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Episode 3: Are Complex Products Engineered Failures for Investors?

March 1, 2023 The Investment Fraud Lawyer Speaks Podcast

Investment Fraud Lawyer, Jake Zamasnky, Examines the Risk Factors in Complex Products or “Structured” Investments


Welcome to The Investment Fraud Lawyer Speaks, a podcast produced by Zamansky Law Firm. I’m Nancy rap from paper And I’m speaking with the founder of the firm Jake Zamansky. Jake is one of the preeminent lawyers in the country for security fraud matters. And FINRA arbitration. The law firm represents individual and institutional clients in cases against Wall Street firms for investment fraud losses. Today, we’re discussing a topic that’s as complicated as its name suggests complex products often engineered by brokerage firms. The name complex products refers to several categories of investment products that often promise a low risk that have high volatility. In fact, FINRA issued a regulatory notice back in March 2022, discussing these products and their risks and concerns. Good morning, Jake. Thanks for joining us today.


Well, good to be here.


Jake, could you take a step into explain to our listeners what a complex product is and why brokerage firms are preparing them?


Right? A complex product is an investment that has features and risks that are difficult for the average retail investor to understand the brokerage firms sell these to try and generate more returns for investors. Also, it’s their large fees associated with complex products. The brokerage firms like a UBS or Merrill Lynch make much more money selling these than they do stocks and bonds. So the questions investors usually ask is, What am I actually invested in? If you buy a stock or a bond, you know, you know, you’re buying an Apple or Tesla. And if it goes up or down, you receive a return or you lose money. These are different types of products. They have different types of risks. There’s also a different timeline. You know, a stock can go up this week, and you can decide to sell it complex products or long term products.

It could be a year or two years or three-year commitment. Just a couple of examples, options. We can talk about what options are an option strategy where you combine different type of options. There are structured products, which are combinations between stocks and bonds, exchange traded funds, a lot of people know about a trade like a stock, and they’re basically similar, you know, to the index, like an s&p 500 index. Well, there’s a lot of these products,


they just interrupt you there are they made individually by brokerage firms. So in other words, one maybe awkward as you said UBS, but not at Merrill Lynch, is that how it works?


Yeah, these brokerage firms, their financial engineers come up with these products, they’re made-up products, and that’s why they’re complex. And that’s why people really have to spend time understanding them. Either do your own homework or talking to a financial professional.


Yeah. Or are there regulations in place for these creation of these products? Or do the brokerage firms have the ability to generate whatever they think is just a good option, you know, not option as you describe it option for investors?


Well, the firms create the product like a UBS will create an option strategy or a structured product. They file a disclosure document with usually the SEC Securities Exchange Commission or FINRA, FINRA doesn’t, you know, give a rubber stamp to the product or stamp of approval? But yeah, the firms create them, they file them, and they usually sell them with a disclosure document, which is very important for clients to read.


Now, when we talk about these investment products, the brokerage firm obviously has reason to gain from them. But why would an investor think that they’re going to gain more from these it’s simply what the brokerage firm presents to them.


Usually, there’s an old expression, complex products are always sold, they’re never bought. People don’t go to their broker saying, you know, I want something a complex product a derivative to put in my portfolio, they’re always sold by brokers who are generating commissions for themselves. I guess the goal is to increase yield over what somebody might get out of a mutual fund or stock portfolio. But generally, it’s sold by brokerage firms to customers, the goal to generate additional yield, but again, I want to emphasize they have very significant risks.


Yeah, Jake, I know that you and I have talked about these kinds of risks and things like that in the cast in terms of how the investors will make money and lose money. But with these products, there’s also the concept of collateral. Can we discuss that a little more? Well,


if you have, let’s say, $100,000 of stock in your portfolio, and a broker will sell you an options overlay, for example, it overlays on top of a collateral portfolio. If the stocks go down and the option strategy goes down, your underlying portfolio could lose money as well. So these investments can jeopardize some of the investments that you already hold, which is another factor that you should consider


interesting. So it has more risks than the actual investment itself. It could invest, in fact, all of your investments. Yeah, Jake, let’s dig into one of your most recent complex product issues that you had to face it was the set of lawsuits concerning yield enhancement strategies, losses. I think if we’ve walked clients, your listeners through that process, they’ll understand a little bit more of how these products can cause problems and what the ramifications were.


For the last four years, my firm has been working on cases involving the UBS yield enhancement strategy, it’s called YES, y e. S. YES, was a complex option strategy, UBS created it, they sold $6 billion dollars’ worth of these investments to supposedly experienced or sophisticated investors. The pitch was that this was a low-risk investment, which would generate a three to 4% Return on top of a portfolio. So if you had a million dollar portfolio of stocks or bonds, you layer this YES, strategy, the option strategy on top of that, to generate an additional three to 4%. So you use the collateral, and you’re really sort of borrowing money to to do the YES strategy, it was pitched as low risk. In fact, we were able to prove that it was a very high-risk strategy. Some investors claimed that they were very conservative investors, and that this was unsuitable for them, because it was a high-risk strategy, it was not appropriate for them to be in.


