SEC and FINRA Alert Investors to Risks and Unsuitability of Structured Securities Products

Posted on August 17th, 2011 at 9:24 AM

Securities regulators SEC (the Securities and Exchange Commission) and FINRA (the Financial Industry Regulatory Authority) have issued warnings to investors and to financial services firms that sales of structured securities products have hurt investors.  Taken together, the SEC and FINRA publications raise significant sales practice and risk disclosure issues.  Let’s examine the key findings of each publication.

                The SEC’s publication, entitled, “Staff Summary Report on Issues Identified in Examinations of Certain Structured Securities Products Sold to Retail Investors” (the “Report”), offers a fairly complex description of the various types of structured securities products and reveals what the SEC has uncovered in its targeted compliance examinations of 11 financial services firms.  The Report overviews the structured securities product industry.  Long offered to institutions and wealthy individuals, the product more recently has been promoted to ordinary, retail investors.  Sales to retail investors have skyrocketed, reaching $45 billion in 2010.  The problem, the SEC notes, is that sales to retail investors have been made through misleading disclosure documents, have been unsuitable for retail investors, have been made at “disadvantageous prices”, and yet have passed muster because of deficient supervisory and compliance structures.

                The Report details the requirements that financial services firms generally must satisfy when selling structured securities products.  They are:

  • Provide balanced disclosure in promotional efforts;
  • Ascertain accounts eligible to purchase structured products;
  • Deal fairly with customers with regard to derivative products;
  • Perform a reasonable-basis suitability determination;
  • Perform a customer-specific suitability determination;
  • Supervise and maintain a supervisory control system; and
  • Train associated persons.

Specifically, in terms of customer suitability, the Report reveals that the examinations uncovered “numerous instances” where sales “did not appear to coincide with the customers’ stated investment objectives and financial profile.”  Likewise, the Report faults firms for having prospectuses misleadingly suggest that certain structured products were “principal protected”, when in fact they were not fully principal protected, or were fully principal protected only if held to maturity.

Finally, the Report details the 5 basic categories of structured products with “varying payouts and risks.”   They are: partial or full “principal protected” notes; enhanced-income notes; performance/market participation notes; leveraged/enhanced participation notes; and reverse convertible notes.  Each category is complicated in structure.  But the SEC cautions that reverse convertible notes particularly deserve scrutiny because they are “perhaps the riskiest” structured product available to retail investors.  The SEC found that reverse convertible notes have caused retail investors to experience “significant losses.”  Further, the SEC found that they were misunderstood because material risks were not adequately disclosed. 

In the second publication (“Structured Notes With Principal Protection: Note the Terms of Your Investment”), FINRA provides valuable information for investors considering principal protected notes.  Preliminarily, FINRA defines a structured note with principal protection as “any structured product that combines a bond with a derivative component – and that offers a full or partial return of principal at maturity.”  Typically, that means combining a zero-coupon bond (which pays no interest until it matures) with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark.

FINRA alerts investors to many important facts.  First, FINRA expresses concern regarding the misleading nature of some of the names of the structured products.  FINRA states, “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.”  That is due to several reasons, according to FINRA.  Among them, the ability to repay some or all of the invested money depends upon the creditworthiness of the issuer or the note.  Likewise, some of the structured products have conditions to the protection, or offer only partial protection.  Finally, investors typically receive principal protection only by holding the investment to maturity.  So, if an investor wishes to sell earlier, there may be no market for that sale, and even when there is a market, the investor may receive “substantially less” than the purchase price.

Another warning that FINRA has issued relates to calculating the return on an investment in a structured product, especially because some structured products with principal protection make periodic interest payments while others do not.  As FINRA puts it, “The return on your investment – over and above any principal guarantee and assuming you hold the note to maturity – will depend on a host of factors, including the method the issuer uses to calculate gains (or losses) linked to the performance of the underlying asset, index or benchmark (the “market-linked returns”), the note’s participation rate and any minimum guaranteed return.”

FINRA also alerts investors to the fact that there can be varying and often complicated methods of calculating a market-linked gain (or loss).  That is because the products base the calculations on different criteria.  For example, some structured products base their calculation on “complex, conditional formulas that allow you to participate in some or all of an index’s gain up to a set level – but significantly limit your return if, at any time during the holding period, the index rises above that level (known as a “shark fin”).”  Still other structured products compare changes in the index at two discrete points in time (like beginning and end), or at various points in time (like annually), or in some other fashion.  As a result, one must understand how this calculation is made.

Finally, FINRA also discusses why investors need to understand “participation rates” and minimum guaranteed returns.  A participation rate is important because it determines how much of the gain in the underlying asset, index or benchmark will be credited to the note.  Regarding minimum guaranteed returns, FINRA states, “If a structured note with principal protection offers a ‘minimum guaranteed return’, be sure to carefully read the prospectus to understand how the issuer defines the term.”  In some instances, the term includes not only the principal guarantee but also a fixed overall investment return.

FINRA summarizes this area best when it states, “The bottom line for investors is that structured notes with principal protection can have complicated payout structures that can make it hard to accurately assess their risk and potential for growth.”  That caveat, plus the additional risk of owning an investment that may earn no profit and yet be tied up for upwards of a decade, make structured products an investment to study carefully before making the decision to invest!



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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