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.

What the Auction Rate Securities Settlement Doesn’t Do

The New York State Attorney General and the other regulators participating in the auction rate securities (ARS) settlement talks are surely to be commended for their action and diplomacy. Auction rate securities clearly were fraudulently marketed to investors and without the regulatory pressure and investigations; there would be no light at the end of the tunnel. And lest anyone think Wall Street is owning up to its mistakes, know the real reason banks have come to the table are the potentially ruinous emails and evidence that would have surfaced had an investigation continued. The emails that surfaced at Merrill Lynch and UBS showing ARSs were sold to unsuspecting investors while internally it was clear the market was poised to collapse is the tip of the iceberg in all likelihood.

But putting Wall Street’s disingenuous generosity aside for the moment, based on details of that have emerged, it seems to fall short of true retribution for the fraud which occurred…and I’m not referring to Goldman Sachs’ apparent non-participation.

First off, though it appears that brokerages will be buying back auction rate securities over the course of the next year, clients that suffered consequential damages are left out in the cold. Many of our clients were not able to close on transactions such as homes and tuitions because of the ARS market’s collapse. Non-profits were not able to meet their philanthropic obligations as well. Cases seeking to recover these consequential damages are likely to continue in arbitration.

Secondly, ARSs were fervently pitched to corporations as “cash equivalents,” so many very sophisticated CFOs and comptrollers tied up their free cash flows in these securities. Payrolls were missed, financing opportunities passed by and business operations were hampered. These claims will likely proceed as well.

Thirdly, some investors were able to sell their ARSs in the secondary market, usually at steep losses. It’s currently unclear whether they will be compensated for their losses.

And importantly, many angry investors moved their accounts to other firms; and burned brokers, switched firms because their brokerages pressured them into buying and selling auction rate securities. This seems to be a grey area as well. For example, if an investor left Merrill Lynch after getting ensnared in its ARS offerings, and moved his/her account to competitor, it is unclear whether that investor will be made good.

Finally, it appears that Wall Street will be customarily let off the hook by not admitting any wrong doing. At the very least, senior managers who oversaw the ARS market and were responsible for its marketing should be held responsible.

Indeed, when the dust settles on the auction rate securities settlements, its likely Wall Street’s problems won’t go away. As they say, the devils in the details.

Mr.Cuomo: ARS Investors Don’t Need a Spitzeresque Settlement

After learning that New York Attorney General Andrew Cuomo is set to bring charges against UBS related to their marketing of auction rate securities, I am of mixed emotions. On the one hand I am pleased that the scandal is resulting in complaints, but I am only cautiously optimistic that the charges and potential settlement will be in the investors’ best interest.

Don’t get me wrong, Mr. Cuomo’s action is certainly welcomed and clearly warranted. Auction rate securities were pitched to investors as cash equivalents and liquidity risks were hidden, which is why I was particularly pleased to see that Mr. Cuomo could file charges against individuals at UBS and seek a broad resolution for investors whose money is tied up in the ARS permafrost.

But a resolution is only as good as its terms and I have reservations that an eventual settlement won’t go far enough. Specifically, it is typical for Wall Street to settle these types of matters without admitting guilt or acknowledging responsibility. Wall Street steadfastly bargains for this because it limits their liability to investor claims. Recall that Eliot Spitzer’s global Wall Street settlement included this “out” clause and many investors lost arbitration claims because of it.

Another common occurrence during the Spitzer regime was Wall Street scapegoating. So long as Mr. Cuomo targets individuals, he should follow the trail as high as it leads and not allow Wall Street’s top brass to sacrifice a few bit players.

Moreover, a resolution that simply makes UBS customers “whole” also is a mistake. For many months ARS holders were prevented from participating in more lucrative investments and making large purchases, such as homes, automobiles and tuition payments. It is reasonable that they should be awarded damages for those lost opportunity costs. And finally, some investors are facing legal fees which should be paid for by UBS.

A UBS settlement could serve as a case study for other ARS investigations. Cuomo and other State securities regulators are investigating Citigroup, Merrill Lynch, J.P. Morgan Chase, Goldman Sachs, Wachovia and many other institutions for similar practices.

We’ve been through the era of headlines, photo-ops and slaps on the wrist. Mr. Cuomo has an opportunity to substantively alter the way in which Wall Street markets its products.

As I said, I am cautiously optimistic.

Don Quixote and ARS Investors

Recent articles in The Boston Globe and Bloomberg underscore how Wall Street firms woefully favor their own interests at the expense of individual investors.

