Brokerage firms and registered reps selling private placements, inverse and leveraged exchange traded funds (ETFs), structured notes and other complex investment products have been put on notice by the Financial Industry Regulatory Authority (FINRA). In a newly issued regulatory notice, FINRA outlined certain due-diligence and supervisory policies and procedures that firms must have in place when selling such products and that the investments themselves can be expected to face greater regulatory scrutiny in the future.

“Registered representatives should compare a structured product with embedded options to the same strategy through multiple financial instruments on the open market, even with any possible advantages of purchasing a single product,” Regulatory Notice 12-03 said in part.

As in previous notices issued by FINRA, Notice 12-03 reiterated the fact that firms should consider whether less complex products can achieve the same objectives for investors. The notice further stated that post-approval follow-up and review are particularly important for any complex investment product.

In recent years, regulators have issued a number of enforcement and disciplinary actions in cases involving complex investments. Two high-profile cases occurred in 2009, when the Securities and Exchange Commission (SEC) filed fraud charges against Medical Capital Holdings and Provident Royalties LLC over the private placements issued by both entities.

Several state regulators, including Massachusetts, also have filed regulatory actions against various broker/dealers that sold Medical Capital and Provident private placements to investors.

Former Morgan Stanley broker Joey Wade Dean is facing regulatory action from the Financial Industry Regulatory Authority (FINRA) in connection to sales of unlisted structured notes.

The action, taken by FINRA on Sept. 10 and outlined on the regulator’s Broker Check Web site, alleges that Dean made significant misrepresentations and omissions regarding the products, as well as failed to disclose certain facts to investors.

Many of the investors apparently were elderly. According to FINRA, Dean told customers that their principal investment was protected and guaranteed a fixed annual rate of return. That didn’t happen. Instead, when the structured notes ceased paying income, Dean, without authorization from customers, sold their shares to raise cash so that they could continue to make withdrawals.

Structured notes are booming, with sales reaching $45 billion just this year. Despite their growth, structured notes can be a risky venture for investors, especially as more and more brokerages push out structured products with the promise of equity returns and less risk.

As reported Nov. 13 by the Wall Street Journal, some financial advisors are urging their clients to consider structured notes as a way to get back into stocks and avoid taking on too much risk.

Before jumping on the structured notes bandwagon, however, investors need to first consider a few issues. To begin, most of today’s structured notes are not 100% “principle protected” products. Instead, they typically offer only partial or limited protection, meaning they provide a fixed amount of contingent protection. Losses are covered only up until the point that the underlying asset drops below a certain level. Once that happens, the protection is canceled and investors bear the brunt of the losses.

Consider UBS AG’s Return Optimization Securities with Contingent Protection, which was priced in July. According to the Wall Street Journal article, investors receive 100% principal protection as long as the Standard & Poor’s 500-stock index hasn’t fallen more than 30% at the end of the product’s three-year term. If the index does fall more than 30%, investors pay the price by suffering all of the losses. If the markets fall by less than 30%, investors get back their principal at the end of product’s term. If the index rises, investors earn 1.5 times the upside, up to a cap of 58.6%, which they get if the index is up 39%. Fees, also called the “underwriting discount,” are 2.5%, says the WSJ.

The kind of protection might not work for all investors. As reported in the Wall Street Journal article, since 1926, a structured note that protected against a drop of 30% in the S&P 500 would have pierced the downside cap 7% of the time, leaving the investor exposed to the entire loss, while protecting them from a loss 17% of the time on a rolling 36-month basis.

Craig McCann of Securities Litigation & Consulting Group is skeptical of structured products. According to McCann, the vast majority of structured products turn out to be worth substantially less than their face value. Moreover, structured notes can be difficult to sell during a market rout. Investors also have to worry about counterparty risk.

Complex investments known as reverse convertibles face growing scrutiny from regulators for their hidden risks, lack of transparency and, in some instances, because of the manner in which they are represented to investors by certain brokers.

As reported in a June 24 story by Bloomberg, brokers for JPMorgan Chase & Co., Royal Bank of Scotland Group Plc, and Barclays Plc have been charging fees on some structured notes that equal or exceed the securities’ highest possible yield.

“It seems inconceivable that the commission could be more than the potential return to clients,” said Durraj Tase in the Bloomberg article. Tase, who is an adviser with First Liberties Financial in New York, added: “If you are paying more fees than your potential return, as an adviser, I would not be able to suggest that note.”

On June 15, RBS gave brokers a 2.75% commission to sell a three-month reverse-convertible note with a 2.56% potential yield, according to the Bloomberg story. In May, JPMorgan charged 5.25% in fees and commissions on a three-month Citigroup-linked note that paid 5% interest, and Barclays offered brokers a 2% commission on a security paying 2% interest.

In February 2010, the Financial Industry Regulatory Authority (FINRA) issued an alert to investors on the risks associated with reverse convertibles. Among things, FINRA warned that reverse convertibles expose investors not only to risks traditionally associated with bonds and other fixed income products – such as the risk of issuer default and inflation risk – but also to the additional risks of the unrelated assets, which are often stocks.

In the case of JPMorgan’s reverse convertibles, investors are exposed to losses if Citigroup declines by more than 20%.

If you have suffered losses in Reverse Convertibles, please contact our securities fraud team. We can evaluate your situation to determine if you have a claim.

UBS AG faces dozens of arbitration claims from U.S. clients who bought 100 percent principal protected notes issued by Lehman Brothers Holdings that turned out to be virtually worthless after the company filed for bankruptcy in September. Now, in one of the first cases to be heard by the Financial Industry Regulatory Authority (FINRA), an arbitration panel has awarded an investor $200,000, ruling that her UBS broker inappropriately sold her the risky investments.

As reported Dec. 5 by the Wall Street Journal, the case serves as one of the first that FINRA has ruled upon concerning Lehman principal protected notes and could be a sign of how future cases may unfold.

Steven Caruso, an attorney with Maddox Hargett & Caruso, said in the article that hundreds or thousands of additional arbitration cases are expected to be filed in connection with Lehman principal protected notes. Caruso’s firm alone will represent roughly 100, according to the Wall Street Journal.

Lehman principal protected notes were structured notes that many banks and securities firms represented as low-risk investments. What they failed to emphasize to investors was the fact that the notes were unsecured obligations of Lehman Brothers. When Lehman filed for bankruptcy on Sept. 15, holders of the notes found themselves with investments that traded for pennies on the dollar.

If you have suffered losses in Lehman principal protected notes and wish to discuss filing an individual arbitration claim with FINRA or have questions about these investments, please contact us.