Explain what made it high risk for our listeners.


If you’re being told that you could generate three to 4% in the portfolio, most people would expect that the downside would be about the same thing three or 4%, they were actually told that the worst year they ever had was 1%, which was in 2008. So most people were said, Hey, there’s no risk here. My broker told me that in the last 12 years, all we ever lost is one year 1%. Well, in fact, US digging around, we found out that this strategy had a 35% maximum loss possibility that quite often, it had an ad had a max loss of say, 20%, who would invest to make four to 5%, if you knew you could lose 20%. So that’s the difference here. People did not know that this was such a risky product. And they did lose 20% in 2018. And people were shocked when they saw such large losses. And many of them have brought cases.


No explain to the audience it how much of this was negligence on UBS, this poor part in that they didn’t do their homework and creating a product that would help investors and how much of it was a fraudulent in the sense that they were simply just pretending that risk wasn’t there?


Well, you asked a good question. Brokers around the country, we’re selling this to 1000s of customers. And I’ve heard from people all over the country, almost 100 people, everybody was told it was a low-risk strategy. It was not. It was not it was a high-risk strategy. Now, was it intentional? Did they leave out key information, you’re not allowed to make a full statement about an investor or an investment or make a material omission leave something out? So we claim that it’s fraud. Now, could it have been negligence as you say, we found out also that these brokers were not properly trained how to sell YES, they didn’t do training courses the way they should with a complicated product like this. So many brokers didn’t even understand what they were selling. And if you don’t understand what you’re selling, it’s unsuitable, you know, it’s not appropriate to sell something you don’t understand.


I would imagine that would help them with a lot of these complex products where the broker just reads the pamphlet the same way the investor does and just tries to sell it that way. Is that correct? Right.


Well, can you see with a complex product is structured product or a hedge fund, the broker will have certain talking points to sell to sell the investment to a customer. And that’s all they know. They don’t have in depth knowledge. They can’t really answer questions and they deflect a lot of times when investors ask questions, and that’s when you get into salesmanship. They’ll just say, look, it’s a low-risk strategy, you got to trust me, this is something good for you. They then send documents like a marketing brochure or, or a disclosure document, which discusses that it’s high risk. So you have this big tension between people being told orally in meetings and on calls, it’s a low risk strategy. And then they get a document saying it’s high risk. And that’s the key to most of these cases.


So it was kind of a disclaimer that was being overlooked.


Well, most people don’t read the disclaimers. Most people will trust their broker they’ve dealt with them for, you know, a decade or more or, or they consider the broker a friend. So most people will listen to the broker what they say, in a call where they’re having a lunch meeting, and then they they’re sent a document, it says sign here, people just sign it. And they generally don’t read it. And generally, the brokers don’t go over it, because if they did, most people wouldn’t buy it. If you said something, you could lose all your money or a large percentage of your money, that this is high risk, most people wouldn’t buy it. And that’s the tension that we see here between a verbal misrepresentation at a meeting and a document that says the opposite.


Very interesting. Well, let’s get back to the UBS case. So what happened in these proceedings? What happened for the investors where what were the penalties for UBS? What happened in these cases?


Well, there have been a number of cases that have gone to arbitration hearings, and arbitrators hear testimony from the broker, the customer, and portfolio managers who sold this and even expert witnesses. These are complex cases, investors have won many of the cases where arbitrators say, you know, I’ve listened to the testimony, it looks like you didn’t understand it, the broker didn’t understand it. And it was misrepresented to you. In those situations, people were awarded money, and sometimes all the money that they lost. Other times some arbitrators said, well, it said here in the document, its high risk, I’m not going to give you money, because you should have read the document. So the cases have gone both ways. Mostly the customers have won significantly, the Securities Exchange Commission has come in. And they found that UBS violated the rules, and they find them $25 million regarding this YES, strategy.


So it’s still ongoing, but investors have done pretty well in recoveries, it would seem a fine of 25 million is very low for a company like that.


Well, it is. But it sends a message that the SEC is the cop on the beat that they’re looking at, at this situation. And they found inadequate disclosures, inadequate training, the same thing that we’ve been talking about in our cases. So the findings were very helpful.


Now, if the YES, strategy was a lot more complicated as it was an acquisition, strategy and things like that, but something that’s a complex product that may not be necessarily that complex, using air quotes, there is something called a structured product, which are often things like combinations of stocks and bonds. How have these fared for investors? Are these also as dangerous?


