Recent FINRA Disciplinary Findings Against UBS Financial Services Demonstrate How Investors Were Misled In Purchasing Lehman-Issued 100% Principal-Protection Notes

Posted on September 19th, 2011 at 9:33 AM

The Financial Industry Regulatory Authority (FINRA) recently fined UBS Financial Services, Inc. $2.5 million, and required the firm to pay $8.25 million in restitution to customers.  The regulator’s action stems from findings that UBS misled investors regarding the "principal protection" feature of 100% Principal-Protection Notes (PPNs) that Lehman Brothers Holdings Inc. had issued prior to its September 2008 bankruptcy filing.  In settling this matter, UBS neither admitted nor denied the charges, but consented to the entry of FINRA's findings.


The action illustrates the risk to investors when purchasing so-called “structured products” as they are complicated, not easily understood even by the advisers at the financial services firms, and often accompanied by sales materials that are misleading.  Let’s examine the important lessons for investors to understand.


Structured Products


Preliminarily, PPNs are a type of structured product.  Structured investments broadly can be divided into three categories: full principal (investment) protection, limited principal protection and no principal protection.  Most structured products pay interest.  Structured products frequently cap or limit the upside potential, particularly if some principal protection is offered or if the structured product pays an above-market rate of interest.  Although some structured products are listed on a national exchange, they nonetheless may be thinly traded.  Structured products typically are comprised of a note (the debt security) combined with a derivative (often an option).  Accordingly, the note pays the interest, and the derivative component establishes the payment at the maturity of the structured product.


Generally, investors considering any type of structured products should review the guidance offered by FINRA’s predecessor, the National Association of Securities Dealers (NASD) in 2005.  Based upon its reviews of its member financial services firms, the regulator stated that, “NASD staff is concerned that members may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers.”  The NASD certainly hit the mark in discussing the risk that investors can lose their principal.  Consequently, the NASD cautioned financial services firms that they should not “portray structured products as ‘conservative’ or a source of ‘predictable current income’ unless such statements are accurate, fair and balanced.”  Similarly, the NASD warned firms not to tout a credit rating assigned to the issuer of a structured product (such as an investment bank) without also indicating the market risk associated with the structured product.  Indeed, NASD warned that the presentation of a credit rating “that suggests that the rating pertains to the safety of principal invested or the likely investment returns will be viewed as misleading.”  


Investors also should take notice that the NASD cautioned firms that structured products are difficult to understand, due to their being new and due to their derivative nature.  In this situation, the NASD warned firms that “as new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer’s financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.” 


Principal Protection Notes


Suspecting that there was a problem with PPNs in particular, in December, 2009 FINRA issued Regulatory Notice 09-73.  FINRA noted that the market for PPNs had grown, in part because PPNs were marketed as combining the relative safety of bonds with a potential for growth not available with traditional fixed-income products.  However, FINRA cautioned that the products were “not risk-free” and that that “their terms and structure can be complex.”  As a result, FINRA called upon firms to ensure that their promotional materials and communications with the public were “fair and balanced”, and did “not overstate either the level of protection offered or an investment’s potential returns.”  FINRA also reminded firms that they had a duty “to ensure that their registered representatives understood the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to a customer.”


Disciplinary Findings Against UBS


From March to June 2008 as the credit crisis worsened, UBS advertised (and some UBS financial advisors described) the structured notes as principal-protected investments, while failing to emphasize that they were unsecured obligations of Lehman Brothers, which eventually filed for bankruptcy in September 2008.  In summary, FINRA found that UBS:


  • failed to emphasize adequately to some investors that the principal protection feature of the Lehman-issued PPNs was subject to issuer credit risk;
  • 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 the use of that information with clients;
  • failed to establish an adequate supervisory system for the sale of the Lehman-issued PPNs, and 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 had the effect of misleading some customers about specific characteristics of PPNs


Specifically, UBS made misrepresentations and omissions regarding the PPNs.  Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, said, "This matter underscores a firm's need to be clear and comprehensive in disclosing risks of the structured products it sells to retail investors.”  FINRA found that certain advertising materials had the effect of misleading customers regarding the characteristics and risks of the PPNs, including the nature, scope and limitations of the 100% Principal-Protection Notes.  Indeed, the materials suggested that a return of principal was guaranteed if customers held the product to maturity.  That was false as UBS did not adequately address that credit risk could result in loss of principal. 


Additionally, FINRA found that UBS' financial advisors did not understand the complex products they were selling.  As a result, they neglected to disclose necessary information to customers about the issuer's credit risk, so that investors would understand the magnitude of the potential losses.  FINRA additionally found that some of UBS' financial advisors did not understand the limitations of the "protection" feature. Consequently, certain financial advisors communicated incorrect information to their customers.


Likewise, FINRA determined that UBS' suitability procedures were also lacking. UBS did not have risk profile requirements for certain PPNs; therefore, the PPNs were sold to some investors for whom the product was not suitable, including investors with "moderate" and "conservative" risk profiles. Moreover, those particular investors were more likely to rely on UBS' representations about the "100% principal protection" feature of Lehman PPNs because of their risk averse investment objectives.


            Finally, FINRA focused on two customer-directed marketing materials, and its discussion about why they were not “fair and balanced” is noteworthy.  The Client Strategies Guide, for example, overplayed the principal protection feature, but underplayed the credit risk disclosure.  Accordingly, FINRA states, “The credit risk disclosure was not prominently placed relative to the references to principal protection, and did not adequately emphasize the relationship between the protection of principal and the issuer’s credit risk.” 


UBS’ principal protection notes will not be the last structured product to be offered.  As a result, investors (and their attorneys) need to be on guard.  Too often, the products are not suitable for the investor, the advisers do not fully understand what they are selling, the promotional materials are misleading, and the risk is great (or at least, much greater than understood by all parties involved)!



About the Author:

James J. Eccleston is the president of Eccleston Law Offices, P.C.   The Chicago-based firm represents investors and advisers nationwide in securities and employment matters.   312-332-0000 


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