Investors in today’s markets, particularly seniors, are caught between extremely low interest rates and the risk of pursuing higher returns they want or need. Brokerage firms are capitalizing on that dilemma by selling structured products as a way to earn above-market returns purportedly without market risk. But as Robert Powel, editor of MarketWatch’s Retirement Weekly, points out in his article entitled “Investors warned about risky structured products,” structured product sellers routinely overstate the potential upside and understate the potential downside of these investments. The net result has been the rampant destruction of investors’ wealth.
Structured products were originally sold almost exclusively to wealthy and financially sophisticated investors and made up only a small fraction of their overall portfolios. Along with the “democratization of all things money,” all that has changed.
The Financial Industry Regulatory Authority (FINRA), which is charged with regulating broker sales practices, issued a warning to investors: “While these products often have reassuring names that include some variant of ‘principal protection,’ ‘capital guarantee,’ ‘absolute return,’ ‘minimum return’ or similar terms, they are not risk-free.” “Many retail structured products today are opaque, if not downright deceptive,” Zvi Bodie, a Boston University professor, was quoted as telling FINRA in a presentation.
Yet sales of structured products rose 46% last year to a record $49.5 billion, according to the article. Why? The answer, as always, is that structured products are far more lucrative for brokerage firms than ordinary fixed income securities. As many have pointed out, the record sales are the result of a big sales-push rather than a demand-pull.
What is a structured product? It is a combination of a zero-coupon bond with a derivative (usually a call option) on a reference asset, such as a stock or a basket of stocks or other securities. The two main categories of structured products that are being sold to retail investors are “principal protected notes” and reverse convertibles.
Principal protected notes are structured products that purportedly “guarantee” a full or partial return of principal at maturity, and provide the potential for an additional return depending on the performance of the reference asset and an agreed-upon participation rate, which is usually less than 100%. The “guarantees” vary from 100% down to 10% based on formulas that are usually not well-explained by sellers nor understood by investors.
Principal protected notes are sold as providing downside protection along with upside potential. But watch that word “guaranteed.” As with an ordinary bond, the return of principal is only as good as the issuer. If the issuer defaults, or goes belly-up like Lehman Brothers did in September 2008, the guarantee is worthless. Many investors in Lehman Brothers “100% Principal Protected” notes found that out the hard way, because the prospectus, sales materials and sales persons said nothing about the true risk of losing one’s entire investment.
FINRA filed an enforcement action against UBS alleging that UBS misled investors by failing to inform them that the Lehman notes (like virtually all such structured notes) were unsecured obligations of the issuer, in this case Lehman Brothers, which could be extinguished by a bankruptcy filing. UBS settled that case by agreeing to pay $10.7 million in fines and restitution. But the FINRA settlement leaves out many investors who purchased Lehman notes.
It should be noted, however, that the seller of Lehman “principal protected” notes, UBS Financial Services, has not won a single arbitration claim filed against it for recovery of losses in those notes. The cases that been resolved to date have been won by investors, or settled.
Reverse convertibles are a different animal. The key feature of reverse convertibles, which is not explained or understood by most advisors or investors, is that they contain an embedded put option on the reference asset ? a Trojan Horse that allows the issuer to return the (possibly depressed or worthless) reference asset at maturity in lieu of a return of principal if the price of the reference asset fell below a certain point. Because of this put option component, FINRA has notified broker-dealers that they should “consider” only selling reverse convertibles to investors who are properly approved for options trading.
FINRA has also warned firms that they have a “duty to ensure that their registered representatives (i.e., stockbrokers) understand the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to a customer.” Richard Ketchum, chairman and CEO of FINRA, said: “A solid understanding of an investment product is at the core of suitability analysis and sound sales practices.”
Unfortunately, structured products are so complex and opaque that most brokers who sell them do not understand them. This has been repeatedly demonstrated in arbitration hearings as the broker, though prepared by attorney for the firm, cannot accurately explain how they work or how they are valued. According to experts who have examined them, structured products are both over-priced and extremely illiquid.
Investors that are considering the purchase of structured products should always keep the following in mind:
Do not use structured products as a core holding. A Securities Industry and Financial Markets Association (SIFMA) study found that investors allocated approximately 0.4% to 1.5% of their holdings to structured products.
Structured products have little or no liquidity. The smaller your nest egg, the lower your allocation to these illiquid products should be.
Only those few with a real understanding of what structured products are and how they work should invest. Do not rely on your broker; he or she probably does not really understand them.
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 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving principal protected notes, reverse convertibles and other structured products. For further information, please contact us.