented in a Letter of Acceptance, Waiver and Consent (AWC) in which Morgan Stanley signed on Dec. 7, 2011, and agreed to pay a $600,000 fine to settle the violations outlined. Among the violations cited: Supervisory deficiencies, as well as unsuitable recommendations of structured products to retail customers.

In the AWC letter, FINRA states that Morgan Stanley failed to create “reasonable systems or procedures to notify supervisors whether structured product purchases complied with the firm’s internal guidelines.” Instead, Morgan Stanley placed the responsibility with branch supervisors.

“During the Review Period, Morgan Stanley had no reports or tools for sales supervisors or compliance personnel that were specific to structured products, or which highlighted and detected single concentrated structured product purchases. As a result, of the 224,000 structured product purchases between September 2006 and August 2008, more than 28,000 were in net amounts that exceeded 25% of the customer’s disclosed liquid net worth and more than 2,600 were effected by customers with slated net worth less than $100,000,” the AWC letter said.

Principal-Protected Notes (PPNs) – and the misrepresentation of them – are back in the news. The Financial Industry Regulatory Authority (FINRA) has fined UBS Financial Services $2.5 million over PPNs, requiring the brokerage firm to pay $8.25 million in restitution for omissions and statements made to investors about the products.

According to FINRA, UBS’s statements about the products effectively misled some investors about the “principal protection” feature of 100% Principal-Protection Notes issued by Lehman Brothers Holdings prior to its September 2008 bankruptcy filing.

Principal-protected notes are considered fixed-income security structured products with a bond and an option component that promise a minimum return equal to an investor’s initial investment.

According to FINRA, as the credit crisis worsened during March to June 2008, UBS advertised – and some UBS financial advisors described – the structured notes as principal-protected investments while failing to emphasize they were actually unsecured obligations of Lehman Brothers.

In making its decision against UBS, FINRA found that the firm:

• Failed to adequately disclose to some investors that the principal-protection feature of the Lehman-issued PPNs was subject to the credit risks of Lehman Brothers Holdings;
• Did not properly advise UBS financial advisors of the potential effect of the widening of credit default swap spreads on Lehman’s financial strength or provide them with proper guidance on using that information with clients;
• Failed to establish an adequate supervisory system for the sale of Lehman-issued PPNs;
• Failed to provide sufficient training and written supervisory policies and procedures;
• Did not adequately analyze the suitability of sales of the Lehman-issued PPNs to certain UBS customers; and
• Created and used advertising materials that essentially misled some customers about specific characteristics of PPNs.

UBS neither admitted nor denied the charges levied by FINRA, but consented to the entry of the findings.

A $2.2 million arbitration award is the latest win for investors in cases involving UBS and Lehman Brothers Principal-Protected Notes. The award, which was announced in December by a three-person arbitration panel of the Financial Industry Regulatory Authority (FINRA), is the seventh consecutive win for investors with pending complaints against UBS over the Lehman Brothers notes.

The focus of investors’ complaints centers on the failure of the 100% principal-protected notes touted by UBS to live up to their hype. Instead of the safety and security of fixed- income investments, the notes were actually complex products comprised of risky derivatives.

What UBS and other brokerages failed to emphasize to investors was the fact that the notes were unsecured obligations of Lehman Brothers. When Lehman filed for bankruptcy on Sept. 15, holders of the notes were left with investments that traded for pennies on the dollar.

UBS sold $1 billion of Lehman Principal-Protected Notes to investors. Commissions on the notes were 1.75%, a far higher percentage than what could be generated from sales of certificates of deposit.

If you’ve suffered financial losses in Lehman Principal-Protected Notes and wish to discuss filing an individual arbitration claim with FINRA or have questions about these investments, please contact us.

Structured notes are booming, with sales reaching $45 billion just this year. Despite their growth, structured notes can be a risky venture for investors, especially as more and more brokerages push out structured products with the promise of equity returns and less risk.

As reported Nov. 13 by the Wall Street Journal, some financial advisors are urging their clients to consider structured notes as a way to get back into stocks and avoid taking on too much risk.

Before jumping on the structured notes bandwagon, however, investors need to first consider a few issues. To begin, most of today’s structured notes are not 100% “principle protected” products. Instead, they typically offer only partial or limited protection, meaning they provide a fixed amount of contingent protection. Losses are covered only up until the point that the underlying asset drops below a certain level. Once that happens, the protection is canceled and investors bear the brunt of the losses.

