UBS' Sale of Structured Notes Promising Protection of Principal Falls Far Short; Investors Must Be On Guard

By James Eccleston

n a market that has witnessed sales of so-called "structured notes" quadruple in the last four years, no firm is closer to the eye of a major storm than UBS. That's because UBS has sold about $1 billion of these "100 percent principal protected notes" in the United States, only to see their value plummet to 10 to 15 cents on the dollar through secondary market trading. In response, UBS clients have filed complaints and state securities regulators have formed a task force to investigate UBS' sale of these products. Let's examine what went wrong at UBS, and how investors - with accounts at any financial services firm and with all types of structured products - can protect themselves.

As background, 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, those listed and those not listed may be very thinly traded. Structured products 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.

UBS customers, many of whom are retirees, claim that UBS touted principal protected notes as low-risk, conservative investments designed to preserve capital with potential for capital appreciation. Further, they allege that UBS failed to disclose that the notes actually were unsecured obligations of the issuer, and worse, that the issuer was Lehman Brothers. Indeed, customers claim that UBS had sold some of the notes to them just weeks before Lehman Brothers declared bankruptcy. Lehman Brothers reportedly used the sales proceeds to help offset its own losses from its subprime mortgage investments.

UBS customers certainly should consider seeking legal recourse to recover their investment losses associated with those principal protected notes. Moreover, all investors must remember that, no matter which financial services firm is selling principal protected notes, investors typically are buying nothing more than the unsecured debt of the issuer and, in troubled times for an issuer, substantial losses can result.

Significantly, the credit crisis has exposed the flaws of not just principal protected notes but also the flaws of other types of structured products. For example, so-called "reverse convertibles" may offer attractive yields but expose investors to steep losses if a stock price collapses. Likewise, so-called "return-enhanced notes" offer a multiple of the gains of a particular index - good news on the upside - but provide no downside protection against declines in that particular index.

Since the Lehman Brothers' debacle raised investors' concerns relating to the credit quality of the issuer, financial services firms have touted structured products that are "wrapped" in certificates of deposit. As such these products come with FDIC coverage, ensuring return of principal should the issuer be unable to satisfy that obligation. While sales of such products -- called "structured CDs or "market-linked CDs" -- have increased, investors still must be wary. That's because investors who wish to sell prior to maturity may have to do so at a discount, perhaps even a substantial discount following a sharp market decline. Moreover, while FDIC coverage is a benefit, it is an expensive benefit: FDIC insurance must be purchased, and it adds an extra layer of cost that may not be justified.

Generally, investors considering any type of structured products should review the guidance offered by the National Association of Securities Dealers (NASD, now FINRA) in 2005. Based upon its reviews of its member financial services firms, the regulator stated that, "NASD staff is concerned that members may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers." The NASD certainly hit the mark in discussing the risk that investors can lose their principal. Consequently, the NASD cautioned 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, the NASD warned firms not to 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 warned 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."

Investors also should take notice that the NASD cautioned firms that structured products are difficult to understand, due to their being new and due to their derivative nature. In this situation, the NASD warned 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."

The NASD's advice is sound, and is true to this day. Beware of structured products!

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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.