The SEC and FINRA Need to Level the Playing Field in Structured Products

Before a derivatives dealer and its counterparty agree on a trade they must enter into a written contract called a “Master Agreement”. The European Union also has an agreement for derivatives trades called a Key Information Document (KID).

Derivatives and structured products are both complex financial instruments and can sometimes, nearly look alike. So, why are contracts similar to the “Master Agreement” not compulsory when Wall Street sells structured products to retail investors? The short answer is that Wall Street’s money isn’t at stake; it’s investors’ hard earned cash that’s at risk.

According to Stacy Marie Ishmael of the Financial Times, “The ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market.” The derivatives market couldn’t exist without the Master Agreement.

Yet the structured products market exists, nay thrives, without any such agreement.

Unfortunately, Wall Street has no interest in fixing something when it works perfectly well….for them. According to Bloomberg, Wall Street banks have sold a record $22 billion in structured products to retail investors so far this year and are expected to top the 2008 high of $38 billion by the end of the year.

To be sure, not all structured products are toxic and some do make sense for the right “accredited investors”. However, investors need to understand what to expect when they are on the other end of a trade. They need to understand that these products carry hidden risks and fees, and in many cases the upside is limited, while the downside isn’t. Before investors purchase a structured product they need a “plain english,” one-page document that clearly spells out the terms and risks of that particular product.

With so much money at stake, regulators desperately need to step in and require that investors truly understand what they are buying. FINRA and the SEC need to fix this issue because Wall Street most certainly will not.

Regulatory “Reform” Bill Shafts Individual Investors

I should have known it was too good to be true.  A few months ago I was enthusiastically optimistic that the regulatory reform bill Congress was looking to pass would include an important investor protection measure known as the “fiduciary duty” standard, which would require brokers to put their clients’ financial interests ahead of their own.  Senator Christopher Dodd (D-CT) said he supported the measure, as did SIFMA, Wall Street’s lobbying arm. Indeed, John Taft, head of the SIFMA committee on regulatory reform, even acknowledged, “It’s a big deal for our industry to do this.”  The SEC and FINRA also indicated support for adopting the standard.

Despite all the declared “public” support, it’s near certain that the regulatory reform bill Congress is expected to pass next week won’t require holding brokers to a fiduciary standard.  The provision has been quietly dropped from the proposed legislation currently being circulated.  The omission should be of major concern to investors who buy stocks, bonds, and other financial products from Wall Street brokers.

Wall Street brokers currently must adhere to what’s known as the “suitability” standard, which Wall Street maintains means that they are only required to sell financial products suitable for clients at the time of sale and they don’t have to disclose commissions.  On a practical level, for example, if a broker puts a client into a certain stock, Wall Street maintains that the broker isn’t responsible for monitoring the performance of that stock after the sale is completed.  The stock only has to be “suitable” at the time of sale.  Under the “fiduciary duty” standard, the broker could be required to monitor a client’s entire portfolio and ensure that it remains consistent with the stated investment objectives.  The broker also could be required to sell financial products at the lowest available cost.

Put simply, the fiduciary duty standard would dramatically raise the standard of client conduct brokers would be legally required to maintain.

There is a compelling argument for requiring brokers to adhere to a fiduciary standard.  They typically market themselves as financial “advisers” and a $875,000 study the SEC commissioned in 2008 found that’s how most investors regard them.  As the saying goes, “It it quacks like a duck…”

It’s not yet clear to me how the fiduciary standard provision from the latest draft bill proposal disappeared, but there is evidence that Wall Street was possibly head-faking support while quietly moving to kill the measure.   A Morgan Stanley memo recently uncovered by Bloomberg advocated that the SEC “should be given the responsibility to thoughtfully review brokerage services and regulations, and promulgate new, specifically tailored rules for the brokerage business.”  Translation: Let’s refer the matter to the SEC and let their staffers study and bury the matter.  Morgan Stanley, the firm with the biggest broker network, has good reason to fear the adoption of a fiduciary standard: the standard could ultimately cost the firm up to seven percent of its earnings, according to an analyst.

Given that Wall Street brought the nation to near ruin, one might have expected that Congress would finally have had the will to stand up to the industry’s powerful lobbyists.  But once again Wall Street has trumped the system.  And the SEC and FINRA, which unilaterally could implement the fiduciary standard, have opted to remain on the sidelines.

Individual investors should take note how there is no one in Washington moving to protect their interests.

UPDATE ALERT: Investors in Securities America and Medical Capital Holdings Investigation

Zamansky & Associates represents a number of investors who purchased private securities issued by Medical Capital Holdings, which were sold to them by brokers associated with Securities America, the independent broker-dealer arm of Ameriprise Financial.  While we continue to represent and hear from additional victims of the alleged fraud, please note that Montana’s commissioner of securities and insurance brought a claim against Securities America, Inc. in August 2010, becoming the second state to file a lawsuit in 8 months. The State of Massachusetts brought a claim against the firm in January 2010.

Both lawsuits center on Securities America’s sales practices, alleging Securities America withheld material information about heightened risks associated with the notes issued by Medical Capital Holdings.

Through the investor arbitration process, investors can file claims against their brokers in order to recover losses.

Last summer, the SEC accused Medical Capital Holdings of fraud for the sale of $700 million of private securities in the form of “notes.” Since that time, a court-appointed receiver has evaluated Medical Capital’s assets and has questioned the structure of the six transactions  which resulted in Medical Capital’s selling of $2.2 billion of notes to investors.

In addition to withholding material information, Montana’s lawsuit alleges Securities America brokers sold the notes to “non-accredited” investors. Non-accredited investors have net worths of less than $1 million.  Allegedly, brokers continued to sell Medical Capital notes even after an executive at Securities America sent an email expressing grave concerns about a possible “run on the bank” at Medical Capital.

To learn more about our investigation or to pursue a potential claim please contact us here.