Okay, when you buy a structured product, there are a number of things you really have to understand. First of all, a structured product is an investment product that’s linked to an underlying asset, like the S&P 500, or even a stock like Apple or Tesla. It’s a combination of a bond, and an option on an index or a stock. So let’s give you an example. If someone buys $100,000 structured product, generally it has a term or a maturity, it could be one year or three years, you know, like a bond, the interest that you get, and I’ll use the example let’s say the reference index is Apple stock. So if Apple goes up 5%, you can double your return, you might get 10%. So at the end of one year, if it’s a one year note, you get your $100,000 back plus $10,000 in interest. Well, what happens if Apple goes down, or if the S&P goes down? Well, you can get no return, you can lose principal. So that same investment of $100,000 in an Apple linked structured product at the end of the one year term, you could get back $90,000. You could have your money out there per year, get no return and lose money. That’s a major risk that a lot of people don’t focus in on. These are bullish products. They don’t work in bearish markets.


Interesting. So who are the people that invest in these? Are these the experienced investors that are investing in complex products? Or are they more of the newcomers that are just persuaded by the brokerage firms?


Well, again, these products are created by financial engineers at these brokerage firms, they’re given over to stockbrokers and financial advisors to sell to customers. So if somebody has a substantial amount of an in an account a million or many millions, you will see these brokers pitching structured products, again, they generate large fees, sometimes five or 10%. Compare that to the average stock or bond portfolio where a broker may get 1% or less. So there’s a big incentive for them to sell these products. But oftentimes, the brokers don’t really explain the risks to customers.


So what are these investors looking for from these products? They feel that they’re safe, or do they promise the high return?


Again, people view these as a hybrid between a stock and a bond. So you’re getting hopefully, the upside of a stock like if Apple or the S&P goes up, you’re looking for that, you know, bump and return. But it’s looks like a bond, because generally they have, you know, an interest rate, Go bond, Yvonne, could be a one year bond with a 5% coupon, this one that may have a base coupon, which could double like I said, one of the problems that a lot of people don’t realize is these are very illiquid. So if you have a bond, and six months after you bought it, you want to sell it and buy something else, or you need money to pay taxes or send your kids to college, you can just go to the market and sell it. The structure products are very illiquid, if you have a structured product with a one-year term or a three year term, you’re kind of stuck, the only person that will buy the structured product perhaps is the brokerage firm that sold it to you. And if they do, they generally give you a big haircut. So if you had $100,000 structured product, and you need to sell it within a few months or six months, you may get an offer of $70,000 losing a lot of money, and there’s no other bidders. So that’s another thing to consider the illiquidity of these products. Yeah, Jake,


you and I discussed that there are five major risks with these complex products and structure products. The liquidity risks are what we talked about. But then there are the others that have been identified by other financial you know, advisement boards and things like that are the market risks, the leverage risks, the credit risks, and the cost of complexity, can we talk about breaking those downs as well, your


market risk, as I said, if you’ve got a structured product that’s based on an index, like the S&P, the S&P was down about 20%. Last year, well, that creates a problem if you had a structured product. With that as an index, not only do you not get any return, you could lose principal, and each one is set differently, you could lose 10%, you could lose 20% or more, it could be that if there’s if it goes to a certain level, you lose a large percentage, they’re all you have to read the fine print. So that’s the market risk that we’re talking about leverage, what you’re doing in a lot of these structured products is the firm is borrowing money or creating a product that’s leveraged. So with leverage, you can increase the return if I have $100,000 of stock, and I’m one margin, two to one, and the stock goes up, I might make twice the amount. But on the downside, leverage is dangerous. Because if things are going down as they have in the past year, you could lose, you know, 234 times the amount depending on the leverage. So that’s the leverage. Credit risk is an interesting thing. We had cases during the financial crisis where Lehman Brothers was the issuer of what UBS who sold them called a 100% principal protected notes. So it sounded pretty safe. 100 Principal 100% Principal protected note, how could something go wrong? Well, Lehman Brothers went bankrupt, and the notes became worthless. We had a whole bunch of cases after the Lehman bankruptcy where people did not realize that the structured product was really even though was sold by UBS, which was in business. The issuer was Lehman Brothers who went bankrupt.


It’s interesting because you know, you feel as though they make these promises, and it’s 100% of what could possibly go wrong. And if anything, you just lost more, so don’t add more danger, right?


That’s why it’s very important that you don’t just take a sales pitch from a broker, you sit down and go over, there’s a document. Usually when these things are sold a disclosure document, go through it in detail. Make sure you understand what they’re talking about what the upside the downside, the risks are, ask the broker, do some homework on your own. And if you don’t understand that, don’t go into the investment, it’s really not worth it.


That’s what I was going to say, how could you really research these because if it’s created by just the brokerage firm themselves, you would almost have to have an outside source, look at the product that’s being sold. So it sounds very complicated to do your due diligence on this complicated this kind of investment.


