FINRA Warns About Principal-Protected Structured Notes

Financial industry regulators have warned brokerage firms not to overstate the security of principal-protected notes (PPNs), which are not risk-free as their names often suggests. The reminder comes after a number of financial fraud lawsuits have been filed against brokers who allegedly sold the notes as conservative and safe investments without adequately disclosing the risks.

The Financial Industry Regulatory Authority (FINRA) released a regulatory notice last month, reminding firms that they are required to ensure fair and balanced information is provided when promoting the use of principal-protected notes. The notice warns brokerages not to overstate the level of protection or the investment’s potential returns, and reminds firms that they have a duty to make certain that all of their registered representatives understand the risks, terms and costs of the products they are selling.

Principal protected notes, also referred to as guaranteed linked notes or structured notes, are often promoted as providing a “guaranteed” protection of 100% of the invested capital as long as the note is held to maturity. Investors are often told that regardless of market conditions, they will receive back all of the money they invested. However, the guarantee is only as good as the company that is making it, and FINRA points out “these products are not risk-free, and their terms and structures can be complex.”

Following the collapse of Lehman Brothers in September 2008, many investors were left with Lehman Brothers principal protected notes that became essentially worthless. Some investors were sold these Lehman structured notes even during the months right before the bankruptcy filing, with no indication that the investment bank had a severely weakened financial position as a result of heavy investments in the subprime mortgage market.

Class action lawsuits and individual stock broker fraud claims have been filed by investors who were sold these principal protected notes without adequate disclosure of the risks and terms. Last month, a panel of arbitrators through FINRA awarded $200,000 to an investor who filed a Lehman Brothers note lawsuit against UBS Financial Services. This was the first of what many expect will be a number of Lehman Brothers principal protected notes awards arising out of sales by UBS and other brokerage firms.

FINRA is a non-governmental regulatory body that oversees more than 5,000 brokerage firms throughout the United States. Investors are able to resolve disputes against brokerage firms through FINRA for claims involving breach of fiduciary duty, negligence, misrepresentation, breach of contract, unauthorized trading and other claims that investments were improperly handled.

The regulatory notice reminds brokerage firms that financial regulations prohibit the use of exaggerated, unwarranted or misleading statements or the omission of facts that would make promotions or advertisements misleading by their absence.

“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,” FINRA warns in the notice. “However, they are not without risk. Most importantly, the principal guarantee is subject to the credit-worthiness of the guarantor.” The notice warns that some PPNs have high fees and hidden costs, and states that firms should take these costs into account when determining customer-specific suitability.

The regulatory notice states that promotional materials used by firms must include disclosures regarding:

• The level of principle protection offered
• The credit-worthiness of the guarantor
• The potential returns and pay-out structure
• The investor’s ability to access funds before maturity date or the expiration of a lock-out period.
• Costs and fees that could affect the return of the principal