Double Dealing: How UBS Profited From Lehman’s Accounting Duplicity

One of the recurring themes of my blog posts is that it’s nearly impossible to orchestrate financial wrongdoing of significant magnitude without the complicity of major financial institutions. Banks and brokerage firms almost invariably put their financial interests ahead of their clients, and any investor who believes otherwise should take the time to read this complaint by Massachusetts Secretary William Galvin alleging fraud in connection with Merrill Lynch’s sale of auction rate securities.  While Galvin’s complaint relates to Merrill, the countless allegations about how that firm failed its customers are pretty typical of how Wall Street treats its clients.

The Lehman bankruptcy examiner’s report made public last week further documents how Wall Street firms are quick to aid and abet wrongdoing.  To dress up its balance sheet, Lehman engaged in a myriad of “Repo 105″ transactions, a financial legerdemain that allowed the company to raise cash by parking assets at rival overseas firms and booking the sham swaps as “sales.”   This accounting hocus pocus, while not permissible under U.S. rules, was deemed kosher in the UK providing that Lehman orchestrated repo transactions through its London-based subsidiary and with non-U.S. banks. The examiner’s report makes clear that the foreign banks that facilitated Lehman’s sham sales were very much aware of the firm’s “desperation” to create the illusion that it had significantly shed assets and reduced its leverage.  For those not well versed in accounting, allow me to explain in simpler but cruder terms about what transpired: About a half dozen foreign banks played an active role in helping Lehman put some heavy duty lipstick on a pig.

One of Lehman’s most active beauticians was UBS.  UBS reportedly transacted approximately $10 billion in Repo 105 deals with Lehman, likely garnering the firm tens of millions of dollars in interest payments relating to the sham sales.  But UBS had another reason to help Lehman deceive investors about its flailing financial health. During the period Lehman was orchestrating its “Repo 105″ transactions, UBS’s retail brokers were aggressively peddling to their customers a product deceptively known as Lehman Brothers “100 Percent Principal Protected Notes.”  Although UBS marketed these notes to investors as being “risk free,” they were in fact extremely risky unsecured IOUs whose repayment was entirely dependent on Lehman’s financial solvency.  UBS paid its brokers high commissions to sell the risky Lehman notes to unsuspecting investors, which explains why the sales force successfully unloaded more than $1 billion of the paper. When Lehman collapsed, its notes instantly became nearly worthless.

UBS’s sale of the Lehman notes was questionable even before the bankruptcy examiner’s disclosure.  New Hampshire’s securities regulator charged in a filing last June that UBS engaged in “dishonest and unethical” practices selling the Lehman notes, causing New Hampshire investors to lose $2.5 million. The North American Securities Administrators Association (NAASA) has said it was considering convening a task force on the Lehman notes, and it’s my understanding the SEC is also looking into the matter.  I recently won a significant arbitration award on behalf of a client in South Carolina who bought Lehman notes from a UBS broker; it was the first arbitration decision relating to UBS’s sale of Lehman notes, and my office has more than a dozen pending.

Rest assured, UBS is going to have to account for why it continued to aggressively market Lehman notes to retail customers as highly conservative investments while on the institutional side facilitating transactions that were designed to mask Lehman’s troubled financial condition.  Ernst & Young, Lehman’s auditor, also has some “accounting” to do; that firm, as it happens, also is UBS’s auditor.  It will be interesting to learn how UBS booked the assets that Lehman “sold” the firm.

Individual investors owe Lehman bankruptcy examiner Anton Valukas a tremendous debt of gratitude. His report lays out in painstaking detail Wall Street’s fundamentally dishonest ways and makes clear the industry cannot be trusted to regulate itself.  Individual investors also should note that in early 2007, the year Lehman began its financial shenanigans, Charles Schumer and Michael Bloomberg, respectively New York’s senior senator and Mayor, issued this report by McKinsey & Company saying that the U.S. markets were fast losing ground to the UK because they were overly regulated.  As Lehman’s “Repo 105″ transactions were only permissible in the UK and not the US, we obviously shouldn’t be looking to that country for a regulatory model worth emulating.

Ironically, a significant number of investors who bought Lehman notes from UBS reside in the UK.  Fortunately for them, they can file arbitration claims in the US to seek redress.

FINRA Puts Wall Street on “Double Secret Probation”

There is a great scene in the cult-classic movie Animal House that provides an appropriate comparison to FINRA’s second warning to its member firms about inappropriately marketing structured products, such as principal protected notes, to unwitting retail investors.