Consider UBS AG’s Return Optimization Securities with Contingent Protection, which was priced in July. According to the Wall Street Journal article, investors receive 100% principal protection as long as the Standard & Poor’s 500-stock index hasn’t fallen more than 30% at the end of the product’s three-year term. If the index does fall more than 30%, investors pay the price by suffering all of the losses. If the markets fall by less than 30%, investors get back their principal at the end of product’s term. If the index rises, investors earn 1.5 times the upside, up to a cap of 58.6%, which they get if the index is up 39%. Fees, also called the “underwriting discount,” are 2.5%, says the WSJ.

The kind of protection might not work for all investors. As reported in the Wall Street Journal article, since 1926, a structured note that protected against a drop of 30% in the S&P 500 would have pierced the downside cap 7% of the time, leaving the investor exposed to the entire loss, while protecting them from a loss 17% of the time on a rolling 36-month basis.

Craig McCann of Securities Litigation & Consulting Group is skeptical of structured products. According to McCann, the vast majority of structured products turn out to be worth substantially less than their face value. Moreover, structured notes can be difficult to sell during a market rout. Investors also have to worry about counterparty risk.

Complex securities sold as 100% principal protected notes have failed to live up to their billing. In recent months, untold numbers of investors have witnessed billions of dollars in losses because of so-called investments that were touted by brokers as good as cash investments.

A May 21 article by Gretchen Morgenson in the New York Times highlights the questions surrounding 100% principal protected notes and how these complex securities became the darling of Wall Street and a disaster for many investors.

Principal protected notes are essentially zero-coupon notes whose return is partly tied to the performance of an equity index, such as the Standard & Poor’s 500 or the Russell 2000. How an investor makes money on these types of investments, however, is a complex process. The securities promise to return an investor’s principal, typically at the end of 18 months, along with the added gain from the index’s performance if that index trades within a certain range.

The tricky part is this: For an investor with one of these notes to earn the return of the index, as well as get his principal back, the index cannot fall 25.5% or more from its level at the date of issuance. The index also cannot rise more than 27.5% above that level. If the index exceeds those levels during the holding period, an investor would receive only his principal back.

As the New York Times article points out, 100% principal protected notes were sold by many brokerages to conservative investors who typically put their money in low-risk financial products like certificates of deposit. Many investors quickly became disenchanted with their decision to buy into principal protected notes, especially those who bought notes issued by Lehman Brothers Holdings. Those investments are now worth mere pennies on the dollar following the company’s bankruptcy filing in September 2008.

Two investors who lost big on 100% principal protected notes with Lehman were Corinne and Gregory Minasian, according to the New York Times. On the suggestion of their UBS broker they invested almost $100,000 – more than half of their savings – into Lehman notes in early 2008. They ultimately lost everything, and currently have an arbitration case pending in an attempt to recover their losses.

The Minasians contend their UBS broker failed to explain the risks in the securities, and never provided them with a prospectus. They contend they didn’t’ even know their investment had been issued by Lehman Brothers until the firm actually collapsed in 2008.

“I am not a sophisticated investor,” said Mr. Minasian in the NYT’s article. “Many years ago I dabbled in the stock market, but I learned my lessons. Over the past 10 to 15 years my wife and I invested in CDs.”

UBS sold $1 billion of these notes to investors. Commissions were 1.75%, a percentage that is far higher than those generated on sales of CDs. When Mr. Minasian asked about the commission, he says his broker said none existed.

UBS AG faces dozens of arbitration claims from U.S. clients who bought 100 percent principal protected notes issued by Lehman Brothers Holdings that turned out to be virtually worthless after the company filed for bankruptcy in September. Now, in one of the first cases to be heard by the Financial Industry Regulatory Authority (FINRA), an arbitration panel has awarded an investor $200,000, ruling that her UBS broker inappropriately sold her the risky investments.

As reported Dec. 5 by the Wall Street Journal, the case serves as one of the first that FINRA has ruled upon concerning Lehman principal protected notes and could be a sign of how future cases may unfold.

Steven Caruso, an attorney with Maddox Hargett & Caruso, said in the article that hundreds or thousands of additional arbitration cases are expected to be filed in connection with Lehman principal protected notes. Caruso’s firm alone will represent roughly 100, according to the Wall Street Journal.

Lehman principal protected notes were structured notes that many banks and securities firms represented as low-risk investments. What they failed to emphasize to investors was the fact that the notes were unsecured obligations of Lehman Brothers. When Lehman filed for bankruptcy on Sept. 15, holders of the notes found themselves with investments that traded for pennies on the dollar.

If you have suffered losses in Lehman principal protected notes and wish to discuss filing an individual arbitration claim with FINRA or have questions about these investments, please contact us.