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Lehman Structured Notes Sold by UBS Gets a Regulator’s Attention

“We believe ‘principal protection’ meant one thing to investors, but something entirely different to UBS”- Kevin Moquin, Staff Attorney, New Hampshire Bureau of Securities Regulation

In a big win for investors of Lehman Structured Notes, New Hampshire’s securities regulator will seek an undisclosed penalty as well as restitution for New Hampshire investors. The move is a clear win for investors in New Hampshire but also bodes well for all investors in Lehman Structured Notes.

When the New Hampshire regulator begins to probe UBS’ selling practices of Lehman Structured Notes, it will likely uncover a wealth of evidence such as e-mail records, telephone conversations, etcetera, that might be used by other investors in their individual securities arbitration cases.

The New Hampshire regulator alleges that UBS sold structured products, such as the Lehman Principal Protected Notes, to investors without sufficiently explaining the risks involved. Investors in Lehman Structured Notes (aka Lehman Principal Protected Notes) were largely risk adverse and only looking for moderate returns on their investments. The standard pitch by brokers at UBS and several other large financial institutions was that investors’ principal was “100 percent protected.” Of course, left out of the pitch was that the investments were only protected so long as Lehman Brother’s did not fail.

Brokers earned substantial commissions on the sale of Lehman Structured Notes. In fact, according to the New Hampshire complaint, the average commission on structured products was often higher than for other similar securities offered by UBS.

This isn’t the first time UBS has been investigated by New Hampshire. During the Auction Rate Securities scandal last year, the New Hampshire regulator filed a complaint against UBS on behalf of the New Hampshire Higher Education Loan Corporation (NHHELCO). UBS allegedly advised the NHHELCO to remain in the ARS market while at the same time removing its assets before the market froze. The NHHELCO lost millions and was unable to front scholarships for thousands of students. UBS eventually was part of a global settlement and paid a hefty fine.

Perhaps UBS will begin to see the error of its ways and begin reforming how it does business. New Hampshire’s Director of Securities regulation isn’t so optimistic. He said, “UBS has not been proactive at addressing regulatory issues at either the state or federal level…[and] that other regulators have experienced similar inflexibility”.

I’m hopeful after this latest spat with the New Hampshire regulator, UBS will become more transparent with investors but I won’t hold my breath.

 

Principal Protected Notes: Heads Wall Street Wins, Tails Investors Lose

It’s often said that no one buys structured products, but rather they are sold to individual investors. A rational investor would never seek to buy a risky and costly derivative security with limited upside potential and lots of downside risk. Most investors prefer to buy relatively risk-free stocks based on a fundamentally simple investment principal, “Buy low, sell high.” Unfortunately, brokers earn paltry commissions buying and selling stocks. Hence they prefer to sell products that line their pockets, not their clients.

And therein was the rationale for the creation of highly toxic securities known as “Principal Protected Notes.”

Principal Protected Notes were structured securities concocted by Lehman Brothers, Morgan Stanley, Merrill Lynch, Goldman Sachs, and other Wall Street firms that supposedly allowed investors to get above-average market returns tied to the performance of an underlying index such as the S&P 500. Investors were led to believe these securities were virtually risk-free as their principal was always “protected” and would be returned when the notes matured. The closest thing to a sure thing, you might say.

But as always is the case with Wall Street’s dubious structured products, the risk is always buried in the fine print. For starters, investors who bought principal protected notes were limited to how much upside return they could realize. The return on the index of stocks they purchased was based on the value of the index, not the index’s total return, which would include incurred dividends. Experts I’ve spoken with insist that in terms of upside return, investors would almost always do considerably better simply buying a low-cost index fund rather than buying a principal protected note, which — Surprise! Surprise! - paid a lucrative broker’s commission.

Here is some of the fine print that investors were never warned about. In the event the underlying index declined before maturity, the value of the underlying note fell accordingly. The biggest attraction of structured notes was the supposed assurance that investors would receive their entire principal back once the notes matured. But there were a host of hidden conditions attached to these obligations, such as a requirement that if the index fell below a certain level, investors were required to double up on their investment in order to get their principal back.

Lehman Brothers was the biggest seller of structured notes and investors who bought the bankrupt firm’s paper have lost all their money. Had these investors simply bought the S&P index, they would be bruised but not financially annihilated. Buyers who bought the structured notes of the other Wall Street firms are faring better, but regardless they, too, were unquestionably exploited by their brokers.

Wall Street benefited mightily from peddling structured notes. Issuing these dubious securities allowed them to raise non-secured capital from their own customers. The firm underwriting the notes was typically paid an investment banking fee of about six percent. And the brokers who unloaded the notes on their unwitting customers were rewarded with hefty commissions. A good and lucrative time was had by all - except the customers who bought the notes!

I never cease being amazed how Wall Street firms systematically rip-off their customers.

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