Exercise Caution in Purchasing Structured Investments, the Latest Hot Product from Wall Street

By James Eccleston

wo seminars that I recently attended both shared the common element of having a speaker discuss the virtues of "structured investments", or "structured products" as they sometimes are called. A financial publication recently ran a story entitled, "The Next Big Thing; Structured Products May Be Difficult to Define, Explain and Track - Yet They're Touted As the Next 12 Figure Asset Class." Indeed, both seminar speakers claimed that, in Europe, structured products are so popular that investors can buy them at the post office! Hype or reality? No one can be sure, but we know that for 2007, analysts predict that investors will purchase $100 billion of them.

What are structured products? According to a website promoting them, structured products "create an investment product that combines some of the best features of equity and fixed income - namely upside potential with downside protection." As the website recognizes, it is the "mix of investments in the basket" that determines risk and return, and it can vary dramatically. Indeed, in 2005 the National Association of Securities Dealers (now FINRA), issued a notice to member financial services firms that based upon its review, "NASD staff is concerned that members may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers."

Let's examine the NASD's notice to members to highlight the characteristics and risks of structured products.

What are the key characteristics of structured products? Structured investments broadly can be divided into three categories: full principal (investment) protection, limited principal protection and no principal protection. Most structured products pay interest. Structured products frequently cap or limit the upside potential, particularly if some principal protection is offered or if the structured product pays an above-market rate of interest. Although some structured products are listed on a national exchange, both these and those not listed may be very thinly traded according to the NASD notice to members. Although the NASD comments that firms often market structured products as debt securities, in actuality they typically are comprised of a note (the debt security) combined with a derivative (often an option). Accordingly, the note pays the interest, and the derivative component establishes the payment at the maturity of the structured product.

What are the risks of structured products? There are several, according to the NASD notice to members. First, there is the risk that an investor can lose his or her principal. In that regard the NASD cautions financial services firms that they should not "portray structured products as 'conservative' or a source of 'predictable current income' unless such statements are accurate, fair and balanced." Similarly, firms should not tout a credit rating assigned to the issuer of a structured product (such as an investment bank) without also indicating the market risk associated with the structured product. Indeed, NASD warns that the presentation of a credit rating "that suggests that the rating pertains to the safety of principal invested or the likely investment returns will be viewed as misleading."

Second, because of the option component inherent in structured products, the NASD suggests that purchasers be limited to those who have been approved to trade options. The NASD states that, "Given the similar risk profile of many structured investment products and options, particularly those where principal invested is at risk from market movements in the reference [underlying] security, it may be an appropriate investor safeguard to require that such structured products only be purchased in accounts approved for options trading." The risk level of the structured product must be appropriate for the individual purchaser, cautions the NASD.

Third, structured products are difficult to understand, due to their being new and due to their derivative nature. In this situation, the NASD warns firms that "as new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products."

As one can see, investors must be careful before jumping on the latest bandwagon from Wall Street!

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About the Author: James J. Eccleston leads the Securities group at the Chicago law firm of Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C., where he represents investors in recovering investment losses and financial services professionals in disciplinary, employment, and compliance matters. He has held numerous securities licenses and Chicago Bar Association leadership positions and serves as an arbitrator and mediator. He is a recipient of Martindale-Hubbell's highest rating (AV) for legal ability and ethics, and is named to the Illinois Super Lawyer and Leading Lawyer lists.
JEccleston@snsfe-law.com, 312.621.4400, www.snsfe-law.com, www.financialcounsel.com.