A structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps.
Broker-dealers have long offered a range of structured securities to institutions and wealthy individuals. Certain structured securities products have been increasingly marketed to retail investors in recent years. Total U.S. sales of SSPs (to both retail and institutional investors) had risen from approximately $32 billion in 2004 to in excess of $100 billion in 2007.
A feature of some structured products is a “principal guarantee” function, which offers protection of principal if held to maturity. It is this feature that most often appeals to investors. Unfortunately, it is this function that is also most often misrepresented by financial professionals to their clients simply because the financial professional doesn’t fully understand the product and its risks.
(1) Sale of Structured Products
FINRA Notice to Member 05-59 sets forth the requirements that any broker-dealer must follow in marketing and selling a structured product. These guidelines include the requirements to: (1) provide balanced disclosure in promotional efforts; (2) ascertain accounts eligible to purchase structured products; (3) deal fairly with customers with regard to derivative products; (4) perform a reasonable-basis suitability determination; (5) perform a customer specific suitability determination; (6) supervise and maintain a supervisory control system; and (7) train associated persons to fully understand the products.
In FINRA Notice to Member 10-09, FINRA reminded broker-dealers of their sales practice obligations with respect to reverse convertible notes (a particularly risky type of structured product). FINRA reminded firms that sell reverse convertibles to ensure that their promotional materials or communications to the public regarding these products are fair and balanced, and do not understate the risks associated with them. Firms are also reminded to ensure that their registered representatives understand the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to any customer.
(2) Brokerage Firm Requirements Prior to Recommending Any Investment
Brokerage firms and financial professionals have certain due diligence responsibilities prior to recommending any investment to a client. These requirements are particularly significant in the context of complicated structured products, as a broker is required to fully understand any product he/she recommends.
Generally speaking FINRA requires that a broker have a reasonable grounds for believing the recommendation is suitable upon the basis of the facts disclosed by such customer as to his/her other security holdings and as to his/her financial situation and needs. This is generally called the Know Your Customer Rule.
Securities rules further provide that recommendations violate the Know Your Customer rule if:
– the agent’s understanding of the investment is insufficient to establish a reasonable basis for making a recommendation;
– the agent inadequately assesses whether the recommendation is suitable for the specific investor; or
– the level of trading is excessive in light of the customer’s investment needs and objectives.
FINRA and the SEC have routinely held that a broker is also responsible for investigating the specific characteristics of an investment. An advisor can be responsible for making an improper recommendation when he/she fails to learn the basic characteristics of an investment and how those characteristics would affect the investment’s risks and liquidity.
Moreover, the test as to whether a broker understood a product sufficiently to recommend the product requires actual objective investigation and knowledge, rather than the rep’s personal subjective belief in the suitability of the investment. See, F.J. Kaufman & Co. of Va., 50 SEC 164, (1989) (“a broker-dealer in his dealings with customers impliedly represents that his opinions and predictions respecting a [security] which he has undertaken to recommend are responsibly made on the basis of actual knowledge and careful consideration. . . . [I]t is not a sufficient excuse that a dealer personally believes the representation for which he has no adequate basis.”);Distribution by Broker-Dealers of Unregistered Securities, Exchange Act Rel. 6721 (February 2, 1962) (“[T]he making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations which, in turn, requires that, as a prerequisite, he shall have made a reasonable investigation.”).
Interestingly, the investor’s sophistication is irrelevant when the broker fails to perform the necessary due diligence on an investment and the client relied on the broker. See, Larry Ira Klein, 52 SEC 1030, 1037, n. 28 (1996); Hanley v. SEC, 415 F.2d, 589, 596 (2d Cir. 1969)(“The fact that [the broker’s] customers may be sophisticated and knowledgeable does not warrant a less stringent [investigation] standard.”).
These due diligence requirements will continue to be significant as more and more firms create complicated structured products and then have their advisors (individuals that do not always understand these investments) go out and sell the products to their clients.
(3) Structured Products To Monitor
Notwithstanding the principal guarantee function of some structured products, many of these investments have gone under over the last few years. Investors in these products may be entitled to recover their investment losses through FINRA arbitration. Some of the structured products that are worth monitoring include:
– Lehman Brothers 100% Principal Protected Notes
– Citigroup MAT Fund
– Citigroup ASTA Fund
– Citigroup Equity Linked Term Notes (“ELKS”)
– Citigroup Leading Stockmarket Return Securities (“LASERS”)
– Citigroup Portfolio Income Strategic Opportunity Notes (“PISTONS”)
– Citigroup Premium Mandatory Callable Equity-Linked Securities (“PACERS”)
– Reverse Convertible Notes linked to risky equities
– UBS Bullish Underlying Linked Securities (“BULS”)
– UBS Enhanced Appreciation Securities (“EAS”)
– Bank of America’s Equity Appreciation Growth Linked Securities (“EAGLES”)
– Bank of America’s Capital Protected Equity Performance Linked Securities (“CYCLES”)
– AMPS (Accelerated Market Participation Securities)
– ARES (Accelerated Return Equity Securities)
– ARNs (Accelerated Return Notes)
– ASTROS (Asset Return Obligation Securities)
– Morgan Stanley Basket Opportunity Exchangeables (“BOXES”)
– Morgan Stanley Broad Index Gauarded Equity Linked Securities (“BRIDGES”)
– Morgan Stanley Commodity Indexed Preferred Securities (“COMPS”)
– Morgan Stanley Equity-Linked Securities with Lock-In Protection (“ELIPS”)
– Morgan Stanley High Income Trigger Securities (“HITS”)
– Morgan Stanley Market Participation Securities (“MPS”)
– Morgan Stanley Corporate Bond Tracers Units (“TRACERS”)
– JP Morgan Chase Principal Protected Notes
– JP Morgan Consumer Priced Indexed Securities (“CPIS”)
– JP Morgan Outperformance Buffered Return Enhanced Notes
– JP Morgan EUR 500 Million Meduim-Term Note Programme
(4) Free Consultation
If you are concerned about a structured product investment recommended to you by your financial professional and would like to speak with an experienced securities attorney for a free consultation, please contact The White Law Group at 312-238-9650.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.
For more information on The White Law Group, visit https://www.whitesecuritieslaw.com.
For more information on the risks of certain structured products, visit http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P120883.