According to a report in today’s Globe, UBS Financial Services warned some of its big investment banking clients of looming problems in the auction rate securities (ARS) market three months before the market for these securities collapsed. Nevertheless, the firm continued marketing the securities as cash equivalents to unsuspecting individual investors.

Adding insult to injury, the Globe and Bloomberg report that UBS, Bank of America, and Wachovia along with others are preventing their clients from unloading auction rate securities at a loss saying – are you ready for this? – it isn’t in their clients’ best interests!

In an ideal world, it would be nice to believe that Wall Street firms are actually trying to do right by unsuspecting investors whose brokers assured them that auction rate securities were cash equivalents. But Bryan Lantagne, the securities division director for Massachusetts, offers Bloomberg a more compelling explanation:

“By allowing customers to sell at a discount, the banks allow customers to establish damages.”

Richard Stahl, a retired New Hampshire car dealer, is one of the auction rate securities victims caught in limbo. The 73-year-old UBS client wants to sell some $650,000 worth of auction rate securities, but UBS won’t let him.

“I feel like Don Quixote fighting windmills,” Mr. Stahl told the Globe.

Sadly, Mr. Stahl, compared to taking on Wall Street, Don Quixote had it easy.

When Wall Street Exploits A Charity

Having represented investors who have been wronged by Wall Street for more than three decades, I’ve seen a lot of scandalous activities. But nothing outrages me more when a brokerage firm seeks to exploit a charitable group. Sadly, I’m dealing with yet another egregious instance, this one involving the peddling of auction rate securities to a charitable foundation in Ohio.

The charity is called the Joffe Foundation, which was founded by Steven N. Joffe, a renowned Cincinnati opthamologist and a pioneer in laser-vision correction surgery. The foundation regularly makes donations and commitments to provide funds on an ongoing basis to support various charities and causes, including low-income patients in the US in need of laser vision correction; AIDS prevention; high school educations; and surgeries to correct cleft palates in children in South Africa and Ghana. Because of its ongoing funding commitments, the Joffe Foundation made clear to its broker at UBS Financial Services that it needed to keep its funds extremely safe and liquid.

But the foundation’s UBS broker wasn’t content having the organization park its money in a simple money market account. Instead, he encouraged it to purchase auction rate securities, which he assured Dr. Joffe were “the equivalent of cash” and could be liquidated within a few days if necessary.

Auction rate securities are long-term government or corporate bond instruments where the interest rates are set at weekly or monthly auctions. As long as there are investors willing to bid on the bonds, they are indeed liquid investments paying higher rates of interests than money market accounts. The problem is that if there aren’t enough investors to buy the bonds, the auctions fail. Investors holding the paper are suddenly stuck with a long-term note with a “penalty” interest rate predefined by the bond’s issuer.

Making a market for auction rate securities was a highly lucrative $330 billion market for the big Wall Street firms, including UBS. But the balance sheets of the big firms have been badly impaired because of the collapse of the mortgage-backed securities market (a crisis of their own doing), so they no longer have the wherewithal to support the auction rate market. That’s why the market for auction rate securities has dried up.

Acting on his broker’s insistence that auction rate securities were as good as cash, Dr. Joffe agreed to allow UBS to invest the foundation’s entire $1.35 million. UBS invested all the money in various ARS series or issues of preferred stock in the Eaton Vance Limited Duration Fund, thereby increasing the Joffe Foundation’s risk because all its auction rate securities investments were tied to that fund.

The auction for the Joffe Foundation’s securities failed on Feb. 15, so all its cash is locked up indefinitely. Although the penalty interest rates of failed auction rate securities can sometimes go as high 17%, the penalty rate on the Joffe Foundation’s paper is a measly 4.97%. That makes it incredibly unlikely that anyone will buy the paper before it matures. Moreover, the Eaton Vance fund itself carries enormous potential risk of principal loss.

As a result of this debacle, the Joffe Foundation cannot make a committed $100,000 donation to laser vision correction patients, nor fund its ongoing commitments. The foundation also needs cash to fund the salary of its administrative assistant.

Zamansky & Associates has already filed an arbitration claim on behalf of the Joffe Foundation, but it will take some time before it can be heard. You might think that UBS, which likely earned tens of millions of dollars peddling auction rate securities, would do right for a worthy charity and rescind the fraudulent and unsuitable investments so the foundation can honor its donation commitments, but unfortunately you would be badly mistaken.