Yeah, again, the first step is to read the disclosure document, but you can do some of your own research. There’s a lot of literature about structured products. I’ve written papers on complex and structured products. There’s a lot of information on my websites, FINRA has information on their website. So you can find out if you make the effort.


With the structure product and complex product losses that we’re seeing, it would seem that whenever there’s a big set of set of losses, it’s going to be a large number of investors that are infected, not just individuals that correct.


Yeah, the structured product is generally sold like a new issue, like a new stock that comes to market, they’ll be selling 10s of millions, sometimes $100 million worth of a particular product. And brokers that a firm like UBS or Merrill Lynch will all start calling their whole customer base. So usually, it’s a large amount of people, most people don’t really pay that much attention to their monthly statements. But you really need to look at things at least quarterly, and certainly have meetings with the brokers see how am I structured products performing? What how’s the index on which their base performing? So it requires a lot of really, really good follow up.


That’s interesting, because you would think if the millions of investors we have millions of dollars are being spent, it would almost lead itself to think that this would be a class action case. But then in actuality, you also have to deal with the actions of the brokerage firm. So are there two sets of litigations that go on with these cases, or no?


You do see some class actions. But most of the time, these are individual arbitrations that come down to well, what did the broker tell you, Mr. or Mrs. Investor about the investment? Had you bought these before? What did you think you were buying? Did you take notes? Did you get emails about them? So it’s usually an individual inquiry of the relationship between the broker who’s selling and the customer who’s buying, and those usually end up in FINRA arbitrations?


Now, we’ve talked about the options and structured products, you said there was another one or two that you’ve seen frequently seen litigation for?


Yeah, we’ve seen cases involving hedge funds and private equity investments. Let me talk a little bit about those hedge funds are usually like an investment partnership, where an experienced Portfolio Manager is trying to generate, you know, much greater returns than the market. But they take a lot of risky strategies, they can use what are called derivatives to trade, they can sell short, meaning that that stocks are going to go down, which is a very risky bet, and other strategies. So if you’re investing in a hedge fund, realize, YES, you could make a lot of money and a lot of hedge fund managers do. They basically charge a percentage of the assets a 2%. And then they get, you know, 10, or 20%, of how much you make, they don’t share the downside at all with you. So some hedge funds go bust, some hedge funds or Ponzi schemes, Bernie Madoff ran a hedge fund that was a Ponzi scheme. I see this a lot. They’re very reputable hedge funds. But again, you’ve got to know who is the manager of this fund? What is their solvency? What’s their experience? What’s their track record, because things can go wrong very quickly, quickly, private equity funds, or funds that invest in private businesses, internet startups, say a new a new biotech kind of company. And, you know, if you invest in let’s say, if you invested in a hedge fund that had Facebook or Google, you know, years ago, you’d make a lot of money. Some of these internet startups did very well. Some of them went bust. Again, know who the manager is the track record, and look at those carefully. You can make a lot but you can lose your shirt.


Now, what’s the difference between a complex product and these funds? Because it seems like the complex product is something that’s new and unique, but a hedge fund would be investing in something more normal will say versus the new engineered products. Is that correct?


To assume the complex products again, we’re talking about option strategies structured products, exchange traded funds, which can be leveraged exchange traded funds, hedge funds are doing some very complicated trading. You know, they don’t tell you everything they’re doing, but they give you know, what’s the strategy that you’re pursuing some hedge funds call themselves distressed debt funds. They’re buying, let’s say real estate that’s beaten up and beaten-up areas of bonds that are near bankruptcy. So a lot of them, these, these hedge funds will buy distressed debt, let’s say something for five cents on the dollar, hoping they can sell it for 10 cents on the dollar. One problem I find with these funds is a lot of times that they’re losing money, they changed the strategy. They do what’s called styled wrist. And I’ve seen that a lot with hedge funds. And that’s a problem. When you get in a hole. Instead of getting out they keep digging and they try something else, and it doesn’t work out. So you get quarterly reports, usually from hedge funds, see what they’re doing. If there’s a trade changing strategy or style drift, you got to talk to the broker or the manager and see if you’re still comfortable with it.


So at the end of the day, we whether it’s a hedge fund, a private equity or a complex product, it’s just it all boils down to how much you can trust your broker and the brokerage firm.


That’s rule number one, can I trust this broker? What they’re saying what they’re selling Rule number two, trust but verify. Do your homework, read the disclosure statement? And, you know, verify what you’re being told.


Very good advice, probably for all investment tips. All right. Well, thank you so much, Jake. I think our listeners learned a lot from what they need to be concerned about with their complex products and how they need to do their homework. Thank you so much. Until next time.


My pleasure. Thank you. Bye, bye.


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