FINRA Reminds Brokerage Firms of Sales Practice Obligations Relating to Principal-Protected Notes


The Financial Industry Regulatory Authority ("FINRA") recently reminded its member brokerage firms of their obligations when recommending and selling principal protected notes ("PPNs"). PPNs have been marketed to retail investors as combining the safety of bonds, but with the potential for growth that generally is not provided by bonds. But these products actually are complex, structured financial instruments that often do not provide nearly as much safety as brokerage firms represented.

What are Principal Protected Notes?

PPNs typically combine a zero-coupon bond with an option or other derivative product whose payoff is linked to an underlying asset, such as an equities index or basket of indices. These investment products purportedly allow investors to participate safely in the gains of an index, a basket of indices, or a derivative while guaranteeing the return of at least a portion of the investors' principal at the maturity of the note. PPNs sold to retail investors often have reassuring names that include some variant of "principal protection," "capital guarantee," "absolute return," "minimum return" or similar terms. But they are not without risk, and often do not provide the level of safety that investors are lead to believe. Financial advisors who sold principal protected notes often failed to disclose the key terms and conditions of the PPNs to clients, including the true risks of these investments.

In most cases, the principal guarantee only applies to notes that are held to maturity. In short, notwithstanding the various optimistic titles given to these complex products, many PPNs do not provide absolute protection to principal. Many investors have lost all of their money that they invested in these products after they had been assured that the investments provided a "guaranteed" return of principal.

Financial Incentives for Brokers to Sell PPNs

Structured products like PPNs often are sold, and not bought. In other words, few investors contact brokerage firms and expressly request PPNs. Part of the reason for this is that structured products often have very large markups and commissions relative to other fixed-income products. The markups or commissions on structured products tend to be two to five times that of more conservative bonds. As a result, many brokers sold the investments not because they were in the best interest of the client but rather because the investments provided the highest compensation.

FINRA's Recent Notice to Members

In December 2009, following millions of dollars of investor losses in principal protected notes, including Lehman Brothers PPNs sold by UBS Financial Services, FINRA issued Notice to Members 09-73 ("NTM 09-73"). Such regulatory notices serve, among other things, to remind brokerage firms of FINRA's rules regarding the recommendation and sale of securities. In NTM 09-73, among other things, FINRA reminded brokerage firms that: (1) they are required to be fully familiar with the characteristics and risks of PPNs, (2) they are required to educate and train their brokers about the characteristics and risks related to PPNs before they let their brokers recommend the investments, and (3) they are not permitted to exaggerate the level of safety associated with principal protected notes. Incidentally, NTM 09-73 was issued only two weeks after a FINRA arbitration panel awarded an investor $200,000, finding that her UBS broker inappropriately sold her risky Lehman Brothers principal protected notes.

This was not the first time that FINRA f/k/a National Association of Securities Dealers ("NASD") has felt the need to remind its members of their obligations when selling structured products. In 2005, the NASD issued Notice to Members 05-59. That notice similarly stated "As a result of a recent review of members that sell structured products, NASD staff is concerned that members may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers."

Further, in July 2009, the New Hampshire Bureau of Securities Regulation stated that UBS Financial Services, Inc. misled investors when it represented that Lehman Brothers principal protected notes were safe during a time when Lehman Brothers faced massive exposure to securities tied to the imploding real estate market. New Hampshire regulators stated that "UBS presented these notes as simple, safe investments when in fact they are highly volatile and are subject to shifting market conditions." The regulators also stated that they believe that "[t]he methods by which UBS offered and sold the Lehman Brothers structured products to its clients constituted dishonest and unethical business practices."

Dimond Kaplan & Rothstein, P.A. (/) currently represents a number of UBS and Banco Hapoalim customers who lost money in Lehman Brothers structured products, including 100% principal protected notes. The firm's clients invested in the products with the expectation that their principal was safe. But the undisclosed risks, namely Lehman Brothers' massive exposure to the declining real estate market, have caused Dimond Kaplan & Rothstein's clients to sustain millions of dollars in investment losses. The firm is pursuing FINRA securities arbitration claims and court cases on behalf of its clients in an effort to recover those investment losses. We represent investors throughout the United States and Latin America in investment fraud and stockbroker fraud cases involving stocks, bonds, options, structured products, and hedge funds. If you suffered investment losses in Lehman Brothers principal protected notes, please contact attorney Jeffrey B. Kaplan of Dimond Kaplan & Rothstein, P.A. at (888) 578-6255 or jkaplan@dkrpa.com for a free case evaluation. You also may visit the firm on the web at / or http://www.investmentfraud-lawyer.com/

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