Securities Regulator Urges Caution Relating to the Sale of Principal-Protected Notes

By James Eccleston

s investors clamor for investments with growth potential and some degree of safety, the retail market for principal-protected notes ("PPN"s) has increased. However, FINRA (the Financial Industry Regulatory Authority) is concerned that investors mistakenly may believe that these investment products are risk-free. They are not. Furthermore, their terms and structures can be complex.

Accordingly, FINRA recently issued Regulatory Notice 09-73 to financial services firms. The Notice addresses communications with investors and the suitability of PPNs as an investment. The Notice also describes the features of, and several hypothetical scenarios associated with, PPNs. Let's examine the key points of the Notice.

First, what are PPNs? They are a subset of the larger category of structured products. PPNs typically are structured so that the product combines a zero-coupon bond with an option or other derivative product whose payoff is linked to an underlying asset (such as an equities index, currencies, foreign exchange rates, commodities, spreads between interest rates, and "hybrid" baskets of various asset types).

In terms of safety, the investor is guaranteed the return of some or all principal at a set maturity date. But the reassuring names of some PPNs - "principal protection", "capital guarantee", "absolute return", "minimum return" can be misleading. FINRA emphasizes that the most important risk is the credit-worthiness of the issuer. Beyond that, principal protection levels can be as low as 10%. Likewise, any level of principal protection applies only at the maturity date, which typically is up to ten years from issuance. FINRA notes that "secondary markets" for sale may exist but there is no obligation that they exist and, if they exist, investors may receive significantly discounted sales prices for their PPNs. Finally, FINRA provides several illustrations to prove the point that some PPNs "have complicated pay-out structures that can make it hard for registered representatives and their customers to accurately assess their risk and potential for growth."

Second, what must financial services firms ensure to disclose in their communications with the public? FINRA states that all communications "must present a fair and balanced picture regarding both the risks and potential benefits", including not overstating "either the level of protection offered of the investment's potential for growth." Thus, the Notice lists several items for "appropriate disclosure": the level of principal protection offered; the credit-worthiness of the guarantee; the potential returns and pay-out structure; the investor's ability to access funds pending maturity date or the expiration of a lock-up period; and any costs or fees that might affect the return of principal.

Third, regarding suitability, the Notice emphasizes certain attributes of PPNs which should be considered. For example, financial services firms should consider whether a particular investor "will need access to their money before the maturity date arrives or if the lock-up period expires." Another inquiry relates to "high fees and hidden costs." Yet another relates to the so-called principal guarantee. Specifically, FINRA cautions that "investors may be sacrificing higher yield to obtain the principal guarantee", and that any principal guarantee "does not offer inflation protection." Most important, the Notice warns that firms should consider imposing stricter suitability standards when dealing with PPNs. FINRA suggests either using the tougher options trading suitability standards - because PPNs do have an option component - or developing "other comparable procedures designed to ensure that structured products are only sold to persons for whom the risk of such products is appropriate."

PPNs are not for the faint of heart - even though the faint of heart may well be the ones attracted to the marketing campaigns for PPNs! Investors need to fully evaluate the risks and the rewards of PPNs before saying "yes" to purported "principal protection."

_______________________________________________________________________
About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.