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.

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.”

Securities Arbitration vs. Class Action: The Choice is Easy

I’m often asked whether aggrieved investors are better off joining a class action suit or pursuing their own individual FINRA arbitration claims.  The answer invariably depends on the individual’s circumstances and the depths of the financial pockets of the company engaged in wrongdoing.

Let’s take Enron for example given the similarity of the cases and that the legal costs would have far outweighed any potential recovery, it would have made more sense to join a class.

However, if you are an individual investor, particularly one with a conservative or risk-adverse profile, who was talked into purchasing dubious Wall Street products such as Lehman Brothers Principal Protected Notes by UBS and other brokers, you would be much better off filing an individual claim.

Here’s why:

-       Depending on the circumstances, aggrieved investors can potentially recover 100 percent of their losses, plus damages - far greater than 2-5 cents on the dollar that is typical in a class.

-       Many investors believe that they must invest a lot of time and money into an arbitration claim when the truth is, it takes a lot less time and if you work with an attorney on a contingency basis, you only pay legal fees in the event of a recovery.

-          Arbitration claims can typically be filed and adjudicated within a year to 18 months; class action cases usually drag on for many years.

-       Class action attorneys must prove that everyone they represent is equal. Arbitration highlights the merits of individual cases.

If you joined a Lehman Protected Notes class action suit your unique circumstances would never be heard. Many investors that we have spoken with never even received a prospectus much less knew that the “protection” on the notes was only good if Lehman survived to make good on the commitment.

UBS and the other Wall Street firms that sold the Lehman notes will almost certainly argue that investors may have headed the risks if they had read the fine print in the prospectus. That argument may hold legal sway in a class action suit involving thousands of investors, however in an arbitration, an investor’s entire circumstances are taken into consideration.

If your broker failed to abide by his or her fiduciary responsibility to only recommend “suitable” products or failed to mention the associated risks of certain products an arbitration panel could award a rescission of the product and possibly damages.

Over the past few months investors have hired Zamansky & Associates to file claims from $100,000 to several millions of dollars. In some cases, brokers put their customers’ entire nest eggs at risk.

The merits of filing an arbitration claim are compelling.

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.