Regulators Express Concerns about “Principal-Protected” and “Capital Guaranteed” Investments

 

So many investors have lost money in investments mis-marketed under assurances the investment was “principal-protected,” or “capital guaranteed,” that the Financial Industry Regulatory Authority (FINRA) has found it necessary to issue a notice (Notice to Member 09-73) reminding brokerage firms of their sales practice duties when recommending investments such as so-called Principal Protected Notes. These securities are structured products that are typically comprised of a zero-coupon linked to the performance of some other asset. That asset might be, for example, a derivative product based on a stock index or a basket of securities as obscure as the Brazilian Real-U.S. Dollar exchange rate and the price of copper.

Investments in principal-protected notes has grown in recent years due to their being marketed as a relatively safe way to increase returns in a low-interest rate environment. The FINRA notice warns that these products often have reassuring (but misleading) names that include “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms, when, in truth, they are complex products that carry significant, often hidden, risks.

Among other things, the FINRA notice reminds brokerage firms that they have a duty to ensure that their promotional materials disclose the risks and do not overstate the level of protection offered by these products, that their representatives perform an adequate suitability analysis before they recommend such products, and that they understand the risks, terms and costs associated with these products.

One major risk is the fact that the principal guarantee is only as good as the credit worthiness of the guarantor. For example, Lehman Brothers 100% Principal-Protected Notes were sold by firms such as UBS, Merrill Lynch, Smith Barney/Citigroup and Wachovia as safe investments, but they became worthless when Lehman declared bankruptcy. In most cases, this risk was not disclosed to purchasers of the notes. In addition, often the guarantees are for less than 100% of the investment.

Another major risk is the prospect of a “haircut,” which can occur if the purchaser has to sell the note to meet an unexpected expense, and is unable to sell the note for the amount invested. While brokers may make a market in the notes, they can and often do stop making a market ? without any advance notice to their customers who bought the notes ? if they perceive it to be in their interest to do so. Such a withdrawal of market support caused the auction rate securities market to freeze.

Other risks include the fact that the pay-out structures are often so complicated that the risk and potential for gain cannot be accurately assessed by the brokers, much less the customers. The FINRA notice provides some eye-crossing examples of this.

The FINRA notice concludes with a reminder that firms must train their registered representatives to understand these products before recommending them to customers, and that such training should emphasize, among other things:

  • The associated risks including the credit-worthiness of the guarantor
  • The terms and conditions of the pay-out
  • An understanding of the underlying derivative or other asset
  • The fee structure.

It has been our experience that registered representatives who have sold these products received little or no training or guidance beyond the firm’s promotional materials, which did not present a fair and balanced picture of the risks.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing investors in Principal-Protected Note cases. For further information, please contact us.