Principal-protected notes don't always protect principal, regulators warn

SEC, Finra issue alert about popular structured products

Jun 3, 2011 @ 12:18 pm

By Liz Skinner

Worried about the increasing number of retail investors jumping into complex financial products, securities regulators Thursday warned that structured notes with principal protection are not risk-free.

The Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. warned that such an investment may come with confusing terms that actually guarantee as little as 10% of the investment and limit the amount investors gain on the upside. It also can tie up those funds for a decade.

Structured notes with principal protection combine a zero coupon bond— that is, one that pays no interest until it matures — and an option whose payoff is linked to an underlying asset, index or benchmark (such as currencies, commodities, the Russell 2000) or a basket of benchmarks. The payoff can vary, based on the performance of the linked index, but the bonds offer the prospect of a greater return than money-market instruments, which makes them appealing.

“The current low-interest-rate environment might make the potentially higher yields offered by structured notes with principal protection enticing to investors,” said John Gannon, Finra's senior vice president for investor education.

Investors typically are interested in such products because they believe they are gaining possible market upside while protecting their principal.

What investors believe and what's true are not necessarily the same thing. The SEC says principal-protected notes vary wildly by issuer, and investors tend to ignore — or don't understand — what's spelled out in prospectuses.

The obvious problem with principal-protected notes: Often, the principal isn't protected. Some sellers of the notes do indeed guarantee 100% of principal. That's fine, unless the issuer of

the note goes bankrupt, in which case the investor will likely lose all or most of the principal.

This is not mere conjecture. In April, UBS Financial Services Inc. agreed to pay $10.75 million in fines and restitution to settle Finra allegations that its advisers misled clients about the “principal protection” feature of structured notes issued by Lehman Brothers Holdings Inc. The notes were sold just a few months before that Wall Street firm collapsed.

In its complaint, Finra said some UBS advisers didn't understand the complexity of the 100% principal protection notes that Lehman issued and failed to tell investors they were unsecured obligations.

In settling the case, without admitting or denying the allegations, UBS said it was pleased to have the matter resolved and that most structured product sales had been done properly.

The SEC warns that other issuers of principal-protected notes guarantee only a certain amount of the principal — in same cases, as little as 10%. Sometimes, the principal is protected only if a contingency stipulated in the prospectus is met.

Lori Schock, director of the SEC's investor education office, said that anyone considering an investment in these products should read the commission's alert, “especially those with the mistaken belief that these investments offer complete downside protection.”

What's more, figuring out upside return can be complicated. In one payout structure, an investor gains fully if the linked index rises up to a certain point. If, for example, the linked index rises 40%, the investor will receive the full 40% gain But if the index rises more than 40%, the gain is substantially less.

Investors also must hold these notes to maturity to receive the full payout — and those maturities sometimes run as long as ten years. That can create an extra burden for holders of the notes, who have to pay taxes on the imputed gains from the investment.

Nevertheless, the market for structured notes with some form of principal protection reached $43 billion last year, a 54% increase over 2009, according to the data-gathering firm

In response to the rising popularity of the notes, the SEC's enforcement division started a group last year to investigate structured products, including those marketed to individual investors. It has brought several cases, the largest of which resulted in The Goldman Sachs Group Inc. agreeing last July to pay $550 million for sales of a collateralized-debt obligation that hinged on the performance of subprime residential-mortgage-backed securities.

In the settlement, the firm said its marketing materials had "incomplete information."

Therein lies the rub. Even when information in prospectuses is complete, individual investors may not comprehend what they're buying.

As Finra's Gannon pointed out, “Retail investors should realize that chasing a higher yield by investing in these products could mean winding up with an expensive, risky, complex and illiquid investment.”


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