In the scene, Dean Wormer, whose character is a severe yet inept disciplinarian, declares that he is going to put the roguish Delta Fraternity on “double secret probation” after being told that he already had them on probation. But the Delta frat boys don’t take Dean Wormer seriously and ante up their campus debauchery.

Sadly, FINRA is proving to be Dean Wormer’s regulatory equivalent.  A week before Christmas the agency issued a notice reminding its members that when peddling principal-protected notes they “must present a fair and balanced picture regarding both their risks and potential benefits.” The select few on Wall Street who actually read FINRA’s notices no doubt felt a sense of déjà vu; in September 2005 FINRA issued a dramatically similar notice advising members that when selling structured products they “must present a fair and balanced picture regarding both the risks and potential benefits.”

FINRA’s decision to dust off its four year old decree quite possibly has to do with an arbitration award Zamansky & Associates won on behalf of a South Carolina client in early December. An arbitration panel ruled that our client’s UBS broker didn’t properly advise her of the risks involved when he sold her Lehman Brothers “100 Percent Principal Protected Notes.”  In addition to ordering UBS to reimburse my client for a significant portion of her principal, the panel found that UBS violated South Carolina’s securities fraud law and also required UBS to pay interest, plus all related expenses, including attorneys’ fees.

UBS reportedly sold nearly $1 billion of Lehman principal-protected notes to retail investors and my client’s award is the first arbitration ruling relating to them in the country. Our office has several more cases pending and without exception, the evidence is overwhelming that our clients were not properly advised of the risks in buying these note, despite FINRA’s 2005 UBS regulatory notice.

Delta Fraternity ultimately was disbanded because the frat boys flunked their college exams, not because of any meaningful action by Dean Wormer. Similarly, retail investors cannot expect FINRA to take any meaningful action to protect them other than re-issue a warning as hollow as Dean Wormer’s “double secret probation.”

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.

Lehman Brothers Principal Protected Notes Not So Protected

Although this story is still relatively nascent, I have to imagine the next big scandal to engulf Wall Street will involve Lehman Brothers principal protected notes.  Lehman Brothers principal protected notes were drummed up behind Wall Street’s closed doors and used as a way to dupe investors and raise capital without diluting shareholder equity.

See, over the past few months Wall Street had trouble selling traditional bonds at attractive interest rates.  So instead, as sub-prime losses mounted, they concocted structured products that masked the risk by tying them to other securities, indexes or some other basket of stocks or bonds.  Indeed, Lehman Brothers was one of the most prodigious issuers of principal protected notes and UBS was one of the biggest brokers selling them.

The selling points of Lehman Brothers principal protected notes were that the principal was “100 percent guaranteed” and they had “uncapped appreciation potential.”  This was as close - investors were told by their brokers - to a “sure thing” that ever comes along.  But the problem was that the guarantee was only good so long as the issuer remained solvent.  And we now know how that story goes.

The market for Lehman Brothers principal protected notes and structured products is extremely large and estimated to be around $114 billion.  And much of that was created over the past year during a period when Wall Street was in dire need of capital and writing down sub-prime losses.  In the past twelve months alone, brokers sold $70 billion worth of these securities.  Naturally, three-fifths of the market was consumed by retail investors and based on the ones that have contacted Zamansky & Associates, they were risk-averse retirees who needed their savings to get by.

While holders of Lehman Brothers principal protected notes have fared the worst, we are also hearing from investors that have been left holding principal protected notes including “Suns” (Stock Upside Note Securities), “Prudents” (Prudential Research Universe Diversified Equity Notes) as well as Merrill Lynch’s “Mitts” (Merrill’s Market Index Target - Term Securities), Citigroup’s “Sequins” (Select Equity Indexed Notes) and Morgan Stanley’s Propels (Protected Performance Equity Linked Security).

Lehman Brothers principal protected note investors have experienced extraordinary losses and are filing claims for misrepresentation, omission of material facts, unsuitability and negligence.  In some cases, investors have claimed they were not even sent a prospectus.  Instead, they got a link to the SEC’s website.

Obviously, losses were severe when Lehman Brothers declared bankruptcy.  This raises some questions about one of the biggest concerns on the minds of regulators at the Federal Reserve and Department of Treasury: counterparty risk.  But who actually is considered counterparty?  Apparently financial regulators hold little regard for counterparties when they are individual investors on the other side of a Lehman Brothers transaction.

Look for Lehman Brothers principal protected notes to be a headline grabber in the weeks to come.  If you have lost money in a Lehman structured note, or principal protected note or structured product issued by another brokerage firm please call Jake Zamansky for a free consultation.  For contact information, click here.