The term “structured product” doesn’t have any widely accepted definition in the investment industry. Structured products are the securities equivalent of Frankenstein’s monster.
Their creation begins with a traditional security, such as a bond, but instead of payments derived from the issuer’s own cash flow and eventual return of principal to the investor, the issuer substitutes payments derived from the performance of one or more underlying assets.
Structured products pay off only if the underlying assets perform at sufficient levels. In other words, if the underlying assets return “x,” the investor will receive “y.”
Structured Product Sales Abuses
The NASD, (now known as FINRA), first expressed concern about structured product sales abuses in September 2005 when it issued Notice to Members 05-59, “NASD Provides Guidance Concerning the Sale of Structured Products.” This Notice can be found on the FINRA website and should be reviewed if anyone pitches you a structured product. FINRA has warned again in 2011 that while structured products can seem attractive to investors because they offer higher returns and a level of principal protection, subject to the credit worthiness of the issuer, they “can also have significant drawbacks such as credit risk, market risk, lack of liquidity, and high hidden costs.”
Structured Products are Not a Suitable Investment
We’ll simply tell you that these products are almost never suitable for a retail investor. Yet they often are marketed to consumers as a predictable source of income or a conservative investment, ignoring the substantial risk posed by the derivative. Moreover, some brokers and brokerage firms assure investors of the safety of structured products by referring to the product’s credit rating, even though these ratings reflect the creditworthiness of the issuing company and have nothing to do with the potential performance of the investment. The bottom line is that these products are far too risky for the average investor. These risks can include:
- Substantial or complete loss of principal
- Fluctuations in the price, level, or yield of underlying investments
- Fluctuations in the interest rates, currency values, and credit quality of issuer
- Limits on participation in appreciation of the underlying investments
- Limited liquidity
- Credit Risk of the issuer and/or conflicts of interest
The sale of structured products can violate a broker’s obligation to recommend only suitable investments and to present a fair and balanced picture of the risks and benefits of an investment.
Types of Structured Products
The SEC categorized structured products into four basic types — principal protected notes; enhanced-income notes; performance/market participation notes; and leveraged/enhanced participation notes — and also mentioned a fifth type consisting of any adjusted or combined versions of the first four types, a prime example being the incredibly risky reverse convertible note. (Collateralized debt obligations (CDOs) and similar asset-backed securities also are often thought of as a subset of or close relation to structured products.) Despite these broad category designations, it’s tricky business for many investors to figure out that they even own a structured product, given that product names alone are rarely descriptive of the investment’s true nature.
Risks of Structured Products
The SEC staff found some serious problems when examining how structured products were sold to investors and the staff’s report highlighted some risks that aren’t obvious to the average retail customer.
Credit Quality of Issuer
One risk concerns the credit quality of the issuer. As with any security, principal can be lost if the issuer becomes insolvent. Nationally, this risk was driven home in a big way when Lehman Principal Protected Notes became worthless upon Lehman’s insolvency. These notes had been sold in droves by the investment firm UBS, whose brokers represented to customers that the investments had no downside risk of principal loss. These brokers rarely, if ever, mentioned to customers that the notes were unsecured, let alone explained what that could mean.
There also are liquidity problems with structured products. There’s almost no secondary market for them. Since they rarely trade after issuance, an investor who is unwilling to sell at a steep discount and eat his or her losses is pretty much stuck with the product until it matures years later.
Lack of Price Transparency
Price transparency also is a problem. In most instances, investors can’t see the extensive costs built into the products so they can’t compare one structured product to another, nor can they compare the costs of a structured product with an alternative type of investment.
Questionable Sales Practices Related to Structured Products
But the biggest problem with structured products isn’t structural. The SEC indicated in its report that the brokerage firms examined by SEC staff often had “weaknesses” in areas related to the sale of structured products. There were questionable sales practices, such as recommending unsuitable products and misrepresenting or omitting material facts about the products, including their inherent risks. The SEC also found that firms often had deficient training of advisors and that some firms had no training at all. Firms also failed to engage in adequate supervisory review of the suitability of recommendations. Finally, some firms inaccurately and misleadingly listed structured products as “preferred securities” or “preferred stocks” on customer statements, though neither title reflected the real characteristics of the investment.
Experienced Structured Products Attorneys Here to Answer Questions
If you have suffered a substantial economic loss because your investment advisor failed to alert you to the inherent risks of a structured product, please contact a financial misconduct lawyer at McCarthy, Lebit, Crystal & Liffman today. Our structured products attorneys have a thorough understanding of these complex investments and can determine whether or not you are the victim of investment fraud or stockbroker misconduct.