Structured Notes

Brokerage firms have been ramping up the sales of structured products, which pay higher commissions than ordinary fixed income investments, to retail investors. They reportedly have sold more than $100 billion of these products over the past several years, often to senior citizens who are seeking to earn more interest while protecting principal.

Generally speaking, structured products are notes that are linked to other assets, such as a security (e.g., stock), a basket of securities, or a derivative, which is in turn linked to an asset or assets. These complex products are often offered to investors who desire or need to earn a higher yield than is usually available from a traditional investment, such as a regular coupon bond. Frequently, such investors are retirees living on a fixed income.

In reality, structured products are little more than IOUs from issuers and brokers who have come up with complex ways to take investors’ money. They are marketed as “low risk and high yield” – an oxymoron when dealing with alternative investments and the market. Moreover, the promises that structured products are producing significant income are generally overstated. The cash generated by structured products is attributable, in large part, to the option premium embedded in the product. Nevertheless, to many older, fixed income investors and those tired of low interest money market or CD offerings, the pitch sounds enticing.

The risk of loss of principal is very real, even when structured products feature a principal protection guarantee. So-called “100% principal protection” notes issued by Lehman Brothers Holdings lost most of their value when Lehman went bankrupt because the notes were an unsecured obligation of Lehman.

Structured products are also difficult for investors to sell as the secondary market for them is very thin if there is one at all. Investors are often misinformed about this illiquidity risk, and only learn about it when they need to cash out but cannot.

The proliferation of structured product sales to retail investors has been condemned by industry experts. For example, securities arbitration consultant Louis Straney recently observed “In my three decades of Wall Street experience, I have not seen any other product as absurdly destructive as retail investments linked to structured products.” Similarly, Janet Tavakoli, a consultant on structured finance and author of several books, was quoted as saying “These notes flunk the suitability and appropriateness test for retail investors. They also flunk the test for most investment managers, investment advisors and pension fund managers. Retail investors may find that managers who are supposed to protect their interests are in fact collecting fees and turn a blind eye to the risks.”

Even the regulators are concerned. CEO Richard Ketchum has stated that structured products are “areas of concern” for the Financial Industry Regulatory Authority (“FINRA”) because of their use of options. FINRA has suggested that sales of structured products to customers whose accounts are not approved for options trading are inappropriate. Firms routinely ignore such suggestions, however, because commissions on sales of structured products are far higher than commissions on ordinary bonds and bond funds.

Similarly, a SEC staff report concluded that structured products “are often quite complex and can present wide-ranging risks and regulatory issues, including suitability and disclosure concerns, limited liquidity, comparatively opaque and often expensive fee structures, paucity of secondary market activity and difficulty in pricing.”

In the past, structured products were generally sold only to institutions and sophisticated investors in private, negotiated transactions designed to meet specific needs. Because of their option component, they were just too complex for ordinary investors and brokers to understand. Indeed, a Nobel Prize was awarded to the finance expert who first explained the model (Black-Scholes) for evaluating whether an option is fairly priced. Structured products are generally overpriced, but a retail investor would need to use a complex application of this model to discover that. Nevertheless, in recent years, structured products have been commercialized with an increasing number being sold to retail investors.

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. In short, many of these products require a Ph.D. in finance to understand, and most retail brokers and customers lack that background.

If you have investment losses or problems involving structured notes, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).